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Monetary policy report to the Congress.

Report submitted to the Congress on July 16, 1991, pursuant to the Full Employment and Balanced Growth Act of 1978,


When the Federal Reserve presented its most recent monetary policy report to the Congress, in February of this year, the economy was still in a downswing that had been precipitated by Iraq's invasion of Kuwait in August 1990 and the associated spike in oil prices. To be sure, several developments early in the year had created conditions that promised to help foster a turnaround in the economy: Not only had oil prices reversed most of their earlier run-up, but monetary policy had been eased substantially in the final months of 1990 and the early part of this year. However, the economy continued to weaken for a time, and in the spring, policy was eased further, with the objective of ensuring a satisfactory recovery.

Recent evidence suggests that a pickup in activity probably is now under way. Much of the uncertainty that had depressed business and consumer sentiment was removed by the successful end of hostilities in the Persian Gulf. The resulting increase in confidence, combined with the boost to real purchasing power provided by the retreat in oil prices, raised consumer spending on balance over the late winter and spring. These same factors, as well as lower mortgage rates, also have spurred a gradual recovery in the housing sector. Reflecting the stimulus from housing and consumer demand, along with the continued growth in U. S. exports, industrial production turned up in April and has advanced appreciably since then; in addition, labor demand showed signs of stabilizing during the spring.

As anticipated earlier this year, inflation has slowed from its pace in 1990. Retail energy prices came down substantially during the first half of the year, and the rise in consumer food prices moderated after several years of relatively large increases. More generally, the softness of labor and product markets has attenuated price pressures for a range of goods and services. This downdrift in "core" inflation was difficult to discern earlier in the year because of a bunching of price increases in January and February; however, most of the significant increases in those months either did not continue or were reversed.

The Federal Reserve's easing moves over the first part of the year not only were taken in light of the contraction of economic activity and the progress in reducing inflationary pressures, but also were prompted by the continued slow growth of the monetary aggregates early in the year and continuing credit restraint by banks and other intermediaries. Reserve market conditions were held steady after April, however, as evidence began to accumulate that the economy was on track toward recovery. Reflecting the Federal Reserve's policy actions and generally weak credit demands, short-term interest rates declined appreciably during the first half of the year. Longer-term rates, which had moved down markedly in the final months of 1990, were mixed over the first half; with bond market participants focusing on signs of an emerging recovery, Treasury bond yields rose a bit, while rates on bonds issued by businesses fell as risk premiums narrowed sharply. In the stock market, share prices have registered sizable increases since January, and broad indexes remain within a few percent of the all-time highs set in the spring. Meanwhile, the value of the dollar has climbed substantially on foreign exchange markets, supported by the successful conclusion of military operations in the Gulf, by expectations of a recovery in the U. S. economy, and by economic developments in Germany and political difficulties in the Soviet Union.

In response to Federal Reserve easings and associated declines in short-term interest rates, growth of both M2 and M3 strengthened somewhat during the first half of 1991 relative to the slow pace of the second half of 1990. M2 expanded more than nominal GNP, and thus its velocity fell, although not as much as might have been expected considering the decline in short-term interest rates. The continued muted response of M2 to the easings in short-term rates probably reflected the ongoing rerouting of credit outside of depositories and an effort on the part of savers to maintain yields on their assets by turning to the stock and bond markets, sometimes via mutual funds. Growth of M3 was boosted early in the year by strong issuance of large time deposits by U. S. branches and agencies of foreign banks in response to a reduction in reserve requirements around the end of 1990. In the second quarter, however, the expansion of M3 slowed as issuance of time deposits at foreign banks waned, and depository credit and associated funding needs contracted. Through June, both M2 and M3 had grown at rates somewhat below the midpoint of their targeted annual growth ranges.

Credit growth was slow in the first half of the year. The federal government's borrowing requirements were held down by reduced activity by the Resolution Trust Corporation (RTC) and by contributions from foreign countries to cover the costs of Operation Desert Storm. Growth of private-sector debt was restrained by slack demand associated with the weakness of the economy and by a reduced appetite for leveraging. On the latter score, a lasting shift toward more conservative patterns of credit use would be a fundamentally healthy development; the excesses of the 1980s clearly left us with problems in our financial sector that will take some time to resolve. In part reflecting earlier credit losses, banks continued to be cautious lenders through the first half of 1991. However, private borrowers who turned to securities markets found readier access to capital as the economic outlook brightened and risk premiums narrowed dramatically; financial intermediaries as well as nonfinancial firms issued large volumes of equity and longer-term debt, making significant progress in strengthening their balance sheets.

Monetary Objectives for 1991 and 1992

At its meeting earlier this month, the FOMC reaffirmed its previously established ranges for money and credit for 1991. The target range for M2 had been lowered in February to 2 1/2 to 6 1/2 percent from the 3 to 7 percent range that had been in place for 1990. To date this year, M2 has grown at an annual rate of a little less than 4 percent, placing it well within the target range for 1991 as a whole. This, in effect, leaves the Committee some room to maneuver as events unfold in the coming months, while remaining within the annual range. The potential need for such maneuvering room arises in part in connection with the significant uncertainties attending the prospects for the velocity of M2. If, for example, the public's demand for M2 balances should be damped by moves among depository institutions to lower deposit rates (in response to earlier declines in market yields and to higher insurance premiums), then velocity might tend to be stronger than otherwise would be the case and less M2 growth would be required to support a given rate of GNP increase. If, on the other hand, institutions were to become more aggressive in bidding for loanable funds in the retail deposit market, and thus the public began to shift its portfolio back in favor of M2 assets, then velocity could weaken and faster M2 growth might be required. The Committee expects that the current annual growth range will permit it to deal with such velocity-altering disturbances in money supply and demand while it fosters financial conditions conducive to moderate economic growth and further progress toward price stability.

The 1 to 5 percent target range for M3 adopted in February took into account an expected continued contraction in the thrift industry and associated redirection of credit flows away from depository institutions. The assets of thrift institutions are expected to shrink further in the second half of 1991, in large part because of closures by the RTC. Issuance of large time deposits by branches and agencies of foreign banks has moderated, but domestic banks may have a greater appetite for funds during the second half as sound lending opportunities increase with the projected improvement in the economy.

Even though growth of the aggregate debt of domestic nonfinancial sectors at midyear was at the lower end of its current 4 1/2 to 8 1/2 percent monitoring range, the Committee anticipates that the debt measure will end the year well within that range. Stronger private credit demands are expected to arise as the economy grows, and federal borrowing will increase to finance stepped-up RTC activity. However, debt growth is likely to continue to be damped by the shift in attitudes about leveraging.

In setting provisional ranges for 1992, the Committee chose to carry forward the 1991 ranges for the monetary aggregates and for debt. Recognizing that the ranges had been reduced significantly over the past few years, the Committee at this time believes that expansion of money and debt in 1992 within the current ranges probably would be consistent with consolidating and extending the gains toward lower inflation that have been made to date, and at the same time would provide sufficient liquidity to support a sustainable expansion of economic activity. The ranges will, of course, be reevaluated next February in light of intervening economic and financial events. The Committee will want to update its assessment of the underlying tendencies in the economy as well as in the relations between money and debt expansion and economic performance. Although the initial indications of money and credit ranges that are given in July always are tentative, flexibility seems all the more warranted in the current circumstances, with the economy apparently at a cyclical turning point and the financial system being buffeted by fundamental change.

Economic Projections for 1991 and 1992

The target ranges for the monetary aggregates and debt have been selected with the objective of supporting a sound economic expansion accompanied by declining inflation-a pattern the Board members and Reserve Bank presidents generally expect to prevail over the coming year and a half. Most forecast that real GNP will grow A to 1 percent over the four quarters of 1991; given the decline during the first quarter, this central tendency range for 1991 as a whole implies an aPPreciable pickup in activity over the remainder of the year. The projections of growth in real GNP over the four quarters of 1992 have a central tendency of 2 A to 3 percent.

In appraising the near-term outlook, the FOMC participants have placed considerable weight on the apparent absence of inventory overhangs in most sectors. Accordingly, the recent firming of aggregate final demand is expected to bring a halt soon to the inventory drawdowns that persisted into the second quarter. The resulting swing in the pace of inventory investment is expected to boost domestic production considerably over the rest of 1991. As typically occurs in the initial stage of a recovery, much of this rise in output is expected to reflect gains in the productivity of existing workers, rather than a marked pickup in employment. Thus, the Board members and the Bank presidents project only modest progress in reducing unemployment over the second half of the year; the projected central tendency for the civilian jobless rate in the fourth quarter is 63A to 7 percent.

The pace of expansion may moderate somewhat in 1992 as the initial impetus from the inventory swing subsides and gains in production track the growth in final demand more closely. The advance in real GNP expected for 1992, though subdued relative to that during the early part of most previous expansions, is anticipated to reduce the margin of slack in the economy over the year. The central tendency of the civilian unemployment rate projected for the fourth quarter of 1992 is 6 1/4 to 6 1/2 percent, roughly 1/2 percentage point below the level expected for the fourth quarter of this year.

Several factors lie behind the expectation of a relatively mild upswing in economic activity. In real estate markets, the persistent overhang of vacant space for many types of buildings, along with continued caution on the part of lenders, will likely limit the amount of new construction. In addition, fiscal policy will remain moderately restrictive because of the federal budget agreement reached last fall and efforts by state and local units to correct serious imbalances in their budgets; although this fiscal restraint ultimately will strengthen the U.S. economy by boosting domestic saving and investment, its near-term effect will be to hold down aggregate demand. Further, with the personal saving rate already at a low level and some households saddled with heavy debt burdens, consumer spending is projected to grow at a relatively slow pace. Finally, the appreciation of the dollar this year has offset some of the previous declines in relative prices of U. S. goods in international markets, thus limiting the contribution that can be expected from the external sector.

By adopting policies intended to put the economy on a path of moderate, sustainable growth, the Board members and Reserve Bank presidents believe that it will be possible to achieve meaningful progress in reducing inflation over the remainder of this year and into 1992. The central tendency of the projected rise in the total consumer price index is 3 A to 3 V4 percent over the four quarters of 1991 and 3 to 4 percent over 1992, well below the 6 1/4 percent rise recorded over the four quarters of 1990. In each of the prior three years, 1987-89, the CPI rose about 4 1/2 percent.

The common midpoint of the forecast ranges for CPI increases in 1991 and 1992, 3 1/2 percent, masks the downtrend in core inflation anticipated over the next year and a half In particular, most of the slowing of inflation observed thus far this year has reflected the sharp drop in energy prices and a move toward smaller increases in food prices; excluding food and energy, the deceleration in the CPI so far has been relatively small. However, with the tempering of labor-cost increases now under way and the reduced pressure on plant utilization, core inflation is expected to recede significantly in coming quarters. As these declines become widely perceived, expectations of inflation should moderate, reinforcing the tendencies toward deceleration. By reducing and ultimately eliminating the distortion to resource allocation stemming from ongoing, generalized price increases, a monetary policy aimed at achieving price stability over time will enhance the economy's potential for growth and thereby will raise standards of living.

The Administration's economic projections for 1991, presented in the budget, differ from the projections of Federal Reserve policymakers mainly with respect to expectations for the consumer price index. The Administration forecast, at 4.3 percent, is above the central tendency projected by the Federal Reserve; however, recent statements by Administration officials suggest that this number will be lowered in the mid-session update of the budget. The Administration is somewhat more optimistic than the FOMC participants about prospects for real GNP growth in 1992; in addition, the Administration anticipates an increase in consumer prices next year near the upper end of the central tendency forecast by the Federal Reserve policymakers. This combination of output and inflation places the Administration's forecast of nominal GNP growth for 1992 somewhat above the range of projections by the FOMC participants. Given the obvious limitations on anyone's ability to forecast the economic future, these differences certainly cannot be said to be large - and the forecasts do have the important common feature of pointing to a relatively moderate recovery, with inflation remaining below the average pace of the past few years. And, in light of the uncertainties attending the behavior of the velocities of money and credit in the current period of flux in patterns of intermediation, there appears to be no necessary inconsistency between the Administrations economic forecast and the FOMC's ranges for money and debt for 1991 and 1992. The FOMC, of course, will be reviewing the prospects for the economy, along with those for velocity, when it reconsiders the 1992 target ranges next February.


Economic activity contracted appreciably this past fall and winter. Although the economy had been sluggish during the first half of 1990, real gross national product registered a further increase in the third quarter, and a substantial downturn in activity began only after the jump in oil prices that followed Iraq's invasion of Kuwait. With consumer and business confidence badly shaken and real income depressed by the higher oil prices, employment and production declined markedly starting in October; real GNP fell at a 1.6 percent annual rate in the fourth quarter. The civilian unemployment rate, which had held around the relatively low level of 5 1/4 percent during the first half of 1990, rose steadily over the second half, to just over 6 percent at year-end.

The downward momentum in activity carried into the early part of 1991. Industrial production decreased through the first quarter, and the shrinkage of private-sector payrolls continued through April as firms moved aggressively to reduce inventories and trim labor costs in response to the weakening of final demand. However, much of the negative impetus to activity was reversed by the cumulative drop in oil prices that occurred between October and February and by the boost in confidence that accompanied the swift and successful conclusion of the Persian Gulf war. These events, combined with a considerable easing of monetary policy, set the stage for a recovery, and a few sectors of the economy actually hit bottom quite early in the year. Notably, construction of single-family homes, which in past recessions turned up before the economy as a whole, reached its low point in January, as did real consumer spending and real personal income.

Recently, further evidence has emerged to indicate that economic activity, in the aggregate, stabilized or began to move up during the second quarter of 1991. Much of this evidence is to be found in developments in the labor market. Initial claims for unemployment insurance-an indicator of the pace of job loss-have fallen from their high level in March; employment on nonfarm payrolls edged up, on balance, over May and June after ten months of decline; and the length of the average workweek increased noticeably in May and June. In addition, industrial production advanced in April, May, and June, with the gains being propelled initially by increased output of motor vehicles and parts. Although these indicators are subject to revision and thus should be read with considerable caution, the weight of the available evidence points in the direction of economic recovery.

The magnitude and length of the recent recession still are not known with certainty, but the decline in real GNP appears to have been considerably smaller than the average decline during the previous postWorld War II recessions; for the industrial sector alone, production dropped 5 percent between the peak in September 1990 and the low point in March 1991, compared with an average falloff of nearly 10 percent during previous recessions. The recent contraction also seems to have been relatively short by historical standards. Aggregate job losses, however, were close to the average in previous recessions, suggesting that firms cut payrolls vigorously in light of the fairly shallow drop in real activity. The resulting rise in the unemployment rate, though, was damped relative to that during earlier contractions, as unusually slow growth of the labor force held down the number of job seekers; the unemployment rate in June of this year, 7 percent, was about 3A percentage point below the average jobless rate at the end of previous recessions.

Consumer price inflation, which exceeded 6 percent last year, slowed to a 23/4 percent annual rate over the first five months of 199 1. Consumer energy prices fell sharply early this year after soaring during the second half of 1990. In addition, the rate of increase in food prices has retreated this year from the pace registered during the preceding three years. - Apart from food and energy, price increases were large early in the year but have been more moderate in recent months. In January and February, prices were boosted by hikes in federal excise taxes and postal rates and by the passthrough of the energy price increases in 1990 to a wide range of goods and services. With no further increases in these federal charges and the reversal of energy prices beginning to show through to other items, the CPI excluding food and energy rose much more slowly over the three months ended in May. On balance, over the first five months of 1991, this portion of the CPI increased a bit more than 5 percent at an annual rate, about 1/2 percentage point below the trend rate of increase as of last summer. In part, the recent headway made on inflation reflects the reduction in labor-cost pressures that accompanied the rise in unemployment. As measured by the employment cost index, compensation per hour increased at an average annual rate of 4 1/4 percent over the second half of 1990 and the first quarter of this year, compared with the 5 1/4 percent (annual rate) rise over the first half of 1990.

The Household Sector

Consumer spending was an area of notable weakness last fall and early this year, largely in response to a substantial decline in real income; purchasing power was cut initially by the jump in oil prices, but it continued to fall even after oil prices were in retreat, reflecting the ongoing declines in employment. Real consumer outlays dropped sharply between September and January; the monthly pattern of spending was distorted to a degree by tax changes that caused some households to shift purchases from early 1991 into late 1990. All told, real consumer spending fell at a 1 1/2 percent annual rate in the first quarter, after a 3 1/2 percent (annual rate) decline in the fourth quarter of 1990. However, in February, real income turned up and consumer confidence rebounded late in the month with the end of the Gulf war; both developments bolstered consumer spending. As a result of the spending gains that began in February, the average level of outlays in April and May stood considerably above the first-quarter average.

Among the major components of consumer spending, outlays for motor vehicles and other durable goods were cut back sharply as the recession unfolded. Indeed, between the third quarter of 1990 and the first quarter of this year, real consumer outlays for motor vehicles fen at a 23 percent annual rate; the resulting level of such outlays in the first quarter was the lowest recorded since 1984. Substantial cuts also were made in purchases of nondurable goods. In contrast, consumer outlays for services trended up at a pace only slightly below that registered during the first three quarters of 1990. Since the January trough in total consumer outlays, purchases of both durable and nondurable goods have turned up. In particular, as of May, real consumer purchases of motor vehicles had risen about 8 percent from the depressed January level; separate data on unit sales of new cars and light trucks suggest that further gains were registered in June.

During late 1990 and early this year, total consumer outlays fell more sharply than they had in most previous postwar recessions. The steepness of the drop this time mainly reflects the unusual weakness in several components of income out of which the propensity to consume is high. Most important, nominal wages and salaries fell more during this recession than would have been expected given the magnitude of the decline in nominal GNP, as firms moved aggressively to control costs by trimming payrolls. In addition, because the percentage of unemployed persons receiving unemployment insurance benefits declined during the 1980s, total payments to job losers were less than during earlier downturns. The weakness in these components of nominal income was compounded, in real terms, by the spurt in energy prices.

Although consumers cut back spending, they cushioned some of the effect of weak income by reducing their savings. After averaging about 5 percent over the first half of 1990, the personal saving rate dropped to 4.2 percent in the third quarter and remained at that level through the first quarter of this year. The decline in the saving rate occurred despite some deterioration, on net, in wealth positions during the second half of 1990, which reflected the softening of house prices and losses in the stock market. The average level of the saving rate dropped another notch in the spring, to about 33A percent. The bounceback in the stock market and the improvement in confidence may have contributed to the decline in saving, but the explanation also could involve the reduction in personal interest income associated with the lowering of short-term interest rates between last fall and this spring. Historically, consumer spending has been rather insensitive to movements in interest income, so that a decline in such income causes the saving rate to fall in the short run. That said, the saving rate is now at the lowest level since late 1987, and it would not be surprising if, in the near term, gains in consumer spending lagged increases in income as households worked to rebuild net worth.

The recession placed some strains on household finances, as indicated by the increase in delinquency rates for all types of consumer loans during the first quarter. By far the sharpest rise was for credit card debt; in fact, the first-quarter delinquency rate was close to the highest on record. This jump partly reflects the relaxation of credit standards by major card issuers in recent years; at the same time, relatively low risk borrowers who have access to home equity lines of credit evidently have reduced their reliance on credit cards. Because of the resulting deterioration in the quality of the pool of credit card users, the rise in delinquencies for this type of debt probably overstates the degree of stress in the household sector as a whole. For other types of consumer loans, the first-quarter delinquency rates were not out of fine with those typically seen during recessions, despite the currently high level of debt relative to disposable income. Apparently, the rise in asset values during the 1980s left most households with sufficient wherewithal to cover the expanded level of debt. Thus, although the recession has weakened the financial position of the household sector, the situation does not appear worse than that at the end of other downturns.

Residential construction activity, which had been trending lower since 1986, slumped further in the second half of 1990. However, the market for single-family homes bottomed out in January of this year and has staged a mild recovery since then, spurred by a finning of demand. Several factors account for the pickup in demand, including the decline in home prices to more affordable levels in a number of markets, improved prospects for employment and

income, and some reduction in mortgage rates from those prevailing in the middle of last year. Recent survey results show a more favorable attitude toward homebuying among consumers than at any other time since 1988. Reflecting this shift in sentiment, sales of existing homes have risen substantially from their low in January. Although sales of new homes have been less impressive, the higher level prevailing since February has reduced considerably the inventory of unsold new homes relative to sales; in response, home builders have boosted production to satisfy consumer demand. Despite continued lender caution about granting land-acquisition and construction loans, the quantity of financing available appears sufficient, on balance, to support a further recovery in this sector.

In contrast, the market for multifamily housing has continued to weaken this year. Starts in May were at the lowest monthly level since the 1950s. Moreover, even with the greatly reduced pace of new construction in recent years, the vacancy rate for multifamily units has remained exceptionally high.

Given current conditions in the market, both lenders and potential investors recognize that the number of viable projects is quite limited.

The Business Sector

During the latter part of 1990 and the first quarter of this year, the business sector experienced considerable stress. Demand for business output was depressed both by the loss of domestic purchasing power and by the enormous uncertainties created by the situation in the Persian Gulf. In response to the slump in demand, industrial production turned downward last October; it continued to fan through March. In most industries, the combination of plummeting sales and rising energy prices caused profit margins, which were already slim, to shrink further during the second half of 1990. In the first quarter of 1991, before-tax profits from current operations of U.S. corporations edged down from the low fourth-quarter level.

An unusual feature of the recent recession was the speed with which producers cut output to avoid a buildup of inventories. The promptness of this adjustment likely reflected a combination of factors. The downturn in final demand was widely anticipated, and some producers cut output preemptively rather than risk being saddled with excessive stocks. In addition, improved systems for monitoring and controlling inventories, which have been installed in recent years, enabled firms to react quickly to signs of slowing demand. Further, the relatively heavy debt burdens in the corporate sector created substantial financial pressures for many firms and focused attention on the need to cut costs.

Accordingly, inventories were run off at a rapid clip beginning late last summer. Automakers slashed production and inventories particularly aggressively; domestic output of motor vehicles in the first quarter of 1991 was nearly 30 percent below that in the third quarter of 1990. The resulting drawdown of inventories at auto dealers accounted for fully one-half of the total liquidation of nonfarm stocks during the fourth quarter and the first quarter. Despite production cutbacks by the automakers and other producers, the inventory-to-sales ratio for total manufacturing and trade moved up through January. However, by May, the ratio had retraced most of the run-up that began with the onset of the recession, reflecting the continued liquidation of stocks and an upturn in sales.

Inventories in most industries appear now to be reasonably well aligned with sales, and output has begun to rise with the expansion of final demand. After reaching a trough in March, industrial production expanded over the next three months at an annual rate of more than 7 percent; although stronger output of motor vehicles and parts accounted for most of the increase early in the second quarter, the gains in recent months have been more widespread. Orders for a range of manufactured goods firmed in April and May, pointing to a further pickup in production during the summer.

Business spending for fixed investment was flat in real terms during the fourth quarter of last year and dropped sharply during the first quarter of this year. Several factors worked to reduce outlays, including the easing of pressures on capacity, the diminished level of cash flow, and the general atmosphere of uncertainty related to events in the Persian Gulf Real spending for equipment plunged during the first quarter; measured in percentage terms, the decline was the sharpest quarterly falloff recorded in nearly eleven years. Reflecting the difficulties in the manufacturing sector, real spending for industrial equipment dropped at an annual rate of more than 20 percent, after smaller declines during the preceding five quarters. Real business outlays for motor vehicles were cut at nearly a 35 percent annual rate in the first quarter, sinking to the lowest level since mid-1983. Purchases of computers and other information-processing equipment also were scaled back during the first quarter, and outlays for aircraft edged down, after jumping 60 percent over the preceding year.

The pace of nonresidential construction fell substantially during the fourth quarter of 1990 and the first quarter of 1991. The decline was broad-based, with the steepest contraction for office and other commercial buildings. Activity in this sector actually peaked in 1985 and has trended lower since then in response to persistently high vacancy rates and the removal of important tax benefits. In the industrial sector, the rate of plant construction has been damped by the emergence of substantial excess capacity in a number of major industries. Petroleum drilling activity, which moved up a bit late last year, retreated during the first quarter with the price declines for crude oil and natural gas; data on drilling rigs in use indicate a further weakening of activity during the second quarter.

Business spending for new equipment typically does not turn up until several months after the end of a recession, and the lag for construction outlays is often substantially longer. As yet, there is little sign of a rebound in spending for either equipment or nonresidential structures. Nonetheless, shipments of industrial equipment and other nondefense capital goods - a coincident indicator of equipment spending-have stabilized in recent months. Similarly, although vacancy rates for commercial buildings remain high, the steepest declines in total nonresidential construction activity may be over; in April and May, the average level of activity was about unchanged from the first-quarter average, and the downtrend in forward-looking indicators, such as construction contracts and permits, has slowed considerably.

The Government Sector

The federal budget deficit over the first eight months of fiscal year 1991 was $175 billion, compared with a $151 billion deficit during the same part of fiscal year 1990. The deficit during the current fiscal year has been boosted considerably by the slowdown in economic activity, and this cyclical increase has masked the fiscal restraint imposed by last autumn's budget agreement. On the revenue side, federal tax receipts have been held down by the anemic growth of nominal income since last fall; indeed, personal income tax payments so far this fiscal year are little changed from the payments made during the same period a year earlier. The slowdown in activity also has raised the deficit by increasing outlays for income-support programs such as unemployment insurance, food stamps, and Medicaid. These effects of the contraction have been offset, to some degree, by the easing of short-term interest rates, which has restrained the growth of interest payments on the federal debt.

Although the deficit has increased during the current fiscal year, the increase has been far smaller than that projected roughly six months ago. At that time, the Administration and the Congressional Budget Office both estimated that the deficit for fiscal year 1991 would top $300 billion. Two developments have caused the 1991 deficit to be lower than was expected, though neither one indicates any fundamental improvement in the budget situation. First, cash contributions from our allies in Operation Desert Storm have exceeded the outlays made to date for U.S. involvement in the Persian Gulf. The contributions not yet spent win be used to pay for the replacement of munitions into fiscal 1992 and beyond. Second, federal outlays related to deposit insurance were well below expectations during the first quarter, mainly reflecting the slow pace at which insolvent thrift institutions were resolved. The activities of the RTC during that period apparently were hindered, in part, by a lack of funding; legislation providing additional funding was enacted in late March, and the RTC has scheduled more rapid resolutions over the rest of the year.

Federal purchases of goods and services, the part of federal spending that is included directly in GNP, rose 5 1/4 percent in real terms over the four quarters of 1990. This increase reflected the fourth-quarter rise in defense purchases to support operations in the Persian Gulf, as well as increases over the year in such nondefense programs as law enforcement, space exploration, and health research. In the first quarter of 1991, real defense purchases moved above the already high fourth-quarter level, while nondefense purchases fell somewhat on net, pushed down by sales of oil from the Strategic Petroleum Reserve. Over the rest of 1991, fiscal policy likely will be a restraining influence on the economy because of the spending limits and tax increases mandated by last fall's budget agreement.

The fiscal position of state and local governments has remained extremely weak in recent quarters. The deficit in operating and capital accounts (that is, the deficit excluding social insurance funds) stood above $40 billion at an annual rate in both the fourth quarter of 1990 and the first quarter of 1991, after holding at a $30 billion rate for a year. The recent increase in the state and local deficit reflects, for the most part, a cyclical shortfall in tax receipts. However, this cyclical effect overlays structural imbalances that have been growing for some time. Since mid-1986, when the sector's accounts (excluding social insurance) were roughly in balance, outlays have risen from about 13 1/2 percent of nominal GNP to 14 1/2 percent while revenues have held fairly steady relative to GNP. The rise in the spending share reflects an expansion of services largely related to rapid growth in public school enrollments, prison populations, and Medicaid expenses.

During the past year, state and local governments moved to address their mounting fiscal difficulties. Many governments trimmed outlays relative to earlier trends. Between the first quarter of 1990 and the first quarter of 1991, real purchases by state and local governments rose only about I percent, well below the 3 1/2 percent annual rate of increase averaged over 1985-89. Moreover, last year several states instituted broad-based hikes in personal income and sales taxes. Looking ahead, state budgets for fiscal year 1992 - which began on July I for all but four states-generally mandate significant further cost-cutting from earlier plans. On balance, these budgets point to a weak picture for real state and local purchases over the current calendar year. Supplementing this restraint on spending, many new budgets include a second wave of major tax increases.

The External Sector

Over the first half of 1991, the foreign exchange value of the dollar appreciated about 15 percent, on balance, in terms of the currencies of the other Group of Ten (G-10) countries. The net appreciation over this period reversed about two-thirds of the decline in the dollar that had occurred between the middle of 1989 and the end of 1990.

In early January, the dollar was boosted by investors seeking a safe haven against the backdrop of growing tensions in the Persian Gulf. However, once the Allied bombing campaign commenced and was perceived as going well, part of the safe-haven demand for dollars evaporated, and the currency resumed its earlier decline. Between mid-January and early February, the dollar fell about 4 percent against the currencies of the other G-10 countries. During this period, U. S. monetary authorities joined with foreign central banks to support the dollar. Subsequently, the dollar surged through the end of March, largely reflecting the quick end of the war and the resulting expectation of an early rebound in the U. S. economy. The sharp run-up prompted official sales of dollars during March and April, mainly by European authorities. After dropping back a bit, the value of the dollar rose again in June on the accumulation of evidence suggesting that the U. S. recession had ended.

On a bilateral basis, the dollar this year has appreciated about 20 percent against the German mark and by similar amounts against the European currencies associated with the mark. The weakness of these currencies partly reflects economic difficulties in Germany and the spillover effects of the turmoil in the Soviet Union and Yugoslavia. In contrast, the dollar has appreciated much less against the currencies of most of our other major trading partners. So far this year, the dollar has risen less than 5 percent, on balance, against the Japanese yen and has changed even less against the currencies of Canada, Korea, Singapore, and Taiwan.

The overall strengthening of the dollar this year has acted to restrain prices for non-oil imports. Over the first quarter of 1991, these prices rose at a 2 1/2 percent annual rate, less than half the rate of increase between June and December of 1990; non-oil import prices then fell during April and May, more than reversing the entire first-quarter rise. The price of imported oil, which surged between August and October of last year, has since retraced most of the rise induced by the Iraqi invasion of Kuwait. Taken together, these two developments have contributed significantly to the restraint on domestic inflation.

Real merchandise imports declined in the first quarter to a level about 5 percent below that in the third quarter of 1990, with the drop largely reflecting the weakness in domestic demand. Import volumes fell in the first quarter for a wide range of non-oil products, including consumer goods, motor vehicles, and industrial supplies. Preliminary data for April show some increase in non-oil imports, a pattern that is likely to continue with the apparent firming of domestic activity. The quantity of oil imports - which plunged after the spurt in oil prices last summer and remained relatively low early this year - has moved back up in recent months, reflecting efforts to rebuild U. S. petroleum inventories.

Merchandise exports continued to move higher through the spring, a factor that clearly tempered the output loss in manufacturing after the oil shock last year. In real terms, merchandise exports rose at a 10 percent annual rate between the third quarter of 1990 and the first quarter of this year, led by increased sales of computers, other capital goods, and industrial materials. Preliminary data indicate that merchandise exports rose again in April. The competitive position of U.S. companies has benefited, at least until quite recently, from the substantial drop in the dollar over 1990 and the latter part of 1989. However, recessions in the economies of some of our major trading partners, especially Canada and the United Kingdom, have offset part of the stimulus to U.S. exports provided by the rapid economic growth in such countries as Germany, Japan, and Mexico.

The merchandise trade deficit narrowed to $74 billion (at an annual rate) in the first quarter of 1991, compared with $111 billion in the fourth quarter of 1990; the first-quarter deficit was the smallest since mid-1983. The current account actually recorded a $41 billion (annual rate) surplus in the first quarter, a sharp improvement over the $94 billion deficit in the fourth quarter of 1990. Most of this improvement reflected unilateral transfers associated with Operation Desert Storm: The fourth-quarter deficit was boosted by a grant from the U.S. government to Egypt for the purpose of repaying outstanding loans, while cash payments to the United States from our coalition partners surged in the first quarter. Excluding these cash contributions and the special grant to Egypt, the current account moved from a deficit of $83 billion in the fourth quarter to a deficit of $50 billion in the first quarter.

A small net capital inflow was recorded in the first quarter of 1991, as an increase in foreign official holdings of reserve assets in the United States more than offset a net outflow of private capital. Within the private-sector accounts, there was a substantial capital outflow in the first quarter associated with U.S. direct investment abroad, the bulk of which was in the countries of the European Community; at the same time, capital inflows related to foreign direct investment in the United States fen to a low level. Increasingly, multinational firms have raised funds in the United States to finance direct investment here and elsewhere, taking advantage of the low U. S. interest rates relative to those in other industrial nations. With regard to other private transactions, banks reported a small net capital inflow in the first quarter, and net purchases of U. S. securities by private foreigners about matched U. S. net purchases of foreign securities.

The net capital inflow during the first quarter, when combined with the surplus on current account, implies a large negative statistical discrepancy in the international accounts. Nearly as large a discrepancy in the opposite direction was registered in the fourth quarter of last year. These wide swings in the statistical discrepancy, along with the huge size of the discrepancy for 1990 as a whole, cast doubt on the accuracy of both the capital account and current account data used in the U. S. international accounts and highlight the need to improve these data.

Labor Markets

Labor demand appears to have stabilized after contracting sharply during the latter part of 1990 and the early part of this year. Employment on private nonfarm payrolls peaked last June, edged lower through September, and then fefl substantially in each month from October through April. However, the most recent data show that payrolls expanded slightly on balance over May and June, and survey results suggest that firms intend to increase employment further in the third quarter.

The cumulative decline in private nonfarm employment through April was slightly more than 1 1/2 million jobs, roughly a 1.7 percent drop. Although that percentage decline is close to the average in the other recessions after World War H, three industries had abnormally large job losses: construction; retail and wholesale trade; and finance, insurance, and real estate. The steep decline in construction employment likely reflected the unusually sharp falloff in office and other commercial construction, which compounded the normal cyclical contraction in residential building. In the trade sector employment was depressed by the sizable decline in consumer spending and the high degree of financial distress among retailers, some of whom were burdened with heavy debt-servicing costs as a result of leveraged buyouts. Employment in finance, insurance, and real estate-which continued to rise during past recessions-edged lower this time, reflecting the shakeout in the financial sector and spillovers from the slump in real estate markets. In contrast, the decline in manufacturing payrolls was somewhat smaller than in previous contractions, largely because the drop in industrial production was relatively shallow. Employment in the services industries continued to trend up during late 1990 and early 1991, as it had in previous recessions, supported entirely by gains in health services.

Although the size of the drop in private nonfarm payroll employment was similar to that m previous contractions, the decline in real GNP during the current episode was relatively small. This contrast confirms the widespread impression that firms shed workers to an unusual degree during the recent downturn. At the same time, the rise in the civilian unemployment rate from 5.5 percent in July 1990 to 7 percent this June was not particularly large relative to the decline in real GNP. Apparently, an unusual proportion of people who lost jobs subsequently dropped out of the labor force and thus were no longer

counted as unemployed. In addition, the muted rise in unemployment and labor-force size during recent quarters may be part of a longer-term deceleration in the rate at which women - especially younger women - have entered the labor market. For this latter group, there has been a shift toward additional school attendance and toward staying at home to care for young children. By reducing the number of new job seekers at a time when jobs were quite hard to find, this shift held down the rate of unemployment.

A variety of indicators suggest that labor demand has stabilized in recent months. Perhaps the earliest signal of this improvement was provided by the data on initial claims, which peaked at a weekly rate of 535,000 in March and then dropped back to about 470,000 in April; the pace of weekly claims has since moved considerably lower. Employment on private nonfarm payrolls rose in May, the first increase since the middle of 1990. Although part of this gain was reversed in June, firms continued to lengthen the average workweek of their employees. This pattern of cautious hiring combined with an extension of the workweek is common in the early stage of a recovery; given the expenses associated with hiring and firing, such a strategy is a natural response to uncertainty about the strength and duration of the pickup in demand. A separate measure of employment, derived from a survey of households, also suggests that labor demand has stabilized; the number of persons reporting themselves as employed was about flat, on balance, over the second quarter, after falling sharply over the three preceding quarters. Although the civilian unemployment rate did continue to inch up over the second quarter, this increase is not too surprising, as the jobless rate often increases during the first several months of a recovery. With the brightening of employment prospects, job seekers enter the labor force at an increasing rate, raising unemployment until hiring accelerates enough to outstrip the growth in labor supply.

The slack opened up in labor markets since last summer has helped damp the rate of increase in labor costs, which had trended higher between the end of 1987 and the middle of 1990. As indicated by the employment cost index (ECI), increases in compensation per hour for private industry workers accelerated from 3 1/4 percent during 1987 to about a 5 1/4 percent annual rate during the first half of 1990; this measure of labor costs covers both wages and payments for worker benefits. The most recent ECI data show that compensation costs rose at an average annual rate of 4 1/4 percent over the second half of 1990 and the first quarter of 1991, a full percentage point below the peak rate recorded early last year. Although this slowing of labor-cost inflation was apparent in both wages and benefits, the latter component of compensation decelerated the most sharply, reflecting declines in nonproduction bonuses and pension contributions per hour of work. However, employer costs for insurance, mainly for health insurance premiums, continued to rise at close to double-digit rates.

Output per hour in the nonfarm business sector was essentially flat, on balance, over the year ended in the first quarter of 1991, after declining during 1989 and the early part of 1990. This pattern differed somewhat from the usual cyclical experience. Typically, productivity continues to rise until shortly before the business-cycle peak, then turns down and falls sharply through the early part of the ensuing recession. Productivity during this episode declined well before the cyclical peak last summer, as output growth slowed, and firms continued to hire at a relatively rapid pace. However, as demand softened at the peak, firms began to trim payrolls, and this pruning continued in an aggressive fashion through the recession; as a result, output per hour was better maintained during the 1990-91 contraction than during previous downturns. In manufacturing, where competitive pressures have been particularly intense, the process of cutting payrolls began well before the onset of recession, and this early action allowed productivity gains to remain robust over the year leading up to the contraction. Although productivity in manufacturing turned down during the recession, the continued cutting of factory jobs kept the drop in output per hour relatively small by historical standards.

Price Developments

Inflation pressures have eased somewhat this year. Most of last year's spike in energy prices has been retraced, and the rate of increase in food prices has slowed. In addition, the margin of slack in labor and product markets that emerged during the recession is placing downward pressure on price increases for other goods and services; this trend toward slower "core" inflation, however, was obscured early in the year by a number of price increases that either were one-time events or have since been reversed.

The Iraqi invasion of Kuwait last August precipitated a sharp rise in oil prices that carried through to early October. At that point, the posted price of West Texas Intermediate oil, the benchmark for U. S. crude prices, reached nearly $40 per barrel, more than double the $16 price prevailing just three months earlier. Then, between October and February, virtually all of this price spike unwound, chiefly as a result of two developments. Saudi Arabia and other oil producers boosted output to offset the embargo on Iraq and Kuwait, and the Allied forces demonstrated that they could prevent significant disruptions to supply. In addition, prices were damped by the slowdown in economic activity in the United States and other industrial nations. After the end of hostilities in February, OPEC sought to bolster prices by trimming production. This effort proved to be largely successful: The posted price of West Texas Intermediate firmed to $20 per barrel in April and has changed little on balance since then.

Energy prices for consumers have followed the movements in world oil prices since last summer. The CPI for energy peaked in November 1990 at a level 15 percent above that in July and then fell sharply through the first quarter of this year. By April, the decline in crude oil prices had been fully passed through to energy prices at the retail level. In May, consumer energy prices edged back up, mainly reflecting price increases for gasoline, the largest component of the CPI for energy. Gasoline demand this spring apparently was stronger than refiners had expected, and inventories fell to exceptionally low levels. Along with the tight inventory situation, retail gasoline prices may have been boosted by the mandatory switch to cleaner - and more expensive -gasoline before the summer driving season. However, as of early June, gasoline inventories had moved back into the normal seasonal range, and survey data suggest that pump prices softened during the second half of June and into early July.

Increases in consumer food prices this year have slowed from the 5 1/4 to 5 1/2 percent range that prevailed over the preceding three years. During the first five months of 1991, the CPI for food rose at only a 3 1/4 percent annual rate, held down in large part by price declines for dairy products and by roughly stable prices on balance for meat, poultry, and eggs. Following the typical pattern in agricultural cycles, prices for these livestock products have been damped by an expansion of supply that was itself spurred by the relatively high prices of recent years. In addition, price increases have been muted for many foods for which labor and other nonfarm inputs represent a large share of total cost. For example, the prices of food consumed away from home rose at a 3 1/4 percent annual rate over the first five months of 1991, down from the 4 1/2 percent increases over 1989 and 1990. The deceleration in food prices this year would have been somewhat greater but for a series of adverse weather developments that have raised prices for fresh fruits and vegetables; given the short production cycles for many of these products, the recent price increases should be reversed, at least in part, in coming months.

The consumer price index for items other than food and energy rose sharply during January and February, but the jumps in those months reflected a number of one-time or transitory increases. Higher federal excise taxes on cigarettes and alcoholic beverages went into effect, raising consumer prices for both items; these tax hikes supplemented the increases in sales and excise taxes that a number of states have imposed over the past year. Postal rates also were raised 16 percent in February. Apparel prices climbed at double-digit annual rates in both January and February, mainly because of the earlier-than-usual introduction of spring clothing lines, which was not anticipated by the seasonal adjustment factors used by the Bureau of Labor Statistics. More generally, the spurt in oil prices last fall spilled over non-early 1991 to prices for a wide range of non-energy goods and services; this pass-through occurred via higher shipping costs and price hikes petroleum-based components. However, each of these factors boosting inflation proved to be short-lived. After the large increases in January and February, the CPI excluding food and energy rose at just a 2 1/4 percent annual rate between February and May. Apparel prices declined over this period, and airfares - which are quite sensitive to changes in oil prices - fell 10 percent (not an annual rate). The uneven pace of inflation this year has tended obscure trends in the general level of retail prices. Nonetheless, there is little doubt that the underlying ace of inflation has moderated since last year. The twelve-month change in the CPI excluding food and energy - which held around 4 1/2 percent throughout 1988, 1989, and the early part of 1990 - moved up to about 5 1/2 percent in August 1990. By May of this year, the twelve-month change in this index had fallen back to 5. 1 percent. This figure slightly overstates the trend rate of inflation because it includes the increases in federal excise taxes and postal rates earlier this year; in addition, the pass-through of lower energy prices to non-energy items probably was not complete as of May. Adjusting for both these factors would put the twelve-month change in the CPI excluding food and energy a bit below 5 percent.

Price developments at earlier stages of processing have been favorable this year, reflecting the easing of capacity pressures and price declines for petrochemical products. The producer price index for finished goods excluding food and energy rose at a 3 1/4 percent annual rate over the first six months of 1991, a bit below the pace in 1990. Prices for intermediate materials excluding food and energy fell about 1 1/2 percent at an annual rate between December and June. Spot prices of raw industrial commodities plunged late last year with the downturn in economic activity, and these prices moved down somewhat further on balance over the first half of 1991.


The progressive easing of money market conditions initiated last fall as the economy weakened continued through much of the first half of 1991. Since the end of last year, open market operations, in combination with two cuts of 1/2 percentage point in the discount rate, have reduced the federal funds rate from 7 percent to 5 3/4 percent-the lowest level in well over a decade. These moves followed a number of easings in the final months of 1990, including a 1/2 point reduction in the discount rate in December, that already had brought the federal funds rate down about 1 percentage point. As a consequence of these and earlier actions, the federal funds rate has declined 4 percentage points from its most recent peak in the spring of 1989.

The policy easings this year were undertaken to foster a turnaround in the economy and to help ensure a satisfactory expansion. They were prompted by evidence that the economy was declining further and that inflationary pressures were abating; early in the year, continuing weakness in the monetary aggregates and further restraint on credit availability, especially at banks, also were important indications of the need for additional policy easing. Policy actions led to a strengthening of money growth over the first half from the slow pace of earlier quarters, and both M2 and M3 in June were in the middle portions of their annual target ranges. The debt aggregate, by contrast, expanded at the lower end of its monitoring range throughout the first half, held down by sluggish spending and also by a cautious attitude toward additional debt by both borrowers and lenders. As the monetary aggregates accelerated and signs accumulated that the economy was bottoming out, the pace of policy easings slowed, and the last such move was made at the end of April.

Despite the drop in short-term interest rates, long-term rates were mixed, on balance, over the first half of the year. In the wake of the rapid conclusion of the Gulf war, expectations became widespread that there would be a strengthening in aggregate demand, and this tended to push yields on Treasury bonds a little higher and contributed to an increase in the foreign exchange value of the dollar. With the brighter outlook for the economy, however, the risk entailed in holding private obligations was seen as considerably reduced, and yields on corporate bonds fefl and stock prices rose. However, substantial loan losses continued to afflict many financial intermediaries, and these institutions maintained cautious attitudes toward extending new loans; the caution was reflected in wide spreads of lending rates over borrowing rates and more stringent nonprice terms on credit.

Implementation of Monetary Policy

The Federal Reserve adjusted policy in three separate steps during the first quarter of the year, extending the series of moves initiated during the final months of 1990. Amid signs of continuing steep declines in economic activity and abating inflation pressures, the Federal Reserve eased reserve provision through open market operations in January and again in early March, leading to a decline in the federal funds rate of a quarter point each time, and reduced the discount rate 1/2 percentage point on February 1, resulting in a similar-sized decline in the federal funds rate? The monetary aggregates were very weak in January, and while strengthening considerably in February and early March, remained on a moderate growth track, especially taking into consideration the lack of expansion late in 19%.

Other short-term rates generally fell about a percentage point over this period. The commercial bank prime loan rate was reduced 1/2 percentage point in early January in lagged response to earlier declines in short-term rates. The drop apparently had been delayed as banks attempted to hold down loan growth as 1990 drew to a close, bolstering their capital positions in response to market concerns and the initial phase-in of risk-based capital requirements. The prime rate was reduced again after the cut in the discount rate in early February.

Longer-term rates also fell, on balance, over the first two months of the year, under the influence of monetary easings and prospects for lower inflation, especially when it became clear that the Gulf war would not interrupt oil supplies. Initial success in the Persian Gulf also led briefly to weakness of the dollar in foreign exchange markets, as safe-haven demands that had been boosting its value since late 1990, in the face of a substantial easing of U. S. monetary policy, evaporated.

In March, however, long-term market rates began to firm, reflecting the rebound in consumer confidence and initial indications of a turnaround in the housing market, which were seen as pointing to a somewhat shorter and milder recession than many had previously feared. Rate increases on private instruments were muted, though, as risk premiums began to shrink in response to brightening prospects for a recovery. These gains extended even to below investment-grade bonds, and growing optimism was reflected as well in a strong stock market in February and into March. The debt and equity instruments of banks generally outperformed broader indexes over this period, as the market apparently expected banks' earnings to be bolstered by lower short-term interest rates and the deterioration in the quality of their loan portfolios to be limited as the anticipated economic recovery materialized. Better prospects for a U.S. economic recovery about coincided with a turn toward more pessimism about the economic outlook abroad. As a result, the exchange value of the dollar reversed, and the dollar began to appreciate sharply.

In the wake of the successful Gulf war and in view of initial signs that the System's earlier easing actions had begun to take hold, the FOMC concluded at its meeting in late March that the risks to the economy had become more evenly balanced. Accordingly, the Committee decided to end the formal tilt toward ease that it had adopted in mid- 1990, when slowing money growth and tightening credit availability aroused concerns that financial conditions might be placing greater-than-anticipated restraint on economic activity. Under the previous instructions, the FOMC's directive to the domestic trading desk at the Federal Reserve Bank of New York had stipulated that possible adjustments to reserve pressures between Committee meetings would be more responsive to unanticipated signs of economic weakness and abating price pressures than to unexpected evidence of strength. The directive issued at the March meeting restored symmetry to these instructions concerning intermeeting adjustments.

Interest rates generally declined during April, mainly at the short end, reflecting market participants' disappointment that the response to earlier monetary easings and to the rebound in consumer confidence they had expected had yet to show through in measures of economic activity. At the same time, with evidence also continuing to point to a further abatement of inflation, particularly as reflected in wage behavior, the Federal Reserve at the end of April reduced the discount rate another 1/2 percentage point, allowing about half that amount to show through to money market rates. As was the case in February, this action was followed by a 1/2 percentage point decline in the bank prime rate. Despite further monetary ease, the dollar continued to rally on foreign exchange markets, in part boosted by political developments abroad, particularly in the Soviet Union, and potential economic difficulties in Germany.

Market interest rates were little changed until early June, when they rose in response to the release of data on employment and retail sales for May that strongly suggested the trough of the recession had been reached, or at least was close at hand. The ensuing rise in interest rates was particularly sharp at the long end of the Treasury market. As signs of the recovery grew more distinct and interest rates firmed, the dollar strengthened further, and by June it had retraced all its declines of late 1990 and early 1991. On balance, Treasury bond yields rose almost 1/4 percentage point over the first half of 1991, while yields on investment-grade corporates were down close to 1/2 percentage point.

Monetary and Credit Flows

Despite the continuing weakness in economic activity, expansion of the monetary aggregates in the first half of 1991 picked up from the lackluster pace of late 1990, and M2 and M3 grew at annual rates of 3 3/4 and 2 1/4 percent respectively, from the fourth quarter of last year through June. M2 growth increased as policy actions reduced short-term market interest rates relative to returns that could be earned on assets in this aggregate (a decline in the `opportunity cost' of holding M2). As a consequence, expansion of M2 exceeded the growth of nominal GNP However, the growth in M2 (and decline in its velocity) was smaller than would have been expected on the basis of past relationships with income, interest rates, and opportunity costs. This shortfall of M2 growth from historical patterns followed an even greater discrepancy in 1990.

The tepid response of M2 to declines in interest rates may partly reflect reduced funding needs at depositories associated with weak credit growth. As discussed below, commercial bank credit expanded sluggishly over the first half of 1991, and thrift institution balance sheets continued to contract. In these circumstances, depositories may well have been less aggressive in supplying retail deposits; although rates on these deposits do not appear on the surface to have fallen unusually rapidly, institutions may have acted in other ways to reduce the cost of funds, including adjusting advertising and marketing strategies. On the demand side, growth in M2 appears to have been held down early in the year by the public's concerns about depository institutions; purchases of Treasury securities through noncompetitive tenders were especially heavy in January. As the turnaround in the economy seemed in prospect, bank access to both deposit and capital markets improved greatly. Later, in the second quarter, a slowdown in M2 growth appeared to be partly related to the developing configuration of returns on assets. Maturing small time deposits could be rolled over only at much lower rates at the same time the steep upward slope of the yield curve seemed to offer an opportunity to preserve high yields by moving into capital market instruments. For example, expansion of stock and bond mutual funds was quite strong over the second quarter. In addition, with returns on M2 assets falling steeply relative to rates charged on loans, households had a greater incentive to finance spending by holding down the accumulation of M2 assets rather than by taking on new debt.

The decline in market interest rates also promoted a marked shift in the composition of M2 toward its liquid household deposit components - other checkable deposits, money market deposit accounts, and savings deposits. As is typically the case, offering rates on these deposits adjusted very slowly to the drop in market rates. As their opportunity costs declined, these deposits accelerated, expanding at double-digit rates over the first half. Small time deposits, by contrast, contracted over the period as some of the proceeds of maturing instruments evidently were shifted into liquid components of M2 and depositors hesitated to commit currently generated savings at available time deposit rates. The strength in other checkable deposits contributed to a strong first-half advance in M 1. In the first quarter, this aggregate also was boosted by a surge in currency stemming from rising demand abroad, particularly the Middle East. Reflecting the strength in currency and in other checkable deposits, the monetary base expanded over the first half at an 8 1/2 percent annual rate, more than twice the pace of M2.

Growth of M3 over the first half of 1991 was concentrated in the early months of the year, when it received a considerable boost from heavy issuance of large time deposits by U. S. branches and agencies of foreign banks. The issuance of these "Yankee CDs" resulted from the reduction in December of the reserve requirement on nonpersonal time deposits and net Eurocurrency deposits from 3 percent to zero. Previously, branches and agencies had been able to borrow a limited volume of funds from their head offices without becoming subject to reserve requirements. With Yankee CDs apparently an inherently cheaper source of funds, institutions that had been able to fund additional asset expansion through reserve-free borrowing from their head offices began to pay down these advances with funds raised in the CD market. Some foreign banks also tapped the CD market to advance funds to affiliates abroad and to pay down other nondeposit liabilities. Domestic banks and thrift institutions, in contrast, ran off large time deposits in the first quarter as core deposit inflows were more than adequate to fund asset growth. The strength of M3 in the first quarter also reflected strong growth of money market mutual funds. The relative attractiveness of these funds tends to rise when market rates are falling, as fund owners receive returns based on average portfolio yields, which decline only as fund holdings mature and must be replaced with lower-yielding instruments.

M3 was about flat between March and June. Shifts of foreign bank liabilities toward large time deposits slowed, large time deposits at domestic depositories ran off more rapidly with a contraction of their credit, and money funds decelerated as their yields came into line with market rates.

Bank credit expanded very slowly during the first half of 1991 and was concentrated in acquisitions of securities, particularly Treasury and agency securities. As in 1990, the recent strength in acquisitions of these securities is due in part to their favorable treatment under risk-based capital requirements. Mainly, however, it reflects the impact on loan growth of weaker spending by potential borrowers and continued lending restraint by banks. A substantial proportion of bank lending officers, citing heightened uncertainties about the economy and, in many cases, weak capital positions, reported implementing still more restrictive lending policies in a Federal Reserve survey conducted early in 1991. Evidence of tightening continued into May, although the percentage of surveyed banks that reported additional tightening declined, perhaps in part because of the more favorable market environment that had developed from earlier in the year and that had allowed banks to issue large volumes of debt and equity.

The asset-quality problems that dogged banks in 1990 continued to crop up in the first half of 1991. Available data on delinquency rates show further increases in the first quarter, for both commercial real estate and other business credits and also for consumer loans. At midyear, when a number of large banks announced surprisingly large loan losses and depressed profits, some of the gains that banks had made in debt and equity markets were reversed.

The contraction in depository credit was not fully reflected in the growth of total debt of nonfinancial sectors. As occurred last year, credit advanced through securities markets and by other intermediaries met an unusually high proportion of credit needs. Banks themselves continued to sell consumer loans and mortgages into securities markets to hold down asset growth and to bolster capital ratios; through these sales, the cost and availability of funds to households has been largely insulated from the possible effects of bank restraint on credit. In addition, businesses turned to long-term securities markets to meet credit needs and to restructure balance sheets, reducing their reliance on banks as well.

Overall, the debt of domestic nonfinancial sectors increased at about a 4 1/2 percent annual rate over the first half of 1991. This was likely a bit above the rate of expansion of nominal GNP, though by considerably less than on average over the previous decade, as both borrowers and lenders apparently have been adopting more cautious attitudes toward additional debt. Businesses, for example, stepped up new equity issuance and greatly reduced the retirement of existing equity in corporate restructurings. These activities, together with the decline in financing needs associated with failing inventories and fixed investment, held down growth of business sector debt to a 2 percent annual rate in the first half. With some consumers also attempting to reduce high debt loads, growth of consumer credit was weak as well. Lower mortgage rates and stronger home sales helped maintain growth of residential mortgages. States and municipalities, facing continuing downgrades and the need to cut back expenditures, put fairly limited net demands on the credit markets in the first half of this year. Federal government debt growth in the first quarter was held down by the slow pace of RTC activity and the receipt of contributions from foreign governments of payments related to the Gulf war; government debt issuance picked up sharply in the second quarter, however.

1. The charts for the report are available on request from Publication Services, Board of Governors of the Federal Reserve System, Washington, D.C. 20551.

2. The federal funds rate came under some upward pressure during much of January, as reduced levels of required reserve balances at Federal Reserve Banks complicated commercial banks' reserve management. Required reserves were low partly because of the effects of the cut in reserve requirements on nonpersonal deposits in December and partly because of seasonal variations. For some banks, balances held in accounts at Reserve Banks threatened to fall below prudent clearing levels. To avoid overnight overdrafts, banks markedly raised holdings of excess reserves and borrowed sporadically at the discount window. But with maintained balances still low relative to clearing needs, the volatility of the federal funds rate increased. As banks became more accustomed to operating with lower levels of required reserves and as these reserves subsequently rose for seasonal reasons, reserve management problems eased, and the volatility of the federal funds rate diminished. The upward pressures on the funds rate in January did not show through to other short-term rates.
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Title Annotation:report of July 16, 1991
Publication:Federal Reserve Bulletin
Date:Sep 1, 1991
Previous Article:David W. Mullins Jr.
Next Article:Industrial production and capacity utilization.

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