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Monetary policy report to the Congress.

MONETARY POLICY AND THE ECONOMIC

OUTLOOK FOR 1992

When the Federal Reserve presented its midyear monetary policy report to Congress last July, a moderate economic upturn was under way. Consumer spending and housing activity had risen considerably since the winter, bolstered by the decline in oil prices, by a rebound in consumer confidence in the wake of the allied victory in the Persian Gulf conflict, and by lower interest rates. Inventories had been trimmed appreciably, orders were rising, and businesses, while still cautious, had begun to increase employment and production. The key monetary aggregates had accelerated and were around the middle of their 1991 target ranges. With the stance of monetary policy seemingly conducive to an upturn in economic activity, the Federal Reserve, after having progressively reduced pressumes on reserve positions earlier in the year, maintained a more nutral money market posture in the spring and early summer.

As the year wore on, however, the incipient recovery lost its momentum. Consumer spending turned down, and business and consumer sentiment began to erode. Inventories at wholesale and retail trade establishments began to increase relative to sales, inducing a new outbreak of production adjustments and layoffs that continued through year-end. Although the economy--as measured by its real gross domestic product--continued to grow in the second half of the year, the pace of expansion was only marginally positive.

The faltering of the recovery process apparently owed to a variety of forces, some of which were operating well before the oil price shock of 1990 tipped the economy into recession. In a sluggish economy and amid unexpectedly weak asset values--particularly in real estate--deteriorating financial positions of debt-laden households and corporations further damped credit demands and aggregate spending. Financial intermediaries, chastened by their negative experience with earlier loans, became more hesitant about extending new credit; the resultant tighter lending standards deepened the slowdown in economic activity and inhibited the subsequent recovery. In the government sector, where deficits remained large, not only at the federal level but also in many state and local jurisdictions, efforts to curb spending and increase revenues constituted a further drag on aggregate demand in the short run.

Inflation, meanwhile, moved down over the second half of 1991. Weak demand reduced pressures in both labor and product markets, and, after some acceleration of wages and prices in 1989 and 1990, an underlying disinflationary trend has now been established. Important in this process has been a reduction in inflation expectations, visible not only in a variety of survey data but also in the behavior of securities markets.

With actual and prospective inflationary pressures easing, economic activity flagging, and the broader monetary aggregates weakening and growing near the bottom of their target ranges, the Federal Reserve resumed easing money market conditions in the second half of the year. As a result, the federal funds rate fell from 5 3/4 percent in July to 4 percent by year-end, and most other short-term rates followed suit; the discount rate was also reduced over this period, from 5 1/2 percent to 3 1/2 percent, the lowest rate in nearly thirty years. Long-term interest rates, which had failed to respond to declines in money market rates in the early months of the year, came down significantly in the latter part of 1991, partly in response to the easing in inflationary expectations. Although long-term rates have backed up some in recent weeks, they remain appreciably below the levels of last summer. The decline in rates has helped reduce the financial burdens of highly leveraged households and corporations, which have taken this opportunity to refinance mortgages and to replace existing debt with new lower-cost bonds. Lower interest rates also have contributed to an increase in stock prices, including firms to boost equity issuance and to pay down debt, further strengthening their balance sheets. With the decline in U.S. interest rates, the foreign exchange value of the dollar has largely reversed the upward movement that had occurred earlier in the year.

The unusually slow growth of the key monetary and credit aggregates last year was, to a degree, indicative of the continuing restraint on private credit usage and spending. The aggregate debt of domestic nonfinancial sectors--abstracting from federal government debt, which continued to grow briskly--expanded only 2 3/4 percent in 1991, the slowest advance in decades, and below the pace of nominal GDP; households, nonfinancial businesses, and state and local governments all retrenched, curbing spending and borrowing in order to buttress deteriorating financial positions.

The weakness in the monetary aggregates M2 and M3 reflected not only subdued overall credit usage but also a continued decline in the share of credit intermediated by depositories. With the thrift industry contracting further, commercial bnaks exercising caution in their credit extensions, and borrowing demand concentrated in longer-term instruments, depository credit continued to shrink as a share of overall credit extensions. As a result, the velocity of M3--a monetary aggregate that comprises most of the liabilities used by depositories to fund credit growth--increased again in 1991, as M3 grew only 1 1/4 percent, near the bottom of its target range. Depository restructuring also restrained M2, which grew in line with nominal GDP despite a steep drop in short-term market interest rates; ordinarily such a drop would have been expected to depress the velocity of this aggregate. Banks, eager to improve capital positions, reduced deposit rates more than loan rates, increasing the incentive for households to pay down debt rather than to accumulate monetary assets. Less aggressive pursuit to retail accounts by depositories also
1. Ranges for growth of monetary and debt aggregates (1)
 Percent
 Aggregate 1990 1991 1992
M2 3-7 2 1/2-6 1/2 2 1/2-6 1/2
M3 1-5 1-5 1-5
Debt (2) 5-9 4 1/2-8 1/2 4 1/2-8 1/2
 (1) Change from average for fourth quarter of preceding year
to average
for fourth quarter of year indicated. Ranges for monetary
aggregate are
targets; range for debt is a monitoring range.
 (2) Domestic nonfinancial sector.


led investors to switch into other financial assets, such as bond and stock mutual funds. Flows into these funds helped finance credit that had formerly been intermediated by depositories, facilitating shifts to longer-term borrowing and reducing the adverse effects of any retrenchment by banks and thrifts on the cost and availability of credit to many borrowers. However, some types of lending that are not so easily rechanneled--such as construction loans and credits to small and lower-rated businesses--have been curtailed, and a number of borrowers now face more stringent credit terms.

Monetary Objectives for 1992

In formulating its objectives for monetary policy for 1992, the Federal Open Market Committee has sought to promote a sustainable upturn in economic activity while continuing to build upon the hardwon gains against inflation that have alreasy been made. The task of translating these objectives into specific ranges for money and debt continues to be complicated by the ongoing restructurings of depositories and by the evolving attitudes toward credit on the part of borrowers and lenders. The Committee believes that the rechanneling of credit flows away from depository institutions could well continue to produce slower growth in the broad monetary aggregates than normally would be associated with a given path for nominal GDP.

Taking account of these effects, the Committee has deemed the ranges for 1992 tentatively adopted last July as appropriate for achieving its objectives. The target range for M2 growth in 1992 is 2 1/2 percent to 6 1/2 percent, unchanged from 1991. Demands for M2 relative to income would be damped if, as seems likely, banks and thrifts continue to reduce deposit rates in lagged response to the decline

[TABULAR DATA OMITTED]

that has occured in market rates. These deposit-rate reductions could be especially large if credit continues to be chanelled outside depositories; in this case, relatively modest growth in M2 would be adequate to support a satisfactory outcome for the economy. On the other hand, as the balance sheets and capital positions of depositories continue to improve, banks and thrifts may adopt a generally more accommodative posture with respect to creedit extensions and would therefore have greater need for retail deposits. In that event, somewhat faster growth of M2 would be appropriate.

On balance, the Committee's M2 range for 1992 allows room for a variety of developments in the intermediation process and thus in the behavior of monetary velocity. Flexibility in interpreting M2 within its range is particularly important at this time, in light of the ongoing and unpredictable shifts in the patterns of credit usage and financial intermediation that likely will continue to buffet our financial system. Looking ahead to future years, the Committee also recognizes that the range for M2 growth may eventually have to be lowered in order to put in place the monetary and credit conditions consistent with price level stability.

The target range for M3 growth in 1992 remains at 1 percent to 5 percent. Although credit growth is expected to pick up somewhat in 1992, in line with a firming of economic activity, much of this credit likely will be financed outside the depository system. The thrift industry is expected to contract further as activity by the Resolution Trust Corporation continues apace, and banks, faced with continued--though moderating--pressures on capital positions, will still be somewhat hesistant to expand. At the same time, additional households are likely to refinance adjustable-rate mortgages with fixed-rate obligations that can easily be securitized, and corporations will probably continue to turn to equity markets and long-term bonds rather than bank loans. As a result, depository funding needs are likely to remain damped relative to the pace of economic activity, and the velocity of M3 should consequently rise further.

The monitoring range for the aggregate debt of domestic nonfinancial sectors for 1992 is 4 1/2 percent to 8 1/2 pecent, also unchanged from 1991. Federal government borrowing is expected to remain heavy in 1992, given the large budget deficit. Debt growth in nonfederal sectors, however, should remain fairly subdued relative to economic activity as borrowers, and lenders alike maintain a cautious approach to leverage, in part because of a desire to make further repairs to damaged balance sheets.

Economic Projections for 1992

Although the long-standing structural problems that aborted the fledgling recovery last summer clearly are being addressed, the speed of their resolution--and the associated restraint on economic growth--is quite difficult to gauge, augmenting the usual uncertainties in assessing the economic outlook. On the whole, however, the members of the Board of Governors and the Reserve Bank presidents believe that, with the easing of monetary conditions to date providing considerable impetus to the economy, the most likely outcome is for a moderate reacceleration of activity over 1992. At the same time, they anticipate that the trend toward price stability, whic now appears to be rooted more securely, will be sustained through this year.

The forecasts of most of the governors and presidents for growth of real gross domestic product are in a range of 1 3/4 percent to 2 1/2 percent measured from the fourth quarter in 1992 to the fourth quarter of 1992. With employers likely to be cautious about hiring until they are fully persuaded of the sustained vitality of the upturn, gains in employment are expected to come slowly. Thus, only a small improvement in the unemployment rate is anticipated this year, with the central tendency of projections being a range of 6 3/4 percent to 7 percent for the fourth quarter of 1992. With regard to inflation, the central tendency range for the CPI increase this year is 3 percent to 3 1/2 percent. These forecasts are, in general, very similar to the projections presented by the Administration in the fiscal year 1993 budget. Indeed, the Administration's forecast for nominal GDP is well within the Committee's central tendency range and thus appears to be quite consistent with the FOMC's monetary ranges.

In early February discussion of the economic outlook, the Board members and Reserve Bank presidents observed that the effects of recent job losses and weak consumer confidence are likely to restrain activity in the near term. Under the circumstances, the Board members and Bank presidents stressed that economic developments need to be monitored closely to guard against the possibility that the economy might falter. Nonetheless, the monetary stimulus already in train is expected to provide effective support for economic growth this year, and in this regard the early indications of a marked pickup in residential real estate activity and a rise in retail sales are a particularly favorable sign.

It is also expected that the drags on growth from disruptions in credit supply and from the restructuring of household and business balance sheets will begin to lessen over the year. As noted above, this is obviously an area of substantial uncertainty. However, as household and corporate debt loads diminish in an environment of stronger economic activity, and as lower interest rates continue to ease financing burdens of borrowers, consumers and businesses should be poised to participate more fully in the economic expansion. Moreover, the problems of credit availability that have plagued the economy over the past couple of years should begin to ease in 1992 as the economic recovery take hold and lenders become more confident about extending credit.

Nonetheless, the pace of expansion this year is expected to remain weaker than in previous business cycle recoveries. In larg part, this expectation reflects some still-unresolved economic and financial imbalances in particular segments of the economy. The persistent overhang of space in office and other commercial buildings undoubtedly will inhibit new construction in that sector for some time. In addition, the budgetary constraints that have capped government spending are likely to linger; a good many states and localities are finding that budget gaps are reopening despite the spending cuts and tax increases they instituted last year. Meanwhile, the external sector is expected to have a relatively neutral net influence on domestic production this year; foreign demand--particularly from Mexico and developing countries in Asia--should continue to boost export growth, but the anticipated pickup in domestic purchases is likely to draw in additional imports as well, limiting the potential for further substantial improvement in the trade balance.

Only a minority of Board members and Reserve Bank presidents foresee a smaller increase this year in the overall CPI than the 3 percent rise experienced in 1991. But the pickup in inflation suggested by the 3 percent to 3 1/2 percent central tendency range is deceptive: the underlying trends in price movement are move favorable. The CPI was held down to a substantial degree last year by the unwinding of the energy price shock that followed Iraq's invasion of Kuwait in August 1990, and further sharp declines in energy prices do not appear likely in the current environment. However, an ongoing deceleration in prices is evident for a wide range of other goods and services, and with inflationary tendencies under considerable restraint from several factors--including further moderation in labor cost growth, continued slack in industrial product markets, and small increases in import prices--"core" inflation is expected to move down appreciably in 1992. Indeed, this trend should carry into 1993--a pattern that bodes well for the achievement of a balanced, sustained economic expansion.

THE PERFORMANCE OF THE ECONOMY

IN 1991

The year 1991 began with the U.S. economy in the midst of recession. Activity had contracted sharply after the jump in oil prices that followed Iraq'a invasion of Kuwait in August 1990, and this weakness spilled into the first quarter with further reductions in production and employment. By the spring, however, economic data indicated that the decline in economic activity had bottomed out. The rapid conclusion of the Persian Gulf war boosted consumer confidence, and the reversal of the earlier runup in oil prices and the cumulative effects of declining interest rates were providing support for an increase in household spending. Indeed, construction of single-family homes had already turned up noticeably by April, and consumer spending posted a moderate rise in the second quarter. Although businesses continued to liquidate inventories at a fairly rapid pace, industrial production grew steadily from April through July, and hiring activity increased.

Howevr, the pickup in the economy evident from April to July failed to develop any momentum, as the thrust to domestic demand initiated by the end of the Gulf war dissipated during the summer. The absence of a more robust recovery likely reflected the drag on aggregate demand from some longer-term economic and financial adjustments. For example, imbalances long evident in the commercial and multifamily construction sectors damped enthusiasm for new projects, and ongoing difficulties in the financial sector continued to restrain credit, availability; these influences undoubtedly muted the stimulus that normally would have been forthcoming from the decline in interest rates. Fiscal restraint evident at all levels of government weighed on aggregate demand in a way not typically observed in previous economic cycles. Significant restructurings of operations in a number of sectors had the effect of retarding employment and income growth, at least in the short run. And concerns about debt-servicing burdens as well as about economic prospects sustained a reluctance on the part of businesses and consumers to borrow and increase spending.

Despite their cautious planning, some businesses experienced inventory backups in the late summer and fall, necessitating another round of production adjustments. In part, the impact of these adjustments was felt abroad as businesses cut back their imports of foreign goods. However, domestic adjustments were evident as well, and, apart from atypical weather patterns that temporarily increased the demand for electricity, industrial production was flat over the second half of the year. The sluggish pace of activity in the industrial sector was joined by weakness in other parts of the economy, and overall, the nation's real gross domestic product is estimated to have risen a scant 1/4 percent at an annual rate in the fourth quarter of last year. In the labor market, layoffs proliferated once again, and the civilian unemployment rate rose to 7.1 percent at the end of 1991.

The deterioration in both industrial activity and nonfarm employment extended into this year, with factort production down sharply in January and private payrolls edging beneath the low of last April. On the other hand, housing market activity appears to have picked up somewhat since the beginning of the year, and nominal retail sales rose about 1/2 percent in January.

Inflation slowed in 1991, with consumer prices up 3 percent over the year, much less than the 6 percent rise posted during 1990. In part, the slowing in inflation reflected the sharp drop in oil prices early in the year; consumer energy prices in December were 7 1/2 percent below their level at the end of 1990, with the decline concentrated in the first quarter of the year. Food price inflation also moderated considerably, amounting to only 2 percent last year after three years of increases in excess of 5 percent.

Even apart from food and energy, inflation now appears to be on a downward trend. To be sure, there were sizable increases in the CPI excluding food and energy early in the year, as higher federal excise taxes and a pass-through of the sharp rise in energy prices boosted prices for a variety of goods and services. With the subsequent reversal in oil prices and no further major tax hikes, however, price pressures eased visibly beginning in the spring. On balance, the CPI excluding food and energy rose less than 4 percent at an annual rate in the second half of 1991, well below the 5 percent pace of 1990. Labor cost pressures also diminished last year, although substantial increases in health care expenses remained a problem for employers. As measured by the employment cost index, nominal compensation per hour rose about 4 1/2 percent over 1991, somewhat less than the increases recorded in each of the three previous years.

Household Spending--Consumption and

Residential Construction

With household finances adversely affected by job losses and declining real incomes, real consumer spending rose just 1/4 percent over the year, the same as in 1990. At the beginning of the year, consumer purchasing power already had been sapped by the rise in energy prices and by declines in employment. And although the retreat in oil prices then in progress and an improvement in consumer confidence following the end of the Gulf war provided a boost to spending in the spring, the failure of the recovery to take hold and concerns about financial prospects and debt burdens restrained spending in the second half of the year. On balance, real consumer outlays edged down between July and December, retracing part of the rise that had occurred during the spring and early summer.

The weakness in consumer spending over the past year was particularly evident for durable goods. A sharp drop in motor vehicle purchases accounted for much of the overall decline in spending on durables; indeed, the elvel of motor vehicle sales in 1991, at 12 1/4 million units, was the lowest since 1983. Outlays for other durable goods were down slightly over the year, after a 1 1/2 percent decline in 1990. As with tota, spending, purchases of other durables picked up somewhat in the spring and early summer, but then fell in the fourth quarter as consumers retrenched. Spending on nondurable goods also declined last year, with expenditures, especially for apparel, down sharply in the fourth quarter. In contrast, outlays for services continued to trend up at a pace similar to that registered in the two previous years.

The patterns of change among the components of consumer spending--particularly the steep decline in outlays for "big ticket" durable goods--underscore the role of household balance sheet concerns in retraining economic growth last year. Household debt burdens rose substantially during the 1980s, when consumers stepped up spending on motor vehicles and other consumer durables, often financing their purchases with credit. In some parts of the nation, this spending boom spread to residential real estate as well, with the associated borrowing, which was often predicated on expectations of rapidly rising family incomes, adding further to the financing burdens of households. As income growth weakened over the past year and a half, consumers struggled to meet the monthly obligations on their accumulated debt and apparently deferred some discretionary spending in the process. This financial stress also was evidenced by an increase in delinquency rates for consumer and mortgage loans last year to levels comparable to those experienced in the previous two recessions.

A renewed pessimism on the part of households may also have contributed to the reluctance of consumers to step up spending over the latter part of 1991. As noted previously, consumer confidence, which was quite low at the beginning of the year, rose markedly upon the conclusion of the Gulf war. However, as it became apparent that the anticipated recovery in the economy was not materializing and announcements of layoffs resumed, confidence turned down, dropping especially sharply toward the end of the year. In January 1992, the Survey Research Center's index of consumer sentiment at the levels of last winter, while the Conference Board's confidence index was below that seen in the 1981-82 recession. Many analysts observed that consumers appeared to be more apprehensive than normally might be expected, given the broad macroeconomic circumstances--for example, the unemployment rate has remained well below that reached in the early 1980s--suggesting that concerns about longer-run economic prospects may have contributed to the heightened anxiety among households last fall.

After dropping sharply in January, housing starts posted a moderate recovery over the remainder of the year, fueled by a reduction in mortgage rates to their lowest levels since the 1970s. Sales of new and existing single-family homes rose over the year, with the pickup in demand reportedly especially pronounced from first-time buyers. Reflecting the strengthening in demand, the excess supply of unsold new homes diminished, and the pace of single-family housing starts moved above 900,000 units at an annual rate by the fourth quarter, an increase of more than 16 percent from a year earlier. Nevertheless, production was well below that of earlier years, and, despite the upturn in activity, the single-family housing market remains softer than would be expected given recent mortagage rates and the rising number of households of prime homebuying age. Continued lender caution about granting land-acquisition and construction loans reportedly has damped production in some locales. However, given the absence of significant price pressures in the housing market, restraint on the demand for single-family homes, stemming from weak income growth, concerns about employment prospects, and poor conditions for home selling, likely has been a more prominent influence on homebuilding than have supply constraints.

In the multifamily housing market, an excess supply of vacant units and restraints on credit availability continued to depress construction last year. Starts of multifamily units fell about 30 percent over the twelve months of 1991, and the number of starts during the year was the lowest since the 1950s. There have been numerous reports of restrictive lending practices damping activity in this sector. However, vacancy rates for rental units remain exceptionally high--and rents soft--suggesting that in many areas new projects might well be of questionable economic viability. Until market supplies begin to tighten discernibly, activity in this segment of the market is unlikely to show appreciable improvement.

Business Spending--Investment in Inventories

and Fixed Capital

In early 1991, the investment climate was dominated by the effects of the decline in the demand for business output and the jump in energy prices during the second half of 1990. With profit margins down sharply and inventory imbalances emerging in a number of sectors, businesses reduced production and employment substantially between October 1990 and March 1991. Cutbacks in the motor vehicle sector were especially sharp over that period, although output of most other types of goods and materials turned down as well.

By the spring, inventories generally were better aligned with sales, and operating profits, while still low, had turned up. As a result, the improvement in aggregate demand in the second quarter was accompanied by an increase in business output, and industrial production rose an average 0.7 percent per month from April to July. Despite the firming in sales, businesses remained cautious, and inventory levels continued to decline through midyear.

In late summer, however, final demand slackened, and after seven months of decline, business inventories accumulated at a substantial rate from September through December. The rise in inventories was centered in wholesale and retail trade, and inventory-sales ratios there moved into ranges that appeared undesirably high in light of carrying costs and expected sales. A portion of the accumulation appeared to consist of goods ordered from abroad; indeed, a partial reaction to the overhang may have been visible in the sharp drop in nonoil imports in November. Nonetheless, retailers evidently also reduced orders from domestic suppliers, contributing to the sluggish pattern of manufacturing output in the fourth quarter. By January of this year, factory production had dropped back to its level of a year earlier, and the operating rate in industry was back down to levels that, prior to last winter had not been seen since the brief industrial slump of 1986.

Business investment in fixed capital fell 7 percent in real terms over the four quarters of 1991. As is typical during recessions, spending was inhibited by weak profits, a rise in excess capacity, and uncertainty regarding the outlook for sales. However, investment outlays last year also were depressed by a desire on the part of many businesses to reduce debt burdens and by a continued oversupply of office and other commercial space. Even adjusting for cyclical considerations, last year's weak pace of investment appeared to extend the relatively slow rate of capital formation evident for some time. The capital stock in the nonresidential business sector, net of depreciation, has risen about 2 3/4 percent at an annual rate over the past decade--down from 2 3/4 percent annually during the previous decade. In part, this pattern has owed to a shift toward shorter-lived assets--such as computers--that depreciate more quickly. However, such outlays, by generating a relatively high flow of capital services per dollar of investment, have cushioned the impact on productivity of the slowing pace of capital formation. Even so, the quantity of investment, which has also been depressed by large federal budget deficits and the resulting low level of national saving, has been inimical to productivity growth and thus to the advance of living standards.

Real spending for equipment fell 3 1/4 percent over 1991, as outlays plunged in the first quarter and showed only limited improvement on net over the remainder of the year. The strongest area in investment spending was computers, for which real outlays increased more than 40 percent at an annual rate over the second half of the year; these gains were driven by product introductions and by the substantial price cuts offered by computer manufacturers. In contrast, business investment in other types of equipment generally declined, on balance, over the year. Outlays for industrial equipment continued to deteriorate as excess capacity limited expansion in the manufacturing sector, and business purchases of motor vehicle dropped off sharply. In addition, domestic orders for commercial aircraft plunged after midyear as a number of domestic airlines trimmed investment plans. Although the large backlog of unfilled orders that still remains should sustain production and shipments for some time, the slackening in demand indicated by the sharp downturn in aircraft orders suggests that the growth surge in this sector may have run its course.

Nonresidential construction plummeted 15 percent in real tersm over the four quarters of 1991. The contraction was broadly based, but especially large declines in outlays were evident for office buildings and other commercial structures. Despite the sharp cutbacks in construction in recent years, prices of existing commercial properties have continued to fall, contributing to the substantial stress evident in the financial sector. Of course, the fundamental problem is the space overhang from the earlier overbuilding; the vacancy rate for office buildings nationwide was still close to 20 percent at the end of the year. However, a lack of liquidity in this market--in particular, the reluctance of lenders to finance acquisitions of commercial properties--has made the adjustment still more difficult. Such problems are especially acute in the market for office buildings, where appraised values have declined nearly 30 percent since 1985 and where lenders and developers generally have shown little interest in new projects. For other commercial structures--primarily shopping centers and warehouses--the outlook is slightly less downbeat, with the data on new contracts and building permits suggesting that the steepest declines may have already occurred. Spending for industrial structures also generally declined over the year, as low rates of capacity utilization curtailed plans for new factory construction. Petroleum drilling activity, meanwhile, dropped sharply in response to the decline in oil prices.

Federal banking regualtors have taken a number of steps to ensure that supervisory pressures do not unduly restrict real estate lending. The agencies have, for example, addressed issues relating to accounting and appraisal, to make sure that illiquid real estate exposures are evaluated sensibly and consistently. And, they have issued guidance to examiners--and simultaneously to bankers--emphasizing that banks should not be criticized for renewing loans to creditworthy borrowers whose real estate collateral has fallen in value--even when the banks need to build up capital or reduce loan concentrations over time. However, with so adverse a supply-demand imbalance in the property market, lenders understandbly have remained reluctant to bear the risks of real estate exposures.

The Government Sector

Budgetary pressures were widespread in the government secton in 1991. At the federal level, the unified budget deficit increased to $269 billion in fiscal year 1991, up $48 billion from the 1990 deficit. In large part, the rise in the deficit was attributable to the slowdown in economic activity, which reduced tax receipts and increased outlays for income-support programs such as unemployment insurance and food stamps. However, as in 1990, the fiscal 1991 deficit also was affected by special factors: A pickup in net outlays for deposit insurance added to the deficit, while one-time contributions from our allies to defray the costs of Operations Desert Shield and Desert Storm reduced it. Excluding deposit insurance and these foreign contributions, the 1991 deficit totaled $246 billion.

On the revenue side, federal tax receipts rose just 2 percent in fiscla 1991, the smallest increase in many years. The slowing in receipts largely stemmed from weak nominal income growth; indeed, cersonal income tax payments in 1991, which accounted for nearly half of total receipts, were about the same as in 1990 despite changes in tax provisions that were projected to raise $16 billion in new revenues.

Meanwhile, spending rose nearly 6 percent in fiscal 1991. Part of the $71 billion increase in nominal federal outlays reflected the slightly more rapid pace at which the Resolution Trust Corporation resolved insolvent thrift institutions last year. In contrast, outlays were reduced by allied contributions, to the Defense Cooperation Account. These contributions, which are scored as negative outlays in the budget accounts, exceeded the outlays made in 1991 for U.S. involvement in the conflict; the excess will be put toward the replacement of munitions in 1992 and beyond. Excluding deposit insurance and contributions of allies, outlays rose about 9 percent in fiscal 1991. Spending for health programs continued to rise rapidly, elevated by large increases in health care costs and in outlays for the medicaid program. Among other entitlement programs, outlays for social security and other income-support programs, which together account for one-third of total federal spending, rose more than 11 percent in fiscal 1991, reflecting substantial increases in the number of beneficiaries. In contrast, declining interest rates reduced the growth of interest payments on the federal debt. Defense outlays--excluding foreign contributions--were up 5 1/2 percent from fiscal year 1990 to fiscal year 1991, as the additional U.S. outlays for the Persian Gulf conflict were only partially offset by the spending cuts enacted in the 1990 budget agreement and in previous years.

Federal purchases of goods and services, the portion of federal spending that is included directly in GDP, fell 3 1/4 percent in real terms over the four quarters of 1991. Defense purchases jumped sharply early in the year to support operations in the Persian Gulf, but declined substantially over the remainder of the year as the effects of scheduled cuts in defense outlays were augmented by a dropoff in purchases for Desert Storm; on net, defense purchases were down about 4 1/2 percent last year. In contrast, nondefense purchases were up slightly in 1991; increases for law enforcement, space exploration, and health research offset a drawdown in inventories held by the Commodity Credit Corporation.

The fiscal position of state and local governments, which had deteriorated sharply in 1990, remained poor in 1991. The deficit in the combined operating and capital accounts (excluding social insurance funds) narrowed to $34 billion in the third quarter of 1991 from a high of nearly $47 billion in the fourth quarter of 1990; the shrinkage of this deficit represents the first major improvement since 1984, when the state and local budget surplus peaked. Even so, relative to GDP, the deficit still is quite high on a historical basis. The credit quality of state and local government debt also continued to deteriorate last year, as illustrated by the downgrading of the general obligation debt of eight states by one rating agency; most of the rating changes were the direct result of budgetary imbalances.

The poor fiscal position of state and local budgets led to both severe restraints on spending and sizable tax hikes. Overall, real purchases of goods and services edged down over the four quarters of 1991. In nominal terms, total expenditures by these governments were up 4 percent last year, less than one-half the average pace in recent years. Receipts rose an stimated 7 percent over 1991, as numerous jurisdictions imposed a variety of new tax measures and federal aid to state and local governments--especially for medicaid--increased substantially. Nonetheless, many state and local governments continue to report revenue shortfalls and spending overruns for the current fiscal year, setting the stage for another around of budget-balancing measures ahead.

The External Sector

Measured in terms of the other Group of Ten (G-10) currencies, the trade-weighted foreign exchange value of the U.S. dollar appreciated 14 percent, on balance, from December 1990 to July 1991, reversing more than one-half of the decline that had occurred from the middle of 1989 to the end of 1990. In large part, the rise in the dollar over this period reflected the quick end to the Gulf war and expectations of a recovery in the U.S. economy, as well as developments in Eastern Europe that initially weighed on the German mark. However, as the U.S. economic recovery faltered in late summer and market participants viewed further easing actions by the Federal Reserve as

more likely, the dollar again turned down, averaging in December 1991 only about 3 percent above its level in December 1990. The dollar rebounded somewhat in January on market perceptions of a diminished likelihood of an additional easing in U.S. interest rates and expectations that German authorities would not push their interest rates up further.

On a bilateral basis, the dollar rose 19 percent against the mark between December 1990 and July 1991, amid disappointment about the effect of German unification on German inflation and trade. During the second half of last year, German monetary policy tightened, and the dollar gave up much of its previous gains, finishing the year just 4 percent above its December 1990 level. Other currencies in the European Monetary System generally moved with the mark during 1991, although sterling slipped somewhat near year-end. The dollar declined about 4 percent on net against the yen in 1991, as increasing Japanese trade surpluses led to the view that an appreciation of the yen would be welcomed by the authorities.

The merchandise trade deficit narrowed to less than $75 billion in 1991, compared with $108 billion in 1990; the trade deficit last year was the smallest since 1983. An especially large decline in the deficit was registered early in the year, as the drop in oil prices sharply reduced the value of imports. In addition, trade flows during the first half of 1991 were influenced by the weakening of U.S. activity (which reduced demand for imports), by continued growth abroad (which boosted exports), and by the lagged effects of the decline in dollar exchange rates that had taken place in 1990. However, imports rose sharply in the third quarter, and the trade deficit widened somewhat in the second half of the year. The current account balance recorded a small surplus, on average, during the first three quarters of 1991, a sharp improvement from the $92 billion deficit in 1990. However, about half of that improvement resulted from cash grants from foreign governments to support operations in the Persian Gulf; excluding these transfers, the current account showed an average deficit of $48 billion at an annual rate over the first three quarters of 1991. The improvement in the current account (excluding transfers) was somewhat greater than that in the trade balance owing to a strengthening of net service receipts in such areas as travel, education, and professional services.

U.S. merchandise exports grew about 10 percent in real terms over the four quarters of 1991, tempering the production declines associated with the weakness in domestic demand. Exports rose fairly strongly in the second quarter, as high levels of investment in such countries as Germany and Japan boosted exports of computers and other capital equipment. Economic activity in the major foreign industrial countries weakened as the year wore on, however, and with a deterioration in the competitive position of U.S. companies following the appreciation of the dollar over the first half of the year, export growth slowed markedly in the third quarter. Exports surged again in the fourth quarter, led by sales of computers, aircraft, and other capital goods. However, some of the recent increase appears to represent a bunching of sales rather than an increase in economic activity abroad.

Merchandise imports excluding oil grew about 4 percent in real terms during 1991. Imports declined early in the year as weak domestic spending reduced the demand for foreign goods. As domestic demand in the United States turned up in the spring, imports--especially of automotive products, computers, and consumer goods--rose and remained strong through the summer. With the subsequent weakening in demand, however, some of the additional import volume apparently ended up on retailers' shelves. In response, U.S. businesses reduced orders from abroad, and import growth slowed sharply over the fourth quarter. The quantity of oil imports, which had plunged after the sharp rise in oil prices in the fall of 1990, generally moved up through the third quarter as refiners moved to rebuild inventories. However, oil import volumes turned down again in the fourth quarter, reflecting sluggish U.S. activity and unseasonably warm weather.

The sharp reduction in the recorded U.S. current account deficit in the first three quarters of 1991 was mirrored by changes in recorded capital inflows and the statistical discrepancy. The statistical discrepancy in the international accounts, which had jumped to $64 billion in 1990, declined to virtually zero in the first three quarters of 1991.

Inflows of official capital in the first three quarters outflows of private capital in the first three quarters of 1991. Net official inflows amounted to $ 16 billion despite net intervention sales of dollars in foreign exchange markets by the G-10 countries and a drawdown of reserves held in the United States by countries helping to cover the costs of Desert Storm; some countries also financed their contributions by borrowing and liquidating investments in the Euromakets. Net private capital outflows were $18 billion in the first three quarters, largely accounted for by banks. In part, these outflows reflected the increased net demand for funds in the Euromarkets associated with Desert Storm transfers. In addition, the elimination by the Federal Reserve of certain reserve requirements in December 1990 led some U.S. agencies and branches of foreign banks to increase their issuance of large time deposits in the United States and to reduce their reliance on borrowing from abroad.

Securities transactions in the first three quarters of 1991 reflected the continued internationalization of financial markets. Although the net inflow was modest, private foreigners added substantially to their holdings of U.S. stocks and bonds, while U.S. residents bought a large volume of foreign stocks and bonds. Reflecting interest rate developments that encouraged shifting from short- to long-term financing, both issues of foreign bonds in the United States and issues of Eurobonds by U.S. corporations were strong. Capital outflows associated with U.S. direct investment abroad also were sizable, as U.S. investors positioned themselves to take advantage of EC 1992 and participated in the privatization of previously state-owned enterprises in such countries as Mexico. In contrast, foreign direct investment in the United States was far below recent peaks; foreign takeovers of U.S. businesses declined, and reinvested earnings were depressed by the recession.

Labor Markets

Labor market conditions generally deteriorated in 1991, and the unemployment rate rose above 7 percent by the end of the year, the highest level since 1986. Employers had moved quickly to shed workers when the recession took hold during the second half of 1990, and this pattern continued into 1991, with nonfarm payroll employment down sharply over the first four months of the year. Economic conditions improved in the spring, and labor demand turned up for a time. However, the subsequent weakening in activity in the late summer led to a renewed about of layoffs that has continued into early 1992, retracing the job gains recorded during the spring and summer.

The net job losses last year were widespread by industry and reflected both the cyclical weakness in labor demand associated with the recession and more fundamental efforts by many businesses to restructure operations and permanently reduce the size of their worforces. Employment in manufacturing, which began its decline in 1989, feel more than 400,000 over 1991 with most of the losses in the durable goods sector. The continued contraction in commercial building depressed construction employment despite the moderate recovery in residential housing demand. Efforts to restructure existing operations and to downsize workforce levels were evident in the finance, insurance, and real estate sector as well, where job losses last year stood in contrast to the past pattern of continued hiring during recessions. Employment in trade establishments also feel substantially over the year, pushed down by the decline in consumer spending and the high degree of financial distress among retailers. In contrast, employment in services continued to trend up over the latter part of the year, as steady gains in health services more than offset sluggish hiring in the more cyclically sensitive business and personal service industries.

Reflecting the substantial declines in output and employment over the past year and a half, the unemployment rate rose more than 1 1/2 percentage points between July 1990 and December 1991. Moreover, the distribution of job losses was especially wide compared with previous episodes of rising unemployment. Increases in unemployment were broadly based across regions, industries, and occupations, and an unusually large proportion appeared to constitute permanent layoffs.

Nonetheless, the rise in the jobless rates has been less than in prior episodes of increasing unemployment. In part, the rise has been smaller because labor force growth has been unusually slow over the past two years. In particular, the labor force participation rate, which stood at about 66 percent at the beginning of this year, is 1/2 percentage point below its average during the first half of 1990. This decline in participation appears to contain some elements of a cyclical pattern: The number of discouraged workers rose over the year, and sizable increases in the number of retirees were reported, perhaps reflecting to some extent a spate of early retirement programs. However, the weak labor force growth of recent years may also represent a downshift in the trend rate of increase in labor supply that--if not offset by productivity gains--could translate into a reduction in the rate of trend potential output growth. In this regard, the composition of the corresponding increase in nonparticipants is, in part, a favorable long-term development. There has been a sharp rise in recent years in the number of individuals who have left the labor force in order to attend school. Although that increase may, to some degree, reflect declining opportunity costs associated with the poor job prospects of last year, recognition of the long-term decline in relative wages among lower-skilled workers may also have played a role. As these individuals reenter the labor force upon completion of their schooling, their increased skills should boost labor productivity and potential output in future years.

Efforts to increase labor productivity have also intensified in the business community. If the aforementioned plans to reorganize corporate structures and to downsize the labor force requirements of existing operations are successful the possible outcome is a significant improvement in the productivity trend, much as occurred in the manufacturing sector after the considerable compression of manufacturing organizations in the early 1980s. The performance of productivity, which rose about 1 percent for the nonfarm business sector in 1991, has been somewhat better than is typical in a weak economy. However, last year's advance came after a decline in 1989 and no change in 1990, and it is difficult at this stage to distinguish more fundamental changes in productivity trends from the apparent cyclical tendency last year for employers to reduce labor inputs aggressively in response to deteriorating sales.

With widespread layoffs and the unemployment rate rising throughout the year, the upward pressures on wages that had intensified between 1987 and mid-1990 diminished somewhat over 1991. As measured by the employment cost index, increases in hourly compensation for private nonfarm workers rose 4 1/2 percent over the four quarters of 1991, down from more than 5 percent in the first half of 1990. The wage and salary component of hourly compensation, which rose 3 percent at an annual rate over the second half of last year, exhibited the most deceleration. although employer costs for benefits have also decelerated from their mid-1990 peak, increases in benefit costs--at 6 1/4 percent in 1991--remained well above those for wages alone. Expenses for health insurance have continued to spiral upward despite considerable efforts on the part of employers to control costs by negotiating directly with providers and by increasing workers' share of health expenditures. Employer premiums for workers compensation insurance also rose sharply last year, reflecting both a swelling in the number of claims and the rapid pace of inflation of medical care costs.

Price Developments

Evidence that a significant slowing of inflation is under way mounted over 1991. The consumer price index rose 3 percent during the year, about half the rate of increase in 1990. A sharp swing in energy prices accounted for a major part of this deceleration. However, the elements of a more fundamental diminution of inflation moved into place: Labor cost increases moderated; expectations of inflation eased; and upward rpessures from import prices and industrial raw material prices were virtually absent during the year.

Energy prices dropped sharply in 1991, mirroring the changes in oil prices over the year. The CPI for energy fell 30 percent at an annual rate in the first quarter of last year, as the sequence of events in the Middle East reduced the posted price of West Texas Intermediate crude oil from a peak of about $39 per barrel in October of 1990 to less than $20 by February of last year. Oil prices subsequently held near that level, but gasoline prices firmed somewhat during the summer as reduced imports and domestic refinery problems led to some tightness in inventories. However, these forces were offset by declines in natural gas and electricity rates, and energy prices changed little, on balance, in the second and third quarters. PRice pressures again emerged in the fall as crude oil prices trended up in September and October on concerns about supplies from the Soviet Union. Since October, however, oil prices have retreated again, with the most recent quotes at about $18 per barrel. These latest reductions probably will show up at the retail level in the first quarter of 1992; indeed, the energy component of the producer price index fell nearly 3 percent in January, and other preliminary information points to sizable declines in both retail gasoline and heating oil prices.

The CPI for food rose just 2 percent over 1991, well below the increases of 5 percent to 5 1/2 percent in the three previous years. In part, the subdued pace of food price inflation reflects an increased supply of livestock products. Beef production turned up last year in response to the strong prices that prevailed in the preceding few years, and supplies of pork and poultry rose sharply; in response, meat and poultry prices fell about 2 percent over the year. The deceleration in food prices also extended to food groups whose prices are influenced more by the cost of nonfarm inpits than by supply conditions in agriculture; for example, the increase in the price of food away from home last year was the smallest since 1964. Elsewhere, there were large monthly variations in prices for fruits and vegetables, as adverse weather conditions temporarily boosted prices in the first half of the year and prices for some fresh vegetables jumped toward the end of the year because of the whitefly infestation in California.

The consumer price index for items other than food and energy rose 4 1/2 percent in 1991, about 3/4 percentage point less than in 1990. The index was boosted early in the year by increases in federal excise taxes on cigarettes and alcoholic beverages and by an increase in postal rates. Price increases last winter also were enlarged by the pass-through of the rise in energy prices to a wide range of nonenergy goods and services. However, the subsequent decline in energy prices soon spread to the nonenergy sector, and except for an uptick during the summer associated with some bunching of price increases, this measure of core inflation moderated significantly over the remainder of the year.

Prices for nonenergy services decelerated considerably last year, rising 4 1/2 percent after an increase of 6 percent in 1990. Reflecting weak real estate markets, rent increases slowed sharply, with both tenants' rent and owners' equivalent rent up less than 4 percent last year. The drop in interest rates pushed down auto financing costs more than 7 percent. And, after a brief spurt early in the year, airfares receded as energy costs fell and the weak economy cut into demand; more recently, however, airfares have turned up again as carriers have reduced the availability of and increased restrictions on low-end "super-saver" fares. In contrast, prices for medical care services rose 8 percent over the year, while tuition costs and other school fees were up nearly 10 percent.

The CPI for commodities excluding food and energy rose 4 percent in 1991, about 1/2 percentage point faster than in 1990. In large part, the more rapid rate of inflation in goods prices reflected the aforementioned hike in excise taxes and, despite weak sales, larger increases in prices for both new and used cars. However, a slowing in price increases was evident for a number of other goods, notably apparel, household paper products, and personal care items.

The easing of inflationary pressures has been even more evidence at earlier stages of processing. The producer price i ndex for finished goods edged down over 1991 after an average 5 percent annual rate of increase over the three preceding years; this index posted another small decline in January of this year. Falling prices for energy and consumer foods accounted for much of the overall deceleration last year. Even apart from food and energy, however, producer prices slowed to a 3 percent pace. Prices for intermediate materials excluding food and energy declined 3/4 percent over the year, reflecting declining fuel and petroleum feedstock costs, an easing of wage pressures, and weak demand. The downturn in economic activity also depressed industrial commodity markets last year. After dropping sharply in the fourth quarter of 1990, spot prices for these commodities continued to decline gradually over most of 1991.

MONETARY AND FINANCIAL DEVELOPMENTS

IN 1991

The principal objective of monetary policy this past year has been to help lay the groundwork for a sustainable expansion without sacrificing the progress against inflation that had already been set in motion. The Federal Reserve progressively eased money market conditions in 1991 amid signs of continued slujggish economic activity, weak growth in the broader monetary and credit aggregates and diminishing inflationary pressures. A more generous provision of reserves through open market operations, coupled with five separate reductions in the discount rate--which now stands at its lowest level in nearly 30 years--brought the federal funds rate and most other short-term interest rates down about 3 percentage points over the course of the year. These actions, building on earlier easing efforts, pushed the federal funds rate down to 4 percent, its lowest sustained level since the 1960s and nearly 6 percentage points below its most recent peak in the spring of 1989.

The faltering of the economic recovery in the second half of 1991 owed in part to an unusually cautious approach to credit on the part of both borrowers and lenders. Efforts by debt-burdened households and businesses to pare debt in order to strengthen balance sheets that had been strained by the general slowdown in income and by declines in property values exerted further damping effects on credit demands and on aggregate spending. Faced with deteriorating asset values and pressures on capital positions, depositories and other lenders maintained tighter lending standards and were somewhat hesitant to extend credit. The more circumspect attitude toward credit and spending on the part of borrowers and financial intermediaries was manifest in the behavior of the aggregate debt of domestic nonfinancial sectors, which grew near the bottom of the Federal Open Market Committee's monitoring range despite burgeoning U.S. Treasury borrowing. Not only was overall credit growth subdued, but credit flows continued to be rechanneled away from depositories, reflecting the more restrictive lending standards at banks and thrifts as well as efforts by borrowers to make greater use of longer-term debt and equity in order to strengthen their balance sheets. Partly as a result, the monetary aggregates M2 and M3 also finished the year near the bottoms of their target ranges.

To prevent these forces from stifling the recovery, the Federal Reserve eased money market conditions aggressively in the latter part of the year. In light of weak aggregate demand and reduced inflationary potential, long-term interest rates--which had largely failed to respond to monetary easings earlier in the year--came down substantially toward the end of 1991. This decline prompted a flood of mortgage refinancings and additional corporate and municipal bond offerings, which helped reduce the financing burdens of nonfederal sectors. Lower interest rates also contributed to a major stock market rally, which induced firms to boost equity issuance and pay down debt, partially reversing the trend of the 1980s toward increased leverage that had severely stretched corporate balance sheets.

On the whole, the nation made considerable progress in strengthening its balance sheet in 1991. Less reliance on debt, greater use of equity, and lower financing costs have helped ease debt-servicing burdens for many financially troubled households and corporations. Although to date the trend toward deleveraging has exerted a restraining effect on aggregate spending, over time this trend should help put consumers, firms, and financial intermediaries on a sounder financial footing, paving the way for healthy, sustainable economic growth.

The Implementation of Monetary Policy

The Federal Reserve eased money market conditions several times in the first few months of 1991, extending the series of easing moves initiated in the latter stages of 1990. Against a backdrop of further declines in economic activity, abating price pressures, weakness in the monetary aggregates early in the year, and continuing credit restraint by banks and other financial intermediaries, a more expansive open market posture was adopted, in conjunction with two 1/2 percentage point reductions in the discount rate, to engender a 125 basis point decline in the federal funds rate over the first four months of the year. Short-term Treasury rates generally followed suit, and banks reduced the prime rate in three 50 basis point increments to 8 1/2 percent.

Long-term interest rates, by contrast, were roughly unchanged on balance over the first few months of the year. At first, these rates fell somewhat in response to the continued downturn in economic activity and declining energy prices, especially in light of initial successes in the Gulf war that ensured an unimpeded flow of oil. Success in the initial phases of the war also prompted a brief dip in the exchange value of the dollar, as safehaven demands that had been propping up the dollar's value in the face of falling interest rates in the United States dissipated.

In March, bond yields drifted up on the post-war rebound in consumer confidence and other evidence, particularly from the housing industry, that an economic upturn was at hand. The improving outlook for recovery also contributed to narrowing risk premiums on private securities, especially on

below-investment-grade issues, which had reached very high levels in January. The debt and equity instruments of banks performed especially well over this period, responding to lower short-term interest rates and the likelihood that an economic rebound would help limit the deterioration in their loan portfolios. Moderate official support for the dollar, better prospects for a U.S. economic recovery, and a rise in U.S. long-term interest rates relative to those abroad, together with an uncertain economic and political situation overseas, especially in the Soviet Union, helped to reverse the dollar's slide on foreign exchange markets.

As evidence of a nascent economic recovery cumulated through the remainder of the spring and into early summer, interest rates and the dollar continued to firms, and quality spreads narrowed further. Although the increases in rates during this period were most pronounced at the long end of the maturity spectrum, short-term rates backed up a bit as well as prospects for additional monetary easings faded. Indeed, with the pace of economic activity apparently quickening, and with the broader monetary aggreages near the middles of their target ranges, the Federal Reserve held money market conditions steady, as the stimulus already in train seemed sufficient to support an upturn in aggregate spending.

As the summer passed, however, the strength and durability of the recovery appeared less assured. Aggregate spending, production, and employment began to falter, easing wage and price pressures. In addition, the broader monetary aggregates suddenly weakened dramatically, with M2 coming to a virtual standstill and M3 actually declining in the third quarter. The softness in the aggregates was symptomatic of a warier approach to spending and borrowing on the part of households and corporations, whose balance sheet problems were excerbated by the stagnant economy. In addition, credit standards at financial intermediaries remained restrictive, and spreads between loan and deposit rates remained high by historical standards, reinforcing households' inclinations to pay down debt rather than to accumulate assets.

To help ensure that these forces did not imperil the recovery, the Federal Reserve moved to ease money market conditions further during the latter part of the year. Pressures on reserve positions were reduced slightly in August and again in September, with the latter move accompanied by a 50 basis point reduction in the discount rate. With the economic climate remaining stagnant, price pressures subdued, and the broader monetary aggregates still mired near the bottoms of their target ranges, the System's easing moves became more aggressive in the fourth quarter, culminating in a full 1 percentage point reduction in the discount rate on December 20. All told, these moves combined to drive the federal funds rate down from 5 3/4 percent in July to 4 percent by year-end. Most other short-term interest rates declined by similar magnitudes, and the prime rate was reduced by 2 percentage points, to 6 1/2 percent.

The decline in short-term interest rates, in combination with flagging economic activity, depressed credit demands, and prospects for lower inflation, contributed to bringing long-term interest rates down significantly in the latter part of 1991. The thirty-year Treasury bond rate dropped about a percentage point over the second half of the year, and mortgage interest rates tumbled to their lowest levels in many years. Declining interest rates prompted a spate of mortgage refinancings, corporate and municipal bond offerings, and a major stock market rally, which propelled most indexes to record highs. Although monetary growth bounced back a bit in the fourth quarter, both M2 and M3 remained near the lower ends of their respective growth cones. The dollar, which had begun to lose ground in foreign exchange markets in the summer--when the weakness in money and credit raised the specter of additional easings of U.S. monetary policy--depreciated further in the fourth quarter as the economic situation deteriorated and the pace of policy easings quickened. Rising interest rates in Germany also put downward pressure on the foreign exchange value of the dollar. In January 1992, the dollar rebounded somewhat, reflecting an emerging view that interest rate declines in the United States and interest rate increases in Germany might have come to an end. The former view was also reflected in the U.S. bond market, where rates retraced a portion of their earlier declines, partly on brightening prospects for the U.S. economy but also on concerns that impending fiscal stimulus may increase federal government demands on credit markets.

Monetary and Credit Flows

Patterns of credit usage and financial intermediation, which began to shift even before the onset of the economic downturn, continued to evolve in 1991, distorting traditional relationships between overall economic actibity and the monetary and credit aggregates.

These changes were evident in the behavior of the aggregate debt of nonfinancial sectors, which expanded 4 3/4 percent in 1991, leaving this aggregate near the bottom of its monitoring range. Robust growth in federal government debt, owing to the economic downturn and to additional outlays for federal deposit insurance, masked an even weaker picture for nonfederal debt. Households, nonfinancial corporations, and state and local governments accumulated debt at an anemic 2 3/4 percent rate in 1991, the slowest advance in decades and below even the sluggish growth rate of nominal GDP.

The small rise in nonfederal debt velocity last year runs counter to the pattern seen in the 1980s, when the accumulation of debt vastly outstripped growth in nominal GDP. The rapid buildup of debt in the 1980s was likely a result of the deregulation of interest rates and financial innovations, which combined to lower the cost of borrowing to households and businesses, spawning a surge in leveraging activity. Greater debt burdens may also have been accumulated under the assumption that nominal

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income growth would be sustained at the elevated pace of the mid-1980s and that the prices of assets purchased with credit would continue to climb.

In recent years, however, asset values and income growth have fallen short of these expectations. In particular, depressed commercial and residential real estate values, coupled with slower income growth, have eroded the net worth of some borrowers and severely strained the ability of highly leveraged households and corporations to service debt. These difficulties, in turn, have fed back on to the strength of the financial intermediaries that extended the credit. In an effort to bolster depleted capital positions, reduce financing burdens, and shore up weakened balance sheets, both borrowers and lenders have adopted a more chary attitude toward additional credit.

This more cautious approach to leverage has interacted with the sluggish pace of economic activity to restrain borrowing across nearly all sectors of the economy. Nonfinancial business sector debt, held in check by the decline in financing needs associated with weak aggregate demand and by efforts of debt-laden firms to restructure their balance sheets, grew only 1/2 percent in 1991. Taking advantage of a buoyant stock market, particularly in the latter part of the year, corporations turned to equity financing; net equity issuance for the year was positive for the first time since 1983, and the ratio of the book value of nonfinancial corporate debt to equity, which had soared in the 1980s amid a flurry of corporate restructurings, actually turned down in 991. Firms also took advantage of lower interest rates to refinance higher-rate long-term bonds and to reduce uncertainty about their future financing burdens by substituting long-term debt for short-term borrowing. Overall, the mixture of less debt, more equity, and lower interest rates had a salubrious effect on the financial positions of many firms. Indeed, the ratio of interest payments to cash flow for all nonfinancial firms declined in 1991, reversing some of the runup seen in the late 1980s. Consistent with an improving financial picture and prospects of an economic rebound, quality spreads on corporate issues narrowed considerably from their peaks in early 1991, especially on below-investment-grade securities. In addition, downgradings of corporate bonds dropped sharply in the third and fourth quarters, although they still ran higher than the pace of upgrades.

Deleveraging was also evident in the household sector in 1991. Consumer credit declined as households reined in expenditures, curbed their accumulation of financial assets, and pared existing debt burdens. Households took advantage of declining interest rates, particularly in the fourth quarter, by refinancing outstanding mortgages; they also substituted home equity loans for installment debt and other consumer credit, which carry higher financing costs and are no longer tax deductible. By reducing their net accumulation of debt and refinancing a substantial volume of their remaining borrowings at lower rates, households were able to ease their financing burdens, reducing the ratio of scheduled debt payments to disposable personal income, which had risen sharply in the 1980s. Even so, loan delinquency rates rose through much of 1991, albeit to levels not out of line with what was seen in previous cyclical downturns. On the other side of the ledger, many households that had net creditor positions saw their interest incomes decline last year.

Faced with intensifying budgetary pressures and numerous downgradings, state and local governments also put only limited net demands on credit markets in 1991. The outstanding debt of this sector grew but 3 percent last year, the smallest increase in more than a decade. Gross issuance of municipal bonds was substantial, however, as states and localities moved to refinance debt at lower rates.

Efforts by borrowers to restructure balance sheets by substituting long-term debt and equity for short-term borrowing, along with more restrictive credit standards by some lenders and the closing and shrinkage of troubled thrifts, have affected the channels through which debt flows. In particular, in recent years there has been a major rerouting of credit flows away from depository institutions. The decline in the importance of depositories, when measured by the credit they book relative to the total debt of nonfinancial sectors, has been striking, and this trend was extended in 1991. Not only did the thrift industry continue to contract, as the direct result of RTC resolutions as well as the retrenchment of marginally capitalized institutions, but commercial banks cut back on their net credit extentions. Indeed, bank credit increased only 4 percent, not even enough to offset the continued runoff at thrifts. Weakness was particularly evident in bank lending, which shrank 1/4 percent last year; banks' holdings of government securities, by contrast, expanded at a rapid clip.

Although the shifting composition of bank asset flows in 1991 was reminiscent of patterns seen in previous periods of languid economic activity, the magnitude of the downturn in loan growth last year was more pronounced than the usual experience. Apparently, loan growth was depressed not only by reduced credit demands, but also by a more restrained bank lending posture. Faced with deterioration in the quality of their assets, higher deposit insurance premiums, and more stringent requirements for capital, banks retrenched, adopting a more cautious attitude regarding credit extensions. Concerns about capital, especially in light of rising loan delinquency rates and mounting loan loss provisions, induced many banks to continue tightening lending standards through the early part of 1991 and to maintain fairly restrictive standards over the balance of the year.

A more prudent approach to capitalization and lending decisions is, in the main, a positive development that ultimately will result in strengthened balance sheets for the nation's depositories. Reflecting this improved outlook, prices of outstanding bank debt and equity increased markedly from their lows in late 1990 and early 1991, outperforming broader market indexes. Bank profits, benefitting from wide spreads between loan rates and deposit rates, also showed improvement relative to the depressed levels of recent years, although they remained low by broader historical standards.

To date, depository retrenchment appears to have had some restraining effects on aggregate borrowing. Of course, in some areas, much of the credit formerly extended by banks and thrifts has been supplanted by other intermediaries and by credit advanced directly through securities markets, at little if any additional cost to borrowers. For example, growing markets for securitized loans largely have filled the vacuum created by depository restraint in the areas of residential mortgage and consumer lending. Similarly, many large businesses have turned to stock and bond markets to meet credit needs and to restructure balance sheets, reducing their reliance on banks as well. Both banks and thrifts have cut back on other types of lending that can less easily be rechanneled, however, including construction and nonresidential real estate loans, loans to highly leveraged and lower-rated borrowers, and loans to small and medium-sized businesses. Other financial intermediaries, including life insurance companies, have been afflicted by some of the same balance sheet problems plaguing depositories and have also curbed their lending to these sectors. As a result of the pullback inc redit supplies, these borrowers now face somewhat more stringent borrowing terms.

As in 1990, the retrenchment of banks and thrifts and the associated redirection of credit flows away from depositories continued in 1991 to have profound effects on the broad monetary aggregates and their traditional relationships with aggregate economic activity. M3, which comprises most of the liabilities used by banks and thrifts to fund credit expansion, has been most affected by the reduced importance of depository credit in funding spending. The velocity of this aggregate, which declined through much of the 1980s, has trended up in recent years; this trend continued in 1991, as M3 rose only 1 1/4 percent, well below the pace of nominal GDP, leaving this aggregate near the bottom of its target range.

In the first few months of the year, M3 showed surprising strength, boosted in part by a firming of its M2 component, which benefited from declining interest rates. The most important single factor contributing to strong M3 growth in the early part of 1991, however, was the rebirth of the market for "Yankee CDs"--large time deposits issued by foreign banks in the United States. After the 3 percent reserve requirement against nonpersonal time deposits and net Euroborrowings was lifted at the end of 1990, foreign banks showed a distinct preference for funding with such instruments, rather than borrowing from their overseas affiliates or in the federal funds or repurchase agreement markets. Domestic depositories, by contrast, faced with high and rising U.S. deposit insurance premiums, exhibited no inclination to alter their funding strategies in favor of large time deposits.

The surge in Yankee CD issuance, which totaled nearly $40 billion over the first quarter, began to taper off a bit as the year progressed, revealing the underlying weakness in M3. After slowing somewhat in the second quarter, this aggregate contracted at a 1 1/4 percent annual rate in the third quarter, reflecting feeble loan demand in a tepid economy as well as the restructuring of depositories. The Resolution Trust Corporation played a direct role in damping M3 growth by taking assets formerly held by thrifts and funded with M3 deposits onto its own books and financing them with Treasury securities. Although M3 rebounded a bit in the fourth quarter, in line with some firming of bank credit, its growth remained subdued.

The effects of depository restructuring on M2 remain imperfectly understood. In the past, the velocity of M2 has tended to move in tandem with changes in a simple measure of the opportunity cost of holding this aggregate--that is, with changes in the returns on alternative short-term investments relative to those available on assets included in M2. Typically, when the opportunity cost of holding M2 declines as decreases in money market interest rates outpace drops in yields on deposits, holdings of M2 strengthen relative to expenditures--and velocity drops. In recent years, however, this relationship appears to have broken down, with the velocity of M2 holding up despite a steep, persistent drop in this measure of opportunity cost. This was particularly evident in 1991, when M2 expanded at about the same pace as nominal GDP despite a significant decline in such opportunity costs. M2 finished the year near the bottom of its target range and much weaker than would be expected on the basis of historical relationship among income, interest rates, and the public's appetite for monetary assets.

In the early months of the year, M2 growth accelerated somewhat from its lackluster pace of late 1990. Narrowing opportunity costs generated substantial inflows to liquid deposits, particularly those in M1, which more than offset continued runoff in small CDs. Money growth also was temporarily boosted by strong foreign demands for U.S. currency as a safe haven during the crisis in the Persian Gulf. Through May, M2 growth remained broadly consistent with the general configuration of opportunity costs and income, and near the middle of its target range.

M2 began to slow in June, however, and stalled in the third quarter, despite expansion in nominal income and further declines in opportunity costs. Growth in this aggregate resumed in the following quartert, fueled by a surge in transactions deposits owing to additional declines in opportunity costs, but inflows to M2 remained fairly weak, and this aggregate ended the year only a little above the bottom of its target range.

Although the unusual behavior of M2 relative to income and opportunity costs has not been fully explained, it surely is related to the restructuring of financial flows and to the downsizing of the banking system. With inflows of M2 deposits apparently tending to be more than sufficient to fund weak depository credit growth, banks and thrifts seem to have pursued additional retail deposits less aggressively than in the past. Although rates offered in these deposits did not, until very recently, fall unusually rapidly in response to declining market interest rates, depositories seem to have acted in other ways to reduce the cost of funds, including adjustments in advertising and marketing strategies that would not show up in traditional measures of opportunity costs. In addition, by keeping deposit rates very low relative to loan rates, partly in an attempt to bolster profit margins while shrinking their balance sheets, depositories provided households with a greater incentive to finance spending by holding down the accumulation of M2 assets rather than by taking on new debt. This incentive likely reinforced the impetus to borrowing restraint stemming from household concerns about their own balance sheets.

The slowdown in M2 growth, particularly in the third quarter, also appears to have been related to the configuration of returns of financial assets. Yields on small time deposits and money market mutual funds largely tracked the downward path of market interest rates, falling to their lowest levels since the deregulation of deposit rates and prompting significant outflows from these components of M2. Although some of these funds shifted into the liquid deposit components of M2--whose offering rates responded slowly, as they normally do, to the declines in market interest rates--a portion of these funds appear to have left the aggregate. The primary lure seems to have been the stock and bond markets, which offered higher returns, in part because of the steep upward slope of the yield curve. Indeed, inflows to stock and bond mutual funds were robust throughout 1991, and especially since midyear, when investors seemed particularly intent on reaching for higher yields by lengthening the maturity of their portfolios. Depositories, faced with weak loan demand and pressures on capital positions, seemed disinclined to compete aggressively for these funds by offering competitive rates on longer-term CDs.

The rapid pace of activity by the Resolution Trust Corporation also likely depressed M2 growth in the third quarter, as it did throughout the year. The abrogation of existing retail CD contracts and the disruption of long-standing depositor relationships often attending resolutions of failed thrift institutions may have encouraged investors to reshape their portfolios, substituting nonmonetary financial assets for M2 deposits.

Despite sluggish income growth, M1 expanded 8 percent in 1991, the swiftest advance since 1986. Unlike M2, this aggregate has responded to declining market interest rates about as would be expected given historical relationships. M1 was boosted by large inflows to NOW accounts, whose offering rates responded very slowly, until the end of the year, to declining market interest rates. Falling rates also brought new life to demand deposits, as compensating balances to pay for bank services surged. Demand deposits likely benefited as well from the pickup in mortgage refinancings, because the proceeds from mortgage prepayments are sometimes housed temporarily in demand accounts. Rapid growth in currency, owing in part to continued strong foreign demands, also contributed to the strength in M1, as well as in the monetary base, which increased 8 1/4 percent last year.
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Publication:Federal Reserve Bulletin
Date:Apr 1, 1992
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