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Monetary policy report to the Congress.

Report submitted to the Congress on July 20, 1993, pursuant to the Full Employment and Balanced Growth Act of 1978(1)


In February, when the Federal Reserve prepared its monetary policy plans for 1993, the broad trends in the economy appeared favorable. After a hesitant beginning, the economic expansion had picked up steam in the latter part of 1992, while inflation seemed still to be headed downward. Most members of the Federal Open Market Committee and nonvoting presidents anticipated that 1993 would be a good year for growth and would also see further progress toward price stability.

As the year has unfolded, however, the economy's performance has fallen short of these expectations. Economic growth has slowed appreciably from the pace late last year; in part, this has reflected a retreat in business and consumer confidence and the effects on our trade balance of weakness in a number of other industrial countries. Like most private forecasters, the Board members and Bank presidents generally have trimmed their projections of growth in real gross domestic product for the year as a whole, although they continue to foresee increases in output large enough to extend the reduction in the unemployment rate that began last summer. Events on the price side also have been disappointing. The inflation rate in the first part of this year was higher than in late 1992. There is evidence that some of the pickup in the consumer price index may have reflected difficulties in seasonal adjustment, and price data for the past couple of months have been much more favorable. Nonetheless, a broad array of indicators points to a leveling out of the underlying inflation trend.

In this circumstance, and with short-term interest rates unusually low, especially when compared with inflation, the Federal Reserve recognized a need to be alert to the possibility that the balance of risks in the economy could shift soon in a direction dictating some firming of policy; failure to act in a timely manner could lead to a buildup of inflationary pressures, to adverse reactions in financial markets, and ultimately to the disruption of the growth process. To this point, however, the moderate thrust of aggregate demand and considerable slack in the economy, taken together with the more subdued price data of late, do not suggest that a sustained upswing in inflation is at hand. Accordingly, the Federal Reserve has not adjusted its monetary policy instruments.

The pace of economic growth in the final quarter of 1992 was not expected to be sustained, but the slowing in the first quarter of 1993 was surprisingly sharp. With the exception of business fixed investment, the slowdown cut across the major categories of final demand. After stepping up their spending in late 1992, consumers became more pessimistic about their economic prospects and more cautious in their spending decisions; the uncertainty surrounding the efforts to reduce the federal deficit may have been a factor in the weakening of household sentiment.. Housing activity, which also had been exceptionally strong late last year, hit a lull--even before the March blizzard on the East Coast--and real defense purchases plunged. Moreover, net exports deteriorated sharply, as exports declined and imports surged; the drop in exports was attributable in part to continued weak growth in some other industrial countries and in part was an adjustment to the big increase in late 1992.

The more recent statistical indicators, taken together, point to a resumption of moderate growth in real GDP in the second quarter. Most notably, on the positive side, the increase in aggregate hours worked for the quarter as a whole--a useful indicator of movements in overall output--was the largest of the current expansion. Sales of motor vehicles also exhibited considerable vigor. But other key indicators were less robust. In particular, after allowing for the effects of the blizzard, consumer spending on items other than motor vehicles was lackluster, and housing activity improved only modestly. In the manufacturing sector, orders generally remained soft, and factory output, after having posted solid gains over the preceding seven months, is estimated to have declined somewhat over May and June.

Broad measures of inflation picked up in early 1993, with monthly increases through April in the upper part of the range of the past couple of years. Although readings on consumer and producer prices were much more favorable in May and June, the cumulative price and wage data for the year to date suggest that underlying inflation has flattened out, after having trended down over the preceding two years. Excluding the especially volatile food and energy components, the twelve-month change in the CPI has held in the range of 3 1/4 to 3 1/2 percent since the summer of 1992.

In financial markets, short-term interest rates have changed little so far in 1993, while intermediate and long-term interest rates have fallen 3/4 to 1 percentage point, reaching their lowest levels in more than twenty years. The decline in longer-term rates seems largely to have been a response to the enhanced prospects for credible fiscal restraint, though the slower pace of economic expansion may also have played a role. Falling interest rates have helped stock market indexes set new records. Despite a decline in the dollar versus the yen, the average value of the dollar on a trade-weighted basis relative to G-10 currencies has risen, on balance, since the end of 1992. Although foreign intermediate-term interest rates have been down, on average, about as much as U.S. interest rates, short-term rates abroad have decreased substantially relative to U.S. rates, as foreign monetary authorities have taken steps to bolster weak economies.

Declining U.S. market interest rates contributed to robust growth in narrow measures of money and in reserves over the first half of the year, but broad monetary aggregates were very weak and their velocities continued to show exceptional increases. Credit demands on depositories remained quite subdued relative to spending, considerable depository credit was funded from nonmonetary sources, and savers continued to demonstrate a marked preference for capital market instruments over money stock assets.

In part because of the drop in bond and stock yields, as well as the desire to strengthen balance sheets, corporate borrowers have continued to concentrate credit demands on long-term securities markets, using the proceeds in part to repay bank loans; business loans at banks have not grown this year, although there were tentative signs of a pickup over May and June. Total lending and credit growth at banks has risen only slightly from the depressed pace of 1992, and these institutions have therefore not needed to pursue deposits. Thrifts have continued to contract but at a much slower pace than in recent years.

Banks have eased lending standards for smaller firms for several quarters, and they recently relaxed standards for medium- and large-sized firms as well. An increased willingness to lend on the part of banks has been associated with considerably more comfortable capital positions. Banks have continued to strengthen their balance sheets by issuing large volumes of equity and subordinated debt while retaining a substantial amount of earnings. As a result, the portion of the industry that is well-capitalized (taking account of supervisory ratings as well as capital ratios) increased from about one-third at the end of 1991 to more than two-thirds by March 1993.

In turning to equity and other nondeposit funds, banks have reduced the share of depository credit that is financed by monetary liabilities. Depositors, for their part, have continued to shift funds into capital markets, attracted by still-high returns in these markets relative to earnings on deposits. Inflows into bond and equity mutual funds have run at record levels this year, and banks have facilitated investing in mutual fund products by increasingly offering them in their lobbies. As a consequence of these various forces, M2 increased at only a 3/4 percent annual rate from its fourth-quarter 1992 average through June, while M3 fell slightly. The sum of M2 and estimated household holdings of long-term mutual funds grew at about a 4 3/4 percent rate from the fourth quarter through June, a pace little changed from that of recent years.

Debt growth has edged up this year, despite a deceleration in nominal spending, perhaps buoyed by improvements in financial positions achieved over the past few years by both borrowers and lenders. Investment outlays are estimated to have exceeded the internal funds of corporations for the first time in two years, while household borrowing has picked up relative to spending. In addition, Treasury financing needs have remained heavy. Nevertheless, nonfinancial debt has grown at only a 5 percent rate this year.

Monetary Objectives for 1993 and 1994

In reviewing the annual ranges for the monetary aggregates in 1993, the Federal Open Market Committee (FOMC) noted that the relationship of broadly defined money to income has continued to depart from historical patterns. The annual velocities of these aggregates last fell in 1986, and their prolonged upward movements since then strongly suggest breaks from previous long-run trends of flat velocity for M2 and slowly decreasing velocity for M3. The rise in the velocity measures has been particularly surprising in the last four years, a period of declining interest rates, normally associated with a reduction in velocity.

In February, anticipating that further balance sheet restructuring and portfolio shifts from deposits to mutual funds would result in further increases in velocity, the FOMC lowered the 1993 growth ranges for M2 and M3 by 1/2 percentage point from the provisional ranges set in July 1992. In fact, velocities of the broad monetary aggregates have been especially strong; in the first quarter of 1993, the velocities of M2 and M3 posted substantial increases of 6 1/4 percent and 8 percent, respectively, and appear to have recorded additional, but smaller, gains in the second quarter. As a consequence, at its meeting this month, the Committee reduced the 1993 range for M2 by an additional percentage point and the range for M3 by another 1/2 percentage point, leaving them at 1 to 5 percent for M2 and 0 to 4 percent for M3.

The reductions of these growth ranges represented further technical adjustments in response to actual and anticipated increases in velocity and not a shift in monetary policy, which remains focused on fostering sustainable economic expansion while making continued progress toward price stability. With further substantial increases in velocities, continued sluggish expansion of M2 and M3, which are now at the lower ends of their revised ranges, would be consistent with an acceptable track for the economy. Also at the July meeting, the annual monitoring range for the domestic nonfinancial debt aggregate was reduced by 1/2 percentage point, to 4 to 8 percent; growth in this aggregate is likely to continue to be roughly in line with that of nominal GDP.

Although the future behavior of the velocities of broad money aggregates was recognized to be difficult to predict with precision at a time of ongoing structural changes in the financial sector, it appeared likely that the forces contributing to the unusual strength in velocities would continue for some time, and the FOMC carried forward the revised 1993 ranges for the monetary and debt aggregates to 1994 as well. With considerable uncertainty persisting about the relationship of the monetary aggregates to spending, the behavior of the aggregates relative to their annual ranges will likely be of limited use in guiding policy over the next eighteen months, and the Federal Reserve will continue to utilize a broad range of financial and economic indicators in assessing its policy stance.

Economic Projections for 1993 and 1994

The members of the Board of Governors and the Reserve Bank presidents, all of whom participate in the deliberations of the FOMC, generally anticipate that economic activity will strengthen in the second half of 1993 and continue to expand moderately in 1994. The growth of output is likely to be accompanied by further gains in productivity, but increases in employment are projected to be large enough to keep the unemployment rate moving down. Inflation is not expected to change materially over this period.

The economic growth forecasted by the Board members and Reserve Bank presidents for 1993 is somewhat weaker than that forecasted in February, mainly because of the shortfall in real growth in the first quarter. Most expect output gains over the balance of the year to be large enough to result in a four-quarter change in real gross domestic product in the range of 2 1/4 percent to 2 3/4 percent; for 1994, the central tendency of the forecasts spans a range of 2 1/2 to 3 1/4 percent. The civilian unemployment rate, which averaged 7 percent in the second quarter of 1993, is projected to fall to the area of 6 3/4 percent by the fourth quarter of this year and to drop slightly further over the course of 1994.

Recent developments in the financial sphere should be conducive to the sustained increases in spending projected for the quarters ahead. The financial positions of many households and businesses have continued to improve, and banks are showing signs of greater willingness to make loans. Short-term interest rates are relatively low, and the appreciable declines in long-term interest rates over the past several months should further the process of balance sheet adjustment and are anticipated to provide considerable impetus to business investment and residential construction. It is likely that business investment also will continue to be bolstered by the ongoing push to improve products and boost efficiency through the use of state-of-the-art equipment. Moreover, with at least a moderate pickup in average growth in foreign industrial countries, the external sector should be exerting a less negative influence on economic activity in the United States.

Despite the improvement in financial conditions, there are reasons to be cautious about the near-term outlook. Efforts this year to bring the federal budget deficit under control already have helped to ease pressures on long-term interest rates, and a successful agreement to reduce deficits significantly will produce substantial benefits over the longer run. But such actions also are expected to exert some restraint on aggregate demand this year and next. Government outlays for defense will continue to contract, extending the dislocations and disruptions that have been evident for some time in industries and regions that depend heavily on military spending. Prospects for higher taxes may already be influencing the behavior of some households and businesses, and the constraint is likely to intensify in 1994. In addition, uncertainties about prospective federal policies reportedly are weighing on businesses and consumers; although the outcome of the congressional budget deliberations will be known shortly, uncertainties about health care reform are not anticipated to be resolved fully for some time.

Most Board members and Bank presidents expect the rise in the consumer price index over the four quarters of 1993 to be in the range of 3 percent to 3 1/4 percent, about the same as the increase over the four quarters of 1992. At this stage, the food and energy sectors are not expected to have much effect, on balance, on the broad price measures in 1993, but the flooding in the Midwest raises the risk of higher food prices in the quarters ahead. For 1994, the central tendency forecast is for CPI inflation in the range of 3 to 3 1/2 percent, not much different than in 1992 and 1993.

The fundamentals remain consistent with additional disinflation; businesses continue to focus on controlling costs, and slack in labor and product markets is anticipated to decrease only gradually in the period ahead. However, the disappointing price performance in the first half of the year suggests that further progress will not come easily--in part perhaps because inflation expectations remain high. Lowering inflation and inflation expectations over time, and achieving sustained reductions in long-term interest rates, will depend importantly on a monetary policy that remains committed to fostering further progress toward price stability. The performance of prices and the economy also will depend on government policies in other areas. Namely, a sound fiscal policy, a judicious approach to foreign trade issues, and regulatory policies that preserve flexibility and minimize the costs they impose are crucial to reestablishing the disinflation trend of the past couple of years and allowing the economy to perform at its full potential.

The Administration has not yet released the midyear update to its economic and budgetary projections. However, statements by Administration officials suggest that the revised forecasts for real growth and inflation in 1993 and 1994 are not likely to differ significantly from those of the Federal Reserve.


Economic activity has continued to advance in fits and starts. After posting robust gains in the second half of 1992, real GDP rose at an annual rate of less than 1 percent in the first quarter of 1993. The slowing in activity was evident in a broad range of production and spending indicators. The more recent data suggest that the economy expanded at a firmer pace in the second quarter, although growth probably was not as rapid as in the second half of last year.

To some extent, the slackening in economic activity in the first quarter of 1993 can be interpreted as a payback after two quarters of strong growth. In particular, much of the slowing was in consumer spending, where large gains in the second half of 1992 had outpaced income growth by a substantial margin. In addition, there was a sharp contraction in defense spending; although real defense purchases clearly will remain on a downtrend for some time, the first-quarter plunge followed a spurt in the second half of 1992 and is not likely to be repeated in coming quarters. In the external sector, exports declined in the first quarter after a big increase late last year, while imports rose markedly. Activity was also depressed, especially in the housing sector, by unusually bad weather last winter.

Moderate growth in real GDP appears to have resumed in the second quarter. Nonetheless, experience thus far in 1993 has underscored that the impediments to a more rapid pace of economic expansion over the near term remain sizable. Besides defense cutbacks, the process of balance sheet adjustment goes on, as do the restructuring efforts under way at many large firms. Moreover, the continued disappointing economic performance of some major foreign industrial countries is taking a toll on U.S. exports. Finally, uncertainties about prospective federal policies on a variety of fronts, although difficult to measure, are reportedly making some businesses and consumers reluctant to make major hiring and spending commitments.

News on the price side was also worrisome in the first half of the year. Month-to-month movements in prices were on the high side through April, but they moderated in May and June. The more favorable recent data helped to ease concerns that a significant pickup in inflation was under way. Nonetheless, the disinflation process seemingly has stalled, with underlying inflation, as measured by the twelve-month change in the CPI excluding food and energy, holding in a narrow band between 3 1/4 percent and 3 1/2 percent since last summer.

The Household Sector

Growth of consumer spending on goods and services continued in a stop-and-go pattern in early 1993: It hit a lull in the first quarter after surging in the second half of 1992. Averaging through the quarterly data, consumption grew at about a 3 percent annual rate over those three quarters, and available data point to a moderate increase in the second quarter. Housing activity appears to have revived in recent months, after sagging earlier in the year.

Consumer spending increased only about 1 percent at an annual rate in real terms in the first quarter. Outlays for goods were especially weak, down at about a 2 percent annual rate; although a part of the drop was probably attributable to the severe blizzard on the East Coast in March, signs of some retreat in spending had already appeared in January and February. Meanwhile, spending on services remained on the moderate uptrend that had been evident for the past few years.

Spending rose appreciably in April, spurred by a post-blizzard bounce-back in outlays for motor vehicles and other goods. Demand for motor vehicles remained strong through June, resulting in an average sales pace for the quarter of almost 14 1/2 million units (annual rate)--the highest since early 1990. Sales were boosted by the replacement needs of households that put off buying vehicles during the 1990-91 recession and the early recovery period. In addition, price increases--at least for models with domestic nameplates, which have accounted for almost all of the rise in sales this year--have been relatively small, and financing terms favorable. Meanwhile, real spending on goods other than motor vehicles appears to have posted a moderate gain for the quarter as a whole, and outlays for services rose slowly through May.

The downshift in overall spending growth this year does not appear to be attributable to any worsening of the current trends in household incomes and financial positions, but it has coincided with a deterioration in consumer confidence. In contrast to the ebullience evident last fall, surveys conducted by the University of Michigan and the Conference Board this year have found respondents more pessimistic about their job and income prospects. Spending may also have been crimped by smaller-than-usual tax refunds--or larger tax bills--this year. Although the change in withholding schedules in March 1992 raised workers' take-home pay, and thus provided the wherewithal to fund additional purchases last year, many households may well have found themselves less liquid than usual in early 1993. More fundamentally, the slowing in spending appears to reflect a return to trend after a surge that outstripped the rise in real disposable income in the second half of last year. Indeed, after having risen somewhat over the preceding couple of years, the personal saving rate dropped from 5 1/4 percent in the second quarter of 1992 to 4 1/2 percent in the fourth quarter, in the lower part of the range of recent years. The saving rate retraced some of that decline in the first quarter, but it appears to have fallen back in the spring.

Real disposable income has remained on the moderate uptrend that has been evident for the past several quarters: In May, it stood about 2 1/4 percent above the level of a year earlier. Growth in wages and salaries has stayed relatively sluggish despite the firmer pace of employment growth this year. Meanwhile, transfer payments have continued to expand, although recent increases have been diminished by a drop in unemployment insurance benefits as the number of unemployed has declined. Interest income, which fell appreciably over 1992, has only edged down thus far this year. Household financial positions have continued to show signs of improvement. The value of household assets has been buoyed by the rising stock market, while debt growth has remained moderate. Moreover, reductions in interest rates have continued to lower debt-servicing burdens; when measured in relation to disposable income, the repayment burden has fallen back to the levels of the mid-1980s. The incidence of financial stress among households also appears to have eased further. Delinquency rates on consumer loans generally dropped again in the first quarter and are down significantly from their recent peaks, and delinquencies on home mortgages are at the low end of the range of the past decade.

Housing activity turned surprisingly soft in the first quarter, after a burst at the end of 1992. However, the most recent monthly indicators suggest that the sector remains on a path of gradual expansion. In the single-family area, both starts and sales of new homes fell back at the beginning of the year and remained below trend through March. Single-family starts rebounded in April and edged up further in May, lifting the average level for the two months about 5 percent above the first-quarter pace; new home sales gyrated in the spring but also were higher, on average, than in the first quarter.

Undoubtedly, some of the recent improvement reflects a reversal of transitory factors that damped homebuilding in the first quarter. The East Coast blizzard delayed both builders and their customers in March; in addition, the weather for the nation as a whole was slightly worse than usual in January and February. Lumber prices ran up sharply between October and March: As measured by the producer price index, prices rose about one-third over that period, and spot market quotes for some lumber products more than doubled. The jump in lumber costs, which has since been reversed, seems not to have left much of a mark on the prices recorded in sales transactions; indeed, the inability of builders to pass along the cost increases may have accounted for some of the disruption in construction activity.

In any event, low mortgage rates clearly are helping to stimulate housing demand. Interest rates on fixed-rate home mortgages, like most other long-term interest rates, fell to near their twenty-year lows last winter and have since declined further; initial rates on adjustable-rate mortgages have been the lowest since these loans first became widely available at the beginning of the 1980s. Given the trends in house prices, these interest rates have pushed the cost of home purchase--as measured by the share of household income needed to make the mortgage payments on an average home--to the lowest levels since the mid- 1970s.

Nonetheless, the trends in house prices this year--small rises in some markets, declines in others--have not been a uniform positive for demand, mainly because they have muted the investment motive for owning a home. Moreover, although most respondents to the Michigan survey in recent months reported that it was a good time to buy a house, only about one-third of those who already owned homes thought it was a good time to sell. In fact, industry reports suggest that first-time homebuyers have accounted for an unusually large share of all home purchases in the past two years, and that sales and prices in many localities have been strongest at the lower end of the market.

Construction of multifamily housing this year has been at its lowest level since the 1950s. These structures--most of which are intended for rental use--now account for less than 5 percent of total residential investment expenditures, compared with a figure of about 15 percent in the mid-1980s. Despite the reduced production in the past several years, vacancy rates and rents have not yet shown clear signs of tightening for the nation overall. By contrast, improvements to all existing housing units have trended up over the past year and now account for nearly one-fourth of total residential construction expenditures.

The Business Sector

Developments in the business sector generally were favorable in the first half of 1993. Business fixed investment, which continued to grow briskly, was boosted by ample profits and cash flow, the relatively low cost of capital, and ongoing efforts to improve productivity. Meanwhile, business balance sheets strengthened further as growth of business debt remained relatively slow and many firms continued to take advantage of lower bond yields and high stock prices to enhance liquidity by funding out short-term liabilities.

Real business fixed investment increased at a 13 percent annual rate in the first quarter of 1993. Real outlays for equipment posted another healthy gain, and investment in structures, which had been on a protracted decline for some time, was about unchanged for a second quarter. The indicators in hand suggest that real business fixed investment remained strong in the second quarter.

Equipment spending has continued to be a mainstay of economic growth. It rose at an annual rate of about 18 percent in real terms in the first quarter, after a 12 1/2 percent rise over the course of 1992. Real outlays for computers and related devices have continued to soar; since early 1991, they have roughly doubled, boosted by product innovations, extensive price-cutting by computer manufacturers, and the ongoing efforts of businesses to achieve efficiencies through the utilization of new information-processing technologies. However, demand for other, more traditional types of equipment also began to grow around the middle of 1992 and continued to expand in early 1993. Domestic purchases of aircraft spurted in the first quarter; but, given the financial problems besetting the airlines, this increase will likely be reversed in coming quarters.

Investment in nonresidential structures appears to be stabilizing after several years of steep declines. Construction outlays were essentially flat in real terms over the fourth and first quarters, and the advance indicators suggest that the bottom has been reached or is close at hand. Trends within the construction sector have been divergent. In the office sector, the excess of unoccupied space remains huge, and spending continues to contract. However, spending for commercial structures other than office buildings, which also had fallen sharply over the past several years, has apparently turned the corner because of both the stronger pace of retail sales over the past year and the ongoing shift of retailing activity to large suburban stores. Outlays for industrial construction have not exhibited the normal cyclical rebound-mainly because utilization of existing capacity has tightened only gradually--but they seem, at least, to be leveling out. Meanwhile, activity in the public utilities sector has continued to trend up, mainly because of capacity expansion at electric utilities but also because of the installation of pollution abatement technology, which the Clean Air Act requires be in place by 1995. In contrast, drilling activity remains depressed.

Nonfarm business inventories, which had shown only small changes, on net, since the middle of 1991, rose considerably last winter and spring. Although the buildup early in the year was likely motivated in part by the need to replenish stocks drawn down by surprisingly strong sales in late 1992, some of the recent increase may be attributable to softer-than-expected sales. Notably, the inventory-sales ratio for non-auto retail stores remained in May around the high end of the range of recent years. By contrast, inventories at factories and at wholesale trade establishments generally seem to be reasonably well aligned with sales.

After advancing markedly over the course of 1992, economic profits of U.S. corporations were little changed overall in the first quarter of 1993. The pretax profits earned by nonfinancial corporations on their domestic operations weakened after a fourth-quarter surge, but they still stood nearly 35 percent above the cyclical low reached in 1991; the upswing in these profits over the past two years has reflected primarily a combination of moderation in labor costs and reductions in net interest expenses. Domestic profits of financial corporations have been buffeted in recent quarters by the losses that insurance companies sustained from major natural disasters; without such losses, domestic financial profits in the first quarter would have surpassed the high reached in the first quarter of 1992.

The farm economy has been beset by numerous weather disruptions so far this year. In the first quarter, severe weather in some regions retarded livestock production and damaged fruit and vegetable crops. In many regions, spring planting was hampered by wet weather, and, in parts of the Midwest, continued heavy rains around mid-year caused major flooding. Because of the planting delays and the floods, uncertainties about acreage and yields are considerably greater than usual for this time of year, and farmers in the flooded regions obviously have suffered financial losses.

Despite the weather-related supply disruptions, farm income and farm financial conditions for the nation as a whole seem to have held up reasonably well in the first half of 1993. On average, farm prices in the first half were slightly above those of a year earlier, with declines for farm crops being offset by higher prices for livestock. Farm subsidies, which have been running well above their 1992 pace, have been lifting farm income and cash flow, and farm investment in new machinery has picked up. The recent jump in crop prices--a consequence of the flooding--will boost the incomes of the many farm producers whose crops are still in good condition.

The Government Sector

Governments at all levels continue to struggle with budgetary difficulties. At the federal level, the unified budget deficit over the first eight months of fiscal year 1993-the period from October to May--totaled $212 billion, somewhat less than during the comparable period of fiscal 1992. However, excluding deposit insurance and adjusting for the inflow of contributions to the Defense Cooperation Account in fiscal 1992, the eight-month deficit was about $230 billion in both fiscal years. In the main, the underlying deficit has failed to drop because the restraint in discretionary spending that was legislated in 1990 and the deficit-closing effects of stronger economic activity have been offset by continued large increases in spending for entitlement programs.

In total, federal outlays in the first eight months of fiscal 1993 were only about 2 percent higher than during the same eight months of fiscal 1992. Outlay growth was damped significantly by a sharp swing in net outlays for deposit insurance that was attributable largely to the improved health of depository institutions. In fact, so far this year, receipts from insurance premiums and proceeds from sales of assets taken over by the government have exceeded by $18 1/2 billion the gross outlays to resolve troubled institutions. Defense spending was also quite weak in the first eight months of fiscal 1993. Outlays for Medicare and Medicaid continued to rise rapidly; however, the increase so far this year--about 10 percent--was only half as large as the one in the preceding year. The deceleration in health care spending appears to stem, in part, from federal regulations issued in 1992 that limit the states' ability to shift Medicaid costs to the federal government.

Federal purchases of goods and services--the part of federal spending included directly in gross domestic product--declined at an annual rate of 18 percent in real terms in the first quarter of 1993. A sharp decrease in defense spending more than accounted for the drop. Real defense purchases have been falling noticeably since early 1991, but the decline has been erratic; at least part of the first-quarter plunge can be interpreted as a correction after a few quarters of surprisingly strong spending. Meanwhile, real nondefense purchases have been almost flat over the past couple of quarters.

Federal receipts in the first eight months of fiscal 1993 were about 5 percent greater than in the same period of a year earlier; the rise was roughly the same as that in nominal GDP. Boosted by the upswing in business profits, corporate taxes rose sharply. However, they account for less than one-tenth of total receipts, and growth in other categories was only moderate in the aggregate.

States and localities continue to face sizable budget deficits: As measured in the national income and product accounts (NIPA), the combined deficit (net of social insurance funds) in the sector's operating and capital accounts has been stuck around $40 billion since late 1990. These outsized deficits have persisted despite ongoing efforts by many governments to adjust spending and taxes. As at the federal level, deficit reduction has been complicated by the upsurge in payments to individuals for health and income support; in the first quarter of 1993, state and local transfer payments for Medicaid and Aid to Families with Dependent Children (in nominal terms) were nearly 20 percent above those of a year earlier.

The deficit-reduction efforts of state and local governments in recent quarters have been concentrated on the spending side. Their purchases of goods and services were nearly flat in real terms in the first quarter of 1993 and have changed little, on net, since early 1992. Outlays for construction, which fell at an annual rate of 7 percent, on average, in the fourth and first quarters, have been especially weak. For all major categories except sewer and water, outlays in recent months have been running significantly below year-earlier levels. State and local employment has continued to expand at the somewhat slower pace that has been evident since 1991, while these governments have continued to hold the line on wages and benefits. The approximately 3 1/2 percent increase in state and local compensation rates over the year ended in March was similar to the rise for workers in private industry; by contrast, in the 1980s, state and local workers received increases that, on average, were more than 1 percentage point per year greater than those in private industry.

Receipts of state and local governments, restrained by the relatively tepid cyclical upswing in the sector's tax bases, have grown only moderately over the past year. Also, these governments have lately been reluctant to raise taxes, after the sizable hikes they enacted in 1990 and 1991. All told, the sector's own-source general receipts, which comprise income, corporate, and indirect business taxes, rose 5 percent over the four quarters ended in the first quarter of 1993, an increase about the same as that in nominal GDP.

The External Sector

Since December 1992, the trade-weighted foreign exchange value of the dollar has risen about 5 percent, on balance, in terms of the currencies of the other Group of Ten (G-10) countries. This net increase has reflected much larger movements in the dollar's value against individual currencies: In particular, a sharp decline against the Japanese yen was more than offset by substantial increases against major European currencies.

Relative to the monthly average for December 1992, the dollar has declined nearly 15 percent against the yen to record lows, prompting heavy Japanese official purchases of dollars and moderate dollar purchases by U.S. authorities. The strengthening of the yen has occurred despite the weak performance of the Japanese economy and market expectations that Japanese short-term interest rates will remain near historically low levels over the next year; it seems to be based largely on the perception that Japan's external surplus, which has grown rapidly over this period, is not sustainable.

Against the German mark, the dollar has risen almost 10 percent since December, reflecting a substantial easing of German interest rates and the expectation of further declines in light of the sharp contraction in German economic activity. The dollar has also appreciated against other European currencies, and it has remained little changed against the Canadian dollar.

Economic activity in the major foreign industrial countries generally has been sluggish so far this year. The recovery in Canada now seems to be reasonably well established, and real GDP in the United Kingdom has been growing slowly. However, continental Europe remained in recession in the first quarter, with a sizable reduction in real GDP in western Germany; recent indicators point to continued weakness in the second quarter. After falling for much of 1992, Japanese real GDP advanced in the first quarter, a rise in large part reflecting the effects of earlier fiscal measures; however, indicators for the second quarter are mixed, and the appreciation of the yen will likely result over time in a drag on net exports.

Unemployment rates have continued to rise (into the double-digit range in many instances) in the countries still in recession; even in the countries showing signs of recovery, unemployment has remained high. Partly as a consequence, wage pressures have ebbed, and underlying inflation has continued to decelerate, on average. A notable exception is western Germany, where the CPI rose more than 4 percent over the twelve months ended in June, partly because of an increase in the value-added tax early this year and large increases in the prices of housing services.

In contrast to the overall weakness of activity in foreign industrial countries, real growth so far this year in major developing countries, especially in Asia, appears to have remained at around the strong pace of 1992.

After expanding rapidly at the end of 1992, real merchandise exports declined during the first quarter of 1993, but they bounced back to their fourth-quarter 1992 high in April and May. Shipments to developing countries, which had risen sharply over 1992, dropped back during the January-to-May period. In the aggregate, exports to industrial countries rose somewhat in the first five months of 1993, but Canada and the United Kingdom accounted for most of the increase.

Real merchandise imports, extending the rapid pace of growth recorded over the four quarters of 1992, rose sharply over the first five months of 1993. Trade in computers continued to soar and was responsible for about one-third of the increase in merchandise imports. More broadly, imports were boosted by the rapid growth of U.S. domestic final demand in the second half of 1992 and inventory restocking this year. In addition, the prices of non-oil imports, reflecting the lagged effects of the appreciation of the dollar during the last quarter of 1992, fell somewhat in the first quarter; much of that decline appears to have been reversed in the second quarter. The price of oil imports fluctuated in a relatively narrow range over the first half of 1993. Mild weather and strong OPEC production pushed oil prices down early in the year, but prices subsequently retraced the decline on signs that OPEC would effectively curb production. Recently, oil prices have dropped on Kuwait's decision not to participate in OPEC's quota allocations for the third quarter and speculation that Iraq may be allowed to resume exporting sooner than had been expected.

The merchandise trade deficit widened to $116 billion (at an annual rate) in the first quarter of 1993, nearly $10 billion greater than in the second half of 1992; it increased somewhat further in April and May, on average. With moderate increases in net income from direct investments and a slight further widening of the surplus on net service transactions, the deficit in the current account deficit rose somewhat less than the trade deficit, to $89 billion (annual rate) in the first quarter, compared with $83 billion in the second half of 1992.

Net capital inflows recorded in the first quarter of 1993 were largely attributable to substantial increases in foreign official assets held in the United States, particularly in those of some newly industrializing Asian economies and of certain Latin American countries. Net private capital inflows were relatively small. Private foreigners added significantly to their holdings of U.S. securities, particularly Treasury bonds. However, U.S. net purchases of foreign bonds reached record levels, and net purchases of foreign stocks, although down from peak levels reached in the last half of 1992, remained heavy. New bond issues by foreigners in the United States also were very strong.

Capital inflows associated with foreign direct investment in the United States recovered substantially in the first quarter but remained far below the peaks reached in 1989. Foreign direct investment in the United States apparently has been deterred by unfavorable returns realized on earlier investments and by financial market conditions less favorable to acquisitions. In contrast, capital outflows associated with U.S. direct investment abroad remained strong.

Labor Market Developments

The labor market showed signs of improvement in the first half of 1993. According to the payroll survey, employment increased about 1 million; this number compares with a rise of about 600,000 over the second half of last year and brings the total increase since the cyclical low in 1991 to about 2 million.

Nonetheless, job gains have continued to fall far short of the norms set by earlier business cycle expansions. For example, only in May did payroll employment return to its pre-recession peak, two years after the cyclical trough; by contrast, recessionary job losses typically have been reversed within the first year of the expansion. Job growth has continued to be restrained by the temperate pace of economic activity and employers' ongoing efforts to improve productivity. In addition, firms are confronting cost pressures associated with sizable increases in health insurance premiums and in other fringe benefits; uncertainties about the future course of government policies may also be contributing to the reluctance of some firms to expand their permanent full-time work forces.

Moreover, firms are relying increasingly on temporary workers, in part because doing so affords them greater flexibility in responding to fluctuations in demand for their products. Indeed, employment at personnel supply firms, which consist largely of temporary-help agencies, rose more than 150,000 between December and June. Over the past two years, the increase has been about 500,000; thus, although these firms currently account for less than 2 percent of total payroll employment, they are responsible for one-quarter of the increase in total employment over this period.

Job gains in the first half of 1993 also reflected a continuation of the steady uptrend in employment in health services. In addition, gains occurred at trade establishments, construction payrolls improved with the recent stronger housing activity, and there were scattered increases in services other than health and personnel supply.

Meanwhile, manufacturing employment declined further, on balance, over the first six months of the year. Although factory output increased steadily through April, firms relied mainly on a combination of productivity improvements and longer workweeks to meet their output objectives; in May and June, output decreased somewhat. Job losses in the first half were concentrated in the durable goods sector, with particular weakness at producers of aircraft and motor vehicles. Since its last peak in January 1989, manufacturing employment has fallen about 1 3/4 million; layoffs in defense-related industries (those industries that depend on defense expenditures for at least 50 percent of their output) have accounted for about one-fifth of the decrease in total factory payrolls.

Employment as measured by the monthly survey of households rose about 900,000 over the first six months of the year--essentially the same as in the payroll series. The number of unemployed fell appreciably at the beginning of the year, and the civilian unemployment rate dropped from 7.3 percent in December to 7.0 percent in February; it has shown little change since that time.

The civilian labor force expanded only moderately over the first six months of 1993--less than 1 percent at an annual rate. Labor force growth continued to be damped by the relatively small increase in the working-age population. In addition, perceptions of meager employment opportunities evidently continued to deter many potential job seekers. The labor force participation rate, which measures the percentage of the working age population that is either employed or looking for work, spurted in late spring; however, this spurt followed a sharp decline earlier in the year, and the level at mid-year was about the same as that in late 1992.

Output-per-hour in the nonfarm business sector declined at an annual rate of 1 1/2 percent in the first quarter, echoing the sharp deceleration in output. Nonetheless, the first-quarter drop followed a string of sizable increases; all told, the rise in productivity over the year ended in the first quarter of 1993 was 1 1/2 percent--smaller than the gains recorded earlier in the economic expansion but still noticeably larger than the norms for the past decade. Productivity growth in the manufacturing sector, where downsizing and restructuring efforts have been under way for some time, has continued to be especially impressive, totaling more than 5 percent over the past year.

Labor compensation has tilted up of late. The employment cost index for private industry--a measure that includes wages and benefits--rose at an annual rate of 4 1/4 percent over the first three months of the year. Even so, the data are volatile, and the total increase since March 1992 amounted to only 3 1/2 percent; by contrast, this index had risen 4 1/4 percent over the preceding twelve months, and, as recently as early 1990, the twelvemonth change had exceeded 5 percent. The increase in wages over the past year was less than 3 percent, whereas the cost of fringe benefits, pushed up by the steep rise in the cost of medical insurance and by higher payments for workers' compensation, rose more rapidly. Primarily because of the drop in productivity, unit labor costs deteriorated markedly in the first quarter, but they still were up less than 2 percent over the past year.

Price Developments

Inflation exhibited considerable month-to-month volatility in the first half of the year. Broad measures of inflation picked up somewhat in early 1993, with monthly readings through April in the upper part of the range of the past couple of years. However, price changes at the consumer and the producer levels were small in May and June. Cutting through the monthly data, the disinflation process evident in 1991 and 1992 seems to have stalled, with underlying inflation, as measured by the twelve-month change in the CPI excluding food and energy, holding in the range of 3 1/4 percent to 3 1/2 percent -that has prevailed since last summer. The total CPI, held down by essentially flat energy prices, has risen 3 percent over the past twelve months.

The CPI for food increased at an annual rate of 2 percent in the first half of 1993, a shade above the rate of increase during 1992. Meat prices jumped sharply during the first few months of the year as production fell short of year-earlier levels. In addition, the prices of fresh vegetables were boosted during the spring by weather-related production setbacks in several regions of the country. By late spring, these supply problems had abated, and the June CPI brought price declines in food categories where the sharpest upward pressures previously had been evident. Since the end of June, however, farm crop prices have moved up in response to the severe flooding in the Midwest. The increases in crop prices have already been reflected in the form of large advances in some commodity price indexes and have raised the possibility that renewed upward pressures on consumer food prices could soon emerge.

Consumer energy prices changed little, on net, over the first half of the year. With world oil markets remaining relatively quiescent, the price of West Texas intermediate generally fluctuated between $18 and $20 per barrel but has weakened recently. Retail prices for refined petroleum products changed fairly little on the whole through April and dropped, on balance, in May and June. Residential natural gas prices rose considerably over the first half, in part because of inventory adjustments associated with last winter's colder-than-usual weather; although recent declines in wellhead prices suggest that some of the increase at the retail level may be retraced in coming months, over the longer haul, natural gas prices are being supported by an ongoing shift toward the use of cleaner-burning fuels.

All told, the CPI excluding food and energy increased at an annual rate of 3 1/2 percent over the first half of the year, after rising 3 percent over the second half of 1992. The CPI for goods soared in January and February, with large increases reported for several items. Apparel prices jumped early in the year, in part because strong sales in late 1992 limited the need for post-Christmas markdowns. Some retailers may also have seen opportunities to widen profit margins on other merchandise; the recent decrease in prices of home furnishings, for example, suggests that not all of these increases stuck.

Increases in prices of non-energy services were steadier but also somewhat larger than in 1992. Part of the step-up was in shelter costs, which account for about half of non-energy services and had posted some unsustainably small increases last summer. However, the substantial deceleration in medical care prices (for both goods and services) that has been in train over the past few years extended into 1993. In fact, the CPI for medical care rose only about 6 percent over the twelve months ended in June; this increase was among the smallest of the past decade.

To some extent, the higher underlying CPI inflation rates in the first half of 1993 may be a statistical phenomenon that will be reversed in the second half: Indeed, over the past several years, price increases early in the year have tended to exceed those for the year as a whole, even after seasonal adjustment by the Bureau of Labor Statistics. But, even allowing for this phenomenon, inflation seems to have leveled out. The lack of further deceleration is puzzling in light of the considerable slack in labor and product markets. One possible explanation is that the pickup in economic activity late last year may have triggered a round of price increases; if so, some deceleration in prices is likely in the wake of the subdued performance of the economy in the first half. Another may be the apparent failure of inflation expectations, as measured by various surveys of consumers and businessmen, to reflect fully the reduction in actual inflation over the past few years; although the survey measures vary considerably, respondents seem to share a sense that inflation has bottomed out.

Prices received by domestic producers have slowed in recent months, after undergoing a pickup earlier in the year. All told, the twelve-month change in the producer price index for finished goods other than food and energy was less than 2 percent in June, down somewhat from a year earlier. At earlier stages of processing, where price movements tend to track cyclical fluctuations in demand, prices of intermediate materials (excluding food and energy) firmed a little early in the year, but they subsequently moderated; although the pattern was exaggerated by the spike in lumber prices, it was evident for some other materials as well. In commodity markets, prices of precious metals have moved up sharply over the past couple of months, and some scattered increases have been evident elsewhere. More broadly, however, industrial commodity prices were down slightly, on net, over the first half of the year.


Monetary policy in 1993 has been directed toward the goal of sustaining the economic expansion while preserving and extending the progress made toward price stability in recent years. In the first half of the year, economic activity slowed markedly from the very rapid pace of the fourth quarter, while inflation indicators fluctuated widely. Although inflation readings were a source of concern for the Federal Open Market Committee, the intensification of price pressures did not seem likely to be sustained over an extended period, and reserve conditions were kept unchanged. With short-term rates steady, prices of fixed-income securities were buoyed by prospects for significant fiscal restraint and by a slowing of the economic expansion, although fears of a pickup in inflation at times prompted partial reversals in bond rates. Yield spreads on private securities relative to Treasury rates remained historically narrow, and stock price indexes set new records.

The monetary aggregates have been sluggish this year, as both the share of depository institutions in overall debt finance and the proportion of depository credit funded with monetary liabilities have fallen further. The reduced role for depositories largely reflects weak demands for loans and deposits by the public. Corporate borrowers have continued to issue heavy volumes of stocks and bonds in part to pay down bank debt, while households have withdrawn deposits to invest in bond and equity funds that finance, among others, corporate issuers. After two years of no growth, bank loans weakened further early this year, but increased fairly vigorously in May and June, posting a small net gain for the first six months of the year. The growth of nonfinancial sector debt so far this year has edged up from the subdued pace of 1992, despite a deceleration of nominal spending, as investment spending is estimated to have exceeded the internal funds of corporations, household borrowing has picked up relative to spending, and Treasury financing needs have remained heavy.

The Implementation of Monetary Policy

Early in the year, incoming data suggested that the faster pace of economic activity that had emerged in the third quarter of 1992 had been maintained through year-end. Indicators of industrial production, retail sales, business fixed investment, and residential construction activity all posted solid gains. Financial impediments to the expansion appeared to be diminishing as the balance sheets of households, business firms, and financial institutions continued to improve, although money and credit growth remained weak. Wage and price data suggested a continuing trend toward lower inflation. Intermediate- and long-term interest rates had declined somewhat, in part reflecting a view that the new Administration's fiscal stimulus package was likely to be modest and that material reductions in future deficits were in prospect. The economic outlook remained clouded, however, by uncertainties regarding details of fiscal policy plans, continued restructuring and downsizing of large businesses, and lingering restraints on credit supplies. At its early February meeting, the FOMC decided that its directive to the Federal Reserve Bank of New York regarding domestic open market operations should retain a symmetric stance regarding possible reactions over the inter-meeting period to incoming indicators; such a directive, which implied no presumption in how quickly changes in operations should be made toward tightness or ease, had been instituted in December, following directives that had been biased toward easing over much of the previous two years.

Economic activity appeared to decelerate in the early months of the year, however, in part because of adverse weather conditions, with softness in retail sales, housing starts, and nonresidential construction. Bank credit was failing to expand significantly, while broad money was declining because of temporary factors and a weak underlying trend. Although short-term interest rates were little changed, bond markets rallied further on weaker economic activity and improved prospects for fiscal restraint, which would reduce the government's demand for credit. Long-term rates fell to the lowest levels in almost twenty years in early March, before backing up somewhat on reports of a second month of substantial increases in consumer and producer prices. The drop in interest rates buoyed stock markets to record highs and contributed to a small decline in the weighted-average value of the dollar. The dollar depreciated substantially against the yen, as market attention focused on Japan's growing trade surplus.

Signs of price pressures were a concern for the FOMC, but the fundamentals of continued slack in labor and capital utilization, subdued unit labor costs, and protracted weakness in credit and broad money suggested that a higher trend inflation rate was not setting in. With the economy slowing, reserve pressures were kept unchanged and a symmetric policy directive was retained at the meeting in March.

After pausing in March, producer and consumer prices leaped again in April. Long-term interest rates backed up further in response; the price of gold surged, and the dollar fell more rapidly. With the Japanese authorities buying dollars in foreign exchange markets, the U.S. Treasury and the Federal Reserve also purchased dollars for yen in late April. After extended weakness, the monetary aggregates jumped in early May by more than could be explained by temporary factors.

At its May meeting, the FOMC was confronted with weak output growth and intensified inflation readings. It was difficult to identify reasons for this juxtaposition. Price increases by business firms in early 1993 could have reflected optimism engendered by strong demand conditions in the second half of 1992 or an upward adjustment of inflation expectations. However, considerable slack remained in labor and product markets, and the pace of economic activity had slowed markedly. The Committee concluded that no policy adjustment was needed at its meeting, but the risks of increased inflation and inflation expectations warranted a directive that contemplated a relatively prompt tightening of reserve pressures if signs of intensifying inflation continued to multiply.

The subsequent readings on inflation for May and June were subdued; moreover, evidence of heightened inflation expectations did not emerge in markets for fixed-income securities. Consequently, the stance of monetary policy was not changed following the May FOMC meeting. The dollar rebounded on foreign exchange markets in June and early July in the wake of the fall of the Japanese government and evidence that economic conditions in Europe had deteriorated further.

On balance, since the beginning of the year, short-term interest rates are little changed, while intermediate- and long-term rates have fallen 1/4 to 1 percentage point, reaching the lowest levels in more than twenty years. In particular, the thirty-year Treasury bond has reached a low of 6.54 percent, while the ten-year Treasury note has touched 5.71 percent, its lowest level since 1971. The interest rate on fixed-rate thirty-year mortgages has dropped to 7.16 percent, a record low in the twenty-two year history of the series. The fall in intermediate-term interest rates in the United States was roughly matched on average abroad, and the trade-weighted value of the dollar in terms of G-10 currencies has increased about 5 percent from its December average, as overseas economies weakened and foreign short-term rates declined substantially.

Monetary and Credit Flows

Growth of the broad money measures was quite slow over the first half of 1993, falling below the subdued pace of 1992, and leaving them near the lower arms of the revised growth cones for 1993. This deceleration did not, however, reflect a moderation in overall credit flows or a tightening in financial conditions. Rather, it resulted from a further diversion of credit flows from depository institutions as well as continued financing of depository credit through capital accumulation rather than deposits, Indeed, growth of the debt of all nonfinancial sectors is estimated to have edged up this year--to 5 percent--despite an apparent slowing in nominal GDP. Continued substantial demand for credit by the federal government as well as more comfortable financial positions and consequent signs of a greater willingness to borrow and lend by private sectors likely supported debt expansion. Nevertheless, overall debt growth remains in the lower portion of its revised 4 to 8 percent annual range for 1993. Nonfederal debt growth has expanded at a still-modest 3 1/4 percent pace, after two years of even weaker growth.

Taking advantage of low long-term interest rates and the strong stock market, businesses have issued an exceptionally large volume of bonds and equity; the proceeds have been used mainly to refund other marketable debt and repay bank loans, Stresses associated with the restructuring of the economy and the earlier buildup of debt linger. However, downgradings of corporate debt by rating agencies have dropped well below the peak levels of a few years ago, and a growing number of firms have received upgradings, as corporate cash flows have strengthened substantially relative to interest expenses.

Debt service burdens of households also have continued to decline relative to disposable income, as households have repaid high interest debt or taken advantage of lower rates to refinance. Indeed, the decline in long-term interest rates during the year has brought a new surge of refinancings of mortgages. With balance sheets improved, households have become somewhat more willing to borrow, and consumer credit has begun growing moderately after two years of weakness. Some of that growth, though, may reflect heavy promotion of credit cards carrying special incentives for use in transactions, such as "frequent-flier miles" or merchandise discounts. Net mortgage debt is estimated to have grown only a bit more than the low rate of 1992.

Gross issuance of state and local government debt has been particularly robust this year. However, refunding volume has accounted for nearly 70 percent of the offerings, compared with about 45 percent in 1992, a record year for refundings. Net debt of state and local governments has grown only moderately again in 1993. The budgetary situations of some state and local governments have improved, as tax receipts have been stronger than expected, but severe financial problems remain in other locales.

With corporate borrowers still relying heavily on financing through capital markets, and depository lending spreads over market rates remaining high, the trend decline in the share of total credit flows provided by depository institutions was extended through the first half of 1993. From the fourth quarter of 1992 to June, bank credit expanded at a 4 1/4 percent annual rate, only a slight pickup from the sluggish pace of the previous two years. Securities acquisitions accounted for most of the expansion, as loans increased at only a 13/4 percent rate. The growth of securities portfolios at banks in part reflects additions to holdings of securitized mortgage and consumer loans; bank financing of consumer spending and real estate transactions is thus stronger than indicated by bookings of loans in those sectors. Although commercial and industrial loans have been about flat on balance so far this year, a few signs of easing in bank lending terms and conditions have recently emerged, and business loans rebounded in May and June. Judging by business loan growth at smaller banks so far this year, a pickup has occurred in lending to smaller nonfinancial firms. Thus, the continuing weakness in overall business loan growth does not appear to he driven primarily by restrictive supply conditions but rather by the preference of larger firms to fund through capital markets.

Lower market interest rates over the past few years have helped strengthen the financial positions of banks and thrifts. The lower rates have resulted in capital gains on securities and improved interest margins--as deposit rates have fallen more than lending rates. Lower rates also have helped bank borrowers by decreasing interest expenses and boosting economic activity, thereby reducing loan loss provisions for banks. Banks posted record earnings in 1992 and remained very profitable in early 1993; prices of their shares on equity markets have risen substantially.

Thrift institutions have continued to contract in 1993, though at a much slower pace than over the past four years. A lack of funding for the Resolution Trust Corporation caused a hiatus in the closure of institutions under its conservatorship. However, privately operated thrifts have not expanded and the industry continues to consolidate.

Slower growth in nominal GDP, moderate demand for credit relative to spending, and the reduced share of credit provided by depositories have all contributed to the lack of significant growth in the broad monetary aggregates this year. Another factor inhibiting money growth has been continued substantial funding of bank and thrift assets with subordinated debt and equity issues as well as with retained earnings--all a byproduct of ongoing efforts to build capital positions. Only about one-third of the industry (by asset volume) had capital ratios and supervisory ratings high enough at the end of 1991 to be considered well-capitalized, but more than two-thirds was so positioned by early 1993. About $10 billion was added to bank equity and subordinated debt during the first quarter, a pace about the same as that in 1992; data on new debt and equity issues indicate another sizable gain over the second quarter.

Depositories have also recently relied more heavily on other nondeposit sources of funds. Weak economies and credit demand abroad have prompted the U.S. offices of foreign banks to draw more funding from overseas and the domestic offices of U.S. banks to reduce foreign lending this year. Overall shifts from deposits to other sources of funding may be driven partly by regulatory inducements--including higher insurance premiums on deposits and incentives to bolster capital. But changes in investor preferences from short-term deposits to longer-term debt and equity may also be playing a role in motivating the restructuring of bank and thrift sources of funds.

Greater reliance by borrowers on capital markets has been facilitated by concurrent shifts in saving preferences away from monetary assets and into capital market investments. Such portfolio realignments are evident in record inflows to bond and stock mutual funds, and money balances were also likely invested directly in stocks and bonds. The incentives for what appears to be an extraordinary adjustment of household portfolios are varied. Interest rates paid on retail time deposits, NOW accounts, and money market deposit accounts (MMDAs) have fallen well below any rate offered since the inception of deregulated deposits in the early 1980s, and savings deposit rates are now the lowest in more than thirty years. The shock effect of historically low deposit interest rates caused many depositors to investigate alternative investments. With the yield curve extraordinarily steep, much higher returns have been available in recent years on longer-term investments. A bond or stock mutual fund offers investors a chance to earn these higher yields and still enjoy liquidity features, including in some cases a check-writing facility. However, investment in such a mutual fund carries with it a higher risk of loss as well, because unlike monetary assets, its principal value fluctuates with market prices. Indeed, the higher yield on bonds relative to short-term instruments probably anticipates some capital losses. Whether all households accurately assess relative risks when comparing returns recently earned on mutual funds with those on money balances remains an open question.
3. Distribution of assets of domestic commercial banks,
by adjusted capital category

 Capital category End of year March
 1991 1992 1993
Well capitalized 34 68 70
Adequate capitalized 45 22 20
Undercapitalized 21 10 10
1. Capital categories adjusted for overall supervisory rating according to
the rule of thumb of downgrading a bank by one category for a low
examination rating by its supervisory agency (CAMEL 3, 4, or 5).

Shifts into mutual funds have become much easier and less costly for households, most notably because many banks have begun offering mutual funds for sale in their lobbies. While many banks now offer discount brokerage services, a survey by the Federal Reserve found that larger banks have recently been making special efforts to promote mutual fund investments among their depositors. An increasing number of banks have sponsored their own mutual funds or entered into exclusive sales relationships with nonbank sponsors of funds. Some banks have promoted these products as a defensive measure to retain long-run relationships with valued depositors. In other cases, however, banks have promoted funds as part of a strategy to earn fee income without booking assets, thereby avoiding the need to raise additional capital.

Substitution between money and long-term mutual funds appears to have become evident in the aggregate data in recent years. There was little increase in such funds from 1987 through 1990, but inflows have surged since then, at the same time that accretions to M2 balances have declined. A comparison of the quarterly growth rates of M2 and the sum of M2 and bond and stock funds shows that growth of the sum has not weakened as dramatically as that of M2 over the last two and half years; it has averaged nearly a 5 percent annual rate, compared with less than 2 percent for M2. Although adding mutual funds and M2 together captures some substitution out of M2 in recent years, the total remains quite volatile, indicating that other forces have affected both M2 and mutual funds. Partly as a consequence, the relationship of the total to aggregate spending is subject to considerable uncertainty. Investments in bond and stock funds are themselves subject to potentially volatile capital gains and losses. More fundamentally, with the public's holdings of mutual funds now vastly expanded, its responses to a variety of interest rate and stock price movements has yet to be tested.

Because weakness in the demand for broad money has resulted largely from shifts of portfolio preferences rather than changes in spending intentions, it has not been reflected in comparable weakness in nominal GDP. Furthermore, the effects of a declining share for depositories in overall credit growth have been substantially offset by increased funding through capital markets, where households now invest a larger share of wealth. The velocity of M2 has been subject to extraordinary and unpredictable surges that have reduced the value of M2 as a guide to policy. Traditional models of velocity based on the difference between short-term market interest rates and interest rates on deposits and money market mutual funds, and even broader models that take account of longer-term interest rates and after-tax loan rates faced by households, cannot explain the full 4 percent rise in M2 velocity in 1992, nor what may be a somewhat faster rate of increase in the first half of 1993.

Money growth in the first quarter was depressed in part by the effects of several temporary factors, including distortions of seasonal factors and a lull in mortgage refinancing. A renewed surge of mortgage refinancing began to bolster demand deposits and MMDAs in April, as mortgage servicers increased balances temporarily before making remittances to investors in mortgage-backed securities. The seasonal-factor distortions began to reverse that month as well. However, substantial shortfalls in individual nonwithheld tax payments relative to recent years produced an offsetting restraint to money growth in April, as the buildup of balances required to pay taxes was smaller than that incorporated into seasonal factors. Even excluding estimated effects of these special factors, however, underlying growth of money through the first four months of the year was far weaker than historical relationships would suggest.

Despite continued heavy inflows to bond and equity funds in May, the monetary aggregates surged, boosted in part by a reversal of the tax effects and an intensification of mortgage refinancing activity. However, the aggregates decelerated substantially in June, and by more than might be suggested by a waning of tax and mortgage refinancing effects.

In 1993, household portfolio adjustments differed somewhat from their previous pattern. In the past, the realignment of household wealth toward capital market investments had mainly involved shifts from money market mutual funds and small time deposit accounts. At the same time, outflows from those accounts had also gone into NOW and savings deposits, the interest rates on which were falling only slowly as market rates declined. This year, the sum of all these M2 balances has fallen at about the same rate as in 1992, but a slower runoff of small time deposits and money funds has been offset by a sharp deceleration in the growth of NOW and savings deposits. Catch up declines in interest rates on liquid deposits may account for part of their slower growth. Some nontransactions balances held in NOW and MMDA deposits have likely been shifted into bond and equity funds. It may be that some depositors who do not ordinarily shop for small rate advantages have been induced to make basic portfolio adjustments because of the historically low deposit interest rates and the increased ease of making investments in capital market instruments.

Partly as a result, narrow measures of money have decelerated this year, but their expansion has remained rapid. M1 has grown at a 9 1/2 percent rate from the fourth quarter of 1992 through June, compared with 14 1/4 percent in 1992. Reserves, now held exclusively against transaction deposits, have grown at an 11 percent pace compared with 20 percent in 1992. The monetary base has slowed by much less, because of continued strong foreign demand for currency this year.

With reduced strength in its M1 component, and in savings and MMDAs, as well as continued runoffs of small time deposits and retail money funds, M2 has grown at only a 3/4 percent annual rate from the fourth quarter of 1992 through June 1993, well below the lower end of its growth cone set in February. The FOMC monitored the behavior of M2 carefully over the first half of the year, but in light of actual and expected strength of velocity, the Committee determined that actions to boost M2 growth were not needed to achieve its underlying objectives for prices and the economy. The aggregate is near the lower arm of the revised annual growth cone established in July, and if velocity continues to increase substantially, M2 may well come in toward the lower end of the revised growth range for the year.

The non-M2 portion of M3 has declined this year at nearly the same pace as that of the previous two years. Large time deposits have continued to fall, and the halt in reductions in short-term rates has ended the rapid growth of institutional money funds, as their slower-adjusting yields have come down to their usual relationship to market interest rates. From the fourth quarter of 1992 through June, M3 fell at about a 1/4 percent annual rate; it lies slightly below its revised annual growth cone.

[TABULAR DATA OMITTED] (1.) The charts for the report are available on request from Publications Services, Board of Governors of the Federal Reserve Systems, Washington, DC 20551.
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Title Annotation:Federal Reserve Board report dated July 20, 1993
Publication:Federal Reserve Bulletin
Article Type:Transcript
Date:Sep 1, 1993
Previous Article:Minutes of the Federal Open Market Committee Meeting of March 23, 1993.
Next Article:Industrial production and capacity utilization for June 1993.

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