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Monetary policy report to the Congress.

Monetary Policy Report to the Congress

Report submitted to the Congress on July 18, 1990, pursuant to the Full Employment and Balanced Growth Act of 1978.(1)

Monetary Policy and the Economic Outlook for 1990 and 1991

The federal Reserve delivered its initial Humphrey--Hawkins report of 1990 to the Congress in February, and the period since then has been an especially challenging one for monetary policy decisionmaking. The already difficult task of moving a quite fully employed economy toward price stability without contractionary mishap has been complicated by a variety of disturbances to business activity and financial markets--among them developments that distorted some of the basic indicators of the Federal Reserve's influence on the economic system.

On the whole, events in the economy have been broadly in line with the projections for 1990 contained in the February monetary policy report. Inflation has been somewhat greater on average than most members of the Federal Open Market Committee (FOMC) and other Reserve Bank presidents expected in February; however, this mainly reflected the influence of transitory factors early in the year, and price increases recently have been more moderate. Meanwhile, the economy has continued to expand, but apparently rather sluggishly overall since the winter.

While these aspects of the economic situation were important elements in the FOMC's review of its policy plans earlier this month, the Committee also gave careful attention to developments in financial markets. Although market interest rates had changed little on net since February, slow growth of the monetary stock and other evidence in hand pointed to a small but significant tightening of credit supplies. This implied greater effective restraint on aggregate demand in the months ahead than was thought desirable, and in the past week the System shifted to a slightly more accommodative stance in the provision of reserves to depository institutions. As a result, the overnight federal funds rate, which had fluctuated narrowly around 8 1/4 percent throughout the first half of the year, has declined to about 8 percent, and other market rates of interest also have eased a bit in recent days.

Developments Thus Far in 1990

In the early part of 1990, economic activity appeared to be regaining momentum, a development that reduced previous concerns about recessionary risks. At the same time, even discounting weather-related spurts in food and energy prices and an unusual bunching of price increases for some other items, there appeared to be no abatement in underlying inflationary pressures. Through the first quarter, M2 remained near the top of the annual range set by the FOMC, and although M3 was near the lower bound of its range, this weakness appeared consistent with the anticipated effects of the restructuring of the thrift industry.

The Federal Reserve maintained a steady pressure on reserve positions during the first quarter, rather than extending the sequence of easing steps that had fostered a drop in the federal funds rate of 1 1/2 percentage points between June and December 1989. However, in keeping with the tenor of most of the economic data released during the quarter, other interest rates generally moved higher, particularly at the long end of the yield curve. This shift suggested that market participants had reevaluated the prospects for moderating inflation and a further easing of monetary policy. Early in the year, bond yields in the United States rose along with rates in Japan and Western Europe, as developments in Eastern Europe suggested a further spur to worldwide economic activity, carrying the potential for greater inflation and heightened pressures on a limited international pool of savings.

In the second quarter, some of the weather-related increases in food and energy prices that had caused inflation to pick up earlier in the year were reversed, and price increases for many other goods and services moderated. Inflation trends remained in the range prevailing over the previous three years, though price pressures in the industrial sector gave signs of some easing. The incoming information pointed to a sluggish pace of economic expansion; most notably, growth in private sector employment slackened, consumer spending flattened, and real estate markets weakened. Moreover, advance indicators in some sectors--particularly durable goods orders and construction contracts--gave no evidence of a significant pickup in the second half. With the economy appearing somewhat less bouyant, over May and June bond yields in the United States retraced some of their earlier increases. Long-term rates in Japan and West Germany also declined, but by much less, with the result that yields in those countries have risen appreciably this year relative to those in the United States.

In foreign exchange markets, the dollar has depreciated somewhat on balance thus far this year, under the influence of a diverse set of economic, financial, and political developments around the world. The dollar has appreciated slightly in terms of the yen, while depreciating somewhat in terms of the German mark and other currencies of the European Monetary System exchange rate mechanism and somewhat more in terms of the Swiss franc and pound sterling.

The monetary aggregates flattened out during the second quarter, and by midyear M2 was in the lower half of its annual range, and M3 had fallen below the lower bound of its annual range. The weakness in the monetary aggregates mainly, though not wholly, reflected a rechannelling of credit flows away from depository institutions. Total borrowing by domestic nonfinancial sectors moderated only a little in the first half of 1990 from the pace of 1989, and growth in the aggregate debt of these sectors was in the middle of the FOMC's monitoring range. However, the proportion of lending accounted for by depositories was down substantially. Much of the decrease related to the shrinkage of savings and loan associations: Marginal institutions continued to retrench, and the Resolution Trust Corporation (RTC) transferred large volumes of assets to banks and onto its own books in the course of closing failed thrift institutions. Meanwhile, concerns about credit quality and pressures on capital positions led banks to adopt more cautious lending postures and to hold down asset growth.

The weakness in lending by depositories was reflected dramatically in the behavior of M3; this aggregate, encompassing managed liabilities as well as M2 deposits, comprises most of the liabilities used by these institutions to fund credit extensions. With depository credit damped, not only were managed liabilities weak, but banks and thrift institutions did not bid aggressively for retail funds--thereby contributing to reduced growth of M2. In addition, increases in expected returns on stocks and bonds may have restrained expansion of this aggregate, although some portion of the slowdown in M2 remains unexplained by changes in relative yields or income. The weakness in depository credit and the monetary aggregates likely has had, to date, only limited effects on spending: The bulk of the credit formerly supplied by depositories has been provided by other lenders, in part through the securities markets, with little change in the terms to most borrowers.

Monetary Objectives for 1990 and 1991

In reevaluating its ranges for money and credit for 1990 and in establishing tentative ranges for 1991, the FOMC had to take account of the redirection of credit flows away from depository institutions and the resulting effect on the growth of the financial aggregates relative to spending and prices. In February, the Committee expected that the continued shrinkage of the thrift industry would damp growth in M3; to take account of this, it lowered the M3 range for 1990 to 2 1/2 to 6 1/2 percent, 1 percentage point below the range set tentatively in July 1989. However, the contraction of thrift assets has been faster than anticipated, in part because of the step-up in RTC activity, and bank credit has expanded less rapidly. As a consequence, through June, M3 grew at an annual rate of only 1 1/4 percent from its fourth-quarter 1989 base.

Barring a marked slowdown in RTC activity or a significant strengthening in bank credit, M3 growth is likely to remain sluggish over the balance of the year. As in the first half, the weakness in M3 growth is expected to be associated with a further substantial increase in velocity--the ratio of nominal GNP to money--rather than with substantial restraint on overall credit supplies. Recognizing this unusual behavior of M3 velocity, the FOMC voted in early July to reduce the M3 range for 1990 to 1 to 5 percent. At the same time, the Committee reaffirmed its range of 5 to 9 percent for total growth in the debt of domestic nonfinancial sectors. The Committee seeks to ensure that credit will remain available in amounts and at terms compatible with moderate expansion of the economy, and it will continue to assess the implications of developments at depositories for credit conditions more generally.

As noted above, the contraction of the thrift industry and the moderate growth in bank credit also have affected the growth of M2, as potential inflows of retail deposits have outpaced the needs of depository institutions for such funds. The velocity of this aggregate has risen, unexpectedly, but less than that of M3: Growth of M2 from its fourth-quarter base through June was at a 3 3/4 percent annual rate, within its annual range, though in the lower half. M2 velocity is likely to increase further over the second half of the year; however, a substantial slowing of M2 could suggest more restraint than would be consistent with sustained upward momentum of the economy, and thus the Committee reaffirmed the established range for M2 growth for 1990.

In setting tentative ranges for 1991, the Committee faced more than the usual uncertainty about the growth of money that would foster its objectives of sustained expansion and a gradual abatement of inflation. Developments in credit markets will be shaped not only by the special factors that have altered patterns of intermediation thus far this year, but also by the outcome of the current deliberations regarding the federal budget. At this point, the forces that recently have diminished the role of depository credit seem likely to persist for some time, and they may foster further upward shifts in monetary velocities, albeit probably smaller ones than now appear in train for 1990. To be sure, though, subsequent events may dictate adjustments to the ranges next February, when they are reexamined in light of developments over the second half of this year.

For growth in M2, the Committee tentatively adopted a range of 2 1/2 to 6 1/2 percent--1/2 percentage point below the 1990 range. The adjustment is consistent with the Committee's intention to move over time toward the low trend rates of monetary expansion that would be consistent with price stability. At the same time, the range is expected to allow for sufficient expansion of money to sustain moderate growth in the economy. There may be some further upward shift in velocity, but the range should be wide enough to accommodate considerable variation in credit market conditions.

The range for growth of M3 was tentatively set at 1 to 5 percent, the same as that now in effect for 1990. Growth of this aggregate is especially sensitive to the pattern of credit flows. Thus, the continuing downsizing of the thrift industry is likely to result in slower growth of M3 than of M2 again next year, as managed liabilities in the broader aggregate run off. It also is likely to mean a substantial further increase in M3 velocity. Given that growth of this aggregate currently is running along the lower bound of the new range for 1990, even if the pace of credit flows at banks and thrift institutions were to pick up somewhat, M3 growth between 1 and 5 percent should be consistent with the Committee's basic objectives.

For debt, the FOMC adopted a tentative monitoring range of 4 1/2 to 8 1/2 percent, a half percentage point below the range for 1990. The Committee viewed slower growth of debt, more in line with the expansion of nominal income, as a healthy development for the economy. The rapid expansion of debt over the past decade, relative to the ability to service it, occasioned many of the difficulties with asset quality now facing our lending institutions.

Economic Projections for 1990 and 1991

The members of the FOMC and the Reserve Bank presidents not currently serving as members believe that the monetary ranges for 1990 and 1991 are consistent with achievement of sustainable economic growth and a reduction of inflation over time. Most of them expect that the pace of expansion will be moderate over the remainder of 1990 and through next year, with the central tendency of their forecasts of real GNP growth being 1 1/2 to 2 percent over the four quarters of 1990 and 1 3/4 to 2 1/2 percent over the course of 1991.

Demand from abroad is likely to provide support for continued growth in U.S. production and employment. At current exchange rates, U.S. producers appear to be in a position to compete effectively in most international markets, and economic activity is growing relatively rapidly on average in other major industrial countries. In time, export demand should be bolstered by the shift toward more open, market-based economic systems in Eastern Europe; although the continental European nations may be most immediately affected by these developments, given the high rates of capacity utilization in those economies, the United States is likely to benefit both directly and indirectly from the increased demand for consumer and capital goods.

In the aggregate, demands from sectors outside of exports are unlikely to provide much impetus to manufacturing activity. Defense procurement is declining in real terms. And there is little prospect of a substantial resurgence in motor vehicle production: High levels of auto sales in the past several years appear to have satisfied demands that were pent up during the deep economic slump of the early 1980s. Demand for construction materials and equipment probably also will remain subdued, because building activity will be damped by the current overhang of vacant residential and commercial space. That overhang, more than any disruption of credit flows, explains the current weakness in construction, and, especially in the case of office building, it will take some time for existing space to be absorbed and to lay the base for a solid upturn in activity.

In sum, the growth of total output projected for 1990 and 1991 probably will involve rather slow gains for the goods-producing sectors of the economy. The service-producing industries are likely to continue to be the locus of important increases in output and, especially, employment. Demands for a wide range of services have remained robust thus far this year, and demographic trends suggest that such sectors as medical care and education will continue to experience appreciable growth.

The overall growth in economic activity forecast by the Board members and Bank presidents for the period ahead is expected to be consistent with a slight easing of pressures on resources and a diminution of inflation. With respect to the labor market, the central tendency of the forecasts for the civilian unemployment rate is 5 1/2 to 5 3/4 percent in the fourth quarter of this year and 5 1/2 to 6 percent in the final quarter of 1991; the jobless rate has fluctuated narrowly at a little below 5 1/2 percent since late 1988. Moderate growth in demands on industrial capacity should be conducive to an extension of the recent more favorable trends in producer prices for intermediate and finished goods, which were, respectively, virtually unchanged and up just 3 percent in the past twelve months.

Inflation at the retail level also should be damped over the remainder of this year by favorable developments in the energy sector. Despite the very recent upturn in crude oil prices, gasoline prices are widely expected to decline in coming months, as the return of refinery output to normal levels alleviates the tightness that has characterized the product market. With inflation for other goods and services expected to remain below the first-quarter pace, the central tendency of the policymakers' forecasts of the overall consumer price index is for an increase of between 4 1/2 and 5 percent over the four quarters of 1990--compared with the 5 3/4 percent annual rate of increase recorded during the first five months of the year. The lower trajectory of the consumer price index is projected to be sustained in 1991, with forecasts for the year centering on the 3 3/4 to 4 1/2 percent range.

The Administration's economic projections, presented in connection with its mid-session update of the budget, indicate similar expectations about inflation trends but a more favorable outlook for real GNP. As a result, the Administration's projection of nominal GNP growth is somewhat above the central tendency of those of the FOMC participants, and might imply the need for faster monetary growth than is currently contemplated by the Committee. These differences must be regarded as small, however, relative to the degree of uncertainty that attaches to any prediction of the economy--and, in particular, of the short-run relation between growth in GNP and the money stock. More important, the differences do not signal any basic inconsistency between the goals of the Federal Reserve and the Administration, for the Federal Reserve would welcome a more rapid expansion of output that occurred in the context of solid progress toward price stability.

The Performance of the Economy during the First Half of 1990

Activity in many sectors of the economy followed an erratic course during the first half of the year, in part because of transitory factors, such as last winter's unusual weather. On balance, production expanded further during the first half of 1990, but evidently no faster than the reduced pace of 1989. The comparatively slow rate of growth largely reflected weaker spending by domestic businesses and households, while merchandise exports apparently remained on a fairly strong growth path. Although job creation in the private sector of the economy has slowed this year, the civilian unemployment rate has remained near 5 1/4 percent, the lowest level in nearly twenty years.

Prices rose sharply early in the year, but the increases moderated this spring. In the first quarter, there were large weather-related surges in food and energy prices and a bunching of increases in prices of some other goods and services. Given the character of the spurt, most analysts--and policy-makers in the Federal Reserve--judged that the runup in aggregate price indexes overstated underlying inflation trends. In the event, some of the transitory elements of the earlier spurt were reversed in the spring, and inflation moved down. Despite the recent slowing, however, the twelve-month change in the CPI as of May, at 4.4 percent, was about the same as that recorded for each of the past three years. In part, the persistence of inflation during a period of slower economic growth reflects continued cost pressures from relatively tight labor markets and weak productivity performance. However, there have been encouraging signs, particularly at the earlier stages of processing, that an easing of resource constraints in the manufacturing sector is reducing some of the pressures that had boosted prices from 1987 to early 1989.

The Household Sector

Total personal consumption expenditures were buffeted this winter by large swings in outlays for energy items and motor vehicles. Expenditures for home heating declined sharply in the first quarter as unseasonably warm temperatures in January and February followed a December that had been colder than usual. This influence was largely offset by a rise in motor vehicle sales. In late 1989 sales of cars and light trucks had been depressed by a scaling back of incentives and by large price increases for new model-year vehicles. Around the turn of the year, enriched incentive programs revived these sales. To date this year, sales of cars and light trucks have averaged 14 million units (annual rate)--a pace not far below the total for 1989--and seem largely to reflect replacement demand and growth in the driving age population.

Abstracting from the swings in outlays on home heating and motor vehicles, consumption spending appears to have stagnated this spring after posting a moderate gain in the first quarter of 1990. The recent sluggishness in spending reflects declines in outlays for a wide variety of consumer goods, including furniture and other household durables. In contrast, spending for services other than energy, especially medical services, continues to outpace real income growth.

Growth of consumption has slowed this year against a backdrop of somewhat smaller gains in real disposable personal income. But consumption has slowed even more than income, and the personal saving rate rose above 6 percent in the spring. Consumers may be spending more cautiously as they reassess their income and wealth prospects in light of the slower growth of the economy and a softening of residential property values in many parts of the country. These factors probably have been particularly important in the Northeast, where consumer sentiment has deteriorated markedly. However, other indicators, such as delinquency rates on consumer loans, do not reveal broad pressure on household finances. Nor are there signs that credit availability has been reduced: Federal Reserve surveys of bank lending officers suggest no change in the willingness to lend to consumers.

Residential investment spending also was affected by unusual weather patterns this winter. Housing starts were strong in the first two months of the year, as mild temperatures allowed builders to catch up on work delayed by cold weather in late 1989 and to begin projects that normally would have been started later in the year. Then starts slumped this spring, in part reflecting a "payback" for the winter activity. Averaging over this period, residential construction appears to have weakened; in the first five months of the year, housing starts totaled 1.36 million units (annual rate), somewhat below the pace of activity in 1989. By region, housing markets have been very weak in the Northeast, while homebuilding has been better maintained, albeit at moderate levels, in the North Central and Western regions of the country.

Both demand and supply factors have contributed to the recent weakness in housing construction. Sales of new and existing homes generally have been moving lower for more than a year; in part, demand may have been restrained by slower growth in income and reduced investment motivation for home purchase because of softening house prices. Demand also may have been tempered this spring by some edging up in mortgage rates. Since early May, however, mortgage rates have moved down about 1/2 percentage point, and there is no evidence that access to home loans has been curtailed.

On the supply side, building is being deterred in some parts of the country by an overhang of unsold or unrented housing units. In addition, it appears that a reduction in credit availability for construction may be playing some role in damping building activity. To a degree, this less favorable credit climate is attributable to the cutback in financing supplied by thrift institutions owing to the closure of savings and loans as well as the more stringent capital requirements and lending limits mandated by the Financial Institutions Reform, Recovery, and Enforcement Act. At the same time, other institutions do not appear to be filling the void completely. In part, the shift in credit availability reflects the elimination of the imprudently aggressive lending that capsized so many thrift institutions. A number of commercial banks also have recently experienced reductions in their lending capacity as they have written off, or reserved against, bad loans. But, in addition, the number of sound lending opportunities undoubtedly has shrunk as a consequence of economic weakness and soft property values in specific locales.

The Business Sector

The financial position of the business sector deteriorated further during the early part of 1990. Before-tax profits from current operations of nonfinancial corporations edged down in the first quarter after falling nearly 18 percent over the four quarters of 1989. Profits have been squeezed by a combination of marked increases in wages and benefits during a period of weak growth in productivity, competitive pressures from both home and abroad that have prevented firms from completely passing increases in labor costs through to prices, and higher debt-servicing costs associated in part with increased leverage.

Shrinking profits, which have reduced the availability of internal funds, along with the slower growth of final sales and easing of capacity pressures over the past year, have muted the demand for new plant and equipment. Reflecting these developments, real business fixed investment has decelerated considerably since the first half of 1989.

Although total real spending on producers' durable equipment rose at an annual rate of about 7 percent in the first quarter, spending was boosted by a rebound in outlays for motor vehicles and a resurgence in aircraft shipments after the settlement of the strike last November at Boeing. Excluding these transitory swings, real equipment spending slowed further in the first quarter, and shipments of most types of capital goods--especially industrial machinery--remained soft in April and May. One bright spot in the equipment picture, however, has been the growth in outlays for computers and other information-processing equipment, after some slowing during the second half of 1989.

Nonresidential construction was boosted by favorable weather early in the year, but most of the gain has since been reversed. The weakness is most evident in office and commercial real estate, for which vacancy rates are high, and data on contracts and permits suggest that the outlook for building remains decidedly negative. In some areas, this reflects sluggish growth in the regional economies. However, activity also may be hindered by the shift in the credit climate, as more speculative projects that previously might have been financed no longer qualify. An exception to the weakness in business construction has been in the industrial sector; lead times can be quite long for these projects, however, and much of the continued strength undoubtedly reflects in large part decisions made when capacity pressures were mounting in 1988 and early 1989. Indeed, contracts and permits for new industrial construction have been trending down for about a year.

The emergence of uncomfortably high inventories in some sectors in late 1989 led to corrective actions in the first part of this year. Most prominently, manufacturers of motor vehicles cut production sharply and reinstated widespread sales incentives to eliminate an overhang of stocks on dealer lots. In most other sectors, stocks have been trimmed or have been increased only modestly this year, and they appear to be in good alignment with sales trends. Among the possible exceptions are wholesale distributors of machinery and nonauto retailers, where some mild overhangs appear to have developed this spring; these could precipitate further adjustments, probably affecting both domestic and foreign producers.

The Government Sector

The federal budget deficit over the first eight months of the fiscal year was $152 billion, up from $113 billion in the year-earlier period. About $15 billion of this increase resulted from spending by the Resolution Trust Corporation, and further RTC outlays during June imply that the year-to-year increase in the deficit is likely to widen. Most of the RTC spending reflects financial transactions in which existing federal insurance obligations to thrift depositors are being recognized in the government's budget outlay and public debt accounts. The RTC's borrowing and spending thus should have little effect on real economic activity or interest rates.

However, several other budget components have contributed to the higher deficit. Spending on Medicare and other health care programs, and some discretionary spending for the space and other programs, has surged. During the same period, revenue growth has lagged as weak corporate profits have cut into receipts and last year's surprisingly large personal income tax collections have not been sustained. The latter suggests that some of last year's receipts reflected special factors, such as the deferral of tax liabilities in response to the phased reduction of income tax rates under the Tax Reform Act of 1986, and the capital gains realized during sharp movements in financial markets.

Federal purchases of goods and services, the part of expenditures that is included directly in GNP, fell in real terms over 1988 and 1989, owing mainly to declines in defense spending. Real defense purchases continued to move lower in the first quarter of 1990; however, the downtrend in total purchases was interrupted by a pickup in nondefense spending, mainly a transitory surge in space expenditures. In the second quarter, compensation for temporary Census workers added to federal purchases.

Real state and local government purchases increased at an annual rate of 4 1/4 percent in the first quarter, compared with the 3 to 3 1/2 percent pace recorded over the past three years. Revenue growth generally has not kept up with gains in spending, however, and an increasing number of state and local governments face significant budgetary difficulties; indeed, the overall deficit of the sector (excluding social insurance funds) was about $45 billion (annual rate) in the first quarter of 1990, almost $11 billion greater than the deficit recorded in the 1989 calendar year. These difficulties are compounded by growing spending requirements in several important areas. An increase in the number of school-age children has boosted public school enrollments, the number of medicaid recipients has increased, and prison populations have risen rapidly. Meanwhile, legislatures have been reluctant to increase personal income taxes, and federal grants and increases in state excise taxes have failed to prevent the widening of the gap between spending and revenues.

The External Sector

Movements in the exchange rate have been smaller than those in 1989, when the dollar appreciated about 12 percent in terms of the other G-10 currencies over the first half of the year and then depreciated by a similar amount between last summer and this past February. The dollar appreciated approximately 2 percent between February and March this year but has since declined about 4 percent, partly in response to publication of weaker data on U.S. economic activity and the associated washing out of expected increases in interest rates.

While the value of the dollar has not changed dramatically on a trade-weighted average basis against the other G-10 currencies this year, there have been some divergences in bilateral exchange rates. On balance, the dollar has depreciated significantly against sterling and the Swiss franc, and somewhat less against the German mark and related currencies. In contrast, the dollar has appreciated against the yen, despite exchange market intervention by the Bank of Japan and other central banks to support the value of the yen early in the year. Against the currencies of our other major trading partners in the Pacific Basin, the dollar has depreciated against the Singapore dollar, but appreciated in terms of the South Korean won and the new Taiwan dollar.

Prices of non-oil imports, which fell at about a 3 percent annual rate between the first and third quarters of last year, rose at a similar pace between the third quarter of 1989 and the first quarter of 1990, partly in response to the drop in the dollar between last summer and the early part of this year. Prices of imported oil surged around the turn of the year, moving above $20 per barrel in January, but since then they have more than retraced this runup. On the export side, prices rose at an annual rate of just 1 3/4 percent in the first quarter of 1990 after recording little change, on balance, over 1989 as a whole. In the first quarter, prices for agricultural exports fell somewhat, but there was an acceleration in prices for exported consumer and capital goods that appears to have been related to some pickup in prices for these items in domestic markets around the turn of the year.

Merchandise exports continue to provide an important impetus to growth in the domestic economy, although the increases in exports have slowed somewhat from the very rapid advances recorded in the latter part of the 1980s. So far this year, exports have been boosted by strong shipments of aircraft with the rebound in activity at Boeing, as well as by notable increases in other classes of machinery, agricultural products, industrial supplies, and consumer goods. Two factors have contributed to further large gains in the quantity of U.S. exports: Many of our major trading partners abroad have continued to register strong economic growth, and the average dollar prices of U.S. exports have declined somewhat relative to average prices abroad. Movements in nominal exchange rates do not appear to have contributed significantly to either export growth or overall U.S. external adjustment in recent quarters; the effects of the large depreciation of the dollar through 1987 have waned, and any residual positive effects probably have been offset by the average strengthening of the dollar last year. However, the depreciation of the dollar since last summer should lend some stimulus to external adjustment in coming quarters.

Meanwhile, slower import growth has accompanied the slackening pace of activity in the United States. Total imports were boosted by a surge in oil imports in the first quarter, but, on balance, non-oil merchandise imports have edged down this year. The slowdown in imports has been pronounced in automotive products and consumer goods, reflecting both weaker domestic final demands and the inventory adjustments in these sectors of the U.S. economy.

Together, the continued growth in exports and the slowdown in imports narrowed the merchandise trade balance to $105 billion at an annual rate in the first quarter of 1990, its lowest rate since early 1985. The current account deficit was reduced to $92 billion at an annual rate.

Net private capital inflows, and a large statistical discrepancy, provided the counterpart to the current account deficit in the first quarter of 1990, as they did for 1989 as a whole. Most of the private capital inflow in the first quarter came through the banking sector. Private foreign investors continued to acquire U.S. corporate bonds in the first quarter; however, they sold a small amount of U.S. Treasury securities, and they continued to sell U.S. corporate stocks as they have since last October. Foreign direct investment flows into the United States slowed markedly in the first quarter to a rate well below that recorded in recent years. Official capital showed a net outflow in the first quarter, as it did throughout most of 1989, reflecting the net sale of dollars in exchange market intervention.

Labor Markets

Job growth was strong early in the year, but has softened recently. In January and February, increases in nonfarm payroll employment averaged more than 350,000, fueled by large increases in service-producing industries as well as by robust hiring in construction during the warmer than normal winter weather. Since March, however, job growth has averaged about 125,000 per month, despite the net addition of about 300,000 temporary workers to help carry out the 1990 Census; private payrolls have increased less than 20,000 per month. Manufacturing employment has continued to shrink this year at about the same rate as in the second half of 1989, and construction payrolls also have declined since the winter. Meanwhile, job growth in the service-producing industries has slowed in recent months. Although hiring gains have continued strong for health services, growth in jobs in business services has moderated, and there have been only small gains in employment at retail establishments.

Growth in the labor force also has been subdued in recent months. To an extent, this reflects longer-run demographic trends; but it may also reflect a tendency for fewer people to seek jobs when the growth of employment opportunities is perceived to have slackened. Survey data suggest that individuals have increasingly viewed jobs as harder to find.

The slower rates of growth in employment and the labor force have been roughly matching, and the civilian unemployment rate has remained near 5 1/4 percent throughout the year. While unemployment rates have risen noticeably in the Northeast and moved up in some Midwestern states, jobless rates in other regions of the country either have changed little or have edged down.

With labor markets remaining relatively tight by historical standards, pressures on labor costs have not abated. Although the rate of increase in straight-time wages has changed little over the past year and a half, benefit costs, which currently constitute roughly one-fourth of compensation, have picked up markedly. In part, this increase reflected the higher social security taxes that went into effect in January, but benefits also have been boosted by the continued rise of health insurance costs and an acceleration of lump-sum payments and bonuses. All told, employee compensation in private nonfarm industry rose 5 1/4 percent over the twelve months ended in March, a bit above the pace recorded in the year ended last December.

In addition to gains in hourly compensation, unit labor costs have been boosted by a poor performance in labor productivity, as output per hour in the nonfarm business sector rose just 1/4 percent between the first quarter of 1989 and the first quarter of 1990. While productivity has remained strong in the manufacturing sector, rising almost 5 percent at an annual rate in the first quarter, productivity performance outside of manufacturing has been quite weak. As a consequence, unit labor costs in the first quarter of 1990 were 5 percent above their level a year earlier, about the same increase as recorded over 1989 as a whole, but well above the rates that prevailed earlier in the expansion.

Price Developments

After surging in the first quarter of 1990, price increases moderated this spring. Food and energy prices were boosted early in the year by weather-related developments, and prices for a wide range of other goods and services also picked up sharply. However, by May, the transitory effects of the weather on inflation largely had been reversed, and price increases for many other items slowed significantly.

Energy prices surged this past winter, as a result of demand pressures from the unreasonably cold weather in December and supply disruptions at U.S. refineries and in Eastern Europe. The posted price of West Texas Intermediate (WTI) oil, the benchmark for U.S. crude prices, rose about $3 per barrel to a peak of $22 in January. Since early February, on balance, the posted price for WTI has moved down substantially, in large part reflecting the effects on crude markets of increased output by OPEC nations. Movements in energy prices at the consumer level normally follow developments in crude oil prices. Gasoline prices, however, remain higher than in December. In part, pump prices have been boosted by the additional costs to refiners of complying with environmental standards. In addition, inventories of gasoline were relatively low during the first half of the year as a result of a variety of supply disruptions at refineries.

Overall, consumer food prices were boosted by sharp increases in prices for fresh fruits and vegetables after the freeze in December, but during the spring these prices retraced most of their earlier climb. The prices for other foods for home consumption have continued on an upward course. In addition, the prices of foods and beverages purchased at restaurants have risen at a 6 percent annual rate so far this year, about 1 1/2 percentage points above the average rate of increase over the past two years; these prices probably have reflected a dwindling supply of entry-level workers and related increases in labor costs, and perhaps in some regions by the higher federal minimum wage.

The CPI excluding food and energy rose about 4 3/4 percent over the twelve months ending in May, near the upper end of the range experienced during the current expansion. Price increases for consumer goods, particularly apparel, rose sharply early in the year. However, the burst in prices did not carry through to the second quarter, as prices for commodities excluding food and energy changed little in April and May.

In the service sector, inflation rose markedly in the first quarter, in part reflecting some bunching of increases for items whose prices tend to change in irregular jumps, such as public transportation fares and auto registration fees. Although inflation in service prices moderated in the spring, there was little retracing of the earlier increases; indeed, in May, the CPI for nonenergy services was 5 1/2 percent above its level twelve months earlier, the upper end of the range of increases seen over the past three and a half years. As in 1989, increases in prices of rents and medical services contributed importantly to the rise in overall service prices so far this year. However, there also have been widespread pickups in prices for a variety of labor-intensive services, and it is likely that, in addition to strong consumer demands, higher labor costs have boosted service prices.

The signs of moderating inflation for goods at earlier stages of processing, which had surfaced as capacity utilization rates moved down during 1989, appear to have continued into 1990. After rising 4 1/4 percent in 1989, the producer price index for finished goods excluding food and energy has increased at an annual rate of about 3 3/4 percent during the first six months of 1990. Producer prices for intermediate materials excluding food and energy increased at an annual rate of just 3/4 percent between December and June, roughly the same rate of increase as recorded over 1989 as a whole. The moderation of inflation for goods at the producer level is perhaps one indication that earlier moves toward monetary restraint and the slower pace of economic activity have worked to ease the resource constraints that had pushed up materials prices between 1987 and early 1989.

Monetary and Financial Developments during the First Half of 1990

Shifts in financial intermediation and credit flows, stemming from the continued restructuring of the thrift industry and a more cautious attitude of banks toward certain credit extensions, exerted a major influence on the monetary aggregates and their relation to economic activity during the first half of 1990. In anticipation of further contraction in the thrift industry, and its associated effects on depository intermediation, the Committee reduced the annual growth range for M3 by a full percentage point in February. In the event, M3 has slowed even more dramatically than had been anticipated, leaving this aggregate below the lower bound of its reduced range. Not only has the thrift industry contracted more rapidly than expected, but commercial banks have picked up little of the lending forgone by thrift institutions and, in fact, have curtailed their own lending in some sectors, thus further depressing depository credit. With little need to fund asset growth, banks and thrift institutions have pursued retail deposits less aggressively, leading to the opening of a sizable gap between yields available in the open market and those on such deposits. Partly as a result, M2 also has slowed, moving down into the lower portion of its annual growth range.

The deceleration of the monetary aggregates mainly reflects a reduction in the share of credit provided by depositories, rather than a sharp slowing of income or total credit flows. The velocities of both M2 and M3 posted sizable increases, particularly in the second quarter. Total debt of domestic nonfinancial sectors grew at an annual rate of 7 percent over the first half of the year--down only slightly from its pace in the latter half of 1989 and in the middle of its monitoring range. However, growth of total debt was boosted by federal government borrowing to support thrift resolutions; the debt of nonfederal sectors grew somewhat less rapidly than it did last year. Uncertainly about the effects of the restructuring of credit flows, and about the reasons for the extent of the slowdown in money growth, underlined the need for the FOMC to assess the behavior of the aggregates in light of information on spending and prices and the likely course of monetary velocities.

The somewhat more cautious lending posture that commercial banks have recently adopted is mainly a response to heightened credit risks caused by the more moderate pace of economic expansion overall and a downturn in several sectors. The resulting loan write-offs and pressures on capital positions may also have induced some tightening of standards. Growing markets for securitized loans largely have filled the vacuum created by the retrenchment of thrift institutions in the area of mortgage lending, with little attendant effect on the cost or availability of residential mortgage credit to households. Both banks and thrift institutions have cut back on other types of lending that can less easily be rechannelled, however, including construction and nonresidential real estate loans, loans to highly leveraged borrowers, and loans to small and medium-sized businesses. To offset tighter credit market conditions, which could exert undue restraint on aggregate demand, the Federal Reserve has recently adopted a slightly more accommodative stance with regard to reserve provision, fostering a small decline in market interest rates.

The Implementation of Monetary Policy

The FOMC maintained a steady degree of pressure in reserve markets during the first six months of the year. Policy had been eased in the second half of 1989 amid concerns that the economic slowdown might cumulate and thereby threaten the expansion. In the first half of 1990, however, the Committee viewed the balance of evidence as suggesting that underlying trends were generally consistent with its objectives of sustaining economic growth while containing and eventually reducing inflationary pressures.

In the opening months of the year, incoming information on spending and prices caused markets to reevaluate the prospects for a near-term reduction of inflationary pressures and further easing of monetary policy. As a result, market interest rates rose, despite a steady federal funds rate. The rise was most pronounced at the longer end of the maturity spectrum, and it restored the usual upward tilt to the yield curve that had been absent much of last year. Developments in Eastern Europe, which portended increases in demands on the world's limited pool of savings, also contributed to increases in long-term rates in the United States and abroad. By late April, market participants expected a near-term tightening of U.S. monetary policy.

In early May, the pendulum of market opinion began to swing away from the view that a tightening of U.S. monetary policy was in the offing. Beginning with a lackluster employment report on May 4, economic data have pointed to a somewhat slower pace of activity and reduced price pressures. In addition, a pronounced slowdown in the monetary aggregates began in April, followed by outright declines in May. Although both M2 and M3 recovered a little in June, they remained below the midpoint and the lower bound respectively of their annual ranges at midyear. Evidence also suggested that restricted credit availability, in part the result of tightened credit standards, may have spread beyond commercial real estate, construction, and merger-related lending. In response to this firming of credit conditions, the Federal Reserve began providing reserves slightly more generously through open market operations in mid-July.

Market interest rates, which already had receded somewhat from their early spring highs, declined further with the Federal Reserve's recent easing, though intermediate and long-term rates remained above the levels seen last December. Lower interest rates also bolstered the stock market, and some share price indexes reached record highs this month.

Spreads between high-quality private instruments and Treasury issues narrowed slightly over the first half of 1989. This narrowing reflected the continued availability of funds for investment-grade borrowing as well as increases in the borrowing needs of the RTC, which are met partly through the Treasury. The pickup in Treasury borrowing for the RTC was necessitated by the faster pace of thrift resolutions, which require the government to carry thrift assets on its own balance sheet pending their disposition. The market for investment-grade issues continued to function reasonably well, with stable rate spreads between quality tiers and generally well-maintained issuance volumes. On average, however, the business sector faced somewhat higher borrowing costs, largely as the result of numerous downgradings of debt issues. The collapse of Drexel Burnham Lambert had a marginal impact on an already debilitated market for below-investment-grade issues, widening spreads somewhat more between yields on such bonds and those on other long-term securities.

Monetary and Credit Flows

Growth of the monetary aggregates was sluggish over the first half of 1990, with M2 and M3 expanding at annual rates of only 3 1/2 percent and 1 1/4 percent respectively from the fourth quarter of 1989 through June. The weakness in money growth primarily reflected a redirection of credit extensions away from depository institutions owing to the continued downsizing of the thrift industry and a more cautious lending posture of commercial banks.

The deceleration of M2 growth did not begin until the second quarter of 1990, when growth slowed to a 2 1/4 percent annual rate from the 6 to 7 percent range seen in the previous three quarters. Retail deposits (which include NOW accounts as well as savings, small time deposits, and similar instruments) had begun to decelerate in the first quarter, slowing to a pace of less than 4 percent from the 5 3/4 percent rate seen in the fourth quarter of 1989. The effects of this slowdown on M2 were partially masked, however, by a surge in currency growth--apparently owing in part to increased demand from overseas--and a bulge in some of M2's wholesale components, mainly overnight RPs and Eurodollars. By the second quarter, a steep runoff in retail money market mutual fund (MMMF) shares and a sharp decline in demand deposits reinforced weakness in core deposits in damping growth in aggregate M2.

Increases in the opportunity costs of holding M2 balances--that is, the rise in other interest rates relative to those on M2--related growth in this aggregate during the first half of the year. This was particularly evident for retail MMMFs. Through much of 1989, the yield curve was inverted, and MMMFs, whose portfolios typically average about 30 to 40 days in maturity, had historically large yield advantages relative to longer-term Treasury bills and short-dated Treasury notes. As a result, MMMFs expanded briskly. As the yield curve began to flatten toward year-end, flows into MMMFs ebbed, though they remained a key element of overall M2 growth. With the steepening of the yield curve in the early part of 1990, MMMF growth stopped in March. The recent rally in the stock market also may have depressed MMMFs, as data through May indicate strong inflows to equity mutual funds, a substantial portion of which may have been transferred from MMMFs.

When yield curves have become more steeply upward sloping in the past, the effect on M2 of weakness in MMMFs and other liquid balances often has been partially offset by strength in retail time deposits, as households lengthen the maturity of their assets. This year, however, retail certificate of deposit (CD) rates were unusually slow to respond to the rise in market rates through April, contributing to unexpected weakness in M2. The reluctance of banks to raise deposit rates in response to rising market rates was particularly evident in the intermediate-term area where, for example, the rise of 100 basis points in the yield on the three-year Treasury note during the first four months of the year elicited an increase of less than 20 basis points in rates on bank retail CDs of comparable maturity. Evidence of the rising opportunity cost of holding M2 can be seen in the unusually heavy volume of noncompetitive tenders in Treasury bill and note auctions, which suggest a shift out of M2 balances.

The unwillingness of banks to price their deposits as aggressively as in the past is partly an indirect result of the contraction of the thrift industry. During the first six months of 1990, commercial banks enjoyed $62 billion in retail deposit inflows--about a 10 percent increase at an annual rate--while thrift institutions were shedding $28 billion in retail deposits--about a 5 percent annual rate of contraction. Much of this deflection of deposits toward commercial banks was the direct result of RTC resolutions. In the first half of the year, the RTC resolved 170 thrift institutions holding $32 billion of nonbrokered retail deposits, much of which was immediately assumed by commercial banks.

Although deposit transfers do not directly depress M2, they may have contributed to the weakness in this aggregate by reducing banks' need to raise their offering rates to attract additional deposits at a time when growth in bank credit was slow. Through the first half of 1990, commercial banks were able to fund nearly 80 percent of their total credit growth with retail deposits--almost people the proportion seen in recent years--even though they allowed spreads between market rates and their retail offering rates to widen substantially.

Widening opportunity costs of holding M2 can explain only some of the moderation in this aggregate in the first half of 1990, however. M2 may also have been responding to slower spending, and other factors, some of which may have been associated with deposit restructuring under the RTC. Brokered deposits formerly attracted to thrift institutions by relatively high yields may have been particularly sensitive to the recent sluggishness in deposit pricing; about $7 billion of brokered deposits were held at thrift institutions that were resolved in the first six months of the year, and many of these high-rate contracts were subsequently abrogated or not rolled over by the acquiring institutions. Evidence also suggests that, in light of large deposit inflows from thrift institutions, banks have curtailed marketing and promotional activity designed to attract retail deposits. Finally, the issuance of short-term Treasury paper to fund RTC holdings of former thrift assets has boosted the supply of, and raised the rates on, a close M2 substitute just when depositories were becoming less aggressive in seeking retail deposits. The rise in opportunity costs and these other factors contributed to an increase in the velocity of M2 in the first half of 1990, though some of this increase remains difficult to explain.

The link between changes in depository intermediation and M3 is somewhat more direct. This aggregate encompasses managed liabilities, as well as deposits and other sources of funds in M2, and is thus a better barometer of the overall funding needs of banks and thrift institutions. As has been evident since last summer, the contraction of the thrift industry and the failure of banks fully to pick up the slack have already resulted in a significant slowdown in growth of depository credit relative to that of aggregate nonfinancial sector debt and a concomitant increase in M3 velocity. This trend continued into the first half of 1990, as growth in depository credit all but ceased--though overall debt growth continued at a moderate pace--and M3 fell well below the lower bound of its annual growth cone.

Although the FOMC foresaw some significant damping effects on M3 growth in 1990 in association with the continued shrinkage of the thrift industry, the actual weakness in M3 so far this year has been more pronounced than anticipated. In setting out its expectations for M3 in 1990, the Committee recognized that considerable uncertainties surrounded the thrift industry contraction in terms of the pace of RTC resolutions, the extent of asset shrinkage at capital-impaired thrift institutions, and the desire of commercial banks to step into the breach. To this point, a faster-than-expected shrinkage of thrift assets has been manifested not only in weaker M2 deposit inflows, but also in faster runoffs of large time deposits and other M3 managed liabilities at thrift institutions. In addition, commercial banks apparently have filled less of the void left by thrift institutions than was originally anticipated. As a result, they too have pared their M3 managed liabilities, further depressing this aggregate.

Rates on large time deposits, like those on retail deposits, have remained low relative to yields on Treasury bills. Facing a substantial deterioration in the quality of their assets and constraints on capital, banks apparently have attempted to bolster profit margins and have not aggressively pursued new lending opportunities. Not only have deposit rates been held down, but loan rates also appear to have been raised slightly relative to market rates and nonprice terms have tightened for certain types of credits.

The pullback in credit supplies, together with some leveling out of demands for credit, likely contributed to a deceleration of bank asset growth. Over the second quarter, growth of bank credit slowed to a 5 3/4 percent pace from the near 7 percent rate of growth seen over the first quarter of 1990 and the second half of 1989, with much of the deceleration centered in real estate and consumer lending. Although the slowdown in real estate lending has been especially pronounced in New England, this type of lending remains sluggish in several other regions as well. Some of the deceleration in consumer lending represents sales of loans by banks attempting to bolster capital-asset ratios. Even adjusted for these sales, however, growth of consumer loans at banks slowed further in the second quarter from an already reduced first-quarter pace. The weakness in consumer borrowing this year is due primarily to sluggish retail sales, particularly of automobiles and other durable goods; banks evidently have remained willing lenders to households, and interest rates on consumer loans have changed little.

Bank lending to businesses also has been depressed this year. Surveys of commercial bank lending officers through early May suggest that the slowdown in bank credit largely reflects diminished demand for credit and deteriorating conditions in the real estate market, although tighter lending terms and more stringent credit standards were frequently cited for borrowers below investment grade, including many small businesses. Banks seem to have raised lending rates somewhat to small firms, judging from the slight increase in the spread between rates on small business loans and on federal funds. Separate surveys in which small businesses were queried about general credit availability have pointed to some recent increases in the difficulty these firms face in obtaining credit, though on balance they found credit availability little changed from mid-1989. The slowdown in bank business lending this year has mainly reflected reduced merger activity. Bank retrenchment in this area is consistent with other private credit judgments, as evidenced by the major slump in the market for bonds below investment grade.

The reduced volume of corporate restructurings, coupled with a diminished household demand for credit, has slowed the growth of the aggregate debt of domestic nonfinancial sectors to a 7 percent annual rate from the fourth quarter of 1989 through May of this year, compared with the 8 percent rate seen last year. Debt growth is currently in the middle of its monitoring range and broadly consistent with growth in nominal GNP. With the increasing leverage and the attendant dramatic declines in debt velocity witnessed in the 1980s apparently ending, the Committee reduced the 1990 monitoring range for debt by 1 1/2 percentage points in February.

Debt growth decelerated in the first half of the year despite a spike in U.S. government borrowing, which owed primarily to the growing working capital needs of the RTC. RTC spending, net of capital raised off-budget by the Resolution Funding Corporation, jumped to $31 billion in the second quarter, up from the $4 billion to $5 billion levels of the previous two quarters. This spending is financed through the Treasury and is therefore included in the debt aggregate.

The pace of household borrowing slowed considerably in the first six months of 1990, reflecting decelerations in both mortgage and consumer credit. The recent slowing of home mortgage borrowing appears to be largely the result of reduced demand, owing to increases in interest rates earlier in the year and weakening economic activity in some regions of the country. Although banks have picked up only some of the slack for thrift institutions in the area of mortgage lending, the expanding market for securitized mortgages has facilitated an orderly flow of mortgage credit. In fact, spreads of mortgage-backed securities over comparable Treasury issues remain low by historical standards and rates on home loans have not risen noticeably relative to other long-term rates.

Consistent with households' sluggish spending, overall consumer installment credit has risen at a 2 3/4 percent rate from the fourth quarter of 1989 through May of this year, well below the 5 1/2 percent clip in 1989. Some of this deceleration reflects substitution of home equity loans for previously existing consumer indebtedness; households apparently continue to recognize the lower relative after-tax cost of mortgage debt since the 1986 tax reform, which phased out the interest deductibility of non-mortgage household indebtedness. The slowdown in consumer loans on the books of depositories has been even more pronounced, reflecting a marked pickup in securitizations. The trend toward securitization of consumer loans, which has been evident in the past few years, appears to have accelerated in 1990, possibly because depositories are making efforts to reduce assets in order to meet the new risk-based capital requirements.

Through the first half of the year, the total borrowing of nonfinancial firms has been maintained at about the same pace as in the last half of 1989, despite a sharp drop in equity retirements. Although business lending by banks has slowed, commercial paper issuance picked up the slack, particularly in the first few months of the year. More recently, in light of declines in bond yields, firms have stepped up their issuance of bonds and slowed their use of commercial paper. Despite a recent slight narrowing of spreads relative to investment-grade securities, issuance of below-investment-grade bonds has remained in the doldrums. Spreads between investment-grade paper and Treasury issues are still low by historical standards, held down in part by supply pressures in the Treasury market.

In the municipal market, the increase in market interest rates and the downgradings of a number of key issuers during the first half of 1990 combined to slow refunding issuance to a crawl. As a result, the total debt of state and local governments expanded at only an annual rate of 3 percent in the second quarter, compared with 4 1/2 percent in 1989. [Tabular Data Omitted]

(1)The charts for the report are available on request from Publications Services, Board of Governors of the Federal Reserve System, Washington, D.C. 20551.
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Title Annotation:July 18, 1990
Publication:Federal Reserve Bulletin
Date:Sep 1, 1990
Previous Article:Industrial productivity.
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