Section 1: Monetary Policy and the Economic Outlook

The economy continued to perform exceptionally well in the first half of 1997. Real output grew briskly, while inflation ebbed. Sizable further increases in payrolls pushed the unemployment rate below 5 percent for the first time in nearly twenty-five years. Although growth in real gross domestic product appears to have slowed in the spring, this slackening came on the heels of a dramatic surge in the opening months of the year; all indications are that the expansion remains well intact. The members of the Board of Governors and the Reserve Bank presidents anticipate that the economy will grow at a moderate pace in the second half of this year and in 1998 and that inflation will remain low. Conditions in financial markets are supportive of continued growth: Longer-term interest rates are in the lower portion of the range observed in this decade, the stock market has registered all-time highs, and credit remains readily available to private borrowers.

Since the February report on monetary policy, Federal Reserve policymakers have revised upward their expectations for growth of real activity in 1997 and trimmed their forecasts of inflation. This combination of revisions highlights the extraordinarily positive conditions still prevailing more than six years into the current economic expansion. In part, the recent confluence of higher-than-expected output and lower inflation has reflected the favorable influences on prices of retreating oil prices and a strong dollar. But it may also be attributable to more durable changes in our economy, notably a greater flexibility and competitiveness in labor and product markets and more rapid, technology-driven gains in efficiency. In essence, the economy may be experiencing an upward shift in its longer-range output potential.

To the extent that aggregate supply is expanding more rapidly, monetary policy can accommodate extra growth in demand without fostering increased inflationary pressures. In late March, however, the Federal Open Market Committee concluded that there was a significant risk that aggregate demand would grow faster in the coming quarters than available supply, which, with utilization already at a very high level, would place the economy's resources under increasing strain. If such unsustainable growth persisted, the resulting inflationary imbalances would eventually undermine the health of the expansion--the all too frequent pattern of past business cycles. To protect against the possibility of such an outcome, the Committee tightened policy slightly. With the softening of demand in the spring, the Committee was able to maintain a steady posture in the money market while closely monitoring economic developments. The ongoing objective of monetary policy is to help the nation achieve maximum sustainable economic growth and the highest average living standards. The Federal Reserve recognizes that it can best accomplish this objective by keeping inflation in check, because an environment of price stability is most conducive to sound, long-term planning by households and businesses.

Monetary Policy, Financial Markets, and the Economy over the First Half of 1997

The rapid economic growth observed in the closing months of 1996 continued in the first quarter of this year, with real GDP advancing almost 6 percent at an annual rate. Consumer spending surged, fueled by a significant increase in income, upbeat consumer attitudes, and the effects of the huge run-up in equity prices over the past couple of years on household net worth. Business fixed investment was strong, and companies restocked inventories that had become thin as sales soared. The advance in real output provided support for considerable new hiring; rising pay and greater job availability drew additional people into the workforce, lifting the labor force participation rate to a new high during the first quarter of the year. The underlying trend in consumer price inflation was still subdued. Inflation pressures were held in check by smaller food price increases, declining prices for non-oil imports, the marked expansion of industrial capacity in recent years, and continuing efforts by businesses to boost efficiency.

At their meeting in late March, Federal Open Market Committee (FOMC) members expected that the growth of economic activity would ease in the coming months, but they were uncertain about the likely extent of that slowing. Although the first-quarter burst in production had owed importantly to a number of temporary factors, many of the fundamentals underlying consumer and business demand remained quite positive. The Committee was concerned about the risk that if outsized gains in real output continued, pressures on costs and prices would emerge that could eventually undermine the expansion. Therefore, to help foster more sustainable trends in output and guard against potential inflationary imbalances, the Committee firmed policy slightly by raising the expected federal funds rate from around 5-1/4 percent to around 5-1/2 percent.

The unsustainably strong pace of economic growth in the first quarter weighed on financial markets. Interest rates rose substantially, even before the System's action, despite favorable news on inflation. Because the policy tightening was widely anticipated, rates were little affected by the announcement, but they moved up a little more in the following weeks as incoming data suggested persistent strength in economic activity. Equity prices rose early in the first quarter and then declined, changing relatively little on net. The trade-weighted value of the dollar in terms of the other G-10 currencies increased about 7 percent in the first quarter, reflecting the unexpectedly strong economic growth in the United States and market uncertainty about economic performance abroad.

As the second quarter progressed, it became increasingly evident that economic activity had indeed decelerated. The expansion of consumer spending eased considerably, while business fixed investment remained strong. Employment continued to climb rapidly, pushing the unemployment rate down below 5 percent on average in the second quarter--the lowest level since the early 1970s. Despite high levels of employment and production through the first half of the year, there were few signs that inflation was deviating significantly from recent trends. Although overall consumer price inflation dipped in the second quarter as energy prices declined, consumer prices excluding food and energy increased at about the same pace in the first half of the year as in 1996.

Continued favorable price movements and the slowing of economic growth suggested to financial market participants that inflation might remain damped without a further tightening of financial conditions, and this belief prompted a substantial drop in interest rates from late April to mid-July, reversing the earlier advance. With resource utilization still at very high levels, and with economic and financial conditions conducive to robust increases in spending, the FOMC at its May meeting continued to view the risks as skewed toward the re-emergence of inflationary pressures. But the moderation in aggregate demand and uncertainty about the relationship between utilization rates and inflation led the Committee to leave reserve conditions unchanged in May and again in July. The drop in market interest rates in the second quarter may also have been encouraged by favorable news about this year's federal budget deficit and by the agreement between the President and the Congress to balance the budget in fiscal year 2002. Spurred by lower rates and greater optimism about the long-term outlook for earnings, the stock market surged in the second quarter and into July. The value of the dollar rose somewhat further in foreign-exchange markets, on balance, an increase more than accounted for by an appreciation against continental European currencies.

During the first half of the year, credit remained available on favorable terms to most households and businesses. High delinquency rates for consumer loans encouraged many banks to tighten standards, but consumer loan rates generally stayed fairly low relative to benchmark Treasury rates, and consumer credit continued to grow faster than income and only a little below the pace of 1996. Home mortgage debt advanced at a moderate rate, with home equity loans expanding especially rapidly in the spring. Businesses continued to have access to ample external funding both directly in capital markets and through financial intermediaries. The spreads between yields on corporate bonds and Treasury securities stayed low or fell further, and, relative to market rates, bank business loan rates held near the lower end of the range seen in the current expansion.

Total domestic nonfinancial debt expanded more slowly in the first half of 1997 than in 1996, mainly because of a reduced pace of federal borrowing. Trends in the monetary aggregates during the first half of 1997 were similar to those in 1996, with M2 near the upper end of the range set by the FOMC and M3 somewhat above its range. This outcome was in line with FOMC expectations, because the ranges had been set to be consistent with conditions of price stability, and inflation, while damped, remained above this level. The behavior of M2 in the first part of the year was again reasonably well explained by changes in nominal GDP and interest rates.

Economic Projections for 1997 and 1998

After growing swiftly on balance over the first half of the year, economic activity is expected to expand more moderately in the second half of 1997 and in 1998. For this year, the central tendency of the GDP growth forecasts put forth by members of the Board of Governors and the Reserve Bank presidents is 3 percent to 3-1/4 percent, measured as the change in real output between the final quarter of 1996 and the final quarter of 1997. For 1998, most of the forecasts anticipate growth of real GDP within a range of 2 percent to 2-1/2 percent. With this pace of continued economic expansion over the next six quarters, the central tendency of forecasts for the civilian unemployment rate remains a little under 5 percent through 1998, about the average for the second quarter of this year.

Economic activity appears to have entered the second half with considerable positive momentum. Households have experienced hefty gains in employment, income, and wealth, and their optimism about the future is quite high. These factors seem likely to outweigh any drag on consumer demand that might be associated with the debt-servicing problems that some households have experienced. Lower mortgage rates are buttressing demand for homes. In the business sector, healthy balance sheets and profits and a moderate cost of external funds, along with a continuing desire to install new technology, are providing support and impetus for investment in equipment. Meanwhile, investment in structures should follow last year's strong performance with further increases, because of declining vacancy rates in some sectors and ready access to financing.

Notwithstanding the economy's positive momentum, growth is expected to be more moderate in the next year and a half than in the first half of 1997. In part, this deceleration is likely to reflect the influence on demand of the substantial buildup of stocks of household durables and business plant and equipment thus far in the expansion. As well, the pace of inventory investment will need to slacken considerably relative to that observed in the first part of this year, lest stock-to-sales ratios become uncomfortably high. In the external sector, the strength of the dollar on exchange markets since last year could damp export sales and encourage U.S. firms and households to purchase foreign-produced goods and services.

Federal Reserve policymakers believe that this year's rise in the CPI will be smaller than that of 1996, mostly because of favorable developments in the food and, especially, energy sectors. After last year's run-up, crude oil prices have dropped back significantly, pulling down the prices of petroleum products. Food price increases also have been subdued this year, as the decline in grain prices that began in the middle of last year has been working its way through to the retail level. Looking ahead to next year, the governors and Reserve Bank presidents expect larger increases in the CPI, with a central tendency from 2-1/2 percent to 3 percent. Food and energy prices are not expected to repeat this year's salutary performance, and non-oil import prices may be less of a restraining influence than in 1997, absent a continued uptrend in the dollar. Moreover, there is a risk that high levels of resource utilization could begin putting upward pressure on business costs.

Economic Projections for 1997 and 1998
Percent

Federal Reserve governors and Reserve Bank presidents Indicator   Range   Central tendency 1997     Change, fourth quarter to fourth quarter1         Nominal GDP 5 to 6   5 to 5-1/2     Real GDP 3 to 3-1/2   3 to 3-1/4     Consumer price index2 2 to 2-3/4   2-1/4 to 2-1/2 Average level in the fourth quarter         Civilian unemployment     rate 4-3/4 to 5-1/4   4-3/4 to 5 1998     Change, fourth quarter to fourth quarter1         Nominal GDP 4-1/4 to 5-3/4   4-1/2 to 5     Real GDP 2 to 3   2 to 2-1/2     Consumer price index2 2-1/2 to 3   2-1/2 to 3 Average level in the fourth quarter         Civilian unemployment     rate 4-1/2 to 5-1/4   4-3/4 to 5

  1. Change from average for fourth quarter of previous year to average for fourth quarter of year indicated.
  2. All urban consumers.

As noted in past monetary policy reports, the CPI forecasts of Federal Reserve policymakers incorporate the technical improvements that the Bureau of Labor Statistics is making to the CPI in 1997 and 1998. A series of technical changes is estimated to have trimmed reported rates of CPI inflation slightly in recent years, and the additional changes will affect the index this year and next. In light of the challenges of accurately measuring price changes in a complex and dynamic economy, the governors and Reserve Bank presidents will continue placing substantial weight on other price indexes, along with the CPI, in gauging progress toward the long-run goal of price stability.

The Administration has not yet released an update of the economic projections contained in the February Economic Report of the President. The earlier Administration forecasts were broadly similar to those in the Federal Reserve's February report, with Administration forecasts for growth and inflation within or near the range anticipated by Federal Reserve policymakers in February. Because of developments in the economy since that time, the central tendency of forecasts for real GDP growth put forth by the members of the Board of Governors and the Reserve Bank presidents has moved higher, while their forecasts for the CPI have moved down.

Money and Debt Ranges
for 1997 and 1998

At its meeting earlier this month, the Committee reaffirmed the ranges for 1997 growth of money and debt that it had established in February: 1 percent to 5 percent for M2, 2 percent to 6 percent for M3, and 3 percent to 7 percent for the debt of the domestic nonfinancial sectors. The Committee also set provisional ranges for 1998 at the same levels as for 1997.

Ranges for Growth of Monetary and Debt Aggregates
Percent

Aggregate 1996 1997 Provisional for 1998     M2 1 to 5 1 to 5 1 to 5     M3 2 to 6 2 to 6 2 to 6     Debt     3 to 7 3 to 7 3 to 7

  Note. Change from average for fourth quarter of preceding year
to average for fourth quarter of year indicated.

In choosing the ranges for M2 and M3, the Committee recognized the continuing uncertainty about the future behavior of the velocities of the two aggregates. For several decades until the 1990s, these aggregates exhibited fairly stable trends relative to nominal spending, and variations in M2 growth around its trend were reasonably closely related to changes in the spread between market rates and yields on the assets in M2. These relationships were disrupted in the first part of this decade. Between 1991 and early 1994, the velocities of M2 and M3 climbed well above the levels that were predicted by past experience, as households shifted substantial amounts out of lower-yielding deposits into higher-yielding stock and bond mutual funds, and as banks and thrift institutions sharply curtailed their lending to focus on rebuilding capital. Since mid-1994, the velocities have been moving more nearly in line with their historical patterns with respect to changes in opportunity costs--albeit at higher levels. This recent period of renewed stability is still brief, however, and has occurred at a time of relatively stable financial and economic conditions, leaving open the important question of whether the stability would be sustained in the future under a wider variety of circumstances.

In light of this uncertainty, the Committee again decided to view the ranges as benchmarks for monetary growth rates that would be consistent with approximate price stability and historical velocity relationships. If velocities change little over the next year and a half, Committee members' expectations of nominal GDP growth in 1997 and 1998 imply that M2 and M3 will likely finish around the upper boundaries of their respective ranges each year. The debt of the domestic nonfinancial sectors is expected to remain near the middle of its range this year and next. The Committee will continue to monitor the behavior of the monetary aggregates and domestic nonfinancial debt--as well as a wide range of other data--for information about economic and financial developments.

Section 2