FRB: Humphrey-Hawkins Report, July 22, 1999
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Monetary Policy Report submitted to the Congress on July 22, 1999, pursuant to the Full Employment and Balanced Growth Act of 1978

Section 1


The U.S. economy has continued to perform well in 1999. The ongoing economic expansion has moved into a near-record ninth year, with real output expanding vigorously, the unemployment rate hovering around lows last seen in 1970, and underlying trends in inflation remaining subdued. Responding to the availability of new technologies at increasingly attractive prices, firms have been investing heavily in new capital equipment; this investment has boosted productivity and living standards while holding down the rise in costs and prices.

Two of the major threats faced by the economy in late 1998--economic downturns in many foreign nations and turmoil in financial markets around the world--receded over the first half of this year. Economic conditions overseas improved on a broad front. In Asia, activity picked up in the emerging-market economies that had been battered by the financial crises of 1997. The Brazilian economy--Latin America's largest--exhibited a great deal of resilience with support from the international community, in the wake of the devaluation and subsequent floating of the real in January. These developments, along with the considerable easing of monetary policy in late 1998 and early 1999 in a number of regions, including Europe, Japan, and the United States, fostered a markedly better tone in the world's financial markets. On balance, U.S. equity prices rose substantially, and in credit markets, risk spreads receded toward more typical levels. Issuance of private debt securities ballooned in late 1998 and early 1999, in part making up for borrowing that was postponed when markets were disrupted.

As these potentially contractionary forces dissipated, the risk of higher inflation in the United States resurfaced as the greatest concern for monetary policy. Although underlying inflation trends generally remained quiescent, oil prices rose sharply, other commodity prices trended up, and prices of non-oil imports fell less rapidly, raising overall inflation rates. Despite improvements in technology and business processes that have yielded striking gains in efficiency, the robust growth of aggregate demand, fueled by rising equity wealth and readily available credit, produced even tighter labor markets in the first half of 1999 than in the second half of 1998. If this trend were to continue, labor compensation would begin climbing increasingly faster than warranted by productivity growth and put upward pressure on prices. Moreover, the Federal Open Market Committee (FOMC) was concerned that as economic activity abroad strengthened, the firming of commodity and other prices might also foster a less favorable inflation environment. To gain some greater assurance that the good inflation performance of the economy would continue, the Committee decided at its June meeting to reverse a portion of the easing undertaken last fall when global financial markets were disrupted; the Committee's target for the overnight federal funds rate, a key indicator of money market conditions, was raised from 4-3/4 percent to 5 percent.

Monetary Policy, Financial Markets, and the Economy over the First Half of 1999

The FOMC met in February and March against the backdrop of continued rapid expansion of the U.S. economy. Demand was strong, employment growth was brisk, and labor markets were tight. Nonetheless, price inflation was still low, held in check by a substantial gain in productivity, ample manufacturing capacity, and low inflation expectations.

Chart of Selected interest rates

Activity was supported by a further settling down of financial markets in the first quarter after a period of considerable turmoil in the late summer and fall of 1998. In that earlier period, which followed Russia's moratorium on a substantial portion of its debt payments in mid-August, the normal functioning of U.S. financial markets had been impaired as investors cut back sharply their credit risk exposures and market liquidity dried up. The Federal Reserve responded to these developments by trimming its target for the overnight federal funds rate by 75 basis points in three steps. In early 1999, the devaluation and subsequent floating of the Brazilian real in mid-January heightened concerns for a while, but market conditions overall improved considerably.

At its February and March meetings, the FOMC left the stance of monetary policy unchanged. The Committee expected that the growth of output might well slow sufficiently to bring production into close enough alignment with the economy's enhanced potential to forestall the emergence of a trend of rising inflation. Although domestic demand was still increasing rapidly, it was anticipated to moderate over time in response to the buildup of large stocks of business equipment, housing units, and durable goods and more restrained expansion in wealth in the absence of appreciable further increases in equity prices. Furthermore, the FOMC, after taking account of the near-term effects of the rise in crude oil prices, saw few signs that cost and price inflation was in the process of picking up. The unusual combination of very high labor resource utilization and sustained low inflation suggested considerable uncertainty about the relationship between output and prices. In this environment, the Committee concluded that it could wait for additional information about the balance of risks to the economic expansion.

By the time of the May FOMC meeting, demand was still showing considerable forward momentum, and growth in economic activity still appeared to be running in excess of the rate of increase of the economy's long-run capacity to expand output. Borrowers' heavy demands for credit were being met on relatively favorable terms, and wealth was further boosted by rapidly rising equity prices. Also, the economic and financial outlook for many emerging-market countries was brighter. Trends in inflation were still subdued, although consumer prices--even apart from a big jump in energy prices--were reported to have registered a sizable rise in April.

At its May meeting, the FOMC believed that these developments tilted the risks toward further robust growth that would exert additional pressure on already taut labor markets and ultimately show through to inflation. Moreover, a turnaround in oil and other commodity markets meant that prices of these goods would no longer be holding down inflation, as they had over the past year. Yet, the economy to date had shown a remarkable ability to accommodate increases in demand without generating greater underlying inflation trends, as the continued growth of labor productivity had helped to contain cost pressures. The uncertainty about the prospects for prices, demand pressures, and productivity was large, and the Committee decided to defer any policy action. However, in light of its increased concern about the outlook for inflation, the Committee adopted an asymmetric directive tilted toward a possible firming of policy. The Committee also wanted to inform the public of this significant revision in its view, and it announced a change in the directive immediately after the meeting. The announcement was the first under the Committee's policy of announcing changes in the tilt of the domestic directive when it wants to communicate a major shift in its view about the balance of risks to the economy or the likely direction of its future actions.

In the time leading up to the FOMC's June meeting, economic activity in the United States continued to move forward at a brisk pace, and prospects in a number of foreign economies showed additional improvement. Labor markets tightened slightly further. The federal funds rate, however, remained at the lower level established in November 1998, when the Committee took its last of three steps to counter severe financial market strains. With those strains largely gone, the Committee believed that the time had come to reverse some of that accommodation, and it raised the targeted overnight federal funds rate 25 basis points, to 5 percent. Looking ahead, the Committee expected demand to remain strong, but it also noted the possibility that a further pickup in productivity could allow the economy to accommodate this demand for some time without added inflationary pressure. In light of these conflicting forces in the economy, the FOMC returned to a symmetric directive. Nonetheless, with labor markets already tight, the Committee recognized that it needed to stay especially alert to signs that inflationary forces were emerging that could prove inimical to the economic expansion.

Economic Projections for 1999 and 2000

The members of the Board of Governors and the Federal Reserve Bank presidents see good prospects for sustained, solid economic expansion through next year. For this year, the central tendency of their forecasts of growth of real gross domestic product is 3-1/2 percent to 3-3/4 percent, measured as the change between the fourth quarters of 1998 and 1999. For 2000, the forecasts of real GDP are mainly in the 2-1/2 percent to 3 percent range. With this pace of expansion, the civilian unemployment rate is expected to remain close to the recent 4-1/4 percent level over the next six quarters.

1. Economic projections for 1999 and 2000
Accessible table
table rule
  Federal Reserve governors
and Reserve Bank presidents
Central tendency
Change, fourth quarter
to fourth quarter
Nominal GDP4-3/4 to 5-1/2 5 to 5-1/2 4.8
Real GDP3-1/4 to 4 3-1/2 to 3-3/4 3.2
Consumer price index31-3/4 to 2-1/2   2-1/4 to 2-1/2 2.4

Average level,
fourth quarter

Civilian unemployment
4 to 4-1/2 4 to 4-1/4 4.3
Change, fourth quarter
to fourth quarter
Nominal GDP4 to 5-1/4 4 to 5 4.2
Real GDP2 to 3-1/2 2-1/2 to 3 2.1
Consumer price index31-1/2 to 2-3/4   2 to 2-1/2 2.4

Average level,
fourth quarter

Civilian unemployment
4 to 4-1/2 4-1/4 to 4-1/2 4.7
table rule

          1.  From the Mid-Session Review of the budget.
          2.  Change from average for fourth quarter of previous year to average for fourth quarter
of year indicated.
          3.  All urban consumers.


The increases in income and wealth that have bolstered consumer demand over the first half of this year and the desire to invest in new high-technology equipment that has boosted business demand during the same period should continue to stimulate spending over the quarters ahead. However, several factors are expected to exert some restraint on the economy's momentum by next year. With purchases of durable goods by both consumers and businesses having risen still further and running at high levels, the stocks of such goods probably are rising more rapidly than is likely to be desired in the longer run, and the growth of spending should moderate. The increase in market interest rates should help to damp spending as well. And unless the extraordinary gains in equity prices of the past few years are extended, the impetus to spending from increases in wealth will diminish.

Federal Reserve policymakers believe that this year's rise in the consumer price index (CPI) will be larger than that in 1998, largely because of the rebound in retail energy prices that has already occurred. Crude oil prices have moved up sharply, reversing the decline posted in 1998 and leading to a jump in the CPI this spring. For next year, the FOMC participants expect the increase in the CPI to remain around this year's pace, with a central tendency of 2 percent to 2-1/2 percent. Futures market quotes suggest that the prevailing expectation is that the rebound in oil prices has run its course now, and ample industrial capacity and productivity gains may help limit inflationary pressures in coming months as well. With labor utilization very high, though, and demand still strong, significant risks remain even after the recent policy firming that economic and financial conditions may turn out to be inconsistent with keeping costs and prices from escalating.

Although interest rates currently are a bit higher than anticipated in the economic assumptions underlying the budget projections in the Administration's Mid-Session Review, there is no apparent tension between the Administration's plans and the Federal Reserve policymakers' views. In fact, Federal Reserve officials project somewhat faster growth in real GDP and slightly lower unemployment rates into 2000 than the Administration does, while the Administration's projections for inflation are within the Federal Reserve's central tendencies.

Money and Debt Ranges for 1999 and 2000

At its meeting in late June, the FOMC reaffirmed the ranges for 1999 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 debt of the domestic nonfinancial sectors. The FOMC set the same ranges for 2000 on a provisional basis.

2. Ranges for growth of monetary and debt aggregates
table rule
M2 1 to 51 to 51 to 5
M3 2 to 62 to 6 2 to 6
Debt    3 to 73 to 7 3 to 7
table rule

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


As has been the case since the mid-1990s, the FOMC views the ranges for money growth as benchmarks for growth under conditions of price stability and the historically typical relationship between money and nominal income. The disruption of the historically typical pattern of the velocities of M2 and M3 (the ratio of nominal GDP to the aggregates) during the 1990s implies that the Committee cannot establish, with any confidence, specific target ranges for expected money growth for a given year that will be consistent with the economic performance that it desires. However, persistently fast or slow money growth can accompany, or even precede, deviations from desirable economic outcomes. Thus, the behavior of the monetary aggregates, evaluated in the context of other financial and nonfinancial indicators, will continue to be of interest to Committee members in their policy deliberations.

The velocities of M2 and M3 declined again in the first half of this year, albeit more slowly than in 1998. The Committee's easing of monetary policy in the fall of 1998 contributed to the decline, but only to a modest extent. It is not clear what other factors led to the drop, although the considerable increase in wealth relative to income resulting from the substantial gains in equity prices over the past few years may have played a role. Investors could be rebalancing their portfolios, which have become skewed toward equities, by reallocating some wealth to other assets, including those in M2.

Even if the velocities of M2 and M3 were to return to their historically typical patterns over the balance of 1999 and in 2000, M2 and M3 likely would be at the upper bounds of, or above, their longer-term price-stability ranges in both years, given the Committee's projections of nominal GDP growth. This relatively rapid expansion in nominal income reflects faster expected growth in productivity than when the price-stability ranges were established in the mid-1990s and inflation that is still in excess of price stability. The more rapid increase in productivity, if it persists for a while and is sufficiently large, might in the future suggest an upward adjustment to the money ranges consistent with price stability. However, considerable uncertainty attends the trend in productivity, and the Committee chose not to adjust the ranges at its most recent meeting.

Debt of the nonfinancial sectors has expanded at roughly the same pace as nominal income this year--its typical pattern. Given the stability of this relationship, the Committee selected a growth range for the debt aggregate that encompasses its expectations for debt growth in both years. The Committee expects growth in nominal income to slow in 2000, and with it, debt growth. Nonetheless, growth of this aggregate is projected to remain within the range of 3 percent to 7 percent.


Section 2

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