Monetary Policy Report forwarded to the Congress on July 20, 2000
MONETARY POLICY AND THE ECONOMIC OUTLOOK
The impressive performance of the U.S. economy persisted in the first half of 2000 with economic activity expanding at a rapid pace. Overall rates of inflation were noticeably higher, largely as a result of steep increases in energy prices. The remarkable wave of new technologies and the associated surge in capital investment have continued to boost potential supply and to help contain price pressures at high levels of labor resource use. At the same time, rising productivity growth--working through its effects on wealth and consumption, as well as on investment spending--has been one of the important factors contributing to rapid increases in aggregate demand that have exceeded even the stepped-up increases in potential supply. Under such circumstances, and with the pool of available labor already at an unusually low level, the continued expansion of aggregate demand in excess of the growth in potential supply increasingly threatened to set off greater price pressures. Because price stability is essential to achieving maximum sustainable economic growth, heading off these pressures has been critical to extending the extraordinary performance of the U.S. economy.
To promote balance between aggregate demand and potential supply and to contain inflation pressures, the Federal Open Market Committee (FOMC) took additional firming actions this year, raising the benchmark federal funds rate 1 percentage point between February and May. The tighter stance of monetary policy, along with the ongoing strength of credit demands, has led to less accommodative financial conditions: On balance, since the beginning of the year, real interest rates have increased, equity prices have changed little after a sizable run-up in 1999, and lenders have become more cautious about extending credit, especially to marginal borrowers. Still, households and businesses have continued to borrow at a rapid pace, and the growth of M2 remained relatively robust, despite the rise in market interest rates. The favorable outlook for the U.S. economy has contributed to a further strengthening of the dollar, despite tighter monetary policy and rising interest rates in most other industrial countries.
Perhaps partly reflecting firmer financial conditions, the incoming economic data since May have suggested some moderation in the growth of aggregate demand. Nonetheless, labor markets remained tight at the time of the FOMC meeting in June, and it was unclear whether the slowdown represented a decisive shift to more sustainable growth or just a pause. The Committee left the stance of policy unchanged but saw the balance of risks to the economic outlook as still weighted toward rising inflation.
Monetary Policy, Financial Markets, and the Economy over the First Half of 2000
When the FOMC convened for its first two meetings of the year, in February and March, economic conditions in the United States were pointing toward an increasingly taut labor market as a consequence of a persistent imbalance between the growth rates of aggregate demand and potential aggregate supply. Reflecting the underlying strength in spending and expectations of tighter monetary policy, market interest rates were rising, especially after the century date change passed without incident. But, at the same time, equity prices were still posting appreciable gains on net. Knowing that the two safety valves that had been keeping underlying inflation from picking up until then--the economy's ability to draw on the pool of available workers and to expand its trade deficit on reasonable terms--could not be counted on indefinitely, the FOMC voted for a further tightening in monetary policy at both its February and its March meetings, raising the target for the overnight federal funds rate 25 basis points on each occasion. In related actions, the Board of Governors also approved quarter-point increases in the discount rate in both February and March.
The FOMC considered larger policy moves at its first two meetings of 2000 but concluded that significant uncertainty about the outlook for the expansion of aggregate demand in relation to that of aggregate supply, including the timing and strength of the economy's response to earlier monetary policy tightenings, warranted a more limited policy action. Still, noting that there had been few signs that the rise in interest rates over recent quarters had begun to bring demand in line with potential supply, the Committee decided in both instances that the balance of risks going forward was weighted mainly in the direction of rising inflation pressures. In particular, it was becoming increasingly clear that the Committee would need to move more aggressively at a later meeting if imbalances continued to build and inflation and inflation expectations, which had remained relatively subdued until then, began to pick up. 1
Some readings between the March and May meetings of the FOMC on labor costs and prices suggested a possible increase of inflation pressures. Moreover, aggregate demand had continued to grow at a fast clip, and markets for labor and other resources were showing signs of further tightening. Financial market conditions had firmed in response to these developments; the substantial rise in private borrowing rates between March and May had been influenced by the buildup in expectations of more policy tightening as market participants recognized the need for higher short-term interest rates. Given all these circumstances, the FOMC decided in May to raise the target for the overnight federal funds rate 50 basis points, to 6-1/2 percent. The Committee saw little risk in the more forceful action given the strong momentum of the economic expansion and widespread market expectations of such an action. Even after taking into account its latest action, however, the FOMC saw the strength in spending and pressures in labor markets as indicating that the balance of risks remained tilted toward rising inflation.
By the June FOMC meeting, the incoming data were suggesting that the expansion of aggregate demand might be moderating toward a more sustainable pace: Consumers had increased their outlays for goods modestly during the spring; home purchases and starts appeared to have softened; and readings on the labor market suggested that the pace of hiring might be cooling off. Moreover, much of the effects on demand of previous policy firmings, including the 50 basis point tightening in May, had not yet been fully realized. Financial market participants interpreted signs of economic slowing as suggesting that the Federal Reserve probably would be able to hold inflation in check without much additional policy firming. However, whether aggregate demand had moved decisively onto a more moderate expansion track was not yet clear, and labor resource utilization remained unusually elevated. Thus, although the FOMC decided to defer any policy action in June, it indicated that the balance of risks was still on the side of rising inflation in the foreseeable future. 2
Economic Projections for 2000 and 2001
The members of the Board of Governors and the Federal Reserve Bank presidents expect the current economic expansion to continue through next year, but at a more moderate pace than the average over recent quarters. For 2000 as a whole, the central tendency of their forecasts for the rate of increase in real gross domestic product (GDP) is 4 percent to 4-1/2 percent, measured as the change between the fourth quarter of 1999 and the fourth quarter of 2000. Over the four quarters of 2001, the central tendency forecasts of real GDP are in the 3-1/4 percent to 3-3/4 percent range. With this pace of expansion, the civilian unemployment rate should remain near its recent level of 4 percent. Even with the moderation in the pace of economic activity, the Committee members and nonvoting Bank presidents expect that inflation may be higher in 2001 than in 1999, and the Committee will need to be alert to the possibility that financial conditions may need to be adjusted further to balance aggregate demand and potential supply and to keep inflation low.
from average for fourth quarter of previous year to average
for fourth quarter
Considerable uncertainties attend estimates of potential supply--both the rate of growth and the level of the economy's ability to produce on a sustained non-inflationary basis. Business investment in new equipment and software has been exceptionally high, and given the rapid pace of technological change, firms will continue to exploit opportunities to implement more-efficient processes and to speed the flow of information across markets. In such an environment, a further pickup in productivity growth is a distinct possibility. However, a portion of the very rapid rise in measured productivity in recent quarters may be a result of the cyclical characteristics of this expansion rather than an indication of structural rates of increase consistent with holding the level of resource utilization unchanged. Current levels of labor resource utilization are already unusually high. To date, this has not led to escalating unit labor costs, but whether such a favorable performance in the labor market can be sustained is one of the important uncertainties in the outlook.
On the demand side, the adjustments in financial markets that have accompanied expected and actual tighter monetary conditions may be beginning to moderate the rise in domestic demand. As that process evolves, the substantial impetus that household spending has received in recent years from rapid gains in equity wealth should subside. The higher cost of business borrowing and more-restrictive credit supply conditions probably will not exert substantial restraint on investment decisions, particularly as long as the costs and potential productivity payoffs of new equipment and software remain attractive. The slowing in domestic spending will not be fully reflected in a more moderate expansion of domestic production. Some of the slowing will be absorbed in smaller increases in imports of goods and services, and given continued recovery in economic activity abroad, domestic firms are expected to continue seeing a boost to demand and to production from rising exports.
Regarding inflation, FOMC participants believe that the rise in consumer prices will be noticeably larger this year than in 1999 and that inflation will then drop back somewhat in 2001. The central tendency of their forecasts for the increase in the chain-type index for personal consumption expenditures is 2-1/2 percent to 2-3/4 percent over the four quarters of 2000 and 2 percent to 2-1/2 percent during 2001. Shaping the contour of this inflation forecast is the expectation that the direct and indirect effects of the boost to domestic inflation this year from the rise in the price of world crude oil will be partly reversed next year if, as futures markets suggest, crude oil prices retrace this year's run-up by next year. Nonetheless, these forecasts show consumer price inflation in 2001 to have moved above the rates that prevailed over the 1997-98 period. Such a trend, were it not to show signs of quickly stabilizing or reversing, would pose a considerable risk to the continuation of the extraordinary economic performance of recent years.
The economic forecasts of the FOMC are similar to those recently released by the Administration in its Mid-Session Review of the Budget. Compared with the forecasts available in February, the Administration raised its projections for the increase in real GDP in 2000 and 2001 to rates that lie at the low end of the current range of central tendencies of Federal Reserve policymakers. The Administration also expects that the unemployment rate will remain close to 4 percent. Like the FOMC, the Administration sees consumer price inflation rising this year and falling back in 2001. After accounting for the differences in the construction of the alternative measures of consumer prices, the Administration's projections of increases in the consumer price index (CPI) of 3.2 percent in 2000 and 2.5 percent in 2001 are broadly consistent with the Committee's expectations for the chain-type price index for personal consumption expenditures.
1. At its March and May meetings, the FOMC took a number of actions that were aimed at adjusting the implementation of monetary policy to actual and prospective reductions in the stock of Treasury debt securities. These actions are described in the discussion of U.S. financial markets. Return to text
2. At its June meeting, the FOMC did not establish ranges for growth of money and debt in 2000 and 2001. The legal requirement to establish and to announce such ranges had expired, and owing to uncertainties about the behavior of the velocities of debt and money, these ranges for many years have not provided useful benchmarks for the conduct of monetary policy. Nevertheless, the FOMC believes that the behavior of money and credit will continue to have value for gauging economic and financial conditions, and this report discusses recent developments in money and credit in some detail.Return to text
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Last update: July 20, 2000, 10:00 AM