Section 1:
Monetary Policy and the Economic Outlook

The U.S. economy performed well in the first half of 1996. In early February, when the Federal Reserve prepared its last report on monetary policy, there was some concern about the strength and durability of the current economic expansion: The economy was operating at a relatively high level of resource utilization, but it was not exhibiting a great deal of forward momentum. As the year has unfolded, however, economic activity has proven quite robust. After rising only fractionally in the fourth quarter of 1995, real gross domestic product posted a solid gain over the first half of 1996, providing a considerable lift to job growth. Looking ahead, the members of the Federal Open Market Committee (FOMC) anticipate that economic activity will grow more moderately, on average, in coming quarters and that the unemployment rate will remain around the level it has averaged over the past year and a half.

Although overall consumer price inflation was boosted by higher energy prices during the first half of the year, the underlying trend of prices still appears to have been well contained. Over the past twelve months, the consumer price index excluding food and energy items has risen 2-3/4 percent--near the lower end of the narrow range that has prevailed since early 1994. Moreover, the deflator for personal consumption expenditures on items other than food and energy derived from data reported in the national income and product accounts has continued to show a slowing trend.

The combination of brisk growth and favorable underlying inflation so far this year has, of course, been welcome. Nonetheless, mounting pressures on resources are apparent in some segments of the economy--most notably in the labor market--and these pressures must be monitored closely. Allowing inflationary forces to intensify would ultimately disrupt the growth process. The Federal Reserve recognizes that its contribution to promoting the optimal performance of the economy involves containing the rate of inflation and, over time, moving toward price stability.

Monetary Policy, Financial Markets, and the Economy over the First Half of 1996

Information available around the turn of the year suggested that the economy had downshifted after posting a strong gain in the third quarter of 1995. The growth of final demand appeared to have slowed, reflecting importantly a deceleration of consumer spending. In addition, hesitant growth abroad and a strengthening in the foreign exchange value of the dollar relative to the levels prevailing at mid-1995 were seen as limiting the prospects for further growth in exports. The slowdown in the growth of final demand had given rise to inventory buildups in some industries; in turn, the production cutbacks undertaken in response to those buildups were having a further damping effect on economic activity. Meanwhile, data on prices and wages suggested that inflation performance continued to be fairly satisfactory--indeed, better than many members of the FOMC had expected as of midyear 1995. To keep the stance of monetary policy from becoming effectively more restrictive owing to the slowdown in inflation in the second half of last year, and to promote sustainable growth, the Committee eased the stance of policy in December 1995 and again at the end of January 1996, bringing the federal funds rate down a half percentage point in total, to 5-1/4 percent.

Most participants in financial markets were unsurprised by these policy adjustments, given the economic backdrop. Moreover, they anticipated that there would be scope for additional easing steps in the coming months. Thus, between mid-December and the end of January, interest rates on Treasury securities generally moved lower, especially at short and intermediate maturities, and stock price indexes edged higher on balance. The dollar strengthened slightly on net against the currencies of the other (Group of Ten) G-10 countries, reflecting in part disappointing news about the pace of activity in Europe and consequently larger declines in interest rates there than in the United States.

The underlying trends in the economy early in the year were obscured to a degree by extraordinarily adverse weather that affected a significant part of the country. Through the course of the next few months, however, it became increasingly clear that the economy had regained vitality. Consumer spending perked up after a lackluster holiday season and was only temporarily depressed by the severe winter. Business demand for equipment proved quite strong, as did housing demand. The strengthening in sales facilitated businesses' efforts to control their inventories, and as that situation improved, industrial production rebounded smartly. Overall employment growth was brisk, and by June the unemployment rate reached its lowest level in six years.

Inflation during the first half of the year was generally well behaved. Energy prices surged, mainly in response to a run-up in the world price of oil, and bad news about grain crops raised the prospect of higher food prices down the road. However, price inflation for consumer items other than food and energy held steady or moved a bit lower. Labor costs presented a mixed picture. The increase in total hourly compensation over the first three months of the year, as measured by the employment cost index (ECI), was in line with its recent moderate trend. However, within total compensation, the wage and salary component of the ECI surged in the first quarter, and further signals of wage acceleration came from a more rapid increase in average hourly earnings in the second quarter.

Against the backdrop of stronger activity but subdued inflation trends, the Federal Reserve made no adjustments to its policy stance after January. With economic activity more clearly on the upswing, however, and prospects for a breakthrough on the federal budget seeming to fade, intermediate- and long-term interest rates reversed course in February and trended up over subsequent months. Since the end of December, the yield on the 30-year Treasury bond has increased about 1 percentage point, on net, while the yield on the 5-year note has risen about 1-1/4 percentage points over the same period. The rate on three-month bills has edged up only slightly. Despite the backup in bond yields, major stock-price indexes rose considerably further through the first half of the year; most of those gains were erased in late June and the first half of July, however, as company reports raised questions about the pace of earnings growth. The rise in bond yields has boosted the dollar in foreign exchange markets; since mid-April, the dollar has generally traded against an average of the currencies of the other major industrial countries about 4 percent above its level at the end of December.

During the first half of the year, credit remained easily available to most household and business applicants. Interest rate spreads on private debt over Treasury securities remained narrow. In response to the recent increase in delinquencies on credit card accounts, many banks have tightened their standards for approval of new accounts, but this appears to have only partially reversed a marked relaxation of such standards earlier this decade, and banks overall remain aggressive in the pursuit of new borrowers, especially business clients. The debt of all domestic nonfinancial sectors combined expanded at about a 4-3/4 percent annual pace, placing this aggregate near the middle of its monitoring range. M2 and M3 are currently near the 5 percent and 6 percent upper boundaries of their respective growth ranges, in line with the FOMC's expectation as of last February. In contrast to the experience of the early 1990s, growth in the monetary aggregates relative to nominal gross domestic product has been broadly in line with historical relationships, given the structure of interest rates.

Economic Projections for 1996 and 1997

Economic Projections for 1996 and 1997

As noted previously, the members of the Board of Governors and the Reserve Bank presidents, all of whom participate in the deliberations of the Federal Open Market Committee, generally think it likely that economic activity will return to a moderate growth path in the second half of 1996 and in 1997 after the larger gains in the first half of this year. For 1996 as a whole, this would result in an increase in real gross domestic product in the range of 2-1/2 percent to 2-3/4 percent, somewhat above the forecasts in the February report on monetary policy. For 1997, the central tendency of the forecasts spans a range of 1-3/4 percent to 2-1/4 percent. The civilian unemployment rate, which averaged around 5-1/2 percent in the second quarter of 1996, is expected to stay near this level through the end of this year and perhaps to edge higher during 1997.

Economic activity clearly retains considerable momentum. The trend in final demand is positive, and inventories appear to be well aligned with the current pace of sales--perhaps even a bit lean. Accordingly, the members of the FOMC recognize the possibility that growth could remain elevated a while, with the potential for putting greater pressure on resources. Nonetheless, most members think that some slowing from the rapid growth pace recorded, on average, in the first half is the most likely outcome. Housing construction and other interest-sensitive activity should be restrained to some degree by the rise in long-term interest rates over the past several months. And, although some of the lagging economies abroad are expected to perform better this year, there are still concerns about the solidity of that acceleration and the associated lift to U.S. exports. In addition, growth in real business fixed investment appears to be tapering off, although spending will likely remain buoyant, owing to the rapid rate of product innovation and dramatic price declines in the computer area. Consumer spending is also expected to grow less rapidly in coming quarters. Household wealth has been boosted substantially by the run-up in stock prices over the past year and a half, but, for many households, debt burdens have risen significantly in recent years and may represent a constraint on purchases of big-ticket items.

Ranges for Growth of Monetary and Debt Aggregates
Percent

Aggregate 1995 1996 Provisional for 1997     M2 1 to 5 1 to 5       1 to 5     M3 2 to 6 2 to 6       2 to 6     Debt1 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.
  1. Monitoring range for debt of domestic
nonfinancial sectors.
 

Most members of the FOMC expect the rise in the consumer price index over the four quarters of 1996 to be in the range of 3 percent to 3-1/4 percent, about 1/4 percentage point higher than they predicted last winter. The projected increase in the CPI is also somewhat larger than that recorded in 1995. However, that step-up would mainly reflect developments in the food and energy sectors, which are likely to add to overall inflation in 1996 after having damped it in 1995. Apart from these volatile sectors, inflation has remained in check so far this year despite high levels of resource utilization and reports that tightness in some parts of the labor market is placing upward pressure on wages. Assuming no further adverse shocks to food and energy prices, and in the context of the Federal Reserve's intent to keep trend inflation well contained, the Committee believes that overall CPI inflation should recede. Accordingly, the central tendency of the FOMC's forecasts shows CPI inflation dropping back to the range of 2-3/4 percent to 3 percent in 1997.

The Committee's inflation projections incorporate the technical improvements the Bureau of Labor Statistics is making to the CPI in 1996 and 1997; they are expected to shave a little from inflation in both years. The Committee also recognizes that the remaining biases in the CPI are not negligible and may not be stable over time. Thus, it will continue to monitor a variety of alternative measures of price change as it attempts to gauge progress toward the long-run goal of price stability.

The Administration has just released its midyear update to its economic and budgetary projections. Its forecasts for real growth and inflation in 1996 and 1997 are broadly in line with the central tendencies of the forecasts of Federal Reserve policymakers.

Money and Debt Ranges for 1996 and 1997

At its meeting earlier this month, the Committee reaffirmed the ranges for 1996 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. In addition, the Committee set provisional growth ranges for 1997 at the same levels.

In setting the ranges for M2 and M3, the Committee intended to communicate its expectation as to the growth of these monetary aggregates that would result under conditions of approximate price stability, assuming that the aggregates exhibit the same trends relative to nominal spending that prevailed for many years until the early 1990s and that seem to have reemerged after an intervening period of marked deviation. Based on that reemergence and on Committee members' expectations for the growth of nominal GDP in 1996 and 1997, the Committee anticipates that both M2 and M3 will probably finish near the upper boundaries of their respective ranges each year. The Committee expects that the debt of the domestic nonfinancial sectors will remain near the middle of its monitoring range in 1996 and 1997. In light of the rapid pace of technological change and innovation still occurring in the financial sector--and the attending uncertainty about the future behavior of the aggregates--the Committee will continue to rely on a wide range of other information in determining its policy stance.

Section 2