Humphrey-Hawkins Report, July 22, 1997
Section 2: Economic and Financial Developments in 1997
The economy has continued to perform exceptionally well
this year. Real gross domestic product surged almost 6 percent at an
annual rate in the first quarter of 1997, and available data point to a
healthy, though smaller, increase in the second quarter. Financial
conditions remained supportive of spending. Despite a modest tightening
of money market conditions by the System, most interest rates were
little changed or declined a bit on net during the first half of the
year, and equity prices surged ahead. With relatively few exceptions,
credit remained readily available from both intermediaries and
financial markets on generally favorable terms. The rapid increases
in output led to a further tightening of labor markets in the first
six months of 1997, and labor costs accelerated a little from the pace
of a year earlier. Price inflation has been subdued, held down in part
by declines in energy prices, smaller increases in food prices, and
lower prices for non-oil imports that have followed in the wake of the
appreciation of the dollar. In addition, intense competition, adequate
plant capacity, and ongoing efficiency gains have helped to restrain
inflation pressures in the face of rising
The Household Sector
Spending, Income, and Saving. After
posting a sizable increase in 1996, real personal consumption
expenditures jumped 5-1/2 percent at an annual rate in the first
quarter of 1997. Although the advance in spending slowed
thereafter--partly because of unusually cool weather in late
spring--underlying fundamentals for the household sector remain
favorable to further solid gains; notably, real incomes have continued
to rise, and many consumers have benefited from sizable gains in
wealth. With this good news in hand, consumers have become
extraordinarily upbeat about the economy's prospects. Indexes of
consumer sentiment--such as those compiled by the Survey Research
Center at the University of Michigan and the Conference Board--have
soared to some of the highest readings since the 1960s. Despite this
generally healthy picture, some households still face difficulties
meeting debt obligations, and delinquency rates for consumer loans
have remained at high levels.
Real outlays for consumer durables surged 18-3/4 percent (annual rate) in the first quarter of this year but apparently slowed considerably in the second quarter. After changing little, on net, last year, consumer purchases of motor vehicles increased rapidly early in the year, a result of sound fundamentals, a bounceback from the strike-depressed fourth quarter, and enlarged incentives offered by auto makers. In the second quarter, sales were once again held down noticeably by strike-related supply constraints, as well as by some payback from the elevated first-quarter pace. Smoothing through the ups and downs, the underlying pace of demand in the first half of the year likely remained reasonably close to the 15 million unit rate that has prevailed since the second half of 1995. Purchases of durable goods other than motor vehicles also took off in the first quarter; computers and other electronic equipment were an area of notable strength, as households took advantage of rapidly falling prices to acquire the latest technology. According to available monthly data, purchases of durables other than motor vehicles and electronic equipment moderated in the second quarter. Although a pause in the growth of spending is not surprising after the strong first quarter, unusually cool spring weather, leading to the postponement of purchases of some seasonal items, may also have contributed to the moderation.
Growth of real spending for nondurables also appears to have slowed considerably from a strong first-quarter pace. Within services, weather conditions held down growth of real outlays for energy services in the first quarter and boosted them in the second. Growth of real outlays for other services--typically the steadiest component of consumption--picked up at the end of 1996 and appears to have stayed ahead of last year's 2-1/2 percent pace in the first half of 1997.
Consumer spending continued to draw support from healthy advances in income this year, as gains in wages and salaries boosted personal disposable income. These gains translated into a 4 percent annual rate advance in real disposable income in the first quarter, after a significant 2-3/4 percent advance last year. Although month-to-month movements were affected by unevenness in the timing of tax payments, the underlying trend in real disposable income remained strong into the second quarter.
On top of rising incomes, further increases in net worth--primarily related to the soaring stock market--have given many households the financial wherewithal to spend. In light of the very large gains in wealth, the impetus to consumption appears to have been smaller than might have been anticipated on the basis of historical relationships, suggesting that other factors may be offsetting the effect of higher net worth. One such factor could be a greater focus on retirement savings, particularly among the large cohort of the population reaching middle age. Concerns about the adequacy of saving for retirement have likely been heightened by increased public discussion of the financial problems of social security and federal health programs. In addition, debt problems may be restraining the spending of some households.
Residential Investment. The underlying pace of housing activity has remained at a high level this year, even though some indicators suggest that activity has edged off a bit from last year's pace. In the single-family sector, housing starts through June averaged 1.14 million units at an annual rate, a shade below the pace of starts in 1996. Although starts dipped in the second quarter, the decline was from a first-quarter level that, doubtless, was boosted by mild weather. Mortgage rates have zig-zagged moderately this year; the average level has differed little from that in 1996. With mortgage rates low and income growth strong, a relatively large proportion of families has been able to afford the monthly cost of purchasing a home. Home sales have remained strong, helping to keep inventories of unsold new units relatively lean--a favorable factor for prospective building activity. Other indicators of demand remain quite positive. According to the latest survey by the National Association of Homebuilders, builders' ratings of new home sales strengthened in recent months to the highest level since last August. Moreover, consumers' assessments of conditions for homebuying, as reported by the Survey Research Center at the University of Michigan, remained very favorable into July. In addition, the volume of applications for mortgages to purchase homes has moved up recently to a high level.
The pace of multifamily starts has been well maintained. These starts averaged close to 320,000 units at an annual rate from January to June, a little above last year's figure for starts. Even so, the pace of multifamily construction remains well below peaks in the 1970s and 1980s, partly because of changes in the nation's demographic composition as the bulge of renters in the 1980s has moved on to home ownership. Another factor that has restrained multifamily construction is the growing popularity of manufactured housing ("mobile homes"), which provides an alternative to rental housing for some households. In particular, the price of a typical manufactured unit is considerably less than that of a new single-family house, making manufactured homes especially attractive to first-time buyers and to people purchasing second houses or retirement homes. Shipments of these homes trended up through last fall and then flattened out at a relatively high level.
Household Finance. Household
balance sheets strengthened in the aggregate during the first half of
1997, but debt-payment problems continued at a high level in several
market segments. Indebtedness grew less rapidly than it had in 1996,
and further gains in equity markets pushed up the ratio of household
net worth to disposable personal income to its highest mark in recent
decades. Consumer credit increased at a 6-1/4 percent annual rate
between December 1996 and May 1997, compared with 8-1/4 percent
in 1996. The growth of mortgage debt was somewhat slower in the first
quarter than in 1996 and, according to available indicators, probably
stayed at roughly the same rate during the second
The estimated ratio of required payments of loan principal and interest to disposable personal income remained high in the first quarter, after climbing rapidly between early 1994 and early 1996 and rising more slowly in the second half of last year. This measure of the debt-service burden of households has nearly returned to the peak reached toward the end of the last business cycle expansion. Adding estimated payments on auto leases to households' scheduled monthly debt payments boosts the ratio a little more than 1 percentage point and places it just above its previous peak.
Indicators of households' ability to service their debt have been mixed. The delinquency rate for mortgage loans past due sixty days or more is at its lowest level in two decades, but delinquency rates for consumer loans are relatively high. According to data from the Report of Condition and Income filed by banks (the Call Report), the delinquency rate for credit card loans was roughly unchanged in the first quarter of 1997, remaining at its highest value since late 1992, when the economy was in the midst of a sluggish recovery and the unemployment rate was more than 2 percentage points higher than today. For auto loans at the finance companies affiliated with the major manufacturers, the delinquency rate rose again in the first quarter, continuing the steady run-up in this measure over the past three years.
Anecdotal evidence suggests that the recent increases in consumer credit delinquency rates had been partly anticipated by lenders, reflecting the normal seasoning of loans as well as banks' efforts to stimulate borrowing by making credit more broadly available and automakers' attempts to stimulate sales using the same approach. During the past several years, lenders have aggressively sought business from people who might not have been granted credit previously, in part because of lenders' confidence in new "credit scoring" models that statistically evaluate an individual's creditworthiness. Despite these new tools, banks evidently have been surprised by the extent of the deterioration of their consumer loans and have tightened lending standards as a result. Nearly half the banks responding to the Federal Reserve's May survey on bank lending practices had imposed more stringent standards for new credit card accounts over the preceding three months, with a smaller fraction reining in other consumer loans. About one-third more of the responding banks expected charge-off rates on consumer loans to increase further over the remainder of the year than expected charge-off rates to decrease; many of those expecting an increase cited consumers' growing willingness to declare bankruptcy. Rising delinquency rates have also put pressure on firms specializing in subprime auto loans, with some reporting reduced profits and acute liquidity problems.
According to the most recently available data, personal bankruptcies surged again in the first quarter of the year after rising 30 percent in 1996. The rapid increases of late are partly related to the same increase in financial stress evident in the delinquency statistics, but they may also be tied to more widespread use of bankruptcy as a means of dealing with such stress. Changes in federal bankruptcy law effective at the start of 1995 increased the value of assets that may be protected from liquidation, and there may also be a secular trend toward less stigma being associated with declaring bankruptcy.
The Business Sector
Note. Changes are
based on quarterly averages.
Consumer prices for goods other than food and energy rose a restrained three-quarters percent at an annual rate between December and June of this year, a touch below last year's pace. Declining prices for non-oil imports helped contain prices of goods in the CPI in the first half of the year, in part by constraining U.S. businesses in competition with importers. For example, prices of new and used passenger cars declined in the first six months of the year, and prices of light trucks were essentially flat. Also, prices of house furnishings were about unchanged, on balance, in the first half of the year, although apparel prices moved up after declining in recent years.
The CPI for non-energy services rose about 3 percent at an annual rate between December and June, a touch below last year's pace. After rising markedly last year, airfares declined, on net, in the first half of this year. Fares fell substantially early in the year when the excise tax on tickets expired, and even with the reimposition of the tax in March, ticket prices were still lower in June than in December. Increases in prices of medical services also continued to slow somewhat this year.3 In addition, the CPI for auto finance fell in May and June as automakers sweetened incentives. In contrast, price increases in the first half of the year picked up in some other areas; shelter prices rose a bit more rapidly than last year, as did tuition and prices for personal care services.
Credit and Depository Intermediation. The total debt of domestic nonfinancial sectors increased at an annual rate of about 4-3/4 percent from the fourth quarter of 1996 through May of this year, placing the aggregate near the middle of the range for 1997 established by the FOMC. This pace is more than half a percentage point below that for 1996, reflecting significantly slower growth of borrowing by the federal government. The total debt of the other sectors has risen at a roughly constant pace over the past few years, even though the growth rate of nominal output has been increasing.
Credit on the books of depository institutions rose more rapidly than total debt in the first half of 1997, indicating that their share of total debt outstanding increased. Credit growth at thrift institutions eased late last year and early this year after increasing moderately in the first three quarters of 1996. However, commercial bank credit grew at a brisk pace in the first half of the year, with both securities and loans increasing more rapidly than they did last year. Real estate lending at banks rose about 9 percent at an annual rate between the fourth quarter of 1996 and June of this year, compared with 4 percent in 1996. In contrast, outstanding home mortgages at thrift institutions grew little in the first part of the year after a large run-up in 1996. Home equity credit lines from banks expanded especially rapidly in the spring, as some banks promoted these loans as a substitute for consumer loans. The growth of consumer loans at banks (including loans that were securitized as well as loans still on banks' books) fell from about 11 percent in 1996 to 3-1/4 percent at an annual rate between the fourth quarter of 1996 and June of this year.
The Monetary Aggregates. Growth of the monetary aggregates during the first half of 1997 was similar to growth in 1996. Between the fourth quarter of last year and June, M2 expanded at an annual rate of almost 5 percent; as the Committee had anticipated, the aggregate was running close to the upper bound of its growth cone, which had been chosen to be consistent with price stability. The behavior of M2 over this period can be reasonably well explained by changes in nominal GDP and interest rates, using historical velocity relationships. In the first quarter, the velocity of M2 (defined as the ratio of nominal GDP to M2) increased a little more than might have been anticipated from its recent relationship to the opportunity cost of holding M2--the interest earnings forgone by owning M2 assets rather than market instruments such as Treasury bills. M2 may have been held down a bit by savers' preferences for equity market funds, for which inflows were quite strong. Growth of M2 was much slower in the second quarter than in the first quarter (4-1/4 percent compared with 6 percent at an annual rate), consistent with the slowing of the economy and almost unchanged M2 opportunity cost. The monthly pattern of M2 growth in the second quarter was heavily influenced by unusually high individual non-withheld tax payments. M2 surged in April, as households apparently accumulated additional liquid balances in order to make the larger tax payments, and was about unchanged on a seasonally adjusted basis in May as payments cleared and balances returned to normal.
The correspondence between changes in M2 velocity and in opportunity cost during recent years may represent a return to the roughly stable relationship observed for several decades until 1990--albeit at a higher level of velocity. The relationship was disturbed in the early 1990s by households' apparent decisions to shift funds out of lower-yielding deposits into higher-yielding stock and bond mutual funds. On one hand, the "credit crunch" at banks and the resolution of troubled thrifts curbed the eagerness of these institutions to attract retail deposits, holding down the rates of return offered on brokered deposits and similar accounts relative to the average deposit rates used in constructing measures of opportunity cost. At the same time, the appeal of longer-term assets was enhanced temporarily by the steeply sloped yield curve and more permanently by the greater variety and lower cost of mutual fund products available to investors. More recently, robust inflows into stock funds apparently have substituted to only a limited extent for holdings of M2 assets, and M2 velocity and opportunity cost have again been moving roughly together since mid-1994, although velocity has continued to drift up slightly. However, the period of renewed stability in the behavior of M2--three years--is still fairly short, and whether the stability will persist is unclear. Variations in opportunity cost and income growth during this period have been rather small, leaving considerable doubt about how M2 would respond to more significant changes in the financial and economic environment.
M3 rose about 7 percent at an annual rate between the fourth quarter of 1996 and June of this year. This pace is a little faster than last year's and again left M3 above the upper end of its growth cone, which, like the growth cone for M2, was set to be consistent with price stability. Large time deposits, which are not included in M2, continued to increase much more rapidly than other deposits. Banks have been funding their asset growth disproportionately through wholesale deposits, leaving interest rates on retail deposits further below market rates than they have been historically. Growth of institution-only money market funds eased just a little from last year's torrid pace, as the role of these funds in corporate cash management continued to increase.
M1 contracted at a 2-1/2 percent annual rate between the fourth quarter of 1996 and June of this year. Growth of this aggregate was again depressed by the spread of so-called sweep programs, whereby balances in transactions accounts, which are subject to reserve requirements, are "swept" into savings accounts, which are not. Sweep programs benefit depositories by reducing their required holdings of reserves, which earn no interest. At the same time, they do not restrict depositors' access to their funds for transactions purposes, because the funds are swept back into transactions accounts when needed. Until late last year, most retail sweep programs were limited to NOW accounts, but demand-deposit sweeps have expanded markedly since then. Adjusted for the estimated total of balances swept owing to the introduction of new sweep programs, M1 expanded at a 4-3/4 percent annual rate between the fourth quarter of 1996 and June 1997, a little below its sweep-adjusted growth rate in 1996.
Growth of Money and
1. From average for fourth
quarter of preceding year to
average for fourth quarter of year indicated.
2. From average for preceding quarter to average
for quarter indicated.
3. From average for fourth quarter of 1996 to
average for June (May in the case of domestic
The drop in the amount of deposits held in transactions accounts in the first half of 1997 caused required reserves to fall about 10 percent at an annual rate, close to the rate of decline last year. Nonetheless, the monetary base has expanded at a moderate pace so far in 1997, because the runoff in required reserves has been more than offset--as it was also last year--by an increase in the demand for currency. Currency growth has been a little higher this year than last, as the effects of strong domestic spending more than offset a slight drop in net shipments of U.S. currency abroad in the first four months of the year.
Further reductions in required reserves have the potential to diminish the Federal Reserve's ability to control the federal funds rate closely on a day-to-day basis. Traditionally, the daily demand for balances at the Federal Reserve largely reflected banks' needs for required reserves, which are fairly predictable. As a result, the Federal Reserve has generally been able to supply the quantity of balances that satisfies this demand at the intended funds rate. Moreover, reserve requirements are specified in terms of an average level of balances over a two-week period, so if the funds rate on a particular day moves above the level expected to prevail on ensuing days, banks can trim their balances and thereby relieve some of the upward pressure on the funds rate. If required reserves were to fall quite low, the demand for balances would become more linked to banks' desire to avoid overnight overdrafts when conducting transactions through their accounts at Reserve Banks. Demand from this source is more variable than is requirement-related demand, and it also cannot be substituted across days; both factors would tend, all else equal, to increase the volatility of the federal funds rate.
The decline in required reserves over the past several years has not created serious problems in the federal funds market, but funds-rate volatility has risen a little, and the risk of much greater volatility would increase if required reserves were to fall substantially further. One factor mitigating an increase in funds-rate volatility has been an increase in required clearing balances. These balances, which banks can precommit to hold on a two-week average basis, earn credits that banks use to pay for Federal Reserve priced services. Like required reserve balances, required clearing balances are predictable by the Federal Reserve and can be substituted across days within the two-week maintenance period. Funds-rate volatility has also been damped by banks' improved management of their balances at Reserve Banks, which in part reflects the improved real-time access to account information now provided by the Federal Reserve. Whether these factors could continue to restrain funds-rate volatility if required reserve balances were to become much smaller is as yet unclear. Also unclear is whether a moderate increase in funds-rate volatility would have any serious adverse consequences for interest rates farther out on the yield curve or for the macroeconomy. The Federal Reserve continues to monitor the situation closely.
Interest Rates. Interest rates on Treasury securities were little changed or declined a bit, on balance, between the end of 1996 and mid-July. Yields rose substantially in the first quarter as evidence mounted that the robust economic activity observed in the closing months of 1996 had continued into 1997. By the time of the March FOMC meeting, most participants in financial markets were anticipating some tightening of monetary policy, and rates moved little when the increase in the intended federal funds rate was announced. Beginning in late April, key data pointed to continued low inflation and a slowing of economic growth in the second quarter, and interest rates retraced their earlier advance.
The yield on the inflation-indexed ten-year Treasury note was little changed between mid-April and mid-July, suggesting that at least part of the roughly 60-basis-point drop in the nominal ten-year yield over that period reflected a reduction in expected inflation or in uncertainty about future inflation, or both. Yet, relative movements in these two yields should be interpreted carefully, as the market's experience in trading indexed debt is relatively brief, making its prices potentially vulnerable to small shifts in market sentiment. Moreover, the Treasury announced this spring a reduction in the frequency of nominal ten-year note auctions, perhaps putting downward pressure on their nominal yields, and some investors may have paid renewed attention to upcoming technical adjustments to the CPI, which will reduce measured inflation. Survey-based measures of expected inflation showed little change in the second quarter.
The interest rate on the three-month Treasury bill was held down in recent months by the reduced supply of bills associated with the smaller federal deficit. Between mid-March and mid-July, the spread between the federal funds rate and the three-month yield averaged about 15 basis points above the average spread in 1996. Interest rates on private short-term instruments increased a little in the second quarter after the small System tightening in March.
Equity Prices. Equity markets have advanced dramatically again this year. Through mid-July, most broad measures of U.S. stock prices had climbed between 20 percent and 25 percent since year-end. Stocks began the year strongly, with the major indexes reaching then-record levels in late January or February. Significant selloffs ensued, partly occasioned by the backup in interest rates, and by early April the NASDAQ index was well below its year-end mark and the S&P 500 composite index was barely above its. Equity prices began rebounding in late April, however, soon pushing these indexes to new highs. Stock prices have been somewhat more volatile this year than last.
The run-up in stock prices in the spring was bolstered by unexpectedly strong corporate profits for the first quarter. Still, the ratio of prices in the S&P 500 to consensus estimates of earnings over the coming twelve months has risen further from levels that were already unusually high. Changes in this ratio have often been inversely related to changes in long-term Treasury yields, but this year's stock price gains were not matched by a significant net decline in interest rates. As a result, the yield on ten-year Treasury notes now exceeds the ratio of twelve-month-ahead earnings to prices by the largest amount since 1991, when earnings were depressed by the economic slowdown. One important factor behind the increase in stock prices this year appears to be a further rise in analysts' reported expectations of earnings growth over the next three to five years. The average of these expectations has risen fairly steadily since early 1995 and currently stands at a level not seen since the steep recession of the early 1980s, when earnings were expected to bounce back from levels that were quite low.
Exchange Rates. The weighted average foreign exchange value of the dollar in terms of the other G-10 currencies rose sharply in the first quarter from its level in December and has moved up somewhat further since then. On balance, the nominal dollar is more than 10 percent above its level at the end of December. A broader measure of the dollar that includes currencies from additional U.S. trading partners and adjusts for changes in relative consumer prices shows appreciation of about 7 percent. After rising nearly 10 percent in terms of the Japanese yen to a recent peak in late April, the dollar retreated; it is currently about unchanged from its value in terms of yen at the end of December. In contrast, the dollar has risen about 17 percent in terms of the German mark since the end of last year.
Early in the year, data showing continued strengthening of U.S. economic activity surprised market participants, raised their expectations of some tightening of U.S. monetary policy, and contributed to upward pressure on the dollar. In light of the FOMC action in late March and the tendency for subsequent economic indicators to suggest a slowing of the growth of U.S. real output, pressure for dollar appreciation abated. While robust economic activity in the United States generated a rise in U.S. long-term interest rates through April, market uncertainty about the strength of output growth in several foreign industrial countries led to little change, on balance, in average long-term (ten-year) rates in other G-10 countries. Since then, U.S. rates have returned to near year-end levels, while rates abroad have moved down. Accordingly, the long-term interest differential, on balance, has shifted further in favor of dollar assets since December, consistent with the net appreciation of the dollar this year.
Despite indications of further recovery of output in Japan, the dollar rose against the yen early in the year as planned fiscal policy in Japan appeared to be more restrictive than had been expected, and Japanese long-term interest rates declined in response. Statements by G-7 officials at their meeting in Berlin in February and on subsequent occasions suggested some concern that the dollar's strength and the yen's weakness not become excessive. The dollar moved back down in terms of the yen in May and has since fluctuated narrowly. The yen has been supported by data showing a widening of Japanese external surpluses and by a partial retracing by Japanese long-term rates of their earlier decline, as indicators have suggested that the fiscal measures may not be as contractionary as previously expected.
The dollar also rose sharply early in the year in terms of the German mark and other continental European currencies. Market participants have been disappointed that the pace of economic activity has not strengthened further in continental European countries. In addition, uncertainties about the prospects for European Monetary Union, including the possibility of delay and the question of which countries will be in the first group proceeding to Stage Three, have resulted in fluctuations in the mark and, on balance, appear to have strengthened the dollar. German long-term interest rates have declined somewhat on balance this year.
Short-term market interest rates in most of the major foreign industrial countries have changed little on average since the end of last year. Rates in the United Kingdom have risen somewhat as the new government increased the official lending rate one-quarter percentage point in May and the Bank of England raised it by the same amount in June and again in July. Short-term rates in Italy and Switzerland have eased. Stock prices have risen sharply so far this year in the major foreign industrial countries, particularly in continental Europe.
The dollar has changed little on balance in terms of the Mexican peso since December, as improved investor sentiment toward Mexico, reflected in narrowing yield spreads between Mexican and U.S. dollar-denominated bonds, has supported the peso. The trend in Mexican inflation has declined this year; nevertheless, the excess of Mexican inflation over U.S. inflation implies about a 7 percent real appreciation of the peso since December.
Since mid-May, financial pressures in Thailand, which caused authorities there to raise interest rates and have led to depreciation of the currency, have spilled over to influence financial markets in some of our Asian trading partners, particularly the Philippines and Malaysia. Interest rates in both of these countries rose sharply. Philippine officials relaxed their informal peg of the peso in terms of the dollar, and the currency declined significantly; the Malaysian ringgit and Indonesian rupiah have also depreciated.
1. More detail is provided in a paper by Lawrence Slifman and Carol Corrado, "Decomposition of Productivity and Unit Costs," Board of Governors of the Federal Reserve System, November 18, 1996.
2. The price measure for personal consumption expenditures (PCE) is closely related to the CPI because components of the CPI are key inputs in the construction of the PCE price measure. Nevertheless, the PCE price measure has the advantage that by using chain weighting rather than fixed weights it avoids some of the substitution bias that affects the CPI.
3. In January 1997, the Bureau of Labor Statistics introduced a new measure of the prices of hospital services--which account for roughly one-third of the CPI for medical services--and this new measure should, over time, provide a more accurate gauge of price movements in this area.