Humphrey-Hawkins Report, February 24, 1998
Section 1: Monetary Policy and the Economic Outlook
The U.S. economy turned in another excellent performance in 1997. Growth was strong, the unemployment rate declined to its lowest level in nearly a quarter-century, and inflation slowed further. Impressive gains were also made in other important respects: The federal budget moved toward balance much more quickly than almost anyone had anticipated; capital investment, a critical ingredient for long-run growth, rose sharply further; and labor productivity, the ultimate key to rising living standards, displayed notable vigor.
Among the influences that have brought about this favorable performance are the sound fiscal and monetary policies that have been pursued in recent years. Budgetary restraint at the federal level has raised national saving, easing the competition for funds in our capital markets and thereby encouraging greater private investment. Monetary policy, for its part, has sought to foster an environment of subdued inflation and sustainable growth. The experience of recent years has provided additional evidence that the less households and businesses need to cope with a rising price level, or worry about the sharp fluctuations in employment and production that usually accompany inflationary instability, the more long-term investment, innovation, and enterprise are enhanced.
The circumstances that prevailed through most of 1997 required that the Federal Reserve remain especially attentive to the risk of a pickup in inflation. Labor markets were already tight when the year began, and nominal wages had started to rise faster than previously. Persistent strength in demand over the year led to economic growth in excess of the expansion of the economy's potential, intensifying the pressures on labor supplies. In earlier business expansions, such developments had usually produced an adverse turn in the inflation trend that, more often than not, was accompanied by a worsening of economic performance on a variety of fronts, culminating in recession.
Robust growth of spending early in the year heightened concerns among members of the Federal Open Market Committee (FOMC) that growing strains on productive resources might touch off a faster rate of cost and price rise that could eventually undermine the expansion. Financial market participants seemed to share these concerns: Intermediate- and long-term interest rates began moving up in December 1996, effectively anticipating Federal Reserve action. When the FOMC firmed policy slightly at its March meeting by raising the intended federal funds rate from 5-1/4 percent to 5-1/2 percent, the market response was small.
The economy slowed a bit during the second and third quarters, and inflation moderated further. In addition, the progress being made by the federal government in reducing the size of the deficit was becoming more apparent. As a consequence, by the end of September, longer-term interest rates fell 3/4 percentage point from their peaks in mid-April, leaving them about 1/4 percentage point below their levels at the end of 1996. The decline in interest rates along with continued reports of brisk growth in corporate profits sparked increases in broad indexes of equity prices of 20 percent to 35 percent between April and September.
Even with a more moderate pace of growth, labor markets continued to tighten, generating concern among the FOMC members over this period that rising costs might trigger a rise in inflation. Consequently, at its meetings from May through November, the Committee adopted directives for the conduct of policy that assigned greater likelihood to the possibility of a tightening of policy than to the possibility of an easing of policy. Even though the Committee kept the nominal federal funds rate unchanged, it saw the rise in the real funds rate resulting from declining inflation expectations, together with the increase in the exchange value of the dollar, as providing some measure of additional restraint against the possible emergence of greater inflation pressures.
In the latter part of the year, developments in other parts of the world began to alter the perceived risks attending the U.S. economic outlook. Foreign economies generally had seemed to be on a strengthening growth path when the Federal Reserve presented its midyear monetary policy report to the Congress last July. But over the remainder of the summer and during the autumn, severe financial strains surfaced in a number of advanced developing countries in Asia, weakening somewhat the outlook for growth abroad and thus the prospects for U.S. exports. Although the circumstances in individual countries varied, the problems they encountered generally resulted in severe downward pressures on the foreign exchange values of their currencies; in many cases, steep depreciations occurred despite substantial upward movement of interest rates. Asset values in Asia, notably equity and real estate prices, also declined appreciably in some instances, leading to losses by financial institutions that had either invested in those assets or lent against them; nonfinancial firms began to encounter problems servicing their obligations. In many instances the debts of nonfinancial and financial firms were denominated in dollars and unhedged. Concerted international efforts to bring economic and financial stability to the region are under way, and some progress has been made, but it is evident that in several of the affected economies the process of adjustment will be painful. Meanwhile, economic activity in Japan stagnated, in part because of the developments elsewhere in East Asia, and the weaknesses in the Japanese financial system became more apparent.
The steep depreciations of many Asian currencies contributed to a substantial further appreciation of the U.S. dollar. Measured against a broad set of currencies that includes those of the advanced developing countries of Asia, the exchange value of the dollar, adjusted for relative consumer prices, has moved up about 8 percent since October and has increased about 16 percent from its level at the end of 1996. The dollar has also appreciated, on balance, against an index of currencies of the G-10 (Group of Ten) industrial countries; this G-10 trade-weighted index of dollar exchange rates is up about 13 percent in nominal terms since the end of 1996.
The difficulties in Asia contributed to additional declines of 1/4 to 1/2 percentage point in the yields on intermediate- and long-term Treasury securities in the United States between mid-autumn and the end of the year. These decreases were due in part to an international flight to the safe haven of dollar assets, but they also reflected expectations that these difficulties would exert a moderating influence on the growth of aggregate demand and inflation in the United States. Equity prices were quite volatile but showed little trend in the fourth quarter. In light of the ongoing difficulties in Asia and the possible effects on the United States, the FOMC not only left interest rates unchanged in December, but shifted its instructions to the Manager of the System Open Market Account to symmetry between ease and tightening in the near term.
Some spillover from the problems in Asia has recently begun to appear in reports on business activity in the United States. Customers in the advanced developing countries reportedly have canceled some of the orders they had previously placed with U.S. firms, and companies more generally are expressing concerns about the possibilities of both reduced sales to Asia and more intense price competition here as the result of the sharp changes in exchange rates. Nonetheless, the available statistics suggest on balance that overall growth of output and employment has remained brisk in the early part of 1998.
Confronted with the marked cross-currents described above--involving both upside and downside risks to the growth of output and prospects for inflation--the FOMC earlier this month once again chose to hold its federal funds rate objective unchanged. In credit markets, interest rates have fallen further this year as the effects of the Asian turmoil seemed even more likely to restrain any tendencies toward unsustainable growth and greater inflation in the United States. With interest rates lower and the negative effects of the Asian problems seen by market participants as mostly limited to particular sectors, broad indexes of equity prices have risen appreciably, many to new highs.
Economic Projections for 1998
The outlook for 1998 is clouded with a greater-than-usual degree of uncertainty. Part of that uncertainty is a reflection of the financial and economic stresses that have developed in Asia, the full consequences of which are difficult to judge. But there are some other significant question marks as well, many of them growing out of the surprising performance of the U.S. economy in 1997: Growth was considerably stronger and inflation considerably lower than Federal Reserve officials and most private analysts had anticipated.
Some of the key forces that gave rise to this favorable performance can be readily identified. An ongoing capital spending boom, encouraged in part by declining prices of high-technology equipment, provided stimulus to aggregate demand and at the same time created the additional capacity to help meet that demand. A further jump in labor productivity that was fueled partly by the buildup of capital helped firms overcome the production and pricing challenges posed by tight labor markets. A surprisingly robust stock market bolstered the finances of households and enabled them to spend more freely. Falling world oil prices reduced the prices of petroleum products and helped hold down the prices of other energy-intensive goods. Finally, a rising dollar imposed additional restraint on inflation, as prices of imported goods fell appreciably. Circumstances as favorable as those of 1997 are not likely to persist, although several elements in the recent mix could help maintain, for some time, a more favorable economic performance than historical relationships would suggest.
In assessing the situation, the members of the Board of Governors and the Reserve Bank presidents, all of whom participate in the deliberations of the FOMC, think that the most likely outcome for 1998 will be one of moderate growth, low unemployment, and low inflation. Most of them have placed their point estimates of the rise in real GDP from the fourth quarter of 1997 to the fourth quarter of 1998 in the range of 2 percent to 2-3/4 percent. The civilian unemployment rate in the fourth quarter of 1998 is expected to be at about its recent level. For the most part, the forecasts have the total CPI for all urban consumers rising between 1-3/4 percent and 2-1/4 percent this year. These predictions do not differ appreciably from those recently put forth by the Administration.
Economic Projections for
1998
Percent
| ||||||||||||||||||||||||||||||||
1. Change from average for
fourth quarter of 1997 to average for fourth quarter of 1998.
2. Chain-weighted.
3. All
urban consumers.
Although developments in Asia over the past few months have not yet affected aggregate U.S. economic performance in a measurable way, these influences will likely become more visible in coming months. Growth of U.S. exports is expected to be restrained by weaknesses in Asian economies and by the lagged effects of the appreciation of the dollar since 1995. Moreover, with the rise in the dollar's value making imports less expensive, some U.S. businesses and consumers will likely switch from domestic to foreign sources for some of their purchases. But the timing and magnitude of these developments are hard to predict.
In contrast to the slower growth that seems to be in prospect for exports, domestic spending seems likely to maintain considerable strength in coming quarters. Households as a group are quite upbeat in their assessments of their personal finances--as might be expected in conjunction with expanding job opportunities, rising incomes, and huge gains in wealth. Recently, many households have taken advantage of lower long-term interest rates by refinancing their home mortgages, and this will provide a little additional wherewithal for spending. Moreover, the decline in mortgage rates is also bolstering housing construction.
Business outlays for fixed investment seem likely to advance at a relatively brisk pace in the coming year, although gains as large as those of the past couple of years may be difficult to match. Outlays for computers, which have dominated the investment surge of the past few years, should climb substantially further as businesses press ahead with new investment in the latest technologies, encouraged in part by ongoing price declines. With labor markets tight, firms continue to see capital investment as the key in efforts to increase efficiency and maintain competitiveness. Internally generated funds remain adequate to cover the bulk of businesses' investment outlays, and those firms turning to the debt and equity markets are most often finding financing generously available on good terms. Inventory growth will likely put less pressure on business cash flow this year; after adding to stocks at a substantial clip in 1997, businesses seem likely to scale back such investment somewhat, especially as they perceive a moderation in sales increases.
The Federal Reserve policymakers' forecasts of the average unemployment rate in the fourth quarter of 1998 are mostly around 4-3/4 percent. The persistence for another year of this degree of tightness in the labor market means that firms will likely continue to face difficulties in finding workers and that hiring and retaining workers could become more costly. Indeed, there are indications that wage inflation picked up further at the end of last year. Improvements in labor productivity have become more sizable in the past couple of years, and if such gains can be extended, wage increases of the magnitude of those of 1997 need not translate into greater price inflation. The more rapid growth in productivity is consistent with the high level of capital investment in recent years, but the extent to which the trend in productivity has picked up is still uncertain. Furthermore, if momentum in nominal wages continues to build, the pay increases will eventually squeeze profit margins and place upward pressures on prices, even with exceptional productivity gains. The strains in labor markets therefore constitute an ongoing inflationary risk that will have to be monitored closely.
In the near term, however, there are several factors that should lessen the risk of a step-up in inflation. Manufacturing capacity remains ample, and bottlenecks are not hampering production. The recent appreciation of the dollar should damp inflation both because of falling import prices and because the added competition from imports may induce domestic producers to hold down prices. Oil prices have weakened considerably since the latter part of 1997 in response to abundant supplies, the softening of demand in Asia, and a mild winter. Ample supplies and the prospect of softer global demand have been depressing the prices of many other commodities, both in agriculture and in industry. Perhaps most important, as the low level of inflation that has prevailed in recent years gets built into wage agreements, other contracts, and individuals' inflation expectations, it will provide an inertial force helping sustain the favorable price performance for a time.
Although many of the factors currently placing restraint on inflation are not necessarily long lasting, the Committee judged that their effect in 1998 would about offset the pressures from tight labor markets. Consequently, the Board members and Reserve Bank presidents anticipate that the rate of price inflation will change little this year. Again in 1998, the FOMC will be monitoring a variety of price measures in addition to the CPI for indications of changes in inflation and will be assessing movements in the CPI in the context of ongoing technical improvements by the Bureau of Labor Statistics that are likely to damp the reported 1998 rise in that index.
Money and Debt Ranges for 1998
In establishing the ranges for growth of broad measures of money over 1998, the Committee recognized the considerable uncertainty that still exists about the behavior of the velocities of these aggregates. The velocity of M3 (the ratio of nominal GDP to the monetary aggregate) in particular has proved difficult to predict. Last year, the growth of this aggregate relative to spending was affected by the rapid increase in depository credit and by the way in which that increase was funded, as well as by the changing cash management practices of corporations, which have been using the services of institution-only money funds in M3. These factors boosted M3 growth last year to 8-3/4 percent, 3 percentage points faster than nominal GDP--an unusually large decline in M3 velocity. Going forward, it seems likely that M3 growth will continue to be buoyed by robust credit growth at depositories and continuing shifts in cash management. Thus, its velocity is likely to decline further, though the amount of decline is difficult to predict.
The relationship of M2 to spending in recent years has come back more into line with historical patterns in which the velocity of M2 tended to be fairly constant, except for the effects of the changing opportunity cost of M2--the spread between yields that savers could earn holding short-term market instruments and those that they could earn holding M2. In the early 1990s, M2 velocity departed from this pattern, rising substantially and atypically. Even after the unusual shift of the early 1990s died out, M2 velocity continued to drift somewhat higher from 1994 into 1997. That drift probably reflected some continued, albeit more moderate, redirection of savings into bond and equity markets, especially through the purchase of mutual funds. However, last year the drift abated. There was little change, on balance, in the opportunity cost of holding M2, and M2 velocity also was about unchanged, as M2 grew 5-1/2 percent, nearly the same as nominal GDP. Nevertheless, the upward drift could resume in the years ahead as financial innovations or perceptions of attractive returns lead households to further shift their savings away from M2 balances. Or velocity might be pushed downward if volatility or setbacks in bond and stock markets were to lead investors to seek the safety of M2 assets, which have stable principal.
In light of the uncertainties about the behavior of velocities, the Committee followed its practice of recent years and established the ranges for 1998 not as expectations for actual money growth, but rather as benchmarks for M2 and M3 behavior that would be consistent with sustained price stability, assuming velocity change in line with pre-1990 historical experience. Thus, the ranges for fourth-quarter to fourth-quarter growth are unchanged from those in 1997: 1 percent to 5 percent for M2, and 2 percent to 6 percent for M3. Given the central tendency of the Committee's forecast for growth of nominal GDP of 3-3/4 percent to 4-1/2 percent, M2 is likely to be in the range, perhaps in the upper half, if short-term interest rates do not change much and velocity continues recent patterns. For M3, however, a continuation of recent velocity behavior could imply growth around the upper end of, if not above, the price-stability range.
Ranges for Growth of
Monetary and Debt Aggregates
Percent
|
Note. Change from
average for fourth quarter
of preceding year to average
for fourth quarter
of year
indicated.
Debt of the nonfinancial sectors grew 4-3/4 percent in 1997, near the middle of the range of 3 percent to 7 percent established by the Committee last February. As with the monetary aggregates, the Committee has left the range for debt unchanged for 1998. The range it has chosen encompasses the likely growth of debt given Committee members' forecasts of nominal GDP. Except for the 1980s, the growth of debt has tended to be reasonably in line with the growth of nominal GDP.
Although the ranges for money and debt are not set as targets for monetary policy in 1998, the behavior of these variables, interpreted carefully, can at times provide useful information about the economy and the workings of the financial markets. The Committee will continue to monitor the movements of money and debt--along with a wide variety of other financial and economic indicators--to inform its policy deliberations.
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Last update: February 24, 1998, 10:00 AM