FRB: Humphrey-Hawkins section 1 -- July 21, 1998
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Humphrey-Hawkins Report, July 21, 1998

Section 1: Monetary Policy and the Economic Outlook

The U.S. economy posted significant further gains in the first half of 1998. The unemployment rate dropped to its lowest level in nearly thirty years, and inflation remained subdued. Real output rose appreciably, on balance, although much of the advance apparently occurred early in the year. Household spending and business fixed investment, supported by the ongoing rise in equity prices and the continued low level of long-term interest rates, appear to have maintained considerable momentum this year. The sizable advance in capital spending and the resulting additions to the capital stock should help bolster labor productivity--the key to rising living standards.

Yet the news this year has not been uniformly good. The turmoil that erupted in some Asian countries last year has generated major concerns about the outlook for those economies and the repercussions for other nations, including the United States. Several Asian countries have had sharp contractions in economic activity, and others have experienced distinctly sub-par growth. Heightened uneasiness among international investors has induced portfolio shifts away from Asia and, to some extent, from other emerging market economies.

These difficulties have created considerable uncertainty and risk for the U.S. economy, but they have also helped to contain potential inflationary pressures in the near term by reducing import prices and restraining aggregate demand. In particular, the substantial rise in the foreign exchange value of the dollar has boosted our real imports and--together with the slower growth in Asia--depressed our real exports. At the same time, the runup in the dollar and slack economic conditions in Asia have helped produce a sharp drop in the dollar prices of oil and other commodities and have pushed down other import prices. Shifts in preferences toward dollar-denominated assets in combination with downward revisions to forecasts of inflation and demand have helped to reduce our interest rates; the lower interest rates have boosted household and business spending, offsetting a portion of the damping of demand from the foreign sector.

The Asian crisis is likely to continue to restrain U.S. economic activity in coming quarters. The size of the effect will depend in large part on how quickly the authorities in the Asian nations can put their troubled financial systems on a sounder footing and carry out other essential economic reforms. Deteriorating conditions in many countries during the past few months created added pressures for reform, and they underscored the depth and scope of the problems that must be addressed.

Despite the pronounced weakening of our trade balance, the already tight U.S. labor market has come under further strain this year owing to robust growth of domestic demand. As a result, the outlook for inflation has taken on a greater degree of risk. Consumer prices actually rose a bit less rapidly in the first half of 1998 than they did in 1997, but transitory factors--the drop in oil prices, the runup in the dollar, and weak economic activity in Asia--exerted considerable downward pressure on domestic prices. These factors will not persist indefinitely. Meanwhile, the pool of individuals interested in working but who are not already employed has continued to shrink. The extraordinary tightness in labor markets has generated a rising trend of increases in wages and related costs, although faster productivity growth has damped the effect on business costs so far.

In conducting monetary policy in the first half of 1998, the Federal Open Market Committee (FOMC) closely scrutinized incoming information for signs that the strength of the economy and the taut labor market were likely to boost inflation and threaten the durability of the expansion. However, despite slightly larger increases in the CPI in some months, inflation remained moderate on the whole. Moreover, the Committee expected that aggregate demand would slow appreciably because of a rising trade deficit and a considerable slackening in domestic spending. Although the Committee was acutely aware of the uncertainties in the economic outlook, it believed that the deceleration in demand--and the associated modest easing of pressures on resources--could well be sufficient to limit any deterioration in underlying price performance. On balance, the FOMC chose to keep the intended federal funds rate at 5-1/2 percent.

Monetary Policy, Financial Markets, and the Economy over the First Half of 1998

Output grew rapidly in the first quarter, with real gross domestic product estimated to have risen 5-1/2 percent at an annual rate. Business fixed investment soared after a weak fourth quarter, and consumption and housing expenditures expanded at a strong clip. In addition, contrary to the expectations of many forecasters, inventory investment rose substantially from its already hefty fourth-quarter pace, with the rise contributing more than 1-1/2 percentage points to overall GDP growth. At the same time, the cumulative effect of the appreciation of the dollar and faster growth of demand here than abroad resulted in a sharp drop in real net exports, with both rapid import growth and the first quarterly drop in exports in four years. Employment continued to advance briskly, and the unemployment rate held steady at 4-3/4 percent. Hourly compensation accelerated somewhat when measured on a year-over-year basis, but impressive productivity growth once again helped to restrain the increase in unit labor costs. The consumer price index rose only 1/4 percent at an annual rate over the first three months of the year, as a sharp drop in energy prices offset price increases elsewhere.

Chart of Selected interest rates

Falling long-term interest rates and rising equity prices over the previous year provided substantial impetus to household and business spending in the first quarter. Interest rates dropped sharply further in early January, and although they moved up a little over the remainder of the quarter, nominal yields on long-term Treasury securities were among the lowest in decades. Interest rates continued to benefit from the improvement in the federal budget and the prospect of reduced federal borrowing in the future; rates were also restrained to a significant extent by the effects of the Asian crisis. Equity prices increased sharply in the first quarter, extending their remarkable gains of the previous three years in spite of disappointing news on corporate profits. Households and firms borrowed at a vigorous pace in the first quarter, and growth in the debt of domestic nonfinancial sectors picked up from the fourth quarter of 1997, as did the growth of the monetary aggregates.

At their March meeting, the members of the FOMC confronted unusual cross-currents in the economic outlook. On the price side, the FOMC noted that, although the incoming data were quite favorable, transitory factors were possibly masking underlying tendencies toward higher inflation. Moreover, the available data on household and business spending confirmed the impressive strength of domestic demand and highlighted the possibility that developments in the external sector might not provide sufficient offset in coming quarters to avoid a build-up of inflation pressures. At the same time, the FOMC noted the substantial uncertainty surrounding the prospects for the Asian economies. Balancing these considerations, the FOMC kept its policy stance unchanged but noted that recent information had altered the inflation risks enough to make tightening more likely than easing in the period ahead.

The second quarter brought both a marked further deterioration in the outlook for Asia and some indications that the U.S. economy might be cooling. In Asia, evidence of steep output declines in several countries was combined with mounting concern that economic and financial problems in Japan were not likely to be resolved as quickly as many observers had hoped or expected. One result was a further rise in the exchange value of the dollar and a decline in long-term U.S. interest rates. Increasing investor concern about emerging market economies raised risk spreads on external debts in Asia, Russia, and Latin America.

The higher value of the dollar and the depressed income in many Asian countries continued to take their toll on U.S. exports and to boost imports in the second quarter. In addition, a marked slackening in the pace of inventory accumulation, which was amplified by the effects of a strike in the motor vehicle industry, was reflected in a sharp slowing in domestic demand. Nonetheless, the utilization of labor resources remained very high: In the second quarter, the unemployment rate averaged a bit less than 4-1/2 percent, its lowest quarterly reading in nearly thirty years. The twelve-month change in average hourly earnings indicated that wages were rising somewhat more rapidly than they had a year earlier. And the CPI rose faster in the second quarter than in the first, mainly reflecting a smaller drop in energy prices.

Financial conditions in the second quarter and into July remained supportive of domestic spending. Yields on private securities declined, although less than Treasury yields, as quality spreads widened a bit. Equity prices rose further in early April before falling back over the next two months in response to renewed earnings disappointments. Prices then rebounded substantially, with most major indexes hitting record highs in July. The growth of money and credit slowed a little on balance from the first-quarter pace but remained buoyant. Banks and other lenders continued to compete vigorously, extending credit on generally favorable terms as they responded in part to the sustained healthy financial condition of most businesses and households.

The FOMC left the intended federal funds rate unchanged at its May and June-July meetings. At the May meeting, the FOMC reiterated its earlier concern that the robust expansion of domestic final demand, supported by very positive financial conditions, had raised labor market pressures to a point that might precipitate an upturn in inflation over time. Yet the FOMC believed that the growth of economic activity would slow. It also judged that the risk of significant further deterioration in Asia, which could disrupt global financial markets and impair economic activity in the United States, was rising somewhat.

Economic Projections for 1998 and 1999

The members of the Board of Governors and the Federal Reserve Bank Presidents, all of whom participate in the deliberations of the FOMC, expect economic activity to expand moderately, on average, over the next year and a half. For 1998 as a whole, the central tendency of their forecasts for real GDP growth spans a range of 3 percent to 3-1/4 percent. For 1999, these forecasts center on a range of 2 percent to 2-1/2 percent. The civilian unemployment rate, which averaged a bit less than 4-1/2 percent in the second quarter of 1998, is expected to stay near this level through the end of this year and to edge higher in 1999. With labor markets remaining tight and some of the special factors that helped restrain inflation in the first half of 1998 unlikely to be repeated, inflation is anticipated to run somewhat higher in the second half of 1998 and in 1999.

The economy is entering the second half of 1998 with considerable strength in household spending and business fixed investment. Consumers are enjoying expanding job opportunities, rising real incomes, and high levels of wealth, all of which are providing them with the confidence and wherewithal to spend. These factors, in conjunction with low mortgage interest rates, are also bolstering housing demand. Business fixed investment appears robust as well: Financial conditions remain conducive to capital spending, and firms no doubt are continuing to seek out opportunities for productivity gains in an environment of rapid technological change, falling prices for high-tech equipment, and tight labor markets.

Nonetheless, a number of factors are expected to exert some restraint on the expansion of activity in the quarters ahead. The demand for U.S. exports will continue to be depressed for a while by weak activity abroad, on average, and by the strong dollar, which will also likely continue to boost imports. The effects of these external sector developments on employment and income growth have yet to materialize fully. In addition, although financial conditions are generally expected to be supportive, real outlays on housing and business equipment have reached such high levels that gains from here are expected to be more moderate.

Economic Projections for 1998 and 1999
  Federal Reserve governors
and Reserve Bank presidents

Central tendency
Change, fourth quarter
to fourth quarter1
    Nominal GDP4-1/4 to 5   4-1/2 to 5 4.2
    Real GDP2-3/4 to 3-1/4   3 to 3-1/4 2.4
    Consumer price index21-1/4 to 2-1/4   1-3/4 to 2 1.6

Average level, fourth quarter
    Civilian unemployment
4-1/4 to 4-1/2   4-1/4 to 4-1/2 4.8
Change, fourth quarter
to fourth quarter1
    Nominal GDP4 to 5-1/2   4-1/4 to 5 4.1
    Real GDP2 to 3   2 to 2-1/2 2.0
    Consumer price index21-1/2 to 3   2 to 2-1/2 2.1

Average level, fourth quarter
    Civilian unemployment
4-1/4 to 4-3/4   4-1/2 to 4-3/4 5.0

  1. Change from average for fourth quarter of previous year to average for fourth quarter of year indicated.
  2. All urban consumers.


With the plunge in energy prices in early 1998 unlikely to be repeated, most FOMC participants expect the CPI for all urban consumers to rise more rapidly in the second half of 1998 than it did in the first half, resulting in an increase in the CPI of 1-3/4 percent to 2 percent for 1998 as a whole. The pickup in the second half should be limited, however, by further decreases in non-oil import prices, ample domestic manufacturing capacity, and low expected inflation. Looking ahead to next year, the central tendency is for an increase in the CPI of 2 percent to 2-1/2 percent. Absent a further rise in the dollar, the fall in non-oil import prices should have run its course. Moreover, even with the expected edging higher of the unemployment rate next year, the labor market will remain tight, suggesting potential ongoing pressures on available resources that would tend to raise inflation a bit. The FOMC will remain alert to the possibility of underlying imbalances in the economy that could generate a persisting pickup in inflation, which would threaten the economic expansion.

As noted in past monetary policy reports, the Bureau of Labor Statistics is in the process of implementing a series of technical adjustments to make the CPI a more accurate measure of price change. These adjustments and the regular updating of the market basket are estimated to have trimmed CPI inflation somewhat over 1995-98, and a significant further adjustment is scheduled for 1999. All told, the published figures for CPI inflation in 1999 are expected to be more than 1/2 percentage point lower than they would have been had the Bureau retained the methods and formulas in place in 1994. In any event, the FOMC will continue to monitor a variety of price measures besides the CPI as it attempts to gauge progress toward the long-run goal of price stability.

Federal Reserve officials project somewhat faster growth in real GDP and slightly higher inflation in 1998 than does the Administration. The Administration's projections for the growth in real GDP and inflation in 1999 are around the lower end of the FOMC participants' central tendencies.

Money and Debt Ranges
for 1998 and 1999

At its most recent meeting, the FOMC reaffirmed the ranges for 1998 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. The FOMC set these same ranges for 1999 on a provisional basis.

Ranges for Growth of Monetary and Debt Aggregates

Provisional for 1999
    M21 to 51 to 51 to 5
    M32 to 62 to 62 to 6
    Debt    3 to 73 to 73 to 7

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


Once again, the FOMC chose the growth ranges for the monetary aggregates as benchmarks for growth under conditions of price stability and historical velocity behavior. For several decades before 1990, the velocities of M2 and M3 (defined as the ratios of nominal GDP to the aggregates) behaved in a fairly consistent way over periods of a year or more. M2 velocity showed little trend but varied positively from year to year with changes in a traditional measure of M2 opportunity cost, defined as the interest forgone by holding M2 assets rather than short-term market instruments such as Treasury bills. M3 velocity moved down a bit over time, as depository credit and the associated elements in M3 tended to grow a shade faster than GDP. In the early 1990s, these patterns of M2 and M3 behavior were disrupted, and the velocities of both aggregates climbed well above the levels that were predicted by past relationships. However, since 1994 the velocities of M2 and M3 have again moved roughly in accord with their pre-1990 experience, although their levels remain elevated.

The recent return to historical patterns does not imply that velocity will be fully predictable or even that all movements in velocity can be completely explained in retrospect. Some shifts in velocity arise from household and business decisions to adjust their portfolios for reasons that are not captured by simple measures of opportunity cost. Some shifts in velocity arise from decisions of depository institutions to create more or less credit or to fund credit creation in different ways. All these decisions are shaped by the rapid pace of innovation in financial institutions and instruments. Between 1994 and early 1997, M2 velocity drifted somewhat higher, probably owing to some reallocation of household savings into bond and equity markets. But M2 velocity has declined over the past year despite little change in its traditionally defined opportunity cost. One explanation may be that the flatter yield curve has reduced the return on longer-term investments relative to the bank deposits and money market mutual funds in M2. Another part of the story may be the booming stock market, which has reduced the share of households' financial assets represented by monetary assets and may have encouraged households to rebalance their portfolios by increasing their M2 holdings. M3 velocity has dropped more sharply over the past year, with strong growth in large time deposits and in institutional money funds that are increasingly used by businesses for cash management.

If the velocities of M2 and M3 follow their average historical patterns over the remainder of 1998 and the growth of nominal GDP matches the expectations of Federal Reserve policymakers, these aggregates will finish this year above the upper ends of their respective ranges. Part of this relatively rapid money growth reflects nominal GDP growth in excess of that consistent with price stability and sustainable growth of real output; the rest represents a decline in velocity. Absent unusual changes in velocity in 1999, policymakers' expectations of nominal GDP growth imply that M2 and M3 will be in the upper ends of their price-stability growth ranges next year. The debt of the domestic nonfinancial sectors is expected to remain near the middle of its range this year and in 1999.

In light of the apparent return of velocity changes to their pre-1990 behavior, some FOMC members have been giving the aggregates greater weight in assessing overall financial conditions and the thrust of monetary policy. However, velocity remains somewhat unpredictable, and all Committee members monitor a wide variety of other financial and economic indicators to inform their policy deliberations. The FOMC decided that the money and debt ranges are best used to emphasize the Committee's commitment to achieving price stability, so it again set the ranges as benchmarks for growth under price stability and historical velocity behavior.


Section 2

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