FRB: Humphrey-Hawkins Report, February 23, 1999
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Monetary Policy Report submitted to the Congress on February 23, 1999, pursuant to the Full Employment and Balanced Growth Act of 1978

Section 1


In 1998, the U.S. economy again performed impressively. Output expanded rapidly, the unemployment rate fell to the lowest level since 1970, and inflation remained subdued. Transitory factors, most recently falling prices for imports and commodities, especially oil, have helped to produce the favorable outcomes of recent years, but technological advances and increased efficiency, likely reflecting in part heightened global competition and changes in business practices, suggest that some of the improvement will be more lasting.

Sound fiscal and monetary policies have contributed importantly to the good economic results: Budgetary restraint at the federal level has bolstered national saving and permitted the Federal Reserve to maintain lower interest rates than would otherwise have been possible. This policy mix and sustained progress toward price stability have fostered clearer price signals, more efficient resource use, robust business investment, and sizable advances in the productivity of labor and in the real wages of workers. The more rapid expansion of productive potential has, in turn, helped to keep inflation low even as aggregate demand has been surging and as labor markets have tightened.

This past year, economic troubles abroad posed a significant threat to the performance of the economy. Foreign economic growth slowed markedly, on average, as conditions in many countries deteriorated. The recession in Japan deepened, and several emerging market economies in Asia, which had started to weaken in the wake of the financial crises of 1997, contracted sharply. A worsening economic situation in Russia last summer led to a devaluation of the ruble and a moratorium by that country on a substantial portion of its debt payments. As the year progressed, conditions in Latin America also weakened. Although some of the troubled foreign economies are showing signs of improvement, others either are not yet in recovery or are still contracting.

The Russian crisis in mid-August precipitated a period of unusual volatility in world financial markets. The losses incurred in Russia and in other emerging market economies heightened investors' and lenders' concerns about other potential problems and led them to become substantially more cautious about taking on risk. The resulting effects on U.S. financial markets included a substantial widening of risk spreads on debt instruments, a jump in measures of market uncertainty and volatility, a drop in equity prices, and a reduction in the liquidity of many markets. To cushion the U.S. economy from the effects of these financial strains, and potentially to help reduce the strains as well, the Federal Reserve eased monetary policy on three occasions in the fall. Global financial market stresses lessened somewhat after mid-autumn, reflecting, in part, these policy steps as well as interest rate cuts in other industrial countries and international efforts to provide support to troubled emerging market economies. Although some U.S. financial flows were disrupted for a time, most firms and households remained able to obtain sufficient credit, and the turbulence did not appear to constrain spending to a significant degree. More recently, some markets were unsettled by the devaluation and subsequent floating of the Brazilian real in mid-January, and the problems in Brazil continue to pose risks to global markets. Thus far, however, market reaction outside Brazil to that country's difficulties has been relatively muted.

The foreign exchange value of the dollar rose substantially against the currencies of the major foreign industrial countries over the first eight months of 1998, but subsequently it fell sharply, ending the year down a little on net. The appreciation of the dollar in the first half of the year carried it to an eight-year high against the Japanese yen. In June, this strength against the yen prompted the first U.S. foreign exchange intervention operation in nearly three years, an action that appeared to slow the dollar's rise against the yen over the following days and weeks. Later in the summer, concerns about the possible impact on the U.S. economy of increasing difficulties in Latin America began to weigh on the dollar's exchange value against major foreign currencies. After peaking in mid-August, it fell sharply over the course of several weeks, reversing by mid-October the appreciation that had occurred earlier in the year. The depreciation during this period was particularly sharp against the yen. The reasons for this decline against the yen are not clear, but repayment of yen-denominated loans by international investors and decisions by Japanese investors to repatriate their assets in light of increased volatility in global markets seem to have contributed. The exchange value of the dollar fluctuated moderately against the major currencies over the rest of the year, and after declining somewhat early in 1999, it has rebounded strongly in recent weeks, as incoming data have suggested continued strength of economic activity in the United States. Since the end of 1998, the dollar has appreciated about 7 percent against the yen, partly reflecting further monetary easing in Japan. At the turn of the year, the launch of the third stage of European Economic and Monetary Union fixed the eleven participating countries' conversion rates and created a new common currency, the euro. The dollar has appreciated more than 5 percent against the euro, in part because of signs that growth has slowed recently in some euro-area economies.

With the U.S. economy expanding rapidly, the economies of many U.S. trading partners struggling, and the foreign exchange value of the dollar having risen over 1997 and the first part of 1998, the U.S. trade deficit widened considerably last year. Some domestic industries were especially affected by reductions in foreign demand or by increased competition from imports. For example, a wide range of commodity producers, notably those in agriculture, oil, and metals, experienced sharp price declines. Parts of the manufacturing sector also suffered adverse consequences from the shocks from abroad. Overall, real net exports deteriorated sharply, as exports stagnated and imports continued to surge. The deterioration was particularly marked in the first half of the year; the second half brought a further, more modest, net widening of the external deficit.

Meanwhile, domestic spending continued to advance rapidly. Household expenditures were bolstered by gains in real income and a further rise in wealth, while a low cost of capital and optimism about future profitability spurred businesses to invest heavily in new capital equipment. Although securities markets were disrupted in late summer and early fall, credit generally remained available from alternative sources. Once the strains on securities markets had eased, businesses and households generally had ready access to credit and other sources of finance on relatively favorable terms, although spreads in some markets remained quite elevated, especially for lower-rated borrowers. All told, household and business outlays rose even more rapidly than in 1997, and that acceleration kept the growth of real GDP strong even as net exports were slumping.

Deteriorating economic conditions abroad, coupled with the strength of the dollar over the first eight months of the year, helped to hold down inflation in the United States by trimming the prices of oil and other imports. These declines reduced both the prices paid by consumers and the costs of production in many lines of business, and the competition from abroad kept businesses from raising prices as much as they might have otherwise. As the result of a reduced rate of price inflation, workers enjoyed a larger rise in real purchasing power even as increases in nominal hourly compensation picked up only slightly on average. Because of increased gains in productivity, corporations in the aggregate were able to absorb the larger real pay increases without suffering a serious diminution of profitability.

Monetary Policy, Financial Markets, and the Economy over 1998 and Early 1999

Monetary policy in 1998 needed to balance two major risks to the economic expansion. On the one hand, with the domestic economy displaying considerable momentum and labor markets tight, the Federal Open Market Committee (FOMC) was concerned about the possible emergence of imbalances that would lead to higher inflation and thereby, eventually, put the sustainability of the expansion at risk. On the other hand, troubles in many foreign economies and resulting financial turmoil both abroad and at home seemed, at times, to raise the risk of an excessive weakening of aggregate demand.

Chart of Selected interest rates

Over the first seven months of the year, neither of these potential tendencies was sufficiently dominant to prompt a policy action by the FOMC. Although the incoming data gave no evidence of a sustained slowing of output growth, the Committee members believed that the pace of expansion likely would moderate as businesses began to slow the rapid rates at which they had been adding to their stocks of inventories and other investment goods, and as households trimmed the large advances in their spending on consumer durables and homes. Relatively firm real interest rates, buoyed by a high real federal funds rate resulting from the decline in the level of expected inflation, were thought likely to help restrain the growth of spending by businesses and households. Another check on growth was expected to come from the effects on imports and exports of the economic difficulties in emerging market economies in Asia and elsewhere. Indeed, production in the manufacturing sector slowed substantially in the first half of the year, and capacity utilization dropped noticeably. Moreover, inflation remained subdued, and a pickup was not expected in the near-to-intermediate term because of declining oil prices, and because of economic weakness abroad and the appreciation of the dollar, which were expected to trim the prices of imported goods and to increase price competition for many U.S. producers. Nonetheless, with labor markets already quite taut and aggregate demand growing rapidly--a combination that often has signaled the impending buildup of inflationary pressures--the Committee, at its meetings from March through July, judged conditions to be such that, if a policy action were to be taken in the period immediately ahead, it more likely would be a tightening than an easing; its directives to the Account Manager of the Domestic Trading Desk at the Federal Reserve Bank of New York noted that asymmetry.

By the time of the August FOMC meeting, however, the situation was changing. Although tight labor markets and rapid output growth continued to pose a risk of higher inflation, the damping influence of foreign economic developments on the U.S. economy seemed likely to increase. The contraction in the emerging market economies in Asia appeared to be deeper than had been anticipated, and the economic situation in Japan had deteriorated. Financial markets in some foreign economies also had experienced greater turmoil, and, the day before the Committee met, Russia was forced to devalue the ruble. These difficulties had been weighing on U.S. asset markets: Stock prices had fallen sharply in late July and into August as investors became concerned about the outlook for profits, and risk spreads in debt markets had widened, albeit from very low levels. Taking account of these circumstances, the Committee again left monetary policy unchanged at the August meeting, but it shifted to a symmetric directive, reflecting its perception that the risks to the economic outlook, at prevailing short-term rates, had become roughly balanced.

Over subsequent weeks, conditions in financial markets and the economic outlook in many foreign countries deteriorated further, increasing the dangers to the U.S. expansion. With investors around the world apparently reevaluating the risks associated with various credits and seemingly becoming less willing or able to bear such risks, asset demands shifted toward safer and more liquid instruments. These shifts caused a sharp fall in yields on Treasury securities. Spreads of yields on private debt securities over those on comparable Treasury instruments widened considerably further, and issuance slowed sharply. Measures of market volatility increased, and liquidity in many financial markets was curtailed. Equity prices continued to slide lower, with most broad indexes falling back by early September to near their levels at the start of the year. Reflecting the weaker and more uncertain economic outlook, some banks boosted interest rate spreads and fees on new loans to businesses and tightened their underwriting standards.

Against this backdrop, at its September meeting the FOMC looked beyond incoming data suggesting that the economy was continuing to expand at a robust pace, and it lowered the intended level of the federal funds rate 1/4 percentage point. The Committee noted that the rate cut would cushion the effects on prospective U.S. economic growth of increasing weakness in foreign economies and of less accommodative conditions in domestic financial markets. The directive adopted at the meeting suggested a bias toward further easing over the intermeeting period. In the days following the policy move, disturbances in financial markets worsened. Movements in the prices of securities were exacerbated by a deterioration in market liquidity, as some securities dealers cut back on their market-making activities, and by the expected unwinding of positions by hedge funds and other leveraged investors. In early October, Treasury yields briefly tumbled to their lowest levels in many years, reflecting efforts by investors to exchange other instruments for riskless and liquid Treasury securities.

Although some measures of market turbulence had begun to ease a bit by mid-October, financial markets remained extremely volatile and risk spreads were very wide. On October 15, consistent with the directive from the September meeting, the intended federal funds rate was trimmed another 1/4 percentage point, to 5 percent. This policy move, which occurred between FOMC meetings, came at the initiative of Chairman Greenspan and followed a conference call with Committee members. At the same time, the Board of Governors approved a 1/4 percentage point reduction in the discount rate. These actions were taken to buffer the domestic economy from the impact of the less accommodative conditions in domestic financial markets, in part by contributing to some stabilization of the global financial situation.

Following the October policy move, strains in domestic financial markets diminished considerably. As safe-haven demands for Treasury securities ebbed, Treasury yields generally trended higher, and measures of financial market volatility and illiquidity eased. Nonetheless, risk spreads remained very wide, and liquidity in many markets continued to be limited. Moreover, although pressures on some emerging market economies had receded a bit, partly reflecting concerted international efforts to provide assistance to Brazil, the foreign economic outlook remained uncertain. With downside risks still substantial, and in light of the cumulative effect since August of the tightening in many sectors of the credit markets and the weakening of economic activity abroad, the FOMC reduced the intended federal funds rate a further 1/4 percentage point at its November meeting, bringing the total reduction during the autumn to 3/4 percentage point. The Board of Governors also approved a second 1/4 percentage point cut in the discount rate. The Committee believed that, with this policy action, financial conditions could reasonably be expected to be consistent with fostering sustained economic expansion while keeping inflationary pressures subdued. The action provided some insurance against an unexpectedly severe weakening of the expansion, and the Committee therefore established a symmetrical directive. By the time of the December meeting, the situation in financial markets had changed little, on balance, and the Committee decided that no further change in rates was desirable and that the directive should remain symmetrical.

Some measures of financial volatility eased further in the new year, although risk spreads on corporate bonds remained at quite high levels. Yields on Treasury securities were about flat, on balance, in January, as the effect of stronger-than-expected economic growth appeared to be about offset by data suggesting that inflation remained quiescent and perhaps also by the effects of some safe-haven flows prompted by the deteriorating situation in Brazil. Over the same period, stock prices surged higher, led by computer and other technology shares, and most stock price indexes posted new highs. By the time of the February 2-3 meeting, financial markets were easily accommodating robust demands for credit, and economic activity seemed to have more momentum than many had anticipated. However, the foreign sector continued to pose a threat to U.S. growth going forward, inflation showed no signs of picking up despite the rapid pace of growth and the very tight labor market, and some slowing of economic growth remained a likely prospect. In these circumstances, the FOMC concluded that it was prudent to wait for further information, and it left policy unchanged.

Economic Projections for 1999

By and large, the members of the Board of Governors and the Federal Reserve Bank presidents, all of whom participate in the deliberations of the FOMC, expect the economy to expand moderately, on average, in 1999. The central tendency of the FOMC participants' forecasts of real GDP growth from the fourth quarter of 1998 to the fourth quarter of 1999 is 2-1/2 percent to 3 percent. The anticipated expansion is expected to create enough new jobs to keep the civilian unemployment rate near its recent average, in a range of 4-1/4 percent to 4-1/2 percent. With tightness of the labor market expected to persist and oil and import prices unlikely to be as weak in 1999 as they were in 1998, inflation is expected to move up somewhat from the rate of this past year but to remain low by the standards of the past three decades: The central tendency of the FOMC participants' CPI inflation forecasts for 1999 is 2 percent to 2-1/2 percent. The Federal Reserve officials' inflation forecasts are closely aligned with that of the Administration, and their forecasts of real GDP and unemployment depict a somewhat stronger real economy than the Administration is projecting.

1. Economic projections for 1999
table rule
  Federal Reserve governors
and Reserve Bank presidents
Central tendency
Change, fourth quarter
to fourth quarter
Nominal GDP3-3/4 to 5   4 to 4-1/2 4.0
Real GDP22 to 3-1/2 2-1/2 to 3 2.0
Consumer price index31-1/2 to 2-1/2   2 to 2-1/2 2.3

Average level, fourth quarter
Civilian unemployment
4-1/4 to 4-3/4 4-1/4 to 4-1/2 4.9
table rule

          1.  Change from average for fourth quarter of 1998 to average for fourth quarter of 1999.
          2.  Chain-weighted.
          3.  All urban consumers.


Present circumstances suggest that domestic demand could continue to rise briskly for a while longer. Consumer spending continues to be driven by strong gains in employment, increases in real incomes, and rising levels of wealth. Those same factors, together with low mortgage interest rates, are keeping housing activity robust. Businesses are still investing heavily in new capital, especially computers and other high-tech equipment. Households and businesses appear willing to take on more debt in support of spending; although spreads on corporate debt remain elevated, rate levels are perceived to be attractive for most borrowers, and restraint on access to finance is not much in evidence.

As the year progresses, however, gains in domestic spending should begin to moderate. Spending increases for housing, consumer durables, and business equipment have been exceptionally large for a while now, substantially raising the rate of growth in the amounts of these goods owned by businesses and households; some moderation in outlays seems likely, lest these holdings become disproportionate to underlying trends in income and output. The outlook for spending continues to be obscured to some degree by uncertainties about the course of equity prices; a failure of these prices to match the outsized gains posted in recent years would contribute to some moderation in spending growth, especially by households. Government spending, which accounts for about one-sixth of domestic demand, seems likely to expand at a moderate pace overall. Along with the numerous other uncertainties that attend the outlook, an additional uncertainty is present this year because of the approach of the year 2000 and the associated Y2K problem.

Growth abroad is expected to remain sluggish, on balance, in 1999, limiting the prospects for exports. At the same time, growth of the U.S. economy probably will continue to generate fairly brisk increases in imports. In total, real net exports of goods and services seem likely to fall further in the coming year, although several factors--the decline in the dollar from its peak of last summer, the expected slowing of income growth in the United States, and the possibility of a slight pickup in economic growth abroad--provide a basis for thinking that this year's drop in net exports might not be as large as that of 1998.

The future course of inflation will depend in part on what happens to the prices of oil and other imports, and restraint from those sources seems unlikely to be as great as it was in 1998. The drop in the price of oil this past year left it toward the lower end of its range of the past couple of decades and has thereby reduced the incentives for exploration, drilling, and production. Futures markets have been showing a gradual rise in the price of oil going forward. Prices of nonoil imports changed little in the fourth quarter of last year after having fallen sharply in previous quarters. Indicators of the pressures on domestic resources provided mixed signals over the past year. In manufacturing, capacity utilization declined considerably, to a level below its long run average, reflecting slower production growth and sizable additions to the stock of capital. However, labor markets remained very taut, and with the economy apparently carrying substantial momentum into this year, data on costs and prices will need to be monitored carefully for signs that a rising inflation pattern might start to take hold. In that regard, the FOMC will continue to rely not only on the CPI but also on a variety of other price measures to gauge the economy's inflation performance in the period ahead.

Money and Debt Ranges for 1999

At its most recent meeting, the FOMC reaffirmed the 1999 monetary growth ranges that were chosen on a provisional basis last July: 1 percent to 5 percent for M2, and 2 percent to 6 percent for M3. As has been the case for some time, the FOMC intends these money growth ranges to be benchmarks for growth under conditions of price stability, sustainable real economic growth, and historical velocity relationships rather than ranges that encompass the expected growth of money over the coming year or that serve as guides to policy.

2. Ranges for growth of monetary and debt aggregates
table rule
M2 1 to 5 1 to 5 1 to 5
M3 2 to 62 to 6 2 to 6
Debt    3 to 73 to 7 3 to 7
table rule

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


Given continued uncertainty about movements in the velocities of M2 and M3 (the ratios of nominal GDP to the aggregates), the Committee would have little confidence that money growth within any particular range selected for the year would be associated with the economic performance it expected or desired. Nonetheless, the Committee believes that, despite the apparent large shift in velocity behavior in the early 1990s, money growth has some value as an economic indicator. Indeed, some FOMC members have expressed the concern that the unusually rapid growth in the money and debt aggregates in 1998 might have reflected monetary conditions that were too accommodative and would ultimately lead to an increase in inflation pressures. The Committee will continue to monitor the monetary aggregates as well as a wide variety of other economic and financial data to inform its policy deliberations.

Last year, M2 increased 8-1/2 percent, and with nominal GDP rising 5 percent, M2 velocity decreased 3 percent. This drop in velocity was considerably larger than would have been expected on the basis of historical relationships and the modest decline in the opportunity cost of M2 (measured as the difference between the interest rate on Treasury bills and the weighted average rate available on M2 assets). The fall in velocity in part reflected an increased demand for the safe and liquid assets in M2 as investors responded to the heightened volatility in financial markets in the second half of the year. Other factors that may have contributed include lower long-term interest rates and a very flat yield curve, which might have suggested to households that they would be giving up very little in earnings by parking savings in short-term assets in M2. In addition, M2 may have been boosted by a desire on the part of some investors to redirect savings flows away from equities after several years of outsized gains in stock market wealth. With equity wealth still elevated and the yield curve likely to remain flat, M2 velocity could continue to fall this year. However, the pace of decline should slow as some households respond to the easing of concerns about financial market volatility by reversing a portion of the shift toward M2 assets that occurred last fall. Indeed, this effect may already be visible, as M2 growth, while still robust, has slowed considerably early this year. If velocity does fall, given the Committee's expectations for nominal income growth, M2 could again exceed its price-stability benchmark range.

M3 expanded 11 percent last year, and its velocity fell 5-1/4 percent, the largest drop in many years. The rapid growth in this aggregate owed in large part to a substantial rise in institutional money funds. These funds have been expanding rapidly in recent years as nonfinancial firms increasingly employ them to provide cash management services. Investments in these funds provide businesses with greater liquidity than direct holdings of money market instruments, and by substituting for such direct holdings, they boost M3. M3 was also buoyed last year by a large advance in the managed liabilities banks used to fund rapid growth in bank credit. In part, the growth in bank credit reflected demand by borrowers shifting from the securities markets, and with these markets again receptive to new issues, bank credit growth this year is expected to slow to a pace more in line with broader debt aggregates However, institutional money funds are likely to continue their robust gains, contributing to a further diminution in M3 velocity and, possibly, to growth of this aggregate above its price-stability range.

Domestic nonfinancial debt grew 6-1/4 percent in 1998, somewhat above the middle of the 3 percent to 7 percent growth range the Committee established last February. This robust growth reflected large rises in the debt of businesses and households owing to substantial advances in spending as well as debt-financed mergers and acquisitions. However, the increase in private-sector debt was partly offset by the first annual decline in federal debt in almost thirty years. As with the monetary aggregates, the Committee left the range for debt growth unchanged for 1999. After an aberrant period in the 1980s during which debt growth greatly exceeded growth of nominal GDP, debt growth over the past decade has returned to its historical pattern of about matching growth of nominal GDP, and the Committee members expect debt to fall within its range this year.


Section 2

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