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For release on delivery 12:30 p.m., E.S.T. March 5, 1987 Address by Manuel H. Johnson Vice Chairman Board of Governors of the Federal Reserve System before Eastern Economic Association Washington, D.C. March 5, 1987 "U.S. Monetary Policy and Prospects for Sustainable Economic Growth" It is a pleasure to be here this afternoon to address members of the Eastern Economic Association. Eastern meetings and it is always I have participated in previous enjoyable talking to fellow economists. U.S. Monetary Policy This afternoon I would like to talk about U.S. monetary policy and its role among broader policies for sustained worldwide expansion. Now is an especially convenient time to talk about this subject since just two weeks ago the Federal Reserve submitted to Congress its semi annual report on monetary policy. In this report, we reiterated our commitment to foster price stability. itself but This commitment because it is is significant not only as a necessary condition for an end other unto important goals; namely promoting sustainable growth in output and contributing to a balanced pattern of international transactions. As I am sure you all are well Federal aware, decisions made by the Open Market Committee regarding money and credit targets for 1987 were also disclosed in this report. In particular, the Committee established target ranges for M2 and M3 of 5-1/2 to 8-1/2 percent from the fourth quarter of 1986 to the fourth quarter of 1987. These ranges for M2 and M3 are one-half percentage point below those in effect for 1986, and are below the actual growth rates last year. Therefore, they are consistent with the belief that a reduction in the growth of money supply measures, over time, will be needed if the economy is to achieve noninflationary growth and external equilibrium. The FOMC elected not to establish a specific target range for « Ml at this time because of uncertainties about its underlying relation ship to the behavior of the economy. More specifically, the demand for money has been rather erratic and unpredictable. For example, the velocity of Ml dropped 9-1/2 percent last year, following a decline of 5 percent 1n 1985. percent. Remarkably, since 1981, velocity has fallen 16 This contrasts sharply with its trend Increase of about 3 percent per year over the previous two decades. There are several explanations for this unusual behavior of velocity. With the deregulation of deposit rates, and the attendant changes In composition, Ml has become much more responsive in the short-run to changes 1n interest rates, and possibly to other factors affecting the portfolio decisions of households. Accordingly, the combination of deregulation, continued disinflation and lower interest rates has Interacted to alter Ml velocity. Only with the passage of time will it become possible to assess with any precision the longerterm trend growth of Ml relative to GNP. And only then will it be possible to make a judgement about its usefulness as an intermediate target of monetary policy. It should be noted that the FOMC decision regarding Ml does not mark the total abandonment of this aggregate. Rather, the Commit tee will continue to monitor Ml behavior carefully, assessing Its growth 1n the context of other financial and economic developments. And depending on circumstances, 1t 1s possible that at some time In the year the Committee might aggregate. set more specific objectives for this Currently, however, the broader aggregates along with a care ful monitoring and assessment of information provided by various finan cial auction markets seem more appropriate as guides for policy. For example, evidence of Inflationary expectations signaled 1n the foreign exchange, bond, money, and commodity markets seems most relevant in this regard. The Economic Setting Before discussing the role of. U.S. monetary policy in the context of other policies for sustained expansion, a brief review of the current economic setting seems appropriate. The U.S. economic expansion is now extending into its fifth year and is already among the longest 1n peacetime history. While the overall rate of economic growth has been rather modest since mid-1984, averaging about 2-1/2 percent a year, that growth has been sufficient to create about 7 million new jobs during this period. At the same time, inflation has continued to moderate as further progress has been made toward the objective of overall price stability. Running counter to past cyclical pressures have also remained subdued. And patterns, labor cost also counter to past cyclical patterns, both the inflation rate and interest rates, after four years of expansion, are substantially lower than when the recovery started. As inflation and expectations of inflation moderated last year, the Federal Reserve was able to supply additional reserves for the banking system and reduce the discount rate four times, by a total of 2 percentage points. I believe that this combination of a lengthy and sustained expansion with a continued reduction in both inflation and long as well as short-term interest rates is at least in part a confirmation of sound policies undertaken by the Federal Reserve. As we all know, however, the current economic setting is not problem free. expansion. There are important risks facing a continued stable Important trade imbalances exist with many of our principal industrial trading partners. These imbalances are due in part from relatively more rapid growth in the U.S. economy combined with more attractive investment opportunities here. This combination produced capital inflows, dollar appreciation, and consequently a large trade deficit. While such trade imbalances are not likely to be indefinitely sustainable,"quick fix" solutions to the problem such as fostering excessive dollar depreciation or protectionist trade legislation seem particularly inappropriate. What is important is that we attempt to maintain healthy returns to capital and adopt policies encouraging genuine economic growth. finance the This approach fosters the wherewithal to trade deficit and allows for its gradual resolution over time. But trade imbalances are not the only risks currently threat ening sustained economic expansion. Federal budget deficits In particular, large persistent and the protracted debt problems developed countries also remain important concerns. of less - 7 - Five Major Ingredients for Sustained Worldwide Expansion In discussing prospects for continued expansion, several ingredients should be considered. First, as suggested earlier, price stability is important not only in and of itself but because it is a necessary condition for the achievement of virtually all other important ingredients. Accordingly, disinf1ationary monetary policy should continue to be the fundamental policy objective of the Federal Reserve. Secondly, a more stable and sustainable alignment of exchange rates is needed for achieving this goal. long-term growth. Certainly, we are nearer to An adjustment from the elevated dollar exchange rate levels of February 1985 was clearly desirable. Moreover, economic expansion in the U.S. has moderated relative to economic growth else where in the world. And industrial country differences in both infla tion and expectations of inflation have generally narrowed -- in part because of the adoption of somewhat more consistent, more coordinated monetary policies. This improved coordination has enabled interest -8- rate differentials to converge. Of course, the Plaza Accord and recent G-6 agreement have certainly contributed to the coordination of or rather the adoption of more consistent monetary and fiscal policies. And, consistency has bolstered the move toward a more stable alignment of exchange rates. Thirdly, the U.S. must get its fiscal house in order. In particular, excessive Federal government spending and the associated large budget deficits must be brought under control. These spending habits together with the severity of the 1981-82 recession worked to dramatically enlarge the budget deficit and saddle the economy with huge public sector borrowing needs. Fortunately, a substantial improvement in the U.S. tax structure together with a disinflationary monetary policy made investment more attractive in the U.S. than else where. Thus, so far, the resulting net capital inflows have supple mented domestic saving enough to finance both private investment and the Federal budget deficit without putting upward pressure on interest rates. - 9 - This situation, however, cannot continue indefinitely. or later spending. score. progress must be made in controlling Sooner excessive Federal Some signs do exist that progress will be made on this In particular, projections and some preliminary data suggest that government spending and deficits as a proportion of 6NP have started to decrease and will continue to do so. Hollings legislation, with all of its faults, The Gramm-Rudmannonetheless has encouraged Congress to focus on the problem and commit to longer-term spending control. This legislation signaled Congress that the process has begun. a recognition by the More important than meeting specific, precise numerical goals, there now does seem to be a contin uing commitment toward slowing the growth of Federal expenditures. This commitment is not only important in and of itself, but as a demonstration to our industrial trading partners that the U.S. will reduce our use of foreign capital for unproductive purposes. More specifically, it demonstrates that the U.S. does not intend to continue to use foreign sources of capital to finance government consumption. * Such a commitment consistent enhances macroeconomic the 10 - likelihood policies among of the adoption industrialized of and more less developed countries. A fourth necessary ingredient for sustainable economic expan sion is more balanced growth among industrialized countries. Nations experiencing high trade surpluses -- such as Germany and Japan -- are currently suggests experiencing that some of very sluggish domestic these countries have growth. Evidence underutilized labor and capital capacity which combined with substantially reduced price pres sures provides the potential for more growth in domestic demand. In both Germany and Japan, wholesale prices actually fell about 10 percent in 1986 and their unemployment rates are very high historically. Economic prospects for 1987 have recently been revised downward in both countries. Accordingly, it would appear that there is room for improvement in domestic income growth so that domestic spending more closely matches their potential for ncn-inflationary capacity growth. - Such improved 11 - growth would not only benefit U.S. export performance but that of worldwide export markets; both global trade patterns and LOC export performance would therefore improve. Moreover, such action would contribute to exchange rate stability — especially if Germany and Japan ultimately adopt a tax policy that improves their growth potential. Some improvement along these lines should be likely if both countries carry through on their commitments made at the recent meetings in Paris. As suggested above, sustained balanced growth in industrial countries 1s a critical element in the orderTy resolution of LDC debt problems since improved export markets for LOC products would improve the prospects for debt service. This brings me to the final necessary condition for a continued stable expansion; namely, sustained growth of LDC's. Such growth is critical not only to promote balanced worldwide expansion but economic growth is the only way that LDC debt problems can be genuinely resolved. - 12 - In prescribing policy conditions, it should be remembered that in order to improve their prospects for growth, LDC's must increase investment and it may be necessary to supplement domestic saving with capital from abroad. And to attract capital, a private sector environ ment in which property rights are well established and tax rates and regulations do not overburden investment is essential. It must be remembered that improved capital inflows to LDC's necessarily imply lower current account surpluses or even current account deficits for some of these countries. Indeed, more rapid economic growth itself may imply current account deficits for such countries -- as was the case in the U.S. for several decades of its early history. Growth objectives and various implications of pro-growth policies must be kept in mind while LDC’s are working their way out of debt financing problems. Such implications may, for example, include current account deficits and even temporary periods of growing debt. After all, it is the use to which debt is put which determines whether it contributes to economic growth. - 13 - Conclusion I have summarized monetary policy's goals for 1987, described the current economic setting, and set out some major necessary ingre dients for sustained non-inflationary worldwide expansion. It is worth reiterating that the Federal Reserve's promotion of price stability is critical to the successful implementation of virtually all of the important ingredients for growth described here. I am confident that we can bring about these necessary condi tions for further economic prosperity. progress on all fronts. Rudman-Hollings Indeed, we have made initial Federal Reserve monetary policy, the Gramm- legislation, the G-6 agreement, and the Baker initiative, for example, all have moved us in the right direction. debt If we can continue to move forward in this manner we can set the stage for the longest non-inflationary expansion of the post-war era. this is an objective worthy of our best efforts. Thank you. Certainly
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