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Senate/House Banking Committees
July 20 and 21, 1982
Midyear Monetary Policy Report
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Federal Reserve Bank of St. Louis
Collection: Paul A. Volcker Papers
Call Number: MC279
Box 13
Preferred Citation: Senate/House Banking Committees Midyear Monetary Policy Report, 1982 July
20-21; Paul A. Volcker Papers, Box 13; Public Policy Papers, Department of Rare Books and Special
Collections, Princeton University Library
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Federal Reserve Bank of St. Louis
Midyear Review of the
Federal Reserve Board
July 20, 1982
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Federal Reserve Bank of St. Louis
Monetary Policy
Objectives for 1982
With tentative monetary growth rangesfor 1983
Summary of Report to the Congress on Monetary Policy pursuant
to the Full Employment and Balanced Growth Act of 1978.
With testimony presented by Paul A. Volcker, Chairman,
Federal Reserve Board, July 20, 1982.
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Contents
Section
Page
Monetary Policy in 1982 and 1983
1
The Growth of Money and Credit in 1982
1
Tentative Ranges for 1983
2
The Outlook for the Economy
3
Testimony of Paul A. Volcker, Chairman,
Federal Reserve Board
5
Appendix—Alternative Seasonal Adjustment Procedures
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13
Monetary Policy in
1982 and 1983
There is a clear need today to promote higher levels
of production and employment in our economy. The
objective of Federal Reserve policy is to create an
environment conducive to sustained recovery in business activity while maintaining the financial discipline needed to restore reasonable price stability.
ables. However, the Committee concluded, based on
current evidence, that growth this year around the
top of the ranges for the various aggregates would be
acceptable.
The Committee also agreed that possible shifts in
the demand for liquidity might require more than ordinary elements of flexibility and judgment in assessing appropriate needs for money in the months
ahead. In the near term, measured growth of the aggregates may be affected by the income tax reductions that occurred on July 1, cost-of-living increases
in social security benefits, and by the ongoing difficulties of accurately accounting for seasonal movements in the money stock. But more fundamentally,
it is unclear to what degree businesses and households will continue to wish to hold unusually large
precautionary liquid balances. To the extent the
evidence suggests that relatively strong precautionary
demands for money persist, growth of the aggregates
somewhat above their targeted ranges would be
tolerated for a time and still would be consistent with
the FOMC's general policy thrust.
The Growth of Money and Credit in 1982
The annual targets for the monetary aggregates
reported to Congress in February were chosen to be
consistent with continued restraint on the growth of
money and credit in order to exert sustained downward pressure on inflation. At the same time, these
targets were expected to result in sufficient money
growth to support an upturn in economic activity.
At its July meeting, the Federal Open Market
Committee concluded that a change in the previously
announced targets was not warranted at this time.
Because of the tendency for the demand for money to
run strong on average in the first half, and also responding to a congressional budget resolution, careful
consideration was given to the question of whether
some raising of the targets was in order. However,
the available evidence did not suggest that a large increase in the ranges was justified; and a small change
in the ranges would have represented a degree of
"fine tuning" that appeared inconsistent with the
degree of uncertainty currently surrounding the precise relationship of money to other economic van -
Ranges of Monetary Growth 1982'
1982 Planned
1982 Actual
1982 Actual
1981
QIV'81-QIV'82
QIV'81-QII'82
QIV'81 -June'82
QIV Levels*
Ml
21
/
2 to 51
/
2 percent
6.8 percent
5.6 percent
436.7
M2
6 to 9 percent
9.7 percent
9.4 percent
1807.4
M3
61
/
2 to 91
/
2 percent
9.8 percent
9.7 percent
2171.3
Commercial
Bank Credit2
6 to 9 percent
8.3 percent
8.0 percent
1323.1
*Billions of dollars, seasonally adjusted.
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1
Tentative Ranges for 1983
The policy of firm restraint on monetary growth
has contributed importantly to the recent progress
toward reducing inflation. But when inflationary cost
trends remain entrenched, the process of slowing
monetary growth can entail economic and financial
stresses. These strains—reflected in reduced profits,
liquidity problems, and balance sheet pressures—
place particular hardships on industries that depend
heavily on credit markets such as construction,
business equipment, and consumer durables.
Unfortunately, these stresses cannot be easily
remedied through faster money growth. The immediate effect might be lower interest rates, especially in short-term markets. In time, however, such an
attempt would founder, embedding inflation and expectations of inflation even more deeply into the nation's economic system. The present and prospective
pressures on financial markets urgently need to be
eased not by relaxing discipline on money growth,
but by the adoption of policies that will ensure a
lower and declining federal deficit. Moreover, a
return to financial health will require the adoption of
more prudent credit practices on the part of private
borrowers and lenders alike.
Looking ahead to 1983 and beyond, the FOMC remains committed to restraining money growth in
order to achieve sustained noninflationary economic
expansion. At its July meeting, the FOMC felt that
the ranges now in effect could remain as preliminary
targets for 1983. Because the monetary aggregates in
1982 will likely be close to the upper ends of their
ranges, or perhaps even somewhat above them, the
preliminary 1983 targets are fully consistent with a
reduction in the actual growth of money in 1983.
In light of the unusual uncertainty surrounding the
economic, financial, and budgetary outlook, the
FOMC stressed the tentative nature of its 1983
targets. On the one hand, experience strongly suggests that, with economic activity on an upward
trend, precautionary motives for holding liquid
balances should begin to fade, contributing to a rapid
rise in the velocity of money. Moreover, regulatory
actions by the Depository Institutions Deregulation
Committee that increase the competitive appeal of
deposit instruments—as well as the more widespread
use of innovative cash management techniques, such
as "sweep" accounts—also could reduce the demand
for money relative to income and interest rates. On
the other hand, the long upward trend in the velocity
of money since the 1950s took place in an environment of rising inflation and higher nominal interest
rates that provided incentives for economizing on
money holdings; as these incentives recede, the attractiveness of cash holdings may be enhanced and
more money may be held relative to the level of
business activity.
Tentative Ranges of Monetary Growth 1983
Based on QIV'82 to QIV'83
M1
/
2 percent
2V2 to 51
M2
6 to 9 percent
M3
61
/
2 to 91
/
2 percent
Commercial Bank Credit
6 to 9 percent
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2
The Outlook for the Economy
The economy at midyear appears to have leveled off
following sizable declines last fall and winter. Consumption has strengthened, with retail sales up significantly in the second quarter. New and existing home
sales have continued to fluctuate at depressed levels,
but housing starts nonetheless have edged upward.
In the business sector, substantial progress has been
made in working off excess inventories, and the rate
of liquidation appears to have declined. On the negative side, however, plant and equipment spending,
which typically lags an upturn in overall activity, is
still depressed. The trend in export demand also continues to be a drag on the economy reflecting the
dollar's strength and weak economic activity abroad.
An evaluation of the balance of economic forces indicates that an upturn in economic activity is highly
likely in the second half of 1982. Monetary growth
along the lines targeted by the FOMC should accommodate this expansion in real GNP, given the increases in velocity that typically occur early in a
cyclical recovery, and absent an appreciable resurgence of inflation. The 10 percent cut in income tax
rates that went into effect July 1 is boosting disposable personal income and should reinforce the growth
in consumer spending. Given the improved inventory
situation, any sizable increase in consumer spending
should, in turn, be reflected in new orders and a
CPI
ri CPI Excluding Food, Energy, and Homeownership
10
5
0
Dec. to May
1978
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6
0
14•••••11•1111.
III
1980
H2
1980
1982
pickup in production. The continuing rise in defense
spending and the associated private investment
outlays needed for the production of defense equipment will be another element supporting real GNP
growth. During its initial phase, the expansion is
likely to be more heavily concentrated in consumer
spending than in past business cycles; current
pressures in financial markets and liquidity strains
may inhibit the recovery in residential and business
investment.
The excellent price performance so far this year
has been helped by slack demand and exceptionally
favorable energy and food supply developments. For
that reason, the recorded rate of inflation may be
higher in the second half of the year. However, prospects appear excellent for continuing the downtrend
in the underlying rate of inflation. There has been
significant progress in slowing the rise in labor compensation, and improvement in underlying cost
pressures should continue over the balance of the
year. Unit labor costs also are likely to be held down
by a cyclical rebound in productivity growth as output recovers. Moreover, lower inflation will contribute to smaller cost-of-living wage adjustments,
which will moderate cost pressures further.
A critical factor influencing the composition and
strength of the expansion in economic activity over
the next year and a half will be the extent to which
pressures in financial markets moderate. This, in
1972 Dollars
1978
15
•••••••••••••
Change from end of previous
period, annual rate, percent
Real GNP
Change from end of previous
period, annual rate, percent
Consumer Prices
HI
1982
3
Federal Government
Borrowing
turn, depends importantly on the progress made in
further reducing inflationary pressures. A decrease in
inflation would take pressure off financial markets in
two ways. First, slower inflation will lead to a reduced growth in transactions demands for money, given
any particular level of real activity. Second, further
progress in curbing inflation will help lower longterm interest rates by reducing the inflation premium
contained in nominal interest rates.
Another crucial influence on financial markets and
thus on the nature of the expansion in 1983 will be
the federal budgetary decisions that are made in
coming months. The budget resolution that was
recently passed by the House and Senate is a constructive first step in reducing budget deficits as the
economy recovers, but appropriation and revenue
legislation is needed to implement this resolution.
How the budget process unfolds will determine
future credit demands by the Federal government
and thus the extent to which deficits will preempt the
net savings generated by the private economy. A
strong program of budget restraint would minimize
pressures in financial markets and thereby enhance
the prospects for a more vigorous recovery in homebuilding, business fixed investment, and other creditdependent sectors.
In assessing the economic outlook, the individual
members of the FOMC have made projections for
economic performance that generally fall within the
ranges in the table below. In addition to the mone-
Combined Deficit Financed by the Public
120
80
40
0
1978
Projected
Actual*
Average level
in the fourth
quarter, percent
1981
1982
1983
Nominal GNP
9.6
/
2
51
/
2 to 71
12
7 to 9/
Real GNP
0.7
1
2
/
1
2 to 1 /
21
/
2 to 4
GNP Deflator
8.9
4% to 6
4 to 5%
Unemployment
Rate
8.3
9 to 9%
/
2
81
/
2 to 91
• Based on revised GNP data that were published after the full Humphrey-Hawkins report was submitted.
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1980
1982
tary targets discussed above, these projections assume
that the federal budget will be put on a course that
over time will result in significant reductions in the
federal deficit.
Looking ahead, the Committee members, like the
Administration and the Congress, foresee continued
economic expansion in 1983, but currently anticipate
a less rapid rate of price increase and somewhat
slower real growth than the assumptions underlying
the budget. The monetary targets tentatively set for
1983—which will be reviewed early next year—would
imply, under the budgetary assumptions, relatively
rapid growth in velocity.
FOMC Members' Economic Projections
Changes, fourth
quarter to fourth
quarter, percent
Seasonally adjusted,
annual rate, billions of dollars
4
Testimony of
Paul A.Volcker, Chairman,
Federal Reserve Board
I am pleased to have this opportunity
once again to discuss monetag policy
with you within the context of recent and
prospective economic developments. As
usual on these occasions, you have the
Board of Governors' "HumphreyHawkins" Report before you. This
morning I want to enlarge upon some
aspects of that Report and amplO) as
fully as I can my thinking with respect
to the period ahead.
in financial markets, in the practices of business and
financial institutions, and in labor negotiations—is a
difficult and potentially painful process. Those, consciously or not, who had come to "bet" on rising
prices and the ready availability of relatively cheap
credit to mask the risks of rising costs, poor productivity, aggressive lending, or over-extended financial
positions have found themselves in a particularly difficult position.
The pressures on financial markets and interest
rates have been aggravated by concerns over prospective huge volumes of Treasury financing, and by
the need of some businesses to borrow at a time of a
severe squeeze on profits. Lags in the adjustment of
nominal wages and other costs to the prospects for
sharply reduced inflation are perhaps inevitable, but
have the effect of prolonging the pressure on profits—and indirectly on financial markets and employment. Remaining doubts and skepticism that public
policy will "carry through" on the effort to restore
stability also affect interest rates, perhaps most particularly in the longer-term markets.
In fact, the evidence now seems to me strong that
the inflationary tide has turned in a fundamental
way. In stating that, I do not rely entirely on the exceptionally favorable consumer and producer price
data thus far this year, when the recorded rates of
1 2 % and
price increase (at annual rates) declined to 3/
21/2 %, respectively. That apparent improvement was
magnified by some factors likely to prove temporary,
including, of course, the intensity of the recession;
those price indices are likely to appear somewhat less
favorable in the second half of the year. What seems
to me more important for the longer run is that the
trend of underlying costs and nominal wages has
begun to move lower, and that trend should be sustainable as the economy recovers upward momentum. While less easy to identify—labor productivity
typically does poorly during periods of business
decline—there are encouraging signs that both management and workers are giving more intense attention to the effort to improve productivity. That effort
should "pay off" in a period of business expansion,
helping to hold down costs and encouraging a revival
of profits, setting the stage for the sustained growth
in real income we want.
Crossroads on Inflation
In assessing the current economic situation, I believe
the comments I made five months ago remain relevant. Without repeating that analysis in detail, I
would emphasize that we stand at an important
crossroads for the economy and economic policy.
In these past two years we have traveled a considerable way toward reversing the inflationary trend
of the previous decade or more. I would recall to you
that, by the late 1970s, that trend had shown every
sign of feeding upon itself and tending to accelerate
to the point where it threatened to undermine the
foundations of our economy. Dealing with inflation
was accepted as a top national priority, and, as
events developed, that task fell almost entirely to
monetary policy.
In the best of circumstances, changing entrenched
patterns of inflationary behavior and expectations—
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5
Economic Strains
I must also emphasize that the current problems of
I am acutely aware that these gains against inflation
have been achieved in a context of serious recession.
Millions of workers are unemployed, many businesses are hardpressed to maintain profitability, and
business bankruptcies are at a postwar high. While it
is true that some of the hardship can reasonably be
traced to mistakes in management or personal judgment, including presumptions that inflation would
continue, large areas of the country and sectors of
the economy have been swept up in more generalized
difficulty. Our financial system has great strength
and resiliency, but particular points of strain have
been evident.
Quite obviously, a successful program to deal with
inflation, with productivity, and with the other
economic and social problems we face cannot be built
on a crumbling foundation of continuing recession.
As you know, there have been some indications—
most broadly reflected in the rough stability of the
real GNP in the second quarter and small increases
in the leading indicators—that the downward adjustments may be drawing to a close. The tax reduction effective July 1, higher social security payments,
rising defense spending and orders, and the reductions in inventory already achieved, all tend to support the generally held view among economists that
some recovery is likely in the second half of the year.
I am also conscious of the fact that the leveling off
of the GNP has masked continuing weakness in important sectors of the economy. In its early stages,
the prospective recovery must be led largely by consumer spending. But to be sustained over time, and
to support continuing growth in productivity and living standards, more investment will be necessary. At
present, as you know, business investment is moving
lower. House building has remained at depressed
levels; despite some small gains in starts during the
spring, the cyclical strength "normal" in that industry in the early stages of recovery is lacking. Exports have been adversely affected by the relative
strength of the dollar in exchange markets.
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the American economy have strong parallels abroad.
Governments around the world have faced, in
greater or lesser degree, both inflationary and fiscal
problems. As they have come to grips with those problems, growth has been slow or non-existent, and the
recessionary tendencies in various countries have fed
back, one on another.
In sum, we are in a situation that obviously warrants concern, but also has great opportunities.
Those opportunities lie in major part in achieving
lasting progress—in pinning down and extending
what has already been achieved—toward price
stability. In doing so, we will be laying the base for
sustaining recovery over many years ahead, and for
much lower interest rates, even as the economy
grows. Conversely, to fail in that task now, when so
much headway has been made, could only greatly
complicate the problems of the economy over time. I
find it difficult to suggest when and how a credible
attack could be renewed on inflation should we
neglect completing the job now. Certainly the doubts
and skepticism about our capacity to deal with inflation—which now seem to be yielding—would be
amplified, with unfortunate consequences for financial markets and ultimately for the economy.
I am certain that many of the questions, concerns
and dangers in your mind lie in the short run—and
that those in good part revolve around the pressures
in financial markets. Can we look forward to lower
interest rates to support the expansion in investment
and housing as the recovery takes hold? Is there, in
fact, enough liquidity in the economy to support expansion—but not so much that inflation is reignited?
Will, in fact, the economy follow the recovery path
so widely forecast in coming months?
These are the questions that we in the Federal
Reserve must deal with in setting monetary policy.
As we approach these policy decisions, we are particularly conscious of the fact that monetary policy,
however important, is only one instrument of
economic policy. Success in reaching our common
objective of a strong and prosperous economy
depends upon more than appropriate monetary
policies, and I will touch this morning on what seem
to me appropriately complementary policies in the
public and private sectors.
6
Review of Money Growth in 1982
Five months ago, in presenting our monetary and
credit targets for 1982, I noted some unusual factors
could be at work tending to increase the desire of individuals and businesses to hold assets in the relatively liquid forms encompassed in the various definitions of money. Partly for that reason—and recognizing that the conventional base for the M1 target of
the fourth quarter of 1981 was relatively low—I indicated that the Federal Open Market Committee
contemplated growth toward the upper ends of the
specificied ranges. Given the "bulge" early in the
year in Ml, the Committee also contemplated that
that particular measure of money might for some
months remain above a "straight line" projection of
the targeted range from the fourth quarter of 1981 to
the fourth quarter of 1982.
As events developed, M1 and M2 both remained
somewhat above straight line paths until very recently. M3 and bank credit have remained generally
within the indicated range, although close to the upper ends. Taking the latest full month of June, M1
grew 5.6% from the base period and M2 9.4%, close
to the top of the ranges. To the second quarter as a
whole, the growth was higher, at 6.8% and 9.7%,
respectively. Looked at on a year-over-year basis,
which appropriately tends to average through volatile
monthly and quarterly figures, M1 during the first
half of 1982 averaged about 4% % above the first
half of 1981 (after accounting for NOW account
shifts early last year). On the same basis, M2 and
M3 grew by 9.7% and 10.5%, respectively, a rate of
growth distinctly faster than the nominal GNP over
the same interval.
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In conducting policy during this period, the Committee was sensitive to indications that the desire of
individuals and others for liquidity was unusually
high, apparently reflecting concerns and uncertainties
about the business and financial situation. One
reflection of that may be found in unusually large
declines in "velocity" over the period—that is, the
ratio of measures of money to the gross national product. M1 velocity—particularly for periods as short
as three to six months—is historically volatile. A
cyclical tendency to slow (relative to its upward
trend) during recessions is common. But an actual
decline for two consecutive quarters, as happened
late in 1981 and the first quarter of 1982, is rather
unusual. The magnitude of the decline during the
first quarter was larger than in any quarter of the entire postwar period. Moreover, declines in velocity of
this magnitude and duration are often accompanied
by (and are related to) reduced short-term interest
rates. Those interest rate levels during the first half
of 1982 were distinctly lower than during much of
1980 and 1981, but they rose above the levels reached in the closing months of last year.
7
V.
Desire for Liquidity
their funds. A similar tendency to hold more savings
deposits has been observed in earlier recessions.
I would add that the financial and liquidity positions of the household sector of the economy, as
measured by conventional liquid asset and debt
ratios, has improved during the recession period.
Relative to income, debt repayment burdens have
declined to the lowest level since 1976. Trends
among business firms are clearly mixed. While many
individual firms are under strong pressure, some rise
in liquid asset holdings for the corporate sector as a
whole appears to be developing. The gap between internal cash flow (that is, retained earnings and depreciation allowances) and spending for plant, equipment, and inventory has also been at an historically
low level, suggesting that a portion of recent business
credit demands is designed to bolster liquidity. But,
for many years, business liquidity ratios have tended
to decline, and balance sheet ratios have reflected
more dependence on short-term debt. In that perspective, any recent gains in liquidity appear small.
In the light of the evidence of the desire to hold
more NOW accounts and other liquid balances for
precautionary rather than transaction purposes during the months of recession, strong efforts to reduce
further the growth rate of the monetary aggregates
appeared inappropriate. Such an effort would have
required more pressure on bank reserve positions—
and presumably more pressures on the money markets and interest rates in the short run. At the same
time, an unrestrained build-up of money and liquidity clearly would have been inconsistent with the
effort to sustain progress against inflation, both
because liquidity demands could shift quickly and
because our policy intentions could easily have been
misconstrued. Periods of velocity decline over a
quarter or two are typically followed by periods of
relatively rapid increase. Those increases tend to be
particularly large during cyclical recoveries. Indeed,
velocity appears to have risen slightly during the second quarter, and the growth in NOW accounts has
slowed.
More direct evidence of the desire for liquidity or
precautionary balances affecting M1 can be found in
the behavior of NOW accounts. As you know, NOW
accounts are a relatively new instrument, and we
have no experience of behavior over the course of a
full business cycle. We do know that NOW accounts
are essentially confined to individuals, their turnover
relative to demand accounts is relatively low, and,
from the standpoint of the owner, they have some of
the characteristics of savings deposits, including a
similarly low interest rate but easy access on demand. We also know the great bulk of the increase
in M1 during the early part of the year—almost 90%
of the rise from the fourth quarter of 1981 to the second quarter of 1982—was concentrated in NOW accounts, even though only about a fifth of total M1 is
held in that form. In contrast to the steep downward
trend in low-interest savings accounts in recent years,
savings account holdings have stabilized or even increased in 1982, suggesting the importance of a high
degree of liquidity to many individuals in allocating
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8
L,
The Monetary Targets—Balance of 1982
Judgments on these seemingly technical considerations inevitably take on considerable importance in
the target-setting process because the economic and
financial consequences (including the consequences
for interest rates) of a particular M1 or M2 increase
are dependent on the demand for money. Over
longer periods, a certain stability in velocity trends
can be observed, but there is a noticeable cyclical
pattern. Taking account of those normal historical
relationships, the various targets established at the
beginning of the year were calculated to be consistent
with economic recovery in a context of declining inflation. That remains our judgment today. Inflation
has, in fact, receded more rapidly than anticipated at
the start of the year potentially leaving more "room"
for real growth. On that basis, the targets established
early in the year still appeared broadly appropriate,
and the Federal Open Market Committee decided at
its recent meeting not to change them at this time.
However, the Committee also felt, in the light of
developments during the first half, that growth
around the top of those ranges would be fully acceptable. Moreover—and I would emphasize this—
growth somewhat above the targeted ranges would be
tolerated for a time in circumstances in which it appeared that precautionary or liquidity motivations,
during a period of economic uncertainty and turbulence, were leading to stronger than anticipated
demands for money. We will look to a variety of factors in reaching that judgment, including such technical factors as the behavior of different components
in the money supply, the growth of credit, the behavior of banking and financial markets, and more
broadly, the behavior of velocity and interest rates.
I believe it is timely for me to add that, in these
circumstances, the Federal Reserve should not be expected to respond, and does not plan to respond,
strongly to various "bulges"—or for that matter
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"valleys"—in monetary growth that seem likely to
be temporary. As we have emphasized in the past,
the data are subject to a good deal of statistical
"noise" in any circumstances, and at times when
demands for money and liquidity may be exceptionally volatile, more than usual caution is necessary in
responding to "blips."*
We, of course, have a concrete instance at hand of
a relatively large (and widely anticipated)jump in
M1 in the first week of July—possibly influenced to
some degree by larger social security payments just
before a long weekend. Following as it did a succession of money supply declines, that increase brought
the most recent level for M1 barely above the June
average, and it is not of concern to us.
It is in this context, and in view of recent declines
in short-term market interest rates, that the Federal
Reserve yesterday reduced the basic discount rate
2 percent.
/
from 12 to 111
*In that connection, a number of observers have noted that the
first month of a calendar quarter—most noticeably in January
and April—sometimes shows an extraordinarily large increase in
Ml—amplified by the common practice of multiplying the actual
change by 12 to show an annual rate. Those bulges, more typically than not, are partially "washed out" by slower than normal
growth the following month. The standard seasonal adjustment
techniques we use to smooth out monthly money supply variations—indeed, any standard techniques—may, in fact, be incapable of keeping up with rapidly changing patterns of financial
behavior, as they affect seasonal patterns. A note attached to this
statement sets forth some work in process developing new seasonal adjustment techniques.
9
The Monetary Targets-1983
The Blend of Monetary and Fiscal Policy
In looking ahead to 1983, the Open Market Committee agreed that a decision at this time would—even
more obviously than usual—need to be reviewed at
the start of the year in the light of all the evidence as
to the behavior of velocity or money and liquidity demand during the current year. Apart from the cyclical influences now at work, the possibility will need
to be evaluated of a more lasting change in the trend
of velocity.
The persistent rise in velocity during the past
twenty years has been accompanied by rising inflation and interest rates—both factors that encourage
economization of cash balances. In addition, technological change in banking—spurred in considerable
part by the availability of computers—has made it
technically feasible to do more and more business on
a proportionately smaller "cash" base. With incentives strong to minimize holdings of cash balances
that bear no or low interest rates, and given the
technical feasibility to do so, turnover of demand
deposits has reached an annual rate of more than
300, quadruple the rate ten years ago. Technological
change is continuing, and changes in regulation and
bank practices are likely to permit still more economization of M1-type balances. However, lower rates
of interest and inflation should moderate incentives
to exploit that technology fully. In those conditions,
velocity.growth could slow, or conceivably at some
point stop.
To conclude that the trend has in fact changed
would clearly be premature, but it is a matter we will
want to evaluate carefully as time passes. For now,
the Committee felt that the existing targets should be
tentatively retained for next year. Since we expect to
be around the top end of the ranges this year, those
tentative targets would of course be fully consistent
with somewhat slower growth in the monetary aggregates in 1983. Such a target would be appropriate
on the assumption of a more or less normal cyclical
rise in velocity. With inflation declining, the tentative
targets would appear consistent with, and should
support, continuing recovery at a moderate pace.
The Congress, in adopting a budget resolution contemplating cuts in expenditures and some new
revenues, also called upon the Federal Reserve to
"reevaluate its monetary targets in order to assure
that they are fully complementary to a new and more
restrained fiscal policy." I can report that members
of the Committee welcomed the determination of the
Congress to achieve greater fiscal restraint, and I
want particularly to recognize the leadership of
members of the Budget Committees and others in
achieving that result. In most difficult circumstances,
progress is being made toward reducing the huge
potential gap between receipts and expenditures. But
I would be less than candid if I did not also report a
strong sense that considerably more remains to be
done to bring the deficit under control as the economy expands. The fiscal situation as we appraise it,
continues to carry the implicit threat of "crowding
out" business investment and housing as the economy grows—a process that would involve interest
rates substantially higher than would otherwise be
the case. For the more immediate future, we recognized that the need remains to convert the intentions
expressed in the Budget Resolution into concrete
legislative action.
In commenting on the budget, I would distinguish
sharply between the "cyclical" and "structural"
deficit—that is, the portion of the deficit reflecting an
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.
10
Time to Move Ahead
imbalance between receipts and expenditures even in
a satisfactorily growing economy with declining inflation. To the extent the deficit turns out to be larger
than contemplated entirely because of a shortfall in
economic growth, that "add on" would not be a
source of so much concern. But the hard fact remains
that, if the objectives of the Budget Resolution are
fully reached, the deficit would be about as large in
fiscal 1983 as this year even as the economy expands
at a rate of 4 to 5 percent a year and inflation (and
thus inflation generated revenues) remains higher
than members of the Open Market Committee now
expect.
In considering the question posed by the Budget
Resolution, the Open Market Committee felt that
full success in the budgetary effort should itself be a
factor contributing to lower interest rates and reduced strains in financial markets. It would thus assist
importantly in the common effort to reduce inflationary pressures in the context of a growing economy. By relieving concern about future financing
volume and inflationary expectations, I believe as a
practical matter a credibly firmer budget posture
might permit a degree of greater flexibility in the actual short-term execution of monetary policy without
arousing inflationary fears. Specifically, market anxiety that short-run increases in the Ms might presage
continuing monetization of the debt could be ameliorated. But any gains in these respects will of course be
dependent on firmness in implementing the intentions set forth in the Resolution and on encouraging
confidence among borrowers and investors that the
effort will be sustained and reinforced in coming
years.
Taking account of all these considerations, the
Committee did not feel that the budgetary effort, important as it is, would in itself appropriately justify
still greater growth in the monetary aggregates over
time than I have anticipated. Indeed, excessive
monetary growth—and perceptions thereof—would
undercut any benefits from the budgetary effort with
respect to inflationary expectations. We believe fiscal
restraint should be viewed more as an important
complement to appropriately disciplined monetary
policy than as a substitute.
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In an ideal world, less exclusive reliance on monetary
policy to deal with inflation would no doubt have
eased the strains and high interest rates that plague
the economy and financial markets today. To the extent the fiscal process can now be brought more fully
to bear on the problem, the better off we will be—the
more assurance we will have that interest rates will
decline and keep declining during the period of recovery, and that we will be able to support the increases
in investment and housing essential to healthy, sustained recovery. Efforts in the private sector—to increase productivity, to reduce costs, and to avoid inflationary and job-threatening wage increases—are
also vital, even though the connection between the
actions of individual firms and workers and the performance of the economy may not always be selfevident to the decision makers. We know progress is
being made in these areas, and more progress will
hasten full and strong expansion.
But we also know that we do not live in an ideal
world. There is strong resistance to changing patterns of behavior and expectations ingrained over
years of inflation. The slower the progress on the
budget, the more industry and labor build in cost increases in anticipation of inflation or Government
acts to protect markets or impede competition, the
more highly speculative financing is undertaken, the
greater the threat that available supplies of money
and credit will be exhausted in financing rising prices
instead of new jobs and growth. Those in vulnerable
competitive positions are most likely to feel the
impact first and hardest, but unfortunately the difficulties spread over the economic landscape.
11
The hard fact remains that we cannot escape those
dilemmas by a decision to give up the fight on inflation—by declaring the battle won before it is. Such
an approach would be transparently clear—not just
to you and me—but to the investors, the businessmen and the workers who would, once again, find
their suspicions confirmed that they had better
prepare to live with inflation, and try to keep ahead
of it. The reactions in financial markets and other
sectors of the economy would, in the end, aggravate
our problems, not eliminate them. It would strike me
as the cruelest blow of all to the millions who have
felt the pain of recession directly to suggest, in effect,
it was all in vain.
I recognize months of recession and high interest
rates have contributed to a sense of uncertainty.
Businesses have postponed investment plans. Financial pressures have exposed lax practices and stretched balance sheet positions in some institutions—
financial as well as non-financial. The earnings position of the thrift industry remains poor.
But none of those problems can be dealt with successfully by re-inflation or by a lack of individual
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discipline. It is precisely that environment that contributed so much to the current difficulties.
In contrast, we are now seeing new attitudes of
cost containment and productivity growth—and
ultimately our industry will be in a more robust competitive position. Millions are benefitting from less
rapid price increases—or actually lower prices—at
their shopping centers and elsewhere. Consumer
spending appears to be moving ahead, and inventory
reductions help set the stage for production increases.
Those are developments that should help recovery
get firmly underway. The process of disinflation has
enough momentum to be sustained during the early
stages of recovery—and that success can breed further success as concerns about inflation recede. As
recovery starts, the cash flow of business should improve. And, more confidence should encourage
greater willingness among investors to purchase
longer debt maturities. Those factors should, in turn,
work toward reducing interest rates, and sustaining
them at lower levels, encouraging in turn the revival
of investment and housing we want.
I have indicated the Federal Reserve is sensitive to
the special liquidity pressures that could develop during the current period of uncertainty. Moreover, the
basic solidity of our financial system is backstopped
by a strong structure of governmental institutions
precisely designed to cope with the secondary effects
of isolated failures. The recent problems related
largely to the speculative activities of a few highly
leveraged firms can and will be contained, and over
time, an appropriate sense of prudence in taking
risks will serve us well.
We have been through—we are in—a trying
period. But too much has been accomplished not to
move ahead and complete the job of laying the
groundwork for a much stronger economy. As we
look forward, not just to the next few months but to
long years, the rewards will be great: in renewed
stability, in growth, and in higher employment and
standards of living. That vision will not be accomplished by monetary policy alone. But we mean to do
our part.
12
Appendix-Alternative Seasonal
Adjustment Procedures
For some time the Federal Reserve has been investigating ways to improve its procedures for seasonal
adjustment, particularly as they apply to the monetary
aggregates. In June of last year, a group of prominent outside experts, asked by the Board to examine
seasonal adjustment techniques, submitted their
recommendations.3 The committee suggested, among
other things, that the Board's staff develop seasonal
factor estimates from a model-based procedure as an
alternative to the widely used X-11 technique that
provides the basis for the current seasonal adjustment
procedure,4 and release the results.
The Board staff has been developing a procedure
using statistical models tailored to each individual
series.5 The table on the last page compares monthly
and quarterly average growth rates for the current
M1 series with those of an alternative series from the
model-based approach.
Differences in seasonal adjustment techniques do
not change the trend in monetary growth, but, as
may be seen in the table, they do alter month-tomonth growth rates owing to differing estimates of
the distribution over time of the seasonal component
in money behavior. Short-run money growth is variable under both the alternative and current techniques of seasonal adjustment, illustrating the inherently large "noise" component of the series.
However, the redistribution of the seasonal component under the alternative technique does on average
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tend to moderate month-to-month changes
somewhat.
The Board will continue to publish seasonally adjusted estimates for M1 on both current and alternative bases at least until the annual review of seasonal factors in 1983. A detailed description of the
alternative method will be available shortly.
Growth Rates of M1 Using Current6 and
Alternative7 Seasonal Adjustment Procedures
1982
1981
Alternative
Current
9.8
1.4
21.0
11.4
Current
Alternative
Monthly Jan.
AverageFeb.
Percent
Annual
Mar.
Rates
4.3
7.5
-3.5
1.3
14.3
16.0
2.7
6.4
Apr.
25.2
22.6
11.0
4.5
May
-11.4
-10.3
-2.4
0.5
June
-2.2
-0.6
-1.6
1.3
July
2.8
2.2
Aug.
4.8
5.3
Sept.
0.3
3.1
Oct.
4.7
0.0
Nov.
9.7
11.1
Dec.
12.4
15.4
Quarterly QI
Average
QII
Percent
Annual
QM
Rates
4.6
3.5
10.4
9.5
9.2
9.6
3.1
3.4
0.3
0.9
QIV
5.7
5.5
13
Footnotes
1. M1 is the sum of currency held by the public, plus
travelers' checks, plus demand deposits, plus other
checkable deposits (i.e., negotiable order of withdrawal
(NOW), automatic transfer service (ATS) accounts, and
credit union share draft accounts.)
M2 is M1 plus savings and small denomination time
deposits, plus shares in money market mutual funds (other
than those restricted to institutional investors), plus overnight repurchase agreements and Eurodollars.
M3 is M2 plus large time deposits at all depository institutions, large denomination term repurchase
agreements, and shares in money market mutual funds
restricted to institutional investors.
Bank credit is total loans and investments of commercial banks.
5. The model-based seasonal adjustment procedures currently under review by the Board staff use methods based
on the well-developed theory of statistical regression and
time series modeling. These approaches allow development
of seasonal factors that are more sensitive than the current
factors to unique characteristics of each series, including,
for example, fixed and evolving seasonal patterns, trading
day effects, within-month seasonal variations, holiday effects, outlier adjustments, special events adjustments (such
as the 1980 credit controls experience), and serially correlated noise components.
6. Current monthly seasonal factors are derived using an
X-11/ARIMA-based procedure applied to monthly data.
7. Alternative monthly seasonal factors are derived using a
model-based procedure applied to weekly data.
2. Because of the introduction of International Banking
Facilities (IBFs), the bank credit data beginning in
December 1981 are not comparable to earlier data. Thus,
the target for 1982 was stated in terms of growth from the
average level of December 1981 and January 1982 (shown
in the last column) to the average level in the fourth
quarter of 1982, so that the initial shift of assets to IBFs
that occurred at the end of the year would not have a major impact on the pattern of growth. Actual growth rates
for bank credit are calculated from the December-January
base.
3. See Committee of Experts on Seasonal Adjustment
Techniques, Seasonal Adjustment of the Monetary Aggregates
(Board of Governors of the Federal Reserve System, October 1981).
4. The current seasonal adjustment technique has most
recently been summarized in the description to the
mimeograph release of historical money stock data dated
March 1982. Detailed descriptions of the X-11 program
and variants can be obtained from technical paper no. 15
of the U.S. Department of Commerce (rev. February
1967) and from the report to the Board cited in footnote 1.
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A copy of the full report to Congress is available free of charge
from Publications Services, Federal Reserve Board, Washington,
D.C. 20551.
14
FRB 2-60000-0782
J
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For release on delivery
9:30 AM, E.D.T.
July 20, 1982
Statement by
Paul A. Volcker
Chairman, Board of Governors of the Federal Reserve System
before the
Committee on Banking, Housing, and Urban Affairs
United States Senate
July 20, 1982
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I am pleased to have this opportunity once again to
discuss monetary policy with you within the context of recent
and prospective economic developments.
As usual on these
occasions, you have the Board of Governors' "Humphrey-Hawkins"
Report before you.
This morning I want to enlarge upon some
aspects of that Report and amplify as fully as I can my thinking
with respect to the period ahead.
In assessing the current economic situation, I believe
the comments I made five months ago remain relevant.
Without
repeating that analysis in detail, I would emphasize that we
stand at an important crossroads for the economy and economic
Solicy.
In these past two years we have traveled a considerable
way toward reversing the inflationary trend of the previous
decade or more.
I would recall to you that, by the late 1970s,
that trend had shown every sign of feeding upon itself and
tending to accelerate to the point where it threatened to
undermine the foundations of our economy.
Dealing with inflation
was accepted as a top national priority, and, as events developed,
that task fell almost entirely to monetary policy.
In the best of circumstances, changing entrenched patterns
of inflationary behavior and expectationsfinancial markets,
in the practices of business and financial institutions, and in
labol- negotiations
process.
a difficult and potentially painful
Those, consciously or not, who had come to "bet" on
rising prices and the ready availability of relatively cheap
2-
credit to mask the risks of rising costs, poor productivity,
aggressive lending, or over-extended financial positions have
found themselves in a particularly difficult position.
The pressures on financial markets and interest rates
have been aggravated by concerns over prospective huge volumes
of Treasury financing, and by the need of some businesses to
borrow at a time of a severe squeeze on profits.
Lags in the
adjustment of nominal wages and other costs to the prospects
for sharply reduced inflation are perhaps inevitable, but have
the effect of prolonging the pressure on profits -- and indirectly on financial markets and employment.
Remaining doubts
and skepticism that public policy will "carry through" on the
effort to restore stability also affect interest rates, perhaps
most particularly in the longer-term markets.
In fact, the evidence now seems to me strong that the
inflationary tide has turned in a fundamental way.
In stating
that, I do not rely entirely on the exceptionally favorable
consumer and producer price data thus far this year, when the
recorded rates of price increase (at annual rates) declined to
2%, respectively. That apparent improvement was magnified
/
2 and 21
/
31
by some factors likely to prove temporary, including, of course,
the intensity of the recession; those price indices are likely
to appear somewhat less favorable in the second half of the
year.
What seems to me more important for the longer run is
that the trend of underlying costs and nominal wages has begun
to move lower, and that trend should be sustainable as the
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-3-
economy recovers upward momentum.
While less easy to
identify -- labor productivity typically does poorly during
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periods of business decline -- there are encouraging signs
that both management and workers are giving more intense
attention to the effort to improve productivity.
That effort
should "pay off" in a period of business expansion, helping
to hold down costs and encouraging a revival of profits, setting
the stage for the sustained growth in real income we want.
I am acutely aware that these gains against inflation
have been achieved in a context of serious recession.
Millions
of workers are unemployed, many businesses are hardpressed to
maintain profitability, and business bankruptcies are at a
postwar high.
While it is true that some of the hardship can
reasonably be traced to mistakes in management or personal
judgment, including presumptions that inflation would continue,
large areas of the country and sectors of the economy have been
swept up in more generalized difficulty.
Our financial system
has great strength and resiliency, but particular points of
strain have been evident.
Quite obviously, a successful program to deal with
inflation, with productivity, and with the other economic and
social problems we face cannot be built on a crumbling foundation
of continuing recession.
As you know, there have been some
indications -- most broadly reflected in the rough stability
of the real GNP in the second quarter and small increases in the
leading indicators -- that the downward adjustments may be drawing
4
to a close.
The tax reduction effective July 1, higher social
security payments, rising defense spending and orders, and the
reductions in inventory already achieved, all tend to support
the generally held view among economists that some recovery is
likely in the second half of the year.
I am also conscious of the fact that the leveling off
of the GNP has masked continuing weakness in important sectors
of the economy.
In its early stages, the prospective recovery
must be led largely by consumer spending.
But to be sustained
over time, and to support continuing growth in productivity and
living standards, more investment will be necessary.
as you know, business investment is moving lower.
At present,
House building
has remained at depressed levels; despite some small gains in
starts during the spring, the cyclical strength "normal" in that
industry in the early stages of recovery is lacking.
Exports
have been adversely affected by the relative strength of the
dollar in exchange markets.
I must also emphasize that the current problems of the
American economy have strong parallels abroad.
Governments
around the world have faced, in greater or lesser degree, both
inflationary and fiscal problems.
As they have come to grips
with those problems, growth has been slow or non-existent, and
the recessionary tendencies in various countries have fed back,
one on another.
In sum, we are in a situation that obviously warrants
concern, but also has great opportunities.
Those opportunities
lie in major part in achieving lasting progress -- in pinning
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-5_
down and extending what has already been achieved -- toward
price stability.
In doing so, we will be laying the base for
sustaining recovery over many years ahead, and for much lower
interest rates, even as the economy grows.
Conversely, to
fail in that task now, when so much headway has been made,
could only greatly complicate the problems of the economy over
time.
I find it difficult to suggest when and how a credible
attack could be renewed on inflation should we neglect completing
the job now.
Certainly the doubts and skepticism about our
capacity to deal with inflation -- which now seem to be yielding -would be amplified, with unfortunate consequences for financial
markets and ultimately for the economy.
I am certain that many of the questions, concerns and
dangers in your mind lie in the short run -- and that those in
good part revolve around the pressures in financial markets.
Can we look forward to lower interest rates to support the
expansion in investment and housing as the recovery takes hold?
Is there, in fact, enough liquidity in the economy to support
expansion -- but not so much that inflation is reignited?
Will, in fact, the economy follow the recovery path so widely
forecast in coming months?
These are the questions that we in the Federal Reserve
must deal with in setting monetary policy.
As we approach
these policy decisions, we are particularly conscious of the
fact that monetary policy, however important, is only one
instrument of economic policy.
Success in reaching our common
objective of a strong and prosperous economy depends upon more
-6
-
than appropriate monetary policies, and I will touch this
morning on what seem
to me appropriately complementary
policies in the public and private sectors.
The Monetary Targets
Five months ago, in presenting our monetary and credit
targets for 1982, I noted some unusual factors could be at
work tending to increase the desire of individuals and businesses
to hold assets in the relatively liquid forms encompassed in the
various definitions of money.
Partly for that reason -- and
recognizing that the conventional base for the M1 target of the
fourth quarter of 1981 was relatively low -- I indicated that
the Federal Open Market Committee contemplated growth toward
the upper ends of the specified ranges.
Given the "bulge"
early in the year in Ml, the Committee also contemplated that
that particular measure of money might for some months remain
above a "straight line" projection of the targeted range from
the fourth quarter of 1981 to the fourth quarter of 1982.
As events developed, M1 and M2 both remained somewhat above
straight line paths until very recently.
M3 and bank credit
have remained generally within the indicated range, although
close to the upper ends.
(See Table I.)
Taking the latest full
month of June, M1 grew 5.6% from the base period and M2 9.4%,
close to the top of the ranges.
To the second quarter as a
•
whole, the growth was higher, at 6.8% and 9.7%, respectively.
I
Looked at on a year-over-year basis, which appropriately tends
to average through volatile monthly and quarterly figures, M1
during the first half of 1982 averaged about 4-3/4% above the
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•
7
first half of 1981 (after accounting for NOW account shifts
early last year).
On the same basis, M2 and M3 grew by 9.7
ctly
and 10.5 percent, respectively, a rate of growth distin
faster than the nominal GNP over the same interval.
In conducting policy during this period, the Committee
was sensitive to indications that the desire of individuals
and others for liquidity was unusually high, apparently reflecting concerns and uncertainties about the business and
financial situation.
One reflection of that may be found in
unusually large declines in "velocity" over the period -that is, the ratio of measures of money to the gross national
product.
M1 velocity -- particularly for periods as short as
three to six months -- is historically volatile.
A cyclical
tendency to slow (relative to its upward trend) during recessions
is common.
But an actual decline for two consecutive quarters,
rather
as happened late in 1981 and the first quarter of 1982, is
unusual.
The magnitude of the decline during the first quarter
was larger than in any quarter of the entire postwar period.
on
Moreover, declines in velocity of this magnitude and durati
are often accompanied by (and are related to) reduced shortterm interest rates.
Those interest rate levels during the
first half of 1982 were distinctly lower than during much of
1980 and 1981, but they rose above the levels reached in the
closing months of last year.
More direct evidence of the desire for liquidity or preor
cautionary balances affecting M1 can be found in the behavi
of NOW accounts.
As you know, NOW accounts are a relatively
8-
new instrument, and we have no experience of behavior over the
course of a full business cycle.
We do know that NOW accounts
are essentially confined to individuals, their turnover relative
to demand accounts is relatively low, and, from the standpoint
of the owner, they have some of the characteristics of savings
deposits, including a similarly low interest rate but easy
access on demand.
We also know the great bulk of the increase
in M1 during the early part of the year -- almost 90% of the
rise from the fourth quarter of 1981 to the second quarter of
1982 -- was concentrated in NOW accounts, even though only
about a fifth of total M1 is held in that form.
In contrast
to the steep downward trend in low-interest savings accounts
in recent years, savings account holdings have stabilized or
even increased in 1982, suggesting the importance of a high
degree of liquidity to many individuals in allocating their
funds.
A similar tendency to hold more savings deposits has
been observed in earlier recessions.
I would add that the financial and liquidity positions of
ntional
the household sector of the economy, as measured by conve
sion
liquid asset and debt ratios, has improved during the reces
period.
Relative to income, debt repayment burdens have declined
to the lowest level since 1976.
are clearly mixed.
Trends among business firms
While many individual firms are under strong
rate
pressure, some rise in liquid asset holdings for the corpo
sector as a whole appears to be developing.
The gap between
ciation
internal cash flow (that is, retained earnings and depre
inventory
allowances) and spending for plant, equipment, and
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%
-9-
has also been at an historically low level, suggesting that a
portion of recent business credit demands is designed to
bolster liquidity.
But, for many years, business liquidity
ratios have tended to decline, and balance sheet ratios have
reflected more dependence on short-term debt.
In that per-
spective, any recent gains in liquidity appear small.
In the light of the evidence of the desire to hold more
NOW accounts and other liquid balances for precautionary rather
than transaction purposes during the months of recession, strong
efforts to reduce further the growth rate of the monetary aggregates appeared inappropriate.
Such an effort would have
required more pressure on bank reserve positions -- and
presumably more pressures on the money markets and interest
rates in the short run.
At the same time, an unrestrained
build-up of money and liquidity clearly would have been inconsistent with the effort to sustain progress against inflation,
both because liquidity demands could shift quickly and because
our policy intentions could easily have been misconstrued.
Periods of velocity decline over a quarter or two are typically
followed by periods of relatively rapid increase.
Those increases
tend to be particularly large during cyclical recoveries.
Indeed,
velocity appears to have risen slightly during the second quarter,
and the growth in NOW accounts has slowed.
_
Judgments on these seemingly technical considerations
ng
inevitably take on considerable importance in the target-setti
(including
process because the economic and financial consequences
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I
-10-
the consequences for interest rates) of a particular M1 or M2
increase are dependent on the demand for money.
Over longer
periods, a certain stability in velocity trends can be observed,
but there is a noticeable cyclical pattern.
Taking account of
those normal historical relationships, the various targets
established at the beginning of the year were calculated to be
consistent with economic recovery in a context of declining
inflation.
That remains our judgment today.
Inflation has,
in fact, receded more rapidly than anticipated at the start of
the year potentially leaving more "room" for real growth.
On
that basis, the targets established early in the year still
appeared broadly appropriate, and the Federal Open Market Committee decided at its recent meeting not to change them at this
time.
However, the Committee also felt, in the light of developments
during the first half, that growth around the top of those ranges
would be fully acceptable.
Moreover -- and I would emphasize
this -- growth somewhat above the targeted ranges would be
tolerated for a time in circumstances in which it appeared that
precautionary or liquidity motivations, during a period of
economic uncertainty and turbulence, were leading to stronger
than anticipated demands for money.
We will look to a variety of
factors in reaching that judgment, including such technical factors
as the behavior of different components in the money supply, the
growth of credit, the behavior of banking and financial markets,
and more broadly, the behavior of velocity and interest rates.
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-11-
I believe it is timely for me to add that, in these
circumstances, the Federal Reserve should not be expected to
respond, and does not plan to respond, strongly to various
"bulges" -- or for that matter "valleys"monetary growth
that seem likely to be temporary.
S.
As we have emphasized in the
the data are subject to a good deal of statistical "noise"
in any circumstances, and at times when demands for money and
liquidity may be exceptionally volatile, more than usual caution
is necessary in responding to "blips."*
We, of course, have a concrete instance at hand of a
relatively large (and widely anticipated) jump in M1 in the
first week of July -- possibly influenced to some degree by
larger social security payments just before a long weekend.
Following as it did a succession of money supply declines, that
increase brought the most recent level for M1 barely above the
June average, and it is not of concern to us.
It is in this context, and in view of recent declines
in short-term market interest rates, that the Federal Reserve
yesterday reduced the basic discount rate from 12 to 111
/
2 percent.
*In that connection, a number of observers have noted
that the first month of a calendar quarter -- most noticeably
in January and April -- sometimes shows an extraordinarily
large increase in M1 -- amplified by the common practice of
multiplying the actual change by 12 to show an annual rate.
Those bulges, more typically than not, are partially "washed
out" by slower than normal growth the following month. The
standard seasonal adjustment techniques we use to smooth out
monthly money supply variations -- indeed, any standard
techniques -- may, in fact, be incapable of keeping up with
rapidly changing patterns of financial behavior, as they
affect seasonal patterns. A note attached to this statement
sets forth some work in process developing new seasonal adjustment techniques.
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-i2-
In looking ahead to 1983, the Open Market Committee
agreed that a decision at this time would -- even more
obviously than usual -- need to be reviewed at the start of
the year in the light of all the evidence as to the behavior
of velocity or money and liquidity demand during the current
year.
Apart from the cyclical influences now at work, the
possibility will need to be evaluated of a more lasting change
in the trend of velocity.
The persistent rise in velocity during the past twenty
years has been accompanied by rising inflation and interest
rates -- both factors that encourage economization of cash
balances.
In addition, technological change in banking --
spurred in considerable part by the availability of computers
has made it technically feasible to do more and more business
on a proportionately smaller "cash" base.
With incentives
strong to minimize holdings of cash balances that bear no or
low interest rates, and given the technical feasibility to do
so, turnover of demand deposits has reached an annual rate of
more than 300, quadruple the rate ten years ago.
Technological
change is continuing, and changes in regulation and bank practices
are likely to permit still more economization of Ml-type balances.
However, lower rates of interest and inflation should moderate
incentives to exploit that technology fully.
In those conditions,
velocity growth could slow, or conceivably at some point stop.
To conclude that the trend has in fact changed would
clearly be premature, but it is a matter we will want to evaluate
carefully as time passes.
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For now, the Committee felt that the
-13--
existing targets should be tentatively retained for next year.
Since we expect to be around the top end of the ranges this
year, those tentative targets would of course be fully consistent
with somewhat slower growth in the monetary aggregates in 1983.
Such a target would be appropriate on the assumption of a more
or less normal cyclical rise in velocity.
declining, the tentative targets would appear consistent with,
and should support, continuing recovery at a moderate pace.
The Blend of Monetary and Fiscal Policy
The Congress, in adopting a budget resolution contemplating
cuts in expenditures and some new revenues, also called upon
the Federal Reserve to "reevaluate its monetary targets in
order to assure that they are fully complementary to a new
and more restrained fiscal policy."
I can report that members
of the Committee welcomed the determination of the Congress to
achieve greater fiscal restraint, and I want particularly to
recognize the leadership of members of the Budget Committees
and others in achieving that result.
In most difficult
circumstances, progress is being made toward reducing the
huge potential gap between receipts and expenditures.
But I
would be less than candid if I did not also report a strong
sense that considerably more remains to be done to bring the
deficit under control as the economy expands.
The fiscal
situation as we appraise it, continues to carry the implicit
threat of "crowding out" business investment and housing as
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With inflation
-14-
the economy grows -- a process that would involve interest
rates substantially higher than would otherwise be the case.
For the more immediate future, we recognized that the need
remains to convert the intentions expressed in the Budget
f
Resolution into concrete legislative action.
In commenting on the budget, I would distinguish
sharply between the "cyclical" and "structural" deficit
that is, the portion of the deficit reflecting an imbalance
between receipts and expenditures even in a satisfactorily
growing economy with declining inflation.
To the extent the
deficit turns out to be larger than contemplated entirely
because of a shortfall in economic growth, that "add on"
would not be a source of so much concern.
But the hard
fact remains that, if the objectives of the Budget Resolution
are fully reached, the deficit would be about as large in
fiscal 1983 as this year even as the economy expands at a
rate of 4 to 5 percent a year and inflation (and thus inflation
generated revenues) remains higher than members of the Open
Market Committee now expect.
In considering the question posed by the Budget Resolution,
the Open Market Committee felt that full success in the budgetary
effort should itself be a factor contributing to lower interest
rates and reduced strains in financial markets.
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It would thus
-15-
to reduce inflationary
assist importantly in the common effort
economy.
pressures in the context of a growing
By relieving
inflationary expectations I
concern about future financing volume and
firmer budget posture
I believe as a practical matter a credibly
4
in the actual shortmight permit a degree of greater flexibility
arousing inflationary
term execution of monetary policy without
fears.
increases
Specifically, market anxiety that short-run
tion of the debt
in the Ms might presage continuing monetiza
could be ameliorated.
But any gains in these respects will
ting the intentions
of course be dependent on firmness in implemen
confidence among
set forth in the Resolution and on encouraging
sustained and
borrowers and investors that the effort will be
reinforced in coming years.
Taking account of all these considerations, the
important
Committee did not feel that the budgetary effort,
ify still greater
as it is, would in itself appropriately just
than I have anticipated.
growth in the monetary aggregates over time
ons thereof
Indeed, excessive monetary growth -- and percepti
rt with
would undercut any benefits from the budgetary effo
respect to inflationary expectations.
We believe fiscal
nt
restraint should be viewed more as an important compleme
as a
to appropriately disciplined monetary policy than
substitute.
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-16-
Concluding Comments
In an ideal world, less exclusive reliance on monetary
policy to deal with inflation would no doubt have eased the
strains and high interest rates that plague the economy and
financial markets today.
To the extent the fiscal process
can now be brought more fully to bear on the problem, the
better off we will be -- the more assurance we will have that
interest rates will decline and keep declining during the
period of recovery, and that we will be able to support the
increases in investment and housing essential to healthy,
sustained recovery.
Efforts in the private sector
increase productivity, to reduce costs, and to avoid inflationary
and job-threatening wage increases -- are also vital, even
though the connection between the actions of individual firms
and workers and the performance of the economy may not always
be self-evident to the deon makers.
We know progress is
being made in these areas, and more progress will hasten full
and strong expansion.
But we also know that we do not live in an ideal world.
There is strong resistance to changing patterns of behavior
and expectations ingrained over years of inflation.
The slower
the progress on the budget, the more industry and labor build
in cost increases in anticipation of inflation or Government
acts to protect markets or impede compeon, the more highly
speculative financing is undertaken, the greater the threat that
available supplies of money and credit will be exhausted in
financing rising prices instead of new jobs and growth.
Those
in vulnerable competitive positions are m5st likely to feel the
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-17-
impact first and hardest, but unfortunately the difficulties
spread over the economic landscape.
The hard fact remains that we cannot escape those dilemmas
by a decision to give up the fight on inflation -- by declaring
the battle won before it is.
Such an approach would be trans-
parently clear -- not just to you and me -- but to the investors,
the businessmen and the workers who would, once again, find
their suspicions confirmed that they had better prepare to
live with inflation, and try to keep ahead of it.
The reactions
in financial markets and other sectors of the economy would,
in the end, aggravate our problems, not eliminate them.
It
would strike me as the cruelest blow of all to the millions
who have felt the pain of recession directly to suggest, in
effect, it was all in vain.
I recognize months of recession and high interest rates
have contributed to a sense of uncertainty.
postponed investment plans.
Businesses have
Financial pressures have exposed
lax practices and stretched balance sheet positions in some
institutions -- financial as well as non-financial.
The
earnings position of the thrift industry remains poor.
But none of those problems can be dealt with successfully
by re-inflation or by a lack of individual discipline.
It is
the
precisely that environment that contributed so much to
current difficulties.
conIn contrast, we are now seeing new attitudes of cost
industry
tainment and productivity growth -- and ultimately our
will be in a xlcre robust competitive position.
Millions are
-18-
benefitting from less rapid price increases -- or actually
I
lower prices -- at their shopping centers and elsewhere.
Consumer spending appears to be moving ahead, and inventory
reductions help set the stage for production increases.
Those are developments that should help recovery get
firmly underway.
I
The process of disinflation has enough
momentum to be sustained during the early stages of recovery
and that success can breed further success as concerns about
inflation recede.
As recovery starts, the cash flow of
business should improve.
And, more confidence should encourage
greater willingness among investors to purchase longer debt
maturities.
Those factors should, in turn, work toward reducing
interest rates, and sustaining them at lower levels, encouraging
in turn the revival of investment and housing we want.
I have indicated the Federal Reserve is sensitive to the
special liquidity pressures that could develop during the
current period of uncertainty.
Moreover, the basic solidity
of our financial system is backstopped by a strong structure
of governmental institutions precisely designed to cope with
the secondary effects of isolated failures.
The recent problems
related largely to the speculative activities of a few highly
leveraged firms can and will be contained, and over time, an
appropriate sense of prudence in taking risks will serve us well.
We have been through -- we are in -- a trying period.
But
too much has been accomplished not to move ahead and complete
the job of laying the groundwork for a much stronger economy.
As we look forward, not just to the next few months but to long
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-
-19-
years, the rewards will be great:
in renewed stability, in
growth, and in higher employment and standards of living.
That vision will not be accomplished by monetary policy alone.
,
But we mean to do our part.
4
* *
1
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* *
* * * *
I
Targeted and Actual Growth of
Money and Bank Credit
(Percent changes, at seasonally adjusted annual rates)
FOMC Objective
198104 to 198204
198104
to June '82
Actual Growth
198104
to 198202
1981H1
to 1982H1
M1
2-1/2 to
5.6
6.8
4.7**
M2
6 to 9
9.4
9.7
9.7
M3
6-1/2 to 9-1/2
9.7
9.8
10.5
Bank Credit*
6 to 9
8.0
8.3
8.4
*
The base for the bank credit target is the average level of December 1981
and January 1982, rather than the average for 198104. This base was adopted
because of the impact on the series of shifts of assets to the new international banking facilities (IBFs); the 1981H1-to-1982H1 figure has been
adjusted for the impact of the initial shifting of assets to IBFs.
** Adjusted for impact of shifts to new NOW accounts in 1981.
-
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Appendix
Alternative Seasonal Adjustment Procedure
For some time the Federal Reserve has been investigating ways
to improve its procedures for seasonal adjustment, particularly as they
apply to the monetary aggregates.
In June of last year, a group of pro-
minent outside experts, asked by the Board to examine seasonal adjustment
1/
techniques, submitted their recommendations.—
The committee suggested,
,iriT
among other things, that the Board's staff develop seasonal
estimates from a model-based procedure as an alternative to the widely
used X-11 technique that provides the basis for the current seasonal
1/
and release the results.
adjustment procedure,
The Board staff has been developing a procedure using statisti,,11
V
models tailored to each individual series.
The table on the last page
monthly and quarterly average growth rates for the current M1
I
series with those of an alterm_ative series from the model-based approach.
Differences in seasonal adjustment techniques do not change
the trend in monetary growth, but, as may be seen in the table, they do
alter month -to-month growth races owing to differing estimates of the
1/
See Committee of Experts on Seasonal AdjustTent Techniques, Seasonal
Adjustment of the Monetary Aggregates (Board of Governors of the Federal
Reserve System, October 1981).
2/
The current seasonal adjustment technique has most recently been
summarized in the description to the mimeograph release of historical
money stock data dated March 1982. Detailed descriptions of the X-11
program and variants can be obtained from technical paper no. 15 of the
U. S. Department of 'Commerce (rev. February 1967) and from the report
to the Board cited in footnote 1.
3/
The model-based seasonal adjustment procedures currently under review by
the Board staff use methods based on the well-developed theory of sta
tical regression and time series modeling. These approaches allow
I- velopment of seasonal factors that are more sensitive than the current
factors to unique characteristics of each series, including, for example,
fixed and evolving seasonal patterns, trading day effects, within-month
seasonal variations, holiday effects, outlier adjustments, special events
adjustments (such as the 1980 credit controls experience), and serially
correlated noise components.
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-2Iistribution over time of the seasonal component in money behavior.
Short-
run money growth is variable under both the alternative and current techniques
of seasonal adjustment, illustrating the inherently large "noise" component
of the series.
However, the redistribution of the seasonal component under
the alternative technique does on average tend to moderate month-to-month
changes somewhat.
i
The Board will continue to publish seasonally adjusted estimates
for M1 on both current and alternative bases at least until the annual
review of seasonal factors in 1983.
method will be available shortly.
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A detailed description of the alternative
Growth Rates of M1 Usin:t
1
Current and AlternativeL
Seasonal Adjustment Procedures
(Monthly Average - Percent Annual Rates)
1982
1981
Jan.
Feb.
Mar.
Apr.
May
June
July
Aug.
Sept.
Oct.
Nov.
Dec.
Current
Alternative
9.8
4.3
14.3
25.2
-11.4
-2.2
2.8
4.8
0.3
4.7
9.7
12.4
1.4
7.5
16.0
22.6
-10.3
-0.6
2.2
5.3
3.1
0.0
11.1
15.4
Jan.
Feb.
Mar.
Apr.
May
June
Current
Alternative
21.0
-3.5
2.7
11.0
-2.4
-1.6
11.4
1.3
6.4
4.5
0.5
1.3
(Quarterly Average - Percent Annual Rates)
QI
QII
QIII
QIV
4.6
9.2
0.3
5.7
3.5
9.6
0.9
5.5
QI
QII
10.4
3.1
9.5
3.4
1/
_
Current monthly seasonal factors are derived using an X-11/ARIMAbased procedure applied to monthly data.
2/
Alternative monthly seasonal factors are derived using a modelbased procedure applied to weekly data.
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Board of Governor:,
of the Federal Reserve System
Washington, D.C. 20551
Official Business
Penalty for Private Use, $300
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Postage and Fees Paid
Rood at Governors
a/ the Federal Reserve Spleen
First Class
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For release on delivery
9:30 AM, E.D.T.
July 20, 1982
Statement by
Paul A. Volcker
Chairman, Board of Governors of the Federal Reserve System
before the
Committee on Banking, Housing, and Urban Affairs
United States Senate
July 20, 1982
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am pleased to have this opportunity once again to
discuss monetary policy with you within the context of recent
and prospective economic developments.
As usual on these
occasions, you have the Board of Governors' "Humphrey-Hawkins"
Report before you.
This morning I want to enlarge upon some
aspects of that Report and amplify as fully as I can my thinking
with respect to the period ahead.
In assessing the current economic situation, I believe
the comments I made five months ago remain relevant.
Without
repeating that analysis in detail, I would emphasize that we
stand at an important crossroads for the economy and economic
policy.
In these past two years we have traveled a considerable
way toward reversing the inflationary trend of the previous
decade or more.
I would recall to you that, by the late 1970s,
that trend had shown every sign of feeding upon itself and
tending to accelerate to the point where it threatened to
undermine the foundations of our economy.
Dealing with inflation
was accepted as a top national priority, and, as events developed,
that task fell almost entirely to monetary policy.
In the best of circumstances, changing entrenched patterns
of inflationary behavior and expectations -- in financial markets,
in the practices of business and financial institutions, and in
labor negotiations -- is a difficult and potentially painful
process.
Those, consciously or not, who had come to "bet" on
rising prices and the ready availability of relatively cheap
-2-
credit to mask the risks of rising costs, poor productivity,
aggressive lending, or over-extended financial positions have
found themselves in a particularly difficult position.
The pressures on financial markets and interest rates
have been aggravated by concerns over prospective huge volumes
of Treasury financing, and by the need of some businesses to
borrow at a time of a severe squeeze on profits.
Lags in the
adjustment of nominal wages and other costs to the prospects
for sharply reduced inflation are perhaps inevitable, but have
the effect of prolonging the pressure on profits -- and indirectly on financial markets and employment.
Remaining doubts
and skepticism that public policy will "carry through" on the
effort to restore stability also affect interest rates, perhaps
most particularly in the longer-term markets.
In fact, the evidence now seems to me strong that the
inflationary tide has turned in a fundamental way.
In stating
that, I do not rely entirely on the exceptionally favorable
consumer and producer price data thus far this year, when the
recorded rates of price increase (at annual rates) declined to
2%, respectively. That apparent improvement was magnified
/
2 and 21
/
31
by some factors likely to prove temporary, including, of course,
the intensity of the recession; those price indices are likely
to appear somewhat less favorable in the second half of the
year.
What seems to me more important for the longer run is
that the trend of underlying costs and nominal wages has begun
to move lower, and that trend should be sustainable as the
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3
economy recovers upward momentum.
While less easy to
identify -- labor productivity typically does poorly during
periods of business decline -- there are encouraging signs
that both management and workers are giving more intense
attention to the effort to improve productivity.
That effort
should "pay off" in a period of business expansion, helping
to hold down costs and encouraging a revival of profits, setting
the stage for the sustained growth in real income we want.
I am acutely aware that these gains against inflation
have been achieved in a context of serious recession.
Millions
of workers are unemployed, many businesses are hardpressed to
maintain profitability, and business bankruptcies are at a
postwar high.
While it is true that some of the hardship can
reasonably be traced to mistakes in management or personal
judgment, including presumptions that inflation would continue,
large areas of the country and sectors of the economy have been
swept up in more generalized difficulty.
Our financial system
has great strength and resiliency, but particular points of
strain have been evident.
Quite obviously, a successful program to deal with
inflation, with productivity, and with the other economic and
social problems we face cannot be built on a crumbling foundation
of continuing recession.
As you know, there have been some
indications -- most broadly reflected in the rough stability
of the real GNP in the second quarter and small increases in the
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leading indicators -- that the downward adjustments may be drawing
4
to a close.
The tax reduction effective July 1, higher social
security payments, rising defense spending and orders, and the
reductions in inventory already achieved, all tend to support
the generally held view among economists that some recovery is
.
likely in the second half of the year.
I am also conscious of the fact that the leveling off
of the GNP has masked continuing weakness in important sectors
of the economy.
In its early stages, the prospective recovery
must be led largely by consumer spending.
But to be sustained
over time, and to support continuing growth in productivity and
living standards, more investment will be necessary.
as you know, business investment is moving lower.
At present,
House building
has remained at depressed levels; despite some small gains in
starts during the spring, the cyclical strength "normal" in that
industry in the early stages of recovery is lacking.
Exports
have been adversely affected by the relative strength of the
dollar in exchange markets.
I must also emphasize that the current problems of the
American economy have strong parallels abroad.
Governments
around the world have faced, in greater or lesser degree, both
inflationary and fiscal problems.
As they have come to grips
with those problems, growth has been slow or non-existent, and
the recessionary tendencies in various countries have fed back,
one on another.
In sum, we are in a situation that obviously warrants
concern, but also has great opportunities.
Those opportunities
lie in major part in achieving lasting progress -- in pinning
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-5-
down and extending what has already been achieved -- toward
price stability.
In doing so, we will be laying the base for
sustaining recovery over many years ahead, and for much lower
interest rates, even as the economy grows.
Conversely, to
fail in that task now, when so much headway has been made,
could only greatly complicate the problems of the economy over
time.
I find it difficult to suggest when and how a credible
attack could be renewed on inflation should we neglect completing
the job now.
Certainly the doubts and skepticism about our
capacity to deal with inflation -- which now seem to be yielding -would be amplified, with unfortunate consequences for financial
markets and ultimately for the economy.
I am certain that many of the questions, concerns and
dangers in your mind lie in the short run -- and that those in
good part revolve around the pressures in financial markets.
Can we look forward to lower interest rates to support the
expansion in investment and housing as the recovery takes hold?
Is there, in fact, enough liquidity in the economy to support
expansion -- but not so much that inflation is reignited?
Will, in fact, the economy follow the recovery path so widely
forecast in coming months?
These are the questions that we in the Federal Reserve
must deal with in setting monetary policy.
As we approach
these policy decisions, we are particularly conscious of the
fact that monetary policy, however important, is only one
instrument of economic policy.
Success in reaching our common
objective of a strong and prosperous economy depends upon more
6-
than appropriate monetary policies, and I will touch this
morning on what seem
to me appropriately complementary
policies in the public and private sectors.
The Monetary Targets
Five months ago, in presenting our monetary and credit
targets for 1982, I noted some unusual factors could be at
work tending to increase the desire of individuals and businesses
to hold assets in the relatively liquid forms encompassed in the
various definitions of money.
Partly for that reason -- and
recognizing that the conventional base for the M1 target of the
fourth quarter of 1981 was relatively low -- I indicated that
the Federal Open Market Committee contemplated growth toward
the upper ends of the specified ranges.
Given the "bulge"
early in the year in Ml, the Committee also contemplated that
that particular measure of money might for some months remain
above a "straight line" projection of the targeted range from
the fourth quarter of 1981 to the fourth quarter of 1982.
As events developed, M1 and M2 both remained somewhat above
straight line paths until very recently.
M3 and bank credit
have remained generally within the indicated range, although
close to the upper ends.
(See Table I.)
Taking the latest full
month of June, M1 grew 5.6% from the base period and M2 9.4%,
close to the top of the ranges.
To the second quarter as a
whole, the growth was higher, at 6.8% and 9.7%, respectively.
Looked at on a year-over-year basis, which appropriately tends
to average through volatile monthly and quarterly figures, M1
during the first half of 1982 averaged about 4-3/4% above the
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•
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7
first half of 1981 (after accounting for NOW account shifts
early last year).
On the same basis, M2 and M3 grew by 9.7
h distinctly
and 10.5 percent, respectively, a rate of growt
faster than the nominal GNP over the same interval.
In conducting policy during this period, the Committee
iduals
was sensitive to indications that the desire of indiv
and others for liquidity was unusually high, apparently reflecting concerns and uncertainties about the business and
financial situation.
One reflection of that may be found in
unusually large declines in "velocity" over the period -that is, the ratio of measures of money to the gross national
product.
M1 velocity -- particularly for periods as short as
three to six months -- is historically volatile.
A cyclical
tendency to slow (relative to its upward trend) during recessions
is common.
But an actual decline for two consecutive quarters,
is rather
as happened late in 1981 and the first quarter of 1982,
unusual.
The magnitude of the decline during the first quarter
was larger than in any quarter of the entire postwar period.
ion
Moreover, declines in velocity of this magnitude and durat
are often accompanied by (and are related to) reduced shortterm interest rates.
Those interest rate levels during the
of
first half of 1982 were distinctly lower than during much
1980 and 1981, but they rose above the levels reached in the
closing months of last year.
preMore direct evidence of the desire for liquidity or
behavior
cautionary balances affecting M1 can be found in the
of NOW accounts.
As you know, NOW accounts are a relatively
-8-
new instrument, and we have no experience of behavior over the
course of a full business cycle.
We do know that NOW accounts
are essentially confined to individuals, their turnover relative
to demand accounts is relatively low, and, from the standpoint
of the owner, they have some of the characteristics of savings
deposits, including a similarly low interest rate but easy
access on demand.
We also know the great bulk of the increase
in M1 during the early part of the year -- almost 90% of the
rise from the fourth quarter of 1981 to the second quarter of
1982 -- was concentrated in NOW accounts, even though only
about a fifth of total M1 is held in that form.
In contrast
to the steep downward trend in low-interest savings accounts
in recent years, savings account holdings have stabilized or
even increased in 1982, suggesting the importance of a high
degree of liquidity to many individuals in allocating their
funds.
A similar tendency to hold more savings deposits has
been observed in earlier recessions.
I would add that the financial and liquidity positions of
the household sector of the economy, as measured by conventional
liquid asset and debt ratios, has improved during the recession
period.
Relative to income, debt repayment burdens have declined
to the lowest level since 1976.
are clearly mixed.
Trends among business firms
While many individual firms are under strong
pressure, some rise in liquid asset holdings for the corporate
sector as a whole appears to be developing.
The gap between
internal cash flow (that is, retained earnings and depreciation
allowances) and spending for plant, equipment, and inventory
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9-
has also been at an historically low level, suggesting that a
portion of recent business credit demands is designed to
bolster liquidity.
But, for many years, business liquidity
ratios have tended to decline, and balance sheet ratios have
reflected more dependence on short-term debt.
In that per-
spective, any recent gains in liquidity appear small.
In the light of the evidence of the desire to hold more
NOW accounts and other liquid balances for precautionary rather
than transaction purposes during the months of recession, strong
efforts to reduce further the growth rate of the monetary aggregates appeared inappropriate.
Such an effort would have
required more pressure on bank reserve positions -- and
presumably more pressures on the money markets and interest
rates in the short run.
At the same time, an unrestrained
build-up of money and liquidity clearly would have been inconsistent with the effort to sustain progress against inflation,
both because liquidity demands could shift quickly and because
our policy intentions could easily have been misconstrued.
Periods of velocity decline over a quarter or two are typically
followed by periods of relatively rapid increase.
Those increases
tend to be particularly large during cyclical recoveries.
Indeed,
velocity appears to have risen slightly during the second quarter,
and the growth in NOW accounts has slowed.
Judgments on these seemingly technical considerations
ng
inevitably take on considerable importance in the target-setti
(including
process because the economic and financial consequences
-10--
the consequences for interest rates) of a particular Ml or M2
increase are dependent on the demand for money.
Over longer
periods, a certain stability in velocity trends can be observed,
but there is a noticeable cyclical pattern.
Taking account of
those normal historical relationships, the various targets
established at the beginning of the year were calculated to be
consistent with economic recovery in a context of declining
inflation.
That remains our judgment today.
Inflation has,
in fact, receded more rapidly than anticipated at the start of
the year potentially leaving more "room" for real growth.
On
that basis, the targets established early in the year still
appeared broadly appropriate, and the Federal Open Market Committee decided at its recent meeting not to change them at this
time.
However, the Committee also felt, in the light of developments
during the first half, that growth around the top of those ranges
would be fully acceptable.
Moreover -- and I would emphasize
this -- growth somewhat above the targeted ranges would be
tolerated for a time in circumstances in which it appeared that
precautionary or liquidity motivations, during a period of
economic uncertainty and turbulence, were leading to stronger
than anticipated demands for money.
We will look to a variety of
factors in reaching that judgment, including such technical factors
as the behavior of different components in the money supply, the
growth of credit, the behavior of banking and financial markets,
and more broadly, the behavior of velocity and interest rates.
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-11-
I believe it is timely for me to add that, in these
circumstances, the Federal Reserve should not be expected to
respond, and does not plan to respond, strongly to various
"bulges" -- or for that matter "valleys" -- in monetary growth
that seem likely to be temporary.
As we have emphasized in the
past, the data are subject to a good deal of statistical "noise"
in any circumstances, and at times when demands for money and
liquidity may be exceptionally volatile, more than usual caution
is necessary in responding to "blips."*
We, of course, have a concrete instance at hand of a
relatively large (and widely anticipated) jump in M1 in the
first week of July -- possibly influenced to some degree by
larger social security payments just before a long weekend.
Following as it did a succession of money supply declines, that
increase brought the most recent level for M1 barely above the
June average, and it is not of concern to us.
It is in this context, and in view of recent declines
in short-term market interest rates, that the Federal Reserve
yesterday reduced the basic discount rate from 12 to 111
2 percent.
/
*In that connection, a number of observers have noted
that the first month of a calendar quarter -- most noticeably
in January and April -- sometimes shows an extraordinarily
large increase in M1 -- amplified by the common practice of
multiplying the actual change by 12 to show an annual rate.
Those bulges, more typically than not, are partially "washed
out" by slower than normal growth the following month. The
standard seasonal adjustment techniques we use to smooth out
monthly money supply variations -- indeed, any standard
techniques -- may, in fact, be incapable of keeping up with
rapidly changing patterns of financial behavior, as they
affect seasonal patterns. A note attached to this statement
sets forth some work in process developing new seasonal adjustment techniques.
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-i2-
In looking ahead to 1983, the Open Market Committee
agreed that a decision at this time would -- even more
obviously than usualto be reviewed at the start of
the year in the light of all the evidence as to the behavior
of velocity or money and liquidity demand during the current
year.
Apart from the cyclical influences now at work, the
possibility will need to be evaluated of a more lasting change
in the trend of velocity.
The persistent rise in velocity during the past twenty
years has been accompanied by rising inflation and interest
rates -- both factors that encourage economization of cash
balances.
In addon, technological change in banking --
spurred in considerable part by the availabty of computers -has made it technically feasible to do more and more business
on a proportionately smaller "cash" base.
With incentives
strong to minimize holdings of cash balances that bear no or
low interest rates, and given the technical feasibility to do
so, turnover of demand deposits has reached an annual rate of
more than 300, quadruple the rate ten years ago.
Technological
change is continuing, and changes in regulation and bank practices
are likely to permit still more economization of Ml-type balances.
However, lower rates of interest and inflation should moderate
incentives to exploit that technology fully.
In those conditions,
velocity growth could slow, or conceivably at some point stop.
To conclude that the trend has in fact changed would
clearly be premature, but it is a matter we will want to evaluate
carefully as time passes.
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For now, the Committee felt that the
-13-
existing targets should be tentatively retained for next year.
Since we expect to be around the top end of the ranges this
year, those tentative targets would of course be fully consistent
with somewhat slower growth in the monetary aggregates in 1983.
Such a target would be appropriate on the assumption of a more
or less normal cyclical rise in velocity.
With inflation
declining, the tentative targets would appear consistent with,
and should support, continuing recovery at a moderate pace.
The Blend of Monetary and Fiscal Policy
The Congress, in adopting a budget resolution contemplating
cuts in expenditures and some new revenues, also called upon
the Federal Reserve to "reevaluate its monetary targets in
order to assure that they are fully complementary to a new
and more restrained fiscal policy."
I can report that members
of the Committee welcomed the determination of the Congress to
achieve greater fiscal restraint, and I want particularly to
recognize the leadership of members of the Budget Committees
and others in achieving that result.
In most difficult
circumstances, progress is being made toward reducing the
huge potential gap between receipts and expenditures.
But I
would be less than candid if I did not also report a strong
sense that considerably more remains to be done to bring the
deficit under control as the economy expands.
The fiscal
situation as we appraise it, continues to carry the implicit
threat of "crowding out" business investment and housing as
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-14--
the economy grows -- a process that would involve interest
rates substantially higher than would otherwise be the case.
For the more immediate future, we recognized that the need
remains to convert the intentions expressed in the Budget
Resolution into concrete legislative action.
In commenting on the budget, I would distinguish
sharply between the "cyclical" and "structural" deficit
that is, the portion of the deficit reflecting an imbalance
between receipts and expenditures even in a satisfactorily
growing economy with declining inflation.
To the extent the
deficit turns out to be larger than contemplated entirely
because of a shortfall in economic growth, that "add on"
would not be a source of so much concern.
But the hard
fact remains that, if the objectives of the Budget Resolution
are fully reached, the deficit would be about as large in
fiscal 1983 as this year even as the economy expands at a
rate of 4 to 5 percent a year and inflation (and thus inflation
generated revenues) remains higher than members of the Open
Market Committee now expect.
In considering the question posed by the Budget Resolution,
the Open Market Committee felt that full success in the budgetary
effort should itself be a factor contributing to lower interest
rates and reduced strains in financial markets.
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It would thus
-15-
reduce inflationary
assist importantly in the common effort to
pressures in the context of a growing economy.
By relieving
inflationary expectations
concern about future financing volume and
er budget posture
I believe as a practical matter a credibly firm
in the actual short• might permit a degree of greater flexibility
sing inflationary
term execution of monetary policy without arou
fears.
eases
Specifically, market anxiety that short-run incr
of the debt
in the Ms might presage continuing monetization
could be ameliorated.
But any gains in these respects will
the intentions
of course be dependent on firmness in implementing
idence among
set forth in the Resolution and on encouraging conf
ained and
borrowers and investors that the effort will be sust
reinforced in coming years.
Taking account of all these considerations, the
rtant
Committee did not feel that the budgetary effort, impo
l greater
as it is, would in itself appropriately justify stil
have anticipated.
growth in the monetary aggregates over time than I
eof
Indeed, excessive monetary growth -- and perceptions ther
would undercut any benefits from the budgetary effort with
respect to inflationary expectations.
We believe fiscal
restraint should be viewed more as an important complement
to appropriately disciplined monetary policy than as a
substitute.
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-16-
Concluding Comments
In an ideal world, less exclusive reliance on monetary
policy to deal with inflation would no doubt have eased the
strains and high interest rates that plague the economy and
financial markets today.
To the extent the fiscal process
can now be brought more fully to bear on the problem, the
better off we will be -- the more assurance we will have that
interest rates will decline and keep declining during the
period of recovery, and that we will be able to support the
increases in investment and housing essential to healthy,
sustained recovery.
Efforts in the private sector -- to
increase productivity, to reduce costs, and to avoid inflationary
and job-threatening wage increases -- are also vital, even
though the connection between the actions of individual firms
and workers and the performance of the economy may not always
be self-evident to the decision makers.
We know progress is
being made in these areas, and more progress will hasten full
and strong Expansion.
But we also know that we do not live in an ideal world.
There is strong resistance to changing patterns of behavior
and expectations ingrained over years of inflation.
The slower
the progress on the budget, the more industry and labor build
in cost increases in anticipation of inflation or Government
acts to protect markets or impede competition, the more highly
speculative financing is undertaken, the greater the threat that
available supplies of money and credit will be exhausted in
financing rising prices instead of new jobs and growth.
Those
in vulnerable competitive positions are most likely to feel the
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a
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-17-
impact first and hardest, but unfortunately the difficulties
spread over the economic landscape.
The hard fact remains that we cannot escape those dilemmas
by a decision to give up the fight on inflation -- by declaring
the battle won before it is.
Such an approach would be trans-
parently clear -- not just to you and me -- but to the investors,
the businessmen and the workers who would, once again, find
their suspicions confirmed that they had better prepare to
live with inflation, and try to keep ahead of it.
The reactions
in financial markets and other sectors of the economy would,
in the end, aggravate our problems, not eliminate them.
It
would strike me as the cruelest blow of all to the millions
who have felt the pain of recession directly to suggest, in
effect, it was all in vain.
I recognize months of recession and high interest rates
have contributed to a sense of uncertainty.
postponed investment plans.
Businesses have
Financial pressures have exposed
lax practices and stretched balance sheet positions in some
institutions -- financial as well as non-financial.
The
earnings position of the thrift industry remains poor.
essfully
But none of those problems can be dealt with succ
ipline.
by re-inflation or by a lack of individual disc
It is
to the
precisely that environment that contributed so much
current difficulties.
cost conIn contrast, we are now seeing new attitudes of
our industry
tainment and productivity growth -- and ultimately
will be in a nore robust competitive position.
Millions are
-18-
benefitting from less rapid price increases -- or actually
lower prices -- at their shopping centers and elsewhere.
Consumer spending appears to be moving ahead, and inventory
reductions help set the stage for production increases.
Those are developments that should help recovery get
firmly underway.
The process of disinflation has enough
momentum to be sustained during the early stages of recovery
.,,•••••
and that success can breed further success as concerns about
inflation recede.
As recovery starts, the cash flow of
business should improve.
And, more confidence should encourage
greater willingness among investors to purchase longer debt
maturities.
Those factors should, in turn, work toward reducing
interest rates, and sustaining them at lower levels, encouraging
in turn the revival of investment and housing we want.
I have indicated the Federal Reserve is sensitive to the
special liquidity pressures that could develop during the
current period of uncertainty.
Moreover, the basic solidity
of our financial system is backstopped by a strong structure
of governmental institutions precisely designed to cope with
the secondary effects of isolated failures.
The recent problems
related largely to the speculative activities of a few highly
leveraged firms can and will be contained, and over time, an
appropriate sense of prudence in taking risks will serve us well.
We have been through -- we are in
a trying period.
But
too much has been accomplished not to move ahead and complete
the job of laying the groundwork for a much stronger economy.
As we look forward, not just to the next few months but to long
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-19-
years, the rewards will be great:
in renewed stability, in
growth, and in higher employment and standards of living.
That vision will not be accomplished by monetary policy alone.
But we mean to do our part.
* *
* *
* * * *
x
Table I
i
Targeted and Actual Growth of
Money and Bank Credit
(Percent changes, at seasonally adjusted annual rates)
FOMC Objective
198104 to 198204
198104
to June '82
Actual Growth
198104
to 198202
M1
2-1/2 to 5-1/2
5.6
6.8
4.7**
M2
6 to 9
9.4
9.7
9.7
M3
6-1/2 to 9-1/2
9.7
9.8
10.5
Bank Credit*
6 to 9
8.0
8.3
8.4
*
The base for the bank credit target is the average level of December 1981
and January 19R2, rather than the average for 198104. This base was adopted
because of the impact on the series of shifts of assets to the new international banking facilities (IBFs); the 1981H1-to-1982H1 figure has been
adjusted for the impact of the initial shifting of assets to IBFs.
** Adjusted for impact of shifts to new NOW accounts in 1981.
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OP
1981H1
to 1982H1
Appendix
Alternative Seasonal Adjustment Procedure
For some time the Federal Reserve has been investigating ways
to improve its procedures for seasonal adjustment, particularly as they
apply to the monetary aggregates.
In June of last year, a group of pro-
minent outside experts, ased by the Board to examine seasonal adjustment
1/
techniques, submitted their recommendations.—
The committee suggested,
among other things, that the Board's staff develop seasonal factor
estimates from a model-based procedure as an alternative to the widely
used X-11 technique that provides the basis for the current seasonal
//
adjustment procedure,
and release the results.
The Board staff has been developing a procedure using statisti, a1
V
models tailored to each individual series.
The table on the last page
compares monthly and quarterly average growth rates for the current M1
series with those of an alternative series from the model-based approach.
Differences in seasonal adjustment techniques do not change
the trend in monetary growth, but, as may be seen in the table, they do
alter month -to-month growth raLes owing to differing estimates of the
1/
See Committee of Experts on Seasonal Adjustment Techniques, Seasonal
Adjustment of the Monetary Aggregates (Board of Governors of the Federal
Reserve System, October 1981).
2/
The current seasonal adjustment technique has most recently been
summarized in the description to the mimeograph release of historical
money stock data dated March 1982. Detailed descriptions of the X-11
program and variants can be obtained from technical paper no. 15 of the
U. S. Department of Commerce (rev. February 1967) and from the report
to the Board cited in footnote 1.
3/
The model-based seasonal adjustment procedures currently under review by
the Board staff use methods based on the well-developed theory of sta
tical regression and time series modeling. These approaches allow
development of seasonal factors that are more sensitive than the current
factors to unique characteristics of each series, including, for example,
fixed and evolving seasonal patterns, trading day effects, within-month
seasonal variations, holiday effects, outlier adjustments, special events
adjustments (such as the 1980 credit controls experience), and serially
cS rrelated noise components.
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Federal Reserve Bank of St. Louis
-2distribution over time of the seasonal component in money behavior.
Short-
run money growth is variable under both the alternative and current techniques
of seasonal adjustment, illustrating the inherently large "noise" component
of the series.
However, the redistribution of the seasonal component under
the alternative technique does on average tend to moderate month-to-month
changes somewhat.
The Board will continue to publish seasonally adjusted estimates
for M1 on both current and alternative bases at least until the annual
review of seasonal factors in 1983.
method will be available shortly.
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Federal Reserve Bank of St. Louis
A detailed description of the alternative
Growth Rates of M1 Using
1
Current and Alternative4
Seasonal Adjustment Procedures
(Monthly Average - Percent Annual Rates)
1982
1981
I
i
Jan.
Feb.
Mar.
Apr.
May
June
July
Aug.
Sept.
Oct.
Nov.
Dec.
Current
Alternative
9.8
4.3
14.3
25.2
-11.4
-2.2
2.8
4.8
0.3
4.7
9.7
12.4
1.4
7.5
16.0
22.6
-10.3
-0.6
2.2
5.3
3.1
0.0
11.1
15.4
Jan.
Feb.
Mar.
Apr.
May
June
Current
Alternative
21.0
-3.5
2.7
11.0
-2.4
-1.6
11.4
1.3
6.4
4.5
0.5
1.3
(Quarterly Average - Percent Annual Rates)
QI
QII
QIII
QIV
4.6
9.2
0.3
5.7
3.5
9.6
0.9
5.5
QI
QII
10.4
3.1
9.5
3.4
1/
_
Current monthly so9sonal factors are derived using an X-11/ARIMAbased procedure applied to monthly data.
2/
Alternative monthly seasonal factors are derived using a modelbased procedure applied to weekly data.
i
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-
Board of Governors
of the Federal Reserve System
Washington, D.C. 20551
Official Business
Penalty for Private Use, 5300
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Postage arid Foes Paid
Rood at Gammon
at the Federal Reserve Systern
First Class
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Federal Reserve Bank of St. Louis
For release on delivery
9:30 AM, E.D.T.
July 20, 1982
Statement by
Paul A. Volcker
Chairman, Board of Governors of the Federal Reserve System
before the
Committee on Banking, Housing, and Urban Affairs
United States Senate
July 20, 1982
I am pleased to have this opportunity once again to
discuss monetary policy with you within the context of recent
and prospective economic developments.
As usual on these
occasions, you have the Board of Governors' "Humphrey-Hawkins"
Report before you.
This morning I want to enlarge upon some
aspects of that Report and amplify as fully as I can my thinking
with respect to the period ahead.
In assessing the current economic situation, I believe
the comments I made five months ago remain relevant.
Without
repeating that analysis in detail, I would emphasize that we
stand at an important crossroads for the economy and economic
policy.
In these past two years we have traveled a considerable
way toward reversing the inflationary trend of the previous
decade or more.
I would recall to you that, by the late 1970s,
that trend had shown every sign of feeding upon itself and
tending to accelerate to the point where it threatened to
undermine the foundations of our economy.
Dealing with inflation
was accepted as a top national priority, and, as events developed,
that task fell almost entirely to monetary policy.
In the best of circumstances, changing entrenched patterns
of inflationary behavior and expectations -- in financial markets,
in the practices of business and financial institutions, and in
labor negotiations -- is a difficult and potentially painful
yr
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Federal Reserve Bank of St. Louis
process.
Those, consciously or not, who had come to "bet" on
rising prices and the ready availability of relatively cheap
2
credit to mask the risks of rising costs, poor productivity,
aggressive lending, or over-extended financial positions have
found themselves in a particularly difficult position.
The pressures on financial markets and interest rates
have been aggravated by concerns over prospective huge volumes
of Treasury financing, and by the need of some businesses to
borrow at a time of a severe squeeze on profits.
Lags in the
adjustment of nominal wages and other costs to the prospects
for sharply reduced inflation are perhaps inevitable, but have
the effect of prolonging the pressure on profits -- and indirectly on financial markets and employment.
Remaining doubts
and skepticism that public policy will "carry through" on the
effort to restore stability also affect interest rates, perhaps
most particularly in the longer-term markets.
In fact, the evidence now seems to me strong that the
inflationary tide has turned in a fundamental way.
In stating
that, I do not rely entirely on the exceptionally favorable
consumer and producer price data thus far this year, when the
recorded rates of price increase (at annual rates) declined to
2%, respectively. That apparent improvement was magnified
/
2 and 21
/
31
by some factors likely to prove temporary, including, of course,
the intensity of the recession; those price indices are likely
to appear somewhat less favorable in the second half of the
year.
What seems to me more important for the longer run is
that the trend of underlying costs and nominal wages has begun
to move lower, and that trend should be sustainable as the
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3-
economy recovers upward momentum.
While less easy to
identify -- labor productivity typically does poorly during
periods of business decline -- there are encouraging signs
that both management and workers are giving more intense
attention to the effort to improve productivity.
That effort
should "pay off" in a period of business expansion, helping
to hold down costs and encouraging a revival of profits, setting
the stage for the sustained growth in real income we want.
I am acutely aware that these gains against inflation
have been achieved in a context of serious recession.
Millions
of workers are unemployed, many businesses are hardpressed to
maintain profitability, and business bankruptcies are at a
postwar high.
While it is true that some of the hardship can
reasonably be traced to mistakes in management or personal
judgment, including presumptions that inflation would continue,
large areas of the country and sectors of the economy have been
swept up in more generalized difficulty.
Our financial system
has great strength and resiliency, but particular points of
strain have been evident.
Quite obviously, a successful program to deal with
inflation, with productivity, and with the other economic and
social problems we face cannot be built on a crumbling foundation
of continuing recession.
As you know, there have been some
indications -- most broadly reflected in the rough stability
of the real GNP in the second quarter and small increases in the
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leading indicators -- that the downward adjustments may be drawing
-4
to a close.
The tax reduction effective July 1, higher social
security payments, rising defense spending and orders, and the
reductions in inventory already achieved, all tend to support
the generally held view among economists that some recovery is
.
likely in the second half of the year.
I am also conscious of the fact that the leveling off
of the GNP has masked continuing weakness in important sectors
of the economy.
In its early stages, the prospective recovery
must be led largely by consumer spending.
But to be sustained
over time, and to support continuing growth in productivity and
living standards, more investment will be necessary.
as you know, business investment is moving lower.
At present,
House building
has remained at depressed levels; despite some small gains in
starts during the spring, the cyclical strength "normal" in that
industry in the early stages of recovery is lacking.
Exports
have been adversely affected by the relative strength of the
dollar in exchange markets.
I must also emphasize that the current problems of the
American economy have strong parallels abroad.
Governments
around the world have faced, in greater or lesser degree, both
inflationary and fiscal problems.
As they have come to grips
with those problems, growth has been slow or non-existent, and
the recessionary tendencies in various countries have fed back,
one on another.
7
In sum, we are in a situation that obviously warrants
concern, but also has great opportunities.
Those opportunities
lie in major part in achieving lasting progress -- in pinning
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down and extending what has already been achieved -- toward
price stability.
In doing so, we will be laying the base for
sustaining recovery over many years ahead, and for much lower
interest rates, even as the economy grows.
Conversely, to
fail in that task now, when so much headway has been made,
could only greatly complicate the problems of the economy over
time.
I find it difficult to suggest when and how a credible
attack could be renewed on inflation should we neglect completing
the job now.
Certainly the doubts and skepticism about our
capacity to deal with inflation -- which now seem to be yielding
would be amplified, with unfortunate consequences for financial
markets and ultimately for the economy.
I am certain that many of the questions, concerns and
dangers in your mind lie in the short run -- and that those in
good part revolve around the pressures in financial markets.
Can we look forward to lower interest rates to support the
expansion in investment and housing as the recovery takes hold?
Is there, in fact, enough liquidity in the economy to support
expansion -- but not so much that inflation is reignited?
Will, in fact, the economy follow the recovery path so widely
forecast in coming months?
These are the questions that we in the Federal Reserve
must deal with in setting monetary policy.
As we approach
these policy decisions, we are particularly conscious of the
9
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fact that monetary policy, however important, is only one
instrument of economic policy.
Success in reaching our common
objective of a strong and prosperous economy depends upon more
41•10 =in
6
than appropriate monetary policies, and I will touch this
morning on what seem
to me appropriately complementary
policies in the public and private sectors.
The Monetary Targets
Five months ago, in presenting our monetary and credit
targets for 1982, I noted some unusual factors could be at
work tending to increase the desire of individuals and businesses
to hold assets in the relatively liquid forms encompassed in the
various definitions of money.
Partly for that reason -- and
recognizing that the conventional base for the M1 target of the
fourth quarter of 1981 was relatively low -- I indicated that
the Federal Open Market Committee contemplated growth toward
the upper ends of the specified ranges.
Given the "bulge"
early in the year in Ml, the Committee also contemplated that
that particular measure of money might for some months remain
above a "straight line" projection of the targeted range from
the fourth quarter of 1981 to the fourth quarter of 1982.
As events developed, M1 and M2 both remained somewhat above
straight line paths until very recently.
M3 and bank credit
have remained generally within the indicated range, although
close to the upper ends.
(See Table I.)
Taking the latest full
month of June, M1 grew 5.6% from the base period and M2 9.4%,
close to the top of the ranges.
To the second quarter as a
whole, the growth was higher, at 6.8% and 9.7%, respectively.
Looked at on a year-over-year basis, which appropriately tends
to average through volatile monthly and quarterly figures, M1
during the first half of 1982 averaged about 4-3/4% above the
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7-
first half of 1981 (after accounting for NOW account shifts
early last year).
On the same basis, M2 and M3 grew by 9.7
distinctly
and 10.5 percent, respectively, a rate of growth
faster than the nominal GNP over the same interval.
In conducting policy during this period, the Committee
s
was sensitive to indications that the desire of individual
and others for liquidity was unusually high, apparently reflecting concerns and uncertainties about the business and
financial situation.
One reflection of that may be found in
unusually large declines in "velocity" over the period -that is, the ratio of measures of money to the gross national
product.
Ml velocity -- particularly for periods as short as
three to six months -- is historically volatile.
A cyclical
tendency to slow (relative to its upward trend) during recessions
is common.
But an actual decline for two consecutive quarters,
rather
as happened late in 1981 and the first quarter of 1982, is
unusual.
The magnitude of the decline during the first quarter
was larger than in any quarter of the entire postwar period.
ion
Moreover, declines in velocity of this magnitude and durat
are often accompanied by (and are related to) reduced shortterm interest rates.
Those interest rate levels during the
of
first half of 1982 were distinctly lower than during much
1980 and 1981, but they rose above the levels reached in the
closing months of last year.
V
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More direct evidence of the desire for liquidity or prebehavior
cautionary balances affecting M1 can be found in the
of NOW accounts.
As you know, NOW accounts are a relatively
new instrument, and we have no experience of behavior over the
course of a full business cycle.
We do know that NOW accounts
are essentially confined to individuals, their turnover relative
to demand accounts is relatively low, and, from the standpoint
of the owner, they have some of the characteristics of savings
deposits, including a similarly low interest rate but easy
access on demand.
We also know the great bulk of the increase
in M1 during the early part of the year -- almost 90% of the
rise from the fourth quarter of 1981 to the second quarter of
1982 -- was concentrated in NOW accounts, even though only
about a fifth of total M1 is held in that form.
In contrast
to the steep downward trend in low-interest savings accounts
in recent years, savings account holdings have stabilized or
even increased in 1982, suggesting the importance of a high
degree of liquidity to many individuals in allocating their
funds.
A similar tendency to hold more savings deposits has
been observed in earlier recessions.
I would add that the financial and liquidity positions of
the household sector of the economy, as measured by conventional
liquid asset and debt ratios, has improved during the recession
period.
Relative to income, debt repayment burdens have declined
to the lowest level since 1976.
are clearly mixed.
Trends among business firms
While many individual firms are under strong
pressure, some rise in liquid asset holdings for the corporate
sector as a whole appears to be developing.
The gap between
internal cash flow (that is, retained earnings and depreciation
allowances) and spending for plant, equipment, and inventory
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9
has also been at an historically low level, suggesting that a
portion of recent business credit demands is designed to
bolster liquidity.
But, for many years, business liquidity
ratios have tended to decline, and balance sheet ratios have
reflected more dependence on short-term debt.
In that per-
spective, any recent gains in liquidity appear small.
In the light of the evidence of the desire to hold more
NOW accounts and other liquid balances for precautionary rather
than transaction purposes during the months of recession, strong
efforts to reduce further the growth rate of the monetary aggregates appeared inappropriate.
Such an effort would have
required more pressure on bank reserve positions -- and
presumably more pressures on the money markets and interest
rates in the short run.
At the same time, an unrestrained
build-up of money and liquidity clearly would have been inconsistent with the effort to sustain progress against inflation,
both because liquidity demands could shift quickly and because
our policy intentions could easily have been misconstrued.
Periods of velocity decline over a quarter or two are typically
followed by periods of relatively rapid increase.
Those increases
tend to be particularly large during cyclical recoveries.
Indeed,
velocity appears to have risen slightly during the second quarter,
and the growth in NOW accounts has slowed.
Judgments on these seemingly technical considerations
inevitably take on considerable importance in the target-setting
ing
process because the economic and financial consequences (includ
-10-
the consequences for interest rates) of a particular M1 or M2
increase are dependent on the demand for money.
Over longer
periods, a certain stability in velocity trends can be observed,
but there is a noticeable cyclical pattern.
Taking account of
those normal historical relationships, the various targets
established at the beginning of the year were calculated to be
consistent with economic recoverycontext of declining
inflation.
That remains our judgment today.
Inflation has,
in fact, receded more rapidly than anticipated at the start of
the year potentially leaving more "room" for real growth.
On
that basis, the targets established early in the year still
appeared broadly appropriate, and the Federal Open Market Committee decided at its recent meeting not to change them at this
time.
However, the Committee also felt, in the light of developments
during the first half, that growth around the top of those ranges
would be fully acceptable.
Moreover -- and I would emphasize
this -- growth somewhat above the targeted ranges would be
tolerated for a time in circumstances in which it appeared that
precautionary or liquidity motivations, during a period of
economic uncertainty and turbulence, were leading to stronger
than anticipated demands for money.
We will look to a variety of
factors in reaching that judgment, including such technical factors
as the behavior of different components in the money supply, the
growth of credit, the behavior of banking and financial markets,
and more broadly, the behavior of velocity and interest rates.
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V
-11-
I believe it is timely for me to add that, in these
circumstances, the Federal Reserve should not be expected to
respond, and does not plan to respond, strongly to various
"bulges" -- or for that matter "valleys" -- in monetary growth
that seem likely to be temporary.
As we have emphasized in the
past, the data are subject to a good deal of statistical "noise"
in any circumstances, and at times when demands for money and
liquidity may be exceptionally volatile, more than usual caution
is necessary in responding to "blips."*
We, of course, have a concrete instance at hand of a
relatively large (and widely anticipated) jump in M1 in the
first week of July -- possibly influenced to some degree by
larger social security payments just before a long weekend.
Following as it did a succession of money supply declines, that
increase brought the most recent level for M1 barely above the
June average, and it is not of concern to us.
It is in this context, and in view of recent declines
in short-term market interest rates, that the Federal Reserve
2 percent.
/
yesterday reduced the basic discount rate from 12 to 111
•
•
*In that connection, a number of observers have noted
that the first month of a calendar quarter -- most noticeably
in January and April -- sometimes shows an extraordinarily
large increase in M1 -- amplified by the common practice of
multiplying the actual change by 12 to show an annual rate.
Those bulges, more typically than not, are partially "washed
out" by slower than normal growth the following month. The
standard seasonal adjustment techniques we use to smooth out
monthly money supply variations -- indeed, any standard
techniques -- may, in fact, be incapable of keeping up with
rapidly changing patterns of financial behavior, as they
affect seasonal patterns. A note attached to this statement
sets forth some work in process developing new seasonal adjustment techniques...
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-12-
In looking ahead to 1983, the Open Market Committee
agreed that a decision at this time would -- even more
obviously than usual -- need to be reviewed at the start of
the year in the light of all the evidence as to the behavior
of velocity or money and liquidity demand during the current
year.
Apart from the cyclical influences now at work, the
possibility will need to be evaluated of a more lasting change
in the trend of velocity.
The persistent rise in velocity during the past twenty
years has been accompanied by rising inflation and interest
rates -- both factors that encourage economization of cash
balances.
In addition, technological change in banking --
spurred in considerable part by the availability of computers -has made it technically feasible to do more and more business
on a proportionately smaller "cash" base.
With incentives
strong to minimize holdings of cash balances that bear no or
low interest rates, and given the technical feasibility to do
so, turnover of demand deposits has reached an annual rate of
more than 300, quadruple the rate ten years ago.
Technological
change is continuing, and changes in regulation and bank practices
are likely to permit still more economization of Ml-type balances.
However, lower rates of interest and inflation should moderate
incentives to exploit that technology fully.
In those conditions,
velocity growth could slow, or conceivably at some point stop.
To conclude that the trend has in fact changed would
clearly be premature, but it is a matter we will want to evaluate
carefully as time passes.
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For now, the Committee felt that the
-13--
existing targets should be tentatively retained for next year.
Since we expect to be around the top end of the ranges this
year, those tentative targets would of course be fully consistent
with somewhat slower growth in the monetary aggregates in 1983.
Such a target would be appropriate on the assumption of a more
or less normal cyclical rise in velocity.
With inflation
declining, the tentative targets would appear consistent with,
and should support, continuing recovery at a moderate pace.
The Blend of Monetary and Fiscal Policy
The Congress, in adopting a budget resolution contemplating
cuts in expenditures and some new revenues, also called upon
the Federal Reserve to "reevaluate its monetary targets in
order to assure that they are fully complementary to a new
and more restrained fiscal policy."
I can report that members
of the Committee welcomed the determination of the Congress to
achieve greater fiscal restraint, and I want particularly to
recognize the leadership of members of the Budget Committees
and others in achieving that result.
In most difficult
circumstances, progress is being made toward reducing the
huge potential gap between receipts and expenditures.
But I
would be less than candid if I did not also report a strong
sense that considerably more remains to be done to bring the
deficit under control as the economy expands.
The fiscal
situation as we appraise it, continues to carry the implicit
as
threat of "crowding out" business investment and housing
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%
-14-
the economy grows -- a process that would involve interest
rates substantially higher than would otherwise be the case.
For the more immediate future, we recognized that the need
remains to convert the intentions expressed in the Budget
Resolution into concrete legislative action.
In commenting on the budget, I would distinguish
sharply between the "cyclical" and "structural" deficit
that is, the portion of the deficit reflecting an imbalance
between receipts and expenditures even in a satisfactorily
growing economy with declining inflation.
To the extent the
deficit turns out to be larger than contemplated entirely
because of a shortfall in economic growth, that "add on"
would not be a source of so much concern.
But the hard
fact remains that, if the objectives of the Budget Resolution
are fully reached, the deficit would be about as large in
fiscal 1983 as this year even as the economy expands at a
rate of 4 to 5 percent a year and inflation (and thus inflation
generated revenues) remains higher than members of the Open
Market Committee now expect.
In considering the question posed by the Budget Resolution,
the Open Market Committee felt that full success in the budgetary
effort should itself be a factor contributing to lower interest
rates and reduced strains in financial markets.
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It would thus
-15-
reduce inflationary
assist importantly in the common effort to
pressures in the context of a growing economy.
By relieving
ationary expectations
concern about future financing volume and infl
er budget posture
I believe as a practical matter a credibly firm
the actual shortmight permit a degree of greater flexibility in
sing inflationary
term execution of monetary policy without arou
fears.
s
Specifically, market anxiety that short-run increase
the debt
in the Ms might presage continuing monetization of
could be ameliorated.
But any gains in these respects will
the intentions
of course be dependent on firmness in implementing
idence among
set forth in the Resolution and on encouraging conf
d and
borrowers and investors that the effort will be sustaine
reinforced in coming years.
Taking account of all these considerations, the
t
Committee did not feel that the budgetary effort, importan
l greater
as it is, would in itself appropriately justify stil
have anticipated.
growth in the monetary aggregates over time than I
thereof
Indeed, excessive monetary growth -- and perceptions
would undercut any benefits from the budgetary effort with
respect to inflationary expectations.
We believe fiscal
restraint should be viewed more as an important complement
to appropriately disciplined monetary policy than as a
_
substitute.
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-16-
Concluding Comments
In an ideal world, less exclusive reliance on monetary
policy to deal with inflation would no doubt have eased the
strains and high interest rates that plague the economy and
financial markets today.
To the extent the fiscal process
can now be brought more fully to bear on the problem, the
better off we will be -- the more assurance we will have that
interest rates will decline and keep declining during the
period of recovery, and that we will be able to support the
increases in investment and housing essential to healthy,
sustained recovery.
Efforts in the private sector -- to
increase productivity, to reduce costs, and to avoid inflationary
and job-threatening wage increases -- are also vital, even
though the connection between the actions of individual firms
and workers and the performance of the economy may not always
I- self-evident to the decision makers.
We know progress is
being made in these areas, and more progress will hasten full
and strong expansion.
But we also know that we do not live in an ideal world.
There is strong resistance to changing patterns of behavior
and expectations ingrained over years of inflation.
The slower
the progress on the budget, the more industry and labor build
in cost increases in anticipation of inflation or Government
acts to protect markets or impede competition, the more highly
speculative financing is undertaken, the greater the threat that
available supplies of money and credit will be exhausted in
financing rising prices instead of new jobs and growth.
Those
in vulnerable competitive positions are most likely to f-- 1 the
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-17-
impact first and hardest, but unfortunately the difficulties
spread over the economic landscape.
The hard fact remains that we cannot escape those dilemmas
by a decision to give up the fight on inflation -- by declaring
the battle won before it is.
Such an approach would be trans-
parently clear -- not just to you and me -- but to the investors,
the businessmen and the workers who would, once again, find
their suspicions confirmed that they had better prepare to
live with inflation, and try to keep ahead of it.
The reactions
in financial markets and other sectors of the economy would,
in the end, aggravate our problems, not eliminate them.
It
would strike me as the cruelest blow of all to the millions
in
who have felt the pain of recession directly to suggest,
effect, it was all in vain.
I recognize months of recession and high interest rates
have contributed to a sense of uncertainty.
postponed investment plans.
Businesses have
Financial pressures have exposed
lax practices and stretched balance sheet positions in some
institutions -- financial as well as non-financial.
The
earnings position of the thrift industry remains poor.
ully
But none of those problems can be dealt with successf
discipline.
by re-inflation or by a lack of individual
It is
to the
precisely that environment that contributed so much
current difficulties.
of cost conIn contrast, we are now seeing new attitudes
ultimately our industry
tainment and productivity growth -- and
tion.
will be in a .nore robust competitive posi
Millions are
-18-
benefitting from less rapid price increases ---.)T.14.tPI
ally
lower prices -- at their shopping centers and elsewhere.
Consumer spending appears to be moving ahead, and inventory
reductions help set the stage for production increases.
Those are developments that should help recovery get
firmly underway.
The process of disinflation has enough
momentum to be sustained during the early stages of recovery
and that success can breed further success as concerns about
inflation recede.
As recovery starts, the cash flow of
business should improve.
And, more confidence should encourage
greater willingness among investors to purchase longer debt
maturities.
Those factors should, in turn, work toward reducing
interest rates, and sustaining them at lower levels, encouraging
in turn the revival of investment and housing we want.
I have indicated the Federal Reserve is sensitive to the
special liquidity pressures that could develop during the
current period of uncertainty.
Moreover, the basic solidity
of our financial system is backstopped by a strong structure
of governmental institutions precisely designed to cope with
the secondary effects of isolated failures.
The recent problems
related largely to the speculative actives of a few highly
leveraged firms can and will be contained, and over time, an
appropriate sense of prudence in taking risks will serve us well.
We have been through -- we are in -- a trying period.
But
too much has been accomplished not to move ahead and complete
the job of laying the groundwork for a much stronger economy.
As we look forward, not just to the next few months but to long
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-19-
years, the rewards will be great:
in renewed stability, in
growth, and in higher employment and standards of living.
That vision will not be accomplished by monetary policy alone.
But we mean to do our part.
* *
,
t
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* *
* * * *
Table I
Targeted and Actual Growth of
Money and Bank Credit
(Percent changes, at seasonally adjusted annual rates)
FOMC Objective
198104 to 198204
198104
to June '82
Actual Growth
198104
to 198202
1981H1
to 1982H1
M1
2-1/2 to 5-1/2
5.6
6.8
4.7**
M2
6 to 9
9.4
9.7
9.7
M3
6-1/2 to 9-1/2
9.7
9.8
10.5
Bank Credit*
6 to 9
8.0
8.3
8.4
The base for the bank credit target is the average level of December 1981
and January 1982, rather than the average for 198104. This base was adopted
because of the impact on the series of shifts of assets to the new international banking facilities (IBFs); the 1981H1-to-1982H1 figure has been
adjusted for the impact of the initial shifting of assets to IBFs.
**
Adjusted for impact of shifts to new NOW accounts in 1981.
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Appendix
Alternative Seasonal Adjustment Procedure
For some time the Federal Reserve has been investigating ways
to improve its procedures for seasonal adjustment, particularly as they
apply to the monetary aggregates.
In June of last year, a group of pro-
minent outside experts, asked by the Board to examine seasonal adjustment
1/
techniques, submitted their recommendations.—
The committee suggested,
among other things, that the Board's staff develop seasonal factor
estimates from a model-based procedure as an alternative to the widely
used :sTE
technique that provides the basis for the current seasonal
2/
adjustment procedure,— and release the results.
The Board staff has been developing a procedure using statis1
V
models tailored to each individual series.
The table on the last page
monthly and quarterly average growth rates for the current M1
:
series with those of an altern.3tive series from the model-based approach.
Differences in seasonal adjustment techniques do not change
I
the trend in monetary growth, but, as may be seen in the table, they do
alter month -to-month growth races owing to differing estimates of the
1/
See Committee of Experts on Seasonal Adjustment Techniques, Seasonal
Adjustment of the Monetary Aggregates (Board of Governors of the Federal
Reserve System, October 1981).
2/
The current seasonal adjustment technique has most recently been
summarized in the description to the mimeograph release of historical
money stock data dated March 1982. Detailed descriptions of the X-1)
program and variants can be obtained from technical paper no. 15 of the
Department of Commerce (rev. February 1967) and from the report
to the Board cited in footnote 1.
3/
The model-based seasonal adjustment procedures currently under review by
the Board staff use methods based on the well-developed theory of statistical regression and time series modeling. These approaches allow
I- velopment of seasonal factors that are more sensitive than the current
factors to unique characteristics of each series, including, for example,
fixed and evolving seasonal patterns, trading day effects, within-month
seasonal variations, holiday effects, outlier adjustments, special events
adjustments (such as the 1980 credit controls experience), and serially
cS rrelated noise components.
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-2distribution over time of the seasonal component in money behavior.
Short-
run money growth is variable under both the alternative and current techniques
of seasonal adjustment, illustrating the inherently large "noise" component
of the series.
However, the redistribution of the seasonal component under
the alternative technique does on average tend to moderate month-to-month
changes somewhat.
The Board will continue to publish seasonally adjusted estimates
for M1 on both current and alternative bases at least until the annual
review of seasonal factors in 1983.
method will be available shortly.
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A detailed description of the alternative
Growth Rates of M1 Usin:g
1
Current and Alternative4
Seasonal Adjustment Procedures
(Monthly Average - Percent Annual Rates)
1982
1981
,
Jan.
Feb.
Mar.
Apr.
May
June
July
Aug.
Sept.
Oct.
Nov.
Dec.
Current
Alternative
9.8
4.3
14.3
25.2
-11.4
-2.2
2.8
4.8
0.3
4.7
9.7
12.4
1.4
7.5
16.0
22.6
-10.3
-0.6
2.2
5.3
3.1
0.0
11.1
15.4
(Quarterly Average
QI
QII
QIII
QIV
4.6
9.2
0.3
5.7
3.5
9.6
0.9
5.5
Jan.
Feb.
Mar.
Apr.
May
June
Current
Alternative
21.0
-3.5
2.7
11.0
-2.4
-1.6
11.4
1.3
6.4
4.5
0.5
1.3
Percent Annual Rates)
QI
QII
10.4
3.1
9.5
3.4
1/
_
Current monthly se3sonal factors are derived using an X-11/ARIMAbased procedure applied to monthly data.
2/
_
Alternative monthly seasonal factors are derived using a modelbased procedure applied to weekly data.
)
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Board of Governors
of the Fecieral Reserve System
Washington, D.C. 20551
Official Business
Penalty for Private Use, $300
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Postage and Fan Paid
Booed of Cowman
of the Federal Rafirve System
First Class
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For release on delivery
9:30 AN, E.D.T.
July 20, 1982
Statement by
Paul A. Volcker
Chairman, Board of Governors of the Federal Reserve System
before the
Committee on Banking, Housing, and Urban Affairs
United States Senate
July 20, 1982
-
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I am pleased to have this opportunity once again to
discuss monetary policy with you within the context of recent
and prospective economic developments.
As usual on these
occasions, you have the Board of Governors' "Humphrey-Hawkins"
Report before you.
This morning I want to enlarge upon some
aspects of that Report and amplify as fully as I can my thinking
with respect to the period ahead.
In assessing the current economic situation, I believe
the comments I made five months ago remain relevant.
Without
repeating that analysis in detail, I would emphasize that we
stand at an important crossroads for the economy and economic
policy.
In these past two years we have traveled a considerable
way toward reversing the inflationary trend of the previous
decade or more.
I would recall to you that, by the late 1970s,
that trend had shown every sign of feeding upon itself and
tending to accelerate to the point where it threatened to
undermine the foundations of our economy.
Dealing with inflation
was accepted as a top national priority, and, as events developed,
that task fell almost entirely to monetary policy.
In the best of circumstances, changing entrenched patterns
of inflationary behavior and expectations -- in financial markets,
in the practices of business and financial institutions, and in
labor negotiations -- is a difficult and potentially painful
process.
Those, consciously ox not, who had come to "bet" on
rising prices and the ready availability of relatively cheap
2
credit to mask the risks of rising costs, poor productivity,
aggressive lending, or over-extended financial poons have
found themselves in a particularly difficult poon.
The pressures on financial markets and interest rates
have been aggravated by concerns over prospective huge volumes
of Treasury financing, and by the need of some businesses to
borrow at a time of a severe squeeze on profits.
Lags in the
adjustment of nominal wages and other costs to the prospects
for sharply reduced inflation are perhaps inevitable, but have
the effect of prolonging the pressure on profits
directly on financial markets and employment.
and in-
Remaining doubts
and skepticism that public policy will "carry through" on the
effort to restore stability also affect interest rates, perhaps
most particularly in the longer-term markets.
In fact, the evidence now seems to me strong that the
inflationary tide has turned in a fundamental way.
In stating
that, I do not rely entirely on the exceptionally favorable
consumer and producer price data thus far this year, when the
recorded rates of price increase (at annual rates) declined to
2%, respectively. That apparent improvement was magnified
/
2 and 21
/
31
by some factors likely to prove temporary, including, of course,
the intensity of the recession; those price indices are likely
to appear somewhat less favorable in the second half of the
year.
What seems to me more important for the longer run is
that the trend of underlying costs and nominal wages has begun
to move lower, and that trend should be sustainable 0s the
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-3-
economy recovers upward momentum.
While less easy to
identify -- labor productivity typically does poorly during
periods of business decline -- there are encouraging signs
that both management and workers are giving more intense
attention to the effort to improve productivity.
That effort
should "pay off" in a period of business expansion, helping
to hold down costs and encouraging a revival of profits, setting
the stage for the sustained growth in real income we want.
I am acutely aware that these gains against inflation
have been achieved in a context of serious recession.
Millions
of workers are unemployed, many businesses are hardpressed to
maintain profitability, and business bankruptcies are at a
postwar high.
While it is true that some of the hardship can
reasonably be traced to mistakes in management or personal
judgment, including presumptions that inflation would continue,
large areas of the country and sectors of the economy have been
swept up in more generalized difficulty.
Our financial system
has great strength and resiliency, but particular points of
strain have been evident.
Quite obviously, a successful program to deal with
inflation, with productivity, and with the other economic and
social problems we face cannot be built on a crumbling foundation
of continuing recession.
As you know, there have been some
indications -- most broadly reflected in the rough stability
of the real GNP in the second quarter and small increases in the
leading indicators -- that the downward adjustments may be drawing
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4-
to a close.
The tax reduction effective July 1, higher social
security payments, rising defense spending and orders, and the
reductions in inventory already achieved, all tend to support
the generally held view among economists that some recovery is
.
likely in the second half of the year.
I am also conscious of the fact that the leveling off
of the GNP has masked continuing weakness in important sectors
of the economy.
In its early stages, the prospective recovery
must be led largely by consumer spending.
But to be sustained
over time, and to support continuing growth in productivity and
living standards, more investment will be necessary.
as you know, business investment is moving lower.
At present,
House building
has remained at depressed levels; despite some small gains in
starts during the spring, the cyclical strength "normal" in that
industry in the early stages of recovery is lacking.
Exports
have been adversely affected by the relative strength of the
dollar in exchange markets.
I must also emphasize that the current problems of the
American economy have strong parallels abroad.
Governments
around the world have faced, in greater or lesser degree, both
inflationary and fiscal problems.
As they have come to grips
with those problems, growth has been slow or non-existent, and
the recessionary tendencies in various countries have fed back,
one on another.
In sum, we are in a situation that obviously warrants
concern, but also has great opportunities.
Those opportunities
lie in major part in achieving lasting progress -- in pinning
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-.5-
down and extending what has already been achieved -- toward
price stability.
In doing so, we will be laying the base for
sustaining recovery over many years ahead, and for much lower
interest rates, even as the economy grows.
Conversely, to
fail in that task now, when so much headway has been made,
could only greatly complicate the problems of the economy over
time.
I find it difficult to suggest when and how a credible
attack could be renewed on inflation should we neglect completing
the job now.
Certainly the doubts and skepticism about our
capacity to deal with inflation -- which now seem to be yielding
would be amplified, with unfortunate consequences for financial
markets and ultimately for the economy.
I am certain that many of the questions, concerns and
dangers in your mind lie in the short run -- and that those in
good part revolve around the pressures in financial markets.
Can we look forward to lower interest rates to support the
expansion in investment and housing as the recovery takes hold?
Is there, in fact, enough liquidity in the economy to support
expansion -- but not so much that inflation is reignited?
Will, in fact, the economy follow the recovery path so widely
forecast in coming months?
These are the questions that we in the Federal Reserve
must deal with in setting monetary policy.
As we approach
these policy decisions, we are particularly conscious of the
fact that monetary policy, however important, is only one
instrument of economic policy.
Success in reaching our common
more
objective of a strong and prosperous economy depends upon
11•••
6
than appropriate monetary policies, and I will touch this
morning on what seem
to me appropriately complementary
policies in the public and private sectors.
The Monetary Targets
Five months ago, in presenting our monetary and credit
targets for 1982, I noted some unusual factors could be at
work tending to increase the desire of individuals and businesses
to hold assets in the relatively liquid forms encompassed in the
various definitions of money.
Partly for that reason -- and
recognizing that the conventional base for the M1 target of the
fourth quarter of 1981 was relatively low -- I indicated that
the Federal Open Market Committee contemplated growth toward
the upper ends of the specified ranges.
Given the "bulge"
early in the year in Ml, the Committee also contemplated that
that particular measure of money might for some months remain
above a "straight line" projection of the targeted range from
the fourth quarter of 1981 to the fourth quarter of 1982.
As events developed, M1 and M2 both remained somewhat above
straight line paths until very recently.
M3 and bank credit
have remained generally within the indicated range, although
close to the upper ends.
(See Table I.)
Taking the latest full
month of June, M1 grew 5.6% from the base period and M2 9.4%,
close to the top of the ranges.
To the second quarter as a
whole, the growth was higher, at 6.8% and 9.7%, respectively.
Looked at on a year-over-year basis, which appropriately tends
to average through volatile monthly and quarterly figures, M1
during the first half of 1982 averaged about 4-3/4% above the
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u
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_ 7-
first half of 1981 (after accounting for NOW account shifts
early last year).
On the same basis, M2 and M3 grew by 9.7
nctly
and 10.5 percent, respectively, a rate of growth disti
faster than the nominal GNP over the same interval.
In conducting policy during this period, the Committee
s
was sensitive to indications that the desire of individual
and others for liquidity was unusually high, apparently reflecting concerns and uncertainties about the business and
financial situation.
One reflection of that may be found in
unusually large declines in "velocity" over the period -that is, the ratio of measures of money to the gross national
product.
M1 velocity -- particularly for periods as short as
three to six months -- is historically volatile.
A cyclical
tendency to slow (relative to its upward trend) during recessions
is common.
But an actual decline for two consecutive quarters,
r
as happened late in 1981 and the first quarter of 1982, is rathe
unusual.
The magnitude of the decline during the first quarter
was larger than in any quarter of the entire postwar period.
Moreover, declines in velocity of this magnitude and duration
are often accompanied by (and are related to) reduced shortterm interest rates.
Those interest rate levels during the
first half of 1982 were distinctly lower than during much of
1980 and 1981, but they rose above the levels reached in the
closing months of last year.
More direct evidence of the desire for liquidity or prebehavior
cautionary balances affecting M1 can be found in the
of NOW accounts.
As you know, NOW accounts are a relatively
-8-
new instrument, and we have no experience of behavior over the
course of a full business cycle.
We do know that NOW accounts
are essentially confined to individuals, their turnover relative
to demand accounts is relatively low, and, from the standpoint
of the owner, they have some of the characteristics of savings
deposits, including a similarly low interest rate but easy
access on demand.
We also know the great bulk of the increase
in M1 during the early part of the year -- almost 90% of the
rise from the fourth quarter of 1981 to the second quarter of
1982 -- was concentrated in NOW accounts, even though only
about a fifth of total M1 is held in that form.
In contrast
to the steep downward trend in low-interest savings accounts
in recent years, savings account holdings have stabilized or
even increased in 1982, suggesting the importance of a high
degree of liquidity to many individuals in allocating their
funds.
A similar tendency to hold more savings deposits has
been observed in earlier recessions.
I would add that the financial and liquidity positions of
the household sector of the economy, as measured by conventional
liquid asset and debt ratios, has improved during the recession
period.
Relative to income, debt repayment burdens have declined
to the lowest level since 1976.
are clearly mixed.
Trends among business firms
While many individual firms are under strong
pressure, some rise in liquid asset holdings for the corporate
sector as a whole appears to be developing.
The gap between
internal cash flow (that is, retained earnings and depreciation
allowances) and spending for plant, equipment, and inventory
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-9-
has also been at an historically low level, suggesting that a
portion of recent business credit demands is designed to
bolster liquidity.
But, for many years, business liquidity
ratios have tended to decline, and balance sheet ratios have
reflected more dependence on short-term debt.
In that per-
spective, any recent gains in liquidity appear small.
In the light of the evidence of the desire to hold more
NOW accounts and other liquid balances for precautionary rather
than transaction purposes during the months of recession, strong
efforts to reduce further the growth rate of the monetary aggregates appeared inappropriate.
Such an effort would have
required more pressure on bank reserve positions -- and
presumably more pressures on the money markets and interest
rates in the short run.
At the same time, an unrestrained
build-up of money and liquidity clearly would have been inconsistent with the effort to sustain progress against inflation,
both because liquidity demands could shift quickly and because
our policy intentions could easily have been misconstrued.
Periods of velocity decline over a quarter or two are typically
followed by periods of relatively rapid increase.
Those increases
tend to be particularly large during cyclical recoveries.
Indeed,
velocity appears to have risen slightly during the second quarter,
and the growth in NOW accounts has slowed.
Judgments on these seemingly technical considerations
inevitably take on considerable importance in the target-setting
(including
process because the economic and financial consequences
-10-
the consequences for interest rates) of a particular M1 or M2
increase are dependent on the demand for money.
Over longer
periods, a certain stability in velocity trends can be observed,
but there is a noticeable cyclical pattern.
Taking account of
those normal historical relationships, the various targets
established at the beginning of the year were calculated to be
consistent with economic recovery in a context of declining
inflation.
That remains our judgment today.
Inflation has,
in fact, receded more rapidly than anticipated at the start of
the year potentially leaving more "room" for real growth.
On
that basis, the targets established early in the year still
appeared broadly appropriate, and the Federal Open Market Committee decided at its recent meeting not to change them at this
time.
However, the Committee also felt, in the light of developments
during the first half, that growth around the top of those ranges
would be fully acceptable.
Moreover -- and I would emphasize
this -- growth somewhat above the targeted ranges would be
tolerated for a time in circumstances in which it appeared that
precautionary or liquidity motivations, during a period of
economic uncertainty and turbulence, were leading to stronger
than anticipated demands for money.
We will look to a variety of
factors in reaching that judgment, including such technical factors
as the behavior of different components in the money supply, the
growth of credit, the behavior of banking and financial markets,
and more broadly, the behavior of velocity and interest rates.
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A
-11-
I believe it is timely for me to add that, in these
circumstances, the Federal Reserve should not be expected to
respond, and does not plan to respond, strongly to various
"bulges" -- or for that matter "valleys" -- in monetary growth
that seem likely to be temporary.
As we have emphasized in the
past, the data are subject to a good deal of statistical "noise"
in any circumstances, and at times when demands for money and
liquidity may be exceptionally volatile, more than usual caution
is necessary in responding to "blips."*
We, of course, have a concrete instance at hand of a
relatively large (and widely anticipated) jump in M1 in the
first week of July -- possibly influenced to some degree by
larger social security payments just before a long weekend.
Following as it did a succession of money supply declines, that
increase brought the most recent level for M1 barely above the
June average, and it is not of concern to us.
It is in this context, and in view of recent declines
in short-term market interest rates, that the Federal Reserve
yesterday reduced the basic discount rate from 12 to 111
/
2 percent.
*In that connection, a number of observers have noted
that the first month of a calendar quarter -- most noticeably
in January and April -- sometimes shows an extraordinarily
large increase in M1 -- amplified by the common practice of
multiplying the actual change by 12 to show an annual rate.
Those bulges, more typically than not, are partially "washed
out" by slower than normal growth the following month. The
standard seasonal adjustment techniques we use to smooth out
monthly money supply variations -- indeed, any standard
techniques -- may, in fact, be incapable of keeping up with
rapidly changing patterns of financial behavior, as they
affect seasonal patterns. A note attached to this statement
sets forth some work in process developing new seasonal adjustment techniques.
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-i2-
In looking ahead to 1983, the Open Market Committee
agreed that a decision at this time would -- even more
obviously than usual -- need to be reviewed at the start of
the year in the light of all the evidence as to the behavior
of velocity or money and liquidity demand during the current
year.
Apart from the cyclical influences now at work, the
possibility will need to be evaluated of a more lasting change
in the trend of velocity.
The persistent rise in velocity during the past twenty
years has been accompanied by rising inflation and interest
rates -- both factors that encourage economization of cash
balances.
In addition, technological change in banking --
spurred in considerable part by the availability of computers -has made it technically feasible to do more and more business
on a proportionately smaller "cash" base.
With incentives
strong to minimize holdings of cash balances that bear no or
low interest rates, and given the technical feasibility to do
so, turnover of demand deposits has reached an annual rate of
more than 300, quadruple the rate ten years ago.
Technological
change is continuing, and changes in regulation and bank practices
are likely to permit still more economization of Ml-type balances.
However, lower rates of interest and inflation should moderate
incentives to exploit that technology fully.
In those conditions,
velocity growth could slow, or conceivably at some point stop.
To conclude that the trend has in fact changed would
clearly be premature, but it is a matter we will want to evaluate
carefully as time passes.
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For now, the Committee felt that the
-13-
existing targets should be tentatively retained for next year.
Since we expect to be around the top end of the ranges this
year, those tentative targets would of course be fully consistent
with somewhat slower growth in the monetary aggregates in 1983.
Such a target would be appropriate on the assumption of a more
or less normal cyclical rise in velocity.
With inflation
declining, the tentative targets would appear consistent with,
and should support, continuing recovery at a moderate pace.
The Blend of Monetary and Fiscal Policy
The Congress, in adopting a budget resolution contemplating
cuts in expenditures and some new revenues, also called upon
the Federal Reserve to "reevaluate its monetary targets in
order to assure that they are fully complementary to a new
and more restrained fiscal policy."
I can report that members
of the Committee welcomed the determination of the Congress to
achieve greater fiscal restraint, and I want particularly to
recognize the leadership of members of the Budget Committees
and others in achieving that result.
In most difficult
circumstances, progress is being made toward reducing the
huge potential gap between receipts and expenditures.
But I
would be less than candid if I did not also report a strong
sense that considerably more remains to be done to bring the
deficit under control as the economy expands.
The fiscal
situation as we appraise it, continues to carry the implicit
threat of "crowding out" business investment and housing as
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-14-
the economy grows -- a process that would involve interest
rates substantially higher than would otherwise be the case.
For the more immediate future, we recognized that the need
remains to convert the intentions expressed in the Budget
Resolution into concrete legislative action.
In commenting on the budget, I would distinguish
sharply between the "cyclical" and "structural" deficit
that is, the portion of the deficit reflecting an imbalance
between receipts and expenditures even in a satisfactorily
growing economy with declining inflation.
To the extent the
deficit turns out to be larger than contemplated entirely
because of a shortfall in economic growth, that "add on"
would not be a source of so much concern.
But the hard
fact remains that, if the objectives of the Budget Resolution
are fully reached, the deficit would be about as large in
fiscal 1983 as this year even as the economy expands at a
rate of 4 to 5 percent a year and inflation (and thus inflation
generated revenues) remains higher than members of the Open
Market Committee now expect.
In considering the question posed by the Budget Resolution,
the Open Market Committee felt that full success in the budgetary
effort should itself be a factor contributing to lower interest
rates and reduced strains in financial markets.
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It would thus
*
-15--
reduce inflationary
assist importantly in the common effort to
pressures in the context of a growing economy.
By relieving
ationary expectations I
concern about future financing volume and infl
er budget posture
I believe as a practical matter a credibly firm
the actual shortmight permit a degree of greater flexibility in
sing inflationary
term execution of monetary policy without arou
fears.
Specifically, market anxiety that short-run increases
of the debt
in the Ms might presage continuing monetization
could be ameliorated.
But any gains in these respects will
the intentions
of course be dependent on firmness in implementing
ce among
set forth in the Resolution and on encouraging confiden
and
borrowers and investors that the effort will be sustained
reinforced in coming years.
Taking account of all these considerations, the
rtant
Committee did not feel that the budgetary effort, impo
l greater
as it is, would in itself appropriately justify stil
cipated.
growth in the monetary aggregates over time than I have anti
eof
Indeed, excessive monetary growth -- and perceptions ther
would undercut any benefits from the budgetary effort with
respect to inflationary expectations.
We believe fiscal
restraint should be viewed more as an important complement
to appropriately disciplined monetary policy than as a
substitute.
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-16-
Concluding Comments
In an ideal world, less exclusive reliance on monetary
policy to deal with inflation would no doubt have eased the
strains and high interest rates that plague the economy and
financial markets today.
To the extent the fiscal process
can now be brought more fully to bear on the problem, the
better off we will be -- the more assurance we will have that
interest rates will decline and keep declining during the
period of recovery, and that we will be able to support the
increases in investment and housing essential to healthy,
sustained recovery.
Efforts in the private sector -- to
increase productivity, to reduce costs, and to avoid inflationary
and job-threatening wage increases -- are also vital, even
though the connection between the actions of individual firms
and workers and the performance of the economy may not always
be self-evident to the decision makers.
We know progress is
being made in these areas, and more progress will hasten full
and strong expansion.
But we also know that we do not live in an ideal world.
There is strong resistance to changing patterns of behavior
and expectations ingrained over years of inflation.
The slower
the progress on the budget, the more industry and labor build
in cost increases in anticipation of inflation or Government
acts to protect markets or impede competition, the more highly
speculative financing is undertaken, the greater the threat that
available supplies of money and credit will be exhausted in
financing rising prices instead of new jobs and growth.
Those
in vulnerable competitive positions are most likely to feel the
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-17--
impact first and hardest, but unfortunately the difficulties
spread over the economic landscape.
The hard fact remains that we cannot escape those dilemmas
by a decision to give up the fight on inflation -- by declaring
the battle won before it is.
Such an approach would be trans-
parently clear -- not just to you and me -- but to the investors,
the businessmen and the workers who would, once again, find
their suspicions confirmed that they had better prepare to
live with inflation, and try to keep ahead of it.
The reactions
in financial markets and other sectors of the economy would,
in the end, aggravate our problems, not eliminate them.
It
would strike me as the cruelest blow of all to the millions
who have felt the pain of recession directly to suggest, in
effect, it was all in vain.
I recognize months of recession and high interest rates
have contributed to a sense of uncertainty.
postponed investment plans.
Businesses have
Financial pressures have exposed
lax practices and stretched balance sheet positions in some
institutions -- financial as well as non-financial.
The
earnings position of the thrift industry remains poor.
But none of those problems can be dealt with successfully
by re-inflation or by a lack of individual discipline.
It is
precisely that environment that contributed so much to the
current difficulties.
conIn contrast, we are now seeing new attitudes of cost
industry
tainment and productivity growth -- and ultimately our
will be in a nore robust competitive position.
Millions are
-18-
benefitting from less rapid price increases
actually
lower prices -- at their shopping centers and elsewhere.
Consumer spending appears to be moving ahead, and inventory
reductions help set the stage for production increases.
Those are developments that should help recovery get
firmly underway.
The process of disinflation has enough
momentum to be sustained during the early stages of recovery
11•••••••
and that success can breed further success as concerns about
inflation recede.
As recovery starts, the cash flow of
business should improve.
And, more confidence should encourage
greater wngness among investors to purchase longer debt
matures.
Those factors should, in turn, work toward reducing
interest rates, and sustaining them at lower levels, encouraging
in turn the revival of investment and housing we want.
I have indicated the Federal Reserve is sensitive to the
sI- cial liquidity pressures that could develop during the
current period of uncertainty.
Moreover, the basic solidity
of our financial system is backstopped by a strong structure
of governmental institutions precisely designed to cope with
the secondary effects of isolated failures.
The recent problems
related largely to the speculative actives of a few highly
leveraged firms can and will be contained, and over time, an
appropriate sense of prudence in taking risks will serve us well.
We have been through -- we are in
a trying period.
But
too much has been accomplished not to move ahead and complete
the job of laying the groundwork for a much stronger economy.
As we look forward, not just to the next few months but to long
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-19-
years, the rewards will be great:
in renewed stability, in
growth, and in higher employment and standards of living.
That vision will not be accomplished by monetary policy alone.
,
f.
But we mean to do our part.
.
* *
.
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* *
* * * *
Table I
Targeted and Actual Growth of
Money and Bank Credit
(Percent changes, at seasonally adjusted annual rates)
FOMC Objective
198104 to 198204
198104
to June '82
Actual Growth
198104
to 198202
1981H1
to 1982H1
M1
2-1/2 to
5.6
6.8
4.7**
M2
6 to 9
9.4
9.7
9.7
M3
6-1/2 to 9-1/2
9.7
9.8
10.5
Bank Credit*
6 to 9
8.0
8.3
8.4
*
The base for the bank credit target is the average level of December 1981
as adopted
and January 1982, rather than the average for 198104. This base w11
because of the impact on the series of shifts of assets to the new international banking facilities (IBFs); the 1981H1-to-1982H1 figure has been
adjusted for the impact of the initial shifting of assets to IBFs.
** Adjusted for impact of shifts to new NOW accounts in 1981.
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Appendix
Alternative Seasonal Adjustment Procedure
For some time the Federal Reserve has been investigating ways
to improve its procedures for seasonal adjustment, particularly as they
apply to the monetary aggregates.
In June of last year, a group of pro-
minent outside experts, asked by the Board to examine seasonal adjustment
1/
techniques, submitted their recommendations.—
The committee suggested,
among other things, that the Board's staff develop seasonal factor
estimates from a model-based procedure as an alternative to the widely
used X-11 technique that provides the basis for the current seasonal
2/
and release the results.
,t,i.isit'iiir
procedure,
The Board staff has been developing a procedure using statisti, a1
V
models tailored to each individual series.
The table on the last page
compares monthly and quarterly average growth rates for the current M1
series with those of an alternative series from the model-based approach.
Differences in seasonal adjustment techniques do not change
the trend in monetary growth, but, as may be seen in the table, they do
alter month -to -month growth raLes owing to differing estimates of the
1/
See Committee of Experts on Seasonal Adjustment Techniques, Seasonal
Adjustment of the Monetary Aggregates (Board of Governors of the Federal
Reserve System, October 1981).
2/
The current seasonal adjustment technique has most recently been
summarized in the description to the mimeograph release of historical
money stock data dated March 1982. Detailed descriptions of the X-1)
program and variants can be obtained from technical paper no. 15 of the
U. S. Department of Commerce (rev. February 1967) and from the report
to the Board cited in footnote 1.
3/
The model-based seasonal adjustment procedures currently under review by
the Board staff use methods based on the well-developed theory of statistical regression and time series modeling. These approaches allow
I- velopment of seasonal factors that are more sensitive than the current
factors to unique characteristics of each series, including, for example,
fixed and evolving seasonal patterns, trading day effects, within-month
seasonal variations, holiday effects, outlier adjustments, special events
adjustments (such as the 1980 credit controls experience), and serially
cS rrelated noise components.
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-2distribution over time of the seasonal component in money behavior.
Short-
run money growth is variable under both the alternative and current techniques
of seasonal adjustment, illustrating the inherently large "noise" component
of the series.
However, the redistribution of the seasonal component under
the alternative technique does on average tend to moderate month-to-month
changes somewhat.
The Board will continue to publish seasonally adjusted estimates
for M1 on both current and alternative bases at least until the annual
review of seasonal factors in 1983.
method will be available shortly.
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A detailed description of the alternative
Growth Rates of M1 Using
1
Current and AlternativeL
Seasonal Adjustment Procedures
(Monthly Average - Percent Annual Rates)
1982
1981
‘
Jan.
Feb.
Mar.
Apr.
May
June
July
Aug.
Sept.
Oct.
Nov.
Dec.
Current
Alternative
9.8
4.3
14.3
25.2
-11.4
-2.2
2.8
4.8
0.3
4.7
9.7
12.4
1.4
7.5
16.0
22.6
-10.3
-0.6
2.2
5.3
3.1
0.0
11.1
15.4
Current
Jan.
Feb.
Mar.
Apr.
May
June
21.0
-3.5
2.7
11.0
-2.4
-1.6
Alternative
11.4
1.3
6.4
4.5
0.5
1.3
(Quarterly Average - Percent Annual Rates)
QI
QII
QIII
QIV
4.6
9.2
0.3
5.7
3.5
9.6
0.9
5.5
QI
QII
10.4
3.1
9.5
3.4
1/
_
Current monthly soasonal factors are derived using an X-11/ARIMAbased procedure applied to monthly data.
2/
Alternative monthly seasonal factors are derived using a modelbased procedure applied to weekly data.
I
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Board of Governors
of the Federal Reserve System
Washington, D.C. 20551
Official Business
Penalty for Private Use, $300
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Postage and Faits Paid
Board of Governer,
at the Federal Reserve System
First Class
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For release on delivery
9:30 AM, E.D.T.
July 20, 1982
Statement by
Paul A. Volcker
Chairman, Board of Governors of the Federal Reserve System
before the
Committee on Banking, Housing, and Urban Affairs
United States Senate
July 20, 1982
I am pleased to have this opportunity once again to
discuss monetary policy with you within the context of recent
and prospective economic developments.
As usual on these
occasions, you have the Board of Governors' "Humphrey-Hawkins"
•
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Report before you.
This morning I want to enlarge upon some
aspects of that Report and amplify as fully as I can my thinking
with respect to the period ahead.
In assessing the current economic situation, I believe
the comments I made five months ago remain relevant.
Without
repeating that analysis in detail, I would emphasize that we
stand at an important crossroads for the economy and economic
policy.
In these past two years we have traveled a considerable
way toward reversing the inflationary trend of the previous
decade or more.
I would recall to you that, by the late 1970s,
that trend had shown every sign of feeding upon itself and
tending to accelerate to the point where it threatened to
undermine the foundations of our economy.
Dealing with inflation
was accepted as a top national priority, and, as events developed,
that task fell almost entirely to monetary policy.
In the best of circumstances, changing entrenched patterns
of inflationary behavior and expectations -- in financial markets,
in the practices of business and financial institutions, and in
laboT negotiations -- is a difficult and potentially painful
process.
Those, consciously or not, who had come to "bet" on
rising prices and the ready availability of relatively cheap
2
credit to mask the risks of rising costs, poor productivity,
aggressive lending, or over-extended financial positions have
found themselves in a particularly difficult position.
The pressures on financial markets and interest rates
have been aggravated by concerns over prospective huge volumes
of Treasury financing, and by the need of some businesses to
borrow at a time of a severe squeeze on profits.
Lags
na
adjustment of nominal wages and other costs to the prospects
for sharply reduced inflation are perhaps inevitable, but have
the effect of prolonging the pressure on profits -- and indirectly on financial markets and employment.
Remaining doubts
and skepticism that public policy will "carry through" on the
effort to restore stability also affect interest rates, perhaps
most particularly in the longer-term markets.
In fact, the evidence now seems to me strong that the
inflationary tide has turned in a fundamental way.
In stating
that, I do not rely entirely on the exceptionally favorable
consumer and producer price data thus far this year, when the
recorded rates of price increase (at annual rates) declined to
2%, respectively. That apparent improvement was magnified
/
2 and 21
/
31
by some factors likely to prove temporary, including, of course,
the intensity of the recession; those price indices are likely
to appear somewhat less favorable in the second half of the
year.
What seems to me more important for the longer run is
that the trend of underlying costs and nominal wages has begun
to m5ve l5wer, and that trend should be sustainable as the
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-3-
economy recovers upward momentum.
While less easy to
identify -- labor productivity typically does poorly during
periods of business decline -- there are encouraging signs
that both management and workers are giving more intense
attention to the effort to improve productivity.
That effort
should "pay off" in a period of business expansion, helping
to hold down costs and encouraging a.revival of profits, setting
the stage for the sustained growth in real income we want.
I am acutely aware that these gains against inflation
have been achieved in a context of serious recession.
Millions
of workers are unemployed, many businesses are hardpressed to
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maintain profitability, and business bankruptcies are at a
postwar high.
While it is true that some of the hardship can
reasonably be traced to mistakes in management or personal
judgment, including presumptions that inflation would continue,
large areas of the country and sectors of the economy have been
swept up in more generalized difficulty.
Our financial system
has great strength and resiliency, but particular points of
strain have been evident.
Quite obviously, a successful program to deal with
inflation, with productivity, and with the other economic and
social problems we face cannot be built on a crumbling foundation
of continuing recession.
As you know, there have been some
indications -- most broadly reflected in the rough stability
of the real GNP in the second quarter and small increases in the
leading indicators -- that the downward adjustments may be drawing
4-
to a close.
The tax reduction effective July 1, higher social
security payments, rising defense spending and orders, and the
reductions in inventory already achieved, all tend to support
the generally held view among economists that some recovery is
likely in the second half of the year.
I am also conscious of the fact that the leveling off
of the GNP has masked continuing weakness in important sectors
of the economy.
In its early stages, the prospective recovery
must be led largely by consumer spending.
But to be sustained
over time, and to support continuing growth in productivity and
living standards, more investment will be necessary.
as you know, business investment is moving lower.
At present,
House building
has remained at depressed levels; despite some small gains in
starts during the spring, the cyclical strength "normal" in that
industry in the early stages of recovery is lacking.
Exports
have been adversely affected by the relative strength of the
dollar in exchange markets.
I must also emphasize that the current problems of the
American economy have strong parallels abroad.
Governments
around the world have faced, in greater or lesser degree, both
inflationary and fiscal problems.
As they have come to grips
with those problems, growth has been slow or non-existent, and
the recessionary tendencies in various countries have fed back,
one on another.
In sum, we are in a situation that obviously warrants
concern, but also has great opportunities.
Those opportunities
lie in major part in achieving lasting progress -- in pinning
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-5-
down and extending what has already been achieved -- toward
price stability.
In doing so, we will be laying the base for
sustaining recovery over many years ahead, and for much lower
interest rates, even as the economy grows.
Conversely, to
fail in that task now, when so much headway has been made,
could only greatly complicate the problems of the economy over
time.
I find it difficult to suggest when and how a credible
attack could be renewed on inflation should we neglect completing
the job now.
Certainly the doubts and skepticism about our
capacity to deal with inflation -- which now seem to be yielding
would be amplified, with unfortunate consequences for financial
markets and ultimately for the economy.
I am certain that many of the questions, concerns and
dangers in your mind lie in the short run -- and that those in
good part revolve around the pressures in financial markets.
Can we look forward to lower interest rates to support the
expansion in investment and housing as the recovery takes hold?
Is there, in fact, enough liquidity in the economy to support
expansion -- but not so much that inflation is reignited?
Will, in fact, the economy follow the recovery path so widely
forecast in coming months?
These are the questions that we in the Federal Reserve
must deal with in setting monetary policy.
As we approach
these policy decisions, we are particularly conscious of the
fact that monetary policy, however important, is only one
instrument of economic policy.
Success in reaching our common
objective of a strong and prosperous economy depends upon more
than appropriate monetary policies, and I will touch this
morning on what seem
to me appropriately complementary
policies in the public and private sectors.
The Monetary Targets
Five months ago, in presenting our monetary and credit
targets for 1982, I noted some unusual factors could be at
work tending to increase the desire of individuals and businesses
to hold assets in the relatively liquid forms encompassed in the
various definitions of money.
Partly for that reason -- and
recognizing that the conventional base for the M1 target of the
fourth quarter of 1981 was relatively low -- I indicated that
the Federal Open Market Committee contemplated growth toward
the upper ends of the specified ranges.
Given the "bulge"
early in the year in Ml, the Committee also contemplated that
that particular measure of money might for some months remain
above a "straight line" projection of the targeted range from
the fourth quarter of 1981 to the fourth quarter of 1982.
As events developed, M1 and M2 both remained somewhat above
straight line paths until very recently.
M3 and bank credit
have remained generally within the indicated range, although
close to the upper ends.
(See Table I.)
Taking the latest full
month of June, M1 grew 5.6% from the base period and M2 9.4%,
close to the top of the ranges.
To the second quarter as a
whole, the growth was higher, at 6.8% and 9.7%, respectively.
Looked at on a year-over-year basis, which appropriately tends
to average through volatile monthly and quarterly figures, M1
during the first half of 1982 averaged about 4-3/4% above the
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7
shifts
first half of 1981 (after accounting for NOW account
early last year).
On the same basis, M2 and M3 grew by 9.7
th distinctly
and 10.5 percent, respectively, a rate of grow
.
faster than the nominal GNP over the same interval
ittee
In conducting policy during this period, the Comm
individuals
was sensitive to indications that the desire of
ly reand others for liquidity was unusually high, apparent
and
flecting concerns and uncertainties about the business
financial situation.
One reflection of that may be found in
-unusually large declines in "velocity" over the period
national
that is, the ratio of measures of money to the gross
product.
M1 velocity -- particularly for periods as short as
three to six months -- is historically volatile.
A cyclical
recessions
tendency to slow (relative to its upward trend) during
is common.
But an actual decline for two consecutive quarters,
1982, is rather
as happened late in 1981 and the first quarter of
unusual.
ter
The magnitude of the decline during the first quar
period.
was larger than in any quarter of the entire postwar
and duration
Moreover, declines in velocity of this magnitude
tare often accompanied by (and are related to) reduced shor
term interest rates.
Those interest rate levels during the
much of
first half of 1982 were distinctly lower than during
in the
1980 and 1981, but they rose above the levels reached
closing months of last year.
or preMore direct evidence of the desire for liquidity
behavior
cautionary balances affecting M1 can be found in the
of NOW accounts.
As you know, NOW accounts are a relatively
8-
new instrument, and we have no experience of behavior over the
course of a full business cycle.
We do know that NOW accounts
are essentially confined to individuals, their turnover relative
to demand accounts is relatively low, and, from the standpoint
of the owner, they have some of the characteristics of savings
deposits, including a similarly low interest rate but easy
access on demand.
We also know the great bulk of the increase
in M1 during the early part of the year -- almost 90% of the
rise from the fourth quarter of 1981 to the second quarter of
1982 -- was concentrated in NOW accounts, even though only
about a fifth of total M1 is held in that form.
In contrast
to the steep downward trend in low-interest savings accounts
in recent years, savings account holdings have stabilized or
even increased in 1982, suggesting the importance of a high
degree of liquidity to many individuals in allocating their
funds.
A similar tendency to hold more savings deposits has
been observed in earlier recessions.
I would add that the financial and liquidity positions of
the household sector of the economy, as measured by conventional
liquid asset and debt ratios, has improved during the recession
period.
Relative to income, debt repayment burdens have declined
to the lowest level since 1976.
are clearly mixed.
Trends among business firms
While many individual firms are under strong
pressure, some rise in liquid asset holdings for the corporate
sector as a whole appears to be developing.
The gap between
internal cash flow (that is, retained earnings and depreciation
allowances) and spending for plant, equipment, and inventory
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-9
has also been at an historically low level, suggesting that a
portion of recent business credit demands is designed to
bolster liquidity.
But, for many years, business liquidity
ratios have tended to decline, and balance sheet ratios have
reflected more dependence on short-term debt.
In that per-
spective, any recent gains in liquidity appear small.
In the light of the evidence of the desire to hold more
NOW accounts and other liquid balances for precautionary rather
than transaction purposes during the months of recession, strong
efforts to reduce further the growth rate of the monetary aggregates appeared inappropriate.
Such an effort would have
required more pressure on bank reserve positions -- and
presumably more pressures on the money markets and interest
rates in the short run.
At the same time, an unrestrained
build-up of money and liquidity clearly would have been inconsistent with the effort to sustain progress against inflation,
both because liquidity demands could shift quickly and because
our policy intentions could easily have been misconstrued.
Periods of velocity decline over a quarter or two are typically
followed by periods of relatively rapid increase.
Those increases
tend to be particularly large during cyclical recoveries.
Indeed,
velocity appears to have risen slightly during the second quarter,
and the growth in NOW accounts has slowed.
Judgments on these seemingly technical considerations
ng
inevitably take on considerable importance in the target-setti
(including
process because the economic and financial consequences
-10-
the consequences for interest rates) of a particular Ml or M2
increase are dependent on the demand for money.
Over longer
periods, a certain stability in velocity trends can be observed,
but there is a noticeable cyclical pattern.
Taking account of
those normal historical relationships, the various targets
established at the beginning of the year were calculated to be
consistent with economic recovery in a context of declining
inflation.
That remains our judgment today.
Inflation has,
in fact, receded more rapidly than anticipated at the start of
the year potentially leaving more "room" for real growth.
On
that basis, the targets established early in the year still
appeared broadly appropriate, and the Federal Open Market Committee decided at its recent meeting not to change them at this
time.
However, the Committee also felt, in the light of developments
during the first half, that growth around the top of those ranges
would be fully acceptable.
Moreover -- and I would emphasize
this -- growth somewhat above the targeted ranges would be
tolerated for a time in circumstances in which it appeared that
precautionary or liquidity motivations, during a period of
economic uncertainty and turbulence, were leading to stronger
than anticipated demands for money.
We will look to a variety of
factors in reaching that judgment, including such technical factors
as the behavior of different components in the money supply, the
growth of credit, the behavior of banking and financial markets,
and more broadly, the behavior of velocity and interest rates.
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-11-
I believe it is timely for me to add that, in these
circumstances, the Federal Reserve should not be expected to
respond, and does not plan to respond, strongly to various
"bulges" -- or for that matter "valleys" -- in monetary growth
that seem likely to be temporary.
As we have emphasized in the
past, the data are subject to a good deal of statistical "noise"
in any circumstances, and at times when demands for money and
liquidity may be exceptionally volatile, more than usual caution
is necessary in responding to "blips."*
We, of course, have a concrete instance at hand of a
relatively large (and widely anticipated) jump in M1 in the
first week of July -- possibly influenced to some degree by
larger social security payments just before a long weekend.
Following as it did a succession of money supply declines, that
increase brought the most recent level for M1 barely above the
June average, and it is not of concern to us.
It is in this context, and in view of recent declines
in short-term market interest rates, that the Federal Reserve
yesterday reduced the basic discount rate from 12 to 111
/
2 percent.
*In that connection, a number of observers have noted
that the first month of a calendar quarter -- most noticeably
in January and April -- sometimes shows an extraordinarily
large increase in M1 -- amplified by the common practice of
multiplying the actual change by 12 to show an annual rate.
Those bulges, more typically than not, are partially "washed
out" by slower than normal growth the following month. The
standard seasonal adjustment techniques we use to smooth out
monthly money supply variations -- indeed, any standard
techniques -- may, in fact, be incapable of keeping up with
rapidly changing patterns of financial behavior, as they
affect seasonal patterns. A note attached to this statement
sets forth some work in process developing new seasonal adjustment techniques-
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-12-
In looking ahead to 1983, the Open Market Committee
agreed that a deon at this time would -- even more
obviously than usual -- need to be reviewed at the start of
the year in the light of all the evidence as to the behavior
of velocity or money and liquidity demand during the current
year.
Apart from the cyclical influences now at work, the
possibility will need to be evaluated of a more lasting change
in the trend of velocity.
The persistent rise in velocity during the past twenty
years has been accompanied by rising inflation and interest
rates -- both factors that encourage economization of cash
I.lances.
In addition, technological change in banking --
spurred in considerable part by the availability of computers -has made it technically feasible to do more and more business
on a proportionately smaller "cash" base.
With incentives
strong to minimize holdings of cash balances that bear no or
low interest rates, and given the technical feasibility to IS
so, turnover of demand deposits has reached an annual rate of
more than 300, quadruple the rate ten years ago.
Technological
change is continuing, and changes in regulation and bank practices
are likely to permit still more economization of Ml-type balances.
However, lower rates of interest and inflation should moderate
incentives to exploit that technology fully.
In those conditions,
velocity growth could slow, or conceivably at some point
I.
To conclude that the trend has in fact changed would
clearly be premature, but it is a matter we will want to evaluate
carefully as time passes.
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For now, the Committee felt that the
-13--
existing targets should be tentatively retained for next year.
Since we expect to be around the top end of the ranges this
year, those tentative targets would of course be fully consistent
with somewhat slower growth in the monetary aggregates in 1983.
Such a target would be appropriate on the assumption of a more
or less normal cyclical rise in velocity.
With inflation
declining, the tentative targets would appear consistent with,
and should support, continuing recovery at a moderate pace.
The Blend of Monetary and Fiscal Policy
The Congress, in adopting a budget resolution contemplating
cuts in expenditures and some new revenues, also called upon
the Federal Reserve to "reevaluate its monetary targets in
order to assure that they are fully complementary to a new
and more restrained fiscal policy."
I can report that members
of the Committee welcomed the determination of the Congress to
achieve greater fiscal restraint, and I want particularly to
recognize the leadership of members of the Budget Committees
and others in achieving that result.
In most difficult
circumstances, progress is being made toward reducing the
huge potential gap between receipts and expenditures.
But I
would be less than candid if I did not also report a strong
sense that considerably more remains to be done to bring the
deficit under control as the economy expands.
The fiscal
situation as we appraise it, continues to carry the implicit
as
threat of "crowding out" business investment and housing
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•
-14-
the economy grows -- a process that would involve interest
rates substantially higher than would otherwise be the case.
For the more immediate future, we recognized that the need
remains to convert the intentions expressed in the Budget
Resolution into concrete legislative action.
In commenting on the budget, I would distinguish
sharply between the "cyclical" and "structural" deficit
that is, the portion of the deficit reflecting an imbalance
between receipts and expenditures even in a satisfactorily
growing economy with declining inflation.
To the extent the
deficit turns out to be larger than contemplated entirely
because of a shortfall in economic growth, that "add on"
would not be a source of so much concern.
But the hard
fact remains that, if the objectives of the Budget Resolution
are fully reached, the deficit would be about as large in
fiscal 1983 as this year even as the economy expands at a
rate of 4 to 5 percent a year and inflation (and thus inflation
generated revenues) remains higher than members of the Open
Market Committee now expect.
In considering the question posed by the Budget Resolution,
the Open Market Committee felt that full success in the budgetary
effort should itself be a factor contributing to lower interest
rates and reduced strains in financial markets.
It would thus
...
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%
-15-
reduce inflationary
assist importantly in the common effort to
pressures in the context of a growing economy.
By relieving
ationary expectations,
concern about future financing volume and infl
er budget posture
I believe as a practical matter a credibly firm
the actual shortmight permit a degree of greater flexibility in
sing inflationary
term execution of monetary policy without arou
fears.
Specifically, market anxiety that short-run increases
of the debt
in the Ms might presage continuing monetization
could be ameliorated.
But any gains in these respects will
ntions
of course be dependent on firmness in implementing the inte
ce among
set forth in the Resolution and on encouraging confiden
borrowers and investors that the effort will be sustained and
reinforced in coming years.
Taking account of all these considerations, the
rtant
Committee did not feel that the budgetary effort, impo
l greater
as it is, would in itself appropriately justify stil
anticipated.
growth in the monetary aggregates over time than I have
eof -Indeed, excessive monetary growth -- and perceptions ther
would undercut any benefits from the budgetary effort with
respect to inflationary expectations.
We believe fiscal
restraint should be viewed more as an important complement
to appropriately disciplined monetary policy than as a
substitute.
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-16-
Concluding Comments
In an ideal world, less exclusive reliance on monetary
policy to deal with inflation would no doubt have eased the
strains and high interest rates that plague the economy and
financial markets today.
To the extent the fiscal process
can now be brought more fully to bear on the problem, the
better off we will be -- the more assurance we will have that
interest rates will decline and keep declining during the
period of recovery, and that we will be able to support the
increases in investment and housing essential to healthy,
sustained recovery.
Efforts in the private sector -- to
increase productivity, to reduce costs, and to avoid inflationary
and job-threatening wage increases -- are also vital, even
though the connection between the actions of individual firms
and workers and the performance of the economy may not always
be self-evident to the decision makers.
We know progress is
being made in these areas, and more progress will hasten full
and strong expansion.
But we also know that we do not live in an ideal world.
There is strong resistance to changing patterns of behavior
and expectations ingrained over years of inflation.
The slower
the progress on the budget, the more industry and labor build
in cost increases in anticipation of inflation or Government
acts to protect markets or impede competition, the more highly
speculative financing is undertaken, the greater the threat that
available supplies of money and credit will be exhausted in
financing rising prices instead of new jobs and growth.
Those
in vulnerable competitive positions are most likely to feel the
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Federal Reserve Bank of St. Louis
-17-
impact first and hardest, but unfortunately the difficulties
spread over the economic landscape.
The hard fact remains that we cannot escape those dilemmas
by a decision to give up the fight on inflation -- by declaring
the battle won before it is.
Such an approach would be trans-
parently clear -- not just to you and me -- but to the investors,
the businessmen and the workers who would, once again, find
their suspicions confirmed that they had better prepare to
live with inflation, and try to keep ahead of it.
The reactions
in financial markets and other sectors of the economy would,
in the end, aggravate our problems, not eliminate them.
It
would strike me as the cruelest blow of all to the millions
who have felt the pain of recession directly to suggest, in
effect, it was all in vain.
I recognize months of recession and high interest rates
have contributed to a sense of uncertainty.
postponed investment plans.
Businesses have
Financial pressures have exposed
lax practices and stretched balance sheet positions in some
institutions -- financial as well as non-financial.
The
earnings position of the thrift industry remains poor.
But none of those problems can be dealt with successfully
.
by re-inflation or by a lack of individual discipline
It is
the
precisely that environment that contributed so much to
current difficulties.
conIn contrast, we are now seeing new attitudes of cost
industry
tainment and productivity growth -- and ultimately our
will be in a nore robust competitive position.
Millions are
-18-
benefitting from less rapid price increases -- or actually
lower prices -- at their shopping centers and elsewhere.
Consumer spending appears to be moving ahead, and inventory
reductions help set the stage for production increases.
Those are developments that should help recovery get
.
firmly underway.
1
The process of disinflation has enough
momentum to be sustained during the early stages of recovery
111••••
and that success can breed further success as concerns about
inflation recede.
As recovery starts, the cash flow of
business should improve.
And, more confidence should encourage
greater willingness among investors to purchase longer debt
maturities.
Those factors should, in turn, work toward reducing
interest rates, and sustaining them at lower levels, encouraging
in turn the revival of investment and housing we want.
I have indicated the Federal Reserve is sensitive to the
special liquidity pressures that could develop during the
current period of uncertainty.
Moreover, the basic solidity
of our financial system is backstopped by a strong structure
of governmental institutions precisely designed to cope with
the secondary effects of isolated failures.
The recent problems
related largely to the speculative activities of a few highly
leveraged firms can and will be contained, and over time, an
aISropriate sense of prudence in taking risks will serve us well.
We have been through -- we aretrying period.
But
too much has been accomplished not to move ahead and complete
the job of laying the groundwork for a much stronger economy.
As we look forward, not just to the next few months but to long
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-1S-
years, the rewards will be great:
in renewed stability, in
growth, and in higher employment and standards of living.
That vision will not be accomplished by monetary policy alone.
,
But we mean to do our part.
i
*
,
0
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*
*
*
* * * *
Table I
Targeted and Actual Growth of
Money and Bank Credit
(Percent changes, at seasonally adjusted annual rates)
FOMC Objective
198104 to 198204
1981H1
to 1982H1
M1
2-1/2 to 5-1/2
5.6
6.8
4.7**
M2
6 to 9
9.4
9.7
9.7
M3
6-1/2 to 9-1/2
9.7
9.8
10.5
Bank Credit*
6 to 9
8.0
8.3
8.4
*
The base for the bank credit target is the average level of December 1981
and January 1982, rather than the average for 198104. This base was adopted
because of the impact on the series of shifts of assets to the new international banking facilities (IBFs); the 1981H1-to-1982H1 figure has been
adjusted for the impact of the initial shifting of assets to IBFs.
** Adjusted for impact of shifts to new NOW accounts in 1981.
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0
198104
to June '82
Actual Growth
198104
to 198202
4
Appendix
Alternative Seasonal Adjustment Procedure
For some time the Federal Reserve has been investigating ways
to improve its procedures for seasonal adjustment, particularly as they
apply to the monetary aggregates.
In June of last year, a group of pro-
minent outside experts, asked by the Board to examine seasonal adjustment
techniques, submitted their recommendations.
The committee suggested,
among other things, that the Board's staff develop seasonal factor
estimates from a model-based procedure as an alternative to the widely
used X-11 technique that provides the basis for the current seasonal
2/
adjErIrnrtustment procedure,— and release the results.
The Board staff has been developing a procedure using statisti, al
V
models tailored to each individual series.
The table on the last page
compares monthly and quarterly average growth rates for the current M1
series with those of an alternative series from the model-based approach.
Differences in seasonal adjustment techniques do not change
the trend in monetary growth, but, as may be seen in the table, they do
alter month -to-month growth raLes owing to differing estimates of the
1/
See Committee of Experts on Seasonal Adjustrrent Techniques, Seasonal
Adjustment of the Monetary Aggregates (Board of Governors of the Federal
Reserve System, October 1981).
2/
The current seasonal adjustment technique has most recently been
summarized in the description to the mimeograph release of historical
money stock data dated March 1982. Detailed descriptions of the X-1]
program and variants can be obtained from technical paper no. 15 of the
Department of Commerce (rev. February 1967) and from the report
to the Board cited in footnote 1.
3/
The model-based seasonal adjustment procedures currently under review by
the Board staff use methods based on the well-developed theory of sta
tical regression and time series modeling. These approaches allow
I- velopment of seasonal factors that are more sensitive than the current
factors to unique characteristics of each series, including, for example,
fixed and evolving seasonal patterns, trading day effects, within-month
seasonal variations, holiday effects, outlier adjustments, special events
adjustments (such as the 1980 credit controls experience), and serially
correlated noise components,
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Federal Reserve Bank of St. Louis
-2distribution over time of the seasonal component in money behavior.
Short-
run money growth is variable under both the alternative and current techniques
of seasonal adjustment, illustrating the inherently large "noise" component
of the series.
However, the redistribution of the seasonal component under
the alternative technique does on average tend to moderate month-to-month
changes somewhat.
Ii
The Board will continue to publish seasonally adjusted estimates
for M1 on both current and alternative bases at least until the annual
review of seasonal factors in 1983.
A detailed description of the alternative
method will be available shortly.
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(
Growth Rates of M1 Using
1
Current and Alternative4
Seasonal Adjustment Procedures
(Monthly Average - Percent Annual Rates)
1982
1981
a
I
Jan.
Feb.
Mar.
Apr.
May
June
July
Aug.
Sept.
Oct.
Nov.
Dec.
Current
Alternative
9.8
4.3
14.3
25.2
-11.4
-2.2
2.8
4.8
0.3
4.7
9.7
12.4
1.4
7.5
16.0
22.6
-10.3
-0.6
2.2
5.3
3.1
0.0
11.1
15.4
Jan.
Feb.
Mar.
Apr.
May
June
Current
Alternative
21.0
-3.5
2.7
11.0
-2.4
-1.6
11.4
1.3
6.4
4.5
0.5
1.3
(Quarterly Average - Percent Annual Rates)
QI
QII
QIII
QIV
4.6
9.2
0.3
5.7
3.5
9.6
0.9
5.5
QI
QII
10.4
3.1
9.5
3.4
1/
_
Current monthly soasonal factors are derived using an X-11/ARIMAbased procedure applied to monthly data.
2/
Alternative monthly seasonal factors are derived using a modelbased procedure applied to weekly data.
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Board of Governor.,
of the Federal Reserve System
Washington, D.C. 20551
Official Business
Penalty for Private Use, $300
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•
For release on delivery
9:30 AM, E.D.T.
July 20, 1982
Statement by
Paul A. Volcker
Chairman, Board of Governors of the Federal Reserve System
before the
Committee on Banking, Housing, and Urban Affairs
United States Senate
July 20, 1982
fa
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I am pleased to have this opportunity once again to
discuss monetary policy with you within the context of recent
and prospective economic developments.
As usual on these
occasions, you have the Board of Governors' "Humphrey-Hawkins"
Report before you.
This morning I want to enlarge upon some
aspects of that Report and amplify as fully as I can my thinking
with respect to the period ahead.
In assessing the current economic situation, I believe
the comments I made five months ago remain relevant.
Without
repeating that analysis in detail, I would emphasize that we
stand at an important crossroads for the economy and economic
policy.
In these past two years we have traveled a considerable
way toward reversing the inflationary trend of the previous
decade or more.
I would recall to you that, by the late 1970s,
that trend had shown every sign of feeding upon itself and
tending to accelerate to the point where it threatened to
undermine the foundations of our economy.
Dealing with inflation
was accepted as a top national priority, and, as events developed,
that task fell almost entirely to monetary policy.
In the best of circumstances, changing entrenched patterns
of inflationary behavior and expectations -- in financial markets,
in the practices of business and financial institutions, and in
labor negotiations -- is a difficult and potentially painful
pr.:)cess.
Those, consciously or not, who had come to "bet" on
rising prices and the ready availability of relatively cheap
2
credit to mask the risks of rising costs, poor productivity,
aggressive lending, or over-extended financial positions have
found themselves in a particularly difficult position.
The pressures on financial markets and interest rates
have been aggravated by concerns over prospective huge volumes
of Treasury financing, and by the need of some businesses to
borrow at a time of a severe squeeze on profits.
Lags in the
adjustment of nominal wages and other costs to the prospects
for sharply reduced inflation are perhaps inevitable, but have
the effect of prolonging the pressure on profits -- and indirectly on financial markets and employment.
Remaining doubts
and skepticism that public policy will "carry through" on the
effort to restore stability also affect interest rates, perhaps
most particularly in the longer-term markets.
In fact, the evidence now seems to me strong that the
inflationary tide has turned in a fundamental way.
In stating
that, I do not rely entirely on the exceptionally favorable
consumer and producer price data thus far this year, when the
recorded rates of price increase (at annual rates) declined to
2%, respectively. That apparent improvement was magnified
/
2 and 21
/
31
by some factors likely to prove temporary, including, of course,
the intensity of the recession; those price indices are likely
to appear somewhat less favorable in the second half of the
year.
What seems to me more important for the longer run is
that the trend of underlying costs and nominal wages has begun
to move lower, and that trend should be sustainable as the
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economy recovers upward momentum.
While less easy to
identify -- labor productivity typically does poorly during
periods of business decline -- there are encouraging signs
that both management and workers are gg more intense
attention to the effort to improve productivity.
should
S.
That effort
off" in a period of business expansion, helping
to hold down costs and encouraging a revival of profits, setting
the stage for the sustained growth in real income we want.
I am acutely aware that these gains against inflation
have been achieved in a context of serious recession.
Millions
of workers are unemployed, many businesses are hardpressed to
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maintain profitability, and business bankruptcies are at a
postwar high.
While it is true that some of the hardship can
reasonably be traced to mistakes in management or personal
judgment, including presumptions that inflation would continue
large areas of the country and sectors of the economy have been
swept up in more generalized difficulty.
Our financial system
has great strength and reency, but particular points of
strain have been evident.
Quite obviously, a successful program to deal with
inflation, with productivity, and with the other economic and
social problems we face cannot be built on a crumbling foundation
of continuing recession.
As you know, there have been some
indications -- most broadly reflected in the rough stability
of the real GNP in the second quarter and small increases in the
leading indicators -- that the downward adjustments may be drawing
4-
to a close.
The tax reduction effective July 1, higher social
security payments, rising defense spending and orders, and the
reductions in inventory already achieved, all tend to support
the generally held view among economists that some recovery is
likely in the second half of the year.
I am also conscious of the fact that the leveling off
of the GNP has masked continuing weakness in important sectors
of the economy.
In its early stages, the prospective recovery
must be led largely by consumer spending.
But to be sustained
over time, and to support continuing growth in productivity and
living standards, more investment will be necessary.
as you know, business investment is moving lower.
At present,
House building
has remained at depressed levels; despite some small gains in
starts during the spring, the cyclical strength "normal" in that
industry in the early stages of recovery is lacking.
Exports
have been adversely affected by the relative strength of the
dollar in exchange markets.
I must also emphasize that the current problems of the
American economy have strong parallels abroad.
Governments
around the world have faced, in greater or lesser degree, both
inflationary and fiscal problems.
As they have come to grips
with those problems, growth has been slow or non-existent, and
the recessionary tendencies in various countries have fed back,
one on another.
In sum, we are in a situation that obviously warrants
concern, but also has great opportunities.
Those opportunities
lie in major part in achieving lasting progress -- in pinning
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down and extending what has already been achieved -- toward
price stability.
In doing so, we will be laying the base for
sustaining recovery over many years ahead, and for much lower
interest rates, even as the economy grows.
Conversely, to
fail in that task now, when so much headway has been made,
could only greatly complicate the problems of the economy over
time.
I find it difficult to suggest when and how a credible
attack could be renewed on inflation should we neglect completing
the job now.
Certainly the doubts and skepticism about our
capacity to deal with inflation -- which now seem to be yielding
would be amplified, with unfortunate consequences for financial
markets and ultimately for the economy.
I am certain that many of the questions, concerns and
dangers in your mind lie in the short run -- and that those in
good part revolve around the pressures in financial markets.
Can we look forward to lower interest rates to support the
expansion in investment and housing as the recovery takes hold?
Is there, in fact, enough liquidity in the economy to support
expansion -- but not so much that inflation is reignited?
Will, in fact, the economy follow the recovery path so widely
forecast in coming months?
These are the questions that we in the Federal Reserve
must deal with in setting monetary policy.
As we approach
these policy decisions, we are particularly conscious of the
fact that monetary policy, however important, is only one
instrument of economic policy.
Success in reaching our common
more
objective of a strong and prosperous economy depends upon
IMM,
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than appropriate monetary policies, and I will touch this
morning on what seem
to me appropriately complementary
policies in the public and private sectors.
The Monetary Targets
Five months ago, in presenting our monetary and credit
targets for 1982, I noted some unusual factors could be at
work tending to increase the desire of individuals and businesses
to hold assets in the relatively liquid forms encompassed in the
various definitions of money.
Partly for that reason -- and
recognizing that the conventional base for the M1 target of the
fourth quarter of 1981 was relatively low -- I indicated that
the Federal Open Market Committee contemplated growth toward
the upper ends of the specified ranges.
Given the "bulge"
early in the year in Ml, the Committee also contemplated that
that particular measure of money might for some months remain
above a "straight line" projection of the targeted range from
the fourth quarter of 1981 to the fourth quarter of 1982.
As events developed, M1 and M2 both remained somewhat above
straight line paths until very recently.
M3 and bank credit
have remained generally within the indicated range, although
close to the upper ends.
(See Table I.)
Taking the latest full
month of June, M1 grew 5.6% from the base period and M2 9.4%,
close to the top of the ranges.
To the second quarter as a
whole, the growth was higher, at 6.8% and 9.7%, respectively.
Looked at on a year-over-year basis, which appropriately tends
to average through volatile monthly and quarterly figures, M1
during the first half of 1982 averaged about 4-3/4% above the
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shifts
first half of 1981 (after accounting for NOW account
early last year).
On the same basis, M2 and M3 grew by 9.7
th distinctly
and 10.5 percent, respectively, a rate of grow
.
faster than the nominal GNP over the same interval
ittee
In conducting policy during this period, the Comm
individuals
was sensitive to indications that the desire of
ly reand others for liquidity was unusually high, apparent
and
flecting concerns and uncertainties about the business
financial situation.
One reflection of that may be found in
-unusually large declines in "velocity" over the period
onal
that is, the ratio of measures of money to the gross nati
product.
M1 velocity -- particularly for periods as short as
three to six months -- is historically volatile.
A cyclical
ssions
tendency to slow (relative to its upward trend) during rece
is common.
But an actual decline for two consecutive quarters,
1982, is rather
as happened late in 1981 and the first quarter of
unusual.
ter
The magnitude of the decline during the first quar
period.
was larger than in any quarter of the entire postwar
duration
Moreover, declines in velocity of this magnitude and
shortare often accompanied by (and are related to) reduced
term interest rates.
Those interest rate levels during the
much of
first half of 1982 were distinctly lower than during
in the
1980 and 1981, but they rose above the levels reached
closing months of last year.
y or preMore direct evidence of the desire for liquidit
the behavior
cautionary balances affecting M1 can be found in
of NOW accounts.
As you know, NOW accounts are a relatively
new instrument, and we have no experience of behavior over the
course of a full business cycle.
We do know that NOW accounts
are essentially confined to individuals, their turnover relative
to demand accounts is relatively low, and, from the standpoint
of the owner, they have some of the characteristics of savings
deposits, including a similarly low interest rate but easy
access on demand.
We also know the great bulk of the increase
in M1 during the early part of the year -- almost 90% of the
rise from the fourth quarter of 1981 to the second quarter of
1982 -- was concentrated in NOW accounts, even though only
about a fifth of total M1 is held in that form.
In contrast
to the steep downward trend in low-interest savings accounts
in recent years, savings account holdings have stabilized or
even increased in 1982, suggesting the importance of a high
degree of liquidity to many individuals in allocating their
funds.
A similar tendency to hold more savings deposits has
been observed in earlier recessions.
I would add that the financial and liquidity positions of
the household sector of the economy, as measured by conventional
liquid asset and debt ratios, has improved during the recession
period.
Relative to income, debt repayment burdens have declined
to the lowest level since 1976.
are clearly mixed.
Trends among business firms
While many individual firms are under strong
pressure, some rise in liquid asset holdings for the corporate
sector as a whole appears to be developing.
The gap between
internal cash flow (that is, retained earnings and depreciation
allowances) and spending for plant, equipment, and inventory
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has also been at an historically low level, suggesting that a
portion of recent business credit demands is designed to
bolster liquidity.
But, for many years, business liquidity
ratios have tended to decline, and balance sheet ratios have
reflected more dependence on short-term debt.
In that per-
spective, any recent gains in liquidity appear small.
In the light of the evidence of the desire to hold more
NOW accounts and other liquid balances for precautionary rather
than transaction purposes during the months of recession, strong
efforts to reduce further the growth rate of the monetary aggregates appeared inappropriate.
Such an effort would have
required more pressure on bank reserve positions -- and
presumably more pressures on the money markets and interest
rates in the short run.
At the same time, an unrestrained
build-up of money and liquidity clearly would have been inconsistent with the effort to sustain progress against inflation,
both because liquidity demands could shift quickly and because
our policy intentions could easily have been misconstrued.
Periods of velocity decline over a quarter or two are typically
followed by periods of relatively rapid increase.
Those increases
tend to be particularly large during cyclical recoveries.
Indeed,
velocity appears to have risen slightly during the second quarter,
and the growth in NOW accounts has slowed.
Judgments on these seemingly technical considerations
ng
inevitably take on considerable importance in the target-setti
(including
process because the economic and financial consequences
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the consequences for interest rates) of a particular Ml or M2
increase are dependent on the demand for money.
Over longer
periods, a certain stability in velocity trends can be observed,
but there is a noticeable cyclical pattern.
Taking account of
those normal historical relationships, the various targets
established at the beginning of the year were calculated to be
consistent with economic recovery in a context of declining
inflation.
That remains our judgment today.
Inflation has,
in fact, receded more rapidly than anticipated at the start of
the year potentially leaving more "room" for real growth.
On
that basis, the targets established early in the year still
appeared broadly appropriate, and the Federal Open Market Committee decided at its recent meeting not to change them at this
time.
However, the Committee also felt, in the light of developments
during the first half, that growth around the top of those ranges
would be fully acceptable.
Moreover -- and I would emphasize
this -- growth somewhat above the targeted ranges would be
tolerated for a time in circumstances in which it appeared that
precautionary or liquidity motivations, during a period of
economic uncertainty and turbulence, were leading to stronger
than anticipated demands for money.
We will look to a variety of
factors in reaching that judgment, including such technical factors
_
as the behavior of different components in the money supply, the
growth of credit, the behavior of banking and financial markets,
and more broadly, the behavior of velocity and interest rates.
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I believe it is timely for me to add that, in these
circumstances, the Federal Reserve should not be expected to
respond, and does not plan to respond, strongly to various
"bulges" -- or for that matter "valleys"monetary growth
that seem likely to be temporary.
As we have emphasized in the
past, the data are subject to a good deal of statistical "noise"
in any circumstances, and at times when demands for money and
liquidity may be exceptionally volatile, more than usual caution
is necessary in responding to "blips."*
We, of course, have a concrete instance at hand of a
relatively large (and widely anticipated) jump in M1 in the
first week of July -- possibly influenced to some degree by
larger social security payments just before a long weekend.
Following as it did a succession of money supply declines, that
increase brought the most recent level for M1 barely above the
June average, and it is not of concern to us.
It is in this context, and in view of recent declines
in short-term market interest rates, that the Federal Reserve
yesterday reduced the basic discount rate from 12 to 111
/
2 percent.
*In that connection, a number of observers have noted
that the first month of a calendar quarter -- most noticeably
in January and April -- sometimes shows an extraordinarily
large increase in M1 -- amplified by the common practice of
multiplying the actual change by 12 to show an annual rate.
Those bulges, more typically than not, are partially "washed
out" by slower than normal growth the following month. The
standard seasonal adjustment techniques we use to smooth out
monthly money supply variations -- indeed, any standard
techniques -- may, in fact, be incapable of keeping up with
rapidly changing patterns of financial behavior, as they
affect seasonal patterns. A note attached to this statement
sets forth some work in process developing new seasonal adjustment techniques.
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In looking ahead to 1983, the Open Market Committee
agreed that a decision at this time would -- even more
obviously than usual -- need to be reviewed at the start of
the year in the light of all the evidence as to the behavior
of velocity or money and liquidity demand during the current
year.
Apart from the cyclical influences now at work, the
possibility will need to be evaluated of a more lasting change
in the trend of velocity.
The persistent rise in velocity during the past twenty
years has been accompanied by rising inflation and interest
rates -- both factors that encourage economization of cash
balances.
In addition, technological change in banking --
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spurred in considerable part by the availability of computers -has made it technically feasible to do more and more business
on a proportionately smaller "cash" base.
With incentives
strong to minimize holdings of cash balances that bear no or
low interest rates, and given the technical feasibty to do
so, turnover of demand deposits has reached an annual rate of
more than 300, quadruple the rate ten years ago.
Technological
change is continuing, and changes in regulation and bank practices
are likely to permit still more economization of Ml-type balances.
However, lower rates of interest and inflation should moderate
incentives to exploit that technology fully.
In those conditions,
velocity growth could slow, or conceivably at some point stop.
To conclude that the trend has in fact changed would
clearly be premature, but it is a matter we will want to evaluate
carefully as time passes.
F5r n5w, the Committee felt that the
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existing targets should be tentatively retained for next year.
Since we expect to be around the top end of the ranges this
year, those tentative targets would of course be fully consistent
with somewhat slower growth in the monetary aggregates in 1983.
Such a target would be appropriate on the assumption of a more
or less normal cyclical rise in velocity.
With inflation
declining, the tentative targets would appear consistent with,
and should support, continuing recovery at a moderate pace.
The Blend of Monetary and Fiscal Policy
The Congress, in adopting a budget resolution contemplating
cuts in expenditures and some new revenues, also called upon
the Federal Reserve to "reevaluate its monetary targets in
order to assure that they are fully complementary to a new
and more restrained fiscal policy."
I can report that members
of the Committee welcomed the determination of the Congress to
achieve greater fiscal restraint, and I want particularly to
recognize the leadership of members of the Budget Committees
and others in achieving that result.
In most difficult
circumstances, progress is being made toward reducing the
huge potential gap between receipts and expenditures.
But I
would be less than candid if I did not also report a strong
sense that considerably more remains to be done to bring the
deficit under control as the economy expands.
The fiscal
situation as we appraise it, continues to carry the implicit
threat of "crowding out" business investment and housing as
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the economy grows -- a process that would involve interest
rates substantially higher than would otherwise be the case.
For the more immediate future, we recognized that the need
remains to convert the intentions expressed in the Budget
Resolution into concrete legislative action.
In commenting on the budget, I would distinguish
sharply between the "cyclical" and "structural" deficit
that is, the portion of the deficit reflecting an imbalance
between receipts and expenditures even in a satisfactorily
growing economy with declining inflation.
To the extent the
deficit turns out to be larger than contemplated entirely
because of a shortfall in economic growth, that "add on"
would not be a source of so much concern.
But the hard
fact remains that, if the objectives of the Budget Resolution
are fully reached, the deficit would be about as large in
fiscal 1983 as this year even as the economy expands at a
rate of 4 to 5 percent a year and inflation (and thus inflation
generated revenues) remains higher than members of the Open
Market Committee now expect.
In considering the question posed by the Budget Resolution,
the Open Market Committee felt that full success in the budgetary
effort should itself be a factor contributing to lower interest
rates and reduced strains in financial markets.
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It would thus
-15-
reduce inflationary
assist importantly in the common effort to
pressures in the context of a growing economy.
By relieving
ationary expectations,
concern about future financing volume and infl
er budget posture
I believe as a practical matter a credibly firm
in the actual short• might permit a degree of greater flexibility
sing inflationary
term execution of monetary policy without arou
fears.
s
Specifically, market anxiety that short-run increase
of the debt
in the Ms might presage continuing monetization
could be ameliorated.
But any gains in these respects will
the intentions
of course be dependent on firmness in implementing
idence among
set forth in the Resolution and on encouraging conf
d and
borrowers and investors that the effort will be sustaine
reinforced in coming years.
Taking account of all these considerations, the
rtant
Committee did not feel that the budgetary effort, impo
greater
as it is, would in itself appropriately justify still
anticipated.
growth in the monetary aggregates over time than I have
eof
Indeed, excessive monetary growth -- and perceptions ther
would undercut any benefits from the budgetary effort with
respect to inflationary expectations.
We believe fiscal
restraint should be viewed more as an important complement
to appropriately disciplined monetary policy than as a
substitute.
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Concluding Comments
In an ideal world, less exclusive reliance on monetary
policy to deal with inflation would no doubt have eased the
strains and high interest rates that plague the economy and
financial markets today.
To the extent the fiscal process
can now be brought more fully to bear on the problem, the
better off we will be -- the more assurance we will have that
interest rates will decline and keep declining during the
period of recovery, and that we will be able to support the
increases in investment and housing essential to healthy,
sustained recovery.
Efforts in the private sector -- to
increase productivity, to reduce costs, and to avoid inflationary
and job-threatening wage increases -- are also vital, even
though the connection between the actions of individual firms
and workers and the performance of the economy may not always
be self-evident to the deon makers.
We know progress is
being made in these areas, and more progress will hasten full
and strong expansion.
But we also know that we do not live in an ideal world.
There is strong resistance to changing patterns of behavior
and expectations ingrained over years of inflation.
The slower
the progress on the budget, the more industry and labor build
in cost increases in anticipation of inflation or Government
acts to protect markets or impede compeon, the more highly
speculative financing is undertaken, the greater the threat that
available supplies of money and credit will be exhausted in
financing rising prices instead of new jobs and growth.
Those
in vulnerable competitive positions are most likely to feel the
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impact first and hardest, but unfortunately the difficulties
spread over the economic landscape.
The hard fact remains that we cannot escape those dilemmas
by a decision to give up the fight on inflation -- by declaring
the battle won before it is.
Such an approach would be trans-
parently clear -- not just to you and me -- but to the investors,
the businessmen and the workers who would, once again, find
their suspicions confirmed that they had better prepare to
live with inflation, and try to keep ahead of it.
The reactions
in financial markets and other sectors of the economy would,
in the end, aggravate our problems, not eliminate them.
It
would strike me as the cruelest blow of all to the millions
who have felt the pain of recession directly to suggest, in
effect, it was all in vain.
I recognize months of recession and high interest rates
have contributed to a sense of uncertainty.
postponed investment plans.
Businesses have
Financial pressures have exposed
lax practices and stretched balance sheet positions in some
institutions -- financial as well as non-financial.
The
earnings position of the thrift industry remains poor.
But none of those problems can be dealt with successfully
by re-inflation or by a lack of individual discipline.
It is
the
precisely that environment that contributed so much to
current difficulties.
cost conIn contrast, we are now seeing new attitudes of
our industry
tainment and productivity growth -- and ultimately
will be in a nore robust competitive position.
Millions are
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benefitting from less rapid price increases -- or actually
lower pricestheir shopping centers and elsewhere.
Consumer spending appears to be moving ahead, and inventory
reductions help set the stage for production increases.
Those are developments that should help recovery get
firmly underway.
f
The process of disinflation has enough
momentum to be sustained during the early stages of recovery
and that success can breed further success as concerns about
inflation recede.
As recovery starts, the cash flow of
business should improve.
And, more confidence should encourage
greater willingness among investors to purchase longer debt
maturities.
Those factors should, in turn, work toward reducing
interest rates, and sustag them at lower levels, encouraging
in turn the revival of investment and housing we want.
I have indicated the Federal Reserve is sensitive to the
special liquidity pressures that could develop during the
current period of uncertainty.
Moreover, the basic solidity
of our financial system is backstopped by a strong structure
of governmental institutions precisely designed to cope with
the secondary effects of isolated failures.
The recent problems
related largely to the speculative actives of a few highly
leveraged firms can and will be contained, and over time, an
appropriate sense of prudence in taking risks will serve us well.
We have been through -- we are
a trying period.
But
1
too much has been accomplished not to move ahead and complete
the job of laying the groundwork for a much stronger economy.
As we look forward, n5t just to the next few months but to long
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years, the rewards will be great:
in renewed stability, in
growth, and in higher employment and standards of living.
That vision will not be accomplished by monetary policy alone.
,
But we mean to do our part.
t
* *
_
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* * * * * *
Table I
I
Targeted and Actual Growth of
Money and Bank Credit
(Percent changes, at seasonally adjusted annual rates)
FOMC Objective
198104 to 198204
198104
to June '82
Actual Growth
198104
to 198202
1981H1
to 1982H1
M1
2-1/2 to 5-1/2
5.6
6.8
4.7**
M2
6 to 9
9.4
9.7
9.7
M3
6-1/2 to 9-1/2
9.7
9.8
10.5
Bank Credit*
6 to 9
8.0
8.3
8.4
*
The base for the bank credit target is the average level of December 1981
and January 1982, rather than the average for 198104. This base was adopted
because of the impact on the series of shifts of assets to the new international banking facilities (TM's); the 1981H1-to-1982H1 figure has been
adjusted for the impact of the initial shifting of assets to IBFs.
** Adjusted for impact of shifts to new NOW accounts in 1981.
_
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I
Appendix
Alternative Seasonal Adjustment Procedure
For some time the Federal Reserve has been investigating ways
to improve its procedures for seasonal adjustment, particularly as they
apply to the monetary aggregates.
In June of last year, a group of pro-
minent outside experts, asked by the Board to examine seasonal adjustment
1/
techniques, submitted their recommendations.—
The committee suggested,
among other things, that the Board's staff develop seasonal factor
estimates from a model-based procedure as an alternative to the widely
used X-11 technique that provides the basis for the current seasonal
//
adjustment procedure,
and release the results.
The Board staff has been developing a procedure using statisti, a1
V
models tailored to each individual series.
The table on the last page
compares monthly and quarterly average growth rates for the current M1
series with those of an alternative series from the model-based approach.
Differences in seasonal adjustment techniques do not change
the trend in monetary growth, but, as may be seen in the table, they do
alter month -to-month growth raLes owing to cliffering estimates of the
1/
See Committee of Experts on Seasonal Adjustment Techniques, Seasonal
Adjustment of the Monetary Aggregates (Board of Governors of the Federal
Reserve System, October 1981).
2/
The current seasonal adjustment technique has most recently been
summarized in the description to the mimeograph release of historical
money stock data dated March 1982. Detailed descriptions of the X-11
program and variants can be obtained from technical paper no. 15 of the
U. S. Department of Commerce (rev. February 1967) and from the report
to the Board cited nSStnote 1.
3/
The model-based seasonal adjustment procedures currently under review by
the Board staff use methods based on the well-developed theory of statistical regression and time series modeling. These approaches allow
development of seasonal factors that are more sensitive than the current
factors to unique characteristics of each series, including, for example,
fixed and evolving seasonal patterns, trading day effects, within-month
seasonal variations, holiday effects, outlier adjustments, special events
adjustments (such as the 1980 credit controls experience), and serially
correlated noise components.
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distribution over time of the seasonal component in money behavior.
Short-
run money growth is variable under both the alternative and current techniques
of seasonal adjustment, illustrating the inherently large "noise" component
of the series.
However, the redistribution of the seasonal component under
the alternative technique does on average tend to moderate month-to-month
changes somewhat.
I
The Board will continue to publish seasonally adjusted estimates
fI r M1 on both current and alternative bases at least until the annual
review of seasonal factors in 1983.
A detailed description of the alternative
method will be available shortly.
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i
a
Growth Rates of M1 Usin
1
Current and Alternative4
Seasonal Adjustment Procedures
(Monthly Average - Percent Annual Rates)
1982
1981
•
I
Jan.
Feb.
Mar.
Apr.
May
June
July
Aug.
Sept.
Oct.
Nov.
Dec.
Current
Alternative
9.8
4.3
14.3
25.2
-11.4
-2.2
2.8
4.8
0.3
4.7
9.7
12.4
1.4
7.5
16.0
22.6
-10.3
-0.6
2.2
5.3
3.1
0.0
11.1
15.4
Jan.
Feb.
Mar.
Apr.
May
June
Current
Alternative
21.0
-3.5
2.7
11.0
-2.4
-1.6
11.4
1.3
6.4
4.5
0.5
1.3
(Quarterly Average - Percent Annual Rates)
QI
QII
QIII
QIV
4.6
9.2
0.3
5.7
3.5
9.6
0.9
5.5
QI
QII
10.4
3.1
9.5
3.4
1/
_
Current monthly seasonal factors are derived using an X-11/ARIMAbased procedure applied to monthly data.
2/
Alternative monthly seasonal factors are derived using a modelbased procedure applied to weekly data.
$
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Board of Governors
of the Federal Reserve System
Washington, D.0. 20551
Official Business
Penalty for Private Use, $300
•
f
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Postage and Fees Paid
Doard of Governors
of the Federal Reserve System
First Class
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Federal Reserve Bank of St. Louis
For release on delivery
9:30 AM, E.D.T.
July 20, 1982
Statement by
Paul A. Volcker
Chairman, Board of Governors of the Federal Reserve System
before the
Committee on Banking, Housing, and Urban Affairs
United States Senate
July 20, 1982
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Federal Reserve Bank of St. Louis
I am pleased to have this opportunity once again to
discuss monetary policy with you within the context of recent
and prospective economic developments.
As usual on these
occasions, you have the Board of Governors' "Humphrey-Hawkins"
Report before you.
This morning I want to enlarge upon some
aspects of that Report and amplify as fully as I can my thinking
with respect to the period ahead.
In assessing the current economic situation, I believe
the comments I made five months ago remain relevant.
Without
repeating that analysis in detail, I would emphasize that we
stand at an important crossroads for the economy and economic
policy.
In these past two years we have traveled a considerable
way toward reversing the inflationary trend of the previous
decade or more.
I would recall to you that, by the late 1970s,
that trend had shown every sign of feeding upon itself and
tending to accelerate to the point where it threatened to
undermine the foundations of our economy.
Dealing with inflation
was accepted as a top national priority, and, as events developed,
that task fell almost entirely to monetary policy.
In the best of circumstances, changing entrenched patterns
of inflationary behavior and expectations -- in financial markets,
in the practices of business and financial institutions, and in
labor negotiations -- is a difficult and potentially painful
process.
Those, consciously ox not, who had come to "bet" on
rising prices and the ready availability of relatively cheap
-2-
credit to mask the risks of rising costs, poor productivity,
aggressive lending, or over-extended financial positions have
found themselves in a particularly difficult position.
The pressures on financial markets and interest rates
have been aggravated by concerns over prospective huge volumes
of Treasury financing, and by the need of some businesses to
borrow at a time of a severe squeeze on profits.
Lags in the
adjustment of nominal wages and other costs to the prospects
for sharply reduced inflation are perhaps inevitable, but have
the effect of prolonging the pressure on profits -- and indirectly on financial markets and employment.
Remaining doubts
and skepticism that public policy will "carry through" on the
effort to restore stability also affect interest rates, perhaps
most particularly in the longer-term markets.
In fact, the evidence now seems to me strong that the
inflationary tide has turned in a fundamental way.
In stating
that, I do not rely entirely on the exceptionally favorable
consumer and producer price data thus far this year, when the
recorded rates of price increase (at annual rates) declined to
2 and 21/2%, respectively. That apparent improvement was magnified
/
31
by some factors likely to prove temporary, including, of course,
the intensity of the recession; those price indices are likely
to appear somewhat less favorable in the second half of the
year.
What seems to me more important for the longer run is
that the trend of underlying costs and nominal wages has begun
to move lower, and that trend should be sustainable as the
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-3-
economy recovers upward momentum.
While less easy to
identify -- labor productivity typically does poorly during
periods of business decline -- there are encouraging signs
that both management and workers are giving more intense
attention to the effort to improve productivity.
That effort
should "pay off" in a period of business expansion, helping
to hold down costs and encouraging a revival of profits, setting
the stage for the sustained growth in real income we want.
I am acutely aware that these gains against inflation
have been achieved in a context of serious recession.
Millions
of workers are unemployed, many businesses are hardpressed to
maintain profitability, and business bankruptcies are at a
postwar high.
While it is true that some of the hardship can
reasonably be traced to mistakes in management or personal
judgment, including presumptions that inflation would continue,
large areas of the country and sectors of the economy have been
swept up in more generalized difficulty.
Our financial system
has great strength and resency, but particular points of
strain have been evident.
Quite obviously, a successful program to deal with
inflation, with productivity, and with the other economic and
social problems we face cannot be built on a crumbling foundation
of continuing recession.
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As you know, there have been some
indications -- most broadly reflected in the rough stability
of the real GNP in the second quarter and small increases in the
leading indicators -- that the downward adjustments may be drawing
4
to a close.
The tax reduction effective July 1, higher social
security payments, rising defense spending and orders, and the
reductions in inventory already achieved, all tend to support
the generally held view among economists that some recovery is
likely in the second half of the year.
I am also conscious of the fact that the leveling off
of the GNP has masked continuing weakness in important sectors
of the economy.
In its early stages, the prospective recovery
must be led largely by consumer spending.
But to be sustained
over time, and to support continuing growth in productivity and
living standards, more investment will be necessary.
as you know, business investment is moving lower.
At present,
House building
has remained at depressed levels; despite some small gains in
starts during the spring, the cyclical strength "normal" in that
industry in the early stages of recovery is lacking.
Exports
have been adversely affected by the relative strength of the
dollar in exchange markets.
I must also emphasize that the current problems of the
American economy have strong parallels abroad.
Governments
around the world have faced, in greater or lesser degree, both
inflationary and fiscal problems.
As they have come to grips
with those problems, growth has been slow or non-existent, and
the recessionary tendencies in various countries have fed back,
one on another.
In sum, we are in a situation that obviously warrants
concern, but also has great opportunities.
Those opportunities
lie in major part in achieving lasting progress -- in pinning
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-5_
down and extending what has already been achieved -- toward
price stability.
In doing so, we will be laying the base for
sustaining recovery over many years ahead, and for much lower
interest rates, even as the economy grows.
Conversely, to
fail in that task now, when so much headway has been made,
could only greatly complicate the problems of the economy over
time.
I find it difficult to suggest when and how a credible
attack could be renewed on inflation should we neglect completing
the job now.
Certainly the doubts and skepticism about our
capacity to deal with inflation -- which now seem to be yielding
would be amplified, with unfortunate consequences for financial
markets and ultimately for the economy.
I am certain that many of the questions, concerns and
dangers in your mind lie in the short run -- and that those in
good part revolve around the pressures in financial markets.
Can we look forward to lower interest rates to support the
expansion in investment and housing as the recovery takes hold?
Is there, in fact, enough liquidity in the economy to support
expansion -- but not so much that inflation is reignited?
Will, in fact, the economy follow the recovery path so widely
forecast in coming months?
These are the questions that we in the Federal Reserve
must deal with in setting monetary policy.
As we approach
these policy decisions, we are particularly conscious of the
vr
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fact that monetary policy, however important, is only one
instrument of economic policy.
Success in reaching our common
objective of a strong and prosperous economy depends upon more
ONE 111•111,
6-
_
than appropriate monetary policies, and I will touch this
morning on what seem
to me appropriately complementary
policies in the public and private sectors.
The Monetary Targets
Five months ago, in presenting our monetary and credit
targets for 1982, I noted some unusual factors could be at
work tending to increase the desire of individuals and businesses
to hold assets in the relatively liquid forms encompassed in the
various definitions of money.
Partly for that reason -- and
recognizing that the conventional base for the M1 target of the
fourth quarter of 1981 was relatively low -- I indicated that
the Federal Open Market Committee contemplated growth toward
the upper ends of the specified ranges.
Given the "bulge"
early in the year in Ml, the Committee also contemplated that
that particular measure of money might for some months remain
above a "straight line" projection of the targeted range from
the fourth quarter of 1981 to the fourth quarter of 1982.
As events developed, M1 and M2 both remained somewhat above
straight line paths until very recently.
M3 and bank credit
have remained generally within the indicated range, although
close to the upper ends.
(See Table I.)
Taking the latest full
month of June, M1 grew 5.6% from the base period and M2 9.4%,
close to the top of the ranges.
To the second quarter as a
whole, the growth was higher, at 6.8% and 9.7%, respectively.
Looked at on a year-over-year basis, which appropriately tends
to average through volatile monthly and quarterly figures, M1
during the first half of 1982 averaged about 4-3/4% above the
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I
7_
-
unt shifts
first half of 1981 (after accounting for NOW acco
early last year).
On the same basis, M2 and M3 grew by 9.7
growth distinctly
and 10.5 percent, respectively, a rate of
rval.
faster than the nominal GNP over the same inte
Committee
In conducting policy during this period, the
re of individuals
was sensitive to indications that the desi
, apparently reand others for liquidity was unusually high
business and
flecting concerns and uncertainties about the
financial situation.
One reflection of that may be found in
od -unusually large declines in "velocity" over the peri
s national
that is, the ratio of measures of money to the gros
product.
M1 velocity -- particularly for periods as short as
three to six months -- is historically volatile.
A cyclical
ng recessions
tendency to slow (relative to its upward trend) duri
is common.
,
But an actual decline for two consecutive quarters
ter of 1982, is rather
as happened late in 1981 and the first quar
unusual.
t quarter
The magnitude of the decline during the firs
war period.
was larger than in any quarter of the entire post
itude and duration
Moreover, declines in velocity of this magn
ced shortare often accompanied by (and are related to) redu
term interest rates.
Those interest rate levels during the
during much of
first half of 1982 were distinctly lower than
reached in the
1980 and 1981, but they rose above the levels
_
closing months of last year.
*
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liquidity or preMore direct evidence of the desire for
be found in the behavior
cautionary balances affecting M1 can
of NOW accounts.
As you know, NOW accounts are a relatively
-8-
new instrument, and we have no experience of behavior over the
course of a full business cycle.
We do know that NOW accounts
are essentially confined to individuals, their turnover relative
to demand accounts is relatively low, and, from the standpoint
of the owner, they have some of the characteristics of savings
deposits, including a similarly low interest rate but easy
access on demand.
We also know the great bulk of the increase
in M1 during the early part of the year -- almost 90% of the
rise from the fourth quarter of 1981 to the second quarter of
1982 -- was concentrated in NOW accounts, even though only
about a fifth of total M1 is held in that form.
In contrast
to the steep downward trend in low-interest savings accounts
in recent years, savings account holdings have stabilized or
even increased in 1982, suggesting the importance of a high
degree of liquidity to many individuals in allocating their
funds.
A similar tendency to hold more savings deposits has
been observed in earlier recessions.
I would add that the financial and liquidity positions of
the household sector of the economy, as measured by conventional
liquid asset and debt ratios, has improved during the recession
period.
Relative to income, debt repayment burdens have declined
to the lowest level since 1976.
are clearly mixed.
Trends among business firms
While many individual firms are under strong
pressure, some rise in liquid asset holdings for the corporate
1
sector as a whole appears to be developing.
The gap between
internal cash flow (that is, retained earnings and depreciation
allowances) and spending for plant, equipment, and inventory
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has also been at an historically low level, suggesting that a
portion of recent business credit demands is designed to
bolster liquidity.
But, for many years, business liquidity
ratios have tended to decline, and balance sheet ratios have
reflected more dependence on short-term debt.
In that per-
spective, any recent gains in liquidity appear small.
In the light of the evidence of the desire to hold more
NOW accounts and other liquid balances for precautionary rather
than transaction purposes during the months of recession, strong
efforts to reduce further the growth rate of the monetary aggregates appeared inappropriate.
Such an effort would have
required more pressure on bank reserve positions -- and
presumably more pressures on the money markets and interest
rates in the short run.
At the same time, an unrestrained
build-up of money and liquidity clearly would have been inconsistent with the effort to sustain progress against inflation,
both because liquidity demands could shift quickly and because
our policy intentions could easily have been misconstrued.
Periods of velocity decline over a quarter or two are typically
followed by periods of relatively rapid increase.
Those increases
tend to be particularly large during cyclical recoveries.
Indeed,
velocity appears to have risen slightly during the second quarter,
and the growth in NOW accounts has slowed.
_
Judgments on these seemingly technical considerations
ng
inevitably take on considerable importance in the target-setti
(including
process because the economic and financial consequences
-1I-
the consequences for interest rates) of a particular M1 or M2
increase are dependent on the demand for money.
Over longer
periods, a certain staty in velocity trends can be observed,
but there is a noticeable cyclical pattern.
Taking account of
those normal historical relationships, the various targets
established at the beginning of the year were calculated to be
consistent with economic recoverycontext of declining
inflation.
That remains our judgment today.
Inflation has,
in fact, receded more rapidly than anticipated at the start of
the year potentially leaving morefor real growth.
On
that basis, the targets established early in the year still
appeared broadly appropriate, and the Federal Open Market Committee decided at its recent meeting not to change them at this
time.
However, the Committee also felt, in the light of developments
during the first half, that growth around the top of those ranges
would be fully acceptable.
Moreover -- and I would emphasize
this -- growth somewhat above the targeted ranges would be
tolerated for a time in circumstances in which it appeared that
precautionary or liquty motivations, during a period of
economic uncertainty and turbulence, were leading to stronger
than anticipated demands for money.
We will look to a variety of
factors in reaching that judgment, including such technical factors
as the behavior of different components in the money supply, the
growth of credit, the behavior of banking and financial markets,
and more broadly, the behavior of velocity and interest rates.
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Federal Reserve Bank of St. Louis
f
-11-
I believe it is timely for me to add that,
nase
circumstances, the Federal Reserve should not be expected to
respond, and does not plan to respond, strongly to various
"bulges" -- or for that matter "valleys"monetary growth
that seem likely to be temporary.
As we have emphasized in the
past, the data are subject to a good deal of statistical "noise"
in any circumstances, and at times when demands for money and
liquidity may be exceptionally volatile, more than usual caution
is necessary in responding to "blips."*
We, of course, have a concrete instance at hand of a
relatively large (and widely anticipated) jump in M1 in the
first week of July -- possibly influenced to some degree by
larger social security payments just before a long weekend.
Following as it did a succession of money supply declines, that
increase brought the most recent level for M1 barely above the
June average, and it is not of concern to us.
It is in this context, and in view of recent declines
in short-term market interest rates, that the Federal Reserve
yesterday reduced the basic discount rate from 12 to 111
2 percent.
/
*In that connection, a number of observers have noted
that the first month of a calendar quarter -- most noticeably
in January and April -- sometimes shows an extraordinarily
large increase
amplified by the common practice of
multiplying the actual change by 12 to show an annual rate.
Those bulges, more typically than not, are partially "washed
out" by slower than normal growth the following month. The
standard seasonal adjustment techniques we use to smooth out
monthly money supply variations -- indeed, any standard
techniques -- may, in fact, be incapable of keeping up with
rapidly changing patterns of financial behavior, as they
affect seasonal patterns. A note attached to this statement
sets forth some work in process developing new seasonal adjustment techniques.
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Federal Reserve Bank of St. Louis
-12-
In looking ahead to 1983, the Open Market Committee
agreed that a decision at this time would -- even more
obviously than usual -- need to be reviewed at the start of
the year in the light of all the evidence as to the behavior
of velocity or money and liquidity demand during the current
year.
Apart from the cyclical influences now at work, the
possibility will need to be evaluated of a more lasting change
in the trend of velocity.
The persistent rise in velocity during the past twenty
years has been accompanied by rising inflation and interest
rates -- both factors that encourage economization of cash
balances.
In addition, technological change in banking --
spurred in considerable part by the availability of computers
has made it technically feasible to do more and more business
on a proportionately smaller "cash" base.
With incentives
strong to minimize holdings of cash balances that bear no or
low interest rates, and given the technical feasibility to do
so, turnover of demand deposits has reached an annual rate of
more than 300, quadruple the rate ten years ago.
Technological
change is continuing, and changes in regulation and bank practices
are likely to permit still more economization of Ml-type balances.
However, lower rates of interest and inflation should moderate
incentives to exploit that technology fully.
In those conditions,
velocity growth could slow, or conceivably at some point stop.
To conclude that the trend has in fact changed would
clearly be premature, but it is a matter we will want to evaluate
carefully as time passes.
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Federal Reserve Bank of St. Louis
For now, the Committee felt that the
-13-
existing targets should be tentatively retained for next year.
Since we expect to be around the top end of the ranges this
year, those tentative targets would of course be fully consistent
with somewhat slower growth in the monetary aggregates in 1983.
Such a target would be appropriate on the assumption of a more
or less normal cyclical rise in velocity.
With inflation
declining, the tentative targets would appear consistent with,
and should support, continuing recovery at a moderate pace.
The Blend of Monetary and Fiscal Policy
The Congress, in adopting a budget resolution contemplating
cuts in expenditures and some new revenues, also called upon
the Federal Reserve to "reevaluate its monetary targets in
order to assure that they are fully complementary to a new
and more restrained fiscal policy."
I can report that members
of the Committee welcomed the determination of the Congress to
achieve greater fiscal restraint, and I want particularly to
recognize the leadership of members of the Budget Committees
and others in achieving that result.
In most difficult
circumstances, progress is being made toward reducing the
huge potential gap between receipts and expenditures.
But I
would be less than candid if I did not also report a strong
sense that considerably more remains to be done to bring the
deficit under control as the economy expands.
The fiscal
situation as we appraise it, continues to carry the implicit
threat of "crowding out" business investment and housing as
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•
-14-
the economy grows -- a process that would involve interest
rates substantially higher than would otherwise be the case.
For the more immediate future, we recognized that the need
remains to convert the intentions expressed in the Budget
Resolution into concrete legislative action.
In commenting on the budget, I would distinguish
sharply between the "cyclical" and "structural" deficit
that is, the portion of the deficit reflecting an imbalance
between receipts and expenditures even in a satisfactorily
growing economy with declining inflation.
To the extent the
deficit turns out to be larger than contemplated entirely
because of a shortfall in economic growth, that "add on"
would not be a source of so much concern.
But the hard
fact remains that, if the objectives of the Budget Resolution
are fully reached, the deficit would be about as large in
fiscal 1983 as this year even as the economy expands at a
rate of 4 to 5 percent a year and inflation (and thus inflation
generated revenues) remains higher than members of the Open
Market Committee now expect.
In considering the question posed by the Budget Resolution,
the Open Market Committee felt that full success in the budgetary
effort should itself be a factor contributing to lower interest
rates and reduced strains in financial markets.
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Federal Reserve Bank of St. Louis
It would thus
-15-
to reduce inflationary
assist importantly in the common effort
omy.
pressures in the context of a growing econ
By relieving
inflationary expectations,
concern about future financing volume and
.
1
firmer budget posture
I believe as a practical matter a credibly
the actual shortmight permit a degree of greater flexibility in
sing inflationary
term execution of monetary policy without arou
fears.
Specifically, market anxiety that short-run increases
of the debt
in the Ms might presage continuing monetization
could be ameliorated.
But any gains in these respects will
the intentions
of course be dependent on firmness in implementing
idence among
set forth in the Resolution and on encouraging conf
ained and
borrowers and investors that the effort will be sust
reinforced in coming years.
Taking account of all these considerations, the
rtant
Committee did not feel that the budgetary effort, impo
greater
as it is, would in itself appropriately justify still
anticipated.
growth in the monetary aggregates over time than I have
eof
Indeed, excessive monetary growth -- and perceptions ther
would undercut any benefits from the budgetary effort with
respect to inflationary expectations.
We believe fiscal
restraint should be viewed more as an important complement
to appropriately disciplined monetary policy than as a
substitute.
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-16-
Concluding Comments
In an ideal world, less exclusive reliance on monetary
policy to deal with inflation would no doubt have eased the
strains and high interest rates that plague the economy and
financial markets today.
To the extent the fiscal process
can now be brought more fully to bear on the problem, the
better off we will be -- the more assurance we will have that
interest rates will decline and keep declining during the
period of recovery, and that we will be able to support the
increases in investment and housing essential to healthy,
sustained recovery.
Efforts in the private sector
increase productivity, to reduce costs, and to avoid inflationary
and job-threatening wage increases -- are also vital, even
though the connection between the actions of individual firms
and workers and the performance of the economy may not always
be self-evident to the decision makers.
We know progress is
being made in these areas, and more progress will hasten full
and strong expansion.
But we also know that we do not live in an ideal world.
There is strong resistance to changing patterns of behavior
and expectations ingrained over years of inflation.
The slower
the progress on the budget, the more industry and labor build
in cost increases in anticipation of inflation or Government
acts to protect markets or impede competition, the more highly
speculative financing is undertaken, the greater the threat that
available supplies of money and credit will be exhausted in
financing rising prices instead of new jobs and growth.
Those
in vulnerable competitive positions are most likely to feel the
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-17-
impact first and hardest, but unfortunately the difficulties
spread over the economic landscape.
The hard fact remains that we cannot escape those dilemmas
4.
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by a decision to give up the fight on inflation -- by declaring
the battle won before it is.
Such an approach would be trans-
parently clear -- not just to you and me -- but to the investors,
the businessmen and the workers who would, once again, find
their suspicions confirmed that they had better prepare to
live with inflation, and try to keep ahead of it.
The reactions
in financial markets and other sectors of the economy would,
in the end, aggravate our problems, not eliminate them.
It
would strike me as the cruelest blow of all to the millions
who have felt the pain of recession directly to suggest, in
effect, it was all in vain.
I recognize months of recession and high interest rates
have contributed to a sense of uncertainty.
postponed investment plans.
Businesses have
Financial pressures have exposed
lax practices and stretched balance sheet positions in some
institutions -- financial as well as non-financial.
The
earnings position of the thrift industry remains poor.
But none of those problems can be dealt with successfully
by re-inflation or by a lack of individual discipline.
It is
the
precisely that environment that contributed so much to
current difficulties.
conIn contrast, we are now seeing new attitudes of cost
industry
tainment and productivity growth -- and ultimately our
will be in a more robust competitive position.
Millions are
-18-
benefitting frI m less rapid price increases
actually
lower prices -- at their shopping centers and elsewhere.
Consumer spending appears to be moving ahead, and inventory
reductions help set the stage for production increases.
Those are developments that should help recovery get
firmly underway.
t
The process of disinflation has enough
momentum to be sustained during the early stages of recovery
AWED 1P
and that success can breed further success as concerns about
inflation recede.
As recovery starts, the cash flow of
business should improve.
i
And, more confidence should encourage
greater willingness among investors to purchase longer debt
maturities.
Those factors should, in turn, work toward reducing
interest rates, and sustaining them at lower levels, encouraging
in turn the revival of investment and housing we want.
I have indicated the Federal Reserve is sensitive to the
special liquidity pressures that could develop during the
current period of uncertainty.
Moreover, the basic solidity
of our financial system is backstopped by a strong structure
of governmental institutions precisely designed to cope with
the secondary effects of isolated failures.
The recent problems
related largely to the speculative activities of a few highly
leveraged firms can and will be contained, and over time, an
appropriate sense of prudence in taking risks will serve us well.
We have been through -- we are
a trying period.
But
#
too much has been accomplished not to move ahead and complete
the job of laying the groundwork for a much stronger economy.
As we look forward, not just to the next few months but to long
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-19-
years, the rewards will be great:
in renewed stability, in
growth, and in higher employment and standards of living.
That vision will not be accomplished by monetary policy alone.
,
But we mean to do our part.
4
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* *
* * * * * *
Table I
Targeted and Actual Growth of
Money and Bank Credit
(Percent changes, at seasonally adjusted annual rates)
FOMC Objective
198104 to 198204
198104
to June '82
Actual Growth
198104
to 198202
1981H1
to 1982H1
M1
2-1/2 to 5-1/2
5.6
6.8
4.7**
M2
6 to 9
9.4
9.7
9.7
M3
6-1/2 to 9-1/2
9.7
9.8
10.5
Bank Credit*
6 to 9
8.0
8.3
8.4
The base for the bank credit target is the average level of December 1981
and January 1982, rather than the average for 198104. This base was adopted
because of the impact on the series of shifts of assets to the new international banking facilities (IBFs); the 1981H1-to-1982H1 figure has been
adjusted for the impact of the initial shifting of assets to IBFs.
**
Adjusted for impact of shifts to new NOW accounts in 1981.
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Appendix
Alternative Seasonal Adjustment Procedure
For some time the Federal Reserve has been investigating ways
to improve its procedures for seasonal adjustment, particularly as they
apply to the monetary aggregates.
In June of last year, a group of pro-
minent outside experts, asked by the Board to examine seasonal adjustment
1/
techniqIses, submitted their recommendations.
The committee suggested,
among other things, that the Board's staff develop seasonal factor
estimates from a model-based procedure as an
!Il
to the widely
used X-11 technique that provides the basis for the current seasonal
2/
adjustment procedure,
and release the results.
The Board staff has been developing a procedure using statisti, al
3/
models tailored to each individual series.—
The table on the last page
compares monthly and quarterly average growth rates for the current M1
series with those of an alternative series from the model-based approach.
Differences in seasonal adjustment techniques do not change
the trend in monetary growth, but, as may be seen in the table, they do
alter month -to -month growth raLes owing to differing estimates of the
1/
See Committee of Experts on Seasonal AdjustTent Techniques, Seasonal
Adjustment of the Monetary Aggregates (Board of Governors of the Federal
Reserve System, October 1981).
2/
The current seasonal adjustment technique has most recently been
summarized in the description to the mimeograph release of historical
money stock data dated March 1982. Detailed descriptions of the X-1)
program and variants can be obtained from technical paper no. 15 of the
U. S. Department of Commerce (rev. February 1967) and from the report
to the Board cited in footnote 1.
3/
The model-based seasonal adjustment procedures currently under review by
the Board staff use methods based on the well-developed theory of statistical regression and time series modeling. These approaches allow
I- velopment of seasonal factors that are more sensitive than the current
factors to unique characteristics of each series, including, for example,
fixed and evolving seasonal patterns, trading day effects, within-month
seasonal variations, holiday effects, outlier adjustments, specird events
adjustments (such as the 1980 credit controls experience), and serially
correlated noise components,
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-2distribution over time of the seasonal component in money behavior.
Short-
run money growth is variable under both the alternative and current techniques
of seasonal adjustment, illustrating the inherently large "noise" component
of the series.
However, the redistribution of the seasonal component under
the alternative technique does on average tend to moderate month-to-month
changes somewhat.
The Board will continue to publish seasonally adjusted estimates
for M1 on both current and alternative bases at least until the annual
review of seasonal factors in 1983.
method will be available shortly.
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A detailed description of the alternative
Growth Rates of M1 Using
1
Current and AlternativeL
Seasonal Adjustment Procedures
(Monthly Average - Percent Annual Rates)
1982
1981
i
Jan.
Feb.
Mar.
Apr.
May
June
July
Aug.
Sept.
Oct.
Nov.
Dec.
Current
Alternative
9.8
4.3
14.3
25.2
-11.4
-2.2
2.8
4.8
0.3
4.7
9.7
12.4
1.4
7.5
16.0
22.6
-10.3
-0.6
2.2
5.3
3.1
0.0
11.1
15.4
Current
Jan.
Feb.
Mar.
Apr.
May
June
21.0
-3.5
2.7
11.0
-2.4
-1.6
Alternative
11.4
1.3
6.4
4.5
0.5
1.3
(Quarterly Average - Percent Annual Rates)
QI
QII
QIII
QIV
4.6
9.2
0.3
5.7
3.5
9.6
0.9
5.5
QI
QII
10.4
3.1
9.5
3.4
1/
_
Current monthly soasonal factors are derived using an X-11/ARIMAbased procedure applied to monthly data.
2/
Alternative monthly seasonal factors are derived using a modelbased procedure applied to weekly data.
)
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Board of Governor!,
of the Federal Reserve System
Washington, D.C. 20551
Official Business
Penalty for Private Use, S300
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Postage and Foes Paid
Rood at Governors
of the Federal Reserve System
First Class
:JP)
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For use at 9:30 a.m., E.D.T.
July 20, 1982
Board of Governors of the Federal Reserve System
Midyear Monetary Policy Report to Congress
Pursuant to the
Full Employment and Balanced Growth Act of 1978
July 20, 1982
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Federal Reserve Bank of St. Louis
Letter of Transmittal
BOARD OF GOVERNORS OF THE
FEDERAL RESERVE SYSTEM
Washington, D.C., July 20, 1982
THE PRESIDENT OF THE SENATE
THE SPEAKER OF THE HOUSE OF REPRESENTATIVES.
The Board of Governors is pleased to submit its Midyear Monetary Policy Report to the Congress pursuant
to the Full Employment and Balanced Growth Act of 1978.
Sincerely,
Paul A. Volcker, Chairman
TABLE OF CONTENTS
Page
Section 1:
Section 2:
Section 3:
Section 4:
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Federal Reserve Bank of St. Louis
The Performance of the Economy in the
First Half of 1982
1
The Growth of Money and Credit in the
First H-,lf of 1982
12
The Federal Reserve's Objectives for
Growth of Money and Credit
17
The Outlook for the Economy
21
9
Section 1:
The Performance of the Economy in the First Half of 1982
The contraction in economic activity that began in mid-1981 continued into the first half of 1982, although at a diminished pace.
Declines
in production and employment slowed, while sales of automobiles improved.
Real GNP fell at a 4 percent annual rate between the third quarter of 1981
and the first quarter of 1982.
With output declining, the margin of unused
plant capacity widened and the unemployment rate rose to a postwar record.
By mid-1982, however, the recession seemed to be drawing to a
close.
Inventory positions had improved substantially, homebuilding was
beginning to revive, and consumer spending appeared to be rising.
None-
theless, there were signs of increased weakness in business investment.
Although final demands apparently fell during the second quarter, the rate
of inventory liquidation slowed, and on balance, real GNP apparently
changed little.
If, in fact, this spring or early summer is determined to
have been the cyclical trough, both the depth and duration of the decline
in activity will have been about the same as in other postwar recessions.
The progress in reducing inflation that began during 1981 continued in the first half of 1982.
The greatest improvement was in prices
of food and energy--which benefited from favorable supply conditions--but
increases in price measures that exclude these volatile items also have
slowed markedly.
Moreover, increases in employment costs, which carry
forward the momentum of inflation, have diminished considerably.
Not only
have wage increases eased for union workers in hardpressed industries as
a result of contract concessions, but wage and fringe benefit increases
also have slowed for non-union and white-collar workers in a broad range of
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Industrial Production
Index, 1967= 100
150
— 140
130
1982
1980
1978
Real GNP
Change from end of previous period, annual rate, percent
1972 Dollars
6
3
1
H1
1978
H2
H1
1982
1980
Gross Business Product Prices
Change from end of previous period, annual rate, percent
Fixed-weighted Index
9
6
3
H1
1978
1980
Note Data for 1982 H1 are partially estimated by the FRB
H2
H1
1982
-2-
industries.
In addition there has been increasing use of negotiated work-
rule changes as well as other efforts by business to enhance productivity
-and trim costs.
At the same time, purchasing power has been rising; real
compensation per hour increased 1 percent during 1981 and rose at about a
3 percent annual rate over the first half of 1982.
Interest rates.
As the recession developed in the autumn of
1981, short-term interest rates moved down substantially.
However, part
of this decline was retraced at the turn of the year as the demand for
money bulged and reserve positions tightened.
After the middle of the
first quarter, short-term rates fluctuated but generally trended downward,
as money--particularly the narrow measure, M1--grew slowly on average and
the weakness in economic activity continued.
In mid-July, short-term rates
were distinctly below the peak levels reached in 1980 and 1981.
Nonethe-
less, short-term rates were still quite high relative to the rate of inflation.
Long-term interest rates also remained high during the first
half of 1982.
In part, this reflected doubts by market participants that
the improved price performance would be sustained over the longer run.
This skepticism was related to the fact that, during the past two decades,
episodes of reduced inflation have been short-lived, followed by reacceleration to even faster rates of price increase.
High long-term rates also have
been fostered by the prospect of huge deficits in the federal budget even
as the economy recovers.
Fears of deepening deficits have affected expecta-
tions of future credit market pressures, and perhaps also have sustained
inflation expectations.
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The resolution on the 1983 fiscal year budget that
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Interest Rates
Percent
18
Home Mortgage
14
10
3-month Treasury Bill
6
1978
1982
1980
Funds Raised by Private Nonfinancial Sectors
Seasonally adjusted, annual rate, billions of dollars
Total
300
Business
200
100
Household
1980
1982
Federal Government Borrowing
Seasonally adjusted, annual rate, billions of dollars
Combined Deficit Financed by the Public
120
80
40
1
1978
1980
Note Data for 1982 H1 are partially estimated by the FRB
1982
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Federal Reserve Bank of St. Louis
-3-
was adopted by the Congress represents a beginning effort to deal with the
prospect of widening deficits; and the passage of implementing legislation
should work in the direction of reducing market pressures on interest rates.
Domestic credit flows.
Aggregate credit flows to private non-
financial borrowers increased somewhat in the first half of 1982 from the
reduced pace in the second half of 1981, according to very preliminary
estimates.
Business borrowing rose while households reduced further their
use of credit.
Borrowing by the federal government increased sharply in
late 1981, after the 5 percent cut in personal income tax rates, and
remained near the new higher level during the first half of 1982 on a
seasonally adjusted basis.
Reflecting uncertainties about the future
economic and financial environment, both lenders and borrowers have shown
a strong preference for short-term instruments.
Much of the slackening in credit flows to nonfinancial sectors in
the last part of 1981 was accounted for by households, particularly by
household mortgage borrowing.
up slightly.
Since then, mortgage credit flows have picked
The advance was encouraged in part by the gradual decline in
mortgage rates from the peaks of last fall.
In addition, households have
made widespread use of adjustable-rate mortgages and "creative" financing
techniques--including relatively short-term loans made by sellers at belowmarket interest rates and builder "buy-downs." About two-fifths of all conventional mortgage loans closed recently were adjustable-rate instruments,
and nearly three-fourths of existing home transactions reportedly involved
some sort of creative financing.
-4-
Business borrowing dropped sharply during the last quarter of 1981,
primarily reflecting reduced inventory financing needs.
However, credit use
:by nonfinancial corporations rose significantly in the first half of 1982,
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Federal Reserve Bank of St. Louis
despite a further drop in capital expenditures.
The high level of bond rates
has discouraged corporations from issuing long-term debt, and a relatively
large share of business borrowing this year has been accomplished in shortterm markets--at banks and through sales of commercial paper.
The persis-
tently large volume of business borrowing suggests an accumulation of liquid
assets as well as an intensification of financial pressures on at least some
firms.
Signs of corporate stress continue to mount, including increasing
numbers of dividend reductions or suspensions, a rising fraction of business
loans at commercial banks with interest or principal past due, and relatively
frequent downgradings of credit ratings.
After raising a record volume of funds in U.S. credit markets
in 1981, the federal government continued to borrow at an extraordinary
pace during the first half of 1982, as receipts (national income and product
accounts basis) fell while expenditures continued to rise.
Owing to the
second phase of the tax cut that went into effect on July 1 and the effects
on tax revenues of the recession and reduced inflation, federal credit
demands will expand further in the period ahead.
Consumption.
Personal consumption expenditures (adjusted for
inflation) fell sharply in the fourth quarter of 1981, but turned up early
in 1982 and apparently strengthened further during the second quarter.
The
weakness in consumer outlays during the fourth quarter was concentrated in
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Federal Reserve Bank of St. Louis
Real Income and Consumption
Change from end of previous period, annual rate percent
Din Real Disposable Personal Income
Real Personal Consumption Expenditures
6
4
2
1
1978
11Th
11
H1
H2
H1
1982
1980
Real Business Fixed Investment
Change from end of previous period, annual rate, percent
1111 Producers' Durable Equipment
n Structures
20
10
at
H1
1978
1980
H2
H1
1982
Total Private Housing Starts
Millions of units
2.0
1.5
10
.5
1978
1980
Note Data for 1982 H1 are partially estimated by the FRB
1982
-5--
the auto sector, as total sales fell to an annual rate of 7.4 million units-the lowest quarterly figure in more than a decade--and sales of domestic
,models plummeted to a 5.1 million unit rate.
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Federal Reserve Bank of St. Louis
Price rebates and other sales promotion programs during the early
months of 1982 provided a fillip to auto demand, and sales climbed to an
8.1 million unit rate.
Auto markets remained firm into the spring, boosted
in part by various purchase incentives.
But as has generally occurred when
major promotions have ended, auto purchases fell sharply in June.
Outside
the auto sector, retail sales at most types of stores were up significantly
for the second quarter as a whole.
Even purchases at furniture and appliance
outlets, which had been on a downtrend since last autumn, increased during
the spring.
Real after-tax income has continued to edge up, despite the sharp
drop in output during the recession.
The advance reflects not only typical
cyclical increases in transfer payments but also the reduction in personal
income tax rates on October 1.
Households initially saved a sizable pro-
portion of the tax cut, boosting the personal saving rate from 5-1/4 percent in mid-1981--about equal to the average of the late 1970s and early
1980s--to 6.1 percent in the fourth quarter of 1981.
During early 1982,
however, consumers increased spending, partly to take advantage of price
markdowns for autos and apparel, and the saving rate fell.
Business investment.
As typically occurs during a recession,
the contraction in business fixed investment has lagged behind the decline
in overall activity.
Indeed, even though real GNP dropped substantially
during the first quarter of 1982, real spending for fixed business capital
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Federal Reserve Bank of St. Louis
-6-
actually rose a bit.
An especially buoyant element of the investment
sector has been outlays for nonfarm buildings--most notably, commercial
office buildings, for which appropriations and contracts often are set
a year or more in advance.
In contrast to investment in structures, business spending for
new equipment showed little advance during 1981 and weakened considerably
in the first half of 1982.
Excluding business purchases of new cars, which
also were buoyed by rebate programs, real investment in producers' durable
equipment fell at a 2 percent annual rate in the first quarter.
evidently accelerated in the second quarter.
The decline
In April and May, shipments
of nondefense capital goods, which account for about 80 percent of the
spending on producers' durable equipment, averaged nearly 3 percent below
the first-quarter level in nominal terms.
Moreover, sales of heavy trucks
dropped during the second quarter to a level more than 20 percent below the
already depressed first-quarter average.
Businesses liquidated inventories at a rapid rate during late 1981
and in the first half of 1982.
The adjustment of stocks followed a sizable
buildup during the summer and autumn of last year that accompanied the contraction of sales.
The most prominent inventory overhang by the end of 1981
was in the automobile sector as sales fell precipitously.
However, with a
combination of production cutbacks and sales promotions, the days' supply
of unsold cars on dealers lots had improved considerably by spring.
Manufacturers and non-auto retailers also found their inventories
rising rapidly last autumn.
Since then, manufacturers as a whole have liqui-
dated the accumulation that occurred during 1981, although some problem areas
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Federal Reserve Bank of St. Louis
-7-
n primary metals.
still
Stocks held by non-auto
own from their cyclical peak, but they remain
retailers
-above pre-r
Rruction.
Housing activity thus far in 1982 has
III'
picked up somewhat from the depressed level in late 1981.
Housing starts
during the first five months of 1982 were up 10 percent on average from the
fourth quarter of 1981.
The improvement in homebung has been supported
by strong underlying demand for housing services in most markets and by the
continued adaptation of real estate market participants to nontraditional
financing techniques that facilIcate transactions.
The turnaround
of the country.
nSusng activity has not occurred in all areas
In the south, home sales increased sharply in the first
part of 1982, and housing starts rose 25 percent from the fourth quarter of
1981.
In contrast, housing starts declined further, on average, during
the first five months of 1q82 in both the west and the industrial north
central states.
Government.
Federal government purchases of goods and services,
measured in constant dollars, declined over the first half of 1982.
The
decrease occurred entirely in the nondefense area, primarily reflecting
a sharp drop in the rate of inventory accumulation by the Commodity Credit
Corporation during the spring quarter.
Purchases by the Commodity Credit
Corporation had reached record levels during the previous two quarters
owing to last summer's large harvests and weak farm prices.
Other non-
defense outlays fell slightly over the first half of the year as a. result
of cuts in employment and other expenditures under many programs.
Real
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Federal Reserve Bank of St. Louis
-8--
defense spending apparently rose over the first half of the year, and the
backlog of unfilled orders grew further.
The federal deficit on a national
Income and product account basis widened from $100 billion at the end of
1981 to about $130 billion during the spring of this year.
Much of this
increase in the deficit reflects the effects of the recession on federal
expenditures and receipts.
At the state and local government level, real purchases of goods
and services fell further over the first half of 1982 after having declined
2 percent during 1981.
Most of the weakness this year has been in construc-
tion outlays as employment levels 'lave stabilized after large reductions
in the federally funded CETA program led to sizable layoffs last year.
The
declines in state and local government activity in part reflect fiscal
strains associated with the withdrawal of federal support for many activities and the effects of cyclically sluggish income growth on tax receipts.
Because of the serious revenue problems, several states have increased
sales taxes and excise taxes on gasoline and alcohol.
International payments and trade.
The weighted-average value of
the dollar, after declining about 10 percent from its peak last August,
began to strengthen sharply again around the beginning of the year and since
then has appreciated nearly 15 percent on balance.
The appreciation of
the dollar has been associated to a considerable extent with the declining
inflation rate in the United States and the rise in dollar interest rates
relative to yields on assets denominated in foreign currencies.
Reflecting the effects of the strengthening dollar, as well as the
slowing of economic growth abroad, real exports of goods and services have
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Federal Reserve Bank of St. Louis
Foreign Exchange Value of the U.S. Dollar
Index, March 1973 = 100
120
110
100
90
80
1978
1980
1982
Current Account Balance
Annual rate, billions of dollars
20
10
Surplus
0
Deficit
10
20
1978
1980
Note Data for 1982 H1 are partially estimated by the FRB.
1982
z
-9-
been decreasing since the beginning of 1981.
The volume of imports other
than oil, which rose fairly steadily throughout last year, dropped sharply
in the first half of 1982, owing to the weakness of aggregate demand-especially for inventories--in the United States.
In addition, both the
volume and price of imported oil fell during the first half of the year.
The current account, which was in surplus for 1981 as a whole, recorded
another surplus in the first half of this year as the value of imports
fell more than the value of exports.
Labor markets.
Employment has declined by nearly 1-1/2 million
since the peak reached in mid-1981.
As usually happens during a cyclical
contraction, the largest job losses have been in durable goods manufacturing industries--such as autos, steel, and machinery--as well as at construction sites.
The job losses in manufacturing and construction during
this recession follow a limited recovery from the 1980 recession; as a
result, employment levels in these industries are more than 10 percent
below their 1979 highs.
In addition, declines in aggregate demand have
tempered the pace of hiring at service industries and trade establishments
over the past year.
As often happens near a business cycle trough, employ-
ment fell faster than output in early 1982 and labor productivity showed a
small advance after declining sharply during the last half of 1981.
Since mid-1981 there has been a 2-1/4 percentage point rise in the
overall unemployment rate to a postwar record high of 9-1/2 percent.
The
effects of the recession have been most severe in the durable goods and
construction industries, and the burden of rising unemployment has been
relatively heavy on adult men, who tend to be more concentrated in these
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Federal Reserve Bank of St. Louis
-10-
industries.
At the same time, joblessness among young and inexperienced
workers remains extremely high; hardest hit have been black male teenagers
-who experienced an umemployment rate of nearly 60 percent in June 1982.
Reflecting the persistent slack in labor markets, most indicators
of labor supply also show a significant weakening.
For example, the number
of discouraged workers--that is, persons who report that they want work
but are not looking for jobs because they believe they cannot find any--has
increased by nearly half a million over the past year, continuing an upward
trend that began before the 1980 recession.
In addition, the labor force
participation rate--the proportion of the working-age population that is
employed or actively seeking jobs--has been essentially flat for the last
two years after rising about one-half percentage point annually between
1975 and 1979.
Prices and labor costs.
A slowing in the pace of inflation,
which was evident during 1981, continued through the first half of this
year.
During the first five months of 1982 (the latest data available),
the consumer price index increased at an annual rate of 3.5 percent, sharply
lower than the 8.9 percent rise during 1981.
Much of the improvement was
in energy and food prices as well as in the volatile CPI measure of homeownership costs.
But even excluding these items, the annual rate of increase
in consumer prices has slowed to 5-1/2 percent this year compared with a
9-1/2 percent rise last year.
evident at the producer level.
The moderation of price increases also was
Prices of capital equipment have increased
at a 4-1/4 percent annual rate thus far this year--well below the 9-1/4 percent pace of 1981.
In addition, the decline in raw materials prices, which
occurred throughout last year, has continued in the first half of 1982.
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Consumer Prices
En
Change from end of previous period, annual rate, percent
CPI
El CPI Excluding Food. Energy, and Homeownership
15
10
11111.01011/
5
Dec to May
1982
1980
1978
Gasoline Prices
Dollars per gallon
1 50
1 00
50
1982
1980
1978
Hourly Earnings Index
Change from end of previous period, annual rate, percent
9
NiellIMMEr
6
3
H1
1978
1980
H2
H1
1982
-11-
Gasoline prices at the retail level, which had remained virtually
flat over the second half of 1981, fell substantially during the first four
-months of 1982.
.
Slack domestic demand and an overhanc, of stocks on world
petroleum markets precipitated the decline in prices.
However, gasoline
prices began to rise again in May in reflection of rising consumption,
reduced stocks, and lower production schedules by major crude oil suppliers.
The rate of increase in employment costs decelerated considerably
during the first half of 1982.
The index of average hourly earnings, a
measure of wage trends for production and nonsupervisory personnel, rose
at a 6-1/4 percent annual rate over the first half of this year, compared
with an increase of 8-1/4 percent during 1981.
Part of the slowing was due
to early negotiation of expiring contracts and renegotiation of existing
contracts in a number of major industries.
These wage concessions are
expected to relieve cost pressures and to enhance the competitive position
of firms in these industries.
Increases in fringe benefits, which generally
have risen faster than wages over the years, also are being scaled back.
Because wage demands, not to mention direct escaltor provisions, are responsive to price performance, the progress made in reducing the rate of inflation should contribute to further moderation in labor cost pressures.
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0
-12-
Section 2:
The Growth of Money and Credit in the First Half of 1982
The annual targets for the monetary aggregates announced in February
were chosen to be consistent with continued restraint on the growth of money
and credit in order to exert sustained downward pressure on inflation.
At
the same time, these targets were expected to result in sufficient money
growth to support an upturn in economic activity.
Measured from the fourth
quarter of 1981 to the fourth quarter of 1982, the growth ranges for the
aggregates adopted by the Federal Open Market Committee (FOMC) were as
follows:
for Ml, 2-1/2 to 5-1/2 percent; for M2, 6 to 9 percent; and for
M3, 6-1/2 to 9-1/2 percent.
The corresponding range specified by the FOMC
for bank credit was 6 to 9 percent.'
When the FOMC was deliberating on its annual targets in February,
the Committee was aware that M1 already had risen well above its average
level in the fourth quarter of 1981.
In light of the financial and economic
backdrop against which the bulge in M1 had occurred, the Committee believed
it likely that there had been an upsurge in the public's demand for liquidity.
It also seemed probable that this strengthening of money demand would unwind
in the months ahead.
Thus, under these circumstances and given the relatively
low base for the M1 range for 1982, it did not appear appropriate to seek
an abrupt return to the annual target range, and the FOMC indicated its
willingness to permit M1 to remain above the range for a while.
At the
1. Because of the authorization of international banking facilities (IBFs)
on December 3, 1981, the bank credit data starting in December 1981 are
not comparable with earlier data. The target for bank credit was put
in terms of annualized growth measured from the average of December 1981
and January 1982 to the average level in the fourth quarter of 1982 so that
the shift of assets to IBFs that occurred at the turn of the year would not
have a major impact on the pattern of growth.
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Federal Reserve Bank of St. Louis
-13-
same time, the FOMC agreed that the expansion in M1 for the year as a
whole might appropriately be in the upper part of its range, particularly
If available evidence suggested the persistence of unusual desires for
liquidity that had to be accommodated to avoid undue financial stringency.
In setting the annual target for M2, the FOMC indicated that
M2 growth for the year as a whole probably would be in the upper part of
Its annual range and might slightly exceed the upper limit.
The Committee
anticipated that demands for the assets included in M2 might be enhanced
by new tax incentives such as the broadened eligibility for IRA/Keogh
accounts, or by further deregulation of deposit rates.
The Committee
expected that M3 growth again would be influenced importantly by the pattern
of business financing and, in particular, by the degree to which borrowing
would be focused in markets for short-term credit.
As anticipated--and consistent with the FOMC's short-run targets-the surge in M1 growth in December and January was followed by appreciably
slower growth.
After January, M1 increased at an annual rate of only 1-1/4
percent on average, and the level of M1 in June was only slightly above the
upper end of the Committee's annual growth range.
From the fourth quarter
of 1981 to June, M1 increased at a 5.6 percent annual rate.
M2 growth so
far this year also has run a bit above the FOMC's annual range; from the
fourth quarter of 1981 through June, M2 increased on average at a 9.4
percent annual rate.
From a somewhat longer perspective, M1 has increased
at a 4.7 percent annual rate, measuring growth from the first half of 1981
Ranges and Actual Monetary Growth
M1
Billions of dollars
— —
Range adopted by FOMC for
1981 04 to 1982 04
Annual Rates of Growth
51
/
2%
460
1981 04 to June
5.6 Percent
1981 04 to 1982 02
6 8 Percent
— 450
1981 H1 to 1982 H1
4.7 Percent l
21
/
2%
1 Adjusted for shifts into new
NOW accounts in 1981
440
0
(DI
IF
1
1
A
1
1981
1J
1
IA
1
0
ID
1982
M2
Billions of dollars
— — Range adopted by FOMC for
1981 04 to 1982 04
Annual Rates of Growth
, 9%
1950
6%
1900
1981 04 to June
9.4 Percent
1981 04 to 1982 02
9.7 Percent
1981 H1 to 1982 H1
9.7 Percent
1850
1800
0
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Federal Reserve Bank of St. Louis
1
1981
Di
IF
1
1 A
1f
1982
1
A
1
1_01
ID
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Federal Reserve Bank of St. Louis
to the first half of 1982 and abstracting from the shift into NOW accounts
in 1981; and M2 has grown at a 9.7 percent annual rate on a half-year over
-half-year basis.
Although M1 growth has been moderate on balance thus far this
year, that growth has considerably exceeded the pace of increase in nominal
Indeed, the first-quarter decline in the income velocity of M1--that
is, GNP divided by M1--was extraordinarily sharp.
the broader aggregates has been unusually weak.
Similarly, the velocity of
Given the persistence of
high interest rates, this pattern of velocity behavior suggests a heightened
demand for M1 and M2 over the first half.
The unusual demand for M1 has been focused on its NOW account
component.
Following the nationwide authorization of NOW accounts at the
beginning of 1981, the growth of such deposits surged.
When the aggregate
targets were reviewed this past February, a variety of evidence indicated
that the major shift from conventional checking and savings accounts into
NOW accounts was over; in particular, the rate at which new accounts were
being opened had dropped off considerably.
As a result of that shift, how-
ever, NOW accounts and other interest-bearing checkable deposits had grown
to account for almost 20 percent of M1 by the beginning of 1982.
Subse-
quently, it has become increasingly apparent that M1 is more sensitive to
changes in the public's desire to hold highly liquid assets.
M1 is intended to be a measure of money balances held primarily
for transaction purposes.
However, in contrast to the other major com-
ponents of Ml—currency and conventional checking accounts--NOW accounts
- 15 -
also have some characteristics of traditional savings accounts.
Apparently
reflecting precautionary motives to a considerable degree, NOW accounts and
-other interest-bearing checkable deposits grew surprisingly rapidly in the
fourth quarter of last year and the first quarter of this year.
Although
growth in this component has slowed recently, its growth from the fourth
quarter of last year to June has been 30 percent at an annual rate.
The
other components of M1 increased at an annual rate of less than 1 percent
over this same period.
Looking at the components of M2 not also included in Ml, the
so-called nontransaction components, these items grew at a 10-3/4 percent
annual rate from the fourth quarter to June.
General purpose and broker/
dealer money market mutual funds were an especially strong component of
M2, increasing at almost a 30 percent annual rate this year.
Compared with
last year, however, when the assets of such money funds more than doubled,
this year's increase represents a sharp deceleration.
Perhaps the most surprising development affecting M2 has been the
behavior of conventional savings deposits.
After declining in each of the
past four years--falling 16 percent last year--savings deposits have
Increased at about a 4 percent annual rate thus far this year.
This turn-
around in savings deposit flows, taken together with the strong increase
in NOW accounts and the still substantial growth in money funds, suggests
that stronger preferences to hold safe and highly liquid financial assets
in the current recessionary environment are bolstering the demand for M2
as well as Ml.
M3 increased at a 9.7 percent annual rate from the fourth quarter of
1981 to June, just above the upper end of the FOMC's annual growth target.
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Ranges and Actual Monetary Growth
M3
Billions of dollars
— — Range adopted by FOMC for
1981 Q4 to 1982 Q4
Annual Rates of Growth
91
/
2%
1981 Q4 to June
9 7 Percent
61
/
2°A
2300
06--
1981 04 to 1982 Q2
9 8 Percent
1981 H1 to 1982 H1
10 5 Percent
••••""
2200
01
IDE
1F1
1
A
1
1981
1
LIJ
0 1
1982
Bank Credit
Billions of dollars
— — Range adopted by FOMC for
Dec. 1981-Jan. 1982 to 1982 Q4
Annual Rates of Growth
Dec.-Jan. to June
8.0 Percent
1400
Dec.-Jan. to 1982 02
8.3 Percent
1981 H1 to 1982 H1
8.4 Percent 1
1350
01
1981
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DI
1
Fl
IA1
1..11
1982
1A1
1 0 I
I
1 Adjusted for initial shifts into
international banking facilitieS.
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Federal Reserve Bank of St. Louis
- 16 -
Farlv in the year, M3 growth was relatively moderate as a strong rise in
large-denomination CDs was offset by declines in term RPs and in money
market mutual funds restricted to institutional investors.
During the
second quarter, however, M3 showed a larger increase; the weakness in its
term RP and money fund components subsided and heavy issuance of large CDs
continued.
With growth of "core deposits" relatively weak on average,
commercial banks borrowed heavily in the form of large CDs to fund the
increase in their loans and investments.
Commercial bank credit grew at an 8.3 percent annual rate over the
first half of the year, in the upper part of the FOMC's range for 1982.
Bank loans have increased on average at about a 9-1/2 percent annual rate,
with loans to nonfinancial businesses expanding at a 14 percent annual
rate.
In past economic downturns, business loan demand at banks has tended
to weaken, hut consistently high long-term interest rates in the current recession have induced corporations to meet the great bulk of their
external financing needs through short-term borrowing.
Real estate loans
have increased at a 7-1/4 percent annual rate this year, somewhat slower
than the growth in each of the past two years.
Consumer loans outstanding
during the first half of the year have grown at the same sluggish pace of
3 percent experienced last year.
The investment portfolios of banks have
expanded at about a 5 percent annual rate, with the rate of increase in
U.S. government obligations about twice as large as the growth in holdings
of other types of securities.
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I
-17--
Section 3:
The Federal Reserve's Objectives for Growth of Money and Credit
There is a clear need today to promote higher levels of production
and employment in our economy.
The objective of Federal Reserve policy is
to create an environment conducive to sustained recovery in business activity while maintaining the financial discipline needed to restore reasonable
price stability.
The experience of the past two decades has amply demonstra-
ted the destructive impact of inflation on economic performance.
Because
inflation cannot persist without excessive monetary expansion, appropriately
restrained growth of money and credit over the longer run is critical to
achieving lasting prosperity.
The policy of firm restraint on monetary growth has contributed
importantly to the recent progress toward reducing inflation.
But when
inflationary cost trends remain entrenched, the process of slowing monetary growth can entail economic and financial stresses, especially when so
much of the burden of dealing with inflation rests on monetary policy.
These strains--reflected in reduced profits, liquidity problems, and balance-sheet pressures--place particular hardships on industries that depend
heavily on credit markets such as construction, business equipment, and
consumer durables.
Unfortunately, these stresses cannot be easily remedied through
accelerated money growth.
The immediate effect of encouraging faster growth
in money might be lower interest rates, especially in short-term markets.
In time, however, the attempt to drive interest rates lower through a substantial reacceleration of money growth would founder, for the result would
be to embed inflation and expectations of inflation even more deeply into
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-18-
the nation's economic system.
It would mean that this recession was another
wasted, painful episode instead of a transition to a sustained improvement
_in the economic environment.
The present and prospective pressures on
financial markets urgently need to he eased not by relaxing discipline on
money growth, but by the adoption of policies that will ensure a lower and
declining federal deficit.
Moreover, a return to financial health will
require the adoption of more prudent credit practices on the part of private borrowers and lenders alike.
In reviewing its targets for 1982 and setting tentative targets for
1983, the FOMC had as its basic objective the maintenance of the longerrange thrust of monetary discipline in order to reduce inflation further,
while providing sufficient money growth to accommodate exceptional liquidity
pressures and support a sustainable recovery in economic activity.
At the
same time, the Committee recognized that regulatory actions or changes in
the public's financial behavior might alter the implications of any quantitative monetary goals in ways that cannot be fully predicted.
In light of all these considerations, the Committee concluded that
a change in the previously announced targets was not warranted at this time.
Because of the tendency for the demand for money to run strong on average
in the first half, and also responding to the congressional budget resolution, careful consideration was given to the question of whether some
raising of the targets was in order.
However, the available evidence did
not suggest that a large increase in the ranges was justified, and a small
change in the ranges would have represented a degree of "fine tuning" that
i
-19-
appeared inconsistent with the degree of uncertainty surrounding the precise
relationship of money to other economic variables at this time.
However,
_the Committee concluded, based on current evidence, that growth this year
around the top of the ranges for the various aggregates would be acceptable.
The Committee also agreed that possible shifts in the demand for
liquidity in current economic circumstances might require more than ordinary
elements of flexibility and judgment in assessing appropriate needs for
money in the months ahead.
In the near term, measured growth of the aggre-
gates may be affected by the income tax reductions that occurred on July 1,
by cost-of-living increases in social security benefits, and by the ongoing
difficulties of accurately accounting for seasonal movements in the money
stock.
But more fundamentally, it is unclear to what degree businesses
and households may continue to wish to hold unusually large precautionary
liquid balances.
To the extent the evidence suggests that relatively
strong precautionary demands for money persist, growth of the aggregates
somewhat above their targeted ranges would be tolerated for a time and
still would be consistent with the FOMC's general policy thrust.
Looking ahead to 1983 and beyond, the FOMC remains committed to
restraining money growth in order to achieve sustained noninflationary
economic expansion.
At this point, the FOMC feels that the ranges now
in effect can appropriately remain as preliminary targets for 1983.
Because monetary aggregates in 1982 more likely than not will be close to
-
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the upper ends of their ranges, or perhaps even somewhat above them, the
-20-
preliminary 1983 targets would be fully consistent with a reduction in the
actual growth of money in 1983.
In light of the unusual uncertainty surrounding the economic,
financial, and budgetary outlook, the FOMC stressed the tentative nature
of its 1983 targets.
On the one hand, postwar cyclical experience strongly
suggests that some reversal of this year's unusual shift in the asset-holding preferences of the public could be expected; with economic activity on
an upward trend, any lingering precautionary motives for holding liquid
balances should begin to fade, thus contributing to a rapid rise in the
velocity of money.
Moreover, regulatory actions by the Depository Institu-
tions Deregulation Committee that increase the competitive appeal of deposit
instruments—as well as the more widespread use of innovative cash management
techniques, such as "sweep" accounts--also could reduce the demand for money
relative to income and interest rates.
On the other hand, factors exist
that should increase the attractiveness of holding cash balances.
The long
upward trend in the velocity of money since the 1950s took place in an
environment of rising inflation and higher nominal interest rates--developments that provide incentives for economizing on money holdings.
As these
incentives recede, it is possible that the attractiveness of cash holdings
will be enhanced and that more money will be held relative to the level of
business activity.
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-21-
Section 4:
The Outlook for the Economy
The economy at midyear appears to have leveled off after sizable
declines last fall and winter.
Consumption has strengthened with retail
sales up significantly in the second quarter.
New and existing home sales
have continued to fluctuate at depressed levels, but housing starts nonetheless have edged up.
In the business sector, substantial progress has been
made in working off excess inventories, and the rate of liquidation appears
to have declined.
On the negative side, however, plant and equipment spend-
ing, which typically lags an upturn in overall activity, is still depressed.
And the trend in export demand continues to be a drag on the economy, reflecting the dollar's strength and weak economic activity abroad.
An evaluation of the balance of economic forces indicates that
an upturn in economic activity is highly likely in the second half of 1982.
Monetary growth along the lines targeted by the FOMC should accommodate this
expansion in real GNP, given the increases in velocity that typically occur
early in a cyclical recovery and absent an appreciable resurgence of inflation.
The 10 percent cut in income tax rates that went into effect July 1
is boosting disposable personal income and should reinforce the growth in
consumer spending.
Given the improved inventory situation, any sizable
increase in consumer spending should, in turn, be reflected in new orders
and a pickup in production.
Another element supporting growth in real GNP
will be the continuing rise in defense spending and the associated private
investment outlays needed for the production of defense equipment.
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-22-
At least during the initial phase, the expansion is likely to
be more heavily concentrated in consumer spending than in past business
-cycles, as current pressures in financial markets and liquidity strains
may inhibit the recovery in investment activity.
With mortgage interest
rates high, residential construction does not seem likely to contribute to
the cyclical recovery to the extent that it has in the past.
Likewise,
the high level of corporate bond rates, and the cumulative deterioration
in corporate balance sheets resulting from reliance in recent years on
short-term borrowing, may restrain capital spending, especially given
the considerable margin of unutilized capacity that now exists.
The excellent price performance so far this year has been helped
by slack demand and by exceptionally favorable energy and food supply
developments.
For that reason, the recorded rate of inflation may be higher
in the second half.
However, prospects appear excellent for continuing the
downtrend in the underlying rate of inflation.
As noted earlier, signifi-
cant progress has been made in slowing the rise in labor compensation, and
improvement in underlying cost pressures should continue over the balance
of the year.
Unit labor costs also are likely to be held down by a cyclical
rebound in productivity growth as output recovers.
Moreover, lower inflation
will contribute to smaller cost-of-living wage adjustments, which will moderate cost pressures further.
The Federal Reserve's objectives for money growth through the end
of 1983 are designed to be consistent with continuing recovery in economic
activity.
A critical factor influencing the composition and strength of
the expansion will be the extent to which pressures in financial markets
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Federal Reserve Bank of St. Louis
-23-
moderate.
This, in turn, depends importantly on the progress made in
further reducing inflationary pressures.
A marked decrease in inflation
-would take pressure off financial markets in two ways.
First, slower
inflation will lead to a reduced growth in transaction demands for money,
given any particular level of real activity.
It follows that a given
target for money growth can be achieved with less pressure on interest
rates and accordingly less restraint on real activity, the greater is the
reduction in inflation.
Second, further progress in curbing inflation
will help lower long-term interest rates by reducing the inflation premium
contained in nominal interest rates.
The welcome relief in inflation seen
recently apparently is assumed by many to represent a cyclical rather than
a sustained drop in inflation.
But the longer that improved price perfor-
mance is maintained, the greater will be the confidence that a decisive
downtrend in inflation is being achieved.
Such a change should be reflected
in lower long-term interest rates and stronger activity in the interestsensitive sectors of the economy.
Another crucial influence on financial markets and thus on the
nature of the expansion in 1983 will be the federal budgetary decisions
that are made in coming months.
The budget resolution that was recently
passed by the House and Senate is a constructive first step in reducing
budget deficits as the economy recovers.
However, much remains to be done
In appropriation and revenue legislation to implement this resolution.
How
the budgetary process unfolds will be an important factor in determining
future credit demands by the federal government and thus the extent to which
deficits will preempt the net savings generated by the private economy.
strong program of budget restraint would minimize pressures in financial
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Federal Reserve Bank of St. Louis
A
•
-24-
markets and thereby enhance the prospects for a more vigorous recovery in
homebuilding, business fixed investment, and other credit-dependent sectors.
In assessing the economic outlook, the individual members of
the FOMC have formulated projections for several key measures of economic
performance that fall generally within the ranges in the table below.
In
addition to the monetary aggregate objectives discussed earlier, these projections assume that the federal budget will be put on a course that over
time will result in significant reductions in the federal deficit.
ECONOMIC PROJECTIONS OF FOMC MEMBERS
Actual
1981
1982
9.8
0.9
8.9
5-1/2 to 7-1/2
1/2 to 1-1/2
4-3/4 to 6
7 to 9-1/2
2-1/2 to 4
4 to 5-3/4
8.3
9 to 9-3/4
8-1/2 to 9-1/2
Projected
1983
Changes, fourth quarter to
fourth quarter, percent
Nominal GNP
Real GNP
GNP deflator
Average level in the fourth
quarter, percent
Unemployment rate
Revised administration forecasts for the economy were not available at the time of the Committee's deliberation.
Our understanding, how-
ever, is that the administration's midyear budgetary review will be presented
within the framework of the economic assumptions used in the first budget
resolution.
For the remainder of 1982, those assumptions imply somewhat more
rapid recovery than the range now thought most likely by members of the FOMC,
but would be consistent with the monetary targets outlined in this report on
the assumption of growth in velocity characteristic of the early stages of a
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Federal Reserve Bank of St. Louis
-25-
number of past recoveries.
Looking further ahead, the Committee members,
like the administration and the Congress, foresee continued economic
-expansion in 1983, hut currently anticipate a less rapid rate of price
increase and somewhat slower real growth than the assumptions underlying
the budget.
The monetary targets tentatively set for 1983, which will be
reviewed early next year, would imply, under the budgetary assumptions,
relatively high growth in velocity.
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•
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Federal Reserve Bank of St. Louis
For use at 9:30 a.m., E.D.T.
July 20, 1982
Board of Governors of the Federal Reserve System
Midyear Monetary Policy Report to Congress
Pursuant to the
Full Employment and Balanced Growth Act of 1978
July 20, 1982
L
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Letter of Transmittal
BOARD OF GOVERNORS OF THE
FEDERAL RESERVE SYSTEM
Washington, D.C., July 20, 1982
THE PRESIDENT OF THE SENATE
THE SPEAKER OF THE HOUSE OF REPRESENTATIVES.
The Board of Governors is pleased to submit its Midyear Monetary Policy Report to the Congress pursuant
to the Full Employment and Balanced Growth Act of 1978.
Sincerely,
Paul A. Volcker, Chairman
TABLE OF CONTENTS
Page
Section 1:
Section 2:
Section 3:
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Section 4:
The Performance of the Economy in the
First Half of 1982
1
The Growth of Money and Credit in the
First H-lf of 1982
12
The Federal Reserve's Objectives for
Growth of Money and Credit
17
The Outlook for the Economy
21
Section 1:
The Performance of the Economy in the First Half of 1982
The contraction in economic activity that began in mid-1981 continued into the first half of 1982, although at a diminished pace.
Declines
in production and employment slowed, while sales of automobiles improved.
Real GNP fell at a 4 percent annual rate between the third quarter of 1981
and the first quarter of 1982.
With output declining, the margin of unused
plant capacity widened and the unemployment rate rose to a postwar record.
By mid-1982, however, the recession seemed to be drawing to a
close.
Inventory positions had improved substantially, homebuilding was
beginning to revive, and consumer spending appeared to be rising.
None-
theless, there were signs of increased weakness in business investment.
Although final demands apparently fell during the second quarter, the rate
of inventory liquidation slowed, and on balance, real GNP apparently
changed little.
If, in fact, this spring or early summer is determined to
have been the cyclical trough, both the depth and duration of the decline
In activity will have been about the same as in other postwar recessions.
The progress in reducing inflation that began during 1981 continued in the first half of 1982.
The greatest improvement was in prices
of food and energy--which benefited from favorable supply conditions--but
increases in price measures that exclude these volatile items also have
slowed markedly.
Moreover, increases in employment costs, which carry
forward the momentum of inflation, have diminished considerably.
Not only
have wage increases eased for union workers in hardpressed industries as
a result of contract concessions, but wage and fringe benefit increases
also have slowed for non-union and white-collar workers in a broad range of
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Industrial Production
Index, 1967= 100
150
140
130
1982
1980
1978
Real GNP
Change from end of previous period, annual rate, percent
1972 Dollars
6
3
0
H1
1978
H2
H1
1982
1980
Gross Business Product Prices
Change from end of previous period, annual rate, percent
Fixed-weighted Index
9
6
3
H1
1978
1980
Note Data for 1982 H1 are partially estimated by the FRB
H2
HI
1982
-2-
industries.
In addition there has been increasing use of negotiated work-
rule changes as well as other efforts by business to enhance productivity
-and trim costs.
At the same time, purchasing power has been rising; real
compensation per hour increased 1 percent during 1981 and rose at about a
3 percent annual rate over the first half of 1982.
Interest rates.
As the recession developed in the autumn of
1981, short-term interest rates moved down substantially.
However, part
of this decline was retraced at the turn of the year as the demand for
money bulged and reserve positions tightened.
After the middle of the
first quarter, short-term rates fluctuated but generally trended downward,
as money--particularly the narrow measure, M1--grew slowly on average and
the weakness in economic activity continued.
In mid-July, short-term rates
were distinctly below the peak levels reached in 1980 and 1981.
Nonethe-
less, short-term rates were still quite high relative to the rate of inflation.
Long-term interest rates also remained high during the first
half of 1982.
In part, this reflected doubts by market participants that
the improved price performance would be sustained over the longer run.
This skepticism was related to the fact that, during the past two decades,
episodes of reduced inflation have been short-lived, followed by reacceleration to even faster rates of price increase.
High long-term rates also have
been fostered by the prospect of huge deficits in the federal budget even
as the economy recovers.
Fears of deepening deficits have affected expecta-
tions of future credit market pressures, and perhaps also have sustained
inflation expectations.
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The resolution on the 1983 fiscal year budget that
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Federal Reserve Bank of St. Louis
Interest Rates
Percent
18
Home Mortgage
14
10
3-month Treasury Bill
6
1978
1980
1982
Funds Raised by Private Nonfinancial Sectors
Seasonally adjusted, annual rate, billions of dollars
Total
300
Business
200
100
Household
1980
1982
Federal Government Borrowing
Seasonally adjusted, annual rate, billions of dollars
Combined Deficit Financed by the Public
120
80
40
1
1978
1980
Note Data for 1982 H1 are partially estimated by the FRB
1982
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Federal Reserve Bank of St. Louis
-3-
was adopted by the Congress represents a beginning effort to deal with the
prospect of widening deficits; and the passage of implementing legislation
_should work in the direction of reducing market pressures on interest rates.
Domestic credit flows.
Aggregate credit flows to private non-
financial borrowers increased somewhat in the first half of 1982 from the
reduced pace in the second half of 1981, according to very preliminary
estimates.
Business borrowing rose while households reduced further their
use of credit.
Borrowing by the federal government increased sharply in
late 1981, after the 5 percent cut in personal income tax rates, and
remained near the new higher level during the first half of 1982 on a
seasonally adjusted basis.
Reflecting uncertainties about the future
economic and financial environment, both lenders and borrowers have shown
a strong preference for short-term instruments.
Much of the slackening in credit flows to nonfinancial sectors in
the last part of 1981 was accounted for by households, particularly by
household mortgage borrowing.
up slightly.
Since then, mortgage credit flows have picked
The advance was encouraged in part by the gradual decline in
mortgage rates from the peaks of last fall.
In addition, households have
made widespread use of adjustable-rate mortgages and "creative" financing
techniques--including relatively short-term loans made by sellers at belowmarket interest rates and builder "buy-downs." About two-fifths of all conventional mortgage loans closed recently were adjustable-rate instruments,
and nearly three-fourths of existing home transactions reportedly involved
some sort of creative financing.
-4-
Business borrowing dropped sharply during the last quarter of 1981,
primarily reflecting reduced inventory financing needs.
However, credit use
2by nonfinancial corporations rose significantly in the first half of 1982,
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Federal Reserve Bank of St. Louis
despite a further drop in capital expenditures.
The high level of bond rates
has discouraged corporations from issuing long-term debt, and a relatively
large share of business borrowing this year has been accomplished in shortterm markets--at banks and through sales of commercial paper.
The persis-
tently large volume of business borrowing suggests an accumulation of liquid
assets as well as an intensification of financial pressures on at least some
firms.
Signs of corporate stress continue to mount, including increasing
numbers of dividend reductions or suspensions, a rising fraction of business
loans at commercial banks with interest or principal past due, and relatively
frequent downgradings of credit ratings.
After raising a record volume of funds in U.S. credit markets
in 1981, the federal government continued to borrow at an extraordinary
pace during the first half of 1982, as receipts (national income and product
accounts basis) fell while expenditures continued to rise.
Owing to the
second phase of the tax cut that went into effect on July 1 and the effects
on tax revenues of the recession and reduced inflation, federal credit
demands will expand further in the period ahead.
Consumption.
Personal consumption expenditures (adjusted for
inflation) fell sharply in the fourth quarter of 1981, but turned up early
in 1982 and apparently strengthened further during the second quarter.
The
weakness in consumer outlays during the fourth quarter was concentrated in
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Federal Reserve Bank of St. Louis
Real Income and Consumption
Change from end of previous period, annual rate, percent
[Th Real Disposable Personal Income
•
Real Personal Consumption Expenditures
6
4
2
11
H1
1978
1980
H2
H1
1982
Real Business Fixed Investment
Change from end of previous period, annual rate, percent
ED Producers' Durable Equipment
I'"
20
10
1980
1982
Total Private Housing Starts
Millions of units
20
1.5
10
5
1978
1980
Note Data for 1982 H1 are partially estimated by the FRB
1982
-5-
the auto sector, as total sales fell to an annual rate of 7.4 million units-the lowest quarterly figure in more than a decade--and sales of domestic
_models plummeted to a 5.1 million unit rate.
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Federal Reserve Bank of St. Louis
Price rebates and other sales promotion programs during the early
months of 1982 provided a fillip to auto demand, and sales climbed to an
8.1 million unit rate.
Auto markets remained firm into the spring, boosted
in part by various purchase incentives.
But as has generally occurred when
major promotions have ended, auto purchase L: fell sharply in June.
Outside
the auto sector, retail sales at most types of stores were up significantly
for the second quarter as a whole.
Even purchases at furniture and appliance
outlets, which had been on a downtrend since last autumn, increased during
the spring.
Real after-tax income has continued to edge up, despite the sharp
drop in output during the recession.
The advance reflects not only typical
cyclical increases in transfer payments but also the reduction in personal
income tax rates on October 1.
Households initially saved a sizable pro-
portion of the tax cut, boosting the personal saving rate from 5-1/4 percent in mid-1981--about equal to the average of the late 1970s and early
1980s--to 6.1 percent in the fourth quarter of 1981.
During early 1982,
however, consumers increased spending, partly to take advantage of price
markdowns for autos and apparel, and the saving rate fell.
Business investment.
As typically occurs during a recession,
the contraction in business fixed investment has lagged behind the decline
in overall activity.
Indeed, even though real GNP dropped substantially
during the first quarter of 1982, real spending for fixed business capital
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Federal Reserve Bank of St. Louis
-6-
actually rose a bit.
An especially buoyant element of the investment
sector has been outlays for nonfarm buildings--most notably, commercial
office buildings, for which appropriations and contracts often are set
a year or more in advance.
In contrast to investment in structures, business spending for
new equipment showed little advance during 1981 and weakened considerably
in the first half of 1982.
Excluding business purchases of new cars, which
also were buoyed by rebate programs, real investment in producers' durable
equipment fell at a 2 percent annual rate in the first quarter.
evidently accelerated in the second quarter.
The decline
In April and May, shipments
of nondefense capital goods, which account for about 80 percent of the
spending on producers' durable equipment, averaged nearly 3 percent below
the first-quarter level in nominal terms.
Moreover, sales of heavy trucks
dropped during the second quarter to a level more than 20 percent below the
already depressed first-quarter average.
Businesses liquidated inventories at a rapid rate during late 1981
and in the first half of 1982.
The adjustment of stocks followed a sizable
buildup during the summer and autumn of last year that accompanied the contraction of sales.
The most prominent inventory overhang by the end of 1981
was in the automobile sector as sales fell precipitously.
However, with a
combination of production cutbacks and sales promotions, the days' supply
of unsold cars on dealers lots had improved considerably by spring.
Manufacturers and non-auto retailers also found their inventories
rising rapidly last autumn.
Since then, manufacturers as a whole have liqui-
dated the accumulation that occurred during 1981, although some problem areas
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Federal Reserve Bank of St. Louis
7-
still exist--particularly in primary metals.
Stocks held by non-auto
retailers have been brought down from their cyclical peak, but they remain
_above pre-recession levels.
Residential construction.
Housing activity thus far in 1982 has
picked up somewhat from the depressed level in late 1981.
Housing starts
during the first five months of 1982 were up 10 percent on average from the
fourth quarter of 1981.
The improvement in homebuilding has been supported
by strong underlying demand for housing services in most markets and by the
continued adaptation of real estate market participants to nontraditional
financing techniques that facilicate transactions.
The turnaround in housing activity has not occurred in all areas
of the country.
In the south, home sales increased sharply in the first
part of 1982, and housing starts rose 25 percent from the fourth quarter of
1981.
In contrast, housing starts declined further, on average, during
the first five months of 1982 in both the west and the industrial north
central states.
Government.
Federal government purchases of goods and services,
measured in constant dollars, declined over the first half of 1982.
The
decrease occurred entirely in the nondefense area, primarily reflecting
a sharp drop in the rate of inventory accumulation by the Commodity Credit
Corporation during the spring quarter.
Purchases by the Commodity Credit
Corporation had reached record levels during the previous two quarters
owing to last summer's large harvests and weak farm prices.
Other non-
defense outlays fell slightly over the first half of the year as a. result
of cuts in employment and other expenditures under many programs.
Real
-8-
defense spending apparently rose over the first half of the year, and the
backlog of unfilled orders grew further.
The federal deficit on a national
Income and product account basis widened from $100 billion at the end of
1981 to about $130 billion during the spring of this year.
Much of this
increase in the deficit reflects the effects of the recession on federal
expenditures and receipts.
At the state and local government level, real purchases of goods
and services fell further over the first half of
2 percent during
S.
after having declined
.Sst of the weakness this year has been in construc-
tion outlays as employment levels uave stabzed after large reductions
in the federally funded CETA program led to sizable layoffs last year.
The
S.clines in state and local government activity in part reflect fiscal
strains associated with the withdrawal of federal support for many activities and the effects of cyclically sluggish income growth on tax receipts.
Because of the serious revenue problems, several states have increased
sales taxes and excise taxes on gasoline and alcohol.
International payments and trade.
The weighted-average value of
the dollar, after declining about 10 percent from its peak last August,
began to strengthen sharply again around the beginning of the year and since
then has appreciated nearly 15 percent on balance.
The appreciation of
the dollar has been associated to a considerable extent with the declining
inflation rate in the United States and the rise in dollar interest rates
.
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Federal Reserve Bank of St. Louis
relative to yields on assets denominated in foreign currencies.
Reflecting the effects of the strengthening dollar, as well as the
slowing of economic growth abroad, real exports of goods and services have
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Federal Reserve Bank of St. Louis
Foreign Exchange Value of the U.S. Dollar
Index, March 1973 =100
120
110
100
90
80
1978
1980
1982
Current Account Balance
Annual rate, billions of dollars
20
10
0
10
20
1978
1980
Note: Data for 1982 H1 are partially estimated by the FRB.
1982
-9-
been decreasing since the beginning of 1981.
The volume of imports other
than oil, which rose fairly steadily throughout last year, dropped sharply
_ in the first half of 1982, owing to the weakness of aggregate demand—
especially for inventories--in the United States.
In addition, both the
volume and price of imported oil fell during the first half of the year.
The current account, which was in surplus for 1981 as a whole, recorded
another surplus in the first half of this year as the value of imports
fell more than the value of exports.
Labor markets.
Employment has declined by nearly 1-1/2 million
since the peak reached in mid-1981.
As usually happens during a cyclical
contraction, the largest job losses have been in durable goods manufacturing industries—such as autos, steel, and machinery--as well as at construction sites.
The job losses in manufacturing and construction during
this recession follow a limited recovery from the 1980 recession; as a
result, employment levels in these industries are more than 10 percent
below their 1979 highs.
In addition, declines in aggregate demand have
tempered the pace of hiring at service industries and trade establishments
over the past year.
As often happens near a business cycle trough, employ-
ment fell faster than output in early 1982 and labor productivity showed a
small advance after declining sharply during the last half of 1981.
Since mid -1981 there has been a 2-1/4 percentage point rise in the
overall unemployment rate to a postwar record high of 9-1/2 percent.
The
effects of the recession have been most severe in the durable goods and
construction industries, and the burden of rising unemployment has been
relatively heavy on adult men, who tend to be more concentrated in these
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Federal Reserve Bank of St. Louis
-10--
industries.
At the same time, joblessness among young and inexperienced
workers remains extremely high; hardest hit have been black male teenagers
-who experienced an umemployment rate of nearly 60 percent in June 1982.
Reflecting the persistent slack in labor markets, most indicators
of labor supply also show a significant weakening.
For example, the number
of discouraged workers--that is, persons who report that they want work
but are not looking for jobs because they believe they cannot find any--has
Increased by nearly half a million over the past year, continuing an upward
trend that began before the 1980 recession.
In addition, the labor force
participation rate--the proportion of the working-age population that is
employed or actively seeking jobs--has been essentially flat for the last
two years after rising about one-half percentage point annually between
1975 and 1979.
Prices and labor costs.
A slowing in the pace of inflation,
which was evident during 1981, continued through the first half of this
year.
During the first five months of 1982 (the latest data available),
the consumer price index increased at an annual rate of 3.5 percent, sharply
lower than the 8.9 percent rise during 1981.
Much of the improvement was
in energy and food prices as well as in the volatile CPI measure of homeownership costs.
But even excluding these items, the annual rate of increase
in consumer prices has slowed to 5-1/2 percent this year compared with a
9-1/2 percent rise last year.
evident at the producer level.
The moderation of price increases also was
Prices of capital equipment have increased
at a 4-1/4 percent annual rate thus far this year--well below the 9-1/4 percent pace of 1981.
In addition, the decline in raw materials prices, which
occurred throughout last year, has continued in the first half of 1982.
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Federal Reserve Bank of St. Louis
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Federal Reserve Bank of St. Louis
Consumer Prices
Change from end of previous period, annual rate, percent
III'.'PI
CPI Excluding Food. Energy, and Homeownership
15
10
5
Dec to May
lieu;
1982
1980
GasoHne Prices
Dollars per gallon
1 50
1 00
50
1978
1982
1980
Hourly Earnings Index
Change from end of previous period, annual rate, percent
9
6
3
H1
1978
1980
H2
H1
1982
-11-
Gasoline prices at the retail level, which had remained virtually
four
flat over the second half of 1981, fell substantially during the first
-months of 1q82.
Slack domestic demand and an overhan7 of stocks on world
petroleum markets precipitated the decline in prices.
However, gasoline
prices began to rise again in May in reflection of rising consumption,
reduced stocks, and lower production schedules by major crude oil suppliers.
The rate of increase in employment costs decelerated considerably
during the first half of 1982.
The index of average hourly earnings, a
measure of wage trends for production and nonsupervisory personnel, rose
d
at a 6-1/4 percent annual rate over the first half of this year, compare
with an increase of 8-1/4 percent during 1981.
Part of the slowing was due
to early negotiation of expiring contracts and renegotiation of existing
contracts in a number of major industries.
These wage concessions are
expected to relieve cost pressures and to enhance the competitive position
of firms in these industries.
Increases in fringe benefits, which generally
have risen faster than wages over the years, also are being scaled back.
Because wage demands, not to mention direct escaltor provisions, are responsive to price performance, the progress made in reducing the rate of inflation should contribute to further moderation in labor cost pressures.
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Federal Reserve Bank of St. Louis
-12-
Section 2:
The Growth of Money and Credit in the First Half of 1982
The annual targets for the monetary aggregates announced in February
were chosen to be consistent with continued restraint on the growth of money
and credit in order to exert sustained downward pressure on inflation.
At
the same time, these targets were expected to result in sufficient money
growth to support an upturn in economic activity.
Measured from the fourth
quarter of 1981 to the fourth quarter of 1982, the growth ranges for the
aggregates adopted by the Federal Open Market Committee (FOMC) were as
follows:
for Ml, 2-1/2 to 5-1/2 percent; for M2, 6 to 9 percent; and for
M3, 6-1/2 to 9-1/2 percent.
The corresponding range specified by the FOMC
for bank credit was 6 to 9 percent.'
When the FOMC was deliberating on its annual targets in February,
the Committee was aware that M1 already had risen well above its average
level in the fourth quarter of 1981.
In light of the financial and economic
backdrop against which the bulge in M1 had occurred, the Committee believed
it likely that there had been an upsurge in the public's demand for liquidity.
It also seemed probable that this strengthening of money demand would unwind
in the months ahead.
Thus, under these circumstances and given the relatively
low base for the M1 range for 1982, it did not appear appropriate to seek
an abrupt return to the annual target range, and the FOMC indicated its
willingness to permit M1 to remain above the range for a while.
At the
1. Because of the authorization of international banking facilities (IBFs)
on December 3, 1981, the bank credit data starting in December 1981 are
not comparable with earlier data. The target for bank credit was put
in terms of annualized growth measured from the average of December 1981
and January 1982 to the average level in the fourth quarter of 1982 so that
the shift of assets to IRFs that occurred at the turn of the year would not
have a major impact on the pattern of growth.
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Federal Reserve Bank of St. Louis
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Federal Reserve Bank of St. Louis
-13-
same time, the FOMC agreed that the expansion in M1 for the year as a
whole might appropriately be in the upper part of its range, particularly
If available evidence suggested the persistence of unusual desires for
liquidity that had to be accommodated to avoid undue financial stringency.
In setting the annual target for M2, the FOMC indicated that
M2 growth for the year as a whole probably would be in the upper part of
Its annual range and might slightly exceed the upper limit.
The Committee
anticipated that demands for the assets included in M2 might be enhanced
by new tax incentives such as the broadened eligibility for IRA/Keogh
accounts, or by further deregulation of deposit rates.
The Committee
expected that M3 growth again would be influenced importantly by the pattern
of business financing and, in particular, by the degree to which borrowing
would be focused in markets for short-term credit.
As anticipated--and consistent with the FOMC's short-run targets-the surge in Ml growth in December and January was followed by appreciably
slower growth.
After January, M1 increased at an annual rate of only 1-1/4
percent on average, and the level of Ml in June was only slightly above the
upper end of the Committee's annual growth range.
From the fourth quarter
of 1981 to June, Ml increased at a 5.6 percent annual rate.
M2 growth so
far this year also has run a bit above the FOMC's annual range; from the
fourth quarter of 1981 through June, M2 increased on average at a 9.4
percent annual rate.
From a somewhat longer perspective, M1 has increased
at a 4.7 percent annual rate, measuring growth from the first half of 1981
to the first half of 1982 and abstracting from the shift into NOW accounts
in 1981; and M2 has grown at a 9.7 percent annual rate on a half-year over
-half-year basis.
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Federal Reserve Bank of St. Louis
Although M1 growth has been moderate on balance thus far this
year, that growth has considerably exceeded the pace of increase in nominal
GNP.
Indeed, the first-quarter decline in the income velocity of M1--that
is, GNP divided by M1--was extraordinarily sharp.
the broader aggregates has been unusually weak.
Similarly, the velocity of
Given the persistence of
high interest rates, this pattern of velocity behavior suggests a heightened
demand for M1 and M2 over the first half.
The unusual demand for M1 has been focused on its NOW account
component.
Following the nationwide authorization of NOW accounts at the
beginninS of 1981, the growth of such deposits surged.
When the aggregate
targets were reviewed this past February, a variety of evidence indicated
that the major shift from conventional checking and savings accounts into
NOW accounts was over; in particular, the rate at which new accounts were
being opened had dropped off considerably.
As a result of that shift, how-
ever, NOW accounts and other interest-bearing checkable deposits had grown
to account for almost 20 percent of M1 by the beginning of 1982.
Subse-
quently, it has become increasingly apparent that M1 is more sensitive to
changes in the public's desire to hold highly liquid assets.
M1 is intended to be a measure of money balances held primarily
fS r transaction purposes.
However, in contrast to the other major com-
ponents of Ml—currency and conventional checking accounts--NOW accounts
Ranges and Actual Monetary Growth
M1
Billions of dollars
Range adopted by FOMC for
1981 Q4 to 1982 Q4
— —
Annual Rates of Growth
51
/
2%
460
1981 Q4 to June
5 6 Percent
1981 Q4 to 1982 02
6 8 Percent
450
1981 H1 to 1982 H1
4 7 Percent l
21
/
2°/0
1 Adjusted for shifts into new
NOW accounts in 1981
---•••""".
440
Of
IDI
IF1
1
A
1_
1981
IJ I
lAl
1982
M2
Billions of dollars
— — Range adopted by FO MC for
1981 Q4 to 1982 Q4
Annual Rates of Growth
, 9%
1950
1981 Q4 to June
9.4 Percent
1981 Q4 to 1982 Q2
9 7 Percent
6')/0
1981 H1 to 1982 H1
9 7 Percent
1850
01
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Federal Reserve Bank of St. Louis
ID1
1981
IF
1A1
1J1
1982
1A1_
101
ID
also have some characteristics of traditional savings accounts.
Apparently
reflecting precautionary motives to a considerable degree, NOW accounts and
-other interest-bearing checkable deposits grew surprisingly rapidly in the
fourth quarter of last year and the first quarter of this year.
Although
growth in this component has slowed recently, its growth from the fourth
quarter of last year to June has been 30 percent at an annual rate.
The
other components of M1 increased at an annual rate of less than 1 percent
over this same period.
Looking at the components of M2 not also included in Ml, the
so-called nontransaction components, these items grew at a 10-3/4 percent
annual rate from the fourth quarter to June.
General purpose and broker/
dealer money market mutual funds were an especially strong component of
M2, increasing at almost a 30 percent annual rate this year.
Compared with
last year, however, when the assets of such money funds more than doubled,
this year's increase represents a sharp deceleration.
Perhaps the most surprising development affecting M2 has been the
behavior of conventional savings deposits.
After declining in each of the
I.st four years--falling 16 percent last year--savings deposits have
increased at about a 4 percent annual rate thus far this year.
This turn-
around in savings deposit flows, taken together with the strong increase
in NOW accounts and the still substantial growth in money funds, suggests
that stronger preferences to hold safe and highly liquid financial assets
in the current recessionary environment are bolstering the demand for M2
as well as Ml.
M3 increased at a 9.7 percent annual rate from teSurt
quarter of
1981 to June, just above the upper end of the FOMC's annual growth target.
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Federal Reserve Bank of St. Louis
Ranges and Actual Monetary Growth
M3
Billions of dollars
— — Range adopted by FOMC for
1981 Q4 to 1982 Q4
Annual Rates of Growth
1981 Q4 to June
9 7 Percent
(Yo
2300
1981 04 to 1982 Q2
9 8 Percent
1981 H1 to 1982 H1
10 5 Percent
..•••••"
01
IDI
I
FI
I
A
I
1981
I-1
1
I
AI
1°1
1
1982
Bank Credit
Billions of dollars
— Range adopted by FOMC for
Dec. 1981-Jan. 1982 to 1982 Q4
Annual Rates of Growth
Dec.-Jan. to June
8.0 Percent
Dec.-Jan. to 1982 02
8.3 Percent
1981 H1 to 1982 H1
8.4 Percentl
.•••••
1350
01
1981
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Federal Reserve Bank of St. Louis
IF I
1AI
IJI
1982
1AI
101
1
1 Adjusted for initial shifts into
international banking facilities.
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Federal Reserve Bank of St. Louis
- 16 -
Farly in the year, M3 growth was relatively moderate as a strong rise in
large-denomination CDs was offset by declines in term RPs and in money
market mutual funds restricted to institutional investors.
During the
second quarter, however, M3 showed a larger increase; the weakness in its
term RP and money fund components subsided and heavy issuance of large CDs
continued.
With growth of "core deposits" relatively weak on average,
commercial banks borrowed heavily in the form of large CDs to fund the
increase in their loans and investments.
Commercial bank credit grew at an 8.3 percent annual rate over the
first half of the year, in the upper part of the FOMC's range for 1982.
Rank loans have increased on average at about a 9-1/2 percent annual rate,
with loans to nonfinancial businesses expanding at a 14 percent annual
rate.
In past economic downturns, business loan demand at banks has tended
to weaken, but consistently high long-term interest rates in the current recession have induced corporations to meet the great bulk of their
external financing needs through short-term borrowing.
Real estate loans
have increased at a 7-1/4 percent annual rate this year, somewhat slower
than the growth in each of the past two years.
Consumer loans outstanding
during the first half of the year have grown at the same sluggish pace of
3 percent experienced last year.
The investment portfolios of banks have
expanded at about a 5 percent annual rate, with the rate of increase in
U.S. government obligations about twice as large as the growth in holdings
of other types of securities.
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Federal Reserve Bank of St. Louis
-17-
Section 3:
The Federal Reserve's Objectives for Growth of Money and Credit
There is a clear need today to promote higher levels of production
and employment in our economy.
The objective of Federal Reserve policy is
to create an environment conducive to sustained recovery in business activity while maintaining the financial discipline needed to restore reasonable
price stability.
The experience of the past two decades has amply demonstra-
ted the destructive impact of inflation on economic performance.
Because
inflation cannot persist without excessive monetary expansion, appropriately
restrained growth of money and credit over the longer run is critical to
achieving lasting prosperity.
The policy of firm restraint on monetary growth has contributed
importantly to the recent progress toward reducing inflation.
But when
inflationary cost trends remain entrenched, the process of slowing monetary growth can entail economic and financial stresses, especially when so
much of the burden of dealing with inflation rests on monetary policy.
These strains--reflected in reduced profits, liquidity problems, and balance-sheet pressures--place particular hardships on industries that depend
heavily on credit markets such as construction, business equipment, and
consumer durables.
Unfortunately, these stresses cannot be easily remedied through
accelerated money growth.
The immediate effect of encouraging faster growth
in money might be lower interest rates, especially in short-term markets.
In time, however, the attempt to drive interest rates lower through a substantial reacceleration of money growth would founder, for the result would
be to embed inflation and expectations of inflation even more deeply into
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Federal Reserve Bank of St. Louis
0
-18-
the nation's economic system.
It would mean that this recession was another
wasted, painful episode instead of a transition to a sustained improvement
_in the economic environment.
The present and prospective pressures on
financial markets urgently need to he eased not by relaxing discipline on
money growth, but by the adoption of policies that will ensure a lower and
declining federal deficit.
Moreover, a return to financial health will
require the adoption of more prudent credit practices on the part of private borrowers and lenders alike.
In reviewing its targets for 1982 and setting tentative targets for
1983, the FOMC had as its basic objective the maintenance of the longerrange thrust of monetary discipline in order to reduce inflation further,
while providing sufficient money growth to accommodate exceptional liquidity
pressures and support a sustainable recovery in economic activity.
At the
same time, the Committee recognized that regulatory actions or changes in
the public's financial behavior might alter the implications of any quantitative monetary goals in ways that cannot be fully predicted.
In light of all these considerations, the Committee concluded that
a change in the previously announced targets was not warranted at this time.
Because of the tendency for the demand for money to run strong on average
in the first half, and also responding to the congressional budget resolution, careful consideration was given to the question of whether some
raising of the targets was in order.
However, the available evidence did
not suggest that a large increase in the ranges was justified, and a small
change in the ranges would have represented a degree of -fine tuning" that
-19-
appeared inconsistent with the degree of uncertainty surrounding the precise
relationship of money to other economic variables at this time.
However,
the Committee concluded, based on current evidence, that growth this year
around the top of the ranges for the various aggregates would be acceptable.
The Committee also agreed that possible shifts in the demand for
liquidity in current economic circumstances might require more than ordinary
elements of flexibility and judgment in assessing appropriate needs for
money in the months ahead.
In the near term, measured growth of the aggre-
gates may be affected by the income tax reductions that occurred on July 1,
by cost-of-living increases in social security benefits, and by the ongoing
difficulties of accurately accounting for seasonal movements in the money
stock.
But more fundamentally, it is unclear to what degree businesses
and households may continue to wish to hold unusually large precautionary
liquid balances.
To the extent the evidence suggests that relatively
strong precautionary demands for money persist, growth of the aggregates
somewhat above their targeted ranges would be tolerated for a time and
still would he consistent with the FOMC's general policy thrust.
Looking ahead to 1983 and beyond, the FOMC remains committed to
restraining money growth in order to achieve sustained noninflationary
economic expansion.
At this point, the FOMC feels that the ranges now
in effect can appropriately remain as preliminary targets for 1983.
Because monetary aggregates in 1982 more likely than not will be close to
-
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Federal Reserve Bank of St. Louis
the upper ends of their ranges, or perhaps even somewhat above them, the
-20-
preliminary 1983 targets would be fully consistent with a reduction in the
actual growth of money in 1983.
In light of the unusual uncertainty surrounding the economic,
financial, and budgetary outlook, the FOMC stressed the tentative nature
of its 1983 targets.
On the one hand, postwar cyclical experience strongly
suggests that some reversal of this year's unusual shift in the asset-holding preferences of the public could be expected; with economic activity on
an upward trend, any lingering precautionary motives for holding liquid
balances should begin to fade, thus contributing to a rapid rise in the
velocity of money.
Moreover, regulatory actions by the Depository Institu-
tions Deregulation Committee that increase the competitive appeal of deposit
Instruments--as well as the more widespread use of innovative cash management
techniques, such as "sweep" accounts--also could reduce the demand for money
relative to income and interest rates.
On the other hand
factors exist
that should increase the attractiveness of holding cash balances.
The long
upward trend in the velocity of money since the 1950s took place in an
environment of rising inflation and higher nominal interest rates--developments that provide incentives for economizing on money holdings.
As these
incentives recede, it is possible that the attractiveness of cash holdings
will be enhanced and that more money will be held relative to the level of
business activity.
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Federal Reserve Bank of St. Louis
-21-
Section 4:
The Outlook for the Economy
The economy at midyear appears to have leveled off after sizable
declines last fall and winter.
Consumption has strengthened with retail
sales up significantly in the second quarter.
New and existing home sales
have continued to fluctuate at depressed levels, but housing starts nonetheless have edged up.
In the business sector, substantial progress has been
made in working off excess inventories, and the rate of liquidation appears
to have declined.
On the negative sidP, however, plant and equipment spend-
ing, which typically lags an upturn in overall activity, is still depressed.
And the trend in export demand continues to be a drag on the economy, reflecting the dollar's strength and weak economic activity abroad.
An evaluation of the balance of economic forces indicates that
an upturn in economic activity is highly likely in the second half of 1982.
Monetary growth along the lines targeted by the FOMC should accommodate this
expansion in real GNP, given the increases in velocity that typically occur
early in a cyclical recovery and absent an appreciable resurgence of inflation.
The 10 percent cut in income tax rates that went into effect July 1
is boosting disposable personal income and should reinforce the growth in
consumer spending.
Given the improved inventory situation, any sizable
increase in consumer spending should, in turn, be reflected in new orders
and a pickup in production.
Another element supporting growth in real GNP
will be the continuing rise in defense spending and the associated private
investment outlays needed for the production of defense equipment.
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Federal Reserve Bank of St. Louis
-22-
At least during the initial phase, the expansion is likely to
be more heavily concentrated in consumer spending than in past business
-cycles, as current pressures in financial markets and liquidity strains
may inhibit the recovery in investment activity.
With mortgage interest
rates high, residential construction does not seem likely to contribute to
the cyclical recovery to the extent that it has in the past.
Likewise,
the high level of corporate bond rates, and the cumulative deterioration
in corporate balance sheets resulting from reliance in recent years on
short-term borrowing, may restrain capital spending, especially given
the considerable margin of unutilized capacity that now exists.
The excellent price performance so far this year has been helped
by slack demand and by exceptionally favorable energy and food supply
developments.
For that reason, the recorded rate of inflation may be higher
in the second half.
However, prospects appear excellent for continuing the
downtrend in the underlying rate of inflation.
As noted earlier, signifi-
cant progress has been made in slowing the rise in labor compensation, and
Improvement in underlying cost pressures should continue over the balance
of the year.
Unit labor costs also are likely to be held down by a cyclical
rebound in productivity growth as output recovers.
Moreover, lower inflation
will contribute to smaller cost-of-living wage adjustments, which will moderate cost pressures further.
The Federal Reserve's objectives for money growth through the end
of 1983 are designed to be consistent with continuing recovery in economic
activity.
A critical factor influencing the composition and strength of
the expansion will be the extent to which pressures in financial markets
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Federal Reserve Bank of St. Louis
-23-
moderate.
This, in turn, depends importantly on the progress made in
further reducing inflationary pressures.
A marked decrease in inflation
-would take pressure off financial markets in two ways.
First, slower
inflation will lead to a reduced growth in transaction demands for money,
given any particular level of real activity.
It follows that a given
target for money growth can be achieved with less pressure on interest
rates and accordingly less restraint on real activity, the greater is the
reduction in inflation.
Second, further progress in curbing inflation
will help lower long-term interest rates by reducing the inflation premium
contained in nominal interest rates.
The welcome relief in inflation seen
recently apparently is assumed by many to represent a cyclical rather than
a sustained drop in inflation.
But the longer that improved price perfor-
mance is maintained, the greater will be the confidence that a decisive
downtrend in inflation is being achieved.
Such a change should be reflected
In lower long-term interest rates and stronger activity in the interestsensitive sectors of the economy.
Another crucial influence on financial markets and thus on the
nature of the expansion in 1983 will be the federal budgetary decisions
that are made in coming months.
The budget resolution that was recently
passed by the House and Senate is a constructive first step in reducing
budget deficits as the economy recovers.
However, much remains to be done
in appropriation and revenue legislation to implement this resolution.
How
the budgetary process unfolds will be an important factor in determining
future credit demands by the federal government and thus the extent to which
deficits will preempt the net savings generated by the private economy.
strong program of budget restraint would minimize pressures in financial
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Federal Reserve Bank of St. Louis
A
-24-
markets and thereby enhance the prospects for a more vigorous recovery in
homebuilding, business fixed investment, and other credit-dependent sectors.
In assessing the economic outlook, the individual members of
the FOMC have formulated projections for several key measures of economic
performance that fall generally within the ranges in the table below.
In
addition to the monetary aggregate objectives discussed earlier, these projections assume that the federal budget will be put on a course that over
time will result in significant reductions in the federal deficit.
ECONOMIC PROJECTIONS OF FOMC MEMBERS
Actual
1981
1982
9.8
0.9
8.9
5-1/2 to 7-1/2
1/2 to 1-1/2
4-3/4 to 6
7 to 9-1/2
2-1/2 to 4
4 to 5-3/4
8.3
9 to 9-3/4
8-1/2 to 9-1/2
Projected
1983
Changes, fourth quarter to
fourth quarter, percent
Nominal GNP
Real GNP
GNP deflator
Average level in the fourth
quarter, percent
Unemployment rate
Revised administration forecasts for the economy were not available at the time of the Committee's deliberation.
Our understanding, how-
ever, is that the administration's midyear budgetary review will be presented
within the framework of the economic assumptions used in the first budget
resolution.
For the remainder of 1982, those assumptions imply somewhat more
rapid recovery than the range now thought most likely by members of the FOMC,
but would be consistent with the monetary targets outlined in this report on
the assumption of grcwth in velocity characteristic of the early stages of a
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Federal Reserve Bank of St. Louis
-25-
number of past recoveries.
Looking further ahead, the Committee members,
like the administration and the Congress, foresee continued economic
-expansion in
I.
hut currently anticipate a less rapid rate of price
increase and somewhat slower real growth than the assumptions underlying
the budget.
S.
which will be
The monetary targets tentatively set for 1,
reviewed early next year, would imply, under the budgetary assumptions,
relatively high growth in velocity.
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Federal Reserve Bank of St. Louis
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•
For use at 9:30 a.m., E.D.T.
July 20, 1982
Board of Governors of the Federal Reserve System
Midyear Monetary Policy Report to Congress
Pursuant to the
Full Employment and Balanced Growth Act of 1978
July 20, 1982
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Federal Reserve Bank of St. Louis
•.• • • ..•
.•,0of GOvtb•.•
'14
,•
O
,
. •
Letter of Transmittal
BOARD OF GOVERNORS OF THE
FEDERAL RESERVE SYSTEM
Washington, D.C., July 20, 1982
THE PRESIDN
ET O F THE SENATE
THE SPEAKER OF THE HOUSE OF REPRESENTATIVES.
The Board of Governors is pleased to submit its Midyear Monetary Policy Report to the Congress pursuant
to the Full Employment and Balanced Growth Act of 1978.
Sincerely,
Paul A. Volcker, Chairman
TABLE OF CONTENTS
Page
Section 1:
Section 2:
Section 3:
Section 4:
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Federal Reserve Bank of St. Louis
The Performance of the Economy in the
First Half of 1982.
1
The Growth of Money and Credit in the
First H-,1f of 1982
12
The Federal Reserve's Objectives for
Growth of Money and Credit
17
The Outlook for the Economy
21
Section 1:
The Performance of the Economy in the First Half of 1982
The contraction in economic activity that began in mid-1981 continued into the first half of 1982, although at a diminished pace.
Declines
In production and employment slowed, while sales of automobiles improved.
Real GNP fell at a 4 percent annual rate between the third quarter of 1981
and the first quarter of 1982.
With output declining, the margin of unused
plant capacity widened and the unemployment rate rose to a postwar record.
By mid-1982, however, the recession seemed to be drawing to a
close.
Inventory positions had improved substantially, homebuilding was
beginning to revive, and consumer spending appeared to be rising.
None-
theless, there were signs of increased weakness in business investment.
Although final demands apparently fell during the second quarter, the rate
of inventory liquidation slowed, and on balance, real GNP apparently
changed little.
If, in fact, this spring or early summer is determined to
have been the cyclical trough, both the depth and duration of the decline
in activity will have been about the same as in other postwar recessions.
The progress in reducing inflation that began during 1981 continued in the first half of 1982.
The greatest improvement was in prices
of food and energy--which benefited from favorable supply conditions--but
Increases in price measures that exclude these volatile items also have
slowed markedly.
Moreover, increases in employment costs, which carry
forward the momentum of inflation, have diminished considerably.
Not only
have wage increases eased for union workers in hardpressed industries as
a result of contract concessions, but wage and fringe benefit increases
also have slowed for non-union and white-collar workers in a broad range of
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Industrial Production
Index, 1967= 100
150
140
130
1
1
1
1982
1980
1978
Real GNP
Change from end of previous period, annual rate, percent
1972 Dollars
6
3
0
H1
1978
H2
H1
1982
1980
Gross Business Product Prices
Change from end of previous period, annual rate, percent
Fixed-weighted Index
9
6
3
H1
1978
1980
Note Data for 1982 H1 are partially estimated by the FRB
H2
H1
1982
-2-
industries.
In addition there has been increasing use of negotiated work-
rule changes as well as other efforts by business to enhance productivity
-and trim costs.
At the same time, purchasing power has been rising; real
compensation per hour increased 1 percent during 1981 and rose at about a
3 percent annual rate over the first half of 1982.
Interest rates.
As the recession developed in the autumn of
1981, short-term interest rates moved down substantially.
However, part
of this decline was retraced at the turn of the year as the demand for
money bulged and reserve positions tightened.
After the middle of the
first quarter, short-term rates fluctuated but generally trended downward,
as money--particularly the narrow measure, 141--grew slowly on average and
the weakness in economic activity continued.
In mid-July, short-term rates
were distinctly below the peak levels reached in 1980 and 1981.
Nonethe-
less, short-term rates were still quite high relative to the rate of inflation.
Long-term interest rates also remained high during the first
half of 1982.
In part, this reflected doubts by market participants that
the improved price performance would be sustained over the longer run.
This skepticism was related to the fact that, during the past two decades,
episodes of reduced inflation have been short-lived, followed by reacceleration to even faster rates of price increase.
High long-term rates also have
been fostered by the prospect of huge deficits in the federal budget even
as the economy recovers.
Fears of deepening deficits have affected expecta-
tions of future credit market pressures, and perhaps also have sustained
inflation expectations.
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The resolution on the 1983 fiscal year budget that
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Interest Rates
Percent
18
Home Mortgage
14
10
3-month Treasury Bill
6
1980
1978
1982
Funds Raised by Private Nonfinancial Sectors
Seasonally adjusted, annual rate, billions of dollars
300
Business
200
100
Household
1980
1982
Federal Government Borrowing
Seasonally adjusted, annual rate, billions of dollars
Combined Deficit Financed by the Public
120
80
40
1
1978
1980
Note: Data for 1982 H1 are partially estimated by the FRB
1982
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Federal Reserve Bank of St. Louis
-3-
was adopted by the Congress represents a beginning effort to deal with the
prospect of widening deficits; and the passage of implementing legislation
_should work in the direction of reducing market pressures on interest rates.
Domestic credit flows.
Aggregate credit flows to private non-
financial borrowers increased somewhat in the first half of 1982 from the
reduced pace in the second half of 1981, according to very preliminary
estimates.
Business borrowing rose while households reduced further their
use of credit.
Borrowing by the federal government increased sharply in
late 1981, after the 5 percent cut in personal income tax rates, and
remained near the new higher level during the first half of 1982 on a
seasonally adjusted basis.
Reflecting uncertainties about the future
economic and financial environment, both lenders and borrowers have shown
a strong preference for short-term instruments.
Much of the slackening in credit flows to nonfinancial sectors in
the last part of 1981 was accounted for by households, particularly by
household mortgage borrowing.
up slightly.
Since then, mortgage credit flows have picked
The advance was encouraged in part by the gradual decline in
mortgage rates from the peaks of last fall.
In addition, households have
made widespread use of adjustable-rate mortgages and "creative" financing
techniques--including relatively short-term loans made by sellers at belowmarket interest rates and builder "buy-downs." About two-fifths of all conventional mortgage loans closed recently were adjustable-rate instruments,
and nearly three-fourths of existing home transactions reportedly involved
some sort of creative financing.
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•
•
-4-
Business borrowing dropped sharply during the last quarter of 1981,
primarily reflecting reduced inventory financing needs.
However, credit use
by nonfinancial corporations rose significantly in the first half of 1982,
despite a further drop in capital expenditures.
The high level of bond rates
has discouraged corporations from issuing long-term debt, and a relatively
large share of business borrowing this year has been accomplished in shortterm markets--at banks and through sales of commercial paper.
The persis-
tently large volume of business borrowing suggests an accumulation of liquid
assets as well as an intensification of financial pressures on at least some
firms.
Signs of corporate stress continue to mount, including increasing
numbers of dividend reductions or suspensions, a rising fraction of business
loans at commercial banks with interest or principal past due, and relatively
frequent downgradings of credit ratings.
After raising a record volume of funds in U.S. credit markets
in 1981, the federal government continued to borrow at an extraordinary
pace during the first half of 1982, as receipts (national income and product
accounts basis) fell while expenditures continued to rise.
Owing to the
second phase of the tax cut that went into effect on July 1 and the effects
on tax revenues of the recession and reduced inflation, federal credit
demands will expand further in the period ahead.
Consumption.
Personal consumption expenditures (adjusted for
Inflation) fell sharply in the fourth quarter of 1981, but turned up early
in 1982 and apparently strengthened further during the second quarter.
The
weakness in consumer outlays during the fourth quarter was concentrated in
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Federal Reserve Bank of St. Louis
Real Income and Consumption
Change from end of previous period, annual rate, percent
Mil Real Disposable Personal Income
Real Personal Consumption Expenditures
6
4
2
IIIh
11
H1
1978
H2
H1
1982
1980
Real Business Fixed Investment
Change from end of previous period, annual rate, percent
Eill Producers' Durable Equipment
H Structures
20
10
H1
1978
1980
H2
H1
1982
Total Private Housing Starts
Millions of units
2.0
1.5
1.0
5
1
1978
1980
Note Data for 1982 H1 are partially estimated by the FRB
1982
-5-
the auto sector, as total sales fell to an annual rate of 7.4 million units-the lowest quarterly figure in more than a decade--and sales of domestic
,models plummeted to a 5.1 mon unit rate.
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Price rebates and other sales promotion programs during the early
IS nths of 1982 provided a fillip to auto demand, and sales climbed to an
8.1 mon unit rate.
Auto markets remained firm into the spring, boosted
in part by various purchase incentives.
But as has generally occurred when
major promotions have ended, auto purchases fell sharply in June.
OutsiI-
- auto sector, retail sales at most types of stores were up significantly
for the second quarter as a whole.
Even purchases at furniture and appliance
outlets, which had been on a downtrend since last autumn, increased during
the spring.
Real after-tax income has continued to edge up, despite the sharp
drop in output during the recession.
The advance reflects not only typical
cyclical increases in transfer payments but also the reduction in personal
income tax rates on October 1.
Households initially saved a sizable pro-
portion of the tax cut, boosting the personal saving rate frompercent in mid-1981--about equal to the average of the late 1970s and early
1980s--to 6.1 percent in the fourth quarter of 1981.
During early 1982,
however, consumers increased spending, partly to take advantage of price
markdowns for autos and apparel, and the saving rate fell.
Business investment.
As typically occurs during a recession,
the contraction in business fixed investment has lagged behind the decline
in overall activity.
Indeed, even though real GNP dropped substantially
during the first quarter of 1982, real spending for fixed business capital
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-6-
actually rose a bit.
An especially buoyant element of the investment
sector has been outlays for nonfarm buildings--most notably, commercial
office buildings, for which appropriations and contracts often are set
a year or more in advance.
In contrast to investment in structures, business spending for
new equipment showed little advance during 1981 and weakened considerably
in the first half of 1982.
Excluding business purchases of new cars, which
also were buoyed by rebate programs, real investment in producers' durable
equipment fell at a 2 percent annual rate in the first quarter.
evidently accelerated in the second quarter.
The decline
In April and May, shipments
of nondefense capital goods, which account for about 80 percent of the
spending on producers' durable equipment, averaged nearly 3 percent below
the first-quarter level in nominal terms.
Moreover, sales of heavy trucks
dropped during the second quarter to a level more than 20 percent below the
already depressed first-quarter average.
Businesses liquidated inventories at a rapid rate during late 1981
and in the first half of 1982.
The adjustment of stocks followed a sizable
buildup during the summer and autumn of last year that accompanied the contraction of sales.
The most prominent inventory overhang by the end of 1981
was in the automobile sector as sales fell precipitously.
However, with a
combination of production cutbacks and sales promotions, the days' supply
of unsold cars on dealers lots had improved considerably by spring.
Manufacturers and non-auto retailers also found their inventories
rising rapidly last autumn.
Since then, manufacturers as a whole have liqui-
dated the accumulation that occurred during 1981, although some problem areas
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Federal Reserve Bank of St. Louis
-7
still exist--particularly in primary metals.
Stocks held by non-auto
retailers have been brought down from their cyclical peak, but they remain
-above pre-recession levels.
Residential construction.
Housing activity thus far in 1982 has
picked up somewhat from the depressed level in late 1981.
Housing starts
during the first five months of 1982 were up 10 percent on average from the
fourth quarter of 1981.
The improvement in homebuilding has been supported
by strong underlying demand for housing services in most markets and by the
continued adaptation of real estate market participants to nontraditional
financing techniques that facilicate transactions.
The turnaround in housing activity has not occurred in all areas
of the country.
In the south, home sales increased sharply in the first
part of 1982, and housing starts rose 25 percent from the fourth quarter of
1981.
In contrast, housing starts declined further, on average, during
the first five months of 1982 in both the west and the industrial north
central states.
Government.
Federal government purchases of goods and services,
measured in constant dollars, declined over the first half of 1982.
The
decrease occurred entirely in the nondefense area, primarily reflecting
a sharp drop in the rate of inventory accumulation by the Commodity Credit
Corporation during the spring quarter.
Purchases by the Commodity Credit
Corporation had reached record levels during the previous two quarters
owing to last summer's large harvests and weak farm prices.
Other non-
defense outlays fell slightly over the first half of the year as a. result
of cuts in employment and other expenditures under many programs.
Real
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Federal Reserve Bank of St. Louis
-8-
defense spending apparently rose over the first half of the year, and the
backlog of unfilled orders grew further.
The federal deficit on a national
_income and product account basis widened from $100 billion at the end of
1981 to about $130 billion during the spring of this year.
Much of this
increase in the deficit reflects the effects of the recession on federal
expenditures and receipts.
At the state and local government level, real purchases of goods
and services fell further over the first half of 1982 after having declined
2 percent during 1981.
Most of the weakness this year has been in construc-
tion outlays as employment levels uave stabilized after large reductions
in the federally funded CETA program led to sizable layoffs last year.
The
declines in state and local government activity in part reflect fiscal
strains associated with the withdrawal of federal support for many activities and the effects of cyclically sluggish income growth on tax receipts.
Because of the serious revenue problems, several states have increased
sales taxes and excise taxes on gasoline and alcohol.
International payments and trade.
The weighted-average value of
the dollar, after declining about 10 percent from its peak last August,
began to strengthen sharply again around the beginning of the year and since
then has appreciated nearly 15 percent on balance.
The appreciation of
the dollar has been associated to a considerable extent with the declining
inflation rate in the United States and the rise in dollar interest rates
relative to yields on assets denominated in foreign currencies.
Reflecting the effects of the strengthening dollar, as well as the
slowing of economic growth abroad, real exports of goods and services have
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Federal Reserve Bank of St. Louis
Foreign Exchange Value of the U.S. Dollar
Index, March 1973 =100
120
110
100
90
80
1978
1980
1982
Current Account Balance
Annual rate, billions of dollars
20
10
0
10
20
1978
1980
Note Data for 1982 H1 are partially estimated by the FRB.
1982
-9-
been decreasing since the beginning of 1981.
The volume of imports other
than oil, which rose fairly steadily throughout last year, dropped sharply
in the first half of 1982, owing to the weakness of aggregate demand-especially for inventories--in the United States.
In addition, both the
volume and price of imported oil fell during the first half of the year.
The current account, which was in surplus for 1981 as a whole, recorded
another surplus in the first half of this year as the value of imports
fell more than the value of exports.
Labor markets.
Employment has declined by nearly 1-1/2 million
since the peak reached in mid-1981.
As usually happens during a cyclical
contraction, the largest job losses have been in durable goods manufacturing industries--such as autos, steel, and machinery--as well as at construction sites.
The job losses in manufacturing and construction during
this recession follow a limited recovery from the 1980 recession; as a
result, employment levels in these industries are more than 10 percent
below their 1979 highs.
In addition, declines in aggregate demand have
tempered the pace of hiring at service industries and trade establishments
over the past year.
As often happens near a business cycle trough, employ-
ment fell faster than output in early 1982 and labor productivity showed a
small advance after declining sharply during the last half of 1981.
Since mid-1981 there has been a 2-1/4 percentage point rise in the
overall unemployment rate to a postwar record high of 9-1/2 percent.
The
effects of the recession have been most severe in the durable goods and
construction industries, and the burden of rising unemployment has been
relatively heavy on adult men, who tend to be more concentrated in these
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Federal Reserve Bank of St. Louis
-10-
industries.
At the same time, joblessness among young and inexperienced
workers remains extremely high; hardest hit have been black male teenagers
-who experienced an umemployment rate of nearly 60 percent in June 1982.
Reflecting the persistent slack in labor markets, most indicators
of labor supply also show a significant weakening.
For example, the number
of discouraged workers--that is, persons who report that they want work
but are not looking for jobs because they believe they cannot find any--has
increased by nearly half a million over the past year, continuing an upward
trend that began before the 1980 recession.
In addition, the labor force
participation rate--the proportion of the working-age population that is
employed or actively seeking jobs--has been essentially flat for the last
two years after rising about one-half percentage point annually between
1975 and 1979.
Prices and labor costs.
A slowing in the pace of inflation,
which was evident during 1981, continued through the first half of this
year.
During the first five months of 1982 (the latest data available),
the consumer price index increased at an annual rate of 3.5 percent, sharply
lower than the 8.9 percent rise during 1981.
Much of the improvement was
in energy and food prices as well as in the volatile CPI measure of homeownership costs.
But even excluding these items, the annual rate of increase
In consumer prices has slowed to 5-1/2 percent this year compared with a
9-1/2 percent rise last year.
evident at the producer level.
The moderation of price increases also was
Prices of capital equipment have increased
at a 4-1/4 percent annual rate thus far this year--well below the 9-1/4 percent pace of 1981.
In addition, the decline in raw materials prices, which
occurred throughout last year, has continued in the first half of 1982.
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Federal Reserve Bank of St. Louis
Consumer Prices
Change from end of previous period, annual rate, percent
MO CPI
ID CPI Excluding Food. Energy, and Homeownership
15
1
10
,
1110111
IMMO=
II
5
Dec to May
1978
1982
1980
Gasoline Prices
Dollars per gallon
1 50
1.00
50
1982
1980
1978
Hourly Earnings Index
Change from end of previous period, annual rate, percent
9
6
3
H1
1978
1980
H2
H1
1982
-11-
Gasoline prices at the retail level, which had remained virtually
four
flat over the second half of 1981, fell substantially during the first
-months of 1982.
Slack domestic demand and an overhan7 of stocks on world
petroleum markets precipitated the decline in prices.
However, gasoline
prices began to rise again in May in reflection of rising consumption,
reduced stocks, and lower production schedules by major crude oil suppliers.
The rate of increase in employment costs decelerated considerably
during the first half of 1982.
The index of average hourly earnings, a
measure of wage trends for production and nonsupervisory personnel, rose
d
at a 6-1/4 percent annual rate over the first half of this year, compare
with an increase of 8-1/4 percent during 1981.
Part of the slowing was due
to early negotiation of expiring contracts and renegotiation of existing
contracts in a number of major industries.
These wage concessions are
n
expected to relieve cost pressures and to enhance the competitive positio
of firms in these industries.
Increases in fringe benefits, which generally
have risen faster than wages over the years, also are being scaled back.
Because wage demands, not to mention direct escaltor provisions, are responsive to price performance, the progress made in reducing the rate of inflation should contribute to further moderation in labor cost pressures.
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Section 2:
The Growth of Money and Credit in the First Half of 1982
The annual targets for the monetary aggregates announced in February
were chosen to be consistent with continued restraint on the growth of money
and credit in order to exert sustained downward pressure on inflation.
At
the same time, these targets were expected to result in sufficient money
growth to support an upturn in economic activity.
Measured from the fourth
quarter of 1981 to the fourth quarter of 1982, the growth ranges for the
aggregates adopted by the Federal Open Market Committee (FOMC) were as
follows:
for Ml, 2-1/2 to 5-1/2 percent; for M2, 6 to 9 percent; and for
M3, 6-1/2 to 9-1/2 percent.
The corresponding range specified by the FOMC
for bank credit was 6 to 9 percent.'
When the FOMC was deliberating on its annual targets in February,
the Committee was aware that M1 already had risen well above its average
level in the fourth quarter of 1981.
In light of the financial and economic
backdrop against which the bulge in M1 had occurred, the Committee believed
it likely that there had been an upsurge in the public's demand for liquidity.
It also seemed probable that this strengthening of money demand would unwind
in the months ahead.
Thus, under these circumstances and given the relatively
low base for the M1 range for 1982, it did not appear appropriate to seek
an abrupt return to the annual target range, and the FOMC indicated its
willingness to permit M1 to remain above the range for a while.
At the
1. Because of the authorization of international banking facilities (IBFs)
on December 3, 1981, the bank credit data starting in December 1981 are
not comparable with earlier data. The target for bank credit was put
In terms of annualized growth measured from the average of December 1981
and January 1982 to the average level in the fourth quarter of 1982 so that
the shift of assets to IliFs that occurred at the turn of the year would not
have a major impact on the pattern of growth.
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Federal Reserve Bank of St. Louis
-13-
same time, the FOMC agreed that the expansion in M1 for the year as a
whole might appropriately be in the upper part of its range, particularly
If available evidence suggested the persistence of unusual desires for
liquidity that had to be accommodated to avoid undue financial stringency.
In setting the annual target for M2, the FOMC indicated that
M2 growth for the year as a whole probably would be in the upper part of
its annual range and might slightly exceed the upper limit.
The Committee
anticipated that demands for the assets included in M2 might be enhanced
by new tax incentives such as the broadened eligibility for IRA/Keogh
accounts, or by further deregulation of deposit rates.
The Committee
expected that M3 growth again would be influenced importantly by the pattern
of business financing and, in particular, by the degree to which borrowing
would be focused in markets for short-term credit.
As anticipated--and consistent with the FOMC's short-run targets-the surge in M1 growth in December and January was followed by appreciably
slower growth.
After January, M1 increased at an annual rate of only 1-1/4
percent on average, and the level of M1 in June was only slightly above the
upper end of the Committee's annual growth range.
From the fourth quarter
of 1981 to June, M1 increased at a 5.6 percent annual rate.
M2 growth so
far this year also has run a bit above the FOMC's annual range; from the
fourth quarter of 1981 through June, M2 increased on average at a 9.4
percent annual rate.
From a somewhat longer perspective, M1 has increased
at a 4.7 percent annual rate, measuring growth from the first half of 1981
Ranges and Actual Monetary Growth
M1
Billions of dollars
— — Range adopted by FOMC for
1981 04 to 1982 04
Annual Rates of Growth
5 t/29/0
460
1981 04 to June
5.6 Percent
1981 04 to 1982 02
6.8 Percent
450
1981 H1 to 1982 H1
4.7 Percent l
1 Adjusted for shifts into new
NOW accounts in 1981
440
Of
ID
F
1
IA!
IJI
1981
IA
1
1
0 1
ID
1982
M2
Billions of dollars
— — Range adopted by FOMC for
1981 04 to 1982 04
Annual Rates of Growth
, 9%
— 1950
6%
1900
1981 04 to June
9.4 Percent
1981 04 to 1982 02
9.7 Percent
1981 H1 to 1982 H1
9.7 Percent
1850
1800
0
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Federal Reserve Bank of St. Louis
1
1981
D
IF!
1 A
1
I
1982
IAI
L 0 1
1
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Federal Reserve Bank of St. Louis
- 14 -
to the first half of 1982 and abstracting from the shift into NOW accounts
in 1981; and M2 has grown at a 9.7 percent annual rate on a half-year over
-half-year basis.
Although M1 growth has been moderate on balance thus far this
year, that growth has considerably exceeded the pace of increase in nominal
TIP.
Indeed, the first-quarter decline in the income velocity of M1--that
is, GNP divided by M1--was extraordinarily sharp.
the broader aggregates has been unusually weak.
Similarly, the velocity of
Given the persistence of
high interest rates, this pattern of velocity behavior suggests a heightened
demand for M1 and M2 over the first half.
The unusual demand for M1 has been focused on its NOW account
component.
Following the nationwide authorization of NOW accounts at the
beginning of 1981, the growth of such deposits surged.
When the aggregate
targets were reviewed this past February, a variety of evidence indicated
that the major shift from conventional checking and savings accounts into
NOW accounts was over; in particular, the rate at which new accounts were
being opened had dropped off considerably.
As a result of that shift, how-
ever, NOW accounts and other interest-bearing checkable deposits had grown
to account for almost 20 percent of M1 by the beginning of 1982.
Subse-
quently, it has become increasingly apparent that Ml is more sensitive to
changes in the public's desire to hold highly liquid assets.
MI is intended to be a measure of money balances held primarily
for transaction purposes.
However, in contrast to the other major com-
ponents of Ml—currency and conventional checking accounts--NOW accounts
also have some characteristics of traditional savings accounts.
Apparently
reflecting precautionary motives to a considerable degree, NOW accounts and
-other interest-bearing checkable deposits grew surprisingly rapidly in the
fourth quarter of last year and the first quarter of this year.
Although
growth in this component has slowed recently, its growth from the fourth
quarter of last year to June has been 30 percent at an annual rate.
The
other components of M1 increased at an annual rate of less than 1 percent
over this same period.
Looking at the components of M2 not also included in Ml, the
so-called nontransaction components, these items grew at a 10-3/4 percent
annual rate from the fourth quarter to June.
General purpose and broker/
dealer money market mutual funds were an especially strong component of
M2, increasing at almost a 30 percent annual rate this year.
Compared with
last year, however, when the assets of such money funds more than doubled,
this year's increase represents a sharp deceleration.
Perhaps the most surprising development affecting M2 has been the
behavior of conventional savings deposits.
After declining in each of the
past four years--falling 16 percent last year--savings deposits have
increased at about a 4 percent annual rate thus far this year.
This turn-
around in savings deposit flows, taken together with the strong increase
in NOW accounts and the still substantial growth in money funds, suggests
that stronger preferences to hold safe and highly liquid financial assets
in the current recessionary environment are bolstering the demand for M2
as well as Ml.
M3 increased at a 9.7 percent annual rate from the fourth quarter of
1981 to June, just above the upper end 5f the FOMC's annual growth target.
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Ranges and Actual Monetary Growth
M3
Billions of dollars
— — Range adopted by FOMC for
1981 Q4 to 1982 Q4
Annual Rates of Growth
/
2%
91
1981 Q4 to June
9 7 Percent
2300
1981 04 to 1982 Q2
9 8 Percent
00*
1981 H1 to 1982 H1
10 5 Percent
2200
01
IDI
1
Fl
1A1
1,11
Al
101
1
1982
1981
Bank Credit
Billions of dollars
— — Range adopted by FOMC for
Dec. 1981-Jan. 1982 to 1982 Q4
Annual Rates of Growth
n
r
°
Dec.-Jan. to June
8.0 Percent
1400
Dec.-Jan. to 1982 Q2
8.3 Percent
1981 H1 to 1982 H1
8.4 Percentl
1350
0
D I
1981
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F
1AI
IJI
1982
I
A1
WI-1
I
1 Adjusted for initial shifts into
international banking facilities.
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- 16 -
Parly in the year, M3 growth was relatively moderate as a strong rise in
large-denomination CDs was offset by declines in term RPs and in money
market mutual funds restricted to institutional investors.
During the
second quarter, however, M3 showed a larger increase; the weakness in its
term RP and money fund components subsided and heavy issuance of large CDs
continued.
With growth of "core deposits" relatively weak on average,
commercial banks borrowed heavily in the form of large CDs to fund the
increase in their loans and investments.
Commercial bank credit grew at an 8.3 percent annual rate over the
first half of the year, in the upper part of the FOMC's range for 1982.
Bank loans have increased on average at about a 9-1/2 percent annual rate,
with loans to nonfinancial businesses expanding at a 14 percent annual
rate.
In past economic downturns, business loan demand at banks has tended
to weaken, but consistently high long-term interest rates in the current recession have induced corporations to meet the great bulk of their
external financing needs through short-term borrowing.
Real estate loans
have increased at a 7-1/4 percent annual rate this year, somewhat slower
than the growth in each of the past two years.
Consumer loans outstanding
during the first half of the year have grown at the same sluggish pace of
3 percent experienced last year.
The investment portfolios of banks have
expanded at about a 5 percent annual rate, with the rate of increase in
U.S. government obligations about twice as large as the growth in holdings
of other types of securities.
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-17-
Section 3:
The Federal Reserve's Objectives for Growth of Money and Credit
There is a clear need today to promote higher levels of production
and employment in our economy.
The objective of Federal Reserve policy is
to create an environment conducive to sustained recovery in business activity while maintaining the financial discipline needed to restore reasonable
price stability.
The experience of the past two decades has amply demonstra-
ted the destructive impact of inflation on economic performance.
Because
Inflation cannot persist without excessive monetary expansion, appropriately
restrained growth of money and credit over the longer run is critical to
achieving lasting prosperity.
The policy of firm restraint on monetary growth has contributed
importantly to the recent progress toward reducing inflation.
But when
inflationary cost trends remain entrenched, the process of slowing monetary growth can entail economic and financial stresses, especially when so
much of the burden of dealing with inflation rests on monetary policy.
These strains--reflected in reduced profits, liquidity problems, and balance-sheet pressures--place particular hardships on industries that depend
heavily on credit markets such as construction, business equipment, and
consumer durables.
Unfortunately, these stresses cannot be easily remedied through
accelerated money growth.
The immediate effect of encouraging faster growth
in money might be lower interest rates, especially in short-term markets.
In time, however, the attempt to drive interest rates lower through a substantial reacceleration of money growth would founder, for the result would
be to embed inflation and expectations of inflation even more deeply into
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-18-
the nation's economic system.
It would mean that this recession was another
wasted, painful episode instead of a transition to a sustained improvement
..in the economic environment.
The present and prospective pressures on
financial markets urgently need to be eased not by relaxing discipline on
money growth, but by the adoption of policies that will ensure a lower and
declining federal deficit.
Moreover, a return to financial health will
require the adoption of more prudent credit practices on the part of private borrowers and lenders alike.
In reviewing its targets for 1982 and setting tentative targets for
1983, the FOMC had as its basic objective the maintenance of the longerrange thrust of monetary discipline in order to reduce inflation further,
while providing sufficient money growth to accommodate exceptional liquidity
pressures and support a sustainable recovery in economic activity.
At the
same time, the Committee recognized that regulatory actions or changes in
the public's financial behavior might alter the implications of any quantitative monetary goals in ways that cannot be fully predicted.
In light of all these considerations, the Committee concluded that
a change in the previously announced targets was not warranted at this time.
Because of the tendency for the demand for money to run strong on average
In the first half, and also responding to the congressional budget resolution, careful consideration was given to the question of whether some
raising of the targets was in order.
However, the available evidence did
not suggest that a large increase in the ranges was justified, and a small
change in the ranges would have represented a degree of "fine tuning" that
-19-
appeared inconsistent with the degree of uncertainty surrounding the precise
relationship of money to other economic variables at this time.
However,
the Committee concluded, based on current evidence, that growth this year
around the top of the ranges for the various aggregates would be acceptable.
The Committee also agreed that possible shifts in the demand for
liquidity in current economic circumstances might require more than ordinary
elements of flexibility and judgment in assessing appropriate needs for
money in the months ahead.
In the near term, measured growth of the aggre-
gates may be affected by the income tax reductions that occurred on July 1,
by cost-of-living increases in social security benefits, and by the ongoing
difficulties of accurately accounting for seasonal movements in the money
stock.
But more fundamentally, it is unclear to what degree businesses
and households may continue to wish to hold unusually large precautionary
liquid balances.
To the extent the evidence suggests that relatively
strong precautionary demands for money persist, growth of the aggregates
somewhat above their targeted ranges would be tolerated for a time and
still would he consistent with the FOMC's general policy thrust.
Looking ahead to 1983 and beyond, the FOMC remains committed to
restraining money growth in order to achieve sustained noninflationary
economic expansion.
At this point, the FOMC feels that the ranges now
In effect can appropriately remain as preliminary targets for 1983.
Because monetary aggregates in 1982 more likely than not will be close to
-
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the upper ends of their ranges, or perhaps even somewhat above them, the
-20-
preliminary 1983 targets would be fully consistent with a reduction in the
actual growth of money in 1983.
In light of the unusual uncertainty surrounding the economic,
financial, and budgetary outlook, the FOMC stressed the tentative nature
of its 1983 targets.
On the one hand, postwar cyclical experience strongly
suggests that some reversal of this year's unusual shift in the asset-holding preferences of the public could be expected; with economic activity on
an upward trend, any lingering precautionary motives for holding liquid
balances should begin to fade, thus contributing to a rapid rise in the
velocity of money.
Moreover, regulatory actions by the Depository Institu-
tions Deregulation Committee that increase the competitive appeal of deposit
instruments--as well as the more widespread use of innovative cash management
techniques, such as "sweep" accounts--also could reduce the demand for money
relative to income and interest rates.
On the other hand
factors exist
that should increase the attractiveness of holding cash balances.
The long
upward trend in the velocity of money since the 1950s took place in an
environment of rising inflation and higher nominal interest rates--developments that provide incentives for economizing on money holdings.
As these
Incentives recede, it is possible that the attractiveness of cash holdings
will be enhanced and that more money will be held relative to the level of
business activity.
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-21-
Section 4:
The Outlook for the Economy
The economy at midyear appears to have leveled off after sizable
declines last fall and winter.
Consumption has strengthened with retail
sales up significantly in the second quarter.
New and existing home sales
have continued to fluctuate at depressed levels, but housing starts nonetheless have edged up.
In the business sector, substantial progress has been
made in working off excess inventories, and the rate of liquidation appears
to have declined.
On the negative side, however, plant and equipment spend-
ing, which typically lags an upturn in overall activity, is still depressed.
And the trend in export demand continues to be a drag on the economy, reflecting the dollar's strength and weak economic activity abroad.
An evaluation of the balance of economic forces indicates that
an upturn in economic activity is highly likely in the second half of 1982.
Monetary growth along the lines targeted by the FOMC should accommodate this
expansion in realgiven the increases in velocity that typically occur
early in a cyclical recovery and absent an appreciable resurgence of inflation.
The 10 percent cut in income tax rates that went into effect July 1
is boosting disposable personal income and should reinforce the growth in
cSnsumer spending.
Given the improved inventory situation, any sizable
increase in consumer spending should, in turn, be reflected in new orders
and a pickup in production.
Another element supporting growth in real GNP
will be the continuing rise in defense spending and the associated private
investS.nt outlays needed for the production of defense equipment.
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-22-
At least during the initial phase, the expansion is likely to
be more heavily concentrated in consumer spending than in past business
,
cycles, as current pressures in financial markets and liquidity strains
may inhibit the recovery in investment activity.
With mortgage interest
rates high, residential construction does not seem likely to contribute to
the cyclical recovery to the extent that it has in the past.
Likewise,
the high level of corporate bond rates, and the cumulative deterioration
in corporate balance sheets resulting from reliance in recent years on
short-term borrowing, may restrain capital spending, especially given
the considerable margin of unutilized capacity that now exists.
The excellent price performance so far this year has been helped
by slack demand and by exceptionally favorable energy and food supply
developments.
For that reason, the recorded rate of inflation may be higher
In the second half.
However, prospects appear excellent for continuing the
downtrend in the underlying rate of inflation.
As noted earlier, signifi-
cant progress has been made in slowing the rise in labor compensation, and
improvement in underlying cost pressures should continue over the balance
of the year.
Unit labor costs also are likely to be held down by a cyclical
rebound in productivity growth as output recovers.
Moreover, lower inflation
will contribute to smaller cost-of-living wage adjustments, which will moderate cost pressures further.
The Federal Reserve's objectives for money growth through the end
of 1983 are designed to be consistent with continuing recovery in economic
activity.
A critical factor influencing the composition and strength of
the expansion will be the extent to which pressures in financial markets
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Federal Reserve Bank of St. Louis
-23-
moderate.
This, in turn, depends importantly on the progress made in
further reducing inflationary pressures.
A marked decrease in inflation
-would take pressure off financial markets in two ways.
First, slower
inflation will lead to a reduced growth in transaction demands for money,
given any particular level of real activity.
It follows that a given
target for money growth can be achieved with less pressure on interest
rates and accordingly less restraint on real activity, the greater is the
reduction in inflation.
Second, further progress in curbing inflation
will help lower long-term interest rates by reducing the inflation premium
contained in nominal interest rates.
The welcome relief in inflation seen
recently apparently is assumed by many to represent a cyclical rather than
a sustained drop in inflation.
But the longer that improved price perfor-
mance is maintained, the greater will be the confidence that a decisive
downtrend in inflation is being achieved.
Such a change should be reflected
in lower long-term interest rates and stronger activity in the interestsensitive sectors of the economy.
Another crucial influence on financial markets and thus on the
nature of the expansion in 1983 will be the federal budgetary decisions
that are made in coming months.
The budget resolution that was recently
passed by the House and Senate is a constructive first step in reducing
budget deficits as the economy recovers.
However, much remains to be done
In appropriation and revenue legislation to implement this resolution.
How
the budgetary process unfolds will be an important factor in determining
future credit demands by the federal government and thus the extent to which
deficits will preempt the net savings generated by the private economy.
strong program of budget restraint would minimize pressures in financial
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Federal Reserve Bank of St. Louis
A
-24-
markets and thereby enhance the prospects for a more vigorous recovery in
homebuilding, business fixed investment, and other credit-dependent sectors.
In assessing the economic outlook, the individual members of
the FOMC have formulated projections for several key measures of economic
performance that fall generally within the ranges in the table below.
In
addition to the monetary aggregate objectives discussed earlier, these projections assume that the federal budget will be put on a course that over
time will result in significant reductions in the federal deficit.
ECONOMIC PROJECTIONS OF FOMC MEMBERS
Actual
1981
1982
9.8
0.9
8.9
5-1/2 to 7-1/2
1/2 to 1-1/2
4-3/4 to 6
7 to 9-1/2
2-1/2 to 4
4 to 5-3/4
8.3
9 to 9-3/4
8-1/2 to 9-1/2
Projected
1983
Changes, fourth quarter to
fourth quarter, percent
Nominal GNP
Real GNP
GNP deflator
Average level in the fourth
quarter, percent
Unemployment rate
Revised administration forecasts for the economy were not available at the time of the Committee's deliberation.
Our understanding, how-
ever, is that the administration's midyear budgetary review will be presented
within the framework of the economic assumptions used in the first budget
resolution.
For the remainder of 1982, those assumptions imply somewhat more
rapid recovery than the range now thought most likely by members of the FOMC,
but would be consistent with the monetary targets outlined in this report on
the assumption of growth in velocity characteristic of the early stages of a
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Federal Reserve Bank of St. Louis
-25-
number of past recoveries.
Looking further ahead, the Committee members,
like the administration and the Congress, foresee continued economic
-expansion in 1983, hut currently anticipate a less rapid rate of price
1
increase and somewhat slower real growth than the assumptions underlying
the budget.
The monetary targets tentatively set for 1983, which will be
reviewed early next year, would imply, under the budgetary assumptions,
relatively high growth in velocity.
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Federal Reserve Bank of St. Louis
•
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Federal Reserve Bank of St. Louis
For use at 9:30 a.m., E.D.T.
July 20, 1982
••••
Board of Governors of the Federal Reserve System
.•o ov Govt •..
••
.RAL RES -s• ••
• •.. • • •
Midyear Monetary Policy Report to Congress
Pursuant to the
Full Employment and Balanced Growth Act of 1978
July 20, 1982
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Federal Reserve Bank of St. Louis
Letter of Transmittal
BOARD OF GOVERNORS OF THE
FEDERAL RESERVE SYSTEM
Washington, D.C., July 20, 1982
THE PRESIDENT OF THE SENATE
THE SPEAKER OF THE HOUSE OF REPRESENTATIVES.
The Board of Governors is pleased to submit its Midyear Monetary Policy Report to the Congress pursuant
to the Full Employment and Balanced Growth Act of 1978.
Sincerely,
Paul A. Volcker, Chairman
TABLE OF CONTENTS
Page
Section 1:
Section 2:
Section 3:
Section 4:
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Federal Reserve Bank of St. Louis
The Performance of the Economy in the
First Half of 1982
1
The Growth of Money and Credit in the
First H-lf of 1982
12
The Federal Reserve's Objectives for
Growth of Money and Credit
17
The Outlook for the Economy
21
I
Section 1:
The Performance of the Economy in the First Half of 1982
The contraction in economic activity that began in mid-1981 continued into the first half of 1982, although at a diminished pace.
Declines
In production and employment slowed, while sales of automobiles improved.
Real GNP fell at a 4 percent annual rate between the third quarter of 1981
and the first quarter of 1982.
With output declining, the margin of unused
plant capacity widened and the unemployment rate rose to a postwar record.
By mid-1982, however, the recession seemed to be drawing to a
close.
Inventory positions had improved substantially, homebuilding was
beginning to revive, and consumer spending appeared to be rising.
None-
theless, there were signs of increased weakness in business investment.
Although final demands apparently fell during the second quarter, the rate
of inventory liquidation slowed, and on balance, real GNP apparently
changed little.
If, in fact, this spring or early summer is determined to
have been the cyclical trough, both the depth and duration of the decline
in activity will have been about the same as in other postwar recessions.
The progress in reducing inflation that began during 1981 continued in the first half of 1982.
The greatest improvement was in prices
of food and energy--which benefited from favorable supply conditions--but
increases in price measures that exclude these volatile items also have
slowed markedly.
Moreover, increases in employment costs, which carry
forward the momentum of inflation, have diminished considerably.
Not only
have wage increases eased for union workers in hardpressed industries as
a result of contract concessions, but wage and fringe benefit increases
also have slowed for non-union and white-collar workers in a broad range of
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Industrial Production
Index, 1967= 100
150
140
130
1982
1980
1978
Real GNP
Change from end of previous period, annual rate, percent
1972 Dollars
6
3
0
H1
1978
H2
H1
1982
1980
Gross Business Product Prices
Change from end of previous period, annual rate, percent
Fixed-weighted Index
9
6
3
H1
1978
1980
Note Data for 1982 H1 are partially estimated by the FRB.
H2
H1
1982
-2-
industries.
In addition there has been increasing use of negotiated work-
rule changes as well as other efforts by business to enhance productivity
-and trim costs.
At the same time, purchasing power has been rising; real
compensation per hour increased 1 percent during 1981 and rose at about a
3 percent annual rate over the first half of 1982.
Interest rates.
As the recession developed in the autumn of
1981, short-term interest rates moved down substantially.
However, part
of this decline was retraced at the turn of the year as the demand for
money bulged and reserve positions tightened.
After the middle of the
first quarter, short-term rates fluctuated but generally trended downward,
as money--particularly the narrow measure, M1--grew slowly on average and
the weakness in economic activity continued.
In mid-July, short-term rates
were distinctly below the peak levels reached in 1980 and 1981.
Nonethe-
less, short-term rates were still quite high relative to the rate of inflation.
Long-term interest rates also remained high during the first
half of 1982.
In part, this reflected doubts by market participants that
the improved price performance would be sustained over the longer run.
This skepticism was related to the fact that, during the past two decades,
episodes of reduced inflation have been short-lived, followed by reacceleration to even faster rates of price increase.
High long-term rates also have
been fostered by the prospect of huge deficits in the federal budget even
as the economy recovers.
Fears of deepening deficits have affected expecta-
tions of future credit market pressures, and perhaps also have sustained
inflation expectations.
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The resolution on the 1983 fiscal year budget that
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Federal Reserve Bank of St. Louis
Interest Rates
Percent
18
Home Mortgage
14
10
3-month Treasury Bill
6
1980
1978
1982
Funds Raised by Private Nonfinancial Sectors
Seasonally adjusted, annual rate, billions of dollars
Total
300
Business
200
Household
PA
1980
1982
Federal Government Borrobving
Seasonally adjusted, annual rate, billions of dollars
Combined Deficit Financed by the Public
1 20
VA
80
40
I
1
lieu.
1980
Note: Data for 1982 H 1 are partially estimated by the FRB
1982
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Federal Reserve Bank of St. Louis
-3-
was adopted by the Congress represents a beginning effort to deal with the
prospect of widening deficits; and the passage of implementing legislation
should work in the direction of reducing market pressures on interest rates.
Domestic credit flows.
Aggregate credit flows to private non-
financial borrowers increased somewhat in the first half of 1982 from the
reduced pace in the second half of 1981, according to very preliminary
estimates.
Business borrowing rose while households reduced further their
use of credit.
Borrowing by the federal government increased sharply in
late 1981, after the 5 percent cut in personal income tax rates, and
remained near the new higher level during the first half of 1982 on a
seasonally adjusted basis.
Reflecting uncertainties about the future
economic and financial environment, both lenders and borrowers have shown
a strong preference for short-term instruments.
Much of the slackening in credit flows to nonfinancial sectors in
the last part of 1981 was accounted for by households, particularly by
household mortgage borrowing.
up slightly.
Since then, mortgage credit flows have picked
The advance was encouraged in part by the gradual decline in
mortgage rates from the peaks of last fall.
In addition, households have
made widespread use of adjustable-rate mortgages and "creative" financing
techniques--including relatively short-term loans made by sellers at belowmarket interest rates and builder "buy-downs." About two-fifths of all conventional mortgage loans closed recently were adjustable-rate instruments,
and nearly three-fourths of existing home transactions reportedly involved
some sort of creative financing.
-4-
Business borrowing dropped sharply during the last quarter of 1981,
primarily reflecting reduced inventory financing needs.
However, credit use
_by nonfinancial corporations rose significantly in the first half of 1982,
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Federal Reserve Bank of St. Louis
despite a further drop in capital expenditures.
The high level of bond rates
has discouraged corporations from issuing long-term debt, and a relatively
large share of business borrowing this year has been accomplished in shortterm markets--at banks and through sales of commercial paper.
The persis-
tently large volume of business borrowing suggests an accumulation of liquid
assets as well as an intensification of financial pressures on at least some
firms.
Signs of corporate stress continue to mount, including increasing
numbers of dividend reductions or suspensions, a rising fraction of business
loans at commercial banks with interest or principal past due, and relatively
frequent downgradings of credit ratings.
After raising a record volume of funds in U.S. credit markets
in 1981, the federal government continued to borrow at an extraordinary
pace during the first half of 1982, as receipts (national income and product
accounts basis) fell while expenditures continued to rise.
Owing to the
second phase of the tax cut that went into effect on July 1 and the effects
on tax revenues of the recession and reduced inflation
federal credit
demands will expand further in the period ahead.
Consumption.
Personal consumption expenditures (adjusted for
inflation) fell sharply in the fourth quarter of 1981, but turned up early
in 1982 and apparently strengthened further during the second quarter.
The
weakness in consumer outlays during the fourth quarter was concentrated in
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Federal Reserve Bank of St. Louis
Real Income and Consumption
Change from end of previous period, annual rate, percent
Real Disposable Personal Income
pi Real Personal Consumption Expenditures
6
4
2
Ilih
H1
H2
H1
1982
1980
1978
Real Business Fixed Investment
Change from end of previous period, annual rate, percent
EIM Producers' Durable Equipment
Structures
20
10
H1
1980
1978
H2
H1
1982
Total Private Housing Starts
Millions of units
2.0
1.5
1.0
.5
1
1
1978
1
1980
Note Data for 1982 H1 are partially estimated by the FRB
1982
-.5-
the auto sector, as total sales fell to an annual rate of 7.4 million units-the lowest quarterly figure in more than a decade--and sales of domestic
-models plummeted to a 5.1 million unit rate.
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Federal Reserve Bank of St. Louis
Price rebates and other sales promotion programs during the early
months of 1982 provided a fillip to auto demand, and sales climbed to an
8.1 million unit rate.
Auto markets remained firm into the spring, boosted
in part by various purchase incentives.
But as has generally occurred when
major promotions have ended, auto purchases fell sharply in June.
Outcide
the auto sector, retail sales at most types of stores were up significantly
for the second quarter as a whole.
Even purchases at furniture and appliance
outlets, which had been on a downtrend since last autumn, increased during
the spring.
Real after-tax income has continued to edge up, despite the sharp
drop in output during the recession.
The advance reflects not only typical
cyclical increases in transfer payments but also the reduction in personal
income tax rates on October 1.
Households initially saved a sizable pro-
portion of the tax cut, boosting the personal saving rate from 5-1/4 percent in mid-1981--about equal to the average of the late 1970s and early
1980s--to 6.1 percent in the fourth quarter of 1981.
During early 1982,
however, consumers increased spending, partly to take advantage of price
markdowns for autos and apparel, and the saving rate fell.
Business investment.
As typically occurs during a recession,
the contraction in business fixed investment has lagged behind the decline
in overall activity.
Indeed, even though real GNP dropped substantially
during the first quarter of 1982, real spending for fixed business capital
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Federal Reserve Bank of St. Louis
-6-
actually rose a bit.
An especially buoyant element of the investment
sector has been outlays for nonfarm buildings--most notably, commercial
office buildings, for which appropriations and contracts often are set
a year or more in advance.
In contrast to investment in structures, business spending for
new equipment showed little advance during 1981 and weakened considerably
in the first half of 1982.
Excluding business purchases of new cars, which
also were buoyed by rebate programs, real investment in producers' durable
equipment fell at a 2 percent annual rate in the first quarter.
evidently accelerated in the second quarter.
The decline
In April and May, shipments
of nondefense capital goods, which account for about 80 percent of the
spending on producers' durable equipment, averaged nearly 3 percent below
the first-quarter level in nominal terms.
Moreover, sales of heavy trucks
dropped during the second quarter to a level more than 20 percent below the
already depressed first-quarter average.
Businesses liquidated inventories at a rapid rate during late 1981
and in the first half of 1982.
The adjustment of stocks followed a sizable
buildup during the summer and autumn of last year that accompanied the contraction of sales.
The most prominent inventory overhang by the end of 1981
was in the automobile sector as sales fell precipitously.
However, with a
combination of production cutbacks and sales promotions, the days' supply
of unsold cars on dealers lots had improved considerably by spring.
Manufacturers and non-auto retailers also found their inventories
rising rapidly last autumn.
Since then, manufacturers as a whole have liqui-
dated the accumulation that occurred during 1981, although some problem areas
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Federal Reserve Bank of St. Louis
7-
still exist--particularly in primary metals.
Stocks held by non-auto
retailers have been brought down from their cyclical peak, but they remain
_above pre-recession levels.
Residential construction.
Housing activity thus far in 1982 has
picked up somewhat from the depressed level in late 1981.
Housing starts
during the first five months of 1982 were up 10 percent on average from the
fourth quarter of 1981.
The improvement in homebuilding has been supported
by strong underlying demand for housing services in most markets and by the
continued adaptation of real estate market participants to nontraditional
financing techniques that facilicate transactions.
The turnaround in housing activity has not occurred in all areas
of the country.
In the south, home sales increased sharply in the first
part of 1982, and housing starts rose 25 percent from the fourth quarter of
1981.
In contrast, housing starts declined further, on average, during
the first five months of 1982 in both the west and the industrial north
central states.
Government.
Federal government purchases of goods and services,
measured in constant dollars, declined over the first half of 1982.
The
decrease occurred entirely in the nondefense area, primarily reflecting
a sharp drop in the rate of inventory accumulation by the Commodity Credit
Corporation during the spring quarter.
Purchases by the Commodity Credit
Corporation had reached record levels during the previous two quarters
owing to last summer's large harvests and weak farm prices.
Other non-
defense outlays fell slightly over the first half of the year as a. result
of cuts in employment and other expenditures under many programs.
Real
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Federal Reserve Bank of St. Louis
8-
defense spending apparently rose over the first half of the year, and the
backlog of unfilled orders grew further.
The federal deficit on a national
Income and product account basis widened from $100 billion at the end of
1981 to about $130 billion during the spring of this year.
Much of this
increase in the deficit reflects the effects of the recession on federal
expenditures and receipts.
At the state and local government level, real purchases of goods
and services fell further over the first half of 1982 after having declined
2 percent during 1981.
Most of the weakness this year has been in construc-
tion outlays as employment levels 'lave stabilized after large reductions
in the federally funded CETA program led to sizable layoffs last year.
The
declines in state and local government activity in part reflect fiscal
strains associated with the withdrawal of federal support for many activities and the effects of cyclically sluggish income growth on tax receipts.
Because of the serious revenue problems, several states have increased
sales taxes and excise taxes on gasoline and alcohol.
International payments and trade.
The weighted-average value of
the dollar, after declining about 10 percent from its peak last August,
began to strengthen sharply again around the beginning of the year and since
then has appreciated nearly 15 percent on balance.
The appreciation of
the dollar has been associated to a considerable extent with the declining
inflation rate in the United States and the rise in dollar interest rates
relative to yields on assets denominated in foreign currencies.
Reflecting the effects of the strengthening dollar, as well as the
slowing of economic growth abroad, real exports of goods and services have
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Federal Reserve Bank of St. Louis
Foreign Exchange Value of the U.S. Dollar
Index, March 1973 =100
120
110
100
90
80
1978
1980
1982
Current Account Balance
Annual rate, billions of dollars
20
10
0
10
20
1978
1980
Note Data for 1982 H1 are partially estimated by the FRB
1982
-I-
been decreasing since the beginning of 1981.
The volume of imports other
than oil, which rose fairly steadily throughout last year, dropped sharply
_ in the first half of 1982, owing to the weakness of aggregate demand—
especially for inventories--in the United States.
In addition, both the
volume and price of imported oil fell during the first half of the year.
The current account, which was in surplus for 1981 as a whole, recorded
another surplus in the first half of this year as the value of imports
fell more than the value of exports.
Labor markets.
Employment has declined by nearly
since the peak reached in mid-1981.
contraction, the largest
mon
As usually happens during a cyclical
is losses have been in durable goods manufactur-
ing industries--such as autos, steel, and machinery--as well as at construction sites.
The job losses in manufacturing and construction during
this recession follow a limited recovery from the 1980 recession; as a
result, employment levels in these industries are more than 10 percent
I.low their 1979 highs.
In addition, declines in aggregate demand have
tempered the pace of hiring at service industries and trade establishments
over the past year.
As often happens near a business cycle trough, employ-
ment fell faster than output in early 1982 and labor productivity showed a
sI.11 advance after declining sharply during the last half of 1981.
Since mid-1981 there has been a
percentage point rise in the
overall unemployment rate to a postwar record high of
-5-rce
The
effects of the recession have been most severe in the durable goods and
construction industries, and the burden of rising unemployment has been
relatively heavy on adult men, who tend to be 555re concentrated in these
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Federal Reserve Bank of St. Louis
-10-
industries.
At the same time, joblessness among young and inexperienced
workers remains extremely high; hardest hit have been black male teenagers
-who experienced an umemployment rate of nearly 60 percent in June 1982.
Reflecting the persistent slack in labor markets, most indicators
of labor supply also show a significant weakening.
For example, the number
of discouraged workers--that is, persons who report that they want work
but are not looking for jobs because they believe they cannot find any--has
increased by nearly half a million over the past year, continuing an upward
trend that began before the 1980 recession.
In addition, the labor force
participation rate--the proportion of the working-age population that is
employed or actively seeking jobs--has been essentially flat for the last
two years after rising about one-half percentage point annually between
1975 and 1979.
Prices and labor costs.
A slowing in the pace of inflation,
which was evident during 1981, continued through the first half of this
year.
During the first five months of 1982 (the latest data available),
the consumer price index increased at an annual rate of 3.5 percent, sharply
lower than the 8.9 percent rise during 1981.
Much of the improvement was
in energy and food prices as well as in the volatile CPI measure of homeownership costs.
But even excluding these items, the annual rate of increase
in consumer prices has slowed to 5-1/2 percent this year compared with a
9-1/2 percent rise last year.
evident at the producer level.
The moderation of price increases also was
Prices of capital equipment have increased
at a 4-1/4 percent annual rate thus far this year--well below the 9-1/4 percent pace of 1981.
In addition, the decline in raw materials prices, which
occurred throughout last year, has continued in the first half of 1982.
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Federal Reserve Bank of St. Louis
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Federal Reserve Bank of St. Louis
Consumer Prices
Change from end of previous period, annual rate, percent
an
CPI
D CPI Excluding Food, Energy, and Homeownership
15
10
5
Dec to May
1978
1982
1980
Gasoline Prices
Dollars per gallon
1.50
1 00
.50
1982
1980
1978
Hourly Earnings Index
Change from end of previous period, annual rate, percent
9
6
3
H1
1978
1980
H2
H1
1982
-11-
Gasoline prices at the retail level, which had remained virtually
four
flat over the second half of 1981, fell substantially during the first
-months of 1Q82.
Slack domestic demand and an overhan,, of stocks on world
petroleum markets precipitated the decline in prices.
However, gasoline
prices began to rise again in May in reflection of rising consumption,
reduced stocks, and lower production schedules by major crude oil suppliers.
The rate of increase in employment costs decelerated considerably
during the first half of 1982.
The index of average hourly earnings, a
measure of wage trends for production and nonsupervisory personnel, rose
at a 6-1/4 percent annual rate over the first half of this year, compared
with an increase of 8-1/4 percent during 1981.
Part of the slowing was due
to early negotiation of expiring contracts and renegotiation of existing
contracts in a number of major industries.
These wage concessions are
expected to relieve cost pressures and to enhance the competitive position
of firms in these industries.
Increases in fringe benefits, which generally
have risen faster than wages over the years, also are being scaled back.
Because wage demands, not to mention direct escaltor provisions, are responsive to price performance, the progress made in reducing the rate of inflation should contribute to further moderation in labor cost pressures.
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Federal Reserve Bank of St. Louis
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Federal Reserve Bank of St. Louis
-12-
Section 2:
The Growth of Money and Credit in the First Half of 1982
The annual targets for the monetary aggregates announced in February
were chosen to be consistent with continued restraint on the growth of money
and credit in order to exert sustained downward pressure on inflation.
At
the same time, these targets were expected to result in sufficient money
growth to support an upturn in economic activity.
Measured from the fourth
quarter of 1981 to the fourth quarter of 1982, the growth ranges for the
aggregates adopted by the Federal Open Market Committee (FOMC) were as
follows:
for Ml, 2-1/2 to 5-1/2 percent; for M2, 6 to 9 percent; and for
M3, 6-1/2 to 9-1/2 percent.
The corresponding range specified by the FOMC
for bank credit was 6 to 9 percent.'
When the FOMC was deliberating on its annual targets in February,
the Committee was aware that M1 already had risen well above its average
level in the fourth quarter of 1981.
In light of the financial and economic
backdrop against which the bulge in M1 had occurred, the Committee believed
it likely that there had been an upsurge in the public's demand for liquidity.
It also seemed probable that this strengthening of money demand would unwind
in the months ahead.
Thus, under these circumstances and given the relatively
low base for the M1 range for 1982, it did not appear appropriate to seek
an abrupt return to the annual target range, and the FOMC indicated its
willingness to permit M1 to remain above the range for a while.
At the
1. Because of the authorization of international banking facilities (IBFs)
on December 3, 1981, the bank credit data starting in December 1981 are
not comparable with earlier data. The target for bank credit was put
In terms of annualized growth measured from the average of December 1981
and January 1982 to the average level in the fourth quarter of 1982 so that
the shift of assets to IBFs that occurred at the turn of the year would not
have a major impact on the pattern of growth.
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Federal Reserve Bank of St. Louis
-13-
same time, the FOMC agreed that the expansion in M1 for the year as a
whole might appropriately be in the upper part of its range, particularly
If available evidence suggested the persistence of unusual desires for
liquidity that had to be accommodated to avoid undue financial stringency.
In setting the annual target for M2, the FOMC indicated that
M2 growth for the year as a whole probably would be in the upper part of
its annual range and might slightly exceed the upper limit.
The Committee
anticipated that demands for the assets included in M2 might be enhanced
by new tax incentives such as the broadened eligibility for IRA/Keogh
accounts, or by further deregulation of deposit rates.
The Committee
expected that M3 growth again would be influenced importantly by the pattern
of business financing and, in particular, by the degree to which borrowing
would be focused in markets for short-term credit.
As anticipated--and consistent with the FOMC's short-run targets-the surge in M1 growth in December and January was followed by appreciably
slower growth.
After January, M1 increased at an annual rate of only 1-1/4
percent on average, and the level of M1 in June was only slightly above the
upper end of the Committee's annual growth range.
From the fourth quarter
of 1981 to June, M1 increased at a 5.6 percent annual rate.
M2 growth so
far this year also has run a bit above the FOMC's annual range; from the
fourth quarter of 1981 through June, M2 increased on average at a 9.4
percent annual rate.
From a somewhat longer perspective, M1 has increased
at a 4.7 percent annual rate, measuring growth from the first half of 1981
Ranges and Actual Monetary Growth
M1
Billions of dollars
r-- — Range adopted by FOMC for
Annual Rates of Growth
1981 04 to 1982 04
51
/
2%
460
1981 04 to June
5.6 Percent
1981 04 to 1982 02
6.8 Percent
450
1981 H1 to 1982 H1
4.7 Percent l
/
2°A)
21
1 Adjusted for shifts into new
NOW accounts in 1981
440
0
1
I
D
IF!
IA
1981
IJI
IA
1
1
01
10
1982
M2
Billions of dollars
— — Range adopted by FOMC for
1981 04 to 1982 04
Annual Rates of Growth
9%
1950
-6%
1900
1981 04 to June
9.4 Percent
1981 04 to 1982 02
9.7 Percent
1981 H1 to 1982 H1
9.7 Percent
1850
1800
0
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Federal Reserve Bank of St. Louis
1
1 0 1
1981
I
F
IAI
LJI
1982
I
A]
1 0 I
ID
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Federal Reserve Bank of St. Louis
to the first half of 1982 and abstracting from the shift into NOW accounts
in 1981
and M2 has grown at a 9.7 percent annual rate on a half-year over
-half-year basis.
Although M1 growth has been moderate on balance thus far this
year, that growth has considerably exceeded the pace of increase in nominal
CNP.
Indeed, the first-quarter decline in the income velocity of M1--that
is, GNP divided by M1--was extraordinarily sharp.
the broader aggregates has been unusually weak.
Similarly, the velocity of
Given the persistence of
high interest rates, this pattern of velocity behavior suggests a heightened
demand for M1 and M2 over the first half.
The unusual demand for M1 has been focused on its NOW account
component.
Following the nationwide authorization of NOW accounts at the
beginning oU;
the growth of such deposits surged.
When the aggregate
targets were reviewed this past February, a variety of evidence indicated
that the major shift from conventional checking and savings accounts into
NOW accounts was over; in particular, the rate at which new accounts were
being opened had dropped off considerably.
As a result of that shift, how-
ever, NOW accounts and other interest-bearing checkable deposits had grown
to account for almost 20 percent of M1 by the beginning of 1982.
Subse-
quently, it has become increasingly apparent that M1 is more sensitive to
changes in the public's desire to hold highly liquid assets.
M1 is intended to be a measure of money balances held primarily
for transaction purposes.
However, in contrast to the other major com-
ponents of Ml—currency and conventional checking accounts--NOW accounts
-15 -
also have some characteristics of traditional savings accounts.
Apparently
reflecting precautionary motives to a considerable degree, NOW accounts and
-other interest-bearing checkable deposits grew surprisingly rapidly in the
fourth quarter of last year and the first quarter of this year.
Although
growth in this component has slowed recently, its growth from the fourth
quarter of last year to June has been 30 percent at an annual rate.
The
other components of M1 increased at an annual rate of less than 1 percent
over this same period.
Looking at the components of M2 not also included in Ml, the
so-called nontransaction components, these items grew at a 10-3/4 percent
annual rate from the fourth quarter to June.
General purpose and broker/
dealer money market mutual funds were an especially strong component of
M2, increasing at almost a 30 percent annual rate this year.
Compared with
last year, however, when the assets of such money funds more than doubled,
this year's increase represents a sharp deceleration.
Perhaps the most surprising development affecting M2 has been the
behavior of conventional savings deposits.
After declining in each of the
past four years--falling 16 percent last year--savings deposits have
increased at about a 4 percent annual rate thus far this year.
This turn-
around in savings deposit flows, taken together with the strong increase
in NOW accounts and the still substantial growth in money funds, suggests
that stronger preferences to hold safe and highly liquid financial assets
in the current recessionary environment are bolstering the demand for M2
as well as Ml.
M3 increased at a 9.7 percent annual rate from the fourth quarter of
1981 to June, just above the upper end of the FOMC's annual growth target.
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Federal Reserve Bank of St. Louis
Ranges andWTtiActual Monetary Growth
M3
Billions of dollars
— — Range adopted by FOMC for
1981 Q4 to 1982 Q4
Annual Rates of Growth
91
/
2%
1981 Q4 to June
9 7 Percent
2300
1981 04 to 1982 Q2
9 8 Percent
1981 H1 to 1982 H1
10 5 Percent
2200
01
1Di
1
Fl
1A1
1,11
1981
1A1
101
1982
Bank Credit
Billions of dollars
— — Range adopted by FOMC for
Dec. 1981-Jan. 1982 to 1982 Q4
Annual Rates of Growth
/r10 0
Dec.-Jan. to June
8.0 Percent
1400
6c/0
V
1981 H1 to 1982 H1
8 4 Percentl
....".
/
..7 ...'...
../
/
-••••'
01
IDI
1981
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Federal Reserve Bank of St. Louis
IF'
1
A
1
1
J
1
1982
1350
1
A
Dec.-Jan. to 1982 Q2
8.3 Percent
1
0
D
1 Adjusted for initial shifts into
international banking facilities.
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Federal Reserve Bank of St. Louis
- 16 -
Farly in the year, M3 growth was relatively moderate as a strong rise in
large-denomination CDs was offset by declines in term RPs and in money
market mutual funds restricted to institutional investors.
During the
second quarter, however, M3 showed a larger increase; the weakness in its
term RP and money fund components subsided and heavy issuance of large CDs
continued.
With growth of "core deposits" relatively weak on average,
commercial banks borrowed heavily in the form of large CDs to fund the
increase in their loans and investments.
Commercial bank credit grew at an 8.3 percent annual rate over the
first half of the year, in the upper part of the FOMC's range for 1982.
Bank loans have increased on average at about a 9-1/2 percent annual rate,
with loans to nonfinancial businesses expanding at a 14 percent annual
rate.
In past economic downturns, business loan demand at banks has tended
to weaken, hut consistently high long-term interest rates in the current recession have induced corporations to meet the great bulk of their
external financing needs through short-term borrowing.
Real estate loans
have increased at a 7-1/4 percent annual rate this year, somewhat slower
than the growth in each of the past two years.
Consumer loans outstanding
during the first half of the year have grown at the same sluggish pace of
3 percent experienced last year.
The investment portfolios of banks have
expanded at about a 5 percent annual rate, with the rate of increase in
U.S. government obligations about twice as large as the growth in holdings
of other types of securities.
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Federal Reserve Bank of St. Louis
-17-
Section 3:
The Federal Reserve's Objectives for Growth of Money and Credit
There is a clear need today to promote higher levels of production
and employment in our economy.
The objective of Federal Reserve policy is
to create an environment conducive to sustained recovery in business activity while maintaining the financial discipline needed to restore reasonable
price stability.
The experience of the past two decades has amply demonstra-
ted the destructive impact of inflation on economic performance.
Because
inflation cannot persist without excessive monetary expansion, appropriately
restrained growth of money and credit over the longer run is critical to
achieving lasting prosperity.
The policy of firm restraint on monetary growth has contributed
importantly to the recent progress toward reducing inflation.
But when
inflationary cost trends remain entrenched, the process of slowing monetary growth can entail economic and financial stresses, especially when so
much of the burden of dealing with inflation rests on monetary policy.
These strains--reflected in reduced profits, liquidity problems, and balance-sheet pressures--place particular hardships on industries that depend
heavily on credit markets such as construction, business equipment, and
consumer durables.
Unfortunately, these stresses cannot be easily remedied through
accelerated money growth.
The immediate effect of encouraging faster growth
in money might be lower interest rates, especially in short-term markets.
In time, however, the attempt to drive interest rates lower through a substantial reacceleration of money growth would founder, for the result would
be to embed inflation and expectations of inflation even more deeply into
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Federal Reserve Bank of St. Louis
-18-
the nation's economic system.
It would mean that this recession was another
wasted, painful episode instead of a transition to a sustained improvement
.in the economic environment.
The present and prospective pressures on
financial markets urgently need to be eased not by relaxing discipline on
money growth, but by the adoption of policies that will ensure a lower and
declining federal deficit.
Moreover, a return to financial health will
require the adoption of more prudent credit practices on the part of private borrowers and lenders alike.
In reviewing its targets for 1982 and setting tentative targets for
1983, the FOMC had as its basic objective the maintenance of the longerrange thrust of monetary discipline in order to reduce inflation further,
while providing sufficient money growth to accommodate exceptional liquidity
pressures and support a sustainable recovery in economic activity.
At the
same time, the Committee recognized that regulatory actions or changes in
the public's financial behavior might alter the implications of any quantitative monetary goals in ways that cannot be fully predicted.
In light of all these considerations, the Committee concluded that
a change in the previously announced targets was not warranted at this time.
Because of the tendency for the demand for money to run strong on average
in the first half, and also responding to the congressional budget resolution, careful consideration was given to the question of whether some
raising of the targets was in order.
However, the available evidence did
not suggest that a large increase in the ranges was justified, and a small
change in the ranges would have represented a degree of "fine tuning" that
-19--
appeared inconsistent with the degree of uncertainty surrounding the precise
relationship of money to other economic variables at this time.
However,
the Committee concluded, based on current evidence, that growth this year
around the top of the ranges for the various aggregates would be acceptable.
The Committee also agreed that possible shifts in the demand for
liquidity in current economic circumstances might require more than ordinary
elements of flexibility and judgment in assessing appropriate needs for
money in the months ahead.
In the near term, measured growth of the aggre-
gates may be affected by the income tax reductions that occurred on July 1,
by cost-of-living increases in social security benefits, and by the ongoing
difficulties of accurately accounting for seasonal movements in the money
stock.
But more fundamentally, it is unclear to what degree businesses
and households may continue to wish to hold unusually large precautionary
liquid balances.
To the extent the evidence suggests that relatively
strong precautionary demands for money persist, growth of the aggregates
somewhat above their targeted ranges would be tolerated for
A
time and
still would he consistent with the FOMC's general policy thrust.
Looking ahead to 1983 and beyond, the FOMC remains committed to
restraining money growth in order to achieve sustained noninflationary
economic expansion.
At this point, the FOMC feels that the ranges now
in effect can appropriately remain as preliminary targets for 1983.
Because monetary aggregates in 1982 more likely than not will be close to
-
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Federal Reserve Bank of St. Louis
the upper ends of their ranges, or perhaps even somewhat above them, the
•
-2I-
preliminary 1983 targets would be fully consistent with a reduction in the
actual growth of money in 1983.
In light of the unusual uncertainty surrounding the economic,
financial, and budgetary outlook, the FOMC stressed the tentative nature
of its 1983 targets.
On the one hand, postwar cyclical experience strongly
suggests that some reversal of this year's unusual shift in the asset-holding preferences of the public could be expected; with economic activity on
an upward trend, any lingering precautionary motives for holding liquid
balances should begin to fade, thus contributing to a rapid rise in the
velocity of money.
Moreover, regulatory actions by the Depository Institu-
tions Deregulation Committee that increase the competitive appeal of deposit
instruments--as well as the more widespread use of innovative cash management
techniques, such as "sweep" accounts--also could reduce the demand for money
relative to income and interest rates.
On the other hand, factors exist
that should increase the attractiveness of holding cash balances.
The long
uS ward trend in the velocity of money since the 1950s took place in an
environment of rising inflation and higher nominal interest rates--developments that provide incentives for economizing on money holdings.
As these
incentives recede, it is possible that the attractiveness of cash holdings
will be enhanced and that more money will be held relative to the level of
business activity.
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Federal Reserve Bank of St. Louis
-21--
Section 4:
The Outlook for the Economy
The economy at midyear appears to have leveled off after sizable
declines last fall and winter.
Consumption has strengthened with retail
sales up significantly in the second quarter.
New and existing home sales
have continued to fluctuate at depressed levels, but housing starts nonetheless have edged up.
In the business sector, substantial progress has been
made in working off excess inventories, and the rate of liquidation appears
to have declined.
On the negative side, however, plant and equipment spend-
ing, which typically lags an upturn in overall activity, is still depressed.
And the trend in export demand continues to be a drag on the economy, reflecting the dollar's strength and weak economic activity abroad.
An evaluation of the balance of economic forces indicates that
an upturn in economic activity is highly likely in the second half of 1982.
Monetary growth along the lines targeted by the FOMC should accommodate this
expansion in real GNP, given the increases in velocity that typically occur
early in a cyclical recovery and absent an appreciable resurgence of inflation.
The 10 percent cut in income tax rates that went into effect July 1
is boosting disposable personal income and should reinforce the growth in
consumer spending.
Given the improved inventory situation, any sizable
increase in consumer spending should, in turn, be reflected in new orders
and a pickup in production.
Another element supporting growth in real GNP
will be the continuing rise in defense spending and the associated private
investment outlays needed for the production of defense equipment.
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Federal Reserve Bank of St. Louis
-22-
At least during the initial phase, the expansion is likely to
be more heavily concentrated in consumer spending than in past business
cycles, as current pressures in financial markets and liquidity strains
,
may inhibit the recovery in investment activity.
With mortgage interest
rates high, residential construction does not seem likely to contribute to
the cyclical recovery to the extent that it has in the past.
Likewise,
the high level of corporate bond rates, and the cumulative deterioration
In corporate balance sheets resulting from reliance in recent years on
short-term borrowing, may restrain capital spending, especially given
the considerable margin of unutilized capacity that now exists.
The excellent price performance so far this year has been helped
by slack demand and by exceptionally favorable energy and food supply
developments.
For that reason, the recorded rate of inflation may be higher
In the second half.
However, prospects appear excellent for continuing the
downtrend in the underlying rate of inflation.
As noted earlier, signifi-
cant progress has been made in slowing the rise in labor compensation, and
improvement in underlying cost pressures should continue over the balance
of the year.
Unit labor costs also are likely to be held down by a cyclical
rebound in productivity growth as output recovers.
Moreover, lower inflation
will contribute to smaller cost-of-living wage adjustments, which will moderate cost pressures further.
The Federal Reserve's objectives for money growth through the end
of 1983 are designed to be consistent with continuing recovery in economic
activity.
A critical factor influencing the composition and strength of
the expansion will be the extent to which pressures in financial markets
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Federal Reserve Bank of St. Louis
-23-
moderate.
This, in turn, depends importantly on the progress made in
further reducing inflationary pressures.
A marked decrease in inflation
-would take pressure off financial markets in two ways.
First, slower
inflation will lead to a reduced growth in transaction demands for money,
given any particular level of real activity.
It follows that a given
target for money growth can be achieved with less pressure on interest
rates and accordingly less restraint on real activity, the greater is the
reduction in inflation.
Second, further progress in curbing inflation
will help lower long-term interest rates by reducing the inflation premium
contained in nominal interest rates.
The welcome relief in inflation seen
recently apparently is assumed by many to represent a cyclical rather than
a sustained drop in inflation.
But the longer that improved price perfor-
mance is maintained, the greater will be the confidence that a decisive
downtrend in inflation is being achieved.
Such a change should be reflected
In lower long-term interest rates and stronger activity in the interestsensitive sectors of the economy.
Another crucial influence on financial markets and thus on the
nature of the expansion in 1983 will be the federal budgetary decisions
that are made in coming months.
The budget resolution that was recently
passed by the House and Senate is a constructive first step in reducing
budget deficits as the economy recovers.
However, much remains to be done
in appropriation and revenue legislation to implement this resolution.
How
the budgetary process unfolds will be an important factor in determining
future credit demands by the federal government and thus the extent to which
deficits will preempt the net savings generated by the private economy.
strong program of budget restraint would minimize pressures in financial
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Federal Reserve Bank of St. Louis
A
-24-
markets and thereby enhance the prospects for a more vigorous recovery in
homebuilding, business fixed investment, and other credit-dependent sectors.
In assessing the economic outlook, the individual members of
the FOMC have formulated projections for several key measures of economic
performance that fall generally within the ranges in the table below.
In
addition to the monetary aggregate objectives discussed earlier, these projections assume that the federal budget will be put on a course that over
time will result in significant reductions in the federal deficit.
ECONOMIC PROJECTIONS OF FOMC MEMBERS
Actual
1981
Projected
1982
9.8
0.9
8.9
5-1/2 to 7-1/2
1/2 to 1-1/2
4-3/4 to 6
7 to 9-1/2
2-1/2 to 4
4 to 5-3/4
8.3
9 to 9-3/4
8-1/2 to 9-1/2
1983
Changes, fourth quarter to
fourth quarter, percent
Nominal GNP
Real GNP
GNP deflator
Average level in the fourth
quarter, percent
Unemployment rate
Revised administration forecasts for the economy were not available at the time of the Committee's deliberation.
Our understanding, how-
ever, is that the administration's midyear budgetary review will be presented
within the framework of the economic assumptions used in the first budget
resolution.
For the remainder of 1982, those assumptions imply somewhat more
rapid recovery than the range now thought most likely by members of the FOMC,
but would be consistent with the monetary targets outlined in this report on
the assumption of growth in velocity characteristic of the early stages of a
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Federal Reserve Bank of St. Louis
-25—
number of past recoveries.
Looking further ahead, the Committee members,
like the administration and the Congress, foresee continued economic
-expansion in 1983, hut currently anticipate a less rapid rate of price
increase and somewhat slower real growth than the assumptions underlying
the budget.
The monetary targets tentatively set for 1983, which will be
reviewed early next year, would imply, under the budgetary assumptions,
relatively high growth in velocity.
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/6Zs
For use at 9:30 a.m., E.D.T.
July 20, 1982
• •• •
Board of Governors of the Federal Reserve System
Gove/e*.
•
‘, •
(-) •
.RAL fitScL:4•44:.
• •...• •
Midyear Monetary Policy Report to Congress
Pursuant to the
Full Employment and Balanced Growth Act of 1978
July 20, 1982
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Federal Reserve Bank of St. Louis
..• •• •..
.•,0 of GOvtli.
• Q•0P
:
co
..
,
-,
••.eRAL
REs• •...
••
Letter of Transmittal
BOARD OF GOVERNORS OF THE
FEDERAL RESERVE SYSTEM
Washington, D.C., July 20, 1982
THE PRESIDENT OF THE SENATE
THE SPEAKER OF THE HOUSE OF REPRESENTATIVES.
The Board of Governors is pleased to submit its Midyear Monetary Policy Report to the Congress pursuant
to the Full Employment and Balanced Growth Act of 1978.
Sincerely,
Paul A. Volcker, Chairman
TABLE OF CONTENTS
Page
Section 1:
Section 2:
Section 3:
Section 4:
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Federal Reserve Bank of St. Louis
The Performance of the Economy in the
First Half of 1982
1
The Growth of Money and Credit in the
First H-lf of 1982
12
The Federal Reserve's Objectives for
Growth of Money and Credit
17
The Outlook for the Economy
21
MMIW.
Section 1:
The Performance of the Economy in the First Half of 1982
The contraction in economic activity that began in mid-1981 continued into the first half of 1982, although at a diminished pace.
Declines
in production and employment slowed, while sales of automobiles improved.
Real GNP fell at a 4 percent annual rate between the third quarter of 1981
and the first quarter of 1982.
With output declining, the margin of unused
plant capacity widened and the unemployment rate rose to a postwar record.
By mid-1982, however, the recession seemed to be drawing to a
close.
Inventory positions had improved substantially, homebuilding was
beginning to revive, and consumer spending appeared to be rising.
None-
theless, there were signs of increased weakness in business investment.
Although final demands apparently fell during the second quarter, the rate
of inventory liquidation slowed, and on balance, real GNP apparently
changed little.
If, in fact, this spring or early summer is determined to
have been the cyclical trough, both the depth and duration of the decline
in activity will have been about the same as in other postwar recessions.
The progress in reducing inflation that began during 1981 continued in the first half of 1982.
The greatest improvement was in prices
of food and energy--which benefited from favorable supply conditions--but
Increases in price measures that exclude these volatile items also have
slowed markedly.
Moreover, increases in employment costs, which carry
forward the momentum of inflation, have diminished considerably.
Not only
have wage increases eased for union workers in hardpressed industries as
a result of contract concessions, but wage and fringe benefit increases
also have slowed for non-union and white-collar workers in a broad range of
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Industrial Production
Index, 1967= 100
150
140
130
1982
1980
1978
Real GNP
Change from end of previous period, annual rate, percent
1972 Dollars
6
3
0
Ui
H1
1978
H2
H1
1982
1980
Gross Business Product Prices
Change from end of previous period, annual rate, percent
Fixed-weighted Index
9
6
3
H1
1978
1980
Note. Data for 1982 H1 are partially estimated by the FRB.
H2
H1
1982
-2--
industries.
In addition there has been increasing use of negotiated work-
rule changes as well as other efforts by business to enhance productivity
-and trim costs.
At the same time, purchasing power has been rising; real
compensation per hour increased 1 percent during 1981 and rose at about a
3 percent annual rate over the first half of 1982.
Interest rates.
As the recession developed in the autumn of
1981, short-term interest rates moved down substantially.
However, part
of this decline was retraced at the turn of the year as the demand for
money bulged and reserve positions tightened.
After the middle of the
first quarter, short-term rates fluctuated but generally trended downward,
as money--particularly the narrow measure, M1---grew slowly on average and
the weakness in economic activity continued.
In mid-July, short-term rates
were distinctly below the peak levels reached in 1980 and 1981.
Nonethe-
less, short-term rates were still quite high relative to the rate of inflation.
Long-term interest rates also remained high during the first
half of 1982.
In part, this reflected doubts by market participants that
the improved price performance would be sustained over the longer run.
This skepticism was related to the fact that, during the past two decades,
episodes of reduced inflation have been short-lived, followed by reacceleration to even faster rates of price increase.
High long-term rates also have
been fostered by the prospect of huge deficits in the federal budget even
as the economy recovers.
Fears of deepening deficits have affected expecta-
tions of future credit market pressures, and perhaps also have sustained
inflation expectations.
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The resolution on the 1983 fiscal year budget that
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Interest Rates
Percent
18
Home Mortgage
14
10
3-month Treasury Bill
6
1978
1980
1982
Funds Raised by Private Nonfinancial Sectors
Seasonally adjusted, annual rate, billions of dollars
300
Total
Business
-1
200
100
Household
f
1980
1982
Federal Government Borrowing
Seasonally adjusted, annual rate, billions of dollars
Combined Deficit Financed by the Public
120
80
40
1978
1980
Note: Data for 1982 H1 are partially estimated by the FRB
1982
•
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-3-
was adopted by the Congress represents a beginning effort to deal with the
prospect of widening deficits; and the passage of implementing legislation
_should work in the direction of reducing market pressures on interest rates.
Domestic credit flows.
Aggregate credit flows to private non-
financial borrowers increased somewhat in the first half of 1982 from the
reduced pace in the second half of 1981, according to very preliminary
estimates.
Business borrowing rose while households reduced further their
use of credit.
Borrowing by the federal government increased sharply in
late 1981, after the 5 percent cut in personal income tax rates, and
remained near the new higher level during the first half of 1982 on a
seasonally adjusted basis.
Reflecting uncertainties about the future
economic and financial environment, both lenders and borrowers have shown
a strong preference for short-term instruments.
Much of the slackening in credit flows to nonfinancial sectors in
the last part of 1981 was accounted for by households, particularly by
household mortgage borrowing.
up slightly.
Since then, mortgage credit flows have picked
The advance was encouraged in part by the gradual decline in
mortgage rates from the peaks of last fall.
In addition, households have
made widespread use of adjustable-rate mortgages and "creative" financing
techniques--including relatively short-term loans made by sellers at belowmarket interest rates and builder "buy-downs." About two-fifths of all conventional mortgage loans closed recently were adjustable-rate instruments,
and nearly three-fourths of existing home transactions reportedly involved
some sort of creative financing.
-4-
Business borrowing dropped sharply during the last quarter of 1981,
primarily reflecting reduced inventory financing needs.
However, credit use
by nonfinancial corporations rose significantly in the first half of 1982,
.
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despite a further drop in capital expenditures.
The high level of bond rates
has discouraged corporations from issuing long-term debt, and a relatively
large share of business borrowing this year has been accomplished in shortterm markets--at banks and through sales of commercial paper.
The persis-
tently large volume of business borrowing suggests an accumulation of liquid
assets as well as an intensification of financial pressures on at least some
firms.
Signs of corporate stress continue to mount, including increasing
numbers of dividend reductions or suspensions, a rising fraction of business
loans at commercial banks with interest or principal past due, and relatively
frequent downgradings of credit ratings.
After raising a record volume of funds in U.S. credit markets
in 1981, the federal government continued to borrow at an extraordinary
pace during the first half of 1982, as receipts (national income and product
accounts basis) fell while expenditures continued to rise.
Owing to the
second phase of the tax cut that went into effect on July 1 and the effects
on tax revenues of the recession and reduced inflation, federal credit
demands will expand further in the period ahead.
Consumption.
Personal consumption expenditures (adjusted for
inflation) fell sharply in the fourth quarter of 1981, but turned up early
in 1982 and apparently strengthened further during the second quarter.
The
weakness in consumer outlays during the fourth quarter was concentrated in
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Federal Reserve Bank of St. Louis
Real Income and Consumption
Change from end of previous period, annual rate, percent
ED Real Disposable Personal Income
Real Personal Consumption Expenditures
6
4
2
1
1
1978
1Ih
H1
H2
H1
1982
1980
Real Business Fixed Investment
Change from end of previous period, annual rate, percent
ITh Producers' Durable Equipment
n Structures
20
10
0
H1
1978
1980
H2
H1
1982
Total Private Housing Starts
Millions of units
2.0
1.5
10
5
1978
1980
Note Data for 1982 H1 are partially estimated by the FRB
1982
-5—
the auto sector, as total sales fell to an annual rate of 7.4 million units-the lowest quarterly figure in more than a decade--and sales of domestic
-models plummeted to a 5.1 million unit rate.
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Price rebates and other sales promotion programs during the early
months of 1982 provided a fillip to auto demand, and sales climbed to an
8.1 million unit rate.
Auto markets remained firm into the spring, boosted
in part by various purchase incentives.
But as has generally occurred when
major promotions have ended, auto purchases fell sharply in June.
Outside
the auto sector, retail sales at most types of stores were up significantly
for the second quarter as a whole.
Even purchases at furniture and appliance
outlets, which had been on a downtrend since last autumn, increased during
the spring.
Real after—tax income has continued to edge up, despite the sharp
drop in output during the recession.
The advance reflects not only typical
cyclical increases in transfer payments but also the reduction in personal
income tax rates on October 1.
Households initially saved a sizable pro—
portion of the tax cut, boosting the personal saving rate from 5-1/4 per—
cent in mid-1981--about equal to the average of the late 1970s and early
1980s--to 6.1 percent in the fourth quarter of 1981.
During early 1982,
however, consumers increased spending, partly to take advantage of price
markdowns for autos and apparel, and the saving rate fell.
Business investment.
As typically occurs during a recession,
the contraction in business fixed investment has lagged behind the decline
in overall activity.
Indeed, even though real GNP dropped substantially
during the first quarter of 1982, real spending for fixed business capital
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Federal Reserve Bank of St. Louis
-6-
actually rose a bit.
An especially buoyant element of the investment
sector has been outlays for nonfarm buildings--most notably, commercial
office buildings, for which appropriations and contracts often are set
a year or more in advance.
In contrast to investment in structures, business spending for
new equipment showed little advance during 1981 and weakened considerably
in the first half of 1982.
Excluding business purchases of new cars, which
also were buoyed by rebate programs, real investment in producers' durable
equipment fell at a 2 percent annual rate in the first quarter.
evidently accelerated in the second quarter.
The decline
In April and May, shipments
of nondefense capital goods, which account for about 80 percent of the
spending on producers' durable equipment, averaged nearly 3 percent below
the first-quarter level in nominal terms.
Moreover, sales of heavy trucks
dropped during the second quarter to a level more than 20 percent below the
already depressed first-quarter average.
Businesses liquidated inventories at a rapid rate during late 1981
and in the first half of 1982.
The adjustment of stocks followed a sizable
buildup during the summer and autumn of last year that accompanied the contraction of sales.
The most prominent inventory overhang by the end of 1981
was in the automobile sector as sales fell precipitously.
However, with a
combination of production cutbacks and sales promotions, the days' supply
of unsold cars on dealers lots had improved considerably by spring.
Manufacturers and non-auto retailers also found their inventories
rising rapidly last autumn.
Since then, manufacturers as a whole have liqui-
dated the accumulation that occurred during 1981, although some problem areas
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Federal Reserve Bank of St. Louis
-7-
still exist--particularly in primary metals.
Stocks held by non-auto
retailers have been brought down from their cyclical peak, but they remain
-above pre-recession levels.
Residential construction.
Housing activity thus far in 1982 has
picked up somewhat from the depressed level in late 1981.
Housing starts
during the first five months of 1982 were up 10 percent on average from the
fourth quarter of 1981.
The improvement in homebuilding has been supported
by strong underlying demand for housing services in most markets and by the
continued adaptation of real estate market participants to nontraditional
financing techniques that facilicate transactions.
The turnaround in housing activity has not occurred in all areas
of the country.
In the south, home sales increased sharply in the first
part of 1982, and housing starts rose 25 percent from the fourth quarter of
1981.
In contrast, housing starts declined further, on average, during
the first five months of 1982 in both the west and the industrial north
central states.
Government.
Federal government purchases of goods and services,
measured in constant dollars, declined over the first half of 1982.
The
decrease occurred entirely in the nondefense area, primarily reflecting
a sharp drop in the rate of inventory accumulation by the Commodity Credit
Corporation during the spring quarter.
Purchases by the Commodity Credit
Corporation had reached record levels during the previous two quarters
owing to last summer's large harvests and weak farm prices.
Other non-
defense outlays fell slightly over the first half of the year as a. result
of cuts in employment and other expenditures under many programs.
Real
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-8-
defense spending apparently rose over the first half of the year, and the
backlog of unfilled orders grew further.
The federal deficit on a national
Income and product account basis widened from $100 bon at the end of
1981 to about $130 billion during the spring of this year.
Much of this
increase in the deficit reflects the effects of the recession on federal
expenditures and receipts.
At the state and local government level, real purchases of goods
and services fell further over the first half of 1982 after having declined
2 percent during 1981.
Most of the weakness this year has been in construc-
tion outlays as employment levels uave stabilized after large reductions
in the federally funded CETA program led to sizable layoffs last year.
The
declines in state and local government activity in part reflect fiscal
strains associated with the withdrawal of federal support for many activities and the effects of cyclically sluggish income growth on tax receipts.
Because of the serious revenue problems, several states have increased
sales taxes and excise taxes on gasoline and alcohol.
International payments and trade.
The weighted-average value of
the dollar, after declining about 10 percent from its peak last August,
began to strengthen sharply again around the beginning of the year and since
then has appreciated nearly 15 percent on balance.
The appreciation of
the dollar has been associated to a considerable extent with the declining
inflatiS n rate in the United States and the rise in dollar interest rates
relative to yields on assets denominated
nSregn currencies.
Reflecting the effects of the strengthening dollar, as well as the
slowing of economic growth abroad, r --l exports of goods and services have
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Foreign Exchange Value of the U.S. Dollar
Index, March 1973=100
120
110
100
90
80
1978
1980
1982
Current Account Balance
Annual rate, billions of dollars
20
10
0
10
20
1978
1980
Note Data for 1982 H1 are partially estimated by the FRB.
1982
-9-
been decreasing since the beginning of 1981.
The volume of imports other
than oil, which rose fairly steadily throughout last year, dropped sharply
in the first half of 1982, owing to the weakness of aggregate demand-especially for inventories--in the United States.
In addition, both the
volume and price of imported oil fell during the first half of the year.
The current account, which was in surplus for 1981 as a whole, recorded
another surplus in the first half of this year as the value of imports
fell more than the value of exports.
Labor markets.
Employment has declined by nearly 1-1/2 million
since the peak reached in mid-1981.
As usually happens during a cyclical
contraction, the largest job losses have been in durable goods manufacturing industries--such as autos, steel, and machinery--as well as at construction sites.
The job losses in manufacturing and construction during
this recession follow a limited recovery from the 1980 recession; as a
result, employment levels in these industries are more than 10 percent
below their 1979 highs.
In addition, declines in aggregate demand have
tempered the pace of hiring at service industries and trade establishments
over the past year.
As often happens near a business cycle trough, employ-
ment fell faster than output in early 1982 and labor productivity showed a
small advance after declining sharply during the last half of 1981.
Since mid-1981 there has been a 2-1/4 percentage point rise in the
overall unemployment rate to a postwar record high of 9-1/2 percent.
The
effects of the recession have been most severe in the durable goods and
construction industries, and the burden of rising unemployment has been
relatively heavy on adult men, who tend to be more concentrated in these
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Federal Reserve Bank of St. Louis
-10-
industries.
At the same time, joblessness among young and inexperienced
workers remains extremely high; hardest hit have been black male teenagers
-who experienced an umemployment rate of nearly 60 percent in June 1982.
Reflecting the persistent slack in labor markets, most indicators
of labor supply also show a significant weakening.
For example, the number
of discouraged workers--that is, persons who report that they want work
but are not looking for jobs because they believe they cannot find any--has
increased by nearly half a million over the past year, continuing an upward
trend that began before the 1980 recession.
In addition, the labor force
participation rate--the proportion of the working-age population that is
employed or actively seeking jobs--has been essentially flat for the last
two years after rising about one-half percentage point annually between
1975 and 1979.
Prices and labor costs.
A slowing in the pace of inflation,
which was evident during 1981, continued through the first half of this
year.
During the first five months of 1982 (the latest data available),
the consumer price index increased at an annual rate of 3.5 percent, sharply
lower than the 8.9 percent rise during 1981.
Much of the improvement was
in energy and food prices as well as in the volatile CPI measure of homeownership costs.
But even excluding these items, the annual rate of increase
in consumer prices has slowed to 5-1/2 percent this year compared with a
9-1/2 percent rise last year.
evident at the producer level.
The moderation of price increases also was
Prices of capital equipment have increased
at a 4-1/4 percent annual rate thus far this year--well below the 9-1/4 percent pace of 1981.
In addition, the decline in raw materials prices, which
occurred throughout last year, has continued in the first half of 1982.
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Consumer Prices
an
U
Change from end of previous period, annual rate, percent
CPI
CPI Excluding Food, Energy, and Homeownership
15
10
vipmEnr
5
Dec to May
1982
1980
1978
Gasoline Prices
Dollars per gallon
1.50
/
1 00
50
1982
1980
1978
Hourly Earnings Index
Change from end of previous period, annual rate, percent
9
6
3
H1
1978
1980
H2
H1
1982
-11-
GasSline prices at the retail level, which had remained virtually
flat over the second half of 1981, fell substantially during the first four
-months of 1982.
Slack domestic demand and an overhang of stocks on world
S. troleum markets precipitated the decline in prices.
However, gasoline
prices began to rise again in May in reflection of rising consumption,
reduced stocks, and lower production schedules by major crude oil suppliers.
The rate of increase in employment costs decelerated considerably
during the first half of 1982.
The Index of average hourly earnings, a
measure of wage trends for production and nonsupervisory personnel, rose
at apercent annual rate over the first half of this year, compared
with an increase of 8-1/4 percent during 1981.
Part of the slowing was due
to early negotiation of expiring contracts and renegotiation of existing
cS ntracts in a number of major industries.
These wage concessions are
expected to relieve cost pressures and to enhance the competitive position
of firms in these industries.
Increases in fringe benefits, which generally
have risen faster than wages over the years, also are being scaled S.
Because wage demands, not to mention direct escaltor provisions, are responsive to price performance, the progress made in reducing the rate of inflation should contribute to further moderation in labor cost pressures.
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-12-
Section 2:
The Growth of Money and Credit in the First Half of 1982
The annual targets for the monetary aggregates announced in February
were chosen to be consistent with continued restraint on the growth of money
and credit in order to exert sustained downward pressure on inflation.
At
the same time, these targets were expected to result in sufficient money
growth to support an upturn in economic activity.
Measured from the fourth
quarter of 1981 to the fourth quarter of 1982, the growth ranges for the
aggregates adopted by the Federal Open Market Committee (FOMC) were as
follows:
for Ml, 2-1/2 to 5-1/2 percent; for M2, 6 to 9 percent; and for
M3, 6-1/2 to 9-1/2 percent.
The corresponding range specified by the FOMC
for bank credit was 6 to 9 percent.'
When the FOMC was deliberating on its annual targets in February,
the Committee was aware that M1 already had risen well above its average
level in the fourth quarter of 1981.
In light of the financial and economic
backdrop against which the bulge in M1 had occurred, the Committee believed
it likely that there had been an upsurge in the public's demand for liquidity.
It also seemed probable that this strengthening of money demand would unwind
In the months ahead.
Thus, under these circumstances and given the relatively
low base for the M1 range for 1982, it did not appear appropriate to seek
an abrupt return to the annual target range, and the FOMC indicated its
willingness to permit M1 to remain above the range for a while.
At the
1. Because of the authorization of international banking facilities (IBFs)
on December 1, 1981, the bank credit data starting in December 1981 are
not comparable with earlier data. The target for bank credit was put
In terms of annualized growth measured from the average of December 1981
and January 1982 to the average level in the fourth quarter of 1982 so that
the shift of assets to IBFs that occurred at the turn of the year would not
have a major impact on the pattern of growth.
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Federal Reserve Bank of St. Louis
-13-
same time, the FOMC agreed that the expansion in M1 for the year as a
whole might appropriately be in the upper part of its range, particularly
if available evidence suggested the persistence of unusual desires for
liquidity that had to be accommodated to avoid undue financial stringency.
In setting the annual target for M2, the FOMC indicated that
M2 growth for the year as a whole probably would be in the upper part of
its annual range and might slightly exceed the upper limit.
The Committee
anticipated that demands for the assets included in M2 might be enhanced
by new tax incentives such as the broadened eligibility for IRA/Keogh
accounts, or by further deregulation of deposit rates.
The Committee
expected that M3 growth again would be influenced importantly by the pattern
of business financing and, in particular, by the degree to which borrowing
would be focused in markets for short-term credit.
As anticipated--and consistent with the FOMC's short-run targets-the surge in M1 growth in December and January was followed by appreciably
slower growth.
After January, M1 increased at an annual rate of only 1-1/4
percent on average, and the level of M1 in June was only slightly above the
upper end of the Committee's annual growth range.
From the fourth quarter
of 1981 to June, Ml increased at a 5.6 percent annual rate.
M2 growth so
far this year also has run a bit above the FOMC's annual range; from the
fourth quarter of 1981 through June, M2 increased on average at a 9.4
percent annual rate.
From a somewhat longer perspective, M1 has increased
at a 4.7 percent annual rate, measuring growth from the first half of 1981
Ranges and Actual Monetary Growth
M1
Billions of dollars
— — Range adopted by FOMC for
1981 04 to 1982 04
Annual Rates of Growth
51/2%
460
1981 Q4 to June
5.6 Percent
1981 04 to 1982 02
6.8 Percent
450
1981 H1 to 1982 H1
4 7 Percent'
/
2%
21
1 Adjusted for shItts into new
NOW accounts in 1981
440
0 1
ID
1
IF
I
IA
I
1981
ij
ID
IA101
1982
M2
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Federal Reserve Bank of St. Louis
Billions of dollars
— — Range adopted by FOMC for
1981 04 to 1982 04
Annual Rates of Growth
, 9%
1950
•
6%
1900
1981 04 to June
9.4 Percent
1981 04 to 1982 02
9.7 Percent
1981 H1 to 1982 H1
9.7 Percent
1850
1800
0
1
1
1981
1
F
I
IA!
IJ I
IA I
1982
0 1
D
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Federal Reserve Bank of St. Louis
- 14 -
to the first half of 1982 and abstracting from the shift into NOW accounts
in 1981; and M2 has grown at a 9.7 percent annual rate on a half-year over
-half-year basis.
Although M1 growth has been moderate on balance thus far this
year, that growth has considerably exceeded the pace of increase in nominal
GNP.
Indeed, the first-quarter decline in the income velocity of M1--that
is, GNP divided by M1--was extraordinarily sharp.
the broader aggregates has been unusually weak.
Similarly, the velocity of
Given the persistence of
high interest rates, this pattern of velocity behavior suggests a heightened
demand for M1 and M2 over the first half.
The unusual demand for M1 has been focused on its NOW account
component.
Following the nationwide authorization of NOW accounts at the
beginning of 1981, the growth of such deposits surged.
When the aggregate
targets were reviewed this past February, a variety of evidence indicated
that the major shift from conventional checking and savings accounts into
NOW accounts was over; in particular, the rate at which new accounts were
being opened had dropped off considerably.
As a result of that shift, how-
ever, NOW accounts and other interest-bearing checkable deposits had grown
to account for almost 20 percent of M1 by the beginning of 1982.
Subse-
quently, it has become increasingly apparent that M1 is more sensitive to
changes in the public's desire to hold highly liquid assets.
M1 is intended to be a measure of money balances held primarily
for transaction purposes.
However, in contrast to the other major com-
ponents of Ml—currency and conventional checking accounts--NOW accounts
-15 -
also have some characteristics of traditional savings accounts.
Apparently
reflecting precautionary motives to a considerable degree, NOW accounts and
-other interest-bearing checkable deposits grew surprisingly rapidly in the
fourth quarter of last year and the first quarter of this year.
Although
growth in this component has slowed recently, its growth from the fourth
quarter of last year to June has been 30 percent at an annual rate.
The
other components of M1 increased at an annual rate of less than 1 percent
over this same period.
Looking at the components of M2 not also included in Ml, the
so-called nontransaction components, these items grew at a 10-3/4 percent
annual rate from the fourth quarter to June.
General purpose and broker/
dealer money market mutual funds were an especially strong component of
M2, increasing at almost a 30 percent annual rate this year.
Compared with
last year, however, when the assets of such money funds more than doubled,
this year's increase represents a sharp deceleration.
Perhaps the most surprising development affecting M2 has been the
behavior of conventional savings deposits.
After declining in each of the
past four years--falling 16 percent last year--savings deposits have
increased at about a 4 percent annual rate thus far this year.
This turn-
around in savings deposit flows, taken together with the strong increase
In NOW accounts and the still substantial growth in money funds, suggests
that stronger preferences to hold safe and highly liquid financial assets
In the current recessionary environment are bolstering the demand for M2
as well as Ml.
M3 increased at a 9.7 percent annual rate from the fourth quarter of
1981 to June, just above the upper end of the FOMC's annual growth target.
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Federal Reserve Bank of St. Louis
Ranges and Actual Monetary Growth
M3
Billions of dollars
— — Range adopted by FOMC for
1981 Q4 to 1982 Q4
Annual Rates of Growth
91
/
2%
1981 Q4 to June
9 7 Percent
/
2%
61
2300
1981 04 to 1982 Q2
9 8 Percent
1981 H1 to 1982 H1
10 5 Percent
2200
01
1Di
1
Fl
1A1
IJ1
1981
1
Al
101
1982
Bank Credit
Billions of dollars
— Range adopted by FOMC for
Dec. 1981-Jan. 1982 to 1982 04
Annual Rates of Growth
Dec.-Jan. to June
8.0 Percent
1400
Dec.-Jan. to 1982 Q2
8.3 Percent
1981 H1 to 1982 H1
8.4 Percentl
1350
01
!DI
1981
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Federal Reserve Bank of St. Louis
IF'
1A1
I
J
1
1982
1
Al
101
nj
1 Adjusted for initial shifts into
international banking facilities.
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Federal Reserve Bank of St. Louis
- 16 -
Farlv in the year, M3 growth was relatively moderate as a strong rise in
large-denomination CDs was offset by declines in term RPs and in money
market mutual funds restricted to institutional investors.
During the
second quarter, however, M3 showed a larger increase; the weakness in its
term RP and money fund components subsided and heavy issuance of large CDs
continued.
With growth of "core deposits" relatively weak on average,
commercial banks borrowed heavily in the form of large CDs to fund the
increase in their loans and investments.
Commercial bank credit grew at an 8.3 percent annual rate over the
first half of the year, in the upper part of the FOMC's range for 1982.
Bank loans have increased on average at about a 9-1/2 percent annual rate,
with loans to nonfinancial businesses expanding at a 14 percent annual
rate.
In past economic downturns, business loan demand at banks has tended
to weaken, hut consistently high long-term interest rates in the current recession have induced corporations to meet the great bulk of their
external financing needs through short-term borrowing.
Real estate loans
have increased at a 7-1/4 percent annual rate this year, somewhat slower
than the growth in each of the past two years.
Consumer loans outstanding
during the first half of the year have grown at the same sluggish pace of
3 percent experienced last year.
The investment portfolios of banks have
expanded at about a 5 percent annual rate, with the rate of increase in
U.S. government obligations about twice as large as the growth in holdings
of other types of securities.
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Federal Reserve Bank of St. Louis
-17-
Section 3:
The Federal Reserve's Objectives for Growth of Money and Credit
There is a clear need today to promote higher levels of production
and employment in our economy.
The objective of Federal Reserve policy is
to create an environment conducive to sustained recovery in business activity while maintaining the financial discipline needed to restore reasonable
price stability.
The experience of the past two decades has amply demonstra-
ted the destructive impact of inflation on economic performance.
Because
inflation cannot persist without excessive monetary expansion, appropriately
restrained growth of money and credit over the longer run is critical to
achieving lasting prosperity.
The policy of firm restraint on monetary growth has contributed
importantly to the recent progress toward reducing inflation.
But when
inflationary cost trends remain entrenched, the process of slowing monetary growth can entail economic and financial stresses, especially when so
much of the burden of dealing with inflation rests on monetary policy.
These strains--reflected in reduced profits, liquidity problems, and balance-sheet pressures--place particular hardships on industries that depend
heavily on credit markets such as construction, business equipment, and
consumer durables.
Unfortunately, these stresses cannot be easily remedied through
accelerated money growth.
The immediate effect of encouraging faster growth
in money might be lower interest rates, especially in short-term markets.
In time, however, the attempt to drive interest rates lower through a substantial reacceleration of money growth would founder, for the result would
be to embed inflation and expectations of inflation even more deeply into
•
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Federal Reserve Bank of St. Louis
-18-
the nation's economic system.
It would mean that this recession was another
wasted, painful episode instead of a transition to a sustained improvement
..in the economic environment.
The present and prospective pressures on
financial markets urgently need to be eased not by relaxing discipline on
money growth, but by the adoption of policies that will ensure a lower and
declining federal deficit.
Moreover, a return to financial health will
require the adoption of more prudent credit practices on the part of private borrowers and lenders alike.
In reviewing its targets for 1982 and setting tentative targets for
1983, the FOMC had as its basic objective the maintenance of the longerrange thrust of monetary discipline in order to reduce inflation further,
while providing sufficient money growth to accommodate exceptional liquidity
pressures and support a sustainable recovery in economic activity.
At the
same time, the Committee recognized that regulatory actions or changes in
the public's financial behavior might alter the implications of any quantitative monetary goals in ways that cannot be fully predicted.
In light of all these considerations, the Committee concluded that
a change in the previously announced targets was not warranted at this time.
Because of the tendency for the demand for money to run strong on average
in the first half, and also responding to the congressional budget resolution, careful consideration was given to the question of whether some
raising of the targets was in order.
However, the available evidence did
not suggest that a large increase in the ranges was justified, and a small
change in the ranges would have represented a degree of "fine tuning" that
-1S -
appeared inconsistent with the degree of uncertainty surrounding the precise
relationship of money to other economic variables at this time.
However,
the Committee concluded, based on current evidence, that growth this year
around the top of the ranges for the various aggregates would be acceptable.
The Committee also agreed that possible shifts in the demand for
liquidity in current economic circumstances might require more than ordinary
elements of flexibty and judgment in assessing appropriate needs for
mS ney in the months ahead.
In the near term, measured growth of the aggre-
gates may be affected by the income tax reductions that occurred on July 1,
by cost-of-living increases in social security benefits, and by the ongoing
difficulties of accurately accounting for seasonal movements in the money
stock.
But more fundamentally, it is unclear to what degree businesses
and households may continue to wish to hold unusually large precautionary
liquid balances.
To the extent the evidence suggests that relatively
strong precautionary demands for money persist, growth of the aggregates
somewhat above their targeted ranges would be tolerated for a time and
still would be consistent with the FOMC's general policy thrust.
Looking ahead to 1983 and beyond, the FOMC remains committed to
restraining money growth in order to achieve sustained noninflationary
economic expansion.
At this point, the FOMC feels that the ranges now
in effect can appropriately remain as preliminary targets for
S.
Because monetary aggregates in 1982 more likely than not will be close to
-
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Federal Reserve Bank of St. Louis
the upper ends of their ranges, or perhaps even somewhat above them, the
-20-
preliminary 1983 targets would be fully consistent with a reduction in the
actual growth of money in 1983.
In light of the unusual uncertainty surrounding the economic,
financial, and budgetary outlook, the FOMC stressed the tentative nature
of its 1983 targets.
On the one hand, postwar cyclical experience strongly
suggests that some reversal of this year's unusual shift in the asset-holding preferences of the public could be expected; with economic activity on
an upward trend, any lingering precautionary motives for holding liquid
balances should begin to fade, thus contributing to a rapid rise in the
velocity of money.
Moreover, regulatory actions by the Depository Institu-
tions Deregulation Committee that increase the competitive appeal of deposit
instruments--as well as the more widespread use of innovative cash management
techniques, such as "sweep" accounts--also could reduce the demand for money
relative to income and interest rates.
On the other hand, factors exist
that should increase the attractiveness of holding cash balances.
The long
upward trend in the velocity of money since the 1950s took place in an
environment of rising inflation and higher nominal interest rates--developments that provide incentives for economizing on money holdings.
As these
incentives recede, it is possible that the attractiveness of cash holdings
will be enhanced and that more money will be held relative to the level of
business activity.
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Federal Reserve Bank of St. Louis
-21-
Section 4:
The Outlook for the Economy
The economy at midyear appears to have leveled off after sizable
declines last fall and winter.
Consumption has strengthened with retail
sales up significantly in the second quarter.
New and existing home sales
have continued to fluctuate at depressed levels, but housing starts nonetheless have edged up.
In the business sector, substantial progress has been
made in working off excess inventories, and the rate of liquidation appears
to have declined.
On the negative side, however, plant and equipment spend-
ing, which typically lags an upturn in overall activity, is still depressed.
And the trend in export demand continues to be a drag on the economy, reflecting the dollar's strength and weak economic activity abroad.
An evaluation of the balance of economic forces indicates that
an upturn in economic activity is highly likely in the second half of 1982.
Monetary growth along the lines targeted by the FOMC should accommodate this
expansion in real GNP, given the increases in velocity that typically occur
early in a cyclical recovery and absent an appreciable resurgence of inflation.
The 10 percent cut in income tax rates that went into effect July 1
is boosting disposable personal income and should reinforce the growth in
consumer spending.
Given the improved inventory situation, any sizable
increase in consumer spending should, in turn, be reflected in new orders
and a pickup in production.
Another element supporting growth in real GNP
will be the continuing rise in defense spending and the associated private
investment outlays needed for the production of defense equipment.
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Federal Reserve Bank of St. Louis
•4
-22-
At least during the initial phase, the expansion is likely to
be more heavily concentrated in consumer spending than in past business
,cycles, as current pressures in financial markets and liquidity strains
may inhibit the recovery in investment activity.
With mortgage interest
rates high, residential construction does not seem likely to contribute to
the cyclical recovery to the extent that it has in the past.
Likewise,
the high level of corporate bond rates, and the cumulative deterioration
in corporate balance sheets resulting from reliance in recent years on
short-term borrowing, may restrain capital spending, especially given
the considerable margin of unutilized capacity that now exists.
The excellent price performance so far this year has been helped
by slack demand and by exceptionally favorable energy and food supply
developments.
For that reason, the recorded rate of inflation may be higher
In the second half.
However, prospects appear excellent for continuing the
downtrend in the underlying rate of inflation.
As noted earlier, signifi-
cant progress has been made in slowing the rise in labor compensation, and
improvement in underlying cost pressures should continue over the balance
of the year.
Unit labor costs also are likely to be held down by a cyclical
rebound in productivity growth as output recovers.
Moreover, lower inflation
will contribute to smaller cost-of-living wage adjustments, which will moderate cost pressures further.
The Federal Reserve's objectives for money growth through the end
•
of 1983 are designed to be consistent with continuing recovery in economic
activity.
A critical factor influencing the composition and strength of
the expansion will be the extent to which pressures in financial markets
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Federal Reserve Bank of St. Louis
-23-
moderate.
This, in turn, depends importantly on the progress made in
further reducing inflationary pressures.
A marked decrease in inflation
-would take pressure off financial markets in two ways.
First, slower
inflatiS n will lead to a reduced growth in transaction demands for money,
given any particular level of real activity.
It follows that a given
target for money growth can be achieved with less pressure on interest
rates and accordingly less restraint on real activity, the greater is the
reduction in inflation.
Second, further progress in curbing inflation
will help lower long-term interest rates by reducing the inflation premium
contained in nominal interest rates.
The welcome relief in inflation seen
recently apparently is assumed by many to represent a cyclical rather than
a sustained drop in inflation.
But the longer that improved price perfor-
mance is maintained, the greater will be the confidence that a decisive
IS wntrend in inflation is being achieved.
Such a change should be reflected
in lower long-term interest rates and stronger activity in the interestsensitive sectors of the economy.
Another crucial influence on financial markets and thus on the
nature of the expansion in 1983 will be the federal budgetary decisions
that are made in coming months.
The budget resolution that was recently
passed by the House and Senate is a constructive first step in reducing
budget deficits as the economy recovers.
However, much remains to be done
in appropriation and revenue legislation to implement this resolution.
How
the budgetary process unfolds will be an important factor in determining
future credit demands by the federal government and thus the extent to which
deficits will preempt the net savings generated by the private economy.
str5ng program 5f 5udget restraint would minimize pressures in financial
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Federal Reserve Bank of St. Louis
A
-24--
markets and thereby enhance the prospects for a more vigorous recovery in
homebuilding, business fixed investment, and other credit-dependent sectors.
In assessing the economic outlook, the individual members of
the FOMC have formulated projections for several key measures of economic
performance that fall generally within the ranges in the table below.
In
addition to the monetary aggregate objectives discussed earlier, these projections assume that the federal budget will be put on a course that over
time will result in significant reductions in the federal deficit.
ECONOMIC PROJECTIONS OF FOMC MEMBERS
Actual
1981
1982
9.8
0.9
8.9
5-1/2 to 7-1/2
1/2 to 1-1/2
4-3/4 to 6
7 to 9-1/2
2-1/2 to 4
4 to 5-3/4
8.3
9 to 9-3/4
8-1/2 to 9-1/2
Projected
1983
Changes, fourth quarter to
fourth quarter, percent
Nominal GNP
Real GNP
GNP deflator
Average level in the fourth
quarter, percent
Unemployment rate
Revised administration forecasts for the economy were not available at the time of the Committee's deliberation.
Our understanding, how-
ever, is that the administration's midyear budgetary review will be presented
within the framework of the economic assumptions used in the first budget
resolution.
For the remainder of 1982, those assumptions imply somewhat more
rapid recovery than the range now thought most likely by members of the FOMC,
but would be consistent with the monetary targets outlined in this report on
the assumption of growth in velocity characteristic of the early stages of a
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Federal Reserve Bank of St. Louis
1
•-•
—25—
number of past recoveries.
Looking further ahead, the Committee members,
like the administration and the Congress, foresee continued economic
-expansion in 1983, but currently anticipate a less rapid rate of price
increase and somewhat slower real growth than the assumptions underlying
the budget.
The monetary targets tentatively set for 1983, which will be
reviewed early next year, would imply, under the budgetary assumptions,
relatively high growth in velocity.
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Federal Reserve Bank of St. Louis
.4
For use at 9:30 a.m., E.D.T.
July 20, 1982
Board of Governors of the Federal Reserve System
.....
.•.0of GOVt •
.•• 41-
/4114i:„
fr#94
•/.<0",
L.5
44Q •
.RAL RESf.C'"
• ••
•••••••
Midyear Monetary Policy Report to Congress
Pursuant to the
Full Employment and Balanced Growth Act of 1978
July 20, 1982
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Federal Reserve Bank of St. Louis
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Federal Reserve Bank of St. Louis
•0
• •rt
• -4
Letter of Transmittal
BOARD OF GOVERNORS OF THE
FEDERAL RESERVE SYSTEM
Washington, D.C., July 20, 1982
THE PRESIDENT OF THE SENATE
THE SPEAKER OF THE HOUSE OF REPRESENTATIVES.
The Board of Governors is pleased to submit its Midyear Monetary Policy Report to the Congress pursuant
to the Full Employment and Balanced Growth Act of 1978.
Sincerely,
Paul A. Volcker, Chairman
•
TABLE OF CONTENTS
_
Page
Section 1:
Section 2:
Section 3:
Section 4:
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Federal Reserve Bank of St. Louis
The Performance of the Economy in the
First Half of 1982
1
The Growth of Money and Credit in the
First H-lf of 1982
12
The Federal Reserve's Objectives for
Growth of Money and Credit
17
The Outlook for the Economy
21
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Federal Reserve Bank of St. Louis
oft
Section 1:
The Performance of the Economy in the First Half of 1982
The contraction in economic activity that began in mid-1981 continued into the first half of 1982, although at a diminished pace.
Declines
in production and employment slowed, while sales of automobiles improved.
Real GNP fell at a 4 percent annual rate between the third quarter of 1981
and the first quarter of 1982.
With output declining, the margin of unused
plant capacity widened and the unemployment rate rose to a postwar record.
By mid-1982, however, the recession seemed to be drawing to a
close.
Inventory positions had improved substantially, homebuilding was
beginning to revive, and consumer spending appeared to be rising.
None-
theless, there were signs of increased weakness in business investment.
Although final demands apparently fell during the second quarter, the rate
of inventory liquidation slowed, and on balance, real GNP apparently
changed little.
If, in fact, this spring or early summer is determined to
have been the cyclical trough, both the depth and duration of the decline
in activity will have been about the same as in other postwar recessions.
The progress in reducing inflation that began during 1981 continued in the first half of 1982.
The greatest improvement was in prices
of food and energy--which benefited from favorable supply conditions--but
increases in price measures that exclude these volatile items also have
slowed markedly.
Moreover, increases in employment costs, which carry
forward the momentum of inflation, have diminished considerably.
Not only
have wage increases eased for union workers in hardpressed industries as
a result of contract concessions, but wage and fringe benefit increases
also have slowed for non-union and white-collar workers in a broad range of
•
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Federal Reserve Bank of St. Louis
Industrial Production
Index, 1967= 100
150
140
130
1978
1980
1982
Real GNP
Change from end of previous period, annual rate, percent
1972 Dollars
6
3
0
H1
1978
H2
H1
1980
1982
Gross Business Product Prices
Change from end of previous period, annual rate, percent
Fixed -weighted Index
9
6
3
H1
1978
1980
Note Data for 1982 Ht are partially estimated by the FRB
H2
H1
1982
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Federal Reserve Bank of St. Louis
-2-
industries.
In addition there has been increasing use of negotiated work-
rule changes as well as other efforts by business to enhance productivity
-and trim costs.
At the same time, purchasing power has been rising; real
compensation per hour increased 1 percent during 1981 and rose at about a
3 percent annual rate over the first half of 1982.
Interest rates.
As the recession developed in the autumn of
1981, short-term interest rates moved down substantially.
However, part
of this decline was retraced at the turn of the year as the demand for
money bulged and reserve positions tightened.
After the middle of the
first quarter, short-term rates fluctuated but generally trended downward,
as money--particularly the narrow measure, M1--grew slowly on average and
the weakness in economic activity continued.
In mid-July, short-term rates
were distinctly below the peak levels reached in 1980 and 1981.
Nonethe-
less, short-term rates were still quite high relative to the rate of inflation.
Long-term interest rates also remained high during the first
half of 1982.
In part, this reflected doubts by market participants that
the improved price performance would be sustained over the longer run.
This skepticism was related to the fact that, during the past two decades,
episodes of reduced inflation have been short-lived, followed by reacceleration to even faster rates of price increase.
High long-term rates also have
been fostered by the prospect of huge deficits in the federal budget even
as the economy recovers.
Fears of deepening deficits have affected expecta-
tions of future credit market pressures, and perhaps also have sustained
Inflation expectations.
The resolution on the 1983 fiscal year budget that
•
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Federal Reserve Bank of St. Louis
Interest Rates
Percent
18
Home Mortgage
14
10
3-month Treasury Bill
6
1978
1980
1982
Funds Raised by Private Nonfinancial Sectors
Seasonally adjusted, annual rate, billions of dollars
Total
300
Business
200
100
Household
1980
1982
Federal Government Borrowing
Seasonally adjusted, annual rate, billions of dollars
Combined Deficit Financed by the Public
120
80
40
1978
1980
Note: Data for 1982 H1 are partially estimated by the FRB
1982
M=11•11.
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Federal Reserve Bank of St. Louis
3-
was adopted by the Congress represents a beginning effort to deal with the
prospect of widening deficits; and the passage of implementing legislation
should work in the direction of reducing market pressures on interest rates.
Domestic credit flows.
Aggregate credit flows to private non-
financial borrowers increased somewhat in the first half of 1982 from the
reduced pace in the second half of 1981, according to very preliminary
estimates.
Business borrowing rose while households reduced further their
use of credit.
Borrowing by the federal government increased sharply in
late 1981, after the 5 percent cut in personal income tax rates, and
remained near the new higher level during the first half of 1982 on a
seasonally adjusted basis.
Reflecting uncertainties about the future
economic and financial environment, both lenders and borrowers have shown
a strong preference for short-term instruments.
Much of the slackening in credit flows to nonfinancial sectors in
the last part of 1981 was accounted for by households, particularly by
household mortgage borrowing.
up slightly.
Since then, mortgage credit flows have picked
The advance was encouraged in part by the gradual decline in
mortgage rates from the peaks of last fall.
In addition, households have
made widespread use of adjustable-rate mortgages and "creative" financing
techniques--including relatively short-term loans made by sellers at belowmarket interest rates and builder "buy-downs." About two-fifths of all conventional mortgage loans closed recently were adjustable-rate instruments,
and nearly three-fourths of existing home transactions reportedly involved
some sort of creative financing.
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Federal Reserve Bank of St. Louis
-4-
Business borrowing dropped sharply during the last quarter of 1981,
primarily reflecting reduced inventory financing needs.
However, credit use
_by nonfinancial corporations rose significantly in the first half of 1982,
I espite a further drop in capital expenditures.
The high level of bond rates
has discouraged corporations from issuing long-term debt, and a relatively
larI. share of business borrowing this year has been accomplished in shortterm markets--at banks and through sales of commercial paper.
The persis-
tently large volume of business borrowing suggests an accumulation of liquid
assets as well as an intensification of financial pressures on at least some
firms.
Signs of corporate stress continue to mount, including increasing
numbers of dividend reductions or suspensions, a rising fraction of business
loans at commercial banks with interest or principal past due, and relatively
frequent downgradings of credit ratings.
After raising a record volume of funds in U.S. credit markets
in 1981, the federal government continued to borrow at an extraordinary
pace during the first half of 1982, as receipts (national income and product
accounts basis) fell while expenditures continued to rise.
Owing to the
second phase of the tax cut that went into effect on July 1 and the effects
on tax revenues of the recession and reduced inflation, federal credit
demands will expand further in the period ahead.
Consumption.
Personal consumption expenditures (adjusted for
inflation) fell sharply in the fourth quarter of 1981, but turned up early
in 1982 and apparently strengthened further during the second quarter.
The
weakness in consumer outlays during the fourth quarter was concentrated in
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Federal Reserve Bank of St. Louis
Real Income and Consumption
Change from end of previous period, annual rate, percent
011 Real Disposable Personal Income
ri Real Personal Consumption Expenditures
6
4
H1
1978
1980
1
H2
2
H1
1982
Real Business Fixed Investment
Change from end of previous period, annual rate, percent
al Producers' Durable Equipment
n Structures
20
10
•••••
11,
0
H1
1978
1980
H2
H1
1982
Total Private Housing Starts
Millions of units
2.0
1.5
1.0
.5
1978
1980
Note: Data for 1982 H1 are partially estimated by the FRB.
1982
411
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-5-
the auto sector, as total sales fell to an annual rate of 7.4 million units-the lowest quarterly figure in more than a decade--and sales of domestic
_models plummeted to a 5.1 million unit rate.
Price rebates and other sales promotion programs during the early
months of 1982 provided a fillip to auto demand, and sales climbed to an
8.1 mon unit rate.
Auto markets remained firm into the spring, boosted
in part by various purchase incentives.
But as has generally occurred when
II.jor promotions have ended, auto purchases fell sharply in June.
Outside
the auto sector, retail sales at most types of stores were up significantly
for the second quarter as a whole.
Even purchases at furniture and appliance
outlets, which had been on a downtrend since last autumn, increased during
the spring.
Real after-tax income has continued to edge up, despite the sharp
drop in output during the recession.
The advance reflects not only typical
cyclical increases in transfer payments but also the reduction in personal
income tax rates on October 1.
Households initially saved a sizable pro-
portion of the tax cut, boosting the personal saving rate from 5-1/4 percent in mid-1981--about equal to the average of the late 1970s and early
1980s--t5 6.1 percent in the fourth quarter of 1981.
During early 1982,
hS wever, consumers increased spending, partly to take advantage of price
markdowns for autos and apparel, and the saving rate fell.
Business investment.
As typically occurs during a recession,
the contraction in business fixed investment has lagged behind the decline
in overall activity.
Indeed, even though real GNP dropped substantially
during the first quarter of 1982, real spending for fixed business capital
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-S-
actually rose a bit.
An especially buoyant element of the investment
sector has been outlays for nonfarm buildings--most notably, commercial
office buildings, for which appropriations and contracts often are set
a year or more in advance.
In contrast to investment in structures, business spending for
new equipment showed little advance during 1981 and weakened considerably
in the first half of
.•
business purchases of new cars, which
also were buoyed by rebate programs, real investment in producers' durable
equipment fell at a 2 percent annual rate in the first quarter.
evidently accelerated in the second quarter.
The decline
In April and May, shipments
of nondefense capital goods, which account for about 80 percent of the
spending on producers' durable equipment, averaged nearly 3 percent below
the first-quarter level in nominal terms.
Moreover, sales of heavy trucks
dropped during the second quarter to a level more than 20 percent below the
already depressed first-quarter average.
Businesses liquidated inventories at a rapid rate during late 1981
and in the first half of 1982.
The adjustment of stocks followed a sizable
buildup during the summer and autumn of last year that accompanied the contraction of sales.
The most prominent inventory overhang by the end of 1981
was in the automobile sector as sales fell precipitously.
However, with a
combination of production cutbacks and sales promotions, the days' supply
of unsold cars on dealers lots had improved considerably by spring.
Manufacturers and non-auto retailers also found their inventories
rising rapidly last autumn.
Since then, manufacturers as a whole have liqui-
dated the accumulation that occurred during 1981, although some problem areas
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Federal Reserve Bank of St. Louis
still exist--particularly in primary metals.
Stocks held by non-auto
peak, but they remain
retailers have been brought down from their cyclical
-above pre-recession levels.
Residential construction.
Housing activity thus far in 1982 has
l in late 1981.
picked up somewhat from the depressed leve
Housing starts
up 10 percent on average from the
during the first five months of 1982 were
fourth quarter of 1981.
orted
The improvement in homebuilding has been supp
services in most markets and by the
by strong underlying demand for housing
participants to nontraditional
continued adaptation of real estate market
.
financing techniques that facilitate transactions
in all areas
The turnaround in housing activity has not occurred
of the country.
in t.he first
In the south, home sales increased sharply
ent from the fourth quarter of
part of 1982, and housing starts rose 25 perc
1981.
on average, during
In contrast, housing starts declined further,
and the industrial north
the first five months of 1982 in both the west
central states.
Government.
ices,
Federal government purchases of goods and serv
first half of 1982.
measured in constant dollars, declined over the
The
, primarily reflecting
decrease occurred entirely in the nondefense area
mulation by the Commodity Credit
a sharp drop in the rate of inventory accu
Corporation during the spring quarter.
Purchases by the Commodity Credit
the previous two quarters
Corporation had reached record levels during
weak farm prices.
owing to last summer's large harvests and
Other non-
t half of the year as a result
defense outlays fell slightly over the firs
under many programs.
of cuts in employment and other expenditures
Real
-8-
defense spending apparently rose over the first half of the year, and the
backlog of unfilled orders grew further.
The federal deficit on a national
Income and product account basis widened from $100 billion at the end of
1981 to about $130 billion during the spring of this year.
Much of this
increase in the deficit reflects the effects of the recession on federal
expenditures and receipts.
At the state and local government level, real purchases of goods
and services fell further over the first half of 1982 after having declined
2 percent during 1981.
Most of the weakness this year has been in construc-
tion outlays as employment levels have stabilized after large reductions
in the federally funded CETA program led to sizable layoffs last year.
The
declines in state and local government activity in part reflect fiscal
strains associated with the withdrawal of federal support for many activities and the effects of cyclically sluggish income growth on tax receipts.
Because of the serious revenue problems, several states have increased
sales taxes and excise taxes on gasoline and alcohol.
International payments and trade.
The weighted-average value of
tne dollar, after declining about 10 percent from its peak last August,
began to strengthen sharply again around the beginning of the year and since
then has appreciated nearly 15 percent on balance.
The appreciation of
the dollar has been associated to a considerable extent with the declining
inflation rate in the United States and the rise in dollar interest rates
•
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Federal Reserve Bank of St. Louis
relative to yields on assets denominated in foreign currencies.
Reflecting the effects of the strengthening dollar, as well as the
slowing of economic growth abroad, real exports of goods and services have
.•••111
Foreign Exchange Value of the U.S. Dollar
Index, March 1973 =100
120
110
100
90
80
1978
1980
1982
Current Account Balance
Annual rate, billions of dollars
20
V
10
urplus
0
Deficit
10
20
1978
1980
Note Data for 1982 H1 are partially estimated by the FRB
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0
1982
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-9-
been decreasing since the beginning of 1981.
The volume of imports other
than oil, which rose fairly steadily throughout last year, dropped sharply
_ in the first half of 1982, owing to the weakness of aggregate demand—
especially for inventories--in the United States.
In addition, both the
volume and price of imported oil fell during the first half of the year.
The current account, which was in surplus for 1981 as a whole, recorded
another surplus in the first half of this year as the value of imports
fell more than the value of exports.
Labor markets.
Employment has declined by nearly 1-1/2 million
since the peak reached in mid-1981.
As usually happens during a cyclical
contraction, the largest job losses have been in durable goods manufacturing industries--such as autos, steel, and machinery--as well as at construction sites.
The job losses in manufacturing and construction during
this recession follow a limited recovery from the 1980 recession; as a
result, employment levels in these industries are more than 10 percent
below their 1979 highs.
In addition, declines in aggregate demand have
tempered the pace of hiring at service industries and trade establishments
over the past year.
As often happens near a business cycle trough, employ-
ment fell faster than output in early 1982 and labor productivity showed a
small advance after declining sharply during the last half of 1981.
Since mid-1981 there has been a 2-1/4 percentage point rise in the
overall unemployment rate to a postwar record high of 9-1/2 percent.
The
effects of the recession have been most severe in the durable goods and
construction industries, and the burden of rising unemployment has been
relatively heavy on adult men, who tend to be more concentrated in these
•
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Federal Reserve Bank of St. Louis
z
-10--
industries.
At the same time, joblessness among young and inexperienced
workers remains extremely high; hardest hit have been black male teenagers
who experienced an umemployment rate of nearly 60 percent in June 1982.
Reflecting the persistent slack in labor markets, most indicators
of labor supply also show a significant weakening.
For example, the number
of discouraged workers--that is, persons who report that they want work
but are not looking for jobs because they believe they cannot find any--has
increased by nearly half a million over the past year, continuing an upward
trend that began before the 1980 recession.
In addition, the labor force
participation rate--the proportion of the working-age population that is
employed or actively seeking jobs--has been essentially flat for the last
two years after rising about one-half percentage point annually between
1975 and 1979.
Prices and labor costs.
A slowing in the pace of inflation,
which was evident during 1981, continued through the first half of this
year.
During the first five months of 1982 (the latest data available),
the consumer price index increased at an annual rate of 3.5 percent, sharply
lower than the 8.9 percent rise during 1981.
Much of the improvement was
in energy and food prices as well as in the volatile CPI measure of homeownership costs.
But even excluding these items, the annual rate of increase
in consumer prices has slowed to 5-1/2 percent this year compared with a
9-1/2 percent rise last year.
evident at the producer level.
The moderation of price increases also was
Prices of capital equipment have increased
at a 4-1/4 percent annual rate thus far this year--well below the 9-1/4 percent pace of 1981.
In addition, the decline in raw materials prices, which
occurred throughout last year, has continued in the first half of 1982.
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Federal Reserve Bank of St. Louis
Consumer Prices
Change from end of previous period, annual rate, percent
cm
CPI
CPI Excluding Food, Energy, and Homeownership
15
10
5
Dec to May
1982
1980
1978
Gasoline Prices
Dollars per gallon
1 50
1 00
50
1982
1980
1978
Hourly Earnings Index
Change from end of previous period, annual rate, percent
9
6
3
H1
1978
1980
H2
H1
1982
-11-
Gasoline prices at the retail level, which had remained virtually
flat over the second half of 1981, fell substantially during the first four
-months of 1982.
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Federal Reserve Bank of St. Louis
Slack domestic demand and an overhang of stocks on world
petroleum markets precipitated the decline in prices.
However, gasoline
prices began to rise again in May in reflection of rising consumption,
reduced stocks, and lower production schedules by major crude oil suppliers.
The rate of increase in employment costs decelerated considerably
during the first half of 1982.
The index of average hourly earnings, a
measure of wage trends for production and nonsupervisory personnel, rose
at a 6-1/4 percent annual rate over the first half of this year, compared
with an increase of 8-1/4 percent during 1981.
Part of the slowing was due
to early negotiation of expiring contracts and renegotiation of existing
contracts in a number of major industries.
These wage concessions are
expected to relieve cost pressures and to enhance the competitive position
of firms in these industries.
Increases in fringe benefits, which generally
have risen faster than wages over the years, also are being scaled back.
Because wage demands, not to mention direct escaltor provisions, are responsive to price performance, the progress made in reducing the rate of inflation should contribute to further moderation in labor cost pressures.
-12-
Section 2:
The Growth of Money and Credit in the First Half of 1982
The annual targets for the monetary aggregates announced in February
were chosen to be consistent with continued restraint on the growth of money
and credit in order to exert sustained downward pressure on inflation.
At
the same time, these targets were expected to result in sufficient money
growth to support an upturn in economic activity.
Measured from the fourth
quarter of 1981 to the fourth quarter of 1982, the growth ranges for the
aggregates adopted by the Federal Open Market Committee (FOMC) were as
follows:
for Ml, 2-1/2 to 5-1/2 percent; for M2, 6 to 9 percent; and for
M3, 6-1/2 to 9-1/2 percent.
The corresponding range specified by the FOMC
for bank credit was 6 to 9 percent.'
When the FOMC was deliberating on its annual targets in February,
the Committee was aware that M1 already had risen well above its average
level in the fourth quarter of 1981.
In light of the financial and economic
backdrop against which the bulge in M1 had occurred, the Committee believed
it likely that there had been an upsurge in the public's demand for liquidity.
It also seemed probable that this strengthening of money demand would unwind
in the months ahead.
Thus, under these circumstances and given the relatively
low base for the M1 range for 1982, it did not appear appropriate to seek
an abrupt return to the annual target range, and the FOMC indicated its
willingness to permit M1 to remain above the range for a while.
At the
1. Because of the authorization of international banking facilities (IBFs)
on December 3, 1981, the bank credit data starting in December 1981 are
not comparable with earlier data. The target for bank credit was put
in terms of annualized growth measured from the average of December 1981
and January 1982 to the average level in the fourth quarter of 1982 so that
the shift of assets to IliFs that occurred at the turn of the year would not
have a major impact on the pattern of growth.
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Federal Reserve Bank of St. Louis
-13-
same time, the FOMC agreed that the expansion in M1 for the year as a
whole might appropriately be in the upper part of its range, particularly
If available evidence suggested the persistence of unt ual desires for
liquidity that had to be accommodated to avoid undue financial stringency.
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Federal Reserve Bank of St. Louis
In setting the annual target for M2, the FOMC indicated that
M2 growth for the year as a whole probably would be in the upper part of
its annual range and might slightly exceed the upper limit.
The Committee
anticipated that demands for the assets included in M2 might be enhanced
by new tax incentives such as the broadened eligibility for IRA/Keogh
accounts, or by further deregulation of deposit rates.
The Committee
expected that M3 growth again would be influenced importantly by the pattern
of business financing and, in particular, by the degree to which borrowing
would be focused in markets for short-term credit.
As anticipated--and consistent with the FOMC's short-run targets-the surge in M1 growth in December and January was followed by appreciably
slower growth.
After January, M1 increased at an annual rate of only 1-1/4
percent on average, and the level of M1 in June was only slightly above the
upper end of the Committee's annual growth range.
From the fourth quarter
of 1981 to June, M1 increased at a 5.6 percent annual rate.
M2 growth so
far this year also has run a bit above the FOMC's annual range; from the
fourth quarter of 1981 through June, M2 increased on average at a 9.4
percent annual rate.
From a somewhat longer perspective, M1 has increased
at a 4.7 percent annual rate, measuring growth from the first half of 1981
Ranges and Actual Monetary Growth
M1
Billions of dollars
— — Range adopted by FOMC for
1981 04 to 1982 04
Annual Rates of Growth
5/
1
2%
460
1981 04 to June
5.6 Percent
1981 04 to 1982 02
6.8 Percent
450
1981 H1 to 1982 H1
4.7 Percent I
21
/
2%
1 Adjusted for shifts into new
NOW accounts in 1981
440
0 1
1
D
IF!
IA!
1
J
1981
1
A
1
1
0 1
ID
1982
M2
Billions of dollars
— — Range adopted by FOMC for
1981 04 to 1982 04
Annual Rates of Growth
, 9%
1950
6%
1900
1981 04 to June
9.4 Percent
1981 04 to 1982 02
9.7 Percent
1981 H1 to 1982 H1
9.7 Percent
1850
,...•••••°
1800
0
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Federal Reserve Bank of St. Louis
1
ID
1981
1
IF
I
1
A
1
1J
I
IA!
1982
1 01
ID
ft•
- 14 -
to the first half of 1982 and abstracting from the shift into NOW accounts
over
in 1981; and M2 has grown at a 9.7 percent annual rate on a half-year
-half-year basis.
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Federal Reserve Bank of St. Louis
Although M1 growth has been moderate on balance thus far this
l
year, that growth has considerably exceeded the pace of increase in nomina
GNP.
Indeed, the first-quarter decline in the income velocity of Ml—that
is, GNP divided by Ml—was extraordinarily sharp.
the broader aggregates has been unusually weak.
Similarly, the velocity of
Given the persistence of
ened
high interest rates, this pattern of velocity behavior suggests a height
demand for M1 and M2 over the first half.
The unusual demand for M1 has been focused on its NOW account
component.
Following the nationwide authorization of NOW accounts at the
beginning of 1981, the growth of such deposits surged.
When the aggregate
ted
targets were reviewed this past February, a variety of evidence indica
ts into
that the major shift from conventional checking and savings accoun
NOW accounts was over; in particular, the rate at which new accounts were
being opened had dropped off considerably.
As a result of that shift, how-
ever, NOW accounts and other interest-bearing checkable deposits had grown
to account for almost 20 percent of M1 by the beginning of 1982.
Subse-
to
quently, it has become increasingly apparent that M1 is more sensitive
changes in the public's desire to hold highly liquid assets.
M1 is intended to be a measure of money balances held primarily
for transaction purposes.
However, in contrast to the other major com-
ts
ponents of Ml—currency and conventional checking accounts--NOW accoun
also have some characteristics of traditional savings accounts.
Apparently
reflecting precautionary motives to a considerable degree, NOW accounts and
-other interest-bearing checkable deposits grew surprisIngly rapidly in the
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Federal Reserve Bank of St. Louis
fourth quarter of last year and the first quarter of this year.
Although
growth in this component has slowed recently, its growth from the fourth
quarter of last year to June has been 30 percent at an annual rate.
The
other comoonents of M1 increased at an annual rate of less than 1 percent
over this same period.
Looking at the components of M2 not also included in Ml, the
so-called nontransaction components, these items grew at a 10-3/4 percent
annual rate from the fourth quarter to June.
General purpose and broker/
dealer money market mutual funds were an especially strong component of
M2, increasing at almost a 30 percent annual rate this year.
Compared with
last year, however, when the assets of such money funds more than doubled,
this year's increase represents a sharp deceleration.
Perhaps the most surprising development affecting M2 has been the
behavior of conventional savings deposits.
After declining in each of the
S.st four years--falling 16 percent last year--savings deposits have
increased at about a 4 percent annual rate thus far this year.
This turn-
around in savings deposit flows, taken together with the strong increase
in NOW accounts and the still substantial growth in money funds, suggests
that stronger preferences to hold safe and highly liquid financial assets
in the current recessionary environment are bolstering the demand for M2
as well as Ml.
M3 increased at a 9.7 percent annual rate from the fourth quarter of
S.
to June, just above the upper end of the FOMC's annual growth target.
Ranges and Actual Monetary Growth
M3
Billions of dollars
— — Range adopted by FOMC for
1981 Q4 to 1982 04
1 2%
9/
Annual Rates of Growth
1981 04 to June
9.7 Percent
•
/
2%
61
2300
1981 04 to 1982 02
9.8 Percent
1981 H1 to 1982 H1
10.5 Percent
2200
Of
JD
1F1
1A1
1981
1,11
I
Al
101
1982
Bank Credit
Billions of dollars
— — Range adopted by FOMC for
Dec. 1981-Jan. 1982 to 1982 04
Annual Rates of Growth
0/,
Dec-Jan. to June
8.0 Percent
V
1400
6%
7
7
Dec.-Jan. to 1982 02
8.3 Percent
1981 H1 to 1982 H1
8.4 Percentl
1350
01
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Federal Reserve Bank of St. Louis
1981
I
Di
1
Ft
IA!
IJ1
1982
1A1
101
1 Adjusted for initial shifts into
international banking facilities.
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Federal Reserve Bank of St. Louis
-16 -
Farly in the year, M3 growth was relatively moderate as a strong rise in
large-denomination CDs was offset by declines in term RPs and in money
market mutual funds restricted to institutional investors.
During the
second quarter, however, M3 showed a larger increase; the weakness in its
term RP and money fund components subsided and heavy issuance of large CDs
continued.
With growth of "core deposits" relatively weak on average,
commercial banks borrowed heavily in the form of large CDs to fund the
Increase in their loans and investments.
Commercial bank credit grew at an 8.3 percent annual rate over the
first half of the year, in the upper part of the FOMC's range for 1982.
Bank loans have increased on average at about a 9-1/2 percent annual rate,
with loans to nonfinancial businesses expanding at a 14 percent annual
rate.
In past economic downturns, business loan demand at banks has tended
to weaken, but consistently high long-term interest rates in the current recession have induced corporations to meet the great bulk of their
external financing needs through short-term borrowing.
Real estate loans
have increased at a 7-1/4 percent annual rate this year, somewhat slower
than the growth in each of the past two years.
Consumer loans outstanding
during the first half of the year have grown at the same sluggish pace of
3 percent experienced last year.
The investment portfolios of banks have
expanded at about a 5 percent annual rate, with the rate of increase in
U.S. government obligations about twice as large as the growth in holdings
of other types of securities.
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Federal Reserve Bank of St. Louis
-17-
Section 3:
The Federa1 Reserve's Objectives for Growth of Money and Credit
There is a clear need today to promote higher levels of production
anI employment in our economy.
The objective of Federal Reserve policy is
to create an environment conducive to sustained recovery in business activity while maintaining the financial discipline needed to restore reasonable
price stability.
The experience of the past two decades has amply demonstra-
ted the destructive impact of inflation on economic performance.
Because
inflation cannot persist without excessive monetary expansion, appropriately
restrained growth of money and credit over the longer run is crcal to
achieving lasting prosperity.
The policy of firm restraint on monetary growth has contributed
importantly to the recent progress toward reducing inflation.
But when
inflationary cost trends remain entrenched, the process of slowing monetary growth can entail economic and financial stresses, especially when so
much of the burden of dealing with inflation rests on monetary policy.
These strains--reflected in reduced profits, liquidity problems, and balance-sheet pressures--place particular hardships on industries that depend
heavily on credit markets such as construction, business equipment, and
consumer durables.
Unfortunately, these stresses cannot be easily remedied through
accelerated money growth.
The immediate effect of encouraging faster growth
in money might be lower interest rates, especially in short-term markets.
In time, however, the attempt to drive interest rates lower through a substantial reacceleration of money growth would founder, for the result would
be to embed inflation and expectations of inflation even more deeply into
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Federal Reserve Bank of St. Louis
-18-
the nation's economic system.
It would mean that this recession was another
wasted, painful episode instead of a transition to a sustained improvement
_in the economic environment.
The present and prospective pressures on
financial markets urgently need to be eased not by relaxing discipline on
money growth, but by the adoption of policies that will ensure a lower and
declining federal deficit.
Moreover, a return to financial health will
require the adoption of more prudent credit practices on the part of private borrowers and lenders alike.
In reviewing its targets for 1982 and setting tentative targets for
1983, the FOMC had as its basic objective the maintenance of the longerrange thrust of monetary discipline in order to reduce inflation further,
while providing sufficient money growth to accommodate exceptional liquidity
pressures and support a sustainable recovery in economic activity.
At the
same time, the Committee recognized that regulatory actions or changes in
the public's financial behavior might alter the implications of any quantitative monetary goals in ways that cannot be fully predicted.
In light of all these considerations, the Committee concluded that
a change in the previously announced targets was not warranted at this time.
Because of the tendency for the demand for money to run strong on average
in the first half, and also responding to the congressional budget resolution, careful consideration was given to the question of whether some
raising of the targets was in order.
However, the available evidence did
not suggest that a large increase in the ranges was justified, and a small
change in the ranges would have represented a degree of "fine tuning" that
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Federal Reserve Bank of St. Louis
-1I-
appeared inconsistent with the degree of uncertainty surrounding the precise
relatiS nship of money to other economic variables at this time.
However,
_the Committee concluded, based on current evidence, that growth this year
around the top of the ranges for the various aggregates would be acceptable.
The Committee also agreed that possible shifts in the demand for
liquidity in current economic circumstances might require more than ordinary
elements of flexibty and judgment in assessing appropriate needs for
IS ney in the months ahead.
In the near term, measured growth of the aggre-
gates may be affected by the income tax reductions that occurred on July 1,
by cost-of-living increases in social security benefits, and by the ongoing
Iculties of accurately accounting for seasonal movements in the money
stock.
But more fundamentally, it is unclear to what degree businesses
and households may continue to wish to hold unusually large precautionary
liquid balances.
To the extent the evidence suggests that relatively
strong precautionary demands for money persist, growth of the aggregates
somewhat above their targeted ranges would be tolerated for a time and
still would be consistent with the FOMC's general policy thrust.
Looking ahead to 1983 and beyond, the FOMC remains committed to
restrag money growth in order to achieve sustained noninflationary
economic expansion.
At this point, the FOMC feels that the ranges now
in effect can appropriately remain as preliminary targets for 1983.
Recause monetary aggregates in 1982 more likely than not will be close to
the upper ends of their ranges, or perhaps even somewhat above them, the
-20-
preliminary 1983 targets would be fully consistent with a reduction in the
actual growth of money in 1983.
In light of the unusual uncertainty surrounding the economic,
financial, and budgetary outlook, the FOMC stressed the tentative nature
of its 1983 targets.
On the one hand, postwar cyclical experience strongly
suggests that some reversal of this year's unusual shift in the asset-holding preferences of the public could be expected; with economic activity on
an upward trend, any lingering precautionary motives for holding liquid
balances should begin to fade, thus contributing to a rapid rise in the
velocity of money.
Moreover, regulatory actions by the Depository Institu-
tions Deregulation Committee that increase the competitive appeal of deposit
instruments--as well as the more widespread use of innovative cash management
techniques, such as "sweep" accounts--also could reduce the demand for money
relative to income and interest rates.
On the other hand, factors exist
that should increase the attractiveness of holding cash balances.
The long
upward trend in the velocity of money since the 1950s took place in an
environment of rising inflation and higher nominal interest rates--developments that provide incentives for economizing on money holdings.
As these
incentives recede, it is possible that the attractiveness of cash holdings
will be enhanced and that more money will be held relative to the level of
business activity.
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0
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-21-
Section 4:
The Outlook for the Economy
The economy at midyear appears to have leveled off after sizable
I.clines last fall and winter.
Consumption has strengthened with retail
sales up signcantly in the second quarter.
New and existing home sales
have continued to fluctuate at depressed levels, but housing starts nonetheless have edged up.
In the business sector, substantial progress has been
made in working off excess inventories, and the rate of liquidation appears
to have declined.
On the negative side, however, plant and equipment spend-
ing, which typically lags an upturn in overall activity, is still depressed.
And the trend in export demand continues to be a drag on the economy, reflecting the dollar's strength and weak economic activity abroad.
An evaluation of the balance of economic forces indicates that
an upturn in economic activity is highly likely in the second half of 1982.
Monetary growth along the lines targeted by the FOMC should accommodate this
expansion in realgiven the increases in velocity that typically occur
early in a cyclical recovery and absent an appreciable resurgence of inflation.
The 10 percent cut in income tax rates that went into effect July 1
is boosting disposable personal income and should reinforce the growth in
consumer spending.
Given the improved inventory situation, any sizable
increase in consumer spending should, in turn, be reflected in new orders
and a pickup in production.
Another element supporting growth in real GNP
will be the continuing rise in defense spending and the associated private
investment outlays needed for the production of defense equipment.
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Federal Reserve Bank of St. Louis
-22-
At least during the initial phase, the expansion is likely to
be more heavily concentrated in consumer spending than in past business
,cycles, as current pressures in financial markets and liquidity strains
may inhibit the recovery in investment activity.
With mortgage interest
rates high, residential construction does not seem likely to contribute to
the cyclical recovery to the extent that it has in the past.
Likewise,
the high level of corporate bond rates, and the cumulative deterioration
In corporate balance sheets resulting from reliance in recent years on
short-term borrowing, may restrain capital spending, especially given
the considerable margin of unutilized capacity that now exists.
The excellent price performance so far this year has been helped
by slack demand and by exceptionally favorable energy and food supply
developments.
For that reason, the recorded rate of inflation may be higher
In the second half.
However, prospects appear excellent for continuing the
downtrend in the underlying rate of inflation.
As noted earlier, signifi-
cant progress has been made in slowing the rise in labor compensation, and
Improvement in underlying cost pressures should continue over the balance
of the year.
Unit labor costs also are likely to be held down by a cyclical
rebound in productivity growth as output recovers.
Moreover, lower inflation
will contribute to smaller cost-of-living wage adjustments, which will moderate cost pressures further.
The Federal Reserve's objectives for money growth through the end
of 1983 are designed to be consistent with continuing recovery in economic
activity.
A critical factor influencing the composition and strength of
the expansion will be the extent to which pressures in financial markets
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-23-
moderate.
This, in turn, depends importantly on the progress made in
further reducing inflationary pressures.
A marked decrease in inflation
-would take pressure off financial markets in two ways.
First, slower
inflation will lead to a reduced growth in transaction demands for money,
given any particular level of real activity.
It follows that a given
target for money growth can be achieved with less pressure on interest
rates and accordingly less restraint on real activity, the greater is the
reduction in inflation.
Second, further progress in curbing inflation
will help lower long-term interest rates by reducing the inflation premium
contained in nominal interest rates.
The welcome relief in inflation seen
recently apparently is assumed by many to represent a cyclical rather than
a sustained drop in inflation.
But the longer that improved price perfor-
mance is maintained, the greater will be the confidence that a decisive
downtrend in inflation is being achieved.
Such a change should be reflected
in lower long-term interest rates and stronger activity in the interestsensitive sectors of the economy.
Another crucial influence on financial markets and thus on the
nature of the expansion in 1983 will be the federal budgetary decisions
that are made in coming months.
The budget resolution that was recently
passed by the House and Senate is a constructive first step in reducing
budget deficits as the economy recovers.
However, much remains to be done
in appropriation and revenue legislation to implement this resolution.
How
the budgetary process unfolds will be an important factor in determining
future credit demands by the federal government and thus the extent to which
deficits will preempt the net savings generated by the private economy.
strong program of budget restraint would minimize pressures in financial
A
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-24-
markets and thereby enhance the prospects for a more vigorous recovery in
homebuilding, business fixed investment, and other credit-dependent sectors.
In assessing the economic outlook, the individual members of
the FOMC have formulated projections for several key measures of economic
performance that fall generally within the ranges in the table below.
In
addition to the monetary aggregate objectives discussed earlier, these projections assume that the federal budget will be put on a course that over
time will result in significant reductions in the federal deficit.
ECONOMIC PROJECTIONS OF FOMC MEMBERS
Actual
1981
1982
9.8
0.9
8.9
5-1/2 to 7-1/2
1/2 to 1-1/2
4-3/4 to 6 ,
7 to 9-1/2
2-1/2 to 4
4 to 5-3/4
8.3
9 to 9-3/4
8-1/2 to 9-1/2
Projected
1983
Changes, fourth quarter to
fourth quarter, percent
Nominal GNP
Real GNP
GNP deflator
Average level in the fourth
quarter, percent
Unemployment rate
Revised administration forecasts for the economy were not available at the time of the Committee's deliberation.
Our understanding, how-
ever, is that the administration's midyear budgetary review will be presented
within the framework of the economic assumptions used in the first budget
resolution.
For the remainder of 1982, those assumptions imply somewhat more
rapid recovery than the range now thought most likely by members of the FOMC,
but would be consistent with the monetary targets outlined in this report on
the assumption of growth in velocity characteristic of the early stages of a
-25-
number of past recoveries.
Looking further ahead, the Committee members,
like the administration and the Congress, foresee continued economic
_expansion in 1983, but currently anticipate a less rapid rate of price
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Increase and somewhat slower real growth than the assumptions underlying
the budget.
The monetary targets tentatively set for 1983, which will be
reviewed early next year, would imply, under the budgetary assumptions,
relatively high growth in velocity.
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For use at 9:30 a.m., E.D.T.
July 20, 1982
Board of Governors of the Federal Reserve System
Midyear Monetary Policy Report to Congress
Pursuant to the
Full Employment and Balanced Growth Act of 1978
July 20, 1982
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• •• •
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Letter of Transmittal
BOARD OF GOVERNORS OF THE
FEDERAL RESERVE SYSTEM
Washington, D.C., July 20, 1982
THE PRESIDENT OF THE SENATE
THE SPEAKER OF THE HOUSE OF REPRESENTATIVES.
The Board of Governors is pleased to submit its Midyear Monetary Policy Report to the Congress pursuant
to the Full Employment and Balanced Growth Act of 1978.
Sincerely,
Paul A. Volcker, Chairman
TABLE OF CONTENTS
Page
Section 1:
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Section 2:
Section 3:
Section 4:
The Performance of the Economy in the
First Half of 1982
1
The Growth of Money and Credit in the
First H-lf of 1982
12
The Federal Reserve's Objectives for
Growth of Money and Credit
17
The Outlook for the Economy
21
Section 1:
The Performance of the Economy in the First Half of 1982
The contraction in economic activity that began in mid-1981 continued into the first half of 1982, although at a diminished pace.
Declines
in production and employment slowed, while sales of automobiles improved.
Real GNP fell at a 4 percent annual rate between the third quarter of 1981
and the first quarter of 1982.
With output declining, the margin of unused
plant capacity widened and the unemployment rate rose to a postwar record.
By mid-1982, however, the recession seemed to be drawing to a
close.
Inventory positions had improved substantially, homebuilding was
beginning to revive, and consumer spending appeared to be rising.
None-
theless, there were signs of increased weakness in business investment.
Although final demands apparently fell during the second quarter, the rate
of inventory liquidation slowed, and on balance, real GNP apparently
changed little.
If, in fact, this spring or early summer is determined to
have been the cyclical trough, both the depth and duration of the decline
In activity will have been about the same as in other postwar recessions.
The progress in reducing inflation that began during 1981 continued in the first half of 1982.
The greatest improvement was in prices
of food and energy--which benefited from favorable supply conditions--but
Increases in price measures that exclude these volatile items also have
slowed markedly.
Moreover, increases in employment costs, which carry
forward the momentum of inflation, have diminished considerably.
Not only
have wage increases eased for union workers in hardpressed industries as
a result of contract concessions, but wage and fringe benefit increases
also have slowed for non-union and white-collar workers in a broad range of
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I
Industrial Production
Index, 1967= 100
150
140
130
1
1980
1978
1982
Real GNP
Change from end of previous period, annual rate, percent
1972 Dollars
6
3
0
H1
1978
H2
H1
1982
1980
Gross Business Product Prices
Change from end of previous period, annual rate, percent
Fixed-weighted Index
9
6
3
H1
1978
1980
Note Data for 1982 H1 are partially estimated by the FRB.
H2
H1
1982
•
-2--
industries.
In addition there has been increasing use of negotiated work-
rule changes as well as other efforts by business to enhance productivity
-and trim costs.
At the same time, purchasing power has been rising; real
compensation per hour increased 1 percent during 1981 and rose at about a
3 percent annual rate over the first half of 1982.
Interest rates.
As the recession developed in the autumn of
1981, short-term interest rates moved down substantially.
However, part
of this decline was retraced at the turn of the year as the demand for
money bulged and reserve positions tightened.
After the middle of the
first quarter, short-term rates fluctuated but generally trended downward,
as money--particularly the narrow measure, M1---grew slowly on average and
the weakness in economic activity continued.
In mid-July, short-term rates
were distinctly below the peak levels reached in 1980 and 1981.
Nonethe-
less, short-term rates were still quite high relative to the rate of inflation.
Long-term interest rates also remained high during the first
half of 1982.
In part, this reflected doubts by market participants that
the improved price performance would be sustained over the longer run.
This skepticism was related to the fact that, during the past two decades,
episodes of reduced inflation have been short-lived, followed by reacceleration to even faster rates of price increase.
High long-term rates also have
been fostered by the prospect of huge deficits in the federal budget even
as the economy recovers.
Fears of deepening deficits have affected expecta-
tions of future credit market pressures, and perhaps also have sustained
inflation expectations.
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The resolution on the 1983 fiscal year budget that
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•
Interest Rates
Percent
18
Home Mortgage
14
10
3-month Treasury Bill
6
1978
1982
1980
Funds Raised by Private Nonfinancial Sectors
Seasonally adjusted, annual rate, billions of dollars
300
Business
200
100
Household
1982
1980
Federal Government Borrowing
Seasonally adjusted, annual rate, billions of dollars
Combined Deficit Financed by the Public
120
80
ao
1
1978
1980
Note Data for 1982 H1 are partially estimated by the FRB
1982
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3-
was adopted by the Congress represents a beginning effort to deal with the
prospect of widening deficits; and the passage of implementing legislation
_should work in the direction of reducing market pressures on interest rates.
Domestic credit flows.
Aggregate credit flows to private non-
financial borrowers increased somewhat in the first half of 1982 from the
reduced pace in the second half of 1981, according to very preliminary
estimates.
Business borrowing rose while households reduced further their
use of credit.
Borrowing by the federal government increased sharply in
late 1981, after the 5 percent cut in personal income tax rates, and
remained near the new higher level during the first half of 1982 on a
seasonally adjusted basis.
Reflecting uncertainties about the future
economic and financial environment, both lenders and borrowers have shown
a strong preference for short-term instruments.
Much of the slackening in credit flows to nonfinancial sectors in
the last part of 1981 was accounted for by households, particularly by
household mortgage borrowing.
up slightly.
Since then, mortgage credit flows have picked
The advance was encouraged in part by the gradual decline in
mortgage rates from the peaks of last fall.
In addition, households have
made widespread use of adjustable-rate mortgages and "creative" financing
techniques--including relatively short-term loans made by sellers at belowmarket interest rates and builder "buy-downs." About two-fifths of all conventional mortgage loans closed recently were adjustable-rate instruments,
and nearly three-fourths of existing home transactions reportedly involved
some sort of creative financing.
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Business borrowing dropped sharply during the last quarter of 1981,
primarily reflecting reduced inventory financing needs.
However, credit use
by nonfinancial corporations rose significantly in the first half of 1982,
despite a further drop in capital expenditures.
The high level of bond rates
has discouraged corporations from issuing long-term debt, and a relatively
large share of business borrowing this year has been accomplished in shortterm markets--at banks and through sales of commercial paper.
The persis-
tently large volume of business borrowing suggests an accumulation of liquid
assets as well as an intensification of financial pressures on at least some
firms.
Signs of corporate stress continue to mount, including increasing
numbers of dividend reductions or suspensions, a rising fraction of business
loans at commercial banks with interest or principal past due, and relatively
frequent downgradings of credit ratings.
After raising a record volume of funds in U.S. credit markets
in 1981, the federal government continued to borrow at an extraordinary
pace during the first half of 1982, as receipts (national income and product
accounts basis) fell while expenditures continued to rise.
Owing to the
second phase of the tax cut that went into effect on July 1 and the effects
on tax revenues of the recession and reduced inflation, federal credit
demands will expand further in the period ahead.
Consumption.
Personal consumption expenditures (adjusted for
Inflation) fell sharply in the fourth quarter of 1981, but turned up early
in 1982 and apparently strengthened further during the second quarter.
The
weakness in consumer outlays during the fourth quarter was concentrated in
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•
Real Income and Consumption
Change from end of previous period, annual rate, percent
ETh Real Disposable Personal Income
Real Personal Consumption Expenditures
6
4
2
Immer
illh
H1
1978
H2
H1
1982
1980
Real Business Fixed Investment
Change from end of previous period annual rate, percent
lin Producers' Durable Equipment
ri Structures
20
10
111•••Ir
0
H1
1978
1980
H2
H1
1982
Total Private Housing Starts
Millions of units
2.0
1.5
1.0
5
1978
1980
Note Data for 1982 H1 are partially estimated by the FRB
1982
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5-
the auto sector, as total sales fell to an annual rate of 7.4 million units-the lowest quarterly figure in more than a decade--and sales of domestic
_models plummeted to a 5.1 million unit rate.
Price rebates and other sales promotion programs during the early
months of 1982 provided a fillip to auto demand, and sales climbed to an
8.1 million unit rate.
Auto markets remained firm into the spring, boosted
in part by various purchase incentives.
But as has generally occurred when
major promotions have ended, auto purchases fell sharply in June.
Outside
the auto sector, retail sales at most types of stores were up significantly
for the second quarter as a whole.
Even purchases at furniture and appliance
outlets, which had been on a downtrend since last autumn, increased during
the spring.
Real after-tax income has continued to edge up, despite the sharp
drop in output during the recession.
The advance reflects not only typical
cyclical increases in transfer payments but also the reduction in personal
income tax rates on October 1.
Households initially saved a sizable pro-
portion of the tax cut, boosting the personal saving rate from 5-1/4 percent in mid-1981--about equal to the average of the late 1970s and early
1980s--to 6.1 percent in the fourth quarter of 1981.
During early 1982,
however, consumers increased spending, partly to take advantage of price
markdowns for autos and apparel, and the saving rate fell.
Business investment.
As typically occurs during a recession,
the contraction in business fixed investment has lagged behind the decline
In overall activity.
Indeed, even though real GNP dropped substantially
during the first quarter of 1982, real spending for fixed business capital
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-6-
actually rose a bit.
An especially buoyant element of the investment
sector has been outlays for nonfarm buildings--most notably, commercial
office buildings, for which appropriations and contracts often are set
a year or more in advance.
In contrast to investment in structures, business spending for
new equipment showed little advance during 1981 and weakened considerably
in the first half of 1982.
Excluding business purchases of new cars, which
also were buoyed by rebate programs, real investment in producers' durable
equipment fell at a 2 percent annual rate in the first quarter.
evidently accelerated in the second quarter.
The decline
In April and May, shipments
of nondefense capital goods, which account for about 80 percent of the
spending on producers' durable equipment, averaged nearly 3 percent below
the first-quarter level in nominal terms.
Moreover, sales of heavy trucks
dropped during the second quarter to a level more than 20 percent below the
already depressed first-quarter average.
Businesses liquidated inventories at a rapid rate during late 1981
and in the first half of 1982.
The adjustment of stocks followed a sizable
buildup during the summer and autumn of last year that accompanied the contraction of sales.
The most prominent inventory overhang by the end of 1981
was in the automobile sector as sales fell precipitously.
However, with a
combination of production cutbacks and sales promotions, the days' supply
of unsold cars on dealers lots had improved considerably by spring.
Manufacturers and non-auto retailers also found their inventories
rising rapidly last autumn.
Since then, manufacturers as a whole have liqui-
dated the accumulation that occurred during 1981, although some problem areas
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7-
still exist--particularly in primary metals.
Stocks held by non-auto
retailers have been brought down from their cyclical peak, but they remain
-above pre-recession levels.
Residential construction.
Housing activity thus far in 1982 has
picked up somewhat from the depressed level in late 1981.
Housing starts
during the first five months of 1982 were up 10 percent on average from the
fourth quarter of 1981.
The improvement in homebuilding has been supported
by strong underlying demand for housing services in most markets and by the
continued adaptation of real estate market participants to nontraditional
financing techniques that facilIcate transactions.
The turnaround in housing activity has not occurred in all areas
of the country.
In the south, home sales increased sharply in the first
part of 1982, and housing starts rose 25 percent from the fourth quarter of
1981.
In contrast, housing starts declined further, on average, during
the first five months of 1982 in both the west and the industrial north
central states.
Government.
Federal government purchases of goods and services,
measured in constant dollars, declined over the first half of 1982.
The
decrease occurred entirely in the nondefense area, primarily reflecting
a sharp drop in the rate of inventory accumulation by the Commodity Credit
Corporation during the spring quarter.
Purchases by the Commodity Credit
Corporation had reached record levels during the previous two quarters
owing to last summer's large harvests and weak farm prices.
Other non-
defense outlays fell slightly over the first half of the year as a result
of cuts in employment and other expenditures under many programs.
Real
-8-
defense spending apparently rose over the first half of the year, and the
backlog of unfilled orders grew further.
The federal deficit on a national
ome and product account basis widened from $100 bon at the end of
1981 to about $130 bon during the spring of this year.
Much of this
increase in the deficit reflects the effects of the recession on federal
expenditures and receipts.
At the state and local government level, real purchases of goods
and services fell further over the first half of 1982 after having declined
2 percent during
.Sst of the weakness this year has been in construc-
tion outlays as employment levels uave stabzed after large reductions
in the federally funded CETA program led to sizable layoffs last year.
The
declines in state and local government activity in part reflect fiscal
strains associated with the withdrawal of federal support for many activities and the effects of cyclically sluggish income growth on tax receipts.
Because of the serious revenue problems, several states have increased
sales taxes and excise taxes on gasoline and alcohol.
International payments and trade.
The weighted-average value of
the dollar, after declining about 10 percent from its peak last August,
began to strengthen sharply again around the beginning of the year and since
then has apnreciated nearly 15 percent on balance.
The appreciation of
the dollar has been associated to a considerable extent with the declining
inflation rate in the United States and the rise in dollar interest rates
.
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relative to yields on assets denominated in foreign currencies.
Reflecting the effects of the strengthening dollar, as well as the
slowing of economic growth abroad, real exports of goods and services have
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Foreign Exchange Value of the U.S. Dollar
Index, March 1973 = 100
120
110
100
90
80
1978
1980
1982
Current Account Balance
Annual rate, billions of dollars
20
10
Surplus
0
Deficit
10
20
1978
1980
Note Data for 1982 H1 are partially estimated by the FRB
1982
z
-9-
been decreasing since the beginning of 1981.
The volume of imports other
than oil, which rose fairly steadily throughout last year, dropped sharply
_ in the first half of 1982, owing to the weakness of aggregate demand—
especially for inventories--in the United States.
In addition, both the
volume and price of imported oil fell during the first half of the year.
The current account, which was in surplus for 1981 as a whole, recorded
another surplus in the first half of this year as the value of imports
fell more than the value of exports.
Labor markets.
Employment has declined by nearly 1-1/2 million
since the peak reached in mid-1981.
As usually happens during a cyclical
contraction, the largest job losses have been in durable goods manufacturing industries--such as autos, steel, and machinery--as well as at construction sites.
The job losses in manufacturing and construction during
this recession follow a limited recovery from the 1980 recession; as a
result, employment levels in these industries are more than 10 percent
below their 1979 highs.
In addition, declines in aggregate demand have
tempered the pace of hiring at service industries and trade establishments
over the past year.
As often happens near a business cycle trough, employ-
ment fell faster than output in early 1982 and labor productivity showed a
small advance after declining sharply during the last half of 1981.
Since mid-1981 there has been a 2-1/4 percentage point rise in the
overall unemployment rate to a postwar record high of 9-1/2 percent.
The
effects of the recession have been most severe in the durable goods and
construction industries, and the burden of rising unemployment has been
relatively heavy on adult men, who tend to be more concentrated in these
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-1I-
industries.
At the same time, joblessness among young and inexperienced
workers remains extremely high; hardest hit have been black male teenagers
-who experienced an umemployment rate of nearly 60 percent in June 1982.
Reflecting the persistent slack in labor markets, most indicators
of labor supply also show a signcant weakening.
of discouraged workers--that
For example, the number
persons who report that they want work
but are not looking for jobs because they believe they cannot find any--has
increased by nearly half a mon over the past year, continuing an upward
trend that began before the 1980 recession.
In addition, the labor force
particiI_ tion rate--the proportion of the working-age population that is
employed or actively seeking jobs--has been essentially flat for the last
two years after rising about one-half percentage point annually between
1975 and 1979.
Prices and labor costs.
A slowing in the pace of inflation,
which was evident during 1981, continued through the first half of this
year.
During the first five months of 1982 (the latest data available),
the consumer price index increased at an annual rate of
lI wer than the 8.9 percent rise during 1981.
.5_rce
sharply
Much of the improvement was
in energy and food prices as well as in the volatile CPI measure of homeownership costs.
But even excluding these items, the annual rate of increase
in consumer prices has slowed to -••e
9-1/2 percent rise last year.
evident at the producer level.
this year compared with a
The moderation of price increases also was
Prices of capital equipment have increased
at a 4-1/4 percent annual rate thus far this year--well below thepercent pace of 1981.
In addition, the decline in raw materials prices, which
I.
occurred throughout last year, has continued in the first half of 182.
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Consumer Prices
Change from end of previous period, annual rate, percent
[ED CPI
CPI Excluding Food, Energy, and Homeownership
15
10
5
Dec to May
1982
1980
1978
Gasoline Prices
Dollars per gallon
1.50
1 00
50
1
1
1
1982
1980
1978
Hourly Earnings Index
Change from end of previous period, annual rate, percent
9
6
3
H1
1978
1980
H2
H1
1982
-11-
Gasoline prices at the retail level, which had remained virtually
flat over the second half of 1981, fell substantially during the first four
-months of 1982.
Slack domestic demand and an overhang of stocks on world
petroleum markets precipitated the decline in prices.
However, gasoline
prices began to rise again in May in reflection of rising consumption,
reduced stocks, and lower production schedules by major crude oil suppliers.
The rate of increase in employment costs decelerated considerably
during the first half of 1982.
The I
- ndex of average hourly earnings, a
measure of wage trends for production and nonsupervisory personnel, rose
at a 6-1/4 percent annual rate over the first half of this year, compared
with an increase of 8-1/4 percent during 1981.
Part of the slowing was due
to early negotiation of expiring contracts and renegotiation of existing
contracts in a number of major industries.
These wage concessions are
expected to relieve cost pressures and to enhance the competitive position
of firms in these industries.
Increases in fringe benefits, which generally
have risen faster than wages over the years, also are being scaled back.
Because wage demands, not to mention direct escaltor provisions, are responsive to price performance, the progress made in reducing the rate of inflation should contribute to further moderation in labor cost pressures.
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-12-
Section 2:
The Growth of Money and Credit in the First Half of 1982
The annual targets for the monetary aggregates announced in February
were chosen to be consistent with continued restraint on the growth of money
and credit in order to exert sustained downward pressure on inflation.
At
the same time, these targets were expected to result in sufficient money
growth to support an upturn in economic activity.
Measured from the fourth
quarter of 1981 to the fourth quarter of 1982, the growth ranges for the
aggregates adopted by the Federal Open Market Committee (FOMC) were as
follows:
for Ml, 2-1/2 to 5-1/2 percent; for M2, 6 to 9 percent; and for
M3, 6-1/2 to 9-1/2 percent.
The corresponding range specified by the FOMC
for bank credit was 6 to 9 percent.1
When the FOMC was deliberating on its annual targets in February,
the Committee was aware that M1 already had risen well above its average
level in the fourth quarter of 1981.
In light of the financial and economic
backdrop against which the bulge in M1 had occurred, the Committee believed
it likely that there had been an upsurge in the public's demand for liquidity.
It also seemed probable that this strengthening of money demand would unwind
In the months ahead.
Thus, under these circumstances and given the relatively
low base for the M1 range for 1982, it did not appear appropriate to seek
an abrupt return to the annual target range, and the FOMC indicated its
willingness to permit M1 to remain above the range for a while.
At the
1. Because of the authorization of international banking facilities (IBFs)
on December 3, 1981, the bank credit data starting in December 1981 are
not comparable with earlier data. The target for bank credit was put
in terms of annualized growth measured from the average of December 1981
and January 1982 to the average level in the fourth quarter of 1982 so that
the shift of assets to IBFs that occurred at the turn of the year would not
have a major impact on the pattern of growth.
-13-
same time, the FOMC agreed that the expansion in M1 for the year as a
whole might appropriately be in the upper part of its range, particularly
if available evidence suggested the persistence of unusual desires for
•
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liquidity that had to be accommodated to avoid undue financial stringency.
In setting the annual target for M2, the FOMC indicated that
M2 growth for the year as a whole probably would be in the upper part of
its annual range and might slightly exceed the upper limit.
The Committee
anticipated that demands for the assets included in M2 might be enhanced
by new tax incentives such as the broadened eligibty for IRA/Keogh
accounts, or by further deregulation of deposit rates.
The Committee
expected that M3 growth again would be influenced importantly by the pattern
of business financing and, in particular, by the degree to which borrowing
would be focused in markets for short-term credit.
As anticipated--and consistent with the FOMC's short-run targets-the surge in M1 growth in December and January was followed by appreciably
slower growth.
After January, M1 increased at an annual rate of only
I- rcent on average, and the level of M1 in June was only slightly above the
upper end of the Committee's annual growth range.
From the fourth quarter
Sf 19R1 to June, M1 increased at a 5.6 percent annual rate.
M2 growth so
far this year also has run a bit above the FOMC's annual range; from the
fourth quarter of 19R1 through June, M2 increased on average at a 9.4
percent annual rate.
From a somewhat longer perspective, M1 has increased
at a 4.7 percent annual rate, measuring growth from the first half of 1981
Ranges and Actual Monetary Growth
M1
Billions of dollars
— — Range adopted by FOMC for
1981 04 to 1982 04
Annual Rates of Growth
51
/
2%
460
1981 04 to June
5 6 Percent
1981 04 to 1982 02
6.8 Percent
450
1981 H1 to 1982 H1
4.7 Percent
/
2%
21
1 Adjusted for shifts into new
NOW accounts in 1981
440
0 1
1
I
LF
I
1981
Ii
1
A
1
I o
1982
M2
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Federal Reserve Bank of St. Louis
Billions of dollars
— — Range adopted by FOMC for
1981 04 to 1982 Q4
Annual Rates of Growth
, 9%
1950
6%
1900
1981 04 to June
9.4 Percent
1981 Q4 to 1982 02
9.7 Percent
1981 H1 to 1982 H1
9.7 Percent
1850
1800
0
1
1981
D
IF
1
IA!
IA!
IJI
1982
1 0 1
1
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Federal Reserve Bank of St. Louis
to the first half of 1982 and abstracting from the shift into NOW accounts
in 1981; and M2 has grown at a 9.7 percent annual rate on a half-year over
-half-year basis.
Although M1 growth has been moderate on balance thus far this
year, that growth has considerably exceeded the pace of increase in nominal
ONP.
Indeed, the first-quarter decline in the income velocity of M1--that
GNP
ded by M1--was extraordinarily sharp.
the broader aggregates has been unusually weak.
Similarly, the velocity of
Given the persistence of
high interest rates, this pattern of velocity behavior suggests a heightened
demand for M1 and M2 over the first half.
The unusual demand for M1 has been focused on its NOW account
component.
Following the nationwide authorization of NOW accounts at the
beginning of 1981, the growth of such deposits surged.
When the aggregate
targets were reviewed this past February, a variety of evidence indicated
that the major shift from conventional checking and savings accounts into
NOW accounts was over; in particular, the rate at which new accounts were
being opened had dropped off considerably.
As a result of that shift, how-
ever, NOW accounts and other interest-bearing checkable deposits had grown
to account for almost 20 percent of M1 by the beginning of 1982.
Subse-
quently, it has become increasingly apparent that M1 is more sensitive to
changes in the pubs desire to hold highly liquid assets.
M1 is intended to be a measure of money balances held primarily
for transaction purposes.
However, in contrast to the other major com-
ponents of Ml—currency and conventional checking accounts--NOW accounts
- 15 -
also have some characteristics of traditional savings accounts.
Apparently
reflecting precautionary motives to a considerable degree, NOW accounts and
-other interest-bearing checkable deposits grew surprisingly rapidly in the
fourth quarter of last year and the first quarter of this year.
Although
growth in this component has slowed recently, its growth from the fourth
quarter of last year to June has been 30 percent at an annual rate.
The
other components of M1 increased at an annual rate of less than 1 percent
over this same period.
Looking at the components of M2 not also included in Ml, the
so-called nontransaction components, these items grew at a 10-3/4 percent
annual rate from the fourth quarter to June.
General purpose and broker/
dealer money market mutual funds were an especially strong component of
M2, increasing at almost a 30 percent annual rate this year.
Compared with
last year, however, when the assets of such money funds more than doubled,
this year's increase represents a sharp deceleration.
Perhaps the most surprising development affecting M2 has been the
behavior of conventional savings deposits.
After declining in each of the
past four years--falling 16 percent last year--savings deposits have
increased at about a 4 percent annual rate thus far this year.
This turn-
around in savings deposit flows, taken together with the strong increase
In NOW accounts and the still substantial growth in money funds, suggests
that stronger preferences to hold safe and highly liquid financial assets
In the current recessionary environment are bolstering the demand for M2
as well as Ml.
M3 increased at a 9.7 percent annual rate from the fourth quarter of
1981 to June, just above the upper end of the FOMC's annual growth target.
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Ranges and Actual Monetary Growth
M3
Billions of dollars
— — Range adopted by FOMC for
1981 04 to 1982 04
Annual Rates of Growth
/
2%
91
1981 04 to June
9.7 Percent
• 61/2%
2300
1981 04 to 1982 02
9 8 Percent
1981 H1 to 1982 H1
10.5 Percent
2200
01
1D1
1
F1
1A1
1981
1,11
1A1
1 0 I
1
1982
Bank Credit
Billions of dollars
- — Range adopted by FOMC for
Dec. 1981-Jan. 1982 to 1982 04
Annual Rates of Growth
9%
Dec -Jan. to June
8.0 Percent
1400
6°A
1981 H1 to 1982 H1
8.4 Percentl
..•••••
1350
01
1981
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1
DI
1F1
IA!
1J'
1982
IA1
Dec.-Jan. to 1982 02
8.3 Percent
1 0 1
1
D
1 Adjusted for initial shifts into
international banking facilities.
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Farlv in the year, M3 growth was relatively moderate as a strong rise in
large-denomination CDs was offset by declines in term RPs and in money
market mutual funds restricted to institutional investors.
During the
second quarter, however, M3 showed a larger increase; the weakness in its
term RP and money fund components subsided and heavy issuance of large CDs
continued.
With growth of "core deposits" relatively weak on average,
commercial banks borrowed heavily in the form of large CDs to fund the
increase in their loans and investments.
Commercial bank credit grew at an 8.3 percent annual rate over the
first half of the year, in the upper part of the FOMC's range for 1982.
Bank loans have increased on average at about a 9-1/2 percent annual rate,
with loans to nonfinancial businesses expanding at a 14 percent annual
rate.
In past economic downturns, business loan demand at banks has tended
to weaken, but consistently high long-term interest rates in the current recession have induced corporations to meet the great bulk of their
external financing needs through short-term borrowing.
have increased at
Real estate loans
percent annual rate this year, somewhat slower
than the growth in each of the past two years.
Consumer loans outstanding
during the first half of the year have grown at the same sluggish pace of
3 percent experienced last year.
The investment portfolios of banks have
expanded at about a 5 percent annual rate, with the rate of increase in
U.S. government obligations about twice as large as the growth in holdings
of other types of securities.
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-17-
Section 3:
The Federal Reserve's Objectives for Growth of Money and Credit
There is a clear need today to promote higher levels of production
and employment in our economy.
The objective of Federal Reserve policy is
to create an environment conducive to sustained recovery in business activity while maintaining the financial discipline needed to restore reasonable
price stability.
The experience of the past two decades has amply demonstra-
ted the destructive impact of inflation on economic performance.
Because
inflation cannot persist without excessive monetary expansion, appropriately
restrained growth of money and credit over the longer run is critical to
achieving lasting prosperity.
The policy of firm restraint on monetary growth has contributed
importantly to the recent progress toward reducing inflation.
But when
Inflationary cost trends remain entrenched, the process of slowing monetary growth can entail economic and financial stresses, especially when so
much of the burden of dealing with inflation rests on monetary policy.
These strains--reflected in reduced profits, liquidity problems, and balance-sheet pressures--place particular hardships on industries that depend
heavily on credit markets such as construction, business equipment, and
consumer durables.
Unfortunately, these stresses cannot be easily remedied through
accelerated money growth.
The immediate effect of encouraging faster growth
In money might be lower interest rates, especially in short-term markets.
In time, however, the attempt to drive interest rates lower through a substantial reacceleration of money growth would founder, for the result would
he to embed inflation and expectations of inflation even more deeply into
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Federal Reserve Bank of St. Louis
-18-
the nation's economic system.
It would mean that this recession was another
wasted, painful episode instead of a transition to a sustained improvement
in the economic environment.
The present and prospective pressures on
financial markets urgently need to be eased not by relaxing discipline on
money growth, but by the adoption of policies that will ensure a lower and
declining federal deficit.
Moreover, a return to financial health will
require the adoption of more prudent credit practices on the part of private borrowers and lenders alike.
In reviewing its targets for 1982 and setting tentative targets for
1983, the FOMC had as its basic objective the maintenance of the longerrange thrust of monetary discipline in order to reduce inflation further,
while providing sufficient money growth to accommodate exceptional liquidity
pressures and support a sustainable recovery in economic activity.
At the
same time, the Committee recognized that regulatory actions or changes in
the public's financial behavior might alter the implications of any quantitative monetary goals in ways that cannot be fully predicted.
In light of all these considerations, the Committee concluded that
a change in the previously announced targets was not warranted at this time.
Because of the tendency for the demand for money to run strong on average
in the first half, and also responding to the congressional budget resolution, careful consideration was given to the question of whether some
raising of the targets was in order.
However, the available evidence did
not suggest that a large increase in the ranges was justified, and a small
change in the ranges would have represented a degree of "fine tuning" that
-19-
appeared inconsistent with the degree of uncertainty surrounding the precise
relationship of money to other economic variables at this time.
However,
the Committee concluded, based on current evidence, that growth this year
around the top of the ranges for the various aggregates would be acceptable.
The Committee also agreed that possible shifts in the demand for
liquidity in current economic circumstances might require more than ordinary
elements of flexibility and judgment in assessing appropriate needs for
money in the months ahead.
In the near term, measured growth of the aggre-
gates may be affected by the income tax reductions that occurred on July 1,
by cost-of-living increases in social security benefits, and by the ongoing
difficulties of accurately accounting for seasonal movements in the money
stock.
But more fundamentally, it is unclear to what degree businesses
and households may continue to wish to hold unusually large precautionary
liquid balances.
To the extent the evidence suggests that relatively
strong precautionary demands for money persist, growth of the aggregates
somewhat above their targeted ranges would be tolerated for a time and
still would he consistent with the FOMC's general policy thrust.
Looking ahead to 1983 and beyond, the FOMC remains committed to
restraining money growth in order to achieve sustained noninflationary
economic expansion.
At this point, the FOMC feels that the ranges now
In effect can appropriately remain as preliminary targets for 1983.
Because monetary aggregates in 1982 more likely than not will be close to
-
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the upper ends of their ranges, or perhaps even somewhat above them, the
-20-
preliminary 1983 targets would be fully consistent with a reduction in the
actual growth of money in 1983.
In light of the unusual uncertainty surrounding the economic,
financial, and budgetary outlook, the FOMC stressed the tentative nature
of its 1983 targets.
On the one hand, postwar cyclical experience strongly
suggests that some reversal of this year's unusual shift in the asset-holding preferences of the public could be expected; with economic activity on
an upward trend, any lingering precautionary motives for holding liquid
balances should begin to fade, thus contributing to a rapid rise in the
velocity of money.
Moreover, regulatory actions by the Depository Institu-
tions Deregulation Committee that increase the competitive appeal of deposit
instruments--as well as the more widespread use of innovative cash management
techniques, such as "sweep" accounts--also could reduce the demand for money
relative to income and interest rates.
On the other hand
factors exist
that should increase the attractiveness of holding cash balances.
The long
upward trend in the velocity of money since the 1950s took place in an
environment of rising inflation and higher nominal interest rates--developments that provide incentives for economizing on money holdings.
As these
incentives recede, it is possible that the attractiveness of cash holdings
will be enhanced and that more money will be held relative to the level of
business activity.
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Federal Reserve Bank of St. Louis
-21-
Section 4:
The Outlook for the Economy
The economy at midyear appears to have leveled off after sizable
declines last fall and winter.
Consumption has strengthened with retail
sales up significantly in the second quarter.
New and existing home sales
have continued to fluctuate at depressed levels, but housing starts nonetheless have edged up.
In the business sector, substantial progress has been
made in working off excess inventories, and the rate of liquidation appears
to have declined.
On the negative side, however, plant and equipment spend-
ing, which typically lags an upturn in overall activity, is still depressed.
And the trend in export demand continues to be a drag on the economy, reflecting the dollar's strength and weak economic activity abroad.
An evaluation of the balance of economic forces indicates that
an upturn in economic activity is highly likely in the second half of 1982.
Monetary growth along the lines targeted by the FOMC should accommodate this
expansion in real GNP, given the increases in velocity that typically occur
early in a cyclical recovery and absent an appreciable resurgence of inflation.
The 10 percent cut in income tax rates that went into effect July 1
is boosting disposable personal income and should reinforce the growth in
consumer spending.
Given the improved inventory situation, any sizable
Increase in consumer spending should, in turn, be reflected in new orders
and a pickup in production.
Another element supporting growth in real GNP
will be the continuing rise in defense spending and the associated private
Investment outlays needed for the production of defense equipment.
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Federal Reserve Bank of St. Louis
•
-22-
At least during the initial phase, the expansion is likely to
be more heavily concentrated in consumer spending than in past business
-cycles, as current pressures in financial markets and liquidity strains
may inhibit the recovery in investment activity.
With mortgage interest
rates high, residential construction does not seem likely to contribute to
the cyclical recovery to the extent that it has in the past.
Likewise,
the high level of corporate bond rates, and the cumulative deterioration
in corporate balance sheets resulting from reliance in recent years on
short-term borrowing, may restrain capital spending, especially given
the considerable margin of unutilized capacity that now exists.
The excellent price performance so far this year has been helped
by slack demand and by exceptionally favorable energy and food supply
developments.
For that reason, the recorded rate of inflation may be higher
In the second half.
However, prospects appear excellent for continuing the
downtrend in the underlying rate of inflation.
As noted earlier, signifi-
cant progress has been made in slowing the rise in labor compensation, and
improvement in underlying cost pressures should continue over the balance
of the year.
Unit labor costs also are likely to be held down by a cyclical
rebound in productivity growth as output recovers.
Moreover, lower inflation
will contribute to smaller cost-of-living wage adjustments, which will moderate cost pressures further.
The Federal Reserve's objectives for money growth through the end
of 1983 are designed to be consistent with continuing recovery in economic
activity.
A critical factor influencing the composition and strength of
the expansion will be the extent to which pressures in financial markets
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Federal Reserve Bank of St. Louis
-23-
moderate.
This, in turn, depends importantly on the progress made in
further reducing inflationary pressures.
A marked decrease in inflation
-would take pressure off financial markets in two ways.
First, slower
inflation will lead to a reduced growth in transaction demands for money,
given any particular level of real activity.
It follows that a given
target for money growth can be achieved with less pressure on interest
rates and accordingly less restraint on real activity, the greater is the
reduction in inflation.
Second, further progress in curbing inflation
will help lower long-term interest rates by reducing the inflation premium
contained in nominal interest rates.
The welcome relief in inflation seen
recently apparently is assumed by many to represent a cyclical rather than
a sustained drop in inflation.
But the longer that improved price perfor-
mance is maintained, the greater will be the confidence that a decisive
downtrend in inflation is being achieved.
Such a change should be reflected
in lower long-term interest rates and stronger activity in the interestsensitive sectors of the economy.
Another crucial influence on financial markets and thus on the
nature of the expansion in 1983 will be the federal budgetary decisions
that are made in coming months.
The budget resolution that was recently
passed by the House and Senate is a constructive first step in reducing
budget deficits as the economy recovers.
However, much remains to be done
in appropriation and revenue legislation to implement this resolution.
How
the budgetary process unfolds will be an important factor in determining
future credit demands by the federal government and thus the extent to which
deficits will preempt the net savings generated by the private economy.
strong program of budget restraint would minimize pressures in financial
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Federal Reserve Bank of St. Louis
A
-24--
markets and thereby enhance the prospects for a more vigorous recovery in
homebuilding, business fixed investment, and other credit-dependent sectors.
In assessing the economic outlook, the individual members of
the FOMC have formulated projections for several key measures of economic
performance that fall generally within the ranges in the table below.
In
addition to the monetary aggregate objectives discussed earlier, these projections assume that the federal budget will be put on a course that over
time will result in significant reductions in the federal deficit.
ECONOMIC PROJECTIONS OF FOMC MEMBERS
Actual
1981
1982
9.8
0.9
8.9
5-1/2 to 7-1/2
1/2 to 1-1/2
4-3/4 to 6
7 to 9-1/2
2-1/2 to 4
4 to 5-3/4
8.3
9 to 9-3/4
8-1/2 to 9-1/2
Projected
1983
Changes, fourth quarter to
fourth quarter, percent
Nominal GNP
Real GNP
GNP deflator
Average level in the fourth
quarter, percent
Unemployment rate
Revised administration forecasts for the economy were not available at the time of the Committee's deliberation.
Our understanding, how-
ever, is that the administration's midyear budgetary review will be presented
within the framework of the economic assumptions used in the first budget
resolution.
For the remainder of 1982, those assumptions imply somewhat more
rapid recovery than the range now thought most likely by members of the FOMC,
but would be consistent with the monetary targets outlined in this report on
the assumption of growth in velocity characteristic of the early stages of a
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Federal Reserve Bank of St. Louis
-25-
number of past recoveries.
Looking further ahead, the Committee members,
like the administration and the Congress, foresee continued economic
-expansion in 1983, hut currently anticipate a less rapLd rate of price
increase and somewhat slower real growth than the assumptions underlying
the budget.
The monetary targets tentatively set for
I.
which will be
reviewed early next year, would imply, under the budgetary assumptions,
relatively high growth in velocity.
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Federal Reserve Bank of St. Louis
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Federal Reserve Bank of St. Louis
For use at 9:30 a.m., E.D.T.
July 20, 1982
Board of Governors of the Federal Reserve System
Midyear Monetary Policy Report to Congress
Pursuant to the
Full Employment and Balanced Growth Act of 1978
July 20, 1982
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Federal Reserve Bank of St. Louis
Letter of Transmittal
BOARD OF GOVERNORS OF THE
FEDERAL RESERVE SYSTEM
Washington, D.C., July 20, 1982
THE PRESIDENT OF THE SENATE
THE SPEAKER OF THE HOUSE OF REPRESENTATIVES.
The Board of Governors is pleased to submit its Midyear Monetary Policy Report to the Congress pursuant
to the Full Employment and Balanced Growth Act of 1978.
Sincerely,
Paul A. Volcker, Chairman
TABLE OF CONTENTS
Page
Section 1:
Section 2:
Section 3:
Section 4:
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Federal Reserve Bank of St. Louis
The Performance of the Economy in the
First Half of 1982
1
The Growth of Money and Credit in the
First H-lf of 1982
12
The Federal Reserve's Objectives for
Growth of Money and Credit
17
The Outlook for the Economy
21
•
Section 1:
The Performance of the Economy in the First Half of 1982
The contraction in economic activity that began in mid-1981 continued into the first half of 1982, although at a diminished pace.
Declines
in production and employment slowed, while sales of automobiles improved.
Real GNP fell at a 4 percent annual rate between the third quarter of 1981
and the first quarter of 1982.
With output declining, the margin of unused
plant capacity widened and the unemployment rate rose to a postwar record.
By mid-1982, however, the recession seemed to be drawing to a
close.
Inventory positions had improved substantially, homebuilding was
beginning to revive, and consumer spending appeared to be rising.
None-
theless, there were signs of increased weakness in business investment.
Although final demands apparently fell during the second quarter, the rate
of inventory liquidation slowed, and on balance, real GNP apparently
changed little.
If, in fact, this spring or early summer is determined to
have been the cyclical trough, both the depth and duration of the decline
in activity will have been about the same as in other postwar recessions.
The progress in reducing inflation that began during 1981 continued in the first half of 1982.
The greatest improvement was in prices
of food and energy--which benefited from favorable supply conditions--but
Increases in price measures that exclude these volatile items also have
slowed markedly.
Moreover, increases in employment costs, which carry
forward the momentum of inflation, have diminished considerably.
Not only
have wage increases eased for union workers in hardpressed industries as
a result of contract concessions, but wage and fringe benefit increases
also have slowed for non-union and white-collar workers in a broad range of
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Industrial Production
Index, 1967= 100
150
140
130
1
1
1
1982
1980
1978
Real GNP
Change from end of previous period, annual rate, percent
1972 Dollars
6
3
0
H1
1978
H2
H1
1982
1980
Gross Business Product Prices
Change from end of previous period, annual rate, percent
Fixed-weighted Index
9
6
3
H1
1978
1980
Note Data for 1982 H1 are partially estimated by the FRB
H2
H1
1982
-2-
industries.
In addition there has been increasing use of negotiated work-
rule changes as well as other efforts by business to enhance productivity
-and trim costs.
At the same time, purchasing power has been rising; real
compensation per hour increased 1 percent during 1981 and rose at about a
3 percent annual rate over the first half of 1982.
Interest rates.
As the recession developed in the autumn of
1981, short-term interest rates moved down substantially.
However, part
of this decline was retraced at the turn of the year as the demand for
money bulged and reserve positions tightened.
After the middle of the
first quarter, short-term rates fluctuated but generally trended downward,
as money--particularly the narrow measure, M1--grew slowly on average and
the weakness in economic activity continued.
In mid-July, short-term rates
were distinctly below the peak levels reached in 1980 and 1981.
Nonethe-
less, short-term rates were still quite high relative to the rate of inflation.
Long-term interest rates also remained high during the first
half of 1982.
In part, this reflected doubts by market participants that
the improved price performance would be sustained over the longer run.
This skepticism was related to the fact that, during the past two decades,
episodes of reduced inflation have been short-lived, followed by reacceleration to even faster rates of price increase.
High long-term rates also have
been fostered by the prospect of huge deficits in the federal budget even
as the economy recovers.
Fears of deepening deficits have affected expecta-
tions of future credit market pressures, and perhaps also have sustained
inflation expectations.
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Federal Reserve Bank of St. Louis
The resolution on the 1983 fiscal year budget that
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Federal Reserve Bank of St. Louis
•
I
Interest Rates
Percent
18
Home Mortgage
14
10
3-month Treasury Bill
6
1
1
1980
1978
1982
Funds Raised by Private Nonfinancial Sectors
Seasonally adjusted, annual rate, billions of dollars
Total
300
Business
200
100
Household
1980
1982
Federal Government Borrowing
Seasonally adjusted, annual rate, billions of dollars
Combined Deficit Financed by the Public
120
80
40
1
1
1
1978
1980
Note Data tor 1982 H1 are partia!ly estImated by the FRB
1982
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Federal Reserve Bank of St. Louis
-3-
was adopted by the Congress represents a beginning effort to deal with the
prS spect of widening deficits; and the passage of implementing legislation
should work in the direction of reducing market pressures on interest rates.
Domestic credit flows.
Aggregate credit flows to private non-
financial borrowers increased somewhat in the first half of 1982 from the
reduced pace in the second half of 1981, according to very preliminary
estimates.
Business borrowing rose while households reduced further their
use of credit.
Borrowing by the federal government increased sharply in
late 1981, after the 5 percent cut in personal income tax rates, and
remained near the new higher level during the first half of 1982 on a
seasonally adjusted basis.
Reflecting uncertainties about the future
ecI nomic and financial environment, both lenders and borrowers have shown
a strong preference for short-term instruments.
Much of the slackening in credit flows to nonfinancial sectors in
the last part of 1981 was accounted for by households, particularly by
household mortgage borrowing.
up slightly.
Since then, mortgage credit flows have picked
The advance was encouraged
na.rt by the gradual decline in
mortgage rates from the peaks of last fall.
In addition, households have
made widespread use of adjustable-rate mortgages and "creative" financing
techniques--including relatively short-term loans made by sellers at belowmarket interest rates and builder "buy-downs." About two-fifths of all conventional mortgage loans closed recently were adjustable-rate instruments,
and nearly three-fourths of existing home transactions reportedly involved
some sort of creative financing.
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Federal Reserve Bank of St. Louis
-4-
Business borrowing dropped sharply during the last quarter of 1981,
primarily reflecting reduced inventory financing needs.
However, credit use
by nonfinancial corporations rose significantly in the first half of 1982,
despite a further drop in capital expenditures.
The high level of bond rates
has discouraged corporations from issuing long-term debt, and a relatively
large share of business borrowing this year has been accomplished in shortterm markets--at banks and through sales of commercial paper.
The persis-
tently large volume of business borrowing suggests an accumulation of liquid
assets as well as an intensification of financial pressures on at least some
firms.
Signs of corporate stress continue to mount, including increasing
numbers of dividend reductions or suspensions, a rising fraction of business
loans at commercial banks with interest or principal past due, and relatively
frequent downgradings of credit ratings.
After raising a record volume of funds in U.S. credit markets
in 1981, the federal government continued to borrow at an extraordinary
pace during the first half of 1982, as receipts (national income and product
accounts basis) fell while expenditures continued to rise.
Owing to the
second phase of the tax cut that went into effect on July 1 and the effects
on tax revenues of the recession and reduced inflation, federal credit
demands will expand further in the period ahead.
Consumption.
Personal consumption expenditures (adjusted for
inflation) fell sharply in the fourth quarter of 1981, but turned up early
In 1982 and apparently strengthened further during the second quarter.
The
weakness in consumer outlays during the fourth quarter was concentrated in
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Federal Reserve Bank of St. Louis
Real Income and Consumption
Change from end of previous period, annual rate, percent
all Real Disposable Personal Income
r7 Real Personal Consumption Expenditures
6
4
2
MEM/
flTh
H1
H2
H1
1982
1980
1978
Real Business Fixed Investment
Change from end of previous period, annual rate, percent
En Producers' Durable Equipment
ri Structures
20
1,=•••••••
10
0
1
1
1
AA&
H1
1978
H2
H1
1982
1980
Total Private Housing Starts
Millions of units
2.0
1.5
1.0
.5
1
1978
1980
Note Data for 1982 H1 are partially estimated by the FRB
1982
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Federal Reserve Bank of St. Louis
-5--
the auto sector, as total sales fell to an annual rate of 7.4 million units-the lowest quarterly figure in more than a decade--and sales of domestic
_models plummeted to a 5.1 million unit rate.
Price rebates and other sales promotion programs during the early
months of 1982 provided a fillip to auto demand, and sales climbed to an
8.1 million unit rate.
Auto markets remained firm into the spring, boosted
in part by various purchase incentives.
But as has generally occurred when
major promotions have ended, auto purchases fell sharply in June.
Outside
the auto sector, retail sales at most types of stores were up significantly
for the second quarter as a whole.
Even purchases at furniture and appliance
outlets, which had been on a downtrend since last autumn, increased during
the spring.
Real after-tax income has continued to edge up, despite the sharp
drop in output during the recession.
The advance reflects not only typical
cyclical increases in transfer payments but also the reduction in personal
income tax rates on October 1.
Households initially saved a sizable pro-
portion of the tax cut, boosting the personal saving rate from 5-1/4 percent in mid-1981--about equal to the average of the late 1970s and early
1980s--to 6.1 percent in the fourth quarter of 1981.
During early 1982,
however, consumers increased spending, partly to take advantage of price
markdowns for autos and apparel, and the saving rate fell.
Business investment.
As typically occurs during a recession,
the contraction in business fixed investment has lagged behind the decline
in overall activity.
Indeed, even though real GNP dropped substantially
during the first quarter of 1982, real spending for fixed business capital
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Federal Reserve Bank of St. Louis
-6-
actually rose a bit.
An especially buoyant element of the investment
sector has been outlays for nonfarm buildings--most notably, commercial
office buildings, for which appropriations and contracts often are set
a year or more in advance.
In contrast to investment in structures, business spending for
new equipment showed little advance during 1981 and weakened considerably
in the first half of 1982.
Excluding business purchases of new cars, which
also were buoyed by rebate programs, real investment in producers' durable
equipment fell at a 2 percent annual rate in the first quarter.
evidently accelerated in the second quarter.
The decline
In April and May, shipments
of nondefense capital goods, which account for about 80 percent of the
spending on producers' durable equipment, averaged nearly 3 percent below
the first-quarter level in nominal terms.
Moreover, sales of heavy trucks
dropped during the second quarter to a level more than 20 percent below the
already depressed first-quarter average.
Businesses liquidated inventories at a rapid rate during late 1981
and in the first half of 1982.
The adjustment of stocks followed a sizable
buildup during the summer and autumn of last year that accompanied the contraction of sales.
The most prominent inventory overhang by the end of 1981
was in the automobile sector as sales fell precipitously.
However, with a
combination of production cutbacks and sales promotions, the days' supply
of unsold cars on dealers lots had improved considerably by spring.
Manufacturers and non-auto retailers also found their inventories
rising rapidly last autumn.
Since then, manufacturers as a whole have liqui-
dated the accumulation that occurred during 1981, although some problem areas
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Federal Reserve Bank of St. Louis
-7
still exist--particularly in primary metals.
Stocks held by non-auto
retailers have been brought down from their cyclical peak, but they remain
-above pre-recession levels.
Residential construction.
Housing activity thus far in 1982 has
picked up somewhat from the depressed level in late 1981.
Housing starts
during the first five months of 1982 were up 10 percent on average from the
fourth quarter of 1981.
The improvement in homebuilding has been supported
by strong underlying demand for housing services in most markets and by the
continued adaptation of real estate market participants to nontraditional
financing techniques that facilIcate transactions.
The turnaround in housing activity has not occurred in all areas
of the country.
In the south, home sales increased sharply in the first
part of 1982, and housing starts rose 25 percent from the fourth quarter of
1981.
In contrast, housing starts declined further, on average, during
the first five months of 1982 in both the west and the industrial north
central states.
Government.
Federal government purchases of goods and services,
measured in constant dollars, declined over the first half of 1982.
The
decrease occurred entirely in the nondefense area, primarily reflecting
a sharp drop in the rate of inventory accumulation by the Commodity Credit
Corporation during the spring quarter.
Purchases by the Commodity Credit
Corporation had reached record levels during the previous two quarters
owing to last summer's large harvests and weak farm prices.
Other non-
defense outlays fell slightly over the first half of the year as a result
of cuts in employment and other expenditures under many programs.
Real
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Federal Reserve Bank of St. Louis
-8--
defense spending apparently rose over the first half of the year, and the
backlog of unfilled orders grew further.
The federal deficit on a national
Income and product account basis widened from $100 billion at the end of
1981 to about $130 billion during the spring of this year.
Much of this
increase in the deficit reflects the effects of the recession on federal
expenditures and receipts.
At the state and local government level, real purchases of goods
and services fell further over the first half of 1982 after having declined
2 percent during 1981.
Most of the weakness this year has been in construc-
tion outlays as employment levels uave stabilized after large reductions
in the federally funded CETA program led to sizable layoffs last year.
The
declines in state and local government activity in part reflect fiscal
strains associated with the withdrawal of federal support for many activities and the effects of cyclically sluggish income growth on tax receipts.
Because of the serious revenue problems, several states have increased
sales taxes and excise taxes on gasoline and alcohol.
International payments and trade.
The weighted-average value of
the dollar, after declining about 10 percent from its peak last August,
began to strengthen sharply again around the beginning of the year and since
then has appreciated nearly 15 percent on balance.
The appreciation of
the dollar has been associated to a considerable extent with the declining
inflation rate in the United States and the rise in dollar interest rates
relative to yields on assets denominated in foreign currencies.
Reflecting the effects of the strengthening dollar, as well as the
slowing of economic growth abroad, real exports of goods and services have
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Federal Reserve Bank of St. Louis
Foreign Exchange Value of the U.S. Dollar
Index, March 1973 =100
120
110
100
90
80
1978
1980
1982
Current Account Balance
Annual rate, billions of dollars
20
10
0
10
20
1978
1980
Note Data for 1982 H1 are partially estimated by the FRB
1982
-9-
been decreasing since the beginning of 1981.
The volume of imports other
than oil, which rose fairly steadily throughout last year, dropped sharply
_ in the first half of 1982, owing to the weakness of aggregate demand—
especially for inventories--in the United States.
In addition, both the
volume and price of imported oil fell during the first half of the year.
The current account, which was in surplus for 1981 as a whole, recorded
another surplus in the first half of this year as the value of imports
fell more than the value of exports.
Labor markets.
Employment has declined by nearly 1-1/2 million
since the peak reached in mid-1981.
As usually happens during a cyclical
contraction, the largest job losses have been in durable goods manufacturing industries--such as autos, steel, and machinery--as well as at construction sites.
The job losses in manufacturing and construction during
this recession follow a limited recovery from the 1980 recession; as a
result, employment levels in these industries are more than 10 percent
below their 1979 highs.
In addition, declines in aggregate demand have
tempered the pace of hiring at service industries and trade establishments
over the past year.
As often happens near a business cycle trough, employ-
ment fell faster than output in early 1982 and labor productivity showed a
small advance after declining sharply during the last half of 1981.
Since mid -1981 there has been a 2-1/4 percentage point rise in the
overall unemployment rate to a postwar record high of 9-1/2 percent.
The
effects of the recession have been most severe in the durable goods and
construction industries, and the burden of rising unemployment has been
relatively heavy on adult men, who tend to be more concentrated in these
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Federal Reserve Bank of St. Louis
-1I-
industries.
At the same time, joblessness among young and inexperienced
workers remains extremely high; hardest hit have been black male teenagers
-who experienced an unemployment rate of nearly 60 percent in June 1982.
Reflecting the persistent slack in labor markets, most indicators
of labor supply also show a signcant weakening.
of discouraged workers--that
For example, the number
persons who report that they want work
but are not looking for jobs because they believe they cannot find any--has
increased by nearly half a mon over the past year, continuing an upward
trend that began before the 1980 recession.
In addition, the labor force
participation rate--the proportion of the working-age population that is
employed or actively seeking jobs--has been essentially flat for the last
two years after rising about one-half percentage point annually between
1975 and 1979.
Prices and labor costs.
A slowing in the pace of inflation,
which was evident during 1981, continued through the first half of this
year.
During the first five months of 1982 (the latest data available),
the consumer price index increased at an annual rate of
lI wer than the 8.9 percent rise during 1981.
.5-rce
sharply
Much of the improvement was
in energy and food prices as well as in the volatile CPI measure of homeownership costs.
But even excluding these items, the annual rate of increase
in consumer prices has slowed to
9-1/2 percent rise last year.
evident at the producer level.
percent this year compared with a
The moderation of price increases also was
Prices of capital equipment have increased
at a 4-1/4 percent annual rate thus far this year--well below the
cent pace of 1981.
In addition, the decline in raw materials prices, which
occurred throughout last year, has continued in the first half of 1982.
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Federal Reserve Bank of St. Louis
per-
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Federal Reserve Bank of St. Louis
Consumer Prices
Change from end of previous period, annual rate, percent
En
CPI
D CPI Excluding Food, Energy, and Homeownership
15
10
5
Dec to May
1982
1980
1978
Gasoline Prices
Dollars per gallon
1.50
1 00
50
1982
1980
1978
Hourly Earnings Index
Change from end of previous period, annual rate, percent
9
6
3
HI
1978
1980
H2
HI
1982
-11-
Gasoline prices at the retail level, which had remained virtually
flat over the second half of 1981, fell substantially during the first four
-months of 1982.
Slack domestic demand and an overhang of stocks on world
petroleum markets precipitated the decline in prices.
However, gasoline
prices began to rise again in May in reflection of rising consumption,
reduced stocks, and lower production schedules by major crude oil suppliers.
The rate of increase in employment costs decelerated considerably
during the first half of 1982.
The index of average hourly earnings, a
measure of wage trends for production and nonsupervisory personnel, rose
at a 6-1/4 percent annual rate over the first half of this year, compared
with an increase of 8-1/4 percent during 1981.
Part of the slowing was due
to early negotiation of expiring contracts and renegotiation of existing
contracts in a number of major industries.
These wage concessions are
expected to relieve cost Dressures and to enhance the competitive position
of firms in these industries.
Increases in fringe benefits, which generally
have risen faster than wages over the years, also are being scaled back.
Because wage demands, not to mention direct escaltor provisions, are responsive to price performance, the progress made in reducing the rate of inflation should contribute to further moderation in labor cost pressures.
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Federal Reserve Bank of St. Louis
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Federal Reserve Bank of St. Louis
z
-12-
Section 2:
The Growth of Money and Credit in the First Half of 1982
The annual targets for the monetary aggregates announced in February
were chosen to be consistent with continued restraint on the growth of money
and credit in order to exert sustained downward pressure on inflation.
At
the same time, these targets were expected to result in sufficient money
growth to support an upturn in economic activity.
Measured from the fourth
quarter of 1981 to the fourth quarter of 1982, the growth ranges for the
aggregates adopted by the Federal Open Market Committee (FOMC) were as
follows:
for Ml, 2-1/2 to 5-1/2 percent; for M2, 6 to 9 percent; and for
M3, 6-1/2 to 9-1/2 percent.
The corresponding range specified by the FOMC
for bank credit was 6 to 9 percent.'
When the FOMC was deliberating on its annual targets in February,
the Committee was aware that M1 already had risen well above its average
level in the fourth quarter of 1981.
In light of the financial and economic
backdrop against which the bulge in M1 had occurred, the Committee believed
it likely that there had been an upsurge in the public's demand for liquidity.
It also seemed probable that this strengthening of money demand would unwind
In the months ahead.
Thus, under these circumstances and given the relatively
low base for the M1 range for 1982, it did not appear appropriate to seek
an abrupt return to the annual target range, and the FOMC indicated its
willingness to permit M1 to remain above the range for a while.
At the
1. Because of the authorization of international banking facilities (IBFs)
on December 3, 1981, the bank credit data starting in December 1981 are
not comparable with earlier data. The target for bank credit was put
In terms of annualized growth measured from the average of December 1981
and January 1982 to the average level in the fourth quarter of 1982 so that
the shift of assets to IBFs that occurred at the turn of the year would not
have a major impact on the pattern of growth.
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Federal Reserve Bank of St. Louis
-13-
same time, the FOMC agreed that the expansion in M1 for the year as a
whole might appropriately be in the upper part of its range, particularly
If available evidence suggested the persistence of unusual desires for
liquidity that had to be accommodated to avoid undue financial stringency.
In setting the annual target for M2, the FOMC indicated that
M2 growth for the year as a whole probably would be in the upper part of
its annual range and might slightly exceed the upper limit.
The Committee
anticipated that demands for the assets included in M2 might be enhanced
by new tax incentives such as the broadened eligibility for IRA/Keogh
accounts, or by further deregulation of deposit rates.
The Committee
expected that M3 growth again would be influenced importantly by the pattern
of business financing and, in particular, by the degree to which borrowing
would be focused in markets for short-term credit.
As anticipated--and consistent with the FOMC's short-run targets-the surge in M1 growth in December and January was followed by appreciably
slower growth.
After January, M1 increased at an annual rate of only 1-1/4
percent on average, and the level of M1 in June was only slightly above the
upper end of the Committee's annual growth range.
From the fourth quarter
of 1981 to June, M1 increased at a 5.6 percent annual rate.
M2 growth so
far this year also has run a bit above the FOMC's annual range; from the
fourth quarter of 19R1 through June, M2 increased on average at a 9.4
percent annual rate.
From a somewhat longer perspective, M1 has increased
at a 4.7 percent annual rate, measuring growth from the first half of 1981
Ranges and Actual Monetary Growth
M1
Billions of dollars
r- — Range adopted by FOMC for
Annual Rates of Growth
1981 04 to 1982 04
51
/
2%
460
1981 04 to June
5.6 Percent
1981 04 to 1982 02
6.8 Percent
450
1981 H1 to 1982 H1
4.7 Percent'
/
2%
21
1 Adjusted for shifts ,nto new
NOW accounts ,n 1981
440
0
I
1
11
IA!
1981
1 J
1982
IA!
M2
Billions of dollars
— — Range adopted by FOMC for
1981 04 to 1982 04
Annual Rates of Growth
, 9%
1950
6%
1900
1981 04 to June
9.4 Percent
1981 04 to 1982 02
9.7 Percent
...••••"".
1981 H1 to 1982 H1
9.7 Percent
1850
1800
0
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Federal Reserve Bank of St. Louis
1
fDf
1981
IF!
IA
I
1
J
1
1982
1
A
1
[0!
ID
- 15 -
also have some characteristics of traditional savings accounts.
Apparently
reflecting precautionary motives to a considerable degree, NOW accounts and
-other interest-bearing checkable deposits grew surprisingly rapidly in the
fourth quarter of last year and the first quarter of this year.
Although
growth in this component has slowed recently, its growth from the fourth
quarter of last year to June has been 30 percent at an annual rate.
The
other components of M1 increased at an annual rate of less than 1 percent
over this same period.
Looking at the components of M2 not also included in Ml, the
so-called nontransaction components, these items grew at a 10-3/4 percent
annual rate from the fourth quarter to June.
General purpose and broker/
dealer money market mutual funds were an especially strong component of
M2, increasing at almost a 30 percent annual rate this year.
Compared with
last year, however, when the assets of such money funds more than doubled,
this year's increase represents a sharp deceleration.
Perhaps the most surprising development affecting M2 has been the
behavior of conventional savings deposits.
After declining in each of the
past four years--falling 16 percent last year--savings deposits have
increased at about a 4 percent annual rate thus far this year.
This turn-
around in savings deposit flows, taken together with the strong increase
in NOW accounts and the still substantial growth in money funds, suggests
that stronger preferences to hold safe and highly liquid financial assets
in the current recessionary environment are bolstering the demand for M2
as well as Ml.
M3 increased at a 9.7 percent annual rate from the fourth quarter of
1981 to June, just above the upper end of the FOMC's annual growth target.
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Federal Reserve Bank of St. Louis
Ranges and Actual Monetary Growth
M3
Billions of dollars
— — Range adopted by FOMC for
1981 04 to 1982 04
91/20/0
Annual Rates of Growth
1981 04 to June
9.7 Percent
2300
1981 04 to 1982 02
9.8 Percent
1981 H1 to 1982 H1
10.5 Percent
..•••••".
2200
0 1
lD
F
!Ai
1981
IJI
I
1982
Ai
ioi
Bank Credit
Billions of dollars
— Range adopted by FOMC for
Dec. 1981-Jan. 1982 to 1982 04
Annual Rates of Growth
9%
Dec-Jan. to June
8.0 Percent
7
1400
6°A
Dec.-Jan. to 1982 02
8.3 Percent
1981 H1 to 1982 H1
8.4 Percentl
1350
01
1981
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Federal Reserve Bank of St. Louis
DI
IF!
I
Al
II
1982
I
AI
101
1 Adjusted for initial shifts into
international banking facilities.
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Federal Reserve Bank of St. Louis
- 16 -
Farly in the year, M3 growth was relatively moderate as a strong rise in
large-denomination CDs was offset by declines in term RPs and in money
market mutual funds restricted to institutional investors.
During the
second quarter, however, M3 showed a larger increase; the weakness in its
term RP and money fund components subsided and heavy issuance of large CDs
continued.
With growth of "core deposits" relatively weak on average,
commercial banks borrowed heavily in the form of large CDs to fund the
Increase in their loans and investments.
Commercial bank credit grew at an 8.3 percent annual rate over the
first half of the year, in the upper part of the FOMC's range for 1982.
Bank loans have increased on average at about a 9-1/2 percent annual rate,
with loans to nonfinancial businesses expanding at a 14 percent annual
rate.
In past economic downturns, business loan demand at banks has tended
to weaken, hut consistently high long-term interest rates in the current recession have induced corporations to meet the great bulk of their
external financing needs through short-term borrowing.
Real estate loans
have increased at a 7-1/4 percent annual rate this year, somewhat slower
than the growth in each of the past two years.
Consumer loans outstanding
during the first half of the year have grown at the same sluggish pace of
3 percent experienced last year.
The investment portfolios of banks have
expanded at about a 5 percent annual rate, with the rate of increase in
U.S. government obligations about twice as large as the growth in holdings
of other types of securities.
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Federal Reserve Bank of St. Louis
-17-
Section 3:
The Federal Reserve's Objectives for Growth of Money and Credit
There is a clear need today to promote higher levels of production
and employment in our economy.
The objective of Federal Reserve policy is
to create an environment conducive to sustained recovery in business activity while maintag the financial discipline needed to restore reasonable
price stabty.
The experience of the past two decades has amply demonstra-
ted the destructive impact of inflation on economic performance.
Because
inflation cannot persist without excessive monetary expansion, appropriately
restrained growth of money and credit over the longer run is crcal to
achieving lasting prosperity.
The policy of firm restraint on monetary growth has contributed
iIII rtantly to the recent progress toward reducing inflation.
But when
inflationary cost trends remain entrenched, the process of slowing monetary growth can entail economic and financial stresses, especially when so
much of the burden of dealing with inflation rests on monetary policy.
These strains--reflected in reduced profits, liquidity problems, and balance-sheet pressures--place particular hardships on industries that depend
heavily on credit markets such as construction, business equipment, and
consumer durables.
Unfortunately, these stresses cannot be easily remedied through
accelerated money growth.
The immediate effect of encouraging faster growth
in money might be lower interest rates, especially in short-term markets.
In time, however, the attempt to drive interest rates lower through a substantial reacceleration of money growth would founder, for the result would
be to embed inflation and expectations of inflation even more deeply into
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Federal Reserve Bank of St. Louis
-18-
the nation's economic system.
It would mean that this recession was another
wasted, painful episode instead of a transition to a sustained improvement
_in the economic environment.
The present and prospective pressures on
financial markets urgently need to be eased not by relaxing discipline on
money growth, but by the adoption of policies that will ensure a lower and
declining federal deficit.
Moreover, a return to financial health will
require the adoption of more prudent credit practices on the part of private borrowers and lenders alike.
In reviewing its targets for 1982 and setting tentative targets for
1983, the FOMC had as its basic objective the maintenance of the longerrange thrust of monetary discipline in order to reduce inflation further,
while providing sufficient money growth to accommodate exceptional liquidity
pressures and support a sustainable recovery in economic activity.
At the
same time, the Committee recognized that regulatory actions or changes in
the public's financial behavior might alter the implications of any quantitative monetary goals in ways that cannot be fully predicted.
In light of all these considerations, the Committee concluded that
a change in the previously announced targets was not warranted at this time.
Because of the tendency for the demand for money to run strong on average
in the first half, and also responding to the congressional budget resolution, careful consideration was given to the question of whether some
raising of the targets was in order.
However, the available evidence did
not suggest that a large increase in the ranges was justified, and a small
change in the ranges would have represented a degree of "fine tuning" that
-1S -
appeared inconsistent with the degree of uncertainty surrounding the precise
relationship of money to other economic variables at this time.
However,
the Committee concluded, based on current evidence, that growth this year
around the top of the ranges for the various aggregates would be acceptable.
The Committee also agreed that possible shifts in the demand for
liquidity in current economic circumstances might require more than ordinary
elements of flexibty and judgment in assessing appropriate needs for
money in the months ahead.
In the near term, measured growth of the aggre-
gates may be affected by the income tax reductions that occurred on July 1,
by cost-of-living increases in social security benefits, and by the ongoing
difficulties of accurately accounting for seasonal movements in the money
stock.
But more fundamentally, it is unclear to what degree businesses
and households may continue to wish to hold unusually large precautionary
liquid balances.
To the extent the evidence suggests that relatively
strong precautionary demands for money persist, growth of the aggregates
somewhat above their targeted ranges would be tolerated for a time and
still would be consistent with the FOMC's general policy thrust.
Looking ahead to 1983 and beyond, the FOMC remains committed to
restraining money growth in order to achieve sustained noninflationary
economic expansion.
At this point, the FOMC feels that the ranges now
in effect can appropriately remain as preliminary targets for 1983.
Recause monetary aggregates in 1982 more likely than not will be close to
-
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Federal Reserve Bank of St. Louis
the upper ends of their ranges, or perhaps even somewhat above them, the
-20-
preliminary 1983 targets would be fully consistent with a reduction in the
actual growth of money in 1983.
In light of the unusual uncertainty surrounding the economic,
financial, and budgetary outlook, the FOMC stressed the tentative nature
of its 1983 targets.
On the one hand, postwar cyclical experience strongly
suggests that some reversal of this year's unusual shift in the asset-holding preferences of the public could be expected; with economic activity on
an upward trend, any lingering precautionary motives for holding liquid
balances should begin to fade, thus contributing to a rapid rise in the
velocity of money.
Moreover, regulatory actions by the Depository Institu-
tions Deregulation Committee that increase the competitive appeal of deposit
Instruments--as well as the more widespread use of innovative cash management
techniques, such as "sweep" accounts--also could reduce the demand for money
relative to income and interest rates.
On the other hand, factors exist
that should increase the attractiveness of holding cash balances.
The long
upward trend in the velocity of money since the 1950s took place in an
environment of rising inflation and higher nominal interest rates--developments that provide incentives for economizing on money holdings.
As these
Incentives recede, it is possible that the attractiveness of cash holdings
will be enhanced and that more money will be held relative to the level of
business activity.
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Federal Reserve Bank of St. Louis
-21-
Section 4:
The Outlook for the Economy
The economy at midyear appears to have leveled off after sizable
declines last fall and winter.
1
Consumption has strengthened with retail
sales up significantly in the second quarter.
New and existing home sales
have continued to fluctuate at depressed levels, but housing starts nonetheless have edged up.
In the business sector, substantial progress has been
made in working off excess inventories, and the rate of liquidation appears
to have declined.
On the negative side, however, plant and equipment spend-
ing, which typically lags an upturn in overall activity, is still depressed.
And the trend in export demand continues to be a drag on the economy, reflecting the dollar's strength and weak economic activity abroad.
An evaluation of the balance of economic forces indicates that
an upturn in economic activity is highly likely in the second half of 1982.
Monetary growth along the lines targeted by the FOMC should accommodate this
expansion in real GNP, given the increases in velocity that typically occur
early in a cyclical recovery and absent an appreciable resurgence of inflation.
The 10 percent cut in income tax rates that went into effect July 1
is boosting disposable personal income and should reinforce the growth in
consumer spending.
Given the improved inventory situation, any sizable
increase in consumer spending should, in turn, be reflected in new orders
and a pickup in production.
Another element supporting growth in real GNP
will be the continuing rise in defense spending and the associated private
investment outlays needed for the production of defense equipment.
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Federal Reserve Bank of St. Louis
-22--
At least during the initial phase, the expansion is likely to
be more heavily concentrated in consumer spending than in past business
,cycles, as current pressures in financial markets and liquidity strains
may inhibit the recovery in investment activity.
With mortgage interest
rates high, residential construction does not seem likely to contribute to
the cyclical recovery to the extent that it has in the past.
Likewise,
the high level of corporate bond rates, and the cumulative deterioration
in corporate balance sheets resulting from reliance in recent years on
short-term borrowing, may restrain capital spending, especially given
the considerable margin of unutilized capacity that now exists.
The excellent price performance so far this year has been helped
by slack demand and by exceptionally favorable energy and food supply
developments.
For that reason, the recorded rate of inflation may be higher
in the second half.
However, prospects appear excellent for continuing the
downtrend in the underlying rate of inflation.
As noted earlier, signifi-
cant progress has been made in slowing the rise in labor compensation, and
improvement in underlying cost pressures should continue over the balance
of the year.
Unit labor costs also are likely to be held down by a cyclical
rebound in productivity growth as output recovers.
Moreover, lower inflation
will contribute to smaller cost-of-living wage adjustments, which will moderate cost pressures further.
The Federal Reserve's objectives for money growth through the end
of 1983 are designed to be consistent with continuing recovery in economic
activity.
A critical factor influencing the composition and strength of
the expansion will be the extent to which pressures in financial markets
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Federal Reserve Bank of St. Louis
-23-
moderate.
This, in turn, depends importantly on the progress made in
further reducing inflationary pressures.
A marked decrease in inflation
-would take pressure off financial markets in two ways.
First, slower
Inflation will lead to a reduced growth in transaction demands for money,
given any particular level of real activity.
It follows that a given
target for money growth can be achieved with less pressure on interest
rates and accordingly less restraint on real activity, the greater is the
reduction in inflation.
Second, further progress in curbing inflation
will help lower long-term interest rates by reducing the inflation premium
contained in nominal interest rates.
The welcome relief in inflation seen
recently apparently is assumed by many to represent a cyclical rather than
a sustained drop in inflation.
But the longer that improved price perfor-
mance is maintained, the greater will be the confidence that a decisive
downtrend in inflation is being achieved.
Such a change should be reflected
in lower long-term interest rates and stronger activity in the interestsensitive sectors of the economy.
Another crucial influence on financial markets and thus on the
nature of the expansion in 1983 will be the federal budgetary decisions
that are made in coming months.
The budget resolution that was recently
passed by the House and Senate is a constructive first step in reducing
budget deficits as the economy recovers.
However, much remains to be done
In appropriation and revenue legislation to implement this resolution.
How
the budgetary process unfolds will be an important factor in determining
future credit demands by the federal government and thus the extent to which
deficits will preempt the net savings generated by the private economy.
strong program of budget restraint would minimize pressures in financial
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A
-24--
markets and thereby enhance the prospects for a more vigorous recovery in
homebuilding, business fixed investment, and other credit-dependent sectors.
In assessing the economic outlook, the individual members of
the FOMC have formulated projections for several key measures of economic
performance that fall generally within the ranges in the table below.
In
addition to the monetary aggregate objectives discussed earlier, these projections assume that the federal budget will be put on a course that over
time will result in significant reductions in the federal deficit.
ECONOMIC PROJECTIONS OF FOMC MEMBERS
Actual
1981
1982
9.8
0.9
8.9
5-1/2 to 7-1/2
1/2 to 1-1/2
4-3/4 to 6
7 to 9-1/2
2-1/2 to 4
4 to 5-3/4
8.3
9 to 9-3/4
8-1/2 to 9-1/2
Projected
1983
Changes, fourth quarter to
fourth quarter, percent
Nominal GNP
Real GNP
GNP deflator
Average level in the fourth
quarter, percent
Unemployment rate
Revised administration forecasts for the economy were not available at the time of the Committee's deliberation.
Our understanding, how-
ever, is that the administration's midyear budgetary review will be presented
within the framework of the economic assumptions used in the first budget
resolution.
For the remainder of 1982, those assumptions imply somewhat more
rapid recovery than the range now thought most likely by members of the FOMC,
but would be consistent with the monetary targets outlined in this report on
the assumption of growth in velocity characteristic of the early stages of a
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-25-
number of past recoveries.
Looking further ahead, the Committee members,
like the administration and the Congress, foresee continued economic
-expansion in 1983, but currently anticipate a less rapld rate of price
increase and somewhat slower real growth than the assumptions underlying
the budget.
The monetary targets tentatively set for 1983, which will be
reviewed early next year, would imply, under the budgetary assumptions,
relatively high growth in velocity.
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Federal Reserve Bank of St. Louis
For use at 9:30 a.m., E.D.T.
July 20, 1982
Board of Governors of the Federal Reserve System
Midyear Monetary Policy Report to Congress
Pursuant to the
Full Employment and Balanced Growth Act of 1978
July 20, 1982
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a
••• •
GOv, •
••• Of '
1? •
Letter of Transmittal
BOARD OF GOVERNORS OF THE
FEDERAL RESERVE SYSTEM
Washington, D.C., July 20, 1982
THE PRESIDENT OF THE SENATE
THE SPEAKER OF THE HOUSE OF REPRESENTATIVES.
The Board of Governors is pleased to submit its Midyear Monetary Policy Report to the Congress pursuant
to the Full Employment and Balanced Growth Act of 1978.
Sincerely,
Paul A. Volcker, Chairman
•
TABLE OF CONTENTS
Page
Section 1:
Section 2:
Section 3:
Section 4:
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The Performance of the Economy in the
First Half of 1982
1
The Growth of Money and Credit in the
First H-1f of 1982
12
The Federal Reserve's Objectives for
Growth of Money and Credit
17
The Outlook for the Economy
21
Section 1:
The Performance of the Economy in the First Half of 1982
The contraction in economic activity that began in mid-1981 continued into the first half of 1982, although at a diminished pace.
Declines
in production and employment slowed, while sales of automobiles improved.
Real GNP fell at a 4 percent annual rate between the third quarter of 1981
and the first quarter of 1982.
With output declining, the margin of unused
plant capacity widened and the unemployment rate rose to a postwar record.
By mid-1982, however, the recession seemed to be drawing to a
close.
Inventory positions had improved substantially, homebuilding was
beginning to revive, and consumer spending appeared to be rising.
None-
theless, there were signs of increased weakness in business investment.
Although final demands apparently fell during the second quarter, the rate
of inventory liquidation slowed, and on balance, real GNP apparently
changed little.
If, in fact, this spring or early summer is determined to
have been the cyclical trough, both the depth and duration of the decline
in activity will have been about the same as in other postwar recessions.
The progress in reducing inflation that began during 1981 continued in the first half of 1982.
The greatest improvement was in prices
of food and energy--which benefited from favorable supply conditions--but
increases in price measures that exclude these volatile items also have
slowed markedly.
Moreover, increases in employment costs, which carry
forward the momentum of inflation, have diminished considerably.
Not only
have wage increases eased for union workers in hardpressed industries as
a result of contract concessions, but wage and fringe benefit increases
also have slowed for non-union and white-collar workers in a broad range of
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Industrial Production
Index, 1967= 100
150
140
130
1982
1980
1978
Real GNP
Change from end of previous period, annual rate, percent
1972 Dollars
6
3
0
w
H1
1978
H2
H1
1982
1980
Gross Business Product Prices
Change from end of previous period, annual rate, percent
Fixed-weighted Index
9
6
3
H1
1978
1980
Note Data for 1982 Ht are partially estimated by the FRB
H2
Ht
1982
•
4
-2-
industries.
In addition there has been increasing use of negotiated work-
rule changes as well as other efforts by business to enhance productivity
-and trim costs.
At the same time, purchasing power has been rising; real
compensation per hour increased 1 percent during 1981 and rose at about a
3 percent annual rate over the first half of 1982.
Interest rates.
As the recession developed in the autumn of
1981, short-term interest rates moved down substantially.
However, part
of this decline was retraced at the turn of the year as the demand for
money bulged and reserve positions tightened.
After the middle of the
first quarter, short-term rates fluctuated but generally trended downward,
as money--particularly the narrow measure, M1--grew slowly on average and
the weakness in economic activity continued.
In mid-July, short-term rates
were distinctly below the peak levels reached in 1980 and 1981.
Nonethe-
less, short-term rates were still quite high relative to the rate of inflation.
Long-term interest rates also remained high during the first
half of 1982.
In part, this reflected doubts by market participants that
the improved price performance would be sustained over the longer run.
This skepticism was related to the fact that, during the past two decades,
episodes of reduced inflation have been short-lived, followed by reacceleration to even faster rates of price increase.
High long-term rates also have
been fostered by the prospect of huge deficits in the federal budget even
as the economy recovers.
Fears of deepening deficits have affected expecta-
tions of future credit market pressures, and perhaps also have sustained
inflation expectations.
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The resolution on the 1983 fiscal year budget that
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Interest Rates
Percent
18
Home Mortgage
14
10
3-month Treasury Bill
6
1980
1978
1982
Funds Raised by Private Nonfinancial Sectors
Seasonally adjusted, annual rate, billions of dollars
300
Business
200
100
Household
1980
1982
Federal Government Borrowing
Seasonally adjusted, annual rate, billions of dollars
Combined Deficit Financed by the Public
120
80
40
1
1978
1980
Note Data for 1982 H1 are partially estimated by the FRB
1982
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-3--
was adopted by the Congress represents a beginning effort to deal with the
prospect of widening deficits; and the passage of implementing legislation
should work in the direction of reducing market pressures on interest rates.
Domestic credit flows.
Aggregate credit flows to private non-
financial borrowers increased somewhat in the first half of 1982 from the
reduced pace in the second half of 1981, according to very preliminary
estimates.
Business borrowing rose while households reduced further their
use of credit.
Borrowing by the federal government increased sharply in
late 1981, after the 5 percent cut in personal income tax rates, and
remained near the new higher level during the first half of 1982 on a
seasonally adjusted basis.
Reflecting uncertainties about the future
economic and financial environment, both lenders and borrowers have shown
a strong preference for short-term instruments.
Much of the slackening in credit flows to nonfinancial sectors in
the last part of 1981 was accounted for by households, particularly by
household mortgage borrowing.
up slightly.
Since then, mortgage credit flows have picked
The advance was encouraged in part by the gradual decline in
mortgage rates from the peaks of last fall.
In addition, households have
made widespread use of adjustable-rate mortgages and "creative" financing
techniques--including relatively short-term loans made by sellers at belowmarket interest rates and builder "buy-downs." About two-fifths of all conventional mortgage loans closed recently were adjustable-rate instruments,
and nearly three-fourths of existing home transactions reportedly involved
some sort of creative financing.
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Business borrowing dropped sharply during the last quarter of 1981,
primarily reflecting reduced inventory financing needs.
However, credit use
_by nonfinancial corporations rose significantly in the first half of 1982,
despite a further drop in capital expenditures.
The high level of bond rates
has discouraged corporations from issuing long-term debt, and a relatively
large share of business borrowing this year has been accomplished in shortterm markets--at banks and through sales of commercial paper.
The persis-
tently large volume of business borrowing suggests an accumulation of liquid
assets as well as an intensification of financial pressures on at least some
firms.
Signs of corporate stress continue to mount, including increasing
numbers of dividend reductions or suspensions, a rising fraction of business
loans at commercial banks with interest or principal past due, and relatively
frequent downgradings of credit ratings.
After raising a record volume of funds in U.S. credit markets
in 1981, the federal government continued to borrow at an extraordinary
pace during the first half of 1982, as receipts (national income and product
accounts basis) fell while expenditures continued to rise.
Owing to the
second phase of the tax cut that went into effect on July 1 and the effects
on tax revenues of the recession and reduced inflation, federal credit
demands will expand further in the period ahead.
Consumption.
Personal consumption expenditures (adjusted for
inflation) fell sharply in the fourth quarter of 1981, but turned up early
in 1982 and apparently strengthened further during the second quarter.
The
weakness in consumer outlays during the fourth quarter was concentrated in
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•
Real Income and Consumption
Change from end of previous period, annual rate, percent
Mil Real Disposable Personal Income
•
Real Personal Consumption Expenditures
6
4
2
1=ml.
11Ih
II
H1
1978
1980
H2
H1
1982
Real Business Fixed Investment
Change from end of previous period, annual rate, percent
ain
Producers' Durable Equipment
ri Structures
20
10
1978
1980
1982
Total Private Housing Starts
10
5
1978
1980
Note Data for 1982 H1 are partially estimated by the FRB
1982
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5-
the auto sector, as total sales fell to an annual rate of 7.4 million units-the lowest quarterly figure in more than a decade--and sales of domestic
_models plummeted to a 5.1 million unit rate.
Price rebates and other sales promotion programs during the early
months of 1982 provided a fillip to auto demand, and sales climbed to an
8.1 million unit rate.
Auto markets remained firm into the spring, boosted
in part by various purchase incentives.
But as has generally occurred when
major promotions have ended, auto purchases fell sharply in June.
Outside
the auto sector, retail sales at most types of stores were up significantly
for the second quarter as a whole.
Even purchases at furniture and appliance
outlets, which had been on a downtrend since last autumn, increased during
the spring.
Real after-tax income has continued to edge up, despite the sharp
drop in output during the recession.
The advance reflects not only typical
cyclical increases in transfer payments but also the reduction in personal
Income tax rates on October 1.
Households initially saved a sizable pro-
portion of the tax cut, boosting the personal saving rate from 5-1/4 percent in mid-1981--about equal to the average of the late 1970s and early
1980s--to 6.1 percent in the fourth quarter of 1981.
During early 1982,
however, consumers increased spending, partly to take advantage of price
markdowns for autos and apparel, and the saving rate fell.
Business investment.
As typically occurs during a recession,
the contraction in business fixed investment has lagged behind the decline
in overall activity.
Indeed, even though real GNP dropped substantially
during the first quarter of 1982, real spending for fixed business capital
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-6-
actually rose a bit.
An especially buoyant element of the investment
sector has been outlays for nonfarm buildings--most notably, commercial
office buildings, for which appropriations and contracts often are set
a year or more in advance.
In contrast to investment in structures, business spending for
new equipment showed little advance during 1981 and weakened considerably
in the first half of 1982.
Excluding business purchases of new cars, which
also were buoyed by rebate programs, real 4 nvestment in producers' durable
equipment fell at a 2 percent annual rate in the first quarter.
evidently accelerated in the second quarter.
The decline
In April and May, shipments
of nondefense capital goods, which account for about 80 percent of the
spending on producers' durable equipment, averaged nearly 3 percent below
the first-quarter level in nominal terms.
Moreover, sales of heavy trucks
dropped during the second quarter to a level more than 20 percent below the
already depressed first-quarter average.
Businesses liquidated inventories at a rapid rate during late 1981
and in the first half of 1982.
The adjustment of stocks followed a sizable
buildup during the summer and autumn of last year that accompanied the contraction of sales.
The most prominent inventory overhang by the end of 1981
was in the automobile sector as sales fell precipitously.
However, with a
combination of production cutbacks and sales promotions, the days' supply
of unsold cars on dealers lots had improved considerably by spring.
Manufacturers and non-auto retailers also found their inventories
rising rapidly last autumn.
Since then, manufacturers as a whole have liqui-
dated the accumulation that occurred during 1981, although some problem areas
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7-
still exist--particularly in primary metals.
Stocks held by non-auto
retailers have been brought down from their cyclical peak, but they remain
-above pre-recession levels.
Residential construction.
Housing activity thus far in 1982 has
picked up somewhat from the depressed level in late 1981.
Housing starts
during the first five months of 1982 were up 10 percent on average from the
fourth quarter of 1981.
The improvement in homebuilding has been supported
by strong underlying demand for housing services in most markets and by the
continued adaptation of real estate market participants to nontraditional
financing techniques that facilicate transactions.
The turnaround
of the country.
nIusng activity has not occurred in all areas
In the south, home sales increased sharply in the first
part of 1982, and housing starts rose 25 percent from the fourth quarter of
1981.
In contrast, housing starts declined further, on average, during
the first five months of 1982 in both the west and the industrial north
central states.
Government.
Federal government purchases of goods and services,
measured in constant dollars, declined over the first half of 1982.
The
decrease occurred entirely in the nondefense area, primarily reflecting
a sharp drop in the rate of inventory accumulation by the Commodity Credit
Corporation during the spring quarter.
Purchases by the Commodity Credit
Corporation had reached record levels during the previous two quarters
owing to last summer's large harvests and weak farm prices.
Other non-
defense outlays fell slightly over the first half of the year as a. result
of cuts in employment and other expenditures under many programs.
Real
•
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-8-
defense spending apparently rose over the first half of the year, and the
backlog of unfilled orders grew further.
The federal deficit on a national
Income and product account basis widened from $100 billion at the end of
1981 to about $130 billion during the spring of this year.
Much of this
increase in the deficit reflects the effects of the recession on federal
expenditures and receipts.
At the state and local government level, real purchases of goods
S.
and services fell further over the first half of
2 percent during 1981.
after having declined
Most of the weakness this year has been in construc-
tion outlays as employment levels uave stabzed after large reductions
in the federally funded CETA program led to sizable layoffs last year.
The
I- clines in state and local government activity in part reflect fiscal
strains associated with the withdrawal of federal support for many activities and the effects of cyclically sluggish income growth on tax receipts.
Because of the serious revenue problems, several states have increased
sales taxes and excise taxes on gasoline and alcohol.
International payments and trade.
The weighted-average value of
the dollar, after declining about 10 percent from its peak last August,
S_•. n to strengthen sharply again around the beginning of the year and since
then has appreciated nearly 15 percent on balance.
The appreciation of
the dollar has been associated to a considerable extent with the declining
inflatiS n rate in the United States and the rise
relative to yields on assets denominated
nISar interest rates
nSregn currencies.
Reflecting the effects of the strengthening dollar, as well as the
slowing of economic growth abroad, r --l exports 5f goods and services have
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Foreign Exchange Value of the U.S. Dollar
Index, March 1973 = 100
120
110
100
90
80
i
1
1978
I
I
1980
I
1982
Current Account Balance
Annual rate, billions of dollars
20
10
Surplus
0
Deficit
10
20
1978
1980
Note Data for 1982 H1 are partially estimated by the FRB
1982
-9-
been decreasing since the beginning of 1981.
The volume of imports other
than oil, which rose fairly steadily throughout last year, dropped sharply
_ in the first half of 1982, owing to the weakness of aggregate demand—
especially for inventories--in the United States.
In addition, both the
volume and price of imported oil fell during the first half of the year.
The current account, which was in surplus for 1981 as a whole, recorded
another surplus in the first half of this year as the value of imports
fell more than the value of exports.
Labor markets.
Employment has declined by nearly 1-1/2 million
since the peak reached in mid-1981.
As usually happens during a cyclical
contraction, the largest job losses have been in durable goods manufacturing industries--such as autos, steel, and machinery--as well as at construction sites.
The job losses in manufacturing and construction during
this recession follow a limited recovery from the 1980 recession; as a
result, employment levels in these industries are more than 10 percent
below their 1979 highs.
In addition, declines in aggregate demand have
tempered the pace of hiring at service industries and trade establishments
over the past year.
As often happens near a business cycle trough, employ-
ment fell faster than output in early 1982 and labor productivity showed a
small advance after declining sharply during the last half of 1981.
Since mid-1981 there has been a 2-1/4 percentage point rise in the
overall unemployment rate to a postwar record high of 9-1/2 percent.
The
effects of the recession have been most severe in the durable goods and
construction industries, and the burden of rising unemployment has been
relatively heavy on adult men, who tend to be more concentrated in these
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Federal Reserve Bank of St. Louis
-10-
industries.
At the same time, joblessness among young and inexperienced
workers remains extremely high; hardest hit have been black male teenagers
-who experienced an umemployment rate of nearly 60 percent in June 1982.
Reflecting the persistent slack in labor markets, most indicators
of labor supply also show a significant weakening.
For example, the number
of discouraged workers--that is, persons who report that they want work
but are not looking for jobs because they believe they cannot find any--has
increased by nearly half a million over the past year, continuing an upward
trend that began before the 1980 recession.
In addition, the labor force
participation rate--the proportion of the working-age population that is
employed or actively seeking jobs--has been essentially flat for the last
two years after rising about one-half percentage point annually between
1975 and 1979.
Prices and labor costs.
A slowing in the pace of inflation,
which was evident during 1981, continued through the first half of this
year.
During the first five months of 1982 (the latest data available),
the consumer price index increased at an annual rate of 3.5 percent, sharply
lower than the 8.9 percent rise during 1981.
Much of the improvement was
in energy and food prices as well as in the volatile CPI measure of homeownership costs.
But even excluding these items, the annual rate of increase
in consumer prices has slowed to 5-1/2 percent this year compared with a
9-1/2 percent rise last year.
evident at the producer level.
The moderation of price increases also was
Prices of capital equipment have increased
at a 4-1/4 percent annual rate thus far this year—well below the 9-1/4 percent pace of 1981.
In addition, the decline in raw materials prices, which
occurred throughout last year, has continued in the first half of 1982.
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Consumer Prices
Change from end of prewous period, annual rate, percent
Eln CPI
U
CPI Excluding Food, Energy, and Homeownership
15
10
5
Dec to May
1982
1980
1978
Gasoline Prices
Dollars per gallon
1.50
1 00
50
1982
1980
1978
Hourly Earnings Index
Change from end of previous period, annual rate, percent
9
6
3
Hi
1978
1980
H2
H1
1982
-11-
Gasoline prices at the retail level, which had remained virtually
flat over the second half of 1981, fell substantially during the first four
-months of 1982.
Slack domestic demand and an overhang of stocks on world
petroleum markets precipitated the decline in prices.
However, gasoline
prices began to rise again in May in reflection of rising consumption,
reduced stocks, and lower production schedules by major crude oil suppliers.
The rate of increase in employment costs decelerated considerably
during the first half of 1982.
The !ndex
of average hourly earnings, a
measure of wage trends for production and nonsupervisory personnel, rose
at a 6-1/4 percent annual rate over the first half of this year, compared
with an increase of 8-1/4 percent during 1981.
Part of the slowing was due
to early negotiation of expiring contracts and renegotiation of existing
contracts in a number of major industries.
These wage concessions are
expected to relieve cost pressures and to enhance the competitive position
of firms in these industries.
Increases in fringe benefits, which generally
have risen faster than wages over the years, also are being scaled back.
Because wage demands, not to mention direct escaltor provisions, are responsive to price performance, the progress made in reducing the rate of inflation should contribute to further moderation in labor cost pressures.
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-12-
Section 2:
The Growth of `Ioney and Credit in the First Half of 1982
The annual targets for the monetary aggregates announced in February
were chosen to be consistent with continued restraint on the growth of money
and credit in order to exert sustained downward pressure on inflation.
At
the same time, these targets were expected to result in sufficient money
growth to support an upturn in economic activity.
Measured from the fourth
quarter of 1981 to the fourth quarter of 1982, the growth ranges for the
aggregates adopted by the Federal Open Market Committee (FOMC) were as
follows:
for Ml, 2-1/2 to 5-1/2 percent; for M2, 6 to 9 percent; and for
M3, 6-1/2 to 9-1/2 percent.
The corresponding range specified by the FOMC
for bank credit was 6 to 9 percent.'
When the FOMC was deliberating on its annual targets in February,
the Committee was aware that M1 already had risen well above its average
level in the fourth quarter of 1981.
In light of the financial and economic
backdrop against which the bulge in M1 had occurred, the Committee believed
it likely that there had been an upsurge in the public's demand for liquidity.
It also seemed probable that this strengthening of money demand would unwind
in the months ahead.
Thus, under these circumstances and given the relatively
low base for the M1 range for 1982, it did not appear appropriate to seek
an abrupt return to the annual target range, and the FOMC indicated its
willingness to permit M1 to remain above the range for a while.
At the
1. Because of the authorization of international banking facilities (IBFs)
on December 3, 1981, the bank credit data starting in December 1981 are
not comparable with earlier data. The target for bank credit was put
in terms of annualized growth measured from the average of December 1981
and January 1982 to the average level in the fourth quarter of 1982 so that
the shift of assets to IFiFs that occurred at the turn of the year would not
have a major impact on the pattern of growth.
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Federal Reserve Bank of St. Louis
-13-
same time, the FOMC agreed that the expansion in M1 for the year as a
whole might appropriately be in the upper part of its range, particularly
if available evidence suggested the persistence of unusual desires for
liquidity that had to be accommodated to avoid undue financial stringency.
In setting the annual target for M2, the FOMC indicated that
M2 growth for the year as a whole probably would be in the upper part of
its annual range and might slightly exceed the upper limit.
The Committee
anticipated that demands for the assets included in M2 might be enhanced
by new tax incentives such as the broadened eligibty for IRA/Keogh
accounts, or by further deregulation of deposit rates.
The Committee
expected that M3 growth again would be influenced importantly by the pattern
of business financing and, in particular, by the degree to which borrowing
would be focused in markets for short-term credit.
As anticipated--and consistent with the FOMC's short-run targets-the surge in M1 growth in December and January was followed by appreciably
slower growth.
After January, M1 increased at an annual rate of only
percent on average, and the level of M1 in June was only slightly above the
upper end of the Committee's annual growth range.
From the fourth quarter
Sf 1981 to June, M1 increased at a 5.6 percent annual rate.
M2 growth so
far this year also has run a bit above the FOMC's annual range; from the
fourth quarter of 1981 through June, M2 increased on average at a 9.4
percent annual rate.
From a somewhat longer perspective, M1 has increased
at a 4.7 percent annual r5te, measuring growth from the first half of 1981
Ranges and Actual Monetary Growth
M1
Billions of dollars
r-- Range adopted by FOMC for
Annual Rates of Growth
1981 Q4 to 1982 04
51
/
2°A,
460
1981 Q4 to June
5 6 Percent
1981 04 to 1982 02
6 8 Percent
450
1981 H1 to 1982 H1
4 7 Percent l
21
/
2%
1 Adjusted tor shifts into new
NOW accounts in 1981
440
/".
A 1
1981
1J
1
1A1
101
ID
1982
M2
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Federal Reserve Bank of St. Louis
— — Range adopted by FOMC for
1981 Q4 to 1982
Annual Rates of Growth
1981 Q4 to June
9.4 Percent
1981 Q4 to 1982 02
9 7 Percent
1981 H1 to 1982 H1
9 7 Percent
A
1981
L
I
1982
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Federal Reserve Bank of St. Louis
to the first half of 1982 and abstracting from the shift into NOW accounts
in 1981; and M2 has grown at a 9.7 percent annual rate on a half-year over
-half-year basis.
Although M1 growth has been moderate on balance thus far this
year, that growth has considerably exceeded the pace of increase in nominal
CNP.
Indeed, the first-quarter decline in the income velocity of M1--that
GNP divided by M1--was extraordinarily sharp.
the broader aggregates has been unusually weak.
Similarly, the velocity of
Given the persistence of
high interest rates, this pattern of velocity behavior suggests a heightened
demand for M1 and M2 over the first half.
The unusual demand for M1 has been focused on its NOW account
cSIPS nent.
Following the nationwide authorization of NOW accounts at the
beginning of 1981, the growth of such deposits surged.
When the aggregate
targets were reviewed this past February, a variety of evidence indicated
that the major shift from conventional checking and savings accounts into
NOW accounts was over; in particular, the rate at which new accounts were
being opened had dropped off considerably.
As a result of that shift, how-
ever, NOW accounts and other interest-bearing checkable deposits had grown
to account for almost 20 percent of M1 by the beginning of 1982.
Subse-
quently, it has become increasingly apparent that M1 is more sensitive to
changes in the public's desire to hold highly liquid assets.
M1 is intended to be a measure of money balances held primarily
for transaction purposes.
However, in contrast to the other major com-
ponents of M1--currency and conventional checking accounts--NOW accounts
also have some characteristics of traditional savings accounts.
Apparently
reflecting precautionary motives to a considerable degree, NOW accounts and
-other interest-bearing checkable deposits grew surprisingly rapidly in the
fourth quarter of last year and the first quarter of this year.
Although
growth in this component has slowed recently, its growth from the fourth
quarter of last year to June has been 30 percent at an annual rate.
The
other comDonents of M1 increased at an annual rate of less than 1 percent
over this same period.
Looking at the components of M2 not also included in Ml, the
so-called nontransaction components, these items grew at a 10-3/4 percent
annual rate from the fourth quarter to June.
General purpose and broker/
dealer money market mutual funds were an especially strong component of
M2, increasing at almost a 30 percent annual rate this year.
Compared with
last year, however, when the assets of such money funds more than doubled,
this year's increase represents a sharp deceleration.
Perhaps the most surprising development affecting M2 has been the
behavior of conventional savings deposits.
After declining in each of the
I.st four years--falling 16 percent last year--savings deposits have
increased at about a 4 percent annual rate thus far this year.
This turn-
around in savings deposit flows, taken together with the strong increase
in NOW accounts and the still substantial growth in money funds, suggests
that stronger preferences to hold safe and highly liquid financial assets
in the current recessionary environment are bolstering the demand for M2
as well as Ml.
M3 increased at a 9.7 percent annual rate from the fourth quarter of
19R1 to June, just above the upper end of the FOMC's annual growth target.
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Federal Reserve Bank of St. Louis
Ranges and Actual Monetary Growth
M3
Billions of dollars
— — Range adopted by FOMC for
1981 04 to 1982 04
Annual Rates of Growth
91
/
2%
1981 04 to June
9.7 Percent
1
2%
6/
2300
1981 04 to 1982 02
9.8 Percent
1981 H1 to 1982 H1
10.5 Percent
2200
01
1Di
1F1
1A1
1981
1J1
1A1
101
1982
Bank Credit
Billions of dollars
— Range adopted by FOMC for
Dec. 1981-Jan. 1982 to 1982 04
Annual Rates of Growth
Dec,-Jan. to June
8.0 Percent
1400
60/0
Dec.-Jan. to 1982 02
8.3 Percent
1981 H1 to 1982 H1
8.4 Percentl
7
1350
7
01
1DI
1981
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Federal Reserve Bank of St. Louis
1
Fl
1A1
1J1
1982
1A1
10
1 Adjusted for initial shifts into
international banking facilities.
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Federal Reserve Bank of St. Louis
- 16 -
Parly in the year, M3 growth was relatively moderate as a strong rise in
large-denomination CDs was offset by declines in term RPs and in money
market mutual funds restricted to institutional investors.
During the
second quarter, however, M3 showed a larger increase; the weakness in its
term RP and money fund components subsided and heavy issuance of large CDs
continued.
With growth of "core deposits" relatively weak on average,
commercial banks borrowed heavily in the form of large CDs to fund the
increase in their loans and investments.
Commercial bank credit grew at an 8.3 percent annual rate over the
first half of the year, in the upper part of the FOMC's range for 1982.
Rank loans have increased on average at about a 9-1/2 percent annual rate,
with loans to nonfinancial businesses expanding at a 14 percent annual
rate.
In past economic downturns, business loan demand at banks has tended
to weaken, but consistently high long-term interest rates in the current recession have induced corporations to meet the great bulk of their
external financing needs through short-term borrowing.
Real estate loans
have increased at a 7-1/4 percent annual rate this year, somewhat slower
than the growth in each of the past two years.
Consumer loans outstanding
during the first half of the year have grown at the same sluggish pace of
3 percent experienced last year.
The investment portfolios of banks have
expanded at about a 5 percent annual rate, with the rate of increase in
U.S. government obligations about twice as large as the growth in holdings
of other types of securities.
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Federal Reserve Bank of St. Louis
n
donit
m
n
and employment in our economy.
The objective of Federal Reserve policy is
to create an environment conducive to sustained recovery in business activity while maintaining the financial discipline needed to restore reasonable
price stabty.
The experience of the past two decades has amply demonstra-
ted the destructive impact of inflation on economic performance.
Because
inflation cannot persist without excessive monetary expansion, appropriately
restrained growth of money and credit over the longer run is crcal to
achieving lasting prosperity.
The policy of firm restraint on monetary growth has contributed
importantly to the recent progress toward reducing inflation.
But when
inflationary cost trends remain entrenched, the process of slowing monetary growth can entail economic and financial stresses, especially when so
much of the burden of dealing with inflation rests on monetary policy.
These strains--reflected in reduced profits, liquidity problems, and balance-sheet pressures--place particular hardships on industries that depend
heavily on credit markets such as construction, business equipment, and
cS nsumer durables.
Unfortunately, these stresses cannot be easily remedied through
accelerated money growth.
The immediate effect of encouraging faster growth
in money might be lower interest rates, especially in short-term markets.
In time, however, the attempt to drive interest rates lower through a substantial reacceleration of money growth would founder, for the result would
be to embed inflation and expectations of inflation even more deeply into
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Federal Reserve Bank of St. Louis
z
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the nation's economic system.
It would mean that this recession was another
wasted, painful episode instead of a transition to a sustained improvement
in the economic environment.
The present and prospective pressures on
financial markets urgently need to be eased not by relaxing discipline on
money growth, but by the adoption of policies that will ensure a lower and
declining federal deficit.
Moreover, a return to financial health will
require the adoption of more prudent credit practices on the part of private borrowers and lenders alike.
In reviewing its targets for 1982 and setting tentative targets for
1983, the FOMC had as its basic objective the maintenance of the longerrange thrust of monetary discipline in order to reduce inflation further,
while providing sufficient money growth to accommodate exceptional liquidity
pressures and support a sustainable recovery in economic activity.
At the
same time, the Committee recognized that regulatory actions or changes in
the public's financial behavior might alter the implications of any quantitative monetary goals in ways that cannot be fully predicted.
In light of all these considerations, the Committee concluded that
a change in the previously announced targets was not warranted at this time.
Because of the tendency for the demand for money to run strong on average
in the first half, and also responding to the congressional budget resolution, careful consideration was given to the question of whether some
raising of the targets was in order.
However, the available evidence did
not suggest that a large increase in the ranges was justified, and a small
change in the ranges would have represented a degree of "fine tuning" that
-1I-
appeared inconsistent with the degree of uncertainty surrounding the precise
relationship of money to other economic variables at this time.
However,
the Committee concluded, based on current evidence, that growth this year
around the top of the ranges for the various aggregates would be acceptable.
The Committee also agreed that possible shifts in the demand for
liquidity in current economic circumstances might require more than ordinary
elements of flexibty and judgment in assessing appropriate needs for
money in the months ahead.
In the near term, measured growth of the aggre-
gates may be affected by the income tax reductions that occurred on July 1,
by cost-of-living increases in social security benefits, and by the ongoing
dculties of accurately accounting for seasonal movements in the money
stock.
But more fundamentally, it is unclear to what degree businesses
and households may continue to wish to hold unusually large precautionary
liquid balances.
To the extent the evidence suggests that relatively
strong precautionary demands for money persist, growth of the aggregates
somewhat above their targeted ranges would be tolerated for a time and
still would be consistent with the FOMC's general policy thrust.
Looking ahead to 1983 and beyond, the FOMC remains committed to
restraining money growth in order to achieve sustained noninflationary
economic expansion.
At this point, the FOMC feels that the ranges now
in effect can appropriately remain as preliminary targets for 1983.
Because monetary aggregates in 1982 more likely than not will be close to
-
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Federal Reserve Bank of St. Louis
the upper ends of their ranges, or perhaps even somewhat above them, the
-20-
preliminary 1983 targets would be fully consistent with a reduction in the
actual growth of money in 1983.
In light of the unusual uncertainty surrounding the economic,
financial, and budgetary outlook, the FOMC stressed the tentative nature
of its 1983 targets.
On the one hand, postwar cyclical experience strongly
suggests that some reversal of this year's unusual shift in the asset-holding preferences of the public could be expected; with economic activity on
an upward trend, any lingering precautionary motives for holding liquid
balances should begin to fade, thus contributing to a rapid rise in the
velocity of money.
Moreover, regulatory actions by the Depository Institu-
tions Deregulation Committee that increase the competitive appeal of deposit
Instruments--as well as the more widespread use of innovative cash management
techniques, such as "sweep" accounts--also could reduce the demand for money
relative to income and interest rates.
On the other hand
factors exist
that should increase the attractiveness of holding cash balances.
The long
upward trend in the velocity of money since the 1950s took place in an
environment of rising inflation and higher nominal interest rates--developments that provide incentives for economizing on money holdings.
As these
incentives recede, it is possible that the attractiveness of cash holdings
will be enhanced and that more money will be held relative to the level of
business activity.
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Federal Reserve Bank of St. Louis
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Section 4:
The Outlook for the Economy
The economy at midyear appears to have leveled off after sizable
declines last fall and winter.
1
Consumption has strengthened with retail
sales up significantly in the second quarter.
New and existing home sales
have continued to fluctuate at depressed levels, but housing starts nonetheless have edged up.
In the business sector, substantial progress has been
made in working off excess inventories, and the rate of liquidation appears
to have declined.
On the negative side, however, plant and equipment spend-
ing, which typically lags an upturn in overall activity, is still depressed.
And the trend in export demand continues to be a drag on the economy, reflecting the dollar's strength and weak economic activity abroad.
An evaluation of the balance of economic forces indicates that
an upturn in economic activity is highly likely in the second half of 1982.
Monetary growth along the lines targeted by the FOMC should accommodate this
expansion in real GNP, given the increases in velocity that typically occur
early in a cyclical recovery and absent an appreciable resurgence of inflation.
The 10 percent cut in income tax rates that went into effect July 1
is boosting disposable personal income and should reinforce the growth in
consumer spending.
Given the improved inventory situation, any sizable
increase in consumer spending should, in turn, be reflected in new orders
and a pickup in production.
Another element supporting growth in real GNP
will be the continuing rise in defense spending and the associated private
investment outlays needed for the production of defense equipment.
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Federal Reserve Bank of St. Louis
a
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At least during the initial phase, the expansion is likely to
be more heavily concentrated in consumer spending than in past business
-cycles, as current pressures in financial markets and liquidity strains
1
I.y inhibit the recovery in investment activity.
With mortgage interest
rates high, residential construction does not seem likely to contribute to
the cyclical recovery to the extent that it has in the past.
Likewise,
the high level of corporate bond rates, and the cumulative deterioration
in corporate balance sheets resulting from reliance in recent years on
short-term borrowing, may restrain capital spending, especially given
the considerable margin of unutzed capacity that now exists.
The excellent price performance so far this year has been helped
bI slack demand and by exceptionally favorable energy and food supply
developments.
For that reason, the recorded rate of inflation may be higher
in the second half.
However, prospects appear excellent for continuing the
downtrend in the underlying rate of inflation.
As noted earlier, signifi-
cant progress has been made in slowing the rise in labor compensation, and
improvement in underlying cost pressures should continue over the balance
of the year.
rebound
Unit labor costs also are likely to be held down by a cyclical
nSroductvt
growth as output recovers.
Moreover, lower inflation
will contribute to smaller cost-of-living wage adjustments, which will moderate cost pressures further.
The Federal Reserve's objectives for money growth through the end
of 1983 are designed to be consistent with continuing recovery in economic
activity.
A critical factor influencing the composition and strength of
the expansion will be the extent to which pressures in financial markets
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Federal Reserve Bank of St. Louis
-23-
moderate.
This, in turn, depends importantly on the progress made in
further reducing inflationary pressures.
A marked decrease in inflation
-would take pressure off financial markets in two ways.
First, slower
inflation will lead to a reduced growth in transaction demands for money,
given any particular level of real activity.
It follows that a given
target for money growth can be achieved with less pressure on interest
rates and accordingly less restraint on real activity, the greater is the
reduction in inflation.
Second, further progress in curbing inflation
will help lower long-term interest rates by reducing the inflation premium
contained in nominal interest rates.
The welcome relief in inflation seen
recently apparently is assumed by many to represent a cyclical rather than
a sustained drop in inflation.
But the longer that improved price perfor-
mance is maintained, the greater will be the confidence that a decisive
downtrend in inflation is being achieved.
Such a change should be reflected
in lower long-term interest rates and stronger activity in the interestsensitive sectors of the economy.
Another crucial influence on financial markets and thus on the
nature of the expansion in 1983 will be the federal budgetary decisions
that are made in coming months.
The budget resolution that was recently
passed by the House and Senate is a constructive first step in reducing
budget deficits as the economy recovers.
However, much remains to be done
in appropriation and revenue legislation to implement this resolution.
How
the budgetary process unfolds will be an important factor in determining
future credit demands by the federal government and thus the extent to which
deficits will preempt the net savings generated by the private economy.
strong program of budget restraint would minimize pressures in financial
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Federal Reserve Bank of St. Louis
A
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markets and thereby enhance the prospects for a more vigorous recovery in
homebuilding, business fixed investment, and other credit-dependent sectors.
In assessing the economic outlook, the individual members of
the FOMC have formulated projections for several key measures of economic
performance that fall generally within the ranges In the table below.
In
addition to the monetary aggregate objectives discussed earlier, these projections assume that the federal budget will be put on a course that over
time will result in significant reductions in the federal deficit.
ECONOMIC PROJECTIONS OF FOMC MEMBERS
Actual
1981
1982
9.8
0.9
8.9
5-1/2 to 7-1/2
1/2 to 1-1/2
4-3/4 to 6
7 to 9-1/2
2-1/2 to 4
4 to 5-3/4
8.3
9 to 9-3/4
8-1/2 to 9-1/2
Projected
1983
Changes, fourth quarter to
fourth quarter, percent
Nominal GNP
Real GNP
GNP deflator
Average level in the fourth
quarter, percent
Unemployment rate
Revised administration forecasts for the economy were not available at the time of the Committee's deliberation.
Our understanding, how-
ever, is that the administration's midyear budgetary review will be presented
within the framework of the economic assumptions used in the first budget
resolution.
For the remainder of 1982, those assumptions imply somewhat more
rapid recovery than the range now thought most likely by members of the FOMC,
but would be consistent with the monetary targets outlined in this report on
the assumption of growth in velocity characteristic of the early stages of a
P
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Federal Reserve Bank of St. Louis
-25-
number of past recoveries.
Looking further ahead, the Committee members,
like the administration and the Congress, foresee continued economic
-expansion in 1983, but currently anticipate a less rapid rate of price
increase and somewhat slower real growth than the assumptions underlying
the budget.
The monetary targets tentatively set for 1983, which will be
reviewed early next year, would imply, under the budgetary assumptions,
relatively high growth in velocity.
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