View PDF

The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.

Senate/House Banking Committees July 20 and 21, 1982 Midyear Monetary Policy Report   https://fraser.stlouisfed.org 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 Find it online: http://findingaids.princeton.edu/collections/MC279/c234 and https://fraser.stlouisfed.org/archival/5297 The digitization ofthis collection was made possible by the Federal Reserve Bank of St. Louis. From the  Ir1is1i1&Ei) of the Seeley G. Mudd Manuscript Library, Princeton, NJ  These documents can only be used for educational and research purposes ("fair use") as per United States copyright law. By accessing this file, all users agree that their use falls within fair use as defined by the copyright law of the United States. They further agree to request permission of the Princeton University Library (and pay any fees, if applicable) if they plan to publish, broadcast, or otherwise disseminate this material. This includes all forms of electronic distribution. Copyright The copyright law of the United States (Title 17, United States Code) governs the making of photocopies or other reproductions of copyrighted material. Under certain conditions specified in the law, libraries and archives are authorized to furnish a photocopy or other reproduction. One of these specified conditions is that the photocopy or other reproduction is not to be "used for any purpose other than private study, scholarship or research." If a user makes a request for, or later uses, a photocopy or other reproduction for purposes not permitted as fair use under the copyright law of the United States, that user may be liable for copyright infringement. Policy on Digitized Collections Digitized collections are made accessible for research purposes. Princeton University has indicated what it knows about the copyrights and rights of privacy, publicity or trademark in its finding aids However, due to the nature of archival collections, it is not always possible to identify this information. Princeton University is eager to hear from any rights owners, so that it may provide accurate information. When a rights issue needs to be addressed, upon request Princeton University will remove the material from public view while it reviews the claim. Inquiries about this material can be directed to: Seeley G. Mudd Manuscript Library 65 Olden Street Princeton, NJ 08540 609-258-6345 609-258-3385 (fax) muddaprinceton.edu   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Midyear Review of the Federal Reserve Board July 20, 1982   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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.   https://fraser.stlouisfed.org .mEmMir Federal Reserve Bank of St. Louis  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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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—   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  "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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  .  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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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 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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -3-  economy recovers upward momentum.  While less easy to  identify -- labor productivity typically does poorly during   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  •  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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  % -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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -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.   https://fraser.stlouisfed.org 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.  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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  •  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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -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  https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  •   https://fraser.stlouisfed.org 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 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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -  -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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  * *  * * * *  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.  -   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Board of Governor:, of the Federal Reserve System Washington, D.C. 20551 Official Business Penalty for Private Use, $300   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Postage and Fees Paid Rood at Governors a/ the Federal Reserve Spleen  First Class   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  •   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -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.   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -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  https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  a   https://fraser.stlouisfed.org 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. 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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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.   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -  Board of Governors of the Federal Reserve System Washington, D.C. 20551 Official Business Penalty for Private Use, 5300   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Postage arid Foes Paid Rood at Gammon at the Federal Reserve Systern  First Class   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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...   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org 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 as threat of "crowding out" business investment and housing   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  %  -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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -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  https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis   https://fraser.stlouisfed.org 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 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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  * *  * * * *  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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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.   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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.  )   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Board of Governors of the Fecieral Reserve System Washington, D.C. 20551 Official Business Penalty for Private Use, $300   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Postage and Fan Paid Booed of Cowman of the Federal Rafirve System  First Class   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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 -   https://fraser.stlouisfed.org 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 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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -.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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  u   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  _ 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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -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.   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -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  https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis   https://fraser.stlouisfed.org 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  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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -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. .  * *  .   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  * *  * * * *  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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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.   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Board of Governors of the Federal Reserve System Washington, D.C. 20551 Official Business Penalty for Private Use, $300   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Postage and Faits Paid Board of Governer, at the Federal Reserve System  First Class   https://fraser.stlouisfed.org 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" •   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -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-   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -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.   https://fraser.stlouisfed.org 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 as threat of "crowding out" business investment and housing   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  •  -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  ...   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  %  -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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -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  https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  *  *  *  * * * *  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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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,   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  (  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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Board of Governor., of the Federal Reserve System Washington, D.C. 20551 Official Business Penalty for Private Use, $300   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Postage and Fees Paid Based at Comournen a/ the Federal itaarve System  First Class  NIP   https://fraser.stlouisfed.org 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  fa   https://fraser.stlouisfed.org 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 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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -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 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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -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  IMM,  -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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  ft,   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -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.  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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -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 --   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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  -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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -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 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  https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis   https://fraser.stlouisfed.org 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. 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 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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -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 * *  _   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  * * * * * *  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.  _   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -2— 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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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.  $   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Board of Governors of the Federal Reserve System Washington, D.0. 20551 Official Business Penalty for Private Use, $300  •  f   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Postage and Fees Paid Doard of Governors of the Federal Reserve System  First Class   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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. *   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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.   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  •  -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.   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -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  https://fraser.stlouisfed.org 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 4.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  * *  * * * * * *  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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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,   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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.  )   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Board of Governor!, of the Federal Reserve System Washington, D.C. 20551 Official Business Penalty for Private Use, S300   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Postage and Foes Paid Rood at Governors of the Federal Reserve System  First Class  :JP)   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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:   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  The resolution on the 1983 fiscal year budget that   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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   https://fraser.stlouisfed.org 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,   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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.   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  1  1981  Di  IF  1  1 A  1f  1982  1  A  1  1_01  ID   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org 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 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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  DI  1  Fl  IA1  1..11  1982  1A1  1 0 I  I  1 Adjusted for initial shifts into international banking facilitieS.   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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   https://fraser.stlouisfed.org 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 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 -   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  •   https://fraser.stlouisfed.org 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 https://fraser.stlouisfed.org 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:   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  The resolution on the 1983 fiscal year budget that   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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,   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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 .   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  IF I  1AI  IJI  1982  1AI  101  1  1 Adjusted for initial shifts into international banking facilities.   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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 -   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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:   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  The resolution on the 1983 fiscal year budget that   https://fraser.stlouisfed.org 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  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   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org 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 IliFs that occurred at the turn of the year would not have a major impact on the pattern of growth.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  1  1981  D  IF!  1 A  1  I  1982  IAI  L 0 1  1   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org 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  / 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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  F  1AI  IJI  1982  I  A1  WI-1  I  1 Adjusted for initial shifts into international banking facilities.   https://fraser.stlouisfed.org 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. 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.   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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  -   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org 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 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.   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  •   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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:   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  The resolution on the 1983 fiscal year budget that   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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,   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  1  1 0 1  1981  I  F  IAI  LJI  1982  I  A]  1 0 I  ID   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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 -   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  /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   https://fraser.stlouisfed.org 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:   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  The resolution on the 1983 fiscal year budget that   https://fraser.stlouisfed.org 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  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  •   https://fraser.stlouisfed.org 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, .   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org 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 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   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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 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   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis   https://fraser.stlouisfed.org 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 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.   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org 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  •   https://fraser.stlouisfed.org 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 -   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis   https://fraser.stlouisfed.org 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:   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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  •   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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  •   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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 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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -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   https://fraser.stlouisfed.org 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 •   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  0  1982   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -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  •   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  0   https://fraser.stlouisfed.org 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 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.   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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  A   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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.   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  • •• • • ',00 GOVe/i• ..* •I•  4' ; s • •  5 gi •  • RAL REc ; •4(::.• • •... • •C: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:   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  The resolution on the 1983 fiscal year budget that   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  •  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   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  •  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   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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  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 .   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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 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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  Jr  -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 •   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org 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  / 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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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.   https://fraser.stlouisfed.org 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 he to embed inflation and expectations of inflation even more deeply into   https://fraser.stlouisfed.org 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 -   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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:   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  The resolution on the 1983 fiscal year budget that   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  per-   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  DI  IF!  I  Al  II  1982  I  AI  101  1 Adjusted for initial shifts into international banking facilities.   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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 -   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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 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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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:   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  The resolution on the 1983 fiscal year budget that   https://fraser.stlouisfed.org 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  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   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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  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   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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 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   https://fraser.stlouisfed.org 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 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  •   https://fraser.stlouisfed.org 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 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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  -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.   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  1  Fl  1A1  1J1  1982  1A1  10  1 Adjusted for initial shifts into international banking facilities.   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  z  -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  -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 -   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis  a  -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 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   https://fraser.stlouisfed.org 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   https://fraser.stlouisfed.org I. 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  P  https://fraser.stlouisfed.org 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.   https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis
Federal Reserve Bank of St. Louis, One Federal Reserve Bank Plaza, St. Louis, MO 63102