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SHADOW OPEN MARKET
COMMITTEE

Policy Statement and
Position Papers

September 17-18, 1989

PPS 89-02

THE BRADLEY
POLICY
RESEARCH
CENTER
Public Policy Working Paper Series

U N I V E R S I T Y

OF

ROCHESTCR

CONTENTS
Page
Table of Contents

i

SOMC Members

ii

SOMC Policy Statement Summary

1

Policy Statement

3

Economic Outlook Through 1990
Jerry L. Jordan

9

The U.S. Economy
Jerry L. Jordan

21

A Federal Budget Update
Mickey D. Levy

27

The Economic Outlook
H. Erich Heinemann

39

P* Type Models: Evaluation and Forecasts
Robert H. Rasche

55

U.S. Monetary Authorities' Foreign Currency
Purchases
Anna J. Schwartz

75

Issues in Foreign Investment in the United States
William Poole

79




i

SHADOW OPEN MARKET COMMITTEE
The Committee met from noon to 5:00 p.m. on Sunday, September 17,
1989 in Washington D.C.
The Committee noted with great sadness the death of Karl Brunner, its
co-chairman and one of its founders. Throughout his lifetime, Karl was a
champion of rational, non-inflationary policies. We miss his wise counsel,
his guidance, his wisdom and his good humor.

Members of the SOMC:
Professor Allan EL Meltzer, Graduate School of Industrial Administration, Carnegie Mellon University, Pittsburgh, Pennsylvania (412/268-2283).
M r . H. Erich H e i n e m a n n , Chief Economist, Ladenburg, Thalmann &
Co., Inc., New York, New York (212/940-0250).
D r . J e r r y L. J o r d a n , Senior Vice President and Chief Economist, First
Interstate Bancorp, Los Angeles, California (213/614-2920).
D r . Mickey D. Levy, Chief Economist, First Fidelity Bancorporation,
Philadelphia, Pennsylvania (215/985-8671).
Professor William Poole, Department of Economics, Brown University,
Providence, Rhode Island (401/863-2697).
Professor Robert H. Rasche, Department of Economics, Michigan State
University, East Lansing, Michigan (517/355-7755).
Dr. Anna J. Schwartz, National Bureau of Economic Research, New York,
New York (212/995-3451).




ii

SHADOW OPEN MARKET COMMITTEE

1

SOMC POLICY STATEMENT S U M M A R Y
Washington, September 18 — The Shadow Open Market Committee today
called on the Federal Reserve, the Administration and Congress to adopt a
three-part program to deal with critical problems confronting the economy:
1. The Federal Reserve should continue restrictive monetary policy to
"bring more than 25 years of inflation to an end."
2. The Treasury should cease and desist from meddling in the foreign
exchange markets. Costs of prior intervention should be fully disclosed.
3. The Administration and Congress should complete their overhaul of
the Federal deposit insurance system. Legislation enacted this summer
deals with the symptoms, but not the primary causes of the massive
problems in the savings and loan industry.
***********************************************

The SOMC is a group of academic and business economists who meet
regularly to comment on public policy. It was founded in 1973 by Professor
Allan H. Meltzer of Carnegie Mellon University and the late Professor Karl
Brunner of the University of Rochester.
In a policy statement, the Committee noted that to date, the response
of the economy to disinflation has been "remarkably good," and the cost of
the policy has remained low. The SOMC warned that may not continue.
"Sluggish economic growth or recession in coming quarters may prompt the
Federal Reserve to seek faster growth of monetary aggregates by pushing
short-term interest rates down aggressively.
"That would be a mistake . . . The main response to faster money growth
would be higher inflation in the future and further delay in returning the
economy to price stability. To avoid this mistake, the Federal Reserve should
give more attention to monetary aggregates and less attention to interest
rates."
The Committee supported proposals by Representative Stephen Nea!
(D-North Carolina) to require the Fed to maintain azero inflation" and by
Representative Lee Hamilton (D-Indiana) to compel the central bank to
disclose its policy decisions immediately. The SOMC reiterated its "longstanding suggestion that if the monetary authorities fail to meet announced
targets within a reasonable tolerance, they should be required to offer their
resignations."




2

SEPTEMBER 17-18, 1989

The SOMC attacked U.S. intervention in the foreign exchange markets
as a "costly gamble" that brings no benefits to the public. "By acquiring $34
billion of foreign currency," the SOMC said, "the monetary authorities have
taken a speculative position that yen, D-marks and other currencies will
appreciate in relation to the dollar. In effect, U.S. authorities are gambling
that their own anti-inflationary policies will fail.
The Committee statement called on the Administration, which is responsible for U.S. exchange policy, to end the practice of intervention, and
on the Treasury and the Fed to account fully for the cost of prior actions.
The Federal Reserve acts as agent for the Treasury in forex trading.




SHADOW OPEN MARKET COMMITTEE

3

S H A D O W OPEN M A R K E T COMMITTEE
Policy Statement
September 18, 1989
At its meeting yesterday, the Shadow Open Market Committee discussed
monetary policy, economic activity, inflation, the budget deficit and international economic developments.
Monetary policy remains restrictive. As a result, inflation will be reduced
and economic growth will remain temporarily below average during the next
several quarters. Growth of Federal entitlement programs continues at a
high rate. The misdirection of Federal outlays to favor consumption over
investment has not changed. Attempts by the U.S. Treasury to manipulate
the value of the dollar involve large hidden costs and are ineffective.
The Committee recommends that:
1. The Federal Reserve continue with its disinflationary policy;
2. The Treasury should cease and desist from meddling in the foreign
exchange markets. Costs of prior intervention should be fully disclosed;
and
3. The Administration and Congress should complete their overhaul of
the deposit insurance system. Legislation enacted this summer deals
with the symptoms, but not the primary causes of the massive problems in the savings and loan industry.
Recent Monetary Policy
Restrictive monetary policy remains in effect. During the past year, the
Federal Reserve has held the growth rate of the monetary base — bank
reserves and currency — at the lowest level since the early 1980s. Relatively
slow growth of the base and other monetary aggregates is part of a pattern
of slower money growth that is now entering its third year.
Continuation of this pattern will bring more than 25 years of inflation to
an end. We urge the Federal Reserve to continue on the path toward stable
prices. To remain on this path, growth of the monetary base should remain
in the neighborhood of 4 percent in the year ahead.
To date, the response of the economy to disinflation has been remarkably
good. The measured rate of inflation has fallen while costs of disinflation
have remained low, encouraging continuation of the policy.




4

SEPTEMBER 17-18, 1989

The costs of disinflation are not likely to remain low in the near future.
Sluggish economic growth or recession in coming quarters may prompt the
Federal Reserve to seek faster growth of monetary aggregates by pushing
short-term interest rates down aggressively.
That would be a mistake. Policy action cannot have much eflfect on
the near-term course of the economy. The main response to faster money
growth would be higher inflation in the future and further delay in returning
the economy to price stability. To avoid this mistake, the Federal Reserve
should give more attention to monetary aggregates and less attention to
interest rates.
Congress is currently considering propoals to increase political oversight
of the Federal Reserve. Representative Stephen Neal (D-North Carolina)
has proposed a Joint Congressional Resolution directing the Federal Open
Market Committee to "adopt and pursue monetary policies leading to, and
then maintaining, zero inflation." We applaud this initiative and urge its
adoption. Representative Lee Hamilton (D-Indiana) has introduced a bill
that, among many provisions, would require the FOMC to disclose its decisions immediately. We support this.
These are excellent proposals. However, they lack adequate means of
enforcement and ignore incentives. We reiterate our long-standing suggestion that, if the monetary authorities fail to meet announced targets within
a reasonable tolerance, they should be required to offer their resignations.

The Fed and P *
In Congressional testimony and in widely circulated analytic work, the Federal Reserve has called attention to the relation between money and the
price level. The particular relation involves a construct, called P*, that in
the past has moved in advance of changes in the rate of inflation, thereby
providing advance warning of changes in inflation. A rise in P* relative to
the current price level signals that inflation will increase, and a fall in P*
relative to the current price level signals disinflation.
Although the relation between money and prices and between money
growth and inflation has been known for centuries, the particular way the
Federal Reserve has expressed the relation is novel. If P* had been allowed
to constrain monetary growth in the 1960s and 1970s, inflation and subsequent disinflation would have been less costly. We, therefore, welcome the
introduction of P* as a factor in the discussion of monetary policy.
Unfortunately, the Federal Reserve has given no indication about how




SHADOW OPEN MARKET COMMITTEE

5

P* will be used to discipline monetary actions. We do not know when, how,
or indeed, whether P* will be used or when it will be ignored or overridden
by other considerations. The Federal Reserve has announced and ignored
many policy indicators in recent years.
Most of these indicators, if followed, would have prevented the high
and persistent inflation of the recent past. The choice of P* may be just
another indicator that is considered, announced and ignored. Until the
Federal Reserve clarifies how P* will affect its decision process, we remain
skeptical that a change has occurred.
There are, in addition, some technical issues raised by the choice of P*.
Two are of particular importance. First, in the derivation of P*, M2 velocity
is assumed to have a constant long-run value. The best available research
suggests that velocity is subject to unpredictable permanent changes in level;
it does not have a stationary mean as assumed in the Federal Reserve's
research.
Second, P* depends on M2, a relatively comprehensive measure of money.
The Federal Reserve has not implemented procedures to control any of the
monetary aggregates reliably, so it is unclear how the Federal Reserve can
restrain growth of M2 to make use of the new P*.
Despite these reservations, we commend the Federal Reserve for its concern about the long-term effects of its policy on price stability. We look
forward with interest to the announcement of plans for using P* as part of
a program to restore and maintain price stability.
E x c h a n g e Market Intervention
During 1989, the nominal value of the U.S. dollar has risen on the foreign
exchange markets as a consequence of the vigorous monetary restraint the
Federal Reserve initiated in May 1988. The rise of the dollar has coincided
with a decline in gold prices and a one percentage point drop in long-term
bond yields between March and September.
These developments demonstrate that the Fed's anti-inflationary policy actions are understood in the financial markets and are achieving their
intended results. Fears that the strong dollar will hamper growth of U.S.
exports are unfounded. Exports depend on real, inflation-adjusted exchange
rates, not on nominal exchange rates. If inflation drops, a fall in the real
value of the dollar will coincide with a rise in its nominal value.
By acquiring $34 billion of foreign currency, the monetary authorities
have taken a speculative position that yen, D-marks and other currencies will




6

SEPTEMBER 17-18, 1989

appreciate in relation to the dollar. In effect, U.S. authorities are gambling
that their own anti-inflationary policies will fail.
These gambles have been costly. In 1988, the Federal Reserve reported
losses of more than $500 million on foreign exchange market intervention.
This is only a small part of the cost of intervention to the U.S. public. There
are three major omissions: One, the Federal Reserve reports only realized
losses. The $500 million loss is the difference between purchases of foreign
currency made at a higher price than was received when the currency was
sold. But if no sales occur, no losses are reported.
Two, the Federal Reserve only accounts for losses on foreign exchange
on its own books. It also intervenes for the account of the Treasury's secret
Exchange Stabilization Fund. The Fund does not report the results of its
operations publicly.
Three, the Federal Reserve made net purchases of $23 billion of foreign
exchange in the 13 months ending July 1989. Most of the holdings are
in Japanese yen and German marks. Since the dollar appreciated against
both currencies during the period, the Federal Reserve has large unreported
losses. We estimate that, on a conservative basis, the Fed had realized and
unrealized losses of $5 billion in the year ending July 1989.
The Federal Reserve, by sterilizing its foreign currency purchases, has
not allowed exchange market operations to alter its restrictive monetary
stance. Hence, the intervention has not changed the growth rate of the
monetary base.
From June 1988 through May 1989 the monetary base grew by $10 billion. However, during the same period, domestic interest-bearing securities
held in the System Open Market Account declined by $7 billion. Net income
of the Federal Reserve Banks, which is normally rebated to the Treasury,
has accordingly been reduced — another loss for taxpayers.
There are no benefits to offset the losses. Sterilized intervention has no
effect on exchange rates. We urge that these costly operations be stopped.
At the same time, the public has a right to know how much has been lost in
foreign exchange market operations. The Congress should insist on a public
accounting of the realized and unrealized losses.

Foreign Investment in the United States
In a well-functioning economy, there is no necessary relation between the
geographic location of saving and the geographic location of investment in
new physical facilities. This proposition holds for a national economy and




SHADOW OPEN MARKET COMMITTEE

7

for the world economy. Individuals and firms save — consume less than
their incomes — for a variety of reasons. Where they invest is determined
primarily by the prospective return on investment after allowing for risk.
For any given individual or business, the problem may involve decisions as
to what financial assets to buy. To understand the process, we need to trace
the funds to the physical assets they finance.
Some analysts argue that U.S. macroeconomic policy may be constrained
by the need to keep foreign financial capital from fleeing the country. This
argument is invalid. Financial capital owned by U.S. residents is just as
mobile as foreign-owned capital. In the late 1970s, dollar depreciation caused
by capital outflow became a policy problem, but the difficulty had nothing
to do with the ownership of the capital that was moving. United States
inflation and low real returns on capital were responsible. Dealing with
these core issues reduced the outflow of capital owned by U.S. residents and
attracted foreign capital.
Capital mobility does not raise policy problems. It is desirable that
policymakers are constrained by market realities. We benefit when market
participants respond to costly policies in a manner that makes life difficult
for politicians. International capital mobility promotes efficient international
investment. The Committee strongly opposes any attempt to interfere with
the free movement of capital across national borders.

Fiscal Policy
Since the mid-1980s, the Federal budget imbalance has been reduced. However, important problems remain. Chief among these is the continued rising
share of outlays for consumption-oriented entitlements and the declining
share for investment and growth-enhancing activities.
Congress and the Administration should focus on the level of spending,
rather than accounting for the precise size of the deficit. Politicians should
eliminate the bias in the Federal budget that favors consumption over investment. Congress should maintain the recent downward trend in spending
relative to GNP. Consistent with the goal of the Humphrey-Hawkins Act of
1978, we urge that spending be reduced to 20 percent of GNP. Entitlement
programs for middle and upper-income individuals should bear the brunt of
reductions in growth of spending.
Improvement in the budget imbalance is illustrated by the primary deficit.
This measure includes all of the items in the conventional budget except net
interest payments; it is a measure of the amount government spends, trans-




8

SEPTEMBER 17-18, 1989

fers and taxes for all purposes other than debt service.
In fiscal 1986, the primary deficit was $85 billion. By fiscal 1989, the primary deficit had been eliminated and replaced by a surplus of approximately
$3 billion. Further, primary government outlays (outlays net of interest) will
be less than 19.5 percent of GNP in fiscal 1989, and total outlays including
interest payments will be reduced to 22.4 percent of GNP.
Much of the reduction in spending as a share of GNP reflects continued
growth of the economy, reduced growth of spending for national defense and
reductions in so-called non-defense, discretionary outlays. Entitlements and
mandatory outlays continue to rise. These categories of spending are mainly
for consumption, so growth of these outlays shows that neither Congress nor
the Administration has been willing to shift resources away from the growth
of consumption spending to reduce the bias in the U.S. economy against
investment spending.
Pressure to enact numerous costly spending programs has mounted. Last
year, Congress passed legislation to provide catastrophic health insurance.
It is now in the process of creating new programs to assist the handicapped.
These programs are financed by higher taxes and/or mandated expenditures
by the private sector. The fact that these bills do not appear to increase
the budget deficit does not alter the reality that their cost must be paid by
consumers and business just as if taxes were raised.
Thus, the Bush Administration has reneged on its promise not to raise
taxes just as if it had acted directly to tax to spend. However helpful and
humane the mandated services prove to be, they will add little to productivity. Like other transfer programs, the cost must be paid from the earnings
of those who work.
Ongoing efforts to meet the Gramm-Rudman-Hollings deficit targets
have influenced the structure of the currently pending capital gains tax
legislation. We fully support indexing capital gains subject to tax for inflation. Congress has already done this for personal income taxes. However,
we oppose a temporary reduction in capital gains taxes designed to generate
temporary revenue gains at the expense of future tax collections.




SHADOW OPEN MARKET COMMITTEE

9

ECONOMIC OUTLOOK T H R O U G H 1990
Jerry L. Jordan
First Interstate Bancorp
Summary
The forecast for the next year is positive. Inflation in the United States
peaked for this cycle in the first half of 1989 and will trend downward in
1990. Internationally, inflation should settle at a lower level. At the same
time, growth of U.S. output and employment in the next year will be above
the slow pace of 1989.
Interest rates will fluctuate in a fairly narrow range compared to the
experience of the past two decades. For example, long-term government
bond yields are forecast to remain in the range of about 7.5-8.5 percent
through 1990. Similarly, the foreign-exchange value of the dollar will trade
in a narrower range than in the past.
As is normal, not all sectors and regions will perform equally well. Both
housing starts and automobile sales peaked for the past cycle in 1986 and
then fell through 1989. We forecast a higher level of housing starts and auto
sales for 1990 than the estimated 1989 levels. Non-residential construction,
however, will be depressed through at least 1990 by high vacancy rates.
Investment spending by businesses will increase in real terms next year, but
at a more moderate pace than in 1988-89.
The U.S. external trade deficit, after falling through 1989, will rise again
in 1990, although we do not expect it to reach its previous peaks. Nevertheless, the continuing deficit will mean strong inflows of foreign capital
into U.S. financial markets. Foreign direct investment in the United States
should also continue at a high level.
After rising to the 5.5-6.0 percent range early next year, the national
unemployment rate will resume a gradual decline.
U . S . O u t l o o k for 1990
Monetary Policy
Actions by the Federal Reserve will continue as the most important U.S.
macroeconomic policy affecting both American business firms and economic
conditions abroad. The Federal Reserve's stated objectives remain unchanged:




10

SEPTEMBER 17-18, 1989

1. reduce and control inflation;
2. sustain economic growth;
3. contribute to a stable dollar on foreign-exchange markets; and
4. safeguard the integrity of the U.S. financial system.
During the past two years the Federal Reserve has focused on the first
of these four objectives, dampening inflation. Between the first part of 1988
and 1989 the target for the federal funds rate was raised by more than
three percentage points. Money growth as measured by the monetary base
(currency plus bank reserves) was cut in half from nearly 7 percent in 1988
to an estimated rate of less than 3.5 percent in 1989.
The Federal Reserve views the potential real growth of the U.S. economy
as about 2.5 percent per year and is trying to keep growth below that pace
to quell inflation. During the first half of 1989, the economy grew at an
average real rate of slightly over 2 percent excluding effects of the drought
rebound. The Fed's goal of a "soft landing" seemed on track.
In its mid-year report on monetary policy to Congress, the Federal Reserve indicated that it looks for real growth to continue in the 1.5-2 percent
range in 1990. A key issue affecting the outlook for next year is whether
the Fed can or will hold the economy to such a low growth track. Two
points are relevant. First, fine-tuning the economy is extremely difficult
and a tight-policy "overshoot," tipping the economy into recession in the
next several months, is a significant possibility. Second, even if the overall
economy continues to post positive growth, important sectors could decline.
Manufacturing, now stagnating, seems particularly vulnerable.
The main assumption behind our forecast is that a substantial weakening
in the economy in the latter part of 1989 will prompt an easing in Federal
Reserve policy. This will imply both lower interest rates and more rapid
monetary growth. While changes in monetary policy affect inflation with
quite a long lead time — about two years — accelerations and decelerations
in monetary base growth affect real economic activity relatively quickly.
Consequently, we would expect the Fed to prevent any downturn in the
economy from becoming deep or prolonged.
We assume that the monetary base will expand somewhat over 5 percent
in 1990. This is a pace which should accommodate both moderate real
economic growth and lower inflation.




SHADOW OPEN MARKET COMMITTEE

11

Resilient Economic Growth
The U.S. economy is resilient and, as a market economy, has a natural
tendency to grow. The economy even seemed to weather, at least through
the first half of 1989, the impact of a major tightening in monetary policy.
While we expect a much weaker performance in the second half of 1989, a
swing to more accommodative monetary policy should allow the economy
to return to a real growth rate of 2.5-3 percent by the spring of 1990.
Following an estimated gain of only 1.7 percent this year (fourth quarter
to fourth quarter), our forecast is a rise of 2.4 percent in real GNP in 1990.
Growth during the next year would thus be close to the 2.5 percent potential
estimated by the Federal Reserve, but below the 3 percent rate we believe
is sustainable. During the past thirty years, real GNP growth has averaged
about 3 percent per year.
Consumer Spending— In 1986, real consumption outlays peaked a,t over
66 percent of gross national product. During 1990 we expect consumer
spending to grow at a slower pace than overall production of goods and
services, reducing the consumer spending-GNP ratio. Several forces appear
to be causing a moderation in consumer spending growth: the maturing of
the "baby boom generation," an easing of inflationary expectations, and the
phasing out of deductions for certain interest expenses.
Auto sales have experienced a difficult year in 1989 and have been supported mainly by costly rebate and incentive programs. In 1990, we expect a
small increase of about 200,000 cars for total sales of 10.2 million. Including
another sales year of 4.6 million light trucks, total motor vehicle purchases
would total 14.8 million in 1990, up slightly from this year's 14.6 million.
Construction Spending — We believe that 1989 will mark the low point
for the current housing cycle and that housing starts will be higher in 1990.
The ability of financial institutions to continue to attract funds during periods of tight money, albeit at higher rates, has dampened significantly the
amplitude of housing cycles.
Our forecast for 30-year, fixed-rate mortgage rates to average below 10
percent in 1990 should shark a moderate recovery in homebuilding. We look
for a gain of 4.7 percent in housing starts to a total of 1.48 million units in
1990. Most of the gain next year will be in the single-family sector. Nonresidential building in most markets will be constrained by high vacancy
rates in 1990. Projects already in the pipeline will support a substantial
amount of construction, and both domestic and foreign investors will develop
projects with longer time horizons. However, the dollar value of permits for




12

SEPTEMBER 17-18, 1989

non-residential building is likely to increase by less than 2 percent in 1990,
a showing similar to that estimated for this year.
Investment Spending — United States business firms have invested heavily during the past two years to improve their competitive position in both
domestic and foreign markets. Between the middle of 1987 and the middle
of 1989, outlays for capital equipment expanded at an annual rate averaging
over 9 percent in real terms.
The slowdown which the manufacturing sector has already started to
see, and which is projected to become more generalized by the end of 1989,
is likely to restrain new capital spending in coming months. Machine tool
companies have already seen deferrals in new orders by the auto industry.
Various companies experiencing a squeeze on profits may delay purchases
of capital equipment, such as new computers or trucks. We expect such
cutbacks to be relatively short lived, however. A return to better economic
growth by next spring, along with lower interest rates, should bolster further
gains in outlays to modernize facilities and improve productivity.
Labor Markets — In just the five years through 1989, the U.S. economy
has generated nearly 13 million jobs, or an average of 2.6 million per year.
In the next year, we expect a still significant, but more modest, average
of 1.5 million new jobs. This smaller number of additions to payrolls will
reflect both more moderate economic growth and efforts by business firms
to raise the productivity of their existing work forces.
The unemployment rate dropped towards the 5 percent level during the
first half of 1989. This level probably represents essentially "full employment." The fact that certain people are unemployed even when the economy
is at "full employment" represents two key factors:
1. frictional unemployment — individuals looking for their first job, people reentering the work force such as formerly retired workers or women,
and individuals between jobs; and
2. structural unemployment — individuals without the skills necessary
to find work at wages they will accept or which are required by law.
We expect the slowing in the economy to push the jobless rate up to an
average of 5.7 percent in the first quarter of 1990. While this will represent
some slack in the overall labor market, sectors and regions experiencing
extremely tight situations this year are likely to see little relief.




SHADOW OPEN MARKET COMMITTEE

13

Inflation Outlook
We believe that inflation peaked in the second quarter of 1989 and should
head lower through the end of this year and in 1990. Consumer prices soared
at an annual rate of 6.4 percent in the second quarter and are likely to be
up 5.0 percent for the fully ear (measured fourth quarter to fourth quarter).
In 1990, we expect prices to be up 4.2 percent.
Inflation remains essentially a monetary phenomenon. Its basic cause in
every country is the expansion of the money supply at a rate more rapid
than a nation's ability to increase the output of goods and services. What is
the appropriate measure of the money supply? Both our own research and
work done at the Federal Reserve suggest that, in the United States, M2
(currency, checking, savings, and small time deposits) is the best predictor
of change in prices.
To gauge the pressure on prices, the Federal Reserve uses 2.5 percent
as the measure of real potential growth and subtracts that from the growth
rate of A/2. Although the lag between accelerations and decelerations in
money and prices can vary, we find that the typical lead time is about eight
quarters or two years. With A/2 growth this year likely to be less than 4
percent, subtracting 2.5 percent for potential growth (a number we believe
is conservatively small) implies an inflation rate for 1991 of less than 2
percent. While inflation is unlikely to be that low, the impact of monetary
policy clearly will be to dampen the rise in prices.
Supply shocks can have short-term but substantial impacts on prices.
Large increases in both food and energy prices contributed to the run-up
in consumer prices in the first part of 1989. However, by the middle of
the year, we had already started to see the unwinding of those price rises.
Larger crops in the United States this year should help to moderate food
price increases in the coming year. Our assumption also is that oil prices
(West Texas Intermediate) will average $16-$18 a barrel through the end of
1990.
Widespread concern exists that a low rate of unemployment will push
wages upward and contribute to higher inflation. Wage increases, however,
are not a cause but rather a result of the same monetary force pushing up
prices of all types of goods and services. Average employee costs are likely
to rise by about 4.8 percent this year and next.




14

SEPTEMBER 17-18, 1989

Interest Rates
Just as inflation probably peaked in the first half of 1989, we believe interest
rates reached their cyclical highs during that time. Both short- and longterm rates, measured in terms of yields on three-month and 30-year Treasury
bonds, reached their highs in March. Interest rates are likely to move lower
through the spring of next year and then move gradually upward through
the end of 1990.
Most of the movement in interest rates during the next year will be in
instruments with shorter maturities. Three forces are especially important
in determining the course of short-term rates:
1. the pace of economic growth;
2. the rate of inflation; and
3. the growth of bank reserves.
Signs of slower economic growth push interest rates lower through weaker
credit demands and expectations of easing on the part of the Federal Reserve.
Lower inflation reduces the inflation premium in interest rates and also leads
to expectations of a relaxing in monetary policy. An easing of monetary
policy, in terms of more rapid growth of bank reserves, also has some shortterm liquidity effect in pushing interest rates downward.
The climb in short-term rates between early 1988 and 1989, a rise prompted largely by Federal Reserve actions, appears much larger than would be
justified by the pace of economic growth and inflation. Consequently, we
believe that a significant reduction in short-term rates will take place in the
latter part of 1989 and first part of 1990. The Federal Reserve will probably
have to allow short-term rates to fall in order to revive monetary growth
and prevent a substantial economic downturn. A return to better economic
growth by the second quarter of next year is then likely to cause a gradual
new upward trend in short-term rates.
Our specific forecast is for short-term rates to drop about 1.5 percentage
points by the spring of 1990 from their levels of early September 1989. This
would take rates on 3-month Treasury bills from 8 percent in the summer
of 1989 to an average of 6.5 percent in the first half of 1990. By the fourth
quarter of 1990, Treasury-bill rates would then have risen about one-half
percentage point to an average of about 7 percent.
Although long-term interest rates generally move in the same direction as
short-term rates, the magnitude of their change is likely to be much smaller




SHADOW OPEN MARKET COMMITTEE

15

than that of short rates during the next two years. This is because of the
greater impact of inflationary expectations on yields of longer term assets
and the "stickiness" of those expectations.
We expect the yield on the benchmark 30-year government bond to stay
within a range of about 50 basis points above and below 8 percent. Investors
need to become much more convinced that inflation in the long-term will
run significantly below the 4.8 percent average (consumer prices) of the past
30 years before accepting much lower returns.
Following the pattern of short-term rates, long-term bond yields are
likely to drift lower through the middle of 1990 and then move gradually
higher. This would result in 30-year government bond yields moving from
an average of 8.1 percent in the third quarter of 1989 to an average of 7.8
percent in the first half of 1990.
Efforts by the Federal Reserve to push short-term rates higher culminated in a flat and even inverted yield curve (short-term yields above longterm yields) during much of 1989. The faster decline of short-term relative
to long-term rates should produce a more normal, positively sloped curve
by the end of 1989 or first part of 1990.
Industry Outlook
Although 1989 has proven stronger than we had expected a year ago, the
slowdown from 1988 is apparent in several industries, particularly automobiles and segments of retail trade. Cyclic industries such as consumer
durables and housing have experienced weaker sales and profits. At the
same time, industries that are less cyclic and those oriented towards export
markets have continued to grow. These trends are likely to continue before
a more general recovery gets under way.
Energy — The domestic production of oil will continue to decline —
barring a sustained increase in world crude oil prices, a development we think
is possible but not very likely in the next decade. Expanded production by
Organization of Petroleum Exporting Countries (OPEC) is likely to at least
offset demand growth, with some decline in price probably needed to clear
markets. While a major price drop is possible within the next two years,
we would not expect a price below $14 would be long sustained; similarly,
we think prices much above $20 before the end of 1990 are likely to set up
corrective market responses.
Manufacturing — Industrial production, as gauged by the Federal Reserve Board Index, is expected to decline in the last quarter of 1989 before




16

SEPTEMBER 17-18, 1989

resuming modest growth in both 1990 and 1991. Global competitive pressures and opportunities will boost durable-goods demand, so we expect the
production of durables to grow somewhat faster during the recovery than
that of non-durables. Similarly, domestic investment and export demand
will tend to favor sectors such as business equipment over consumer goods,
both in the next two years and longer term.
Wholesale and Retail Trade — The slowdown in economic growth has
been very apparent in retail trade. Inflation, of course, tends to boost retail
sales; constant-dollar sales are a better indication of the health of the business. There has been little growth in constant-dollar sales figures for the
last three quarters, and the situation is not likely to improve dramatically.
T h e International E c o n o m y
Industrial Countries
Economic activity in the industrial countries outside the United States is
expected to remain relatively buoyant in 1990. In 1988, the collective real
growth rate of the six largest economies (the G-7 minus the United States)
reached 4.5 percent, its highest level of the decade. Japan, with a 5.6 percent rise in real GNP, was the growth leader, but the European economies
and Canada also turned in sound growth performances. At the same time,
inflation was quite modest in Japan and Germany, the two largest of these
economies.
During 1989, growth in Japan and Germany appears to be continuing
at a fairly rapid pace. The economic restructuring of Europe is providing
considerable impetus to investment throughout the EC. Thus, although aggregate growth in the industrial countries will be slower than last year, the
pace of economic expansion will still be higher than earlier in the 1980s.
This pattern should generally continue during 1990. The United Kingdom
and Canada, however, appear likely to slow more than the other large industrial economies. Inflationary pressure, closer relations with the slowing
U.S. economy, and balance-of-payments trends all indicate that monetary
policy in these two countries may remain tighter than elsewhere. Overall
the collective increase in real GDP in the six largest industrial economies
outside the United States is likely to remain in the 3-4 percent range during
the forecast period.
Following a "boom" in investment last year, private-sector capital formation should continue to be one of the leading growth factors during the




SHADOW OPEN MARKET COMMITTEE

17

forecast period in most major industrial countries. The new dimensions
of global competition are causing corporations throughout the world to revise strategies and to focus on increased productivity. Investments to take
advantage of more rapid economic growth, a less regulated business environment, and economies of scale are underpinning the rise in capital formation.
Producers of capital goods, such as Germany, are beneficiaries of the shift
toward investment.
One factor that has affected investment decisions globally is the prospect
of a unified European economy by the end of 1992. European companies
and financial institutions are attempting to position themselves to compete
effectively in this market, while non-EC companies are also looking at Europe as an increasingly attractive market. During the coming two years,
the approach of 1992 will continue to support a higher level of investment
globally.
During 1989, some rise in inflation has occurred, although in most countries price rises remain moderate. In Japan, inflation should remain in the
1-2 percent range during the forecast period, while in Germany a 2-3 percent range is expected. In the United Kingdom, however, an inflationary
surge in 1989 has been brought about by previously expansive monetary
policy and by a lower pound. Monetary policy has been tightened, and inflation is expected to decline after this year. Similarly, moderate rises in
the inflation rates in France and Italy are occurring, but by 1991 the rate
of inflation in most countries will be back to 1988 levels.
Higher rates of economic growth have begun to bring down unemployment levels in Europe, where job creation had previously been low. The
EC unemployment rate, which was 10.8 percent in 1986, was in the 9.09.5 percent range during the first half of 1989, and further declines are in
prospect during 1990. Nevertheless, unemployment rates in Europe remain
significantly higher than in North America or Japan.
Although economic growth and inflation are tending to converge among
the major countries, wide disparities in balance-of-payments performances
remain. Japan and Germany continue to record large surpluses in their trade
and current accounts, while the other large countries this year have recorded
substantial deficits. In the United Kingdom and Canada, in particular,
the magnitude of the current-account deficits has become a constraint on
monetary policy and is one factor leading to slower growth prospects in both
countries. During 1990, both Japan and Germany are forecast to record
only modest reductions in their surpluses, but the deficits of the other large
industrial countries should decline.




18

SEPTEMBER 17-18, 1989

World Trade — Volume expanded vigorously in 1988 and continues to
do so in 1989 as collective industrial-country real economic growth remains
solid. During the 1980s, we have seen substantial realignments in world
trade as some parts of the world economy have achieved higher growth than
others. Developing Asia, for example, now produces about 13 percent of
world exports, an increase from 8.5 percent in 1980. The Middle East's
share of world imports has fallen from 12.3 percent in 1980 to less than 4.5
percent. During the same period, Africa's share of world trade has been cut
nearly in half, and Latin America's share has fallen as a result of external
debt and other political and economic burdens.
The volume of world trade measured by imports is recording its seventh consecutive year of expansion since the contraction of 1982. Growth
of world trade has outpaced overall economic growth since the world-wide
recession of 1981-82. The industrial countries have recorded a collective real
economic growth rate of 3.6 percent annually since 1982, while the volume
of world trade has increased 6.2 percent per year. Our forecast is for the
volume (adjusted for inflation) of world trade to grow more slowly in 1990
as industrial-country growth slows. World trade in nominal terms should
show the same pattern.
Less-Developed Countries — The heavily indebted developing countries
appear to be moving in the direction of market-oriented policies, although
the process varies across countries. In addition, a number of countries continue to suffer the legacy of past decades of statism and oligopoly. In those
countries where policies are changing, however, the beginning of the 1990s
may be a period of increasing economic growth and improving external-debt
indicators.
Overall, global economic conditions will be relatively favorable for an
improvement in the financial positions of the heavily indebted countries. In
particular, lower international interest rates, fairly high rates of economic
growth in the industrial countries, and a generally free-trade environment
mean that developing-country exports should perform fairly well.
Very high inflation remains a problem in some countries where the reform of economic policies has still not gone far enough. Brazil, with the
largest economy and the largest external debt among the countries classified
as "highly indebted," continues to suffer from inflation in excess of 1,000
percent annually, while Argentina's efforts to cope with even higher inflation rates have only just began. Economic growth in the highly indebted
countries was only barely positive during 1988.
Despite the considerable problems still faced, the realization that eco-




SHADOW OPEN MARKET COMMITTEE

19

nomic policy reform is essential to a revival of growth and longer-term development is now becoming widespread. Chilean economic policies have
produced a record of fairly rapid growth, export diversification, and an improved external financial position during the past few years. Venezuela's
new government has also begun to implement a new set of market-oriented
policies that include privatization of some public enterprises and reducing
trade and foreign-exchange restrictions.
For the United States, perhaps the most significant changes in economic
policy are occurring in Mexico. The longer-term problems of Mexico —
including inadequate social and physical infrastructure — remain significant.
Nevertheless, a major reduction of trade restrictions, partial liberalization
of foreign-investment regulations, privatization of public-sector enterprises,
and moves toward domestic deregulation have all occurred. In addition,
the government's program to reduce inflation from earlier triple-digit levels
appears to be working. Mexico's position as the third largest trading partner
of the United States has been solidified as a result of rapid rises in imports
and exports of an increasing variety of industrial products.
Mexico appears poised for an increase in the level of foreign investment,
and economic growth will be more rapid in 1990 than during the recent past.
The restructuring of the country's foreign debt, which has been negotiated
with official creditors and commercial banks, will improve the country's financial position, although foreign debt will remain a constraint on economic
policymaking.
United States commercial banks have continued to reduce their exposure
to the highly indebted developing countries. The so-called "Brady Plan,"
proposed by Secretary of the Treasury Brady earlier this year, gave official
recognition and support to the trend of debt reduction that had already
been in place. United States banks other than the money-center banks have
actively reduced their exposure to the highly indebted countries, which has
declined by more than one-third during the past two years. Only the moneycenter banks remain significantly exposed to this problem.
17.5. Dollar — Various factors combined in 1989 to keep the U.S. dollar
much stronger than expected. Increasing political problems in West Germany, Japan, and then the United Kingdom enhanced the value of the dollar
in relation to those countries' currencies. Continued economic strength in
the U.S. economy also helped buoy the dollar.
It is very likely that we will see considerably less foreign-exchange volatility during 1990 than in earlier years. If monetary policy is more stable and
leads to a lower inflation rate, then we should expect that the dollar will




20

SEPTEMBER 17-18, 1989

also be more stable. A dollar that fluctuates less would be a great benefit
to U.S. businesses in supporting trade and investment.
Our forecast is for the dollar to average somewhat lower in 1990 compared with 1989. The major risk to this forecast would be difficulties abroad
that would add considerable strength to the dollar. Developments that
would lead to a serious depreciation of Japanese land values and other asset
values could result in a lower yen against the dollar and some substantial
revisions in cross rates with other currencies.
US. Current-Account Deficit — Our forecast for the U.S. trade and
current-account deficits is that they have bottomed out in 1989 and that
both will increase somewhat during 1990. We expect that the 1989 merchandise-trade deficit will fall about 13 percent from the 1988 level. Export
growth in 1989 will be somewhat more than twice import growth, but the
differential has narrowed considerably from that in 1988 when export growth
was nearly triple import growth.
We expect U.S. export growth to slow as most of the potential of the dollar's depreciation since February 1985 is fulfilled and growth abroad slows.
United States exports have benefited from the appreciation of the Taiwanese
and South Korean currencies and from lower barriers to imports in both of
these countries. Since Taiwran and South Korea have given up some of their
international competitiveness, other countries are moving in rapidly to replace them in the more labor-intensive industries. The leading example of a
newly emerging NIE (Newly Industrializing Economy) is Thailand; another
is probably Malaysia. Both should be potentially good markets for U.S.
exports of plant and equipment.







THE U.S. ECONOMY

C/3

W

>

O

Shadow Open Market Committee

o
w
>
w
H
O
O

Jerry L. Jordan
Senior Vice President and Chief Economist
First Interstate Bancorp

§
|

to

Washington, D.C.
September 17-18,1989

GROWTH OF TOTAL BANK RESERVES

MONETARY BASE

(4-week moving avg., percent change from 13 weeks ago, annual rate)

(Quarterly, s.a.&r.)

15

T

-10 4-

81

82

83

84

85

86 87

90f

911

-5 I 1 M M M M M I M II M II II I M II I 1II I
1
03
04
Q1
02
03
1988
1989

w
H
w
X

w
w
I

REALGNP
(Percent change, 4th quarter to 4th quarter)

NOMINAL AND REAL GNP
(Percent changefromprior quarter, annual rate)
10 T

85

' 86




'

87

• 88

' 89e •

gof '

911

S.hscfow On^n M^ke*

85

Committee

86

87

88

90!

911

September 17-18, 1989

MONETARY BASE AND GNP
(Percent change over year ago)

MONETARY GROWTH POINTS TO LOWER INFLATION
(Quarterly, percent change over year ago)

CO

>

o
o
o

I I t M I I M M f M M M M M M M M M M I f 1 1
83

84

85

86

87

89e

90f

911

83

84

85

86

87

89e

90f

91 f

w
as
S

>

8




K

FEDERAL BUDGET DEFICIT

CONSUMER AND EMPLOYEE COSTS
(Percent change, 4th quarter to 4A quarter)

(Billions of dollars, fiscal years)

w
w

to
GO

90f

911

1985

Shadow Ooen Market Committee

1986

1987

1988

1989

1990 1991

September 17-18, 1989

REAL CONSUMER SPENDING AS A SHARE OF GNP

IMPACT OF MONEY GROWTH ON CONSUMER
SPENDING

(Quarterly, percent)
67

(Quarterly percent change over year ago)

T

Real Consumption
66 +
N5
.fe.

65 +

64 +
RealM2
63

I II I I I I I I I I I I I I I I I I I I I II I I I I I I I I I I t I
83

84

85

86

87

901

88

911

61

63

65 67 69

71

73

75

77 79 81

83 85 87 89

W

HOUSING STARTS

AUTO AND TRUCK SALES
(Miffions of urrits)

(Millions of units)
24 T

16 r

no

Peak
Peak

18+

I

1

Trough

I.Illl
78

82

86

D Multi-family
83

84




85

87

88

89e

901

89e

901

911

I Single-family

911

Shadow Open Market Committee

September 17-18, 1989

EXCHANGE RATE-DM1

EXCHANGE RATE- YEN/$

(Weeky Averages*)

(Weekly Averages*)

>
DMt

u
o

1.9780
YerV$

146.58

o
W.
04
1988

03

01
'Last point kipotntf

02

Q3

03

04
1988

1989

a

Q1
02
Last point is spot rato

Q3
1989

>

pi
PI
w
O
O

FOR EIGN-TRADE DEFICIT
(BXons of dollars, balance of payments method)

s
s:

YIELD CURVE ANNUALLY 1 TO 30 YEARS
(Percent)
10

T

March 89

December 91 f

December 90f

7+

85




86

87

88

89e

90f

91 f

1 3

Shffdow Open Market Committee

5

7

10

20

30

September 17-18, 1989

SHORT-TERM INTEREST RATES
(Percent, quarterly averages)

LONG-TERM INTEREST RATES
(Percent, quarterly averages)

16 T

to

4 I I I I 1 I I I I I I I 11 I I I I I 11 11 1 I I
63

84

86

87

88

89s

83

9 f 911
0

84

85

86

87

88

89e

901 911

C/5

W

H
w
w
w

NONFARM EMPLOYMENT GROWTH

UNEMPLOYMENT RATE
(Unemployment as percent oftotallabor force,
mcMnq military, quarterly averages)

(Change horn prior month. In thousands)
12

T

00

4-Monlh

0 I M | | I 11 M l M l l l l l l l l l l l l l l l l l l l H I I I I I I M I I I
J F M A M J J A S O N D I
1968



F M A M J J A
1989
Shs6ow

Open Market

81

82

Committee

8
3

8
4

8
5

8
6

87

8
8

8e
9

90! 9 1
1

September 17-18,1989

SHADOW OPEN MARKET COMMITTEE

27

A Federal Budget Update
Mickey D. Levy
First Fidelity Bancorporation
The federal budget process continues to plod along. The latest round
of negotiations has followed a well-known script: the Administration's MidSession Review of the 1990 Budget optimistically proposes a dramatic decline in the deficit to $105 billion in FY1990; OMB's Initial Sequestration
Report, which includes its estimated on-budget costs of the savings and loan
restructuring legislation, projects a deficit of $116.2 billion, just over the
Gramm-Rudman-Hollings (GRH) maximum allowable level to avoid acrossthe-board cuts ($110 billion: the $100 billion target plus $10 billion leewray);
the CBO projects significantly higher deficits based on seemingly more realistic assumptions; and Congress considers action on the reconciliation instructions stemming from the Congressional Budget Resolution adopted in
May 1989 which, if enacted, would generate sufficient savings to avoid the
automatic cuts.
The current rendition of the budget process may suggest little "progress."
But in fact a string of budget legislation since the mid-1980s has yielded a
substantial net shift in the budget: federal spending has declined sharply as
a share of GNP, deficits have receded and the budget excluding net interest
outlays is now in surplus, and the ratio of federal debt-to-GNP has stabilized.
Yet the mix of federal spending continues to shift, with a rising share for
entitlement programs, and a declining portion for investment and growthenhancing activities. And a steady stream of costly new spending legislation
has been proposed with little discussion of how it will be financed.
A Budget Update
The FY1989 deficit should be approximately $160 billion, slightly higher
than the $155 billion in FY1988. Large rises over 1988 levels have occurred
in both outlays (8.3 percent) and tax revenues (9 percent). While enactment
of the Financial Institutions Reform Recovery and Enforcement Act adds
approximately $15 billion to FY1989 outlays, over half of the total increase in
outlays has occurred in the category of entitlements and other mandatory
spending. Stronger than expected tax revenues have partially offset this
impact on the federal deficit.
The budget outcome in FY1990 depends crucially on economic performance, interest rate trends, the extent of the savings from the spring 1989




28

SEPTEMBER 17-18, 1989

budget resolution that the Congress enacts, and the on-budget spending pattern for the savings and loan industry restructuring. OMB's projection of a
$116.2 billion budget deficit is based on 2.6 percent real GNP growth from
fourth quarter 1989 to fourth quarter 1990, sharp interest rate declines, full
enactment of the earlier budget resolution, and a front-loading into FY1989
of on-budget outlays incurred by the Resolution Trust Corporation for the
savings and loan industry restructuring (see tables 1 and 2). The CBO baseline projection, based on 2 percent real GNP growth, more modest interest
rate declines, and a spreading out of the on-budget outlays for the savings
and loan restructuring, projects a deficit of $141 billion, without enactment
of the budget resolution.
Real GNP growth should be significantly weaker than either the CBO's
or Administration's projections, based on the monetary restrictiveness in
1988-1989 and several indicators of economic activity (see chart 1). This
would suppress tax revenues, add modestly to outlays, and prevent the
deficit from falling significantly below $135 billion, even with full enactment
of the Congressional Budget Resolution.
Since avoiding GRH's across-the-board cuts requires only that OMB's
projections, not actual budget outcomes, meet GRH's deficit targets, automatic cuts for FY1990 are not expected. Meeting the GRH target of
$64 billion in FY1991, however, is virtually impossible. Even the Administration's budget, which is based on sustained strong economic growth and
declining real interest rates — a seemingly inconsistency — falls far short
of the target with a projected deficit of $88 billion. The CBO projects the
FY1991 deficit to be substantially higher — $138 billion using its own estimating procedures but the Administration's economic assumptions, and
$146 billion in its baseline projection. The actual budget outcome will be
even worse with weaker economic performance or without full enactment of
the Administration's budget proposals.
There is a reasonable chance that the GRH sequestration process will be
suspended for FY1991. Under the amended GRH law, if either
1. real GNP growth is below 1 percent for two consecutive quarters, or
2. OMB or CBO forecasts recession.
The House and Senate must vote on a joint resolution to suspend sequestration. Under such circumstances, the magnitude of the automatic cuts
necessary to meet the current GRH targets would be intolerable politically,
and Congress likely would vote for suspension.




SHADOW OPEN MARKET COMMITTEE

29

Of course, suspending GRH would not resolve anything, and would
only generate more questions about the budget process. Subsequently, "rebenching" the GRH deficit targets and stretching out the artificial deficit
reduction schedule would not constitute meaningful fiscal policy reform.

Shifting Budget Outcomes
Although recent budget negotiations seem stuck on a perpetual muddlethrough track, a series of incremental changes since the mid-1980s has generated a sizeable shift in the budget, most notably, reductions in actual and
projected deficits. In the early 1980s, federal spending rose sharply as a
share of GNP, driven by large increases in defense outlays and entitlement
programs (see chart 2). Spending peaked at 25.1 percent GNP in FY1983,
up dramatically from 21.4 percent in FY1979. Tax revenues, which rose
to 20.8 percent of GNP in FY1981, and were projected to rise substantially
higher by pre-Reagan policymakers, were reduced temporarily below 19 percent of GNP in FY1983-1984 by the Economic Recovery Tax Act of 1981,
and since then have stabilized between 19 and 19.5 percent of GNP. Consequently, deficits rose sharply, from an average of 2.6 percent of GNP between
FY1977 and FY1981 to a peak 6.4 percent in FY1983. It remained above 5
percent through FY1986. In nominal terms, deficits averaged $206.7 billion
from FY1983 to FY1986, and peaked at $221.2 billion in 1986.
The deterioration in the budget is also illustrated by the so-called "primary deficit" (the deficit minus net interest outlays) and the ratio of publiclyheld federal debt-to GNP. In FY1979, excluding net interest outlays, the
budget was in surplus by $2.4 billion. As spending soared, this "primary
surplus" evaporated and, by FY1983, the primary deficit reached $118 billion. It was $85.2 billion in FY1986 (see chart 3). The ratio of federal
debt-to-GNP rose substantially in response to the unprecedented deficits
and high Treasury interest rates, which far exceeded nominal GNP growth.
The ratio, which reached a postwar trough of 25 percent in FY1974, rose to
40 percent in FY1985 and was projected to rise dramatically higher.
These earlier budget trends have been reversed: the deficit will fall to
approximately 3.1 percent of GNP in FY1989 and is expected to recede substantially further (in FY1991, it falls to 1.5 percent in the Administration's
budget and 2.5 percent in the CBO baseline projection). In a dramatic turnaround since FY1986, the primary deficit has been completely eliminated.
In FY1989, tax receipts will exceed federal outlays, excluding net interest
outlays, by $3 billion. The primary surplus is projected to rise sharply in




30

SEPTEMBER 17-18, 1989

FY1990 and FY1991, substantially exceeding peak levels of the 1970s. Insofar as net interest outlays to service the outstanding federal debt reflects
primarily the costs of earlier policies, this sharp reversal accentuates the shift
in fiscal policy. As a consequence of this deficit trend and the lower level of
interest rates, the federal debt-to-GNP ratio has stabilized at approximately
42 percent and is projected to recede.
This reversal has been accomplished through modest tax increases —
tax receipts have risen to 19.3 percent of GNP in FY1989 — and significant
cuts in spending — to 22.4 percent of GNP in FY1989. This has involved a
sizeable shift in the mix of spending: outlays for social security and retirement programs and net interest outlays have risen as shares of total outlays,
while outlays for defense and non-defense non-entitlement programs have
declined (see chart 4). Measured as a share of GNP, outlays for defense
— 5.9 percent in FY1989 and an estimated 5.5 percent in FY1990 — have
retraced most of their early 1980s build-up. Since the peak in spending in
FY1983, 58.8 percent of the increases in non-interest outlays have been for
entitlements and other mandatory spending.
The shifting mix of federal outlays reveals the change in national priorities and also the impact of GRH. While actual budget outcomes have
never achieved either the original or the revised GRH targets, the GRH law
appears to have been an effective political restraint on spending. No doubt
it has also contributed to higher taxes. While GRH has successfully helped
to lower deficits, it has also contributed unintendedly to the changing mix
of outlays. Contrary to GRH's original intent of evenly distributed automatic cuts, the law sequesters an uneven patchwork of programs, and over
50 percent of total outlays escape its grip. Most notably, GRH excludes social security and several other non-means-tested entitlement programs; since
GRJETs adoption, social security and net interest outlays have been the most
rapidly growing outlay categories in the budget. Those programs subject to
GRH have incurred some of the largest budget cuts.
While large deficits and efforts to reduce them have been the primary focus of the fiscal policy debate, the sizeable shift in the mix of federal spending that has resulted from recent deficit-cutting legislation may not meet
acceptable standards of equity or efficiency in terms of the proper allocation
of national resources consistent with long-run economic growth. Transfer
payments constitute a rising portion of total federal outlays, with a sizeable share going to non-poor households through the ballooning non-meanstested entitlement programs. Meanwhile, notable pockets of poverty persist.
An insufficient share of budget outlays is allocated to investment-oriented




SHADOW OPEN MARKET COMMITTEE

31

activities, including education, research and development, and public infrastructure. These trends are reinforced by some recent spending initiatives,
including the savings and loan industry restructuring and the new drug
enforcement program. While spending for these programs may be necessary, they will be extraordinarily costly, regardless of how they are financed
(whether on or off-budget, subject to GRH, or financed on the state or local
level), they do not contribute to long-run economic growth, and they may
displace other investment or growth-enhancing budget initiatives.
Unfortunately, although there will be future efforts to push deficits lower,
an improved allocation of national resources — one that provides a larger
share of budget resources for investment and growth-enhancing activities,
and also eliminates some glaring inequities - is not a likely outcome of the
flawred budget process imposed by GRH.




32

SEPTEMBER 17-18, 1989

Table 1
Selected Budget Projections
actual
1988

1989

1990

1991

1992

1993

Receipts
^
President's Budget
CBO Baseline

909.0
909.0

995.9
991.0

1080.1
1071.0

1151.3
1138.0

1220.9
1207.0

1298.3
1287.0

Outlays
^
President's Budget
CBO Baseline

1064.0
1064.0

1144.1
1152.0

1179.4
1212.0

1237.2
1282.0

1287.7
1348.0

1328.8
1430.0

Deficits
^
President's Budget
CBO Baseline

155.1
155.0

148.3
161.0

105.0
141.0

88.0
144.0

66.7
141.0

30.3
143.0

Memo:
New GRH Targets
Original GRH Targets

144.0
108.0

136.0
72.0

100.0
36.0

64.0
0.0

28.0
0.0

0.0

Receipts, % Change
President's Budget
CBO Baseline

6.4
6.4

9.6
9.0

8.5
8.1

6.6
6.3

6.0
6.1

6.3
6.6

Outlays, X Change
President's Budget
CBO Baseline

6.0
6.0

7.5
8.3

3.0
5.2

4.9
5.8

4.1
5.1

3.2
6. 1

As a Percentage of GNP:
Revenues
^
President's Budget
CBO Baseline

19.0
19.0

19.3
19.3

19.6
19.6

19.6
19.5

19.4
19.4

19.3
19.3

Outlays
^
President's Budget
CBO Baseline

22.3
22.3

22.2
22.4

21.4
22.2

21.0
22.0

20.4
21.7

19.8
22.5

Deficit
President's Budget
CBO Baseline

3.2
3.2

2.9
3.1

1.9
2.6

1.5
2.5

1.1
2.3

0.4
2.1

Publicly-held debt
President's Budget
CBO Baseline

42.9
42.9

42.7

42.8

42.6

42.1

41.5

* Excludes asset sales
** Based on unofficial estimates of GNP levels




33

SHADOW OPEN MARKET COMMITTEE

Table 2
Administration and CBO Economic Projections
actual
1986

1989

1990

1991

1992

1993

Real GNP
Administration
CBO

2.8
2.8

2.7
2.4

2.6
2.0

3.3
2.4

3.2
2.5

3.1
2.5

Nominal GNP
Administration
CBO

6.8
7.2

7.1
6.8

6.8
6.4

7.2
6.8

6.8
6.9

6.4
6.9

CPI-W
Administration
CBO

4.2
4.3

4.9
5.3

4.1
4.7

3.8
4.6

3.5
4.6

3.2
4.6

Nominal GNP
Administration
CBO

7.5
7.5

7.5
7.4

6.6
6.2

7.2
6.7

7.0
6.9

6.8
6.9

Real GNP
Administration
CBO

3.9
3.9

2.9
2.8

2.3
1.7

3.1
2.3

3.2
2.5

3.1
2.5

GNP Deflator
Administration
CBO

4.5
4.5

4.5
4.4

4.2
4.3

3.9
4.3

3.6
4.3

3.3
4.3

CPI-U
Administration
CBO

4.1
4.1

5.0
5.2

4.2
4.7

3.9
4.6

3.6
4.6

3.3
4.6

3-Month T-Bill
Administration
CBO

6.7
6.7

8.0
8.2

6.7
7.2

5.3
6.8

5.0
6.5

b. 3

10-Year Government Bond
Administration
CBO

8.8
8.8

8.5
8.6

7.7
8.2

6.8
8.1

6.0
7.9

5.7
7.7

Memo:
Inflation-Adjusted Rates (CPI)
3-Month T-Bill
Administration
CBO

2.6
2.6

3.0
3.0

2.5
2.5

1.4
2.2

1.4
1.9

1.4
1.7

10-Year Government Bond
Administration
CBO

4.7
4.7

3.5
3.4

3.5
3.5

2.9
3.5

Percent change, fourth
quarter over fourth quarter:

Percent change, calendar years:

Interest Rates, percent.
Calendar Year Averages:




4.7

2.4
3.1

34

SEPTEMBER 17-18, 1989

CHART 1
MONETARY POLICY INDICATORS OF DOMESTIC DEMAND GROWTH
YR/YR

C H A N G E IN REAL

M2

REAL (INFLATION-ADJUSTED)
M2 HAS BEEN DECLINING
YEAR-OVER-YEAR SINCE
LATE 1988.
*-.6X

SPREAD: 30 YR.T—BOND — FED FUNDS
THE SPREAD BETWEEN TEE
LONG-TERM TREASURY BOND
YIELD AND THE FEDERAL
FUNDS RATE HAS INVERTED
FOR TEE FIRST TIME SINCE
THE 1981-1982 RECESSION.
A DECLINE IN REAL M2 AND
AN INVERSION OF THE
SPREAD HAS PRECEDED EVERY
RECENT RECESSION.

YR/YR

n




C H G . IN REAL D O M E S T I C

DEMAND

THESE INDICATORS OF
MONETARY POLICY, WHEN
COMBINED, HAVE ALWAYS
PROVIDED AN ACCURATE
PREDICTION OF MAJOR
ECONOMIC SHIFTS. THEY
NOW POINT TOWARD SHARPLY
SLOWER DOMESTIC DEMAND
GROWTH.

CHAPT 2

FEDERAL OUTLAYS AND TAXES
(AS A PERCENTAGE OF GNP)

26

25 H

24 H

23
Z
id
O
£

22 H

Q.

21 H

20 H

19 H

18




TAXES

FISCAL YEAR
+

OUTLAYS

CHART 3

BUDGET DEFICIT LESS NET INTEREST OUTLAY
50

co

40 H
30 H
20
10

i

0 o
LL

CO

-10 H

bJ
Q

(Z
O

H

-20
-30

V)
D
_J
Q.

<Z
D
V)




- 4 0 -I

-4
i

-50 -I

<o
00
to

-60
-70 H
-80 H
- 9 0 -j

-100
-110 H
-120

—I

70

74

1

1-

78
FISCAL YEAR

CHART 4

OUTLAYS FOR MAJOR SPENDING CATEGORIES
(AS A PERCENT OF FEDERAL OUTLAYS)

D
O
_J
<

or
u

Q
UJ

u.
ti.

o
z
u
o
o:
u
Q.




FISCAL YEAR




SHADOW OPEN MARKET COMMITTEE

39

The Economic Outlook
H. Erich Heinemann
Ladenburg, Thalmann & Co., Inc.
Federal Reserve actions have resulted in a major slowdown in monetary
growth since early 1987. Both total bank reserves and the transaction component of the money supply have posted record contractions. Economic
growth has decelerated. The Baseline Forecast prepared by Heinemann
Economic Research projects a recession during the first half of 1990 (see
attached table).
Incoming economic data highlight this pattern. Total civilian employment rose at an annual rate of 3.7 percent in the first quarter, 1.3 in the
second quarter and at a rate of only three-tenths of one percent in July and
August. Industrial production, which rose at a rate of 5.25 percent during
the 18 months ended December 1988, has gone up at a rate of less than 2
percent so far this year.
Consumer spending has stalled. On the assumption that consumer prices
rose no more than three-tenths of one percent in August, real retail sales
last month were unchanged from November 1988. That was well below the
5-percent-plus growth typical during the prior year. In July, total business
sales slumped and inventories of unsold goods rose by almost $5 billion, or
six-tenths of one percent.
New orders for non-defense capital goods have gained at a rate of only
3.2 percent over the past three quarters, a fraction of the 19 percent rate
of increase from third quarter 1986 through third quarter 1988. Moreover,
business investment has focused narrowly on just two areas: computers and
jet aircraft.
Outlays for structures (the "plant" side of plant and equipment) have
been going down for more than a year. Spending for machinery other than
information processing and related equipment dropped at an annual rate of
almost 10 percent in the second quarter.
Corporate profits have been exceptionally weak. Operating profits per
unit of real output in non-financial corporations dropped at an annual rate of
32 percent in the first quarter and 23 percent in the second. At last reading,
unit profits were down more than 13 percent from 1988. Price/earnings
ratios based on earnings per share of the S&P 500 appear to be stable and
modest.
However, equity multiples based on operating earnings have risen sharply.
This is a very typical pre-recession pattern. There are two reasons:




40

SEPTEMBER 17-18, 1989

1. large companies that dominate the S&P do better during recessions
than smaller concerns; and
2. operating earnings are a better measure of corporate performance.
Each of these indicators — plus a host of other measures — point clearly
toward an economic contraction. Federal Reserve actions over the past six
months have increased the likelihood that the next recession will be more
severe than was likely at the time of our meeting in mid-March.
Policymakers have been reluctant to allow short-term interest rates to
decline, even though demand for credit is weak. During the three months
ended in July (the most recent period for which data are available) domestic
non-financial debt rose at a rate of only 7 percent, its slowest growth rate in
the past 15 years — including the bottom of the severe 1981-82 recession.
In this environment, the Federal Reserve has had to drain reserves from
the banking system to prevent interest rates from declining. Total bank reserves averaged $58.8 billion in August, down 3.5 percent from a year earlier
— the largest year-over-year decline in reserves in the post-war period.
Total checkable deposits, the transaction component of the money supply, dropped $25 billion in the first half of 1989. In 1986, these deposits rose
by almost $100 billion. Bank reserves and checkable deposits were lower in
August 1989 than in April 1987. Broader measures of monetary expansion
have also shown marked decelerations.
This pattern of violent go-stop monetary policy has placed the economy in jeopardy. Federal Reserve chairman Alan Greenspan conceded two
months ago that he could not "rule out a policy mistake as the trigger for
a downturn." Mr. Greenspan told the House Subcommittee on Domestic
Monetary Policy that "we at the Federal Reserve might fail to restrain a
speculative surge in the economy or fail to recognize that we were holding
reserves too tight for too long."
Under current circumstances, he added, "our policy . . . is not oriented
toward avoiding a slowdown in demand, for a slowing from the unsustainable
rates of 1987 and 1988 is probably unavoidable. Rather, what we seek to
avoid is an unnecessary and destructive recession."
As Mr. Greenspan's gratuitous mea culpa made clear, the probability
that this will occur has risen. The SOMC should monitor Federal Reserve
actions closely and, if necessary, be prepared to issue an appropriate warning
prior to the Committee's next scheduled meeting in mid-March.
Senior policymakers are well aware that when real economic activity
begins to decline in earnest, the Fed will find itself under intense pressure




SHADOW OPEN MARKET COMMITTEE

41

to reverse course and reflate the economy. Go-stop-go monetary policy —
the Fed's traditional trade mark — will be perpetuated. This will impose
needless costs on the economy. It will also tend to raise the expected rate
of inflation over the long run.
The reported rate of inflation has slowed in recent months as a result
of the Fed's long campaign of monetary restraint. This slowdown was predictable, indeed inevitable. The jump in the rate of change in prices during
the first half of 1989 was typical of the latter stages of a cyclical expansion
in the American economy.
The short-lived surge in prices reflected lingering aftereffects of excessive
expansion in the U.S. money stock in 1985 and 1986. But because the
monetary authorities took preemptive action to contain these price pressures
long before they became obvious, inflation did not accelerate for an extended
period.
At this point, the Fed's challenge is to devise a strategy to consolidate
these gains. The danger, as an anonymous member of the Federal Open Market Committee warned at the FOMC meeting in July, is that "a substantial
weakening of the economy would be followed by rapid monetary growth and
a marked rebound in activity — a pattern that would be unlikely to foster
the [Federal Reserve's] objective of price stability over time."
The foreign exchange value of the dollar is likely to be volatile during the
forecast period (1989-1990). To date during 1989, the combination of a tight
monetary policy and high real rates of return on dollar assets have acted
as a magnet for overseas investors. The Federal Reserve's trade-weighted
dollar index is currently above 102, up more than 10 percent from its low in
November 1988.
Central banks have intervened to limit the rise in the dollar. This intervention had only temporary effects on foreign exchange values because
the transactions were "sterilized" — purchases of international assets were
offset by comparable sales of domestic securities. If the Baseline Forecast
is correct, the real return on dollar assets will decline in the months ahead.
Federal Reserve policy will ease. In that case, the dollar will weaken and
continue to decline through much of 1990.
The deficit in U.S. international payments has improved steadily since
1986. Real "net exports," as defined in the national income accounts, were
at a negative $52.5 billion annual rate in the second quarter of 1988, a gain
of more than $20 billion from a year earlier. Even though the growth rate
of U.S. merchandise exports has dropped substantially, further gains in U.S.
trade performance are likely as domestic demand slows.




42

SEPTEMBER 17-18, 1989

If the Baseline Forecast is accurate, imports will grow less rapidly. Exports should pick up considerably as domestic capacity is freed to service
markets overseas. Overall, the trade deficit should gain by more than $30
billion between second quarter 1989 and second quarter 1990. Trade should
play a major role in limiting the 1990 downturn.
The federal budget, by contrast, is likely to suffer substantially if economic growth falls short of the optimistic scenario outlined by the Bush
Administration. On the basis of the national income accounts, the federal
deficit — including the "surplus" in Social Security — was at an annual rate
of about $148.4 billion in the second quarter of 1988.
The Baseline Forecast indicates that GNP will decline at an annual rate
of 2 percent to 3 percent in the first half of 1990. If this is correct, then the
red ink flowing out of the Treasury is likely to show a major increase — to
an annual rate of more than $180 billion by the end of next year.
Tax receipts will dwindle as the rate of growth in income slows. Expenditures will rise as contracyclical income maintenance programs automatically
kick into action. The Gramm-Rudman "budget balancing" program (which
may well have hindered the budget process more than it has helped) will
likely be suspended. Improbable as it may seem, members of Congress may
actually make some difficult decisions about fiscal policy.
Were the Federal Reserve to adhere to a policy of moderate stable expansion in the money supply, over the long run the economy would prosper.
But when the authorities deviate from this path - either by freezing the
money supply or by bringing it to a boil — the economy will suffer. The
Federal Reserve has made a major gain against inflation over the past two
years. It would be sad if this advantage were frittered away with erratic
monetary policy.




30-Aug-89

HEIIERARIECOHNIC RESEARCH
Baseline Forecast • Augest 111! (1919-3.2)

IV88 A I'89 A II'SI A 111*89 F IV'89 F I ' M F II'10 F III'10 F IV10 F
THE ECOROOT:
Gross Rational Product ($82) 4049.4 4109 4133.9 4153.8 4110.0 4135.8 4101.4 4149.1 4204.2
4. IX
0.7t -2.4X -2.lt
$.31
1.9$
2.7$
Pet Chg
2.7* 3
Person] Consuption ($82) 2127.7 2941 2*55.3 2(94.9 21(7.9 2M4.4 2656.0 2(71.4 2112.3
0.51 -l.$t -l.lt
Pet Chg
3.m 2
3.21
1.4$
l.lt
2.21
$17.2 $21.9 506.4 411.2 491.9 505.9
$11.0
Business Ievestient ($82) 492.7 $01
4.1$
3.7! - l l . t t -1S.lt 4.5X 12.21
8.21
Pet Chg
-Ml I
399.1 414.4 315.5 311.3 310.2 413.1
392.8
Prod. Oar. Equip. ($82) 371.3 379,
(.St
Pet Chg
-Ml 9
13.61
14.3$
5.41 -I.St -13.lt l.7t
199.9 213.1 26l.fi 217.S
194.7
Residential Uvest. ($82) 118.1 19$
189.1
197.2
Pet Chg
I.31 -5
-12.lt
12.3$
5.31 $.71 (.It 13.41 15.6*
22.3
Chuge Is Iivutory ($12)* H.I 21
12.0
I.I -14.4 -23.$ -17.2 -13.1
-$2.5
let Exports ($82)
-73.8 -$S
-49.1 -45.1 -43.4 -37.9 -41.1 -42.4
(08.7
Governaent Purchases ($82)* 808.9 (03
(14.4
818.1 122.9 127.3 134.5 144.1
2.21 3.S!
2.4t
2.9X
Pet Chg
6.51 -2
4.6*
2.9X
l.lt
Final DoMStic Sales ($82) 4127.1 4140 41(4.1 4190.9 4205.1 4193.7 4175.7 4207.1 42S9.7
2.fit
Pet Chg
2.71 1
$.11
2.3$
l.tt -1.lt -1.it 3.0t
Gross l a t ' l Prod. ($ Current) $017.3 $113 $203.8 $2(9.2 5306.8 S32S.2 S339.0 S44S.2 5582.5
l.tt
l.tt
Pet Chg
1.51 7
8.21 10.S1
4.9X
7.3$
3.1X
Disposable tneote ($82)
283S.9 2881 2886.6 2895.7 2884.2 2144.1 2854.1 2180.1 2913.1
Pet Chg
4.3$ 5
3.71
4.71
1.3X -1.lt -2.7t -I.St
0.7$
Savings Rate (Percent)
4.8: S
$.41
5.5$
5.3$
5.7X S.St 5.91 S.St
Operating Profits ($ Current) 340.2 316
307.2 301.2 284.0 256.6 291.7 277.3
309.1
Pet Chg
11.71 -25
-8.8$
-2.5$ -7.5$ -20.9t -33. tt l.2t
26.01
Industrial Prod. (1977000) 139.9 140
141.4
142.0
131.3
142.2 138.7 134.5 13S.7
Pet Chg
4.41 2
1.81
2.0$
7.91
0.4$ -9.M -11.51 3.IX
Hcusing Starts ( d i l l . Units) 1558.7 1517
1350.7
1199
1422
1431 1470 1523 1921
-37.2$
Pet Chg
27.5$ -10
23. OX
3.9$ 9.8t 15.2t 23.81 19.31
Auto Sales (Hillion Units)
10.494 8.727 10.251
9.9
10.1
9.9
8.9
9.3
9.1
23.4$
Pet Chg
- 6 . i l -29
27.31
-7.8X -18.4$ -18.51 -7.7* 21.7*
117.3
Total Eaployaent (Millions) 115.8 119
111.$
117.4
117.5 117.0 118.7 117.5
Pet Chg
2.31 3
2.61
0.3X -1.lt -0.K
1.3$
3.21
0.5X
UieaplovieRt Rate (Percent)
$.3$ 5
$.3$
l.lt
$.4$
1.71 7.11
5.8X (.It
Coap. Per Hoar Ion-Fan Bus" 203.3 205
208.9
211.3 213.7 219.9 217.4 219.7 222.1
Pet Chg
$.7$ 4
$.8$
4.5*
$.2$
4.7$ 4. It 3.0: 4. It
Productivity Ion-Fan l i s " 112.1 111
112.0
111.9 111.7 111.3 111.1 111.3 111.7
Pet Chg
l.tt -1
l.tt
0.7$
l.tt
-l.tt
-(.It -1.2t - M l
k i t Liter Cost Ion-Fan ins" 181.3 1(4
1((.3
111.8 111.4 113.1 195.7 117.3 199.8
3.41
Pet Chg
3.0S J
3.11
4.11
5.5X
$.lt $.31 3.R
I V kflitor (1982:100)
123.3 124
125.J
126.8 127.$ 121.1 12M 131.2 132.1
4.11
Pet Chg
4.71 4
4.$t
2.1X
2.«
3.B 3.71 4.11
CPI Less Energy (1182-84:161) 124.fi 12*
127.7
121.9 130.1 131.1 132.$ 134.1 135.4
Pet Chg
4.R $
4.51
4.4$
J.7X
3.9X 3.11 3.11 4.41
Fodera) k f i d t ($ Current) -1fi7.fi -147 S -141.4 -151.4 -t$$.3 •171.1 -117.1 -203.5 -215.3
FHAlttAl HAJtlETS:
7.5X 9.91 l.tt
7.31
7.B
1.41
Feteral Fktfe Rata
8.47$ 8.441 I.73S
Ml
4.1$ l.tt
l.tt
7.3X
1.31
Tiree-ooath Rills (Biscout) 7.721 8.54$ 1.41$
8.5X 7.11 7.11 1.31
l.tt
Priie Rite, Major links
II. i n 10.981 11.311
l.tt
7.71 7.41 7.11 7.3X
9. IX
3Heir Treiury loads
M B I.I4X 1.711
7.11
771.3 713.4 119.2 127.1 143.3 ISM
loaey Supply (R-1, $ Current) 717.4 711.7 775.fi
1.21 9.1X 1.11
l.tt
Pet Chg
2.31 -O.tt -5.5X
l.tt
7.41
Velocity (Ratio: MP TO R-1) (.372 1.500 (.710
6.781 6.688 (.$11 8.456 I.4S7 MI2
Pet Chg
$.11 i.a 13.(1
3.tt -4.5X -l.tt -7.41 1.11
Ml
13.1 11.1 11.7
Trade-fciuhted $ (1I73=1M)
11.1 H.I I N . !
19.9
N.7
11.1
Reao: CCC Purchases
-2.2 -3.3
3.3
-1.3
3.( -2.0
4.1
-3.1
2.3
A=Actaal Forecast l i 11 ions of dollars unless noted.

adjusted for Coaaodit; Credit Core, purchases, ttCoapensatiei, productivity and unit liter costs are Index
http://fraser.stlouisfed.org/
Federal Source: Cttitese: St. Louis Eeonoaic Research
Reserve Bank of Heineaaiu

1118 A 1189 F 1110 F
4124.4 4131.1 4149.8
4.41 2.81 6.31
2568.4 2657.2 2171.1
3.41 2.31 I.St
413.1 512.8 417.5
l.tt
3.11 -3.lt
371.1 314.1 312.5
11.51 l.tt - l . t t
164.1 114.1 217.5
-1.31 1.11 1.61
12.3 14.1 -11.1
-74.1 •50.4 -41.1
110.7 111.1 132.2
1.61 1.31 2.61
4017.0 4175.2 4209.0
3.51 2.21 M l
4180.1 5222.5 5423.0
7.11 7.81 3.81
2763.2 2887.1 2878.0
4.41 3.41 -0.31
4.21 5.5X 5.71
321.6 308.5 269.9
10.0X -6. IX -12.5X
137.2 141.6 136.8
5.7X 3.2X -3.4X
1494.1 1432 1579
-8.5X -4.2X 10.3X
9.3
9.9
10.842
-5.9X
3.5t -7.01
115.0 117.3 117.4
2.21 2.01 0.1X
Ml
5.41 l.tt
165.2 219.1 211.8
4.51 5.31 4.31
111.4 111.1 111.4
2.21 1.41 - l . t t
171.1 117.1 114.4
2.71 4.11 4.71
121.3 126.2 131.7
3.31 4.1X 3.11
122.5 121.3 133.3
4.41 4.71 3.11
-14S.I - I S M -114.7
$.471
4.7IX
1.711
1.741
T7I.I
4.31
6.286
3.S1
I2.S
-«.l

I.R
7.71
16.11
8.41
783.5
1.81
6.666
(.11
68.4
6.8

maters, 1977=100.

7.21
t.3t
l.tt
7.4*
834.5
I.St
1.419
-2.S1
61.3
6.3

I'88 A
THE ECOROKY:
Cross Ration! Product ($82)

n'88 A

III'88A

IV'88 A

$ Chuge Pet Chg $ Chuge Pet Chg $ Chuge Pet Chg $ Chuge Pet Chg $ Cbuge Pet Chg
4.1X $36.0
4.0X $16.0

3.IX $32.0
1.8X $21.3

3.21 $2f.7
2.1X $19.1

1.1X

$14.2

1.4X

$3.2

I.3X

1.5X

$13.5

1.4X

$2.7

•0.3! $5.1
-0.3: $5.1

O.U

($2.8)

Chuge in Inventory ($82)* ($41.2)
Ret Exports ($82)
$31.1
Goveruent Pnrchases ($82)* $1.9
Final DOKStie Sales ($82)
$48.5
UP ($82) Four qtr chg (X)

-4.11 ($11.8)
3.3! $5.f
0.21 $8.9
5.01 $42.2
5.1X

-1.21
O.tt
0.71
4.31
4.9X

Personal Coosuption ($82)

$38.9
$38.5

Itsioess Iavtstteat ($82) $10.9
Prod. Our. Equip. ($82)
Residential Invest. ($82)

$14.8

1*89 A
THE ECORWY:
Gross Rational Product ($82)

1188 A

II'8S A

2.0X

$84.8

4.41
2.2!

($1.3)

-CM

$38.3

l.tt

0.3X

($$.7)

-0.7*

$38.4

l.tt

$0.9

0.1X

$3.0

0.3X

($0.7)

-O.tt

$15.5
($2.3)
($(.{)
$18.8

MX
-8.21
-0.71
1.9X
4.4X

($1.3)
$1.1
$12.6
$26.9

-O.U
O.U
1.31
2.7X
3.4X

111*89 F

2.71 $170.8

($7.5) -0.21
$40.1
Lit
$15.0 1.4*
$137.3
3.SX

IV'85 F

IMS F

$ Chuge Pet Chg $ Chuge Pet Chg $ Chuge Pet Chg $ Chuge Pet Chg $ Chuge Pet Chg
$37.4

3.71 127.1

2.7! $19.9

1.9X

$6.8

0.7X $114.4

2.8X

Personal Consniption ($82)

$13.3

1.3X $14.3

1.4X

$9.3

0.9X

$3.3

0.3X $58.8

1.5X

Business Investtent ($82)

$8.3

0.8X $10.0

1.0X

$6.2

0.6X

$4.7

0.5X $19.0

0.5X

Prod. Dyr. Equip. ($82)

$8.6

0.8X $12.9

1.3!

$6.3

0.6X

$5.3

0.5X $22.4

0.6X

Residential Invest. ($82)

($2.5)

-0.2X ($6.5)

0.2X $0.0

O.IX

Chuge in Inventory ($82)*
Ret Exports ($82)
Goveruent Parehases ($82)*
Final Domestic Sales ($82)
MP ($12) f a r qtr chg (X)

$5.1
$18.8
($5.6)
$13.5

0.5X
1.9X
-0.5*
1.3X
3.3X

nop

TKEC0RMY:
Sross Rational Predict ($82)

$1.1
$2.5
$5.7
$23.5

-0.6X $5.6
O.U
0.2X
O.tt
2.3X
3.11

II'IOF

(110.3)
$3.4
$5.7
$26.8

0.5X $2.5
- l . t t ($11.4)
0.3X $4.0
O.tt $3.7
2 . K $14.2
2.7*

III'IIF

-1.1!
0.4X
l.tt
1.4X
2.2X

n'HF

$1.8
$24.5
$10.3
$88.2

O.tt
O.tt
O.tt
2.2X

IIIOF

$ Chuge Pet Chg $ Chuge Pet Chg $ Chun Pet Chg $ Chuge Pet Chg $ Chuge Pet Chg
($24.1)

-2.4X ($27.2)

- l . t t $41.3

4 . 0 $54.3

5.2X $11.1

l.tt

-0.3X

($5.5)

-t.SX

$12.5

1.2X

$20.1

2.81 $14.1

1.4*

tasiMSS i i m t M i t (112)

($15.5)

•LSI ($21.1)

-Ltt

$5.3

LSI

$14.3

L t t ($15.2)

-1.4*

Prod. Sir. Eqiip. ($12)

($1.1)

O.tt ($14.2)

-1.41

$19

0.1*

$12.$

Ltt

($1.5)

-i.n

Residential Invest. ($12)

$2.7

O.tt

O.tt

$15

0.IX

$7.1

i.n

$u.4

1.3*

-l.tt ($15.1)
0.2! $5.8
$4.4
0.5X

-Ltt
l.tt
O.tt

$12.3
($2.4)
$7.1

L»
-1.2*
1.7*

$4.1
($2.4)
$95

1.11 ($18.0)
O.T*

-1.TX
-0.8X

$31.4

3.1*
-0.1*

$52.0

Chuge in Inventory ($l2)t ($15.0)
let Exports ($12)
$1.7
Goveruent Pnrchases ($82)* $4.1
Digitized forFinal totestic Sales ($12)
FRASER
http://fraser.stlouisfed.org/
6RP ($82)Bank of St. Louis
Four qtr chg (X)
Federal Reserve

($11.4)

$3.2

1.4* ($32.1)
-1.2*
$1.8
1.1* $21.1
$.1*
Ltt

$33.9

-l.tt
1.2*
l.tt
0.8*




f

SS
<rf

7

If

8

I

i s * mm mm mm m*» mm mm mm a * mm - ^
CM» C M

4»» «t» —» *r» «*» rv»

o^S9tr

IN»M#IN»IS»IHftf^*IN»f>»l>*l>k»fS»IN*r^l>*IN»fS»l^
•*M«^«^«^t^fM»tok»ff^^lN»IS»fS»IS»fS»^C»«»

is*
CN»

r*» —4

fs> mm r o « o —« «=»

<M»

CM»

p» f »

I

I
i

Iff

fffli

f!

- J S c«
<»
<p

i i

!

i

-3

I

3*3

?Ill
- If

«•*

—* -—I rv» rs» m*> —*• tv»

<=» e » c=» e n . * » «»» r \ »

r^i****f^r*fN»r*fN»fSft>is»r<*fs»rs»rs»«sa»fs»
m» • • « M mm mm mm 5 * £ » Z* «a» S • • —i S -«»• <*> #sj» «=> * o CM» «or» or» **> —-. c=> «c» —~» —-» mm -**• c*> r o

S S S s S S S s s s s s s i s s ^ ^ ^ H H s s ^ s "

fI =
*

8

•19

i

8

«7
8
3

*•—•».

I* j 7

£

[able 1 - Part 2

Federal Reserve Actios ud Hnetary Growth

(11)

(12)

(13)

(14)

(15)

(16)

(17)

(11)

Savings
t Stall

Larpe

IN-

TlK

Tin

Fortlft
BtpOitt
Ratio

Trusiry
kposit
Ratio

•ney
fcltipller

Ju 1117

Fb
e
Rtr
Ar
p
By
a
JIM

Jul
Ag
u
Sp
e
Ot
c
Rv
o
Dc
e
Ju ISIS

Fb
e
Mr
a
Ar
p
Ry
a
Jn
o
Jul
Ag
u
Sp
e
Ot
c
lov
Be
e
Ju 111)

Fb
e
Rir
Ar
p
«ty
Ju
Jil
All PE

Cirrucy
Ratio

(•posit
Ratio

fcposit
Ratio

cteposit
Liuil.
Ratio

(3/10)

Dtte

Adjusted
Reserve
Ratio

(2/4)

(5/4)

(1/4)

(7/4)

(1/4)

(1/4)

(2M/1)

0.03(1
0.0357
0.0361
0.0312
0.03(1
0.0358
0.0354
0.0358
0.0355
0.03S3
0.0352
0.0347
0.8356
0.0350
0.0350
0.0351
0,0348
0.0350
0.0347
0.0349
0.0345
0.0343
0.0343
0.0337
1.1341
0.0333
0.0334
1.1331
1.1121
1.1127
1.1320
1.1325

0.3357
0.3394
0.3396
0.3300
0.3316
0.3430
0.3450
0.3464
0.3413
0.3466
0.3531
0.3579
0.3591
0.3603
0.3610
0.3605
0.3(30
0.3626
0.3621
0.3643
0.3674
0.31)0
0.3701
0.3710
0.3775
0.3701
1.3127
0.315$
1.3131
1.3914
0.3941
1.3158

1.1116
1.1731
1.1716
1.1401
1.1344
1.1534
1.1563
1.1102
1.1516
1.1319
1.1123
1.1814
1.1712
1.6119
1.1)12

1.1377
0.1451
0.5412
6.5*87
O.S571
0.56)6
0.56)1
0.5725
0.5734
0.5717
0.5163
0.5)30
0.5056
0.5)33
0.5)54
0.5)09
0.5963
0.1016
0.1073
0.1174
0.1252
0.1321
0.1351
1.1312
0.1551
0.1116
0.4842
0.7111
1.72(3
1.7214
0.7214
(.7215

0.3713
(.3771
(.3115
0.3104
0.3113
0.3707
(.3123
(.3121
(.3171
(.3111
0.3144
0.3774
0.3757
0.3765
0.37(9
0.3751
0.3130
0.3)45
0.3111
0.4(09
(.3122
(.3161
(.3114
(.3)36
(.3)41
(.3)54
(.4M1
(.1127
(.1111

(.(217
(.HIS
(.(1)2

LOW

2.(512
2.(472
2.(447
2.1438
2.(478
2.(33)
2.1342
2.(116
2.(117
2.1217
2.7N3
2.7116
2.7112
2.7721
2.7114
2.7711
2.7110
2.75M
2.7150
2.7521
2.7414
2.7414
2.7371
2.7434
2.7041
2.7130
2.(127
2.1135
2.(1(2
2.(137
2.6509
2.6505

i.i an
1.6)55
1.1965
1.1)15
1.1115
1.7)52
1.7134
1.72)0
1.7301
1.7515
1.7511
1.7712
1.7991
1.1313
1.1534
1.1431
1.8(12

Soiree: Fedenl tesenre Ictrt; fcieetui Ecomic hsetrch




(.(IN
(.(D)

o.ow
(.(206
(.12(1
(.(201
0.(2(5
(.(201
0.02M
0.0213
0.0119
0.01)1
(.(1)6
0.01)5
(.0202

(.(20
(.(1)4
(.(1)7
(.(1)1
(.(117
1.(2(3

(.Mti
(.10)

0.8266
0.62W
6.81911
(.11(1
(.(1(3
(.1214
0.0211

1.3895

Milt

(.1127
(.(315
(.(311
1.(551
(.Kt4
0.8485
(.(314
(.(414
(.(14)
(.(467
1.(406
0.(450
(.(50)
0.(4(1
(.(316
(.(543
(.(372
(.(317
(.1211
(.(431
(.(4(7
(.1215
(.(401
(.(442
8.0458
(.1321
1.1361
(.1124
(.MM
1.1417
1.1214

Tattle 2
Federal Reserve Actio* u d Hctetiry Grovtb
(Coipowd A M M ) Kites of Cbuje)
This is tccouted for by coups 1i the:

Dtte

J U 1987
Fb
e
Itr
Ar
p
h»
Jin
Jul
Aig
Sp
e
Ot
c
lov
Be
e
JU 1988
Fb
e
Ntr
Ar
p
•if
JH

Jil
Al9
Sp
e
Ot
c
lev
tec
JU 1189
Fib
Itr
Ar
p
by
in
Jil
All PE

Federal
Reserve
Actions
Routtry (Nouttry
Growth Itse
(H) Grwth)

10.491
-0.50
4.14
18.91
2.13
-1.15
2.48
2.14
3.97
11.15
-3.93
-4.09
10.41
2.59

e.oe
12.21
-0.31
8.99
9.94
-0.15
1.8?
2.50
1.87
5.53
-5.91
2.12
-1.53
-4.12
-14.28
-4.M
11.58
1.13
1985
12.41

tm
17.15
1117
3.91
1118
5.13
1189
-2.08

n.oi:
3.3f
5.81
9.80
9.22
-0.48
2.34
10.84
8.10
8.51
7.98
0.00
21.12
0.89
7.30
11.07
4.44
9.97
7.11
5.28
4.79
4.77
3.44
2.99
11.50
-1.85
7.78
-1.13
-J.41
3.12
1.11
1.13
1115
1.17
19M
11.17
1117
1.73
lilt
1.13
1119
2.14

Contribitiu
of the
Kotey

•miplier

-6.52X
-3.15
-1.07
9.16
-7.08
-5.59
0.14
-8.00
-2.83
7.54
-11.89
-4.09
-10.61
1.70
-1.24
1.15
-4.76
-0.98
2.83
-5.41
-2.92
-2.27
-1.57
2.53
-17.48
3.88
-9.30
-3.19
-13.17
-7.42
8.31
-1.21
1985
3.41

till
7.27
lit?
-2.12
1988
-1.11
1111
-5.02

Adjisted
Reserve
little

-2.21X
3.72
-3.15
-0.98
0.19
3.19
1.82
-3.10
2.89
2.45
0.90
5.25
-9.27
5.24
-0.06
-1.21
3.36
-2.52
2.88
-2.17
4.91
1.51
0.63
5.41
-3.18
6.18
-0.89
2.54
2.14
1.51
1.21
Ml
1115
-1.11
UK
-1.15
1N7
1.11
1NI
1.72

-1.213
-6.34
-0.42
6.88
-4.54
-7.10
-1.85
-2.52
-3.33
3.10
-10.53
-8.09
-2.15
-1.66
-1.31
0.99
-4.10
0.71
-0.31
-2.39
-5.16
-2.57
-1.13
-1.25
-1.19
-1.10
-5.13
-4.22
-11.80
-1.41
S.N
-1.11

ins
3.24
1IH
1.23
1117
-3.11
1988
-1.75

till

till

1.25

-4.31

Soiree: Federal Reserve loird; tteineuie Ecotoiic Research




Cirreicy
Ittio

Stviigs
ISttll
Tin
lepesit
Ittio

6. I l l
-1.43
1.24
3.19
1.64
-1.71
-0.15
-0.37
1.15
1.16
-2.11
-1.80
0.33
-0.85
-0.67
8.62
-0.53
-1.10
0.46
-0.61
-9.93
-1.72
-1.15
-1.14
-1.75
-1.19
-1.59
-1.71
-2.11
-1.11
1.71
-t.Sl
INS
1.71

tm
l.H
1987
-1.14

Ltrje
TIM
lepesit
Ittio

-•.111
-0.81
-1.35
1.05
-0.11
-1.10
-8.01
-0.26
-1.19
1.17
-1.38
-0.64
0.77
-0.62
-0.20
0.43
-1.41
-0.51
-0.52
-l.lt
-0.74
-CM
-1.27
-0.32
-1.41
-1.15
-1.21
-1.31
-1.43
-1.4?
1.11
1.68
1915
1.11
19tt
1.77
1987
-1.46

lot
HMSH

nihility
Ittio

-0.861
1.17
9.99
1.13
-1.78
-1.23
1.44
-1.91
-1.51
1.19
1.41
1.86
0.18
-9.96
-1.03
1.17
-1.11
-8.15
1.52
-1.16
1.13
1.54
-1.47
-1.17
-1.11
-8.85
-1.12
1.11
-1.23
-1.41
l.H
1.11

tm
6.25

-1.14*
1.14
1.12
-8.04
-1.14
-1.17
0.00
0.16
-1.15
1.11
0.04
-0.05
-8.08
0.12
0.02
1.00
1.11
-1.07
-0.07
1.14
-1.13
1.86
-I.II
-1.15
1.13
l.N
l.H
-1.11
-1.11
-1.16
t.U
1.1!
1995
1.13

Truury
lepesit
Ratio

-1.381
-1.21
2.23
-1.77
-1.65
1.89
-8.11
1.89
-1.19
-1.84
0.75
0.58
-0.45
-0.47
1.01
0.14
-1.40
1.66
-0.13
1.57
-2.98
-0.49
1.78
-0.33
-0.35
-1.12
1.14
-1.31
-l.H
1.11
I.S1
1.14

tm
9.91

im

tm

im

1.21
1917
-1.11

1.12
111?
1.11
1918
-9.98
INI
1.12

-1.94
HIT
-1.94

till

till

-8.35
INI
-1.21

-1.33

-i.ii

tm

1981
8.85

-1.80

Forelft
lepesit
Ittio

tm

tm
1.12

tm
1.14

Table 3
Federal Reserve Actios ud Roiettry Growth
' (CopoBid Aiietl Rites of Chuje)
THREEHMTtt HOVIK AVERA6ES
This is iccoiited forfeychufts is the:

Date

JIB

t»7

Feb
Kir
Apr

m
y
JIB

J«l
A«9
Sp
e
Oct
lov
Sec
J u 1988
Feb
Kir
Apr
lay
JH

J|]
AlS
Sp
e
Oct
lov
lee
Jaa 1119
Feb
Har
Apr
Ui

in
Jil
tag PE

Federal
Reserve
Actlots
Konetiry (Moietiry
finwth
lase
Growth)
OH)

23.321
15.1?
4.91
7.13
(.ft
4.)1
-0.51
-0.35
3.03
7.58
5.40
2.71
0.81
2.88
8.37
J.95
5.19
(.98
1.21
8.25
3.89
1.41
2.(8
3.30
0.41
0.53
-1.12
-1.44
-8.88
-7.80
-2.33
2.84

14.821
11.79
8.72
8.32
1.27
5.18
3.70
4.17
8.53
8.58
7.89
5.49
9.70
7.34
9.77
4.42
7.60
8.49
7.17
7.45
5.72
4.94
4.33
3.73
5.18
4.28
5.17
1.77
Ml
1.13
1.17
2.38

Coitnbitioe
of the
lOKY
Holtiplier

1.701
4.18
-3.81
1.41
0.34
-1.20
-4.21
-4.52
-3.50
-1.00
-2.29
-2.78
-8.88
-4.38
-3.40
0.53
-1.62
-1.53
-0.97
-1.19
-1.13
-3.53
-2.25
-0.43
-5.50
-3.75
-7.70
-1.21

-I.N
-1.43
-4.11
1.21

-

Adjisted
Reserve
Ratio

-3.341
-0.70
-0.89
-0.37
-1.55
0.97
1.90
0.54
0.27
0.48
2.08
2.87
-1.04
0.41
-1.37
1.32
0.70
-0.12
1.24
-0.61
1.87
1.41
2.35
2.51
1.11
2.10
1.71
2.11
1.53
2.12
1.56
I.N

Soiree: FMertl I m m letrt; H e l i u m EcoMic Research




Carreecy
Ratio

9.251
3.16
-2.71
0.04
0.64
-1.58
-4.49
-3.82
-2.57
-0.92
-3.59
-5.18
-6.93
-3.97
-1.71
-0.66
-1.47
-0.80
-1.23
-0.66
-2.62
-3.38
-3.19
-1.89
-4.32
-4.31
-5.14
-1.15
-1.15
-7.14
-1.14
-1.17

Saviais
ISatll
Tite
ktosit
Ratio

2.601
1.56
-0.02
1.00
1.36
1.19
-0.43
-0.77
-0.12
0.55
-0.03
-0.68
-1.19
-0.77
-0.40
-0.30
-0.19
-0.00
-6.M
-0.08
-t.26
-0.15
-MO
-0.74
-I.N
-1.71
-1.25
-1.21
-1.12
-1.H

-I.N
-1.11

Lerae
TIM
ttfoslt
Ratio

O.ltt
1.30
-1.43
-0.37
-0.40
-0.15
-0.18
-1.48
-0.12
-0.M
-0.44
-0.62
-1.42
-0.16
-1.01
-0.13
-0.08
-0.19
-1.50
-0.64
-0.71
-0.74
-1.54
-1.40
-1.67
1.89
-1.22
-1.11
-1.14
-1.17
-1.51
I.N

In
leposlt
Liability
Ratio

-O.IK

-I.N
0.01
1.12
1.33

-I.N
-0.19
-1.57
-0.99
-0.14
-0.07
0.15
1.41
1.26
1.03
0.02
-0.49
-1.53
-1.41
-0.23
1.10
1.11
1.30

-I.N
-1.25
-1.11
-1.34
I.M
-1.12
1.15
-1.11
1.21

Foreita
leposlt
Ratio

6.611
I.N
0.07
1.17
0.02
-I.N
-1.13
-I.N
0.00
0.11
-0.10
-1.10
-0.03
-0.10
0.02
1.15
0.01
-1.02
-I.M
-1.00
0.01
I.N
-0.01
-1.12
-1.13
-1.11
M4
1.12
0.12
-Mb*
-1.05
1.12

Treasary
leposlt
Ratio

-0.711
-1.11
1.15
1.42
-0.N
-0.51
-0.29
0.56
0.03
-0.21
-0.25
0.18
0.30
-0.11
0.03
1.22
-1.09
0.13
1.14
1.13
-1.22
-1.34
-1.27
1.12
1.17
-1.47
1.22
1.24
-1.38
-t.lt
-1.12
1.11




Tible 4

Federal Reserve Action u i Hoietiry firovth
(Cotpouid Aiaial Rites of ChM9e)
(Hew)

Dite
in 111?

Fb
e
tor
Apr
toy
Jun
Jul
A9
1
Sp
e
Oct
ICY

Dc
e
J u 1188

Fb
e
tor
Apr
toy
Jen
Jul
Ag
u
Sp
e
Oct
lot
Dc
e
J u IMS

Fee
tor
Apr
toy
Ju
Jil
AqPE

Reserve
firovth Rite
Hoith to Hoith
28.935
-11.12

f.lt
14.33
I.IS
-13.10
-11.11
22.28
0.10
1.17
-4.1?
-19.84
44.44
-10.93
8.10
12.22
0.00
15.19
-1.11
10.18

-MS
1.00
1.00
-1.30
17.11
-11.14

LSI
-7.14
-1.40
-4.21
2.19
-4.15
tits
13.17
19M
17.14
1917
LIS
1111
4.14
1919
-2.17

firovth

leserve
lite
Tkroo-mtb
Hovlig Average
H.451
17.3S
1.21

L40
1.19
3.02
-5.45
-0.91
3.72
7.11
-1.15
-7.il
8.IS
4.82
12.17
2.13
5.77
1.34
4.73
1.12
1.27
1.11
•2.51
-3.10
2.77
-3.51
2.38
-1.12
-2.11
-7.15
-3.14
-2.13

Soiree: Federal Reserve k i r t ; ReimiM Ecoooaic Resurcti

16-Sep-89
Table 1 - Part 1

(Mara) Reserve leird Reaetary lasa)

Ftideral Reserve Actiet art Roietary Grorth
($ l i l l i o i s )

(1)

Date

J u 198?

Fab
Kir
Apr
Hy
a
Jin
Jil
A tig

Sep
Oct
lev
Dc
e

m mt
Feb
Htr
Apr
Rty
in
Jul
A19
Sep
Oct
lot
He
J u 118*

Feb
Itr
Apr
*»

Ju
Jtl
AigPE

*
»

Roietary
list

$243.8
245.2
245.7
247.7
249.4
249.7
250.5
251.9
253.2
255.5
257.2
258.6
251.6
212.6
213.3
255.6
255.8
281.2
278.3
271.0
272.4
»1.7
274.4
275.5
275.1
277.6
271.1
271.7
271.3
279.1
210.1
280.3

(3)

Currency

Total
Adjisted
lull
Reserves

Oetud
Deposits

$182.2
183.6
184.4
185.6
187.0
187.8
185.6
190.0
191,4

$61.6
61.6
61.3
62.1
62.4
61.9
61.6
61.9
61.8

193.1
195.1
196.4
198.5
199.4
206.7
202.4
203.4
204.7
206.4
207.0
208.6
211.7
210.5
211.1
211.4
214.1
215.1
215.1
211.4
217.4
211.1
211.5

62.5
62.0
61.6
62.5
62.6
62.6
63.2
63.4
63.5
63.9
64.0
61.1
64.0
11.9
11.7
11.4
13.3
43.0
12.1
11.1
11.7
12.1
11.1

b r i n e s Rotey Market Deposit Accents
(4+5+5+7t»t!)




(4)

(2)

(i)

(T)

(1)

(1)

(ID)

Ltrje
TIM

(eposlt

Deposits*

Deposits

Hull.

Ferelfi
Deposits

Trtasery
Deposits

Total
Deposits!

$542.7
541.0
543.0
552.4
552.3
547.6
547.9
548.5
549.5

$106.1
105.6
ID7.7
106.4
102.7
905.4
907.5
910.6
911.4

$291.1
215.3
218.2
313.1
308.1
111.9
312.2
114.0
315.1

$205.3
214.1
200.1
119.1
201.4
203.0
198.5
209.6
218.5

$11.8
11.0
10.4
10.8
11.1
11.3
11.3
11.0
11.3

12T.5
28.5
17.1
21.6
10.1
25.4
26.6
21.6
25.5

$1,915.2
1II5.T
1176.5
1193.4
2088.3
2604.6
2004.0
2015.3
2031.3

557.1
552.6
548.7
552.8
553.5
555.9
561.5
560.3
564.5
568.9
568.2
567.8
568.3
568.7
571.1
565.3
515.7
513.4
551.1
541.5
$45.7
552.1
552.0

913.6
118.6
922.6
927.7
134.8
142.9
148.7
150.0
157.7
M2.3
N5.1
961.2
173.7
983.3
988.1

118.5
124.0
125.4
123.7
121.4
111.0
111.1
314.1
119.6
145.5
158.8
155.0
159.2
151.2
164.9
171.7
171.2
315.5
392.5
115.1
194.4
1M.3
117.7

216.5
212.4
207.1
207.7
208.4
2D9.5
210.6
220.2
222.7
221.2
227.1
222.7
219.4
222.1
224.7
221.2
223.7
221.1
211.1
217.5
218.6
81.1
215.1

11.4
11.1
11.3
11.8
11.0
10.9
11.1
10.1
11.4
11.9
11.0
11.2

10.6
25.1
22.3
24.9
28.2
22.3
21.7
30.4
21.0
22.0
11.9
24.5
27.7
11.2
22.1
25.1
26.9
11.1
26.2
14.1
21.2
21.1
55.1

2047.7
2044.5
2037.4
2048.6
2064.3
2172.5
2015.3
2115.9
2116.9
2131.1
2134.1
2141.4
2151.1
2111.2
2111.1
2115.5
2191.4
2217.1
2211.5
2214.1
2216.3
2221.5
2211.2

(5)
Savlaas
1 Stall

TIN

HI.1
M3.6
10O0.7
1N7.1
1M4.3
1111.4
1117.1
1127.4

M.I
11.2
11.4
11.1
11.1
11.7
11.7

1M
11.7
11.1

H.4

Table 1 - Part 2
Federal Reserve Actios aad Hoietary Grovth

(12)

(11)

(13)
Saviags
J Stall

iU 1SS7

Fb
e
Rtr
Apr
Hy
a
JOB

Jul
Ag
u
Sp
e
Oct
lov
Dc
e
Jaa 1988

Fb
e
Mr
a
Apr
»»y
Jen
Jul
Ag
u
Sp
e
Oct
lov
Dc
e
J U 1119

Fee
Mr
a
Apr
my
Ju
Jil
Aag PE

(16)

(17)

(10

Foreiga
(•posit
Ratio

Trusary
(•posit
latic

Dony
ftaltiplier
(2*4/1)

loi

TiK

Cirreacy
Ratio

(•posit
Ratio

deposit
Ratio

deposit
Llabil.
Ratio

(2/4)

(5/4)

(8/4)

(7/4)

((/4)

(0/4)

0.3357
0.3394
0.3391
0.3380
0.3388
0.3430
0.3450
0.3484
0.3483
0.3488
0.3531
0.3579
0.3591
0.3803
0.3810
0.3805
0.3830
0.3828
0.3828
0.3843
0.3874
0.3890
0.3701
0.3710
0.3775
1.3710
(.3027
1.3858
1.0131
8.3984
1.11(9
8.3958

1.8898
1.8739
1.8718
1.8408
1.8344
1.8534
1.8583
1.8802
1.8588
1.8399
1.8823
1.8814
1.8782
1.8889
1.8982
1.8896
1.8955
1.8985
1.8915
1.8985
1.7Q52
1.7134
1.7290
1.7308
1.7515
1.7500
1.77(2
1.7981
1.(313
1.0534
1.(435
1.(412

0.5377
0.5458
0.5492
0.5487
0.5578
0.5898
0.5898
0.5725
0.5734
0.5717
0.5(83
0.5930
0.5(58
0.5933
0.5954
0.5909
0.5983
0.8016
0.0073
0.6174
0.6252
0.6321
0.6351
0.6392
6.6558
0.6688
(.((42
6.7610
(.7213
(.72(4
(.7214
(.72(5

(.37(3
(.3778
0.3(05
0.3604
0.36(3
0.3707
0.3623
0.3(21
0.3976
0.3(86
0.3(44
0.3774
0.3757
0.3765
0.3769
0.3751
0.3930
0.3945
0.38!!
0.4009
0.3922
0.3(61
0.3914
0.3936
0.3(48
(.3(54
(.4(66
(.((27
0.3958
(.4(11
0.399!
6.3895

(.(217
(.(2(3
(.0192
8.0196
0.(1(9
0.(2(8
0.0206
(.0201
0.0206
0.0205
0.0201
0.0206
0.0213
0.0199
0.0196
0.0196
0.0196
0.0202
0.0209
0.0194
0.0197
(.0190
0.0197
0.(2(3
6.0266
(.(2(0
(.(1(0
0.6191
(.(1(3
1.(214
(.(210
(.9188

0.0507
8.8527
(.(315
(.(391
(.(550
0.6484
0.(485
0.0394
0.04(4
0.0549
9.0467
0.0406
0.0450
0.(509
9.0401
0.0306
0.0543
0.0372
0.03(7
(.(209
0.(431
(.(4(7
(.(2(5
(.(4(1
(.(442
0.0458
(.(321
(.(3(1
(.((24
0.(400
1.(417
0.0286

0.0310
0.0310
0.0310
0.0311
0.0311
0.0309
0.0307
0.0307
0.0304
0.0305
0.0303
0.0302
0.0305
0.0303
0.0302
0.0303
0.0301
0.0300
0.0300
0.0300
0.0217
0.0291
0.0295
0.0292
0.0290
1.0210
0.1285
1.1214
8.8210
1.1279
1.1279
1.1279

Soiree: M i n i bsirvt Boird; Beiteiui




Large

(15)

TIM

(3/10)

Dtte

Adjusted
Reserve
Ratio

(14)

ECQMIC Research

2.(739
2.(556
2.9604
2.9795
2.9640
2.(456
2.9411
2.9311
2.9256
2.9351
2.9076
2.(081
2.8787
2.0735
2.(737
2.(758
2.(629
2.(0(0
2.(6(2
2.(807
2.(500
2.(430
2.(399
2.(410
2.(134
2.(1(3
2.7940
2.T(3(
2.7518
2.7(40
2.7505
2.7488




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Table 3
Federal Reserve Actios ted Hoeetary trovth
(Cotpound ABPiual Rates of Change)
IHREE-WTH ROVIK AVERAGES
This Is accoiited for by chuies 1i the:

Date

J « 1117

Fb
e
Kir
Ar
p

m
y
JB
U
Jll
AlS
Sp
e
Ot
c
lov
Oc
e
lu mi
Fb
e
Kir
Ar
p
"ay
JII

Jil
A9
>
Sp
e
Ot
c
lov
tec
Ju till

Fb
e
lar
Ar
p
•ay
Jn
it]
All fE

Federal
Reserve
Actiois
RoDetary (Motetiry
Growth
lase
( H ) Grovth)

23.321
15.97
4.11
7.73
l.il
4.98
-0.51
-0.35
3.03
7.58
5.40
2.71
O.tl
2.91
€.37
1.95
5.99
$.91
1.21
1.26
3.89
1.41
2.00
3.30
0.40
0.53
-1.12
-1.44

-I.I!
-7.11
-1.33
2.14

13.22:
11.42
7.31
1.15
7.20
(.17
4.75
4.13
5.87
8.34
8.54
7.71
8.78
7.90
8.56
7.35
7.47
7.71
7.25
1.51
1.47
5.(6
5.13
4.11
4.15
4.71
4.10
2.71
1.11
1.15
1.92
2.17

Couthbvtion
of the
Honey
ftaltlplier

-•

10.101
4.54
-2.40
1.08
1.41
-1.69
-5.26
-4.48
-2.84
-0.75
-3.14
-5.05
-7.97
-4.92
-2.19
-0.40
-1.48
-0.75
-1.04
-0.25
-2.58
-3.il
-3.04
-1.31
-4.11
-4.11
-1.43
-4.22
-1.13
-1.45
-4.25
-1.24

Mjisted
Reserve
Ratio

-2.131
-0.47
0.70
-0.49
-0.30
0.50
1.47
1.16
1.47
0.69
1.37
0.72
0.03
-0.00
-0.04
0.49
0.72
0.61
1.16
0.40
1.06
1.22
1.50
1.58
1.95
2.42
2.14
2.12
2.51
2.IJ
1.11
1.37

Soiree: Federal Reserve loerd; fciieiuo Ecomic Research




Cirrticy
Ratio

9.741
4.10
-2.82
0.10
0.70
-1.16
-5.32
-4.59
-3.28
-0.95
-3.81
-5.35
-7.18
-4.13
-1.76
-0.69
-1.45
-0.85
-1.31
-0.71
-2.70
-3.50
-3.31
-1.97
-4.49
-4.51
-1.22
-4.27
-7.37
-7.il
-4.11
0.11

Saviigs
1 Still
Tile
kposit
Ritio

2.321
1.48
-0.03
0.09
1.21
0.61
-0.42
-0.72
-0.15
0.50
-1.03
-0.59
-1.06
-0.71
-0.35
-0.26
-0.13
-0.00
-0.05
-0.07
-0.23
-0.51
-0.10
-0.16
-0.16
-0.19
-1.13
-1.14
-1.71
-1.73

-Ml
-1.17

Large

Mt-

TIN

Befttlt
Liability
Rati*

fttposit
Ratio

1.17!
1.27
-0.37
-0.32
-1.31
-0.51
-0.61
-0.41
-0.11
-0.05
-0.39
-0.55
-0.38
-0.17
-0.04
-0.13
-0.06
-0.16
-0.44
-0.56
-0.13
-1.15
-1.47
-0.35
-1.59
•1.13
-1.12
-1.H
-1.21
-1.95
-1.45
-I.M

•*.m
-1.17
-0.02
0.52
1.27
-I.K
-0.06
-0.38
-0.77
-1.75
-0.01
0.58
0.36
0.22
0.02
0.02
-0.44
-1.47
-0.31
-0.20
0.08
1.19
1.26
-1.13
-1.22
-1.11
-1.32
1.13
-1.12
8.13
-1.11
1.15

Foraifi
teposit
Rati!

I.03J
1.15
1.16
1.06

Ml
-M4
-M3
-0.00
0.00
1.10
-0.00
-0.M
-0.03
0.00
0.02

M5
0.01
-0.02
-0.04
0.00

Ml
M5
-1.01
-0.11
-0.12

-Ml
M3
1.12
1.12
-I.M
-1.14

Ml

Truury
taposU
Ratio

-0.661
-0.73
0.07
0.31
-1.12
-0.46
-0.29
0.46
-0.11
-0.20
-0.22
0.15
0.27
-0.12
-0.05
0.12
-0.14
1.09
1.01
0.89
-0.18
-1.21
-0.21
1.12
1.17
-1.41
1.20
1.21
-1.34
-1.35
-1.11
1.71




Table 4
Federil Reserve Actioi aid Moietiry Grwth
~ (CotpouRd A i n i l Rites of Chaige)

(Me*)

Date

Ju tst?

Feb
Kir
Apr
»aj

Jan
ill
Ag
v
Sp
e
Oct
lOY

Dc
e
Ju 1988

Fb
e
Ntr
Apr
*»y
Jyn

Jel
Ag
u
Sp
e
Oct

m

Be
e

J u IMS

Reserve
Growth Rate
Month to Month

10.501
-0.00
-4.78
18.45
1.73
-10.34
-S.I1
I.IK
-2.00
13.48
-8.31
-8.52
18.81
2.i(
-0.SS
13.05
2.50
2.78

7.M
1.34
-2.14
2.15
-1.47
-3.31
-$.81

Feb

-MS

mr

-4.42
-4.41
-1S.I3
-5.11
I.Si
-3.43
INS
13.31
IMS
11.27
1117
1.21
1188
3.11
1181
-4.21

Apr

m
y
Jll
Jll
All PE

Reserve
Growth Rite
Tkne-mtli
Hoviif Atarax

27.3U
1f.ll

1.H
3.11
f.13
4.21
-3.17
-2.73
0.05
1.51

1.M
-1.12
O.li
4.32

Mi
5.04
4.08
f.ll
4.31
4.00
2.10
0.35
-0.5!
-0.71
-3.S3
-3.M
-4.23
-3.TJ
-7.17
-1.22
-4.S5

-ui

Soiree: Federal Reserve loard; M e i m i i i Ecomic Restart

SHADOW OPEN MARKET COMMITTEE

55

P* Type Models: Evaluation and Forecasts
Robert H. Rasche
Michigan State University
Recently members of the research staff of the Board of Governors have
constructed a model of the inflation process that has received considerable
attention. 1 The purpose of this paper is to review critically the assumptions
that are the basis of that inflation model and to examine a model of nominal
income, real output and inflation that is implicit in the assumptions of that
model, given the behavior of the monetary base and potential real output.
In section I, the fundamental assumptions of the P* model are examined in
light of the existing literature on the behavior of A/2 velocity. In section II
some implicit assumptions of the P* model about the behavior of velocity of
the monetary base and the base-M2 multiplier are discussed and developed.
An explicit statistical model of these variables is estimated, which satisfies
the assumptions of the P* model is estimated. In section III, the historical
performance and forecasts of that model are examined.
Critical A s s u m p t i o n s of t h e P* M o d e l
In past deliberations of this Committee, we frequently have referred to different kinds of shocks that affect the economy. In particular, we have discussed
transitory shocks to the level of a variable, permanent shocks to its level and
permanent shocks to its growth rate. As an example we frequently have employed the working hypothesis that the velocity of the monetary base is a
random walk; i.e., that it's behavior is predominantly affected by permanent
shocks to its level. Many other economic variables appear to share this characteristic [Nelson and Plosser, 1982]. Such variables do not exhibit reversion
to a trend or mean. 2
The fundamental proposition of the P* model of Hallman, Porter and
Small (HPS) is a hypothesis about the type of shocks that drive the behavior
of the velocity of M2 (V2). HPS assume that shocks to V2 are transitory
shocks to the level of F2, and that V2 eventually reverts to an unchanged
mean.3 The mean to which V2 reverts they label V*. They measure V*
1

Jeffrey J. Hallman, Richard D. Porter and David H. Small, UM2 per Unit of Potential
GNP as an Anchor for the Price Level," Staff Study 157, Board of Governors of the Federal
Reserve System.
3
In more technical terms such variables are said to be non-stationary in levels, to
possess unit roots, to be drift stationary, or to be integrated or order > = 1.
3
HPS leave open the possibility that the mean of V2 may have changed since 1981.




56

SEPTEMBER 17-18, 1989

by the sample mean of V2 over the period 55,1 through 88,1 (quarterly) as
1.6527. The hypothesis about the mean reverting behavior of V2 is crucial
to the entire P* model. If it is false, then V* does not exist!
While all the statistical analysis produced by HPS is careful and exhaustive, they present very little evidence about V2 shocks. This is surprising,
because their hypothesis conflicts with, or at least is not strongly supported
by, previous research. HPS acknowledge that the behavior of V2 prior to
1955 differs from their characterization of the post-Accord period, but do
not elaborate on this statement.
Previous research contradicts the V* hypothesis. Gould and Nelson
[1974] introduced the idea of permanent shocks to levels into macroeconomics with the analysis of the behavior of U.S. M2 velocity over most of
a century. They concluded that during their sample period, M2 velocity
was characterized as a random walk. Unfortunately, this conclusion is not
directly comparable to that of HPS, since Gould and Nelson used data from
Friedman and Schwartz [1963]. A/2 defined by Friedman and Schwartz is
not the same concept as M2 defined in the 1980 revisions of the U.S. money
stock data (as if things aren't confusing enough, even names are not unique)!
M2 under current official definitions is related most closely to the concept
that Friedman and Schwartz call A/3. Official estimates of A/2 are available
only for the period starting January 1959. HPS do not indicate how they
construct their data back to January 1955 nor what Af2 concept they mean
in their reference to the pre-Accord behavior of V2.4
The conclusion reported by Gould and Nelson regarding the random walk
character of V2 is supported by the research of Nelson and Plosser [1982]
using annual data ending in 1970 (again the A/2) concept is that of Friedman
and Schwartz). In addition, Engle and Granger [1987] find only marginal
evidence that In A/2 (new definitions) and InGNP are co-integrated using
quarterly data from 59,1 through 81,2. Co-integration of these variables is a
necessary (but not sufficient) condition for V2 to exhibit the mean reversion
property assumed by HPS.
The properties of V* are critical to the P* model because P* is defined
4
Rasche [1988]discusses the construction of a consistent M2 series on the current official
definition from January 1948 through December 1958. I have used these estimates, plus
the March 1989 revisions to the official Af2 series, with the July 1989 revisions of the GNP
estimates to construct a series on V2. The mean of V2 so constructed over the sample
period 55,1 — 88,1 is 1.6525 compared with the mean of 1.6527 reported by HPS. I know
of no data that permit estimates of the current official M2 concept prior to January 1948
because data for S&L shares prior to that data are rudimentary.




SHADOW OPEN MARKET COMMITTEE

57

P* = (M2 x V*)/QPOT

(1)

in terms of V*:
where QPOT is a measure of potential real output and M2 is actual M2.
In terms of logs:
In P; = In M2t + In V* - In QPOT*

(2)

In P t = In M2t + In V% - In Qt

(3)

Since:
where Q< is actual real GNP, the "Price-Gap" which is the driving variable
in the HPS inflation model is:
[In Pt - In Pt*] = [In V2t - In V*] - [In Q< - In QPOP*]

(4)

By assumption the first term of the right hand side of equation (4) is the
deviation of V2 from its sample mean. The second term is the deviation
of actual real output from real potential output. They typical construction
of real potential output imposes the condition that real output reverts to
real potential output over the course of one or more business cycles, or
alternatively that [In Qt — In QPOTt] reverts to zero. Hence by construction
[InQt - In QPOTt] typically is forced to exhibit transitory shocks to its
level. Since [In Pt — InP*] is just the sum of these two terms, under the
critical V* assumption deviations of In Pt from In P* revert to zero. Thus the
V* hypothesis establishes P* as the equilibrium price level in the economy
towards which the actual price level reverts.
HPS model the dynamics of this reversion process by their "Price-Gap"
hypothesis:
4

AINFt

= a [In P ^ - In P,*] + £ (3tAINFt-i

+ et

(5)

where IN Ft = A In Pt measures the inflation rate. They attempt to justify
this equation as a model of economic behavior based upon an inflation expectation mechanism. These assumptions are reminiscent of the attempts
to construct an economic theory of the empirical Phillips curve relationship in the early 1960s. We know the Phillips curve broke down with the
emergence of inflation in the late 1960s and 1970s because it was not based
on economic behavior, but rather a reduced form that was specific to the
inflationary experience of the 1950s and early 1960s. We should be equally
concerned about the "Price-Gap" model.




58

SEPTEMBER 17-18, 1989

An alternative interpretation is that the "Price-Gap" equation is not a
model of economic behavior, but a model of the time series properties of
In Pt (or a reduced form model). It is known that the time series behavior
of the quarterly GNP deflator is well described by an ARIMA(0,2,1) model
where the estimated value of the single moving average parameter is on the
order of —.65 [Rasche, 1987, table IV.1]. This process is:
AINFt

= \fjLt - .65/zt-i],

(6)

or in autoregressive representation:
£(.65)«'A/tfF t _ t - = m

(7)

t=0

or:
AINFt

=

-.GSAINFt-!

- A2AINFt-2

- .27AJA r F^ 3

- A8AINFt-4 - J2(-65)iAINF*-i

+^

(8)

t=5

Note the similarity of the estimated lag coefficients in the HPS "PriceGap" equation to the first four lag coefficients in equation (8). Since 88
percent of the coefficient weights in an infinite geometric distributed lag
with a coefficient of .65 is achieved by lag 4, the fourth order autoregressive
structure assumed by HPS in the "Price-Gap" equation will be an extremely
close approximation to the infinite order AR structure of the ARIMA(0,2,1)
model of In P . The only other difference is the inclusion of [In P*_i ~ In Pf-i]
in equation (5), but not in equation (7). However, this term is an appropriate
addition to the time series model in equation (7) under the V* hypothesis.
Under this hypothesis deviations of In Pt from In P* are only transitory as
argued above. HPS test and fail to reject this hypothesis. If, in addition,
In Pt is an ARIMA(0,2,1) model, then In Pt and In Pt* satisfy the properties of
co-integrated variables [Granger and Engle, 1987]. Under these conditions
we know from the Granger Representation Theorem that the time series
(reduced form) of In Pt (and In Pt*) is described by an error correction model
of the form

AINFt = £ PiMXFt-i + £
t=i

a A ln

« * *t-i + 0 P n P<-i - l n p*-iJ + e* (9)

i=i

Note that if we assume a, = 0 for all i, the error correction model for
[INFt - INFt-i] has the identical form to the "Price-Gap" equation.




SHADOW OPEN MARKET COMMITTEE

59

There is no difficulty in using a correctly specified time series model
of the inflation rate for forecasting purposes. However, some caution is
required in using such an equation to investigate the outcomes of monetary
policies that differ significantly from the way that the Federal Reserve has
historically conducted monetary policy. Under such conditions the time
series properties of the inflation rate could change considerably, and a model
such as equation (9) or equation (5) would be inappropriate and inaccurate.
The "Price-Gap" equation can be seriously affected by the "Lucas Critique"
problem under such conditions.
T h e V* - "Price-Gap" M o d e l as a M o d e l of I n c o m e D e t e r m i nation
At first glance, it is not apparent that the V* - "Price-Gap" model offers an
explanation of the impact of monetary policy on the economy. Clearly it is
capable of predicting the impact of changes in M2 on nominal income, the
price level and real output, but as Mickey Levy notes in his recent Congressional testimony, the model does not appear to link any of the important
macro aggregates to anything directly under the control of the monetary
authorities. 5
Upon closer examination, it is clear that a link between the monetary
base and economic activity is implicit in the assumptions of the T7* - "PriceGap" model. It is well documented that the velocity of the monetary base is
driven by permanent shocks to the level of the base, and does not exhibit a
tendency to revert to trend. As a first approximation it is wrell characterized
as a random walk (e.g., [Rasche, 1987, 1988]).
Base velocity and M2 velocity are related by the identity:
InVB - In MULT2 = In V2

(10)

where VB is base velocity and MULT2 is the base multiplier for M2. It
is also likely that the M2 multiplier is dominantly affected by permanent
shocks to its level [Rasche and Johannes, 1987]. If the hypothesis that V2
reverts to its mean is correct, then In VB and In MULT2 satisfy the definition of co-integrated time series? The Granger Representation theorem
5

"Economic Performance, Inflation and Monetary Policy,'' Subcommittee on Domestic Monetary Policy, Committee on Banking, Finance and Urban Affairs, U.S. House of
Representatives, August 2, 1989.
6
This is true regardless of whether In MULT2 is driven by permanent or transitory
shocks to its level.




60

SEPTEMBER 17-18, 1989

proves that there is an error correction model for all co-integrated variables.
Hence the assumption that In V2 reverts to its mean is an assumption of the
existence of an error correction model in In VB and In MULT2. Estimates
of such an error correction model are given in table I over the 55,1-88,1
sample period used in HPS. 7 Note that the maximum lag in the VAR is the
log differences of VB and MULT2 is 2. A preliminary estimation was constructed with a lag length of 4, but all estimated coefficients of lags greater
than 2 were insignificant. When the lag length is truncated at 2 all autocorrelation coefficients up to order 4 are less than .09 in absolute value, so
there is no apparent evidence of significant serial correlation in the residuals
of this specification. The error correction model includes both a constant
and a dummy variable (D82) which is zero through 81,4 and 1.0 thereafter.
The latter variable is included because of the strong evidence in the "shift
in the drift" in base velocity in late 1981 [Rasche, 1987, 1988]. The equations for InVB and In MULT2 are estimated by generalized least squares
and the cross equation differences of the estimated constants and the estimated coefficients of D82 are constrained to zero. This is required to be
consistent with the assumption that In V2 reverts to its mean and does not
exhibit any trend [Engle and Yoo, 1987]. The estimated constant and the
estimated coefficient on D82 are constrained to sum to zero, since there is
substantial evidence that there is no drift in base velocity after 1981. These
three restrictions are not rejected by the data.
The significance of the estimated coefficients on the lagged deviations of
In V2 from its sample mean (QV2Dt-.\) in both of the equations in table I is
another test of the hypothesis that V2 reverts to its mean. The ^-ratios on
these coefficients are —1.41 and 3.02, respectively. Once again, the evidence
for the V2 hypothesis is mixed: it is strongly supported in the base multiplier
error correction equation, but is rejected in the base multiplier equation.
For a given path of the monetary based established (explicitly or implicitly) by the Federal Reserve, the error correction model of In VB forecasts
the resulting path of nominal GNP. For the same path of the monetary
base, the error correction model for In MULT2 forecasts the resulting path
of M2. Both forecasts are constrained by the assumption that V2 reverts
to its mean by the structure of the error correction process. Thus, the V*
model is implicitly a model of nominal income driven by the monetary base.
7

The Monetary Base data are those for the St. Louis Federal Reserve Bank Adjusted
Monetary Base as published in August 1989. The GNP and Af 2 data are those described
above.




61

SHADOW OPEN MARKET COMMITTEE

The error correction model is an explicit reduced form representation of that
implicit model.
The forecast of M2 from the M2 multiplier model and the path of the
monetary base can be combined with the estimate of V* and the value of
potential output to produce a forecast of P*. This forecast of P* can be used
with the HPS "Price-Gap" hypothesis to generate forecasts of the path of the
price level and inflation. The forecast path of real GNP is then determined
as the residual component of nominal GNP through the identity:
l n Y - l n P = lnQ

(11)

where Y is nominal GNP and Q is real GNP.
The structure, though not the equations, of the V* - "Price-Gap" model
is closely related to the structure of the old "St. Louis Model" [Andersen
and Carlson, 1970].
Our data closely replicate the estimates of the OLS "Price-Gap" equation
reported by HPS. For the sample period 55,1-88,1 our estimates are:
AINFt

= -.030[lnP*_! - In Pt*^]-M3&INFt-l-A45&INFt-2
(.008)
(.085)
(.098)
-.262AJArFt-3(.097)

.077AJATFt-4
(.080)

(

( m
j

# 2 = .307
se = .00392

We have estimated all three stochastic equations of the income determination model (the two error correction equations and the "Price-Gap"
equation) by generalized least squares. The resulting estimates are given in
table II. The estimates in table II can be used in several ways. First, wre
can investigate the in-sample and post-sample (88,2-89,2) accuracy of the
model given the historical behavior of the monetary base. Second, we can
construct forecasts for 89,3-91,4 based on assumed values for real potential
output and the monetary base. We assume real potential output will follow
a 2.5 percent annual trend rate over this entire period. 8 We have assumed
the following annualized growth rates for the monetary base to be consistent
with Jerry Jordan's assumptions for this meeting:
8
For the sample period 83,1-88,4 a regression of In QPOT on a constant and a time
trend yields the following result:

In QPOU = 7.242605 + .06235406
with an R2 of 1.00.




62

SEPTEMBER 17-18, 1989

Quarter

Base Growth Rate

89,3
89,4
90,1
90,2
90,3
90,4
91,1
91,2
91,3
91,4

3.0
4.3
4.8
6.0
5.5
5.0
5.0
5.0
5.0
5.0

Finally, we can investigate the behavior of the model under a variety of
assumed rules for the behavior of the monetary base. In particular, we can
compare constant growth rules for the monetary base at various rates and
the behavior of the model under a Meltzer-McCallum type feedback rule in
response to fluctuations in base velocity.

Historical Accuracy of V* - "Price-Gap" Income Determination Model
Some characteristics of the model accuracy during the in-sample and recent
post-sample periods is presented in the attached figures for the growth rate
of the monetary base, nominal GNP, the inflation rate, the price level, and
real GNP. These figures show the (static) model errors for the estimation
period (55,1-88,1) and the immediate post-sample period (88,2-89,2). The
velocity growth graph illustrates the residuals of the first equation in table II.
These residuals are exactly the forecast errors for the growth rate of nominal
GNP (and the level of nominal GNP), since the path of the monetary base
is taken to be exogenous. The graph of the inflation rate forecasts shows
the errors from the third ("Price-Gap") equation in table II.
The important post-sample characteristic of these graphs is that the
base velocity equation does not pick up the upward drift that has occurred
in 1988-1989. During the five post-sample quarters, the mean error in base
velocity growth is 2.5 percent (annual rates) which is significantly different
from zero (t-ratio = 3.16). The residuals of the inflation equation on the
other hand, are not significantly different from zero.
We have constructed a forecast from the equations in table II over the
period 88,2-89,2 given the assumed path for the monetary base given above.




SHADOW OPEN MARKET COMMITTEE

63

The projections are as follows:

Quarter
89,3
89,4
90,1
90,2
90,3
90,4
91,1
91,2
91,3
91,4

(All At Annual Rates)
Nominal GNP Real GNP
Growth
Growth
-1.63
2.70
3.60
-.56
-.14
3.90
1.29
5.18
4.98
1.15
4.72
.99
4.90
1.30
5.02
1.53
5.07
1.71
1.84
5.10

Inflation
4.33
4.16
4.04
3.89
3.83
3.73
3.60
3.49
3.36
3.26

Taken literally this model forecasts a recession beginning with the current
quarter, since there are three quarters for which real GNP growth is forecast
to be negative. This is probably unduly pessimistic an interpretation, since
— .56 and —.14 percent real GNP growth is not likely to be significantly
different from zero.
More significant is the very slow real growth that is forecast over the
entire period through the end of 1991. This is substantially the implication
of the assumption of the mean reversion characteristic of M2 velocity and
the initial condition of mid-1989. In the second quarter of 1989 M2 velocity
according to current estimates is 1.6902 compared with the assumed value of
V* of 1.6525. Thus under the initial conditions for this forecast M2 velocity
is approximately 2.25 percent above its assumed equilibrium value. The
assumption built into the model is that A/2 velocity will decline toward this
equilibrium value (which it does steadily throughout the forecast period to
achieve a value of 1.661 by the end of 1991). In the early part of the forecast
period, this decline in M2 velocity is accomplished by a negative growth
rate in base velocity given the structure of the estimated error correction
model. In the latter part of the forecast period the reversion of M2 velocity
to its assumed equilibrium value is accomplished by positive growth in the
M2-monetary base multiplier with virtually no change in the base velocity.
Thus in the early portion of the forecast period, the assumption of mean
reversion of V2 holds forecast nominal income growth below the assumed
growth rate of the monetary base; in the latter part of the forecast period
nominal income growth follows base growth quite closely.




64

SEPTEMBER 17-18, 1989

The structure of the "Price-Gap" equation implies that there is considerable inertia in the adjustment of the actual inflation rate. The assumption
that base growth will stabilize at a 5.0 percent implies that the equilibrium
growth rate of nominal income is 5.0 percent. With the assumed trend in
real potential output of 2.5 percent, the structure of the three equations in
table II implies that ultimately the inflation rate will revert to 2.5 percent
under these conditions. Thus a slow decline in the inflation rate toward 2.5
percent is projected by the model.
Above all, it should be remembered that these forecasts are very imprecise. The R2 of the base velocity equation in table II is quite small (.14)
and the estimated standard error of the growth rate of base velocity during
the sample period is in excess of 4.0 percent at annual rates. I had hoped
to present the results of stochastic simulations of the entire model over the
forecast period to show some estimated confidence errors for these forecasts,
but a computer software bug has foiled these efforts to date.
There is probably room for substantial improvement in the quality of
these forecasts. Substantial reductions in the standard error of the residuals
of monetary base velocity equations can be accomplished by allowing for a
feedback from changes in interest rates and the growth rate of real income
[Rasche, 1988]. It is possible to modify the error correction model in table
II to allow for such effects. Most important, however, is to establish beyond
reasonable doubt the validity of the mean reversion hypothesis of V2. If this
can be ascertained, then this line of research can have considerable potential;
if it is false the basic structure of the model is critically flawed.




65

SHADOW OPEN MARKET COMMITTEE

Table I
DEPENDENT VARIABLE
FROM
55: 1 UNTIL
K
NO

VAR LAG

LABEL

*
i

**#«#*«

2
3
4
5
6
7

#«**•««**««*

•••••«•••••*

0
0
1
2
1
2
1

.3480809E-02
-.3480809E-02
.2280595
-.391071IE-01
-.1151299
.3590652
-.4124354E-01

.7200136E-03
.7200136E-03
.8279808E-01
.8475201E-01
.1443930
.1452109
.2921858E-01

0
1
18
18
19
19

CONSTANT
AlnVB
AlnVB
AlnMULT2
AlnMULT2
QV2D

T-STATISTIC

STAND. ERROR

*##

«*«

D82

COEFFICIENT

AlnQVB
88: 1

14

4.834365
-4.834365
2.754406
-.4614298
-.7973374
2.472715
-1.411552

i

.142
.181
R2
2.005
.103E-01 1DURBIN-WATSON ,

R2

SEE
Q( 33)=

28.8569

SIGNIFICANCE LEVEL

.67

Estimated Residual Autocorrelations
1
-.045855

2

3

-.008085

4

-.039172

-.029918

DEPENDENT VARIABLE AlnMULT2
FROM
55: 1 UNTIL
88: 1

NO.

LABEL

LAG

#ft *

8
9
10
11
12
13
14

VAR

*ft*

CONSTANT
D82
AlnVB
AlnVB
AlnMULT2
AlnMULT2
QV2D

0
1
18
18
19
19
14

COEFFICIENT

STAND. ERROR

.3480809E-02
0
0 -.3480809E-02
1 -.6333032E-01
2 -.1086692
.4387845
1
.1836402
2
.4888616E-01
1

.7200136E-03
.7200136E-03
.4684530E-01
.479432IE-01
.8181721E-01
.8159270E-01
.1616503E-01

.42
R2
.562E-02 DURBIN-WATSON

R2
SEE

T-STATISTIC
4.834365
-4.834365
-1.351904
-2.266624
5.362986
2.250694
3.024193
.40
1.94

Estimated Residual Autocorrelations

1
.011620
Q(
Restrictions:



33)=

-.014840
34.7542

CHI-SQUARE(3) =

3
.056297

-.072790

SIGNIFICANCE LEVEL
5.22

.38

SIGNIFICANCE LEVEL

.156

66

SEPTEMBER 17-18, 1989
Table

II

DEPENDENT VARIABLE
FROM
5 5 : 1 UNTIL
NO.
1
2

3
4
5
6
7

LABEL

VAR

CONSTANT
D82
AlnVB
AlnVB
AlnMULT2
AlnMULT2
QV2D

LAG

0
1
18
18
19
19
14

0
0
1
2
1
2
1

.3400168E-02
-.3400168E-02
.2203893
-.1445296E-01
-.4979653E-01
.3225544
-.4910907E-01

R2
SEE
Q(

COEFFICIENT

28.1136

Estimated Residual

.1366344
.2848073E-01
R2
DURBIN-WATSON

T-STATISTIC

4.734912
-4.734912
2.801413
-.1795268
-.3656645
2.360711
-1.724291
.14
1.98

SIGNIFICANCE LEVEL

.71

Autocorrelations

3
.025436

2
,022528

1
-.034685

STAND. ERROR
.7181057E-03
.7181057E-03
.7867077E-01
.8050591E-01
.1361809

.18
.103E-01

33)=

AlnVB
88: 1

-.029907

DEPENDENT VARIABLE
AlnMULT2
FROM
5 5 : 1 UNTIL
88: 1
NO.
ft ft ft

8
9
10
11
12
13
14

VAR
•«•
CONSTANT
0
D82
1
AlnVB
18
AlnVB
18
AlnMULT2 19
A1nMULT2 19
QV2D
14
LABEL

LAG

ftftft* «ftft

ftftft




0
0
1
2
1
2
1

12
R
(
SEE
Q(

COEFFICIENT
ftftftftftftftftftftftft

.3400168E-02
-.3400168E-02
-.6101330E-01
-.1099130
.4341700
.1898260
.4974711E-01
.42
.562E-02

33)=

34.9213

Estimated Residual

1
.015675

2
-.018003

STAND. ERROR

T-STATISTIC

ftftftftftftftftftftftft ftftftftftftftftftftftft

.7181057E-03
.7181057E-03
.4675357E-01
.4784931E-01
.8162360E-01
.8139773E-01
.1614885E-01
R2
DURBIN-WATSON

4.734912
-4.734912
-1.304998
-2.297065
5.319172
2.332080
3.060536
.40
1.93

SIGNIFICANCE LEVEL
Autocorrelations

3
.054273

4
-.072068

.38

67

SHADOW OPEN MARKET COMMITTEE

Table II, Cont i nued
DEPENDENT VARIABLE
FROM
55: 1 UNTIL

NO.

LABEL

»«*

«*##«*«

15
16
17
18
19

VAR LAG
««#

««*

23
20
20
20
20

1
I
2
3
4

QDIFP
AINF
AINF
AINF
AINF

R2
SEE
Q(

COEFFICIENT

STAND. ERROR

*«*«*««*««**

•««««««##*««

-.3088223E-01
-.6766859
-.4735397
-.2904600
-.1189892

.33
.393E-02
26.7781

33):

AINF
88: 1

.7363251E-02
.7875914E-01
.9071340E-01
.8908796E-01
.7326262E-01

T-STATISTIC
••••••••••••
-4.194103
-8.591840
-5.220174
-3.260373
-1.624146

R2

.31

DURBIN-WATSON

1.94

SIGNIFICANCE LEVEL

.77

Estimated Residual Autocorrelations
1
.013686
Restrictions:

2
.002958

CHI-SQUARE(3) =

3
-.007391
3.17

4
-.057763
SIGNIFICANCE LEVEL

COVARIANCE MATRIX OF RESIDUALS
VARIABLE




AlnVB
AlnMULT2
AINF

AlnVB
.10136E-03
.87926E-05
.14818E-04

AlnMULT2
.15977
.29881E-04
-.15917E-05

AINF
.38219
-.75613E-01
.14830E-04

.37

BRSE

VELOCITY

GROWTH

00

w
H
M
X
w
w

pa
I

<o
00
to

-3 .

X10~

I

'

I

'

I

'

I

'

I

•

l

2

55 57 59 61 63 65 67 69 71 73 75 77 79 81 83 85 87 89




DQVB
DQVBH

NOMINRL

GNP

55,1-89,2

6 .
CO

>
O

o
H

w
a;
S
>

—

w
H

8
as
K

1 . H
0 .

T—i—r

I

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'

I

T—I—i—\—i—I—i—I—r

I

' I

T—1—i—I—i—I—i—I—r

p-r-y

xlO




55 57 59 61 63 65 67 69 71 73 75 77 79 81 83 85 87 89
GNP
GNPH

INFLRTION,

QURRTERLY

RRTES

-4
O

CO

W

2 .

H
W
X
w

w
i

00

-1 .

xi 0 -2




I • I 'I

i—i—r

- i — i — i — \ — i — iI — r • I

T — r — i — i — i — i — i — i — r

55 57 59 61 63 65 67 69 71 73 75 77 73 81 83 85 87 89
INF
INFH

RERL

GNP

55,1-89,2

H .2 CO

3.8-

>
O

o

3 H -J

w
>

3.0-

w

H
O
O
SS

2.6-

w
w

2 .2 —I
1.81 H

I

'

I

'

I

'

I

'

I

' I

T

1—i—I—i—r—r

X10
55




57

59

61

63

65

67

69

71

73

75

77

79

B l 8 3 85
GNP82
GN P 82H

87

89

PRICE

LEVEL

5 5 , 1 -89 ,2

-4

to

1 .H

1 .2

1 .0 —




C/5

W

H
W

pa

I

•

I

•

I

• I

'

I

'

I

•

I

'

!

'

I

'

I

'

I

55 57 59 61 63 65 67 69 71 73 75 77 79 81 83 85 87 89
PH

SHADOW OPEN MARKET COMMITTEE

73

References
Andersen, and Carlson (1970).
Engle, R. and C. Granger (1987), "Forecasting and Testing in Co-Integrated
Systems," Journal of Econometrics, 35, 143-59.
Friedman, M. and A. Schwartz (1963), A Monetary History of the United
States, Princeton University Press.
Gould, J. and C. Nelson (1974), "The Stochastic Structure of the Velocity
of Money," American Economic Review, 64 (June), 405-18.
Nelson, C. and C. Plosser (1982), "Trends and Random Walks in Macroeconomic Time Series," Journal of Monetary Economics, 15, 139-62.
Rasche, R. (1988), "Demand Functions for U.S. Money and Credit Measures." forthcoming.
Rasche, R. (1987), "Ml-Velocity and Money Demand Functions: Do Stable Relationships Exist?," in K. Brunner and A. Meltzer (eds.), Empirical Studies of Velocity, Real Exchange Rates, Unemployment and
Productivity, Carnegie-Rochester Conference Series on Public Policy,
North-Holland, 9-88.
Rasche, R. and J. Johannes (1987), Controlling the Growth of Monetary
Aggregates. Kluwer Academic Publishers.







SHADOW OPEN MARKET COMMITTEE

75

U.S. Monetary Authorities' Foreign Currency Purchases
Anna J. Schwartz
National Bureau of Economic Research
Federal Reserve and Treasury combined foreign currency holdings totaled
$34 billion at the end of July 1989, the latest reporting date. In the thirteen
months since June 1988, the monetary authorities have increased by $23.2
billion their reserves of foreign currencies, mainly yen and D-marks. In
months other than November and December 1988, when foreign currency
holdings declined by $2.2 billion, substantial increases were reported.
Regulation A7 is the Federal Reserve's authority for foreign currency
purchases. It authorizes the FOMC to direct any Federal Reserve Bank
to "carry on or conduct through any other Federal Reserve Bank which
maintains an account with a foreign bank, any open market transactions
authorized by section 14 of the Federal Reserve Act."
At each meeting of the FOMC, it issues two separate authorizations
to the Federal Reserve Bank of New York to execute transactions for the
System Open Market Account, one for Domestic Operations and one for
Foreign Currency Operations. It also issues two directives, a domestic policy
and a foreign currency directive.
The authorization for foreign currency operations in effect January 1,
1977, authorized an over-all open position in all foreign currencies not exceeding $1 billion. That amount after repeated increases stood at $12 billion
at the beginning of 1988.
Three questions arise:
1. Why are the authorities engaged in foreign currency purchases of this
magnitude?
2. Has the exercise achieved its objective?
3. What costs do the purchases portend for the economy?
• The answer to the first question is that the authorities buy foreign
currencies when they want to prevent dollar appreciation. Ten years ago
foreign currency reserves were $3.8 billion, so the current figure represents
almost a ten-fold increase, far more than the increase in the Federal Reserve
portfolio of assets over that time span. In 1979, Federal Reserve assets
totaled $160 billion. Currently they total $285 billion.
• The answer to the second question is that foreign current purchases
have not achieved their objective, judged by the change in the dollar-mark




76

SEPTEMBER 17-18, 1989

and dollar-yen exchange rates over the thirteen months since June 1988.
The exchange rate for the D-mark has risen from 1.758 to approximately
1.96, for the yen, from 127.5 to approximately 1.44. The reason intervention
has been ineffective is that Federal Reserve policy has sterilized its monetary
effects. This is so whether intervention has involved currency purchases or
sales.
In November-December 1988, for example, when the U.S. sold marks
and yen to prevent dollar depreciation, the exchange rate for the D-mark
declined from 1.816 to 1.756 and for the yen, from 128.7 to 123.6.
When the Federal Reserve buys foreign currencies, it sterilizes the purchase by selling domestic assets to maintain the money supply unchanged
from what it would otherwise have been. When it sells foreign currencies, it
sterilizes the sale by buying domestic assets to maintain the money supply
at the level that it would otherwise have been.
What determines exchange rate fluctuations are differences in relative
rates of money growth of central banks. The differences in money growth
rates produce different inflation rates. The differences in inflation rates in
turn produce either exchange rate depreciation or appreciation.
Since early 1987, with the possible exception of the months at the turn
of 1988, the Federal Reserve has been restrictive in permitting monetary
growth; Japan and West Germany on the whole have been expansionary.
Monetary policy has been expansionary in those countries because they have
engaged in exchange rate intervention in the attempt to prevent dollar depreciation. Their central banks have bought dollars that they did not fully
sterilize. As a result monetary growth has accelerated there.
As a result of these differences in monetary growth rates, inflation rates
have been restrained in the United States and resurgent in the other countries, with the expected consequences for exchange rates. Central bank
intervention in exchange markets has been a pointless activity with some
costs.
• Thirdly, for this country at least two costs may be noted. One is an
increase in exchange rate volatility related to the episodic intervention not
only by the monetary authorities here but also that undertaken on behalf
of other central banks. In addition, the taxpayer bears a double pecuniary
loss.
One aspect of the loss is related to the Fed's sterilization activity. It
offsets open market purchases of foreign currency with open market sales
of Treasury and federal agency obligations. The monetary base grew by
$10 billion from June 1988 to May 1989. The net change in the System




SHADOW OPEN MARKET COMMITTEE

77

Open Market Account over the period was a decline of $7 billion. Interest
payments to the Treasury by the Federal Reserve have accordingly been
reduced. That is one part of the loss sustained by taxpayers.
The other aspect of the loss is related to growing exchange rate risk to
which the taxpayer is exposed as foreign currency assets held by the Federal
Reserve and the Treasury balloon.
In 1987 the loss on foreign exchange rate transactions by the Federal
Reserve was $146 millon. In 1988, the last year for which information is
available, the loss was $511 million.
Which Committee of the Congress is paying attention to these losses?







SHADOW OPEN MARKET COMMITTEE

79

Issues in Foreign Investment in the United States
William Poole
Brown University
The United States exported capital almost every year from World War
I to 1970. In the 1970s capital flowed out some years and in others. From
1982 to the present capital flowed in every year, and the inflows have been
very large from an historical perspective.
Is the United States better off or worse off as a result of these flows?
This question cannot be answered in simple fashion; an answer requires
that we specify what might have been different to yield a different result
on international capital flows. We surely would have been worse off, for
example, if capital had fled the United States because the inflation rate had
accelerated and taxes on capital had risen. We surely would have been better
off if vigorous growth in Latin America had kept capital from fleeing that
part of the world for the safe haven of the United States. I take up some
of these macroeconomic issues in the second major section of this position
paper.
I begin, however, with a discussion of microeconomic issues. These issues
arise even when net capital flows are zero. The net flow is the difference between capital going out and capital coming in. Capital coming in purchases
U.S. assets, and some observers are concerned about foreign ownership of
U.S. assets regardless of the amount of foreign assets owned by U.S. residents.
Following these two sections on the microeconomic and macroeconomic
aspects of foreign investment in the United States I discuss constraints on
U.S. policy from foreign investment.
M i c r o e c o n o m i c A s p e c t s of International I n v e s t m e n t
In the 1980s the United States generally pursued pro-growth investment
policies. The Economic Recovery Tax Act of 1981 reduced taxes on the
earnings from new business investment, although at the cost of introducing
some distortions in the type of investment favored. The Tax Reform Act
of 1986 unwisely raised taxes on earnings from new business investment,
but reduced disparities in taxation of different types of investment. There
were only minor gains in reducing regulatory burdens in the 1980s, but at
least the rapid growth of such burdens in the 1960s and 1970s was halted.
There has been a major improvement in the inflationary environment; although the current inflation rate of 4-5 percent is too high, the outlook for




80

SEPTEMBER 17-18, 1989

the level and stability of the rate of inflation is greatly improved over the
1970s. Reduced cyclical instability has important microeconomic benefits
for investment through reduction in risk.
Net flows of capital internationally are the result of macroeconomic conditions, which are discussed in the next section. The gross flows of foreign
investment into the Untied States and of U.S. capital abroad are themselves
important regardless of the net flows. In 1988, for example, U.S. assets
abroad rose by $82 billion while foreign assets in the United States rose by
$219 billion. Some would be concerned about foreign capital coming to the
United States even if the net flow were zero. That is, issues arise from foreign ownership of land and reproducible capital in the United Sates and of
U.S. financial assets independently of the size of such assets relative to U.S.
owned assets abroad.
Some reactions in the United States today are quite similar to reactions abroad in the years following World War II. Countries receiving U.S.
capital were not always overjoyed; the response was sometimes "Yankee go
home." In the 1950s and 1960s U.S. observers argued that it wras in the interest of other countries to accept U.S. capital. United States firms brought
new products, new technologies, and new methods of management to foreign markets. Competition from U.S. subsidiaries abroad forced local firms
to improve efficiency. The result was lower costs for foreign consumers of
products produced by both U.S. subsidiaries and local firms. United States
firms abroad hired many foreign nationals, providing both employment and
training not available from local firms.
Why should the United States be receptive to foreign capital? The arguments are identical to those we have so long offered foreigners concerned
about U.S. investment abroad. Foreign subsidiaries in the United States
bring new products, new technologies, and new methods of management.
Competition from foreign subsidiaries is forcing U.S. firms to improve efficiency and has lowered prices for U.S. consumers. Foreign firms hire many
U.S. residents providing employment and training not available from local
firms. United States subsidiaries of foreign firms are challenging U.S. firms
with entrenched oligopolistic positions. It is worth pointing out that in
some industries — the automobile industry is an excellent example — foreign firms first entered U.S. markets by exporting goods produced abroad
to the United States, but then found that U.S. protectionism eliminated
prospects of further growth in their U.S. sales.
Protectionism, of course, flows from the political power of firms and their
workers, who are often unionized in oligopolistic manufacturing industries.




SHADOW OPEN MARKET COMMITTEE

81

Thus, foreign direct investment challenges the economic and political power
of entrenched U.S. firms and their unions to the benefit of U.S. consumers.
Does anyone doubt that U.S. consumers are better off by virtue of their
access to Japanese cars? One year's worth of foreign direct investment in
the United States is worth fifty years of federal antitrust cases in terms of
increasing the competitiveness of U.S. markets. The process works both
ways; U.S. firms operating abroad have increased the competitiveness of
foreign markets to the benefit of both foreign consumers and U.S. investors
who have profited from entering new markets.

Macroeconomic Aspects of International Investment
In a well-functioning economy there is no necessary relation between the
geographic location of saving and the geographic location of investment in
newly-constructed physical facilities. This proposition holds for a national
economy and for the world economy. Individuals and firms save — consume
less than their incomes — for a variety of reasons but wThere they invest is
determined primarily by the prospective return on investment after allowing
for risk. For any given individual (or business) saver the problem may involve
decisions as to what financial assets to buy but ultimately we need to trace
the use of the funds raised back to the physical investments they finance.
From the perspective of the investor it may matter little whether an
investment involves newly-constructed physical facilities or facilities constructed at some prior time. However, for the economy as a whole we must
distinguish between new construction and changes of ownership of existing
assets. When owners of assets sell them and consume the proceeds the issue
involves saving behavior rather than investment behavior. When the owners reinvest the proceeds in newly-constructed facilities we are back to an
investment issue.
The geographic location of investment is determined in some cases by
natural advantages such as the availability of mineral resources. There is no
surprise when we see investment in coal mines in West Virginia rather than
in Rhode Island. But most investment today is determined by man-made
advantages and disadvantages. These conditions, which involve political
stability, taxes, regulations, the labor climate, and so forth determine the
return on investment and its riskiness. Conditions in one region relative to
another determine the regional distribution of investment of the total world
supply of saving.
In the 1980s U.S. domestic investment has exceeded U.S. saving, with the




82

SEPTEMBER 17-18, 1989

difference reflecting inflow of capital from abroad. The difference between
U.S. investment and saving is sometimes referred to as an investment-saving
"imbalance," but that term is very misleading as it implies that the "correct"
or "normal" situation is for the geographic location of investment to match
the geographic location of saving. No one expects such a match across
regions within the United States, and there is no reason to expect such a
match across countries either.
What conditions explain net international capital flows in the 1980s?
Although improvement in the U.S. investment climate has been important,
deterioration of investment climates in many nations abroad has probably
been even more important. The United States traditionally exported large
amounts of capital to Latin America, but those exports came to an end with
the debt crisis in 1982. Many Latin American countries have become capital
exporters instead of importers as they have struggled to service debts accumulated in prior years and as private capital fled poor investment climates.
The investment climate in Europe has not been robust, as most of the region
has experienced low growth and chronically high unemployment. In Japan
a high saving rate has outrun the country's capacity to generate profitable
internal investment opportunities.
In previous SOMC meetings I provided charts comparing saving and
investment rates as percentages of Gross Domestic Product in the 1980s with
earlier years for the United States, Japan, and OECD Europe. These charts
document the point that investment rates have declined abroad. The other
important development in this context in the 1980s is that the saving rate
in the United States has declined. Declines in U.S. saving and in investment
abroad are not desirable, although the decline in Japan's investment rate
was no doubt inevitable given how high this rate has been. But these simple
facts make clear that the key issue for U.S. policy is the U.S. saving rate; it
is simply foolish to argue that foreign investment in the United States per
se is a problem.
If the U.S. rate of return is higher it makes sense for capital to flow
to the Untied States regardless of how much capital is already here. We
would hope, of course, that capital would flow from capital-rich areas to
capital-poor areas where returns are potentially very high. Unfortunately,
many capital-poor areas have very low or negative actual returns because
their economies are so screwed up through political instability and/or statist
policies. It is in the political and economic interest of the Untied States to
improve economic conditions abroad but many of the problems are simply
beyond U.S. influence. We have no choice but to take as given conditions




SHADOW OPEN MARKET COMMITTEE

83

we can do nothing about, and if that means that capital flows to the United
States where the return on capital is positive rather than to poor countries
where the return is negative, then so be it. It is better to get some return
on capital than to throw it away.
If the United States were to scare off foreign investment without increasing its saving rate the inevitable result is a decline in U.S. domestic investment — reduced construction of new houses, new plant, and new equipment.
Consider plant and equipment. This physical capital earns a rate of return
that the U.S. must forego if the capital is not put in place. Of course, much
of the return must be paid to the foreigners who made the investment, but
in general some of the return is left over for the United States. Of special
importance is the fact that a larger capital stock raises the marginal product
of labor, raising real wages in the United States.
Suppose the United States were to be successful in raising its saving rate.
Would that then justify restricting inflows of capital? The answer is clearly
"no." Whatever may be the U.S. saving rate the issue is still the rate of
return on investment in the United States relative to that abroad.
Depending on how the Untied States were to manage to increase its
saving rate, the U.S. rate of return on investment could be either higher or
lower than before. The critical issue in this context is that tax increases to
reduce the federal deficit could reduce the after-tax rate of return on U.S.
investment. Such action would be counterproductive given that the purpose
of raising U.S. saving is to increase the amount of capital available in the
future.
Another way to look at this matter is to note that the same conditions
that determine the return on investment to investors determine the return
on investment to the economy as a whole, and therefore the economy's rate
of growth. Returns to the investor and to the economy are obviously not
identical; tax preferences, for example, may provide high returns to the
investor on projects that have low or even negative returns for the economy.
But it is generally true that high returns to investors go hand in hand with
high returns to the economy. Thus, policies that maintain low tax and
regulatory burdens and thereby permit investors to realize high returns on
investments providing high returns to the economy will encourage economic
growth.
The bottom line is that the United States has one of the most attractive
investment climates in the world. Until investment opportunities improve
dramatically elsewhere in the world, or deteriorate at home, the United
States will continue to import capital. It would be a major mistake for the




84

SEPTEMBER 17-18, 1989

United States to pursue policies with the effect, deliberate or otherwise, of
degrading its investment climate.

Constraints on U.S. Policy from Foreign Investment
It is common to hear objections to foreign investment based on claims that
such investment creates national security hazards, compromises U.S. industrial secrets, opens up the possibility that the United States will be "held
hostage" to foreign interests, or that U.S. policy will be constrained in some
way or other. These arguments are not convincing, and the basic reason
is that they apply equally to activities of both U.S. and foreign owners of
assets in the United States.
Consider the problem of defense secrets. Many industries attempt to use
the government to keep competitors out, and one of the common strategies
is to appeal to "national defense" as a reason to restrict competition. But
we should note that the government has an elaborate system of maintaining classified information and of providing security clearances for defense
contractors. Those who compromise classified information have many motivations, and the simple facts of citizenship or country of birth probably
provide little useful information relevant to providing security clearances.
There is also little relevant information in knowing the country in which a
firm is incorporated or the distribution by country of a firm's shareholders.
The important point is that the national interest in protecting defense secrets should be focused on security issues and not used to provide cover for
protectionist actions.
In private legal disputes lawyers often point out that possession is ninety
percent of the battle. The same is true for foreign-owed assets in the United
States. Attempts by foreign owners to abuse or misuse assets physically
located in the United States are risky for the owners since U.S. authorities
may seize the assets. Foreign owners may have less legal protection and they
certainly have less protection through the political process than do domestic
owners. It is hard to see how the United States can be held hostage by foreign
ownership of assets in the United States; the reverse situation is much more
likely.
As for industrial secrets and technology transfers, the issues cut both
ways. Foreign firms are probably more important for the technology they
bring to the United States than for the technology they take away. For
one thing, there are a lot of cheaper ways for foreign firms to obtain U.S.
technology than to establish subsidaries in the United States. United States




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subsidiaries abroad are surely more important in transferring U.S. technology than are foreign subsidiaries in the United States.
Finally, it is sometimes argued that U.S. macro policy may be constrained by the need to keep foreign financial capital from fleeing the country.
This argument is invalid because financial capital owned by U.S. residents is
just as mobile as is foreign-owned capital. In the late 1970s dollar depreciation caused by capital outflows became a policy problem, but the problem
had nothing to do with the ownership of the capital that was moving. United
States inflation and low real returns on capital were the core problems; dealing with these core problems reduced the outflow of capital owned by U.S.
residents and attracted foreign capital.
In fact, we should not regard capital mobility as a rising policy problems
at all. It is a good thing that policymakers are constrained by market realities. We are better off rather than worse off wrhen markets respond to costly
policies in ways that make life difficult for politicians. International capital mobility promotes efficient international investment, which is the basic
microeconomics argument for free movement of capital, and in so doing constrains both micro and macro policy. It is a good thing that the government
cannot pursue inflationary policies or impose onerous taxes and regulations
on investment without seeing the immediate negative consequence of a depreciating currency and capital outflows. Limited government is a good
thing, and the limits arise from both economic and political processes.





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