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SHADOW OPEN MARKET COMMITTEE
(SOMC)
Policy Statement and Position Papers

September 29-30, 1991

IP 91-02

BRADLEY POLICY
RESEARCH
CENTER
Industry Policy Studies
Working Paper Series

Shadow Open Market Committee

TABLE OF CONTENTS

Page
Table of Contents

i

SOMC Members

ii

SOMC Policy Statement Summary

1

Policy Statement

3

Economic Outlook
Jerry L. Jordan
The Economy in ; °92
H. Erich Heinemann

29

Fiscal Policy Lacks Direction and Credibility
Mickey D 1 evy

67

Recent Behavior of Monetary Aggregates
Robert H. Rasche

77

Choosing a Monetary Aggregate: Another Look
WilliamPoole

91

11

Economic Policy Towards Russia and the Soviet Republics
Charles I. Plosser

105

The Misuse of the Fed's Discount Window
Anna J. Schwartz

109




i.

September 29-30,1991

SHADOW OPEN MARKET COMMITTEE

The Shadow Open Market Committee met on Sunday, September 29, 1991 from 2:00 PM to
6:00 PM in Washington, D.C.

Members oftheSOMC:

Professor Allan H. Meltzer, Graduate School of Industrial Administration, Carnegie Mellon
University, Pittsburgh, Pennsylvania 15213 (412/268-2283,412/268-6837 FAX); and Visiting
Scholar, American Enterprise Institute, Washington, DC (202/862-7150)
Mr H. Erich Heinemann, Chief Economist, Ladenburg, Thalmann & Co., Inc., New York,
Ne York 10022 (212/940-0250, 212/751-3788 FAX)
Dr. Jerry L. Jordan, Senior Vice President and Economist, First Interstate Bancorp, Los
Angeles, California 90017 (213/614-2920, 213/624-1347 FAX)
Dr. Mickey D. Levy, Chief Economist, CRT Government Securities, Ltd., New York, New
York 10004 (212/858-5545,212/858-5741 FAX)
Professor Charles I. Piosser, William E. Simon Graduate School of Business Administration
and Department of Economics, University of Rochester, Rochester, New York 14627
(716/275-3754,716/461-3309 FAX)
Professor William Poole, Department of Economics, Brown University, Providence, Rhode
Island 02912 (401/863-2697,401/863-3700 FAX)
Professor Robert H. Rasche. Department ofv. onomics, Michigan State University, East Lansing, Michigan 48823 (517/3 5-7755, 517/33c 068 FAX)
Dr. Anna J. Schwartz, National Bureau of Economic Research, New York. New York 10003
(212/995-3451,212/995-4040 FAX)




ii.

Shadow Open Market Committee

SOMC POLICY STATEMENT SUMMARY

Washington, September 30—The Shadow Open Market Committee today called on the
Federal Reserve System to avoid further easing by holding the current growth rate of the monetary
base to a range of 5 percent to 6 percent. The SOMC said that the monetary base (bank reserves
and currency) "remains the most reliable indicator of the thrust of current monetary policy."
Slow growth of M2 (currency, checking accounts and individual thrift deposits) has raised
concerns about whether money growth is adequate to sustain the current recovery. The Committee
said that the "reported growth of M2 is misleading; monetary stimulus is understated."
The committee also said that the Federal Reserve should stop making loans to failing banks.
The committee charged that "this practice only adds to the price that taxpayers must pay to protect
depositors."
In a policy statement, the Shadow Committee, a group of academic and business economists
who regularly comment on economic issues, recommended that the Treasury Department overhaul
bidding practices in the government securities market. However, the committee said that an increase
in regulation would be counterproductive.
The SOMC rejected proposals that western nations bail out the Soviet economy. The
Committee said such actions "would waste scarce resources" and delay needed reforms in the Soviet
republics.
The Shadow Open Market Committee meets in March and September. It was founded in
1973 by Professor Allan H. Meltzer of Carnegie-Mellon University and the late Professor Karl
E runner of the University of Rochester.
The Committee charged that the so-called credit crunch was a red herring. The recent drop
in business loans neither indicates a shortage of credit nor a refusal by bankers to lend. To the
contrary, banks are cutting loan rates in an effort to drum up business. Bank loans (especially bank
loans to business) always lag behind the economic cycle. Banks typically buy Treasury securities
in the early stage of an expansion.




1

September 29-30,1991

The committee asserted that a modest recovery with growth in consumer spending below the
growth of output will have lasting benefits. The expansion will be durable. Inflation will continue
to fall. The saving rate will increase, providing resources for investment and productivity gains.
Since the recession was moderate, the recovery is likely to be moderate as well. Rapid growth
in demand would be dissipated in rising prices. A boom in consumer spending would risk rapid
growth of imports, thus increasing trade frictions abroad and calls for protection at home




2

Shadow Open Market Committee

SHADOW OPEN MARKET COMMITTEE
Policy Statement
September 30,1991

A moderate economic recovery is underway. We believe growth will continue. Inflation has
fallen below the average rate of 4 1/2 percent that persisted through the last half of the 1980s. We
expect further declines. Market interest rates have fallen, reflecting the decline in inflation. Markets
have shown, once again, that the best way to reduce interest rates is to maintain moderate money
growth. A steady monetary policy will result in lower inflation and lower interest rates.
To achieve sustained economic growth and stable prices, we urge the Federal Reserve to limit
the growth rate of the monetary base to the range of 5 percent to 6 percent. The Federal Reserve
should desist from making loans to failing banks. This practice only adds to the price that taxpayers
must pay to protect depositors. The Treasury Department should overhaul bidding practices in the
government securities market. However, an increase in regulation would be counterproductive.
Proposals to bail out the Soviet economy would waste scarce resources. We reject them.
The Economic Outlook
Most projections and forecasts anticipate a moderate recovery of 2 1/2 percent to 3 percent
in the first year of the current expansion. These projections are consistent with a well established
fact about economic fluctuations: the strength of the initial phase of the expansion is related to the
severity of the preceding recession. Moderate recessions are typically followed by moderate
recoveries. The 1991 recession was relatively mild. This is true whether we measure the decline
by the fall in output and employment or the rise in unemployment (see chart). For that reason alone,
we expect the pace of the recovery to be moderate.
A modest recovery with growth in consumer spending below the growth of output will have
lasting benefits. The expansion will be durable. Inflation will continue to fall. The saving rate
will increase, thereby providing resources for investment and future productivity gains. We believe
that a noninflationary monetary policy will yield that result.
Many cumparisons of the recovery now underway to the average postwar expansion neglect
to point out that postwar expansions typically produced rising inflation after two or three years.




3

September 29-30,1991

Rapid expansions and subsequent inflations were the result of a common cause—excessive
monetary expansion that at first encouraged a boom in consumer spending but later spilled over
into rising prices.
Attempts to accelerate consumer spending now would reproduce this pattern. A more rapid
expansion would have less effect on jobs and domestic output than is commonly assumed. Since
the recession was moderate, rapid growth in demand would be dissipated in rising inflation. A
boom in consumer spending would risk rapid growth of imports, thus increasing trade frictions
abroad and calls for protection at home.
Recent Federal Reserve Policy
The Committee believes that monetary policy should aim at moderate, sustainable expansion
with declining inflation. The Federal Reserve's current target for M2 is an annual growth rate of
2.5 percent to 6.5 percent. The mid-point of that range, 4.5 percent, is the average rate of M2 growth
during the past four years. The policy of slow money growth has produced welcome evidence of
a parallel reduction in inflation.
Slow growth of M2, particularly in the third quarter, has brought M2 growth below the lower
bound of the Federal Reserve's target range and raised concerns about whether money growth is
adequate to sustain the current recovery. Narrower monetary aggregates such as Ml (currency and
checkable deposits), the monetary base (bank reserves and currency) or total reserves are currently
growing at rates consistent with sustained economic expansion. In our view, the monetary base,
adjusted for changes in foreign currency holdings, remains the most reliable indicator of the thrust
of current monetary policy.
We believe that reported growth of M2 is misleading; monetary stimulus is understated. This
is a judgment based on our evaluation of the available data. It is based on methods that we have
used successfully in the past to predict changes in the monetary aggregates. Two main findings
support this judgment:
First, continued decline of small time deposits at thrift institutions is a principal reason that
reported M2 growth is sluggish. As deposits reach maturity, many holders appear to withdraw
them, perhaps out of concern about the safety of thrift institutions or inconvenience associated with
failures.




4

Shadow Open Market Committee

Second, interest rates on small time deposits at banks and savings and loans have fallen relative
to the rates on checkable deposits. The difference in rates is now negligible. The public no longer
has incentives to sacrifice immediate availability by acquiring time deposits instead of checkable
deposits. As small time accounts have declined, depositors have reinvested some of these funds in
assets that are not counted as part of M2.
A shift of deposits from time deposits to checkable deposits will leave M2 unchanged but
increase Ml. The deposit components of Ml are subject to reserve requirements while time and
saving deposits are not. If the Federal Reserve had not supplied sufficient additional reserves to
the banks, the shift to checkable deposits would have constrained banks and increased interest rates.
This was not the case. Reserve growth has increased sharply this year as a result of the Federal
Reserve's efforts to lower short-term interest rates.
For many years, we advocated and cited the growth of the monetary base as the most reliable
measure of Federal Reserve actions. In spring 1990, we recognized that growth of the base was
distorted by large increases in currency to meet demands for a relatively stable and generally
acceptable money in Eastern Europe and Latin America. These distortions continue to affect the
level of the monetary base but no longer substantially affect its current growth rate. Our calculations
show that the annual growth of the monetary base for the year to date has remained in a range of 5
percent to 6 percent after correcting for past distortions.
Growth at that rate is sufficient to maintain moderate recovery with declining inflation. This
growth is also consistent with growth in nominal GNP of 5 percent to 6 percent in 1992. The Federal
Reserve should maintain growth of the monetary base within this range next year, excluding changes
in demand for U.S. currency from the Soviet republics, Eastern Europe, Latin America or elsewhere,
which should be accommodated.
Credit Crunch
At our meeting in March, we identified the so-called credit crunch as a red herring. The credit
crunch continues to be a red herring today. The drop in business loans in recent months neither
indicates a shortage of money nor a refusal by bankers to lend. To the contrary, banks are cutting
loans rates in an effort to drum up business. Anyone with the inclination to read history knows that
bank loans (especially bank loans to business) usually lag behind the economic cycle. Banks
typically buy Treasury securities in the early stages of an expansion.




5

September 29-30,1991

As activity rebounds, corporate cash flow typically improves from higher profits and from
the sale of goods from inventory. Business people use this cash to repay debt—often for many
months after the expansion gets under way.
At the same time, sales of corporate bonds soared to a rate of $160 billion in the second
quarter, the highest since 1986. Companies used the proceeds of these sales to pay off short-term
debt. Net demand for credit from the corporate sector dropped to zero last spring. That reflected
both the aftermath of the recession and the beginning of a rebound in corporate cash flow. There
is no credit crunch.
Reserve Bank Lending
The House Banking Committee requested the Federal Reserve to make available data on
Reserve Bank lending. These data show that since 1985 Federal Reserve lending has permitted
hundreds of weak and insolvent banks to remain open. This practice is akin to forbearance. Like
other types of forbearance, Federal Reserve lending permits banks to continue their losses. Many
of the banks that received these loans subsequently failed.
These Federal Reserve loans are collateralized by relatively safe assets. When banks fail, the
Federal Reserve stands first in line for repayment from the deposit insurance fund. Losses are
borne by the taxpayers. The Federal Reserve's policy increases the cost that taxpayers pay for bank
failures. Uninsured depositors can withdraw their deposits without loss. They have additional time
to let deposits reach maturity.
The Federal Reserve should close its extended credit facility.
The Government Securities Market
The integrity of a marketplace is a valuable public good. Recent scandals in the government
securities market reflect badly on some participants in these markets. If participants have violated
laws, they should be punished.
Some see the need for additional regulation to prevent further abuse. We believe this would
be a mistake. Few dealers in this enormous market have participated in such illegal practices. Some
dealer firms have been victims, forced to pay a premium to complete obligations to their customers.
They should not be forced to comply with unnecessary and burdensome regulations.




6

Shadow Open Market Committee

We are also convinced that additional regulation is not the answer. What needs to be corrected
is the excessive protection of primary dealers by the Federal Reserve Bank of New York and the
Treasury. In addition, the Treasury does not gain a benefit for taxpayers from the advantage of
being a monopoly issuer of secure obligations—U.S. Treasury bills, notes and bonds.
The Treasury had the opportunity to break the market squeeze last May by announcing a
reopening of the two-year note issue. It failed to do so. If it had, those who attempted to corner
the market would have experienced large losses. They would have been unlikely to renew their
efforts to corner the market at subsequent auctions.
We believe that reform of the bidding process is desirable. The goal of reform should be to
minimize the cost to the taxpayers of issuing and rolling over nearly $3 trillion of Treasury securities.
Many reform proposals have been made. We recommend that the Treasury experiment with new
techniques. These include the Dutch auction that Milton Friedman proposed more than 20 years
ago, allowing large purchasers to deal directly with the Treasury, and offering new instruments
such as index-linked bonds. The Treasury should insist on open access to primary price information.
Helping the Soviet Republics
The bleak economic outlook predicted for the Soviet republics this winter engenders concerns
about famine and disease. Contingency plans for emergency assistance and relief continue an
honorable and established American tradition of aiding the victims of disasters. We support contingency planning in the event that relief is needed.
The major current need of the Soviet republics is to establish institutions under which capitalism will flourish. Granting long-term loans and credit is not in the interest of U.S. taxpayers or
the Soviet public.
This represents a structural change. Food supplies sent in anticipation of famine or food
shortages would have a negative effect on the development of the Soviet agricultural and food
processing industries. Prices would be reduced, so less would be harvested. Losses to producers
would discourage creation of a market system for agriculture.
Long-term assistance in the form of loans and grants has many advocates at home and abroad.
Some favor a new Marshall Plan or a Grand Bargain that would finance economic development.
Others favor loans to stabilize the ruble. These proposals are misguided. None of the Soviet
republics has made the basic reforms required for growth. The economy seems headed toward
hyperinflation arising from financing budget deficits by printing money.




7

September 29-30,1991

Reforms that would establish private property, accounting systems, commercial codes,
financial systems, private pricing and other preconditions for development of market economies
are not in place. The Soviet republics cannot develop a viable market economy until these reforms
are in place. Once reforms are made, loans should be arranged in the marketplace, not in government
bureaus or international organizations.
There is no reason for the U.S. government to borrow so that it can lend to the Soviet republics.
Soviet republics own vast amounts of underdeveloped and undeveloped resources. The republics
can obtain hard currency in large amounts by selling gold, diamond, platinum, oil, gas, and other
materials. They can, and should, attract foreign capital by selling participations in gold, diamond
and platinum mines, oil and gas wells, and other assets.
Borrowing should be arranged by private owners of these resources who use the resources
as collateral for loans from foreigners. Asset sales to foreigners will bring not only capital but
management and technology. Foreign owners or partners would train Soviet managers and
employees in western methods. This would assist economic development and avoid wasteful
government to government loans.
The Soviet republics are in a much different position than western Europe at the time of the
Marshall Plan. The Marshall Plan provided capital to war damaged countries with a history of
well-developed market economies. They had trained labor forces, experienced managers,
accounting systems, financial systems, commercial codes, legal arrangements and other conditions
for renewed development. Once capital and infrastructure were rebuilt, western Europe nations
redeveloped quickly. As the countries recovered, they were able to export to open economies.
However, the Soviet republics lack experience in the market system. A Marshall Plan or
Grand Design would waste scarce western capital and encourage government supervision of
investment and development. Western governments have a vital role to play. They should facilitate
trade by lowering barriers to imports from the republics and Eastern Europe. Unfortunately, some
governments in Western Europe that have been eager to lend money and give aid have been reluctant
to reduce barriers to trade.
France scuttled a modest expansion of food and agricultural exports from Poland, Hungary
and Czechoslovakia. Germany has not shown leadership in removing protection. The U.S. Congress
has delayed approval of trade treaties calling for extension of most favored nation treatment to the




8

Shadow Open Market Committee

Soviet republics. Trade will "^courage growth an^; s development of a market economy. We
urge western governments to remove barriers and to reiy on trade, not aid, to encourage development
of the former Communist states.




9

100

Comparisons with

II

Cyclic:al Pe

<d

*




ndex

1

»-H

Previous

Recessions

100.2
100.1
100.0
99.9
99.8
99.7
99.6
99.5
99.4
99.3
99.2
99.1
99.0
98.9
98.8
98.7
98.6
98.5
98.4
98.3
98.2
98.1
98.0
97.9
0

12
Months From Cyclical Peak
Last 8 Recessions +
1990-91 Recession

15

18

Shadow Open Market Committee

ECONOMIC OUTLOOK
Jerry L. JORDAN
First Interstate Bancorp

Summary
Eight years of economic growth in the 1980s ended in 1990 with the third Middle East oil
shock in two decades. A number of factors, including the quick and decisive defeat of Iraq, suggest
that the Middle East will not produce another oil shock in the next few years. Monetary policy also
has become less destabilizing. These trends suggest that the fluctuations of inflation and interest
rates, as well L* of output and employment growth, will be much smaller than in recent decades.
Less volatility means that business decision makers will have less uncertainty about the future than
at any time in several decades. The resulting lower "hurdle rates" for investment decisions will
foster better trends of capital formation, productivity, and real income gains.
The narrower corridor in the variability of major national economic indicators will obscure
considerable diversity of performance among the major sectors and industries of the economy.
Some regions ;hat were strong during the recovery from the 1981-82 recession—such as New
England—are expected to trail the national expansion. Other regions that were weak in the previous
recovery—mainly the Southwest and the Rocky Mountain states—will outperform the nation as
a whole.
Similarly, industries such as defense and commercial construction that were vigorous during
most of the 1980s will remain depressed in the expansion of the 1990s. Meanwhile, basic manufacturing "smokestack" industries are expected to be stronger in this expansion, in contrast to the
weak performance of the 1980s recovery.
Slower growth of the working-age population in the past decade means that far fewer jobs
will need to be created in the 1990s expansion in order to lower the unemployment rate. It also
means much slower growth in entry level housing, but a greater need for schools as the baby-boom
"echo" builds.




11

September 29-30,1991

The aging of the ,fbaby-boom generation" will be reflected in faster growth of real per capita
personal income and higher saving rates. Several "superior-goods industries" will be the main
beneficiaries of these major demographic trends. Employment growth in health-care fields will
continue to be rapid, as it will in the leisure group of industries—recreation, travel, tourism, and
entertainment.
A broad spectrum of industries also will be affected by growing concerns over the environment. From heavy construction projects to recycling and trash disposal facilities, the challenge will
be to find private-sector financing to meet the growing demands for less pollution.
In the early years of recovery for 1981-82 recession, the value of the U.S. dollar rose sharply
relative to other major currencies, rendering much of U.S. manufacturing non-competitive on world
markets. The resulting trade deficit reflected both strong import growth and weakness in exports.
As the expansion of the 1990s gets under way, the dollar is at a level that leaves U.S. exporting
and import-competing industries much more competitive. The strong improvement in manufacturing productivity during the eight-year expansion held unit labor costs of manufacturing flat
between 1982 and 1990. This achievement will help sustain export growth in the 1990s, while U.S.
manufacturers also will recapture domestic markets from foreign producers.
In the expansion of the 1980s, defense spending consumed a growing share of the nation's
resources; in the 1990s that trend is being reversed. Those industries and regions of the country
that benefited from a growing defense sector are now challenged by the necessity to diversify into
non-defense production.
Construction resources in the 1980s were used to house the baby-boom generation and to
build a large inventory of office, hotel and shopping space. Now, the demand will be for infrastructure projects, including transportation, education, water, trash and sewage disposal, pollution
abatement, penal institutions, and health-care facilities. The challenge will be to provide adequate
funding and private-sector incentives to address these areas, especially in view of the budgetary
constraints on the public sector.
U.S. Economy
The 1990s began with a recession, a pattern that has been repeated during each of the past
three decades. Compared with other economic downturns since World War II, however, the latest
contraction was relatively mild. Real GNP declined a total of 1.1 percent—about half the postwar
average drop of 2.3 percent. The economy is now likely to experience a period of more stable
growth with lower inflation and lower interest rates.




12

Shadow Open Market Committee

Expansion of the 1990s—Dominant Forces
Four major forces will influence the economy' s direction during the next two years: monetary
policy, fiscal policy, demographics, and oil prices.
Monetary Policy—Keys to the Future
To accommodate the recovery following the Gulf war, the Federal Reserve set its 1991 growth
target for M2 (currency, checking & savings accounts, and small certificates of deposit) at 2.5-6.5
percent. M2 growth was quite rapid early in 1991, and the Fed was apparently aiming at the upper
half of its target range. Money growth stalled around the middle of the year, however, and by
August this measure of the money supply was barely above its lower target bound.
Over the long run, nominal GNP tends to grow at about the same pace as M2. Over short
periods of time, GNP gains can outstrip M2 increases. Such situations are generally characterized
byrisinginterest rates, however, in contrast to the falling rates of 1991. The Fed might take some
solace in the sizable growth of Ml (currency and checkable deposits), which by August had recorded
an annual growth of 7.0 percent measured from 1990's fourth quarter. The steepness of the yield
curve also appeared to be encouraging investors to move out of bank CDs into stock and bond funds
not included in M2.
The weakness of M2 growth, nevertheless, represented the greatest risk of a "double-dip"
recession. The poor performance of employment and income in the middle of 1991 indicated that
even if M2 were overstating the tightness of monetary policy, more rapid money growth would be
necessary to prevent the incipient recovery from being aborted.
Our forecast is based on the assumption that money growth revives by the end of 1991, with
M2 growth of 5.5 percent occurring in 1992. As the Fed pursues its long-term goals of quashing
inflation, M2 growth is likely to moderate to about 4.7 percent in 1993.
Fiscal Policy—Red Ink Persists
Little near-term change is anticipated in U.S. fiscal policy, despite demands to address
domestic priorities, requests to aid the Soviet Union, lingering effects of the recession, and a
presidential election in 1992.
The budget agreement reached in 1990 (the Omnibus Budget Reconciliation Act or OBRA)
established individual spending caps for three categories of "discretionary spending"—defense,




13

September 29-30,1991

international, and domestic—for fiscal years 1991, 1992, and 1993. "Mandatory" (required by
law) benefit programs were set on a "pay-as-you-go basis." One program's outlays could be raied
only if another's were cut or if taxes were increased.
The jury is still out as to the success of OBRA in restraining the deficit. Certain loopholes
appear to have allowed spending limits to be overshot, but the new budget process has still imposed
some discipline on congressional actions.
The deficit for fiscal 1991 (which ended September 30) was an estimated $282 billion,
compared with 1990' s spending-revenue gap of $220 billion. We expect the 1992 deficit to balloon
to about $375 billion before it is reduced to about $294 billion in 1993.
Three major factors are causing the near-term escalation in the deficit. Delays in dealing with
the S&L debacle have pushed deposit insurance expenditures from 1991 into 1992. Allied contributions for project Desert Storm held down 1991' s deficit, while some replacement-part spending
for equipment damaged or destroyed during the Gulf war will add to 1992's outlays. The recession
also dampened tax revenue while raising required spending for such programs as unemployment
compensation.
The Federal Reserve is unlikely to accommodate these large deficits through rapid monetary
growth because of the concern about inflation. As private credit demands begin to pick up in late
1992 or 1993, greater potential will exist for "crowding" out of consumer or business borrowing.
Demographics—A Generation of "Grumpies"
The "baby boomers" born between 1946 and 1964 are gradually changing in the eyes of
marketers from "yuppies" (young upwardly-mobile professionals) to "grumpies" (grown-up mature
professionals). Census numbers show that this 26-44 age group accounted for nearly a third of the
population in 1990.
Trends of the baby-boom generation have heavily influenced economic events during the past
three to four decades. The strong gains during the 1980s in consumer spending and housing
investment were in significant part driven by this population segment. This group is now likely to
save at higher rates for several reasons: provision for their own retirement, smaller tax benefits
from interest expense, and lower inflation.
Demographic trends in the near term should be relatively favorable for the economy by
fostering greater saving and investment The next major demographic challenge will occur in the
next century when the first of the baby boom generation begins to retire.




14

Shadow Open Market Committee

Other demographic features will have important effects on the near-term outlook. The number
of new young adults has dropped dramatically because of the "baby bust" of twenty years ago. At
the same time, the annual number of new births has recently jumped back to the levels of the mid
1960s. Immigration from Latin America and Asia will also continue to have important effects on
the U.S. economy.
Oil Prices—Moderate
Oil prices, in terms of the West Texas Intermediate benchmark, are likely to average slightly
over $21 a barrel in 1991. We assume that prices will generally average in the $20-$21 a barrel
range during 1992 and 1993. Winter heating demand could put upward pressure on prices late in
1991, and stronger industrial-country growth could lead to a firming in worldwide demand in 1992.
At the same time, however, the gradual restoration of Kuwaiti and Iraqi supplies will limit any
upward pressure on prices, as will continued sizable production by Saudi Arabia.
Economic Recovery
The U.S. recession, which began in 1990's third quarter, appears to have ended in the second
quarter of 1991. We expect real GNP growth to average about 2.6 percent in 199l's second half
after the 2.8 percent annualized decline in the first quarter and a virtually flat performance in the
second quarter.
Our forecast is for substantial economic improvement in 1992, with a 3.4 percent real GNP
gain. Gradual tightening by the Federal Reserve in 1993 because of inflation concerns is likely to
temper that year's growth to 2.8 percent.
Just as the recession was comparatively mild, the recovery will be moderate by historical
standards. The averagefirst-yearrise in real GNP in the recoveries since World War II was 6.7
percent. We expect growth in the first year of the currency recovery to be 3.1 percent.
Opportunities and Risks
Consumer spending will grow moderately in the new expansion. Both demographic forces
and the accumulation of debt by households during the 1980s will restrain spending. Income gains
should improve, however, with a resumption of employment growth and increases in wages and
salaries that exceed the rise in consumer prices. The advances in stock and bond prices which have
taken place, together v* th at least a stabilization of real estate prices, have also bolstered the net
worth of many individuals.




15

September29-30,1991

Home sales will continue to improve with stronger consumer confidence and lower interest
rates. After plunging to only 1.04 million units in 1991, we expect housing starts to rise to 1.28
million units in 1992 and 1.38 million in 1993. The single-family market will return to healthier
levels relatively quickly. National apartment vacancy rates remain high and are preventing a
recovery in the multi-family sector. Lower vacancy rates, rising rents, and better returns may
develop by the end of 1992, leading to more multi-family housing construction in 1993.
Business firms will continue to rebuild inventories over the next several months, which should
give a sizable boost to economic activity. Companies will also raise capital spending plans as efforts
continue to bolster productivity. Outlays for business equipment are likely to rise at a real rate of
about 6 percent over the course of 1992 and 5 percent during 1993.
Direct government spending will be restrained by fiscal problems at local, state, and federal
levels. Defense cuts are likely to be accelerated, while contracts based on defense against the Soviets
will be shelved or scaled back. Construction of roads, other transportation facilities, schools, and
prisons will remain strong because of funding by specially-earmarked tax revenues or by bond
financing.
Nonresidential construction will remain the weakest economic sector of the national economy
through 1993 because of excess capacity in hotels, office buildings, and shopping centers. Most
of the commercial construction work will involve completion of projects previously started or
renovation of older structures.
Brighter Outlook—Jobs and Profit
Nearly 22 million jobs were created in the expansion that ended in July 1990. Manufacturing
employment had started to shrink early in 1989, and weakness eventually spread to nearly all other
major economic sectors. Only health care appears to have escaped the impact of layoffs.
We expect modest job growth in the final months of 1991, with moderate gains continuing
in 1992 and 1993. Employment growth will trail advances in output as industries throughout the
economy, especially in the broad services sector, strive to enhance productivity. Our forecast
indicates a rise of 2.0 million jobs on nonfarm payrolls in both 1992 and 1993 (measured fourth
quarter to fourth quarter). The year 1991 will show a loss of about 800,000 jobs.
The unemployment rate reached a peak of 7.0 percent in mid 1991 and is likely to remain
relatively high for the first few months of the recovery until hiring begins to pick up. We expect
the jobless rate to ease to 6.2 percent by the end of 1992 and 5.5 percent by December 1993. A
significant reduction in the jobless rate will be achievable even with moderate job gains because




16

Shadow Open Market Committee

of relatively sluggish growth of the labor force. The working-age population (16 and over) is
currently rising by less than 1 percent per year and, after climbing substantially during the past two
decades, the labor-force participation rate is likely to be relatively stable.
Corporate profits have borne much of the brunt of the latest recession. We focus on "economic"
after-tax profits, which value depreciation on a replacement-cost basis and exclude inventory gains.
This profit measure dropped sharply during the past two years, before edging up an estimated 2
percent in 199.1.
Corporate profits should rebound by about 8 percent in 1992, followed by another 7 percent
climb in 1993. The ability of most firms to raise prices aggressively will be limited during the next
two years by a lower inflation environment and a generally moderate growth of sales. A lower
level of interest rates compared with that of recent years, however, will help restrain financing costs.
Many firms have also lowered their break-even points by cutting costs and improving efficiency.
Increases in sales and/or output volumes should, therefore, feed through quickly to the bottom line.
Inflation—Winning the Battle
Inflation jumped in 1990, as higher oil prices drove consumer prices up 6.2 percent from the
prior year's fourth quarter level. The reversal of last year's run-up in oil prices will help cut inflation
in half in 1991 to only about 3.1 percent.
Prospects for inflation appear favorable for the early 1990s. Monetary growth, the dominant
force behind inflation, has been slow during the past four years. We estimate that the annual increase
in M2 over the five years ending in 1991 will amount to only about 4.3 percent. Assuming that the
economy's potential real growth rate is 2.5 percent, this would imply that inflation could trend as
low as 2 percent.
Oil and food supply shocks can cause large swings in relative prices, which can affect the
general inflation indices. World oil output, however, is likely to match increases in demand.
Agricultural supplies are sizable, although prospects will be affected by developments in the Soviet
Union, weather, and U.S. farm policies.
On balance, our forecast is for consumer prices to rise 3.5 percent in 1992 and 3.3 percent in
1993. Although prices, along with employment, were affected most significantly in the goodsproducing sector during this past recession, more price restraint has recently been evident in service
industries. That trend is likely to continue during the next two years.




17

September 29-30,1991

Wage and salary increases have been temperate for some time. Continued increases in the
cost of health care and non-wage benefits are likely to boost the average cost of total compensation
by 4.7 percent during each of the next two years, following 1991's estimated 4.5 percent rise.
Interest Rates-Milder Cycle
Changes in interest rates during the next two years are likely to be confined to a narrower
range than during much of the 1980s. This will reflect a generally moderate pace of economic
growth and lower inflation.
The Federal Reserve influences the course of short-term yields through its control of the
overnight federal funds rate. Five major forces will guide the Fed in setting its interest-rate targets
during coming months: 1.) the current and expected trend of economic growth; 2.) the pace of
monetary expansion; 3.) the rate of inflation; 4.) the financial market's confidence in Fed policy,
as indicated by bond prices; and 5.) the dollar's behavior in foreign-exchange markets.
Weak economic and money growth, low inflation, and rising bond prices would encourage
the Fed to lower interest rates and vice versa. The dollar's foreign-exchange rate acts more as an
ancillary constraint: a sharp plunge in the dollar could prevent easing and a steep climb could delay
tightening.
The Federal funds rate is forecast to bottom out at about 5 percent at the end of 1991 as the
Federal Reserve acts to accommodate the economic expansion. For comparison, the fed funds rate
reached a peak of nearly 10 percent in early 1989. An acceleration in economic activity by the first
part of 1992 is likely to prompt a gradual process of tightening, taking the funds rate to a peak of
about 7.25 percent by the middle of 1993. Such an increase should be sufficient to restrain the
growth of the economy, causing the funds rate to ease to 7.0 percent by the end of 1993.
Most short-term rates will parallel movements in the funds rate, with a rise of 125 basis points
(1.25 percentage points) over the course of 1992 and 75 basis points between the beginning and
end of 1993. We expect the bank prime rate to average slightly over 8 percent in 1992 and 9 percent
in 1993, compared with an average 8.5 percent in 1991, and well below 1990's 10 percent average.
Long-term interest rates, as represented by the yield on Treasury securities, will reflect three
fundamental factors: 1.) the real return, based on the productivity of capital; 2.) the anticipated rate
of inflation over the life of the asset; and 3.) a risk factor based on uncertainty about the prospects
for inflation.




18

Shadow Open Market Committee

The real rate of return currently is around 4 percent. Its one-half percentage point increase
during the past two years may reflect the impact of higher investment demands from Eastern Europe,
Asia, and Latin America.
If investors can be convinced that the long-term inflation rate will hold at 3.5 percent or less,
the likelihood is that the 30-year Treasury bond yield will remain near 8 percent. Our forecast is
for the long bond to generally yield less than 8 percent in the latter part of 1991 and in the early
part of next year. Signs of more rapid economic growth and rising short-term rates are expected
to push the 30-year bond yield up gradually during the course of 1992, but to a peak of only 8.25
percent in the middle of 1993. Following our general outlook for long-term yields, we expect
30-year mortgage rates to range between 9.0 percent and 9.5 percent during 1992-93, a welcome
respite from the double-digit mortgage rates that characterized nearly all of the 1980s.




19

GROSS NATIONAL PRODUCT
(Billons erf $. annual M)
% Change, annual rale

IV

5680.7

57S4.S

1

II

1993

in

Forecast
5948.3
5848.5

IV

1

604$.$

5141$

6234$

U

III

IV

Forecast
6412.7
6327.S

6494.S

22

42

4.7

13

6.7

7.0

6.7

6.5

6.2

6.1

S.S

4124.1

4123.0

4149.2

4176.2

4211.2

4249.4

4284.0

4317.8

4350.5

4382.8

4411.9

4439.0

28

•0.1

2.6

2.6

14

3.7

3.3

3.2

3.1

3.0

2.7

41436

4158.5

4169.7

4181.7

4211.1

4245.6

4276.0

4305.3

4334.3

4362.8

4368.7

4412.3

-4 5

1.4

1.1

1.2

2.8

3.3

2.9

2.8

2.7

2.7

2.4

•250

•27.7

-12.5

4.0

10.0

14.0

17.0

20.0

22.0

24.0

25.0

28.0

GNP DEFLATOR
(19B2-100)
% Change, annual rale

1348

136.2

136.9

137.8

138.9

140.0

141.1

142.2

143.3

144.4

145.4

42

2.1

2.8

3.2

3.2

3.3

3.2

3.1

3.0

2.6

135.0

135.7

136.7

137.9

139.1

140.3

141.6

142.8

144.0

145.1

146.3

2.1

3.0

3.6

3.6

3.5

3.6

3.4

3.4

3.3

3.2

8.5

8.9

9.3

9.4

9.6

9.7

9.6

10.1

10.0

9.7

1.35

1.37

1.38

1.37

1.39

43013

XO

4412.3

2.5

4.0

N/A

20.0

N/A

26.0

N/A

3.5

14X2

X2

146.3

2.9

XI

14X8

XS

147.4

X3

-8.2

9.6-

10.4

9.8-

XI

1.04-

.12.5

1.28-

2X7

1.38-

7.5

108.7

0.2

11X3

4.2

117.2

XS

109.0

-0.8

111.0

1.8

11X9

1.7

6.0

N/A

XS

N/A

16

N/A

169.8-

X2

18X5-

XI

19*8-

7.2

3436.4

3.3

36214

IS

37917

4.7

9.6

1.32

-0.2

3.2

82

4181.7

147.4

3.6

2-8

2.7

CONSUMER PRICE INOEX
(1982 84.100)
% Change, annual rate

4439.0

146.3

52

14

2.2

REAL CHANCE IN INVENTORIES
(Billons ol 1982 S. a.r.)

4317J

2.5

REAL FINAL DOMESTIC SALES*
(Billons Ol 1982J. i f )
% Change, annual rale

0.5

1091

5.2

REALGNP
(Billons ol 1982$. i f . )
% Change, annual rale

4176.2

8.7-

Actual
5557.7
5615.8

III

4 lh Quarter
% Change
% Chang*
1992
'92/91
1993
'9V92
Forecast
6141.$
6.7
6494 .5
5.7

137.9

II

% Chang*
'91/-90
Estimate
5754.S
4.1

137.8

Quarterly
1992

1991
1

AUTO SALES
(MiUons. annual rate)

0.92

1.00

INDUSTRIAL PRODUCTION
(1987.100)
% Change, annual rate

105.8

106.3

107.9

108.7

109.8

111.0

112.2

113.3

114.4

115.4

116.3

117.2

•9.6

1.9

6.2

3.0

4.0

4.S

4.3

4.0

3.9

3.7

3.3

3.1

NONFARM EMPLOYMENT
(Millons)

109.2

108.8

108.8

109.0

109.3

109.8

110.4

111.0

111.5

112.0

112.5

112.9

6.5

6.8

6.9

6.9

6.6

6.7

6.5

6.3

6.0

5.8

17

5.6

171.1

168.1

169.0

171.0

176.0

183.0

186.0

189.0

193.0

196.0

198.0

200.0

2.5

•3.1

4.6

5.3

2.9

8.9

10.1

10.5

9.7

7.1

6.5

5.6

33543

3394.5

3396.6

3436.4

3486.6

3533.8

3579.7

3625.4

3670.7

3715.6

3756.9

3795.7

3.5

4.9

0.2

4.8

6.0

5.5

5.3

5.2

5.1

5.0

4.5

4.2

HOUSING STARTS
^MiUons. annual rate)

UNEMPLOYMENT
RATE. ALL WORKERS (Percent)
ECONOMIC PROFITS
AFTER TAXES
(BtBons ol t. annual rale)
% Change over year ago
MONEY SUPPLY M2
(Bilons ol S. a.r.)
% Change, annual rate

NOTE: All quarterly series are seasonally adjusted: % change, annual rale calculated from prior quarter;
caiculaions based on untoun<jiKi data; a.r. • annual rale. 'Excluding Commodity Credit Corp. purchase*.




••Annual total; N/A - Not applicable.

REAL GNP RECOVERS
INDEX OF LEADING ECONOMIC INDICATORS

(Quarterly percent change, annual rate)

(Percent change from prior month)
6-Month

1.5 T

Average

J

PURCHASING MANAGERS1 INDEX
(Percent)
55

F

M

A

M

J

J A
1990

S

O

N

O

J

F

M A M J
1991

J

INDUSTRIAL PRODUCTION
(Percent change from prior month, annual rate)

5-Month
Average

T

J F M A M J J A S O N 0 | J F M A M J J A
1990
1991

 Interstate
First


Economics

F M A M J J A S O N O U F M A M J J A
1990
1991

September 29, 1991

HOUSING STARTS & PERMITS

NEW AND EXISTING SINGLE-FAMILY HOME SALES
(Seasonally adjusted annual rate)

(Millions oi units, annual rate)

Thousands
T 650

J F M A M J J A S O N D
1990

J|

F M A M J
1991

J F M A M J J A S O N O ' J F M A M J J A S
1990
1991

J A

NONFARM EMPLOYMENT

RETAIL SALES

*

(Percent change in 3-month moving average, annual rate)

6-Month

(Change from prior month, in thousands)

Average
4-Month
Average

J

F

M

A


http://fraser.stlouisfed.org/
First Interstate
Federal Reserve Bank of St. Louis

M

J

J A
1990

S

O

Economics

N

D

J

F

M A M J
1991

J

J F M A M J J A S O N D
1990

I J F M A M J J A
1991

September 29, 1991

MERCHANDISE EXPORTS AND IMPORTS

U.S. DOLLAR-TRADE WEIGHTED INDEX

(Percent change in 3-month moving average from •$••

(Quarterly\ Index March 1973=100)
160 j

15 T

150 +
140 +

130 I
120 I
110 |

100 I
.90 I
1 I I I I 1 1 1 1 I I I 1 1 I | 1 I 1 | 1 I 1 | I I 1 I I I I | 1 1 1 | I 1 i I 1 11
81
82
83
84
85
last point is September 26 close

86

87

88

89

90

91

-5 4 - H — I

1 1 I

I

I—hH—I—I—I—I—I—I—HH—HH

J F M A M J J A S O N D U F M A M J J
1990

1991

CO

CONSUMER PRICE INDEX

CRUDE OIL PRICES
(West Texas Intermediate, dollars per barrel)

42 r

Contract

•2-I—l—I—I—|—|—|—|—i—i—i—i—|—|—i—i—i—i—i—|
Q4
1989

Q1

Q2

03
1990


First Interstate Economics


04

Q1

02

03
1991

J F M A M J J A S O N O I J F M A M J J
1990

1991

September 29, 1991

FED FUNDS & 3-MONTH T-BILL QUOTED RATES

PRIME RATE & 3-MONTH CDs

(Weekly averages, percent)

(Weekly averages, percent)
11 T
10

Fed Funds

9

\

i

Prime

'lw*'«wO**%

\

8+
7

CDs

^Sf^^**\^

6

iiiiiiiiiiiiiiiiiiiiiiiiitiiiiiiitiiiiiiininninminiiniiiiiiiiiiiiiniinnimnimiiiiiiiiini

5
04

Ql

Q2

1989

Q3

Q4

Q1

1990

Q2
03
1991

04

Ql

Q2

1989

Q3

04
1990

Q1

Q2

03
1991

C4
I N T E R E S T R A T E S - M O D E R A T E C Y C L I C A L RISE
(Percent, quarterly average)

J-

MOODY'S CORPORATE AAA, MORTGAGE &

to

30-YEAR GOVERNMENT BONDS

12T-

(Weekly averages, percent)
11 T Conventional Mortgage Rate

iOr-


http://fraser.stlouisfed.org/
First Interstate
Federal Reserve Bank of St. Louis

04
1989

Economics

Ql

02

03
1991

September 29, 1991

AVERAGE MMF YIELD, FICAL CONSUMER MIA YIELD

YIELD CURVE, 3 MONTHS TO 30 YEARS

& PRIME RATE
(Weekly averages, percent)

(Percent)

September 24,1990

1 3

5

7

10

Q4
1989

Years

Qi

Q2

Q3
1990

i
INFLATION AND MONETARY GROWTH
•§

REAL YIELDS AND 30-YEAR U.S. TREASURY BONDS

(Percent change, 8-qtr moving average)

(Percent, quarterly average)

30-year T-Bond

M2' lagged 2 years less 2.5%

0 ||H|III|III|III|III|III|III|III|III|IIIIIII|III|III|III|III|IM|III|IIII
1

80'

821


First Interstate


84
86' ' 88'
'90
' 92'
'Adjusted for MMDAs in '83 and currency in '89-'9t

Economics

941

96

September 29, 1991

M2--NEAR LOWER 1991 TARGET
(Billions of dollars, monthly average)

M2GROWTH

3600

(Percent change, 4th qtr to 4th qtr)
14
12
10
8
6

Lower Target = 2.5%

2

3300 1

1
N

1
D

J

1
F

1
M

1
A

1
M

1
J

1
A

1
1
1
1
S O N D

1

h/puckEP

nm

0

79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96

1991

1990

3t

1
J

1 i^
fall!1
I 1.

4

CURRENCY ADJUSTED FOR FOREIGN HOLDINGS

MONETARY GROWTH IN 1991

($ Billions, seasonally adjusted quarterly averages)

(90Q4 to 91Q3et annual rate)

10 T




First Interstate Economics

September 29, 1991

M1 VELOCITY G R O W T H
(Annual percent change based o n 8-quarter moving averages)

62Q1

nun III II II III II n III II II III n II II III ii n I I I I I I
68Q1
65Q1
71 Q 1
74Q1

77Q1

80Q1

83Q1

86Q1

89Q1

91Q1

rCN

M2 & BASE VELOCITY GROWTH
(Annual percent change based on 8-quarter moving averages)

VM2 Net

I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I llll I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I N I

62Q1

First Interstate


65Q1

Economics

68Q1

71Q1

74Q1

77Q1

80Q1

83Q1

86Q1

89Q1

91Q1

September 29, 1991

GROWTH RATES OF MONETARY AGGREGATES AND GNP
(Percent Change From Prior Quarter, Annual Rate)*
90.01
90.02
90.03
90.04
91.01
91.02
91.036

M1
3.9
2.9
1.8
1.6
2.9
7.6
7.0

M1C
5.6
4.2
2.2
0.6
3.8
13.3
9.8

M2
6.0
3.6
2.6
1.6
2.7
4.9
-0.3

M2Net
8.3
4.5
3.0
1.7
4.4
11.9
4.9

1.2
-1.9
3.5
2.2

GNP
6.7
5.1
5.3
0.9
2.2
4.0
N/A

Base

1.6
-0.2
0.8
0.8

5.0
4.1
3.9
5.1
6.3
3.9
5.9

AVERAGE ANNUAL RATE OF CHANGE IN VELOCITY
60.01 to 90.04
83.01 to 90.04
87.01 to 90.04
88.01 to 90.04

2.1
0.0
3.4
3.4

1.9
-2.2
5.3
4.7

0.0
0.1
1.5
0.9

plemb er 29-30,

O

to

PROJECTED GROWTH OF GNP, FIRST HALF OF 1991 BASED ON VELOCITY GROWTH TREND 83.01 TO 90.0
MONEY GROWTH
VELOCITY
GNP FORECAST

5.2
0.0
5.2

8.4
-2.2
6.2

3.8
0.1
3.9

8.1
-1.9
6.2

5.1
-0.2
4.9

ACTUAL
3.1

BASE
4.1

ACTUAL
3.1

FORECAST BASED ON ECONOMETRIC MODEL
M2
0.6
MIC = M1 + SAVINGS + MMDAs
M2 Net = M2-TDS
*AII growth rates adjusted for changes in foreign currency holdings for five quarters, 90 Q 1 through 91 Q1

First Interstate Economics




September 29, 1991

oo
CN

Shadow Open Market Committee

THE ECONOMY IN 1992
H. Erich HEINEMANN
Ladenburg, Thalmann & Company, Inc.

The American economy is moving slowly but surely out of recession. There is little risk of
a "double-dip" slump that would drive business activity to a new low. To the contrary, a surge in
business investment should push real gross domestic product (measured in 1987 dollars) up more
than 4 percent next year. The dynamics of recovery are in place. Once begun, this process rarely
reverses.
The rate of inflation is down. In our opinion, prices will continue to decelerate in the months
ahead. Our Baseline Forecast (see tables) indicates that the GNP deflator will rise only 2.5 percent
in 1992. If Fed policy remains on a disinflationary course, the rate of increase in prices should drop
still lower in 1993.
We expect corporate profits to be a catalyst for growth. Earnings from current operations
were up last spring, even though the economy was still in the doldrums. Productivity is going up.
Total business sales advanced at an annual rate of more than 8 percent from April to July. The
change in unit labor costs in manufacturing is dropping month by month.
The combination of increased business volume and falling unit labor costs suggests that profit
margins will widen at an accelerating rate. Tight cost control in U.S. industry is bearing fruit. We
believe that the financial community will be pleasantly surprised by the upbeat tone of third quarter
earnings reports, and enthusiastic about the resurgence this fall. As cash flow improves, so will
capital spending—particularly for investment in machinery and equipment that promises to enhance
productivity by a significant amount.
Threat to Recovery
The biggest threat to prospects for solid expansion and low inflation could come from the
Federal Reserve. Conventional wisdom in both Wall Street and Washington is that monetary policy




29

September 29-30,1991

is restrictive. According to the chief U.S. economist of a major British bank, there is simply "not
enough money" in circulation. This view is incorrect. It is based on a mistaken reading of the
recent slowdown in broadly-defined measures of the money supply.
Meanwhile, whether from the right or the left, politicians are bringing intense pressure on the
central bank to reflate. Spurred by both the White House and Congress, the Federal Reserve cut
the discount rate to 5 from 5.5 percent. Political operatives in the Administration clearly want to
control the election agenda next fall. They expect lower short-term interest rates to boost the
economy well in advance of the coming campaign. On the other side, Democrats believe that money
(in whatever form, from whatever source) is a universal balm for social ills.
This is a formula for disaster. Easy money will boomerang, if not in 1992, then in 1993.
Attempts to hold down the cost of credit during an economic expansion always lead to higher, rather
than lower, rates. Pushing rates down forces the Fed to print money. The more money the Fed
prints, the more the expected inflation rate will rise. As a result, rates will go up at an accelerating
pace as lenders seek to maintain the real rate of return on their funds. While inflation is falling at
present because of tight money from 1987 through 1990, easy money could rekindle the fire of
inflation before November 3, 1992.
The Fed cut the discount rate at a time when total bank reserves (high powered funds that
represent raw material for the money supply) are rising. The rate of increase in reserves is still
modest by the standards of the mid-1980s. Nonetheless, it is now going up rapidly. As measured
by the Federal Reserve Bank of St. Louis, total reserves rose at an annual rate of almost 10 percent
from January through August this year. Were this rate of increase to continue for another six to
nine months, that would lead to a new found of inflation—and another recession. Both stock and
bond prices dropped immediately after the discount rate cut. Obviously, investors are alert to the
risk of renewed inflation.
<

It is true that broadly defined measures of the money supply—for example "M2," currency,
checking accpunts and individual thrift deposits—have been weak. However, this weakness does
not indicate that Fed policy is, or has been, a drag on the economy. The slowdown was not due to
policy action, but to portfolio decisions by the public in investing liquid assets. The Fed was mostly
an innocent bystander.
In its conduct of policy, the only thing that the Fed controls directly is the size of its balance
sheet—namely, the monetary base. The principal source of the base is the Fed's $260-billion-plus




30

Shadow Open Market Committee

portfolio of Treasury securities. The two uses of the base are currency in the hands of the public
and total bank reserves. Put simply, The Fed's job is to increase its Treasury portfolio enough to
satisfy the demand for U.S. currency, but not so fast as to flood banks with unwanted reserves.
The money that individuals and businesses keep on deposit and use to make payments to third
parties is subject to reserve requirements. Bank and thrifts set aside a portion of such deposits at
the Fed. However, only the Fed can add or subtract the total amount of reserves. From January
through August this year, both bank reserves and transaction balances went up at annual rates close
to 10 percent. This indicates that the Fed is adding to the part of the money supply for which it is
responsible at a rapid pace.
Crises of Confidence
By contrast, depositors have pulled large amounts of investment funds out of time deposits
at thrift institutions. Over the last two years, such accounts have dropped by almost $200 billion.
By contrast, money market and savings accounts (which can be withdrawn on demand) have gone
up at banks and thrifts, though much faster at the banks. With this background, the sluggish record
of the higher Me begins to make sense.
A tight-fisted stance by the central bank does not account for the slow growth of the nontransaction parts of the money supply. Rather, the slowdown reflects a crisis of confidence in thrift
institutions. This is obvious in the contrasting behavior of savings deposits and small time deposits
at the thrifts. The former was going up at modest rate; the latter was dropping rapidly. Federal
deposit insurance covers amounts up to $100,000. With thrifts failing at record rates, investors are
naturally wary. Deposit insurance or no, savers are not willing to tie up their funds at institutions
they do not trust.
The money that flowed out of thrift institutions did not go into a black hole. It went to
alternative investments—for example, bond funds—that the Fed does not count as part of the
money supply. According to an internal study by the Federal Reserve Bank of Dallas, if bond funds
were included in the broadly-defined money supply, that aggregate would be well within its growth
target range. The thrift crisis redirected the flow of funds in the economy. It did not cut off that
flow. Economic performance will not be affected if savers choose to invest through mutual funds
rather than mutual savings banks.
The threat of future inflation would be even greater if the central bank were to hold back from
its next round of monetary tightening because of weakness in the banking sector. Conventional
wisdom in lower Manhattan is that the fragile state of the nation's banks could become a major




31

September 29-30,1991

barrier to the Fed in tightening policy. Any increase in the Federal funds rate, so the story goes,
would squeeze bank lending margins. As a result, the money managers could be hesitant to let rates
go up. We trust that Federal Reserve officials will ignore such nonsense.
More to point, the Fed cannot restore confidence in the thrifts by flooding commercial banks
with excess money. Stop-go-stop monetary policy will eventually lead to inflation and a real credit
crunch. The Federal Reserve has no role to play on the committee to re-elect the President. Happily,
central bank officials appear to agree with this view.
Fed Governor Wayne Angell told the National Grain Trade Council the other day that "illconceived monetary policies will raise uncertainty about future prices and make investment decisions less efficient." Repeated speed-ups and slow downs in money growth, he added, will waste
economic resources and lead to lower living standards. "Needless to say, the Federal Reserve is
trying to avoid these costs by pursuing the goal of price stability" as one key to achieving maximum
prosperity.
He added that trade policies which increase real economic activity will reduce the temptation
to use Fed policy to boost short-term growth and thus damage long-term performance. "The rate
of price increases can be edged down while real economic activity remains relatively vigorous."
A key element in the campaign to pressure the Fed into printing more money is the allegation
that bankers need fresh cash so they can make loans. In fact, banks already have plenty of money.
Not only have bank reserves been rising at close to a double digit rate since last winter, bank holdings
of Treasury and state and local bonds have gone up almost $50 billion, a 13 percent rate of gain.
Bank loans, by contrast, have hardly changed over the last seven or eight months. John P.
LaWare, a member of the Fed, claims this is because banks are "backing away from making loans
at all and [are] reluctant to renew loans except for the most creditworthy borrowers." According
to another leading expert on financial institutions, loans to commercial and industrial firms at the
nation's banks dropped $19 billion from May 1990 through June 1991. These data purportedly
"give credence to the cries of a credit crunch."
Red Herring
At its previous meeting in March, The Shadow Open Market Committee correctly identified
the so-called credit crunch as a red herring. The credit crunch continues to be a red herring today.
The drop in business loans neither indicates a shortage of money nor a refusal by bankers to lend.




32

Shadow Oven Market Committee

To the contrary, banks are cutting >an rates in an effort to drum up business. Anyone with the wits
or inclination to read history knows that bank loans (especially bank loans to business) always lag
the economic cycle. Banks always load up on Treasury bonds in the early stage of an expansion.
As activity rebounds, corporate cash flow naturally improves from higher profits and from
the sale of goods from inventory. Business people use this cash to repay debt—typically for many
months after the expansion gets under way. At the same time, sales of corporate bonds soared to
a rate of $160 billion in the second quarter, the highest since 1986. Companies used the proceeds
to pay off short-term debt. Net demand for credit from the corporate sector dropped to zero last
spring. That reflected both the aftermath of the recession and the beginning of the rebound in cash
flow.
Even though the growth of nonfederal, nonfinancial debt dropped to a postwar low this year,
the ratio of private debt to GNP has merely stabilized. This ratio has not gone down since the
recession began. From 1983 through 1989, it rose rapidly. The slowdown in debt was caused by
three factors: One, the borrowing binge of the 1980s inevitably had to end. Individual and corporate
borrowers had to rebuild their balance sheets. Two, as the rate of inflation declined, there was a
paralltx slowing in the growth of debt. Three, the demand for credit fell when the economy slipped
into recession.
Notably absent from this list are references to a refusal by bankers to lend or by the Fed to
add to the money supply (at least since last winter). As a matter of fact, the credit crunch is a myth.
Fed officials created the myth of a credit crunch in 1990 to divert attention from the fact that monetary
policy was too tight. Now that the Fed has eased, easy money advocates in the White House and
on Capital Hill have perpetuated the myth to pressure the Fed to pump up the money supply even
more.
In reality, there is little to suggest that structural problems in the financial system will block
the recovery. While some real estate developers are having trouble getting credit, that is appropriate.
Bankers are correct in tightening up. The last thing the U.S. needs at present is more empty office
buildings or failed banks.
Economic recovery in 1991-92 should be largely internally financed. The improvement in
corporate profits and cash flow should obviate most borrowing needs. Indeed, on an overall basis,
nonfinancial corporations were modest net suppliers of funds to the credit market in the second




33

September 29-30,1991

quarter. Meanwhile, bank profits are improving on new loans. A recent Federal Reserve survey
of loan officers showed that fewer banks were tightening credit standards than in the fourth quarter
of 1990.
The difficulties in the banking system are real enough. Demand for credit is weak, and lenders
are properly cautious about lending to marginal borrowers. The economy went into recession
because the Federal Reserve overdid its preemptive strike against inflation, not because lenders
went on strike against borrowers. Now that the Federal Reserve is once again adding to the supply
to high powered money, the economy is coming back.
In the end, responsibility for ending the recession lies with the institution that caused it—the
Federal Reserve. Don't be deceived by the canard that U.S. banks are so weak that when the Fed
doles out a few bucks, no one will use them. The real story is that if the Fed puts money in the
marketplace, someone, somewhere will use it. As the U.S. Chamber of Commerce warned the other
day, "many analysts and policy makers mistakenly believe the Fed can jumpstart the economy with
a flood of new money. It has not and it should not."
Expansion or Double Dip
Economists have sharply divided over whether the sluggish pattern in the labor market during
the last several months suggest continued expansion or a double dip recession. The consensus, by
a wide margin, is that the limited gains in jobs since April point to sluggish growth for an indefinite
period—perhaps well into 1993. On September 6, the Labor Department reported that payroll
employment rose 34,000 in August after falling a revised 73,000 in July. Labor also said that the
average work week rose by 0.3 hour, partly offsetting July's drop of 0.5 hour.
We take a different tack. Our comparison of the current cycle with the eight earlier postwar
downturns makes plain that we are seeing a classic pattern. The 1990-91 slump was shorter and
shallower than its predecessors, but the track that it is taking is right on course with the typical
slump since World War II. Most important, it is characteristic for payroll employment to hit bottom
and then move sideways for anywhere from four to eight months.
Our advice—to portfolio mangers and to the Fed—is to be patient. The rapid improvement
in profitability which is already underway will soon lead to increased demand for labor, and thus,
in time, to higher income and spending. Indeed, the underlying trend in real retail sales—despite
ragged ups-and-downs from month to month—makes clear that business must boost its orders to
rebuild inventories of consumer goods and materials.




34

Shadow Open Market Committee

As it is, new orders for consumer durables averaged almost $82 billion per month in the three
months ended July, up at an annual rate of more than 20 percent from the comparable period ending
in March. Our Baseline Forecast does not suggest a large inventory cycle in 1991-92. However,
actions to rebuild inventories should play an important role in kicking off the growth process.
Our analysis of the real economy measured in 1987 dollars shows that business activity turned
up modesdy, but decisively in the second quarter. By contrast, the current 1982 dollar estimate
shows a small decline. The Commerce Department expects to convert to a 1987 base for measuring
real GNP in later November when it releases revised data for the third quarter. At the same time,
Commerce plans to shift the emphasis of its report to gross domestic product from gross national
product. (The two measures are very similar. GDP is GNP less net investment income from
overseas.)
Gross national product in 1987 dollars rose at an annual rate of almost $9 billion in the second
quarter, after falling $34 billion in thefirstquarter and $38 billion in the fourth. The principal factor
in the turnaround was consumer spending, which rose almost $19 billion. The increase was concentrated entirely in outlays for nondurables and services. Business investment was down, but only
by $5 billion, following a $23 billion slump during the winter months.
Housing posted a small increase. Inventory investment made a modest contribution to the
upswing (the rate of decline was slower in the second quarter than in the first). However, this was
more than offset by a cutback in the trade surplus. Imports of goods and services rose more than
exports. On balance, these data point to the beginning of a solid, sustainable upswing.




35

REFLATION BEGINS: BANK RESERVES ARE GOING UP AT A RAPID RATE
1
2

9-30 ,1991

M
0
N
T
H

olem

•Si

C
H
A
N
G
E
S




22.5'/-|
15.0'/

CO

-7.5*
1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990
Notes: The chart shows yeap-ovep-yeap changes in total bank pesepves
less the Mean pate of change (4.42X) fpoM 1960 through 1991.
Bank pesepves ape the FRB Monetary base less currency held by
the public. The vertical lines show official recessions.
Soupces

Citibase; Heinewann EconoMic Research

SPENDING NONEV IS UP; THRIFT ACCOUNTS ABE DOWN

D
E
U
I
A
T
I
0
N
F
R
0
N
N
0
R
N

CO

1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990
Notes: The chart shows year-over-year changes in M-l (currency and transaction balances) and in non transact ion parts of M-2 (Mostly individual thrift accounts), less the Mean change 1960-1991 - respectively, 5.9% and 9.3%. Uertical lines show official recessions.
Sources: Citibase; HeineMann EconoMic Research




September 29-30,1991

Corporate Profits -1990-1991
(Billions of Dollars - Seasonally Adjusted Annual Rates)
INDUSTRY:
[~ 19901
Manufacturing
•
Durable Goods
Primary Metals
$4.1
Fabricated Metal
4.9
Machinery, ex Elec.
6.7
6.8
Elec & Electronic
Motor Vehicles
-7.0
Other
15.6
Total Durables
31.1
Nondurables
Food & Kindred
14.2
Chemicals
21.3
Petroleum & Coal
4.3
Other
17.9
Total Nondurables
57.7
Total Manufacturing
88.8
Services
Transport & Pub Util
41.6
Wholesale & Retail
41.5
Other
45.9
Total Services
129.0
Total Pom. Nonfinancial
217.8
Foreign
56.9
Total Nonfinancial
274.6
Private Financial
-2.8
Federal Reserve
21.6
TOTAL PROFITS
293.3

19901J

1990021

199003r 1990041

CHANGE CHANGE
Q/QT
^

M H M M H H

$4.9
6.4
7.3
8.6
-7.2
17.4
37.4

$5.4
6.0
7.9
7.8
-4.3
16.7
39.5

$3.6
4.8
6.3
6.6
-5.4
14.3
30.2

$2.4
2.4
5.2
4.3
-11.2
14.1
17.2

$14
2.0
5.8
5.9
-14.2
11.3
12.2

$1.4
4.0
5.6
5.0
-11.0
11.9
16.9

0.0%
100.0%
-3.4%
-15.3%
NM
5.3%
38.5%

-74.1%
-33.3%
-29.1%
-35.9%
NM
-28.7%
-57.2%

10.9
21.9
1.0
18.9
52.7
90.1

15.3
22.7
3.7
19.6
61.3
100.8

15.7
22.1
3.7
19.4
60.9
91.1,

14.8
18.6
8.7
13.8
55.9
73.1

17.1
16.2
10.5
11.1
54.9
67.1

18.4
18.8
4.8
13.1
55.1
72.0

7.6%
16.0%
-54.3%
18.0%
0.4%
7.3%

20.3%
-17.2%
29.7%
-33.2%
-10.1%
-28.6%

41.5
39.2
45.7
126.4
216.5
52.9
269.4
-4.7
20.8
285.5

41.9
44.4
44.6
130.9
231.7
48.9
280.6
-2.9
21.1
298.8

42.8
39.5
45.9
128.2
219.3
57.6
276.9
-0.8
22.6
298.7

40.2
42.8
47.4
130.4
203.5
68.0
271.5
-2.9
21.7
290.3

41.9
46.2
43.7
131.8
198.9
68.2
267.1
1.3
21.2
289.6

43.7
47.6
39.7
131.0
203.0
57.9
260.9
2.8
20.4
284.1

4.3%
3.0%
-9.2%
-0.6%
2.1%
-15.1%
-2.3%
NM
-3.8%
-1.9%

4.3%
7.2%
-11.0%
0.1%
-12.4%
18.4%
-7.0%
NM
-3.3%
-4.9%

Profits are pretax, adjusted for inventory profits or losses.
NM = Not Meaningful
Sources: Bureau of Economic Analysis; Heinemann Economic Research




199T0lT 199102T

38

GROSS NATIONAL PRODUCT
(Billions of 1987 Dollars)

Gross National Product ($87)
Pet Chg
Personal Consumption ($87)
Pet Chg
Durables ($87)
Pet Chg
Nondurables ($87)
Pet Chg
Services ($87)
Pet Chg
Business Investment ($87)
Pel Chg
Structures ($87)
Pel Chg
< Prod. Dur. Equip. ($87)
3
Pet Chg
Residential Invest. ($87)
Pet Chg
Change in Inventory ($87)
Exports ($87)
Pet Chg
Imports ($87)
Pet Chg
Net Exports ($87)
Government Purchases ($87)
Pet Chg
Final Domestic Sales ($87)
Pet Chg
GNP Deflator (1987=100)
Pet Chg
Fixed Weight Deflator (1987=100)
Pet Chg

190
$4,836.2
1.00%
$3,198.9
1.53%
$468.8
15.00%
$1,027.5
-2.45%
$1.702.6
0.57%
$489.9
5.14%
$135.1
1.80%
$354.8
6.45%
$216.9
14.90%
($11.9)
$610.6
7.54%
$626.9
0.32%
($16.3)
$958.7
4.11%
$4,864.4
2.96%
111.1
5.62%
111.4
5.96%

II'90
$4,849.8
1.13%
$3,201.8
0.36%
$455.6
-10.80%
$1,023.3
-1.63%
$1,722.8
4.83%
$482.9
-5.59%
$133.1
-5.79%
$349.8
-5.52%
$210.6
-11.12%
$10.6
$605.2
-3.49%
$629.9
1.93%
($24.7)
$968.7
4.24%
$4,863.9
-0.04%
112.2
3.97%
112.5
4.01%

lll'90
$4,869.9
1.67%
$3,223.0
2.67%
$458.8
2.84%
$1,028.7
2.13%
$1,735.6
3.01%
$495.2
10.58%
$134.4
3.96%
$360.8
13.18%
$199.2
-19.96%
$8.8
$613.4
5.53%
$640.6
6.97%
($27.2)
$970.7
0.83%
$4,888.3
2.02%
113.2
3.61%
113.5
3.60%

Source: Bureau of Economic Analysis; Heinemann Economic Research



IV'90
$4,831.6
-3.11%
$3,199.4
-2.90%
$443.2
-12.92%
$1,012.7
•6.08%
$1,743.5
1.83%
$485.3
-7.76%
$127.0
-20.27%
$358.3
-2.74%
$188.0
-20.66%
($27.1)
$628.7
10.36%
$623.8
-10.08%
$4.9
$981.1
4.35%
$4,853.8
-2.79%
114.4
4.16%
114.7
4.30%

l'91
$4,797.4
-2.80%
$3,188.5
-1.36%
$428.0
-13.03%
$1,007.9
-1.88%
$1,752.6
2.10%
$462.0
-17.87%
$124.0
-9.12%
$338.0
-20.81%
$174.8
-25.26%
($31.1)
$622.9
-3.64%
$599.6
-14.64%
$23.3
$980.0
-0.45%
$4,805.2
-3.95%
115.8
5.16%
116.1
4.97%

ll'91
$4,806.4
0.75%
$3,207.4
2.39%
$424.7
-3.05%
$1,013.6
2.28%
$1.769.2
3.84%
$457.0
-4.26%
$119.5
-13.74%
$337.5
-0.59%
$175.9
2.54%
($30.6)
$628.3
3.51%
$615.0
10.68%
$13.3
$983.3
1.35%
$4,823.7
1.55%
116.8
3.47%
117.0
3.14%

1988
$4,703.4
4.16%
$3,114.7
3.50%
$450.4
6.37%
$1,019.3
1.80%
$1,645.1
3.81%
$477.2
7.25%
$133.6
-0.04%
$343.6
1u...i9%
$224.5
-0.81%
$26.4
$526.7
17.15%
$595.8
5.57%
($69.0)
$929.6
0.88%
$4,746.0
3.13%
103.6
3.61%
103.7
3.67%

1989
$4,809.1
2.25%
$3,172.7
1.86%
$458.8
1.88%
$1,031.6
1.20%
$1,682.3
2.26%
$487.8
2.22%
$134.9
0.95%
$352.9
2.71%
$215.5
-4.04%
$25.1
$584.1
10.90%
$621.4
4.31%
($37.3)
$945.5
1.71%
$4,821.4
1.59%
108.1
4.37%
108.3
4.44%

1990
$4,846.9
0.78%
$3,205.8
1.04%
$456.6
-0.48%
$1.023.1
-0.82%
$1,726.1
2.61%
$488.3
0.11%
$132.4
-1.85%
$355.9 c
0.86% "*
$203.7
-5.47%
($4.9)
$614.5
5.20%
$630.3
1.43%
($15.8)
$969.8
2.57%
$4,867.6
0.96%
112.8
4.27%
113.0
4.39%

1*90
THE ECONOMY:
Gross National Product ($87)
Personal Consumption ($87)
Durables ($87)
Nondurabies ($87)
Services ($87)
Business Investment ($87)
Structures ($87)
Prod. Dur. Equip. ($87)
Residential Invest. ($87)
Change in Inventory ($87)
Exports ($87)
imports ($87)
Net Exports ($87)
Government Purchases ($87)
Final Domestic Sales ($87)

$ Change

Pet Chg

$ Change

Pet Chg

$ Change

P e l Chg

$ Change

$11.9
$12.1
$16.1
($6.4)
$2.4
$6.1
$0.6
$5.5
$7.4
($33.8)
$11.0
$0.5
$10.5

1.00%
1.02%
1.35%
-0.54%
0.20%
0.51%
0.05%
0.46%
0.62%
-2.84%
0.92%
0.04%
0.88%
0.81%
2.96%
1.05%

$13.7
$2.9
($13.2)
($4.2)
$20.2
($7.0)
($2.0)
($5.0)
($6.3)
$22.5
($5.4)
$3.0
($8.4)
$10.0
($0.5)

1.13%
0.24%
-1.09%
-0.35%

$19.8
$21.2
$3.2
$5.4
$12.8
$12.3
$1.3
$11.0
($114)
($1.8)
$8.2
$10.7
($2.5)
$2.0
$24.4

1.67%
1.79%
0.27%
0.45%
1.08%
1.04%
0.11%
0.93%
-0.96%
-0.15%
0.69%
0.90%
-0.21%
0.17%
2.06%
0.93%

($38.1)
($23.6)
($15.6)
($16.0)

-3.11%
-1.93%
-1.27%
-1.31%
0.64%
-0.81%
-0.60%
-0.20%
-0.91%
-2.93%

$37.7
$33.1
($2.2)
($8.5)
$43.8

$ Change

Pet C h g

$ Change

($34.1)
($10.9)
($15.2)
($4.8)
$9.1
($23.3)
($3.0)
($20.3)
($13.2)
($40)
($58)
($24.2)
$18.4

-2.80%
-0.90%
-1.25%
-0.39%
0.75%
-1.91%
-0.25%
-1.67%
-1.08%
-0.33%
-0.48%
-1.99%
1.51%
-0.09%
-3.99%
-0.80%

$8.8
$18.9
($33)
$5.7
$16.6
($5.0)
($45)
($0.5)
$11
$0.5
$5.4
$15.4
($10.0)
$3.3
$18.5

$9.6
$35.3

1*91

Gross National Product ($87)
Personal Consumption ($87)
Durables ($87)
Nondurabies ($87)
Services ($87)
Business Investment ($87)
Structures ($87)
Prod. Dur. Equip. ($87)
Residential Invest. ($87)
Change in Inventory ($87)
Exports ($87)
Imports ($87)
Net Exports ($87)
Government Purchases ($87)
Final Domestic Sales ($87)
GNP ($87) Four qtr chg (%)




1990

IV 90

Pet Chg

GNP ($87) Four qtr chg (%)

THE ECONOMY:

111*90

11*90

$ Change

($11)
($48.6)

1.67%
-0.58%
-0.16%
-0.41%
-0.52%
1.86%
-0.45%

0.25%
-0.69%
0.82%
-0.04%
1.01%

H'91
Pet Chg
0.75%
1.62%
-0.28%

0.49%
1.42%
-0.43%
-0.38%
-0.04%

0.09%
0.04%
0.46%
1.32%

-0.86%
0.28%
1.58%

-0.89%

$ Change

111*91
Pet Chg

$7.9
($9.9)
($7.4)
($25)
($11.2)

($35.9)
$15.3
($16.8)
$32.1
$10.4
($34.5)

1.25%
-1.37%

2.62%
0.65%
-2.82%

$0.6
($2.5)
$3.1
($11.8)
($30.0)
$30.4
$8.9
$21.5
$24.3
$46.3

Pet C h g
0.78%
0.69%
-0.05%
-0.18%
0.91%
0.01%
-0.05%
0.06%
-0.25%
-0.63%
0.63%
0.18%
0.45%
0.51%
0.96%

0.15%

$ Change

IV*91
Pet C h g

1991
$ Change
Pet C h g




THE ECONOMIC LANDSCAPE IS CHANGING
P
E
R
C
E
N
T
0
F
G
N
P

13*

Business Fixed Investment:

12*
11*
18* I
9*

ipiipiipiliBl

1982 1983 1984 1985 1986 1987 1988 1989 1990 1991
Notes: The chart shows business fixed investnent in new plant and
equipment as a percent of gross national product< Measured,
respectively, in 1982 and 1987 dollars, underlying data
at seasonally adjusted annual rates.
Sources: Citibase; Heinenann EconoMic Research

THE ECONOMIC LANDSCAPE IS CHANGING
P
E 36,25*
R
C
E 35,08*/
N
T
0
F
5

8-

33.75*

32.50X

G
N
P 31.25/




Personal Consumption of Services:

Measure

BE*}*.

m

fen

m

mm
IMA
Measured in 1 8; Pol lars

*

I
1991

iimi,^ir;iiiiiiiiijmyiirmi^

1982 1983 1984 1985 1986 1987 1988 1989 1990
Notes: The chart shows personal consunption of services as a percent
of gross national product. Measured, respectively, in 1982
and 1987 dollars. Underlying data are at seasonally
adjusted annual rates.
Sources: Citibase; HeineMann EconoMic Research

H E I N E M A N N E C O N O M I C RESEARCH
Baseline Forecast • September 1991
1
hriK ECONOMY:
Groas Nauonal Product ($82)
Pet Chg
Personal Consumption ($82)
Pet Chg
Bunneas Investment ($82)
Pet Chg
Structures ($82)
Prod. Dur. Equip. ($82)
Reasdcnual Invest. ($82)
Pet Chg
Change io Inventory ($82)*
NctEaporta($82)
Government Purchases ($82) •
Pet Chg
Final Domestic Seles ($82)
Pet Chg
Gross N a i l Prod. ( $ Current)
Pet Chg
Disposable Income ($82)
Pet Chg
{Savings Rate (Percent)
Operating rYofiU($ Current)
Pet Chg
Industrial Prod. ( 1 9 8 7 - 1 0 0 )
Pet Chg
Housing Start* (Thou. Units)
Pet Chg
Auto Ssica (Million U o i u )

[

Pet Chg

[Total Ea»j>Joyment (Millions)
Pet Chg
Uncnmtoymcrsf Rale (Percent)
b o o p . Per Hour Non-farm B u s "
Pet Chg
1 Productivity Non-Farm B u s "
Pet Chg
Unit Labor Coat Non-Farm Bua**
Pel Chg
JGNP Deflator ( 1 9 8 2 - 1 0 0 )
Pel Chg
p r t Leas Energy ( 1 9 8 2 4 4 - 1 0 0 )
Pet Chg
P e d l Deficit ( $ Current N I A )

IV9QA~~
$4,153.4
-1.6%
$2,673.6
-3.4%
$519 4
0.1%
$1)6.4
$403.1
$163.3
-20.6%
($28.9)
(S8.8)
$834.8
6.7%
$4,191.1
•1.8%
$5,527.3
0.9%
$2,872.4
-3.5%
4.2%
$288.9
-14.8%
108.5
-7.0%
1.042
-27.8%
8.972
-27.4%
117.6
-09%
5.9%
139.5
3.8%
111.2
-1.1%
125.4
4.6%
133.1
2.5%
137.2
4.1%
($184.3)

191 A
$4,124.0
-2.8%
$2,663.7
-1.5%
$496.8
-16.3%
$113.7
$383.1
$151.8
-25.3%
($26.5)
$7.1
$831.1
-1.8%
$4,143.4
-4.5%
$5,557.7
2.2%
$2,861.9
-1.5%
4.2%
$286.2
-3.7%
105.8
-96%
915
-40.5%
8.230
-29.2%
116.9
-2.4%
6.5%
140.9
4.1%
111.2
0.0%
126.7
4.2%
134.8
5.2%
139.4
6.4%
($126.9)




192F

1192 F

1H'92 F

1V92 F

1990 A

1991 F

$4.1500
3.0%
$2,695.1
2.2%
$503.9
4.4%
$110.5
$393.4
$156.6
11.6%
($21.4)
($13.7)
$829.4
1.4%
$4,185.1
2.6%
$5,709.2
7.1%
$2,912.5
4.9%
4.8%
$294.9
15.6%
108.5
8.2%
1.078
36.2%
8.6
9.8%
117.4
1.4%
7.0%
143.7
3.5%
112.5
4.1%
127.7
-0.9%
137.6
3.9%
141.4
2.6%
($191.4)

$4,191.4
4.1%
$2,710.3
2.3%
$518.6
12.2%
$111.7
$4069
$163.8
19.7%
($17.3)
($18.1)
$834.0
2.3%
$4,226.8
4.0%
$5,805.2
6.9%
$2,953.3
5.7%
54%
$310.8
23.5%
111.1
9.7%
1.107
11.3%
8.8
12.1%
117.9V
1.9%
6.8%
144.9
3.4%
113.6
3.9%
127.6
-0.5%
138.5
2.7%
142.3
2.5%
($211.5)

$4,239.5
4.7%
$2,725.9
2.3%
$542.1
19.4%
$112.0
$430.1
$170.5
17.4%
($14.3)
($2)6)
$836.9
1.4%
$4,275.5
4.7%
$5,902.6
69%
$2,983.1
4.1%
5.8%
$321.5
14.4%
112.5
5.4%
1.155
18.2%
9.1
13.8%
118.6
2.2%
6.5%
146.2
3.6%
114.5
3.2%
127.7
0.4%
139.2
2.1%
143.1
2.3%
($216.9)

$4,287.2
4.6%
$2,745.0
2.8%
$551.9
7.4%
$112.1
$439.7
$176.4
14.6%
($14)
($23.4)
$8387
0.8%
$4,312.0
3.5%
$6,010.3
7.5%
$3.0104
3.7%
5.8%
$335.7
18.9%
115.8
12.3%
1.227
27.5%
9.5
18.3%
119.3
2.6%
6.2%
147.4
3.2%
115.2
2.3%
128.0
0.8%
140.2
2.8%
144.2
3.1%
($238.4)

$4,337.8
4.8%
$2,763.0
2.6%
$5635
8.7%
$1135
$449.9
$184.5
19.7%
$9.9
($24.2)
$841.2
1?%
$4,352.2
3.8%
$6,124.1
7.8%
$3,040.7
4.1%
6.0%
$343.9
10.2%
118.0
7.7%
1.292
22.8%
9.7
9.5%
119.7
1.4%
6.0%
149.0
4.4%
115.7
1.9%
128.8
2.5%
141.2
2.8%
145.3
3.2%
($220.2)

$4,388.4
4.7%
$2,779.5
2.4%
$5784
11.0%
$115.7
$462.7
$192.2
17.7%
$16.0
($25.2)
$847.5
3.1%
$4,397.6
4.2%
$6,245.1
8.1%
$3,065.5
3.3%
6.2%
$354.1
12.3%
120.4
8.2%
1.386
32.4%
10.0
13.2%
120.6
2.7%
5.7%
151.1
5.8%
116.6
3.0%
1296
2.7%
142.3
3.2%
146.7
3.9%
($189.2)

$4,157.3
1.0%
$2,681.6
0«%
$515.4
1.8%
$120.9
$3946
$176.9
-5.4%
($5.4)
($33.8)
$822.6
2.5%
$4,196.5
1.1%
$5,465.2
5.1%
$2,893.5
0.9%
4.6%
$298.3
-4.3%
109.2
1.0%
1.203
-13.4%
9.508
-4.1%
117.9
0.5%
5.5%
137.2
3.9%
111.3
-0.5%
123.4
4.4%
131.5
4.1%
134.9
5.2%
($166.1)

$4,146.1
-0.3%
$2.6874
0.2%
$504.5
-2.1%
$111.4
$393.1
$1562
-11.7%
($22.9)
($9.3)
$830.3
0.9%
$4,178.3
-0.4%
$5,671.1
3.8%
$2,901.4
0.3%
4.7%
$294.1
-14%
107.9
-1.1%
1.025
-14.8%
8.5
-10.7%
117.3
-0.5%
6.8%
143.0
4.2%
112.2
0.8%
127.5
3.4%
136.8
4.0%
1409
4.4%
($178.7)

5.5%
5.4%
8.1%
8.2%
$8660
7.4%
6.593
-0.3%
94.3
$3.1

$4,118.9
-0.5%
$2,680.5
2.5%
$498.5
1.4%
$109.5
$389.0
$1524
1.6%
($26.5)
($12.6)
$826.6
-2.1%
$4,158.0
1.4%
$5,612.4
4.0%
$2,877.9
2.3%
4.2%
$284.4
-2.5%
106.4
2J%
998
41.3%
8J58
6.4%
117.0
0J%
6.8%
142.5
4.6%
111.4
0.7%
128.0
4.2%
136.3
4.5%
140.5
3.3%
($185.0)

FINANCIAL MARKETS;
7.74%
643%
|PcdcraJ Funds Rate
6.99%
602%
hrnrec-flnonth Bills (Discount)
10.00%
9.19%
(Prime Rate. Major Banks
8.55%
8.20%
30-Year Treasury Bonds
$835.4
$822.6
Money Supply ( M - l , $ Current)
64%
3.5%
Pet Chg
6.719
6.653
Velocity (Ratio: G N F to M l )
•3.9%
-2.5%
Pet Chg
84.6
84.3
bradc-Weighted $ ( 1 9 7 3 - 1 0 0 )
($2.5)
($1.5)
Memo: OCC Purchase.
1A «* Actual F * Forecast Billions of dollars unless noted.
1* Adjusted for Commodity Credit Corp. purchases. * 'Compensation productivity and unit
[Source: Ohbasc. Heinemann Economic Research

IV91 F

5.3%
5.1%
8.1%
7.8%
$882.7
8.0%
6.576
-1.0%
94.0
($3.9)

5.8%
5.4%
8.0%
7.9%
$897.7
7.0%
6.575
-0.1%
93.0
($2.0)

6.2%
5.6%
8.8%
8.1%
$911.5
6.3%
6.594
1.2%
90.2
$5.9

6.3%
5.8%
9.0%
8.3%
$923.5
5.4%
6.631
2.3%
91.1
$3.3

6.6%
60%
9.3%
8.4%
$932.6
4.0%
6.696
40%
92.0
($2.9)

8.1%
7.5%
10.0%
8.6%
$811.4
3.5%
6.735
1.5%
894
($1-8)

HI91 F ~

11*91 A

5.86%
5.56%
8.67%
8.39%
$850.7
7.5%
6.597
-3.3%
93.0
$68

labor costs are index numbers. 1982 » 100.
.„

....

._

, . —

.

_

1992 F
$4,313.2
4.0%
$2,753.3
2.5%
$559.0
10.8%
$113.3
$445.6
$180.9
15.9%
$2.6
($23.6
$841.1
1.3%
$4,334.3
3.7%
$6,070.5
7.0%
$3,024.9
4.3%
5.9%
$338.8
15.2%
116.7
8.1%
1.265
23.4%
9.6
12.8%
119.5
1.9%
6.1%
148.4
3.8%
115.5
3.0%
128.5
0.8%
140.7
2.9%
144.8
2.8%

(S216.2J

5.8%

6.2%

*<;%

5-7% 1

b.i*
$858.7
5.8%
6.605
-1.9%
91.4
$11

8.8% j
8.2%
$916.3
6.7%
6.624
0.3%
91.6
$1.1

I- ""° A I
[THE E C O N O M Y :

$ Change
$17.2

Gross National Product ($82)

Pel Chg
1.67%

$ Change
$4.6

|
Pet Chg
0.44%

IH'90A

y

1VQQA

|

$ Change
$149

Pet Chg
1.44%

$ Change
($16.6)

Pet Chg
-1.58%

$ Change
$39.5

Pet Chg
096%

Personal Consumption ($82)

$7.4

0.72%

$1.5

0.14%

$18.0

1.74%

($23.2)

-2.21%

$24.8

0 60%

Business Investment ($82)
Structures ($82)
Prod. Dur. Equip. ($82)

$6.2
$0.7
$5.4

0.60%
0.07%
0.53%

($6.2)
($2.9)
($3.3)

-0.60%
-0.28%
-0.32%

$10.9
$1.5
$9.5

1.05%
0.15%
0.92%

$0 1
($6.0)
$6.1

001%
-0.57%
0.58%

$93
($1.5)
$10.9

0.23%
-0 04%
0.26%

Residential Invest. ($82)

$6.5

0.63%

($5.5)

-0.53%

($9.8)

-0.95%

($9.7)

-0.92%

($10.2)

-0.25%

($23.1)
$12.5
$7.7

-2.25%
1.22%
0.75%

$19.8
($9.2)
$4.2

1.91%
-0.89%
0.41%

($4.6)
($19)
$2.3

-0.45%
-0.18%
0.22%

($34.9)
$37.7
$13.4

-3.33%
3.59%
1.28%

($244)
$20.3
$19.7

-0.59%
0.49%
0.48%

$27.8

2.71%
1.34%

($6.0)

-0.58%
1.05%

$21.4

2.07%
0.98%

($19.4)

-1.85%
0.49%

$43.7

1.06%

Pet Chg
3.0%

$ Change
$41.4

Pet Chg
4.1%

$ Change
($11.2)

Change in Inventory ($82)*
Net Exports ($82)
Government Purchases ($82)*
Final Domestic Sales ($82)
GNP ($82) Four qtr chg (%)

L

™A I

1

H'Ol A~""^

IIPOl F
Pet Chg)
-0.3%

$ Change
($29.4)

Pel Chg
-2.80%

($9.9)

-0.94%

$16.8

1.6%

$14.6

1.4%

$15.2

1.5%

Business Investment ($82)
Structures ($82)
Prod. Dur. Equip. ($82)

($22.6)
($2.7)
($20.0)

-2.15%
•0.26%
-1.91%

$1.7
($4.2)
$5.9

0.2%
-0.4%
0.6%

$5.4
$1.0
$4.4

0.5%
0.1%
0.4%

$14.7
$1.2
$13.5

14%
0.1%
1.3%

($110)
($9.5)
($15)

-0.3%
-0.2%
-0.0%

Residential Invest. ($82)

($11.5)

-1.10%

$0.6

0.1%

$4.2

0.4%

$7.2

0.7%

($20.7)

-0.5%

$2.4
$15.9
($3.7)

0.23%
1.52%
•0.35%

$0.0
($19.7)
($4.5)

0.0%
-1.9%
-0.4%

$5.1
($1.1)
$2.8

0.5%
*0.1%
0.3%

$4.1
($4.4)
$4.6

0.4%
-0.4%
0.5%

($17.5)
$24.5
$7.7

-0.4%
0.6%
0.2%

($47.7)

-4.55%
-0.64%

$14.6

1.4%
-0.9%

$27.1

2.7%
-0.5%

$41.7

4.1%
0,9%

($18.1)

-0.4%

Pet Chg
4.8%

$ Change
$50.5

Pet Chg
4.7%

$ Change
$167.2

Pel Chg
4.0%

[THE ECONOMY:
Gross National Product ($82)
Personal Consumption ($82)

Change in Inventory ($82)*
Net Exports ($82)
Government Purchases ($82)*
Final Domestic Sales($82)
GNP($82) Four qtr chg (%)

i

$ Change
($5.1)

"-MP

Pet Chg
-0.5%

1

^

$ Change
$31.1

$5.8

0.1%

IH'92 F ji

$ Change
$48.2

Pet Chg
4.7%

Personal Consumption ($82)

$15.6

1.5%

$19.1

1.8%

$18.0

1.7%

$16.5

1.5%

$65.9

1.6%

Business Investment ($82)
Structures ($82)
Prod. Dur. Equip. ($82)

$23.5
$0.2
$23.3

2.3%
00%
2.3%

$9.8
$0.2
$9.6

0.9%
00%
0.9%

$11.6
$14
$10.2

1.1%
0.1%
1.0%

$14.9
$2.2
$12.7

1.4%
0.2%
1.2%

$54.5
$20
$52.5

1.3%
00%
1.3%

$6.7

0.7%

$5.9

0.6%

$8.1

0.8%

$7.7

07%

$24.8

0.6%

$3.0
($3.5)
$2.9

0.3%
-0.3%
0.3%

$12.9
($18)
$1.7

1.2%
-0.2%
0.2%

$11.3
($0.8)
$2.5

1.1%
•0.1%
0.2%

$6.1
($10)
$6.3

06%
-0.1%
0.6%

$25.5
($14.3)
$10.8

06%
-0.3%
0.3%

$48.7

4.7%
2.8%

$36.5

3.5%
4.1%

$40.2

3.8%
4.5%

$45.4

4.3%
47%

$1560

38%

iTHE E C O N O M Y :

Gross National Product ($82)

Residential Invest. ($82)
Change in Inventory ($82)*
Net Export* ($82)
Government Purchases ($82)*
Final Domestic Sales ($82)
GNP($82) Four qtr chg 1%)




$ Change
$47.6

Pet Chg
4.6%

$ Change
$50.7

^t

^

100

Comparisons w i t h Previous

I
I




1

ndex

©

Cyclic:al Pe

<d

•"
"*

Recessions

100.2
100.1
100,0
99.9
99.8
99.7
99.6
99.5
99.4
99.3
99.2
99.1
99.0
98.9
98.8
98.7
98.6
98.5
98.4
98.3
98.2
98.1
98.0
97.9

12
Months From Cyclical Peak
Last 8 Recessions + 1990-91 Recession

15

18

GROWTH IN SERVICE EMPLOYMENT IS CYCLICAL

D
E
V
I
A
T
I
0
N
F -1.5Z
R
0
N -3.8% J

N
0 -4.5X
R
1947 1952 1957 1962 1967 1972 1977 1982 1987 1992
M
Notes: The chart shows yeap-ovep-yeap changes in total ewploMhent in
service-producing sectors (public and ppivate) less the Mean
pate of incpease (2.86 pepcent) fpoM 1947 thpough 1991. The
veptical lines show official periods of pecession.




Sources: Citibase; HeineMann EconoMic Research

D
E
U
I
A
T
I
0
N

NET INUESTHENT IS AT A POSTWAR LOW
8/.
47.
8

a
I

F
R
0
N
N
0
R
N




-47. J
-8'/.
1946 1951 1956 1961 1966 1971 1976 1981 1986 1991
Notes: The chart shows net investMent as a percent of net national
product, less the Mean ratio, 1946-1991. Net investMent is
gross doMestic investMent less econoMic depreciation plus net
foreign investMent. The vertical lines show official recessions.
Sources: Citibase; Heinenann EconoMic Research

D
£
U
I
A
T
I
0
N

•JO

I-

THE LONG-TERM EROSION IN CORPORATE PROFITABILITY
ll'/> \ Return on Equity:
Nonfinancial Corporations (Line)
Private Financial
Institutions
(Dot)

F
R
0
N
N
0
R
N




oo

1946 1950 1954 1958 1962 1966 1970 1974 1978 1982 1986 1990
Notes: The chart shows pretax corporate profits (IUA adjusted) as a
percent of net worth, less the Mean ratio, 1946-1990. Assets at
historical cost. FR6 national balance sheets and GNP accounts.
Sources: Citibase; Heinewann EconoMic Research

<

CO)

Z

<
CD I
-J

<
at

2

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COMMERCIAL BANKS NEED TO REBUILD THEIR BALANCE SHEETS
90.0^
82,5/,
75.0K-I

Loan/Deposit
Ratio - All
CoMMercial
Banks

67.5*
60.0X-I
1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990
Notes: The chart shows the ratio of total loans and leases held by
doMestic offices of all commercial banks to deposit and nondeposit liabilities, net of uncollected cash ileus. Seasonally
adjusted. The vertical lines show official periods of recession.
Sources: Citibase; Heinewann Econonic Research

D
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HOW BANKS ADJUST TO RECESSION - SECURITIES UP, LOANS DOWN

F
R
0
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N
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1968 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990
Notes: The chart shows gear-over-gear changes in commercial bank earning
assets: securities (line) and loans and leases (dot) less their
Mean chancres, 1968-1991 (respectively, 6.97, and 10.8X). The
vertical lines show official periods of recession.
Sources: Citibase; Heineaann Economic Research

Table 1

SOURCES AND USES OF FUNDS - 1988-1991
Seasonally Adjusted Annual Rates
($ Billions)
Qlt'89

TOTAL SOURCES:
fbomestic
Private Sectors
Financial
Commercial Banks
Nonbank Financial
Nontinancial
Corporations
Households
Other
Public Sectors
United States Government
Federal Agencies
Mortgage Pools
Federal Reserve
State and Local Governments
Foreign

TOTAL USES:
Domestic
Private Sectors
Financial
Commercial Banks
Nonbank Financial
Nontinancial
[
Households
Corporations
Agriculture and Other
Public Sectors
United States Government
Federal Agencies
Mortgage Pools
I
State and Local Governments
Foreign
Memo: Net Sales of Common Stock*

Qlll'89

Q|V^9

Ql'90

Qll'90

oyr9Q

QIV'90

Ql'91

$814.0
818.9
791.2
600.9
160.9
440.0
190.3
26.7
163.5
0.1
27.7
-6.0
-78.3
106.3
-1.6
7.3
-4.9

$833.1
700.7
631.2
354.0
183.7
170.3
277.2
20.2
259.0
-2.0
69.5
-9.3
14.8
111.6
-31.2
-16.4
132.4

$824.3
780.1
620.5
561.9
184.3
377.6
58.6
-22.1
82.3
-1.6
159.6
5.7
-2.7
161.1
-4.6
0.1
44.2

$995.6
992.6
744.0
444.8
184.1
260.7
299.2
25.0
275.6
-1.4
248.6
37.7
25.4
162.0
-6.3
29.8
3.0

$808.5
748.7
521.5
266.4
132.1
134.3
255.1
21.2
235.0
-1.1
227.2
36.2
-3.8
166.8
40.4
-12.4
59.8

$867.4
795.1
504.3
366.7
101.7
265.0
137.6
10.7
127.7
-0.8
290.8
63.3
48.7
116.9
24.4
37.5
72.3

$788.0
710.1
590.3
500.4
56.9
443.5
89 9
-11.6
101.9
-0.4
119.8
-2.7
-4.8
155.5
-25.9
-2.3
77.9

$564.8
532.4
255.8
185.8
134.2
51.6
70.0
40.8
31.5
-2.3
276.6
30.3
17.5
141.3
53.3
34.2
32.4

$813.9
820.8
558.6
25.3
5.4
19.9
533.3
264.0
217.4
51.9
262.2
100.1
22.5
106.3
33.3
-6.9
-98.7

$833.0
802.6
475.3
-0.9
20.0
-20.9
476.2
290.8
147.3
38.1
327.3
173.9
13.2
111.6
28.6
30.4
-146.3

$824.4
807.5
449.6
30.8
-4.6
35.4
418.8
291.8
83.1
43.9
357.9
185.0
-4.7
161.1
16.5
16.9
-79.3

$995.8
993.8
558.8
18.7
-13.7
32.4
540.1
377.2
111.2
51.7
435.0
247.3
9.7
162.0
16.0
2.0
-69.0

$808.4v
767.2
337.9
-13.6
-46.0
32.4
351.5
257.5
101.3
-7.3
429.3
228.2
17.1
166.8
17.2
41.2
-48.0

$867.4
837.7
384.3
40.9
-46.0
86.9
343.4
227.3
84.8
31.3
453.4
286.1
22.3
116.9
28.1
29.7
-74.0

$788.1
767.0
256.5
93.2
-9.3
102.5
163.3
154.0
20.2
-10.9
510.5
328.4
19.0
155.5
7.6
21.1
-61.0

$564.7
514.1
141.4
-53.2
-40.5
-12.7
194.6
162.6
46.0
-14.0
372.7
204.7
14.5
141.3
12.2
50.6
-12.0

•By nontinancial corporations. Discrepancies between sources and uses are due to rounding errors. Ql'91 data are preliminary.
Sources. Federal Reserve Board; Heinemann Economic Research




1988

1989

1990

$505.0
447.3
260.4
91.6
15.7
75.9
168.8
15.4
154.9
-1.5
186.9 !
32.1
-24.0
173.0
12.2
-6.4
57.7

$1,014.8
917.2
799.9
562.3
156.3
406.0
237.6
-12.5
250.8
-0.7
117.3
-9.4
37.1
74.9
10.5
4.2
97.6

$894.7
822.6
708.1
511.1
177.3
333.8
197.0
2.2
196.0
-1.2
114.5
-2.4
-0.5
125.8
-7.3
-1.1
72.1

$864.8
8116
590.1
394.6
118.7
275.9
195.5
11.3
185.1
-0.9
221.5
33.6
16.4
150.3
8.1
13.1
53.2

$504.9
557.9
148.7
-55.3
-23.7
•31.6
204.0
199.7
9.5
-5.2
409.2
241.8
-22.4
173.0
168
-53.0
11.0

$1,014.6
1008.3
685.4
127.7
2.2
125.5
557.7
314.9
184.6
58.2
322.9
157.5
449
74.9
45.6
6.3
-129.5

$894.5
883.6
551.4
54.5
4.8
49.7
496.9
285.0
159.5
52.4
332.2
151.6
25.2
125.8
29.6
10.9
-124.2

$865.0
841.5
384.5
34.8
-28.8
63.6
349.7
254.0
79.4

QIT91P

16.31
457.0
272.5
17.0
150.3
17.2
23.5
-63.0

Table 2

NET DEMAND FOR FUNDS -1988-1991
Seasonally Adjusted Annual Rates
($ Billions)
(Positive Number Indicates Net Supply; Negative Number Net Demand)
TOTAL NET LENDING - TOTAL NET BORROWING

-

J-

SECTOR:
Commercial Banks
Nonbank Financial
Households
Corporations
United States Government
I
State and Local Governments
!
Federal Agencies
Federal Reserve
Other Sectors
Total Domestic
Foreign

onw
$155.5
420.1
-100.5
-190.7
-106.1
-26.0
-100.8
-1.6
-51.8
-1.9
2.0

Qlll'89

QIV89

QT90

$163.7
191.2
-31.8
-127.1
-183.2
-45.0
1.6
-31.2
-40.1
-101.9
102.0

$188.9
342.2
-209.5
-105.2
-179.3
-16.4
2.0
-4.6
-45.5
-27.4
27.3

$197.8
228.3
-101.6
-86.2
-209.6
13.8
15.7
-6.3
-53.1
-1.2
1.0

Qll'90

Qlll'90

QIV'90

QP91

Q1I91P

1988

1989

1990

$178.1
101.9
-22.5
-80.1
-192.0
-29.6
-20.9
40.4
6.2 k
-18.5 '
18.6

$147.7
178.1
-99.6
-74.1
-222.8
9.4
26.4
24.4
-32.1
-42.6
42.6

$66 2
341.0
-52.1
-31.8
-331.1
-9.9
-23.8
-25.9
10.5
-56.9
56.8

$174.7
64.3
-131.1
-5.2
-174.4
22.0
3.0
53.3
11.7
18.3
-18.2

$39.4
107.5
-44.8
5.9
-209.7
-23.2
-1.6
12.2
3.7
-110.6
110.7

$154.1
280.5
-64.1
-197.1
•166.9
-41.4
-7.8
10.5
-58.9
-91.1
91.3

$172.5
284.1
-89.0
-157.3
-154.0
-30.7
-25.7
-7.3
-53.6
-61.0
61.2

$147.5
212.3
-68.9
-68.1
-238.9
-4.1
-0.6
8.1
-17.2
-29.9
29.7

*By nonfinancial corporations. Discrepancies between domestic and foreign are due to rounding errors. QH'91 data are preliminary.
Sources: Federal Reserve Board; Heinemann Economic Research




F
0
li
R

THE DROP IN DEBT REFLECTS SLOWER SPENDING, LOWER INFLATION

Q

a

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A
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1956 I960 1964 1968 1972 1976 1988 1984 1988 1992
Notes: The chart shows year-over-year changes in gross dOMestic product
(line) and in nonfinancial, nonfederal debt (dot), Minus their
Mean rates of change - respectively, 7.6H and 9.5X. In current
dollars. The vertical lines show official recession periods.
Sources: Citibase; HeineMann EconoMic Research

LEVERAGE IS LEVELING OFF
R
A
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I
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*

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D
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1955 1959 1963 1967 1971 1975 1979 1983 1987 1991
Notes: The chart shows the ratio of total nonfinancial, nonfederal debt
outstanding (quarterly averages of Month figures) to gross
doMestic product. Data are in current dollars. The vertical
lines show official periods of recession.
Sources: Citibase; HeineMann EconoMic Research

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Table 4
Federal Reserve Action and Monetary Growth
(Compound Annual Rates of Change)
(Memo)

Date

Reserve
Growth Rate
Month to Month

Jan 1080
Feb
Mar
Apr
May
Jun
Jul
Aug
Sep
Oct
Nov
Dec
Jan 1000
Feb
Mar
Apr
May
Jun
Jul
Aug
Sep
Oct
Nov
Dec
Jan 1001
Feb
Mar
Apr
May
Jun
Jul
Aug
SepPE

-5.00
-6.08
-5.73
•1.13
-7.83
-1.23
7.04
-7.24
0.50
11 8 0
4.58
11.85
0.03
1.04
3.75
2.65
-5.74
•0.28
-7.56
8.18
5.80
•5.85
12.47
20.74
3.82
10.11
-1.23
•5.05
16.05
4.25
3.13
13.56
1.80
1080
0.87
1000
3.01

Reserve
Growth Rate
Three-month
Moving Average
-0.03
-3.30
-5.00
-4.31
•4 00
-3.30
-0.37
-0.18
3.40
472
8.66
0.37
5.72
4.54
1.01
248
0 22
-1.12
-4.53
0.11
2.14
2.71
4.14
0.12
12.34
14.58
7.23
3.07
2.05
4.78
7.81
608
6.16

1001 -IN
6.01
1001 -IIH
6.16
0.16

Source: Federal Reserve Board; Heinemann Economic Research

(Federal Reserve Bank of St. Louis Monetary Base)

Table 1 - Part 1

26-Sep-01

Federal Reserve Action and Monetary Growth
($ Billions)
(1)

Date

Jan 1060
Feb
Mar
Apr
May
Jun
Jul
Aug
Sep
Oct
Nov
Dec
Jan 1000
Feb
Mar
Apr
May
Jun
Jul
Aug
Sep
Oct
Nov
Dec
Jan 1001
Feb
Mar
Apr
May
Jun
Jul
Aug
SepPE

(2)

Monetary
Base

286.8
287.5
280.3
286.4
280.0
2808
200.2
200.0
202.1
203.2
204.2
206.1
207.0
300.1
303.4
304.6
305.0
307.0
300.3
312.7
316.5
318.0
320.0
322.0
328.8
332.8
335.2
333.5
335.6
336.2
337.1
340.1
3437

(3)

Currency

213.2
214.1
215.3
215.7
216.6
217.2
217.8
218.7
210.2
220.0
220.5
222.2
224.5
226.6
228.4
230.3
231.0
233.7
235.7
236.4
241.5
243.0
245.0
246.4
251 6
255.1
2567
256.8
256.8
257.8
258.0
260.7
261.5

* includes Money Market Deposit Accounts
••(4+5+6+7+6+0)




(4)

Tout
Ad|usted
Bank
Reserves

736
73.4
74.0
72.7
72.4
726
724
72.2
72.0
73.2
73.7
73.0
73.4
73.5
75.0
74.3
74.0
74.2
73.6
74.3
75.0
74.1
75.0
75.6
75.2
777
78.5
760
78.8
78.6
78 2
70.4
82.2

(5)

Demand
Deposits

565.1
565.1
563.0
550.2
552.4
540.3
554.1
554.0
555.4
560.8
561.0
563.0
563.4
586.0
568.7
560.8
567.8
570.0
567.3
570.1
572.1
568.0
570.0
570.7
566.8
573.0
578.1
577.7
586.8
5030
503.1
507.0
500.1

(6)

Savings
& Small
Time
Deposits*

1050.6
1060.7
1064.2
1060.3
1071.6
10784
1080.7
2001.0
2000.5
2017.6
2028.1
2036.1
2040.7
20473
2055.8
2063.0
2065.3
2066.7
2072.0
20760
2070.8
2070.8
2070.7
2080.0
2081.1
2080.6
2008.0
21040
2100.7
2110.1
2108.7
2106.4
2106.8

(7)

Large
Time
Deposits

546.7
553.3
560.1
568.3
573.1
574.0
574.7
571.2
568.1
566.2
565.3
563.5
560.0
554 0
540.3
543.7
540.5
538.0
535.0
520.2
521.0
515.1
512.5
507.1
511.0
516.0
511.5
507.3
503.0
408.8
401.1
484.3
478.4

(8)

Nondeposit
Liabll.

310.1
310.1
316.6
305.0
302.5
301.4
206.0
286.4
275.5
266.5
264.5
257.0
252.0
251.2
247.0
242.0
2406
240.0
240.3
2530
240.7
240.3
2434
235.7
231.4
220.6
223.5
220 1
214.0
211.4
208.3
200.8
208.6

(0)

Foreign
Deposits

11.1
11.2
10.5
10.5
10.5
11.7
11.7
10.5
11.0
11.5
10.8
11.1
11.3
10.6
10.6
10.7
11.1
10.6
10.5
110
113
10.5
10.3
10.2
10.7
0.7
0.5
10.0
0.7
0.1
06
06
0.5

(10)

Treasury
Deposits

25.0
25.0
181
20.2
343
26.2
23.0
15.8
24.0
20.7
14.7
106
23.2
22.0
16.7
200
25.2
20.0
15.3
23.5
310
21.0
10.1
23.1
20.4
303
284
20.3
10.8
236
208
17.1
16.7

Total
Deposits**

3417.6
3426.3
3432.5
3432.5
3444.4
3441.0
3450.1
3430 8
3444 4
3443.1
3444.4
3451.2
3451.5
34520
3448.1
3450.1
3450.5
3457.2
3450.3
3463 7
3465.8
3444 4
3435.0
3427.7
3431.3
3457.2
3440.0
3430.4
3444.8
3446.0
3431.8
3425.1
3410.1




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Table 2
Federal Reserve Action and Monetary Growth
(Compound Annual Rates of Change)
Thistoaccounted for by changes In the:

Date

*

Jan 1980
fmb
Mar
Apr
May
Jun
Jul
Aug
Sep
Oct
Nov
Dec
Jan 1000
Feb
Mar
Apr
May
Jun
Jul
Aug
Sep
Oct
Nov
Dec
Jan 1001
Feb
Mar
Apr
May
Jun
Jul
Aug
SepPE




Monetary
Growth
fM-H
-2.73
1.40
•1.36
-5.12
-8.76
•3.83
8.70
1.25
2.00
0.70
1.30
7.30
2.78
8.87
5.58
4.81
-0 60
617
-1.04
8.54
784
•1.17
3.30
3.14
1.03
15.10
10.15
-0.72
14 23
1042
1.00
0.70
2.87
1080
0.02
1000
4.00

Federal
Reserve
Actions
(Monetary
Base
Growth)
3 64
2.07
7.78
•3.67
2.53
3.37
1.67
2.03
5.06
4.61
4.17
8.03
7.54
0.23
14.02
4 85
5.24
6.13
5.50
14.02
15.60
5.84
7.81
7.76
10.43
24.40
0.01
-5.02
7.82
217
3.26
11.22
13.42
1080
3.61
1000
8.80

Contflbutlon
of the
Money
Mutth
plier

Adjusted
Reserve
Ratio

Currency
Ratio

Savings
& Small
Time
Deposit
Ratio

-6 58
•6.06
2.56
-1 57
1.71
•246
•0.15
-5.36
-2.02
•1.45
•5.56
6.54
•8.85
-11 20
2.34
-4.66
-7.21
-1.06
712
1.62
3.53
•1.68
-0.07
•2.51
0.14
-2.07
•2.80
-1.41
3.43
5.00
•0.00
-2.78
•1.08
-1.55
-0.73
-0.24
-4.78
2.27
-672
•2.02
-0.36
-0.33
-8.44
-2.00
-607
•6.07
-0.24
5.03
-5.84
•6.02
2.11
-2.34
•1.06
-1.05
1.80
-6 64
-7.68
-4.04
-5 48
-1.70
•2.81
•5.00
-7.78
-7.01
•0.00
1.80
-1.55
-4 52
•4.38
•4 83
•2.65
•3.00
-17.50
2.11
-16.07
•0.21
•8.37
-2.01
1.47
1.15
-3.52
520
4.80
-0.16
•6.23
6.40
8.70
4.30
626
085
-127
0.27
•2.83
5 68
0.77
-1.52
-10.56
•11.03
-0.73
1080
1060
1080
•2.60
•2.84
0.45
1000 1000 -IIH
1000 -IIH
1000 •IIH
-4 80
•4.82
•0.53
1001 -IH
1001 -IH
1001 •IH
1001 -IH
1001 •IH
1001 •IH
0.48
•0.05
8.53
-172
-0.78
1001 -IIH
1001 -IIH
1001 •IIH
1001 -IIH
1001 -IIH
1001 •IIH
0.30
-4 45
•5.48
4.85
-0.03
-3.50
•0.18
-378
-0.17
-3.68
5 84
-1 45
-0.08
4 80
4.30

Large
Time
Deposit
Ratio

NonDeposit
Liability
Ratio

•0 83
•0.62
-0 83
•1.26
•1.05
-045
0.47
0.31
0.42
066
012
0.45
0.20
0.65
0.71
1.15
0.12
0.42
0.04
0.70
0.86
0.35
0.32
0.53
-0.81
0.15
0.74
0.30
0 01
0.89
067
1.06
0.65
1080
•0.22

-0.07
0.00
-0.72
1.01
-0.11
•0.05
0.65
0.05
1.07
1.06
0.20
0.85
0.37
0.32
0.48
0.70
•0.68
0.14
-0.13
-0.23
0.30
-0.00
0.56
0.70
0.27
0.43
0.67
0.25
060
040
0.27
0.02
0 15
1080
0.40

•1.00
-0.10
-1.01
-1.03
•2.33
-1.58
0.54
-1.14
-0.23
0.08
-0.81
0.24
-0.61
0.60
-0.10
•0.55
•0.66
0.42
-1.25
0.58
0.41
-1.02
0.34
0.12
-1.41
1.42
0.84
-0.57
2.22
1.88
0.15
1.02
0.36
1080
-0.71
1000 •IIH
-0.17

1000 •IIH
0.53

1001 -IH
0.73

0.36

0.81
0.08
0.75

1000 •IIH

0.70
043
0.03

0.47

1000 •IIH
-0.05
1001 -IH
•0 04

0.02
1001 •IIH

0.15
-0 32
0.14

-0.21
-0.00
0.73
-0.24
-1.28
0.71
0.31
0.66
-0.83
0.40
0.54
-0.46
-0.35
0.13
0.52
-0.56
-0.47
0.40
0.50
-0.75
•0 60
0.88
0.17
-0.35
-0.63
-0.04
0.02
0.62
0.07
•0.30
0.24
0.38
0.04
1080
0.02

0.01
1001 •IH

1001 -IIH

Treasury
Deposit
Ratio

0.02
-0.01
0.06
-0.01
-0.01
-0.11
0.01
0.11
-0.04
-0.04
0.06
•0.02
•0.02
0.08
0.00
-0.01
•0.04
005
000
-0 04
•0 02
0.07
002
0 01
-0.06
0.11
0.02
-0 04
004
0.06
-0 04
0.01
001
1080
0.00

0.22
1001 -IH

1001 -IIH

Foreign
Deposit
Ratio

1001 -IIH
•0.01
•0.03
0.00

0.22
0.27
0 08




s

-

I

b» kj *»

N - O O O M M r o O N -

O O - 6 W « 3 B N * O I I U *

0000666666666660606666----666

-•">»«

65

0 0 0 0 0 0 6 6 6 0 0 6 6 0 0 6 6 0 0 6 6 0 0 0 0 0 6 6 6 0 0 6 0

6 0 0 0 0 0 0 0 6 0 0 0 6 0 0 0 6 0 0 0 0 0 6 0 0 0 6 6 0 0 0 6 6

0 0 0 0 0 0 0 0 0 0 0 0 0 6 6 0 0 0 0 0 0 0 0 - 0 0 0 0 0 0 6 6 6
l > i o * * u i i i w u i o b b b N b N u i u u i * N ^ b o u i ^ N O ^ M i p l <
U l Q « a « W O t S » O C b ^ N i o S o u O ( O N O B U O M Q ( B S o O > a )

O C D U ) O W 1 O U * - O - N O W ( D 0 ) O 6 M U C -

0 0 0 0 0 0 0 6 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 6 6
6666
•
W
6
^ f t a s o i b b b i v a n i ^ i r b i p 6 u i i o i i » 4 > a*»* o.u - »* >W b uU) M **io» r J) 6* *
3 ow
> - < - ( Dr o b -

C U * -* C O
D
B J

-

•• a a s u
<

K) b

U I - W 6 - W S M O O C - W O O O U N O

M U U - - - ' O O O O f O O O

> 6 f t o a u i o a s i .
r o ' c u i A a b * N i s Q
t n u i N u i a o u u i u c

O O l N 5 * 0 - O S * O l f O * U l f 3 5 i s s M O u N O N 6 W

* ^ a * g ^ o c a f o - » u u i u i « > - ' U U O > u i o b u a > > » f O ' * u i a i a o o o

©

D

m

Shadow Open Market Committee




Table 4
Federal Reserve Action and Monetary Growth
(Compound Annual Rates of Change)
(Memo)

Date
Jan 1080
Fmti
Mar
Apr
May
Jun
Jul
Aug
Sep
Oct
Nov
Dec
Jen 1000
Feb
Mar
Apr
May
Jun
Jul
Aug
Sep
Oct
Nov
Dec
Jan 1001
Feb
Mar
Apr
May
Jun
Jul
Aug
SepPE

Reserve
Growth Rate
Month to Month
-7 80
-321
10.26
-10 16
•4 84
3.37
•3.26
-3.27
12.28
5.05
8.51
3.31
-7.82
1.65
27.43
-10.64
•4.74
3.20
-0.28
12.03
11.01
-13.40
15.50
10.03
-8 17
48.06
13.08
-21.80
34.03
-3.00
•5.04
20.05
5077
1080
0.10
1000
3.00
1001 -IH
10.68
1001 -IIH
21 6 3
10.04

Reserve
Growth Rate
Three-month
Moving Averaoe
•1.88
-576
-0.25
-4 04
•4.58
•6.88
•1 5 8
•1 0 5
1.02
4.60
861
5.62
1.33
•0.06
7.00
6.15
4.02
•4 0 3
-358
2.01
4.80
348
4.87
4.05
640
17.31
18.32
13.06
8.40
3.04
8 36
3.70
21.63

Source: Federal Reserve Board; Heinemann Economic Research

Shadow Open Market Committee

FISCAL POLICY LACKS DIRECTION AND CREDIBILITY
Mickey D LEVY
CRT Government Securities, Ltd.

The track record and credibility of fiscal policymakers continue to deteriorate. Federal
spending growth is rising rapidly, and massive budget revisions have dramatically raised deficits.
The federal debt-to-GNP ratio is rising sharply and will exceed 50 percent in fiscal year 1992 for
the first time since the late 1950s. Official projections of lower deficits have been postponed. The
response of Congress to these unfavorable trends has been an affront to fiscal responsibility. Within
a year of enacting the Budget Enforcement Act of 1990 with much fanfare, the House and Senate
passed an extension of unemployment insurance benefits—the $5 billion bill was vetoed by the
President—and Congress is now considering a new expensive spending package, in direct violation
of the new budget discipline.
Not all aspects of the budget outlook are dismal: excluding the costs of deposit insurance,
under current law spending growth and deficits should fall beginning in 1993, and the primary
deficit (deficit excluding net interest outlays) is very small and should become a primary surplus
by FY 1993 or 1994, depending on the net costs of deposit insurance. However, the more favorable
out-year budget projections require adhering strictly to the discretionary spending caps imposed by
the Budget Enforcement Act, and thefiscalpolicymakers give us no reason to believe them.
This lack of progress on reducing the deficit and the continued bias toward deficit spending
for consumption-oriented entitlement programs rather than productivity-enhancing investment
programs will have a mounting negative impact on national savings, the -nix of output, and long-run
potential growth. Moreover, the lack of direction infiscalpolicy strains credibility and may induce
undesirable monetary policy responses. Emerging trends in internationalfinanceheighten the need
for a new direction infiscalpolicy.




67

September 29-30,1991

Unpleasant Revisions in Budget Projections
Most notable in OMB's and CBO's mid-session budget reviews is the dramatic jump in
deficits. The FY 1991 deficit should be approximately $280 billion, up from $220 billion in FY 1990.
This is actually less than was projected in early 1991. Two sources have suppressed 1991 spending
and the deficit: higher-than-expected contributions by Allied nations for the costs of Desert
Storm/Desert Shield ($48 billion versus $15 billion estimated in January) which, as offsetting
receipts, are counted as negative spending, and the lower-than-anticipated costs of deposit insurance,
reflecting some delays in the RTC's savings and loan case load resolution. However, these factors
will reserve, as Gulf War related spending will continue to in 1991 after allied contributions end,
and RTC working capital needs will peak in 1991. The deficit is expected to surge to a record $350
billion in FY 1992. This would constitute over 6 percent of GNP, the highest since 6.3 percent in
FY1983, and more than double the 2.9 percent in FY 1989.
Moreover, the out-year projections of deficits are dramatically higher than estimates in early
1991. The deterioration stems from downward revisions in tax receipts and significantly higher
spending. The recession has suppressed taxable income, and there has been a shortfall of taxes
relative to income. The shortfall is expected to persist as the economy rebounds.
Federal spending growth has accelerated markedly during the Bush Administration. Real
spending, which grew 2.8 percent annually from 1980 to 1989, is expected to grow 5.6 percent
annually from 1989 to 1992. Following 9.5 percent nominal growth in FY1990, spending growth
should slow to slightly over 7 percent in 1991 and then accelerate sharply to approximately 12
percent in 1992. The largest source of this spending surge is the costs of deposit insurance. The
costs of clearing up the S&L industry are a realization of prior government obligations, and any
economic impact should properly be attributed to earlier years. Eventually, these costs will diminish,
and the proceeds from the disposition of the government's acquired assets will reduce deficits.
OMB is significantly more optimistic than the CBO about when this switch in budgetary impact
occurs. Moreover, although the costs of funding the bank-related activities of the Bank Insurance
Fund should be significantly less than the costs of the S&L clean-up, they remain highly uncertain,
and may include unpleasant surprises.
Besides deposit insurance, however, spending for other domestic programs is growing very
rapidly. Meanwhile, real defense spending excluding the costs of Desert Storm/Desert Shield has
been declining since 1986. Sharp growth in the nonmeans-tested entitlement programs, particularly
Medicare, has been persistent, with no slow down in sight. In FY 1991, recession related increases
in means-tested entitlement programs, including Medicaid, food stamps, Supplemental Security




68

Shadow Open Market Committee

Income, and unemployment insurance, have jumped. Medicaid costs increases will not abate: after
rising from $14 billion in 1980 to $52 billion in 1991, the CBO projects them to double again to
$150 billion by 1996. The Administration has also sharply revised its projected outlays of Medicaid
costs.
During the Bush Administration, there has also been a marked pick-up in spending for space,
drugs, energy, housing and several other nondefense discretionary programs. These increases, as
well as those in the entitlement and mandatory programs, created a high base for the new flexible
limited established by the Budget Enforcement Act of 1990.
The surging deficits have added dramatically to the publicly-held debt. From 1989 to 1992,
the publicly-held debt will grow from $2.2 trillion to approximately $3 trillion, a 37 percent increase.
Consequently, the debt-to-GNP ratio, which was 42.5 percent in 1989, will rise about 50 percent
in 1992, and approach 53 percent by 1994. The rising debt is highly undesirable in terms of national
saving, capital formation, and long-run potential growth. This issue is particularly pressing given
the heavy transfer payment and consumption orientation of the deficit spending, the heightened
demand for worldwide capital, and the slow down in foreign capital inflows.
The Good Budget News, as Usual, is Years Off
Two angles on the budget outlook are encouraging, but the good news is years away, and will
unfold only if the budget policymakers adhere to current law, which may prove difficult. First,
excluding the costs of deposit insurance and net interest outlays, the budget is nearly in balance and
will turn into surplus beginning in FY 1993. Second, spending growth is projected to slow sharply
in FY 1993 and decline significantly as a share of GNP through the projection period.
The primary budget (budget excluding net interest outlays), which reached a small surplus
inFY1989, will fall into deficit of over $80 billion in 1991 and over $150 billion in 1992, an all-time
record, before shrinking sharply. Most of the primary deficit buildup in 1990-1992 is due to the
costs of deposit insurance. Excluding both net interest outlays and the costs of deposit insurance,
the budget is in slight deficit in 1991-1992, but under current law will enjoy mounting surpluses in
later years. While these long-term projections suggest improvement in limiting new spending
growth, they should not overshadow the budgetary and economic costs of deposit insurance, the
burden of the mounting costs of debt service, or the fact that actual budget outcomes have consistently
fallen short of projections.




69

September 29-30,1991

The sharp slow down in spending beginning in 1993 is projected to occur as deposit insurance
costs become net surpluses, real defense outlays decline, a and on-defense discretionary program
spending falls flat in real terms. However, these budget outcomes hinge on full implementation of
the discretionary caps imposed by the Budget Enforcement Act of 1990. This will require no
legislative slippage through 1993 and significant spending-cut legislation in 1994-1995. Unless
Congress finds a new sense of fiscal responsibility, achieving these spending and deficit projections
will not occur, and further modification of the budget process will be necessary at that time.
The Lack of Fiscal Resolve and Credibility
As with the old Gramm-Rudman-Hollings (GRH), the effectiveness of the new Budget
Enforcement Act relies on the resolve of the budget policymakers. That is not particularly comforting. While GRH probably helped marginally to prevent passage of certain deficit widening tax
and spending bills, it was substantially revised twice before being completely abandoned when
Congress found it too imposing. Moreover, GRH did not encourage meaningful budget reform in
terms of considering tradeoffs among key spending programs, and only postponed debate about the
rapid growth in the nonmeans-tested entitlement programs.
The new process has more flexibility, by allowing spending caps in discretionary domestic,
(non war-related) defense and international programs to be adjusted for changing in economic
conditions, budget emergencies and technical assumption. Since its passage, Congress has struggled
with the process and has attempted to violate its intent. While Congress has twice rejected legislation
that would have suspended the process, and voted against a payroll tax cut (which would not have
been in violation of the law because social security is off-budget), it passed a $5 billion temporary
extension of unemployment insurance benefits and is now considering a large spending package.
These latter actions illustrate Congress's lack of fiscal resolve, and its disregard for the new budget
discipline. Most disappointing, the Congressional budgetary debate generally neglects spending
tradeoffs among programs, one of the key objectives of the new law. With this inauspicious start,
full compliance with the law's discretion caps, particularly in 1994-1995, seems highly unlikely.
Even if the deficits eventually recede according to official projections, the new budget process
reinforces the 1980's trend of more spending on consumption-oriented entitlement programs and
less on investment-oriented activities. It does so by placing absolute limits on the cluster of domestic
discretionary programs which includes many investment activities, but allows spending increases
in entitlement programs scheduled under current law, and legislated increases in those programs if
they are matched by tax hikes. The mix of spending and its implications for the allocation of national
resources should receive closer scrutiny in the budget debate.




70

Shadow Open Market Committee

The mounting lack of fiscal credibility generates its own set of adverse consequences. It
suppresses the U.S. dollar exchange rate, which involves a lower standard of living, and probably
keeps interest ^ates higher than they would be with credible fiscal policy. Uncertainty about the
future course of specific tax and spending policies distorts decisions to spend, save and invest, and
generates deadweight economic losses. The lack of credibility also reduces the effectiveness and
reliability of fiscal policy as an aggregate demand tool by raising the uncertainty about economic
responses to a shift in tax or spending policy. Restoring credibility will remain illusive if budget
resolutions and each newly instituted budget process are quickly violated; if programs that constitute
over half of all spending are automatically excluded from budget negotiation, even if some of those
programs are structurally flawed; and if short-term political considerations overwhelm issues of
national resource allocation, long-run economic growth, and intertemporal equity.
Monetary Policy Responses to Fiscal Policy
The Federal Reserve must avoid the temptation to adjust monetary policy in an attempt to
offset the perceived consequences offiscalor budget policy. For any reasons, the unprecedented
deficits must not be monetized. Monetary and fiscal policies are not substitutable in their short or
long-run effects on either the real economy or inflation. The Fed has clearly stated its long-run
objective as maximum sustainable economic growth and has also stated that the primary role of
monetary policy in pursuit of this goal is to foster price stability. The Fed must not alter monetary
policy in a direction inconsistent with its long-term objectives in response to the perceived failures
of fiscal policy, or offer lower interest rates as a political inducement to extract a change in fiscal
policy. Such practice is unsound economically and may produce undesired side effects. For
example, in Fall 1990, the Fed effectively offered an easier funds rate if Congress would pass a
meaningful deficit-cutting package. During a prolonged Congressional debate, the Fed pegged the
funds rate too high as economic conditions deteriorated, which involved draining bank reserves
and an inadvertently tight monetary policy. Subsequent sharp declines in the funds rate in early
1991 generated a perceived loss in Fed credibility, a sharp steepening of the yield curve, and an
uneven pattern of monetary policy.
In response to the record deficits since the early 1980s, the Fed has been absorbing a lower
portion of the publicly-held debt. The ratio of the monetary base-to-federal debt has declined on
average. Of course, this is only a simple calculation and does not measure the response to the Fed
to changes in federal debt independent of economic perfon nee, inflation in financial market
trends. However, it is a necessary requirement in the Fed's pursuit of the long-run objective of
stable prices.




71

September 29-30,1991

Table 1

CBO AND ADMINISTRATION ECONOMIC PROJECTIONS
(Calendar Year 1989-1995)

1992

Projections
1993
1994

1995

1996

5,655
5,674

6,037
6,076

6,409
6,521

6,798
6,976

7,211
7,442

7,650
7,923

1.0
1.0

-0.1
-0.2

3.4
3.2

2.7
3.5

2.6
3.3

2.6
3.1

2.6
3.0

Consumer Price Index
(Percentage change,
Year-over-year)
CBO
Adminstration

5.4
5.4

4.3
4.4

3.8
3.8

3.9
3.8

3.9
3.6

3.9
3.4

3.9
3.3

Implicit GNP Deflator
(Percentage change,
Year-over-year)
CBO
Administration

4.1
4.1

3.6
4.0

3.2
3.8

3.4
3.7

3.4
3.5

3.4
3.5

3.4
3.4

Three-Month Treasury
Bill Rate (Percent)
CBO
Administration

7.5
7.5

5.8
5.7

6.2
5.9

6.2
5.8

6.0
5.6

5.9
5.4

5.8
5.3

Ten-Year Treasury
Note Rate (Percent)
CBO
Administration

8.6
8.6

8.2
8.0

8.3
7.8

8.0
7.0

7.7
6.6

7.4
6.4

7.3
6.3

Inflation-Adjusted
91-day Treasury
Bill Rate
CBO
Administration

2.1
2.1

1.5
1.3

2.4
1.9

2.3
2.0

2.1
2.0

2.0
2.0

1.8
2.0

Actual
1990

1991

Nominal GNP
(Billions of dollars)
CBO
Administration

5,465
5,465

Real GNP
(Percentage change,
Year-over-year)
CBO
Administration

Sources: Executive Office of the President, Mid-Session Review of the Budget, July 1 9 9 1 , and Congressional
Budget Office, The Economic and Budget Outlook: An Update, August 1 9 9 1 .




72

Shadow Open Market Committee

Table 2

SELECTED BUDGET PROJECTIONS
(Fiscal Years)
Estimated
1990

Forecast
1992
1991

1993

Projected
1994
1995

1996

Receipts
President's Budget
CBO Baseline

1031.3
1031.3

1068.7
1058.0

1145.5
1141.0

1233.3
1228.0

1334.3
1299.0

1427.1
1377.0

1517.0
1449.0

Outlays
President's Budget
CBO Baseline w/caps

1251.7
1252.0

1350.9
1337.0

1493.8
1504.0

1478.9
1501.0

1466.4
1534.0

1500.7
1534.0

1572.5
1605.0

118
115

49
58

-25.4
32.0

-45.2
-32.0

-37.4
44.0

Outlays for Deposit Insurance
President's Budget
CBO
Deficits
President's Budget
CBO Baseline w/caps
President Ex. Dep
Ins & Desert Storm/
Desert Shield

76

83.5
89.0

220.4
220.0

282.2
279.0

348.3
362.0

245.7
278.0

132.1
234.0

73.6
157.0

55.5
156.0

220.0

-227.7

213.5

192.9

155.8

118.1

92.6

Receipts. % Change
President's Budget
CBO Baseline

4.1
4.1

3.6
2.6

7.2
7.8

7.7
7.2

8.2
6.2

7.0
6.0

6.3
5.2

Outlays, % Change
President's Budget
Ex. Deposit Insurance
CBO Baseline w/Caps
Ex. Deposit Insurance

9.5
6.5
9.5
6.5

7.9
8.7
6.7
8.0

10.6
3.8
12.5
5.2

-1.0
4.3
-0.2
4.6

-0.8
4.2
2.2
2.8

2.3
3.2
0.0
4.3

4.8

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

19.1
19.1

18.9

19.2

19.4

19.4

19.4

19.2

Outlays
President's Budget
CBO Baseline w/Caps

23.2
23.2

23.9

23.3

23.8

22.9

21.6

21.3

Deficit
President's Budget
CBO Baseline w/Caps

4.1
4.1

5.0
5.0

5.8
6.1

3.8
4.4

1.9
3.5

1.0
2.2

0.7
2.1

44.6
44.6

48.0

51.2

52.5

53.0

52.2

51.3

Publicly-held debt
President's Budget
CBO Baseline

4.6

Sources: Executive Office of the President, Mid-Session Review of the Budget, July 1 9 9 1 , end Congressionei Budget Office, The Economic end
Budget Outllok: An Update, August 1 9 9 1 .
,.




September 29-30,1991

Table 3

SELECTED BUDGET MEASURES
(Fiscal Years, $ Billions)

1991

1992

1993

1994

1995

1996

Deficit (-), CBO Baseline
w/caps

-279

-362

-278

-234

-157

-156

Net outlays for
Deposit insurance

77

115

58

32

-32

-44

deposit insurance

-202

-247

-220

-202

-125

-112

Net Interest Outlays

196

208

229

246

257

266

-83

-154

-49

12

100

110

-6

-39

9

44

132

154

Deficit (-) minus costs of

Primary Deficit (-) or
Surplus ( + )
(Ex. net interest)
Primary Deficit (-) or
Surplus ( + )
(Ex. deposit insurance)

Sources:

Congressional Budget Office, The Economic and Budget Outlook: An Update, August 1991.




74

Shadow Open Market Committee

Ratios: Public Debt to Monetary Base

•

62

64

66




68

iVN
\

i

70

/

i

i

72

74

76

78

Levels

80

82

Changes (Yr/Yr)

75

84

86

88

90

92




September 29-30,1991

76

Shadow Open Market C

nittee

RECENT BEHAVIOR OF MONETARY AGGREGATES
Robert H. RASCHE
Michigan State University

During the past several years, M2 has emerged as the monetary aggregate which is the focus
of Fed attention, to the extent that monetary aggregates have played any role ir fhe formulation of
monetary policy during this period. In recent months, growth of M2 has slowed almost to a standstill,
provoking considerable comment that the Fed is setting the stage for a slow if not aborted recovery
from the recent recession. This analysis focuses on three questions: what is the cause of the slow
growth in M2 since the beginning of 1991; has the relationship between M2 and nominal income
c mged in some fundamental way, and is the recent behavior of M2, real income and prices con;;nt with past observations?
Sources of the Slowdown in M2 Growth
The slow growth in M2 during 1991 is in dramatic contrast to the behavior of the narrower
aggregates, the monetary base and ML From a January, 1991 base, the adjusted monetary base
has increased 3.10 percent through July, Ml has increased 3.91 percent, while M2 has increased
only 1.73 percent1,2. Consequently the Ml multiplier has increased 0.81 percent while the M2
multiplier has decreased by 1.37 percent. What accounts for this disparate behavior?
mportant consideration in the analysis of this issue is the reduction of all reserve
require nts on time deposits to zero last December. Traditionally we have looked at the Ml
multiplier as:

1

1 have chosen January, 1991 as a base point deliberately to avoid the questions about the appropriate magnitude of the adjustment for the reserve requirement change that was implemented last
December. We discussed the conceptual problems associated with this adjustment last March. It
is worth noting in passing that "surplus vault cash" has averaged 4.2 billion over the five months
January-May, 1991, compared with 2.9 billion in November, 1990 before the change in reserve
requirements.
2
The same story is reflected in the monetary base of the Board which increased 2.83 percent
from January through July.




77

September 29-30,1991

MI

""r(l + ',+ * + / ) + *

where:
k
tc
g
/
r
tj

= currency/private checkable deposit ratio
= travelers check/currency ratio
= government deposits/private checkable deposits ratio
= foreign official deposits/private checkable deposit ratio
= total reserves/total deposits ratio
= ratio of non-Mi components of M2 to private checkable deposits

Since the reserve requirement on all non checkable deposits is now zero, it is more accurate
to express the Ml multiplier as:

MI = !+k{l+lc)
r(l+g+f)+*

where:
r

= the ratio of total reserves to total checkable deposits (government
foreign and private checkable deposits)

The important change in 1991 is that fluctuations in the ratio of "time deposits" to private
checkable deposits have n > impact on the M1 multiplier, since they do not absorb or release reserves.
£
The corresponding M2 multiplier is:
l+k(i+tc)+t«

M2=-

r{l + g+f)+k

The broad conclusions that emerge from all of the analysis constructed by Rasche and Johannes is
that given the historical size of tc, g, and/, the elasticities of the various multipliers with respect to
these components are so small that they have only minor influences on multiplier fluctuations. This
means that under the new reserve requirement rules the k and r ratios are the only major sources
of fluctuations in the Ml. This is certainly true in the past six months. Of the 0.81 percent increase
in Ml, .78 percent is attributable to the decline in the k ratio from .4440 in January to .4365 in July.
The decline in the reserve ratio of about 0.6 percent contributed 0.14 percent to the increase in Ml,
while other factors and the residual of the linearization contributed -0.08 percent.3 The story for
M2 is much different. From January through July the tx ratio declined from 4.4226 to 4.2629,3.68
3

Elasticities of the multipliers with respect to the component ratios are evaluated at January levels.




78

Shadow Open Market Committee

percent. This had the impact of reducing the M2 multiplier by 27 percent, which more than offset
the combined effects of the lower k and r ratios, which by then, ^Ives would have increased M2
by 1.16 percent (not much different from their combined contribution to Ml growth).
The decline in the tt ratio came about with a dramatic redistribution of the components of M2
that are not in Ml. Overnight RPs (which are not insured deposits) shrunk continually since the
middle of 1990. Savings deposits increased steadily since the beginning of 1991, while small time
deposits (small CDs) declined steadily. It is of interest to examine the pattern of interest rates over
the past 18 months. In the first half of 1990 the spread of the Treasury bill rate over the estimated
average rate on M2 (RM2) was around 180 basis points. By December 1990 this spread had declined
to 120 basis points and during the first several months of 1991 the spread has fluctuated around 90
basis points4. During the same period the rate on other checkable deposits (ROCD) held steady
during 1990 and declined by about 25 basis points from the beginning of 1991 through July5.
Consequently the spread of RM2 over ROCD has dropped from around 90 basis points in the first
half of 1990 to zero by April, 1991, where it remains. Thus on average there is now no net return
to holding M2 deposits compared to other checkable deposits.
Is the behavior of the time deposit (tx) ratio predictable? Rasche and Johannes [1987], Table
7.1, estimate a simple IMA model for this multiplier component using not seasonally adjusted
monthly data over a 1971-83 sample period as:
(1 -B) (1 - 5 1 2 ) 1 ^ = (14- .30255) (1 - .68995 n)er
(3.68)

(10.52)

A corresponding model, using monthly seasonally adjusted data over the same sample period is:
(1 -B)\ntx = .03746 + (1 + .30735 >?,
(5.57)

(4.00)

Extending the sample period through the end of 1990 gives the following estimates:
(1 -B)lntx = .02339 +(1 + 3969B)et
(3.88)

(6.67)

so the model has remained quite robust over the most recent seven years. The one month ahead
forecasts from the model estimated over the full 1971-90 sample period are:
4

As discussed below, this spread is an important player in the Board's model of M2 behavior.
The average rate on Ml as estimated by the staff of the Board has declined by about 10 basis
points, most of which occurred during 1991.
5




79

September 29-30,1991

Month

Actual tj

Forecast tj

Error (%)

91:1
91:2
91:3

4.42262
4.39347
4.37893

4.40023
4.44192
4.38464

.0051
-.0109
-.0013

91:4
91:5
91:6

4.39855
4.33367
4.28364

4.38692
4.41348
4.31248

.0026
-.0182
-.0067

91:7
91:8

4.26286

4.28226
4.26515

-.0045

The only big forecast error occurs in May when the tj ratio fell sharply. All the remaining forecast
errors are small compared to the standard error of the regression. Since the elasticity of the M2
multiplier with respect to t2 is about .75. The overestimate of tj in May contributed 1.35 percent to
the forecast error of M2 in that in that month.
It would be useful to have a set of forecasts for the Ml and M2 multipliers. Unfortunately,
given the change in reserve requirements and its implications for the structure of the multipliers, it
is not immediately clear how to construct an appropriate historical time series for r \
The Relationship Between M2 and Nominal Income
The source of recent interest in M2 within the Federal Reserve System stems in part from
research conducted by Hallman, Porter, and Small [1988]. Their investigation and construction of
so called P* is predicated on the assumption that the velocity of M2 in the post-Accord period is
stationary around a mean of approximately 1.65. The stationary assumption asserts that when
velocity deviates from its mean, it has a tendency to revert back to the mean. The end of the HPS
sample period, 88:1 is marked in the attached graph by a vertical line. The data generated since
then provide no evidence to contradict the assertion that M2 velocity is stationary and no evidence
to support a conclusion that the relationship between M2 and nominal income has changed.
Throughout 1989 M2 velocity increased toward the sample period mean, and in recent quarters it
has fluctuated very close to that mean. If anything, the recent data strongly reject the HPS conjecture
that the mean of M2 velocity may be smaller in the 80s than the mean during the previous two
decades.
It is important to remember what is not assumed in the above hypothesis. Stationarity does
not imply that M2 velocity is constant, nor that it cannot deviate considerably from its mean, nor
that deviations from the mean velocity will necessarily be quickly reversed. It is evident from the
graph of M2 velocity against it mean over the 55:1 - 88:1 sample period that there have been periods




80

Shadow Open Market Committee

of large and persistent deviations from the mean. Such deviations translate into short-run
(quarter-to-quarter or year-to-year) growth rates of M2 velocity that are highly variable. Therefore,
it does not follow from the stationarity assumption that slow growth in M2 necessarily implies slow
growth in nominal income. This point seems to be lost in many recent commentaries, including
some by economists, who have argued that without an acceleration in M2 growth nominal income
growth will necessarily be sluggish and the economy cannot recover from the recent recession.
Given the considerable historical variance in M2 velocity, considerable probability must be attached
to the possibility that nominal income can grow strongly in the future even if M2 growth remains
very low; the difference resulting from a positive growth in M2 velocity.
The Relationship Between M2, Real GNP and the Price Level
Recently rumors have spread that the Federal Reserve has experienced considerable difficulty
in forecasting M2. Apparently the primary forecasting instrument is a model developed by Moore,
Porter and Small [1990] that includes two equations, one for the spread between the own rate on
M2 deposits and the Treasury bill rate, and a second that purports to be a short-run demand equation
for M2 deposits that depends upon the spread between the M2 own rate and the Treasury bill rate,
changes in aggregate consumption expenditures, and includes an "error correction" term to reflect
the assumed stationarity of M2 velocity. The structure of this model is quite simple. The Fed funds
rate is assumed to be an exogenous variable, controlled by the Fed. In the model, the spread between
the Treasury bill rate and the own rate on M2 is driven by changes in the Fed funds rate, under the
assumption that the Treasury bill rate reacts quickly on the changes in the funds rate, while the rates
paid on deposits react much more slowly. The spread between the Treasury bill rate and the own
rate on M2 deposits in turn is the driving force in the demand for M2 relative to scale variables
such as income and consumption. The equation determining M2 is described in Table 11 of Moore,
Porter and Small (herewith). The characteristic of this equation is that in the long run M2 velocity
depends on the spread between the Treasury bill rate and the own rate on M2 deposits and a very
small time trend. In the short run, M2 velocity depends upon changes in the rate spread, changes
in personal consumption expenditures and past changes in M2. The logic of the model structure
is that as the funds rate is lowered, Treasury bill rates will fall much more rapidly than the rates on
M2 components, so the opportunity cost of holding M2 balances relative to Treasury bills (short-term
money market instruments) will decline and the demand for M2 will increase relative to income
(M2 velocity will fall).




81

September29-30,1991

The difficulties that this specification has in forecasting the recent behavior of M2 are evident
from elasticity calculations presented in Table 12 of Moore, Porter and Small [1990] (herewith).
That table indicates that for a one percent maintained drop in the funds rate, M2 will increase, all
else equal by .055 percent after two quarters and .084 percent after three quarters. In the third
quarter of 1990 the funds rate averaged around 8.25 precedent; by the second quarter of 1991 it had
declined to the 5.75 percent range where it remains in late August. This is a decline of 36 percent,
which given the computed elasticities implies an increase in M2 of 2-3 percent ($70-$ 100 billion)
for given levels of nominal GNP.
This model has been criticized harshly by Sims [1990] who argues "to use the system of
equations developed here for policy conclusions, requires that the model's foundations be better
supported. It is quite possible to treat a dynamic system like the one estimated here as a restriction
of a reduced-form system that does not impose the Wold causal chain form or the restrictions on
long-run relationships. In such a framework, many of the dubious assumptions on which this paper' s
conclusions rest could be tested. Without such tests, readers are likely to discount the results,
treating them as if they came from a reduced form in any case."
Since we are interested in forecasting M2, real GNP and the price level, an adequate device
is a simple reduced form model. Given the assumed stationarity of M2 velocity, we know that the
reduced form relationship among the three variables can be expressed in the form of a vector error
correction model (VECM) (see Engle and Granger [1987]). Such a model is simply a traditional
VAR in the first differences of the three variables, augmented by an additional, so called error
correction, term involving the lagged levels of M2 velocity. We have constructed such a model for
the U.S., drawing upon the work of Yoshida andRasche [1990] for Japan which extended the VECM
by including lagged changes in the spread between the Treasury bill rate and the own rate on M2
as additional regressors. In addition we have included three dummy variables which define four
different implicit monetary regimes: the 55-65 period of approximately constant and very low
inflation, the 66-79 period of increasing inflation, the 79-81 period of decreasing inflation (the New
Operating Procedures period) and the post-81 period of approximately constant inflation at a four
percent annual rate. These dummy variables are included as a rough way of accounting for different




82

Shadow Open Market Committee

patterns in inflation expectations. Within the subperiods so defined, the evidence is strongly
consistent with the hypothesis that the inflation rate is a stationary variable (see Pecchenino and
Rasche[1991])6.
The estimated VECM over the sample period 56-89 is given in Table 1. The model is estimated
through 1989:4 and one period ahead forecasts have been constructed for the seven quarters 90:1
- 91:3 (all of the right hand side variables in the model, including the rate spread are lagged one
quarter, so no assumptions are required 10 forecast through thi current quarter. The actual (through
91:2) and forecast values, converted from logs to levels are as follows:
Quarter

M2
Forecast

90:1
90:2
90:3
90:4
91:1
91:2
91:3

Actual

3259.2
3299.8
3327.7
3348.5
3367.5
3395.8
3439.5

3252.7
3284.4
3308.2
3326.9
3353.4
3392.0

RealGNP
Forecast
Actual
4152.5
4163.0
4164.0
4173.0
4154.5
4125.3
4129.8

4150.6
4155.1
4170.0
4153.4
4124.1
4124.3

Deflator
Forecast
Actual
129.1
130.8
132.3
133.5
134.1
136.0
137.6

129.5
131.1
132.2
133.1
134.8
136.2

The model certainly is not perfect, though most of the errors during the 90:1-91:2 period are small
relative to the standard errors of the equations (.005 for M2, .008 for real GNP and .004 for the
deflator). In particular, the model shares a general characteristic of autoregressive models that it
fails to pick up turning points, and so catches the 90:4 downturn in real GNP only with a one quarter
lag. It is also clearly going to miss the (likely) downturn in nominal M2 during the current quarter,
through if M2 ultimately is estimated in the 3390 range for the quarter the error will not be so large
as to suggest a dramatic breakdown in the historical relationships. It predicts a turning point in real
GNP for the current quarter, though certainly a weak one. Again, given the known poor performance
of VARs around tin ing points, in light of the information that we have about the economy so far
this quarter, I expect that the model will prove to underpredict GNP in the third quarter when the
estimates are finally in.
The point of this discussion is not be brag about or lament the forecasting ability of a simple
VECM. Rather it suggests that the experience of the economy over the past year, as reflected in
current estimates, is generally consistent with historical patterns in the data.
6

The model described here is drawnfrommy paper on "Indicators of Inflation" prepared for the
forthcoming Fifth International Conference of the Institute for Monetary and Economic Analysis,
the Bank of Japan, October 24-25,1991.




83

September29-30,1991

BIBLIOGRAPHY
Engle, R.F. and Granger, C.WJ., 1987, "Cointegration and Error Correction: Representation,
Estimation and Testing," Econometrica, 55 251-276.
Hallman, J. J., Porter, R.D., and Small, D.H., 1989, "M2 per Unit of Potential GNP as an Anchor
for the Price Level," Board of Governors of the Federal Reserve System, Staff Study 157,
April.
Moore, G.R., Porter, R.D., and Small, D.H., 1990, "Modeling the Disaggregated Demand for M2
and Ml in the 1980s: The U.S. Experience," in Board of Governors of the Federal Reserve
System, Financial Sectors in Open Economics: Empirical Analysis and Policy Issues.
Pecchenino, R. A. and Rasche, R.H., 1991, "A Simple Univariate Test of the Adaptive Expectations
- Natural Rate Hypothesis."
Rasche, R.H. and Johannes, J.M., 1987, Controlling the Growth of Monetary Aggregates, Boston:
Kluwer Academic Publishers.
Sims, C, 1990, "Comment on Modeling the Disaggregated Demands for M2 and Ml in the 1980s:
The U.S. Experience," in Board of Governors of the Federal Reserve System, Financial
Sectors in Open Economics: Empirical Analysis and Policy Issues.
Yoshida, T. and Rasche, R.H., 1990, "The Demand for M2 in Japan: Shifted and Unstable?," in
Bank of Japan Monetary and Economic Studies, September.




84

Shadow Open Market Committee

e 1
ected Intere t Rates, 1990-1
ROCD

RM2

RTB

90:1
90:2
90:3

5.06
5.05
5.05

5.88
5.89
5.93

7.64
7.74
7.90

90:4
90:5
90:6

5.04
5.05
5.05

5.93
5.92
5.92

7.77
7.74
7.73

90:7
90:8
90:9

5.06
5.04
5.03

5.85
5.79
5.77

7.62
7.45
7.36

90:10
90:11
90:12

5.01
4.99
4.98

5.73
5.66
5.54

7.17
7.06
6.74

91:1
91:2
91:3

4.93
4.87
4.85

5.31
5.06
4.98

6.22
5.94
5.91

91:4
91:5
91:6

4.81
4.76
4.74

4.84
4.75
4.72

5.65
5.46
5.57

91:7

4.73

4.68

5.58




85

Quarterly M2 Velocity
55:1-91:2
1.820
VEL

1.785

VELMEAN

1.750 H

1.715
VD
OO

1.680 H
J1.645 H

1.610

1.575

1.540



I' I' I' I' I' I' I' I ' I ' I' I' I ' I ' I ' I' I' I' I' I' I' I' I' I' I' I' I' I' I ' I' I' I * I' I 1 1 ' I' I

55

58

61

64

67

70

73

76

79

82

85

88

60

George R. Moore, Richard D . Porter, and David H. Small

Part J

11. Continued

11. Estimation results from aggregate M2 model
for alternative sample periods1
' Model restricted in long run and short run*
Item

Unrestricted model

EC

Level of deposits being modeled (log). This is the error-correction
coefficient.

1964:1-1986:2

TIME
MMDA
OC
EC
Y
Aeons
Aeons-i
Aeons-i
AOC
AC cons
Dwn&3:l
Dum83:2
Amoney.t

1964:1-1978:1

1964:1-1986:2

JNOW

a)

Index for the number of NOW accounts.

(1)
Variable
Constant

(3)

MMC

Dummy variable for the introduction of money market certificates: 0
through 1978:2, 1 thereafter.

MMDA

Dummy variable for the introduction of MMDAs: 0 through 1982:4,
1 thereafter.

-.074
(6.0)
-.00007
(2.5)
.005
(2.2)
-.011
(6.7)
-.185
(6.1)
.185
(6.1)

-.085
(5.0)
-.00004
(1.2)

-.009
(5.0)
-.198
(5.2)
.198
(5.2)

.083
(13)
-.00007
(2.2)
.0009
(3.5)
-.010
(7.0)
-.17
(5.2)
.14
(44)

.261
(3.7)
.178
(2.5)
.096
(1.6)
-.009
(5.5)
-.017
(3.4)
.025
(5.5)
-.006
(1.1)
.466
(5.7)

.262
(3.3)
.192
(2.3)
-.048
(-.6)
-.006
(3.2)

.593
(5.6)

.17
(2.3)
.08
(I.I)
.02
(.2)
-.007
(4.2)
-.01
(3.3)
.026
(5.9)
-.002
(3.1)
.35
(4.5)

.704
1.32

.762
1.79

.737
1.67

Regression statistic

*
Durbin-H
Standard error
of regression

.0041

.0043

.0041

1. The mnemonics for this table and for tables 16. 17. 18. and 21 are defined as follows:
Coefficient

Associated variable

C com

Dummy variable for credit controls: 1 in 1980:2 and 0 otherwise.

cons

Personal consumption expenditures.

DumSLl

Dummy variable for introduction of nationwide NOW accounts: 1 in
1981:1 and 0 otherwise.

Dum33:J

Short-run dummy vanabie for (he introduction of nationwide super
NOW and MMDA accounts: 1 in 1983:1 and 0 otherwise.


Dum&3:2


(

Same as Dwn&3:l but 0 in 1983:1 and 1 in 1983:2.

money

Value of deposits being modeled (log).

OC

Opportunity cost of the deposit being modeled (Treasury bill rate
minus own rate). The opportunity cost generally enters in logarithmic
form, except at or close to negative values of the opportunity costs.
The spreads between the rate on Treasury bills and the rates on
small tunc deposits and MMMFs enter linearly tor this reason. The
opportunity costs of aggregate M2 and OSM are linear for values of
the opportunity cost below 50 basts points.

OC2

Difference between the rate on small time deposits and the OSM
own rate. Enters linearly for values below 50 basis points and
logarithmically for values at or above 50 basts points.
Deposit-weighted average of the rates on OCDs, savings deposits,
MMDAs. MMMFs, and small time deposits. Enters in logarithmic
form.

ROSSME

Shift

Dummy vanabie for the "missing money" period of the mid-1970s:
0 througn 1974:2, and increasing by steps of 1 per quarter until
reaching a value of 10 in 1976:4; 10 thereafter.

Y

Nominal GNP (two-quarter moving average).

2. The coefficient Y is constrained to equal the negative of the error-correction coefficient v
as to impose a long-run unitary elasticity of M2 demand with respect to GNP. Also, the cocfl >
cicnts on current and lagged changes in consumption plus the coefficient on the lagged change
in M2 are constrained to sum to one. This is the "convergence" restriction.

restriction so that the model is stable in steady-state experiments, as discussed above. 17

37. The mean errors for the restricted model in table II, column I, and the unrestricted
model of column 3 are 0.1 percent and - 1 . 8 percent respectively. The root mean-squared
errors for the restricted and unrestricted models are 0.4 percent and 2 percent respectively.
Moreover, the restrictions save on estimated coefficients. This advantage becomes especial!
important for the shorter sample periods over which we estimated tne disaggregated models, i
we allowed for a less than unitary elasticity, our approach would be to separate the nominal
scale variables into their real and price components, allow for a less than unitary elasticity U>
the real scale variable, and impose homogeneity of degree zero of real money demand with
respect to the price level vanabie. Such a specification would increase the number of
parametera significantly. It is also interesting to observe that our restricted velocity specifican
tracks M2 more closely during the 1986:3-1988:1 out-of-sample period than does an
unrestricted specification.

oo

September 29-30,1991

George R. Moore, Richard D. Porter, and David H. Small

63

12. Elasticities of M2 to selected variables, quarterly aggregate model

Quarters after shock
0
1
2
3
4
6
8
10
12
Long run

Opportunity
cost

Scale
vtriible'

(1)
-.008
-.022
-.034
-.045
-.052

(2)
.26
.60
.93
1.10
1.16
1.13
1.06
1.01
1.00

-.058
-.059
-.059
-.058
-.058

1.00

Mirket interest rate'
Upward

Downwtrd

(3)
-.022
- 056
- 089
- 113
- 128

(4)
-.023
-.055
-.084
-.102
-.112

-

-111
-.099
-.081
-.081
-.06

136
131
122
115
06

1. In computing the elasticity for the sctle vtriible, ONP tnd personal consumption expend*
itures ire changed in tandem by the same percentage.
2. These ire elisticities with respect to the fedenl funds rite; they Incorporate endogenous
responses of the Treasury bill rate and deposit rates.




88

Shadow Open Market Committee

Table 2
Vector Error Correction Model
U.S. M 2 , GNP, GNP Delfator, 1956-89

lnM2
InGNP ; spread - RM2 - RTB
InP

a + 0-D66 + £ 0 D 7 9 + 0-D82 +

.00366
.08039
.00579

V

.4386
.2765
.0536

.0142
.0490
.0360

.0055
.0003
.0018

0047
1521
0068




.00185
.00381
.00449

V

.0047
-.1521
-.0068

2

Po-

6.A spread +

.00024
.00456
.00258

;

P.1649

-.0884
-.1304

7

.3060

.0013
.0014
.0002

.0047
-.1521
-.0068

89

2~

.2571
-.0148

2

v

7.A X_ .+ <j> X

n+€

-.00241
-.00500
.00572

.0203
-.0734
-.0430

.1359
-.1790
2369




September 29-30,1991

90

Shadow Open Market Committee

CHOOSING A MONETARY AGGREGATE: ANOTHER LOOK
William POOLE
Brown University

The SOMC has traditionally summarized its monetary-policy advice in a recommended rate
of growth of the monetary base. However, since the SOMC meeting in the spring of 1991, our
recommendation has deemphasized the base because rapid growth in currency arising from liberalization in Eastern Europe and the Soviet Union distorted the data. Instead of the base, we have
couched our recommendation in terms of M2, but our discussions of the issue of the choice of an
aggregate target have been brief. My purpose here is to begin a reexamination of this issue. I say
"begin" because the issue is a large and complex one requiring more research than I could complete
at this time; we will almost certainly want to revisit the subject in the future.
The need for this review is well-illustrated by recent growth rates of the aggregates. Expressing
growth at a continuously compounded rate, over the twelve months ending in July 1991 the St.
Louis base grew by 8.61 percent, Ml by 5.87 percent, and M2 by 2.86 percent. By past standards,
base growth suggests that monetary policy may be too expansionary, Ml growth seems about right
(or perhaps a tad high), and M2 growth seems too low. Policymakers must, if only be default, form
a view on which policy implication is correct. The SOMC should also come to a view on which
policy implication is correct and, if possible, use the current experience to refine our position on
what aggregate is likely to be most reliable in the future.
General Considerations
When I consider the problem of selecting a monetary target I like to keep four general considerations in mind.
1.)
2.)

The aggregate should be reliably related to nominal GNP.
The aggregate should be defined by some a priori principle and not purely
empirically. Historically, many economists were attracted to Ml because this
aggregate included all transactions assets—currency and deposits subject to
check. However, many observers came to believe that the transactions principle,
upon close examination, is unsatisfactory because people hold far more currency
and checkable deposits than makes sense on transactions grounds. Milton
Friedman and Anna Schwartz long emphasized a different principle—they




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September 29-30,1991

viewed money as a "temporary abode of purchasing power." That phase has
always rung true to me, but has never seemed to provide much a priori guidance
as to what assets should be included in an empirical definition of money and what
assets excluded. As I discuss more fully below, I have reached the tentative
conclusion that the assets that should be included are all those that have zero
maturity and remain continuously at par with currency.
3.)

Closely related to the previous consideration, we should seek a single monetary
target and not switch from one to another unless we accumulate compelling
evidence of the need for a change. Good science requires that we form hypotheses
and evaluate their success; we risk deluding ourselves if we frequently change
the empirical definition of money in response to what appears to "work" at any
given time. Also, public debate over monetary policy cannot proceed at a highly
technical level; we need to promote a consistent position and not confuse people
with frequent fine-tuning of our definitions, or frequent changes in target growth
rates to reflect special conditions.

4.)

The central bank should be able to control the aggregate closely if it chooses to
do so. This consideration was important in the 1960s and 1970s when debates
raged about the Fed's ability to control the monetary aggregates. The unadjusted
monetary base is unquestionably within the Fed's control, and this fact made the
base an attractive target. (The St. Louis base adjusted for reserve requirements
cannot be controlled perfectly because the adjustment requires data on deposits,
which become available after control decisions must be made.) I believe that the
control issue is no longer a pressing one; twenty-five years of research and
extensive experience both in the United States and in other countries have made
abundantly clear that any of the aggregates through M3 can be controlled accurately enough for all practical purposes. The issue is not the feasibility of tight
control of any particular aggregate but its desirability.

The Problem with the Base
Since Friedman and Schwartz published the Monetary History, we have known that the
monetary base is potentially an unsatisfactory monetary target. Friedman and Schwartz showed
that the base remained essentially flat from the peak of business in 1929 to the trough in 1933 while
Ml and M2 declined precipitously. This outcome, of course, was a consequence of a flight to
currency caused by growth distrust of the solvency of a large number of banks. With the introduction
of deposit insurance and the federal government's assumption of responsibility for banking stability,
the prospect of another flight to currency disappeared and the Great Depression experience with
the base seemed irrelevant for choosing an aggregate to target. Economists reasoned, correctly,
that bank runs, if any, would take the form of transfers of deposits to other banks rather than a flight
to currency. Transfers of deposits to other banks do not change the relationship of Ml and M2 to
the base. Thus, there was good reason to believe that close control of the base, which everyone




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Shadow Open Market Committee

agreed was feasible, would yield reasonably close control over Ml and M2. Even if Ml, or M2,
were a better target than the base, base control would do the job because the relationship between
the base and Ml and M2 would be reasonably stable.
However, economists (certainly this one) did not foresee that another problem could arise
with the base—that of a greatly enlarged world demand for U.S. currency. This demand has arisen
especially in Eastern Europe and the Soviet Union, but also in Latin America. Moreover, as Congress
and the Federal Reserve reduced bank reserve requirements in the 1970s and 1980s, currency grew
as a fraction of the total base. Figure 1 shows that currency has gone from about 65 percent of the
base in 1959 to about 77 percent today. Employing the monetary base as a monetary target today
is almost equivalent to employing currency as the target. Given experience in the United States
and elsewhere, I do not think it wise to concentrate on currency to the exclusion of the large volume
of assets in various types of deposits.
The Problem with Ml
The income velocity of Ml (ratio of nominal GNP to Ml) rose at a trend rate of about three
percent per year from the end of World War II to 1981. This increase was so steady that many
economists (including this one) came to believe that Ml velocity could be expected to continue to
rise at about the same rate. In fact, Ml velocity fell in the 1980s. My own judgment is that both
the rise in velocity before 1981 and the fall after were largely due to interest rates, which trended
up before 1981 and down thereafter. However, this issue is still in dispute; many believe that
regulatory changes had much to do with the changes in velocity—both the change in trend and the
apparently unpredictable fluctuations after 1981.
The principle behind Ml is to distinguish transactions assets from other assets. Empirically,
transactions assets defined to be currency, travelers checks, and checkable balances in financial
institutions. The distinction between checkable and other balances is now questionable. Many
money market mutual funds (MMMFs) permit checks, but only in excess of a minimum size such
as $500. Money market deposit accounts (MMDAs) at banks have a restricted number of checks
per month. Sweep account arrangements automatically transfer a checking account balance above
a certain minimum into a savings account or an MMMF, and transfer funds the other direction when
the checking account falls below a certain minimum. A similar arrangement exists for large
depositors, whose non-interest-bearing demand deposit may be swept into an interest-bearing
overnight repurchase agreement at the end of every day.




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September 29-30,1991

The official definitions of the aggregates place MMMFs and MMDAs in M2 but not Ml; this
classification seems inherently arbitrary. At a minimum, it is not hard to imagine changes in the
way people use these accounts that would lead us to want to classify them in Ml without there
being any change in the characteristics of the accounts themselves.
Because the distinction between checkable and noncheckable accounts has lost force given
the prevalence of automatic sweep arrangements and quasi-checkable accounts, the present dividing
line between Ml and M2 has little economic logic. The logic instead calls for a dividing line
between time accounts and zero-maturity accounts. By "zero-maturity accounts" I mean all those
that can be accessed without notice and at par.
The Problem with M2
By the end of the 1980s many economists believed that M2 velocity was more stable than
Ml velocity and would continue to be so in the future. This view depended on both experience and
theory. The experience included the greater actual stability of M2 velocity than Ml velocity and
observed reallocations of assets between transactions and savings components as regulations first
changed and later disappeared. A transfer from, say, demand deposits to savings deposits affects
Ml but not M2.
An important piece of theory in this context relates to the interest rate banks will pay on time
(and savings) deposits in the absence of Regulation Q interest-rate ceilings. When market interest
rates rise (fall), banks will sooner or later increase (decrease) the rates they pay on time deposits.
The spread between market rates and time deposit rates will over time be more stable than the
market rate itself. This spread is an important determinant of the amount of time deposits people
want to hold; if the spread is constant, the amount of time deposits people hold will tend to be
constant, other things equal. Demand deposits, on the other hand, pay zero interest by law; the
spread between the zero demand-deposit rate and the market rate changes one for one as the market
rate changes. Thus, the amount of demand deposits people want to hold will likely change as market
interestrates change, creating a possibly unstable relationship between demand deposits and nominal
GNP. Currently, the non-interest bearing part of Ml—currency, travellers' checks, and demand
deposits—are about 64 percent of total Ml but only about 16 percent of M2. The fact that most
of M2 bears interest suggests that changes in market interest rates will not cause lasting changes
in M2 velocity.




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Shadow Open Market Committee

Although the case for M2 initially seems convincing, further examination raises trouDit^
questions. We can divide M2 into three main classes of assets: 1.) the transactions assets in Ml;
2.) all M2 assets other than transactions assets that can be converted to transactions assets at par
without delay—these include savings deposits, which can be converted at any time through a visit
to the bank, MMD As, MMMFs, and a few other miscellaneous items; 3.) small time deposits—these
are time deposits of less than $100,000 and with maturities of a few days to several years. (Large
time deposits are in M3 but not M2.) The distinction between the second and third classes is that
small time deposits cannot be converted on short notice to transactions assets at par. Holders of
time deposits who want to convert before maturity must bear an early redemption penalty or the
extra cost of taking out a loan using the time deposit as collateral.
Small time deposits make up a significant share of M2—about 35 percent at present—as
shown in Figure 2. One issue here is that close substitutes for these deposits exist in the market;
intermediate bond mutual funds provide one example. Changes in competitive conditions in the
financial markets may lead people to switch into or out of small time deposits depending on their
yields relative to close substitutes. In fact, such a switch may explain some of the weakness in
current M2 growth. Figure 3 shows the small time deposit component of M2 broken out between
commercial banks and thrifts. The substantial decline in the thrift component after 1988 reflects
the large number of insolvent thrifts being shut down and, probably, depositor unease with many
of the thrifts still operating. Some of these time deposits have been moved to commercial banks,
but some have probably been moved out of depository institutions altogether. Small time deposits
at commercial banks reached a peak in January 1991; by July (latest data available as of this writing)
these deposits were about $45 billion lower. I suspect that what is going on is that commercial
banks face weak credit demand and a difficult regulatory environment; in this situation, banks are
not bidding for time deposits, large or small, and so these funds are being placed outside the
depository institutions.
Another problem with the small time deposit component of M2 is that these deposits have a
surprisingly long maturity. Figure 4 shows the maturity distribution based on a Federal Rest

e

sample of commercial banks and federally insured savings banks. Of these deposits, 42 percent
have maturities (original maturities, I assume) over one year. These funds do not fit my notion of
a temporary abode of purchasing power. Only 7 percent of small time deposits have maturities in
the 7-91 day range. Figure 5 shows a time series graph of the available data on time-deposit maturity.
(Data on the 7-91 day maturity start in mid 1989).




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September 29-30,1991

Further Observations
The market for time deposits functions in fundamentally different ways with and without
Regulation Q. Refer again to Figure 2, which shows small time deposits as a percentage of M2
from 1959 to 1991. The sharp upward bend in the small time share in 1966 was clearly a result of
the interaction of Regulation Q and rising market interest rates. Banks tried to lure depositors by
finding a way to place temporary-abode funds in small time deposits, which had a yield advantage
over other deposits, while maintaining ready availability of the funds. Banks initially permitted
depositors to redeem time deposits early, but regulators responded by insisting on early withdrawal
penalties. Banks could avoid this regulation, in part anyway, by waiving the penalty in defined
"hardship" cases and by permitting depositors to borrow against their time deposits at attractive
rates.
Under Regulation Q, the competition of time deposits with unregulated non-depository assets
was distorted in two ways. First, of course, depository institutions could not adjust time-deposit
rates in response to market pressures. Second, the terms of time-deposit contracts, both formal and
informal, reflected regulatory avoidance. For example, a bank's service charges and minimum
balance requirements on an individual's demand deposit might depend in part on the size of the
individual's time deposits in the bank. With the end of Regulation Q and the national spread of
NOW accounts, banks have much less incentive to link checkable and time deposit accounts in this
way. In sum, under Regulation Q the relative amounts in demand, savings, and time deposits
reflected regulation and regulatory avoidance as well as depositor responses to the changing
characteristics of these three different types of accounts.
Figure 6 provides another illustration of the importance of regulation. When the regulators
authorized the MMDA account in 1983, many depositors converted small time deposits to the new
account Total M2 was relatively little affected but individual components of M2 were greatly
affected. We may conclude that under Regulation Q the M2 aggregate had the most stable characteristics of the various aggregates because M2 was relatively little affected by shifts among M2
components occasioned by regulation and regulatory avoidance.
At present, banks have little incentive to pursue regulatory avoidance through ties between
small time deposits and other types of deposits. However, banks do have an incentive to link
overnight repurchase agreements, savings deposits, and bank-sponsored MMMFs to checkable
deposits through automatic transfers. Checkable deposits carry a 12 percent reserve requirement
whereas repos, savings deposits, and MMMFs carry a 0 percent reserve requirement. Automatic
transfers cannot occur in both directions between checking and time deposits.




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Shadow Open Market Committee

Many marketable assets can be accessed quickly through sale. What distinguishes monetary
assets from, say, common stock is that monetary assets can be converted to a transactions balance
at par. Many marketable assets are highly liquid—they can be converted to checkable deposits
very quickly—but they cannot be converted at a price known in advance. This fact must be central
to the economic effects of central bank open-market operations that exchange treasury bills for
money or money for bills. Open-market operations do not affect the private sector's wealth but
only the composition of that wealth. Thus, it seems to me that the fundamentals of monetary theory
call for an empirical definition of money that is based on the distinction between zero-maturity
assets payable at par and all other assets. We should also note that all goods with constant relative
prices can be aggregated, which means that financial assets that always trade at par with each other
can be aggregated into a simple-sum aggregate.
The economic effects of open market operations could not arise if money and, say, treasury
bills had the same yield because the two assets would then be perfect substitutes at the margin. In
fact, zero-maturity assets have a lower yield because of the costs incurred by financial institutions
that issue them. That is, making good on a contract to convert zero-maturity balances into cash, or
cash into such balances, on demand is not a costless operation. A financial institution that offers
this service must maintain a fraction of its portfolio in very short maturity assets that can be bought
and sold cheaply. The institution must also find capital providers willing to bear the risk of making
good on the contract at a time when the value of the assets in the portfolio is depressed either because
interest rates have risen or some of the assets have defaulted. Because of these costs of creating
zero-maturity assets, those who hold them receive a lower yield than they otherwise would. People
hold zero-maturity assets up to the point where the marginal services they provide equal the cost
in terms of the lower yield.
These considerations point to an aggregate consisting of all the zero-maturity assets in the
economy. At present, the zero-maturity assets in M2 include essentially all such assets in the
economy; my proposed target aggregate is then M2 less small time deposits, which I denote
"M2-ST." Figure 7 shows Ml, M2, and M2-ST from 1959 to 1991 and Figure 8 shows the 12-month
growth rates of the same aggregates from 1960 to 1991. I have not made any income-velocity
calculations for M2-ST, but from Figure 7 we know that over the 1959-91 period as a whole velocity
of M2-ST grew a bit more rapidly than the velocity of M2. Also, the behavior of M2-ST growth
in the early 1980s is more consistent with the severity of the 1981-82 recession than is the growth




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September 29-30,1991

of M2, which did not decline at all. However, the moderate decline in M2 growth before the 1990
cycle peak seems more in keeping with the mild nature of the recession than is the much larger
decline in the growth of M2-ST.
Another way to view the logic of M2-ST is to note that there are many assets outside M2 that
have essentially the same characteristics as small time deposits. Short-dated bonds provide a
quantitatively significant example. To include time deposits in our definition of money while
excluding short-term bonds we would have to give great weight to two major differences between
these assets. First, most time deposits are federally insured. This fact distinguishes time deposits
from private bonds but not from treasury bonds. Second, time deposits are held infinancialinstitutions that also issue zero-maturity deposits; this fact may affect the way holders of time deposits
regard them.
Having said all this, I would not underestimate the legacy of regulation. Banks and their
customers are still adjusting to the current environment of no Regulation Q ceilings and zero reserve
requirements on time and savings deposits. I doubt that banks' patterns of adjusting time and savings
deposit interest rates and terms are entirely free of practices developed during the long period of
sustained regulatory constraints. For this reason, changes in market conditions of various kinds
may continue to cause reallocations within the current definition of M2. However, if my argument
is correct, these same changes in market conditions will eventually occasion different responses
that make M2-ST the more stable aggregate.
Implications of M2-ST for Current Monetary Policy
Over the twelve months ending July 1991, M2-ST grew at a rate of 6.06 percent, compared
to 2.86 percent for M2, which is just slightly above the lower end of the Fed's announced target
range for M2 of 2.5 to 6.5 percent growth. My bet is that M2-ST is providing a more accurate
picture of monetary conditions than is M2 and will continue to do so. The thrift industry will
continue to decline for several years; commercial banks may well continue under considerable
pressure. Thp market will reallocate credit flows around floundering banks and thrifts, but the
process will not, I believe, have much monetary significance.
The M2-ST aggregate has not, however, been the subject of extensive research. I would,
therefore, not abandon M2 in framing my views on the stance of monetary policy. However, I
believe that we should watch both M2 and M2-ST and should recommend that the Fed condition
its adherence to an M2 target by the behavior of M2-ST. Applying these thought to today's conditions, I would not recommend that the Fed lower interest rates aggressively to raise the growth




98

Shadow Open Market Committee

of M2; I think M2 growth at the bottom of its target range is acceptable. The growth of M2-ST is
satisfactory, and other information leads me to believe that the economy is on a sound recovery
path.




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September 29-30,1991

Figure 1
Monetary Base (St. Louis Fed Definition) and
Currency, 1959- 1991
500

78

iiT

Curr. % of base (right scale)

(0 3 0 0
O
C
O
. 0 200

76
74
72 <_

c

CO

J|100
"o

Currency (left scale)

70

C
D
O
C
D

68°-

«•—

66

c
o

I30
20

64
J

J__i I L J _ L . J „ L _ . L J _ J _ _
I L_ I I ±
1960
1965
1970
1975

-_1_J_1_J_J_LJ_ J__L_J.._ L I...
1980
1985
1990

62

Figure 2
Small Time Deposits as Percent of M2
1959 -1991
50

40

*-30
CD
O
CD

20

10

_L_L_1_J_L_LJ__L_J_J._I._I...L_.L_L_]_ _L_l__l_JL_JL-1 A.. -JL I J...L-1„L. I.I..
.
1960
1965
1970
1975
1980
1985
1990




100

Shadow Open h:

"ommittee

Figure 3
Banks and Thrifts
Small Time Deposits, Cor
1980-1991
700
^600
C
O
O
C
O

Thrifts

o500

05
i_

1

•

C 400
O

"o

Comm. banks

T5
l
O300
CO

c
o
C
D
J

200
1980

1982

L

1984

1

1986

i

L

1988

1

J-

1990

Figure 4
Maturity Distribution of Small Time Deposits
July 1991




V?%$&?&5:

92-182 days 22%

7-91 days 7%

1-2.5 yrs. 22%

101

September 29-30,1991

Figure 5
Small Time Deposits by Maturity
1983-1991
300
183 days-1 yr.
250 \92-182 days
J|200

o
*0150

---•~-^_,~-

2.5 yrs. and over

0)

c
o

= 100
CD

1-2.5 yrs.
s

50
7-91 days
l
1984

1988

1986

_j
1990

Figure 6
Selected Monetary Aggregates

1978 - 83

3000

100




L

1978

1979

1980

102

1981

1982

1983




Figure 7
M1, M2, and M2 Less Small Time Deposits
Levels, 1959-91

O

1960

1970

1980

1990

Figure 8
M1, M2, and M2 Less Small Time Deposits
12-Month Percentage Changes, 1960 - 91

o

1960




1970

1980

1990

Shadow Open Market Committee

ECONOMIC POLICY TOWARDS RUSSIA
AND THE SOVIET REPUBLICS
Charles I. PLOSSER
W.E. Simon Graduate School of Business Administration
University of Rochester

There is growing pressure on Western governments to move quickly and make available large
sums of economic resources to aid the Soviet Union. Daily we read about the prospects for Soviet
economic collapse: The risks of major food shortages during the coming "harsh" winter (they must
have better weather forecasters than the U.S.) primarily due to a distribution system where food
rots before it reaches the processing plants and not the lack of grain or other agricultural products;
the risks of hyperinflation caused by the rapid printing of money to meet payrolls and other
expenditures of state-owned enterprises that produce goods that no longer have markets. While no
one doubts the sincerity of those arguing for aid, there is a strong case to be made that loans or
credits to either the central government or the governments of the new republics is not in their
interest or the interests of the West.
Prior to the attempted coup, most proposals for economic assistance involved direct loans or
credits to the central Soviet authorities. In exchange for this assistance, the Soviet government was
to embark on a step by step program of economic reform designed to transform their inefficient
command economy into a market economy and bring the Soviet Union into the world trading
community.
The break-up of the Soviet Union we have witnessed over the past month requires a complete
re-assessment of all such strategies. A major problem is that it is no longer clear who we are to
extend credits to. Do we negotiate with the new central government or the individual republics on
a case by case basis? The emerging central government appears to have little power to affect any
sort of change. Dealing with the governments of the individual republics is also questionable. Are
these governments stable? Do they have the taxing authority to pay back loans? Are those individuals in power any better than what existed before? In the Republic of Georgia, for example,




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September 29-30,1991

there are riots protesting the actions of their President who they accuse of being a dictator. Moreover,
who will have the responsibility for financial and currency arrangements? It seems clear that
proposals to aid the Soviet Union, as such, are no longer relevant.
Even if the relationship between the republics and a central government (should it exist) were
clear, the more fundamental question remains. Is government to government aid an effective means
of promoting the transition to a market economy?
There is no doubt that it is in the interest of the West for the republics that comprised the
Soviet Union to move quickly towards market-focussed economies. More importantly, we should
not forget that it is in their interests as well. Now, with the collapse of the Communist Party and
its strangle hold on the government and economic decisions, the opportunities exist for individual
initiative to re-assert itself. The people and emerging government officials clearly see that moving
to a market economy is the only path to sustained economic progress. On what grounds, however,
should the West believe that bribing the government will speed-up the process or providing massive
amounts of aid to the government will result in an efficient allocation of those resources? Experience
does not offer much support for such a belief.
It is often claimed that the model ought to be the Marshall Plan which assisted in the
reconstruction of Europe after World War II. Unfortunately, the analogy is not a good one. The
economies of Europe were essentially market economies before the War and during the War, so
the people were both knowledgeable and experienced. At that time the critical requirement was to
rebuild physical capital. This is not the current situation in the Soviet republics. They need
experience and knowledge in market organization as well as physical investment. Moreover, while
the Marshall Plan is generally viewed as a major success, it is not clear that private initiative would
not have achieved similar results.
Many observers argue that there needs to be government aid primarily in terms of loan
guarantees to reduce the risk to Western investors. But it is unlikely that this is a good idea. Taxpayer
guarantees are responsible for the S & L crisis in this country. Why should the U.S. taxpayer be
exposed to such risks? Shouldn't those parties engaged in the investments recognize the risks and
negotiate the terms accordingly?
The problems with the economies of the Soviet republics are unlikely to be solved through
massive amounts of government aid dispensed through a central government or even through the
republics. The money is likely to only serve to entrench the existing bureaucrats. Besides, the




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Shadow Open Market Committee

governments do not have the knowledge to implement the market structures required. This would
amount to just another form of the command economy that has already failed. Decentralization of
economic decision-making is what is needed not centralized allocations.
What is desperately needed in the Soviet economy is the knowledge that can best be brought
into the country through private contracts: individual companies from the West contracting with
private groups in the Soviet Union in ways that bring valuable knowledge of operating and organizing
markets. Of course to entice Western firms into the Soviet Union, there will have to be many
changes. These changes are the key features to success of the economic reform of the Soviet
economy.
The governments of the Soviet republics mm
"rm their commitment to private property
and the privatization of industry allowing domestic
es to adjust to world prices and by establishing a system of commercial law that is broadly in keeping with the other Western countries.
If private companies are to engage in commercial transactions with either private parties or
governments in the Soviet republics, there must be a clearly described set of laws that govern such
transactions. Uncertainty about the interpretation or adjudication of contractual issues and fears
of potential expropriation can make the costs of doing business prohibitive and thus discourage
investment.
Both private and state-run enterprises must be prepared to attract capital by selling substantial assets or future income streams to foreign investors. In many ways the Soviets are very
wealthy. Their natural resources such as oil and gold are very large. Given the risks of investing
in the Soviet republics, the Soviets must be willing to sell assets and claims to future income streams
at prices that attract foreign investors. Direct foreign investment is absolutely essential to the success
of economic development. The reaction of some governments to close economic borders or pursue
merchantilist strategies will not promote reform or development.
Russia and the republics must quickly agree on monetary arrangements. Whether they involve
one currency or many the principle of convertibility is essential. There can be no convertibility as
long as rubles are being printed to finance the massive government deficits. Once again, the Soviets
could choose to stabilize their currency by selling assets such as state-owned housing and enterprises.
Convertibility and credibility can then be achieved quite easily by pegging the exchange rate to
some stable currency. A convertible currency is essential if the Soviet economy is going to participate in world trade.




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September 29-30,1991

The U.S. and other Western nations can help the Soviets achieve these goals through technical
assistance and perhaps management training and education. But, these are objectives that the Soviets
must set for themselves and achieve themselves. Otherwise, economic reform cannot be sustained.




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Shadow Open Market Committee

THE MISUSE OF THE FED'S DISCOUNT WINDOW
Anna J. SCHWARTZ
National Bureau of Economic Research

The lending practices of the Federal Reserve Banks have allowed hundreds of nonviable or
insolvent banks since 1985 to remain open long beyond the point of viability, according to extensive
data on discount window use that the Federal Reserve furnished in May 1991 at the request of the
House Banking Committee. In effect the Federal Reserve has conducted a policy of forbearance.
Because of the delayed resolution of failures, the ultimate result of forbearance—a lesson of the
savings and loan industry debacle—has been to increase the losses borne by the insurance fund
and taxpayers.
Key Features of the Discount Window
Three types of loans are advanced at the discount window: adjustment, seasonal, and extended
credit. Adjustment credit may be extended to meet reserve requirements or to avoid an overnight
overdraft and is limited to at most a few business days. Seasonal credit is available to small banks
for that part of the year when their loans are regularly high. For extended credit, the guidelines
require "a plan for eliminating the liquidity problem of the institution" and "appropriate weight
. . . given to the financial condition of the institution." No time limit is set on extended credit.
According to the House Banking Committee Staff, the Fed "routinely" extends credit to institutions
thefinancialcondition of which has not been appropriately weighed by it.
All discount window credit is subject to collateral requirements. What is eligible collateral
is the decision of each Federal Reserve Bank. All of them, however, apply varying discounts to
the par value of the collateral they accept, and the ratio of loan to collateral value is not uniform
across district banks.
The collateral the Federal Reserve Banks accept is usually the most liquid, high-quality assets
the borrowing institutions hold. When the borrowers are finally closed, the FDIC repays the Federal
Reserve Banks in cash ahead of all other creditors.




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September 29-30,1991

With the haircut of the collateral, these are riskless loans for the Fed. Hence there is no
incentive to shut the discount window. George Kaufman has proposed that the Fed be permitted
to lend only on an uncollateralized basis to problem-ridden institutions, on the theory that if the
Fed's own money were at risk, it would be hesitant to lend. I favor a different approach to which
I refer below.
Condition of Borrowing Institutions
Of the 530 borrowers from 1985 on, that failed within three years, 437 were classified as
most problem-ridden. Regulators grade banks on their performance, according to a scale of 1 to 5,
the best performance graded a 1, the worst a 5. The grades are based on five measures known by
the acronym of CAMEL for Capital adequacy, Asset quality, Management, Earnings, Liquidity.
The 437 institutions that were most problem-ridden had a CAMEL rating of 5, the poorest rating;
51 borrowers had the next lowest rating, CAMEL 4. One borrower with a CAMEL rating of 5
remained open for as long as 56 months. The average length of time the whole class of CAMEL
5 institutions was allowed to continue operations was about one year.
At the time of failure, 60 percent of the borrowers had outstanding discount window loans,
nearly all of which were extended credit. These loans to insolvent institutions increased daily, new
borrowings rolling over balances due. In aggregate the loans of this group at the time of failure
amounted to $8.3 billion, of which $7.9 billion was extended when the institutions were operating
with a CAMEL 5 rating. Three months prior to failure, borrowing of all 530 institutions peaked at
$18.1 billion.
Some Federal Reserve staff members have asserted that it is impossible to know whether an
institution that applies for discount window help faces a liquidity or solvency problem. Since
CAMEL 4 and 5 ratings are known with little lag time, it should not be a problem to distinguish
between an illiquid and an insolvent bank.
Deterioration of Condition of Borrowers as Result of Loans
By turning over to their Federal Reserve Banks as collateral their best assets, the borrowing
banks are worse off. Case studies of banks that were borrowing at time of failure show that the
loans enabled uninsured depositors to withdraw their funds without taking a loss. Uninsured deposits
in this way were covered just as if they were insured. Moreover, the weakened institution increased
its borrowing as its condition worsened. When it was finally taken over by the regulator, it had
higher operating losses than at the start of the loan arrangement.




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Shadow Open Market Committee

Reforming Discount Window Practices
Existing practices delay timely resolution of insolvent institutions, and thereby increase costs
to the insurance fund and taxpayers. Existing practices also contribute to moral hazard.
The main avenue for discount window lending to insolvent institutions is extended credit.
The board should forthwith amend Regulation A that prescribes the authority, scope, and purpose
of Federal Reserve lending to depository institutions. It should explicitly declare that no Federal
Reserve Bank may advance extended credit to an institution with a CAMEL rating as low as 4 or
5.
The evidence of the savings and loan industry collapse has made clear that delayed resolution
of failures accounts for the largest losses to the federal insurance agencies. Continued operation
of insolvent institutions permits the generation of losses and also encourages risk-taking by solvent
institutions since the penalty of insolvency appears to be minimized. The Federal Reserve should
not be in the business of extending loans to insolvent institutions.




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Federal Reserve Bank of St. Louis, One Federal Reserve Bank Plaza, St. Louis, MO 63102