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An international economist pointed
out, however, that growth rates of foreign economies have been sluggish and
that prospects for accelerated growth
that might benefit U.S. exports are not
encouraging, especially in the absence
of fiscal stimulus on the part of foreign
governments.
Since mid-1985, industrial production
abroad, especially in Western Europe
and Japan, has been relatively flat.
Also, until 1986, growth of domestic
demand among major trading partners
was generally weaker than foreign real
GNP, with the difference being made
up by exports-especially
to the U.S.
Private and public forecasts for foreign economies in 1987 suggest little
change from 1986, with Japan's growth
in real GNP expected to be about the
same as last year's rate of 2.5 percent,
and with West Germany's growth rate
being slightly less than in 1986. West
Germany and Japan both have relatively large trade surpluses with the
U.S., and both countries had relatively
high unemployment rates and declining
inflation during most of 1986.
U.S. public officials have for some
time urged West German and Japanese
officials to take stimulative fiscal and
monetary action to boost domestic
demand. Both nations, however, have
been reluctant to do so for fear of reigniting inflation.

Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101

Material may be reprinted provided that the
source is credited. Please send copies of reprinted
materials to the editor.

A report on the international outlook
also pointed out that the U.S. may have
difficulty improving its trade deficit
with the newly industrialized nations
(NICs) of the Pacific Basin, which
includes South Korea, Taiwan, Hong
Kong, and Singapore. Our deficit with
these Asian countries equals our entire
deficit with Western Europe. The bulk
of this trade deficit, however, is with
Taiwan. The primary problem is that
the U.S. dollar has not depreciated very
much against the Taiwan dollar until
the past six to 12 months.
If the U.S. dollar were to depreciate
further against other currencies, then
an improvement in the U.S. trade deficit
would depend importantly on the cause
of the depreciation. According to simulations produced by an International
Monetary Fund (IMF) computer model
of U.S. and foreign economies, the most
positive exchange-rate effect on the
U.S. trade deficit would come from foreign fiscal stimulus. The IMF model
predicted that a reasonable amount of
foreign fiscal stimulus would improve
the U.S. trade deficit by an estimated
$14 billion in its first year.
Monetary expansion, on the other
hand, was estimated to have an initial
perverse effect, which would result in a
three-year lag before the trade deficit
shows a net improvement.
During the Roundtable discussion, it
was pointed out that neither fiscal nor
monetary policies alone can explain the
dollar's recent decline. The fall in the
dollar was seen to be due to a complicated combination of factors.

The problem underlying the trade
deficit with Japan is linked to the
imbalance between saving and domestic investment in the U.S. compared
with Japan. The U.S. has inadequate
savings relative to domestic investment
because of unusually large federal
budget deficits.
In summary, it appears that
improvement in the U.S. trade account
requires slower growth in domestic
demand relative to domestic production, and that saving must increase to
balance domestic investment. An
increase in growth rates of domestic
demand abroad would help the U.S.
trade deficit, although prospects for
this happening are not encouraging.
Conclusion
The Roundtable group uniformly
agreed that overall growth of the economy will be sustained at least through
the first half of 1988, which would
make the current expansion the second
longest in the post-World War II period.
Considerable differences surfaced,
however, over whether the level of output and prices in 1987 first quarter
represents the beginning of a higher
inflationary growth path, or if it is
simply a temporary "bubble." Differences also surfaced over whether or not
the Federal Reserve should place a
higher priority on resisting inflation
and rising expectations of inflation.

BULK RATE
U.S. Postage Paid
Cleveland, OH
Permit No. 385

Address Correction Requested: Please send
corrected mailing label to the Federal Reserve
Bank of Cleveland, Research Department,
P.O. Box 6387, Cleveland, OH 44101.

Federal Reserve Bank of Cleveland

June 15, 1987
ISSN 042R·1276

ECONOMIC
COMMENTARY
The economy is in the fifth year of an
expansion that has been characterized
by a relatively moderate inflation rate,
by moderate growth in output, and by
the continuation of large trade and federal deficits.
Some observers feel that the economy, like Shakespeare's character
Hamlet, is trying to make up its mind
and is currently wavering between
tendencies toward accelerated growth
in output and inflation, or toward
another year of moderate growth in
inflation and output.
Predicting which path will be taken
was one of the topics discussed at the
May 8 meeting of the Fourth District
Economists' Roundtable. The meeting,
held at the Federal Reserve Bank of
Cleveland, was attended by about 25
economists from a mixture of financial,
industrial, and retail firms headquartered within and outside the Fourth
Federal Reserve District, which
includes Ohio and parts of Pennsylvania, West Virginia, and Kentucky.
Roundtable meetings are scheduled
three times a year to give economists
an opportunity to exchange views
about national and industry conditions.
In spite of turbulence that marked
financial markets since the group's
first meeting of the year in February,
and despite the widely unanticipated
surge in output and prices last quarter,
Roundtable forecasts as of May 8 were
essentially unchanged from those made
in February. The group still expects
about the same growth path for output,
except that second quarter expectations

John]. Erceg is an assistant vice president and
economist at the Federal Reserve Bank of Cleoeland. William G. Murmann is editor of the Economic Review and Economic Commentary for the
Federal Reserve Bank of Cleveland. The authors
would like to thank Mark Sniderman and Gerald
H. Anderson for their helpful comments.

were cut back in view of higher-thanexpected output gain reported for the
first quarter of the year. The economists' inflation forecasts were virtually
unchanged from those made in February, despite a surge in consumer and
producer prices earlier this year.
This Economic Commentary summarizes the Roundtable forecasts and
the discussion that centered on
whether the unanticipated first-quarter
surge in both output and prices was
transitory, or if it was the beginning of
a stronger growth path that would
indicate that a higher policy priority
should be given to controlling inflation
and inflation expectations.
Economic Prospects
As indicated in table 1, the median forecast of the Roundtable economists anticipates much slower growth in real gross
national product (GNP) in the second
quarter of this year than in the first
quarter (1.1 percent annual rate vs. 4.4
percent, respectively). A $19 billion
reduction in inventory investment in the
second quarter and a smaller improvement in net exports are expected to
account for the slower second quarter
growth in real GNP. From 1987:IIIQ to
1988:IIQ, however, growth in real GNP
is still expected to accelerate to about a
3 percent average annual rate, which is
about the same as the Roundtable forecasters expected in February.
A few of the participants were more
cautious about the median forecast,

The views stated herein are those of the authors
and not necessarily those of the Federal Reserve
Bank of Cleveland or of the Board of Governors of
the Federal Reserve System.

Reappraising the

1987-88 Outlook

by John]. Erceg

and William G. Murmann

especially in light of the run-up in
interest rates since last March. Concern was expressed that higher interest
rates would dampen interest-rate sensitive sectors, especially autos and housing. Sustained higher interest rates
might warrant a cutback in consumer
spending for durable goods, especially
automobiles, and in real GNP, according to one economist. Another Roundtable member expects that the jump in
mortgage interest rates to about 10.5
percent, if sustained at the May level,
could weaken new housing starts,
dropping them to a 1.6 to 1.65 million
rate from last year's 1.8 million level.
Still, the tone of the May Roundtable
meeting was even more upbeat than
indicated in the group's median forecast. One prediction was that a
stronger-than-median performance for
both output and inflation would result
because four forces are pointing in the
same direction: 1) Fiscal policy, especially government spending, will show
less restraint than widely expected; 2)
lagged effects of declines in real interest rates will be positive to interestrate-sensitive sectors; 3) lagged effects
of rapid money stock expansion in
1986, along with higher oil and import
prices, will produce higher-thanexpected rates of inflation; and 4) the
effects of dollar depreciation will
increase output and employment for
U.S. manufacturers.
If these four forces materialize, real
GNP growth could amount to nearly 4
percent between second quarter 1987
and second quarter 1988, and prices
could accelerate close to a 4.5 percent
annual rate by the first half of 1988.

Table 1 Median Forecasts of Change in GNP and Related Items

Table 2 Automobile Outlook
Median Forecasts of Output, Sales and Inventories"

Change in Levels, Billions of Dollars, s.a.a.r."

1987
Year

GNP in constant (1982) dollars
Personal consumption expenditures
Nonresidential fixed investment
Residential construction
Change in business inventories
Net exports
Government purchases

1986
---

~

90.7
52.1
-7.3
2.4
9.3
20.7
16.2

9.7
-2.2
3.4
2.5
-28.2
15.3
18.9

5.4
2.8
2.5

1.7
0.7
1.1

(Number of cars· 000 units)

1987

.zs., .us..
39.8
-6.9
-8.5
-2.2
63.6
10.8
-14.0

10.4
19.9
5.8
1.3
-19.4
5.1
3.6

1986

1988
IIIQ

27.0
16.6
3.0
0.2
1.5
4.0
3.5

IQ

30.9
16.0
4.0
0.0
3.0
6.0
2.0

28.0
16.1
4.0
-0.5
2.0
4.0
2.6

7.3
4.1
3.2

7.4
3.7
3.3

7.0
4.1
2.9

1987

IQ

.ns..

~
30.0
16.0
4.3
0.0
0.5
4.3
4.7

1987

Domestic production
Domestic sales
Change in dealer stocks
Import sales
Total new car sales

7,827
8,215
-129
3,238
11,453

7,295
7,275
+109
3,040
10,200

.us..

2,075
1,668
+439
656
2,324

1,969
2,057
-75
790
2,835

~
1,500
1,800
-300
800
2,600

1988

IVQ

1,760
1,782
+30
782
2,550

.zs.. .us.,
1,900
1,770
+100
750
2,620

1,960
2,000'
-10
850
2,840

*Nonseasonallyadjusted.
Source: Fourth District Economists' Roundtable, May 8, 1987.

Percent Changes (Annual Rates)

GNP in current dollars
GNP implicit price deflator
GNP in constant (1982) dollars

8.7
4.1
4.4
Interest

Prime Rate
Moody AAA Corporate
Bond Price

4.8
3.5
1.1

6.6
3.8
2.9

Rates (Percents)

8.3

7.8

7.5

7.5

7.8

7.9

8.0

8.0

9.0

8.9

8.7

8.4

8.8

8.9

9.0

9.1

• Seasonally adjusted annual rate.
Source: Fourth District Economists' Roundtable, May 8, 1987.

With the exception of autos, there is
ample room for growth in durable and
nondurable goods inventories, according to one report.
Prospects for real nonresidential fixed
investment (NRFI) also appear to be on
a rising trend for 1987 following a decline in 1986. It was pointed out that
NRFI last year was weakened by the
effects of tax reform - especially by
the loss of tax incentives and by increases in the after-tax cost of capital.
With tax reform completed, the introduction of new information-processing
products, plus a swing from a deficit to
a small surplus in trade for capital
goods, should help increase investment
in producers' durable goods by 5 percent in 1987 and 8 percent in 1988.
Even larger increases are anticipated
for information-processing equipment.
Improvement is also expected in transportation equipment, and for industrial, agricultural, construction, and oil
equipment.
Investment in structures, however,
in 1987 will continue to be depressed
because of the oil-price decline in early
1986, because of overbuilding of office
and commercial buildings, and because
of tax reform. Commercial and industrial contracts have been rising irregularly since the steep decline in late 1985
and early 1986, suggesting that business spending for structures will likely
hit a low point this year before resuming a rising trend in 1988.

Autos
The Roundtable discussion of the
domestic economy included the automotive industry, where the steep decline
in the foreign-exchange value of the dollar since early 1985 has boosted prices
and reduced demand for foreign cars.
An industry economist said that
there has been a shift linked to the falling value of the dollar and that the Iapanese cost advantage has shrunk considerably. japanese automakers, he
said, used to have about a $2,500 cost
advantage over U.S. carmakers on certain models. This advantage has
shrunk to about $400.
japanese automakers have been forced
to raise import prices of 1986 models by
about 13.4 percent because of the drop
in the dollar. Prices of 1987 models
have been raised another 5.3 percent.
Price increases for domestic cars have
amounted to about 8.8 percent over the
1986 and 1987 model years.
This change in relative price has
brought down the japanese market
share to a more "natural" level, according to the auto analyst. Also, at one
point, he added, it was expected that
total imports would capture about 40
percent of the market, so the dollarinduced decline has been beneficial for

domestic manufacturers. Unit sales of
japanese imports, in particular, are
leveling out at about 20 percent of the
market, although market shares of
some other foreign producers, especially Korea, are rising.
This doesn't mean, however, that
there will be smooth sailing for domestic manufacturers. The industry, said
the analyst, faces a serious overcapacity problem. There are too many cars
and not enough customers. For example, production capacity of foreign carmakers in the U.S. amounts to an
estimated 815,000 units for the present
model year, and may be boosted to 1.9
million units by 1990.
Overcapacity is seen as a worldwide
problem. Cars entering the U.S. market
are being manufactured domestically,
plus being produced in Canada, Mexico,
japan, Korea, and Yugoslavia.
More and more countries are producing cars and all are competing for U.S.
customers. This will result in an
extremely competitive market. In addition, demand in the near future is
expected to show little growth, which
will put a squeeze on profits for some
manufacturers.
As indicated in table 2, the Fourth
District panel expects a 7 percent
decline in auto output this year compared to last year, primarily in
response to lower sales of both domestic and imported cars.

Monetary Policy Issues
The Roundtable discussion of monetary
policy centered largely on Federal Reserve objectives and on how those objectives should be influenced by domestic
and international considerations. The
spurt in prices in recent months has
contributed to rising expectations about
inflation, and has led some financial
market participants to call for greater
emphasis on controlling inflation.
Several Roundtable economists expressed a view that the discount rate
should be increased in the near future
as a signal to domestic and foreignexchange markets that the Federal Reserve is willing and prepared to deal
with the possibility of accelerating
inflation.
Several key issues underlie the course
of monetary policy. The first relates to
the strength of the economy. Those who
urge immediate further action assert
that the growth of the economy shows
signs of accelerating from the 2.4 percent annual rate of change that has
existed since mid-1984. They are also
convinced that probabilities about the
economy have shifted in favor of fasterthan-expected growth-which
is something that was not predicted at the last
few meetings of the Roundtable.
Concern was also expressed by some
of the Roundtable economists over
whether the first quarter 1987 spike in
prices is indicative of accelerating inflation. Most Fourth District forecasters
expect prices to increase in a 3.5 to 4
percent range through the balance of
1987, and in a 4 percent zone at least
through the first half of 1988. A few
expect inflation to accelerate to a 4 to 5
percent range, mostly in response to
higher prices of imports.
Those economists urging immediate
tightening action by the Federal Reserve
pointed to similarities to economic con-

ditions in May 1983, when a period of
accelerated growth in both output and
prices led to tightening action. The
claim was made that willingness to
raise interest rates at that time contributed to lower interest rates since
then - which may not have occurred
to the same degree if the policy action
had not been taken.
Those Roundtable economists who
see clear signs of accelerating growth
in output and inflation believe that the
priority in Federal Reserve policy
should be to counter inflationary tendencies. Some support a more strict
adherence to monetary targeting to
achieve their desired inflation objective.
Although not necessarily supporting
targeting narrow money stock (Ml) at
present, one member suggested keeping
growth of the broader money stock
aggregates, particularly M2, within
their target ranges for 1987. He felt
that regained confidence in foreignexchange markets would be a byproduct of control over money stock
growth, especially if growth of money
at home were less than growth among
key trading partners.
Some others, however, doubted that
there is sufficient information to corroborate the view that the growth rate of
output and of inflation is accelerating.
According to them, the economy is still
giving mixed signs. Likewise, they feel
it is still uncertain whether the price
increases that occurred last quarter represent the early stage of accelerating
inflation or if they are simply a return
to the "core" rate of inflation-the
3 to
4 percent rate that existed before the
energy price declines in early 1986.
Uncertainty over whether or not
inflation will accelerate beyond the 3 to
4 percent core rate that apparently has

been accepted by markets and policymakers suggests that it may be premature to tighten monetary policy. The
best course, one participant suggested,
may be to adopt a wait-and-see
approach, and to avoid taking downside
risks to the economy in response to
what may be a temporary run-up in
market expectations about inflation.
The concern of another economist,
however, is that the core inflation rate
may reach as high as 4 percent. When
the economy's output growth was
about 2.5 percent in 1985 and 1986, he
said, prices rose in a 3.5 to 4 percent
range - even with the benefit of lower
import prices. Now, however, the effects
of dollar depreciation are probably
adding one percentage point to the
domestic inflation rate, so that the
overall inflation rate is already moving
above the core rate.
International Prospects
Many Roundtable forecasters expect
that a primary source of thrust in domestic output will be an improvement in the
international trade sector, which has
been a major drag on domestic output
during most of the current expansion.
Over the next four quarters, for example, the median forecast by the 25 Fourth
District economists shows a sizable improvement in real net exports of nearly
$20 billion, following the $29 billion increase that has taken place between
third quarter 1986 and first quarter 1987.
Even with such an improvement, however, a sizable trade deficit would remain and many analysts are skeptical
that further dollar depreciation alone
can contribute much more to reducing
it. Among other things, they look to
faster growth in exports for continued
improvement in U.S. net exports.

Table 1 Median Forecasts of Change in GNP and Related Items

Table 2 Automobile Outlook
Median Forecasts of Output, Sales and Inventories"

Change in Levels, Billions of Dollars, s.a.a.r."

1987
Year

GNP in constant (1982) dollars
Personal consumption expenditures
Nonresidential fixed investment
Residential construction
Change in business inventories
Net exports
Government purchases

1986
---

~

90.7
52.1
-7.3
2.4
9.3
20.7
16.2

9.7
-2.2
3.4
2.5
-28.2
15.3
18.9

5.4
2.8
2.5

1.7
0.7
1.1

(Number of cars· 000 units)

1987

.zs., .us..
39.8
-6.9
-8.5
-2.2
63.6
10.8
-14.0

10.4
19.9
5.8
1.3
-19.4
5.1
3.6

1986

1988
IIIQ

27.0
16.6
3.0
0.2
1.5
4.0
3.5

IQ

30.9
16.0
4.0
0.0
3.0
6.0
2.0

28.0
16.1
4.0
-0.5
2.0
4.0
2.6

7.3
4.1
3.2

7.4
3.7
3.3

7.0
4.1
2.9

1987

IQ

.ns..

~
30.0
16.0
4.3
0.0
0.5
4.3
4.7

1987

Domestic production
Domestic sales
Change in dealer stocks
Import sales
Total new car sales

7,827
8,215
-129
3,238
11,453

7,295
7,275
+109
3,040
10,200

.us..

2,075
1,668
+439
656
2,324

1,969
2,057
-75
790
2,835

~
1,500
1,800
-300
800
2,600

1988

IVQ

1,760
1,782
+30
782
2,550

.zs.. .us.,
1,900
1,770
+100
750
2,620

1,960
2,000'
-10
850
2,840

*Nonseasonallyadjusted.
Source: Fourth District Economists' Roundtable, May 8, 1987.

Percent Changes (Annual Rates)

GNP in current dollars
GNP implicit price deflator
GNP in constant (1982) dollars

8.7
4.1
4.4
Interest

Prime Rate
Moody AAA Corporate
Bond Price

4.8
3.5
1.1

6.6
3.8
2.9

Rates (Percents)

8.3

7.8

7.5

7.5

7.8

7.9

8.0

8.0

9.0

8.9

8.7

8.4

8.8

8.9

9.0

9.1

• Seasonally adjusted annual rate.
Source: Fourth District Economists' Roundtable, May 8, 1987.

With the exception of autos, there is
ample room for growth in durable and
nondurable goods inventories, according to one report.
Prospects for real nonresidential fixed
investment (NRFI) also appear to be on
a rising trend for 1987 following a decline in 1986. It was pointed out that
NRFI last year was weakened by the
effects of tax reform - especially by
the loss of tax incentives and by increases in the after-tax cost of capital.
With tax reform completed, the introduction of new information-processing
products, plus a swing from a deficit to
a small surplus in trade for capital
goods, should help increase investment
in producers' durable goods by 5 percent in 1987 and 8 percent in 1988.
Even larger increases are anticipated
for information-processing equipment.
Improvement is also expected in transportation equipment, and for industrial, agricultural, construction, and oil
equipment.
Investment in structures, however,
in 1987 will continue to be depressed
because of the oil-price decline in early
1986, because of overbuilding of office
and commercial buildings, and because
of tax reform. Commercial and industrial contracts have been rising irregularly since the steep decline in late 1985
and early 1986, suggesting that business spending for structures will likely
hit a low point this year before resuming a rising trend in 1988.

Autos
The Roundtable discussion of the
domestic economy included the automotive industry, where the steep decline
in the foreign-exchange value of the dollar since early 1985 has boosted prices
and reduced demand for foreign cars.
An industry economist said that
there has been a shift linked to the falling value of the dollar and that the Iapanese cost advantage has shrunk considerably. japanese automakers, he
said, used to have about a $2,500 cost
advantage over U.S. carmakers on certain models. This advantage has
shrunk to about $400.
japanese automakers have been forced
to raise import prices of 1986 models by
about 13.4 percent because of the drop
in the dollar. Prices of 1987 models
have been raised another 5.3 percent.
Price increases for domestic cars have
amounted to about 8.8 percent over the
1986 and 1987 model years.
This change in relative price has
brought down the japanese market
share to a more "natural" level, according to the auto analyst. Also, at one
point, he added, it was expected that
total imports would capture about 40
percent of the market, so the dollarinduced decline has been beneficial for

domestic manufacturers. Unit sales of
japanese imports, in particular, are
leveling out at about 20 percent of the
market, although market shares of
some other foreign producers, especially Korea, are rising.
This doesn't mean, however, that
there will be smooth sailing for domestic manufacturers. The industry, said
the analyst, faces a serious overcapacity problem. There are too many cars
and not enough customers. For example, production capacity of foreign carmakers in the U.S. amounts to an
estimated 815,000 units for the present
model year, and may be boosted to 1.9
million units by 1990.
Overcapacity is seen as a worldwide
problem. Cars entering the U.S. market
are being manufactured domestically,
plus being produced in Canada, Mexico,
japan, Korea, and Yugoslavia.
More and more countries are producing cars and all are competing for U.S.
customers. This will result in an
extremely competitive market. In addition, demand in the near future is
expected to show little growth, which
will put a squeeze on profits for some
manufacturers.
As indicated in table 2, the Fourth
District panel expects a 7 percent
decline in auto output this year compared to last year, primarily in
response to lower sales of both domestic and imported cars.

Monetary Policy Issues
The Roundtable discussion of monetary
policy centered largely on Federal Reserve objectives and on how those objectives should be influenced by domestic
and international considerations. The
spurt in prices in recent months has
contributed to rising expectations about
inflation, and has led some financial
market participants to call for greater
emphasis on controlling inflation.
Several Roundtable economists expressed a view that the discount rate
should be increased in the near future
as a signal to domestic and foreignexchange markets that the Federal Reserve is willing and prepared to deal
with the possibility of accelerating
inflation.
Several key issues underlie the course
of monetary policy. The first relates to
the strength of the economy. Those who
urge immediate further action assert
that the growth of the economy shows
signs of accelerating from the 2.4 percent annual rate of change that has
existed since mid-1984. They are also
convinced that probabilities about the
economy have shifted in favor of fasterthan-expected growth-which
is something that was not predicted at the last
few meetings of the Roundtable.
Concern was also expressed by some
of the Roundtable economists over
whether the first quarter 1987 spike in
prices is indicative of accelerating inflation. Most Fourth District forecasters
expect prices to increase in a 3.5 to 4
percent range through the balance of
1987, and in a 4 percent zone at least
through the first half of 1988. A few
expect inflation to accelerate to a 4 to 5
percent range, mostly in response to
higher prices of imports.
Those economists urging immediate
tightening action by the Federal Reserve
pointed to similarities to economic con-

ditions in May 1983, when a period of
accelerated growth in both output and
prices led to tightening action. The
claim was made that willingness to
raise interest rates at that time contributed to lower interest rates since
then - which may not have occurred
to the same degree if the policy action
had not been taken.
Those Roundtable economists who
see clear signs of accelerating growth
in output and inflation believe that the
priority in Federal Reserve policy
should be to counter inflationary tendencies. Some support a more strict
adherence to monetary targeting to
achieve their desired inflation objective.
Although not necessarily supporting
targeting narrow money stock (Ml) at
present, one member suggested keeping
growth of the broader money stock
aggregates, particularly M2, within
their target ranges for 1987. He felt
that regained confidence in foreignexchange markets would be a byproduct of control over money stock
growth, especially if growth of money
at home were less than growth among
key trading partners.
Some others, however, doubted that
there is sufficient information to corroborate the view that the growth rate of
output and of inflation is accelerating.
According to them, the economy is still
giving mixed signs. Likewise, they feel
it is still uncertain whether the price
increases that occurred last quarter represent the early stage of accelerating
inflation or if they are simply a return
to the "core" rate of inflation-the
3 to
4 percent rate that existed before the
energy price declines in early 1986.
Uncertainty over whether or not
inflation will accelerate beyond the 3 to
4 percent core rate that apparently has

been accepted by markets and policymakers suggests that it may be premature to tighten monetary policy. The
best course, one participant suggested,
may be to adopt a wait-and-see
approach, and to avoid taking downside
risks to the economy in response to
what may be a temporary run-up in
market expectations about inflation.
The concern of another economist,
however, is that the core inflation rate
may reach as high as 4 percent. When
the economy's output growth was
about 2.5 percent in 1985 and 1986, he
said, prices rose in a 3.5 to 4 percent
range - even with the benefit of lower
import prices. Now, however, the effects
of dollar depreciation are probably
adding one percentage point to the
domestic inflation rate, so that the
overall inflation rate is already moving
above the core rate.
International Prospects
Many Roundtable forecasters expect
that a primary source of thrust in domestic output will be an improvement in the
international trade sector, which has
been a major drag on domestic output
during most of the current expansion.
Over the next four quarters, for example, the median forecast by the 25 Fourth
District economists shows a sizable improvement in real net exports of nearly
$20 billion, following the $29 billion increase that has taken place between
third quarter 1986 and first quarter 1987.
Even with such an improvement, however, a sizable trade deficit would remain and many analysts are skeptical
that further dollar depreciation alone
can contribute much more to reducing
it. Among other things, they look to
faster growth in exports for continued
improvement in U.S. net exports.

An international economist pointed
out, however, that growth rates of foreign economies have been sluggish and
that prospects for accelerated growth
that might benefit U.S. exports are not
encouraging, especially in the absence
of fiscal stimulus on the part of foreign
governments.
Since mid-1985, industrial production
abroad, especially in Western Europe
and Japan, has been relatively flat.
Also, until 1986, growth of domestic
demand among major trading partners
was generally weaker than foreign real
GNP, with the difference being made
up by exports-especially
to the U.S.
Private and public forecasts for foreign economies in 1987 suggest little
change from 1986, with Japan's growth
in real GNP expected to be about the
same as last year's rate of 2.5 percent,
and with West Germany's growth rate
being slightly less than in 1986. West
Germany and Japan both have relatively large trade surpluses with the
U.S., and both countries had relatively
high unemployment rates and declining
inflation during most of 1986.
U.S. public officials have for some
time urged West German and Japanese
officials to take stimulative fiscal and
monetary action to boost domestic
demand. Both nations, however, have
been reluctant to do so for fear of reigniting inflation.

Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101

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A report on the international outlook
also pointed out that the U.S. may have
difficulty improving its trade deficit
with the newly industrialized nations
(NICs) of the Pacific Basin, which
includes South Korea, Taiwan, Hong
Kong, and Singapore. Our deficit with
these Asian countries equals our entire
deficit with Western Europe. The bulk
of this trade deficit, however, is with
Taiwan. The primary problem is that
the U.S. dollar has not depreciated very
much against the Taiwan dollar until
the past six to 12 months.
If the U.S. dollar were to depreciate
further against other currencies, then
an improvement in the U.S. trade deficit
would depend importantly on the cause
of the depreciation. According to simulations produced by an International
Monetary Fund (IMF) computer model
of U.S. and foreign economies, the most
positive exchange-rate effect on the
U.S. trade deficit would come from foreign fiscal stimulus. The IMF model
predicted that a reasonable amount of
foreign fiscal stimulus would improve
the U.S. trade deficit by an estimated
$14 billion in its first year.
Monetary expansion, on the other
hand, was estimated to have an initial
perverse effect, which would result in a
three-year lag before the trade deficit
shows a net improvement.
During the Roundtable discussion, it
was pointed out that neither fiscal nor
monetary policies alone can explain the
dollar's recent decline. The fall in the
dollar was seen to be due to a complicated combination of factors.

The problem underlying the trade
deficit with Japan is linked to the
imbalance between saving and domestic investment in the U.S. compared
with Japan. The U.S. has inadequate
savings relative to domestic investment
because of unusually large federal
budget deficits.
In summary, it appears that
improvement in the U.S. trade account
requires slower growth in domestic
demand relative to domestic production, and that saving must increase to
balance domestic investment. An
increase in growth rates of domestic
demand abroad would help the U.S.
trade deficit, although prospects for
this happening are not encouraging.
Conclusion
The Roundtable group uniformly
agreed that overall growth of the economy will be sustained at least through
the first half of 1988, which would
make the current expansion the second
longest in the post-World War II period.
Considerable differences surfaced,
however, over whether the level of output and prices in 1987 first quarter
represents the beginning of a higher
inflationary growth path, or if it is
simply a temporary "bubble." Differences also surfaced over whether or not
the Federal Reserve should place a
higher priority on resisting inflation
and rising expectations of inflation.

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Federal Reserve Bank of Cleveland

June 15, 1987
ISSN 042R·1276

ECONOMIC
COMMENTARY
The economy is in the fifth year of an
expansion that has been characterized
by a relatively moderate inflation rate,
by moderate growth in output, and by
the continuation of large trade and federal deficits.
Some observers feel that the economy, like Shakespeare's character
Hamlet, is trying to make up its mind
and is currently wavering between
tendencies toward accelerated growth
in output and inflation, or toward
another year of moderate growth in
inflation and output.
Predicting which path will be taken
was one of the topics discussed at the
May 8 meeting of the Fourth District
Economists' Roundtable. The meeting,
held at the Federal Reserve Bank of
Cleveland, was attended by about 25
economists from a mixture of financial,
industrial, and retail firms headquartered within and outside the Fourth
Federal Reserve District, which
includes Ohio and parts of Pennsylvania, West Virginia, and Kentucky.
Roundtable meetings are scheduled
three times a year to give economists
an opportunity to exchange views
about national and industry conditions.
In spite of turbulence that marked
financial markets since the group's
first meeting of the year in February,
and despite the widely unanticipated
surge in output and prices last quarter,
Roundtable forecasts as of May 8 were
essentially unchanged from those made
in February. The group still expects
about the same growth path for output,
except that second quarter expectations

John]. Erceg is an assistant vice president and
economist at the Federal Reserve Bank of Cleoeland. William G. Murmann is editor of the Economic Review and Economic Commentary for the
Federal Reserve Bank of Cleveland. The authors
would like to thank Mark Sniderman and Gerald
H. Anderson for their helpful comments.

were cut back in view of higher-thanexpected output gain reported for the
first quarter of the year. The economists' inflation forecasts were virtually
unchanged from those made in February, despite a surge in consumer and
producer prices earlier this year.
This Economic Commentary summarizes the Roundtable forecasts and
the discussion that centered on
whether the unanticipated first-quarter
surge in both output and prices was
transitory, or if it was the beginning of
a stronger growth path that would
indicate that a higher policy priority
should be given to controlling inflation
and inflation expectations.
Economic Prospects
As indicated in table 1, the median forecast of the Roundtable economists anticipates much slower growth in real gross
national product (GNP) in the second
quarter of this year than in the first
quarter (1.1 percent annual rate vs. 4.4
percent, respectively). A $19 billion
reduction in inventory investment in the
second quarter and a smaller improvement in net exports are expected to
account for the slower second quarter
growth in real GNP. From 1987:IIIQ to
1988:IIQ, however, growth in real GNP
is still expected to accelerate to about a
3 percent average annual rate, which is
about the same as the Roundtable forecasters expected in February.
A few of the participants were more
cautious about the median forecast,

The views stated herein are those of the authors
and not necessarily those of the Federal Reserve
Bank of Cleveland or of the Board of Governors of
the Federal Reserve System.

Reappraising the

1987-88 Outlook

by John]. Erceg

and William G. Murmann

especially in light of the run-up in
interest rates since last March. Concern was expressed that higher interest
rates would dampen interest-rate sensitive sectors, especially autos and housing. Sustained higher interest rates
might warrant a cutback in consumer
spending for durable goods, especially
automobiles, and in real GNP, according to one economist. Another Roundtable member expects that the jump in
mortgage interest rates to about 10.5
percent, if sustained at the May level,
could weaken new housing starts,
dropping them to a 1.6 to 1.65 million
rate from last year's 1.8 million level.
Still, the tone of the May Roundtable
meeting was even more upbeat than
indicated in the group's median forecast. One prediction was that a
stronger-than-median performance for
both output and inflation would result
because four forces are pointing in the
same direction: 1) Fiscal policy, especially government spending, will show
less restraint than widely expected; 2)
lagged effects of declines in real interest rates will be positive to interestrate-sensitive sectors; 3) lagged effects
of rapid money stock expansion in
1986, along with higher oil and import
prices, will produce higher-thanexpected rates of inflation; and 4) the
effects of dollar depreciation will
increase output and employment for
U.S. manufacturers.
If these four forces materialize, real
GNP growth could amount to nearly 4
percent between second quarter 1987
and second quarter 1988, and prices
could accelerate close to a 4.5 percent
annual rate by the first half of 1988.