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FRBSF

WEEKLY LETTER

December 23, 1988

The Economic Outlook for 1989
The following is a modified text of the speech
given by Robert T. Parry, President and Chief
Executive Officer of the Federal Reserve Bank of
San Francisco, before a General Meeting of the
Town Hall of California, in Los Angeles on December 6, 1988. In this speech, President Parry
discusses the recent performance of the U.S.
economy and his views regarding the economic
outlook and monetary policy in the coming year.

A remarkable expansion
The past six years have seen a strong expansion
in the U.S. economy-the longest peacetime expansion in U.s. history. More than 18112 million
jobs have been created since the business cycle
trough in 1982. The unemployment rate has fallen to a fourteen-year low of under 5112 percent.
At the same time, consumer price inflation has
been brought down from a peak of nearly 15 percent in 1980 to 4 percent over the past twelve
months.
In 1987, real output grew by 5 percent, a remarkably robust performance for an economy in its
fifth year of expansion. The economy slowed
modestly to a 3% percent rate of growth in the
first half of this year. This still is surprisingly
strong, considering the October 1987 stockmarket crash and the drought in 1988.
Improvement in our foreign trade balance has
been an engine for growth in the past year and a
half. Spending by businesses on equipment, and
consumer spending on services and durable
goods also have kept things moving along.
Since midyear, the economy has continued to
grow ata robust pace, growing at a 2.6 percent
annual rate in the third quarter. That's down
slightly from the first half, mainly due to the temporary effects of the drought on agricultural
production. The effects of this decline in the agricultural sector will be felt through the fourth
quarter. However, we're seeing signs of considerable strength in the nonfarm sectors. If we
abstract from the effects of the drought, thirdquarter growth registered a 3114 percent annual

rate, and recent monthly numbers on unemployment, retail sales, and industrial production were
strong. Thus, overall, the slowdown in the economy compared with the first half of the year
probably is more apparent than real.
From my perspective as a central banker, a
slowing trend actually would be desirable. In the
Summer of 1987, the Federal Reserve was becoming increasingly concerned that the economy
was in danger of "overheating:' The unemployment rate was dropping and capacity utilization
was rising-both into ranges that signalled the
economy was approaching its maximum capability to produce goods and services. Long-term
interest rates were rising, reflecting the market's
concern about future inflation. So, the Fed raised
the discount rate in September 1987 from 5112
percent to six percent to make clear our intention to cool things off a bit.
The stock-market crash in October required a
detour in the course of monetary policy. As fears
of recession rose, the Fed provided the liquidity
needed by the financial and economic system.
By March of this year, however, the threat of recession largely had passed, and the Fed returned
to its anti-inflation course.
Since then, we have raised the discount rate another 112 percent to 6112 percent. Market interest
rates have risen about 1112 percentage points
since Spring, partly as a result of the discount
rate hike and a series of other tightening moves.
Overall, financial markets have responded favorably to our efforts: long-term interest rates have
not risen as fast as short-term rates, reflecting
lower expectations of inflation.

Key concerns
But the economy still is growing at a pace that
cannot be sustained in the long run without
higher inflation. The pattern of growth, particularly in the third quarter, also is of concern.
Consumer spending remained strong while business spending on plant and equipment tapered
off sharply. Likewise, our trade balance (adjusted

FRBSf
for price changes) worsened for the first time
since the end of 1986. Andalthough federal government spending has declined rnarkedlyover
the course of this year, the federal budget deficit
remains massive.
Thes~ developments illustrate the persistent and
dangerous structural imbalances i[lour economy
that have arisen in the current ewansion. By
"structural. imbalances," I. mean. the federalbudget and trade deficits,. and the low personal
saving rate. The combination of strong spending
in the private sector and unprecedented deficits
in the. federaLgovE?mment'sbudget have outstripped ournation'~ saving and productive
capacity. Asa result, we have had to rely on importsofforeign goods and foreign funds to make
uptheshortfalLAs a nation/weare spending
beyondour means.

ForeignJinancing has enabled. us to do this. B.ut
inthe process,. we are mortgaging our future inc
come, and the income of our children,to pay for
this spending spree. Of.course, as every homeownerin·Californiaknows, a big mortgage is not
so onerous when we expectourjncome~ and
wealth to rise. But I worry when I look at how
we'~espendjng.themoney. The combination of
continued strength. in consumption, large budget
deficits, and only moderate business investment
in plant and. equipme[lt .is .troublesome: we're
simply not)nvesting enough in productive capacity.to boost our future incomea[ld cover the
rising foreign debt service.
An()ther problem with these imbalances is that
they have madeUS. economic developments
highlysensitivetochanges in the foreignexchangev<;llue of the.donar. After falling sharply
from early 1985 through 1987,the donar has risen
of,l.balancein 1988, In September,. itwas 10 percent higher on a trade-weighted basis than atthe
end Of .198?.5incethen, the dollar has fallen, but
its level stin is 2 percent higher now than at the
end of last year. The dollar's higher level throughout much of the year has had, and could continue to have, a dampening effect on the growth
of net exports and the economy generally. Of
course, slower growth in our export sector actu:
ally is beneficial in one respect: itishelpingto
keep inflation under control and reducing upward pressure on. interest rates. B.utthe higher
dollar also is slowing the needed adjustment in
our trade deficit and increasing our foreign debts.

Conversely, a weaker dollar would help out on
the foreign trade front, but also wou Id have a
d()wnside:a lowerdollarwould increase inflationaryand interest-rate pressures. In effect, the
dollar has become a "catch-n" for the
economy. If it falls, it creates inflation, and if it
rises, it.delaystbeneededadjustment in our foreign deficit.

u.s.

Some have embraced trade barriers as a way to
reduce the trade deficit. But this approach would
be disastrous. Trade protectionism invites retaliation, thereby threatening the world-wide economicexpansion and raising prices in the U.S.
without helping our overall trade situation.
However, there is one way out of the "catch-n"
of the dollar: reduce the federal budget deficit.
Reduci ng the budget deficit would lower the .demandfor foreign funds as well as the demands
on the economy's resources. This would allow
the dollar, the trade deficit, and interest rates to
subside simultaneously. It also would set the
stage for more balanced and sustainable economi<;: growth over the long run, and thus enhance the chances of extending the expansion
well into the next decade.
Prospects for reducing the deficit are very difficult to assess. The projections of the Administration and the Congressional Budget Office present
very different pictures. The Administration expects that Gramm-Rudman-Hollings spending
cuts will reduce the deficit by about $25 billion
per year over the next five years and bring the
budget close to balance in 1993. The CBO sees
improvement of only $7 billion per year. These
differences rest mainly on alternative assumptions about economic developments. over the
next five years, and my outlook.is doserto that
of the CBO.
But more important than difference~ in economic
assumptions are the actions the new Administration will take to reduce the deficit. Unfortunately,
the gargantuan potential liability of the Federal
Savings. and Loan Insurance Corporation won't
help matters. Estimates of the cost of dealing
with all.the insolventS&Ls run as high as $100
biUion! But despite the problems, it is imperative
that strong actions be taken-,-and soon-to.set
the deficit on a decidedly .downward course.

Price stability
There is very little the Federal Reserve can do to
correct the imbalances I have described. Until
concrete progress is made in lowering the budget
deficit, we are stuck with structural imbalances
that foster underlying inflationary pressures. Although overall inflation has not accelerated this
year compared to 1987, there have been disquieting signs of a pick-up in wages, salaries, and
benefits. The most comprehensive measure of labor compensation rose by 4% percent over the
twelve months ending last September, versus less
than 3% percent over the prior twelve months.
Although part of this increase was due to special
factors, it does suggest that underlying wage
pressures are rising. And the longer the economy
cOhtinues to grow at rates thatstrain capacity, the
more these wage pressures will mount.
Now, I don't want to give the impression that inflation is about to return to double-digit levels.
The combination of a higher dollar and lower oil
prices so far this year provides some temporary
relief. But we can't depend on these factors,
which are beyond our control, to solve our inflation problem. For example, developments at the
recent OPEC meeting raise the specter of higher
oil prices, and threaten to put upward pressure
on inflation in the future.
We should not shy away from corrective medicine while the inflation problem is still manageable. Even so, it takes time for this medicine to
work. The choices we make today will have a
larger impact on inflation in 1990 than in the
coming year.
But some may wonder, "what's wrong with a little inflation in the future if reining it in means we
have to accept slower economic growth now?"
The problem is, a little inflation has a disturbing
tendency to turn into a lot of inflation. Inflation
stunts economic growth and exacerbates business cycle swings. And the experience ofthe
early 1980s showed that once inflation gets embedded in expectations, it's difficult to root out. It
took two back-to-back recessions, soaring interest rates, and postwar-record unemployment to
tame inflation the last time around.

For this reason, we need to make steady progress
towards price stability. Now that we're operating
in the range of full employment, the economy
can't afford to grow faster than the rate of growth
in our long-run capability to produce goods and
services. This means the economy should expand next year (and over the next several years)
at less than a 2112 percent pace.

Looking ahead
Fortunately, the monetary tightening so far and
the behavior of the dollar this year should restrai n econom ic growthsomewhaFiriT98-9.
Whether these factors alone will be sufficient to
hold economic growth to a sustainable rate of
under 2112 percent next year remains to be seen. I
expect to see prices (as measured by the fixedweight GNP price index) rise at about the same
rate next year as this year; that is, in the 4 to 4%
percent range. Inflation at this pace next year is
worrisome because luck has had a lot to do with
keeping a lid on prices recently. Movements in
the dollar and the price of oil this year as well as
expected favorable developments in agriculture
next year should contribute to slightly lower inflation next year. However, underlying inflationary pressures, which are of primary concern to
monetary policy, most likely will continue to accelerate.
Thus, the key issue in 1989 will be whether
growth is balanced and conducive to the longerrun health of the economy. Unfortunately, the
prospects for more balanced growth in 1989 are
not as bright as I'd like. Improvements in the
trade balance and investment spending seem
likely to slow. Moreover, I expect the personal
saving rate to remain around its present low level
through the end of next year. Finally, the federal
budget deficit will remain massive, by even the
most optimistic projections.
As I have stressed, the Fed's number one job is to
promote price stability. We can't solve these
structural imbalances in the economy, but we
can and will resist the inflationary pressures they
create.

Robert T. Parry
President and Chief Executive Officer

Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of
San Francisco, or of the Board of Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor (Barbara Bennett) or to the author...• Free copies of Federal Reserve
publications can be obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702,
San Francisco 94120. Phone (415) 974-2246.

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