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1 • • • • • • • The Economy in Perspective FRB Cleveland • March 2000 On the road again … U.S. stock markets rallied on news that employment grew only 43,000 in February; market participants had expected a figure five times that size. Reactions like this no longer puzzle readers of the business press, who have been conditioned to believe that strong economic growth increases the risk that inflation will accelerate. This outcome is not entirely unthinkable, but neither is it inevitable. Vigorous economic growth in itself does not cause inflation to accelerate, but it can appear to do so. Inflation is a monetary phenomenon: Money growth in excess of the public’s need eventually decreases the purchasing power of money or, equivalently, raises the general price level. This long-term relationship between money and prices has been documented for so many countries and eras that few economists doubt it. In theory, monetary authorities desiring to promote price stability need only gear supply to demand. Complications arise when monetary authorities cannot discern the true level of money demand. In the United States, for example, the inconsistency of the public’s demand for money over the past few decades has given the Federal Reserve difficulty in gauging how much to supply. Federal funds rate targeting has filled the void. The public cares about its economic welfare— the ultimate outcome—not directly about the price level and its fluctuations. But suppose short-term changes in underlying (nonmonetary) economic conditions depend partly on actual or expected movements in the price level, and vice versa. And suppose further that the public dislikes volatile business-cycle fluctuations. In these circumstances, monetary authorities must understand the interactions between price-level movements and fundamental economic activity, and how their own policy actions affect each of these factors. Economists have been divided over the relative usefulness of money and labor market information for understanding, predicting, and controlling inflation over the past 40 years. One school of thought teaches that inflation accelerates in boom times because central banks mistakenly let money supplies expand beyond the quantities needed to meet the increased needs of commerce. Labor markets become tight, factories operate at high levels of capacity utilization, and imports increase to fill the demand that domestic firms cannot supply. Implementing monetary policy in this framework requires knowing, among other things, when monetary growth is excessive. Boom conditions may reflect, rather than cause, this excess. A competing school teaches that excessive labor market tightness can induce businesses to increase product prices in an effort to maintain their profit margins in the face of rising labor costs. Prudent monetary policy requires hiking interest rates to slow economic activity and relieve wage pressures that otherwise would lead to inflation. Implementing monetary policy within this framework entails knowing at what point labor market tightness will spark inflationary wage-setting practices. If money plays a role in this framework, it is a decidedly passive one. Unreliable money-demand estimates, coupled with a statistical relationship between inflation and unemployment rates, encouraged U.S. policymakers to rely on labor market conditions for guidance in conducting monetary policy. After all, even if a tight labor market does not truly cause inflation to accelerate, why ignore the unemployment rate if its decline (arguably following prior excessive monetary stimulus) appears to foreshadow accelerating inflation? It is easy to see why a sizeable pickup in the rate of productivity growth poses challenges for both designing and discussing monetary policy. When improved productivity can generate faster output growth and absorb the profit-margin impact of higher wages, how should estimates of labor market tightness be recalibrated? How much confidence can be placed in this indicator, which may be just as problematic as the money supply? Experience in the practice of monetary policy over many decades shows that reliable guideposts come and go, sometimes requiring policymakers to adjust their theories and methods. At the same time, historical observation suggests caution after long periods of strong economic growth, if only because such periods have often been followed by inflationary and financial imbalances. The Federal Reserve’s recent policy actions could be regarded as steps taken to keep the economy on a steady path. 2 • • • • • • • Monetary Policy Percent 6.75 IMPLIED YIELDS ON FEDERAL FUNDS FUTURES Percent, weekly average 6.0 RESERVE MARKET RATES 6.50 Effective federal funds rate 5.8 February 18, 2000 5.6 6.25 Intended federal funds rate 5.4 February 16, 2000 February 25, 2000 5.2 6.00 December 30, 1999 Discount rate 5.0 January 31, 2000 5.75 4.8 November 30, 1999 4.6 5.50 4.4 5.25 November February May 2000 1999 August 4.2 1996 1997 1998 1999 2000 1999 2000 Percent, weekly average 9 LONG-TERM INTEREST RATES Percent, weekly average 6.25 SHORT-TERM INTEREST RATES 1-year T-bill a Conventional mortgage 5.75 8 5.25 7 30-year Treasury a 3-month T-bill a 4.75 6 4.25 5 10-year Treasury a 3.75 1996 1997 1998 1999 2000 4 1996 1997 1998 FRB Cleveland • March 2000 a. Constant maturity. SOURCES: Board of Governors of the Federal Reserve System; and Chicago Board of Trade. On February 17, the Board of Governors of the Federal Reserve System submitted its semiannual Monetary Policy Report (or Humphrey– Hawkins Report) to the Congress, as mandated by the Full Employment and Balanced Growth Act of 1978. On the same day, Federal Reserve Chairman Alan Greenspan testified on the report to the House of Representatives’ Committee on Banking and Financial Services. Chairman Greenspan commented that the economy’s strong performance in 1999 was “unprecedented in my half-century of observing the American economy.” He noted that continued acceleration in productivity is a key factor in this economic strength. However, in a cautionary note that drew a great deal of media attention, he also pointed out that “those profoundly beneficial forces driving the American economy to competitive excellence are also engendering a set of imbalances that, unless contained, threaten our continuing prosperity.” Despite the media fanfare, the chairman’s cautionary remarks did not cause any strong reaction in implied yields on federal funds futures, which are often used as a proxy for market participants’ expectations about the future path of policy. The implied yield curve shifted upward only slightly following his testimony, and has since fallen back below pretestimony levels. Apparently, market participants had already built in expectations of significant future interest rate increases, and the chairman’s testimony was largely in line with those expectations. As of February 25, the August contract traded at 6.26%, 51 basis points (bp) above the current intended federal funds rate of 5.75%. (continued on next page) 3 • • • • • • • Monetary Policy (cont.) Percent 7.0 SELECTED INTEREST RATES 6.5 30-year Treasury a 6.0 5.5 Intended federal funds rate 2-year Treasury a 1-year T-bill a 5.0 4.5 4.0 3.5 January April July 1998 October Economic Indicators (percent) 1999 Actual January April July 1999 October January 2000 Growth Ranges for Monetary and Debt Aggregates (percent) Projections for 2000b Central tendency Range Nominal GDPc 5.9 5–6 5¼–5½ Real GDPd 4.2 3¼–4¼ 3½–3¾ PCE chain-type price indexc 2.0 1½–2 ½ 1¾–2 Civilian unemployment ratee 4.1 4–4¼ 4–4¼ 1998 1999 2000 M2 1–5 1–5 1–5 M3 2–6 2–6 2–6 Debt 3–7 3–7 3–7 FRB Cleveland • March 2000 a. Constant maturity. b. By Federal Reserve governors and Reserve Bank presidents. c. Change, fourth quarter to fourth quarter. d. Chain-weighted change, fourth quarter to fourth quarter. e. Average level, fourth quarter. SOURCE: Board of Governors of the Federal Reserve System. Beginning on June 30, 1999, the Federal Open Market Committee (FOMC) raised the intended rate a full percentage point through a series of four 25-bp increments. The first three increases can be interpreted as “taking back” the rapid 75 bp decrease associated with concerns about international financial markets that prevailed in the second half of 1998. The latest 25 bp increase, on February 2, marked the first time the intended rate exceeded the level that held throughout 1997 and most of 1998. Recent increases in the intended federal funds rate may be viewed as responses to increases in market interest rates. Over essentially the same period as the increases in the intended rate (June 25, 1999–February 4, 2000), the 3-month Treasury and the 1-year Treasury rates rose 94 bp and 110 bp, respectively. Furthermore, recent changes in the federal funds rate substantially lagged increases in other interest rates, lending some credence to this view (although plausible alternative stories could be told). Long-term interest rates show a similar pattern. As of February 18, the 10-year Treasury bond yield reached 6.55%, up 57 bp since June 25, 1999. Rates on 30-year conventional mortgages have risen 75 bp over the same period. In contrast, the 30-year Treasury yield for February 18 of 6.23% is only 12 bp higher than it was on June 25, 1999. However, supply and demand factors may be affecting the yield on 30-year Treasury bonds, causing the (continued on next page) 4 • • • • • • • Monetary Policy (cont.) Trillions of dollars 6.8 THE M3 AGGREGATE M3 growth, 1995– 2000 a 12 6.4 2% 4.7 9 M2 growth, 1995–2000 a 9 5% 1% 6 6% 6 5% 4.5 3 6.0 Trillions of dollars 4.9 THE M2 AGGREGATE 6% 3 2% 0 0 1% 4.3 6% 5% 5.6 4.1 2% 1% 6% 5.2 5% 3.9 1% 2% 3.7 4.8 1996 1998 1997 1999 Trillions of dollars 18.5 DOMESTIC NONFINANCIAL DEBT 18.0 17.5 17.0 16.5 Debt growth, 1994– 99 a 7 6 5 4 3 2 1 0 1997 2000 1998 1999 2000 Billions of dollars 640 THE MONETARY BASE 7% Sweep-adjusted base growth, 1994– 99 a 12 3% 600 9 Sweepadjusted base b 6 7% 3 3% 560 0 5% 16.0 520 15.5 3% 7% 5% 15.0 480 3% 5% 14.5 440 14.0 1996 1997 1998 2000 1997 1998 1999 FRB Cleveland • March 2000 a. Growth rates are percentage rates calculated on a fourth-quarter over fourth-quarter basis. b. The sweep-adjusted base contains an estimate of required reserves saved when balances are shifted from reservable to nonreservable accounts. NOTE: Data are seasonally adjusted. Last plots for M2, M3, and the monetary base are estimated for February 2000. Last plots for domestic nonfinancial debt and the sweep-adjusted base are December 1999. Dotted lines for M2, M3, and debt are FOMC-determined provisional ranges. All other lines represent growth in levels and are for reference only. SOURCE: Board of Governors of the Federal Reserve System. 30-year rate to fall below the 10year rate. On average, the intended federal funds rate tends to move with shortand long-term interest rates, partly because the underlying rate of inflation is a common factor in determining all interest rates. However, daily data show that changes in the federal funds rate can be associated with no change in market interest rates—and sometimes with changes in the opposite direction. The simplistic and oft-cited view that an increase in the federal funds rate translates directly into same-sized increases in rates on mortgages and car loans is simply not borne out by the data. The Humphrey–Hawkins report contains economic projections for 2000. Members of the Board of Governors and Federal Reserve Bank presidents expect another strong year. The central tendency of projections for real GDP growth is 31/2%–33/4% for inflation (as measured by the Chain-Type Price Index for personal consumption expenditures), the central tendency is 13/4%–2%. The unemployment rate is expected to be 4%–41/4% in the fourth quarter of the year. The report also contains the monetary growth ranges provisionally adopted on July 28 and confirmed at the February 2 meeting. The ranges are intended to reflect conditions of price stability and historical velocity relationships, not to serve as guides for policy. The report states that “the Committee still has little confidence that money growth within any particular range selected for the year would be associated with the economic performance it expected or desired,” but also notes that “the Committee believes that money (continued on next page) 5 • • • • • • • Monetary Policy (cont.) Percent 15 WEALTH-TO-INCOME RATIO AND INFLATION Ratio 6.25 Trillions of dollars 10 COMPONENTS OF HOUSEHOLD ASSETS Pension fund reserves 12 8 5.75 CPI (all items) a Corporate equities excluding mutual funds 9 6 Wealth-to-income ratio Mutual fund shares 5.25 6 Other 4 Equity in noncorporate business 4.75 3 2 0 1959 1964 1969 1974 1979 1984 1989 1994 4.25 1999 Trillions of dollars 4.5 COMPONENTS OF HOUSEHOLD LIABILITIES Total deposits and currency 0 1959 1964 1969 1974 1979 1984 1989 1994 1999 Percent 10.0 HOUSEHOLD DEBT SERVICE BURDEN AS A SHARE OF DISPOSABLE PERSONAL INCOME 4.0 Home mortgages 9.0 3.5 Credit market 3.0 8.0 2.5 7.0 2.0 1.5 6.0 All other Consumer credit 1.0 Mortgage Other credit market liabilities 5.0 0.5 0 1959 1964 1969 1974 1979 1984 1989 1994 1999 4.0 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 FRB Cleveland • March 2000 a. Year-over-year change. NOTE: Wealth is defined as household net worth. Income is defined as personal disposable income. Data are not seasonally adjusted. SOURCES: U.S. Department of Labor, Bureau of Labor Statistics; and Board of Governors of the Federal Reserve System. growth has some value as an economic indicator, and will continue to monitor the monetary aggregates... .” M2 and M3 growth rates started out the year at or above the upper ranges, mirroring the experience of the past several years. Finally, Chairman Greenspan expressed concern that the wealth effect associated with the rising stock market has contributed to a sharp rise in consumer spending that may soon place inflationary pressures on the economy. Households’ wealth- to-income ratio has climbed to unprecedented levels, while the personal savings rate has declined dramatically. A comparison of inflation to the wealth-to-income ratio does not suggest an obvious relationship, but this may merely indicate that the relationship cannot be captured by such a simple graph. Consider the constituent elements of the wealth-to-income ratio. Have the components of wealth that are tied to equity markets driven the increase in this ratio? Yes. Wealth, measured by a household’s net worth, is simply an accounting identity, calculated as total assets minus total liabilities. Total assets have risen across the board, but the fastestgrowing components—mutual fund shares, corporate equities, and pension reserves—are all tied to equity markets. While liabilities (most notably those reflected in home mortgages and consumer credit) are also rising substantially, their increase has not matched asset growth. 6 • • • • • • • Interest Rates Percent 22 30-YEAR VS. 2-YEAR TREASURY BOND YIELD Percent 8 YIELD CURVES a 20 18 7 January 2000 c 16 February 25, 2000 b 6 14 12 February 1999 c 30-year Treasury bond 10 5 8 6 4 2-year Treasury bond 4 3 0 5 10 15 20 Years to maturity 25 30 Interest-Bearing Public Debt Outstanding (millions of dollars) January 31, 1999 Treasury bills 662,725 Treasury notes 1,917,738 Treasury bonds 621,166 Treasury inflationindexed notes 59,131 Treasury inflationindexed bonds 17,043 Federal financing bank 15,000 2 1978 15 669,954 1,764,027 643,695 10 32,561 1983 1986 1989 1992 1995 1997 2000 Percent 20 TREASURY BOND YIELD SPREAD d January 31, 2000 74,563 1980 5 30-year, 2-year Treasury bond yield spread 0 15,000 –5 Total marketable 3,292,804 3,199,800 –10 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 FRB Cleveland • March 2000 a. All yields are from constant-maturity series. b. Averages for the week of February 25, 2000. c. Monthly averages. d. Shaded areas indicate recessions. SOURCES: U.S. Department of the Treasury, Bureau of the Public Debt; U.S. Department of Commerce, Bureau of Economic Analysis; and Board of Governors of the Federal Reserve System, “Selected Interest Rates,” Federal Reserve Statistical Releases, H.15. Unlike most, this month’s yield curve cannot be described as either flatter or steeper than last month’s. Rather, it is more hump-shaped. The inversion at the long end has become more pronounced, as the 30year rate fell below even the 1-year rate. The short end remains upward sloping, however, with the 3-year, 3-month spread at 76 basis points (bp), near its historical average; likewise, the 10-year, 3-month spread remains positive at 57 bp. The current inversion at the long end represents a small shift among spreads that have been relatively stable since 1995. A new concern is the federal budget surplus and the consequent reduction of Treasury debt. Surprisingly, yields have fallen most for Treasury bonds (with maturities of 10 years or more), whose supply actually has increased over the past year. Chalk this one up to expectations. Early in February, the Treasury announced that it will buy back $30 billion of debt, concentrating initially on the longer-term ma- turities (though full details have not been announced). Does this inversion portend anything about the future of the economy? The traditional wisdom is that inversions imply, or at least suggest, recessions. The 30-year, 2-year spread has gone negative prior to the last several recessions. Since other spreads thought to predict recessions (particularly the 10-year, 3-month spread) remain positive, any prediction based on the long spread should be treated with caution. 7 • • • • • • • Inflation and Prices 12-month percent change 3.50 CPI AND CPI LESS ENERGY January Price Statistics 3.25 Percent change, last: 1 mo.a 3 mo.a 12 mo. 5 yr.a 1999 avg. CPI, all items 3.00 Consumer prices All items 2.2 2.4 2.7 2.3 2.7 2.75 CPI, all items less energy Less food 2.50 and energy 2.0 1.8 1.9 2.4 1.9 3.1 2.9 2.3 2.9 2.3 2.25 Median b 2.00 Producer prices Finished goods 0.0 1.2 2.6 1.2 3.0 Less food 1.75 1.50 and energy –2.4 –0.5 0.8 1.2 0.8 1.25 1995 Index, January 1999 = 100 145 CPI GASOLINE AND FUEL OIL INDEXES 1996 1998 1997 1999 2000 U.S. dollars per barrel 35 CRUDE OIL SPOT AND FUTURES PRICES c Fuel oil Futures prices d 135 30 125 25 Spot price Gasoline 115 20 105 15 95 January April July 1999 October January 2000 10 1995 1996 1997 1998 1999 2000 2001 FRB Cleveland • March 2000 a. Annualized. b. Calculated by the Federal Reserve Bank of Cleveland. c. West Texas Intermediate crude oil. d. As of February 29, 2000. SOURCES: U.S. Department of Labor, Bureau of Labor Statistics; Federal Reserve Bank of Cleveland; Bloomberg Financial Information Services; and Dow Jones Energy Service. The Consumer Price Index (CPI) rose at a 2.2% annualized rate in January, about the same as each of the previous three months. Likewise, the CPI excluding food and energy, a gauge of so-called core inflation, increased at a 2.0% annualized rate. Over the past 12 months, however, the two indexes have diverged, the CPI growing by 2.7% and the CPI excluding food and energy by 1.9%. Much of the difference in these measures can be attributed to last year’s dramatic ascent of petroleumbased energy prices. Eliminating en- ergy from the CPI suggests a very different price trend than is indicated by the “all items” CPI. Indeed, over the last half decade, while energy prices have sent the “all items” index up and down, the CPI excluding energy has fallen almost steadily. Selected CPI energy components show just how stark energy-related price movements have been over the past year. Both the CPI gasoline and fuel oil indexes have risen 30% to 40% during this period. The reason, in large measure, is the action of the OPEC nations. OPEC, along with a few non-OPEC countries like Mexico and Norway, agreed last March to reduce daily world oil supplies by nearly 7% for one year, seeking an end to the global oil glut that sent prices to a 12-year low in December 1998, near the nadir of Asia’s economic crisis. But as the world economy began to recover—and with it global oil demand—OPEC’s reduced production sent oil prices to a level much higher than that during the pre–Asian crisis period. Over the past year, in fact, oil prices have more than doubled, reaching their (continued on next page) 8 • • • • • • • Inflation and Prices (cont.) 12-month percent change 3.75 TRENDS IN THE CPI 12-month percent change 3.50 CPI AND PCE CHAIN-TYPE PRICE INDEX 3.50 3.25 CPI, all items Median CPI a 3.00 3.25 FOMC central tendency projection as of July 1999 b 3.00 2.75 2.50 FOMC central tendency projection as of February 2000 b 2.75 2.50 2.25 2.00 1.75 2.25 1.50 CPI, all items 2.00 PCE Chain-Type Price Index 1.25 1.75 1.00 1.50 0.75 1.25 1995 1996 1998 1997 1999 2000 2001 4-quarter percent change 7 SELECTED LABOR COST MEASURES 0.50 1995 1996 1997 1998 1999 2000 2001 Annual percent change 2.5 UNIT LABOR COSTS c 6 2.0 Hourly compensation c 5 1.5 4 1.0 3 Employment Cost Index 0.5 2 1 1991 0 1992 1993 1994 1995 1996 1997 1998 1999 2000 1991 1992 1993 1994 1995 1996 1997 1998 1999 FRB Cleveland • March 2000 a. Calculated by the Federal Reserve Bank of Cleveland. b. Upper and lower bounds for inflation path as implied by the central tendency growth ranges issued by the FOMC and nonvoting Reserve Bank presidents. c. Nonfarm business sector. SOURCES: U.S. Department of Labor, Bureau of Labor Statistics; U.S. Department of Commerce, Bureau of Economic Analysis; and Federal Reserve Bank of Cleveland. highest point since the Gulf War. As a result, American consumers have begun to clamor for lower oil prices. Meanwhile, the cartel appears to be fracturing, with oil ministers from Saudi Arabia, Mexico, and Venezuela all favoring production increases. This is no surprise to futures markets participants, who have consistently been forecasting a drop in oil prices. The median CPI, another measure of core inflation, confirms the effect of energy prices on the CPI. Like the CPI excluding food and energy, the median CPI has also fallen almost steadily over the past five years. Though it ticked up 0.3% in January (3.1% annualized), its rate over the previous 12 months, at 2.3%, remains below that of the CPI. The inflation outlook for the next 12 months is discussed in the Board of Governors’ Monetary Policy Report to Congress, which accompanied the recent semiannual congressional testimony of Federal Reserve Chairman Alan Greenspan. Unlike years past, the report’s inflation outlook is not framed in terms of the CPI, but an alternative price statistic — the Chain-Type Price Index for Personal Consumption Expenditures. In general, both statistics have tended to register the same rates of acceleration in inflation. In his testimony, Chairman Greenspan pointed to still other price measures. For example, he noted the remarkably low rates of increase in the labor price measures. “Importantly,” the Chairman indicated, “unit labor costs … declined in the second half of the year.” 9 • • • • • • • Economic Activity Annualized percent change from previous quarter 7 GDP AND BLUE CHIP FORECAST a a,b Real GDP and Components, 1999:IVQ Actual percent change (Preliminary estimate) Change, billions of 1996 $ Real GDP Consumer spending Durables Nondurables Services Business fixed investment Equipment Structures Residential investment Government spending National defense Net exports Exports Imports Change in private inventories Percent change, last: Four Quarter quarters 150.3 87.0 25.4 31.3 32.4 6.9 5.9 13.0 7.2 3.8 4.5 5.6 10.5 5.7 4.5 7.7 11.4 – 2.7 1.0 34.3 13.7 –11.5 22.2 33.7 2.5 4.7 – 4.3 1.1 9.2 16.7 — 8.7 10.0 7.0 11.0 –4.8 3.7 5.0 5.0 — 4.5 13.0 30.7 — — 6 Blue Chip forecast, February 10,.2000 5 4 30-year average 3 2 1 0 IIIQ IVQ 1998 CONTRIBUTIONS TO PERCENT CHANGE IN REAL GDP: DIFFERENCE IN PRELIMINARY AND ADVANCE ESTIMATES GDP Personal consumption expenditures IQ IIQ IIIQ 1999 IVQ IQ IIQ 2000 IIIQ Portion of GDP growth rate 5 CONTRIBUTIONS TO PERCENT CHANGE IN REAL GDP GDP 4 3 Personal consumption expenditures Fixed investment 2 Residential Nonresidential fixed investment 1 Change in private inventories Exports Government spending 0 Residential investment Imports –1 Government consumption Inventory investment Net exports 0 0.2 0.4 0.8 0.6 Percent change 1.0 1.2 –2 1991: IVQ 1992: IVQ 1993: IVQ 1994: IVQ 1995: IVQ 1996: IVQ 1997: IVQ 1998: IVQ 1999: IVQ FRB Cleveland • March 2000 a. Chain-weighted data in billions of 1996 dollars. b. Components of real GDP need not add to totals because current dollar values are deflated at the most detailed level for which all required data are available. NOTE: All data are seasonally adjusted. SOURCES: U.S. Department of Commerce, Bureau of Economic Analysis; and Blue Chip Economic Indicators, February 10, 2000. GDP increased at a surprisingly robust 6.9% rate in 1999:IVQ, according to the preliminary estimate released late in February. This was 1.1 percentage points more than the advance estimate released just one month earlier. Such a sizeable increase is outside the range of more than two-thirds of all revisions from advance to preliminary values observed between 1978 and 1998. Values of all major GDP components increased. The smallest revision was to the volume of imports that is subtracted from exports in calculating GDP; the largest was to the already high contribution of personal consumption expenditures. GDP growth has been on a high plateau since 1996. Personal consumption expenditures (PCE) have made an increasing contribution to GDP growth, and the Blue Chip consensus forecast does not foresee a reversal of this pattern until 2000:IVQ. Government expenditures also have increased their contribution to the GDP growth rate. Declining contributions from other sectors have made room for these expanding sectors. Slowing growth of inventory investment, as well as last year’s slow- down in residential and nonresidential fixed investment, have played only a small role. Increasing imports and the resulting substantial decline in net exports have provided most of the room for growth in PCE and government spending. Growth of the capital stock and labor force, plus a modest decline in the unemployment rate, provided a basis for continued brisk GDP growth. In addition, productivity increases in the nonfarm business sector remain about one full percentage point above the average for the (continued on next page) 10 • • • • • • • Economic Activity (cont.) Percent 100 SHARE OF FUEL USE Percent 7 PRODUCTIVITY GROWTH 90 1991–1999 manufacturing average 1961–1990 manufacturing average 1991–1999 nonfarm business average 1961–1990 nonfarm business average 6 5 Billions of gallons 160 150 Total 80 140 Passenger cars Manufacturing 4 3 2 70 130 60 120 50 110 40 100 30 90 Light trucks 1 20 Nonfarm business 80 Heavy trucks 0 10 70 Buses –1 1991 1992 1993 1994 1995 1996 1997 1998 0 1966 1999 60 1970 1974 1978 1982 1986 1990 1994 1998 1994 1998 Gallons per dollar of real GDP a 0.30 FUEL USE AND GDP Miles per gallon 25 FUEL EFFICIENCY Passenger cars and light trucks 0.25 20 Passenger cars 0.20 15 All uses Light trucks 0.15 10 0.10 Buses 5 Heavy trucks 0.05 Buses and heavy trucks 0 1966 1970 1974 1978 1982 1986 1990 1994 1998 0 1966 1970 1974 1978 1982 1986 1990 FRB Cleveland • March 2000 a. Chain-weighted data in billions of 1996 dollars. NOTE: All data are seasonally adjusted. SOURCES: U.S. Department of Labor, Bureau of Labor Statistics; and Federal Highway Administration, Highway Statistics Report. 30 years ending in 1991 and about half a percentage point above the average since 1991. Manufacturing clearly is a major source of this splendid productivity performance. The growth rate of productivity in the manufacturing sector took another upward leap in 1999, rising 6.9% between 1998:IVQ and 1999:IVQ. Memories of cartel-induced petroleum price increases and escalating inflation in the 1970s make current fuel-price hikes a matter of widespread concern. How has the role of motor-vehicle fuel in GDP changed since that earlier experience? Total fuel consumption has grown at an average annual rate of 2.1% since 1970, about one percentage point slower than GDP growth. Passenger cars’ share of annual fuel use declined markedly, but a rising share of fuel consumption in light trucks (a category that includes the increasingly popular sport-utility vehicles) offset about three-quarters of this decline. Combined, the share of fuel that is used in these two categories has dropped from 86% to 79%. The share used by heavy trucks and buses has risen correspondingly. Fuel efficiency has changed in a similar way. Passenger cars and light trucks averaged 13.3 miles per gallon (mpg) in 1970. Since then, efficiency has increased at an average annual rate of 1.3%, reaching 19.7 mpg in 1998. The 5.5 mpg averaged by heavy trucks and buses in 1970, on the other hand, crept up at an average annual rate of only ½ percent through 1998, to 6.4 mpg. Still, because these industrial and commercial gas-guzzlers account for little more than 20% of all fuel used, fuel consumption relative to GDP has declined by one-fourth since 1970, from more than 24 gallons to just over 18 gallons per $1,000 of GDP (both in 1996 prices). 11 • • • • • • • Labor Markets Change, thousands of workers 400 AVERAGE MONTHLY NONFARM Labor Market Conditions EMPLOYMENT GROWTH Average monthly change (thousands of employees) 350 300 250 200 1997 1998 1999 YTDa Feb. 2000 Payroll employment 281 Goods-producing 48 Mining 2 Construction 21 Manufacturing 25 Durable goods 27 Nondurable goods –2 244 8 –3 30 –19 –9 –10 226 –6 –3 18 –21 –10 –11 214 59 1 45 13 17 –4 43 –19 2 –26 5 20 –15 235 32 26 32 119 27 232 18 12 37 121 29 155 –2 2 34 74 33 62 –8 10 33 6 13 Service-producing b TPU FIREc Retail trade Services Government 150 100 233 24 14 24 117 17 50 Average for period (percent) Civilian unemployment 4.9 4.5 4.3 4.1 4.1 0 1992 1993 1994 1995 1996 1997 1998 1999 IVQ Dec. Jan. Feb. 1999 2000 Percent 65.0 LABOR MARKET INDICATORS d Percent 8.0 Percent rising, three-month span 80 DIFFUSION INDEX OF EMPLOYMENT 7.5 64.5 Private nonfarm payrolls 70 Employment-to-population ratio 64.0 7.0 63.5 6.5 63.0 6.0 60 50 5.5 62.5 40 Civilian unemployment rate Manufacturing payrolls 62.0 5.0 61.5 4.5 30 61.0 1992 1993 1994 1995 1996 1997 1998 1999 2000 4.0 2001 20 1992 1993 1994 1995 1996 1997 1998 1999 2000 FRB Cleveland • March 2000 a. Year to date. b. Transportation and public utilities c. Finance, insurance, and real estate. d. Vertical line indicates break in data series due to survey redesign. NOTE: All data are seasonally adjusted. SOURCE: U.S. Department of Labor, Bureau of Labor Statistics. After making substantial increases in January, employers added only 43,000 workers to payrolls in February. Another measure of employment growth, the employmentto-population ratio, nevertheless remained at a record high of 64.8%. The unemployment rate was up slightly in the month to 4.1%; it has now remained below 4.2% for five consecutive months. February’s average hourly earnings rose 4 cents to $13.53, marking an increase of 3.6% over the levels of February 1999. Because of sharp declines in employment in construction and nondurable-goods manufacturing, the goods-producing sector showed a net loss of 19,000 jobs in February. After an increase of 116,000 jobs in January, construction employment fell by 26,000 jobs last month. However, durable-goods manufacturers increased payrolls by 20,000 jobs in February. Manufacturing employment as a whole, after decreasing about 480,000 jobs in 1998 and 1999, has increased an average of 13,000 per month thus far this year. In the service-producing sector, the pace of employment growth slowed substantially for a net gain of only 62,000 jobs, more than half of which were concentrated in retail trade. The Diffusion Index of Employment shows the fraction of industries in which employment is rising. For the three months ending January 2000, 61% of the 349 nonfarm industries surveyed showed increasing employment. In the manufacturing sector, which has rebounded recently, half of all survey participants reported an increase in their employment. 12 • • • • • • • The Federal Budget Percent of GDP 5 BUDGET SURPLUS, 1999–2010 Percent of GDP 23 REVENUES AND OUTLAYS, 1999–2010 Revenues Outlays 21 Capped baseline 4 Nominal spending freeze 19 Spending at rate of inflation 17 3 15 2 13 11 1 9 0 7 1999 2001 2003 2005 2007 2009 Percent of GDP 16 REVENUE COMPONENTS, 1999–2010 1999 2007 2009 Discretionary spending 13 Social insurance Mandatory income Net interest plus offsetting receipts Other 12 2005 Percent of GDP 15 OUTLAY COMPONENTS, 1999–2010, CAPPED BASELINE Individual and corporate income 14 2003 2001 11 10 9 8 7 6 5 4 3 2 1 0 –1 1999 2001 2003 2005 2007 2009 1999 2001 2003 2005 2007 2009 FRB Cleveland • March 2000 NOTE: All data are for fiscal years. SOURCE: Congressional Budget Office. Strong economic growth in the U.S. has produced a federal budget surplus for the second consecutive year: $124 billion for fiscal year 1999 on the heels of 1998’s $69 billion surplus. The surpluses are projected to continue and, indeed, to increase if Congress adheres to its current discretionary spending policy. The size of future surpluses, however, depends on the precise interpretation of “current discretionary spending policy.” The cumulative surplus for the period 2000–10 is projected to be $4.2 trillion if discretionary spending is kept within statutory caps in 2001 and 2002 and allowed to grow with inflation thereafter. An almost identical cumulative surplus is projected if discretionary spending is frozen in nominal terms at its fiscal year 2000 level. Alternatively, if Congress allows discretionary spending to grow at the same rate as inflation, the cumulative 2000–10 surplus will be smaller—$3.1 trillion. The main factors underlying federal surpluses are strong revenue growth and declining discretionary spending. During fiscal 1998 and 1999, federal personal plus corporate income taxes exceeded 11.5% of GDP for the first time since the late 1960s. At 6.3%, federal discretionary spending as a share of GDP is at a post–World War II low. Depending on which policy assumption is adopted, discretionary spending falls to between 4.2% and 5.3% of GDP by 2010. In addition, budget surpluses imply a decline in federal debt relative to GDP and, hence, lower servicing costs. As a result, net interest outlays fall from 2.5% of GDP in fiscal year 1999 to only 0.5% of GDP in 2010. The current economic boom is historically unique. It has already outlasted the longest previous growth spurt. It has also reversed the decline in income tax revenues that began with the recession and (continued on next page) 13 • • • • • • • The Federal Budget (cont.) Percent of GDP 15 INCOME TAXES Percent 30 SHARE OF TAXES PAID BY HOUSEHOLDS WITH TOP 0.5% OF TAX BILLS 14 25 13 Income taxes 12 20 11 Average, 1970–99 10 15 9 8 10 7 6 5 5 4 1962 0 1968 1974 1980 1986 1992 1998 2004 1990 2010 1991 1993 1992 1994 1995 Percent 10 GROWTH IN DISCRETIONARY OUTLAYS Percent of GDP 15 DISCRETIONARY OUTLAYS 14 Defense 8 Nondefense 13 6 12 11 4 10 2 9 0 8 7 –2 6 –4 5 4 1962 –6 1968 1974 1980 1986 1992 1998 2004 2010 1992 1993 1994 1995 1996 1997 1998 1999 2000 FRB Cleveland • March 2000 NOTE: All data are for fiscal years. SOURCE: Congressional Budget Office. marginal rate cuts of the early 1980s. Since that time, sustained increases in earnings and asset income, the partial reversal of tax rate cuts in 1993, and the strong surge in asset prices since 1995 have swelled U.S. income tax revenues. Larger incomes have shifted some Americans into higher tax brackets, and much of the recent income growth has been concentrated at the upper end of the income distribution. In addition, the strong surge in asset prices has raised the rate of asset turnover, increasing revenue from capital gains taxes. Indeed, the share of income taxes paid by households at the top 0.5% of the income distribution has jumped from 19.7% in 1990 to 24.2%. These higher income tax revenues, along with reduced discretionary spending in the 1990s, have transformed the federal budget; it has gone from producing deficits in the 1980s and 1990s to generating large projected surpluses in 2000 and beyond. The decline in discretionary spending during the early 1990s can be traced to post–Cold War defense cutbacks—retrenching personnel, forgoing replacement of old equipment, and reducing new acquisitions. Although defense spending has bounced back since 1996, it has grown more slowly than the overall rate of inflation. Growth in nondefense spending, which outstripped the overall inflation rate during the early 1990s, slowed in the latter half of the decade. Generational accounts show the present values of future taxes minus transfers for Americans who were alive in a given year. The calculations use survey data on distribution of taxes and transfers and the Congressional Budget Office’s July 1999 baseline projections of spending within statutory caps. Generational (continued on next page) 14 • • • • • • • The Federal Budget (cont.) Thousands of constant 1998 dollars 300 GENERATIONAL ACCOUNTS WITH CAPPED BASELINE Percent 50 GENERATIONAL IMBALANCE UNDER 250 45 ALTERNATIVE POLICIES 1998 newborns Male 40 200 Future generations Female 35 150 30 100 25 50 20 0 15 –50 10 –100 5 0 –150 90 80 70 60 50 40 30 Age in 1998 20 10 0 FG a Percent 30 INCREASE IN ALL TAXES REQUIRED TO ACHIEVE Capped baseline Slower income tax growth Percent 30 GENERATIONAL BALANCE 25 Faster federal purchases growth CUT IN ALL TRANSFERS REQUIRED TO ACHIEVE GENERATIONAL BALANCE If implemented in 1999 25 If implemented in 1999 If implemented in 2004 If implemented in 2004 20 20 15 15 10 10 5 5 0 0 Capped baseline Faster federal purchases growth Slower income tax growth Capped baseline Faster federal purchases growth Slower income tax growth FRB Cleveland • March 2000 a. Future generations SOURCE: Jagadeesh Gokhale, Benjamin R. Page, John R. Sturrock, and Joan L. Potter, “Generational Accounts for the United States, ” American Economic Review, forthcoming, May 2000. accounts for 1998 show a significant life-cycle pattern: Older generations are net recipients because the transfers they will receive—Social Security and Medicare benefits—exceed the taxes they will pay in the future. The opposite is true for workingage generations, who will pay taxes for several years before receiving transfers. Given projected federal purchases and assuming that living (including newborn) generations will continue to be treated under 1998 policy, future generations’ net taxes must be higher, on average, than those of 1998 newborns to balance the budget over the indefinite future. With spending capped, future generations’ lifetime net tax rate (their generational account as a fraction of their lifetime labor income) will be 29.2%—14% larger than the 25.6% rate faced by 1998 newborns. The difference becomes still greater if federal purchases are assumed to grow at the same rate as GDP or if the ratio of future federal income taxes to GDP equals 10.4%, its average since 1970. Restoring intergenerational balance to U.S. fiscal policy requires hiking taxes or cutting transfers so that living generations face larger net taxes and future generations face smaller ones. For example, under the capped-baseline assumption, all taxes would have to rise 2% immediately and permanently. Bigger hikes are required under the other assumptions mentioned earlier. Alternatively, government purchases could be reduced from projected levels (not shown). Moreover, postponing policies for restoring a generationally balanced fiscal policy makes the required policy changes larger. 15 • • • • • • • Federal Home Loan Banks Thousands of institutions 7 VOLUNTARY AND MANDATORY FHLB MEMBERSHIP Thousands of institutions 7 FHLB MEMBERSHIP BY TYPE OF INSTITUTION 6 6 Thrift institutions Voluntary Commercial banks Mandatory Credit unions and insurance companies 5 5 4 4 3 3 2 2 1 1 0 0 1994 1995 1996 1997 1998 1995 1996 1997 1998 1999 1997 1998 1999 Billions of dollars 500 FHLB LIABILITIES Billions of dollars 500 FHLB ASSETS Consolidated obligations Advances 400 1994 1999 400 Investments a Capital Other assets Deposits and borrowing 300 300 200 200 100 100 0 0 1994 1995 1996 1997 1998 1999 1994 1995 1996 FRB Cleveland • March 2000 a. Investments include federal funds sold. NOTE: 1999 data are as of September 30, 1999. SOURCE: Federal Home Loan Bank System, Quarterly Financial Report for the nine months ended September 30, 1999. The 12 Federal Home Loan Banks are stock-chartered, governmentsponsored enterprises designed to provide liquidity for specialized housing finance lenders. FHLB membership has increased steadily over the years, reaching its high of 7,856 institutions at the end of 1999:IIIQ. Mandatory membership, however, continued its decline to 929 institutions, partly because of consolidation in the thrift industry. (All federally chartered savings associations must belong to their district Federal Home Loan Bank.) Growth in voluntary FHLB membership is driven by commercial banks, which account for more than 66% of all members and nearly 72% of voluntary members. FHLB advances, which represent an important funding source for member institutions’ mortgage portfolios, increased from $288.2 billion at the end of 1998 to $365.3 billion at the end of 1999:IIIQ. This latest recorded increase in advances is partly the result of members locking in funding for mortgage portfolios that mature after January 1, 2000. Collectively, Federal Home Loan Banks increased their investment portfolios by $18.5 billion during the first nine months of 1999, offsetting a $2.9 billion decline in 1998. The lion’s share of funding for FHLB assets comes from the $477.5 billion consolidated obligations of the FHLB System — bonds issued on behalf of the 12 Federal Home Loan Banks collectively. Member institutions’ deposits and short-term borrowings provided another $16.2 billion in funding, and equity capital supplied $26.9 billion. (continued on next page) 16 • • • • • • • Federal Home Loan Banks (cont.) Percent of assets 7 FHLB CAPITAL RATIO a Billions of dollars 2.0 FHLB EARNINGS b 1.8 6 1.6 5 1.4 1.2 4 1.0 3 0.8 0.6 2 0.4 1 0.2 0 0 1994 1995 1996 1997 1998 1998:IIIQ 1999:IIIQ Percent 1.0 FHLB INCOME 1994 1995 1996 1997 1998 1998:IIIQ 1999:IIIQ Percent 10 FHLB RETURNS TO SHAREHOLDERS Return on equity Weighted-average dividend d Return on assets Net interest margin c 0.8 8 0.6 6 0.4 4 0.2 2 0 0 1994 1995 1996 1997 1998 1998:IIIQ 1999:IIIQ 1994 1995 1996 1997 1998 1998:IIIQ 1999:IIIQ FRB Cleveland • March 2000 a. Total capital ratio is calculated as capital stock plus retained earnings as a percent of total assets at period’s end. b. Net income. c. Net interest margin is calculated as annualized net interest income as a percent of average earning assets. d. Weighted average dividend rates are calculated by dividing annualized dividends paid in cash and stock by the daily average of capital stock eligible for dividends. NOTE: Bars labeled 1998:IIIQ and 1999:IIIQ include data for the first three quarters of the year. SOURCE: Federal Home Loan Bank System, Quarterly Financial Report for the nine months ended September 30, 1999. The tremendous growth in FHLB assets has had a negative impact on profitability. Despite steady increases in net income from 1994 to 1998, return on assets has fallen steadily from 52 basis points (bp) in 1995 to 47 bp in 1998. This trend continued during the first nine months of 1999, as return on assets came in at 44 bp, down from 47 bp during the same period in 1998. This decrease in profitability is due in part to deterioration of the net interest margin from 59 bp to 52 bp over the first nine months of 1998 and 1999, respectively. Asset growth has also lowered the capital-to-assets ratio from 5.8% in 1996 to 5.2% at the end of 1998. The capital ratio at the end of 1999:IIIQ stood at 5.1%, down from 5.4% at the end of 1998:IIIQ. Greater leverage is responsible for the increase in return on equity from 8.26% in 1996 to 8.73% in 1998. At 8.59%, however, the return on equity over the first nine months of 1999 was off slightly from the same period in 1998. Finally, the weighted-average dividend mirrored the performance of return on equity — slightly lower over the first three quarters of 1999 than for the comparable period in 1998. Overall, the Federal Home Loan Banks’ performance last year suggests that they remain an important source of funding for the housing finance industry. 17 • • • • • • • Banking Conditions Thousands of institutions 16 FDIC-INSURED INSTITUTIONS a Thousands of offices 80 OFFICES OF FDIC-INSURED INSTITUTIONS a Banks Banks 14 70 Savings institutions 12 60 10 50 8 40 6 30 4 20 2 10 0 Savings institutions 0 1984 1987 1990 1993 1996 1999:IIIQ 1984 1987 1990 1993 1996 1999:IIIQ INTERSTATE BRANCHES AS A SHARE OF ALL OFFICES b,c More than 30% 15% to 30% More than 1% and less than 15% 1% or less FRB Cleveland • March 2000 a. Includes insured branches of foreign banks that file call reports. b. Figures reflect percent of branches owned by out-of-state commercial banks and savings institutions. c. Data as of September 30, 1999. NOTE: Data include all FDIC-insured institutions. SOURCE: Federal Deposit Insurance Corporation, Quarterly Banking Profile, third quarter 1999. The passage of the Reigle–Neal interstate banking legislation in 1994 spurred on the consolidation of the depository institutions sector. The total number of FDIC-insured commercial banks and savings associations in the U.S. declined from 17,900 in 1984 to 10,019 at the end of 1999:IIIQ. However, despite a sharp drop in the number of savings association offices (from 23,888 to 14,337) over the same period, the total number of FDIC-insured depository institution offices increased slightly (from 80,220 to 84,917). These office numbers do not take account of other means of delivering banking services such as automated teller machines, telephone banking, and online banking. Hence, the reduction in the number of banks has decreased the availability of banking services for the average consumer. Finally, the effect of interstate consolidation of the banking industry is evident in the large number of states reporting that more than 15% of all their bank branches are offshoots of out-of-state banks. The number of states reporting that interstate branches exceed 15% of all branches will continue to grow as depository institutions, no longer distracted by Y2K compliance issues, will doubtless seek opportunities to enter new markets and lines of business through mergers and acquisitions. 18 • • • • • • • The Euro Dollars per euro 1.20 EURO EXCHANGE RATE Index 96 NOMINAL EFFECTIVE EURO EXCHANGE RATE a 94 1.15 92 1.10 90 88 1.05 86 Inception of the Monetary Union 1.00 84 0.95 1/4/99 3/12/99 5/18/99 7/26/99 9/30/99 12/9/99 2/15/00 Percent 5.0 ECB INTEREST RATES 82 1/97 7/97 1/98 7/98 1/99 7/99 1/00 7/99 1/00 Index 96 REAL EFFECTIVE EURO EXCHANGE RATE a 4.5 92 4.0 Marginal lending rate 88 3.5 3.0 84 Main refinancing rate 2.5 80 2.0 Inception of the Monetary Union 76 Deposit rate 1.5 1.0 1/4/99 3/26/99 6/17/99 9/8/99 11/30/99 2/23/00 72 1/97 7/97 1/98 7/98 1/99 FRB Cleveland • March 2000 a. The International Monetary Fund constructs a synthetic dollar/euro exchange rate for the period prior to January 1999 by applying official conversion factors to the dollar exchange rates of individual participant countries. The nominal and real effective trade weights for the euro are based on the total foreign trade of the euro area. The real effective euro uses unit labor costs as inflation proxies. SOURCES: Board of the Governors of the Federal Reserve System; European Central Bank, http://www.ecb.int/; and International Monetary Fund, International Financial Statistics. The euro fell below one-to-one parity with the dollar on January 27, 2000, initiating calls for foreignexchange-market intervention. On a nominal effective basis, the euro has depreciated about 11% since its inauguration on January 1, 1999. The European Central Bank (ECB) has two choices for influencing the dollar/euro exchange rate. One option is to tighten monetary policy relative to the U.S. On February 3, 2000, the ECB raised interest rates 25 basis points, following a similar hike in the U.S. federal funds and discount rates on February 2. A second option is to sell official dollar reserves without changing targeted interest rates. When central banks maintain interest-rate objectives — as do the ECB, the Federal Reserve, and the Bank of Japan — they automatically neutralize (or sterilize) any impact intervention might otherwise have on the target. Sterilized intervention does not alter relative money-growth rates, a key determinant of exchange rates. It only influences exchange rates in the unlikely event that it affects market expectations or perceptions, so most economists regard sterilized intervention as largely ineffectual. Neither intervention nor monetary policy has any lasting effect on nations’ real exchange rates, which incorporate inflation differentials between countries. Since January 1, 1999, the euro has depreciated 12% on a real effective basis, an indication that its competitive position has improved. 19 • • • • • • • Dollarization and Ecuador’s Sucre Sucre per dollar 30,000 ECUADOR’S EXCHANGE RATE Annual percent change 80 ECUADOR’S GDP 70 25,000 60 50 20,000 Nominal 40 30 15,000 20 Real 10 10,000 0 5,000 1/4/99 4/20/99 7/28/99 11/4/99 ECUADOR’S TRADING PARTNERS, 1999:IQ a 2/11/00 –10 1971 1975 1983 1979 1987 1991 1995 1999 Index, January 1990 = 100 500 DOLLAR EXCHANGE RATES b 450 400 350 Other countries (26%) 300 U.S. (42%) 250 Colombian peso Colombia (12%) 200 Chilean peso 150 Japan (8%) German mark 100 Chile (6%) 50 Japanese yen Germany (6%) 0 1/90 1/92 1/94 1/96 1/98 1/00 FRB Cleveland • March 2000 a. Total trade is the sum of exports and imports. b. Units of foreign currency per dollar. SOURCES: Board of Governors of the Federal Reserve System; and International Monetary Fund, International Financial Statistics. On January 9, 2000, the president of Ecuador proposed official dollarization as a way to halt the rapid depreciation of the country’s currency (the sucre), prevent hyperinflation, and establish economic stability. Official dollarization occurs when a country adopts a foreign currency as legal tender, either exclusively or predominantly. Today, 13 of the 29 officially dollarized countries use the U.S. dollar as their predominant currency. By doing so, they relin- quish monetary sovereignty and link their inflation rates to U.S monetary policy. In return, these countries assure themselves a rate of inflation close to that of the U.S. Dollarization precludes governments in emerging markets from using inflation as a revenue source. Sound monetary policies improve the prospects for real economic growth. The U.S. accounts for 42% of Ecuador’s foreign trade. This is more than the U.S. share of foreign trade for Argentina (17%), which maintains rigid links between the peso and the U.S. dollar, but smaller than the trade share for Mexico (80%), whose currency is not formally tied to the dollar. Linking the sucre to the dollar would expose Ecuador’s trade to fluctuations in dollar exchange rates. A dollar appreciation could reduce the country’s trade balance, forcing Ecuadorans to reduce prices and wages in order to reestablish their trade competitiveness.
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