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http://clevelandfed.org/research/trends November 1996 Best available copy Tbe Economy in Perspective Potentialpl-oblems . .. Has the economy been expanding beyond its potential, threatening to boost inflation? Or has the level of econonlic activity only now reached its potential? Can it grow at rates of 3% or Inore in real terms before inflation begins to drift up? The Commerce Department recently announced that real GDP rose 2.25% during the last four quarters, a pace consistent with n~ost analysts' estimates of the growth rate for potential GDI? The Labor Department followed with a report that the nation's unemployment rate held steady at 5.2% in October, a figure at or below conventional estimates for full employment. No wonder speculation about inflation's future course remains intense. The concept of potential output (or full eruployment in the labor ~narliet)has a long, checkered history in n~acroeconomics.Early Keynesians aclvancecl the idea, arguing that since inflation would result from resource utilization above potential, and cleflation would arise from underutilization, governments should use monetary and fiscal policies to keep the level of actual economic activity equal to its potential. Keynesian econornists in the 1960s thought that potential output changecl very slomrly, and that its value could be closely pinpointecl. I<ennecly-Johnson era policymalters also believecl that inflation and unemployment, which they regarclecl as inversely related, coulcl be tradecl off against one another in a preclictable way through the use of elernand-management stmtegies. Against the bacliclrop of the Great Depression, an event that created public fear of wiclespreacl unenlployment, the Keynesians' faith in full ernployrnent is unclerstanclable; however, in view of the accelerating inflation of the late 1760s ancl the poor economic perfornlance of the 1770s, their confidence seems misplaced. By the early 1970s, many econo~nistsembraced a more sophisticatecl ~~ersion of potential output, callecl the natural rate concept. Milton Friedman, among others, theorizecl that actual unelnploynlent would ala-ays gravitate towarcl a "natural rate" of unemployment. The actual and natural rates woulcl equalize only when inflation nlatchecl the rate that people had already incorporatecl into their wage- anel price-setting plans (that is, expected inflation). Natural-rate aclvocates emphasizecl that clemand-management policies shoulcl not be usecl to holcl unemployment permanently below the natural rate, since this strategy m~oulclresc~ltin escalating inflation. Policymakers coulcl, however, attenlpt to keep unemployrnent at the natural rate ancl accept the prevailing pace of inflation. Aclvocates also reasonecl that the natural rate of unemploy~nentcould fluctuate both slowly- through changes in the con~positionof the labor force, for example-ancl quickly-through changes in tax policy, unemployment compensation benefits, nlininlunl wage laws, and other factors affecting labor supply. Proponents of this logic urged policymakers to be more cautious in estinlating economic potential and less ambitious in their objectives. Nevertheless, the practice of using demancl-management policies to guide the economy along a path of full resource ~~tilization persisteel throughout the 1970s. And, although the intellectual basis for taking greater care in policy design and implenlentation had been established, macroeconomic performance was dismal. Have we learned from our experiences? Many economists have abancloned potential output as a conceptual guide for policymakers. Some think the idea itself is banltl~ipt,depencling as it does on being able to quantify the supply and procluctivity of lancl, labor, ancl capital in some idealized state of econonlic activity. Others accept the concept, but m~orryabout not being able to aclequately estiinate potential output or current and future econonlic conclitions. These factors combine to rnalie an "output gap" framework problematic for policynlakers who try to lteep real econonlic activity on any predetermined path, including that of full employruent. Despite these shortcomings, many econonlists still cherish the ambition of closing the output gap. This is partly because politicians ancl the public have been conclitioned for decades to think that econonlic policy toolsprincipally those of monetary policy-shoulcl be continually geared towarcl keeping aggregate clernancl high. Ironically, although economists realize that monetary policy can be used to stinlulate aggregate demand, nlost of the evictence suggests that these effects are short lived. Conten~porarynlacroeconornic theorists teach that nlonetary policy does not affect the econonly's level of potential output ancl cannot be relied on to lteep output mo\~ingalong a precletermineel path. Monetary policy can be used systen~aticallyfor only one purpose-to determine the price level. Indeed, a low inflation environluent is nlonetary policy's best contribution to better econo~nicconctitions. Closing the output gap remains a popular aspiration because people want to believe it can be clone. Even though history has shown repeatedly that estinlates of potential output are unreliable, when the nest generation of econornists and policymalters arrive on the scene they inevitably push-or get pushed-to create inflation. Unfortunately, our nation's ability to learn that fill1 elnploynlent is no guide for macroecononlic policy has fallen far short of its potential. S 0 8 8 http://clevelandfed.org/research/trends November 1996 Best available copy 8 Monetay Policy Blll~onsoi dollarsa 460 MONETARY BASE 440 - 420 - 400 - 380 - 360 - Billions of dollarsa , ' Average growth rate = 7 3% 280 0 1991 1992 1993 1994 1995 1996 Billions of dollarsa 3,800 Billions of dollarsa 7,000 6,900 3,700 6,800 6,700 3,600 6,600 3,500 6,500 6,400 3,400 6,300 6,200 3,300 6,100 3,200 19 6,000 1991 1992 1993 1994 1995 1996 a. Seasonally adjusted. b. Chain-weighted 1992 dollars. SOURCES: U.S. Department of Commerce, Bureau of Economic Analysis; and Board of Governors of the Federal Reserve System. Over the last five years, the narrower monetary aggregates have tenclecl to grow 111ore rapidly than their [nore broadly definecl counterparts. In particular, the monetary lxtse grew I'aster than MI,\vliich in turn grew faster than M2. One contrihutor to this phenomenon may have been the rapid increase in the amount of currency held outsicle the I1.S.over this periocl. Since currency represents a larger fraction of tile 1nonet:tsy h:lse than, say. M2,rapicl growth in currency will have a Inore noticeable ililpact on the narrower :tggrega tes. In a growing economy, the ; ~ ~ n o u nof t money in circulation nl~lstexpand over time to facilitate the incre:tsing number of tr:tnsactions hetsveen buyers and sellers. In any given year, the total value of final goods and services transactions is meas~ireclby real GDP. Over long periocls, therefore, we woulcl expect the growth mte of the monetary aggregates to be at least as large as the growth sate of real GDP. However, if the monetary aggregates grow faster than real GDI' over sustailled periocls, then there is a danger of ..too much money chasing too few goocls." 'rhis can lead to an erosion in the purchasing power of money-othe1wise known as inflation. Notice that the average annual compound growth rate of &/I2over the last five years (2.3%) is ve1y close to the average growth rate of real GI)I-' (2.4%). This may help to explain the low levels of inflation espcricnced over this periocl. (coi ~tiizrled017 nextpagt.) http://clevelandfed.org/research/trends November 1996 Best available copy Monetary Policy (cont.) Percent 20 1 M I GROWTH: ACTUAL VERSUS PREDICTED Real GDP, deviation from trend in percent 5 Real GDP, deviation from trend in percent 5 4 4 3 3 2 2 1 1 0 0 -1 -1 -2 -2 -3 -3 -4 -5 -1 0 -5 0 5 10 15 Unanticipated money growth (actual less predicted), percent 20 -4 -5 -4 -3 -2 -1 0 1 2 3 Unaniicipated change in interest rate (actual less predicted), percent 4 a. Predicted values are constructed by regressing each variable on its own lagged value and a constant term over the entire sample period. b. One-year nominal interest rate is the nominal one-year Treasury yield. c. Real growth is measured in chain-weighted 1992 dollars, seasonally adjusted. SOURCES: Board of Governors of the Federal Reserve System; and the Federal Reserve Bank of Cleveland. Monetary policy is thought to influence the level of real economic activity over the course of the business cycle. In this regarcl, two principal tools that the Federal Iieserve has at its clisposal are the growth rate of the money stocli ancl the level of short-term nolninal interest rates. By regressing the growth rate o f the M I money stocli on its lagged value and a constant terrn, w e can construct a simple one-cluarteraheact forecast for preclictecl &I1 growth. A plot of preclictecl versus actual PI1 growth shows that large forecast errors occur whenever the actual series experiences a sudden ~ ~ p ~ v aor r c lclownward n~ovement. These errors can be interpretecl as a measure of "unanticipated" money gro~vth.An analogous procedure can I,e used to construct a measure of i~nanticipateclchanges in the oneyear nominal interest rate. The deviation of real GDI' from its trencl line provides a measure of the business cycle conlponent of real econo~nicactivity. A scatterplot of this measure versus the level of ~111:lnticipatecl money gro\vth reveals :I \\leal< negative relationship between the two variables, 1 ~ 1 to n e that is extremely i~nprecise.Fro111 this eviclence. it does not appear that un:tnticipatetl money growth exerts an important inflilence o n real economic activity. In co~ltlxst, there seems to Ile a positive relationship between the business cycle component of real GDP ancl unanticipatecl changes in the one-ye;lr (cot~tintredon tre.~/ pqri http://clevelandfed.org/research/trends November 1996 Best available copy Monetary Policy (cont.) Growth rate of per capita GDP, percent 1 CROSS-COUNTRY GROWTH AND INFLATION Growth rate of per capita GDP, percent I ICROSS-COUNTRYGROWTH AND INFLATION VARIABILITY I Inflationvariability lnflation, percent Growth rate of per capita GDP, percent Inflation oercent lnvestmentltotalincome, percent Inflation variability,percent NOTE: Data for Brazil were removed from the data set. lnflation variability is defined as the standard deviation of inflation within a given year, averaged over the time period of the sample. System. Finance and SOURCE: Ruth Judson and Athanasios Orphanides, "lnflation, Volatility, and Growth," Board of Governors of the Federal R e S e ~ e Economics Discussion Series No. 96-19, May 1996, pp. 15-17. nominal interest rate. However, this picture may simply reflect the Federal Reserve's response to c)~clical changes in nominal mtes. Thus, ca~1sation may run from real GDI' to unanticip:ltecl chzlnges in interest rates, lather than \.'Ice versa. Sollle policynlalters believe that high ancl variahle mtes of inflation are detri~nentalto economic growth. A cross-countl-). comparison s h o ~ v s that very high levels of inflation tencl to h e associated with lo\ver growth rates. Mow~ever,at lower levels of inflation, there does not seem to be much of a l i ~ i l tbetween the two variables. A similar story applies to the relationship between growth and inflation variability. There appears to he a positive relationship between the level of inflation and its v:lriability. One possible explanation is that governments which undertalte illadvised monetary policies that leacl to higll ancl variable rates of inflation are also more lilcely to enact fiscal ancl regulatory policies that are harmh~lto growth. Fiscal policy can influence gro~vththrough channels such as tax rates, which affect people's incentives to \vorlt, save, invest. ancl talte entrepreneurid risks. There is a positive relationship between the share of income clevotecl to capit:il investment ancl economic gro\i~th. This suggests that policies which encourage investment-such as tax policies that remove clisincelltives for private saving-will sti~n~llate econornic gro\vth. http://clevelandfed.org/research/trends November 1996 Best available copy Interest Rates Percent, weekly averages Percent weekly averages 75 9.5 [CAPITAL MARKET RATES YIELD CURVESa 70 - 65 - 60 - 55 - 50 I l l I Basis points 700 600 500 400 300 200 100 0 1992 1993 1994 1995 1996 2.5 3.0 3.5 4.0 45 50 3-month Treasury yield, percenlage po~nts 5.5 6.0 a. b. c. d. All instruments are constant-maturity series. Estimate of the yield on a recently offered, A-rated utility bond with a maturity of 30 years and call protection of five years. Bond Buyer Index, general obligation, 20 years to maturity, mixed quality. Three-month instrument is quoted from the secondary market on a yield basis; 10-year instrument is a constant-maturity series. SOURCE: Board of Governors of the Federal Reserve System. 'The yielcl ccirve has flattenecl since ~ s eslast month. with ;ill I . ; L ~falling cept those on short-term bills of three ancl sis months. The .?-year. 3month spre:tcl clroppecl to 95 basis points ancl the lO-)~ear, .?-month spread tell to 141 basis points. Despite this decline, the yield cume re~ n a i n ssteeper ancl straighter than it w a s at the beginning of the year. Longer-term capital market rates have been moving clown since early Septernl~er..A1 one extreme, utilities have fallen by 30 l~asispoints: at the other. state and local boncls have clroppecl hp only 11. This has closecl the spreacls between utilities and other rates, even pushing utility Iates below mortgages. A longer perspective confirms the yielcl curve picture-long rates in the broad nlarket senlain significantly above their Januasy level. Is there any relatioll between the level of the yielcl curve and its slope? When the short rate rose in 1994, the yielcl spread initially rose n-ith it. Marliet observers attributed this to preclictions of even larger future increases. heighteneel infl~ltionfears, or greater uncertainty over rates. Soon the pattern reversed, ho~vever; conforming to the generally negative relationship between short rates ancl the yield spreacl. A higher short rate usually means a flatter yielcl curve. since long rates clo not increase by quite 21s much. This represents a tendency. howevec not an exact relationship, ancl 1996 saw the spreatl xviclen clespite little change in short-term rates. http://clevelandfed.org/research/trends November 1996 Best available copy I~fllationand P r i m 12-month oercen: chanoe September Price Statistics Annualized percent change, last: Imo. 1995 9 mo. 12 mo. 5 yr. avg. Consumer Prices All items 3.1 3.2 3.0 2.9 2.6 Less food and energy 3.7 2.8 2.6 3.0 3.0 Mediana 2.1 2.8 2.9 3.0 3.2 Finished goods 2.8 2.3 2.7 1.6 2.1 Less food and energy 3.4 0.8 1.4 1.6 2.6 Commodity futures pricesb -9.3 1.1 1.9 2.8 5.4 Producer Prices Four-quarter percent change Percent oi iorecasts 70 Y." IQ IIIQ IVQ 1995 lia IQ IIIQ Iva 1996 Ila la ila itla 1997 Iva IDISTRIBUTION OF ECONOMISTS, 1997 CPI FORECASTS~ I 1.8-2.2 2.3-27 2.8-3.2 3.3-3.7 Annualized percent change 38-4.2 a. Calculated by the Federal Reserve Bank of Cleveland. b. As measured by the KR-CRB composite futures index, all commodities. Data reprinted with permission of the Commodity Research Bureau, a Knight-Ridder Business Information Service. c. Upper and lower bounds for CPI inflation path as implied by the central tendency growth ranges issued by the FOMC and nonvoting Reserve Bank presidents. d. Consensus forecast of the Blue Chip panel of economists. SOURCES: U.S. Department of Labor, Bureau of Labor Statistics; the Federal Reserve Bank of Cleveland; the Commodity Research Bureau; and Blue Chip Economic Indicators, January 16 and October 10, 1996. . , I h e S e p t e ~ ~ i t )price o ~ stat15tlc5 remain gei~e~,ill\ In Ilne \\ ~ t hthe11 3% trencl of tile Ici5t fen 1e,rrs 711e 1'10ducer 1)tlce Inclex .ind the Consumel 1'11ce Inclex (01'1) lose dt dnnclal~/ecl [,ires of 2 Si%/ir.inti 3 1% during the month (tmt .I 111t h l g h e ~ when foocl .mcl enel#) goods .ire cxcluclecl) R,IIto elcite the Cl'I 15 LIP 3 2%) \\ h ~ l ei t 5 core me,lsures (the CI'I e\clucl~ngfoocl .mcl eneig] ancl the medl'in CI'I) hci\ c I l5en .it ,I slightl) mole rnocle~.lte 2 8%)/o>,~cc llnless retail prices break sharply from their recent trend, it's liltely tilac [lie inclex will e n d the pear at the lo\\-er end of the Fec1er;il Ope11 M:krliet Com~nittee'sJuly central tendency projection (3%4), but near the top of the r-ange set for 1997 (2%% to 3'%). Economists gener:tlly agree that the CPI will remain at or very near 3%) tthro~lglithe encl of nest year. F c n w tllan 40% foresee a CPI gain of less t112111 2.8% or Illore than 3.2% in 1997. Last Jailuary, at>out 30% ~>reclictecla clrop below the 2.8% level. ancl 34% espectecl a rise o f muse that1 3.2(H). Economists look at several factors in ascertaining the econonly's nearterm inflationary course, but chief among them are the past stance of monetary policy ancl the degree to which economic resources are capacity constrainecl. The latest Blue Chip S L I ~ reveiils I . ~ ~ a wicle range of opinions reg:~rcling the future path f c o t z t i ~ ~ ion ~ e ?zextpc~g~) ~l http://clevelandfed.org/research/trends November 1996 Best available copy Inflation and Prices (cont.) Annual percent change Chanoe in CPI lorecasts, oercentaae ooints I O LONG-RUN INFLATION OUTLOOK -2.5 -2.0 -15 -1.0 -0.5 0.0 0.5 1.0 Change in real GOP forecast, percentage points Annual percent change 2 E. a. Individual forecasts of the Blue Chip panel of economists. October 10, 1996. b. Consensus forecast of the Blue Chip panel of economists. c. Survey of the Blue Chip panel of economists. SOURCES: Blue Chip Economic Indicators, October 10, 1996; and Blue Chip Econometric Detail, September 10, 1996 of inflation :Inel econr~micgro~vth. About half of those responding to the October 10 poll see inflation adcelerati~lgin 1997, b ~ l tof those, only about 40%) expect the economy to g r o w at a k~sterr:lte. Of the econonlists \v21o 1,elieve hat inflation will moclerate nest year. most also see the economy slowing from its 1996 pace and, I X ~ S L I I ~ ; I ~p I~~~~ t, t i less ~ l g strain on capacity. Only :I small number of responclenis :lnticipatc both faster growth :uncl lo\xrer inflation (6%). Over the longer term, economists generally believe that inflation is preclominantly the outcome of rnonetary policy. The most opti~ilistic long-term outlook comes from the Office of Management and Buclget (OMB). which projects a 2.7% increase over each of the five years spanning 1998 ancl 2002. Both the Co~lgressionalB~lcigetOffice (CBO) :uncl the Blue Chip panel see inflation moderating slightly before sho\iTing a s~llallrising trencl between 2000 ancl 2002. O\~erall,the three groups expect that rnonetaly policy will keep itflation in the 2%?4 to 3% ~utlgethrough 2002. This is :I slightly less sanguine long-term outlool< than economists gave seven months ago. Indeed, in the past year, surveys of econonlists have listed inflation as an increasingly serious problem fdcing America. ~vhilethe threat of economic recession is seen as having recetlect. Still, neither inflation nor a clownturn in the business cycle Llppears high on the list of important concerns. Topping this year's list-21s in 1995-is the growth in government spending and entitlements. I http://clevelandfed.org/research/trends November 1996 Best available copy EconomicActiviy Percent change from preced~ngquarter s a a r IGDP AND BLUE CHIP FORECAST IQ Percent change from corresponding month of previous yea1 7 110 ilia 1996 Iva la I IIIQ 1997 IIQ IVQ Percent of Iota1 consumer spending a. Chain-weighted data in 1992 dollars, seasonally adjusted annual rate. b. Seasonally adjusted annual rate. SOURCES: U.S. Department of Commerce. Bureau of Economic Analysis; and Blue Chip Economic Indicators, October 10, 1996 Accorcling to initial Commerce Department esti~nates,the economy slowecl to a 2.2%)sate of growth in the third cluarter, down from 4.7% in 1996:IIQ. Except for husiness fixed investlllent ancl the pace of inventory accumulation, most sectors wealcenecl. Consumer spencling \\;as flat! while residential in\.estment and fedel21 government spencling cleclined. Net exports continned to kill, a result of the relati1.e strer~gtho f the U.S. economy. Economists generally expected this slowclown. Although growth of approximately 2.0% to 2.3% is l,elo\ij historical norms, it cloes not seem unusual given that the economy is operating at high levels of resource ~ltilizationand that procluctivity growth has declined over the past decade or so. Through 1997, forecasters expect output to remain in the '1.8% to 2.3% range. Judging the economy's performance on a year-over-year rather than a quarter-to-cluarter basis probahly gives a cleaser picture of how various sectors are faring. From this perspective, the growth of consumer spending has ~natchedthe overall pace of the economy during the past four quarters. Consu~llershave tilted their purchases toward clurable goocls since 1991, with about 13% of now going their total expenclit~~res for these items. Because durables (coirtin~led012 nextpclge) 0 O O Q http://clevelandfed.org/research/trends November 1996 Best available copy Q EconomicActivig (cont.) Billions of current dollars, ~.a.a.r.~ Percent change s a a r a 25 20 Billions 3i curreni dolla:~, s a 2.r." Producers' durable equlpme 15 10 5 0 -5 -1 0 -1 5 -20 -25 IQ IlIQ 1990 lQ lllQ 1991 IQ IIlQ 1992 lQ lllQ 1993 lQ Ill0 1994 Billions of 1992 dollars. s.a a.ra l a lllQ 1995 lQ IIlQ 1996 Ratio Percent chanoe from corres~ondinomonth of orevious vear a. Seasonally adjusted annual rate. b. Chain-weighted data in 1992 dollars, seasonally adjusted. c. Excludes inventory valuation adjustment. d. Includes inventory valuation and capital consumption adjustment. e. Seasonally adjusted. SOURCE: U.S. Department of Commerce, Bureau of the Census and Bureau of Economic Analysis. typically provicie ho~~seholcls with a stream of ser-vices over many years, their purchase is some\vl;hat analogous to savings. With r e d clisposable personal income growing :it a 3% clip ancl with consumer conficlence holciing steacly. the oiitlook for this sector is hi\.ol.able. Consumers may I1al.e pared their- spencling over the summer rnonths to improve their 1,alance sheets. Business fisecl investriient remains strong, particul:lrly in comput- ers ancl transportation equip~nent, and healthy corporate profits ancl cash flow should continue to bolster this area. Resiclential investment also remains solicl, notwithstanding the third-cluarter downturn. Despite an accelerateel accumulation of nonfarm business inventories in 1996:IIIQ, stockpiling does not see111 excessive. The ratio of total inventories to shipments has remainecl fairly flat over the past two years. The incl~~strial production inclex, which tr-acks output alllong the nation's manufacturers, utilities, and mines, has risen at a 5.7% annualized rate since January, with especially large gains in business equipnlent production. Although new orclers for manufacturing declined in August. they increased a healthy 4.5% over last year. Advance estim:ltes indicate that clurable goods orders grew 5.9Oh on a year-overyear basis in September. f Federal Deficits and the Economy Percent o i GDP Percent 01 GDP 1 15 FEDERAL GOVERNMENT DEFICIT AND DEBTa Percent 01 GDP Percent or GDP http://clevelandfed.org/research/trends November 1996 Best available copy Percent GO Index, 1980 = 100 a. U.S. federal government debt is debt held by the public less that portion held by the Federal R e s e ~ System. e Deficit is the year-to-year change in the federal government debt. b. Calculated using the 10-year Treasury rate and the expected inflation rate from the Survey of Professional Forecasters. NOTE: 1996 data are the average of the first two quarters. SOURCES: Board of Governors of the Federal Reserve System, Flow o f Funds Accounts of the United States; and the Federal Reserve Bank of Philadelphia, Survey of Professional Forecasters. Accortling to conventional \\.istiom. U.S. government I~utlget deficits compete against private investtilent for a fised supply of' loana1,le fi~ncls. The resulting increase in real interest r:ltes ;ittracts foreign lentlers. who I,icl up the clollar's eschange value in their zeal to acc1i1ir.ehigheryielcling U.S. securities. A clollar appreciation resi~ltsin n current account cleficit, n-hich is a necessary counterpart to an inflow of' foreign savings (see page 19). 'I'he p ~ ~ b l ewith m this accepteel psogression is that except for the fiscal espansion of the early 198Os, the relevant cl;~tado not seem to m:irch in step. Statistical analyses of these connections also fail to offer 1111et~itivocalsupport. An alternative way of examining f'sc:il policies focuses on how particillas tax ancl spending progl-arns infli~ence savings, production, ancl worli effort, ratlies than on the clef'icit per se. To illustrate this idea in t h e estreme, we coulcl conceiv- ably lower the cleficit by raising tases 011 c:lr)ital gains, on the wealthiest inclividuals, ancl on payrolls, while simultaneously cutting e s p ~ ~ d i t u r for e s roacls :ind po1-t~.Although such policies might lower the buclget cleficit, they alrllost cert;iinly xvoilld raise real interest rates I,y cliscouraging saving ancl han?pering procluction. In this view, deficits 1,ecorne lilie shaclo\vs cast h y Inore deep-seated and consequential fiscal clistortions. http://clevelandfed.org/research/trends November 1996 Best available copy Exchange Rates and Inflation Percent change from corresponding quarter of previous year Percent change irom correspond~ngquarter of prevlous year l 2 [TRADE-WEIGHTED DOLLAR AND IMPORT PRICES IQ IIIQ IQ Ilia IQ IIIQ IQ IIIQ IQ IIIQ IQ IIIQ IQ Ilia 1990 1991 1992 1993 1994 1995 1996 Percent chanae from correspond~nqquarter oi previous year I l2 ITRADE-WEIGHTED DOLLAR AND EXPORT PRICES IQ IIIQ IQ iila la IIIQ IQ IIIQ IQ IIIQ 1990 1991 1992 1993 1994 I IQ Ilia IQ IIIQ 1995 1996 Percent chanae irom corresoond~noauarter of orevious vear a. Index, 1980=100. b. Index, 1990=1.0. c. Calculated by the Federal Reserve Bank of Cleveland. SOURCES: U.S. Department of Labor, Bureau of Labor Statistics; Board of Governors of the Federal Reserve System; the Federal Reserve Bank of Cleveland; and Citibank. When the clollar clepreciates in the foreign exchange market. Americans must pay more for foreign goocls. Although the price effects of exchange-rate changes can ripple through stanclarcl price indeses. under no circ~~mstances can a clollar clepreciation cause inflation. Exchange rates never move on their o\\.n; sather, they responcl as other economic events change the s ~ t p p l yancl clemand for clollars. If t h e clollar clepreciates because the F c d e 1 ~ 1 Iieserve increases the money supply excessively. then the tnoneta~yexpansion, not the accompanying dollar clepreciation. is the cause of inflation. If the clollar depreciates because foreigners-for whatever reasonb u y fewer American exports, the price of U.S. inlports will eventually rise. The increase in import prices, however, can be sustained only if some other prices fall, the money supply increases, or the velocity of money rises. The first conclition is not inflationary and will only affect those aggregate price indexes that weight import prices more heavily t1l:in the prices that h l l . The second conclition is also ~~nliltely. If anything, the central bank will react to a n unwantecl clepreciation by tightening-not easing-monetary policy. Finally, if higher clomestic interest rates acconlpany a depreciation, \-elocity night rise. Evidence o f s ~ ~ an c heffect is lacking, however. Inflation is a decline in t h e purchasing po\ver of money that manifests itself in higher prices. I-Iigher prices are not always eviclence o f inflation. http://clevelandfed.org/research/trends November 1996 Best available copy Labor Markets Change, thousands of workersa I AVERAGE MONTHLY NONFARM EMPLOYMENT GROWH I t 185 s-producing -5 Manufacturing -12 9 Service-producing 190 110 4 36 9 Household employ. 34 160 -10 -22 15 170 70 12 44 31 253 280 34 24 10 246 84 12 1 122 171 -35 -53 -59 8 18 56 4 27 -67 313 210 17 6 10 193 119 26 62 -40 259 Average for period Civilian unemployment 5.6 5.2 5.1 5.2 5.2 L"" 1990 1991 1992 1993 1994 1995 1996 to dale Ill0 Aug. Sept. Oct. 1996 Percent Percent Percent change, year over yeara 9 8 7 6 5 4 3 2 1 1988 1989 1990 1991 1992 1993 1994 1995 1996 a. Seasonally adjusted. b. Finance, insurance, and real estate. c. Production and nonsupervisory workers. d. Vertical line indicates break in data series due to survey redesign. SOURCE: U.S. Department of Labor. Bureau of Labor Statistics. After a slight clecline in Septeml>er. nonfilsm payrolls rose by 210,000 in Octol>er, contin~~ing the trencl of moclerate p i n s that l ~ e g a nin 1995. T h e eml1loyment-to-po1~~11i1tim KItio rem:lined essentially ~lnchangecl from September: ho\vever, it stands half a percentage point higher than a yeas ago. Unemployment lielcl steady at 5.2%. comparecl to 5.5% in Octol~es1995 ;mcl 5.6% cluring all of last year. In :iddition, the nleclian cluration of unemployme~~t fell to 8.3 weelis from 8.9 weeks in September. The largest employment gains occurred in services, LIP 119,000, and retail ttxcle, up 62,000. The governIllent sector experienced the only clecli~le for the month, clropping 40.000 jobs on the heels of Septemlxr's 67,000 loss. Goocls-proclucing inelustries adclecl 17,000 jobs, a welcome ti~rnarounclafter September's sharp 53,000 decline. There is little eviclence of increasing w g e growth, as base wages anct salaries rose at a n annual rate of al~out3.1%1in the thircl q u a ~ ~ conlec parecl to 3.2% anel 3.1% in the first ancl scconcl cluarters, respectively. Growth in benefits has continuecl its gerleral clownwarcl trencl. with the annual rate of increase falling from Illore than 7%)per year in 1990 to ahout 2% today. I'otal compensation growth retreateel over the first half of ~ tS ~ O W ~ O W sI Ie e ~ n s the ctecacle, b ~ the to have n~otleratcclsomewiiat in recent months, avemging sliglitly rnorc th2u11 2.6% (:inn~ializecl). http://clevelandfed.org/research/trends November 1996 Best available copy Average Annual Productivity Growth: Nondurables (Percent) Total mfg. Nondurables Food Tobacco Textiles Apparel Paper Printing/ publishing Chemicals Petroleum Rubber/ misc. plastics Leather 19491994 19491973 19741994 2.53 2.46 2.59 2.32 3.96 2.42 2.55 2.59 2.83 2.75 2.98 4.36 2.08 2.95 2.45 2.01 2.39 2.09 3.96 2.83 2.08 1.30 3.01 3.30 2.05 4.41 4.36 0.41 1.33 2.02 2.21 1.77 2.61 I .74 1.73 1.80 Average Annual Productivity Growth: Durables (Percent) Total mfg. Durables Lumber Furniturelfixtures Stone/clay/glass Primary metals Fabricated metals Industrial machinery Electricalequip. Transportation equip. Instruments Misc. mfg. 19491994 19491973 19741994 2.53 2.69 2.54 1.89 1.96 1.92 1.63 2.59 2.66 3.38 1.97 2.54 2.19 1.93 2.45 2.73 1.54 1.79 1.27 1.59 1.26 3.20 3.77 2.22 2.89 4.37 4.83 2.22 3.76 2.43 2.80 3.52 3.43 1.53 4.05 1.22 a. Seasonally adjusted. Productivity is defined as output per labor hour. SOURCES: U.S. Department of Labor, Bureau of Labor Statistics; and U.S. Department of Commerce, Bureau of the Census. NIuch Iias Ixen rnade of the C.S. proclucti\-ity slo\vdon.n, which began in the early 1970s. Procluctivity, or o~ttputper labor hour; grew at an average annual rate of about 2.3%) fronl 195') to 1973. I,ut only around 0.8% from 1974 to 1993. The causes of this slo\vdown are ~lnclear.Some economists point to the oil shock of 1973, measurement error, sectoral reallocation, :uncl technological innovation clue mainly to computers (since it talies time for workers to learn new techniclues). A f ~ ~ r t h ecomplication r in pin- pointing the source of the procluctivity slo\\rdo\\m is the lack of uniformity across sectors. For example, :tnn~lalprod~~ctivity g r o ~ in h manufacturing senlairled steady, averaging z ~ h o 2.6% ~ ~ t hetween 1949 ancl 1973 ancl 2.5% between 1974 anel 1994. E\.en within that sector there ~ v a s substantial variation. Nondur:~bles manufacturing exhibited a slight decline in productivity across the t11~) periocls. \vhile clurables showed a nloclest increase. A further brealidon-n inclicates that large procluctivity gains occurred in industrial machinery, \vhich includes computer equipment, ancl electrical equipment. 13y contrast, gro\\.th in printing and p~~blishing, chemicals, petsoleurn, anci lumt~erincreaseel by less than half in the latter 1>eriocl cornp:md to the forrner. Over the entire 44-year span, there \\..as a s~~lxtantial labor realloseccation ~vithinthe nx~nufiucti~ring tor as well as an overall clo\v~lwarcl trend in employment. A movement of lal,or to less procluctive sectors may partially explain the procluctivity slo\vclo\\-n. http://clevelandfed.org/research/trends November 1996 Best available copy TheAuto Industry Shaie 01 U S nonfaiiii employment Share ol U S nonfarm employment 50 1982-84 dollars Der week 5 U.S. EMPLOYMENT -1 30 - 20 - 10 - -3 Motor veh~clesand equipment 0 I I I I I I I I 1 0 a. Numbers indicate final assembly plants in state. Data are unavailablefor Alaska, Arizona, Colorado, Hawaii, Montana, Nevada, South Dakota, and Wyoming. SOURCES: U.S. Department of Labor, Bureau of Labor Statistics; and Ward's Automotive Reports, September 2, 1996. With :tnothel- r o ~ ~ nol' c l negotiations l~enveenthe m:tjor auto~n:tkersanel the unions wincling donin. a potelltially large shocli to Foilrth Fecle~xl Reserve Ilistrict employment appears to h:lve l x e n a\;ertecl. &lost auto procl~lctionin the 17.S. follo\\;s Interstate 75 s o ~ ~ t lfrom i Iletroit through Ohio. ICentncliy. Tennessee: ancl Georgia. blichigan ancl O h i o ha\-e the most final assernbly plants, :l~-idpans proclucers are typically locatecl ne:ut>y. Like manuk~cturingemployment, motor vehicle procluction represents a decreasing share of the U.S. employment base. Despite this trend, :ts of 19% about 968,000 workers still liacl jolx in the inclustry, down only slightly from 1978's peal< of over I million. With foreign automakers espancling their U.S. procluctiotl :tncl clonlestic companies recovering some of their market share, employment in the industry has ac- tually expancleci each year since 1971. Over the 1773-94 ancl1994-75 periocls, 111otor vehicle manufacturers aclded to their payrolls at the robust rates of 8.7% ancl 6.5%. respectively. Iluring the same time, manufacturing employment remainecl ahout even. Despite the flat~lessin manuhtct~lringemploy~nentancl the clrop in re:tl earnings in 120th nunufactusing ; ~ n dtotal nonfarm employment over (cotztit7zle~lotz~ ~ e x t p u g e ) 0 0 0 , @ 6 $ http://clevelandfed.org/research/trends November 1996 Best available copy 0 TheAuto industry (cont.) Percent Percent 6 5 4 3 2 1 0 1956 1961 1966 1971 1976 1981 1986 1991 1996 a. For some Fourth District counties, transportation equipment employment shares are based on the midpoint of the employment size class. Asterisks indicate final assembly plant(s) located within county b. Does not include medium or heavy trucks. c. 1984-87 data for West V~rginiaare unavailable. SOURCES: U.S. Department of Labor, Bureau of Labor Statistics; County Business Patterns; and Ward's Automotive Reports, September 2, 1996. the past 20 years, real earnings of worlters in the motor \.chicle and transpcxtation ecliiipment inclustries have remainecl lul;~ti.i.ely high. In fact, average weelily earnings in motor vchicles and cqciipment have esceedecl those in t~inspo~tation equipment as a \z;hole. \.i;hicli inclucles aircraft procluction and shipl~uilding. I n the Fourtll District, employment in the transportation equip- 111ent inclustry is heaviest along the western border. Even though final assembly plants are founcl in only 10 Ohio counties, automotive parts suppliers are common ancl account for a large share of the District's auto industly employment. Ohio leads the District in transportation equipment employment. Lilce the U.S., the state has seen ernployment in the industry decline as a share of total nonfarm employment, I x i t it has been able to keep en~ploynlent levels stable at around 139,000. Michigan follows a similar pattern: Transpostation equipment accoc~ntecl for nearly 17.5% of total employment in 1956, but by 1995, that figure liad plummetecl to 7%. States that have been able to l ~ u c kthis trend, lilte ICent~~cky ancl Tennessee, have benefited from the automotive inticistry's move southnrarcl. http://clevelandfed.org/research/trends November 1996 Best available copy http://clevelandfed.org/research/trends November 1996 Best available copy Banking Conditions (cont.) Percent Boston New York Philadelphia Cleveland Richmond Atlanta Chicago Federal Reserve District St. Louis Minneapolis Kansas City Dallas San Francisco a. Horizontal lines represent the distribution of loans in each category for the U.S. as a whole b. Totals may not sum due to rounding. NOTE: Data are for commercial banks. SOURCE: Board of Governors of the Federal Reserve System, Call Reports, June 30, 1996. Because large h:lnks are able to make loans to. any customer while s~llallbanlis x e limitetl to s~llallbusiness financing (l>ecaclseof their size a n d regul:ttions go\.erning incliviclual risk exposure), the clrop-off in the n ~ l m h e r of slnall institutions has raisecl concerns a l ~ o t the ~ t ax.ailal,ility of small firm cr-eclit. Av:lilal~lc cl:~taconfirm that most of the commercial ancl inclustrial (C&I) loans maclc by slnall banlts go to sm;lll fir~ns.However. large banlts account for a gre:lter share of small b ~ ~ s i n e financing. ss For example, as of June 1996, about 67% of U.S. Ixnlis hacl assets helo~v$100 million. These institutions were respollsible for allout 25%) of C&I loans below S1OO.OOO and for about 12% of loans with original amounts between S100,000 ancl S250.000. At the same time. the comparable figures for l,anl<s \vith assets above $1 billion (less than 4% of the industry) were about 41% ancl 56%. respectively. Sirnilas patterns are present in nonfr-lrm, nonresidential real estate lenciing. S~ilallh;unlis hanclleci about 32% of loans below 6100,000 and 13% of loans bet\veen S1OO.OOO :111d S250,OOO. For large banks. the comparable fig~lreswere 27% and 33%. To a certain extent. these figures should allay some of the concern that banking consolidation will reduce the funcls avail:~hle for s~nall I~usinessloans. Finally, note that in the Fourth Federal Reserve District, the proportion of C&I loans catagorizecl as srllall is slightly below the U.S. average, but s~llallreal estate loans exceed the national norli1. 0 0 I 0 http://clevelandfed.org/research/trends November 1996 Best available copy I International Developments Billions of U.S dollars Output and Inflation (Percent change, s.a.a.ca) Real GDP: 1996.110 CPI: August 1996 Year over year Change from previous quarter Year over year Change from previous month 2.7 4.7 2.8 0.2 Germany 1.2 6.1 1.8 -0.1 U.S. Japan 2.6 -2.9 -0.1 -0.1 Canada 1.2 1.3 2.2 0.1 U.K. 1.7 1.5 3.4 -0.4~ France 0.4 -1.5 1.7 -0.3 Percent a. Seasonally adjusted annual rate. b. Change from June to July 1996. c. Weekly average of daily rates. d. The foreign G-10 countries comprise Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden, Switzerland, and the U.K. SOURCES: U.S. Department of Commerce. Bureau of Economic Analysis and Bureau of the Census: U.S.Department of Labor, Bureau of Labor Statistics; Board of Governors of the Federal Reserve System; the Federal Reserve Bank of New York; and Citibank. The econo~nicsof the 1J.S.. Can:lda, Japan. ancl their m:~jor Eiiropean tracling partners grebv at a slow to moclel.ate pace over the past year. The 1I.S. fr~reclIxst n.itli a n annual growth r:lte of 2.7?4. while France saw the slo\vest growth at 0.4%). Consumer. prices z11so appear to e lt~oth y the be increasing ~ n o c l e ~ ~ tin Europe:in ancl North Americzln countries. I~lflation over the past year langccl from 1.7%)in France to 3.4%)in the 1J.Ii.l'hc bunching of long-term interest rates froin 6% to 7%) in these nations suggests that nlarlcet ~ , I tlc1p~lnt4 I expect long- term int1;ttion to remain in the 3% to 4% range. Collsutner prices in Japan were nearly unchangecl, falling a slight O.l(Yii since last year. Japan's long-term interest rate is nearly three percentage points below that of its tracling partners, suggesting that consclrner price increases will rernain relatively lo\\; tl~ere. In August, the U.S. trade cleficit fell by $0.7 I,illion, to $15.6 billion. This slight clecline was caused by :I surge in exports of nearly $1.8billion. Imports continued their steacly march iip~vv~rcl, increasing nearly $1 billion. I)c\p~tetile nioclerate nallon lng In the tracle deficit over the past month, the long-term trencl to~v\ircl everlarger clef'icits contin~~es. On a tradeweighted basis, the clollar appreciated slightly in micl-Octol,er (up 0.3%), remaining little cha~igeclfrom Janua~y. Thro~ighthe first two quarters of 1996, the I1.S. current account deficit was riinning at a $147 billion an11~1alrate. A country running a current account deficit essentially borrows output from the rest of the world to finance its own consutnption ancl investment. To finance its (~ol2rlil~le 01d 2 tze.~tpc[ge) http://clevelandfed.org/research/trends November 1996 Best available copy International Developments (cont.) U S oollars [u.s. BALANCE OF PAYMENTS Bill~onsof 40 B~lltonsof U S dollars 150 I OFFICIAL CAPITAL F L O W S ~ 1 Pr~vatecap~talilowsa Current account Billions of U S dollars U.S. Current Account: Saving and Investment (Percent of GDP) 1993 1994 1995 1996 14.3 15.2 15.6 16.4 Private 14.7 14.5 14.5 15.1 Government -0.4 0.7 1.1 1.4 Gross saving Foreign capital inflowC 1.5 2.1 2.0 2.0 Gross domestic investment 16.5 17.7 17.4 17.6 Statistical discrepancy -0.7 -0.4 0.2 0.8 a. Private capital flows have signs reversed and include the statistical discrepancy as unrecorded capital flows. Positive values represent a capital outflow. b. Positive vaiues represent a capital inflow. c. Foreign cap~talinflows are the current account deficit with the sign reversed. NOTE: All 1996 data are annualized averages of the first two quarters. SOURCES: U.S. Department of Commerce, Bureau of Economic Analysis; and the Federal Reserve Bank of New York. imports, tlle L.S. 111~1st export finanliving clepends o n whether it borcial assets-claims o n ~ L I nS ; ~ t i o ~ ~ ' srows to finance consumption or inf ~ i t u r e1~roductivity-resulting in a vestment. The ctralllatic clifferellce hetween the current account cleficit n e t inflo~vof foreign capital. Incleecl, a net pri\;:ltc c:lpit:il inflo\v of and private capital inflows suggests thxt ~ L I current S accoullt cleficit is $17.8 I,illion h:is accompaniecl this year's t > ~ ~ i l di11 ~ ~the j ) current acnot supporting higher U.S. private investment. Insteacl, the rate at count elelicit. I-Io\ve\.er, the majority which foreign governments have of the reclc~isite net capitzll inflow ;~clcledto their holdings of L.S. govhas occurred as foreign goverllernment securities indicates that our Inents 11ar.c :~clclecl$130 I~illion(211tlacle cleficit is primarily supporting nualized) to their official holclings. domestic government spencling. A co~lntry's al3ility to service Whether this results in a decline in these f ~ t u r cclaims without sufferour fi~tureliving star-iclarcl hinges on ing a clecline in its onin stanclarcl of whether the increasecl government borrowing is financing government consumption or investment, such as public infr-~~str~lcture. Despite years of increasecl I3orro\ving fro111al~roatl.total net investIlleIlt income \\?\;aspositive prior to 1994: that is, we e:lmecl more from our offshore investments than foreigners earnecl from their investments in the L.S. Recently, however, the long-awaited payhacl< has started, as total net investment incolile has turnecl slightly negative. 1
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