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APPENDIX Larry Promisel Introduction May 21, 1984 The U.S. External Position This afternoon we will provide a long-term perspective on the external position of the United States. Our presentation will use the package of materials that has been distributed to you and will be in three parts. First, Peter Hooper will analyze how we got to where we are, focusing on the unprecedented deficit now being observed in the U.S. current account. Peter Isard then will discuss where the present high level of the dollar -- if it were maintained -- would take us, in terms of our current account and our external investment position. Finally, Dale Henderson will consider the implications of alternative scenarios -- embodying both exogenous and policy-induced declines in the dollar. Let me turn to Mr. Hooper. Peter Hooper Part I The first chart in the package of materials places recent movements in the U.S. current account in a historical perspective. shown in the top panel, As the United States ran a current account surplus, on average, during most of the post-war period. about in balance in 1980, but it The current account was has dropped sharply over the past two years, reaching an estimated deficit of about $85 billion at an annual rate in the first quarter of this year, more than five times as large as any annual deficit recorded prior to last year. panel, As shown in the bottom the recent decline in the current account is less dramatic when expressed relative to GNP, but it still reaches a level that is well outside the post-war historical range of plus or minus one percent of GNP. The top panel of Chart 2 presents two measures of the U.S. external investment position, or the level of U.S. assets held abroad minus foreign assets held in the United States. The solid line shows the officially recorded external investment position, and the dashed line, which begins at the recorded position in 1948, shows movements in the cumulated current account. By either measure the external investment position has been substantially positive during most of the past 35 years, contributing to a comfortable surplus on U.S. income receipts. net investment In recent years, the cumulated current account has fallen substantially below the recorded series. This difference largely reflects recent increases in the statistical discrepancy, or unreported transactions, in the U.S. international accounts. The solid line implicitly treats the discrepancy as unreported current account transactions, capital while the dashed line implicitly treats it flows. as unreported We have reason to believe that much of the discrepancy does reflect unreported capital flows, so that the recorded series, or the solid line in the chart, gives an optimistic picture of our present external investment position. In any event, the evidence points to a substantial decline in the U.S. external position. The developments underlying this decline can be analyzed at two levels, as outlined in Chart 3. The first involves accounting for the effects of the proximate determinants of the trade and non-trade components of the current account. include: The proximate determinants (1) changes in U.S. price competitiveness, (2) movements in the relative cyclical positions of the United Sates and its major trading partners, and (3) changes in other factors that have directly affected the current account. These other factors include international debt problems, which have affected our exports, and changes in oil prices and oil consumption, which have affected our imports. The second level of analysis involves accounting for shifts in more fundamental factors that affect the current account indirectly, through their impacts on the proximate determinants. In particular, these include fiscal and monetary policies--here and abroad--and other exogenous factors affecting international asset preferences. Movements in the first proximate determinant, competitiveness, U.S. price are indicated in the top panel of Chart 4, which shows the weighted average foreign exchange value of the dollar adjusted for relative consumer prices. On this index, the dollar rose more than 40 percent between the fourth quarter of 1980 and the first quarter of 1984. Movements in relative cyclical positions are illustrated in the bottom panel, countries. which shows real GNP in the United States and other G-10 Since the fourth quarter of 1980, three percent more than foreign GNP. U.S. GNP has risen about Most of this relative increase took place over the past year, as the U.S. economy recovered faster from a deeper recession in 1982. Chart 5 shows U.S. exports to developing countries. As indicated by the solid line, our total exports to this area declined between 1980 and the first quarter of 1984. This decline reflects, in particular, the efforts of countries burdened by debt to cut back on their imports. U.S. exports to the ten major countries experiencing serious debt problems, indicated by the dashed line, fell by $15 billion over this period. Chart 6 provides a summary allocation of the $85 billion decline in the current account since 1980 among the main proximate determinants. Based, in part, on model simulations, we would allocate about $70 billion to the decline in U.S. price competitiveness, roughly $20 billion to the relative strength of the U.S. cyclical recovery, and another $15 billion to the contraction of demand from developing countries with debt problems. Working in a positive direction was a $20 billion effect due to the decline in oil prices during this period and further declines in domestic oil consumption. Several fundamental developments underlie the shifts in these proximate determinants. The change in U.S. fiscal policy over the past three years has attracted considerable attention. 7 shows the increase in the structural, The top line in Chart or high employment, budget deficit from its low of $30 billion in 1981. federal The structural deficit in 1984 is expected to have risen by about $100 billion since The chart also shows model- 1981, or by about 3 percent of current GNP. based estimates of the effects of that increase. We estimate that the U.S. fiscal expansion will increase real GNP to a level about 2-1/2 percent above where it otherwise would be in 1984, contributing substantially to the growth of import demand. growth, the fiscal expansion keeps U.S. real Assuming unchanged money interest rates about 2-1/2 percentage points above where they otherwise would be. Taking into account some sypathetic increase in foreign interest rates, such a rise in U.S. interest rates suggests that the dollar is about 8 percent higher in 1984 as a result of the U.S. fiscal expansion. The appreciation of the dollar, in turn, has two effects. First, by reducing the price of imports, it largely offsets the inflationary effects of the expansion, leaving the path of domestic prices about unchanged, as shown in line 5. Second, it contributes, along with the expansion of real GNP, to the widening of the current account deficit--shown in line 6. The current account is also affected by the rise in interest rates, which has a small effect on net investment income receipts, and which tends to depress exports to countries with debt problems. The net impact of the fiscal expansion on the current account by 1984 is an estimated $30 billion larger deficit. These estimates leave most of the rise in the dollar and its impact on the current account unexplained. at least in part, This shortfall could reflect, the limitations of the models employed. In particular, the models do not incorporate forward looking expectations and, therefore, miss the effects of anticipated future budget deficits on real interest rates and exchange rates. fundamental However, it also indicates that other factors were influencing the dollar. The price adjusted dollar is shown again as the solid line in Chart 8. The dashed line in the chart shows the differential between a measure of U.S. long-term real interest rates and a weighted average of foreign long-term real rates. In theory, this differential provides a link between the exchange rate and underlying economic policies. In practice, the relationship between the real interest rate differential and the real exchange rate has varied considerably in the short run, but it is evident that the longer-run movements in the two series have been fairly consistently correlated over most of the floating-rate period. Since mid-1979, U.S. real interest rates have risen more than 6 percentage points relative to foreign real rates. Most of this rise followed the move to greater monetary restraint in the United States than abroad, beginning in late 1979. By the time the shift in U.S. fiscal policy was implemented at the end of 1981, the interest rate differential had begun to level off. Some of the effects of the U.S. could have been anticipated earlier. fiscal expansion However, the primary effect of that expansion, against a background of fiscal restraint abroad, was to keep the interest differential from falling to a substantially lower level in 1982 and beyond. As indicated in the chart, the rise in the real interest differential since 1979, has been associated with much of the dollar's appreciation in real terms. However, the dollar continued to rise after the interest differential leveled off in 1982. A good deal of this subsequent gap has been attributed to exogenous political and economic developments abroad, including "safe haven" considerations, that have shifted preferences in favor of dollar-denominated assets. In the absence of these factors, the dollar would have been noticeably lower and the interest rate differential somewhat higher. In conclusion, a rough accounting of the various fundamental factors suggests that changes in economic policies in recent years can explain most of the widening of the current account deficit due to cyclical factors. To the extent that these policy changes were responsible for changes in real interest rates, they could also explain more than half of the increase in the deficit due to reduced price competitiveness. This combined effect would amount to about two thirds of the widening of the current account deficit, excluding the favorable movement in oil imports. Much of the remaining increase in the deficit reflects the effects of other exogenous developments that have influenced international asset preferences. Mr. Isard will now continue our presentation. -8- Peter Isard Part II I will focus on the implications for our international accounts during the rest of the decade if average value. the dollar remains around its current I will also discuss why the staff believes that the current high level of the dollar is not sustainable. The top panel of Chart 9 shows a simulation of how the U.S. merchandise trade and current account deficits would expand through 1990 with the average nominal foreign exchange value of the dollar unchanged at its recent index level of 130. The lower panel shows the simulated values of key explanatory variables. The simulated values for 1984 and 1985 are based on the staff's current Greenbook projections, but are adjusted to be consistent with the assumption that the value of the dollar will remain constant; the Greenbook forecast is that the dollar will depreciate by roughly 15 percent by the end of 1985. The simulated values for 1986 through 1990 were derived by making similar adjustments to an extrapolation of the Greenbook projections, which assumed fairly similar growth and inflation rates in the United States and the G-10 countries, and a somewhat higher growth rate for the developing countries. The assumption of an unchanged value of the dollar tends to depress U.S. growth and inflation and to stimulate foreign growth and inflation relative to the Greenbook forecast and its extrapolation. Referring to the upper panel, the simulated values of the trade and current account deficts widen to around $180 billion in 1990. Much of the widening of these deficits occurs in 1984. The diminishing year-to-year changes in the trade deficit from 1984 through 1987 mainly reflect three factors: first, the wearing off of the lagged effects on trade flows of the dollar's appreciation to date; second, pick up in foreign activity growth and slowdown in U.S. a projected activity growth; and third, the assumption that the dollar price of oil will remain constant through 1987, which reduces temporarily the growth in the value of imports. Starting in 1988, however, the trade deficit again begins to widen by $10 to $15 billion a year, and that underlying trend would continue into the next decade had we extended our simulations. The period beginning in 1988 is one in which imports and exports are simulated to be expanding at fairly similar percentage rates, and the underlying trend in the trade deficit results from the initial condition that imports exceed exports by nearly $150 billion in 1988. It may also be noted from the chart that the difference between the current account and the trade balance declines fairly gradually and shows only a small deficit in 1990. The explanation for the gradual decline in the current account relative to the trade balance is summarized in Chart 10, which compares the simulated values of current account components for 1990 with data for 1983. The last column shows that under an unchanged dollar, our net income from portfolio investments (line 4) would decline by $62 billion from 1983 to 1990, while our net income from direct investments (line 5) would rise by $21 billion and our net receipts from other services and transfers (line 6) would increase by $15 billion. The decline in net income from portfolio investments mainly reflects the rapid build-up of our external debt, while a large part of the rise in net direct investment income reflects a rebound in earnings on our existing stock of -10- direct investments overseas as rising foreign economic growth and capacity utilization rates lead to a substantial pick-up in profits from levels that recently have been very depressed, and as foreign inflation increases the nominal value of those earnings. Given this simulation of how our external deficits would expand if the dollar remained around its current average value, it is natural to ask whether the current strength of the dollar is sustainable. One analytic framework for discussing sustainability is to consider whether variables that seem relevant are projected to get better or worse. A starting point is the question of whether the state of U.S tradable goods industries would get better or worse. question. Chart 11 helps to address this Under the assumptions of a constant nominal exchange value of the dollar and inflation rates slightly higher in foreign countries than in the United States, prices of U.S. tradable goods would decline gradually relative to prices of foreign tradable goods. In other words, although the value of the dollar would remain unchanged in nominal terms, it would depreciate gradually in real terms. In this sense, U.S. tradable goods industries as a group would benefit gradually from an easing of the pressures that they have been placed under by the substantial appreciation of the dollar over the past several years. The expansion of economic activity abroad would also stimulate the volume of U.S. exports, which are simulated to recover by 1990 to a volume nearly 20 percent higher than the 1980 peak. Even though the volume of merchandise imports after 1984 would rise at almost the same pace as exports, the continuing growth of the U.S. economy would lead to continuing expansion in U.S. tradable goods industries. -11- Although the projected state of U.S. tradable goods industries does not appear to suggest that the current strength of the dollar is unsustainable, a different picture emerges from focusing on the extent to which the United States would be relying on saving from abroad. In Chart 12, the top panel shows that our current account deficit, or net capital inflow, would be absorbing a growing proportion of foreign net saving. Although estimates of foreign saving are necessarily crude, we estimate that with an unchanged exchange rate the fraction would rise to about 61/2 percent in 1984 and 7-1/2 percent in 1990. The lower panel shows that our current account deficit is expected to expand to about 2-1/2 percent of our GNP this year and would exceed 3 percent of GNP in 1990. If we extended our simulations beyond 1990, we would expect these ratios to continue to grow gradually, rather than to move back toward zero. An important implication is illustrated in Chart 13. Based on the estimate that our recorded external investment position was $135 billion at the end of 1983 (which, as Mr. Hooper suggested, may well overstate the true position), and also making the assumption that future statistical discrepancies in the balance of payments accounts will average to zero, the simulated stream of current account deficits would lead to a net debtor position for the United States of around $800 billion by the end of 1990. Moreover, as indicated in the lower panel, the stock of our net external debt would expand by 1990 to about 14 percent of the GNP available to service the debt, and that ratio would not level off over the foreseeable future. The prospect of a rising ratio of external debt to GNP over the foreseeable future is the basis for the staff's view that the current strength of the dollar is not sustainable over the long run. As -12- highlighted in Chart 14, in our view, and consistent with analytic models of steady-state equilibrium, an essential requirement for sustainability is that our external investment position relative to GNP must stabilize. On the assumption that foreign GNP and wealth variables will grow at about the same rate as U.S. GNP over the long run, our sustainability criterion is also a requirement for stabilizing the share of U.S. the portfolios of foreign wealth holders. As an approximation, meeting the sustainability criterion requires that the dollar depreciate, terms, debt in sufficiently to eliminate the trade deficit. in real With the trade accounts roughly in balance, the growth rate of the stock of net external debt would be approximately equal to the nominal interest rate, since the change in the external debt -- namely, the current account deficit -would be approximately equal to net investment income payments, or to the stock of debt multiplied by the nominal interest rate. Thus, to the extent that the nominal interest rate can be expected to be approximately equal in the long run to the growth rate of nominal GNP, with the trade accounts roughly in balance over the long run, the growth rates of external debt and nominal GNP could be expected to be approximately the same, thus satisfying the sustainability criterion. The issue of sustainability should be distinguished from considerations of desirability, which are also highlighted in the chart. In the short run, the strength of the dollar and our current account deficit provide several benefits. Our current account deficit reduces the upward pressure on domestic interest rates that would develop if large federal budget deficits and growing private domestic demands for credit had to be financed from domestic saving alone. Moreover, the growth of U.S. imports has expansionary effects on economic activity -13- abroad and eases the process of adjustment in countries burdened with debt. Over the longer run, judgements about desirability can be framed in terms of two questions. To what extent is borrowing from abroad leading to greater capital formation in the United States? And is borrowing by the United States consistent with an efficient and equitable allocation of world saving -- that is, into countries where it with world saving being channeled can be invested most productively, or where it desired to support consumption levels that are considered to be appropriate on the basis of welfare judgements? While these issues of desirability are important, a more central focus of our presentation today is on the issue of sustainability, which Mr. Henderson will now address further. is -14- Dale W. Henderson Part III According to the analysis presented by Mr. Isard, if the foreign exchange value of the dollar were to remain at its current high level, the U.S. external position would be unsustainable, in the sense that our net external debt would continue to rise relative to our GNP. Such analysis has led many observers to conclude that sooner or later there will be a substantial drop in the exchange value of the dollar. Therefore, I will first discuss the implications of two possible paths of dollar depreciation that are shown in Chart 15. In each case, the dollar's depreciation is assumed to be caused by a shift in market sentiment against the dollar with no change in U.S. or foreign economic policies. This shift might result from a negative reappraisal of the U.S. external position or a reduction in "safe haven" demand for dollar assets. The path of gradual depreciation is the path projected by the Staff in the Greenbook plus an extension through early 1988. Along this path the dollar falls from its current level to about its average level for the floating rate period through 1980 -- a total depreciation of about 30 percent. Depreciation could follow this path if all private agents gradually revised their views about the prospects for the dollar or if some groups revised their views later than others. Another possible path is the path of rapid depreciation. Along this path, the dollar falls over two years from its current level to one that is roughly consistent with a sustainable external position -- a total depreciation of about 45 percent. This path might be generated by an abrupt change in opinion about the implications of the current value of the dollar for our external position. -15- The effects of the two depreciations on the U.S. position are shown in Chart 16. external As shown in the top panel, both the gradual depreciation and the rapid depreciation contract the current account deficit relative to the level implied by an unchanged dollar. However, as shown in the bottom panel only the rapid depreciation generates a sustainable U.S. external position by stopping the decline in the external investment position relative to GNP. The depreciation required for sustainability is larger than the one that would be necessary to return to historical exchange rate relationships because it must compensate for a permanently lower level of demand for our exports by both developed and developing countries. Chart 17 shows some of the effects of the two hypothetical depreciation paths on the U.S. economy. As shown in the top panel, U.S. real GNP is initially higher with the depreciations than with an unchanged dollar because the depreciations stimulate demand for U.S. goods. However, real GNP is subsequently lower because demand is choked off by interest rate increases. The average annual growth rate of real GNP along all three paths is about 3 percent. The bottom panel indicates the extent to which the depreciations affect the rate of consumer price inflation both directly, through the price of imports, economic activity. and indirectly, through the level of The inflation rate, like real GNP, is first higher and later lower than with an unchanged dollar. In 1985 and 1986, inflation is 2 percentage points higher with the gradual depreciation and 3 percentage points higher with the rapid depreciation. For both depreciations the level of consumer prices is always higher. As shown in Chart 18, given an unchanged path of money, the initial increases in GNP and prices lead to substantial increases in the Treasury bill rate. These increases explain why real GNP is eventually lower for a time than with an unchanged dollar. The depreciations have contractionary effects abroad; weighted average foreign real GNP and consumer price inflation are lower throughout the simulation horizon. So far I have discussed the implications of exchange rate changes that might result from a shift in market sentiment with no change in economic policies. The gradual depreciation by itself does not appear to be enough to stabilize the ratio of the external investment position to GNP by 1990. However, the gradual depreciation combined with plausible policy actions can achieve this result. I will consider the implications of two possible policy scenarios. The first is contraction with no change in monetary policy. The second is a change in a fiscal the policy mix, that involves the same fiscal contraction accompanied by a monetary expansion sufficient to keep real GNP roughly unchanged. In both cases, the fiscal contraction represents a 40 percent reduction in the structural budget deficit beginning in 1986. Chart 19 shows how the two policy actions affect the exchange value of the dollar. As you have already seen, the dollar depreciates significantly along the gradual depreciation path. Its value is even lower with the policy actions -- an average of 4 percent lower with the fiscal contraction and 11 percent lower with the change in policy mix. The dollar is lower with the policy actions because U.S. interest rates are lower. -17- Chart 20 shows how both policy actions reinforce the effects of the gradual depreciation alone on the U.S. external position. As indicated in the top panel, both actions lead to substantial narrowing of the U.S. current account deficit in the last five years of the decade. These reductions occur because the value of the dollar and U.S. interest rates are lower with both actions. In addition, U.S. GNP and prices are lower with the fiscal contraction. The effect of the change in mix is greater than that of the fiscal contraction because the decreases in the value of the dollar and U.S. interest rates are so much larger. indicated in the bottom panel, As combining either policy action with a gradual depreciation yields a roughly sustainable external position. With the fiscal contraction the U.S. external investment position relative to GNP stops declining by the end of the simulation period. With the change in mix that ratio actually starts to rise. Some of the effects of the two policy actions on the U.S. economy are summarized in Chart 21. As shown in the top panel, with the change in policy mix, real GNP follows the gradual depreciation path by assumption. With the fiscal contraction alone, real GNP is below the gradual depreciation path from the fourth quarter of 1985 on by an averge of one percent. The bottom panel shows the impacts of the policy actions on the rate of consumer price inflation. With the fiscal contraction, inflation is initially higher than without it, because of the additional depreciation of the dollar. However, the effects of the additional depreciation are transitory, and inflation is eventually lower because of the reduced level of economic activity. With the change in policy mix, the increase in inflation is more pronounced and longer lasting than with -18- the fiscal contraction because there is even more additional depreciation. According to the top panel of Chart 22, with the fiscal contraction the Treasury bill rate is percentage points. lower by an amount that reaches two The bill rate is lower because nominal GNP is lower. The change in policy mix generates a much more rapid and larger drop in the path of the bill rate because interest rates must fall by enough to keep the path of GNP unchanged in the face of the fiscal contraction. These decreases in the interest rate explain why both policy actions cause additional dollar depreciation and why the change in mix causes more. The bottom panel of Chart 22 shows that both policy actions generate significant improvements in the federal budget deficit. the fiscal contraction the deficit is With reduced by an amount that reaches $95 billion by the end of the simulation horizon. The reduction in the actual deficit is less than the reduction in the structural deficit because the decrease in nominal GNP leads to a loss in tax revenues that more than offsets the decline in interest payments. With the change in policy mix, the deficit is reduced by an amount that reaches $140 billion by 1990. The reduction in the actual deficit is greater than the reduction in the structural deficit because the price level and, therefore, nominal income and tax revenues are higher and because interest payments are lower. Both policy actions have relatively small effects abroad. U.S. The fiscal contraction slightly reduces foreign real GNP and foreign inflation during the last five years of the decade. In the case of the change in the U.S. policy mix -- often suggested by Europeans -- foreign real GNP is roughly unchanged compared to just a gradual depreciation -19- while foreign inflation is reduced by somewhat less than 1 percent on average over the simulation period. Let me summarize the presentation we have made this afternoon. The enlargement of the U.S. current account deficit in the 1980's can be directly attributed to the sharp reduction in U.S. price competitiveness and, to a lesser extent, to the relative strength of the U.S. recovery and reduced imports by developing countries. In turn, these developments can be traced in large part to changes in monetary and fiscal policies at home and abroad and, in the case of the reduction in price competitiveness, to a shift in asset preferences in favor of the dollar. In our view an unchanged dollar exchange rate implies a U.S. external position that is not sustainable in the long run because our net external debt would rise faster than our nominal GNP. Our scenarios illustrate several ways in which the ratio of our external investment position to GNP could be stablized by 1990. One possibility is an abrupt shift in market sentiment away from the dollar that generates a rapid depreciation of the dollar by 45 percent from its current high level. Another possibility is a more gradual shift in sentiment away from the dollar that takes the dollar down to historical average levels combined with one or another plausible U.S. macroeconomic policy action that takes the dollar somewhat lower for a total depreciation of 35 to 40 percent. Finally, I would like to emphasize that our scenarios are intended to be illustrative of the general process of correction: a stable ratio of net external debt to GNP could be achieved by other combinations of changes in sentiment about the dollar and policy actions here and abroad. Moreover, a stable ratio need not be achieved by 1990. STRICTLY CONFIDENTIAL (FR) CLASS II-FOMC MaterialsforStaff Presentation to the Federal Open Market Committee The U.S. External Position May 21, 1984 Chart 1 U.S. Current Account Billions of dollars 25 + 0 25 1948-80 Average = $.9 billion 50 75 Q1 100 1955 1950 1960 1965 1970 1975 1980 U.S. Current Account Relative to GNP Percent 2 1 + 0 1 1948-80 Average = .2 % 2 Q1 1950 Note: 1984 data are 1955 Q1 1960 estimates at an annual rate. 1965 1970 1975 1980 Chart 2 U.S. External Investment Position Billions of dollars 250 -200 Recorded External Investment Position -150 -- 1100 Cumulated Current Account* I I 1950 I l I I 1955 ------------------------ II I 1960 *From base of 1948 recorded external investment position. Note: 1984 data are Q1 estimates. I I l 1965 I 1970 Qt01 II i 1975 l l l 1980 I I Chart 3 ANALYTICAL FRAMEWORK I Proximate Determinants * Price competitiveness * Relative cyclical positions * Other factors International debt problems Oil II Fundamental Determinants * Economic policies * Asset preferences Chart 4 Price Adjusted Foreign Exchange Value of the U.S. Dollar : :: ::: : March 1973= 100 :: : 130 :: . -- 110 :: ... . Weighted Average Dollar*/ .......... Relative Consumer Prices 1 .......... ...... - 100 .. 90 1976 1978 1980 1982 1984 Weghted 1974 against or of foreign G-1 countries using total 1972-76 average trade of these countries. average 1980 Q4= 100 - I I I ::1: :: : :: ::: :: : : : .. 115 u.s . ...... :.... ,III1....... . ....... 1....... 1974 1976 1978 1980 1982 7 1984 Chart 5 U.S. Exports to Developing Countries - Countri::::::::: Total STen Debt Problems* / Billions of dollars : : : : : : : 100 :::::::::::::::::::-- ... :::: 'i - I SI 1970 1972 1974 1976 1978 : - .. ..... . ...... 1980 *Includes Argentina, Brazil, Chile, Colombia, Ecuador, Mexico, Nigeria, Peru, Philippines and Venezuela. Note: 1984 data are Q1 estimates at an annual rate. 1982 1984 20 Chart 6 Allocation of Decline in Current Account Among Proximate Determinants Billions of dollars 1. Decline in Current Account, 1980 to 1984 Q1 -85 2. Decline in U.S. Price Competitiveness -70 3. Cyclical - Relative Strength of U.S. Recovery -20 4. International Debt Problems -15 5. Decline in Oil Prices and Consumption +20 Chart 7 Estimated Impacts of Increase in Structural Budget Deficit Calendar Years 1982 1. Increase in Structural Deficit from 1981 Level ($ billions) 1983 35 66 1984 102 Impact on Levels of: 2. Real GNP (percent) 11/4 21/2 21/2 ¾ 2 2 1/2 8 3. Treasury Bill Rate (percentage points) 4. Exchange Rate (percent) 3 6 5. Prices (percent) 0 0 6. Current Account Balance ($ billions) -8 -17 1/4 -30 Chart 8 Price Adjusted Dollar and Long-Term Real Interest Rate Differential Percentage points March 1973= 100 S- 120 6- Price Adjusted Dollar -110 3 -100 -90 Interest Rate Differential* 3-80 1974 1976 1978 1980 1982 1984 *Differential between U.S. and weighted average foreign long-term government bond yields minus differential between 12-quarter centered moving averages of U.S. and foreign consumer price inflation rates. Chart 9 U.S. Merchandise Trade and Current Account Balances 1990 1988 1986 1984 1982 1980 Billions of dollars Explanatory Variables Simulated With Unchanged Dollar 1984 1. Exchange Rate Index 1985 Annual Average 1986-1990 130 130 130 Percent change, Q4/Q4 Real GNP Growth Rates 2. United States 5 21/2 3 3. G-10 Countries 2¾ 3 31/2 4. Developing Countries 31/2 41/2 5 5. United States 5 5¼ 5 6. G-10 Countries 5¾ 6 1/2 63/4 Inflation Rates* *Based on consumer price indexes. Chart 10 Current Account Components Simulated with Unchanged Dollar Billions of dollars 1983 1990 Change 1. Current Account -41 -183 -142 2. Merchandise Trade -61 -177 -116 3. Net Investment Income 4. 24 -17 -41 9 -53 -62 Portfolio 5. Direct 6. Other Services and Transfers 15 -4 36 21 11 15 Chart 11 Volume of Merchandise Exports and Imports Ratio scale, 1980= 100 180 Simulated with unchanged dollar SActual 170 SO- 160 - -150 Imports - 140 - 130 -120 S- 110 Exports 1980 1982 1984 1986 1988 1990 Chart 12 U.S. Current Account Relative to Foreign Net Saving* F 1980 Actual 1982 Simulated with unchanged dollar 1984 U.S. Current Account Relative to U.S. GNP Percent *Estimated gross saving less capital consumption. Chart 13 U.S. External Investment Position 1980 1982 1984 1986 1988 1990 1988 1990 U.S. External Investment Position Relative to GNP Actual 1980 1982 Simulated with unchanged dollar 1984 1986 Chart 14 SUSTAINABILITY * External investment position relative to GNP must stabilize. DESIRABILITY * Short run benefits * Current account deficit reduces upward pressure on domestic interest rates. * Growth of U.S. imports has expansionary effects on economic activity abroad and eases current account adjustment in countries burdened with debt. * Long run questions * To what extent is borrowing from abroad leading to greater capital formation in the United States? * Is borrowing by the United States consistent with an efficient and equitable allocation of world saving? Chart 15 Foreign Exchange Value of the U.S. Dollar March 1973= 100 130 Unchanged Dollar -120 110 Gradual Depreciation \ \ 100 - 90 \ 80 - Rapid Depreciation \ L ------------------- 1986 1988 70 1990 Chart 16 Effects on U.S. External Position Current Account Billions of dollars External Investment Position Relative to GNP Percent 1980 1982 1984 1986 1988 1990 Chart 17 Effects on U.S. Economy Real GNP Billions of 1972 dollars / - 1950 -11900 /0/ -- 1850 -- 1800 Rapid Depreciation -1750 radual Depreciation -- 1700 Unchanged Dollar -11650 1600 1984 1986 1988 1990 Inflation Rapid Depreciation Gradual 1984 Unchanged Dollar 1986 1988 1990 Chart 18 Treasury Bill Rate Percent 116 Rapid Depreciation -- 14 1 --- -- 12 Gradual Depreciation -10 - 1984 98 198 1986 198 1988 1990 1990 8 Chart 19 Foreign Exchange Value of the U.S. Dollar March 1973= 100 -- -130 -120 Gradual Depreciation Plus Fiscal Contraction -110 - 100 \ S\ Gradual Depreciation - - 90 Gradual Depreciation Plus Change in Policy Mix ----80 1980 1982 1984 1986 1988 1990 Chart 20 Effects on U.S. External Position Current Account Billions of dollars 0 Plus Change in Policy Mix 0 ; -Plus 40 Fiscal Contraction S 80 Gradual Depreciation 120 160 1980 1982 1984 1986 1988 1990 1988 1990 External Investment Position Relative to GNP 1980 1982 1984 1986 Chart 21 Effects on U.S. Economy Real GNP Billions of 1972 dollars I 1950 -- Gradual Depreciation Plus Change in Policy Mix / 1900 -1850 -- 1800 / -1750 / Plus Fiscal Contraction / 1700 -11650 L I I 1986 1988 1 1 1600 1990 Inflation Percent 8 Plus Change in Policy Mix 7 Gradual Depreciation 6 5 Plus Fiscal Contraction 1984 1984 1986 1986 1988 1988 1990 1990 Chart 22 Treasury Bill Rate Percent 1 11 Gradual Depreciation 10 9 Plus Fiscal Contraction 8 Plus Change in Policy Mix 7 I L 1984 1986 I I 1988 I Federal Budget Deficit I 6 1990 Billions of dollars -100 Plus Change in Policy Mix - -- -140 ---180 Plus Fiscal Contraction -- -220 Gradual Depreciation 1984 198 198 1986 198 1988 -260 190 1990 -300 Notes for F.O.M.C. Meeting May 22, 1984 Sam Y. Cross Since your last FOMC meeting the dollar has risen by 6 percent against the European currencies and 4 percent against the Japanese yen. It has regained most of the decline registered in February and early March, and now stands only a few percentage points below the highs of last January. The dollar started rising right after the last FOMC meeting, and the rise continued through most of the period. The main factor buoying the dollar was the fresh evidence of robust expansion in the U.S. economy. The prospect of heavy private credit demands,along with continuing large government financing needs, led exchange market participants to expect U.S. interest rates to be under upward pressure, perhaps strong upward pressure, and the dollar moved upward in response. The rises in U.S. interest rates which occurred were not equaled by increases elsewhere. In the Euromarkets, differentials in favor of the dollar over both mark-and yen-denominated deposits increased by about 1 percentage point period. and ranged between 5 and 6 points at the end of the These widening interest rate differentials, at a time when price data showed little or no acceleration of U.S. inflation, appear to have restored the dollar's attractiveness for investment. The deterioration in the long term credit markets both in the U.S. and abroad, associated with uncertainties about the interest rate and economic outlook, has led many investors to liquidate long-term fixed-rate securities and park funds temporarily in high yielding short term dollar instruments. And the talk about portfolio shifts out of dollars that was so prevalent earlier in the year- has subsided. There were also factors tending to depress investor interest in major foreign currencies, particularly the mark and the yen. Labor problems in Germany raised questions about the sustainability of that country's outstanding industrial performance. Recently, the yen declined reflecting Japan's particular dependency on the Persian Gulf and concern about the choking off of oil supplies from that region. In both countries, recent weakness in stock prices appears to have been associated with renewed inflows into U.S. equities. With the German mark weakening during much of the intermeeting period, pressures against the other EMS currencies subsided. Their central banks took advantage of the opportunity to rebuild official reserves, and to reduce domestic interest rates in some cases so as to encourage economic recovery. In April as the dollar continued to move higher, the Bundesbank sold dollars occasionally and sometimes in size to resist the dollar's rise. In early May the Bundesbank stepped up its intervention, and on May 10 enlisted the cooperation of several other European central banks in coordinated dollar sales of nearly Following that day's operations, the dollar eased back against the European currencies for several days. That easing reflected some wariness in the market that the central banks might be gearing up for major and concerted intervention to push the dollar lower. In addition, it reflected some skittishness that developed in the exchange markets over the emerging funding problems of Continental Illinois and also concerns over the effect of rising interest rates on heavily indebted LDCs. These developments were seen in the exchange markets as possible constraints on U.S. monetary policy. Today the dollar is slightly below the levels reached in early May against the major currencies. There were no Treasury or Federal Reserve operations during the period. There was an arrangement, announced at the end of March, under which a temporary bridging credit of $500 million was provided to the Government of Argentina to enable that country to repay certain bank interest arrears while it negotiates with the IMF on an adjustment program. Within the credit package, the Governments of Mexico, Venezuela, Brazil and Colombia provided with an understanding that after Argentina signs a letter of intent with the IMF, the U.S. Treasury will provide $300 million in temporary swap credits which can be used to repay the four Latin American lenders. Any credit provided by the Treasury, in turn, will be repaid from Argentina's IMF drawings. arrangement was proposed by the Mexican authorities, regard it This and we as a very constructive move, designed to encourage agreement between Argentina and the IMF. Discussionsare still continuing between Argentina and the IMF on an adjustment program, and also between Argentina and the commercial banks on a rescheduling and financing agreement. May 21, Mr. 1984 Sternlight made the following statement: Domestic open market operations during the past inter-meeting interval were driven by a huge run-up and then sharp decline in Treasury balances at the Federal Reserve. complications arose in the huge rise in Further the final two weeks of the period because of discount window borrowing by Continental Illinois National Bank, which faced severe funding problems. Throughout the period the Desk was aiming essentially for a steady degree of restraint on bank reserve positions, about unchanged from the degree of reserve availability prevailing shortly before the late March meeting, and deemed to be consistent with the Committee's preferred growth rates for monetary aggregates for the March-to-June period. Taken together, track. the monetary aggregates seemed to be reasonably on Questions about the appropriate seasonal adjustments made the data for M1 difficult to interpret, although by mid-May it looked as though M1 was coming back to around the middle of its annual growth range after slipping quite low in its April. M2 seemed to grow in the lower part of its while M3 was pushing a little range in late annual range over the upper bound of its range. Notwithstanding the approximately steady reserve pressures sought during the period-associated with seasonal and adjustment borrowing of $1 billion and excess reserves of $600 million-most market interest rates increased sharply. The Federal funds rate edged up irregularly through most of the period, advancing from an average ranging around 10 percent in the latter half of March to roughly 10 1/4 percent up to late April -2- and closer to 10 1/2 percent from late April to mid-May. reflected the discount rate increase in The rise early April and then particular reserve stringencies when the Treasury balance was peaking in late April and early May. In the last few days the rate fell off again to the 9 - 10 percent area reflecting the bulge in reserves produced by Continental's borrowing, not all of which the Desk mopped up immediately. In the first two maintenance periods, nonborrowed reserves came in below path and borrowings somewhat above. In the April 11 period there was substantial discount window borrowing possibly in anticipation of a discount rate hike; this produced an abundance of reserves and Desk action to meet the path in full would have caused a misleading over-abundance. In the April 25 period, the undershoot resulted from an inability to provide as many reserves as had been intended, as Treasury balances soared on the final day. borrowed and nonborrowed reserves were close to path in period, but fresh problems arose in Both the May 9 this final period-the one ending May 23-as borrowing began to be inflated by Continental's large-scale use of the window. While the path was not formally changed because of this special borrowing, the Account Management increasingly regarded the special borrowing as closely akin to nonborrowed reserves, and therefore aimed in effect for an undershoot of the formal path. To meet the huge reserve need occasioned by the run-up in Treasury balances at the Federal Reserve from a customary $3 billion in early April to over $16 billion late in that month, the Desk used -3- a combination of bill and coupon issue purchases in purchases from foreign accounts, At the peak point at the the Desk had added nearly $6.4 billion to outright System holdings, Committee. bill and both System and customer-related repurchase agreements. end of April, the market, making use of the enlarged leeway approved by the As the Treasury balance dropped, and later as the special borrowing augmented reserves, the System sold bills to foreign accounts and ran off bills in several auctions. For the whole period, outright holdings were up a net of just $2.1 billion, including $1.5 billion in bills. Treasury coupon issues and the rest in Repurchase agreements were used heavily in late April as Treasury balances peaked, but also at other times to smooth out reserve flows. Matched sales were employed on the first then more extensively in day, and the last few days to help cope with the bulge in reserves from Continental's borrowing. The steep rise in market interest rates since late March rested on several factors, but chiefly the press of heavy credit demands from the private sector, augmented by unrelenting Treasury demands. A number of market observers have commented that the long-awaited clash of private and public sector demands is now here and is producing its expected result. business news has continued robust. In the background, the Market participants discounted signs of weakness in the data for March as partly weather-related, while the expected bounce-back in data for April has at least equaled expectations. The market remains skeptical about Congressional action to trim the deficit-questioning whether it will be enough in total and particularly whether it will be enough in the next year or so to be of significant help near-term. Inflation is seen as not bad at the moment but prospectively troublesome as the economic expansion continues and takes up slack in productive capacity and employment. narrow money supply in The flat performance of April gave only modest comfort, attributed to seasonal adjustment problems, being widely while there is some concern that growth in May could more than offset the earlier weakness. Against this background, investors had minimal appetite for intermediate and longer term issues, so that sizable new Treasury coupon issues had to be crammed into an exceptionally unreceptive market. As auctions approached, market rates backed up to levels where dealers anticipated that investors might have an interest, but time and again that appetite failed to develop and rates had to move still higher before supplies could be moved off the street. For the whole interval, Treasury yields on intermediate and longer issues rose about 80-100 basis points. Thirty-year Treasury bonds, which yielded around 12 1/2 percent in late March, pushed up to about 12 7/8 percent by the time the Treasury mid-quarter financing was announced in early May. 13.32 but in the poor after-market sold off to yield as high as The new bonds were actually auctioned at 13.75 - 80 briefly before backing down again to about 13 1/2 percent by the end of the period. In the course of these rate moves, some dealers have taken painful losses, although our tracking of the primary dealers does not suggest that the losses have been beyond their capacity. The liquidation of Marsh-McLennan's large positions added to market supplies at an inopportune time. Two small non-reporting dealer firms, Lion Capital Group and RTD Securities, filed for bankruptcy, leaving a wake of problems in the repo market. Rate moves were more moderate in the Treasury bill area, especially in the case of short bills which showed little net change or even some declines for the very shortest maturities. This pattern reflected the Treasury's sizable bill paydowns, engineered in order to provide debt limit room to accommodate the regular schedule of intermediate and longer term issues. Also, in the latter part of the period, the lower rates on short bills partly reflected some flight to quality stemming from Continental's funding difficulties. In today's three-and six-month bill auctions, the average issuing rates were about 9.95 and 10.38 percent, compared with 9.76 and 9.88 percent just before the last meeting. In contrast with the moderate rise in bill rates, bank CDs pushed up fairly substantially over the period. This partly reflected the different supply situation-paydowns of bills as against some net issuance of CDs in the latter part of the period, possibly to fund loan demands. Later, the widening differential of CDs over bills also reflected quality concerns. As we measure it, the spread of 3-month CD yields over bills widened from 43 basis points at the start of the period to a high of 137 on May 11 and a reading this morning (May 21) of about 110 basis points. Consonant with rising costs, banks raised their prime rate twice during the interval to a current level of 12 1/2 percent. Given the press of recent events, it is difficult to gauge what monetary policy point. "stance" the market is attuned to at this Host observers probably expect to see Federal funds around 10 1/2 percent given their assessment of our recent objectives. Meantime, the intermediate and longer maturities may have gotten a bit ahead of themselves perhaps being priced to something more like an 11 percent rate even though I don't believe that such a rate is an imminent market expectation. market view is Indeed, that a tightening is if anything, the current not likely for the moment because of the Continental Illinois and perhaps the LDC situations, and there could even be a nod to the accommodative side because of these factors. Finally, touching on developments in the Government securities market surveillance area, I'd like to inform the Committee that the Subcommittee on Domestic Monetary Policy of House Banking Committee plans to hold hearings at the end of this month on the capital adequacy of Government securities dealers. A particular focus, I understand, is to be on a proposed approach to the standards of capital adequacy that the New York Fed sent out for comment to the dealer community a few months ago. We are now in the midst of a dialogue with the dealer community on this topic. JLKichline May 22, 1984 FOMC BRIEFING Economic activity on average has remained strong in recent months while inflation has held to around the same rate as last year. Since the last meeting of the Committee a good deal of information on the economy has become available, including data for March and April as well as two official readings on GNP in the first quarter. The first-quarter growth of real GNP is now reported to have been 8-3/4 percent, somewhat above the staff's last forecast of 8 percent. The staff has made only small adjustments to its projection for subsequent periods, and essentially interprets most of the available information as consistent with its earlier view on the outlook. That view is one of still strong, but moderating, growth of real GNP in the current quarter and further moderation of growth later this year. The information on March and April for many sectors of the economy points to considerable weakening in March and a rebound in April, a pattern that seems to reflect the effects of bad weather in March and in a few cases faulty seasonal adjustment. Cutting through the monthly gyrations, in the labor market there were continuing sizable increases of employment, a very high level of the workweek, and a pickup of growth - 2 - in the labor force; faster growth of the labor force has led to an unchanged rate of unemployment of 7.8 percent since February. Industrial production has continued to grow rapidly, averaging 1 percent per month during the March-April period, with large increases in output of business equipment, defense products, and materials and intermediate products. Given the strong start on the second quarter, a slackening in the rate of expansion of production, which is built into the forecast, would still yield growth during the second quarter of 11 to 12 percent annual rate--the same as in the first quarter. The fast growth of production has been absorbing unutilized capacity, of course, and in April capacity use in manufacturing was a little above 82 percent. Consumers have been very willing to spend in recent months, with personal consumption expenditures up at nearly a 7 percent annual rate in the first quarter, a rate marginally above the fourth-quarter pace. The fastest growing major cate- gory of outlays has been automobiles, an item that we expect will exhibit much less growth this quarter and throughout the projection. After all, auto sales now are at high levels--the first-quarter rate was 2 million units annually above the year earlier and there are capacity constraints for the more popular - models. 3 - More generally, however, consumer spending is pro- jected to slow as many urgent pent up demands probably have been satisfied, consumer loan rates are on the rise, and developments in other sectors point to a moderation of income growth. In the housing market, starts declined 15 percent during March and April from the very elevated pace earlier in the year. The staff forecast implicitly has starts remaining around the recent average of 1.8 million units annual rate for the next couple of months and then drifting lower as mortgage interest rates restrain activity. In the context of current and prospective mortgage rates, residential construction activity after this quarter will be a drag on real economic growth. Fixed investment by the business sector, however, seems sure to continue contributing in a substantial way to overall economic expansion. New commitments for equipment and structures continue to rise, and reported business plans for expansion seem consistent with the staff's forecast of a 12 percent increase during the year. In contrast, investment in inventories seems unlikely to contribute much if anything to economic growth later this year and in 1985. Inventories grew rapidly in the first quarter and aside from autos may evidence some further growth this quarter. But the level of short-term - 4 - interest rates should reinforce the desire of firms to keep inventories in line with sales. For autos, the early model changeover at some General Motors plants this quarter is expected to depress inventories, knocking about 3/4 percentage point off growth of real GNP and adding about as much next quarter. Recent developments in the wage-price arena have been in line with the staff forecast or, especially for prices, somewhat better. Over the first four months of this year hour- ly earnings were up at a 4 percent annual rate, the same as last year; the forecast entails a rise in wage and price increases later this year and in 1985 as labor and product markets tighten further. FOMC Briefing S. H. Axilrod 5/22/84 Since the last FOMC meeting, M1 and M2 have been running quite close to the March-to-June path set by the Committee, although M1 has done so only in an erratic way, presumably the result mostly of seasonal adjustment difficulties. There have, however, been rather less expected, and in a sense, less assuring developments. The rise in money market rates in general has been roughly in line with what might have been expected from the reserve path set following the meeting. But within the short-term rate structure, there has been a deterioration in quality spreads, particularly as judged from the spread of CD rates over bill rates. The Continental Illinois episode made all bank CDs relatively more expensive, and the guarantee offered by the FDIC has not yet occasioned any marked narrowing of spreads. Another somewhat unexpected development, perhaps, since the last meeting has been a rise in long-term interest rates of about the same dimension as the rise in short rates-and greater than the rise in the funds rate. Same market observers conclude from the prevailing steepness of the yield curve that monetary policy is not yet sufficiently restrictive-a conclusion that would seem to depend in some part on observing that a downward sloping yield curve has normally developed at same sort of culminating point. But, however that may be, I would not interpret the recent failure of the yield curve to flatten in face of a further rise in the funds rate as somehow indicating that some additional monetary restraint has not taken hold. For that to be the case, one would have to believe that inflationary expectations have also worsened over the past few weeks -2by a percentage point or so. They have probably worsened some, but I doubt to that extent given the absence of evidence in wages, commodity prices, or the foreign exchange market of incipient inflationary pressures. What I suspect is that uncertainties in general have increased-perhaps partly in response to the raft of official statements in an election year, growing doubts about whether the budget situation can or will be resolved, and various pieces of evidence that all may not be well in financial marketsso that many investors have siply decided to stay short for a while until the atmosphere clears. The deterioration of quality spreads and rise in long-term rates in my view would, if sustained without a further worsening of inflationary expectations, have restrictive effects beyond what would be expected from changes ordinarily associated with a 1/2 point rise in the funds rate. Mortgage rates have been steadily creeping up and would be expected to rise a bit further perhaps. lenders. And at the margin banks should become more cautious However, it may well be that, given money market conditions indexed by a federal funds rate on the order of 10-1/2 percent, we could see same narrowing of quality spreads and a minor bond market rally, should we have a passage of several generally quiet weeks. In any event, the credit market has not to date witnessed any significant lessening of credit demands. We expect a 12-1/4 percent rise in total domestic nonfinancial debt over the first quarter to be followed by a rise of about 13 percent over the second. This has been accompanied by above target growth in M3 as depository institutions have financed a good share of the credit growth. The private debt component of the total is expected to increase at about an 11-1/2 percent annual rate in both the first and second quarters. This would be about the same rate of increase as in the fourth quarter of 1983, but would be noticeably more rapid than over any year of the first four years of the 1980's. The relatively rapid increase has been absorbed with what seem only moderate upward real interest rate pressures since the beginning of the year because of the substantial rise in the volume of domestic saving generated by the relatively large increase in real income made possible by an economy starting well below its capacity, rise in the personal savings rate), (as well as a recent crucially supplemented by the enlarged inflow of saving from abroad. We are projecting a substantial slowing in debt formation during the second half of the year. The question naturally arises whether such a slowing does or does not imply further interest rate increases, especially since it is unlikely that we will have sufficient growth in the volume of real saving to finance continued rapid credit growth given that the expansion of real income will be retarded as capacity limitations are approached. In that context, if real interest rates are not to rise over the period ahead, real demands must moderate. Whether they readily will or not more or less in line with the slower increase in saving depends in large part on how restrictive the present level of real interest rates may be. Our forecast of a slowing in growth of both nominal and real GNP, as the second half progresses, does assume that present market conditions are at least working in the direction of restraint, as Jim indicated with respect to housing and consumer durables. The behavior of M1 and M2 thus far this year, which traditionally have more predictive value than M3 or credit, are not inconsistent with a slowing of the economy and of credit demands. But a principal policy question at this time would be what should be the response if M1 and -4- M2 were to begin accelerating relative to the Committee's desired pace. Given the restraining effects implicit in the deterioration of quality spreads and the sharp recent further rise of long-term rates, and assuming that these are not soon reversed, there is an argument for being accommodative for a time-at least for a sufficient time to determine whether or not there may be any shift toward greater demand for liquidity in an uncertain environment on the part of the public. Absent that, however, the evidence of the past few months--where it seems apparent that M1 velocity is on a fairly strong rising trend-suggests that continued moderate growth in M1 and M2 would increase the odds on a reduction in credit growth. Perhaps I should point out, Mr. Chairman, that the suggested directive language to take account of "any unusual financial strains" in the implementation of open market operations was not meant to be necessarily interpreted as indicating any change in the Committee's basic policy thrust toward more concern with, say, interest rates or a greater willingness to accommodate money behavior; rather it was meant to provide a handle for undertaking day-to-day actions perhaps temporarily inconsistent with reserve paths should something like disorderly market conditions emerge, as they certainly threatened to at times in recent weeks. It would, if adopted as presented, be applicable whether the reserve path came to imply unchanged, higher, or lower interest rates. It would seem more likely to be relevant, of course, should higher rates begin to emerge, either as a product of a deliberate reserve path change or, perhaps more relevantly, from a distinct further worsening in market attitudes.
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