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Monetary Policy
. Objectives for 1987
Midyear Review of the
Federal Reserve Board
July 21, 1987
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Monetary Policy
Objectives for 1987
Testimony of Paul A. Volcker, Chairman,
Board of Governors of the Federal Reserve System
July 21, 1987
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Federal Reserve Bank of St. Louis
Testimony of Paul A. Volcker
Chairman, Federal Reserve Board
Most interest rates, long- and short-term , have
retraced part of the earlier rise. However, longterm interest rates and prices of sensitive commodities, some of which had been deeply
depressed, remain well above their levels of earlier
this year.
The approach of the Federal Reserve toward
the provision of reserves has not changed since
May. However, growth in the various monetary
aggregates slowed further in the second quarter.
A reduction in the rate of growth of those
aggregates from the relatively high levels of 1986
had been both anticipated and desired by the Federal Open Market Committee, as reported to you
in February. However, it is also true that, with
institutional and market developments importantly
affecting the relationships between the various
measures of money and the variables we ultimately care about, judgments about the appropriate growth of the aggregates have become both
more difficult and more dependent on prevailing
economic and market circumstances.
For that reason, the Committee did not set
forth a particular target range for M 1 this year in
February. That judgment was reaffirmed at the
meeting earlier this month. M2 is currently running below, and M3 around, the lower ends of
their 5 ½ to 8 ½ percent ranges established in
February . The Committee decided not to change
those ranges for 1987. In doing so, however,
there was agreement that, depending on further
evidence with respect to emerging trends in economic activity, inflation, and domestic and international financial markets, actual growth around
the lower ends of those ranges may well remain
appropriate.
In judging appropriate monetary growth during
the course of the year, or from year to year,
account needs to be taken of the apparent
increase in the sensitivity of demands for money,
and for money-like assets, to absolute and relative
changes in market interest rates. Interest rates
administered by institutions, especially those on
transactions accounts, tend to lag market rates
I appreciate this, my last) opportunity to appear before you as
Chairman of the Federal Reserve
Board in connection with the semiannual review of monetary policy.
You have the official Report of the
Board of Governors before you and
I will be blessedly brief in touching
upon some of the main points.
As you know, the economy has continued to grow
this year, carrying the expansion well into its fifth
year. At the same time, however, the inflation
rate has accelerated appreciably relative to the low
rate prevailing in 1986.
A change in that direction had been widely
anticipated in response to the rebound in oil
prices and the depreciation of the dollar.
Nevertheless, the size and pervasiveness of the
price increases-which have included many nonenergy materials as well as services-affected the
psychology and expectations in financial markets,
particularly in April and early May. Recurrent
concerns about the dollar internationally also at
times affected the mood of domestic markets, and
interest rates rose rather sharply for a time.
Through the early part of the year, Federal
Reserve operations placed minimal pressure on
bank reserve positions. As reported earlier, however, beginning in late April definite but modest
steps were taken to increase reserve pressures
somewhat. Perceptions of that action appeared to
help calm concerns about the future course of the
dollar and inflation.
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2
both when interest rates are rising and when they
are falling (of course, no explicit interest can be
paid on demand deposits). At the same time, the
cost and effort involved in shifting funds between
types of accounts, or into and out of market
instruments, has greatly diminished. Experience
suggests that, as a result of these factors, demand
deposits, NOW accounts, and money market
deposit accounts all tend to grow relatively slowly,
if at all, when market rates are rising ( as during
the second quarter) but much faster than normally as market rates fall, as during 1985 and
1986. Those differences in growth rates in money
will tend to be reflected in inverse movements in
the velocity (that is, the measured rate of turnover) of money rather than commensurate
changes in economic activity or prices.
That sensitivity of velocity to changes in interest
rates makes it more difficult to judge the appropriate rate of monetary growth-particularly over
periods as short as a quarter or a year-and
impossible without reference to the stream of
available evidence on economic activity, prices,
and other factors. This year, too, concerns about
the international performance of the dollar have
at times had a significant bearing on operational
decisions. Specifically, the tightening of reserve
availability in the spring was related in substantial
part to the desirability, in the light of the substantial cumulative depreciation over the previous two
years and other economic policy undertakings
here and abroad, of maintaining reasonable stability in the external value of the dollar. That judgment is, as you know, shared with the Administration and the finance ministers and central bank
governors of other leading industrialized countries.
Looking ahead to 1988, the Open Market Committee decided tentatively to reduce the target
ranges for M2 and M3 by 1/2 percent to 5-8 percent. While recognizing the inevitable range of
uncertainty I referred to earlier, some reduction
in the target ranges clearly appeared appropriate
in recognition of the importance of assuring that
the temporary bulge in price increases foreseen
for this year not become a base for a renewed
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inflationary process. The appropriate range for
1988 will, of course, again be reviewed with care
at the start of the year .
More broadly, policy has to be judged against
progress toward the more basic goals of growth
and stability-and it seems to me fatuous to think
the first could long be sustained without the latter. At the same time, now and for some years
ahead, we will need to work to narrow and ultimately correct the large imbalances in our internal
and external economic positions-adjustments that
necessarily have implications for the policies and
prospects of other countries as well. What is at
issue is whether we can make those necessary
adjustments while sustaining progress toward the
broader goals.
In some areas, developments in the past six
months have been strongly encouraging in that
respect.
• The evidence by now is pretty clear that,
in real terms, our trade balance is improving, even in the face of continuing sluggish
growth, high unemployment and excess
capacity abroad.
• While growth in domestic consumption has
slowed-one essential part of the adjustment process-the expansion of domestic
output and employment has been well
maintained, and unemployment, at close to
6 percent, has dropped to the lowest level
in this decade. Manufacturing has picked
up and prospects for business investment
may be improving.
• Helped by some large unanticipated capital
gains tax receipts, this year's budget deficit
will apparently be driven even below
earlier expectations, and thus very substantially below the fiscal 1986 level.
• Internationally, leading nations are not only
agreed upon the desirability of greater
exchange rate stability but appear to be
working more effectively to that end.
3
• In another area demanding a high level of
The already slow growth in other industrialized
countries appears to have slowed further this year,
working against the adjustments needed in trade
and current account positions among Japan,
Western Europe and the United States. And, in
that ·environment the dangers of protectionist
trade legislation and a breakdown in the servicing
of international debts are enlarged. For all those
reasons and more, my very able successor, and
the Federal Reserve generally, will have challenge
aplenty. But, I, as I have spelled o_ut earlier, .
would like to think there is somethmg upon which
to build as well.
Finally, Mr. Chairman, I would like to acknowledge specifically the usefulness from my standpoint of these regular semi-annual hearings on
monetary policy.
.
You and I are both conscious of the special
position of the Federal Reserve System within the
overall framework of government. The long terms
of members of the Board of Governors, the participation of the Regional Federal Reserve Banks
in the policy process, our budgetary autonomy,
and the professionalism of our staff are all
designed to provide some insulatio~, in decidi1:g
upon money creation , against partisan or passmg
political pressures.
.
In our system of government, however, msulation cannot be equated to isolation, and particularly isolation from reporting and accountability
to the Congress and to the public. These hearings
are an important element in that discipline. I
have welcomed the opportunity they have provided
for us to consult with the Congress, and to
explain our purposes, our approaches, and our_
problems in dealing with a complicated, changmg
economic environment. And I want to express my
appreciation as well for the many courtesies you
have extended me personally over these past eight
years as we have worked together to foster economic stability and growth.
international cooperation, the basic approach
for dealing with the international debt
problems has continued to be implemented
with substantial success despite doubts and
challenges by some.
Of central importance, there has been continuing evidence of restraint and discipline on costs
and wages in much of American i~dus:ry, _offering the prospect of lower rates of mflation m the
months ahead. Over time, that must be an absolutely essential element in maintaii:iing our_ international competitivness as well as m restormg
domestic stability after the bulge in prices this
year.
At the same time, it would be nonsense for me
to claim that all is safely and securely on path.
The remaining risks and problems are apparent.
Even the otherwise satisfying fall in the unemployment rate this year implicitly ?as a discou:aging aspect. Outside of manufact~rmg'. the_ statistics suggest productivity growth is qmte dismalso slow, in fact, that I cannot dismiss the thought
that the reported statistics may partly reflect
measurement error.
But no error of measurement can entirely
explain away that our private saving, in historical
or in international context, remains so low , or
that our federal deficit remains so large, or that
we, the putative leader of the weste_rn world,. are
so dependent on other people's capital. De_spite
the better news on this year's federal deficit, some
projections of future deficits assuming current programs are being raised rather_ than redu~ed and
the political impasse over domg somethmg about
it apparently remains. In the circumstances, th~
Gramm-Rudman-Hollings targets are threatenmg
to become pie in the sky.
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FRB12-48000-0787
4
Monetary Policy
Objectives for 1987
Summary of Report to the Congress on Monetary Policy pursuant to the Full
Employment and Balanced Growth Act of 1978. July 21, 1987.
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Contents
Section
Page
Monetary Policy in 1987 and 1988
3
Economic and Financial Background
3
Ranges for Money and Credit Growth in 1987 and 1988
5
Economic Projections
6
Economic Performance During the First Half of 1987
9
The External Sector
10
The Household Sector
11
The Business Sector
12
The Government Sector
13
Labor Markets
14
Price Developments
14
Monetary Policy and Financial Markets
in the First Half of 1987
15
Money, Credit, and Mondary Policy
16
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Monetary Policy and the Economic
Outlook for 1987 and 1988
The economy expanded at a somewhat accelerated
pace in the first half of 1987, and the civilian
unemployment rate declined over the period to 6.1
percent in June, the lowest level in this decade.
Moreover, the pattern of activity has exhibited
encouraging signs that a turnaround in the trade
sector is under way. An improvement in net
exports, in real terms, appears to be providing a lift
to activity in the industrial sector, offsetting slower
growth of domestic spending and sustaining a
moderate rise in overall domestic production. However, the process of restoring balance to the U.S.
external accounts has involved a sizable increase in
the prices paid for imported goods. These price
increases have occurred at the same time that a
rebound in world oil prices carried inflation rates
above last year's modest pace.
Although some of the elements necessary for sustaining economic growth are now beginning to fall
into place, the economic outlook continues to be
clouded by a number of imbalances, risks, and
uncertainties. The experience of the first half of
198 7 underscored, in particular, the dangers
associated with a loss of market confidence in the
dollar and the related potential for a rekindling of
inflation expectations. The Federal Reserve, in
implementing monetary policy, was sensitive to these
dangers, while it continued to provide support for
sustainable economic growth. During the first part
of the year, growth in money and credit slowed
from the rapid pace of 1986, even though pressures
on the reserve positions of depository institutions
remained mild. Those pressures were increased
somewhat in late April and May, however, as the
dollar fell sharply against other key currencies, inflation expectations flared up, and long-term interest
rates jumped to higher levels. In response to these
steps, and to complementary policy actions taken
abroad, the dollar has stabilized, and interest rates
have retreated somewhat from their May highs.
If the nation is to achieve an orderly transition to
better external balance, one marked by a minimum
of financial or inflationary pressures, responsible
action by many parties-in addition to the Federal
Reserve-will be necessary. Further progress in
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reducing our federal budget deficit is essential: a
failure to achieve this often-stated objective could
only damage confidence in o~r ability to deal with
our economic problems and contribute to imbalances
in financial markets and the economy. In addition,
satisfactory growth in the other major industrialized
countries is crucial, as are efforts on all sides to
maintain and improve the openness of the international marketplace. The private sector also must
play a constructive role, by remaining sensitive to
wage and price practices that promote the international competitiveness of American business.
Economic and Financial Background
The economic expansion has now progressed well
into its fifth year. Real GNP rose at a 4 ¾ percent
annual rate in the first quarter. However, much of
the increase in production reflected a rebuilding of
business inventories that had been drawn down late
in 1986, and real GNP appears to have increased at
an appreciably more moderate pace in the second
quarter. Nonetheless, growth remained strong
enough to sustain a downtrend in unemployment.
Ranges of Growth for Monetary and
Debt Aggregates (Percent Change)
3
1987
Tentative for 1988
1986 Q4 to 1987 Q4
1987 Q4 to 1988 Q4
M2
5 ½ to 8 ½
5 to 8
M3
5 ½ to 8 ½
5 to 8
Debt
8 to 11
7 ½ to 10½
notable restraint on labor costs, has greatly enhanced
the competitiveness of U.S. producers in international markets. At the same time, though , the
depreciation has caused prices of imported goods to
increase-sharply in some cases-and exacerbated a
bulge in prices coming from higher energy costs.
The rise in consumer prices, averaging more than 5
percent at an annual rate over the first five months
of this year , was a disturbing departure from recent
experience. Moreover, as the dollar exhibited continued weakness in the early spring, and with
progress toward improvement in the U.S. current
account slower than many had anticipated, concerns
mounted about inflation prospects. This was
reflected for a time in rising prices of precious
metals and other actively traded commodities, an
event that only served to reinforce the inflation fears
that simultaneously were unsettling U.S. securities
markets.
In these circumstances, and with the economic
advance evidencing reasonable momentum, the Federal Reserve in late April and May adjusted its open
market operations to impose a somewhat greater,
but still quite limited, degree of pressure on the
reserve positions of depository institutions. This step
was reassuring to the markets. Coupled with complementary actions by monetary authorities abroad
and more favorable news on prices and U.S . merchandise trade flows, the firming of money market
conditions contributed not only to a turnaround in
the dollar on exchange markets but also to a rally in
bond prices. On balance, however, short-term interest
rates currently are about one-half percentage point
above their levels at the time of the Board's February monetary policy report to the Congress, and
long-term rates · are up about a full percentage point.
Beneath these solid gains in aggregate economic
activity have been welcome improvements in the fortunes of sectors that have failed to participate in the
increasing prosperity of the past several years. As
suggested above, the most significant development
has been the emerging improvement in the nation's
trade performance, which has begun to close the gap
between the pace of growth in the industrial sector
and the rest of the economy. Indeed, some segments
of manufacturing have reached relatively high levels
of capacity utilization and strong profitability . Economic strains also appear to be easing in other
troubled sectors . Oil-well drilling, while still at
depressed levels, has turned up as a consequence of
the firming of world oil prices . Agricultural income
was quite high last year, although it continued to be
heavily dependent on government support. Farmland
values seem to have stabilized , and the amount of
delinquent farm loans h as begun to decline.
While the external sector has been strengthening,
in real terms , in recent quarters, growth in domestic
demand has moderated considerably. To some
extent, the slower rise in household and business
purchases in the early months of this year was a
reflection of the acceleration that had occurred at the
end of 1986 , motivated by tax considerations. However, consumers, in particular, have shown signs of
less exuberance in their expenditure patterns after a
period of several years in which their willingness to
spend increasing proportions of their income
provided considerable thrust to business activity . A
moderation of domestic spending growth is , of
course, a fundamental ingredient in achieving better
external balance without putting excessive strains on
available resources.
A key element in the recent trade developments
has been the steep drop in the foreign exchange
value of the dollar-almost 40 percent on a tradeweighted basis against other G-10 currencies-since
early 1985. That decline, in conjunction with
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4
The rate of growth of the money stock measures,
M2 and M3, has been well below that of last year
and close to, or below, the lower end of the target
ranges adopted in February. This has been viewed
as acceptable by the Federal Open Market Committee (FOMC), given the inflation and exchange rate
developments, as well as indications of greater than
anticipated strength in the velocity of money (that
is, the ratio of nominal GNP to money). M2 rose at
an annual rate of only 4 percent between the fourth
quarter and June, appreciably below the 5 ½ to 8 ½
percent growth range for the year. M3 grew at a
5 ¼ percent rate, a shade below the lower bound of
its identical range.
The marked deceleration of monetary growth, and
the accompanying rise in M2 and M3 velocity after
two years of decline, reflected a variety of influences.
Some unwinding of the buildup in balances that
occurred late last year in connection with a huge
volume of tax-related transactions may have been
involved; tax reform also may have damped growth
in money as individuals reduced their additions to
deposit holdings rather than using consumer credit,
on which interest is no longer fully tax-deductible.
Capital constraints on the growth of bank and thrift
institution assets may have limited the depositories'
efforts to seek funds, an effect likely to express itself
most fully at the level of M3, which encompasses a
broad range of depository-institution liabilities.
But it is another factor that appeared most important, particularly in the case of M2. Changes in
deposit rates have lagged changes in market rates-a
behavior exhibited quite consistently in the period
since most restrictions on deposit rates were
removed. With market rates rising, financial assets,
other than those included in M2, became relatively
more attractive to the public, the opposite of
developments in 1985 and 1986. This same
phenomenon, reinforced by the normal downward
adjustment of compensating balance requirements as
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rising interest rates enable banks to earn more on
business demand deposits, had a marked effect on
Ml growth as well, which slowed to a 10 percent
.a nnual rate between the fourth and second quarters
( and a 7 ¾ percent rate between the fourth quarter
and June); Ml velocity appears to have changed little in the second quarter, after more than two years
of steep decline.
Reflecting in large part the diminution of the federal deficit and a slowing in state and local government borrowings, influenced ·by the Tax Reform
Act, aggregate credit expansion in the economy has
slowed noticeably this year. The debt of domestic
nonfinancial sectors is estimated to have expanded at
about a 9 ¾ percent annual rate through June, still
high relative to the growth of nominal GNP, but less
rapid than in the past several years and within the 8
to 11 percent monitoring range specified by the Federal Open Market Committee.
Ranges for Money and Credit
Growth in 1987 and 1988
At its meeting earlier this month, the FOMC did
not change the 1987 ranges for money and credit
growth that it had established in February. As indicated at that time, operating decisions will continue
to be made not only with due regard to the behavior
of these aggregates, but also in light of evidence on
emerging trends in economic activity and inflation
and developments in domestic and international
financial markets. At this juncture, given the actual
growth achieved in the first half, it seems likely that,
absent major movements in interest rates that alter
the incentives to hold monetary assets, expansion in
M2 and M3 around the lower ends of their 5 ½ to
8 ½ percent annual ranges may well be appropriate.
Indeed, should the recent tendency toward a
5
strengthening in velocity, which has been particularly noticeable in the case of M2, persist, or if
inflationary pressures appear to be mounting, some
shortfall from the annual ranges might well be
appropriate. With regard to the domestic debt
aggregate, the FOMC anticipated that the slower
pace of debt growth in the first half would continue
and that the aggregate would end the year well
within the 8 to 11 percent monitoring range .
Consistent with the objective of maintaining progress over time toward general price stability, while
supporting sustainable growth in economic activity,
the FOMC decided to adopt, on a tentative basis,
lower growth ranges for money and credit in 1988.
The target growth ranges for M2 and M3 were
reduced 1/2 percentage point, to 5 to 8 percent ,
measured from the fourth quarter of 1987 to the
fourth quarter of 1988. At the same time, the
monitoring range for growth of nonfinancial sector
debt also was tentatively reduced by 1/2 percentage
point, to 7 ½ to 10 ½ percent.
The Committee noted that M1 has continued to
exhibit considerable sensitivity to changes in interest
rates, among other factors, as illustrated by its sharp
deceleration in the first half of this year . In view of
this, and the still-limited experience with the
behavior of deregulated transactions accounts, the
Committee decided not to set a specific target range
for M1 for the second half of 1987 , and no tentative
range was adopted for 1988. In its policy deliberations over the remainder of the year, the FOMC
will take account of M 1 growth in light of the
behavior of its velocity, incoming information about
the economy and financial markets, and the degree
of emerging price pressures.
expected to generate jobs in about sufficient number
to match the expansion of the work force. Consequently, the civilian unemployment rate is not
expected to change appreciably from the 6 ¼ percent
average of the second quarter, although recent
-experience suggests that the projected growth of real
GNP might lead to somewhat lower unemployment.
Real net exports of goods and services are expected
to strengthen further while the growth of domestic
demand remains relatively subdued. The improved
competitive position of U.S. producers, resulting in
large part from the dollar depreciation of the past
two years, has only begun to be reflected in trade
flows , and further improvement in the nation's
external position should be realized in coming
quarters. Household spending is expected to grow
slowly, but stronger increases in business investment,
especially in equipment, are anticipated as industrial
firms respond to more favorable sales trends.
Prices, as measured by the implicit deflator for
GNP, are expected to rise 3 ½ to 4 percent over the
four quarters of 1987-slightly more than the central
tendency range reported to the Congress in February. For 1988, projections of the increase in the
GNP deflator center on 4 percent. Assuming world
oil prices are more stable, there should be no repetition of the rebound in domestic energy prices that
raised the general rate of inflation earlier this year.
However , the acceleration in prices of non-oil
imported goods, that is occurring in the wake of the
decline in the foreign exchange value of the dollar,
likely will continue for a time to provide some impetus to inflation, even if the dollar is more stable over
the period ahead, as assumed. The size of further
increases in import prices, resulting from the depreciation to date, will depend on the aggressiveness
with which foreign exporters and U.S. distributors
seek to restore profit margins that have been
squeezed in the past two years. The view that inflation next year will not rise significantly from the
pace projected for 1987 is grounded in a belief that
recognition of the potential for losses of market
share and job opportunities will continue to
influence wage- and price-setting behavior.
Economic Projections
The Committee believes that the monetary objectives that it has set are consistent with restraint on
inflation in the context of continued moderate
growth in economic activity and progress toward a
sustainable external position. The central tendency
of the forecasts of Committee members and other
Reserve Bank presidents is for growth in real GNP
of 2 ½ to 3 percent in 1987 and 1988. Between now
and the end of next year, this pace of activity is
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6
While restraint on inflation is crucial in achieving
an orderly adjustment as our massive external
imbalance is corrected, so too is continued progress
in reducing the federal budget deficit. Inflows of foreign capital will shrink in step with the reduction in
our current account deficit. In that context, excessive federal borrowing requirements, as they put
pressure on financial markets, pose a threat to the
ability of our economy to fund necessary private
capital formation.
Finally, the members of the Committee and other
Reserve Bank presidents also view the prospects for
a healthy U.S., and world, economy as depending
significantly on the avoidance of further protectionist
measures here and abroad and on satisfactory economic growth in other major industrial countries.
Economic Projections for 1987 and 1988 *
FOMC Members and other FRB Presidents
1987
Percent Change,
fourth quarter to
fourth quarter:
Average level in
the fourth quarter,
percent:
Range
Central Tendency
Nominal GNP
5¾ to 7 ¼
6 ¼ to 7
Real GNP
2 to 3 ¾
2 ½ to 3
Implicit deflator for GNP
3 to 4¼
3 ½ to 4
Civilian Unemployment Rate
6.1 to6 .5
6.2 to 6.4
Range
Central Tendency
Nominal GNP
5 to 8
5¾ to 7
Real GNP
1 to 3
2 ½ to 3
Implicit deflator for GNP
2½ to 5
3¾ to 4¼
Civilian Unemployment Rate
5.9 to 6.8
6 to 6.5
1988
Percent change,
fourth quarter to
fourth quarter:
Average level in
the fourth quarter,
percent:
*The Administration has yet to publish its mid-session budget review, but spokesmen have indicated that earlier
forecasts will be revised. As a consequence , the customary comparison of FOMC forecasts and Administration
economic goals has not been included in this report.
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7
Economic Performance
During the First Half of 1987
Industrial Production
The economy continued to expand in the first half
of 1987, and, in contrast to the pattern of the
preceding four years, the composition of activity
appeared to be moving toward a better balance
between domestic spending and domestic production. The overall growth in output during the first
six months of the year led to a net gain in jobs of
around 1 ¼ million, a faster pace of hiring than during 1986. Moreover, the civilian unemployment
rate, which had hovered close to 7 percent throughout most of last year, moved down to 6.1 percent by
June.
Inflation picked up early this year, while most
broad indexes of prices increased substantially above
those of the past several years. In large part, the
acceleration reflected developments in oil markets,
where prices have retraced part of last year's
decline. But rising prices for other imported goods
also began to surface at the retail level, and, at the
producer level, prices paid for raw materials and
other supplies clearly turned up. Wage trends, however, have remained stable and restrained.
130
120
110
100
1982
6
4
1982
1983
1984
1985
1986
1987
*Consumer Price Index for all urban consumers.
•• Percent change from December 1986 to May 1987 .
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1983
1984
1985
1986
1987
Higher inflation rates have been, in part, a consequence of the ongoing adjustment of the U.S. economy to a lower foreign exchange value of the dollar.
Prices of non-oil imports, particularly for finished
consumer goods and capital equipment, have been
rising at rates in excess of domestic prices in recent
quarters, damping the demand for imported goods.
At the same time, goods produced in the United
States have become more competitive in world markets. The volume of exports, which began to pick up
noticeably in the second half of 1986, continued to
expand in early 1987, although the rebound likely
has been limited by slow economic growth abroad.
Toward the end of 1986, some manufacturing
industries-notably those producing textiles, apparel,
steel, chemicals, and paper-began to experience a
firming in demand apparently associated with
improved trade conditions. In the first six months of
1987, production of office equipment and some
other high-tech capital goods as well as several categories of industrial machinery also picked up. Moreover, domestic energy output stabilized, after having
been a serious drag on industrial production last
year. On the whole, the pace of activity in the
goods-producing sector moved back into line with
the overall rise in GNP. The index of industrial
production increased at a 3 percent annual rate
between the third quarter of 1986 and the second
quarter of 1987, after little change during the
preceding year.
Percent change from end
of previous period , annual rate
Consumer Prices*
Index 1977 = 100
9
The External .Sector
The dollar depreciated further against other major
currencies in the first half of 198 7, with most of the
adjustment concentrated in one episode early in
January and in another during a period of unsettled
markets in the early spring. Since mid-May the dollar has retraced part of its recent decline, but, on a
trade-weighted basis against other G-10 currencies,
remains about 6 percent below its average level in
December 1986, and almost 40 percent below its
peak in February 1985. The underlying downward
pressure on the dollar during the first half of 1987
was fueled by perceptions that progress in reducing
the U.S. current account deficit had been slow and
prospects for policy adjustments, here and abroad,
aimed at restoring better balance in the world economy, had been disappointing. An offsetting factor
until recently was the widening of interest rate
differentials between the United States and the other
major industrialized countries, as rates rose in the
United States while they declined abroad.
Foreign Exchange Value of the
U .s. Dollar*
Index, March 1973 = 100
150
125
100
1982
1983
1984
1985
1986
1987
•Index of weighted average exchange value of U.S. dollar against currencies of
other G-10 countries plus Switzerland. Weights are 1972-76 global trade of each
of the 10 countries .
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Federal Reserve Bank of St. Louis
Annual rate ,
billions of dollars
U.S. Current Account
+
1·
l
I
50
100
I
I;
H2
1982
1983
1984
1985
1986
150
Ql
1987
The U.S. current account deficit stood at just
under $150 billion in the first quarter of 198 7, little
changed, in nominal terms, from the deficit in the
second half of 1986. The volume of merchandise
imports, other than oil, was basically unchanged in
recent quarters, after rising steadily for three and
one-half years. Demand has leveled off for a wide
range of imported industrial materials, consumer
goods, and capital equipment. This adjustment,
however, occurred as dollar prices for these goods
began to pick up, and , thus the value of non-oil
imports has continued to edge higher. Demand for
imported petroleum products dropped back early
this year, but with world oil prices higher, the U.S.
oil import bill stayed at approximately its 1986 level.
At the same time, the expansion in the volume of
merchandise exports that began in mid-1986
extended into early 1987. The improvement in foreign sales has been broadly based. In particular,
shipments abroad of industrial materials and capital
goods, which account for the bulk of U.S. merchandise exports, both were up about 10 percent in real
terms in the first quarter from the average in the
first half_of 1986. The recent volume of agricultural
exports also firmed somewhat as sharply reduced
support prices appeared to be combining with the
lower dollar to boost foreign demand for some U.S.
farm products.
10
The adjustment in the U.S. trade position to date
has occurred without much impetus from economic
expansion abroad. Growth of real GNP in other
industrial countries averaged less than 2 ½ percent
last year; moreover, economic activity began to slow
in the second half of the year, and, at least in
Europe, the weakness continued into early 1987.
Export and import volumes in Europe and Japan
have begun to adjust to the exchange rates movements of the past two years, cutting into the growth
generated by their external sectors. While growth in
domestic demand has been maintained above the
rate for domestic production, it, too, has slowed and
has not taken up the slack from a weak external
sector.
Outside of the industrial countries, average
growth last year was quite uneven and, on balance,
provided only a limited offset to slower economic
activity in Europe and Japan. Weakness in oil markets held down OPEC growth while the newly
industrialized countries in Asia continued to expand
strongly. In Latin America, which is an important
market for U.S. exports, output rose close to 4 percent for a third year, a marked turnaround from the
1982-83 period when the onset of external financing
difficulties seriously disrupted trade. Internal pressures to maintain reasonably strong growth persist in
these countries; such growth could be facilitated by
an improved performance of the industrial economies as a group.
U.S. Real Merchandise Trade
6
3
H1
I
1982
300
___________ ..... _, , , -
Exports
1982
1983
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Federal Reserve Bank of St. Louis
1984
200
1985
1986
1984
1985
1986
1987
Consumer spending weakened considerably in the
first half of 1987, after three years in which real
gains averaged 3 ¾ percent per annum. In particular, households cut back sharply their purchases of
durable goods as outlays for nondurables flattened
out. Spending for services, however, continued to
trend up. Slower sales of new automobiles contributed importantly to the overall deceleration in
consumer spending. During the first half of 1987,
sales of new cars averaged 10 million units at an
annual rate, down from a record 11 ½ million units
in 1986. The slackening in demand was most noticeable for domestic makes and persisted despite the
continuation of special incentive programs on a wide
range of models.
The deceleration in consumer outlays, especially
for durables such as motor vehicles, furniture, and
home appliances, followed a period of several years
during which a variety of factors were working to
encourage households to increase their holdings of
big-ticket items: relatively moderate increases, or
even decreases, in the prices of many home goods;
declines in interest rates; and pent-up demands from
the period of economic weakness in the early 1980s.
Annual rate,
billions of 1982 dollars
..... ,
1983
H2
The Household Sector
400
-- ... -- ---
Percent change from end of
previous period , annual rate
Real GNP
1987
11
Consumer Prices Excluding
Food and Energy*
D
Percent change from end
of previous period , annual rate
Services Less Energy
8
IITl Commodities Less Food and Energy
-
- -
-
6
y_ · ,
.
H2
.
4
2
- -
1982
1983
i.....--L-
1984
lll!IIII
1985
11
1986
I
+
1987
*Consumer Price Index for all urban consumers.
• *Percent change from D ecember 1986 to May 1987.
As those influences dissipated, and with the personal
saving rate reaching an historically low level by late
1986, consumers apparently became more cautious
in their buying patterns. Nonetheless, survey evidence still suggested that households' evaluations of
market conditions for major purchases and of their
personal finances remained generally positive.
During the first five months of 1987, growth in
nominal disposable income picked up from its 1986
pace; but, with consumer prices rising more rapidly,
mcome growth, in real terms, was little different
from the 2 percent pace of the preceding two years.
However, the aggregate balance sheet of the household sector showed further improvement early this
year. Asset holdings were bolstered especially by
gains in the stock prices, while debt accumulation
slowed. Growth of mortgage debt dropped back
from the extraordinary pace of late 1986, despite the
popularity of home equity loans, and growth of consumer credit dropped sharply. To some extent, the
deceleration in consumer debt, as well as the slowdown in spending on durable goods, may be a consequence of the rapid rise in household debt .burdens
during the past several years . In addition, the new
tax law diminished the incentive to finance expenditures with installment credit. Despite the slower
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growth of consumer and mortgage debt, some indicators suggest that a considerable number of househ?~d_s still are having problems servicing existing liab1ht1es. Although some loan delinquency rates
dropped a bit, others rose in the first quarter, as did
personal bankruptcies.
Spurred by a decline in mortgage interest rates
which reached a nine-year low at the end of Mar~h,
starts of new single-family homes averaged 1 ¼ million. units at_ an annual rate from January through
Apnl, the highest level since the late 1970s. Sales of
singl_e-fam~ly homes , which had been boosted by tax
cons1derat10ns at the end of 1986, also remained
brisk through April. Subsequently, the backup in
mortgage rates to early-1986 levels resulted in some
reduction in single-family homebuilding by May, to
about the pace that prevailed last fall. In the multi~amily market, the downtrend in activity that began
m early 1986 continued through the first half of
1987. By May multifamily starts were almost onethird below last year's peak. Despite the adjustment
thus far to overbuilding and the reduced after-tax
profitability of multifamily housing investment,
rental vacancy rates nationwide are still close to
record levels .
The Business Sector
Business spending on plant and equipment fell
sharply in the first quarter of 1987. For equipment,
the weakness was concentrated in January, following
the effective date of the new tax reform law . In subsequent months, shipments of nondefense capital
goods recovered, leaving the average level for April
and May, in nominal terms, 1 ¾ percent above the
third quarter of last year. New orders for nondefense capital goods also dipped at the beginning of
the year, but then strengthened noticeably as bookings for aircraft and for office and computing equipment rose sharply. The recent level of orders
appears consistent with a continuation in the near
term of the moderate uptrend in spending on equipment that has prevailed over the past two years.
According to private survey responses concerning
business capital spending plans for the year as a
whole, firms still intend to direct the bulk of these
purchases toward modernization and cost-saving
improvements in their production lines.
12
Changes in Real Business
Inventories
D
lilll
tion of the auto industry. Domestic car makers
boosted production in early 1987 in excess of slackening sales, leading to a substantial sales backlog of
unsold cars on dealer lots. By June the scaling back
of assemblies had stemmed further accumulation,
but the industry entered the summer with stocks
that were quite large by historical standards .
Before-tax profits of nonfinancial corporations,
which had slipped a bit relative to GNP since 1984,
rose in the first quarter. After-tax profits relative to
GNP were up as well, although the rise was damped
by increases in corporate tax liabilities associated
with the new tax law. Corporations paid out a
slightly larger share of earnings as dividends in the
first quarter; nonetheless, internally generated fund s
remained sizable relative to investment outlays.
Annual rate,
billions of dollars
Nonfarrn Less Autos
Autos
60
30
+
1982
1983
1984
1985
1986
1987
The Government Sector
In contrast, the environment for expansion of
plant facilities and office space is still generally unfavorable. Large amounts of vacant and underused
space in both office buildings and factories began to
take a toll on nonresidential construction last year.
Also , less favorable treatment of commercial structures under the new tax code reinforced the tendencies toward a lower level of activity in this sector. As
a result, spending for commercial and industrial
buildings dropped further in the first quarter of 198 7,
to a level about 20 percent below a year earlier. The
decline in spending for these types of buildings
accounted for the overall weakness in nonresidential
structures early this year, in the face of an upturn in
oil drilling and some increases in other categories.
A sizable swing in business inventories around the
turn of this year was associated with sharp, taxinduced fluctuations in sales. The surge in consumer
and business spending at the end of 1986 was met to
a considerable extent by drawing down stocks, which
were then rebuilt at the beginning of this year. This
spring, inventory-sales ratios generally were not indicating serious imbalances, with the notable excep-
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Federal Reserve Bank of St. Louis
A substantial reduction in the fede r al budget deficit
for fiscal year 1987 appea rs in train , with the most
recent estimate from the Congressional Budget Office at $161 billion, compared with $221 billion in
fiscal 1986. Growth in receipts has been extremely
rapid; this reflects , in large part , a one-time surge in
tax payments this April from individuals who realized capital gains last December, taking advanta ge
of lower tax rates under the old tax code. But more
fundamental progress in reducing spending growth
also appears to have been made in th e wake of the
Gramm-Rudman-Hollings legislation. To tal outlays
have been rising at a rate of around 2 percent in the
current fiscal year, a marked slowing from 8 percent
per year during the precedin g five years .
Real purchases of goods and services by state and
local governments rose at a 4 percen t annual rate in
the first quarter of 198 7, close to the brisk p ace of
the past several years.
13
Labor Markets
Employment accelerated early in 1987, and, despite
a slowing in recent months, the average monthly
increase in nonfarm payroll employment of just over
200,000 so far this year exceeds the pace of hiring in
1986. The improvement in labor demand has been
fairly broad based. In manufacturing, a two-year
string of cutbacks in durable goods industries ended
late last year, and hiring picked up a bit in the nondurable goods sector. As a result, factory employment, overall, edged higher over the first six months
of 1987. In addition, the number of jobs in oil and
gas extraction stabilized after the sharp retrenchment
in 1986. At the same time, the expansion of jobs in
the trade, services, and finance industries, despite
some recent slowing, remained sizable.
The combination of strong gains in employment
and declining numbers of unemployed workers over
the first half of the year lowered the civilian jobless
rate to 6 ¼ percent on average in the second quarter
from just under 7 percent at the end of last year.
The rate for adult men (aged 25 years and over),
which remained at around 5 ½ percent from
mid-1984 to late 1986, moved below 5 percent this
spring. Further improvement also occurred for adult
women, whose unemployment rate in the past year
has moved below that of their male counterparts.
Quarterly
average , percent
Civilian Unemployment Rate
10
8
6
1982
1983
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Federal Reserve Bank of St. Louis
1984
1985
1986
1987
Percent change from end of
previous period, annual rate
GNP Prices
Fixed-weighted Price Index
4
H2
Hl
1I
U1
ii
Iii
!I
n
11
,I
!I
I!
!I
1982
1983
1984
1985
1986
2
11
I'II
I!
, I
I!
I;
i !
+
1987
Price Developments
As expected, inflation rates haye been higher so far
this year, largely reflecting a rebound in energy
prices. The GNP fixed-weighted price index, a
broad measure of inflation for goods and services
produced by the United States, increased at about a
4 percent annual rate in the first quarter; it had
risen 2 ½ percent during 1986. Sharper accelerations
occurred in the consumer price index, which was up
at a 5 ½ percent rate over the first five months of
the year, and in the producer price index for finished goods, which rose at a 4 ½ percent annual rate
over the six months ended in June.
The rebound in energy prices began in January
when spot prices of crude oil jumped about $3 per
barrel in response to the reductions in output.
Higher crude oil costs were quickly passed on to
end-users, and by May consumer prices for gasoline
and fuel oil had risen about 15 percent, retracing
half of last year's decline. Spot prices of petroleum
products moved up a bit further early in the summer as inventories tightened, and these increases
were supported subsequently by the renewal of
OPEC's agreement to control production.
14
Monetary Policy and Financial
Markets in the First Half of 1987
The Federal Open Market Committee at its meeting
in February established 1987 target ranges, measured from the fourth quarter _o f 1986 to the fourth
quarter of 1987, of 5 ½ to 8 ½ percent for both M2
and M3. The FOMC also set a 1987 monitoring
range for domestic nonfinancial debt of 8 to 11 percent. The M2 and M3 ranges represented a 1/2 percentage point reduction from last year's target
ranges, and the Committee expected growth to be
well within the ranges, especially in the absence of
dramatic movements in interest rates. The range for
debt was unchanged from 1986 but below the actual
outcome in that year and other recent years; thus,
the Committee anticipated that debt growth also
would slow this year.
The Committee viewed a substantial slowing in
money and credit growth from the rapid pace of
1986 as likely to be consistent with a continuation of
sustainable economic expansion and conducive to
further progress over time toward reasonable price
stability. Growth of M 1 also was expected to moderate considerably this year. However, the Committee
in February elected not to set a target range for Ml
for 1987 because of the continuing uncertainties
about the relationship of this aggregate to the economy. These uncertainties partly reflected the substantial sensitivity of its velocity to changes in financial conditions that had been evident in recent years,
capped by a record postwar decline in the velocity of
M2
Billions of Dollars
3050
2700
0
N D J
F M A M J
1986
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Federal Reserve Bank of St. Louis
J A S O N D
1987
M3
0
Billions of Dollars
N D J
1986
F M A M J
J A S O N D
1987
M 1 over 1986. Instead, the FO MC decided to continue evaluating movements in this aggregate in
light of the behavior of its velocity, the rate of economic expansion, inflationary pressures, and
developments in financial markets.
Over the first half of 198 7, monetary policy was
conducted against a backdrop of heightened concerns about inflation, stimulated in part by substantial downward pressure on the dollar in foreign
exchange markets. At the same time, growth of
money and credit aggregates moderated considerably
and the velocities of the broader aggregates turned
up after several y~ars of very rapid money growth
and falling velocities. Measured from the fourth
quarter of 1986, M2 in June was below the lower
end of its target growth range, while M3 was
around the lower end of its range. l\1eanwhile,
growth in M 1 slowed to a 7 ¾ ·p ercent pace and
debt expansion moderated to a 9 ¾ percent rate. f\s
pressures on the dollar and inflation worries intensified in April and May, interest rates began to rise
substantially, especially in long-term markets. In late
April and May, the Federal_Reserve adopted a
somewhat less accommodative stance with respect to
the provision of reserves through ·open market operations. These actions, together with monetary easing
moves by key industrial trading partners, helped to
stabilize the dollar and calm inflation fears, contributing to some decline in long-term interest rates
and strengthening of the dollar.
15
Money, Credit, and :Monetary Policy
The effects of these developments also were evident in short-term credit markets, where rates rose
in April partly in anticipation that monetary policy
would have to firm to contain pressures on prices
and the dollar. In late April and again in May, the
Federal Reserve did move to tighten the availability
of nonborrowed reserves through open market operations. Short-term interest rates rose about 1/2 to
3/4 percentage point during April and May, and the
prime rate was raised twice, on May 1 and May 15,
in 1/4 point increments. The System's firming
actions, along with complementary moves abroad,
helped to stabilize the dollar and ameliorate the concerns about the inflation outlook.
Along with some better price news and evidence
of improvement in our trade deficit, this policy
appeared to impart an improved tone to short-term
and, especially, long-term credit markets over the
latter part of May and June. Since May, most
short-term rates have posted declines of 1/4 percentage point or more. Longer-term markets generally
have registered greater gains, and in early July long
rates were off 1/2 to 3/4 percentage point from their
May highs. The dollar, meanwhile, has shown more
dramatic improvement, regaining most of the
ground it lost in April and May.
Consumer use of installment credit was considerably diminished during the first half of the year. To
some degree , this reflected a shift to mortgage debt
in the form of loans taken down under home equity
lines of credit. Overall consumer borrowing was
probably nevertheless damped by reduced deductibility of consumer interest payments under the new tax
code. In addition to credit taken down under home
equity lines, mortgage growth in the first half of the
year was maintained by heavy volumes of new and
existing home sales.
The financial system has continued to evidence
strains in 1987. Indications that the agricultural sector is beginning to stabilize have emerged, with loan
delinquencies declining, land prices bottoming out ,
and export volume firming; the failure rate among
agricultural banks seems likely to have peaked.
However, the Farm Credit System, the nation's
largest farm lender, lost considerable sums in 1985
and 1986, and many of its units continue to struggle
with troubled loan portfolios.
In its conduct of policy thus far this year, the Federal Reserve has given a good deal of weight to a
number of considerations in addition to the monetary aggregates. These include recurrent episodes of
heavy downward pressure on the dollar, indications
from long-term securities and commodity markets of
heightened inflationary expectations, and evidence
that the economy continued to advance at a pace
sufficient to produce rising levels of resource utilization. Under these circumstances, interest rates
tended to move higher, and the patterns of rapid
money growth and declining velocities of the last
several years, when inflation and interest rates were
moving down , began to be reversed. Growth of the
broad aggregates remained around the lower bounds
of their growth cones through most of the first half
of the year, although M2 dropped well below its
long-run range later in the period. Growth of both
M2 and M3 was considerably below the pace of
recent years, and their velocities increased. Expansion of Ml also slowed markedly, while growth of
domestic nonfinancial sector debt moderated.
Long-term interest rates, which had not been
affected very much by the transitory credit demands
of late 1986, continued to drift down in the early
months of 1987, displaying little short-term volatility . The placid conditions in long-term markets were
abruptly changed in late March, primarily by
developments in the international sphere. Announcements of trade sanctions by the United States, persisting weakness of the dollar, and disappointing
trade figures all raised questions about continuing
private demands for dollar assets, prospects for inflation, and the response of monetary policy. The dollar dropped sharply in the last three weeks of
March, and between late March and late April
yields on 30-year government bonds rose about
1 percentage point on balance. The exchange and
bond markets became highly volatile during this
period, as the dollar continued to drop and inflation
fears appeared to be intensified by the publication of
adverse price data. Mortgage rates and yields on
mortgage pass-through securities reacted very
promptly to the deterioration in the bond markets
and, indeed, rose more than most other long-term
rates as many investors shied away from these
instruments subject to substantial prepayment risk.
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Federal Reserve Bank of St. Louis
16
In addition to difficulties with agricultural loans,
commercial banks have been saddled with persisting
problems in th_e ir energy and developing country
loan portfolios. Although some banks remain highly
profit~ble, 19 percent lost money last year, com-.
pared with about 3 percent as the decade began;
loan loss provisions were the main cause of the earnings problems. The banking system is likely to post
record losses this year owing to huge reserve provisions taken by large banks primarily as a consequence of developments in the international debt
area. Despite the shrinkage in the book value of
shareholder equity recognized by these actions, share
prices rose at many banks announcing large
increases in loan loss reserves.
Growth of Money and Credit (Percentage changes at annual rates)
M1
Period
M2
M3
Domestic
N onfinancial Debt
Fourth quarter 1986 to
second quarter 1987
9.9
4.5
5.3
9.8e
Fourth quarter 1986
to June 1987
7.7
4.0
5.3
9.8e
1979
7.9
8.2
10.4
12.2
1980
7.3
8.9
9.6
9.6
1981
5.1 (2.4) 1
9.3
12.3
9.9
1982
8 .6
9.1
9.9
8.9
1983
10.2
12.1
9.8
11.5
1984
5.4
7.9
10. 7
13 .9
1985
12.1
8.8
7.7
13.4
1986
15.3
8.9
8.8
13 .2
Q1
8.8
5.3
7.7
15. 5
Q2
15.5
9.4
8.7
10.2
Q3
16.5
10.6
9.7
12.5
Q4
17 .0
9.2
8.0
12 .1
Q1
Q2
13.1
6.4
6.3
2.5
6.3
4.1
10 .4
9.oe
Fourth quarter to
fourth quarter
Quarterly
average
1986
Quarterly
average
1987
e-estimated
1. M1 figure in parentheses is adjusted for shifts to NOW accounts in 1981.
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Federal Reserve Bank of St. Louis
17
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Federal Reserve Bank of St. Louis
Footnotes
1. M1 is currency held by the public, plus travelers'
checks, plus demand deposits, plus other checkable
deposits {including negotiable order of withdrawal (NOW
and Super NOW) accounts, automatic transfer service
(ATS) accounts, and credit union share draft accounts).
M2 is Ml plus savings and small denomination time
deposits, plus Money Market Deposit Accounts, plus
shares in money market mutual funds (other than those
restricted to institutional investors), plus overnight repurchase agreements and certain overnight Eudodollar
deposits.
M3 is M2 plus large time deposits, plus large denomination term repurchase agreements, plus shares in money
market mutual funds restricted to institutional inv·e stors
and certain term Eurodollar deposits.
A copy of the full report to Congress is available from
Publication Services, Federal Reserve Board,
Washington, D.q. 20551
FRB12-48000-0787
18
@FedFRASER