Full text of Policy Statement and Position Papers : September 11, 1995

View original document

The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.

SHADOW OPEN MARKET COMMITTEE
(SOMC)

Policy Statement and Position Papers
September 10-11,1995

PPS 95-02

BRADLEY POLICY
RESEARCH
CENTER

Public Policy Studies
Working Paper Series

W I L L I A M

SIMON
GRADUATE SCHOOL
OF BUSINESS ADMINISTRATION

UMVERSTIYOFR(XHESrER
ROCHESTER.

NEW

YORK

14627

TABLE OF CONTENTS

Page
Table of Contents

SOMC Members

SOMC Policy Statement Summary

Policy Statement

Tight Money, Tight Budget, Profit Squeeze in Services
H. Erich Heinemann

Heinemann Economics, Prospects for Money and the Economy
H. Erich Heinemann

Some Observations on Monetary Policy
Lee Hoskins

Positive Implications of Deficit Reduction and Fiscal Reform
Mickey D. Levy

Soft-Landing Succeeds: Moderate Economic Growth
and Improving Inflation Fundamentals
Mickey D. Levy

The Dollar
William Poole

How Useful and Reliable is the Unemployment Rate
in Forecasting Inflation?
Robert H. Rasche

G-7 Countries at Halifax Summit Repeat the Mexican Myth
Anna J. Schwartz

109

SHADOW OPEN MARKET COMMITTEE

The Shadow Open Market Committee met on Sunday, September 10, 1995 from 2:00
p.m. to 6:30 p.m. in Washington, DC.
Members of the SOMC:
Professor Allan H. Meltzer; Graduate School of Industrial Administration; Carnegie
Mellon University; Pittsburgh, Pennsylvania 15213 (412-268-2282 phone, 412-268-7057
fax); and Visiting Scholar; American Enterprise Institute; Washington, DC (202-8627150 phone)
Mr. H. Erich Heinemann; Heinemann Economic Research; Division of Brimberg &
Co.; 7 Woodland Place; Great Neck, NY 11021 (516-466-3893 phone, 516-466-3872
fax)
Dr. W. Lee Hoskins, Chairman and CEO; Huntington National Bank; 41 S. High Street;
Columbus, Ohio 43287 (614-480-4239 phone, 614-480-5485 fax)
Dr. Mickey D. Levy, Chief Financial Economist; NationsBanc Capital Markets, Inc.; 7
Hanover Square, New York, New York 10004 (212-858-5545 phone, 212-858-5741 fax)
Dean Charles I. Plosser; William E. Simon Graduate School of Business Administration
and Department of Economics; University of Rochester; Rochester, New York 14627
(716-275-3316 phone, 716-275-0095 fax)
Professor William Poole; Department of Economics; Brown University; Providence,
Rhode Island 02912 (401-863-2697 phone, 401-863-1970 fax)
Professor Robert H. Rasche; Department of Economics; Michigan State University;
East Lansing, Michigan 48823 (517-355-7755 phone, 517-432-1068 fax)
Dr. Anna J. Schwartz; National Bureau of Economic Research; 269 Mercer Street, 8th
Floor; New York, New York 10003 (212-995-3451 phone, 212-995-4055 fax)

SOMC POLICY STATEMENT SUMMARY
Washington, D.C., September 11—The Shadow Open Market Committee called
on the Federal Reserve System to "promptly reduce short-term interest rates until the
monetary base grows at a 6 percent rate." The monetary base—the sum of currency and
bank reserves—has decelerated to a 4.5 percent annual growth rate.
The SOMC, a group of academic and business economists who regularly analyze
and critique public policy issues, asserted that a 6 percent annual growth rate of the
monetary base is "currently consistent with steady real growth without inflation." The
committee warned that "If the present growth rate of the base continues, the economy
risks recession or deflation in 1996."
The Shadow Open Market Committee, which meets in March and September, was
founded in 1973 by Professor Allan H. Meltzer of Carnegie-Mellon University and the
late Professor Karl Brunner of the University of Rochester.
The SOMC urged the Federal Reserve to reject the "mistaken" notion that
economic growth causes inflation. "There is little evidence that faster economic growth,
or a lower unemployment rate, affect inflation." The committee statement noted that the
typical error in forecasting inflation from the unemployment rate (a relationship that
economists call the "Phillips Curve") "is so large that it covers much more than the range
that is of interest."
The Shadow group charged that the Federal Reserve's practice of "targeting
interest rates is a bad idea in general but is especially so during the transition to a
balanced budget when the effects of deficit reduction on interest rates are
unpredictable...The Federal Reserve should not try to anticipate the effects of deficit
reduction."
The SOMC also rejected the notion that reducing the federal deficit will lead to
depreciation of the U.S. dollar. "There is no reliable evidence that deficit finance affects
the exchange rate...A credible policy of deficit reduction by cutting transfer payments and
raising expected rates of return would strengthen the dollar exchange rate."

The committee statement attacked proposals to expand the role of the
International Monetary Fund as "a wrong-headed response to the Mexican devaluation."
This plan, which was announced by the major industrial nations at the Economic Summit
in Halifax, Nova Scotia in June, "Goes in the wrong direction. It would encourage bad
policies, not discourage them." The SOMC urged Congress to "reject the Halifax
proposal and should not expand the role of the IMF. It should end U.S. participation in
the IMF."

SHADOW OPEN MARKET COMMITTEE
Policy Statement
September 11,1995

Federal Reserve policy remains restrictive whether measured by monetary
aggregates or by interest rates.

Growth of the monetary base—bank reserves and

currency—is below the rate required for sustained growth with low inflation. Market
interest rates from 3 to 18 month maturities are below the overnight rate on Federal funds
that is set by the Federal Reserve. To keep the Federal funds rate at its current level, 5
3/4 percent, the Federal Reserve drains reserves from the banking system. This lowers
bank reserves and the monetary base. Continued growth of the base at the current annual
rate of 4.5 percent risks recession.
In 1994, the Federal Reserve responded to excessive monetary growth by raising
interest rates in a series of steps. As a result of its effective anti-inflationary actions in
1994, the rise in inflation has been small. The Federal Reserve now has the opportunity
to restore growth with price stability or low inflation in 1996 and future years.
This is a significant achievement. The Federal Reserve has achieved stability—
sustained growth with low inflation—in less than 20 percent of the years since its
founding. It has taken 15 years of disinflation to reduce inflation to current low levels.
The Federal Reserve should promptly reduce short-term interest rates until the
monetary base grows at a 6 percent annual rate. A 6 percent growth rate of the base is the
rate currently consistent with steady real growth without inflation. If the present growth
of the base—4.5 percent for the past year—continues, the economy risks recession or
deflation in 1996.

ECONOMIC GROWTH DOES NOT CAUSE INFLATION
The Federal Reserve and financial markets respond to reports of renewed growth
and lower unemployment rates by raising interest rates.
announcements suggest that the economy has slowed.

Interest rates fall when

The reason is that market

participants believe that the Federal Reserve will not reduce the short-term interest rate if

the economy grows at a 2 1/2 percent or higher rate. Their rationale for this belief is
either that economic growth causes inflation and higher interest rates or that the Federal
Reserve acts on the presumption that economic growth causes inflation and will raise (or
not reduce) interest rates, if the economy shows evidence of faster growth.
This is mistaken and leads to poor policy. Economic growth does not cause
inflation. There is little evidence that faster economic growth, or a lower unemployment
rate, affect inflation.
The association between inflation and the unemployment rate is known as the
Phillips Curve. Two-thirds of the errors in predicting inflation in the next quarter from a
Phillips-Curve relating inflation to the unemployment rate and past rates of inflation fall
in a range of plus or minus 1.4 percent at an annual rate for the period 1960-1993. This
error is so large that it covers much more than the range that is of interest. Because of the
large error, a forecast of 3 percent inflation is consistent with actual inflation as low as 1
1/2 percent or as high as 4 1/2 percent.
Further, the unemployment rate contributes very little to the inflation forecast. (A
typical Phillips Curve estimate of the effect of a one percentage point change in the
unemployment rate is minus 5.9 basis points in the annual inflation rate.) Almost all of
the forecast reflects past changes in inflation. The same is true of other measures of
output such as capacity utilization. There is, therefore, no basis for the belief at the
Federal Reserve or in the market that faster growth will cause inflation to increase.
Chart 1 compares the deviations of annual inflation from its mean to the deviation
of unemployment from its mean multiplied by the estimated effect of unemployment on
inflation (-0.059 percent). The chart shows that only a very small proportion of changes
in inflation is accounted for by fluctuations in unemployment or output.
The Federal Open Market Committee, through its Chairman, should publicly
renounce use of the Phillips Curve to forecast inflation. Growth does not cause inflation;
inflation is caused by excessive monetary growth.

THE DEFICIT AND THE FED
Targeting interest rates is a bad idea in general but is especially so during the
transition to a balanced budget when the effects of deficit reduction on interest rates are
unpredictable. The prospective shift in the deficit over the next two years is smaller than
the reduction in the past two years.
The Federal Reserve should not try to anticipate the effects of deficit reduction.
The magnitude and direction are uncertain. By targeting monetary growth the Federal
Reserve can assure that the economy will receive the benefits of deficit reduction and
continued disinflation.
THE DEFICIT AND THE DOLLAR
The budget resolution that Congress approved in July proposes reductions in
spending sufficient to balance the budget at the end of seven years and lower tax rates.
Most of the reductions in spending come from entitlement programs, particularly
Medicare and Medicaid. We have long recommended changes such as those now
proposed. We welcome them, and we urge Congress and the administration to carry them
out by enacting a budget and a long-term budget plan.
A major reaction in the budget deficit achieved by reducing transfer payments
permits the economy to shift resources from consumption to investment.

Higher

investment in productive physical capital and productive education raises living
standards. The Kerrey-Danforth Commission, the trustees of the Social Security fund,
the Concord group, and many others have warned about the long-term effects of
continued deficits and a growing debt. These groups provide a public service by warning
about the costs of delay in reducing spending on entitlements, but they often fail to point
out that the present generation leaves both unfunded Social Security liabilities and real
capital to its progeny. A major policy goal should be to remove the bias against
investment. This would increase the capital stock and reduce the burden of unfunded
Social Security liabilities.
The main effects of deficit reduction depend on how the deficit is reduced.
Government transfer payments and entitlements encourage consumption at the expense of

investment.
welfare.

Removing that bias has positive effects on resource use and economic

Further, should the reduction in tax rates lower taxes on investment, the

anticipated after-tax return to investment in the U.S. would rise relative to returns abroad.
These changes would strengthen the dollar relative to other currencies and increase the
capital stock.
Some analysts argue the opposite—that reducing the budget deficit would
depreciate the dollar.

Their analyses consider only the direct effects of reduced

government borrowing and neglect the more important effects of changes in the
composition of spending and taxes.

Evidence suggests that the direct effects of

borrowing have been relatively small. There is no reliable evidence that deficit finance
affects the exchange rate.
Chart 2 compares the deficit as a share of GDP to the real exchange rate for more
than thirty years. There is no apparent relation. More detailed studies that hold constant
other relevant factors, show the same result. The principal effects of reducing the deficit
depend on how the deficit is reduced. A credible policy of deficit reduction by reducing
transfer payments and raising expected rates of return would strengthen the dollar
exchange rate.

THE HALIFAX PROPOSALS FOR THE IMF
At Halifax in June, the leaders of the G-7 countries proposed that the International
Monetary Fund (IMF) establish a new "Emergency Funding Mechanism" to provide
faster access to borrowing arrangements. The G-7 governments also proposed to double
the amount of lending under the General Agreements to Borrow by adding $28 billion to
that fund.
These proposals are a wrong-headed responses to the Mexican devaluation.
Mexico's problems were caused by excessive spending and monetary expansion by the
Mexican government, not by an absence of lending. The Halifax proposal addresses
symptoms, not causes.
Quite apart from the causes, the proposal to increase foreign lending ignores the
main lessons of the savings and loan failures in the 1980s and similar experience in other

countries: If lenders know they will be rescued, they will be less prudent about the loans
they make. If borrowers can expect that economic mismanagement will bring more
foreign financing, they will relax their policies and postpone solutions.
The Halifax proposal goes in the wrong direction. It would encourage bad
polices, not discourage them. The lesson of Mexico is that loose monetary and fiscal
policies lead to capital flight and devaluation. The proper response is more stable
policies, not more foreign lending.
The IMF has drawn the wrong conclusion from the Mexican devaluation. Its
report, "International Capital Markets: Developments, Prospects and Policy Issues,"
advises developing countries to consider using "temporary" exchange controls on foreign
capital inflows. This advice shifts the blame for currency fluctuations or devaluations
from policymakers to markets, private lenders and investors.
Mexico's devaluation would have been avoided if Mexico had controlled
spending and money growth. The flight of capital from Mexico prior to devaluation
reflected judgments, mainly by Mexican nationals, that Mexican policy was too
expansive to sustain the prevailing exchange rate. Exchange controls would have been
evaded; they would not have prevented the outflow or the devaluation.
The IMF's recommendation is bad advice. Congress should reject the Halifax
proposal and should not expand the role of the IMF. It should end U.S. participation in
the IMF.

CHART 1
INFLATION AND UNENPLOVNENT

Ql
I960
Notes:

Ql
1964

Ql
1968

Ql
1972

Ql
1980

Ql
1984

Ql
1988

Ql
1992

The chart shows annual changes in the GDP deflator minus
its mean rate of change 1960-1994 (line) and the unemployment rate lagged one quarter multiplied by -.059 minus
its mean ualue (dot). The uertical lines show recessions

Sources: Haver Analytics;

Ql
1976

Heinemann Economic Research

Ql
1996

CHART 2

Federal Budget Deficit Versus Trade-Weighted Real Exchange Rate 1960-1994
440r-

• 1985

I960

• 1961
_ „
# 1962
196*
• 1969|
• 1970 • 1964
1905*
4 1966 4 1967

• 1971

• 1968

• 1984

120

• 1983
• 1972
• 1982

100

• 1974

80 4-

* 1986

• 1973

• 1979

• 1976
1977 ^ 8 1 9 8 9 9 ¥ * 1975
1978 • 1994* • 1988 1 9 9 0 •• 1993 ^ 1 9 9 1
• 1992
1980

40 4-

20 4-

-1.0%

0.0%

1.0%
2.0%
3.0%
4.0%
5.0%
Federal Budget Deficit as Percentage of GDP (Fiscal Year)

6.0%

7.0%

TIGHT MONEY, TIGHT BUDGET, PROFIT SQUEEZE IN SERVICES
H. Erich HEINEMANN
Heinemann Economic Research
Division of Brimberg & Co.
The Federal Reserve has intensified its money squeeze thus far in 1995. Total
bank reserves—the high-powered raw material for the money supply—fell at a rate of 7.8
percent in the second quarter. Reserves rose in July, following 12 months of decline.
This was only the second monthly gain since February 1994. The previous gain was in
July 1994, which suggests a possible seasonal adjustment problem. The drop in reserves
last spring was the fifth consecutive quarter of decline and was by far the largest of the
current round of tight money. Growth in the monetary base has dropped well below the
level recommended by the Shadow Open Market Committee (first chart).
The Fed's token reduction in its target for overnight interest rates has not and
probably will not lead to a meaningful easing in monetary policy. The Fed implements
its policy by setting a target for the Fed funds rate, which is the price of bank reserves.
The central bank controls the supply of bank reserves through its open market
operations.

However, the Fed cannot control the short-run demand for reserves.

Therefore, officials must supply whatever amount of reserves bankers wish to hold at the
prevailing target price—5 3/4 percent at present. Under current credit-market conditions,
the Federal Reserve must limit the supply of high-powered money in the banking system
to keep rates from declining below that level.
The notion of a policy choice between jobs and inflation is false. Attempts to
trade more inflation for more jobs backfire. The country gets higher prices and lower
jobs. However, history also shows that sustained monetary contractions end in recessions
and sustained accelerations lead to inflation.
Forcing rates down sufficiently to induce a substantial increase in the quantity of
reserves could trigger a further drop in dollar. That would put more upward pressure on
the cost of imports. Import prices, which fell almost 12 percent in 1991, 1992 and 1993,
have risen 3.4 percent in the past year and one-half. In the second quarter alone, import

prices rose at an annual rate of 5 percent. Imports are about 30 percent of goods
consumed in the U.S.
Fiscal policy is also restrictive. The primary surplus in the federal budget is
growing rapidly (second chart). The primary budget balance (revenues minus outlays
other than net interest) is the best measure of the economic impact of the government's
decisions about taxes and spending. A primary budget surplus means that tax revenues
exceed current outlays for goods, services and transfer payments. Any remaining red ink
reflects previous, rather than current, fiscal policy. Cause and effect are far from clear,
but a primary budget surplus has preceded every recession since World War II.
Finally, profits are under pressure in the private service sector. These companies
have been responsible for almost nine of every 10 new jobs added in the current business
expansion, well above their postwar average of 71 percent. These firms added more than
6-million workers to their payrolls since 1991—mostly in businesses with low
productivity.
This is the Achilles' Heel of the U.S. expansion—some of the weakest parts of the
service-producing sector (for example, retailing and health care) have created the vast
majority of the new jobs. Measures of productivity in services are either slowing sharply
or are actually falling. Profits of private service companies were slightly lower in the
fourth quarter of 1994 and were up only 3 percent from a year earlier.
The slowdown in service jobs over the last few months shows that the incentive to
continue to add to the headcount has eroded.

When it becomes unprofitable for

employers in the service sector to add to their payrolls, they will stop doing so. When the
great American job machine goes into reverse, so does the economy.
The Labor Department's index of unit profits in nonfincial corporations rose
modestly in the second quarter, following a sharp drop during the winter months. This
index is a key measures of profitability. It has not changed in the past year, following
fours years of steady gains at an annual rate of 11.5 percent (third chart). These data
appear closer to economic reality than the steamy increases reported by Business Week
magazine and The Wall Street Journal.

This erosion in profitability has already led to slower growth in employment,
income, consumption and investment. The Labor Department estimated that private
employers added 3.3 million jobs from January to July, 1 million fewer than in the same
period in 1994. Seasonally adjusted, this was a gain of 698,000 jobs, down from 1.74
million last year.
Our Baseline Forecast indicates that these forces should culminate in a recession
toward the end of 1996 or in early 1997 (table). Slower growth in business investment is
likely to be a key element in the decline. The Ridgewood Index of leading indicators of
the computer industry has slowed sharply in recent months. The authors of this measure
were senior members of the IBM Economics Department for many years. We regard
their data as among the best available to track investment in information processing
technology. Their numbers are fair warning of the coming decline. Inventories of
communications equipment have started to snowball.
GLOBAL COOLING
The world economy has begun to slow.

While there are few signs of an

impending recession outside the U.S., business executives in many countries anticipate
that the expansion will proceed at a more moderate pace. Sales expectations in Japan
have dropped for two quarters in a row, and prices continue to fall. The short-run outlook
has deteriorated in Germany and Italy.
In France, production of consumer goods has all but stalled over the past year. In
Britain, real retail sales have slowed sharply. Favorable inflation prospects in Germany
could set the stage for additional interest rate reductions by the Bundesbank. This global
cooling could undermine the rapid expansion in some developing nations—Brazil is one
example.
Exports continue to be on the cutting edge of the American economy despite the
global cooling Real exports of merchandise averaged $556 billion at a seasonally
adjusted annual rate during the second quarter. That was up 14 percent in the past year
and 24 percent since the spring of 1993. The record was all the more remarkable because

Mexico, the third-largest U.S. trading partner, has been in a deep recession since the
beginning of 1995.
In dollar terms,. American exports gained more than $100 billion over the last 24
months. Not only is the U.S. the world's largest exporter, but very few nations have total
exports that match the $100 billion increase in American sales since 1993. The U.S.
share of the world export market has been rising steadily (fourth chart). The United
States sells a huge variety of goods and services to overseas buyers, but its greatest
advantages are in agricultural products and industrial materials and supplies. A good
example of the latter would be the chemical industry, which traditionally runs a large
trade surplus.
The biggest change in U.S. trade patterns in recent years is the emergence of a
large and rapidly growing deficit in transactions involving computers, peripherals and
parts. American producers have not lost their leadership in information technology, but
they now assemble more of their computer components abroad. Among other reasons,
U.S. regulations make it difficult to build new factories that produce circuit boards, a
basic building block in any computer. In the first half of 1995, imports of computer
accessories and semiconductors rose by more than $10 billion from a year earlier.
Measurement of U.S. trade in current dollars is distorted by the 9 percent
devaluation of the dollar in the year ended second quarter 1995. (We use J.P. Morgan's
real effective exchange rate index to track the value of the dollar.) The "J-curve" effect
from the cheap dollar exaggerates the trade deficit and makes profits of U.S.
multinationals look better than they really are.
Cut through the fog and you find that in real terms the merchandise deficit has not
changed significantly since July of 1993. Meanwhile, steady upward pressure on import
prices has played a major role in the surge in the U.S. producer price index for all
commodities in 1995. In recent months, prices of crude and intermediate materials have
risen much more than those for finished or consumer goods. Such pressures are part of
the overall squeeze on profitability which we believe will tip the U.S. economy into
recession in 1996 or 1997.

GUIDELINES FOR THE FED
We believe the U.S. economy is slowly sliding toward a recession.

The

government's "chain-weight" index of gross domestic product—the new standard for
GDP measurement starting next year—showed little increase in the second quarter. A
rising risk of recession will complicate the Presidential election in 1996. It will also
muddy the pending transition in leadership at the Federal Reserve. Vice Chairman Alan
S. Blinder9s term at the Fed expires January 31, 1996. Chairman Alan Greenspan's term
as chairman runs out four weeks later on March 2. Moreover, there is already one
vacancy on the seven-person board due to the resignation of Governor John LaWare.
Thus, President Clinton has an unprecedented opportunity to influence the
direction of the Federal Reserve. The Senate Banking Committee should take the
opportunity created by the hearings on these appointments to review the basic guidelines
that govern monetary policy in the U.S. Congress, rather than the White House, holds the
Constitutional authority to "coin money and regulate the value thereof." Such an
examination, should it occur, would be long overdue.
The notion among members of the Washington press corps is that policymakers
exploit a tradeoff between inflation and growth. This leads to a classification of Fed
members as either "hawks" or "doves." Hawks supposedly want high interest rates and
low inflation to service creditors on Wall Street—essentially the haves of American
society. The doves, populists in another era, are for the have-nots, common folk who
benefit from low rates and rapid growth.
This taxonomy may be popular inside the Beltway, but it is false. There is no
policy choice between jobs and inflation. Attempts to trade more inflation for more jobs
backfire with the result that the country ends up with higher prices and lower jobs
Thomas C. Melzer, president of the Federal Reserve Bank of St. Louis, recently
published an excellent restatement of one of the SOMC's central positions: namely, that
focusing monetary policy on long-run price stability best serves the interests of all
Americans—rich and poor, haves and have-nots. Members of the Senate should ponder
Mr. Melzer's thoughtful analysis as they prepare to advise President Clinton on his

upcoming nominees to the central bank—nominees who may or may not include Alan
Greenspan as Fed chairman for another four years.
It is obvious that the ultimate goal of economic policy should be to achieve the
highest sustainable standard of living, but as Mr. Melzer said, the Fed's direct influence
over long-term trends in real output and employment is negligible. "These trends depend
largely on population and technology growth, the skill and education levels of the work
force and the accumulation of capital."
"The only lasting monetary policy contribution to the real output trend is to create
an environment conducive to growth, one in which relative price signals are clear and
markets are not distorted by high and variable inflation." The problem, he went on to
say, is that "current legislation and official Federal Reserve statements list multiple
objectives . . . including real growth, low unemployment and stable prices."
Firing at economic targets with a shotgun rather than a rifle leaves Federal
Reserve officials "with no clear ranking of priorities. Multiple objectives also allow
policymakers—as well as their critics—to shift from one priority to another at any given
time." While such artful dodging may seem to be little more than adjusting policy to
current events, it actually creates "substantial uncertainty" about the Federal Reserve's
objectives over time. Consequently, long-term interest rates—which should reflect longterm expectations about inflation—gyrate in response to short-term news about the
economy.
Uncertainty about future inflation has practical results. Most important, it leads to
an increase in the risk premium that lenders demand to protect the real value of their
principal over time. "The fact that long-term interest rates in Japan are roughly three
percentage points lower in Japan than in the United States," Mr. Melzer asserted, "says a
lot about how different markets view inflation risks ..."
Far from the antithesis of growth, low inflation tends to be a common
denominator in most high-performance economies, whether the Asian tigers (Korea,
Hong Kong, Taiwan and Singapore) or mature industrial nations such as Germany and
Japan. As a result, an increasing number of nations are following the lead of New

Zealand in establishing an explicit target for inflation and then making the central bank
responsible for achieving it.
Mr. Melzer said that "I strongly support the independence of the Federal Reserve
from the short-run political process, but this independence can be maintained in a
democratic society only if the Federal Reserve can be held accountable for its policies.
With multiple objectives, it cannot. Accountability in terms of price stability represents
an achievable and measurable objective. It is, therefore, likely to affect the behavior and
improve the performance of policymakers."
These views are now not part of the conventional wisdom inside the Beltway. But
the record shows that an unequivocal commitment to low inflation would lead to lower
long-term interest rates and faster growth. President Clinton should take note. Come to
think of it, he should name Tom Melzer to the Federal Reserve Board.
THE BUDGET "SURPLUS"
When Congress goes back to Washington after Labor Day, the federal budget will
be at center stage. Democrats and Republicans will trumpet their rival, if largely
spurious, plans for balancing the government's accounts sometime after the turn of the
century. Bureaucrats are getting ready to shut down the government on October 1 if there
is no agreement.
Chances are, much of the public debate will focus on hot-button issues such as
foreign aid or federal funding of abortions. These questions dominate the political
agenda, but they are trivial in spending terms. Debate about fundamental fiscal reforms
to boost incentives to work, save, invest and curtail the growth of $l-trillion-dollar-a-year
in government transfer programs will probably get short shrift.
Temporarily, the budget is actually in better shape than Washington seems willing
to admit. Using data from the national income accounts, the second quarter Treasury
deficit was at an annual rate of $127.8 billion, the lowest in more than six years.
Projections by the Organization for Economic Cooperation and Development indicate
that the U.S. deficit will average less than 2 percent of GDP during the next 18 months,
the lowest percentage of any major country.

The forces behind this improvement are easy to find. During the past two years,
federal revenue has risen at an annual rate of 8.8 percent, while outlays have increased at
a pace of only 3.7 percent. Were those trends to continue, the Treasury would be in the
black by fiscal year 1998. In fiscal year 2000, which will start October 1, 1999, there
would be a surplus of $250 billion.
Unfortunately, the pattern of big gains in revenue and modest increase in outlays
is probably not sustainable. There are two main reasons: First, a recession is likely to
start within the next two years. In part, this will likely be a consequence of the abrupt
tightening of fiscal policy in the Clinton Administration. If the economy does turn down,
revenues will slow, expenditures will accelerate and the tide of red ink will rise rapidly.
Second, Mr. Clinton's fiscal program—huge tax increases coupled with draconiaii
cuts in Pentagon spending—was full of provisions designed to produce big one-time
gains. For example, many analysts believe the White House must stop cutting real
defense outlays if the U.S. is to retain its role of global political leadership. Since the
first quarter of 1993, real defense spending has dropped 18.5 percent. The Pentagon's
share of the economy is now the smallest since 1940.
Budget watchers also note that despite the talk about rolling back Washington's
share of the economy, members of Congress still fund pet projects. At the same time,
Social Security—Washington's largest single program—is "off the table," outside the
budget talks. Sad to say, the recent news about the Federal budget may be literally too
good to be true. During the year ended in June 1995, in fact, federal revenue growth
already started to slow, and expenditures to accelerate.
This is not to say that fiscal policy is not restrictive. The primary surplus in the
federal budget is growing rapidly (second chart). The primary budget balances (revenues
minus outlays other than net interest) is the best measure of the economic impact of the
government's decisions about taxes and spending.
A primary budget surplus means that tax revenues exceed current outlays for
goods, services and transfer payments. Any remaining red ink reflects payments for
previous, rather than current, outlays. While the link between cause and effect is not
clear, a primary budget surplus has preceded every recession since World War II.

Governments have two basic economic functions: Number one, they purchase
goods and services. Examples include maintaining military and police forces, operating
schools, hospitals, parks and air traffic control systems and building bridges, dams and
highways.
Thus far under the Clinton Administration, non-military government purchases
have gone up at a rate of about 3 percent, just slightly over the inflation rate in the same
period. Real military outlays, as noted, are sharply lower. Real purchases of goods and
services at all levels are currently the smallest share of real GDP since 1931 (fifth chart).
Governments also redistribute income through transfer payments, which generally
take money from individuals who work to give to those who do not. Over the last two
and one-half years, these payments have increased at a rate of 6.2 percent, double the
growth of non-military purchases.
In the last 30 years, transfer payments, measured in current dollars, have grown
from $39 billion to $1 trillion annually—from 6.5 percent of national income to more
than 17 percent. More than 90 percent of transfers come directly or indirectly from
Washington.
Government actions that restrict individual choice (say, by shifting income from
workers to non-workers) usually impair the efficiency of the economy. However, an
efficient economy may not be fair to all its participants. Some people earn and/or receive
too few of the economy's goods and services to have a minimum living standard.
Mostly, this is what the stream of $1 trillion in transfer payments is supposed to cure.
Equally important is whether cutting traditional government functions to facilitate
rapid growth in transfer programs may create problems for the future.

Defense,

education, infrastructure and public safety, after all, are critical to the smooth running of
the society.
There is no magic level of transfer spending that will produce optimum growth.
But seeking equity by redistributing income involves costs that go beyond the dollars in
the budget. These costs are often hidden. Voters, who must make the final decisions,
should beware.

CYCLES IN FEDERAL RESERUE POLICY
C
H
A 12*
N
G
E 10*

Monetary Base, Left Scale
Total Bank Reserves, Right Scale

C
30.0V. H
A
N
ZZ.5y. G

I
N
to
O

P
E
R
C
E
N

15.Ox I
N

Qy. -I

6x 4
4x
- i — i — i — i — i — i — i — i — i

Jan
1984
Notes:

Jan
1986

i i—i—i

i — i — i — i — i — i — i — i — i — i — i — I — i — i

Jan
1988

Jan
1990

'i i

i — i — i — i — i — i — i — i — i — i — r -

Jan
1992

Jan
1994

The chart shous year-ouer-year changes in the
base (line) and in total bank reserves (dot).
Reserve Board data, adjusted for seasonal and
requirement changes. The vertical lines shou

\ 7.5* P
E
R
C
0
E
N
-7.5* T
Jan

I I

19%

monetary
Federal
reserve
the recession.

Sources: Haver Analytics; Heinemann Economic Research

THE RISING SURPLUS IN THE PRMARY FEDERAL BUDGET

Ql
1966
Notes:

Ql
1969

Ql
197Z

Ql
1975

Ql
1978

Ql
1981

Ql
1984

Ql
Ql
1987 1990

Ql
1996

The chart shous the prinary balance in the federal budget total reuenues minus expenditures other than net interest
paid to the public. Surplus (+), Deficit (-). Billions
of current dollars. The uertical lines shou recessions.

Sources: Haver Analytics; Heinemann Economc Research

Ql
1993

HONEMANN ECONOMIC RESEARCH /DIVISION OF BRIM BERG & CO.
Baseline Forecast - August 1995
IV94A
F95A
il'95 F
111*95 F
IV95 F
F96 F
THE ECONOMY:
$5,514.9
$5,433.8
$5,582.4
$5,556.3
$5,477.3
$5,470.1
Gross Domestic Product ($87)
5.07%
2.8%
PctChg
3.0%
0.5%
2.70%
1.9%
$3,681.7
$3,629.6
Personal Consumption ($87)
$3,699.7
$3,666.5
$3,710.8
$3,643.9
5.11%
2.0%
1.7%
1.59%
Pet Chg
2.5%
1.2%
$785.3
$708.2
$764.6
$743.6
Business Investment ($87)
$814.9
$798.7
11.3%
21.54%
17.65%
PctChg
7.0%
11.8%
8.4%
$164.7
$168.1
$155.6
$169.6
$159.9
Structures ($87)
$1632
Prod. Dur. Equip. ($87)
$620.6
$601.4
$552.6
$645.3
$630.6
$583.7
Residential Invest. ($87)
$227.7
$227.7
$227.5
$229.5
$231.5
$220.9
0.4%
12.5%
-3.41%
Pet Chg
0.0%
2.28%
-14.2%
Change in Inventory ($87)
$17.5
$49.4
$26.5
$30.4
$51.1
$25.2
($112.6)
($118.5)
($118.6)
Net Exports ($87)
($126.1)
($125.0)
($107.1)
Government Purchases ($87)
$924.0
$922.2
$921.3
$922.2
$920.5
$919.9
0.4%
0.8%
0.6%
-0.74%
-4.14%
Pet Chg
-0.3%
$5,648.3
$5,677.5
$5,615.8
Final Domestic Sales ($87)
$5,571.9
$5,537.5
$5,491.5
2.3%
2.1%
3.2%
4.85%
2.5%
3.39%
PctChg
$7,317.6
$7,110.0
$7,216.6
$6,977.4
$6,897.2
Gross Dom. Prod. ($ Current)
$7,011.8
6.1%
5.7%
5.7%
6.36%
4.73%
2.0%
Pet Chg
$3,999.5
$3,960.3
$3,961.3
$3,937.6
$3,950.5
$3,911.0
Disposable Income ($87)
1.9%
1.9%
2.4%
4.10%
-1.3%
7.50%
PctChg
4.7%
4.8%
4.7%
4.6%
4.1%
5.10%
Savings Rate (Percent)
$567.8
$565.3
$562.1
$559.3
$569.7
$560.3
Operating Profits ($ Current)
1.8%
2.3%
2.0%
-7.1%
6.9%
3.13%
Pet Chg
122.7
121.9
123.5
121.00
122.00
120.50
Industrial Prod. (1987=100)
2.6%
2.4%
3.1%
-3.24%
5.07%
5.95%
Pet Chg
1.30
1.28
1.28
1.265
1.308
1.511
Housing Starts (Mill. Units)
4.0%
2.1%
3.9%
-12.3%
-43.85%
11.13%
Pet Chg
14.6
14.34
14.40
14.6
14.890
15.420
Tot Vehicle Sales (Mill Units)
0.4%
-4.9%
6.6%
•13.98%
23.08%
•13.06%
Pet Chg
116.7
117.0
117.3
116.351
115.329
116.078
Nonfarm Payroll Jobs (Mill)
1.0%
1.1%
1.2%
0.94%
2.99%
2.63%
Pet Chg
6.1%
5.9%
5.8%
5.57%
5.70%
5.53%
Unemployment Rate (Percent)*
174.6
169.8
172.2
167.6
164.4
166.1
Comp. Per Hour Non-Farm Bus**
5.7%
5.5%
5.5%
3.7%
3.73%
4.20%
Pet Chg
120.7
121.5
121.2
120.2
118.6
119.3
Productivity Non-Farm Bus**
1.9%
0.9%
1.5%
3.05%
4.51%
2.38%
PctChg
140.8
142.1
143.7
139.4
138.7
Unit Labor Cost Non-Farm Bus**
139.2
4.0%
3.7%
4.6%
0.6%
-0.29%
1.45%
PctChg
128.9
131.1
129.9
128.0
GDP Deflator (1987a 100)
126.9
127.6
3.0%
2.9%
3.8%
1.5%
1.23%
1.98%
PctChg
153.7
155.3
156.8
152.23
150.97
149.83
Consumer Prices (1982-84=100)
4.1%
3.9%
4.0%
2.25%
3.38%
3.08%
PctChg
($161.4)
($150.0)
($158.8)
($153.1)
($148.6)
($161.1)
Fed! Deficit ($ Current NIA)
FINANCIAL MARKETS:
5.4%
5.8%
5.5%
5.81%
6.02%
5.17%
Federal Funds Rate
5.4%
5.0%
5 60%
5.2%
5.28%
Three-month Bills (Discount)
5.74%
8.1%
8.83%
Prime Rate, Major Banks
8.8%
8.2%
9.00%
8.13%
6.4%
30-Year Treasury Bonds
6.2%
6.6%
7.96%
7.64%
6.96%
Money Supply (M-l, $ Current)
$1,161.0
$1,154.7
$1,145.4
$1,146.5
$1,147.9
$1,147.8
0.4%
2.9%
2.2%
-0.87%
0.03%
-1.22%
PctChg
6.30
6.20
6.25
6.078
6.12
6.009
Velocity (Ratio: GDP to M-I)
87.7
84.3
86.0
82.27
88.00
86.43
Trade-Weighted $ (1973=100)
A * Actual F=» Forecast Billions of dollars unless noted.

* Break in series, January 1994. ** Compensation, productivity and unit labor costs are index numbers, 1982= 100.
http://fraser.stlouisfed.org/
Sources: Haver Analytics: Heinemann Economic Research

Federal Reserve Bank of St. Louis

1196 F

111*96 F

IV'96 F

1994 A

1995 F

19%

$5,605.5
1.7%
$3,716.4
0.6%
$826.3
5.7%
$173.1
$653.2
$228.4
1.1%
$13.5
($104.7)
$925.7
0.7%
$5,696.8
1.4%
$7,405.5
4.9%
$4,013.4
1.4%
5.0%
$558.5
-6.4%
124.1
2.0%
1.29
-0.9%
14.04
•9.6%
117.6
0.9%
6.1%
177.3
6.4%
121.7
0.8%
145.6
5.5%
132.1
3.2%
158.1
3.6%
($137.2)

$5,616.3
0.8%
$3,712.7
-0.4%
$837.9
5.7%
$174.9
$663.0
$230.1
3.1%
$9.5
($100 2)
$926.3
0.3%
$5,707.0
0.7%
$7,479.5
4.1%
$4,023.4
1.0%
5.3%
$552.9
•3.9%
124.4
1.0%
1.29
-2.0%
13.89
-4.1%
117.8
0.8%
6.3%
179.3
4.6%
121.8
0.0%
147.3
4.6%
133.2
3.3%
159.4
3.2%
($170.1)

$5,606.1
-0.7%
$3,709.7
-0.3%
$834.8
•1.4%
$173.1
$661.7
$230.1
-0.0%
($0.5)
($94.2)
$926.1
-0.1%
$5,700.8
-0.4%
$7,525.1
2.5%
$4,029.3
0.6%
5.4%
$528.8
-16.3%
122.9
-4.7%
1.27
-5.1%
13.57
-9.1%
117.8
-0.1%
6.5%
181.1
4.2%
121.6
•0.6%
149.0
4.9%
134.2
3.2%
160.5
2.8%
($175.2)

$5,344.0
4.08%
$3,579.6
3.50%
$672.4
13.66%
$150.6
$521.8
$231.4
8.59%
$47.8
($110.0)
$922.8
-0.75%
$5,406.2
4.10%
$6,738.4
6.23%
$3,835.7
3.55%
4.10%
$542.7
11.73%
118.07
5.33%
-1.446
11.54%
15.060
8.46%
114.028
2.98%
6.09%
162.6
2.68%
117.4
1.93%
138.5
0.75%
126.1
2.06%
148.3
2.61%
($159.1)

$5,504.6
3.0%
$3,673.0
2.6%
$773.0
15.0%
$164.0
$609.1
$226.4
-2.1%
$33.3
($122.0)
$921.0
-0.2%
$5,593.4
3.5%
$7,078.9
5.1%
$3,957.4
3.2%
4.6%
$564.1
3.9%
121.9
3.3%
1.28
-11.2%
14.6
-3.1%
116.5
2.2%
5.7%
168.9
3.9%
120.3
2.5%
140.4
1.3%
128.6
£0%
153.0
3.2%
($152.6)

$5,602.6
1.8%
$3,712.4
1.1%
$828.5
7.2%
$172.7
$655.8
$229.1
1.2%
$10.0
($102.9)
$925.5
0.5%
$5,695.5
1.8%
$7,431.9
5.0%
$4,016.4
1.5%
5.1%
$552.0
-2.1%
123.7
1.5%
1.29
0.3%
14.0
-4.2%
117.6
0.9%
6.3%
178.1
5.4%
121.6
1.1%
146.4
4.3%
132.6
3.2%
158.7
3.7%
($161.0)

5.2%
4.8%
7.9%
6.2%
$1,178.2
6.1%
6.29
88.8

4.7%
4.4%
7.4%
6.0%
$1,200.0
7.6%
6.23
89.8

4.3%
4.0%
7.0%
5.9%
$1,230.0
10.4%
6.12
91.6

4.20%
4.25%
7.14%
7.37%
$1,145.1
6.2%
5.884
91.32

5.8%
5.5%
8.7%
6.9%
$1,148.6
0.3%
6.16
84.8

4.9%
4.6%
7.6%
6.1%
$1,192.3
3.8%
6.23
89.5

21-Aug-95

10:30 AM
l'94A

THE ECONOMY:
Gross Domestic Product ($87)

Change In Inventory ($87)
Net Exports ($87)
Government Purchases ($87)
Final Domestic Sales ($87)
GDP ($87) Four qtr chg (%)

$ Change
$53.0

PctChg
4.04%

$ Change
$66.8

PctChg
5.07%

$ Change
$209.4

PctChg
4.08%

$40.1

3.11%

$11.5

0.89%

$26.9

2.05%

$44.9

3.41%

$120.9

2.35%

1.27%
-0.36%
1.62%

$14.3
$6.9
$7.5

1.11%
0.53%
0.58%

$22.1
$0.6
$21.5

1.69%
0 05%
1.64%

$28.2
$4.0
$24.2

2.14%
0.30%
1.84%

$80.8
$2.9
$78 0

1.57%
0.06%
1.52%

$5.4

0.42%

$3.9

0.30%

($3.6)

-0.27%

$1.3

0.10%

$18.3

0.36%

1.13%
-1.69%
•0.90%

2.61%
•0.60%
-0.22%

($2.1)
($52)
$14.9

•0.16%
-0.40%
1.14%

($7.7)
$9.9
($9.8)

-0.58%
0.75%
-0.74%

$32.5
($36.1)
($70)

0.63%
-0.70%
-0.14%

$50.3

3.90%
3.66%

$27.0

2.09%
4.09%

$60.2

4.59%
4.43%

195 A
THE ECONOMY:
Gross Domestic Product ($87)

PctChg
4.09%

1994 A

111

Residential Invest. ($87)

$ Change
$52.9

IV94A

il!

Business Investment ($87)
Structures ($87)
Prod. Dur. Equip. ($87)

PctChg
3.35%

111*94 A

ill

Personal Consumption ($87)

$ Change
$43.1

ll'94 A

$ Change
$36.3

11195 F

11*95 F
PctChg
2.70%

$ Change
$7.2

PctChg
0.53%

$ Change
$37.6

$64.6

4.91%
4.14%

$213.1

4.15%

1995 F

IV'95 F
PctChg
2.77%

$ Change
$41.4

PctChg
3.0%

$ Change
$160.7

PctChg
3.0%

Personal Consumption ($87)

$14.3

1.06%

$22.6

1.66%

$15.2

1.12%

$18.0

1.3%

$93.4

1.7%

Business Investment ($87)
Structures ($87)
Prod. Dur. Equip. ($87)

$35.4
$4.3
$31.1

2.63%
0.32%
2.31%

$21.0
$3.3
$17.7

1.54%
0.24%
1.30%

$20.7
$1.5
$19.2

1.53%
0.11%
1.42%

$13.4
$3.4
$9.9

1.0%
0.3%
0.7%

$100.6
$13.4
$87.3

1.9%
0.3%
1.6%

Residential Invest. ($87)

($2.0)

-0.15%

($8.6)

-0.63%

$6.6

0.49%

$0.2

0.0%

($4.9)

-0.1%

$1.7
($114)
($17)

0.13%
-0.85%
-0.13%

($20.7)
($6.5)
($0-6)

-1.52%
-0.48%
-0.04%

($52)
($11)
$1.4

-0.38%
•0.08%
0.10%

$1.3
$7.6
$0.9

0.1%
0.6%
0.1%

($14.5)
($12.1)
($18)

-0.3%
-0.2%
-0.0%

$46.0

3.42%
3.97%

$34.4

2.52%
3.07%

3.24%
2.76%

$32.5

2.4%
2.3%

Change In Inventory ($87)
Net Exports ($87)
Government Purchases ($87)
Final Domestic Sales ($87)
GDP ($87) Four qtr chg (%)

T96F
THE ECONOMY:
Gross Domestic Product ($87)

$ Change
$26.1

111*96 F

ll'96 F
PctChg
1.9%

$ Change
$23.1

$43.9

PctChg
1.7%

$ Change
$10.8

IV96F
PctChg
0.8%

$187.2

3.5%

1996 F

$ Change
($10.2)

PctChg
-0.7%

$ Change
$97.9

PctChg
1.8%

Personal Consumption ($87)

$11.1

0.8%

$5.6

0.4%

($37)

-0.3%

($3.0)

-0.2%

$39.4

0.7%

Business Investment ($87)
Structures ($87)
Prod. Dur. Equip. ($87)

$16.3
$1.5
$14.8

1.2%
0.1%
1.1%

$11.4
$3.5
$7.9

0.8%
0.3%
0.6%

$11.5
$1.7
$9.8

0.8%
0.1%
0.7%

($3.1)
($1.7)
($1.3)

-0.2%
-0.1%
•0.1%

$55.4
$8.7
$46.7

1.0%
0.2%
0.8%

Residential Invest. ($87)

$0.0

0.0%

$0.6

0.0%

$1.7

0.1%

($0.0)

-0.0%

$2.7

0.0%

Change in Inventory ($87)
Net Exports ($87)
Government Purchases ($87)

($9.0)
$5.9
$1.8

0.7%
0.4%
0.1%

($40)
$7.9
$1.6

•0.3%
0.6%
0.1%

($40)
$4.6
$0.7

-0.3%
0.3%
0.0%

($10.0)
$6.0
($0.2)

-0.7%
0.4%
-0.0%

($23.3)
$19.1
$4.6

-0.4%
0.3%
0.1%

0.7%

($6.3)

-0.4%

http://fraser.stlouisfed.org/
Final Domestic Sales ($87)
Federal Reserve Bank of St. Louis

$29.2

2.1%

$19.2

1.4%

$10.2

$102/1

•1.9%

THE SQUEEZE OM COPORATE PROFITABILITV
C
H
A
N
G
E

—

Unit Profits - Nonfinancial Corporations

I
N
to
4^

P
E
R -12.5x
C
E
N -25.0*
T

I
Ql
1985

-r—l—i—i—i—i—i—i—i—i—i—i—i

Ql
1986

Ql
1987

Ql
1988

Ql
1989

T—1

i — i — r — r

Ql
1990

Ql
1991

Ql
1992

l—l

Ql
1993

Ql
1994

Notes: The chart shous year-over-year percentage changes in the
Bureau of Labor Statistics' Index of Unit Profits in
Nonfinancial Corporations (1982=100). Second quarter 1995
plotted. The vertical lines shou the 1990-91 recession.
Sources: Haver Analytics; Heinemann Economic Research

Ql
1995

THE RISING MARKET SHARE OF AMERICAN EXPORTS
P
E
R 22.5X H
C
E
N 21.Ox
T

—

U.S. Exports/OECD Exports

0 19. S/. \
F
T 18.Ox
0
T
A 16.5*
L
r—I

Ql
1960
Notes:

Ql
1964

i—i

Ql
1968

i ' i

'i 'i — i — i — T

Ql
1972

Ql
1976

Ql
1980

' » — r — T — r

Ql
1984

Ql
1988

*-!—r—i—i—r

Ql
1992

Ql
19%

The chart shous real U.S. exports of goods and seruices as
a percent of real exports from the members of the Organization
for Economic Cooperation and Development. Data are in 1990
dollars. Vertical lines shou U.S. recessions.

Sources: Haver Analytics; Heinemann Economic Research

i—i—r

GOUERNMENT PURCHASES HAUE DROPPED AS A SHARE OF THE ECONOMY
p

—

Government Purchases of Goods d Services ($87)

T 60* -

0
F 5Cfc

to
0\

R
E 40x. A
L
30x \
G
D
P 2&/.

Jjyw^l
7

1ftv J

1929
Notes:

1935 1941 1947 1953 1959 1965 1971 1977 1983 1989 1995
The chart shous real federal, state and local purchases of
goods and services (defense, education, infrastructure,
health etc.) as a percent of real GDP. The horizontal line
is 16.81*, the average for the first half of 1995.

Sources: Haver Analytics;

Heinenann Economic Research

THE GAP BETUEEH PRODUCTIUITY AMD INCOME IN MANUFACTURING

Ql
1977
Notes;

Ql
1979

Ql
1981

Ql
1983

Ql
1985

Ql
1987

Ql
1989

Ql
1991

Ql
1993

The chart shous Bureau of Labor Statistics indexes of output per hour (line) and real compensation per hour (dot)
in manufacturing. Index, 1982 equals 100. Semilog scale,
The vertical lines shou periods of recession.

Sources: Hauer Analytics; Heinemann Economic Research

Ql
1995

HEINEMANN ECONOMICS
PROSPECTS FOR MONEY AND THE ECONOMY
VOLUME XI, NUMBER 18/SEPTEMBER 5,1995
H. Erich HEINEMANN
Heinemann Economic Research
Division of Brimberg & Co.
I WROTE AS I PLEASED
After 21 years, nearly one thousand reports and several million words, the time
has come to end my regular letters to the investment community. It has been a long road
from Morgan Stanley's Weekly Federal Reserve Report in August 1974 to Prospects for
Money and the Economy in August 1995. New management at Ladenburg, Thalmann has
decided to focus on small-cap stocks, so I have retired as chief economist.
However, retirement is not he same as pregnancy; you can do it half way.
Effective immediately, Heinemann Economic Research will become a division of
Brimberg & Co., an institutional brokeragefirmin New York. I expect to work closely
with a small number of key clients. Following a short vacation, I will be in touch. My
telephone numbers will be 212-838-3100, 516-466-3893 or 516-466-3872.
HIGHLIGHTS
If the Fed sticks to its strategy of a disciplined monetary policy aimed at zero
inflation, long-term interest rates should continue to decline. THE CASE FOR A 6
PERCENT LONG BOND (Page 29)
Inflation occurs only when central banks print more money than people wish to
hold. Inflation is not due to capacity use in manufacturing, unemployment or even
the price of oil. ROOTS OF INFLATION (Page 30)
Profits are under pressure in private services. These companies, mostly with low
productivity, have added to their payrolls. Now their profit margins are suffering.
THE SOFT UNDERBELLY OF GROWTH (Page 32)
The U.S. Budget is in better shape than Washington admits. However, rapid growth
in revenue and stagnant spending (which would produce a large surplus) are not
sustainable. THE DISAPPEARING BUDGET "SURPLUS" (Page 34)

THE CASE FOR A 6 PERCENT LONG BOND
Somewhere lost in the fog of history, Wall Street's twenty-something bond
traders decided that easy money means lower interest rates. Even superficial knowledge

of basic economic principles would have shown them that their story was backward.
Nations with low long-term interest rates generally have tight monetary policies.
However, right or wrong has little relevance on Wall Street. What counts is what
traders believe—the people who author Tom Wolfe satirized in his brilliant novel Bonfire
of the Vanities. Right now, these self-appointed "masters of the universe" are at it again,
regularly bidding up bond prices at any hint of economic weakness that could push the
Federal Reserve to ease.
In fact, there is an excellent case for a 6 percent long bond over the next 6 to 18
months, but not because of what passes as conventional wisdom in the canyons of
downtown lower Manhattan. If the cost of long-term credit continues to decline and bond
prices continue to rise as we expect, it will be because the Federal Open Market
Committee sticks to its strategy of a disciplined monetary policy aimed at achieving zero
inflation.
ROOTS OF INFLATION
Remember, inflation is a monetary phenomenon. It is not due to high levels of
capacity use in manufacturing, low levels of unemployment or even the price of oil. Such
measures are symptoms of the inflation process, not its causes. Inflation is determined by
the number of dollars that chase the available supply of goods and services. Inflation
occurs only when central banks print more money than people wish to hold. Transitory
price changes—up and down—happen all the time. Such short-run adjustments translate
into sustained changes in rates of change in the overall price level only in response to
monetary policy. Too much money will create inflation; too little money leads to
deflation.
Federal Reserve officials generally concur with this view. Therefore, their actions
are likely to be guided by these principles. To paraphrase recent Fed testimony to
Congress, price stability is the key ingredient to maximize productivity, real incomes, and
living standards. Thus, it is crucial to extend the current period of low inflation. As the

Federal Reserve Bank of Cleveland put it, "Economic polices should create the
conditions in which the natural incentives of a capitalist system foster the creativity and
ingenuity necessary for innovation and capital accumulation. . .The relationship between
monetary polices and the economy can be summarized by four key points:
"(1)

The Fed seeks to restrain inflation in order to promote economic growth in the
conviction that inflation hampers growth."

"(2)

Growth is not sacrificed in order to maintain price stability."

"(3)

Monetary policy is the only tool for preventing inflation."

"(4)

Even 1994's low rate of inflation is too high for the nation's long-term good."

SPEAKING TO THE SHADOWS
Total bank reserves, which are raw material for the money supply, were down
again in August—the 16th monthly decline in the last 18 months. From January through
August, bank reserves fell at an annual rate of 4.5 percent in contrast to a 1.9 percent rate
of decline during calendar year 1994. In 1992 and 1993, reserves were up 20 percent and
12 percent, respectively. The monetary base averaged $430.6 billion last month, up at a
3.9 percent rate thus far in 1995. That was less than half the growth rate of the base last
year (see Figure 1).
At their meeting in early July, members of the Federal Open Market Committee
decided that "they favored or could support a directive that called for some slight easing
in the degree of pressure on reserve positions and that included a bias toward possible
further easing of reserve conditions. . ." In a memorandum to our colleagues on the
alternative Shadow Open Market Committee, which is scheduled to meet next weekend,
we observed that this token reduction in the Fed's target for overnight interest rates would
probably not lead to a meaningful easing in monetary policy.
The Fed implements its policy by targeting the Fed funds rate, the price of bank
reserves. The central bank controls the supply of bank reserves through its open market
operations.

However, the Fed cannot control the short-run demand for reserves.

Therefore, officials must supply whatever amount of reserves bankers wish to hold at the
prevailing target price—5 3/4 percent at present. Under current credit-market conditions,

the Federal Reserve must limit the supply of high-powered money in the banking system
to keep rates from declining below that level.
We reiterate that the notion of a policy choice between jobs and inflation is false.
Attempts to trade more inflation for more jobs backfire. The country would get higher
prices and fewer jobs. Forcing rates down sufficiently to induce an increase in the
quantity of reserves could trigger a further drop in the dollar, which would put upward
pressure on import prices. Imports make up 30 percent of goods consumed in the U.S.
Fiscal policy is also restrictive. The primary surplus in the federal budget soared
to a record annual rate of $90.6 billion in the second quarter. In the first quarter of 1993,
the primaryUdance was a deficit of $101 billion (see Figure 2). The primary budget
balance (revenues minus outlays other than net interest) is the best measure of the impact
of government decisions about taxes and spending. A primary budget surplus means that
tax revenues exceed current outlays for goods, services and transfer payments. Any
remaining red ink reflects previous, rather than current, fiscal policy. Cause and effect
are not clear, but a primary budget surplus has preceded every recession since World War
II.

THE SOFT UNDERBELLY OF GROWTH
Profits are under pressure in the private service sector. These companies have
been responsible for almost nine of every 10 new jobs added in the current business
expansion, well above their postwar average of 71 percent. These firms have added more
than 6 million workers to their payrolls since 1991—mostly in businesses with low
productivity. This is the soft underbelly of the expansion. Some of the weakest parts of
the service-producing sector (for example, retailing and health care) have created the vast
majority of the new jobs. Measures of productivity in services are either slowing sharply
or are actually falling. Profits of private service companies were slightly lower in the
fourth quarter of 1994 and were up only 3 percent from a year earlier.
The slump in service jobs over the last few months shows that the incentive to
continue to add to the headcount has eroded.

When it becomes unprofitable for

employers in the service sector to add to their payrolls, they will stop doing so. When the
great American job machine goes into reverse, so does the economy.
THE CONSEQUENCES OF LOWER PROFITS
The Labor Department's index of unit profits in nonfinancial corporations rose
modestly in the second quarter, following a sharp drop during the winter months. This
index is a key measure of profitability. It has not changed in the past year, following four
years of steady gains at an annual rate of 11.5 percent.
The erosion in profitability has already led to slower growth in employment, and
therefore also in income, consumption and investment. The Bureau of Labor Statistics
estimated that private employers added 3.6 million jobs from January through August, 1
million fewer than in the same period of 1994. Roughly 20 percent of the slowdown was
due to reduced estimates by the BLS of net job creation by newly-formed enterprises.
Seasonally adjusted, the data add up to a gain of 858,000 jobs in 1995, down from 2
million in the same period last year.
More critical, the BLS index of aggregate hours worked in the private nonfarm
economy is essentially unchanged thus far in 1995, following two years of gains at a rate
of 4 percent. This sluggishness is beginning to back up in the investment sector. Real
contracts and orders for plants and equipment, which rose at an average annual rate of 17
percent in the second half of 1993 and full-year 1994, fell sharply in July to an average
annual rate of $582 billion. Compare that to the average of more than $600 billion during
the first six months of this year.
In manufacturing, the diffusion indexes compiled by the National Association of
Purchasing Management are generally down sharply from their levels in mid-1994. The
overall NAPM composite index was 47.6 during June, July and August, well below its
long-term average of 53.1. New orders have declined, supplier deliveries are improving
and price pressures on basic materials are evaporating.

Only export orders show

consistent strength. Put these numbers on a chart, and they look more and more like a
typical prerecession pattern.

THE DISAPPEARING BUDGET "SURPLUS"
When Congress goes back to Washington after Labor Day, the federal budget will
be at center stage.

Democrats and Republicans will trumpet their rival, if largely

spurious, plans for balancing the government's accounts sometime after the turn of the
century. Bureaucrats are getting ready to shut down the government on October 1 if there
is no agreement.
Chances are that much of the public debate will focus on hot-button issues such as
foreign aid or federal funding of abortions.

These questions dominate the political

agenda, but they are trivial in spending terms. Debate about fundamental fiscal reforms
to boost incentives to work, save, invest and curtail the growth of $l-trillion-dollar-a-year
in government transfer programs will probably get short shrift.
For the time being, the budget is actually in better shape than Washington seems
willing to admit. In the 12 months ended in July, the Treasury's cash accounts were in
the red by $157 billion, the smallest shortfall since 1990. Projections by the Organization
for Economic Cooperation and Development indicate the U.S. deficit will average less
than 2 percent of GDP during the next 18 months, the lower percentage of any major
country.
The forces behind this improvement are easy to find. During the past two years,
federal revenue has risen at an annual rate of 8.8 percent, while outlays have increased at
a pace of only 3.7 percent. Were those trends to continue, the Treasury would be in the
black by fiscal year 1998. In fiscal year 2000, which will start October 1, 1999, there
would be a surplus of $250 billion.
This pattern of big gains in revenue and modest increases in outlays is not
sustainable. There are two main reasons: First, a recession is likely to start within the
next two years. In part, this will likely be a consequence of the abrupt tightening of fiscal
policy during the Clinton Administration. If the economy does turn down, revenues will
slow, expenditures will accelerate and the tide of red ink will rise rapidly.
Second, Mr. Clinton's fiscal program—huge tax increases coupled with draconian
cuts in Pentagon spending—was full of provisions designed to produce big one-time
gains. For example, many analysts believe the White House must stop cutting real

defense outlays if the U.S. is to retain its global political leadership. Since the first
quarter of 1993, real defense spending has dropped 18.5 percent. The Pentagon's share of
the economy is now the smallest since 1940.
TOO GOOD TO BE TRUE
Budget watchers also note that despite the talk about rolling back Washington's
share of the economy, members of Congress still fund pet projects. At the same time,
Social Security—Washington's largest single program—is "off the table," outside the
budget talks. Sad to say, the recent news about the Federal budget may be literally too
good to be true. During the year ended in June 1995 federal revenue growth had already
started to slow and expenditures to acceralte. This is not to say that fiscal policy is not
restrictive. The primary surplus in the federal budget is growing rapidly.
Governments have two basic economic functions: Number one, they purchase
goods and services. Examples include maintaining military and police forces, operating
schools, hospitals, parks and air traffic control systems and building bridges, dams and
highways.
Thus far under the Clinton Administration, non-military government purchases
have gone up at a rate of about 3 percent, just slightly over the inflation rate in the same
period. Real military outlays, as noted, are sharply lower. Real purchases of goods and
services at all levels of government currently represent the smallest share of real GDP
since 1931.
Governments also redistribute income through transfer payments, which generally
take money from individuals who work to give to those who do not. Over the last two
and one-half years, these payments have increased at a rate of 6.2 percent, double the
growth of non-military purchases.
THE GROWTH OF TRANSFERS
In the last 30 years, transfer payments, measured in current dollars, have grown
from $39 billion to $1 trillion annually—from 6.5 percent of national income to more
than 17 percent. More than 90 percent of transfers come directly or indirectly from

Washington. There are serious matters in an economy facing a long-term decline in its
saving rate (Figure 3) and eroding rates of return on productive investment (Figure 4).
Government actions that restrict individual choice (say, by shifting income from
workers to non-workers) usually impair the efficiency of the economy. However, an
efficient economy may not be fair to all its participants. Some people earn and/or receive
too few of the economy's goods and services to have a minimum living standard. Mostly,
this is what the stream of $1 trillion in transfer payments is supposed to cure.
Equally important is whether cutting traditional government functions to facilitate
rapid growth in transfer programs may create problems for the future.

Defense,

WEEKLY MONETARY DATA
(Billions of dollars, except as noted)
Latest Change from
Week Previous week

MONEY SUPPLY
M-l (Cash, Demand and other
Checkable Deposits)
M-2 (M-l Plus RPs, Euros, MMMFs,
MMDAs, Consumer Time A/Cs)
M-3 (M-2 Plus Large time A/Cs,
Term RPs and Euros)
Domestic M-l
FRB RESERVE AGGREGATES
Monetary Base
Total Reserves
Nonborrowed Reserves
Borrowing, ex. Extended Credit (NSA)
(millions of dollars)
ST. LOUIS RESERVE AGGREGATES
Adjusted Monetary Base
Adjusted Fed Credit
Total Commercial Paper
C&I Loans • All Large Banks

-Rates of Change Over3 Months 6 Months 12 Months

Week
Ended

$1,145.6

$2.3

0.3%

-0.3%

-0.5%

21-Aug-95

3744.5

9.4

9.0

6.2

3.3

21-Aug-95

4521.2

7.8

10.7

8.7

5.7

21-Aug-95

531.9

2.9

5.3

1.7

0.5

21-Aug-95

430.725
57.476
57.189
0.288

0.323
-0.062
-0.100
0.038

-0.3
-0.5
-1.3
NM

3.8
-4.7
-5.4
NM

5.2
•3.8
2.6
NM

30-Aug-95
30-Aug-95
30-Aug-95
30-Aug-95

469.0
437.7

0.3
0.4

-0.2
-2.5

2.9
1.9

4.3
4.2

30-Aug-95
30-Aug-95

659.320

-1.681

4.8

15.6

15.7

344.3

-1.500

5.1

11.8

14.4

23-Aug-95
16-Aug-95

Notes: Data, except as noted, are seasonally adjusted. NM - Not meaningful. NA - Not available
Domestic M-l is an estimate of holdings of American currency in the U.S. plus demand deposits.
Rates of change are compound annual rates based on four-week moving averages.

Figure 1
CYCLES IN FEDERAL RESERVE POLICY
C
H
A
N
G
E
I
N
P
E
R
C
E
N
T

... r~

12% -

TWTnnphflPTf R H Q P T«A1rf.

a.t a l a

C
•30.0% H
A
N
22.5% G
E

Total Bank Reserves, Right Scale

A
10% •
8% •

6% .

15.0% I
N
. 7.5%
-•i

.0
i

4% .

P
E
R
C
E
N

1 -7.5% T
«.Ian
]L984

Notes:

Jan
1986

Jan
1988

Jan
1990

Jan
1992

Jan
1994

Jai i
19<96

The chart shows year-over-year changes in the monetary
base (line) and in total bank reserves (dot). Federal
Reserve Board data, adjusted for seasonal and reserve
requirement changes. The vertical lines show the recession.

Sources: Haver Analytics; Heinemann Economic Research
37

1
1
1

W E E K L Y E C O N O M I C DATA
Latest Change from
—Rates of Change Over—Week Previous Week 3 Months 6 Months 12 Months
BUSINESS W E E K P R O D U C T I O N I N D E X *
4.3%
124.9
2.1%
12.1%
-0.1
O U T P U T . Production:
Autos (Units)
P
133168
-7.2
-14.1
54.7
13758
Trucks (Units)
P
124261
-7.2
3.2
91.9
-112
Paper (Thousands of tons)
2.0
P
838.4
4.5
-1.4
-15.3
Paperboard (Thousands of tons)
P
0.5
882.0
-4.5
-8.8
-7.4
Raw Steel (Thsds of short tons)
P
4.7
1935
•8.5
1.6
32
Bit urn. Coal (Thsds of short tons)
19883
-2.9
-12.3
P
-1.1
•160
Crude Oil (Thousands of bbls)
-0.9
P
13613
-2.5
-13.7
47
Electricity (Millions of kwh)
12.4
66856
17.2
48.0
P
-3467
Rotary Rigs (US units operating)
-1.9
2.0
P
762
4.6
5

26-Aug-95
26-Aug-95
19-Aug-95
19-Aug-95
26-Aug-95
19-Aug-95
26-Aug-95
26-Aug-95
01-Sep-95

TRANSPORTATION
Class I Railroad Freight Traffic
(Billions of ton-miles)
PRICES
Spot Index All Commodities 1967= 100
Raw Industrials
Foodstuffs
Domestic Spot Mkt Crude Oil Price
Trade-weighted Value of the US
Dollar (March 1973=100)
Common Stock Prices SAP 500

Week
Ended
19-Aug-95

24.1

0.2

-2.7

1.8

0.4

19-Aug-95

293.44
342.00
235.02
17.83

-0.43
-0.13
-0.72
-1.87

5.1
-13.3
38.9
-21.0

5.2
0.3
12.7
-1.5

10.6
11.1
9.9
2.5

29-Aug-95
29-Aug-95
29-Aug-95
31-Aug-95

85.90
561.88

-0.20
4.42

9.6
27.0

-5.4
33.2

-4.9
19.7

30-Aug-95
31-Aug-95

349
2654

0
25

-29.7
16.1

3.9
8.0

4.5
-1.5

26-Aug-95
19-Aug-95

EMPLOYMENT
Initial Unemployment Claims (Thsds)
Claimant Level (Thousands)

1
1

Notes: 'Copyright, McGraw-Hill, Inc. Used with permission. Data, except prices, seasonally adjusted . P - Preliminary. Changes
are compound annual rates based on four-week averages.

Figure 2
THE RISING SURPLUS IN THE PRIMARY FEDERAL BUDGET

Ql
Ql
Ql
Ql
Ql
Ql
Ql
Ql
Ql
Ql
1969 1972 1975 1978 1981 1984 1987 1990 1993 1996
The chart shows the primary balance in the federal budget
- total revenues minus expenditures other than net interest
paid to the public. Surplus (+) f Deficit (-). Billions
of current dollars. The vertical lines show recessions.
Sources: Haver Analytics; Heinemann Economic Research

Figure 3
THE LONG-TERM DECLINE IN THE SAVING RATE
P
E
R
C
E
N
T

Savings - Plow of Funds Concept
Savings - National Income Concept, FOF Data
Savings - National Income Concept

20%
16% -I
12%

0
F
I
N
C
0
M
E

8% ]
4%

Ql
Ql
Ql
Ql
Ql
Ql
Ql
Ql
Ql
Ql
Ql
1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996
Notes:

The chart shows saving as a percent of after-tax income:
Solid line, flow of funds concept. Close dot, flow of funds
concept, national income data. Wide dot, national income
concept. 4-quarter averages. Vertical lines show recessions.

Sources: Haver Analytics; Heinemann Economic Research

Figure 4
LONG-TERM RATES OF RETURN IN NONFINANCIAL CORPORATIONS
R
A
T
E
S
0
F
R
E
T
U
R

15% \

Ratio: Profits to Domestic Income
Ratio: Profits to Net Worth (Historic Cost)
Ratio: Profits to Net Worth (Current Cost)

12% •
/>.
9% • // \
1}
6% • s •
:'
3% -

1946 1951 1956 1961 1966 1971 1976 1981 1986 1991
Notes:

1996

The chart shows after-tax operating profits of domestic
nonfinancial corporations as a percent of domestic income (line),
net worth based on historic costs (close dot) and net worth
based on current costs (wide dot). In current dollars.

Sources: Haver Analytics; Heinemann Economic Research
39

SOME OBSERVATIONS ON MONETARY POLICY
LeeHOSKINS
The Huntington National Bank
The FOMC appears to be successfully containing inflationary pressure created by
policy actions from 1991-93. Now the FOMC has an opportunity to make reality out of
its rhetoric of the past decade with regard to price stability, or zero inflation. Yet the
ability of its FOMC to seize the opportunity may be more fragile than it was five years
ago. A minority of members of the current FOMC view price stability as merely one of
several equally important goals, rather than as the single means by which the Fed can
make indirect but lasting contributions to other objectives. Attempts to balance multiple
objectives creates uncertainty about future rates of inflation and weakens the credibility
of the Federal Reserve. Fortunately, support for a statutory designation of price stability
as the sole objective of monetary policy is again gaining ground in Washington.
Congress should alter the Federal Reserve's charter to give primacy to price stability.

MONEY GROWTH, INFLATION AND CREDIBILITY
The high growth rate for the monetary base from 1991-94 began to produce a
rising inflation rate by early 1995. The year-to-year change in the CPI increased from 2.3
percent in May 1994 to 3.2 percent in May 1995. FOMC policy actions in 1994 and early
1995 have begun to slow growth in the monetary base and inflation pressures appear to
be receding. Base growth year-to-date is less than 6 percent, significantly below the 9
percent trend rate of the previous four years (see figure) and below the 7 percent we
recommended last March. Base growth of less than 6 percent, will limit and reverse the
rise in the inflation rate in 1996 and restore price stability. A continuation of base growth
at 6 percent is consistent with progress toward that goal.
The monetary history of the U.S. demonstrates that moderate base growth is
associated with zero inflation. From 1871 to 1994 the mean of monetary base growth
was 5.5 percent. The two-year moving average of base growth was above the mean in 63
years and below the mean in 61 years. During the fast growth periods, base growth

averaged 9.8 percent and inflation averaged 4.8 percent. In the moderate growth years,
base growth averaged 1.8 percent and inflation averaged zero percent—the price level
was stable (see table). During periods throughout the last 123 years, then, the price level
was stable on average when base growth remained below 5.5 percent.1
Despite the historical record, policy makers have yet to directly and consistently
pursue low and steady monetary growth. For a brief period in the early 1980's, the
FOMC did attempt to manage money growth and money began to gain some credibility
as an instrument of policy. Since then, the FOMC has relied less and less on monetary
targets and more on other instruments to carry out its objectives. In Humphrey-Hawkins
testimony before Congress in July 1993, Chairman Greenspan explicitly downgraded the
importance of monetary aggregates as indicators of financial conditions. Today, targets
are set for some aggregates but they have little operational or policy significance within
the FOMC. Decisions in recent years appear to have been guided by an evolving mix of
concern for various objectives with money growth being held hostage to the concern of
the moment.
PRICE STABILITY AND CREDIBILITY
While policy makers have been unwilling to explicitly manage money growth to
achieve price stability, they have, it seems to me, been willing to place more emphasis on
price stability as the dominant objective over the past decade, at least in their rhetoric. In
1990, all 12 Presidents signed a letter in support of the Neal Resolution (House Joint
Resolution 409).

Chairman Greenspan, representing all members of the Board of

Governors, testified in favor of the Resolution. In effect, all of the members of the
FOMC supported the Resolution which would have made price stability the dominant
objective of monetary policy and set a timeframefor achieving it. The Resolution failed
in Committee. Recently, Chairman Greenspan has said in Congressional testimony that
the Federal Reserve's unwavering goal is to foster maximum sustainable economic
growth and rising standards of living and that it can best do so by achieving and
maintaining price stability.

Encouragingly, the sole reason given for the July 6

adjustment to policy was that inflationary pressures have receded.

The statement of a zero inflation objective is an important step, but several more
are needed to achieve a credible monetary policy. An announced policy is credible when
the public acts on it even when faced with evidence that seems to contradict the policy.
To gain this kind of credibility, the FOMC must have a clear objective with a verifiable
outcome and rules that are consistently adhered to in order to minimize uncertainty. If it
has consistent rule, a policy of zero inflation satisfies these requirements: it is clear and it
is verifiable. A predictable, verifiable policy ensures efficient long-term planning and
resource allocation decisions. Such a policy requires a resolute focus on the long-term
and a resistance to short-run policy fixes aimed at recession, unemployment weak
exchange value of the dollar or other perceived economic ills. The direct pursuit of
multiple goals will only introduce more uncertainty into an already uncertain world.
The current FOMC seems unable to give unanimous and consistent support to a
price stability objective. At least one member has publicly stated that the goal of
monetary policy is to balance inflation and economic growth and several others seem to
share this view. Still others are concerned about the exchange value of the dollar or the
unemployment rate. And, you can be sure that expectations of fiscal drag from Federal
budget cuts will be put forth by some as a reason for lowering the funds rate. The
historical record also demonstrates that maximum sustainable growth is achievable only
in an environment of a stable price level. There is no long-run, exploitable trade-off
between inflation and unemployment or growth. Attempts to exploit any short-run tradeoff that might exist are deceitful, at best. In practice, they often have been counterproductive. In the 63 years since 1871, when the monetary base grew rapidly, real
economic growth averaged 3.3 percent. In the 61 moderate money growth years, real
growth averaged 3.6 percent (see table).

CONGRESS TO THE RESCUE?
I doubt that today Chairman Greenspan could muster unanimous support form
members of the FOMC for a bill making zero inflation the dominant objective of
monetary policy. Clearly, to make zero inflation a more credible policy objective, there
must be a commitment to achieving it within a specific time frame and with a penalty for

failure.

This requires a change in the Fed's charter through Congressional action.

Senator Connie Mack (R-Florida) seems a sure bet to lead the charge since he has
publicly stated his desire for price stability as the sole objective for monetary policy.
Legislation should direct the FOMC to promote the maximum attainable level of
employment and output by achieving and sustaining a stable price level. The Federal
Reserve should have complete freedom to design and adopt procedures and set and seek
intermediate targets, without political interference. At the same time, the Fed must
constantly be held accountable for the results of its actions—for producing a stable price
level over time. The appropriate committees of Congress or the Executive Branch must
have the authority to, and be specifically directed to, remove and replace monetary
policymakers if and when the actual price level deviates from stability over a prespecified time by a pre-specified amount. In short, policymakers should be explicitly
directed to promote maximum sustainable growth by delivering zero inflation.
The FOMC cannot successfully fine-tune or even coarsely-tune the economy. By
trying to do so, it jeopardizes the one economic objective it can achieve over time—zero
inflation. This is not an insignificant objective. By eliminating inflation, the FOMC can
reduce at least some of the uncertainties that individuals and businesses face, laying the
foundation for a more efficient, and ultimately, more prosperous economy.

NOTES
This analysis is adapted jfrom Charles I. Plosser, "Some Observations on
Monetary Base Growth During Recoveries," Policy Statement and Position Papers,
March 7-8,1993, pp. 51-59.

FIGURE

Monetary Base
Level in Billions, Rate of Change in Percent

— Level (left)
3-Mo % d i g (right)
Source: FRB St. Louis.
Latest month plotted: July 1995.

—- 12-Mo % Chg (right)

TABLE
MONETARY BASE GROWTH AND
INFLATION AND REAL OUTTUT GROWTH1

Base
Growth2

Inflation

Real
Output
Growth

Base Growth
;> 5.5%

9.8

4.8

3.3

< 5.5%

1.8

0.0

3.6

'Data from 1872 to the start of the modern series are from R. J. Gordon, The American Business
Cycle: Continuity and Change. (Chicago and London: University of Chicago Press, 1986), pp. 781786 and Milton Friedman and Anna J. Schwartz, Monetary Trends in the United States and the United
Kingdom: Their Relation to Income, Prices, and Interest Rates. 1867-1975 (Chicago: University of
Chicago Press, 1982), pp. 122-29.
2

Base growth is the two-year moving average of annual monetary base growth.

POSITIVE IMPLICATIONS OF DEFICIT REDUCTION
AND FISCAL REFORM
Mickey D. LEVY
NationsBanc Capital Markets, Inc.
The political and economic environment for budget and tax reform is favorable.
Congress's Concurrent Resolution to balance the budget by 2002, passed in June 1995,
involves dramatic cuts in nondefense domestic programs, although its implementation
awaits detailed instructions from the appropriation and authorization committees. By
reallocating national resources from consumption-oriented deficit spending on transfer
payments toward more productive private uses, improving the structure of key spending
programs, and raising national saving, this fiscal reform would raise long-term growth
and would be relatively neutral economically in the short run. Standard demand-driven
macroeconomic models that rely on deficit measures offiscalthrust and project all deficit
reduction to restrict eoncomic activity are misleading.

The Fed must avoid an

accommodative monetary stance specifically designed to offset any anticipated fiscal
restraint.

Meanwhile, tax reform is not expected until after the 1996 presidential

elections.
Deficit cutting is the top priority of the reform-minded fiscal policymakers, while
significant tax reform (not just tax cuts) is on the back-burner. Appropriation and
authorization committees presently are developing legislative instructions to implement
the proposed $1.1 trillion cumulative savings from current law. They are scheduled to
submit reports on September 22. The depth and breadth of the required cuts will test the
resolve of these committees, particularly in Medicare, Medicaid, and welfare. The
Administration proposes somewhat smaller savings from a more optimistic budget
baseline and a balanced budget by 2004. Political fisticuffs are anticipated, and the
political process may involve a continuing appropriation resolution and/or a Presidential
veto. Such political maneuvering may briefly disrupt general government operations or
debt-financing schedules by delaying approval of the necessary rise in the federal debt

ceiling. When the dust clears, major deficit-cutting legislation is the expected outcome,
although actual (rather than projected) budget balancing seems a long-shot.
CURRENT BUDGET STATUS
In recent years, the budget deficit has narrowed significantly, from $290 billion in
Fiscal Year 1992 (4.9 percent of GDP) to approximately $155 billion in 1995 (2.3 percent
of GDP). Excluding net interest outlays of approximately $230 billion in 1995, the
budget is in significant surplus. The dramatic improvement reflects favorable economic
conditions (stronger growth and lower interest rates), the tax hikes of 1993, and the
reversal of the government's earlier massive outflows to bail out the thrift industry. Tax
receipts rose 8.5 percent annually in 1994-1995, while spending growth slowed to 3.8
percent annually. Spending growth in entitlements, particularly Medicare and Medicaid,
continues to rise rapidly, but outlays for discretionary programs have slowed sharply.
Without legislation, however, the budget outlook deteriorates beginning in 1996,
with the deficit rising to approximately $220 billion in 1997 and 1998. After that,
projected spending and deficits soar, under the assumption that spending on discretionary
programs, capped through 1998 by the Omnibus Budget Resolution Act of 1993, keeps
pace with inflation.

The Congressional Budget Office (CBO) projects current law

deficits to exceed $300 billion in 2001 and rise sharply thereafter, reflecting surging
entitlement spending. The Administration's baseline projections of gently rising deficits
rely on economic assumptions similar to the CBO's, but optimistically assume continued
caps on discretionary spending after 1998. In the past, such unrealistic optimism has
misled and muddled the budget process and lowered policymakers' credibility.
THE PROPOSALS
Congress's resolution to balance the budget proposes increasingly stringent
spending constraints on both discretionary spending programs and entitlements. It leaves
social security untouched. Measured from the CBO's baseline, it proposes $440 billion
in cumulative cuts in discretionary programs between 1996 and 2002. This includes
holding defense outlays in 2002 nearly unchanged from 1995 levels, an approximate 25

percent decline in inflation-adjusted terms, and a $30 billion reduction in nondefense
outlays, a 30 percent decline in real terms. Crucially important, achieving these proposed
cuts requires more than a dozen appropriation committees in each house legislate
increasingly deeper cuts in discretionary programs in each year though 2002.
The resolution also proposes cuts of $623 billion in entitlement programs, nearly
three-quarters of which are from Medicare and Medicaid. This involves slowing the
annualized spending growth of Medicare from a projected 10.3 percent to 6.3 percent and
Medicaid from 10.4 percent to 4.8 percent. Programmatic changes have not yet been
determined.
The resolution's proposed budget savings reflect $182 billion in lower debt
service as a result of slower growth of federal debt and a "fiscal dividend" of $170 billion
that the CBO says would result from assumed lower interest rates and modestly stronger
economic growth. Finally, the resolution provides for a $240 billion tax cut if the
appropriation committees legislate the proposed savings in the reconciliation directive.
Cuts of the magnitudes proposed would require significant reductions in the level
of real services and subsidies the government provides in a wide array of programs,
including medical services, welfare and agricultural support. This is particularly true
since social security (22.8 percent) and net interest outlays (15.9 percent) combined
constitute nearly two-fifths of total federal spending. To date, with key committees tied
up on major substantive issues as well as program detail, skepticism about Congress's
fiscal resolve is warranted. Successful deficit reduction will require definitive resolution
of these issues.
The Administration's proposal to balance the budget by 2004 is more a case of
deficit bean-counting in political response to the Congress's aggressive initiative than a
solid proposal based on programmatic legislation. It is based on an unrealistically
optimistic budget baseline and most of its deficit cuts are what the Administration calls
"indicative proposals" (they do not reflect specific policies). Even more than Congress's
proposal, its savings are heavily backloaded into the last years of its projection period
(2003-2004). Ignore it.

ECONOMIC AND FINANCIAL IMPACTS
Congress's proposal would not have a significant negative short-run economic
impact, contrary to the projections of standard demand-driven macroeconomic models,
and would raise long-run growth potential. Any assessment of the economic impact of
fiscal legislation requires detail on the mix of deficit-cutting and the implications for the
allocation of national resources and incentives.

Standard demand-driven models

incorrectly rely nearly exclusively on deficits to measure fiscal thrust—and assume that
all deficit reduction is restrictive and reduces national wealth. These are inadequate
oversimplifications and largely wrong, particularly for the task at hand—cutting transfer
payments. Changes in deficits (cyclically-adjust or otherwise) provide little information
about economic effects and are a misleading basis for evaluating fiscal policy. Different
types of deficit spending have diverse effects on resource allocation and economic
behavior. Reducing the deficit through spending cuts must be distinguished from tax
increases; moreover, government transfer payments have different economic impacts than
government purchases. Similarly, different tax structures producing similar revenues
may generate different economic andfinancialoutcomes. Thus, the economic impact of
deficit reduction depends crucially on how it is accomplished.
The most important contributions of the Congressional budget resolution are:
reallocating national resources from public uses to private uses; improving the structures
of key government spending programs and reducing existing economic disincentives;
raising national saving; and establishing the credibility of fiscal policymakers. These
factors would raise long-run economic growth; although estimates are uncertain, the
cumulative rise in standards of living is quite substantial. These factors are not captured
in the short-term projections of standard macro models.
In recent years, higher taxes and debt havefinanceda gradually declining amount
of inflation-adjusted government purchases, which directly absorb national resources, and
a sharply rising amount of transfer payments, which are redistributed through entitlement
and discretionary programs and generallyfinanceconsumption by the beneficiaries. The
government's tax structure encourages consumption over saving, raises the demand for
medical services, and generates disincentives to supply.

Congress's budget resolution would begin to reverse these trends, reallocating
resources from public to private uses,freeingresources for more productive activities and
raising long-run standards of living. At issue is the short-run transition costs and
distributional consequences. A relatively small portion of the budget savings is from
defense, which reduces government purchases and directly lowers absorption of
resources. Since there is little if any private sector substitution for spending on national
defense, economic output is reduced in a short-run static sense. Most of the budget
savings in Congress's proposal would derive from cuts in transfer payments and
entitlements.

While transfer payments redistribute resources form taxpayers to

beneficiaries and do not directly absorb them, a hefty portion of the proposed entitlement
cuts are in Medicare and Medicaid, which are associated with the provision of medical
services. Reducing these entitlements will temporarily lower GDP to the extent that
reducing government subsidies reduces total demand for medical services. Cutting other
transfer payments will temporarily depress the disposable income and consumption of the
beneficiaries.
The direct, short-run impact on GDP would be the amount of the reduction in
government purchases for defense and nondefense (infrastructure, commerce, research
and development, etc.), plus any reduction of medical output as a result of the cutback in
government subsidies. Based on Congress's budget resolution, this impact would be
minor, particularly through 1998. The reduction in consumption as a consequence of
reduced disposable income of beneficiaries depends on the size and timing of the cuts in
transfers.
These negative short-run impacts on output would be largely offset by a number
of economic and financial responses that would stimulate increased activity in other
sectors, assuming the implementation of a credible deficit reduction package. The result
would be a change in the mix of GDP, as increases in private investment, durable goods
consumption and a reduction in the net export deficit offset the declines in government
purchases, medical care output, and consumption of services.
A credible fiscal package would lower interest rates (reduce inflation
expectations) and raise national wealth. Net national saving would rise (the reduction in

government dissaving would be partially offset by lower private saving), and an increase
in the investment share of output would lift the nation's capital stock.

Ultimately,

reduced transfers will, lessen the current bias toward consumption, further boosting
savings and investment.

With more domestic saving to finance U.S. investment,

borrowing from abroad would fall, lowering the current account deficit. The credibility
gained by fiscal responsibility would raise expected rates of return on investment, provide
support to the U.S. dollar, and lift purchasing power. Also, in addition to reducing waste,
presumably the fiscal reform would improve the structures of certain government
programs, raise efficiency and reduce existing disincentives that constrain labor supply,
productive output, and private saving.
Certainly, this outcome depends crucially on the credibility of any deficit-cutting
legislation.

The Federal Reserve's long, arduous road is a benchmark for fiscal

policymakers who lack credibility, following over a decade of bungling. Recent deficit
reduction has enhanced the image of fiscal poliycmaking only modestly, as policymakers
have relied excessively on tax increases and have avoided reform of key spending
programs. Congress's budget resolution sets the stage for meaningful fiscal reform, but
effective and stringent legislation by the appropriation committees is now required. To
gain credibility, reforming Medicare is a minimal first step. Any legislative slippage now
or in the future would be dilutive.
Is Congress's deficit reduction proposal worthwhile economically? Yes, insofar
as the positive cumulative long-run impacts on economic growth and living standards
would be substantial, far outweighing any minor short-run transition costs. Much of the
programmatic detail of Congress's proposal remains undeveloped.

The only glaring

omission of the proposal is the failure to initiate social security reform, ultimately a
necessity for long-run fiscal solvency.

Leaving untouched the government's largest

spending program ignores its many inefficiencies and inequities, raises the cost-cutting
burdens on other spending programs, and only delays and raises the costs of eventual
reform.

THE FEDERAL RESERVE'S RESPONSE AND THE MONETARY-FISCAL MIX
The Fed's pursuit of its long-run objective of price stability as a foundation for
healthy sustained economic expansion requires that it maintain a neutral monetary policy
in response to any deficit reduction package. The notion that accommodative monetary
policy is a necessary complement to offset the temporary restrictive nature of the fiscal
belt-tightening is misguided and dangerous. It has potentially adverse consequences and
only confuses the current macroeconomic debate. Similarly, attempts by the Fed to lower
its funds rate target to reflect an assumed decline in the equilibrium level of real interest
rates associated with deficit reduction is also problematic and may have unintended
monetary policy consequences.
Monetary policy and fiscal policy are not substitutes for achieving the desirable
objectives of healthy, sustained economic expansion and stable prices. Fiscal policy
determines the allocation of national resources between the public and private sectors and
influences long-run potential output by altering incentives to consume, save, and invest,
but it is not capable of generating permanent shift in aggregate demand. Accommodative
monetary policy is incapable of lifting long-run productivity or output, and only generates
higher inflation that interrupts economic expansion.
Attempts to change the policy mix to achieve a desired outcome require that the
magnitude and timing of the economic responses to fiscal and monetary policies are
understood; they are not. Even the direction of the fiscal policy multipliers are in
question: standard macroeconomic models project that Congress's budget resolution
would reduce GDP in the short run, while the CBO projects a positive economic
response, although the specific posture it assumes for monetary policy is unclear.
While interest rates are likely to fall with credible fiscal reform, the magnitude
and timing of the effects on real rates and inflationary expectations are highly uncertain.
As a result, the correct adjustment of the funds rate consistent with maintaining monetary
neutrality is a high risk proposition for the Fed. Instead, relying on the monetary
aggregates to measure monetary thrust is critical.

Recent history illustrates the pitfalls of the Fed's misplaced efforts to coordinate
monetary policy with fiscal policy, its excessive reliance on funds rate targeting, and
allowing the long-run objectives of monetary policy to be sidetracked by short-term
concerns. Witness the second half of 1990, when the Fed maintained an excessively
restrictive monetary policy by pegging the funds rate too high and allowing real money
balances to decline while waiting for a fiscal compromise; this contributed to recession.
Tying monetary policy to fiscal policy is counterproductive in terms of actual outcomes
and underlines the Fed's independence and credibility.

SOFT-LANDING SUCCEEDS: MODERATE ECONOMIC GROWTH
AND IMPROVING INFLATION FUNDAMENTALS
Mickey D.LEVY
NationsBanc Capital Markets, Inc.
The economy has glided into the soft-landing policymakers desired. In response
to the monetary tightening initiated in early 1994, real economic growth decelerated
sharply in the first half of 1995, and is now stabilizing toward its long-run trendline. Real
GDP is projected to expand at a 2.0-2.5 percent rate in the second half of 1995 and
approximately 2.75 percent in 1996. The probability of recession is very low.
The inflation fundamentals continue to improve. The Federal Reserve's preemptive monetary tightening in 1994 has slowed current dollar spending growth while
businesses have boosted productivity and suppressed unit labor costs. As a result,
inflation is now peaking around 3.0 percent, and the best is yet to come: in lagged
response to the monetary restrictiveness, inflation is projected to recede toward 2.0
percent through 1997.
In contrast to recent cyclical slowdowns, the economy entered 1995 very sound
structurally, and businesses have responded quickly and efficiently to the slowdown in
product demand. As a result, the economy is adjusting toward its long-run growth path.
The trend toward moderate real growth and declining inflation provides sound
fundamentals for sustained economic expansion. The Fed's funds rate target requires
lowering to reflect these trends.
These fundamentals are positive for financial markets. Interest rates are projected
to decline further as inflationary expectations recede and lower inflation provides the Fed
room to ease. The stock market is projected to remain firm, reflecting lower interest
rates, strong productivity gains, and expected sustained economic and profits expansion.
The Fed's heightened inflation-fighting credibility supports a firming U.S. dollar.

ORCHESTRATING AN ECONOMIC SOFT-LANDING
The slowdown from robust economic growth in 1994 unfolded in very typical
cyclical fashion. In response to accelerating real and nominal GDP growth in 1994 and
the associated threat of rising inflation, the Federal Reserve tightened monetary policy,
reducing real money balances and generating a sharp flattening of the yield curve.
Similar to earlier episodes of monetary tightening, while financial markets experienced a
very bumpy adjustment, the economy did not respond immediately, leading many to
assert that financial innovations had diminished the ability of monetary policy to
influence the economy.

In late 1994, with a lag similar to historical experience,

aggregate demand weakened abruptly.
The monetary tightening had its initial impact on housing activity and durable
goods consumption, a typical cyclical pattern. By February, new home sales had fallen
19 percent from their peak; as the inventories of unsold homes mounted, new housing
starts declined, eventually falling 20 percent from their peak.

Durable goods

consumption also slumped: auto sales fell and department store sales softened. Real
consumption growth decelerated from 4.1 percent in the second half of 1994 to 2.5
percent in the first half of 1995. While residential investment fell, business fixed
investment remained strong, growing at a robust 16.6 percent pace. This helped sustain
strong import growth; at the same time, export growth slumped largely in response to the
jarring recession in Mexico, the weakening of economic growth throughout Europe and
recession in Japan. The subsequent continued to rise in the net export deficit, along with
further declines in real government purchases, subtracted from economic growth.
In recent months, aggregate demand has begun to rebound. Housing activity
troughed in Spring 1995, and sales and new housing starts have risen significantly. Retail
sales have resumed a moderate growth path, and automobile sales spurted in August.
While restrictive monetary thrust points to moderate growth in demand, the decline in
interest rates has cushioned the impact of the Fed's restrictiveness and facilitated the
adjustment of the economy toward its long-run growth path.

STRUCTURAL SOUNDNESS AND RAPID
ADJUSTMENT TO SLOWER DEMAND
The Fed's decisive monetary tightening steps to pre-empt inflation pressures were
the crucial cyclical force in slowing current dollar spending growth, but two relatively
unique factors have increased the efficiency of the adjustment to the Fed's disinflationary
monetary policy and contributed to the economic soft-landing. First, businesses were
very sound structurally as the slowdown began to unfold. Second, businesses adjusted
production and labor inputs to the slowdown in demand more rapidly than in the past.
Structural Soundness
A wide array of measures illustrates the present soundness in corporate structure
and the economy:
•Strong Productivity Growth. Increased efficiency in production, strong capital
investment, and trimming and reallocating labor inputs have generated strong gains in
productivity. In the current expansion, which began second quarter 1991, productivity
has risen 2.1 percent annually in the nonfarm business sector and 3.2 percent in
manufacturing. Moreover, many efficiencies in service-producing industries are not
captured in these aggregate productivity statistics.
•Low Unit Labor Costs. Increases in wages and nonwage compensation have
been strictly limited. In the last year, the employment cost index has increased 2.8
percent and, for the first time since 1985, non-wage compensation costs have risen more
slowly than wages. With compensation increases nearly matched by productivity gains,
ULC inflation has been zero in the last year and ULCs have declined in the
manufacturing sector. The level of ULCs in the U.S. manufacturing sector is now below
the average of other large industrialized nations, and far below those in Germany and
Japan.
•Low Inventory/Sales Ratios.

Despite the typical cyclical pattern of rapid

inventory accumulation during the strong economic growth in 1994, aggregate ratios of

inventories-to-sales have remained in long-term declining patterns and are close to
historical lows.
•Cash Rich Corporations. Boosted by a sustained rise of profits since 1991,
corporations began the slowdown flush with cash. This has provided a buffer against the
cyclical slump, as firms use internal funds to finance capital investment.
•Low Business Indebtedness. Levels of business indebtedness have remained
relatively low, as efficient financial restructuring and lower interest rates have reduced
debt service costs.
•Strong Stock Market. The rising price-earnings ratio and high stock prices have
reduced the cost of raising capital through the equity markets, providing a valuable source
of capital for business investment.
•A Sound Banking System.

The banking sector is well capitalized, highly

profitable and willing to lend. Loan delinquencies remain low. These characteristics
contrast sharply with recent economic slowdowns, particularly 1989-1990.

Efficient Adjustment to Weaker Demand
Typically, businesses adjust production slowly in response to weaker product
demand and reduce labor inputs even more gradually.

Undesired rapid inventory

building resulting from the delay subsequently requires more dramatic production
cutbacks; meanwhile, slow business adjustment contributes to accelerating unit labor
costs that reduce corporate profits and exert inflation pressures; this also leads to more
exaggerated declines in employment. These lagged responses prolong the adjustment
process and contribute to recession.
Not this time. So far in 1995, businesses have adjusted production and labor
inputs more rapidly than in past slowdown episodes.

Manufacturing industrial

production has declined in five of the last six months. Major automobile manufacturers
have pared production schedules and manufacturers of nondurable goods also have
adjusted rapidly.

Most importantly, businesses have reduced labor inputs swiftly:

employment growth has slowed sharply and aggregate hours worked have declined. So
far this year, nonfarm payrolls have grown an average 145,000 monthly, half last year's

290,000 average. Beginning in early 1995, businesses trimmed overtime hours and in the
second quarter, aggregate hours worked declined 1.4 percent annualized in the nonfarm
business sector and 7.4 percent in the manufacturing sector, the fastest decline since the
1990-1991 recession. Average aggregate hours worked in July-August are only 0.3
percent higher than their second quarter average.
While these rapid adjustments in the goods, labor and capital markets have
suppressed real economic activity and incomes—real GDP grew at a 1.9 percent
annualized rate in the first half of 1995, less than half of its second half 1994 pace, while
real disposable personal income slumped even more markedly—they are necessary
adjustments that will allow a speedier recovery in economic performance. The rebound
to long-term trend growth will also be accelerated by the rapid decline n real interest
rates.
The early cuts in production have significantly trimmed the overhang in inventory
building and helped avoid prolonged or jarring production decline. The equally rapid
trimming of payrolls and hours worked has resulted in sustained healthy productivity
gains despite the slowdown in product demand. Productivity in the nonfarm business
sector rose an astonishing 3.6 percent annualized in the first half of 1995, somewhat
faster than its 3.4 percent pace in the second half of 1994, and well above its long-term
trend. This is unique during an economic slowdown, with positive implications for
corporate profit margins, inflation and financial markets.
INFLATION; PEAKING AND HEADING DOWN
The Fed's pre-emptive monetary tightening beginning in early 1994 has shortcircuited a rise in inflation following the accommodative monetary policy in 1992-1993
and the strong economic growth in 1994. Consumer price inflation is now peaking
cyclically close to 3.0 percent, approximately half its previous cyclical peak of 6.0
percent in 1990, thereby maintaining the downward-ratcheting trend that began in 1980.
As the lagged impact of the monetary restrictiveness continues to constrain current dollar
spending growth, inflation will decline to approximately 2.5 percent in 1996 and toward

2.0 percent in 1997. Thus, the outlook of inflation is the most optimistic since the early
1960s.
The improved outlook for inflation stems primarily from the Fed's restrictive
monetary policy. Bank reserves and real Ml have been declining year-over-year since
October 1994. The monetary base—reserves plus currency—has grown somewhat faster,
but has recently decelerated, as the growth of currency has slowed. Reflecting this
restrictive monetary stance, the yield curve has been relatively flat. M2 grew slower than
inflation through February 1995, but recently has accelerated sharply, fueled by rapid
increases in small time deposits and MMDAs. This spurt has been due primarily to
portfolio adjustments as depositors seek higher yields, and does not imply any shift in the
Fed's monetary thrust. In any case, year-over-year M2 growth remains a low 2.7 percent.
This sustained monetary restrictiveness has generated a significant slowdown in
current dollar spending: nominal GDP grew 3.7 percent annualized in the first half of
1995, sharply slower than its 6.5 percent pace from fourth quarter 1993 to fourth quarter
1994. The slowdown in demand has constrained the ability of businesses to raise product
prices. While prices have increased rapidly for goods and services in strong demand—for
example, certain popular car models—such increases have been scattered and offset by
modest price increases or outright declines for most goods and services.
Nominal GDP growth is projected to bounce back but remain approximately 5.0
percent through 1996. The Congressional Budget Office (CBO) projects 3.8 percent
growth from fourth quarter 1994 to fourth quarter 1995, implying a very modest pickup
in the second half of 1995, and 5.1 percent in 1996; the Administration projects 4.7
percent and 5.5 percent, respectively. As real GDP reaccelerates toward its long-run
trendline of 2.75 percent, inflation will recede.
Business efforts to control operating costs and maintain strong productivity
growth have contributed to lower inflation. Unit labor cost increases in the nonfarm
business sector have decelerated continuously since their peak of nearly 6.0 percent in
1990 to 0.0 percent in the last year as businesses have controlled employment costs and
generated strong productivity gains. In the last year, compensation costs increased 3.6
percent while productivity in the nonfarm business sector rose 3.5 percent. Mirroring the

stability of ULCs, producer prices for finished goods excluding food and energy have
risen 2.1 percent in the last year, and the PPI for intermediate goods has decelerated in
recent months.
The international environment is also favorable for inflation. Inflation is low and
receding in every large industrialized nation except Japan, which is experiencing
deflation, and Italy, where price pressures persist. Real economic growth in most
industrialized nations is weakening. Importantly, central banks in most industrialized
nations are pursuing disinflationary monetary policies. In this context, the weak U.S.
dollar in the first half of 1995, which occurred despite the Fed's monetary restrictiveness,
has had a larger impact on relative prices than domestic inflation. In the last year, prices
of non-oil imports have risen 4.7 percent.

Expanding international trade and the

international mobility of labor have contributed to more efficient production processes
and labor allocation that exert downward pressure on wages and inflation.
The Fed's inflation-fighting credibility also contributes to lower inflation. Its preemptive monetary tightening has successfully short-circuited the typical cyclical bout of
inflation by slowing current dollar spending and forcing businesses, households and
financial markets to adjust behavior to a moderate growth, low inflation environment.
The persistently disinflationary monetary policy since then reinforces those expectations;
a steady policy lowers uncertainty and reduces the short-run output and employment costs
of achieving lower inflation.
FINANCIAL MARKET IMPLICATIONS
The economic soft-landing and improving inflation conditions are unambiguously
positive for bonds, stocks and the U.S. dollar. Interest rates have fallen with the
decelerating real economic performance and improving inflation fundamentals.

inflation recedes and the Fed's credibility mounts, rates will fail further. Although lower
inflation raises the real federal funds rate and provides more room for the Fed to ease, the
Fed is expected to lower rates only gradually.
Inflationary expectations have ratcheted downward since 1980, but they continue
to lag the actual improvement iin inflation. Although the timing is uncertain, the next

decline in inflationary expectations and bond yields likely will be triggered by evidence
that the real economy is growing along a moderate, disinflationary path. Enactment of a
credible deficit-cutting package would contribute positively to those expectations.
The moderation of economic growth, improving inflation fundamentals and
sustained productivity gains will continue to support a strong stock market. Corporate
profit and cash flow growth has slowed temporarily, but the lower interest rates have
raised the present value of expected earnings, lifting price-earning multiples. Efficiencies
in production and sustained strong productivity gains and amid economic slowdown
support long-run profit growth. Furthermore, lower inflation raises the quality of profits.
The seemingly successful soft-landing and improving inflation outlook, by raising the
probability of sustained economic expansion, increase expected long-run earnings
potential. And the outlook remains optimistic. P/Es were dramatically higher than
present levels in the mid-1960s prior to the significant upward tilt in inflation that
followed.
The improving inflation outlook and the Fed's mounting inflation-fighting
credibility are unambiguously positive for the U.S. dollar.

Unit labor costs in

manufacturing are significantly below those in Germany and Japan.

Strong U.S.

productivity gains lift expected rates of return on dollar-denominated assets. The dollar is
projected to remain firm, and would be boosted further by a credible fiscal package.

ECONOMIC AND FINANCIAL PERSPECTIVES

MICKEY D. LEVY
CHIEF ECONOMIST

NATIONSBANC CAPITAL MARKETS, INC.

SHADOW OPEN MARKET COMMITTEE
WASHINGTON, DC
SEPTEMBER

10-11,1995

Levels

QUARTERLY DATA
1 Nominal GDP
Domestic Demand
Final Sales
Domestic Final Sales
Disposable Personal Income
Consumption
Residential Investment
Business Investment
Inventory Investment
Government Purchases
Exports
Imports
Current Account
L.!?DP..Deflator _
_
„

™

Quarterly % Change (annualized)
|
YNP-YT% Change
|[
1995
1994
1994
1994
• 1995
1995
I C&94
Q3-94
Q4-94
Q1-95
C&95
J Q3-94 Q4^94 Q1^95 Q2-95
04-94
01^95
Q2-95
11
6977.4
7024.9 I
1 6791.7
£5~"
-23TT
6897.2
Ks~
53
£2~
—sin
5.1
4.0
5470.1
5367.0
4.1
4.0
4.4
1.1
2.7
5485.2
5433.8
3.2
1.7
4.4
5612.0
5588.6
4.5
3.4
4.9
3.5
5540.9
5484.0
4.2
4.2
2.5
5452.5
5419.0
3.4
3.5
3.8
3.6
5.7
2.6
4.3
5384.4
5310.0
3.1
4.8
3.4
5579.3
5426.9
3.8
3.7
4.0
4.1
4.6
5491.5
5537.5
-1.1
3939.1
4.4
4.5
3.6
7.5
4.1
3.1
3.3
3911.0
3950.5
3840.9
3674.3
3643.9
3.5
2.8
3.4
5.1
1.6
3.1
3629.6
3584.7
3.3
3.2
9.1
-13.2
2.3
-3.4
-6.0
221.5
229.5
3.1
-0.2
-5.3
231.5
230.2
11.8
12.9
13.7
17.6
14.1
764.7
15.5
21.5
743.6
680.0
16.2
708.2
N/A
N/A
N/A
N/A
32.7
51.1
N/A
N/A
N/A
N/A
49.4
57.1
-0.8
918.7
0.1
0.0
-4.1
-1.0
-0.7
6.7
920.5
932.0
0.2
922.2
6.1
11.6
14.0
12.0
20.2
4.8
14.8
716.8
11.3
697.9
706.2
666.5
9.5
11.4
10.1
843.6
13.8
14.0
11.6
15.0
15.6
824.6
805.0
783.5
-8.8
-5.6
-4.6
-3.6
4.3
-43.6
-12.7
-1.7
-39.0
-12.1
-43.3
-39.7
(cj
2.3
1.7
2.3
1.6
2.1
2.2
1.9
128.1
127.6
126.9
126.5
1
_1.3_
2:3"" "... . 2 _ | * 373"
125.2""
3.3"""
2.9
" 2.81
123:6 " _ _ _
|228 ~
_ .
-1.1
-0.3
138.8
139.2
1.4
1.0
0.0
0.8
1.4
0.0
138.7
138.8
120.7 |
119.3
1.8
2.0
3.5
1.7
4.8
4.5
2.4
2.4
118.6
117.3
167.5
166.1
3.2
3.0
3.5
2.6
3.4
3.7
4.2
2.7
164.4
162.9
14.1
355.8
17.1
10.7
350.7
8.9
1.5
2.5
3.8
2.5
337.9
329.5
(aj
-0.8
364.7
349.8
0.7
7.9
5.8
7.4
4.3
1.5
0.8
344.7
347.4
(a)
625.8
616.9
(aj
6.3
7.8
7.5 I
9.5
1.4 I
1.6
2.7
1.6
600.9
591.7
12 Month % Change
l
Monthly % Change
I
Levels

~n—

GDP

Unit Labor Costs (Non-Farm)
Productivity (Non-Farm)
Compensation (Non-Farm)
Corporate Profits A/T
Operating Profits A/T
1 Net Cash Flow

—&r~

MONTHLY DATA

MayffiP" JufrSS" 7uT-95
1 Purchasing Managers Index
Non-Farm Payrolls
(b)
Manufacturing Payrolls
(b)
Unemployment Rate
(c)
Average Workweek (sa)
Avg. Hourly Earnings (sa)
Total Vehicle Sales, incl. Lt. Trucks
Domestic Unit Auto Sales
Industrial Production
Capacity Utilization

PPI
PPI Ex. Food & Energy

CPI
CPI Ex. Food & Energy
Retail Sales
Housing Starts
Permits
Federal Budget Surplus/Deficit (d)
Durable Goods Orders
Manufacturing Orders
Personal Income ($)
Consumption ($87)
Personal Saving Rate
(c)
Leading Economic Indicators
Total Business Inventories
Inventory/Total Sales
(c)
International Trade
(c
3 Month Bill
'"'—(cj
2 Year Note
(c)
10 Year Note
(c)
30 Year Bond
(c)
DJIA
S&P500
U.S. Dollar (FRB)
Yen/$
DM/$

M1
M2

45T"
116.547
18.428
18.456
5.6
5.7
34.2
34.4
11.37
11.43
14.5
14.7
7.0
7.1
121.1
121.2
83.6
83.9
127.8
127.9
139.9
139.6
152.3
152.5
161.3
161.0
196.7
195.1
1293
1282
1275
1243
12.8
-39.6
159.5
159.0
296.8
297.0
5990.5
6018.9
3681.1
3697.1
3.9
4.0
101.0
101.2
956.5
960.5
1.41
1.41
-11.0
-11.3
"""'5.67
5.47"
6.17
5.72
6.63
6.17
6.57
6.95
4510.8
4391.6
539.35
523.81
82.3
82.7
85
85
1.40
1.41
1143.8
1142.9
3695.7
3659.9
57352
57761
868.3
862.2
970.7
959.6

—wr~
116.248

Bank reserves
C&l Loans & Non-Financial CP
I
|| Consumer Credit
(a) Quarterly % changes are not annualized
(b) Monthly changes are in levels
(c) All changes are in levels or basis points
(d) Monthly: change from same month last year;

http://fraser.stlouisfed.org/
Mickey D. Levy, Chief Financial Economist
Federal Reserve
Bank of St. Louis

AUg-95

5CT5
116.553
18.340

Ma"y*95 "Jun-95

*£9^ — T T 3 ~

116.802
18.352

-62
-50

299
-28

5.7

5.6
34.4
11.47

-0.1
-1.2
-0.3

-0.1

34.6
11.49
13.7

NA
8.1
NA
NA

6.7
121.3
83.4
127.8
140.2
152.8
161.7
196.5
1380
1355
-13.6
155.6
292.9
6058.2
3698.6

127.7
140.3

NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
NA !
NA !
NA
NA
NA

NA
101.0

NA
NA
NA

__
5.78
6.28
6.72
4684.8
557.37
81.9

~54o
5.98
6.49
6.86
4639.3
559.11
84.6

1.39
1144.9
3714.6
57655

1.45

NA
979.6

NA
NA
NA
NA
NA I

5.3
6.8
0.0
-0.2

0.0
0.3
0.3
0.2
1.1
1.0
0.0
-7.5

2.5
1.4
-0.2

1.0
-0.4
-0.2

0.4

0.6
0.5
1.1
-1.3
-0.1
-0.4
-0.1

0.2
0.1
0.2
0.8
0.9
2.6

Jul 195 ~Tu~o>95 ] MayffiT^
-7.1 I
-19.8
~1U3
2.30
249
6
1.09
12
-88
-0.1
-0.4
0.1
-0.6
-1.4
0.6
-0.2
2.6
0.5
-0.7
-6.5
NA
20.7
-0.5
-4.7

0.2
-0.2

0.0
0.2
0.2
0.2
-0.1

6.7
6.3

-2.0
-0.3
-0.1

19.6
-2.1
-1.3

0.5
0.4

0.7
0.0
NA

-0.1

0.2
0.4

-0.2

NA
NA

0.4

0.00
-0.3

" 0J02

"""-bT2b

-0.40
-0.43
-0.41

-0.45
-0.46
-0.38

0.06
0.11
0.15

3.8
3.1
1.1
1.7
2.1

2.7
3.0

3.9
3.3

-0.6
-0.6
-0.6

-0.4

0.4

0.1
1.0

-0.3

-0.7

0.6

0.7
1.2

0.1
0.5
0.5
NA
0.9

-0.01

-0.6

1.4

_ NA
_

3.3
-0.9

NA
NA
-0.1
0.1 '

NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
"-6^02"
0.20
0.21
0.14
-1.0

0.3 j
3.3
8.4
4.1
NA
NA
NA
NA
NA I

I
-21.9
2.29
0.72
-0.5
-0.9

-13.4

3.1
1.7
1.1
2.6

3.2
0.0
2.8
2.6

-0.6

-0.8

2.1
2.0
3.0
2.9
6.3

1.8
2.1
2.9
3.0
6.2

-13.9
-9.7
-175.0

-5.6
-5.6
-177.0

-4.2

6.8
7.1
5.7
3.5

5.2
6.1
6.1
3.6

-0.1
-0.5

-0.3
-0.5

8.6

8.5

0.01
-1.9

0.02
-2.4

TBI

"iir

3.2
0.1
2.2
2.0
3.2
3.1
6.5

0.20
-0.55
-0.46
18.4
16.2
-10.8
-18.0
-14.9
-0.1

-0.21
-0.93
-0.83
20.7
18.6
-10.2
-17.4
-13.9
-0.3

2.09
0.24
-0.4
-0.3

0.6
-157.4

7.1
6.8
6.2
3.7
NA
-0.7

NA
NA
NA
"1.69 "
-0.35
-1.02
-0.86
26.0
23.5
-8.0
-11.2
-11.4
-0.6

1.4

2.5

2.7

-3.9
13.3

-4.4
12.9
15.2

-4.1

15.3

NA
15.3

-18.4
2.00
0.03
-0.4
-0.6

3.0
NA
8.1
NA
NA
1.3
2.0
NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
~0.'9'2""
-0.20
-0.75
-0.63
22.2
20.4
-5.2
-5.2
-7.6

NA
NA
NA
NA
NA I

09/13/95
Annual: sum of past 12 months

64
Peter E. Kretzmer, Economist

Chart 1
MONETARY THRUST AND DOMESTIC PRODUCT
Real M1
(yr/yr % change)

i i i » i i I i i i i i i i i i i i » i i i i i i i i *

68 70 72 74 76 78 80 82 84 86 88 90 92 94

Spread of 10-YrT-Bond minus Federal Funds Rate
400-

200

-200-1

-400-J

-600

-800
68 70 72 74 76 78 80 82 84 86 88 90 92 94

Real Gross Domestic Product
(yr/yr % change)

68 70 72 74 76 78 80 82 84

i i i i i i

88 90 92 94

i '

09/06/95

Chart 2
Aggregate Demand Slows...and then Rebounds Modestly
Retail Sales

1800
§ 1600
o

: Hoo

60%

ang*

Housing Starts
3%

40% O
d^
20% k.

CO
CD

rr
i
i 1200

i
k.

-20%

2%
c
a>

a
CL

i l
CO

1000

-1%

-40% >-

i.l.-lil M iiii-i i ii

-2%

I I H l i l l l l . l t

—Housing Starts, Total (SAAR, Thous)

New 1-Family Homes Sold

800

20%

700

600

-20% >

500

-40%

year % Cha

40%

».:,

g 15
o
14

oi i

1 I

Unit Auto Sales
<B
O)
c

900

• Total Retail Sales, Mth/Mth % Change

—Year-over-year % Change

A ; ^\

20%

Ar\
\\k
MOT MT-A v\
V
\[ h

A".

13 h

12 L i

1 1 1 — 1

i • i i t t t i i i i

— New 1-Family Homes Sold (SAAR, Thous)
—Year-over-year % Change

30%

10%
0%
-10%
-20%

• Unit Auto Sales, SAAR, Mil—Year-over-year % Change

Real Consumption

Imports
5.0%

4.5%

_ 4.0%
c

I 3.5%
CD

°" 3.0%
2.5%
— Imports: Goods & Services (BOP Basis)
—Year-over-year % Change

v * 1
V
\J

1 1 i i i i i i i i i i i

2.0% 93

i i i i i i i 1.1

i... 1

i i i i i i i i J

— Personal Consumption Expenditures, Yr/Yr % Change

RONDTBLE.WK4

NationsBanc Capital Markets, Inc.

09/06/95

Chart 3
Inventories Correct as Business investment Begins to Slow
Change in Business Inventories
100
80

&> 60
r^
00
40
W
c
o

...II..I
llllill'll
1
If T

m
-20
-40

-J

L_J

I I

I..

• • Change in Business Inventories (Bil, 87$)

Business Investment in Producer Durable Goods
700
«* 600

J—l

i/
1/

® 300
1—i

1
i . i . i

n .1,,.

200

—v

500

m 400

—^^

K /

i t ,

i—i

10 £
co

^Kl

r \

;

CO
JE

<© ,

-10 o

i . i

—i—i

, i

;

-20 £

Nonresidential Fixed Investment, Producer Durable Equipment, (Bil, 87$)
— Year-over-year % Change

Business investment in Structures
220
!

5 200
W

c
o

= 180

5 160

I /

/-n

^ y

1 J\

;

140

1 1 1 1 1 1 U-J

I—i—i—i—i—i—i—i—i—i—i—i— 1

•

I , , , 1 . • • —i
89
90
91

L_I

i„, »

i,, i„ , i

o
Urn

l
I

I jj

« i «

-10 &
-20 l l
CO
<D

— Nonresidential Fixed Investment, Structures, (Bil, 87$)— Year-over-year % Change
RON0TBLEWK4

NationsBanc Capital Markets, Inc.

09/08/95

Chart 4
Production and Labor Adjust Rapidly
Industrial Production

Employment
600
co 400
tuu
TJ

•

1
I I I !

—I
' I

i "roliitiiW
-200

11.1

•

124
122
120
§ 118
J3 116
114
112
110

•

7 7

r ^ !\ "

ti \
[|

i i i i » t i i i i i 1 i » i i i > i i i i i

1 1 1

I,I

—Year/Year % Change

Capacity Utilization

Aggregate Hours Worked

_ 4%
c
2 3%
a
°- oo/
2%

^W w

/"v

A^ A
\
^

1 V '

./\A

i t i

• Manufacturing Payroll Employment, Mth/Mth Change

— Industrial Production: Total Index

wV^w^

• Non-Farm Payroll Employment. Mth/Mth Change

—Weekly Hours Index, Private Nonfarm, Yr/Yr % Change

NAPM

Labor Productivity-Nonfarm Business
65

4.0%

C
CO
JZ

3.0%

CO
CD

>»
u.
CD

>
o

2.0%

li
CO
CD

1.0%

— NAPM: Composite Index

RONDTBLE.WK4

NationsBanc Capital Markets, Inc.

09/06/95

Chart 5
While Income and Profits Begin to Moderate
Personal Income
CD

10%

c
CO
sz

t
CO
CD

6%
4%

>
2
CO
CD

2%
0%
93

94
—

Personal Income, (Bil $)

Real Disposable Personal Income
4000
3900 h

3700 h
3600

-4%
93
—

94
Real Disposable Personal Income (Bil 87$)

95
—

Year-over-year % Change

Corporate Profits
380
360
340
§ 320
300

260

40%

«-

B—3^=
94

o
en
c

30% O
5?
20%
10%
0%

—

Corporate Profits after tax with IVA & CCADJ (SAAR, Bil 87$)

—

Year-over-year % Change

J.
$•
o
CO
CD

RONDTBLE.WK4

NationsBanc Capital Markets, Inc.

09/06/95

Chart 6
Current Dollar Spending Continues to Slow, Squeezing Inflation
Nominal GDP
20.0
Oi

OJ
SZ

15.0

O
to
<D

d
>-

10.0

5.0
0.0
75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95

Real GDP
10.0
i
c
CO

4.0

i i \ AJAA

2.0

o
%L

0.0

6.0

a>
>»
J.

i 1

/ 1\

i /' \ '

;

•

8.0

=1 /

-2.0
-4.0

1 L_l i

•i / /

\ _-/

M ^ \/

Vl/

\ i

! 1 !
i

V/i \i /I

^^^L

\
|

T\
NS

\
!

1 1 1 1 1 1 , . X 1 .L...1 ..!_!_ 1..1..1 J_.1_L_1.-L 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 I 1 1 1 1 1 1 1 I

1
1 1 1 1 1 1 1

75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95

Fraction of Nominal GDP growth that is Inflation
2.5

;

: :

2.0

;

1.0

0.0

< \i

i A

i
:

i ;
1| !'
!
i

• A! / \
v-^^^^^^^^**^

I
I

' '• I \

0.5

1.5
CO

.
i i i.i_i

i i.i

•

;

i i i • i i i i i i i i i t i i i i

M M
i

i ! •
•V

• ^^^V^^^-—^\_

i,„s,T....[.i
i i i i i i

i i i i i i i i t i i i i i i i i i i i i i

M
I M
I
i
i

: /\M

^^^^

i\__L

;. I.I T "
i i i i » i i i i

» i

i i i i

i i i

1 1 1 1 1 1 1

t i i i

75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95
RONDTBLE.WK4

NationsBanc Capital Markets, Inc.

09/08/95

Chart 7
Optimism on inflation: Low and Going Lower
Consumer & Producer Price Indexes

Compensation & Productivity
8.0%

CD
O)

r\w\J\

O
$S 4

6.0%

CO
JO

\ \

O
4.0%

/^^A

hf\

>
2

is o
i
1
u u u u i i U.IH 11 lunnniitiiiiiiiiiuj—

1 111 Ml i »IIII111111111II U 111II U l l l l l l l l l l l l l

-2

2.0%

0.0%

-2.0%
89

- Nonfarm Business Sector Output Per Hour of All Persons (SA)
• Nonfarm Business Sector Compensation Per Hour (SA)

- CPI-U, All items (SA) - PPI-U, All Items, (SA)

Unit Labor Costs

Import Price Index
8%

10%
0}
O)

8 o% !A/f
>$
2 -5% I '
1

_7-f *

jS 6%
o
#

\w
I

g 4%

i
1

-10%

•: i

1 Li.i 11 I M H H III II II 11 l_l_l 11_1» l i m i i U U l L I J l i l i t l l l l l l l l l l l l l l l l l l l l l l l l l

0%
89

— Import Price Index: All Imports (Yr/Yr)

40
CD

CO
£L

>$
?

;

•

/ r\

• i

i Jb>*tt ^ .

•I ' i
I

\ 1

>^L

A'
I

!
94

11II i n i n i l l i n i n n m i m i u i i n i i m i

n i n i i i i i i i im i i i i i i i m i i i i m i u i i i UiXII I I I I I I I I I I U I I I I I I I I I I I I I I I l l

i 1

A/A.

7^^ A i ^

100

NAPM: Survey of Prices

-10
-20

Commodity Prices

CO
CD

— Unit Labor Costs: Nonfarm Business

i
• \

— Import Price Index: Non Petroleum (Yr/Yr)

CO
CD

I I I II I I I I I I I I I I I H I I I I

• CRB FPI: Industrial Materials
— CRB Spot Commodity Market Index: Raw Industrials

— NAPM Survey-Diffusion Index, Prices, SA, (%)

MTGPAOCWK4

NationsBanc Capital Markets, inc.

09/08/95

Chart 8
Selected Interest Rates and Yield Spreads

30 Year Treasury Bond

- » . 5 Year Treasury Note

91
—

2 Year Treasury Note

30 Year Treasury Bond minus 2 Year Treasury Note

30 Year Treasury Bond minus 5 Year Treasury Note

-*— 5 Year Treasury Note minus 2 Year Treasury Note

I
<P

2 Year Treasury Note minus Federal Funds Rate

NationsBanc Capital Markets, Inc.

09/07/95

Chart 9
Money and Credit Market Conditions
Broad Money: M2

Narrow Money: M1
<D

5
O 15

xv
1

Q.
0)

o>
c

8
i

i ! v-

>" -5

\~r

•
i

! \r

1
1 i l i u m I I I i n n i in i n n n u n i n m m in m in
I i n m i m i n u n iii] i m i i i i i i n i i i —

/ \

(0
<D

j\y~

a- 4

>• 0

* \\

^ N r-J* \ ' J

l—i i i i i i n i i n i n n i i n i i i i n m i t i i n i i i i i i i n i i i m i i m i i i i i i i m . m i i i i i i i i i i i . L i ± 1

- M o n e y Stock, M2 (SA, Bil$)

- M o n e y Stock, M1 (SA, Bil$)

C & I Loans

Adjusted Reserves
o 15

o>
c
(0

O 10
c 5

i
I

<D
Q.

is
89

'
t

1 -5

/">*•'\

i
a>
>" -10 1 m m m n n i m m i m
89
90
91

l i i n i i i m i i i i i i i M i n u I_LL i m i i i i i i i i i u n i i i jLJ

. ... .
y

—^
"

\'
!

V^^

! 1/
,

i
t

Government Securities

1 A

Consumer Loans

— Bank Credit Ail Commercial Banks (SA, Bil$)

f^
/

— Depository Institutions (SA, Mil$)

o»
C
(0
SI

i l l /

a>
>

i
!

i i n m i i i i i i i i.i a 111111111 in 11 n 111111111i1i1i i i i i m

— Bank Credit, All Commercial Banks (SA, Bil$)

— Bank Credit, All Commercial Banks (SA, Bil$)
MONEY.WK4

NationsBanc Capital Markets, Inc.

Table 1
Federal Reserve Objectives and Monetary Policy
I.

Federal Reserve Objectives and Actual Performance
Selected Economic Variables, Percent Change

Real GDP
CPI Inflation
Nominal GDP
Unemployment Rate (4th Qtr)

Central Tendency Forecast*
Q4:94 - Q4:95
Q4;95 - Q 4 : 9 6
2.25% to 2.75%
1.5% to 2.0%
3.125% to 3.375% 2.875% to 3.25%
4.75% to 5.375%
4.25% to 4.75%
5.75% to 6.125% 5.75% to 6.125%

Actual Performance
Year/Year Latest Qtr.
3.2%
1.1%
2.9%
3.4%
5.0%
2.8%
na
5.7%

<1
4^

The Fed's Money Targets and Actual Trends
Money Supply Targets*
Q4:94 - Q4:95
Not Targeted
Bank Reserves
Not Targeted
Ml
1 % to 5%
M2
2% to 6%
M3
3% to 7%
Debt

^Source:

Annualized % Change
Last 3 Months
Last 6 Months
Yr/Yr
-2.1
-4.9
-4.1
-1.6
-0.7
-0.6
8.0
4.8
2.7
10.3
7.7
5.0
5.8
6.0
5.4

n, 7 995 Monetary Policy Objectives. July 1995.

09/08/95

Chart 10
Federal Budget Trends

Federal Spending and Tax Receipts
(Percent of GDP, Fiscal Year)

1962

1964

1966 1968 1970

1972 1974 1976 1978 1980
—

Revenues

—

1982

1984 1986 1988 1990

1992 1994

Outlays

Fiscal Year 1995 Estimates

Federal Budget Deficit
(Sum of Past 12 Months)
-100

-150

k. i

•5 -200

1 -250
-300

M
1,

i/ ^ "^ns
i

I I JA.H.JA.A.AJ..I

1
I

-350

AA 1
\ '

V *

! IY

U l l l l

i VvK\ '

;

Publicly-Held Debt-to-GDP Ratio
70%
60%
50%
40%
30%
20%
52

SOMC.WK4

NationsBanc Capital Markets, Inc.

09/08/95

Chart 11
Government Purchases and Tax Receipts Net of Transfers

Total Government
24%

1 2

•

t i i i i i i i i ii t it ii i i i i i i i i i i i i i i i i I i i i ii i i i i i i i i i i I i i i ii n i i i i ii ii I i i i i i t i I i i i i i i i I i i m

— Total Government Purchases (Federal and State & Local)

i i I m

i i ii I i i i n i ii i m

i i i i

— Total Tax Receipts Net of Transfers

Federal Government

0 %

i
i
.
i i i i i i i i i n i n n i i i i i i i i I i i i i i n I i i i m i

— Federal Purchases

i
i i i i i m

i
!
;
i i i i i i i n i i i II n i II i i i i i I i i

I
1 I i t i i I1 I i i it i i i I i i i i i n i i

— Federal Tax Receipts Net of Transfers

SOMC.WK4

NatlonsBanc Capital Markets, Inc.

Table 2
Initiatives to Balance the Budget:
Congress's Budget Resolution and the President's July Budget
Cumulative Savings
1996-1002
President's July Budget
Reestimated by CBO
Discretionary Spending •
Mandatory Spending
Medicare
Medicaid
Other
Subtotal

Congress's Budget
Resolution

-208

-440

-124
-54
-211

-270
-182
=1Z5
-626

-1

-25

-54

-181

-399

-1.248

na
na

245
-1,003

=22

Revenues
Corporate Subsidies
I Debt Service
Total Changes
Memorandum
Contingent tax cut
Savings with contingent tax cut

Sources: Congressional Budget Office; 'Mid-Session Review of the 1996 Budget9
Savings are measured from CBO* baseline that assume discretionary spending is equal to the limits that are in effect
through 1998 and equal to the 1998 limit adjusted for inflation after that

Comparison of Projected Deficits (By fiscal year)
Billions of Dollars
600

450 CBO's April Baseline
400?
350 «300 i-

CBO's August Baseline

250-

..**"

200 t
Budget Resolution
Without Tax Cut or
Fiscal Dividend

150*
100 r

.
CBO's Illustrative
. Deficit Reduction Path
Of-

.50'
1995

SOURCE:

1997

1999

2001

Congressional Budget Office.

President's July
Budget as
Estimated by CBO

2003

2005

THE DOLLAR
William POOLE*
Brown University
...[Tjhese conclusions suggest that not only many short-run
exchange rate movements, but also some of the medium-term
swings, simply are not susceptible to explanation in terms of
available models. In addition to displaying inexplicable, temporary
day-to-day movements, the exchange rate may become
substantially "misaligned" over longer periods...through
cumulative changes that are difficult to explain either
quantitatively or qualitatively in terms of fundamentals. (Maurice
Obstfeld, "International Currency Experience: New Lessons and
Lessons Relearned," Brookings Papers Economic Activity,
1995:1, p. 138)
The dollar has seen its downs and ups this year. (See figure at the end of this
document). Using the Fed's trade-weighted index, the dollar's daily high in December of
last year was 90.10 (23 December). The index fell to 80.73 on 8 May of this year, and
was back to 86.30 by 17 August. Most of the recovery came in August, as the dollar
opened the month at 81.60. Do we know what is driving these fluctuations?
No. As indicated by the Obstfeld passage, economists have tied numerous
statistical approaches in an effort to link the exchange rate to economic fundamentals of
monetary and fiscal policy, productivity growth, real interest rates, and so forth. The
bottom line today is that there is no confirmed knowledge showing that the fundamentals
are responsible for short-run fluctuations in exchange rates. The modeling problem is
extremely difficult because there are many reasonable formulations of the fundamentals,
because many countries are involved, and expectations about fundamentals are obviously
important but often mistaken (inevitably so). Obstfeld's exhaustive survey (almost nine
pages of references) cited above makes clear just how risky are claims that we know what
is driving short run fluctuations in exchange rates.

IS THE U.S. BUDGET DEFICIT TO BLAME?
Still, economists and others enjoy spinning out explanations for exchange-rate
fluctuations, and the most frequently heard arguments concern the U.S. budget deficit.
One argument for the decline in the dollar in the first half of this year is that the new
Republican Congress made significant and credible progress toward deficit reduction.
Another argument is that the Congress has failed to make significant and credible
progress toward deficit reduction. Let's review these arguments.
The first argument is usually based on the national accounts identity.
CDP = C + I +G + (X-M)
Total GDP equals domestic consumption, C, plus domestic investment, I, plus
government purchases, G, plus net export, which is the difference between exports, X,
and imports, M. Rearranging terms, and subtracting taxes net of transfers, T, from both
sides of the equation, we obtain
GDP-C-T = I + G-T + (X-M),or
(GDP - C - T) + (T - G) = I + (X - M).
Given that GDP is total output, and that C is the part consumed and T the part taxed
away, the first term in parentheses is private saving. The second term is government
saving, which is negative when the government runs a budget deficit. If the government
reduces its deficit and private saving stays the same, then total national saving rises. The
increase in national saving must show up in some combination of higher domestic
investment, I, and higher net exports, X - M. The conventional argument is that if the
budget deficit falls, then to maintain full-employment GDP the Fed must permit some
combination of a lower interest rate to obtain more I and a lower dollar to obtain more X M. (Other things equal, a lower dollar stimulates exports and reduces imports.)

What can go wrong with this argument? For one thing, the government must
reduce the budget deficit without reducing private saving by as much. Deficit reduction
must reduce the sum of private and government consumption if total national saving is to
rise. In fact, almost any outcome is possible depending on how the budget deficit is
reduced. For example, cuts in government spending accompanied by tax cuts stimulating
investment could raise national saving but the incentive effects of tax cuts could so
stimulate domestic investment and net exports would fall. The mechanism behind this
result is that the higher return on U.S. investment attracts foreign capital, strengthens the
dollar, and reduces net exports.
The main problem with the argument, as applied to this year, is that nothing has
yet happened to change the budget deficit. Therefore, the argument must depend on
expectations that the budget deficit will be cut in the future. Expectations of a weaker
dollar in the future depress the dollar today. With lags in the system, no changes in
domestic investment or net exports need show up in the short run. However, it seems
unlikely that expectations of a lower dollar in the future could be held with much
confidence given that deficit reduction is uncertain and the details of how the deficit
might be reduced—details that are critical in determining the direction of effect on the
exchange rate—are even more uncertain.
We have also heard exactly the opposite argument. There were, the argument
goes, great expectations of deficit reduction after the November election. However,
Congress has failed to pass any significant legislation so far, and defeated the balancedbudget amendment to the Constitution. This lack of progress has created pessimism
about controlling the budget deficit and rising concern about the U.S. economy in the
long run. The result has been a weaker dollar. Or so the argument goes. This argument
is highly suspect for the same reasons the previous argument is.
Given the failure of econometric studies to show the relative importance of
various fundamental conditions in determining short-run fluctuations in exchange rates,
are economists doomed forever to engage in unsubstantiated speculation about what is
going on? Perhaps.

WHAT DOES THE MARKET THINK IS GOING ON?
Financial commentators spin out as many explanations as economists do, and then
add some more that economists dismiss out of hand. But the traders and portfolio
managers actually making the bets and taking the risk clearly respond to current news.
Over the period from January 1994 through August 1995, the standard deviation of the
daily change in the trade-weighted dollar index was 0.50 percent. I dug out the microfilm
of the Wall Street Journal for the period when the dollar was falling most significantly—
December 1994 through June 1995—and examined what was being reported just after the
days when the dollar index changed either up or down by 0.50 percent or more. The table
at the end of this memo shows what I found. The table reports the percentage change in
the trade-weighted index (TWD) and in the yield on the 30-year government bond. Note
that the bond-yield data are percentage changes in the yield and not percentage point
changes.
In no case did any news about the budget deficit appear responsible for the
changes in the exchange rate I studied, where I mean by "news" congressional action,
new data on the deficit, and so forth. From time to time the Wall Street Journal might
report that some government official expressed worry about the budget deficit, but such
expressions appear constantly and are not "news" in the sense of providing genuine
information to the market.
The news that seemed to move the market most during this period falls into three
categories. The Mexican situation was clearly important; the dollar fell as news of new
Mexican problems hit the market, and as the congressional debate on the Mexican bailout
proceeded. Mexican news seemed important on 29-Dec-94, 09-Jan-95, 12-Jan-95, 30Jan-95, 31-Jan-95, 16-Feb-95, 06-Mar-95, and 15-Mar-95. With the exception of 31-Jan95, these are all dates when the dollar declined. The rise in the dollar on 31-Jan-95
strengthens the case for the Mexican explanation, for on this date it appeared that
uncertainties over U.S. policy toward the Mexican bailout would be resolved.
The second-most important determinant of dollarfluctuationsseemed to be policy
actions (or expectations about them) in Europe and, to a lesser extent, in Japan.
Developments in Europe and Japan (including the U.S. auto-trade dispute with Japan)

seemed important on 16-Feb-95, 06-Mar-95, 07-Mar-95, 20-Mar-95, 30-Mar-95, 13-Apr95, 08-May-95, 10-May-95, 18-May-95, 06-Jun-95, 07-Jun-95, 28-Jun-95, and 29-Jun95. Through 13-Apr-95, most of these exchange-rate changes were negative. Third,
news of the slowing U.S. economy affected the dollar. From 23-Dec 94 to 08-May-95,
the long bond fell by 83 basis points, mostly in response to news of a weaker economy.
Central-bank intervention in the foreign-exchange market was the news on several
occasions. This intervention—designed to strengthen the dollar during this period of
dollar weakness—seemed sometimes successful and sometimes not. For example, on 03Mar-95, the weak dollar prompted intervention, but the failure of intervention to check
the dollar's fall may have contributed to an even larger drop in the dollar than would have
otherwise occurred. On 31-May-95, however, intervention seemed to "work."
Central-bank intervention is more politics than economics. The Fed typically
characterizes its intervention in the foreign-exchange market as "buying dollars" or
"selling dollars." The Fed describes domestic open-market operations, however, as
buying or selling government securities. Symmetry and clarity call for the Fed's openmarket operations in foreign exchange to be labeled "sales of foreign exchange" or
"purchases of foreign exchange." The Fed creates or destroys dollars—it does not sell or
buy them.
Beyond this list of events that seemed to move the dollar, another indication that
expectations of a lower budget deficit played no role in the dollar's decline this year is
that the correlation between exchange-rate changes and interest-rate changes was negative
instead of positive. The usual story is that a lower budget deficit should reduce domestic
interest rates and the dollar together. In fact, between the local peak 23-Dec-94 and local
trough 8-May-95 the correlation between changes in the dollar and in the bond yield is
-0.364, although the correlation between levels is of course positive (0.349) as the
exchange rate and the interest rate both trended lower over this period.
In sum, the most plausible story about the dollar in the first half of this year is that
it fell because several individually small shocks all worked in the same direction. The
Mexican problem, the strong DM against most currencies, the U.S.-Japan trade squabble,
and the weakening U.S. economy accompanied by falling U.S. interest rates were the

main factors. In no cases were comments or actions relating to the budget by the
President or by congressional leaders cited in the Wall Street Journal as reasons for dollar
fluctuations.
The events that moved the dollar down would seem to be relatively insignificant
and transitory. Why they should have had such an impact on the dollar is unclear, and the
lack of logic for such an impact casts some doubt on my analysis. Still, for those who
trust the market, evidence on what moves the market should not be dismissed.

NOTES

*I thank Data Resources, Inc. for providing access to its data bank, from which I
drew the exchange rate and bond yield data used in this memorandum.

Trade-Weighted Index

CD
CD
CJ1

—A.

C
CQ

CO
CD

Q.
CD
X

CD
Q.

i—*-

CD
(D

0)
Q.
*> CD

p H

D 03

o D
ily

Table
Large Changes in Trade-Weighted Dollar Index, December 1994 - June 1995
Percentage Changes
30-Year
Bond
TWD
Date
Yield
29-Dec-94 -1.04
0.26

06-Jan-95

0.54

-0.51

09-Jan-95

-0.75

0.38

12-Jan-95

-0.51

0.38

20-Jan-95

-0.50

1.02

30-Jan-95

-0.59

0.13

31-Jan-95

0.95

-0.65

16-Feb-95

-0.93

-0.13

03-Mar-95
06-Mar-95
07-Mar-95

-1.22
-1.66
-1.24

0.80
0.40
0.66

08-Mar-95

0.91

-1.05

10-Mar-95
15-Mar-95

1.18
-1.33

-0.93
0.14

16-Mar-95

0.78

-0.41

20-Mar-95
27-Mar-95
28-Mar-95
30-Mar-95
3l-Mar-95
10-Apr-95
13-Apr-95

0.51
-0.78
-0.52
1.20
-1.88
0.90
-0.90

0.41
-0.68
1.09
0.40
0.13
0.00
-0.27

17-Apr-95
20-Apr-95

-1.30
1.35
-0.73

0.68
-0.27
0.14

25-Apr-95

News
(WSJ, 29 Dec. 94, p. CIO) rumors of dollar selling by Latin Am. cen banks;
WSJ, 30 Dec. 94, p. CIO) dollar decline was in early afternoon Wed. (i.e. 28
Dec.)
(WSJ, 9 Jan. 95, p. A2, CI5) strong employ report; dollar strength linked to
strong employ report.
(WSJ, 10 Jan.95, p. A2, C20) Fed intervention to support Mexican peso; DM
strong against almost all currencies.
(WSJ, 13 Jan. 95, p. A3, C6) plan for expanded financial support for Mexico;
mark and yen as havens given Mexican problems
(WSJ, 23 Jan. 95, p. CI, CI5) stronger than expected Dec. housing starts;
concern over all N. Am. currencies
(WSJ, 31 Jan. 95, p. Al, C6) peso plunges nearly 10 percent, concern that
bailout package might not pass Congress; dollar drops on fears over Mexico
(WSJ, 1 Feb. 95, p. A1, CI6) Clinton abandons Mexican rescue plan requiring
Congressional approval and instead relies on plan not requiring approval;
Clinton plan ignites rallies in Mexican stock market and in peso and dollar
(WSJ, 17 Feb. 95, p. A6, CIO) peso weak, concerns over Mexican corp bond
defaults; DM strong against most currencies
(WSJ, 6 Mar. 95, p. CI) dollar weak, futile cen bank intervention
(WSJ, 7 Mar. 95, p. CI) peso weak; European currency turmoil, flight to DM
(WSJ, 8 Mar. 95, p. Al) most currencies down against DM, gold up, (WSJ, 8
Mar. 95, p.) no particular news
(WSJ, 9 Mar. 95, p. A3) "Fed Chairman Blames Deficit for Dollar's Fall"; no
particular news — technical dollar recovery
(WSJ, 13 Mar. 95, p. Al) Feb U rate down 0.3; strong jobs growth.
(WSJ, 16 Mar. 95, p. Al, A18) Feb Indus Prod up 0.5%, PPI up 0.3%; "Peso
Plunges, Interest Rates Soar in Mexico"
(WSJ, 17 Mar 95, p. A2, CI5) Feb CPI up 0.3%, Feb housing starts down
2.6%; Bundesbank fails to cut rates - dollar first fell on this news, and then
later rose as U.S. bond market rose
(WSJ, 21 MAR. 95, p. CI5) aggressive dollar buying by BoJ
(WSJ, 28 Mar. 95, p. Al) Feb. existing home sales down
(WSJ, 29 Mar. 95, p. A2) FOMC leaves rates unchanged.
(WSJ, 31 Mar. 95, p. Al) Bundesbank cut rates; BoJ signals it will too.
(WSJ, 1 Apr. 95, p. ) no particular news
(WSJ, 11 Apr. 95, p. ) no particular news
(WSJ, 14 Apr. 95, p. Al) BoJ cuts discount rate; Japan announces fiscal
stimulus
(WSJ, 18 Apr. 95, p.) no particular news
(WSJ, 21 Apr. 95, p. CI) weak Phila. Fed survey report
(WSJ, 26 Apr. 95, p. CI5) "Growing Doubts G-7 Will Reach Accord"

Table
(Continued)
Percentage Changes
30-Year
Bond
TWD
Date
Yield
-0.14
0.85
26-Apr-95
08-May-95

-0.73

0.00

10-May-95

0.82

0.43

1 l-May-95

1.88

0.29

12-May-95
18-May-95

1.00
0.97

0.14
0.73

19-May-95
24-May-95
25-May-95

-0.83
-0.57
-2.06

0.00
-1.47
-0.59

26-May-95
3 l-May-95

-1.37
1.38

0.30
0.00

05-Jun-95
06-Jun-95
07-Jun-95

-0.85
0.69
-0.51

-0.15
0.00
0.31

09-Jun-95
15-Jun-95
16-Jun-95
20-Jun-95
23-Jun-95
28-Jun-95
29-Jun-95

-0.63
0.68
-0.50
-0.50
-0.60
1.11
-1.06

2.26
0.61
0.15
0.15
0.46
-0.61
1.97

News
(WSJ, 27 Apr. 95, p. CI9) rumors that central banks might intervene
(WSJ, 9 May 95, p. CI 5) fears of U.S. trade curbs cited (auto trade talks with
Japan failed previous week)
(WSJ, 11 May 95, p. Al) U.S. says it will impose trade sanctions on Japan
unless Japan opens its markets
(WSJ, 12 May 95, p. Al) dollar short covering; PPI up 0.5% in May; Fed
unlikely to cut rates
(WSJ, 15 May 95, p. Al) Apr. CPI up 0.4%
(WSJ, 19 May 95, p. C13) worries about political stability in Germany, weak
mark
(WSJ, 22 May 95, p. ) no particular news
(WSJ, 25 May 95, p. Al) Apr. durable goods orders down 4%,
(WSJ, 26 May 95, p. Al) Apr. sales of existing homes down 6.4%, jobless
claims jumped
(WSJ, 30 May 95, p. ) no particular news
(WSJ, 1 Jun 95, p. A2) "U.S. and 11 Other Countries Intervene In Currency
Markets to Bolster Dollar"
(WSJ, 6 Jun 95, p. ) no particular news
(WSJ, 7 Jun 95, p. C26) speculation over German rate cut
(WSJ, 8 Jun 95, p. A1, CI5) Greenspan does not see recession ahead;
Bundesbank signals that German rates could go down
(WSJ, 12 Jun 95, p. Al) May PPI unchanged
(WSJ, 16 Jun 95, p. Al) May IP down
(WSJ, 19 Jun 95, p. ) no particular news
(WSJ, 21 Jun 95, p. ) no particular news
(WSJ, 26 Jun 95, p. ) no particular news
(WSJ, 29 Jun 95, p. Al) U.S.-Japan trade compromise
(WSJ, 30 Jun 95, p. A1, CI 5) stronger economic news; Bundesbank does not
cut rates

HOW USEFUL AND RELIABLE IS THE UNEMPLOYMENT
RATE IN FORECASTING INFLATION?
Robert H. RASCHE
Michigan State University
The unemployment rate and the growth rate of real GDP havefiguredprominently
in recent discussions of monetary policy and the outlook for future inflation.

For

example, in February Chairman Greenspan testified "The prospects in this regard
[extending the period of low inflation] are fundamentally good, but there are reasons for
some concern, at least with respect to the nearer term. Those concerns relate primarily to
the fact that resource utilization rates have already risen to high levels by recent historical
standards. The current unemployment rate, for example, is only a bit above the average
of the late 1980s, when wages and prices accelerated appreciably. The same holds true of
the capacity utilization rate in the industrial sector."1
The origin of this concern is the so-called Phillips Curve. Modem Phillips Curve
analysis derives from research by Friedman (1968) and Phelps (1970) who postulate a
relationship between the deviation of wage (or price) inflation and the expected rate of
price inflation and deviations of wage (or price) inflation and the expected rate of price
inflation and deviations of unemployment (or employment or real output) from the
equilibrium (or natural) rate of unemployment (or employment or real output). This
concept admitted a short-run (transitory) trade-off between inflation and unemployment,
but denied any long-run (permanent) trade-off between the two variables.
One strand of macroeconometric analysis equates the Friedman/Phelps
"expectations augmented Phillips Curve" with a relationship between current wage (or
price) inflation, past unemployment rates, and past price inflation (e.g. Fuhrer (1995)):
N

w, = a + £P,tf,_, + J] VP.-J + e,
,=1

(1)

7=1

or:

Pi +ZfW-i Z^^+s/

(2)

where wt is the nominal wage rate, pt is the price inflation rate and Ut is the
M

unemployment rate and the coefficients y } are restricted to: ^jyj = 1.0.
This relationship is equated to Phillips Curve under the assumptions that the expected
M

inflation rate at t based upon information available through t-1 is equal to ^jYJp^j

and

7=i

that the unemployment rate affects inflation only with a lag of one period. Whether such
an empirical specification is truly the Phillips Curve is problematic and untestable, since
the secondary assumptions cannot be validated.
In the form of equation (2), the relationship becomes one between accelerations
and decelerations in the inflation rate and the level of the unemployment rate. This result
can be seen by rewriting (2) as:
M

A-ZYyA-,=<*+ZfW-i+e,
>i

(3)

i-i

and observing that the sum of the coefficients on the contemporaneous and lagged
inflation rates is zero given the restriction on the y .. Any distributed lag whose
coefficients sum to zero can be rewritten as a distributed lag in the differences of the
variable:
M-\

Apt - YfiJ*P-j
.7=1

= <* + Z P /tfM+ 81

(4)

i=l

If the unemployment rate is constant at a level such that the inflation rate is not changing
— —ex
( Apt_j = 0 for all j) then the constant level of the unemployment rate is: U = — .

ip,
/=i

U is referred to as the Non-Accelerating Inflation Rate of Unemployment (NAIRU).
Whether or not this specification represents a Phillips Curve, it certainly offers a
forecasting equation for the inflation rate conditional upon information on previous
values of the unemployment rate.3 Fuhrer (1995) argues that "conventional tests of the

stability of the Phillips Curve indicate remarkable stability. There may be no other
macroeconomic relationship that could perform as well by these criteria" (p. 49). King
and Watson (1994) conclude "a strikingly stable negative correlation exists over the
business cycle" (p. 157) between inflation and unemployment. The question addressed
here is how useful and/or reliable such a specification is in forecasting inflation.
USING THE UNEMPLOYMENT RATE TO FORECAST
ONE-PERIOD AHEAD INFLATION
The starting point for this analysis is one of the models estimated by Fuhrer
(1995), though not the one that he analyzes extensively. Rather we investigate the model
for the GDP deflator in the Fuhrer's Table lc. There are two reasons for this choice.
First, it is the simplest of his four models. Second it is the only one that does not utilize
the oil price series. Since Fuhrer does not document his source or definition of this
variable, it is impossible to replicate his other equationsfromthe published information.
Equation 1 in Table 1 reproduces Fuhrer's result in Table lc, but without any
restriction on the sum of the lag coefficients on the inflation rate. Inflation is measured in
percentages at annual rates. Without restriction, these coefficients sum to 1.09, but this is
not significantly different from 1.0 by the conventional "t-test."4 Note that the "tstatistics" on lagged inflation rates greater than four lags are generally very small. This is
also true of the regression reported by Fuhrer (column 2). In column 3 of Table 1, we
report the restricted regression in which all coefficients on inflation lagged more that four
periods are restricted to zero, and the remaining four lag coefficients are restricted to sum
to 1.0. The nine joint restriction are not rejected by a standard F test (F(912i)=1.63, p=
.11). Therefore it is possible to work with a much simpler model than that reported by
Fuhrer with almost no increase in the residual variance. The standard error of the
residuals of this equation is 1.46 percent per annum compared with the 1.44 percent per
annum reported by Fuhrer for his 12 lag equation.
Estimates of the same model for the two subperiods considered by Fuhrer are
shown in columns 4 and 6 of Table 1. From these columns it becomes apparent that the
"Phillips Curve" is not as robust as sometimes advertised. First the standard error of the

residuals in the 80:1-93.4 subsample is over 30 percent smaller than the standard error of
the residuals in the 60:2-79:4 subsample. This can be rationalized by the absence of
severe energy shocks during the 80s. More damaging to the stable Philips Curve view is
the absence of a significant estimated coefficient on he lagged unemployment rate during
the 80s.
One way to judge the usefulness of this equation as a forecasting device is to
compare it against an alternative model. The alternative model estimated in columns 5, 7
and 9 of Table 1 omits the unemployment rate from the regression.5 The addition of the
unemployment rate to the alternative model reduces the residual standard error from 1.69
to 1.67 percent per annum in the 60:2-79:4 subsample and from 1.15 to 1.14 percent per
annum in the 80:1-93:4 subsample. These are hardly noticeable improvements in the
precision of the forecasting model
A second way to consider the contribution of the unemployment rate to forecasts
of the inflation rate is shown in Figure la. Here the deviations of the inflation rate from
its mean are plotted (solid line) in comparison to the contribution of deviations of the
unemployment rate (-.2342UM) from its mean.6 Clearly only a very small proportion of
the historical inflation variation is accounted for by unemployment fluctuations.
The corresponding results for the CPI inflation rate and the CPI ex food and
energy inflation rate are shown in Figures lb and lc, respectively, using the estimated
coefficients from Fuhrer (1995) Table la and Table 1. In these cases the contribution of
deviations of the unemployment rate from its mean is measured as deviations of the
estimated distributed lag on the unemployment rate in the "Phillips Curve" equation from
its mean. In Figure lb, the contribution of the unemployment rate to CPI inflation has a
much larger variance than in Figure la (it is measured as a four period distributed lag on
the unemployment rate), but in many cases moves in the opposite direction to the
observed inflation rate. In Figure lc, the measured contribution of the unemployment
rate to CPI inflation ex food and energy is quite similar to the contribution measured in
Figure la; it has very small variation relative to the variation in the observed measure of
inflation.

A third way to judge the usefulness of the forecasting model is to consider the
range of future inflation rates consistent with an observed unemployment rate and the
history of inflation. This is illustrated in Figures 2 and 3. Figure 2 is comparable to
Figure 4 in Fuhrer (1995). Actual inflation (the solid line) is plotted against the
prediction from the estimated equation (the dashed line) constructed from the estimated
coefficients over the 60:2-79:4 subsample (column 4 in Table 1). In addition, a 95
percent confidence interval (±1.96 standard errors of forecast) is plotted around the
predicted values (broken lines).

This interval indicates clearly the substantial

unexplained component of observed inflation. The model estimated over the 60:2-79:4
subsample gives an inflation prediction interval from around 6 percent to less than -1
percent for each quarter in 1994. The same exercise is demonstrated in Figure 3 utilizing
the estimates from the 80:1-93:4 subsample to predict inflation during the 60-79 period.
The prediction interval here is smaller because the standard error of the residuals in the
later subsample is lower, but it still exceeds four percent. The important thing to
remember in interpreting both graphs is that essentially the pictures produced by the
estimated equations from columns 5 and 7 of Table 1 would be identical. Neither the
time series model nor the "Phillips Curve" model produces one period ahead forecasts of
inflation that are sufficiently precise to be of use in policy analysis.
MULTIPERIOD INFLATION FORECASTS
As pessimistic as the above conclusion are for one period ahead inflation forecasts
from "Phillips Curve" type models, they do not really address the question fundamental
to macroeconomics policy discussions, namely what is inflation likely to be over some
intermediate horizon. Fuhrer (1995) presents three graphs (his Figures 3, 5 and 6) of
"dynamic simulations" of his estimated models. The corresponding graphs for the GDP
deflator models in columns 3, 4 and 8 of Table 1 are presented in Figures 4-6). The
"dynamic simulation" results are comparable for both price series. The only substantial
difference between the graphs shown here and those constructed by Fuhrer is that the
dynamic simulation of the GDP deflator starting in 1980 based on the estimated

coefficients from the 60:2-79:4 subsample does not track the decline in inflation in the
early 80s as well as the model for the core CPI inflation does.
It is important to distinguish these "dynamic simulations" from multiperiod
forecasts of the inflation rate that are conditional only on information known at the
beginning of the forecast period. The "dynamic simulations" use only the history of the
inflation rate up to the beginning of the simulation period, but they utilize the actual value
of the unemployment throughout the simulation period. In effect, these simulations
assume perfect foresight with respect to the unemployment rate over the entire simulation
period.
To analyze the multiperiod forecasting performance of the "Phillips Curve"
model, a joint model of the inflation rate and the ynemployment rate is required. King
and Watson (1994) propose a bivariate vector autoregression (VAR) for such a model. A
slight modification of their approach is adopted here. Estimates of a bivariate VAR
model of the inflation rate and the unemployment rate are shown in Table 2.

The

estimates in column 1 of that table are for an unrestricted VAR in changes in the inflation
rate and levels of the unemployment rate with three lags over the full sample period for
the Fuhrer "Phillips Curve" regressions. Two features are apparent in these regressions.
First, changes in the inflation rate are not significant at any lag in the unemployment rate
regressions. This result is analogous to that found by King and Watson. Second, only the
first lag in the unemployment rate is significant in the equation for changes in the
inflation rate. Therefore, the inflation rate change equation satisfies the restrictions of the
equation estimated by Fuhrer and the unemployment rate forecasting equation is
equivalent to a simple autoregressive equation. Estimates of the VAR subject to these
restrictions appear in the second column of Table 2. Imposition of these restrictions has a
negligible effect on the residual variation in both equations.

The third and fourth

columns of Table 2 indicate the estimates of the restricted VAR for the sample periods
that are used by Fuhrer for his out-of-sample dynamic simulation experiments. The
estimates of both equations are robust to these changes in sample period, though the
significance of the lagged unemployment rate in the inflation change equation is marginal
for the 60:2-79:4 sample period.

How well does the unemployment rate reall forecast the inflation rate in a
multiperiod experiment? The results of the dynamic forecasts of the restricted VAR
models from Table 2 are shown in Figures 7-9. These forecasts are joint forecasts of both
the unemployment rate and the inflation rate. Figure 7 is constructed from the estimated
coefficients of the 60:2-93:4 sample period in column 2 of Table 2. Figure 8 is
constructed from the estimated coefficients of the 60:2-79:4 sample period in column 3 of
Table 2 and Figure 9 is constructed from the estimated coefficients of the 60:2-87:4
sample period in column 4 of Table 2. Thus the results shown in Figure 7 are within
sample forecasts and those in Figures 8 and 9 are true out-of-sample forecasts.
The results in Figures 7-9 contrast dramatically with those in Figure 4-6 and
can only be characterized as truly miserable multiperiod forecasts of inflation. The
reason for the extremely poor forecasting results is not difficult to determine. Since the
unemployment rate equation in the VAR model is a very low order autoregressive
process, the prediction of the unemployment rate very quickly approaches a constant
level as the forecasting horizon is lengthened. Once the predicted unemployment rate
settles down at the steady-state level, the inflation change equation ("Phillips Curve")
behaves like a low order autoregressive process and approaches a steady-state change in
the inflation rate. This change will be positive, negative, or zero depending on whether
the steady-state unemployment rate implied by the unemployment rate equation is greater
than, less than, or equal to the "NAIRU" implied by the inflation rate change equation. In
the estimates from the full sample period (Figure 7) the unemployment rate equation
implies a steady-state unemployment rate that is slightly lower than the NAIRU implied
by the inflation rate change equation, so the multiperiod inflation rate forecasts rapidly
settle down to a small negative trend. This small negative trend completely fails to
capture the sharp drop in the actual rate of inflation that occurred during 1982.
In the estimates from the sample period ending 79:4, the steady-state
unemployment rate is slightly higher than the NAIRU implied by the inflation change
equation, so the multiperiod forecasts of the inflation rate in Figure 8 settle down to a
small positive trend. Again, this fails to capture the sharp decline in the inflation rate that

occurred in 1982, and by the end of the forecast period (85:4) the predicted inflation rate
is almost as high as the actual inflation rate measured in 1980!
In the estimates from the sample period ending in 87:4, the steady-state
unemployment rate is almostly exactly equal to the NAIRU implied by the inflation
change equation. Consequently as the unemployment rate approaches the steady-state
value in the multiperiod forecasts, the change in the inflation rate approaches zero.
Predicted inflation after 1990 is almost constant and is consistently higher than observed
inflation.
CONCLUSIONS
The conclusion from this analysis is that conditional predictions of inflation from
a "Phillips Curve" which presumes that the employment rate can be predicted without
error are highly misleading.

Without a very accurate forecasting model for the

unemployment rate, multiperiod forecasts from "Phillips Curve" type equations are
effectively useless. The autoregressive model used here to forecast the unemployment
rate probably is not the most accurate forecasting model that can be developed for this
variable. However, it is unlikely that other forecasting models of the unemployment rate
will produce substantially more accurate forecasts, since economists generally have found
that simple time series models are difficult to beat in forecasting "horse races."
Therefore, the forecasts shown in Figures 7-9 are likely illustrative of the uselessness of
"Phillips Curve" type models in predicting future inflation and in making assessments of
appropriate policy actions.

NOTES
Testimony of Alan Greenspan Chairman, Federal Reserve Board, February 22,
1995. In Monetary Policy Objectives 1995, Summary Report of the Federal Reserve
Board.
Fuhrer (1995), footnote 13 reports that he was unable to find a statistically
significant relationship between inflation and the contemporaneous unemployment rate, a
result that he attributes to simultaneous equation bias. Absent a contemporaneous
unemployment rate, the instantaneous Phillips Curve is just a horizontal line when
inflation is plotted against the unemployment rate, not the familiar negatively sloped line
of macroeconomics textbooks.
3

Note that the Friedman/Phelps Philllips Curve is not a useful forecasting
instrument, since it presumes that inflation and unemployment are jointly determined.
^Note that the test that these coefficients sum to 1.0 is a test of the hypothesis that
the inflation rate has a unit root. Consequently the test statistic does not have a standard
distribution. Failure to reject the unit root using the conventional "t-test" implies failure
to reject using the appropriate nonstandard distribution. For an investigation that also
concludes there is a unit root in U.S. inflation data see King and Watson (1994), Table 3.
When the sum of the lagged inflation coefficients is restricted to unity, we reproduce
Fuhrer's estimates exactly.
5

The alternative model is just an ARIMA (3,1,0) time series model of the inflation

rate.
6

The rationale for this graph is that a least squares regression of the form
Yl=a + blXl+.~+b„Xn
can be written as:
!;=&,*,+
+bnxn
where the lower case variable symbols represent deviations of the variables from their
respective means.
King and Watson use monthly data and conclude that both the inflation rate and
the unemployment rate are subject to permanent shocks (both series are nonstationary).
Hence their VARs are estimated on first differences of the inflation rate and the
unemployment rate. In the spirit of the Phillips Curve analyses, but at the risk of
constructing "spurious regressions," the VAR analysis presented here is constructed with
differences of the inflation rate but with levels of the unemployment rate.

REFERENCES
Friedman, M. (1968). "The Role of Monetary Policy." American Economic Review.
May, 1-17.
Fuhrer, J.C. (1995). "The Phillips Curve is Alive and Well." New England Economic
Review. March/April, 41-56.
King, R.G. and Watson, M.W. (1994). "The Post-War U.S. Phillips Curve: A
Revisionist Econometric History." Carnegie-Rochester Conference Series on Public
Policy. 41, December, 157-220..
Phelps, E.S. (1970). "Money Wage Dynamics and Labor Market Equilibrium." in E.S.
Phelps (ed.) Microeconomic Foundations of Employment and Inflation Theory. New
York: W.W. Norton & Co.

Table 1
Estimated Models of Inflation
Sample Period

Regressor
pM
p,.2
p,_3
pM
pt.5
Pt . 6

p,.7
pt.8
pt.9
Pt-io
PHI

Pt-i2
U,.,
Constant

60:2-93:4

(1)

(2)

.286 .297
(3.15) (3.28)
.251
.255
(2.70) (2.74)
.188 .188
(1.98) (1.98)
.164 .162
(1.70) (1.68)
-.090 -.094
(-.93) (-.97)
-.111 -.120
(-1.14) (-1.23)
.084
.075
(.87)
(.77)
-.012 -.021
(-.12) (-.21)
.048
.034
(.50)
(.37)
-174
.160
(1.87) (1.72)
.107
.088
(1.20) (1.00)
-004
-.026
(-.05) (-.32)
-.133 -.376
(-3.56) (-3.70)
2.507 2.297
(3.80) (3.62)

| 60:2-79:4 | 80:1-93:4 | 60:2 - 87:4

(3)

(4)

(5)

(6)

(7)

(8)

.346
(3.98)
.255
(2.85)
.220
(2.46)
.179
(1.79)

.315
(2.79)
.251
(2.16)
.196
(1.68)
.239
(2.12)

.341
(3.02)
.257
(2.19)
.187
(1.60)
.215
(1.91)

.461
(3.24)
.264
(1.79)
.317
(2.17)
-.043
(-.29)

.512
(3.73)
.283
(1.92)
.310
(2.11)
-.106
(-.76)

.343
(3.56)
.280
(2.52)
.216
(2.18)
.161
(1.68)

.504
(3.77)
.272
(2.69)
.179
(1.78)
.084
(0.87)

-.234 -.227
-.157
-.224
(-2.75) (-1.58)
(-1.25)
(-2.38)
1.424 1.423 .170 .885 -.201 1.394 .504
(2.65) (1.74) (.89) (1.01) (-1.27) (2.34) .(1.54)

.71

.70

.66

.65

.76

.75

.68

see

1.43

1.46

1.67

1.69

1.14

1.15

1.57

1.95

1.93

1.94

(9)

1.93

1.99

1.93

Table 2
Estimated Vector Autoregressions
60:2-93:4
Ap,

60:2-93:4
Apt

60:2-79:4

60:2-87:4

Apt

-.666 .007
(-7.69) (-.42)

-.652
(-7.67)

-.687
(-6.36)

-.655
(-6.97)

Ap,-.2 -.397 -.022

-.404
(-4.20)

-.434
(-3.51)

-.382
(-3.58)

(-2.19) (-.25)

-.180
(-2.11)

-.246
(-2.27)

-.162
(-1.73)

u,.,

-1.094 1.670
(-2.35) (19.5)

-.235 1.603
(-2.81) (24.9)

-.228 1.592
(-1.64) (18.9)

-.224 1.598
(-2.44) (22.4)

u«

1.120 -.802
(1.36) (-5.3)

-.649
(-7.7)

-.641
(-9.0)

u«

-.255 .088
(-.55) (1.02)

.30

.97

.29

.97

.30

.96

.28

.97

see

1.45

.27

1.46

.27

1.67

.27

1.57

.29

1.92

1.93

1.82

1.92

1.72

1.94

1.82

Ap,.|

(-4.04) (-1.24)
APt-3 -.189 -.004

-.648
(-10.1)

100

Figure la
Deviations from Means
Actual Inflation and Contribution of Unemployment Rate

1.5

5.0 -\

2.5 A
0.0
-2.5 H
-5.0
-1.5

""' ' "

r '

i'"

i "

• "i

' "

•

I"1 •

i" •

•

f '"

•

Figure lb
Deviationsfrom Means
Actual CPI Inflation and Contribution of Unemployment Rate
12.0

i
i

8.0

4.0 A

•4.0

j_w

0.0

-8.0 A
-12.0

Figure lc
Deviationsfrom Means
Actual CPI Inflation Ex Food and Energy and Contribution of Unemployment Rate

8 -j

I
<

6 A
4 A
2
0
-2
-4
-6

" i

101

•

Figure 2
GDP Inflation, Forecasts & Confidence Interval
Using Coefficients Estimated over 60:2 - 79:4

14
12 H

10
8 H

6 H

4 H

2 -\

^'\
-i—i

i i I i i i i i i i—i i r i | i i i r

r r i i i i i t i i i | i v i i i i t | r i i i—i—i—»

102

i i i—» i r r i—i—i—r—i

Figure 3
GDP Inflation, Forecasts & Confidence Interval
Using Coefficients Estimated over 80:1 - 93:4

14
12 H

8 H
6 H

4 -\

vv / v

-2 H

• i • i '—i

' i • i ' i ' i • i • i " i

103

• i ' i ' i • i • i • i •

i '—i

' i

Figure 4
Dynamic Simulation of GDP Inflation
Estimated over 60:2 -93:4
12.5

|
10.0
7.5

£
5.0
2.5 H
0.0

—

•

)

•

Figure 5

12.5

Dynamic Simulation of GDP Inflation
Estimated over 60:2 - 79:4

10.0 H

Figure 6
Dynamic Simulation of GDP Inflation
Estimated over 60:2 -87:4

104

Figure 7
Actual and Forecast Inflation

12.5

10.0

7.5 H

50 H
2.5 H

0.0

•

82 ~^5i

'Til

*~85

~88

Actual and Forecast Unemployment Rate

105

*~91

•

Figure 8
Actual and Forecast Inflation

Actual and Forecast Unemployment Rate
10.4 H

9.6 A
8.8 H
8.0 «-]
7.2
6.4
5.6

106

'"• T - » -

i • • — — , • w y M «q

«5

Figure 9
Actual and Forecast Inflation

Actual and Forecast Unemployment Rate

107

108

G-7 COUNTRIES AT HALIFAX SUMMIT REPEAT THE MEXICAN MYTH
Anna J. SCHWARTZ
National Bureau of Economic Research
In an 11-page single-spaced communique, listing 50 pronouncements on 12
subjects, issued by the G-7 countries following the June 15-17 Halifax Summit, what is
most striking is that included among the pieties expressed in the document is the myth
about Mexico's financial debacle in 1994-95.
THE MEXICAN MYTH
The myth comes in two parts. Part One is that overreaction by foreign investors
to a run of bad news undermined an essentially vibrant economy. Part Two is that the
United States did the right thing in organizing a $50 billion rescue plan. Part One of the
myth has spawned an IMF report, "International Capital Markets:

Developments,

Prospects and Policy Issues," issued in August, that advises developing countries to
consider imposing temporary controls on inflows of foreign capital.

The advice

presupposes that the central problem in Mexico and by extension in other developing
countries is the behavior of foreign investors rather than the behavior of policymakers in
Mexico and elsewhere.
PARTS ONE AND TWO OF THE MYTH IN THE COMMUNIQUE
Both parts of the myth, as noted, are enshrined in the communique. On the
subject, "Meeting the Challenges of the 21st Century," and the subhead, "Strengthening
the Global Economy," pronouncements 14-18 read as follows:
"14. The growth and integration of global capital markets have created both enormous
opportunities and new risks. We have a shared interest in ensuring the international
community remains able to manage the risks inherent in the growth of private capital
flows, the increased integration of domestic capital markets, and the accelerating pace of
financial innovation."

109

"15.

The development in Mexico earlier this year and the repercussions have sharpened

our focus on these issues. We welcome the recent positive turn of events in Mexico, as
well as the positive developments in a number of emerging economies. [On August 16,
the Mexican government announced a 10.5% decline from a year ago in second-quarter
economic output.]"
"16.

The prevention of crisis is the preferred course of action. This is best achieved

through each country pursuing sound fiscal and monetary policies. But it also requires an
improved early warning system, so that we can act more quickly to prevent or handle
financial shocks..."
"17.

If prevention fails, financial market distress requires that multilateral institutions

and major economies be able to respond where appropriate in a quick and coordinated
fashion. Financing mechanisms must operate on a scale and with the timeliness required
to manage shocks effectively. In this context, we urge the IMF to:
•establish a new standing procedure—"Emergency Financing
Mechanism"—which would provide faster access to Fund arrangements
with strong conditionally and larger upfront disbursements in crisis
situations."
"18.

To support this procedure, we ask:
•the G-10 and other countries with the capacity to support the system to
develop financing arrangements with the objective of doubling as soon as
possible the amount currently available under the GAB ($28 billion) to
respond to financial emergencies."
Two highly questionable assumptions underlie these pronouncements. One is that

Mexico's financial crisis, triggered by devaluation of the peso on December 20, 1994,
was attributable to an overreaction by foreign investors who immediately withdrew their
short-term portfolio capital, and that the crisis had contagious effects on other countries.
The second questionable assumption is that a bailout of the scale that the United States
arranged was required to control the damage.

110

WHAT PART ONE ASSUMES
Although one communiquerightlystates that the best way to prevent a crisis is for
each country to pursue sound fiscal and monetary polices, it does not then proceed to
indict Mexico for the policies it adopted in 1994 that landed it in trouble.

The

communique further neglects to state what the IMF report referred to above concedes:
capital flight from Mexico in late 1994 was initiated not by foreign investors but by
Mexican residents, a sure indication that it was internal misguided polices that created the
crisis. In addition, the evidence for contagious effects of the Mexican crisis, which the
communique takes for granted, is weak at best.
WHAT PART TWO ASSUMES
It is the second assumption that is most offensive. For whose benefit was the $50
billion plus bailout arranged? Mexico has acquired a massive debt, but the funds paid out
have not been available for its internal use. They have been transferred to U.S. creditors
who had dollar claimes. It is hypocrisy for the United States to act as if it was rescuing
Mexico, when in fact it was bailing out U.S. private investors. Gunboat diplomacy is out
of fashion, but loading up an LDC with debt to pay off developed country private
investors is apparently okay. Comment on the episode neglects this feature.
Even worse, the communique endorses the provision of billions of dollars in new
loans comparable to what was done in Mexico for the next country in financial distress.
Whether the money will actually be available for such lending is a different matter—the
communique expresses the pious hope that the G-10 will respond "as soon as possible."
But the issue the communique does not address is the message this proposal conveys.
The message to the countries that are likely candidates for rescue is, it's all right to
mismanage your economy; borrow as much as you can, we won't let you default; and to
the lenders, don't worry, we have the money to pay you back.

Ill

OTHER PROPOSED SOLUTIONS
Press comment in advance of the Halifax Summit had anticipated some reference
in the communique to two recommendations by Jeffrey Sachs of Harvard as solutions for
financial crises: the IMF should serve as an international lender of last resort or,
preferably, as a bankruptcy court. There is no direct statement in the communique on
either of these recommendations, but an ambiguous item 20 may be hinting at one or
both:
"20.

Solid progress on the elements discussed above should improve our ability to

cope with future financial crisis. Nevertheless, these improvements may not be sufficient
in all cases. In line with this, and recognizing the complex legal and other issues posed in
debt crisis situations by the wide variety of sources of international finance involved, we
would encourage further review by G-10 Ministers and Governors of other procedures
that might also usefully be considered for their orderly resolution."

THE IMF AS AN INTERNATIONAL LENDER OF LAST RESORT?
If "other procedures" includes transforming the IMF into an international lender
of last resort to prevent banking panics, how to go about it would require solving some
thorny issues. A lender of last resort has the capacity to create high-powered money. It
doesn't need permission from an outside source to do so. The IMF can issues SDRs but
only if authorized by the member countries and the distribution among the members is
again what the members authorize. An SDR is not any member country's high-powered
money but, when issued, a member country can convert its holdings into its own local
money.
A lender of last resort is autonomous, deciding on the spot that the situation
requires an infusion of high-powered money. Would the member countries agree to
empower the IMF to create SDRs on its own initiative, and to distribute them to
whichever country it deemed was confronting a domestic panic? A lender of last resort

112

can withdraw high-powered money once a panic has subsided to remove possible
inflationary effects. Would the IMF have comparable authority as an international lender
of last resort?
More basic questions, however, remain. Are banking panics at the core of
financial crises in developing countries? What can an international lender of last resort
accomplish that is not attainable by each individual country's lender of last resort?
THE IMF AS A BANKRUPTCY COURT
If "other procedures" includes transforming the IMF into a bankruptcy court,
complex legal issues are obviously involved. Assuming the possibility of resolving them,
sovereign countries in distress that would file for bankruptcy could enjoy the solution of
corporate and municipal bankruptcy law: priority lending, debt restructuring, and debt
standstills. What is in doubt is whether such provisions are in the interest of the
sovereign borrowers. Bankruptcy arrangements for sovereign debtors might impact their
future ability to borrow rather than be a source of support when they are in financial
distress.

CONCLUSION
The Halifax Summit did not provide a dispassionate account of what went wrong
in Mexico in 1994. The remedial action of massive lending to a sovereign debtor in
distress that the Summit endorsed in line with the U.S. loan arrangement for Mexico does
not address the problems in developing countries that occasion loss of their
creditworthiness.

113

Full text of Policy Statement and Position Papers : September 11, 1995

FRASER