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Regional Economist October 1996 Eighth Note Is the Fed Out of Touch? From time to time, the Federal Reserve is criticized for conducting monetary policy in an ivory tower. From high atop that tower, so the argument goes, the Fed enacts its policies, unaware of their effects on the nation’s workers, consumers and businesses. Unfortunately, this criticism reflects a fundamental misunderstanding of the Fed’s decentralized structure and the opportunities it affords us to stay in touch with regional concerns. As president of the St. Louis Fed, for example, I spend almost a fourth of my time talking with and listening to various constituencies in the Eighth Federal Reserve District. Other Bank staff spend time in similar endeavors. Our contacts are far-ranging, including: • Boards of Directors—All four District offices have a board of directors, drawn from a broad cross-section of the public, as well as the banking community, in our seven-state area. Meetings are monthly. • Economic Advisory Council—We meet twice a year with members of this 10- to 12-member group to discuss the economic concerns of small business and agriculture. • District Dialogues—Four or five times a year, we host road shows for bankers, rotating among 18 cities. Two senior officers and I speak before each group, take questions and continue the discussion over dinner. The following morning, we host a similar meeting for community leaders. • Beige Book contacts—Eight times a year, just prior to Federal Open Market Committee (FOMC) meetings, we check in with dozens of District contacts in a wide range of industries for late-breaking trends in their businesses. A report on this information is distributed to FOMC members before the meeting and is released to the public. • Economic Forums—Four or five times a year, a senior economist and supervisory officer travel to District cities to speak to representatives of the local business and banking communities. • Speeches and presentations—Each year, Bank staff make almost 100 presentations to audiences ranging from local Rotary Clubs to national economic and trade associations. • Industry luncheons—Eight or nine times a year, we invite representatives from specific industries in for lunch and an economic discussion. In 1996, we met with homebuilders, retailers, corporate CEOs and CFOs, investment counselors and health care providers, among others. Similar programs are going on in other Fed Districts. No doubt, my counterparts find, as I do, that the public is eager for the opportunity to interact directly with a principal in the monetary policymaking process. Not surprisingly, such interaction leads to some frank exchanges about economic prospects The point here is that the Fed’s unusual structure—with policymaking balanced between a central board in Washington and 12 Reserve Banks in the field—ensures that national policies are never enacted from an ivory tower. In my view, it should be no other way. 3 Thomas C. Melzer President Regional Economist October 1996 policyU. S. politicians, makers and ordinary citizens are now talking openly about a topic that has long been taboo: altering the nation’s Social Security system. Frequently called “the third rail of American politics”—touch it and you die—social security reform is an issue that prompts heated debates among its supporters and detractors. And although Social Security has been changed a number of times since its inception in 1935, the reforms being discussed today are much more substantial than those previously considered or undertaken. And for good reason: It has become widely accepted that the long-term financial viability of the Social Security system is in doubt. Although the reasons are numerous, the key factor appears to be the enormous demands the aging of the baby boom population will place on the system early in the next century. To avert the financial crunch that most analysts see looming, a growing number of social security experts and policymakers are supporting the privatization of all or parts of the system. Humble Beginnings The U.S. Social Security system—formally Old Age, Survivors and Disability Insurance (OASDI) —was launched in response to the Great Depression, when the savings of a large portion of American families were wiped out. Even before the Depression, however, a number of policymakers recognized the need for government social insurance because of sweeping economic and demographic changes like increased urbaniza- BY Michelle Clark Neely tion and life expectancy, which threatened the traditional familybased support for the elderly. Social Security was introduced as a fully funded program; workers and their employers were each subject to a 1 percent payroll tax on earnings up to $3,000. The taxes went into a fund to pay future benefits, which were based on an individual’s lifetime contribution. But in 1939, recognizing that Americans nearing retirement age would never be able to contribute enough to finance a socially acceptable retirement income, Congress made a number of changes to the program. First, benefits for dependents—spouses and children—were introduced. Second, benefits became based on average earnings over some minimum period, rather than total lifetime contributions. Finally, and most important, to finance benefits for the newly eligible, as well as higher benefits for workers close to retirement, the program was changed to a “pay-as-you-go” system. Under pay-as-you-go, payroll tax contributions from future retirees and their employers are immediately paid out as benefits to current retirees. Other modifications have also been made over the years. Disability benefits were added in 1954. Workers not previously covered—farmers, the self-employed, certain government employees— were added to the program. Per capita benefits and payroll taxes have been increased a number of times; the current payroll tax of 12.4 percent (employee and 5 employer combined) is six times the original rate.1 Benefits have been indexed for inflation. They are also subject to an earnings test and taxed if income exceeds a given level, which redistributes benefits across income classes. Workers can retire as early as 62, but receive reduced benefits before age 65. The maximum level of earnings subject to the payroll tax has also risen over time, and currently stands at $62,700. Under the Social Security Act amendments passed in 1983, benefits will be reduced beginning in the year 2000, and the retirement age will gradually increase, reaching 67 by 2022. A trust fund was also established in 1983 to help finance future benefits. Payroll taxes in excess of what’s needed to pay current benefits go into the fund and are invested in U.S. Treasury securities—the only investments permitted under law. The fund currently has a surplus of $496 billion, which is expected to increase sharply over the next 15 years because of a larger number of workers and higher payroll tax contributions. The Coming Crunch The Social Security trust fund was established because of an increasing concern among policymakers about what demographics would do to the system. The number of workers supporting retirees and the disabled has been declining for decades and is expected to keep dipping well into the next century as the huge cohort of baby boomers begins to retire in 2010. The baby boom generation, defined as those born between 1946 and 1964, numbers 74 million and accounts for about 30 percent of the U.S. population. Compounding the problem is a continuing drop in the U.S. fertility rate and a continuing increase in life Social Security Income, Outgo and Assets, NOTE: Figures are for combined OASI and DI Trust Funds. SOURCE: Board of Trustees of the Social Security Administration, June 1996 expectancy. The number of workers per supported retiree is expected to fall from about five today to 3.6 in 2010 and 2.4 in 2030.2 At that rate, according to the OASDI trust funds’ board of trustees, benefits will exceed payroll tax income by 2012 and total income, which is payroll taxes plus interest income, by 2019. By 2029, the trust fund will be exhausted (see figure).3 Although benefits still will be paid because tax revenue will continue to be collected, most social security analysts believe, barring government borrowing to cover the shortfall, that either taxes will need to be raised, benefits will need to be decreased—or both—to meet system obligations. Unhappy Returns In addition to the solvency concern, reform advocates also bemoan the low financial returns to be received by current and future generations under the current system. To date, each generation of recipients has received a lower rate of return than the previous one—a trend that is expected to continue well into the next century. Early program recipients received far more in benefits than they paid in, enjoying real (after inflation) returns of more than 12 percent by some estimates. In contrast, baby boomers can expect a real return of about 2 percent.4 Why the declining returns? First, the program’s initial retirees received 6 full benefits—retirement, spousal, dependent and survivor—regardless of either the number of years they paid in to the system or the size of their contributions following the switch from a fully funded to pay-as-you-go system. Large increases in benefits and the introduc1996-2030 tion of cost of living adjustments in the 1970s also boosted returns for earlier retirees. There was even a period in the mid-1970s when benefits were overindexed for inflation because of a flaw in the indexing formula used. These benefit increases meant that fewer dollars began accumulating in the trust fund when it was set up in 1983. And the dollars that were accumulating were invested in low-yielding Treasury securities. How Radical Reform? Given the mounting concerns about long-term solvency and the low returns being generated under the current system, momentum is gaining for social security reform. The United States is not alone in this predicament. Most industrialized nations, as well as a number of developing countries, also face aging populations and declining fertility rates and are saddled with payas-you-go systems that redistribute income across generations and income levels. Reform efforts of various sorts have been launched in a number of countries, including Australia, Chile and Sweden.5 What these reform movements have in common is an effort to more closely link benefits with actual contributions. For example, Chile’s movement from a pay-asyou-go system to one that’s mostly privatized has been closely scrutinized and touted as a model for the United States and other nations (see sidebar). In the United States, reform proposals that address the solvency issue and the benefits-contribution link are now being seriously contemplated. For example, Senators Bob Kerrey and Alan Simpson have introduced legislation that would increase the normal retirement age to 70 by 2029. More significantly, the senators have also introduced a bill that would direct a portion of payroll taxes to IRA-like personal investment plans—an Regional Economist October 1996 approach that could be considered partial privatization of the system. In its last several annual reports, the OASDI trust funds’ board of trustees has forecasted that the system is failing the 75-year test for actuarial balance, which is the difference between annual income and annual costs, summed over the next 75 years. Every four years, an advisory council is appointed to review these forecasts and comment on policy issues related to Social Security. The council appointed in 1994 has tackled the imbalance issue and is expected to issue its policy recommendations by year-end. The council’s stated goal was to bring the system into actuarial balance, while preserving its popularity, by minimizing benefit cuts and payroll tax increases.6 Although council members could not unanimously agree on one plan, the three drafted share two common features. First, each proposes a way of bridging the gap between benefits and income by raising taxes, trimming benefits, taxing benefits, gradually raising the retirement age or requiring mandatory private saving. Second, to address the low returns generated on workers’ contributions, each plan has provisions for directing some portion of these savings into the stock market. The council notes that even after adjusting for risk, the stock market outperforms the bond market over long time horizons, a phenomena economists call “the equity premium.”7 One substantial difference among the plans is the degree to which they move Social Security away from a pay-as-you-go system toward a fully funded one. According to economist Ed Gramlich, a University of Michigan economics professor and head of the council, these plans can be described as follows. The Maintain Benefits Proposal The objective of this proposal is preservation of the current system. To meet this objective, benefits would be subject to tougher tax treatment, and a portion of the OASDI trust funds would be invested in stocks. Currently, above certain income thresholds, 50 percent to 85 percent of benefits are taxable, with tax revenue divided between the OASDI and Medicare trust funds. Under this first proposal, however, all benefits in excess of previously taxed contributions (payroll tax payments) would be treated as taxable income, and all of that tax revenue would eventually be diverted to the OASDI funds. One controversial aspect of this tougher tax treatment is that it forces current retirees—who are receiving higher returns than future generations will receive—to pay for some of the system’s actuarial imbalance. The other provision of this plan would permit the OASDI trust funds to gradually hold up to 40 percent of their assets in stocks, a move that would be expected to raise the overall return on the portfolio by nearly 50 percent. The shift from government securities to stocks is a controversial one. Some analysts have expressed concerns about whether the equity premium will hold up; if it doesn’t, the Social Security system would have new financial and credibility problems. Another concern is over government involvement in the stock market. A 40 percent investment in stocks would tally about $1 trillion, or one-seventh of GDP. Although the plan calls for the OASDI trust funds to hold passive investments, like index funds, there are still fears about political meddling in the management of these sizable accounts.8 EQUITY PREMIUM PRIVATIZATION Fully Funded The Individual Accounts Proposal The primary objective of this proposal is to scale back benefits to eradicate the long-term actuarial deficit in the program. To accomplish this, three steps would be taken. First, the normal retirement age would gradually be raised. Second, the ratio of benefits to contributions for highwage workers would be scaled back. Third, and most important, this plan would create mandatory individual savings accounts equivalent to 1.6 percent of payrolls.9 Although these accounts would be held in the Social Security system, individuals would direct their contributions to specific investments, choosing from among five to 10 index funds of stocks, bonds or both. The accumulations in these accounts would be packaged as an annuity and added to regular benefits at retirement. The establishment of individual accounts would represent a radical departure from the current system, which is basically a defined benefit program that also partially redistributes income from high- to low-wage earners.10 Under this second plan, the system would be part defined benefit and part defined contribution. Because the individual account contributions are a fixed percentage of payroll, high earners would automatically accumulate more income than low earners, assuming the same investment choices. Proponents of this plan cite several advantages, including decentralized decision-making, an increased sense of “ownership” of retirement funds because of the partial funding, and 7 benefits Annuity BABY BOOM Transition Plan TRUST FUNDS Chile boasts two firsts in provide a floor, government the world of public penassistance is given to retirees sions. It was one of the first countries in the Western Hemisphere to whose pension trusts are less than 85 percent of the prevailing miniadopt such a program (in 1924) and the first country anywhere to mum wage. In addition, there is some limit on the proportion of scrap its pay-as-you-go system in favor of one that’s largely privatized retirement funds that may be invested by AFP administrators in (in 1981). Because Chile faced a number of the same long-term domestic and foreign stocks. demographic and financial problems plaguing the United States and By most accounts, the new system is an unqualified success. Real other industrialized countries, and because its transition to the new sys- rates of return have averaged 14 percent per year since the program’s tem has been relatively smooth, privatization proponents extol its plan inception. Much of the previous inefficiencies have been eliminated, as a prototype for the rest of the world. and workers can now retire any time they please, The problems with Chile’s old pay-as-you-go so long as their pension benefits meet the 70 persystem became apparent in the late 1970s when cent requirement. And, although both programs large deficits and low and unequal benefits threatguarantee the same minimum pension (85 percent ened the program’s financial health and popularity. of the minimum wage), the likelihood of receiving By the late 1970s, expenditures exceeded revenues the minimum has been reduced because of the new because of a continued decline in the ratio of conprogram’s superior returns. Some analysts have tributors to retirees, which fell from eight in 1960 estimated that pensions under the new system are to about two in 1980. Moreover, high inflation durabout 70 percent larger than those paid to workers ing that period had eroded the value of existing under the old system. And, privatization of the benefits, and other program inefficiencies made the public pension system, combined with other macrofunding deficit worse. In addition, the program was economic reforms, is credited with raising Chile’s highly inequitable by anyone’s measure. For national savings rate and broadening and deepenexample, blue collar workers were required to work ing its financial markets. until age 65 to receive retirement benefits, while Given this success, it isn’t surprising that policytheir white collar counterparts could retire after 35 makers in other countries are eager to copy the years of work, regardless of age. White collar Chilean model. But some caveats are in order. workers also received higher benefits than blue First, the transition in Chile was much easier than it collar workers. would be in countries like the United States because The system was completely overhauled in demographic, economic and political conditions 1981. Payroll taxes were eliminated, and workers were more favorable there. At the time of transiare now required to contribute 10 percent of their tion, Chile had nine persons of working age (not paychecks to one or more of 21 individually necessarily contributors) supporting each retiree, funded and privately administered trusts, called versus five in the United States. Chile was also runAFPs (Administradoras de Fondos de Pensiones). The individual ning a budget surplus, and was therefore able to fund the transition out accounts are fully vested and portable. Each employee contributes of general government revenues. In addition, Chile was under the conuntil retirement (age 65 for men, 60 for women), at which time he trol of a dictator, Augusto Pinochet, who could single-handedly make may choose between a gradual withdrawal of the balance or an infla- economic policy without having to worry, as U.S. reformers do, about tion-indexed annuity sold by private insurance companies. Besides answering to special interest groups or the U.S. Congress. the age requirement, each employee is also required to have Second, because of the millions of individual accounts created, the contributed enough to his account to finance an annual pension that is program is very costly to administer. Finally, it may be that the high equal to 70 percent of his average indexed wage during his last returns enjoyed by Chilean pension recipients thus far are directly 10 years of employment. related to the massive inflows into the AFPs, and that these returns Although the system is described as privatized, the government is will not hold up over time. After all, 15 years is a short time to meastill involved in the country’s pension system. For example, to PAGE EIGHT sure long-term returns. Regional Economist October 1996 risk diversification through the combination of defined benefit and defined contribution components. However, this plan shares some of the same disadvantages as the first, such as the risks associated with equities and the political repercussions of having the federal government invest in the stock market. In addition, it raises concerns about poor invest-ment choices by plan participants. The Personal Security Accounts Proposal The third proposal features even larger individual accounts and is closest in spirit to a privatized system like Chile’s. Under this plan, 2.4 percentage points of the current 12.4 percent payroll tax would be earmarked for survivors and disability insurance, which would essentially be unchanged. The remaining 10 percentage points of the tax would be split equally and directed to: a flat Social Security benefit equal to two-thirds of the poverty line, which would be financed by employers and administered by the Social Security system; and an individual personal security account or PSA, which would be financed by employees. Unlike the second proposal, however, these PSAs would not be managed by the Social Security system and packaged as annuities. Rather, the accounts would be administered by private registered investment companies. At retirement, a PSA holder would be able to choose among an annuity, a lump sum payout or an addition to his estate. Under this proposal, the retirement age would also gradually rise, to match increases in life expectancy. The biggest question this plan raises is how to finance the transition from the current system to the new system. The current generation is paying now for their parents’ retirement, and, after the transition, this generation’s children will be paying for their own retirement. But who would pay for this generation’s retirement? The transition plan calls for all workers over 55 to remain in the present system and all workers under 25 to enter the new system (those under 25 may earn some credit for payroll taxes already paid). Workers between the ages of 25 and 55 would receive a two-tiered benefit. Tier 1 would consist of the benefit already accrued in the current system, plus a pro rata share of the flat benefit in the new system; Tier 2 would consist of the funds and returns from the PSA. But because these benefits would be greater than the 7.4 percent being paid into the OASDI trust funds (the 2.4 percent payment for disability and survivor’s insurance, plus the 5 percent employer-paid payroll tax), a supple- mental transition tax would need to be levied to make up for the shortfall. The main advantages of the PSA plan are twofold: It encourages individual responsibility and ownership because the taxpayer essentially pays a tax to himself; and it guarantees a flat minimum benefit. In addition, its proponents, as well as proponents of other partially privatized plans, believe it would create positive macroeconomic effects by increasing national savings.11 But as with the other two plans, the PSA proposal is saddled with several disadvantages and unanswered questions. For starters, retirees would face even more risk in this plan than in the other two because of the larger share of tax payments being invested in the stock and bond markets. Secondly, lump sum withdrawals from PSAs could be problematic if retirees are short-sighted. There would be enormous political pressure to bail out these people, as well as those who did not make wise investment choices. Another concern is whether the administrative costs of managing all of these individual accounts would seriously erode the expected higher returns. ENDNOTES 1 This rate includes the payroll tax deduction for disability insurance, but not for Medicare, which is currently 2.9 percent for employers and employees combined. 2 These forecasts are based on the projected working age population and the projected retirement age population. 3 These estimates are based on an “intermediate” forecast of economic and demographic factors. If fertility declines more than expected, or if people live longer than expected, the trust funds will be depleted earlier. See Board of Trustees (1996). 4 See Gokhale and Lansing (1996). 5 See Schieber and Shoven (1996). 6 See Gramlich (1996). 7 Since the 1920s, for example, the inflation-adjusted return on common stocks has averaged more than 7 percent, compared with a return of less than 2 percent on Treasury bonds. 8 An index fund is one that is tied to a fixed set of assets, like the stocks of the nation’s top 500 companies. By definition, because the components of the fund are predesignated, there is no “stock picking” involved. 9 This 1.6 percent levy would be on top of the 12.4 percent payroll tax. 10 A defined benefit plan is one in which individuals in similar circumstances pay the same fixed contribution and receive the same fixed benefit; the traditional corporate pension is an example. A defined contribution plan is one in which individuals can choose how much, within limits, to contribute, with the benefit depending on the size of the contribution and the interest income earned on that contribution; 401(k) plans are defined contribution plans. 11 Of course, national savings would increase only if additional funds are saved because of these changes. Individuals could opt to reduce other private saving, leaving total savings unchanged. High Stakes, Tough Choices Social Security is an enormously popular program among U.S. citizens. And for more than 60 years, it has largely met its goal of providing a socially adequate retirement for the nation’s elderly, regardless of income. Unlike most private pension programs, it provides inflation protection. But despite all of these attributes, Social Security is also a program with serious long-term problems. Although pay-asyou-go financing solved the system’s early shortcomings, it has proven to be financially unsound. Social security experts are divided, however, on whether the system needs only minor tinkering or more serious overhaul. Privatization proponents point to the prospect of increased returns and national savings—as well as the end of risky intergenerational transfer payments—as the major pluses of their reform thrust. But such sweeping changes would effectively end Social Security as we know it. Given the high stakes, this choice should not be made hastily or lightly. Michelle Clark Neely is an economist at the Federal Reserve Bank of St. Louis. Thomas A. Pollmann provided research assistance. 9 REFERENCES Board of Trustees, Federal Old-Age and Survivors Insurance and Disability Insurance Trust Funds. 1996 Annual Report (June 5, 1996). Gokhale, Jagadeesh. “Should Social Security be Privatized?” Federal Reserve Bank of Cleveland Economic Commentary (September 15, 1995). Gokhale, Jagadeesh and Kevin J. Lansing. “Social Security: Are We Getting Our Money’s Worth?” Federal Reserve Bank of Cleveland Economic Commentary (January 1, 1996). Gramlich, Edward M. “Different Approaches for Dealing with Social Security,” Journal of Economic Perspectives, Vol. 10, No. 3 (Summer 1996), pp. 55-66. Kerrey, Bob and Alan K. Simpson. “How to Save Social Security,” The New York Times (May 23, 1995). Santamaria, Marco. “Privatizing Social Security: The Chilean Case,” Columbia Journal of World Business, Vol. 27, No. 1 (Spring 1992), pp. 38-51. Schieber, Sylvester J., and John B. Shoven. “Social Security Reform: Around the World in 80 Ways,” The American Economic Review, Vol. 86, No. 2 (May 1996), pp. 373-77. [ R b y K ev in ecent economic research suggests that monetary policy will be more effective if it is both transparent and credible. A transparent monetary policy is one in which the central bank clearly states its commitment to some goal— in this case achieving price stability—and how it intends to get there. Credibility is attained when the central bank’s actions are consistent with reaching this goal. For the Federal Reserve, the goal is a sustained, low inflation rate. But a low inflation rate does not necessarily guarantee a credible monetary policy, for straightforward reasons: If financial markets are unsure of the Federal Reserve’s commitment to keeping inflation in check, then the Fed’s credibility with them will be suspect. Many economists believe that one way the Fed, or any central bank, can enhance its credibility is with a transparent policy rule that is deliberately designed to achieve long-term price stability. L . K l i ese n ] A Monetary Insurance Policy Although it is difficult to measure precisely, a credible monetary policy could be summed up in the following phrase: Policymakers must always say what they mean and mean what they say. Three ingredients are crucial in this respect. The first is a stated commitment to achieving a given policy goal. Federal Reserve Chairman Alan Greenspan does this by reiterating that the Fed’s ultimate goal should be long-term price stability, of which the benefits are many and varied.1 The second ingredient is a recognition that there are limits as to what monetary policy can and cannot accomplish. From this, two points follow: First, the only variable the Fed can reliably control over a long time period is the money supply, which is the major factor that determines the inflation rate; and second, because there is no trade-off between inflation and unemployment in the long run, an economy with a low inflation rate is preferable to one with a high inflation rate.2 The final ingredient that goes into a credible monetary policy is a welldefined plan—announced beforehand—which stipulates how the Fed intends to achieve and maintain its 10 stated goal of long-run price stability. This last feature recognizes that the best monetary policy is a transparent one which—because it is well publicized and well understood—creates the least uncertainty in financial markets. The goal of the Federal Reserve’s Federal Open Market Committee (FOMC) is to keep inflationary expectations from worsening. If the committee fails to do so, uncertainty will creep into financial markets. For example, suppose that an acceleration in the current inflation rate occurs, but—because Fed policymakers perceive the movement to be temporary—they take no restraining action. If this decision is viewed positively by financial market participants, they will be less apprehensive about the increase in inflation. If financial markets are not convinced of this, and expect instead a permanent increase in the inflation rate to result from the Fed’s inaction, they will react in a manner that increases financial market volatility. Accordingly, the heightened inflationary expectations— which arise from less confidence in the Fed’s ability to curtail future inflation— could cause a rise in long-term interest rates, since there will now be more risk associated with holding fixed-income securities (bonds). Thus, a credible monetary policy tends also to yield low and stable nominal interest rates. Are Policy Rules Needed? Given the relatively low inflation rate that has persisted over the past four and a half years, some economists and policymakers maintain that the Federal Reserve has finally achieved its long-sought-after goal of full credibility. This environment stands in stark contrast to the 1960s and 1970s, when monetary policymakers seemed more committed to keeping unemployment from accelerating than to achieving long-term price stability. This stance largely reflected the view, which was commonly held at the time, that there was an inflation-output tradeoff that policymakers could reliably exploit. The result, as shown in the figure, was a substantially higher average inflation rate during the 1970s than during the previous two decades. Many economists have since argued that the best way to prevent a repeat of the substandard inflation performance of the late 1960s to early 1980s is through an arrangement that consistently strives to achieve the goal of long-run price stability. One recent tactic that has been taken along these lines is to announce fixed inflation targets, which has been done by the central banks of Canada, England and New Zealand. Some have Regional Economist October 1996 proposed that the Fed go a step further by adopting a policy that would more explicitly bind policymakers. Several types of these rules have been advocated. Probably the best-known rule is the one advanced by Milton Friedman, which calls on the Fed to increase the growth of the money stock at a known, fixed rate. However, changes in the financial structure of the economy since the early 1980s have made the reliability of this rule questionable. Three other popular policy rules that have been proposed in recent years and are, therefore, perhaps more reliable are: the “McCallum rule,” the “Taylor rule” and the “Svensson rule.” Essentially, the McCallum Rule, proposed by Carnegie-Mellon professor Bennett McCallum, states that the FOMC should specify a target growth rate for nominal GDP (the current dollar value of final goods and services produced) since it is the product of two components: price and quantity. By targeting nominal GDP, the Fed can, therefore, implicitly target the prevailing inflation rate. By contrast, the Taylor rule, named after Stanford University professor John Taylor, stipulates that the FOMC should raise or lower the federal funds rate in response to how real GDP and inflation are behaving relative to two benchmark measures. For example, the rule says that the Fed should attempt to push up the federal funds rate through open market operations if the prevailing inflation rate is above a specific target rate set by the Fed. Similar restraint would be needed if real GDP is greater than potential GDP.3 The third rule, which is advocated by Swedish economist Lars Svensson, is a variation of targeting inflation. Under this rule, the Fed’s short-run (or intermediate) inflation target is the inflation rate that is forecasted to prevail two years hence. By continually setting policy that is tied to a two-year-ahead inflation forecast, the Fed can deliberately bring about its long-run goal of price stability. Are Rules Better Than Discretion? Few economists would quibble with the notion that some discretion is appropriate when setting monetary policy. After all, economic events seldom transpire exactly as predicted. For this reason, some believe that any sort of a fixed rule is inferior to a discretionary framework because it locks policymakers in a box. But policy rules have several advantages over discretion. First, because financial markets tend to be forward-looking in their behavior, a rule that is also forward-looking would tend to reduce the uncertainty associated with future policy actions. A stated policy rule would also hold the monetary authority more accountable for its ENDNOTES 1 See Federal Reserve Bank of St. Louis (1994). 2 This means that a higher average inflation rate over a long horizon will not translate into a lower average unemployment rate, and vice versa. Consumer Price Index Inflation Rates SOURCE: Bureau of Labor Statistics actions, making it easier to evaluate policy outcomes. Finally, a framework that allows policymakers to adjust policy in response to every wiggle in the economic data (discretion) could lead to a more erratic monetary policy. At the same time, because policy rules must be developed on the basis of past historical economic relationships, which do not always hold, they can break down over time. Whichever side one takes in the rules vs. discretion debate, one thing is clear: To ensure economic stability, monetary policy must be implemented in a forward-looking fashion. In other words, policymakers must consider how their actions will affect both the current and future inflation rates. In this vein, policy rules enhance the credibility of monetary policy by increasing accountability and improving the transparency of policy actions with the public and financial markets. Without some form of a rule, monetary policy could be significantly influenced by personalities or unpredictable economic events. Kevin L. Kliesen is an economist at the Federal Reserve Bank of St. Louis. Daniel R. Steiner provided research assistance. 11 3 The economy’s potential growth is usually defined as the rate of growth that is possible given the existing supply of labor, capital, technology and natural resources. It can also be influenced by the existing regulatory and tax structure. In the Taylor model, inflation begins to accelerate if real GDP rises above potential GDP. FOR FURTHER READING Federal Reserve Bank of St. Louis. “A Price Level Objective for Monetary Policy,” 1994 Annual Report. Friedman, Milton. “The Role of Monetary Policy,” The American Economic Review (March 1968), pp. 1-17. McCallum, Bennett. “Robustness Properties of a Rule for Monetary Policy,” Carnegie-Rochester Conference Series on Public Policy, No. 29 (1988), pp. 173-204. Svensson, Lars E. “Comment on John B. Taylor, ‘How Should Monetary Policy Respond to Shocks while Maintaining Long-Run Price Stability,’ ” Achieving Price Stability, a symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, August 29-31, 1996. Taylor, John B. “Policy Rules as a Means to a More Effective Monetary Policy,” Institute for Monetary and Economic Studies, Bank of Japan, Discussion Paper 96-E-12 (March 1996). Manufacturing is the third most important sector in the MSA, although its employment share has fallen almost two percentage points since 1992. The transportation equipment industry employed more manufacturing workers in the second quarters of 1992 and 1996 than any other such industry. Its share of employment is roughly double that of any other manufacturing industry in the St. Louis MSA. Food processing and production, and industrial machinery and computer equipment share the second manufacturing spot in the region. Although the latter wasn’t even near the top of the list four years ago, it moved up the ranks because of losses in other industries like food processing, which has seen its growth rates decline. And although its rate of decline has ebbed recently, there are no signs yet of a coming resurgence. Have They Been Gearing Up? by Adam M. Zaretsky L ast year’s economy did not end on a strong note. Although the year, overall, posted average growth in real output, it was only because of one strong quarter. The picture was still pretty grim at the beginning of 1996, due in part to the federal government shutdown and a fierce winter storm that struck most of the Midwest, Southeast and Eastern Seaboard. Many analysts and policymakers believed a recession was looming. Then came the surprise. Payroll employment grew phenomenally in February, and real output rebounded to its average annual growth rate in the first quarter. Output growth accelerated further in the spring, making the first half of this year one of the strongest in the decade. Payroll employment growth did not keep up its pace, however, slowing somewhat during the spring. How did the Eighth District fare over this period? Although output growth is hard to determine because the data are not timely enough to be useful, District employment growth slowed somewhat through the spring.1 However, the effects of the slowdown differed from region to region. St. Louis Nonagricultural employment growth in the St. Louis MSA slowed in 1995, then saw a mild resurgence in the first quarter of this year. This rebound mirrored that of the region’s nonmanufacturing sector, which represents about 84 percent of all area employment. Manufacturing employment growth in the region, on the other hand, has been slowing since the second quarter of 1995, and, at the beginning of this year, turned negative. That is, manufacturing employment levels have actually been declining since the beginning of this year. Over the past four years, St. Louis’ list of leading employment sectors has not changed. In the second quarters of both 1992 and 1996, general services represented the largest employment sector. This sector includes health, legal, educational and entertainment services. Retail and wholesale trade, which includes department and discount stores and supermarkets, was the second largest employment sector in the region in both years. This sector has recently experienced some slowing in its growth rate, however. 12 Little Rock The growth rate of nonagricultural payroll employment in the Little Rock MSA has declined since the first quarter of last year. By the end of the year, though, the decline had eased, reflecting moderation in the region’s nonmanufacturing sector, which accounts for about 88 percent of area employment. The region’s manufacturing sector, on the other hand, has seen its employment growth rate decline since the last quarter of 1994. By the third quarter of last year, growth became negative and has continued to fall by about 3 percent a year. Over the past few years, Little Rock’s list of leading employment sectors has remained unchanged. General services represented the largest employment sector in the second quarters of 1992 and 1996, and, while there has been some recent slowing in the growth of this sector, it is still experiencing an almost 3 percent annual gain. Retail and wholesale trade was the second largest employment sector in both years, and, for the past three quarters now, has seen an acceleration in its growth rate. Unlike the St. Louis MSA, manufacturing does not hold the No. 3 spot in the Little Rock region; rather, government employment—federal, state and local—does. In fact, as the accompanying chart shows, government’s share of total employment in the Little Rock region is greater than that in any other major metropolitan area in the District. This is understandable, however, since Little Rock is the state’s capital. Manufacturing currently accounts for less than 12 percent of all employment in the region. While fabricated metal production is the largest manufacturing industry, its yearly growth rate, which just recently turned nega- Regional Economist October 1996 tive, is down dramatically from its high of more than 25 percent about a year ago. Electrical equipment, and printing and publishing share the No. 2 spot. Although a surge in employment at electrical equipment firms in 1994 helped boost the industry, its employment levels have been declining rapidly in recent quarters. Louisville Nonagricultural employment growth in the Louisville MSA also declined in 1995, but most of the drop occurred in the second quarter. Since then, growth has been relatively stable—around a 2 percent annualized rate. This also mimics the movements of the region’s nonmanufacturing sector, which accounts for about 83 percent of total employment. Manufacturing employment growth has been declining since the second quarter of 1994 and turned negative a year later. It has remained so since. This downward trend reversed in the third quarter of last year, however, and, while still negative, has been moving toward renewed positive growth. The three leading employment sectors in the Louisville region have remained unchanged since 1992. General services represented the largest sector in the second quarters of 1992 and 1996. Spurred on by the region’s health care industry, growth in general services has been accelerating recently, and employment is more than 5 percent above its level of a year ago. While ranking as the second largest employment sector in the area, retail and wholesale trade has seen a recent decline in its growth rate, which now stands at slightly less than 2 percent per year. Manufacturing is the third largest employment sector in the region. In fact, the Louisville area employs a larger share of its workers in manufacturing jobs than any other District MSA. And as in the St. Louis area, transportation equipment is the dominant industry in the sector, when only four years ago, it was not even near the top of the list. Transportation equipment gained the pole position by undergoing phenomenal year-overyear employment growth rates—none below 12 percent—during the past few quarters. Much of this growth can be tagged to the additional shift the local Ford plant has added to its production schedule. Memphis The growth rate of nonagricultural employment in the Memphis MSA fell through 1995, followed by a one-quarter rebound at the beginning of this year. Once again, these movements matched those of the region’s nonmanufacturing sector, which accounts for about 88 percent of all employment. Manufacturing employment growth began to slide in the beginning of 1994, then moderated for two quarters late in 1994, before resuming its downward trend. Currently, manufacturing employment is declining at almost 3 percent a year. General services is the leading employment sector in the Memphis region. Retail and wholesale trade, which was the leading employment sector in 1992, is now second. Although the area has some major players in this field, growth in retail and wholesale trade has been slowing since the fourth quarter of 1994. Like Little Rock, government employment holds the third spot in Memphis, representing about 15 percent of total employment. Manufacturing firms employ less than 12 percent of all payroll workers. At its current rate of decline, manufacturing will soon fall behind the transportation, communication and public utilities industry in its share of total employment. Industrial machinery and computer equipment, food processing and production, and chemicals all tie as the leading manufacturing industries. DISTRICT NONAGRICULTURAL PAYROLL EMPLOYMENT Second Quarter 1996 Regional Flavors The District’s major metropolitan areas have not necessarily followed the nation’s employment pattern in recent years. All of the four MSAs discussed saw employment growth decline during 1995—as did the nation— but most saw a mild rebound earlier this year, which the nation did not. Manufacturing industries, which, at best, account for less than one-fifth of total employment, continue to be the crosswinds blowing the trends off-track. Ultimately, the picture that emerges is one of diverse regional strengths and weaknesses, all acting to determine the final outcome. Manufacturing Trade FIRE: finance, insurance and real estate Government TCPU: transportation, communication and public utilities Construction and Mining General Services SOURCE: Bureau of Labor Statistics Adam M. Zaretsky is an economist at the Federal Reserve Bank of St. Louis. Thomas A. Pollmann and Eran Segev provided research assistance. 13 ENDNOTES 1 Gross state product, the output measure that is the state equivalent of GDP, is available only with a two-year lag. Pieces Eight News bulletins from the Eighth Federal Reserve District There’s No Business Like Small Business? Despite a big push by bankers to make more small business loans, the percentage of such loans in bank portfolios declined by about 5 percentage points over the past three years in the Eighth Federal Reserve District. At the end of second quarter 1996, small business loans—those for $1 million or less—made up about 56 percent of the District’s business loans. “This is a healthy chunk of banks’ loan portfolios,” says Fed economist Michelle Clark Neely, “but not as healthy a chunk as we might have expected.” The ratios declined, Neely explained, because overall business lending grew faster than small business lending. “No one is quite sure yet how to explain the trend,” she said, “but one possibility is that small business loans have gotten larger over time, and, thus, are no longer counted in the small business loan category.” The decline is not a statistical fluke. Similar trends are apparent when one looks at small commercial loans collateralized by real estate: District loans under $1 million made up 62 percent of Economic Development Issues Fresh Off the Farm About 50 economists, researchers, educators and policymakers from across the country met at the Federal Reserve Bank of St. Louis Oct. 3 to discuss a range of issues affecting America’s rural communities. Presenters at the symposium called, “The Rural Economy: Heading into the 21st Century,” spoke on the challenges confronting rural communities, as well as the opportunities they need to take advantage of if they are going to survive—and thrive—in the next century. Among the presenters were: • Nicholas Filippello of Monsanto Company, who spoke on the changes that biotechnology has brought to the field of agriculture in the last decade; • David Freshwater of the University of Kentucky, who spoke on the increasingly unskilled nature of the rural labor force; • James Rubenstein of Miami University of Ohio, who spoke on the trend of auto manufacturers to locate their plants in suburban, rather than rural, areas; and • Nick Walraven of the Federal Reserve System’s Board of Governors, who spoke on the effect that bank mergers have had on lending in rural communities. To receive a copy of one of these papers or District Residents Living any of the others prethe American Dream sented at the symposium, contact Sandra Butler Homeownership Rates, 1995 of the St. Louis Fed’s State Rate Research Department at (314) 444-8591. the total secured and unsecured commercial loans at the end of June, compared with 67 percent at the end of June 1993. The downward trend shows up nationwide as well. To receive a copy of “Economic Forces Shaping the Rural Heartland,” a Kansas City Fed report, call their Public Affairs Office at (816) 881-6701. To receive a copy of “Agriculture, Technology and the Economy,” a Dallas Fed publication, contact their Public Affairs Office at (214) 922-5254. 14 Kentucky Mississippi Indiana Missouri Arkansas Tennessee Illinois 71.2% 71.1 71.0 69.4 67.2 67.0 66.4 National Average 64.7 SOURCE: U.S. Bureau of the Census Regional Economist October 1996 District Data Selected economic indicators of banking, agricultural and business conditions in the Eighth Federal Reserve District Commercial Bank Performance Ratios U.S., District and State All U.S. U.S. District <$15B 1 AR IL IN KY MS MO TN Return on Average Assets (Annualized) 2nd quarter 1996 1.21% 1.33% 1.29% 1.31% 1.02% 1.30% 1.19% 1.50% 1.34% 1.40% 1st quarter 1996 1.12 1.33 1.24 1.25 0.97 1.31 1.13 1.45 1.27 1.38 2nd quarter 1995 1.14 1.31 1.28 1.24 1.23 1.23 1.22 1.41 1.29 1.41 Return on Average Equity (Annualized) 2nd quarter 1996 15.00% 14.76% 14.58% 13.78% 10.03% 14.25% 13.58% 15.72% 16.12% 16.89% 1st quarter 1996 13.79 14.70 13.96 13.12 9.43 14.24 13.11 15.22 15.14 16.49 2nd quarter 1995 14.49 15.07 14.74 13.44 12.58 13.21 13.95 15.65 15.92 17.55 Net Interest Margin (Annualized) 2nd quarter 1996 4.27% 4.77% 4.33% 4.43% 4.22% 4.37% 4.35% 4.93% 4.15% 4.36% 1st quarter 1996 4.18 4.74 4.27 4.33 4.14 4.36 4.34 4.92 4.08 4.29 4.21 4.80 4.30 4.24 4.50 4.47 4.21 5.03 4.18 4.22 2nd quarter 1996 1.12% 1.10% 0.81% 0.80% 1.09% 0.69% 0.87% 0.74% 0.77% 0.72% 1st quarter 1996 1.17 1.12 0.83 0.80 1.01 0.63 0.88 0.78 0.85 0.72 2nd quarter 1995 1.26 1.09 0.70 0.68 1.04 0.53 0.83 0.64 0.57 0.62 2nd quarter 1996 0.57% 0.70% 0.31% 0.19% 0.34% 0.20% 0.41% 0.28% 0.28% 0.36% 1st quarter 1996 0.55 0.64 0.30 0.19 0.30 0.15 0.36 0.25 0.32 0.34 2nd quarter 1995 0.42 0.50 0.18 0.10 0.32 0.13 0.23 0.22 0.14 0.19 2nd quarter 1996 1.99% 1.89% 1.53% 1.34% 1.62% 1.36% 1.53% 1.58% 1.63% 1.49% 1st quarter 1996 2.01 1.92 1.55 1.36 1.65 1.41 1.53 1.62 1.65 1.50 2nd quarter 1995 2.12 1.91 1.57 1.37 1.61 1.43 1.59 1.65 1.67 1.57 2nd quarter 1995 Nonperforming Loans ÷ Total Loans 2 Net Loan Losses ÷ Average Total Loans (Annualized) Loan Loss Reserve ÷ Total Loans NOTE: Data include only that portion of the state within Eighth District boundaries. 1 2 U.S. banks with average assets of less than $15 billion are shown separately to make comparisons with District banks more meaningful, as there are no District banks with average assets greater than $15 billion. Includes loans 90 days or more past due and nonaccrual loans SOURCE: FFIEC Reports of Condition and Income for Insured Commercial Banks 15 Commercial Bank Performance Ratios by Asset Size 2nd Quarter 1996 Earnings Asset Quality Return on Average Assets Net Loan Loss Ratio Percent Percent Annualized 1 Annualized Return on Average Equity Nonperforming Loan Ratio Percent Percent Annualized Net Interest Margin 2 Loan Loss Reserve Ratio 3 Percent D = District < $100 Million $300 Million – $1 Billion US = United States $100 Million – $300 Million $1 Billion – $15 Billion NOTE: Asset quality ratios are calculated as a percent of total loans. 1 2 3 Loan losses are adjusted for recoveries. Includes loans 90 days or more past due and nonaccrual loans Interest income less interest expense as a percent of average earning assets SOURCE: FFIEC Reports of Condition and Income for Insured Commercial Banks 16 Regional Economist October 1996 Agricultural Bank Performance Ratios U.S. Return on average assets (annualized) 2nd quarter 1996 1st quarter 1996 2nd quarter 1995 Return on average equity (annualized) 2nd quarter 1996 1st quarter 1996 2nd quarter 1995 Net interest margin (annualized) 2nd quarter 1996 1st quarter 1996 2nd quarter 1995 Ag loan losses ÷ average ag loans (annualized) 2nd quarter 1996 1st quarter 1996 2nd quarter 1995 Ag nonperforming loans1 ÷ total ag loans 2nd quarter 1996 1st quarter 1996 2nd quarter 1995 AR IL IN KY MS MO TN 1.27% 1.27 1.23 1.40% 1.35 1.23 1.24% 1.26 1.22 1.32% 1.34 1.20 1.47% 1.50 1.44 1.63% 1.49 1.54 1.31% 1.34 1.26 1.40% 1.42 1.19 12.37% 12.30 12.02 12.99% 12.47 11.86 11.34% 11.49 11.27 13.61% 13.92 12.24 14.24% 14.45 14.38 17.79% 15.23 16.40 12.82% 13.01 12.35 13.22% 13.46 12.40 4.48% 4.46 4.57 4.39% 4.23 4.29 4.09% 4.08 4.15 4.55% 4.56 4.71 4.58% 4.53 4.68 5.27% 5.16 5.28 4.47% 4.46 4.51 4.52% 4.44 4.36 0.28% 0.23 0.14 0.06% 0.01 -0.06 0.19% 0.14 -0.07 -0.15% -0.16 -0.05 0.18% 0.12 0.09 1.37% 0.60 0.39 0.29% 0.19 -0.10 0.29% 0.68 0.10 1.92% 1.95 1.43 0.74% 0.62 0.62 0.97% 1.14 1.57 1.99% 1.48 0.67 2.01% 1.72 1.73 3.10% 4.86 1.96 1.26% 1.93 1.05 0.44% 1.52 0.32 NOTE: Agricultural banks are defined as those banks with a greater than average share of agricultural loans to total loans. Data include only that portion of the state within Eighth District boundaries. 1 Includes loans 90 days or more past due and nonaccrual loans SOURCE: FFIEC Reports of Condition and Income for Insured Commercial Banks U.S. Agricultural Exports* U.S. Agricultural Exports by Commodity Commodity Apr May Jun 1.04 1.01 .86 8.41% 11.6% .84 .88 .63 6.71 47.2 Cotton .23 .14 .11 2.79 -10.8 Rice .10 .07 .07 .77 -5.8 21.3 Livestock & products Corn U.S. Crop and Livestock Prices Dollar amounts in billions Year-to-date Change from year ago Soybeans .43 .35 .42 5.16 Tobacco .11 .11 .95 1.17 5.1 Wheat .52 .48 .45 4.81 40.9 TOTAL 5.11 4.83 4.83 46.30 12.7 Indexes of Food and Agricultural Prices Growth 1 Level 2 Prices received by U.S. farmers Prices received by District farmers 3 Arkansas Illinois Indiana Missouri Tennessee Prices paid by U.S. farmers Production items Other items Consumer food prices Consumer nonfood prices II/96 I/96 II/95 I/96-II/96 II/95-II/96 112 108 100 18.5% 12.7% 136 136 146 110 138 134 120 124 104 136 118 92 97 91 129 8.2 61.6 90.4 23.6 8.1 15.2 46.9 50.2 21.3 7.5 115 115 152 157 113 113 151 156 108 109 148 153 4.8 4.8 4.3 3.8 6.2 4.9 2.7 2.9 NOTE: Data not seasonally adjusted except for consumer food prices and nonfood prices. 1 Compounded annual rates of change are computed from unrounded data. 2 Index of prices received for all farm products and prices paid (1990-92=100) 3 Indexes for Kentucky and Mississippi are unavailable. 17 Selected U.S. and State Business Indicators Compounded Annual Rates of Change in Nonagricultural Employment United States II/1996 I/1996 II/1995 Labor force 133,647 133,192 132,183 (in thousands) Total nonagricultural employment 119,272 118,462 116,956 (in thousands) 5.4% 5.6% 5.6% Unemployment rate I/1996 IV/1995 I/1995 Real personal income* (in billions) $3,995.1 $3,978.4 $3,912.6 Arkansas II/1996 Labor force 1,234.0 (in thousands) Total nonagricultural employment 1,082.4 (in thousands) 4.8% Unemployment rate I/1996 Real personal income* (in billions) $29.1 I/1996 II/1995 1,236.4 1,216.4 1,081.0 1,063.9 4.9% 4.6% IV/1995 I/1995 $28.9 $28.2 Illinois II/1996 Labor force 6,149.3 (in thousands) Total nonagricultural employment 5,687.6 (in thousands) 5.2% Unemployment rate I/1996 Real personal income* (in billions) $195.6 I/1996 II/1995 6,147.0 6,074.1 5,672.4 5,584.2 5.2% 5.1% IV/1995 I/1995 $194.3 $192.1 Indiana II/1996 I/1996 II/1995 Labor force 3,096.3 (in thousands) Total nonagricultural employment 2,799.1 (in thousands) 4.2% Unemployment rate 2,799.9 2,781.0 4.4% 4.7% I/1996 IV/1995 I/1995 Real personal income* (in billions) $81.3 3,116.1 3,139.7 $81.3 $81.3 18 Regional Economist October 1996 Kentucky II/1996 I/1996 II/1995 Labor force 1,829.0 (in thousands) Total nonagricultural employment 1,671.1 (in thousands) 5.2% Unemployment rate 1,656.4 1,640.2 5.2% 5.4% I/1996 IV/1995 I/1995 Real personal income* $47.8 (in billions) 1,854.3 1,864.3 $47.7 $46.9 Mississippi II/1996 I/1996 II/1995 Labor force 1,266.4 (in thousands) Total nonagricultural employment 1,080.9 (in thousands) 6.1% Unemployment rate 1,078.1 1,073.1 6.2% 6.1% I/1996 IV/1995 I/1995 Real personal income* (in billions) $29.9 1,260.6 1,252.9 $29.7 $29.1 Missouri II/1996 I/1996 II/1995 Labor force 2,847.0 (in thousands) Total nonagricultural employment 2,559.2 (in thousands) 4.3% Unemployment rate 2,554.1 2,516.7 3.7% 5.1% I/1996 IV/1995 I/1995 Real personal income* (in billions) $76.7 2,815.9 2,830.9 $76.3 $75.2 Tennessee II/1996 I/1996 II/1995 Labor force 2,747.8 (in thousands) Total nonagricultural employment 2,554.1 (in thousands) 4.8% Unemployment rate 2,554.8 2,489.0 5.3% 5.1% I/1996 IV/1995 I/1995 Real personal income* $72.6 (in billions) Total Manufacturing 2,757.3 2,701.2 $72.0 $69.7 Construction Government General Services Finance, Insurance and Real Estate Transportation, Communication and Public Utilities Wholesale/Retail Trade NOTE: All data are seasonally adjusted. The nonagricultural employment data reflect the 1995 benchmark revision. * Annual rate. Data deflated by CPI, 1982-84=100. 19
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