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APR 0 9 1987
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For Release on D e l i v e r y
12 Noon P . D . T .
(3:00pm E . D . T . )
A p r i l 8 , 1 987
THE OUTLOOK FOR THE U.S.
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ECONOMY
H. Robert H e l l e r
Member o f t h e Board o f Governors o f t h e Federal
Chapman C o l l e g e Economic Forum
Orange, C a l i f o r n i a
A p r i l 8 , 1987
Reserve System
THE OUTLOOK FOR THE U.S. ECONOMY
We are now in the fifth year of the current expansion
and the economy continues to grow with surprising
vigor.
New records continue to be established on an almost
weekly basis.
The employment rate is now near an
alltime high, while the unemployment rate has reached a
six year low.
The stock market continues to surge ahead and interest
rates are close to their lowest levels in ten years.
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But during this expansion, large imbalances have
developed in the government and in the foreign trade
sectors.
The challenge confronting us during the
next few years will be to rectify these imbalances.
A second challenge is to consolidate the enormous
strides that we have made in the fight against
inflation and avoid backsliding into an inflationary
environment.
As you well know, we entered this
decade with double-digit inflation rates and
stagflation became a new household word.
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During
the last year the consumer price index rose only a
modest 1.1 percent.
While we at the Federal Reserve
have a special responsibility to fight inflation,
the containment of inflationary tendencies in our
country will be up to all of us.
The Consumer Is Still Strong
• s B M a a M H a a B a H H O B i i M B i H a a m D H B n M p n
The American consumer has been the mainspring of the
current expansion.
New jobs continue to be created
at a rapid pace and helped by this continuing surge in
employment, salary disbursement continues to climb at a
rapid pace.
American farmers still benefit from large
federal subsidy payments.
The federal tax cuts contributed to a significant "
decline in personal tax payments early this year.
On balance, these tax cuts provide a $15 billion
benefit to American consumers per year.
Considering
that many Americans made substantial gains in stock
and bond markets that resulted in a record level of
net personal wealth, it comes as no surprise that
consumer expenditures continue to increase.
At the
present time, the data on consumer spending are
strongly dominated by wide swings in automobile
purchases that were influenced by sales promotion
programs of the big automakers and the phase-out of the
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tax deductibility of sales taxes.
Looking to the
future, there is every reason to expect that American
consumers will continue to provide a modest but
positive stimulus to the economy.
But it also
stands to reason that consumers will no longer
rely as heavily on debt finance as in the past.
Investment Remains Sluggish
The current pace of business fixed investment is very
sluggish.
Here, too, we observed a bunching of
expenditures in the last few months of 1986 when
business firms could still take advantage of favorable
tax treatment.
Now we experience a lull that reflects
these advance purchases.
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Of course, the overall data on investment will be
influenced by the continued decline of the nonresidential real estate sector which continues to
suffer from overbuilding - especially in the large
cities.
At the present time, construction activity
is running at only 75 percent of its 1985 peak.
However, there is reason to believe that an improved
trade performance may well have a positive effect on
investment spending in the coming year, and
consequently I would expect that business investment
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spending will perform well during the next few years.
The residential housing sector continues to benefit
from a high demand spurred by low interest rates.
New home prices have risen considerably over the past
year, but after adjustment for quality changes we
observe only a 3 percent increase in prices.
However,
there are large regional differences. In the northeast
new home prices have jumped 20 percent over the past
year after adjustment for quality changes.
On the
other hand, housing prices in the oil states are
depressed.
The Need For Fiscal Discipline
Turning to the government, it is clear that the
persistent growth in the share of GNP absorbed by
federal spending is largely responsible for the very
large budget deficits of the past few years.
During
the last fiscal year, federal spending amounted to
23.8 percent of GNP while receipts were only equal to
18.5 percent.
This left a deficit of 5.3 percent
of GNP to be financed.
It is particularly disturbing that the deficit is still
so large in this advanced phase of the economic
expansion.
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That deficit is due to excessive spending
and not due to tax cuts.
Tax revenues stayed
virtually constant as a percentage of GNP since the
late 1970s, while federal spending continued to soar.
It therefore makes sense to reduce the federal deficit
through spending restraint rather than the imposition
of new taxes.
The imposition of new taxes would
tend to rekindle inflation and certainly not make us
more competitive in international markets.
In spite of some recent backsliding, progress is being
made.
Last year, we had a federal deficit of
$221 billion that needed to be financed.
This year,
the deficit will be $50 billion smaller.
This
amounts to a reduction by one full percentage point
in terms of GNP.
As long as we succeed in holding real federal
expenditures constant and benefit from tax revenue
increases due to economic growth, the budget deficit
should continue to shrink.
But clearly it is
important to avoid a new burst of mandated
expenditures. In a macro-economic sense, the declining
federal deficit represents a contractionary
influence.
It sets resources free that can be
utilized in other sectors of the economy.
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International Trade Will Expand
This brings me to the international trade sector,
which is now poised to expand.
In terms of its
contribution to economic growth, I believe that
this will be the leading sector in the next two
years.
But we have a lot of catching-up to do.
Clearly it will be easier for American industry to make
progress on the import-competing front than to
penetrate and capture new foreign markets.
Here at
home we have well established distribution systems
and the rise in the value of the yen and the
European currencies will allow American manufacturers
to compete more effectively against their foreign
competitors.
To capture and penetrate new foreign markets will be
more difficult.
In the agricultural sector we
continue to face stringent protectionist policies
in Japan as well as in Europe.
In the manufacturing
sector it will be exceedingly difficult to compete
against entrenched domestic suppliers.
Foreign
government procurement policies are particularly
difficult to change as price incentives seem to play
only a secondary role in this sector.
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This leaves the possibility for us to compete more
effectively in the third-country markets of the
world.
But it will be difficult to make quick gains
because most of these markets are growing sluggishly.
Latin American economic growth is constrained by the
debt burden that these countries carry.
There is
not much hope for a rapid improvement in the African
economic situation.
The Middle East is dominated by
civil strife and outright wars.
In Asia, we continue
to have sluggish growth in the commodity-exporting
countries.
Clearly, it will be difficult for
Americans to compete head-on in the newly
industrialized countries of Korea, Taiwan, Singapore
and Hong Kong.
That leaves Europe and Canada as
potential export markets.
I believe that the free
trade agreement with Canada, which is now
being negotiated, would be exceedingly helpful in
allowing American producers to compete more effectively
in that country.
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We should also keep in mind that in trying to capture
foreign markets American producers face enormous
obstacles.
New languages have to be learned and
new legal systems adapted to.
Different health and
safety codes have to be observed and technological
adaptations will in many cases be necessary.
All that
will take time and effort to accomplish.
To sum up, the outlook for economic growth is not
at all unsatisfactory and the U. S. economy should be
able to expand by almost 3 percent during the coming
year.
Inflation Outlook
What does all that imply for inflation?
During the last year, the inflation performance of the
U. S. economy has been excellent.
The consumer price
index advanced only 1.1 percent during the course of
1986.
But the main reason for that superb
performance was the drop of almost 20 percent in
energy prices.
Prices in all other sectors continued
to increase at a annual rate of almost 4 percent.
In particular, service sector inflation continued at
over 5 percent.
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There is little reason to assume that energy prices
will drop in 1987 - as a matter of fact there is reason
to expect a slight increase.
Since the December OPEC
meeting domestic energy prices have turned up.
Prices of crude petroleum climbed about 20 percent
in January and another 4 percent in February.
At the
retail level energy prices have also begun to increase
and it is likely that there will be a further passthrough of higher crude oil prices as the year unfolds.
In other words, we will be back to the regular
inflation performance that we have come to expect
during the last few years.
Overall, the consumer price
index may well rise by about 4 percent in the current
year, which represents a return to the long-run trend
of the last six years.
However, the more broadly based GNP deflator is likely
to increase only 3 percent.
This discrepancy is
largely due to the fall in the value of the dollar
which impacts more strongly on the consumer price
index because it directly reflects the prices of
expensive imported goods.
Instead, the GNP deflator
more closely reflects the prices of goods actually
produced in the United States.
One reason why I am pretty optimistic on the inflation
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outlook is that the performance of wages and salaries
continues to be very satisfactory.
Hourly earnings
are rising now at a modest pace of only 2 percent
and total wage costs are increasing at slightly
less than 3 percent per annum.
This has a very
favorable impact on the competitiveness of American
industry.
We gain an added competitive advantage
because wage costs in most other industralized
countries are increasing at a more rapid pace.
Monetary Policy
What does that imply for monetary policy?
As you well know, the monetary aggregates grew rather
rapidly during the past year.
Measured frtom fourth
quarter to fourth quarter, Ml grew by over 15 percent
last year while M2 and M3 increased almost 9 percent.
This high monetary growth reflected a variety of
circumstances.
For one, inflation plummeted sharply
as I pointed out previously.
As people regained their
confidence in the currency, they began to hold more of
it.
This is a natural catch-up in the demand for
monetary assets that one can observe at the end of
any inflationary episode.
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Second, we went through a period of financial
deregulation that made it possible for banks and
thrift institutions to pay interest on transaction
balances.
Consequently, it became more attractive
to hold money in interest bearing NOW accounts
and other transaction accounts.
Third, the rapid increase in the value of stocks and
bonds resulted in a sharp increase in wealth.
It
stands to reason that people want to hold some of this
wealth in the form of money.
As a result of all these cross currents affecting the
demand for money, the monetary aggregates behaved in an
extraordinarily volatile fashion last year.
As a
matter of fact, the bfehavior of Ml became so unreliable
that we at the Federal Reserve decided not to
establish a formal Ml target for the current year.
While it is difficult to provide hard evidence, it
stands to reason that the effect of lower inflation and
financial deregulation on the monetary aggregates
has now largely run its course.
Consequently,
monetary growth may return to more modest levels.
In my view, this would not only be a logical, but also
a most desirable development.
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As a matter of fact, the monetary aggregates have grown
only very modestly since mid January, when the
bulge related to year-end financial activity
disappeared.
I would not be surprised at all if the
monetary aggregates were to grow rather slowly during
the balance of the year as well.
The Need For Discipline
As I stated at the beginning, we are now in a period
where we, as a nation, are trying to execute one of the
most difficult policy maneuvers ever attempted:
namely, to wind down our $200 billion federal budget
deficit and at the same time improve our trade
performance by almost the same amount.
The magnitude of that task is truly astounding.
It
will affect the economic life of every American worker
and consumer.
As can be expected in an undertaking
of such enormous dimension, there is no assurance
that everything will go smoothly and according to plan.
One area that bears watching is inflation.
Prices
of imported goods are rising at a rate of about
7 percent.
The pricing behavior of American producers
in response to price increases of their foreign
competitors will be crucial for our economic future.
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If American producers are going to match the price
increases of their foreign competitors, they will not
only generalize the inflationary forces emanating
from the foreign trade sector but will also be unable
to gain domestic and foreign market shares.
Thus
our own trade performance will improve slowly or
perhaps not at all while inflation at home will
increase.
A return to the stagflation of the late
1970s may well be the result of such a behavior
pattern.
If, on the other hand, American producers take the
opportunity offered to them and hold their prices
stable, they will gain rapidly in competitive
advantage.
Consequently, they should be able to
expand their market share here at home and to
develop new foreign markets.
Let me take just one more moment of your time to
deflate a popular myth that is cited frequently
these days.
It is the myth that inflation and interest
rates inevitably have to rise as a consequence of the
decline in the dollar exchange rate.
This is simply
not so.
During the early 1980s the German mark and the
Japanese yen declined sharply in value —
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as a
matter of fact, it is precisely that currency movement,
which is being reversed at the present time. During
that period of decline in the mark and the yen,
inflation rates and interest rates declined in both
Germany and Japan.
In Germany, consumer price
inflation declined from 6.3 percent in 1981 to
2.2 percent in 1985, while money market interest
rates dropped from 11 percent to 5.5 percent.
Similarly, in Japan inflation dropped from
8 percent in 1980 to a mere 2 percent in 1985, and
interest rates fell from 11 percent to 6 percent.
While a period of currency depreciation is no time for
complacency, there is nothing inevitable about a
decline in the external value of the currency and an
associated surge in inflation and interest rates.
If we are disciplined and determined, we can continue
to contain inflation, while enjoying the benefits of
low interest rates.
The crucial decisions are now up to us.
To fail
when we have the opportunity to move ahead would
certainly be most frustrating.
To succeed on the international front, American
businessmen will need to exercise a high degree of
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self-discipline and show a lot of determination.
That same degree of self-discipline will be required in
the government sector if we are to bring the federal
deficit under better control.
And we at the Federal Reserve will have to be
disciplined in our conduct of monetary policy.
These are the keys to our future success and
prosperity.
I trust that we will not let that
opportunity slip away.
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@FedFRASER