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For R e l e a s e on D e l i v e r y
April 8, 1988
12 Noon P . D . T .
3:00pm E.D.T.
THE O U T L O O K FOR THE U.S. E C O N O M Y
H. R o b e r t H e l l e r
M e m b e r , Board of G o v e r n o r s of the Federal R e s e r v e S y s t e m
Los A n g e l e s Town Hall
and E c o n o m i c s and F i n a n c e A f f i l i a t e s of the
C a l i f o r n i a M u s e u m of S c i e n c e and I n d u s t r y
Los A n g e l e s , C a l i f o r n i a
April 8, 1988
THE OUTLOOK FOR THE U.S. ECONOMY
By
H. Robert Heller
I am happy that you asked me to speak today on the
outlook for the American economy because there is much
to be proud of.
But at the same time, we have to face
important challenges:
we have to prevent a resurgence
of inflation, put our financial house in order, and
begin to restructure the American economy.
Economic growth has been sustained much better than one
could have hoped for when the current expansion began
five and a half years ago.
In 1987, economic activity
expanded at a robust pace.
Fourth quarter GNP has just
been revised up to 4.8 percent.
At the same time, the
unemployment rate dropped to its lowest level since
1979, and consumer prices last month showed only a 0.2
percent increase.
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We have every reason to believe that economic activity
will continue at a healthy pace - in spite of the
doomsday prophets who always see a recession just a few
quarters ahead.
The fact that we are moving forward is plain in the
surge of U.S. industrial activity.
Operating rates are
climbing, investment is booming, and new jobs are being
created at a rapid pace.
That progress is even more impressive because it takes
place against a background of large imbalances in our
economy:
excess federal spending compared to tax
revenues; excessive imports compared to our exports;
and insufficient domestic saving compared to our need
to finance our investment.
These imbalances must be
rectified if they are not to imperil growth in the
years to come.
In this regard, a continued reduction in the federal
deficit is crucial.
Lowering the federal government's
claims on domestic savings and reducing its presence in
the credit markets will make more financial resources
available to American industry for investment in
capacity and competitiveness.
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Attaining a better balance between domestic saving and
investment will help us achieve an improved external
equilibrium.
It will also allow us to reduce our
dependence on foreign funds.
The fall in the value of the dollar should help
American business to price more competitively in world
markets and to expand its market share at home and
abroad.
For the year as a whole, we expect economic growth in
the 2 to 2-1/2 percent range, which is in line with the
Administration forecast.
We also expect only moderate inflation, of about 3-1/2
percent for the year, though the Administration's
forecast is slightly higher than that.
Old Sources of Growth Weaken
The old workhorses of consumer spending, defense
spending, and construction, which led the expansion
from 1983 until 1986, are now tired.
In those years,
rapid growth in consumption was the force driving
domestic spending.
But this burst in consumer spending
exceeded not only the long-run trend growth in real
disposable personal income but also actual income gains
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during that period.
In other words, our consumption
grew faster than our income.
That situation cannot be
sustained forever.
Last year, consumer spending slowed markedly, and the
stock market crash darkened its prospects.
At this
juncture, a deep retrenchment in household spending
«{Oes not appear to be in the cards; but the consumer is
certainly more cautious about fancy sports cars,
vacations in Europe and other discretionary spending.
Looking ahead, continued moderate growth in consumer
spending appears likely - and, indeed, desirable.
Slower growth in consumption will foster a better
bal&no^ between consumption and income, allow our
savings to increase, and therewith provide the
wherewithal for badly needed investment.
Investment Surges
After a sluggish 1986, business spending for plant and
equipment revived last year.
Factories reopened and
upgraded their facilities as the drop in the value of
the dollar on international currency markets made
American firms more competitive at home and abroad.
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The demand for new business equipment continues to
surge, and orders for capital goods post solid gains.
All that bodes well for the future because we are
building additional capacity and enhancing our
productivity.
Both of these developments are important
to sustain domestic growth and to Keep our export boom
alive.
In some industries, booming export sales have combined
with rising domestic demand to push capacity
utilization rates to high levels.
The pickup in
industrial activity has also encouraged additional
spending on industrial buildings.
Yet, we still face
serious overbuilding of offices in many cities.
Until recently, the news about residential investment
has been disappointing.
at the turn of the year.
Home sales and starts slumped
But mortgage interest rates
have fallen a point and a half from the October peaks,
and the effects of these lower rates have finally begun
to show through in stronger housing starts.
Although
the market for multi-family housing units remains
lackluster, the lower mortgage rates have made new
homes more affordable and should promote sales and
construction of single-family homes.
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More Fiscal Discipline Needed
One of the most encouraging developments of the past
year has been the substantial progress made by the
Congress and the Administration in reducing the federal
deficit.
By clamping down on spending, and with the
help of favorable boosts to revenues, the budget
deficit was cut $50 billion in fiscal 1987.
We must recognize, however, that the recent progress
has merely dented the problem.
Federal spending, which
took 20 percent of GNP during the 1970s, claimed 24
percent between 1983 and 1986.
In contrast, tax
receipts remained stable at 19 percent of GNP during
the last two decades.
Now, the gap between spending
and income amounts to 3 percent of GNP, or $150
billion.
The implications of these trends in outlays and
revenues for the years to come are clear:
we must
further reduce the ratio of government spending to GNP.
The Gramnv-Rudman-Hollings legislation laid down an
ambitious deficit-reduction program, and it remains the
standard for all other deficit-reduction packages.
I
hope that the new National Economic Commission also
will help in the difficult task of determining further
politically feasible cuts in spending.
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Dependence ,_on Foreign Capital Must Be Reduced
To a significant extent, heavy inflows of capital from
abroad have cushioned domestic capital markets and
investment against the impact of the federal deficit.
Indeed, these foreign capital inflows are now, roughly,
equivalent to the credit needs of the federal
government.
However, history shows that a country cannot forever
depend on savings from abroad.
At some point, we will
have to generate our own financing for our spending
needs.
Waiting can only compound the problem because
sooner or later the costs of external debt service will
begin to drag heavily on our economy.
Thus, without further reductions in the federal
government's claims on savings, we run the risk of
putting severe pressure on foreign exchange and
financial markets sometime in the future.
Exports Pose Challenge
The external sector will be the key to U.S. economic
growth in the years to come.
Now that the dollar is at
a more reasonable level, our international competitive
position has dramatically improved so that American
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business cui again conquer new foreign markets.
Exports are now surging over 15 percent per year in
volume terms.
American firms have in general maintained good price
discipline.
Thereby they have helped to consolidate
the competitive advantage gained by the fall in the
U.S. dollar.
This new, outward-looking orientation has
not been easy for many firms:
they had to learn new
languages, absorb new legal codes, apply new technolology, and develop new marketing and distribution
systems.
But this expansion of export business will be
essential if our country is to remain a leader in the
world economy.
And the payoff to American businessmen
and workers will be substantial.
But these efforts should not be confined to foreign
sales.
American business should be able to increase
rapidly its penetration of domestic markets —
all the
more easily because marketing and distribution systems
are already well established.
Indeed, the higher
prices for imported goods have already begun to
restrain the growth of import volume.
Much of last
year's increase in imports was attributable to the
surge in demand for business machines and the buildup
of petroleum stocks.
The flow of consumer durables and
apparel into the country actually declined,
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particularly in the second half of the year.
The benefits of these trade shifts are now obvious in
our manufacturing sector.
Industrial production, which
had been lackluster in 1985 and 1986, grew almost 6
percent last year.
Much of that pickup was
attributable to a sharp increase in production at
industries with above-average trade shares.
Industrial
materials, high-tech equipment, and even traditional
capital goods all did extremely well.
The weaker
dollar and export subsidies also strengthened
agricultural exports, and thus further helped to reduce
the trade deficit and to ease the farm problem.
Because calls for protectionism still can be heard from
those less optimistic about the trade deficit, I want
to applaud the efforts to foster American and Canadian
well-being through the Canadian/American Free Trade
Agreement.
As you know, on January 2, President Reagan
and Prime Minister Mulroney initialed this important
document.
If the agreement is approved by Congress and
Parliament, it will open the way for broader trade
flows between our two countries.
Lower consumer prices
and higher employment in both countries should result.
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Inflation Remains Under Control
—I. I
II—
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What do these prospects for continued growth and the
movement toward better economic balance imply for
inflation?
First, the process of external adjustment has involved
a pronounced acceleration in the prices of imported
goods.
Over the past two years, this trend has been
particularly noticeable in the prices of imported
consumer goods, such as motor vehicles, photographic
equipment, and apparel.
Nonetheless, the effect on
domestic inflation has been smaller than most
forecasters predicted.
One key reason is that foreign
producers have sacrificed profits to maintain their
market shares.
But we cannot count on them to do that
indefinitely; and we should expect more upward
adjustments in prices of imported goods this year even
though the dollar is now much more stable.
What is
crucial is that the impetus to inflation from this
change in relative prices stop with the direct effect
on the prices of imported goods and does not feed
through to domestic prices and ultimately wages.
For many years, we have enjoyed labor cost developments
that have enhanced our international competitiveness.
These developments have helped to moderate increases in
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producer prices despite much higher costs for
materials.
In the non-farm business sector, increases
in unit labor costs have averaged less than 2 percent
in the past two years; in manufacturing, unit labor
costs have been flat.
American labor has reaped the
rewards in the form of an unemployment rate of only 5.6
percent and the creation of over 15 million new jobs in
the current expansion.
Over two million of these jobs
were created in the last six months alone - evidence of
the continued strength of the expansion.
Continued advances in productivity have improved
the performance of the manufacturing sector.
The
pressure to lower break-even points and to be more
competitive in world markets has spurred businesses on
to noticeable gains in efficiency.
As a consequence, producer prices have increased less
than one percent per year since 1983.
Producer prices
have been unchanged for the last half year.
If we are
able to perpetuate these trends, the outlook for
further price stability is bright indeed.
Monetary Policy Carefully Balanced
We at the Federal Reserve are committed to do our share
to sustain this favorable trend.
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As you know, growth in the money supply was moderate
for most of 1987 as we leaned in the direction of
countering potential inflationary pressure from the
depreciation of the dollar and the rise in oil prices.
The stock market crash in October —
it brought —
whatever the ills
also contributed to a lowering of
inflation expectations.
Subsequent to the crash, the maintenance of financial
stability and confidence became crucial, and the
Federal Reserve increased liquidity rapidly.
This
easing should be seen as a precaution against serious
retrenchment by businesses and consumers, and it seems
to have been successful: confidence rebounded, and the
fallout from the stock market decline has remained
within narrow bounds.
For 1988, our aim is to continue to support economic
growth at a pace consistent with further progress
toward price stability.
In February, the Federal Open
Market Committee set the 1988 target ranges for growth
of M2 and M3 at 4 to 8 percent.
The midpoint of this
range, 6 percent, is a full percentage point lower than
last year's target, and is designed to keep inflationary pressures in check.
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We must also be sensitive to the loosening of the
linkage between monetary growth and income in recent
years.
It therefore behooves us to factor a broad
range of economic and financial indicators into our
decision-making.
Interest rates, exchange rates, and
commodity prices determined in auction markets not only
are sensitive indicators of inflationary expectations;
they also are available instantaneously, and they offer
timely information on the. economic and financial
environment that should not be neglected.
With careful
surveillance of the economic and financial environment,
we can and will detect early indicators of a resurgence
of inflationary or deflationary pressures and take
timely action to forestall greater economic and
financial problems later on.
The Challenge Ahead
As I indicated at the outset, we have begun to make
considerable progress in restoring better balance to
the U.S. economy.
Yet the task ahead remains
challenging indeed, and we have no assurance that
everything from here on will go according to plan.
reduction and eventual elimination of the federal
deficit continues
to be of central importance.
We
must also increase our domestic saving if we are to
generate the financial resources we need for our
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The
investment program —
a program that, in turn, will lay
the foundation for continued noninflationary growth.
But if we persevere, there is good reason to expect
continued progress.
For American business and workers,
that perseverance calls for self-discipline and
determination.
An equal effort will be required by the
political leadership in the Administration and in
Congress.
And we, at the Federal Reserve, must remain
disciplined in our conduct of monetary policy.
We confront formidable challenges, but they are, in the
end, tractable.
We know our goal —
to maintain
growth within a framework of financial stability.
The remaining challenge lies in mustering the discipline to execute our plans.
will succeed.
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I am confident that we
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