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For release on delivery 10:00 A.M. M.S.T. (12:00 Noon E.S.T.) January 25, 1985 The Economy and Monetary Policy Remarks by Lyle E. Gramley Member Board of Governors of the Federal Reserve System before the Metro Denver Business Outlook Conference Denver, Colorado January 25, 1985 The Economy and Monetary Policy I am happy to participate in this Business Outlook Conference, and to give you a few thoughts on the economy and monetary policy. I must emphasize that what you will hear are my personal views, not necessarily those of the Board of Governors or any of its other Members. My remarks today will focus on some of the salient features of the current recovery to date, and on the role that monetary policy may have played in those developments. I will also look to the future, and ask what course of policy is likely to maximize the chances of sustaining economic expansion. The current recovery is now two years old. According to data released by the Commerce Department earlier this week, real GNP over the past two years has risen at an annual rate of six percent. This is higher than the average for comparable periods of earlier postwar recoveries, despite the reduced rate -2- of growth that has occurred since mid year 1984. The increase in real disposable income during the past two years has been particularly robust, aided on the one hand by substantial income tax reductions, and on the other by large increases in employment. Nearly seven million new jobs have been created, and the unemploy ment rate has declined by 3-1/2 percentage points. Particularly heartening is the fact that this enviable record of growth has been achieved without any increase in the inflation rate. History warns that inflationary pressures may intensify as a recovery proceeds, but as yet that has not happened. Indeed, the rate of inflation--at around a 3-1/2 to 4 percent annual rate currently, according to the broadest measures of prices--actually appears to be a little lower than it was at the start of the recovery. The tremendous increase in the international value of the dollar over the past several years has been an important factor in this improved inflation performance--directly through its influence on prices -3of imported products, and indirectly by increasing competition powerfully in both product and labor markets. Developments in markets for fuel and food have also contributed to the further moderation of inflation over the past two years. While the average rate of expansion thus far in the recovery has been comparatively strong, the pace of recovery has been uneven. Growth was very rapid during the first six quarters, and then slowed substantially beginning shortly after midyear 1984. For a time, there were concerns that the slowdown might be a harbinger of recession. I would remind you that slowdowns during cyclical expansions, followed by a resumption of growth, are the rule, not the exception. They have happened in virtually every recovery during the postwar period. The four percent growth rate estimated by Commerce for the fourth quarter of last year suggests that the economy has begun to emerge from its recent period of sluggish growth. Moreover, we appear to have headed into the new year with added momentum. For example, manufacturing employment rose in December by the largest -4amount since last March, and the workweek lengthened also. Consumer spending has picked up recently. Retail sales advanced strongly in November and held those gains in December. sales have continued to increase this month. Auto Housing starts are also on the upswing, stimulated by the decline in mortgage interest races that began late last summer. The current cyclical expansion, therefore, seems to me far from over. It is not my purpose today to provide a quantita tive forecast for 1985--that task was assigned to another speaker at this conference. Let me simply note that the chances seem to me reasonably good that our economy will continue to grow during 1985 at a rat;e above our long-term growth potential, so that additional progress will be nade in rediicing unemployment. I am also optimistic that the inflation rate will not move up appreciably this year, and with a little luck it might move down. A substantial decline in the dollar's exchange value could worsen the inflation outlook, however, a subject to which I will return lacer. -5Overall, the course of this recovery thus looks quite satisfying. Nevertheless, some sectors of the economy and some regions of the country are falling far behind. The weak sectors are those experiencing greatly increased competi tion from international sources because of the prolonged rise in the value of the dollar in exchange markets. Industries heavily dependent upon export markets have been badly damaged, as have others losing a significant share of their domestic markets to foreign producers. The amount of external drag on the domestic economy reached a peak in the third quarter of last year, when declining net exports reduced the annual growth rate of real GNP by almost four percentage points--a record for any postwar quarter. But the effects of the dollar's rise on imports and exports have acted as a powerful restraint on growth throughout the recovery. Indeed, it is my judgment that the rise in the real value of the dollar over the past four years has had a direct depressing effect on aggregate demand for goods and services roughly as large as the stimulative effect of the increase since early 1981 in the structural deficit in the Federal budget. Let me turn now to the role that monetary policy may have played in shaping the general contours of this recovery. This is not an easy issue to deal with, because there is no single, widely accepted, way to characterize monetary policy. Interest rates are always hard to interpret, and particularly so in a world of dramatic increases in the Federal deficit, enormous inflows of capital from abroad, and changing inflationary expectations. And the monetary aggregates themselves often give off conflicting signals that are potentially misleading, especially over short time periods. -7- During the two years ending in the fourth quarter of 1984, however, the principal monetary aggregates have been growing at annual rates that are quite high by standards of the past decade--7-l/2 percent for Ml, 8 percent for the monetary base, and 10 percent for M2. (Similar rates of increase prevailed over the past three years.) It is particularly striking that such growth rates of the monetary aggregates have occurred while the inflation rate was not only low, but actually declining somewhat. Indeed, the real stock of narrow money balances--that is Ml adjusted for inflation as measured by the GNP deflator--has been rising at about a four percent annual rate over the past several years. This compares with a trend rate of growth of real Ml of less than one percent a year over the past twenty five years. -8The magnitudes that I have cited probably overstate the expansive thrust of monetary policy during the recovery, because the velocity of Ml dropped precipitously during 1982 for reasons that are only dimly understood. Nonetheless, making such rough allowances as one can for an unusual in crease in the demand for money (and such allowances are necessarily very rough), it still appears to be true that growth in real money balances has acted as a strong expansive force during the current recovery. Such a judgment seems confirmed by the unusually high growth rates of private credit-even after adjusting for merger-related financing— that have characterized this recovery. Did monetary policy contribute to the unusually rapid rates of economic expansion that occurred during the first six quarters of recovery? Presumably it did, since growth rates of the monetary aggregates were quite high during most of that period. -9Nevertheless, the enormous increase in fiscal stimulus, and the strengthening of business and consumer confidence that accompanied steady progress against inflation, may well have been the dominant factors. Did monetary policy contribute to the slowdown in expansion during the second half of last year? did* Presumably it since growth rates of all of the major monetary aggregates moderated as the recovery proceeded. But the second half slowdown also reflected other developments that are only remotely related to monetary restraint. For example, by the first half of 1984, nonfarm inventory investment had risen to more than one percent of GNP, an unusually high level by historical standards; the personal saving rate increased somewhat in the third quarter; and, as I mentioned earlier, the drag on domestic output coming from the international sector increased substantially further. In any event, the moderation of monetary growth rates that has occurred during this recovery was a necessary ingredient of a monetary policy whose long-run objective has been, -1Qand still is, to reduce gradually the growth of money and credit to rates consistent with stable prices. yet been achieved. That objective has not Four percent inflation is vastly better than double-digit inflation, but it is not price stability. And growth rates of the major monetary aggregates like those of 1984-5 percent for Ml, 7 percent for the monetary base, and 7-1/2 percent for M2--are still higher than the rates that would be consistent with long-run price stability in an economy whose long-run growth potential is probably around 3 percent or a little less. Let me be clear. The present course of monetary policy will, in my judgment, permit a reasonably satisfactory growth of the economy during 1985 without risking a renewal of in flationary pressures. But further reduction in the growth of money and credit will be needed at some time in the future if the goal of price stability is to be realized. -11As I look through 1985 and beyond, I see reasons to be optimistic about our nation's potential for sustaining economic expansion over a prolonged period. low and declining; Inflation is the work force is gaining in maturity and experience} productivity has improved; business fixed investment is relatively high as a share of Gross National Product, and a large part of the investment in producers durable equipment is in the form of high technology capital. The single most important contribution that we in the Federal Reserve can make to realizing our nation’s long-run growth potential is, I believe, in sticking to the course of monetary policy adopted five years ago— namely, by focussing primary attention in the conduct of monetary policy on the goal of restoring an inflation-free economy. Whether we as a nation succeed in sustaining economic growth over a prolonged period will, I believe, depend less on the course of monetary policy than on our ability as a -12nation to deal effectively, and in a timely way, with the very troubling deficits that have developed over the past several years in the Federal budget, and in our external accounts. Early in this recovery, there were widespread concerns that the huge increase in the structural deficit in the Federal budget would stimulate the economy excessively, exert extreme upward pressures on interest rates, and perhaps aggravate inflation. These developments have not materialized, in large measure because of a dramatic rise in capital inflows from abroad that has driven up the exchange rate by unprecedented amounts. As a result, the effects of the rise in the structural Federal deficit on aggregate demand for goods and services and on interest rates have been offset by an increase in the current account deficit on international transactions. -13We cannot realistically expect this situation to continue indefinitely. Capital is now flowing into the U.S. at an annual rate of around $100 billion a year. Historically, the U.S. has been an international creditor nation, but we may have already crossed the line to become an international debtor. Just when that happened, or will happen, can't be determined precisely because of inadequacies of available data. But at current rates of capital inflow, our net international debt will rise to $1 trillion in ten years or less, and the U.S. will become the world's largest debtor nation. Both economic theory and common sense suggest that, before our international debt reaches such a magnitude, foreign investors will grow wary of further accumulation of dollardenominated assets. The dollar will then begin to decline; the current pattern of trade flows will reverse; inflation will accelerate, and pressures will be exerted on interest rates. -14If the declines in the dollar were both large and abrupt, the resulting economic and financial consequences could seriously threaten our ability to sustain economic expansion. Such a development does not seem near at hand; indeed, the dollar's strength continues to be amazing. Our nation, therefore, has time to take what steps we can to ameliorate the potential problem. There is no simple way to reduce deficits in our international accounts that stem from an overvalued dollar. Ironically, the dollar is as high as it is, in part, because our economy has shown both great dynamism and a declining inflation rate. No one would wish to see those sources of the dollar's strength wasted away. -15It would be of great benefit, however, if the structural deficit in the Federal budget were declining when the dollar begins to fall. Then, the impact of the reduction in demands for dollar assets on interest rates and on aggregate demand for goods and services would tend to be offset. Actually, even the anticipation of further reductions in the structural budgetary deficit might well be enough to begin an orderly process of downward adjustment of the dollar in exchange markets. The discussions now underway in Washington to find ways to reduce massive deficits in the Federal budget are of crucial significance for the ability of our nation to maintain a strong and healthy economy in the years ahead. We must, therefore, hope fervently that these discussions will finally lead to tangible results. ########
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