The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.
FOR RELEASE ON DELIVERY THURSDAY, APRIL 12, 1984 12:00 NOON E.S.T. Remarks by LYLE E. GRAMLEY Member, Board of Governors of the Federal Reserve System before The Mid-America Committee April 12, 1984 Chicago, Illinois The current economic recovery is now well into its second year. happy life. All of u s , I am sure, wish it a long and That hope is more likely to be realized if we avoid events that often happen during the course of an economic expansion--namely, accelerating inflation, decisions of consumers, businesses, and workers becoming more heavily influenced by expectations of rising prices, and imbalances and distortions developing that undermine the strength of the economy. As yet, we have not seen developments of that kind on a wide scale. But warning signs are beginning to emerge that suggest the need for concern and caution. Let me try to develop briefly the reasoning behind this conclusion, and then discuss with you its implications for monetary policy. I must emphasize at the outset that what I say about both the condition of the economy and the course of monetary policy reflects my own personal views, and nothing more. Looking back, the recovery that began early last year has been much stronger than had generally been expected. To be sure, growth of real GNP in the first four quarters of recovery--at 6-1/A percent--was somewhat below the average for the comparable period of earlier postwar recoveries. - 2 - But the growth of domestic aggregate demand--that is, real GNP less net exports--amounted to 7-3/4 percent, and was about equal to the average for the first year of recovery. We simply resorted more extensively to foreign sources of supply to meet aggregate demand during this recovery, in large measure because of the strength of the dollar in exchange markets. For a time late last year and in early January, it looked as though the pace of economic expansion might be slowing. That is no longer so clear. rising strongly; Employment has been activity in housing is moving up again, new orders for capital goods continue to strengthen, and consumer spending remains robust. As you know, the very preliminary estimate of first quarter real GNP indicates a rise of 7-1/4 percent, annual rate, up from the five percent figure of the fourth quarter. Of course, these early estimates are based on fragmentary data, and are often revised. The next estimate might be somewhat lower, or somewhat higher--there is no way now to make a good judgment. -3- What accounts for the unusual sti'ength of the recovery relative to expectations, particularly when real interest rates are so high by historical standards? Perhaps by asking this question, we might gain some insight into the future. There are, I believe, several factors that deserve mention. First, the decline in inflation over the past several years has acted as a powerful stimulant to economic growth in a variety of ways. It played an important role in facilitating the decline in interest rates that began in mid-1982, and in the associated boom in stock prices. Reduced inflation also made possible increases in the real value of wages during 1982 and 1983--for the first time since 1977--increases that occurred even through the nominal rise in wage rates was moderating. Perhaps most important of all, the decline in inflation con tributed to a strong economic performance through bolstering the confidence of consumers and businesses--confidence in their own and the nation's economic future. That shows up clearly in indexes of consumer and business confidence, but even more so in the strength of consumer spending for a wide range of goods and services, and in the surge of business investment in new equipment during the last half of 1983. -4- A second factor contributing strength to the recovery was an improvement in consumer balance sheets. The ratio of consumer debt to income declined substantially from early 1980 through mid-1982, and stocks of durable goods aged considerably during that period. Moreover, the total net worth of consumers has increased substantially, mainly because of the dramatic rise in stock prices from mid-1982 through early this year. Third, advancing technology appears to be an important driving force behind the exceptionally strong rise in business investment in durable equipment. High-technology capital--such as computers, scientific instruments, communications equipment, and office machinery--is being installed at a dramatic pace around the country, and accounts for almost half of total investment in producers durable equipment in 1983. Fourth, and by no means least, is the effect of the most expansive fiscal policy our country has ever experienced in peacetime history. Estimates of current and prospective Federal budget deficits have been so widely discussed that I need not repeat them. Let me note, however, that when Federal -5- tax rates were reduced dramatically a few years ago, it was hoped that the incentive effects would increase both the rate of personal saving and the willingness to work. Con sequently, aggregate supply would increase along with the rise in aggregate demand. but it did not happen. not risen; That was a theoretical possibility, The personal saving rate has declined, and the increase in the civilian labor force last year was the smallest in two decades. Thus, the result of large and rising structural deficits in the Federal budget has been large and rising fiscal stimulus to demand, with little or no corresponding effect on supply. None of these four factors will provide as much thrust to economic expansion this year as they did in 1Q83. But their influence on consumer decisions to spend, and on business decisions to invest, is still being felt. The possibility exists, therefore, that the rebound of economic growth in the first quarter reflects continued underlying strength in aggregate demand. - 6 - This possibility is a bit worrisome in light of the very slow growth that has been occurring in labor and capital resources. For example, because growth in the labor force has been exceptionally slow, the unemployment rate has dropped almost three percentage points from its peak in late 1982. That is a much larger decline than in the comparable period of any economic recovery during the past three decades. In the manufacturing sector, idle capacity has also declined sharply, because capacity to produce has risen at only about two percent a year--while output has been increasing at an annual rate of around 15 percent. Since its trough in November 1982, the rate of capacity use in manufacturing has risen nearly 18 percent, and is already near the average leve], prevailing over the past 25 years. Indeed, pressures on available productive capacity are already being felt in some areas. The paper industry apparently is operating at close to 100 percent of theoretical capacity. Some electronic components are in short supply. Domestic auto producers are having trouble keeping up with the demand for the more popular cars, hampered to some degree by shortages of parts. And the percent of all business firms reporting slower deliveries has risen to the highest level since early 1979. -7- As the degree of slack in markets for goods has diminished, prices have begun to firm--not just for sensitive industrial materials, but for a broader range of producer and consumer goods. For example, the rise of consumer prices excluding food and energy reached its trough in late 1982 and early 1983, when the annual rate of increase was down to about two percent. Recently, the figure has been running a little over five percent, or about in line with the long-term trend of unit costs of production. Such a pickup in the rise of consumer prices is not unusual during the early stages of recovery. What is at issue is whether we can hold the line at this point, or whether inflation will worsen as recovery proceeds. In this respect, 1984 and 1985 will be critical years in our national effort to end inflation. In each business expansion from 1960 through 1980, inflation rose to a higher level than had prevailed at the peak of the previous business cycle. We are all only too familiar with the end result of that process. If events of the next year or two were to convince the public that the U.S. economy was back on that treadmill again, much of the gain against inflation since late 1979 might be lost--a gain that was achieved at enormous cos t . -8- The chief concern of economic policy now, therefore, should be to avoid a resurgence of fresh inflationary forces as the recovery proceeds. That is a task to which both of our major instruments of policy--fiscal and monetary--need to be directed. There is, 1 believe, reason to hope that concrete steps on the fiscal front will soon be taken. A downpayment on deficit reduction would, of course, be only a first step in dealing with the massive structural deficits that lie ahead. And, unfortunately, one cannot realistically expect that deficit reduction measures enacted this year will have significant restraining effects on the economy much before the middle of 1985. Thus, over the next year or so, the course of monetary policy is particularly crucial to the fight against inflation. The course being followed by the Federal Reserve does not, and in my view should not, start from the presumption that the economy will grow too strongly over the remainder of 1984, or that inflation will inevitably accelerate as the recovery proceeds. Yet, those are clearly possibilities that must be guarded against. -9- The 1984 targets for the monetary and credit aggregates announced by the Federal Reserve in February are designed to do just that. They provide for moderate increases in the principal monetary aggregates and also in the credit extended to domestic nonfinancial borrowers-increases that will permit continuation of a sustainable recovery. They also provide latitude for restraining the economy if costs and prices threaten to advance more rapidly. To date, growth in the monetary aggregates has remained within the announced ranges--at the lower end of the range for M2, and at the upper end for Ml and M3. But the amount of borrowing by the domestic nonfinancial sectors, judging by early estimates, was extremely large in the first quarter. Indeed, relative to GNP, the volume of such credit appears to have returned to the record pace of 1978--even after allowance for merger-related financings. External credit needs of businesses have begun to hit the markets on a substantial scale. As a consequence, the competition for funds between public and private borrowers has sharpened, and market interest rates have moved up correspondingly. -10- I am extremely sensitive to the fact that rising interest rates have damaging effects on farmers, on small businesses, on thrift institutions, and on developing countries struggling to find ways to service large external debts. But there is little that monetary policy alone can do to ameliorate those effects. Indeed, if the Federal Reserve were to try to limit rising interest rates by increasing supplies of money and credit at an excessive pace, the rise in inflation and interest rates that would occur later on would take an even larger toll. The challenge facing monetary policy over the next year or two is a large one. It is to preserve the gains already made against inflation, and to move on to regain price stability. The Federal Reserve must not shrink from that challenge. ####«###
@FedFRASER