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Prospects for the U.S. Economy Remarks o f Robert P. Forrestal, President Federal Reserve Bank o f Atlanta To the Economic Society o f South Florida Miami, Florida October 9, 1985 Good afternoon! I am delighted to be here with you today to share my thoughts on the outlook for our nation's economy, a topic I'm sure is very much on the minds o f each o f you in your daily work. My comments will focus first on where we have been and where we are now, economically speaking. Next Til o ffe r my views o f where we seem to be headed over the next year or so. Finally, Til be making some remarks about the imbalances that are currently generating pressures in several areas and which portend serious long-range problems unless measures are quickly undertaken to correct them. When I've finished, Til be happy to entertain questions not only about the economic outlook but also other topics o f current interest, such as the financial services industry. Review o f Recent Economic Perform ance A fter two years marked by dramatic recovery and expansion from a severe recession, economic performance became hardly more than lackluster in the first half o f 1985. Although many people, including myself, fe lt the pace o f growth had to slow from the extrem ely high rates we had been experiencing early in 1984, lest bottlenecks develop and a rekindling o f inflation ensue, I expected a transition or adjustment period o f about a quarter followed by sustained growth o f around 3 percent that has proven our long-term average in the post-war period. Thus, I admit that I have been a bit surprised that economic expansion slowed by as much and for as long a time as it did. GNP growth was virtually fla t in the first quarter and a modest 1.9 percent in the second. Last December and January the nation's jobless rate actually edged up slightly and then held steady at 7.3 percent for six months. Moreover, these developments occurred despite the fact that money and credit have been expanding at a very rapid pace for almost a year. - 2 - Fortunately, the third quarter seems to have brought the economy closer to the 2 l/2-to-3 percent growth rate that 1 fe e l is consonant with this stage o f the business cycle. The "flash" estimate o f GNP indicated growth for the July-September period was 2.8 percent, stronger than many analysts anticipated. Many other indicators o f economic activity support the view that we are seeing a meaningful improvement in business activity, and, quite frankly, I sense more positive expectations in many business people with whom I have spoken lately. percent mark. The unemployment rate finally dipped below the 7.3 In September the proportion o f the labor force unable to find work was 7.1 percent, up only slightly from the August rate o f 7.0 percent. Consumers propelled much o f this long awaited revival in economic activity. Housing has improved over the summer, apparently in response to declines in interest rates. Auto sales also surged as consumers rushed to take advantage o f manufacturers' low financing rates. August. Factory orders, including those for nonmilitary goods, rose in Finally, one o f the most positive features o f our recent economic performance is the very low level o f inflation we have had. The rate o f price increases for consumer goods has actually fallen lately, and we are likely to finish the year at a full-year inflation rate o f less than 4 percent, a better performance than last year. Despite this moderate rebound, several sectors o f the economy remain cause for concern. Paramount among these, in my view, is the international sector. Between July 1980 and February o f this year the foreign exchange value o f the dollar rose over 90 percent against the currencies o f our major trading partners. Last year we had a record trade d eficit o f over $120 billion, and this year the figure is likely to be even higher given the lags with which changes in exchange rates usually a ffe c t trade flows. Ongoing increases in the value o f imports over exports have exerted a considerable drag on economic growth. - 3 - Why has the dollar become so strong in the 1980s after almost a decade o f sustained weakness relative to other currencies? Certainly, a primary cause o f the dollar's strength is the very large federal budget deficits we have been running up in the last few years. The sheer size o f these deficits and the expectation that they would continue have put substantial upward pressure on interest rates especially in the context o f a strong recovery in which both businesses and consumers have also been borrowing heavily. Our total demand for credit might well have outstripped the supply available from our pool o f savings had it not been for foreign investors. Attracted by our high interest rates, lenders from abroad provided a very large share o f the funds we needed to finance our public and private spending spree. O f course, other factors no doubt contributed to the availability o f foreign savings to fund American debt. There appears to have been an shift in the preference o f foreigners for dollar-denominated assets compared with the 1970s, and this shift may have occurred for reasons that lie beyond the dynamics o f our economy alone. Whether perceived political instability elsewhere in the world enhanced the view o f the United States as a "safe haven" for investments or other explanations account for this change in foreign preference for dollars, this shift, along with the deficit-generated pressures exerted on U.S. interest rates, has attracted a vast amount o f foreign financing. On one hand, we have benefited from the availability o f foreign funds to supplement our own inadequate pool o f savings. For example, we have been able to sustain high deficits without sharp increases in interest rates that normally would have brought construction to a virtual standstill. Consumers have been able to go deeply into debt to pay for purchase o f new homes, cars, appliances, and numerous other items. Businesses have been borrowing heavily to finance mergers and acquisitions as well as investment in inventories, equipment, buildings, and other purchases that are usually financed. A t the same time and on an even larger scale, the public sector has been - 4 - relying on debt to make up for the difference between spending and revenues. Rising government expenditures, especially for defense, have fostered strong gains in both output and employment in related industries. For several years, thanks largely to foreign creditors, Americans as individuals and as a nation have been on a spending binge that, at least until a year ago, propelled enormous macroeconomic growth. "guns and butter," as it were. We have had both However, this foreign source o f credit has not been without its costs. The key problem has been the rise in the foreign exchange value o f the dollar that has been associated with the increased demand for dollar-denominated assets. The deleterious effects o f the sharp rise in the dollar are most apparent in the manufacturing and agricultural sectors. A heavy toll has been taken on those manufacturers and farmers who rely on exports as a major source o f revenues. A t the same time, and perhaps in a more noticeable fashion, industries most sensitive to import competition have suffered the strains o f increased pressure from foreign producers whose goods have become less expensive in terms o f dollars. Some textile, apparel, and footwear plants have been forced to furlough workers, reduce hours, or even shut down permanently. pressures. Even some capital-intensive industries have not been immune to import Moreover, the efforts o f many manufacturers to meet foreign competition by improving productivity often entail reduced need for labor inputs. For farmers the e ffe c t has been less noticeable in terms o f jobs than in financial affairs. Worldwide surpluses o f many farm commodities have depressed agricultural commodity prices and, concomitantly, farm revenues. Thus, farmers have found it increasingly difficu lt to service, let alone retire, the heavy debt burden they built up during a period several years ago when expanding markets and the expectation o f higher land values spurred farmers to borrow heavily. When you add to these factors the dollar's negative e ffe c ts on foreign demand for U.S. crops, it is easy to see why some farmers as - 5 - w ell as the financial institutions that service them are considered to be on the verge o f crisis. It is true that through the end o f September the dollar declined about 20 percent from its February peak. However, the beneficial e ffects o f this decline will take some time to be fe lt in trading patterns for industrial and agricultural goods. Many trading relationships are established by contract and remain in e ffe c t until the expiration date regardless o f exchange rate fluctuations. Other buyers o f imported goods may actually rush sales into the present because they anticipate prices will rise in the future. For these and other reasons, it seems unlikely that improvements in the exchange value o f the dollar will have an appreciable e ffe c t for six months to a year or more. Certain farmers and manufacturers feel that they cannot hold on that long and are actively seeking either protectionist legislation, public financial support, or both. The current flare-up we are legislators is deeply troubling to me. seeing in protectionist sentiment among our I fully sympathize with the desire o f our elected officials to come to the aid o f their constituents. However, the history o f well- intentioned protectionist measures is marked by a consistent pattern o f reprisals from abroad, reduced trade flows, and sometimes even recessions. If Congress enacts either some form of tariffs or the putatively more benign measure o f subsidies, I fe e l certain that other countries w ill retaliate, and the network o f anti-trade measures that is likely to ensue could well take years to undo. Even in the short run such measures could have serious consequences. For example, some o f the industries most likely to be aided by protectionism are the same industries on which our less developed trading partners most heavily rely to boost their own exports and thereby to service their debts to American financial institutions. - 6 - Although the LDC debt situation is not as ominous as it once was, dislocations to some o f these fragile foreign economies would probably have ripple effects, some would say tidal wave effects, on certain financial institutions and perhaps subsequently on the safety and soundness o f our financial system in general. When you add to this potential problem others already troubling the financial services industry, such as the pressures on farm banks and even Government-sponsored farm credit agencies that I’ve already mentioned, I think you will agree that there is due cause for concern about problems in the international sector and how they impinge on the economy. Economic Outlook Notwithstanding the array o f problems I’ve just outlined, I do expect the economy to sustain a growth rate o f around 3 percent for the foreseeable future, and as I noted earlier, such a growth rate in a mature phase o f expansion such as the present is quite respectable. Nonetheless, given the sluggish pace o f the first half, the moderate dimensions o f this acceleration in the second half probably spell full-year growth for 1985 of modest proportions. Looking ahead, though, if we can maintain the improvements we’ve experienced in the third quarter, we are likely to enjoy a better record o f expansion during 1986 than this year. Aside from the rapid growth o f money and credit that has occurred for a number o f months, one o f the main factors I see underlying this improved picture is the decline in the value o f the dollar that has taken place since February. By next year the lagged effects o f our more favorable foreign exchange rate should begin to benefit many factories and farms. Once manufacturers and farmers increase sales abroad, their capital spending plans are likely to pick up, thereby boosting orders for machinery, equipment, and even new plants. - 7 - I doubt that the improvement will be translated into dramatic progress toward reducing unemployment even though we could see the proportion o f those unable to find work drop below the 7 percent mark. Yet, I am not too troubled about a jobless rate that lingers in the 7 percent range. This remark does not reflect callousness on my part. Rather, it is due to the fact that we already have such a large percentage o f our population working. As high as 7 percent sounds, it is probably not much above a reasonable "fu ll employment" level, given the high labor force participation rate currently prevailing. In my view, the jobless rate w ill fall on its own over the longer term as a result o f demographic changes. Now that the baby-boom generation has virtually been absorbed into the labor force, there will be few er new entrants seeking their first jobs each year. Thus, as long as economic growth continues at a reasonable pace, there seem to be grounds for expecting a gradual decline in the unemployment rate. On the inflation front, though, this anticipated improvement in overall economic performance has some negative implications since some o f the growth I foresee is predicated on past and expected future declines in the value o f the dollar. As the dollar's exchange rate falls, not only will the prices o f U.S. goods drop, but also the price we pay for imports w ill rise. While this development should help American producers regain reduced market shares and promote job growth, the resulting stimulus to the economy could create price pressures, particularly if we are already near the full-employment level. In addition, American consumers will have to pay higher prices for goods from abroad. What's more, there is always the danger that American producers will become somewhat less price conscious once they are relieved o f some o f the pressure o f foreign competition. The net result could be a rise in prices from the current level o f around 4 percent. Nonetheless, other factors such as declines in the price o f oil, augur inflation o f moderate proportions at worst in the year ahead. - 8 - Summing up the near-term outlook, I believe we could experience a better year in 1986 than in 1985, with full-year growth in the 3 percent range. The unemployment rate is unlikely to dip dramatically at this point in the expansion, but continuing respectable gains in the number o f people employed appear quite probable. Finally, it seems possible that inflation w ill accelerate somewhat as prices o f imports, on which we have come to depend so heavily, rise in concert with declines in the foreign exchange value o f the dollar. Nevertheless, there is little reason to expect price increases to accelerate sharply. Imbalances and the Longer Term Outlook Beyond the next year or so, I am concerned that the imbalances that have been troubling the economy will adversely a ffe c t longer term developments, and, I fear, they might do so in far more negative ways unless their underlying cause is corrected. negative e ffects o f the federal budget d eficit mount over time. to feel the drag of an "overvalued” dollar on The We have already begun employment and output in our manufacturing and agricultural sectors, as I described a few minutes ago. Although we should recoup many o f our losses as the dollar declines, some manufacturing concerns that closed down may never reopen and the decline in market share that certain industries have been experiencing as international comparative advantage shifts may have taken place faster than it otherwise would have done. Other potential problems also loom over us. The continuing high level o f interest rates makes it more difficu lt for thrift institutions to correct portfolio imbalances between assets and liabilities. A large portion o f S<5cL loan portfolios still consists o f low interest rate mortgages, whereas thrifts must o ffer higher interest rates on their deposits to compete with money market funds and MMDAs. Until the decline in the dollar's value has time to a ffe c t trade flows and contracts, American farmers will have -9 - difficulty selling abroad and retiring or reducing their debt burden. Consequently, I am afraid that many farm banks as well as other depositories w ill remain in a tenuous condition until we can make a convincing expression o f our determination to reduce the federal budget deficit. The large federal budget d eficit also creates imbalances with respect to monetary policy. As you well know, money and credit have expanded at a rapid pace for about the past 11 months. This trend has certainly contributed to the decline in interest rates this year and the associated revival in interest-sensitive industries such as housing and autos. It may also have helped foster the fa ll in the value o f the dollar this year. While monetary policy has thus helped ease the pressures o f increased demand for money and credit by increasing supply, our elected representatives have done virtually nothing either to reduce the demand for borrowed funds by cutting spending or to increase the supply o f funds to support the current level o f federal spending by raising taxes. Thus, fiscal and monetary policy, while both in one sense stimulative, are ’’out o f sync" given the present situation and its particular problems. In the longer term other e ffe c ts w ill come to have equal or even more serious consequences. It's not just that we're borrowing heavily as a nation. We've done that before in our history and not usually suffered problems other than perhaps some redistribution o f income in favor o f those in upper income brackets and thus generally in the best position to provide the savings needed to finance such borrowing. The troubling feature o f our current level o f borrowing is that a major portion o f these funds has come from abroad. We appear to have become a debtor nation after half a century o f net creditor status. Borrowing from abroad to finance growth is appropriate for a developing country such as the United States was during the nineteenth century. However, it is unseemly for the world's largest economy to become dependent on other, smaller - countries to finance its growth. 10 - This situation is bound to constrain the development potential for many less developed, third-world countries. Furthermore, it transfers an enormous responsibility to future generations to repay the debt and the ever-mounting interest we are accumulating. Eventually foreigners will become less willing to finance our spending urge. Since this willingness has been motivated not only by the expectation o f continuing high interest rates but also by certain external dynamics pertaining to the preference for dollars -- dynamics that we neither understand fully nor control, it could shift again, perhaps suddenly. Ultimately, we shall have to find ways not only to reduce spending but also to save more just to pay o ff the debt we have already built up. Is it fair to force our children and grandchildren to save in order to pay for the high level o f consumption that we have been enjoying? Policy Implications What should we be doing as a nation? Perhaps I should say, what MUST we be doing? First and foremost, we need to take steps to bring federal spending back into line with federal revenues. The reduction o f the d eficit that results must be o f sufficient magnitude to assure financial markets that we are serious about coming to grips with this problem. Once this medicine has been prescribed, pressure on interest rates should ease and, with that cutback in future demand for credit, the foreign exchange value o f the dollar should continue to decline without the added stimulus o f rampant money supply growth. This measure in turn should speed up the scenario I have already predicted whereby manufacturers and farmers find it easier to export and less difficult to compete against imports. and sales. Employment advances could accelerate along with orders, production, In addition, this change in policy and its effects should mitigate the difficult situation in which many financial institutions now find themselves. O f course, there will be adjustments o f a less sanguine nature, such as the potential for higher prices, but in the long run I fe e l gains w ill far outweigh any transitional problems. - li lt is essential that we begin to take this medicine as soon as possible so that the burden we transfer to future generations and the negative effects on longer term growth are kept as small as possible. As I've mentioned, the interest alone on the debt we've already accumulated is appreciable and will have to be paid back to our foreign lenders eventually, either by us or by following generations. Another policy prescription that we should begin to think about concerns the very low savings rate o f the United States. Insofar as public policies discourage savings, we should be considering alternatives that would foster the expansion o f our domestic pool o f savings. We must do so in order to fund the ongoing capital investment that w ill be increasingly necessary to compete in a global marketplace. In addition, it is in our own interest to return as quickly as possible to the status o f a creditor nation so that we can help other economies develop to the point at which they can become expanding markets for American products. However, whatever reforms we adopt to increase our propensity as a nation to save should, in my view, come to the top o f our policy agenda only after we have addressed the pressing issue o f the budget deficit. Otherwise, we might find well-meaning reforms designed to alter Americans' long-established savings habits are being introduced so abruptly that we inadvertently send the economy into a temporary tailspin. Conclusion In conclusion, I see the nation's economic outlook as basically sound. We are closer to the maximum non-inflationary expansion rate we can expect to sustain over time. From my perspective, the intermittent performance of the economy we experienced earlier this year is attributable primarily to the large federal budget deficit and the imbalances it has introduced into the economy. We can overcome these imbalances and launch the economy onto a sustained trajectory o f growth, but to do so - 12 - w ill require reducing the d eficit as quickly as possible and then devising policy measures designed to alter the savings customs o f Americans. problems in the past and resolved them. We have faced equally difficult I am optimistic that we have the will as a people to take the necessary steps to rise to today’s economic challenges.
@FedFRASER