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For release on delivery 10:00 a.m. EDT March 10, 1993 Summary "Testimony on the Economic Conditions in the Seventh Federal Reserve District" Remarks of Silas Keehn President, Federal Reserve Bank of Chicago Before the United States Senate Committee on Banking, Housing and Urban Affairs March 1o, 1993 Washington, D.C. https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Mr. Chairman and Members of the Committee I am pleased to be here today to discuss economic conditions in the Seventh Federal ReseNe District and to comment on my views on monetary policy. These topics are inherently intertwined and seNe as important complements to one another. The Seventh District, which includes all of the state of Iowa and most of the states of Illinois, Indiana, Michigan and Wisconsin, is an economically large, important and diverse region which both reflects and drives a substantial portion of the U.S. economy. By any measure, the District ranks as a major economic force and therefore, conditions in the District directly influence my views regarding monetary policy. And in turn monetary policy actions have an important impact on economic activity in our District. The five states of the District account for about 14 percent of the nation's GDP and 18 percent of U.S. manufacturing employment. The District produces 45 percent of the nation's automobiles, 30 percent of the trucks, 38 percent of the nation's steel and more than 40 percent of the country's farm machinery. Farmers in the Seventh District account for nearly a fifth of the nation's annual sales of farm commodities and half of the corn, soybeans and pork produced nationwide. The District is the headquarters of some of the largest manufacturing, retailing and financial service firms in the United States. With the exception of defense activity and some computer related production, the District is a representative and sizable slice of the American economy. Given its size and diversity, it is not surprising that the District mirrors the economic challenges and opportunities in the U.S. economy as a whole. As in the nation, recent District performance has improved but the pace of improvement continues to be impeded by further financial and industrial restructuring. Restructuring problems are not a recent development in our District. As a result of excesses in the 1970s, the District's agricultural sector went through a sizable and painful adjustment in the 1980s. The https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 2 expenditures and the leveraging by farmers that occurred during the export-led boom of the 1970s proved to be unsustainable by the market realities of the 1980s. As farm earnings and land valued receded, the adjustment was extremely difficult for those who were directly involved. But to a significant extent, this adjustment has been accomplished. The subsequent improvement in farm earnings, income-return to farm assets and the level and quality of farm debt has placed the industry on more solid footings. Nevertheless, the painful memories of the 1980s has left a mood of uncertainty and caution in the agricultural community. Structural change in other sectors has also been impacting the District since the mid1960s, but accelerated rapidly in the 1980s. The recession of 1981-82, was devastating to District industry. The District lost nearly 1.5 million jobs during 1980-82 accounting for a sizable portion of the nation's job loss of 2 million over this period. Somewhat like our recent experience, expectations that the cyclical downturn would be followed by the usual rapid recovery in District jobs proved false. A vigorous recovery followed the 1981-1982 recession and some of the cyclically sensitive jobs returned, but many jobs never returned as a result of structural change. Intense competition and changing markets both domestically and internationally have forced firms, particularly those involved in the manufacture of durable goods, to put heavy emphasis on productivity as a way of reducing manufacturing costs. District manufacturing firms have invested an average of 5 to 10 percent more in equipment per production wo.rker annually than firms in the rest of the nation. Estimates on the relative improvement in District manufacturing suggest that efficiency in the District improved about 20 percent more than in the rest of the nation. These improvements, in conjunction with the very painful process of restructuring, put these firms in a better position to compete in the domestic and international markets. This bodes well since exports are very important to the District's economy, accounting for https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 3 over 20 percent of the production of District goods. Industrial restructuring combined with financial restructuring led to intensified and broadened change in the District in the late 1980s and continues today. As we moved through the most recent recession, expectations about job recovery have again proved false as a result of longer term structural changes being super-imposed on a business downturn. Within the District, the most dramatic restructuring has been in the auto industry. The Big Three auto producers have cut annual production capacity by about 2.5 million units and within our District direct job losses have amounted to over 70,000 (most in Michigan) since 1985 with another 40,000 job eliminations announced for the next 2 years. These numbers do not take into account additional losses in the related supplier firms. Retailing and financial firms have also reduced employment levels as they strive to achieve competitiveness in today's economy. Nor did the District escape unscathed from the financial trauma that afflicted the rest of the nation. But it suffered less. The excesses in commercial real estate speculation were not as prevalent in the District. Banks were more conservative in their loan evaluations having learned from their experiences in the severe 1981-1982 economic downturn. As a result, there has been a 70 percent decline in the number of low rated banks in the District since the end of 1986. Further, District banks have continued to improve earnings and capital and thus are in a good position to provide the credit necessary for more rapid economic activity. Recognizing the problems confronting the District, I have consistently favored monetary policy actions that would foster financial conditions necessary for sustainable economic growth. It has been obvious from our continuing and extensive contacts in the District that the economy would need assistance to deal with the significant structural drags on job creation and growth. It has also been clear that the needed adjustments would be https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 4 painful, but a vital, growing national economy cannot be assured as long as there are significant financial and industrial imbalances. Restructuring has resulted in major gains in productivity for District firms. But as much as productivity gains are needed to maintain competitiveness and promote long term economic growth in our District, there is a continuing concern about what this means for job creation and the income gains necessary to generate improved standards of living. Today, I am guardedly optimistic about the current outlook for the District economy. The level of economic activity in the District has improved and in a modest context, the outlook is positive. Auto production schedules in the first quarter of this year have been set about 20 percent ahead of last year. This translates into a domestic production level of 6.2 million cars at an annual rate. We currently forecast that the combined sales of cars and light trucks will total 13.4 million units for the year, a 3.8 percent increase from last year. The steel industry has shown improvement and mills in the Midwest are currently operating at over 85 percent of capacity and industry forecasts suggest that some 85 to 86 million tons of steel on a nationwide basis will be shipped this year. The machine tool and equipment industries, also very important to our District, have shown signs of improvement with industry sources forecasting 8 percent growth for this year with a 5 percent increase in exports and a 7 percent decline in imports. Retailing activity has been comparatively good with the higher levels of retail sales that we experienced during the Christmas selling season holding up rather well, as we have moved into the new year. Construction activity has been mixed, but on balance has shown some strength. And there are tentative indications that the values of commercial properties have stabilized. Still, we are dealing with relatively high vacancy levels in our commercial office buildings and do not expect a resumption of construction activity in this sector in the near term. However, home construction and expenditures for construction on public projects have shown an improvement. https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 5 While there has been an increase in employment in the District from the low levels reached at the bottom of the last recession, unemployment levels in District states, except Illinois (as of February, the latest month for which data is available), were running under the national average. Michigan's unemployment as of February was 6.8 percent, down from 8 percent in December. Over this period Michigan has averaged unemployment rates significantly higher than the national average as a result of conditions in the auto industry that I commented on previously. Significantly, the employment increases in the District have been more modest than the overall increase in economic activity. This dichotomy results from the enormous productivity efforts on the part of District companies to retain the competitive positions obtained at such great cost. While this has very beneficial effects in an overall economic context, it raises in my mind the question of the sustainability of this expansion; personal expenditures have been moving ahead at rates higher than the increases in disposable income. Unless there is a commensurate increase in employment and a resulting increase in disposable income, it will be very hard to maintain this higher level of personal consumption that has been so fundamental to the growth in the economy over the two last quarters. This brings me back to monetary policy. In my view, the role of monetary policy in this environment is to provide a financial environment that will assist in correcting the financial imbalances and restructuring issues discussed above. The basic goal of monetary policy must be to maximize the economic well being of the nation as a whole. This means promoting financial conditions consistent with maximum sustainable growth. Specifically, it is my view that it is incumbent upon monetary policy to maintain a level of sustainable growth in the economy accompanied by sufficient job creation to absorb new workers, and sufficient investment to insure our ability to produce and compete in today's global economy. This is not to say that we can or should ignore other aspects of https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 6 our environment such as inflation or other signals of long term problems, but that these conditions need to be considered in light of the real performance of the economy. As you well know, our economy over the last few years has been experiencing significant difficulties in maintaining an adequate rate of real growth. Economic progress has been uneven both across regions and industries. Economic statistics during this period have not always provided sufficient information to form an adequate picture of the economy. In this environment I have, consequently, tended to rely heavily on information from our Boards of Directors in Chicago and Detroit, our Small Business and Agriculture Advisory Councils, groups of industry observers meeting with us, frequent individual contacts with District firms and continued participation in regional economic development groups in all of our District states as well as major contacts through the Council of Great Lakes Governors and the Council of Great Lake Industries. These types of contacts both in the Seventh District and elsewhere in the Federal Reserve System are extremely helpful in the formulation of monetary policy. As I see it, examination of District conditions is an important tool in keeping the monetary policy process in touch with the challenges faced by the economy. The most recent economic downturn provides a graphic illustration of exactly why it is so important to keep policy firmly grounded to local business conditions. Given the low level of inventories, the quick response by firms to the short fall in demand, and falling interest rates, both economic theory and most forecasting models suggested that the recession should have ended quickly and, that without any additional policy actions, the economy should have experienced a solid bounce back in jobs and growth. It was our contact with local businesses, banks, and other groups that suggested that the recovery was much slower than usual getting started and was likely to be fragile. The debt build up of the 1980s and the substantial requirements to restructure https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 7 corporations that had grown larger than their markets could sustain were going to generate a significant drag on economic activity. Interest rates were reduced well in advance of the slowdown and continued to ease over this period despite periodic indications that the economy was on the verge of taking off. Since mid-1989, the Federal Open Market Committee has taken actions that resulted in the Federal Funds rate falling from a high of 9 7/8 percent to 3 percent today, a reduction of over 675 basis points. The discount rate and the three month treasury bill rate are at their lowest levels since 1963 and the thirty year bond which has a somewhat shorter history is at its lowest rate in history. I believe that without the types of District concerns and contacts that keep the policy process in tune with the underlying economy, far less would have been done and the economy would have faced a far harsher retrenchment. Remember that economists basing their analysis entirely on economic statistics would have us believe that the recovery began in early 1991. While this is correct in a statistical sense, contact with District firms suggested that the recovery was much slower getting started than usual and that continued policy actions were necessary. Monetary policy needs to remain sensitive to current economic conditions and challenges. Policy must take into account the whole range of economic experiences and special characteristics of each period. Inflation posed major problems for long term growth in the early 1980s. Today, in my assessment, we are operating in an economic environment that could be described as approaching price stability. In the current environment, job creation and balance sheet restructuring are the major challenges facing monetary policy. This is not a change in philosophy or goals, but a simple recognition of what today's problems are versus yesterdays. At today's 3 percent inflation rate, inflation does not represent the same type of threat to the economy that it did at 10 percent. But we should not forget that this very significant improvement in https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 8 inflation was achieved at a very high cost in both human and economic terms and that if growth were allowed to exceed its long run potential for an extended period of time that inflation would return. Generating the maximum sustainable growth rate for the economy must remain the primary and essential mission of monetary policy. In conclusion, I would like to reiterate that while I am guardedly optimistic about the economy both in my District and in the nation, it is the issues of structural impediments to growth and job creation, in terms of debt levels, international competition and other issues of restructuring that dominate the economic landscape. If we continue to make progress on these fundamental issues and begin to see an increase in employment levels, the economic outlook for the next few years is quite positive. https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis