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US Federal Reserve: 860212StaffState1 | Economic Growth | Government Budget Balance
US Federal Reserve: 860212StaffState1
Notes f o r FOMC Meeting F e b r u a r y 11-12, 1986 P e t e r D. S t e r n l i g h t
S i n c e t h e l a s t Committee m e e t i n g , t h e Domestic Desk h a s aimed f o r t h e s l i g h t l y more accoolmodative c o n d i t i o n s of r e s e r v e a v a i l a b i l i t y a g r e e d t o i n December. Undertaken a g a i n s t a background of s e a s o n a l reserve p r e s s u r e s ,
O f t e n v e r y h i g h T r e a s u r y b a l a n c e s , and some s i g n s of more v i g o r o u s economic e x p a n s i o n , r e s u l t s were r a t h e r mixed. For most o f t h e p e r i o d , t h e F e d e r a l
f u n d s r a t e hugged t h e 8 p e r c e n t l e v e l c h a r a c t e r i s t i c o f t h e weeks j u s t b e f o r e t h e l a s t m e e t i n g , and i q d e e d i n t h e d a y s around year-end Considerably h i g h e r than t h a t . t h e r a t e was
By l a t e J a n u a r y t h e r a t e was more o f t e n below
8 p e r c e n t and i n t h e l a s t few d a y s , w i t h t h e b e n e f i t o f much lower T r e a s u r y
b a l a n c e s a t t h e Fed, f u n d s have t r a d e d c l o s e t o t h e 7 3 / 4 p e r c e n t a r e a c o n t e m p l a t e d a t t h e time o f l a s t m e e t i n g . Gauged by borrowing l e v e l s , p r e s s u r e s were a b o u t as i n t e n d e d or even somewhat lower--except f o r t h e r e s e r v e p e r i o d e n d i n g J a n u a r y 1, when year-end
s t r a i n s , e x a c e r b a t e d by u n s e a s o n a l l y h i g h T r e a s u r y b a l a n c e s , r e s u l t e d i n a v e r a g e borrowing n e a r $900 m i l l i o n .
I n t h e n e x t p e r i o d , w i t h t h e Desk
r e s o l v i n g u n c e r t a i n t i e s on t h e s i d e of more abundant r e s e r v e p r o v i s i o n , borrowing f e l l o f f t o a v e r a g e under $150 m i l l i o n , a l t h o u g h f u n d s s t i l l a v e r a g e d above 8 p e r c e n t . Borrowing i n t h e J a n u a r y 29 p e r i o d was j u s t
s l i g h t l y above t h e $350 m i l l i o n p a t h l e v e l w h i l e t h e a v e r a g e s o f a r i n t h e c u r r e n t p e r i o d i s c l o s e to $200 m i l l i o n w i t h funds a v e r a g i n g about 7.90 p e r c e n t t h r o u g h y e s t e r d a y (Monday). Nonborrowed r e s e r v e s h a v e come i n f a i r l y
c l o s e to p a t h e x c e p t i n t h e r e s e r v e p e r i o d e n d i n g J a n u a r y 15, when d o u b t s
were r e s o l v e d on t h e accommodative s i d e and nonborrowed r e s e r v e s t u r n e d o u t
roughly a h a l f - b i l l i o n over path.
Among the background factors for the conduct of operations, money growth measures were reasonably in line with Committee expectations. December M-1 turned out strong, as had been anticipated, but January growth was quite modest and the current month seems to be starting on the moderate side, too.
M-2 growth was moderate in December and much weaker than expected
in January, while M-3 has been moderate in both those months.
the dollar in the exchange markets cast its shadow across domestic Uesk
operations as sporadic sinking spells were sometimes a factor counseling
particular caution in providing reserves.
Normally, January is a time of substantial reserve absorption by the
Desk, particularly to offset the release of reserves from post-Christmas
declines in currency in circulation and declines in required reserves. This
year was quite different because of the unusually high Treasury balances.
turn, this resulted largely from a huge issuance of special nomarketable securities to State and local governments in the final weeks of 1985 as those bodies sold a record volume of tax-exempts to beat a possible year-end cut-of� for certain types of securities. For us, this meant that the usual
heavy reserve absorption was delayed until about the beginning of February when Treasury paid down part of its high balances through the usual round of monthly benefit outlays. Earlier in the intermeeting period, the Desk added
reserves through purchases of about $500 million of bills from foreign accounts.
Then from January 30 through February 10 we sold about $1.8 bil­ lion of bills to foreign accounts, and arranged to run off $7G0 million of bills in the February 3 auction. Substantial use was made of System and customer repurchase agreements
provide temporary reserves on 21 out of 36 business days in the period;
this included a couple of occasions when System transactions were announced
the afternoon before they were to be consummated in order to provide the
market with extra time to round up propositions. Matched sale-purchase
transactions with the market were used in early February to help absorb the
glut of reserves as Treasury balances came down.
Interest rates responded to a bundle of crosscurrents during the
recent period and ended
with mixed and mostly moderate changes--somewhat
higher rates for Treasury bills and private money market instruments, very
little net change for intermediate and longer-term Treasury issues, and more
noticeably lower rates for tax-exempts where the supply suddenly abated after
year-end. Among the crosscurrents were periodic bouts of "disco fever''--or
The fever ran fairly
imminent expectation of a cut in the discount rate.
strong in December, almost disappeared after the December employment data came out in early January, but reappeared around the time of the January G-5 meeting and the rumored and then actual cut in the Japanese discount rate. The fever receded again late last week with another strong employment report, but it hasn't disappeared altogether as market participants have sensed that our Desk is happier with a shade lower borrowings and Fed funds rates than was the case a couple of months ago. Also, while the business picture is
seen as stronger now, and therefore providing less reason for official easing moves, the persistent weakness in oil prices is considered a counterweight-­ both because it will tend to dampen inflation and because it is adding to financial fragility. In addition, some market participants see a plus from
oil price weakness in that it could add to the economy's growth and help reduce budget deficits.
Also bearing on the budget deficit, the market had of course drawn a
lot of encouragement late last year from the passage of the Gramm-RudmanHollings amendment. Optimism faded early this year as doubts were aired
about its constitutionality, and last Friday's ruling that it is not consti­
tutional detracted further. Still, the market is left with some feeling that
there will nevertheless be serious efforts at budget deficit restraint, even
if the Supreme Court follows the District Court on constitutionality.
All these ups and downs to sentiment have, as noted, left Treasury bill rates somewhat higher than seven weeks ago, with the increase perhaps attributable a s much as anything to the lessened expectation of an early move
on the discount'rate. The three- and sixlnonth issues were auctioned
yesterday at average rates of 7.18 and 7.23 percent compared with 7.00 and 7.01 percent on December 16. bills in the meantime.
In the coupon sector, the Treasury raised roughly $32 billion during the period, close to half of it in the quarterly refunding scheduled for payment next Tuesday. While rates for intermediate and longer issues were The Treasury paid down about $1 billion of
little changed on balance over the period. there were day-to-day variations that could catch the unwary. Thus bidders in the 20-year bond auction in
early January took a swift loss when sentiment soured on stronger economic numbers, and bidders in the February refunding also took some lumps initially as bullish pre-auction sentiment got ahead of itself and then was dampened by fresh news on the economy and Gram-Rudman. Briefly, late last week, all of
the February refunding securities were trading below issue price, but yesterday's price gains brought the 10-year slightly above and the 30-year more noticeably above the auction levels. While these issues are not all
distributed, and there is clearly day-to-day vulnerability, there is also an underlying market feeling, particularly with respect to longer-term issues, that somehow rates will work lower with the passage of time.
like to inform the Committee that the Domestic Desk That was Greenwich
began trading w i t h a n additional dealer o n January 23.
Capital Markets, w h i c h had been on the prinlary dealer list for a year and a
We now h a v e trading relationships with all 36 primary reporting
Notes f o r FOMC M e e t i n g F e b r u a r y 11-12, 1 9 8 6 Sam Y. C r o s s Since your l a s t meeting t h e d o l l a r has f a l l e n n e a r l y 6 p e r c e n t a g a i n s t m a j o r C o n t i n e n t a l c u r r e n c i e s and a b o u t 7-l/2 a g a i n s t t h e yen. T h i s means t h a t s i n c e a r o u n d t h e t i m e of t h e G - 5 m e e t i n g i n
l a t e September t h e d o l l a r h a s d e c l i n e d by 18 p e r c e n t a g a i n s t t h e mark and n e a r l y 24 p e r c e n t a g a i n s t t h e yen (2.90 t o 2.37-314 DM: Y 2 4 2 t o
Y187).
A l t h o u g h t h e d o l l a r has been buoyed a t t i m e s by p o s i t i v e economic d e v e l o p m e n t s , m a r k e t s e n t i m e n t t o w a r d t h e d o l l a r h a s t e n d e d t o become more n e g a t i v e . I n d e e d , t h e d e c l i n e of t h e d o l l a r i s a l l t h e
more n o t e w o r t h y when viewed a g a i n s t t h e b a c k d r o p o f e v e n t s t h a t n o r m a l l y would s u p p o r t i t . The l a s t two months’ g a i n s i n U . S .
employment, which would n o r m a l l y t r i g g e r s h a r p b u y i n g o f d o l l a r s , f a i l e d t o g e n e r a t e any l a s t i n g r i s e i n t h e d o l l a r . The d e c l i n e i n t h e
p r i c e of o i l , i n s t e a d of b e i n g s e e n a s a b e n e f i t t o t h e d o l l a r b e c a u s e
o f t h e e f f e c t i n s l o w i n g i n f l a t i o n and r e d u c i n g i m p o r t s , i s viewed by
market p a r t i c i p a n t s a s p r o v i d i n g a r e l a t i v e b e n e f i t t o our major c o m p e t i t o r s and t r a d i n g p a r t n e r s and h e l p f u l t o t h e i r c u r r e n c i e s . I n d e e d , t h e s e v e r i t y o f t h e o i l p r i c e d e c l i n e was s e e n a s r a i s i n g q u e s t i o n s a b o u t t h e c o n d i t i o n s of o u r b a n k s due t o t h e i r e x p o s u r e on l e n d i n g t o t h e e n e r g y s e c t o r and t o m a j o r o i l p r o d u c i n g L D C s . Also
s t r i k i n g was t h e f a c t t h a t t h e d o l l a r c o n t i n u e d t o e a s e e v e n on t h e d a y t h e Bank o f J a p a n c u t i t s d i s c o u n t r a t e by 1 1 2 p e r c e n t a g e p o i n t from 5 p e r c e n t t o 4-112 p e r c e n t . O f f i c i a l a t t i t u d e s t o w a r d t h e d o l l a r h a v e remained a p r i m a r y f a c t o r i n t h e exchange m a r k e t s . By mid-December many p a r t i c i p a n t s had
c o n c l u d e d t h a t t h e a u t h o r i t i e s of J a p a n and Germany were c o n c e r n e d o v e r t h e d o m e s t i c impact o f t h e i r c u r r e n c i e s ’ s h a r p a p p r e c i a t i o n and
would r e s i s t a n y f u r t h e r d r o p of t h e d o l l a r .
T h i s p e r c e p t i o n was
p a r t i c u l a r l y s t r o n g i n J a p a n , and t h e y e n t r a d e d s t e a d i l y a r o u n d Y200 t o t h e d o l l a r t h r o u g h December and most o f J a n u a r y e v e n a f t e r plummeting o i l p r i c e s had l e d some t o p r e d i c t a h i g h e r y e n .
o n l y a f t e r J a p a n ’ s F i n a n c e M i n i s t e r was q u o t e d a s s u g g e s t i n g t h a t t h e J a p a n e s e a u t h o r i t i e s would a c c e p t a h i g h e r exchange r a t e t h a t t h e yen s u d d e n l y jumped up t o w a r d Y190. The yen d i d n o t s t o p r i s i n g even
a f t e r t h e Bank o f J a p a n c u t i t s d i s c o u n t r a t e , u n t i l p u b l i c comments by Governor S u m i t a l e d m a r k e t p a r t i c i p a n t s t o a n t i c i p a t e o f f i c i a l intervention t o stop t h e dollar’s f a l l .
A t t h e same t i m e , exchange m a r k e t p a r t i c i p a n t s have c o n t i n u e d
t o weigh p u b l i c s t a t e m e n t s by some U . S . e f f o r t s t o lower t h e d o l l a r . o f f i c i a l s pointing t o further
The P r e s i d e n t ’ s c a l l f o r a s t u d y o f t h e
p o s s i b i l i t y o f a n i n t e r n a t i o n a l m o n e t a r y c o n f e r e n c e h a s been viewed a g a i n s t t h i s b a c k g r o u n d , and t a l k o f t a r g e t z o n e s h a s c o n t r i b u t e d t o apprehension over a possible f u r t h e r decline o f t h e d o l l a r . S i n c e t h e J a n u a r y G - 5 m e e t i n g , a n a l y s t s seem t o have g i v e n up e x p e c t a t i o n s t h a t t h e m a j o r c o u n t r i e s w i l l a g r e e on j o i n t a c t i o n t o lower i n t e r e s t r a t e s . The r e c e n t d r o p i n o i l p r i c e s i s e x p e c t e d t o
p r o v i d e a b o o s t t o t h e J a p a n e s e and German e c o n o m i e s , and h a s h e l p e d r e l i e v e p r e s s u r e f o r more s t i m u l a t i v e a c t i o n f o r t h e t i m e b e i n g .
S t i l l , c e n t r a l bank o f f i c i a l s i n b o t h c o u n t r i e s acknowledge t h a t t h e y
m i g h t c o n s i d e r c u t t i n g r a t e s f u r t h e r i f t h e d o l l a r becomes t o o weak, i n o r d e r t o p r o t e c t t h e i r e c o n o m i e s ’ growth p r o s p e c t s . In t h e case of
Germany, t h e d e s i r e t o s t a v e o f f a r e v a l u a t i o n o f t h e mark w i t h i n t h e
EMS i s a n a d d i t i o n a l f a c t o r t h a t c o u l d i n f l u e n c e t h e Bundesbank t o c u t
i t s lending r a t e s .
EMS p r e s s u r e s have i n c r e a s e d from t i m e - t o - t i m e
w i t h t h e a p p r o a c h of March n a t i o n a l e l e c t i o n s i n F r a n c e - - s i n c e most t r a d e r s b e l i e v e t h e p r e s e n t government would n o t a c c e p t t h e p o l i t i c a l
c o s t of s e e k i n g d e v a l u a t i o n b e f o r e h a n d .
These EMS p r e s s u r e s h a v e been
e x a c e r b a t e d a t t i m e s by t h e weakness o f t h e d o l l a r , which c a u s e s a d d i t i o n a l s p e c u l a t i v e f l o w s i n t o t h e German mark.
I n summary, M r . Chairman, d u r i n g t h e p e r i o d s i n c e t h e l a s t
Committee m e e t i n g , t h e p s y c h o l o g y i n t h e m a r k e t seems t o h a v e s h i f t e d . There i s a view t h a t t h e d o l l a r w i l l i f anything c o n t i n u e t o s o f t e n , and t h e r e i s a l o t o f a t t e n t i o n and i n t e r e s t on w h e t h e r o r when t h e r e would b e o f f i c i a l moves t o r e s i s t f u r t h e r d o l l a r d e c l i n e s .
February 11-12, 1986
During our presentations this afternoon we will be referring to the package of charts distributed to you. The first
chart displays the principal assumptions that underlie the staff's economic and financial forecast for 1986 and 1987. For monetary policy, we have assumed M1 growth near 7 percent this year and around 6 percent in 1987. 112 is assumed to grow between
7 and 8 percent in each year. Those assumptions likely provide
for some drifting down of interest rates over the course of the projection. For fisczl policy we have assuned deficit-reducing
actions of around $15 billion this fiscal year and an additional
$30 billion for fiscal year 1987. The foreign exchange value of
the dollar is expected to move moderately lower over time, with the bulk of the decline behind us. Oil inport prices now are
assumed to move to about $20 per barrel and stay in that area during the projection period. Additional information on the federal budget is
displayed in chart 2. The staff and Administration estimates on
outlays, receipts, and the deficit are very similar for fiscal
year 1986. These estimates include some savings from final
actions on the 1986 budget and the first stage of the
Gram-Rudman cuts to begin March 1.
The court ruling declaring
the implementation process of Gramm-Rudman unconstitutional apparently will not affect these cuts but throws into question what will happen on the 1987 budget; fallback procedures in the legislation could well stand although that removes the automaticity of cuts should the Congress fail to meet GrammRudman target deficits.
In any event, the staff assumes $30
billion of additional deficit-reducing actions for FY 1987 which provides a staff deficit estimate appreciably higher than that of the Administration. A part of the difference between the two estimates reflects policy assumptions, but more than half stems from the economic assumptions given the staff's slower growth of nominal GNP. Nevertheless, the lower panel shows that the budget is a
restraining force in the projection. For the first time since
1981 the structural deficit in absolute terms or as a percent of
GNP--the red line--moves down somewhat in 1986 and particularly
Chart 3 shows the behavior of various indicators of recent economic activity. The top left panel displays changes in
payroll employment; employment in manufacturing rose in the fourth quarter while other employment gains continued large and were unusually sizable in January. Some of the increase in
January may be a statistical aberration, but even discounting the figure one is left with a strong picture. Industrial production
also has been on the rise in recent months and the available information now suggests a further increase of . 3 or . 4 percent in January. In the automobile market, the middle left panel, there
has been considerable volatility in domestic sales given the off
again-on again sales incentive programs. Dealer stocks were
rebuilt in the fourth quarter and the reinstitution of financing
discounts led to improved sales in December and January. Sales
of imported models, not shown on the chart, have continued
robust. Other retail sales, the middle right panel, have
remained on an upward path with December showing a good gain.
The only data on January sales are for chain stores and they
appeared sluggish but are virtually impossible to relate to total
The housing market, bottom left, also showed life in the
fourth quarter. Total home sales rose somewhat and were at a
high level, while housing starts finally picked up.
for nondefense capital goods, bottom right panel, shot up in
December reflecting the strength in orders for aircraft and parts
which have very long lead times; excluding this category, new
orders were sluggish. After allowing for the surge in shipments
late in the year, apparently to guard against possible tax
changes, orders and other information suggest little near-term
change in business equipment spending. On the whole, however,
incoming information since the last meeting of the Comittee has
been upbeat.
The f o u r t h c h a r t shows t h e broad contours of the s t a f f ' s projection. Real GNP t h i s y e a r and n e x t i s f o r e c a s t e d t o grow
around 3 p e r c e n t p e r y e a r , up somewhat from the performance i n 1985 and c l o s e t o t h e average over t h e p a s t 15 y e a r s . Prices, as
measured by t h e GNP d e f l a t o r , a r e expected t o change l i t t l e t h i s y e a r and r i s e somewhat i n 1987 from r e c e n t t r e n d s and c o n t i n u e much b e t t e r t h a n t h e average pace over t h e 7 0 ' s and 8 0 ' s .
unemployment r a t e i s p r o j e c t e d t o move s l i g h t l y lower during t h e p r o j e c t io n period. Mike P r e l l w i l l d i s c u s s t h e s t a f f ' s domestic economic and f i n a n c i a l p r o j e c t i o n i n d e t a i l .
Domestic Economic and Financial Outlook
It is clear that there are some significant uncertainties associated
with the basic assumptions of our forecast. other aspects of the projection. And the same can be said of many
If we are on the right track, though, the
economy should experience not only appreciable overall growth in the next two
years, but a more balanced expansion as well.
This is reflected in the top panel of chart 5 , which shows the percen­ tage point contributions to real GNF' growth of selected components. past six quarters, private domestic final purchases--i.e., Over the
the sum of consumption,
residential construction, and business fixed investment--grew substantially, but declines in inventory investment and net exports held back output growth. Look­
ing ahead, we believe that the inventory correction probably has come to an end and that the external balance should begin
Inventory investment actually turned upward in the nonfarm business sector at the end of last year, but only because of the unsustainable buildup in auto dealers' stocks. As you can see in the bottom panel, though, stocks outside of manufacturing in particular--and We are not expecting
the auto sector have reached quite low levels-in
some renewed inventory accumulation should be in prospect.
a massive resurgence, given still high real carrying costs, the lack o f imminent
shortages of goods or materials, and a rather cautious attitude toward sales prospects.
But we are anticipating that businesses will want to increase stocks
in line with their rising sales. As indicated at the top of the next chart, we are forecasting moderate
gains in real consumer spending. To date in the cyclical upswing, strong demands
for autos and other durables have paced an expansion of overall consumer spending
that moved well ahead of disposable income growth last year, as may be seen in
the table a t the right.
In our f o r e c a s t , income and spending move roughly
in p a r a l l e l , which means t h a t t h e personal saving r a t e remains low.
The low saving r a t e is both a puzzle and a p o t e n t i a l risk in our projec­ tion. The five-year r e v i s i o n of t h e n a t i o n a l income accounts d i d t u r n up some t h e middle panel shows--it was n o t enough t o b r i n g
a d d i t i o n a l income, but--as
t h e saving r a t e back i n t o l i n e w i t h h i s t o r i c a l norms.
Later henchmarkings may
w e l l uncover more income, but t h e r e were some developments l a s t year t h a t could
have depressed t h e saving r a t e . Among t h e s e a r e t h e weakness of i n t e r e s t income
and t h e plunge i n farm income; t h e evidence is t h a t spending a d j u s t s l e s s in t h e s h o r t run t o changes in t h e s e income c a t e g o r i e s than t o changes in l a b o r income.
In a d d i t i o n , wealth has been r i s i n g s t r o n g l y , owing t o t h e s t o c k and bond
r a l l i e s ; t h i s n o t only may have boosted spending r e l a t i v e t o c u r r e n t income l a s t year, b u t , b a r r i n g a major market r e v e r s a l , i t should buoy consumption t h i s year a s w e l l , given t h e normal l a g s . To be s u r e , t h e s p e c t a c u l a r climb in consumer debt t h a t has helped f i n a n c e a l l t h i s spending e v i d e n t l y has been more than some households could handle, and t h i s is r e f l e c t e d in r i s i n g i n s t a l l m e n t l o a n d e l i n q u e n c i e s , such as f o r a u t o paper a t t h e lower l e f t . Nonetheless, r i s i n g incomes and a s s e t values have
kept consumer sentiment regarding personal f i n a n c i a l t r e n d s predominantly on the plus side. Moreover, t h e r e is no i n d i c a t i o n t h a t l e n d e r s a r e becoming less
w i l l i n g t o provide f i n a n c e .
Thus, while t h e high debt l e v e l and low saving r a t e
a r e t r o u b l i n g , we a r e n o t looking f o r any s i g n i f i c a n t retrenchment in spending.
On a more a f f i r m a t i v e n o t e , w e a r e p r o j e c t i n g a p p r e c i a b l e improvement in
housing c o n s t r u c t i o n , portrayed in t h e next c h a r t . O v e r a l l s t a r t s a r e expected
t o r i s e c o n s i d e r a b l y , w i t h t h e g a i n centered in t h e single-family market.
the middle left panel shows, the combination of rising incomes, declining
interest rates, and limited price increases on average has made homes much
Of course, one of the disappointments of 1985 was the flatness of housing
construction in the face of a sizable drop in interest rates. At least two factors may help explain why housing activity has not exhibited a stronger response. First, as suggested by the survey data at the right, the softness
of home prices in many locales has reduced the feeling that one needs to buy now because prices will be going up; in effect, the perceived real mortgage rates may not have dropped as much as nominal rates. A second factor is the tightening of various non-rate terms--including the reduced availability of low downpayment conventional mortgages, shown at the bottom left. Although,
in all likelihood, these forces will remain in the market, they probably will not increase in intensity. As Jim Kichline noted, home sales have in fact perked
up recently, and, in our view, the lagged effects of the recent sizable drop in mortgage rates and the further decline anticipated--combined with favorable demographics--will push single-family building upward in the months ahead. In contrast, though, reduced tax-exempt financing and substantial overbuilding of multi-family structures in many markets--reflected in the high rental vacancy rate at the right--will put a damper on that segment of the market. Deep crosscurrents are no less apparent in nonresidential investment. As the top panels of the next chart indicate, we are projecting a small increase in real business fixed investment this year, followed by somewhat stronger growth in 1987.
You will recall that surveys of '86 capital spending plans
taken last fall depicted a weaker performance than we are forecasting. light of the limited growth of overall output and the declining level of
capacity utilization in the industrial sector, plotted at the left, some
slackening in investment growth was to be expected. The prospect of tax
reform measures also may have had a negative impact on spending plans.
The tax reform picture unfortunately has yet to clarify, but a few recent developments could underpin a better investment performance. One is the con­
tinued depreciation of the dollar and the resultant improvement in the sales prospects of domestic producers; the greater competitiveness of our industrial sector should contribute to a small rise in capacity utilization. Another plus
is the effect of the securities market rally on the cost of capital, charted
In our forecast, there is some further decline in capital costs,
though, of course, businessmen's calculations in this regard will be influenced importantly by their perceptions of potential tax law changes. These considerations on the whole suggest to us that, as has happened in the past, the surveys will prove to have underpredicted capital spending. There will, however, be areas of weakness.
It will come as no surprise that,
under our assumptions, investment in oil production is projected to be soft. Drilling activity has been supported until recently by declining drilling costs, by desires to get oil out of the ground and perhaps by efforts to beat tax law changes.
In the current environment, however, we expect that the decline in
exploration reflected in the seismic crew figures at the lower left will presage lower outlays in this important component of structures.
high vacancy rates will cut into office building, although the behavior of contracts suggests that no near-term collapse in actual outlays is likely. Other
categories of structures may be more buoyant than these, but it is the continued desire to replace outmoded equipment that should provide the basic thrust to investment in the next two years.
On t h e f i n a n c i a l s i d e , summarized i n t h e next c h a r t , conditions in t h e business s e c t o r appear g e n e r a l l y s u p p o r t i v e of rising investment. Operating
p r o f i t s , i n t h e t o p p a n e l , d i d v e r y w e l l in t h e aggregate i n t h e f a c e of t h e slowdown i n economic expansion--in part r e f l e c t i n g t h e strenuous e f f o r t s t o W s e e a f l a t t e n i n g in p r o f i t s i n e
reduce c o s t s and lower breakeven p o i n t s .
1986-87, but with r i s i n g cash flow from d e p r e c i a t i o n , i t should be p o s s i b l e
t o f i n a n c e t h e b u l k of o u t l a y s f o r i n v e n t o r i e s and f i x e d c a p i t a l out of i n t e r ­
n a l l y generated funds, a s i n d i c a t e d in t h e middle panel. Borrowing is pro­
j e c t e d t o remain s i z a b l e , because w e have assumed t h a t t h e s u b s t i t u t i o n of debt f o r e q u i t y i n connection with mergers, buyouts, and r e s t r u c t u r i n g s w i l l diminish only slowly. There i s an obvious r i s k i n t h i s p a t t e r n of f i n a n c e ,
which h a s d r a m a t i c a l l y weakened t h e balance s h e e t s of a good many companies. However, a s shown a t t h e r i g h t , n o n f i n a n c i a l c o r p o r a t i o n s a s a group have reaped major b e n e f i t s in terms of a reduced i n t e r e s t payment burdens as r a t e s have d e c l i n e d and they have refinanced a t lower c o s t . One might s a y t h a t , i n our f o r e c a s t , p r i v a t e c a p i t a l formation i s being "crowded in" by t h e retrenchment in t h e government s e c t o r ( a g a i n s t a backdrop of accommodative monetary p o l i c y ) . The upper panel of t h e next c h a r t shows
t h a t f e d e r a l purchases of goods and s e r v i c e s a r e s l a t e d , under our p o l i c y assumptions, t o d e c l i n e s u b s t a n t i a l l y i n real terms during t h i s c a l e n d a r year a f t e r having been boosted t h e l a s t h a l f of 1985 by strong i n c r e a s e s i n defense and CCC o u t l a y s ; purchases w i l l t h e n l e v e l o u t i n 1987. S t a t e and l o c a l
government purchases a l s o appear l i k e l y t o be r e s t r a i n e d : even with t h e slow spending growth we have p r o j e c t e d , i t is probable t h a t many u n i t s w i l l be s t r u g g l i n g t o balance t h e i r budgets-needing t o r a i s e t a x e s in many c a s e s t o
offset the l o s s of federal grants and oil-related revenues.
the deterioration of the operating and capital account balance of states and localities i s great enough to offset the steady growth of the trust funds for employee retirement benefits. The top panel of the next chart pulls together the projected sectoral
surpluses and deficits in a way that reveals again the departure from the
patterns of the past several years that is implied by the assumed fiscal
restraint and dollar depreciation.
As you can see, both the combined government
sector and net foreign investment are expected to begin moving back toward
balance. The share of total private saving drifts downward a bit, reflecting
declining retained earnings and weak personal saving, but it remains within
the historical range--as does private investment, which edges up.
The reduction in the federal deficit helps retard the growth of total
debt in the economy. However, as plotted below, the ratio of domestic nonfinan-
cia1 sector debt to GNP is projected to rise considerably further. debt growth is expected to remain sizable, as I noted earlier.
borrowing remains heavy, too, as mortgage credit use picks up while consumer
installment debt decelerates.
The willingness and ability of households to continue borrowing and
spending depends, of course, on satisfactory employment conditions. In the
next chart you can see that we are projecting continued strong growth in total
employment, with the manufacturing sector sharing modestly in the gains.
The growth in domestic output is showing through quite strongly in employ­
ment because we have assumed only a small pickup in the trend rate of produc­
tivity growth--to a shade over 1 percent a year. The recent revisions of GNP
and employment data suggest that, when one strips away the cyclical element in productivity, the underlying trend in output per hour during the first half of the '80s was only around 314 percent per annum. We can see demographic and other reasons for expecting some improvement, but that improvement is overdue and we are wary of forecasting a marked takeoff. This productivity assumption has significant implications for business cost trends.
In the next two years, we would expect to see some acceleration
in hourly compensation, as the greater pressure in labor markets associated with a declining unemployment rate causes real wages to firm up. However, the
renewed rise in productivity more than offsets the impact of greater wage gains
on unit labor costs in 1986 and holds the cost rise to 4 percent next year.
The implications for prices are indicated in the next chart. panels highlight some special factors in the outlook.
At the left, you can
see that a bigger consumer food price increase is expected this year, owing
to recent developments in the meat and coffee markets. However, the anticipated
decrease in world oil prices should produce a more than offsetting decline
in consumer energy prices.
It should be recalled, however, that the oil price
drop has a bigger impact on price measures relating to domestic consumption
than on those relating to total domestic output. Moreover, the dollar depre­
ciation we have assumed will he putting upward pressure on the prices of
nonpetroleum imports and easing competitive pressures on domestic firms.
Thus, all things considered, we are projecting a slight acceleration in GNP
Ted Truman will now discuss the international aspects of our forecast.
E.M. Truman
As is shown i n the top panel of chart 14, the U.S. dollar has
been declining for almost a year on a weighted-average basis against the other G-10 countries' currencies. The dollar's decline since the end of
February last year has been about 25 percent; less than half of that decline has occurred in the four and a half months since last September's G-5 announcement.
A s can be seen in the lower panel, the dollar's decline
appears to have been influenced by a reduction in U.S. real long-term interest rates relative to the average of such rates in foreign industrial countries. The peak in the differential pre-dated the peak in the dollar. Nevertheless, the differential narrowed significantly
further during the past year; most of the movement was generated by declines in dollar interest rates that can be attributed in large part to changes in the outlook for the U . S . economy.
As Jim Kichline indicated in his introduction, we have
incorporated into our projection a further decline of the dollar but at
a much more moderate rate than we have seen over the past year.
Nonetheless, the decline that has already occurred is one of the key
factors affecting our outlook.
A s can be seen in the top panels of the next chart, the
dollar's movement has already begun to influence comparative price developments here and abroad. The left-hand panel indicates that at the
end of last year not only did U.S. wholesale prices begin to accelerate
the black l i n e
-- but t h e y d i d a0 a t a t i m e when wholesale
p r i c e i n f l a t i o n was continuing t o moderate i n o t h e r major i n d u s t r i a l countries
t h e red l i n e .
The right-hand panel focuses on t h e subset of commodities included i n t h e Economist's index of commodity p r i c e s . The black l i n e
shows t h e index of t h o s e p r i c e s expressed i n d o l l a r s ; on t h i s b a s i s , t h e index
helped along by sharp i n c r e a s e s i n c o f f e e p r i c e s changes f o r t h e p a s t two months.
p o s i t i v e year-over-year
translated i n t o foreign currencies
t h e red l i n e a g a i n
t h e index
has continued t o r e c o r d s u b s t a n t i a l year-over-year
One commodity not included i n t h e Economiat's index i s o i l . A s you can s e e from t h e r e d l i n e i n t h e bottom panel, t h e U.S. oil
import p r i c e expressed i n d o l l a r s has been d e c l i n i n g g r a d u a l l y s i n c e t h e second q u a r t e r of 1981. t h a n 25 p e r c e n t . Through 1985, t h e d e c l i n e had cumulated t o more
However, a s shown by t h e black l i n e , o i l p r i c e s i n
f o r e i g n c u r r e n c i e s a c t u a l l y i n c r e a s e d by about 10 percent through mid-1985, though they subsequently have d e c l i n e d r a p i d l y a s t h e d o l l a r
has d e p r e c i a t e d . One of t h e major u n c e r t a i n t i e s i n our f o r e c a s t concerns a t what l e v e l stabilize.
-- I could say whether -- U.S. o i l import p r i c e s w i l l
W a r e assuming t h a t t h e y w i l l s t a b i l i z e a t around $20 p e r e judgment t h a t OPEC crude o i l
b a r r e l ; t h i s assumption i s based on a
production t h i s y e a r w i l l average c l o s e t o 18 m i l l i o n b a r r e l s p e r day up from about 16-1/2 m i l l i o n b a r r e l s per day l a s t y e a r
-- w i t h
Arabia and I r a q supplying most of t h e expected i n c r e a s e .
The upper left-hand panel of Chart 16 summarizes some of t h e economic i m p l i c a t i o n s of t h e s e commodity p r i c e t r e n d s . W expect e
t h a t consumer p r i c e i n f l a t i o n i n t h e f o r e i g n i n d u s t r i a l c o u n t r i e s shown by t h e red b a r s i n t h e upper left-hand panel
w i l l record a
f u r t h e r s u b s t a n t i a l r e d u c t i o n t h i s y e a r but w i l l n o t be s i g n i f i c a n t l y lower on average than i n t h e United Stat'es. The primary reason i s t h a t
t h e lower p r i c e of crude petroleum has a r e l a t i v e l y l a r g e r impact on consumer p r i c e i n f l a t i o n i n t h i s country than abroad because of our h e a v i e r u s e of energy and t h e lower c o n t r i b u t i o n of t a x e s t o t h e energy p r i c e s consumers face. Moreover, t h e average f o r t h e f o r e i g n c o u n t r i e s
obscures t h e f a c t t h a t i n s e v e r a l of them particular
Germany and Japan i n
-- consumer p r i c e i n f l a t i o n t h i s y e a r i s expected t o be less
I n 1987, a f t e r t h e e f f e c t s of lower o i l p r i c e s a r e
i n f l a t i o n of t h e d o l l a r ' s
than 1-1/2 p e r c e n t .
l a r g e l y behind u s , t h e i n f l u e n c e on U.S. d e p r e c i a t i o n dominates, and U.S.
i n f l a t i o n i s expected t o pick up
s i g n i f i c a n t l y r e l a t i v e t o i n f l a t i o n abroad. With r e s p e c t t o economic a c t i v i t y i n t h e f o r e i g n i n d u s t r i a l countries
t h e right-hand panel
we a r e p r o j e c t i n g t h a t t h e average
pace of economic expansion during t h e next two y e a r s w i l l
s i g n i f i c a n t l y from t h e t h r e e percent r a t e recorded d u r i n g t h e p a s t two y e a r s , d e s p i t e t h e f a v o r a b l e e f f e c t s of lower o i l p r i c e s . This year, we
a r e e x p e c t i n g a pick-up i n growth i n c o n t i n e n t a l Europe t o o f f s e t slower growth i n Japan, Canada and t h e United Kingdom.
I n c o n t r a s t t o t h e r a t h e r s t a b l e average r a t e of economic
growth expected f o r t h e i n d u s t r i a l c o u n t r i e s , we have h i l t i n t o our f o r e c a s t an assumption t h a t t h e non-OPEC developing c o u n t r i e s , helped by
-4Secretary Baker's "Program for Sustained Growth," will be able to achieve more rapid growth over the forecast period, as can be seen in the middie panel. This faster growth should be facilitated by the
availability of additional external financing which should permit these countries to cover somewhat enlarged trade and current account deficits
shown in the lower panel. Turning to the influence of these various factors on the U.S.
external accounts, the upper panels in chart 17 show that prices of U . S . exports of nonagricultural and agricultural products have declined relative to the average price level
industrial countries. Our competitive position is expected to continue
to improve in 1986 and 1987.
As can be seen in the lower left-hand
panel, this trend in price competitiveness should begin to have positive
effects on the volume and value of our non-agricultural exports by the
middle of 1986.
However, the lower right-hand panel shows that we do not expect a similar recovery in the volume of our agricultural exports. The lower dollar and lower U . S . agricultural support prices should arrest the decline in our agricultural exports that we have seen during the past five years, but in the face of ample supplies abroad these factors are not projected to produce any significant reversal of that deterioration. Non-oil imports are depicted in the next chart.
seen in the top panel, the depreciation of the dollar is projected to
push up the average price of these goods relative to tlie domestic price
In the second half of this year and in 1987, these higher
prices are projected to slow growth in the volume of non-oil imports -
the red line in the bottom panel. The higher prices of these imports
are a necessary part of the adjustment process and, indeed, set it in
motion. However, they also will help to maintain the growth in the
value of such imports at close to a 10 percent annual rate through the
end of the projection period.
This differential movement of import volumes and values has a
strong influence on the contour of our external projection that is
presented in chart 19.
Given the similar rates of economic expansion
expected here and abroad, the projected increases in the dollar prices
of our non-oil imports, and the normal lagged response of quantities of
both imports and exports to price incentives, we are projecting, in the
top panel, no improvement this year in our trade and current account
deficits compared with the second half of last year.
projecting a perceptible improvement in 1987.
OUK trade and current account deficits are conventionally analyzed in terms of current-dollar magnitudes. the focus in the GNP accounts is on services In contrast, much of We
Mike Prell has
already noted, we are projecting a significant positive impetus to
growth by the second half of this year and an even larger contribution
This overall projection appears to be consistent with the
information provided by the Reserve Banks in their recent "theme report"
on the dollar's depreciation.
It is not surprising that the respondents
did not identify uniformly significant influences from the dollar's
depreciation to date; the process of economic adjustment involves
institutional lags, and there are many differences in circumstances
across firms and industries. What I believe is noteworthy in the report
is the sense that the climate has changed over the past twelve montha.
The survey essentially describes an inflection point that can also be
seen in the aggregate statistics:
prices of non-oil imports have begun
to rise -- or decline less rapidly have begun to decelerate. The last international chart provides an overview of U.S. capital account transactions. Comparing 1984 and 1985, we estimate that
and the quantities of such imports
recorded increases in private capital inflows (line 21, especially through net purchases of U.S. bonds and stocks, more than covered the increase last year in the U.S. current account deficit. The major
change in the pattern of U.S. capital account transactions that we now anticipate for 1986 is a shift in official transactions (line 6 ) . We
expect that the substantial U.S. and foreign intervention sale6 of
dollars in 1985 will be replaced by a moderate accumulation this year.
Jim Kichline will now complete our presentation.
JLHichline
A good deal of uncertainty surrounds the staff's
econonic projection given the underlying assumptions, but one could also question the assumptions themselves.
In chart 21 are
displayed illustrative impacts of alternative assumptions for money growth, oil prices, and fiscal policy. For purposes of this exercise the impacts are thought to be roughly symmetrical, that is lower money growth would provide about the same impacts of opposite sign as those with higher money growth. That need
not always be the case, of course, and the oil price is of particular interest since a further plunge in oil prices could produce severe econonic and financial dislocations with uncertain outcomes for the aggregate economy. In any event an easier monetary policy as indexed by M1 growth 1-112 percent higher than in the staff forecast could have a powerful effect on real growth. However, the effect wanes over
time as increased pressure on labor and capital resources brings with it much higher inflation, with the deflator in 1988 rising at a rate 2-112 percent higher than otherwise. Lower oil prices have much different effects.
A $ 5 per barrel reduction in oil prices is thought to lead to a reduction in prices of about'1/2
percent in both 1986 and 1987 and an equivalent increase in real
GNP. Those immediate effects wear out, however, and the change
in prices and real growth are negligible in 1988. Less fiscal
restraint also would act to stimulate real GNP in the short run,
but would eventually entail greater pressures on resources.
higher interest rates and prices, and in 1988 a slower growth
The last chart in the package displays economic forecasts of Board members, presidents, staff, and the Administration. The
lower panel displays the 1986 forecast reported to the Congress last July. In general the various forecasts are similar although
FOMC forecasts are weighted toward somewhat less real growth than
the Administration projection.
On the GNP deflator, FOMC
projections are clustered at or below the Administration. Conpared to the projection prepared in July, forecasts of real
GNP have moved up a bit while inflation estimates have moved
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