Monetary policy - United States ; Economic conditions - United States

Hang-Sheng Cheng

English

Research Papers in Economics

FABSF
February 12, 1988 WEEKLY LETTER
Monetary Policy, 1987
The opening of a new year seems to be an
opportune time to review United States mone-
. tary policy developments in the year just closed.
Monetary policy has a profound influence on
the national economy. A sound understanding of
its evolution in the recent past may provide a
useful perspective for a clear vision ofwhat lies
ahead.
Last year was a challenging one for U.5. mone-
tary policy. The economy completed the fifth
year of the longest peacetime expansion on rec-
ord. For the first time since'979, the unemploy-
ment rate dropped to under 6 percent, and the
capacity utilization rate increased to 82 percent.
Both suggested that the economy might be close
to full employment, and that further strengthen-
ing of aggregate demand growth might bring
back the inflationary pressures for which the
nation had paid dearly to keep under control.
It was also a year in which the international
aspects of the U.5. economy played an
increasingly prominent part in monetary policy
deliberations, giving rise to concerns over the
extent to which U.S. monetary policy was aimed
at maintaining the stability ofthe dollar rather
than that of the domestic economy. And, finally,
it was the year of the stock market crash, with its
manifold ramifications for the economy and
monetary policy.
How U.S. monetary policy met these challenges
is reviewed in this Letter. As the year drew to a
close, considerable interest was focused on the
role of dollar stability and the related question of
international policy coordination. With the high
exchange rate volatility and concerted central
bank interventions in the exchange market
around the turn ofthe year, these issues con-
tinue to be germane to current monetary policy.
Monetary indicators
Money market conditions tightened somewhat
between 1986 and 1987, up to the stock market
crash in October. As shown in Chart 1, a sharp
interest rate decline during the first half of 1986
was reversed in the period March through Octo-
ber of 1987. By October 1987, short-term inter-
est rates recovered to where they were in March
1986, and long-term rates were higher than their
levels in 1986.
The growth rates of M2 and M3 dropped from 9
percent for both in 1986 to 4.1 percent and 5.5
percent, respectively, in 1987 (Chart 1). Since
bank deposit rates adjust more slowly than mar-
ket rates, the decline in open market short-term
rates in the first half of 1986 caused bank
deposits to grow rapidly throughout that year,
thereby boosting the aggregates. In contrast, the
subsequent rise in open market short-term rates
through much of 1987 caused the opposite.
Part of the decline in money growth rates and
the rise in interest rates in 1987, however, also
was due to a deliberate tightening of Federal
Reserve monetary policy. In his testimony before
a House subcommittee in late April, then-Fed
Chairman Paul Volcker acknowledged a "some-
what less accommodative policy - a slight
snugging approach" in providing reserves to
banks. During most of the year up to the stock
market crash, in the Federal Reserve Board's
mid-year monetary policy report to Congress as
well as in published records of policy actions of
the Federal Open Market Committee (FOMC),
which sets U.5. monetary policy, the Fed consis-
tently stressed two immediate concerns: the risk
of a resurgence of inflationary pressures and
excessive declines in the exchange value of the
dollar.
U.S. and abroad
The change in money market conditions
between 1986 and most of 1987 was reflective
also of the changes in domestic macroeconomic
conditions between the two years. Chart 2
shows that, in 1986, the national economy was
characterized by sluggish output growth after the
first quarter, an unyielding unemployment rate
hovering about a level slightly below 7 percent,
and a sharp drop in the rate of consumer price
inflation (due largely to an oil price decline) to a
little over one percent a year - the lowest rate
in the preceding twenty-five years.FRBSF
Economic conditions changed in the first half of
1987. As a result ofthe rebound in oil prices in
late 1986 and the accumulated impact of two
years of dollar depreciation, the increase in the
consumer price index accelerated rapidly to a 6
percent annual rate during the first quarter; it
slowed somewhat in the second quarter but
remained at a high 4.4 percent annual rate. Dur-
ingthe firsrhalf ofthe year,output growth rose
to a 3.5 percent annual rate, while the unem-
ployment rate dropped from 6.7 percent at the
start of the year to 6 percent at mid-year.
The economy appeared to be near full utiliza-
tion of its productive capacity, and financial
market indicators suggested rising inflation
expectations. Clearly, monetary policy would
need to put a greater emphasis on containing
inflation in 1987 than it had done in 1986.
Meanwhile, the international environment also
changed. The steep dollar depreciation since
February 1985 was at first hailed as a long-over-
due corrective for huge international payments
imbalances. By the beginning of 1987, however,
international sentiments had shifted. Primarily
because of declining exports caused by their
currencies' appreciation against the dollar,
Japan's output growth rate had fallen from 4.7
percent in 1985 to only 2.5 percent in 1986,
and Germany's ha.d stayed at a sluggish 2.5 per-
cent in both years. For industrial countries as a
group, the average economic growth rate had
declined from 3 percent in 1985 to 2.4 percent
in 1986, and was expected to fall further in
1987.
Because of the dual concerns - rising inflation-
ary pressures in the United States and the risk of
economic slowdowns in the rest of the world-
the finance ministers and central bank governors
ofthe G-7 countries (Britain, Canada, France,
West Germany, Italy, Japan, and the United
States) agreed to limit exchange rate fluctuations
through international economic policy coordina-
tion in a meeting in Paris in February 1987.
The accord, known as the Louvre agreement,
soon met a severe test. The dollar, which had
stabilized since the beginning of the year, began
falling sharply again in mid-March despite heavy
exchange market intervention by the major cen-
tral banks. The dollar's decline was accom-
J
panied by sharp rises in long-term U.5. interest
rates. The interest rate rises reflected the mar-
ket's concern over the consequences of the dol-
lar's decline for inflation in the United States and
over a tightening of U.5. monetary policy in
response to the dollar's decline. In the face of
renewed dollar depreciation in mid-August, U.5.
interest rates again rose, and on September 4,
the Federal Reserve raised its discount rate from
5V2 percent to 6 percent.
The stock market crash
Then came the stock market crash on October
19. Observers have attributed the crash to a long
list of causes, ranging from concerns over the
continuing large federal budget and trade defi-
cits to technical factors, such as program trading
and interactions with the stock index futures
market. Whatever its causes, the crash raised a
serious risk of financial failure and a potential
crisis of some magnitude.
The Fed's response was prompt and forceful. In
a one-sentence statement, the new Chairman
Alan Greenspan assured the market of the Fed's
determination to provide sufficient liquidity "to
support the economic and financial system."
Reserves were provided generously to accom-
modate banks' enhanced demand for both
excess reserves and required reserves for sharply
increased transactions deposits. Interest rates fell
rapidly as investor preferences shifted from
equity to safer and more liquid assets.
The stock market crash created a new economic
environment. Given the large decline in stock
prices, the prospect of continued strong consum-
mer spending was cast in doubt. Business fixed
investment was projected to grow at a slower
pace, and residential construction was likely to
fall somewhat in the near term. Under the cir-
cumstances, and given the unsettled conditions
in financial markets, monetary policy eased after
the crash.
Dollar vs. domestic stability
One week after the stock market crash, the dol-
lar began another steep decline that carried
through to year-end despite the G-7 ministerial
announcement on December 22 of a renewed
resolve to maintain exchange rate stability.
Between October 26 and the end of the year,
the trade-weighted dollar declined another 10Chart 1
Monetary Indicators
Interest Rates
7.0
6.0
6.5
Percent
7.5
III
1987
IV III
1986
• Estimate
2
3
4
o
-1
Real GNP Growth
(Left Scale) •.•• . .
.... ,. +••
...I' .... "
:I' X ,
: I ' , ....l\.... . " ,
.: I ' I ,
......... I " *
: I
:' I
.....,, ,1
......!
.. : Unemployment
(Right Scale)
•.•• ~.... Inflation
(Left Scale)
-2 +---,-----,--,--,-----,------,----+ 5.5
IV
Chart 2
Percent Macroeconomic Indicators
Annual Rates
6
-,
, 30-Year U.S. ,/ \ ...
" Government Bonds,'.....'
\ I
\ I
, ..... I
\""'-',-.;~ ' ...-;-
Percent
10.0
9.5
9.0
8.5
8.0
7.5
7.0
6.5
6.0
5.5 +-,..--,---r-,..--,---r-r-r--r-r-rn--.-r---,-.,-,--,.,-,--,-,--,
Percent Change
Annual Rates
12
10
8
6
4
2 +--';-11--.".III:-----;;Iv~--,--~~:::;:------"IV
1986
percent. Even though the decline was steeper
than the average 3 percent decline in the March-
May episode and about as steep as the 5 percent
decline in the August-September episode,
interest rates rose little this time.
The contrast between the three episodes of
steep dollar depreciation in 1987 helps shed
some light on policy actions. The tightening of
monetary policy in spring and late summer was
marked by a decline of the dollar combined
with expectations of higher inflationary pres-
sures and moderate domestic economic growth.
In contrast, during the November-December
period, monetary policy eased in spite of the
dollar decline, in an environment of general
apprehension over the unsettled conditions in
financial markets and the impact of the stock
market crash on the economy. The contrast in
policy stance during the three episodes clearly
indicates that, where a choice had to be made,
the Fed placed greater emphasis on domestic
economic and financial market stability than on
dollar stability.
ministers' statement on December 22 expressed
their desire for dollar stability. The unanswered
question, beyond the scope of this Letter, is to
what extent they are ready to adjust their
national economic policies to achieve dollar
stability.
What this review of U.s. monetary policy in
1987 does show, however, is thatthere is no
evidence to indicate that the Fed was willing to
let its desire for dollar stability undermine its pri-
mary goal of domestic economic stability.
Nor is it reasonable - one might add - to
expect otherwise, of the Fed or any other central
bank. International policy coordination can con-
tribute to exchange rate stability only to the
extent that it is also consistent with the goal,
common to all the G-7 governments, of sus-
tained domestic output growth at a low rate of
inflation. Attaining this common goal is of par-
ticular importance in the u.s. case because of
the pivotal role of the Unites States in the world
economy.
International policy coordination
At the time of this writing in January, the
exchange market remains unsettled. The G-7
Hang-Sheng Cheng
Opinionsexpressed in this newsletterdo not necessarily reflect theviews ofthe managementofthe Federal Reserve Bank ofSan
Francisco,orofthe Board ofGovernorsofthe Federal Reserve System.
Editorialcommentsmay beaddressedtotheeditor(GregoryTong) ortotheauthor....FreecopiesofFederal Reservepublications
can beobtainedfrom the Public Information Department, Federal Reserve Bank ofSan Francisco, P.O. Box 7702, San Francisco
94120. Phone(415) 974-2246.uo~6U!4S0m 4o~n U060JO 0POI\0U
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BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT
(Dollar amounts in millions)
Selected Assets and Liabilities
Large Commercial Banks
Amount
Outstanding
1/20/88
Change
from
1/13/88
Changefrom 1/21/87
Dollar Percent?
Loans, Leases and Investments1 2 203,916 278 4,996 2.5
Loans and Leases1 6 180,840 227 1,934 1.1
Commercial and Industrial 51,073 - 171 - 2,458 - 4.5
Real estate 70,667 - 70 4,173 6.2
Loans to Individuals 36,437 4 - 4,750 - 11.5
Leases 5,829 - 12 406 7.4
U.S. Treasury and Agency Securities2 16,025 56 2,869 21.8
OtherSecurities2 7,051 - 4 128 1.8
Total Deposits 204,050 797 - 1,308 - 0.6
Demand Deposits 51,893 1,326 - 1,030 - 1.9
DemandDeposits Adjusted3 32,288 - 2,179 - 2,748 7.8
OtherTransaction Balances4 20,185 - 273 1,113 5.8
Total Non-Transaction Balances6 131,972 - 256 - 1,391 - 1.0
MoneyMarket Deposit
Accounts-Total 43,311 230 - 3,959 8.4
Time Deposits in Amounts of
$100,000 or more 29,884 - 513 - 1,703 - 5.3
Other Liabilities for Borrowed MoneyS 23,511 1,435 - 8,672 - 26.9
Two WeekAverages
of Daily Figures
Reserve Position, All Reporting Banks
Excess Reserves (+ljDeficiency(-)
Borrowings
Netfree reserves (+ljNetborrowed{- l
Period ended
1/11/88
2
20
17
Period ended
12/28/87
37
15
22
1 Includes loss reserves, unearned income, excludes interbank loans
2 Excludes trading account securities
3 Excludes U.S. government and depository institution deposits and cash items
4 ATS, NOW, Super NOWand savings accounts with telephone transfers
S Includes borrowingvia FRB, TI&L notes, Fed Funds, RPs and other sources
6 Includes items notshown separately
7 Annualized percent change

Monetary policy, 1987

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Monetary policy, 1987

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