Section 1:
Monetary Policy and the Economic Outlook

The economy performed impressively this past year, and members of the Board of Governors and Reserve Bank presidents anticipate that 1997 will bring further appreciable economic expansion with relatively low inflation. In 1996, solid advances in the real expenditures of households and businesses led to sizable gains in output. Employment rose briskly, and the unemployment rate edged down to its lowest level of the current expansion. Consumer price inflation increased owing to the likely temporary effects of firmness in food and energy markets, but some broader price measures showed inflation holding steady or even declining. With the economy strengthening, intermediate- and long-term interest rates rose on net, but credit continued to be amply available to businesses and most households, and equity prices soared.

Several factors helped to restrain price increases this past year in the face of high levels of resource utilization. With workers still concerned to some degree about job security, acceleration in hourly compensation was not so pronounced as in comparable periods in the past; wage increases picked up relatively moderately, and further success in controlling health care costs helped to temper the rise in benefits. Moreover, significant declines in the prices of U.S. imports, owing to low inflation abroad and appreciation of the dollar on foreign exchange markets, tended to hold down domestic prices. Damped inflation expectations probably contributed as well to the favorable price performance: A lengthening run of years during which inflation has been in a more moderate range, together with an understanding of the Federal Reserve's commitment to maintaining progress toward price stability, may have discouraged aggressive pricing behavior. Business firms continued to rely on cost control and gains in productivity, rather than on price increases, as the primary channels for achieving profit growth.

Still, the Federal Open Market Committee (FOMC) recognized the danger that pressures emanating from the tight labor market might trigger an acceleration of prices, which could eventually undermine the ongoing economic expansion. Consequently, although conditions last year were not deemed to warrant immediate policy action, the Committee's policy directives starting in mid-1996 reflected a perception that the most likely direction of any policy action would be toward greater restraint in the provision of reserves to the banking system. Forestalling a disruptive buildup of inflationary pressures in the near term and moving toward price stability over time remain central to the System's mission of promoting maximum sustainable growth of employment and production.

Monetary Policy, Financial Markets, and the Economy in 1996

The FOMC eased the stance of monetary policy twice around the beginning of last year--in December 1995 and in January--lowering the federal funds rate 1/2 percentage point in total, to 5-1/4 percent. These actions were taken to offset the effect on the level of the real federal funds rate of declines in inflation and inflation expectations in the second half of 1995 and thereby to help ensure the resumption of moderate economic growth after the marked slowdown and inventory correction in late 1995. By the spring, economic growth had become more vigorous than either the Committee or financial markets had foreseen. In response, intermediate- and longer-term interest rates as of mid-May were up around a full percentage point from the two-year lows reached early in the year. In combination with some softening of economic activity abroad and declines in interest rates in major foreign industrial countries, these developments contributed to a further appreciation of the dollar, building on the rise that had started in mid-1995. The Committee anticipated that the increase in the cost of credit, along with the higher exchange value of the dollar, would be sufficient to foster a downshift in economic expansion to a more sustainable pace and contain price pressures; thus, it left its policy stance unchanged at its spring meetings.

By early summer, however, the continued momentum in demand and pressures on labor resources that were being reflected in faster growth in wages were seen as posing a threat of increased inflation. Core inflation remained moderate, but in light of the heightened risk that it would turn upward, the Committee in its early July directive to the Manager of the Open Market Account indicated its view that near-term economic developments were more likely to lead to a tightening of policy than to an easing. Labor markets continued to be taut over the balance of the year, and this bias toward restraint was included in directives adopted at all of the Committee's remaining meetings in 1996.

After peaking during mid-summer, interest rates moved down on balance through the fall, as expansion of consumer spending and economic activity in general appeared to be moderating and markets saw less likelihood of a need for Federal Reserve firming action. Equity prices fell back for a time during the summer, reversing some of the substantial increase registered over the first half of the year, but by autumn they had reached new highs. Interest rates and dollar exchange rates turned back up late in the year when signs of rapid growth and more intense use of the economy's resources reemerged. Since year-end, interest rates have changed little, on net. The foreign exchange value of the dollar has posted further gains, in part reflecting greater-than-expected weakness in Europe and renewed pessimism about economic and financial prospects in Japan. Equity prices have registered new highs since the start of the year. As of mid-February, intermediate- and long-term interest rates were up about 1/2 to 3/4 percentage point, on balance, since early 1996, and the value of the dollar was up around 9 percent against an average of other G-10 currencies.

For the nonfinancial business sector, the effect of the higher intermediate- and long-term interest rates on the overall cost of funds last year was offset to some degree by an easing of lending terms at banks and a narrowing of yield spreads on corporate bonds over Treasuries, as well as by declines in the cost of capital in the equity market. Encouraged, perhaps, by the prospects of sustained economic expansion and low inflation, banks, market lenders, and equity investors displayed a strong appetite for business obligations and seemed willing to require less compensation for the possible risks entailed. Some households, by contrast, faced a tightening of standards and terms with respect to credit card debt and some other types of consumer debt last year, as banks reacted to a rising volume of delinquencies and charge-offs on these instruments. However, credit availability under home equity lines increased, particularly from finance companies but also from banks. Overall debt growth slowed slightly but remained near the midpoint of its 3 percent to 7 percent monitoring range. The growth rates of M2 and M3 edged up last year and, as was anticipated in the monetary policy reports to the Congress last February and July, both aggregates ended 1996 near or above the upper end of their growth ranges. Again last year, the growth of M2 relative to nominal income and interest rates was generally in line with historical relationships, in contrast to its behavior during the early years of the decade.

Economic Projections for 1997
Percent

Federal Reserve governors and Reserve Bank presidents   Indicator Range Central tendency Administration Change, fourth quarter to fourth quarter1           Nominal GDP 4-1/4 to 5-1/4   4-1/2 to 4-3/4 4.6     Real GDP2 2 to 2-1/2   2 to 2-1/4 2.0     Consumer price index3 2-3/4 to 3-1/2   2-3/4 to 3 2.6 Average level, fourth quarter           Civilian unemployment     rate 5-1/4 to 5-1/2   5-1/4 to 5-1/2 5.4

  1. Change from average for fourth quarter of 1996 to average for fourth quarter of 1997.
  2. Chain-weighted.
  3. All urban consumers.
 

Economic Projections for 1997

With the economy free of serious imbalances, prospects appear favorable for further growth of activity and expansion of job opportunities in the coming year, although resource constraints seem likely to keep the pace of growth below that of 1996. The central tendency of the GDP growth forecasts put forth by members of the Board of Governors and the Reserve Bank presidents is from 2 percent to 2-1/4 percent, measured as the change in real output between the final quarter of 1996 and the final quarter of 1997. Output growth of this magnitude is expected to result in little change in the civilian unemployment rate, which is projected to be between 5-1/4 percent and 5-1/2 percent in the fourth quarter of this year. These forecasts of GDP growth and unemployment are similar to those of the Administration. The central tendency of the policymakers' CPI forecasts for 1997 spans the relatively narrow interval of 2-3/4 percent to 3 percent, with the lower bound near the inflation forecast of the Administration.

Consumer spending, which accounts for about two-thirds of total GDP, should be supported in coming quarters by further gains in income and the substantial increase in household net worth that has occurred over the past two years; debt problems, although rising of late, do not seem to be so widespread as to threaten the ongoing expansion of household expenditures in the aggregate. In the business sector, balance sheets are strong, profits have been rising, and efforts to bolster efficiency through the use of technologically advanced equipment are continuing at an intense pace. In the commercial real estate market, the supply--demand balance has shifted in many locales to a point at which interest in office building projects has picked up noticeably. These conditions, together with the ready access to a wide variety of sources of finance that businesses currently are enjoying, should keep investment spending on an upward trajectory. Foreign demand for U.S. products should continue to rise with growth of the world economy, even in the wake of the significant appreciation of the dollar since the first half of 1995; however, imports also seem likely to remain on a clear upward trend, given the prospects for continued expansion of the U.S. economy. Government expenditures for consumption and investment probably will follow recent trends, with further cutbacks in real outlays at the federal level and moderate increases in the combined purchases of state and local governments.

Although the risk of increased inflation pressures is significant, especially in view of the tightness of the labor market and the strength in activity that has been evident recently, Federal Reserve policymakers expect this year's rise in the consumer price index to be somewhat smaller than that of 1996. The major reason for expecting a smaller CPI increase this year is a more favorable outlook for food and energy prices. Prices of farm products have dropped back from the highs of last summer, and, barring further weather problems, this year's rise in food prices at retail should be considerably smaller than that of 1996. Oil prices have recently declined and seem likely to ease further in coming months as world production and consumption come back into better balance; this price relief is important not only because of the direct effects on the price of gasoline and other consumer energy items but also because petroleum is a major element in the cost of producing and distributing many other goods. By contrast to the favorable outlook for food and energy prices, some risk exists that core inflation could turn up during the coming year. The minimum wage will be moving up further in 1997, compounding whatever cost pressures might be in train as a result of labor market tightness, and the degree to which businesses can continue to absorb stepped-up increases in labor costs without raising prices more rapidly is not certain.

As noted in the July 1996 monetary policy report, the CPI forecasts of the governors and Reserve Bank presidents incorporate allowances for the technical improvements to this index that have been made by the Bureau of Labor Statistics. These technical changes are estimated to have trimmed the reported rate of CPI inflation slightly in each of the past two years, and additional changes will be affecting the rise in the index in 1997. In view of the remaining difficulties of accurately measuring price change in a highly complex and rapidly changing economy, alternative price indexes will continue to be given substantial weight, along with the CPI, in monitoring progress toward the long-run goal of price stability. Some of the broad measures of inflation derived from the GDP accounts slowed in 1996; the Committee is concerned that, even if the CPI decelerates as expected in 1997, other indexes--with different scope and weights--may pick up in reflection of the pressures on productive resources.

Money and Debt Ranges for 1997

Again in 1997, the Committee has set ranges for M2 and M3 that would encompass monetary growth expected to be consistent with approximate price stability and a sustainable rate of real economic growth, assuming that the behavior of velocity is in line with historical norms. These ranges are unchanged from those for 1996: 1 to 5 percent for M2 and 2 to 6 percent for M3.

Ranges for Growth of Monetary and Debt Aggregates
Percent

Aggregate 1995 1996 1997     M2 1 to 5 1 to 5 1 to 5     M3 2 to 6 2 to 6 2 to 6     Debt     3 to 7 3 to 7 3 to 7

  Note. Change from average for fourth quarter
of preceding year to average for fourth quarter
of year indicated.

As has been the case for several years, the 1997 ranges for M2 and M3 were set against a backdrop of uncertainty about the stability and predictability of their velocities. A long-run pattern of reasonably stable velocity behavior broke down in the early 1990s when the public's holdings of monetary assets were depressed by several factors: the contraction of the thrift industry; a tightening of credit supplies and deleveraging by businesses and households; an extremely wide spread between short- and intermediate-term interest rates that heightened the attractiveness of capital market instruments relative to bank deposits; and the expanding availability and growing acceptance of stock and bond mutual funds as household investments.

With the waning of all but the last of these influences, movements in velocity have become more predictable over the past couple of years. This recent evidence of stability, however, covers only a relatively brief period, and its durability remains uncertain. In these circumstances, the Committee has opted to continue treating the ranges as benchmarks for the trends of money growth consistent with price stability rather than as short-run targets for policy. Meanwhile, the actual behavior of the monetary measures will be monitored for such information as it may convey about underlying economic developments.

The central tendency of the Committee's expectations for nominal GDP growth in 1997 is slightly below that registered in 1996. Thus, if velocity behaves as it did last year, M2 and M3 might decelerate a bit but even so would again expand around the upper ends of their growth ranges. Debt of the nonfinancial sectors is anticipated to increase this year at around the pace of last year, remaining near the midpoint of its unchanged 3 to 7 percent range.

Section 2