In August, 1999, the Federal Reserve Bank of Kansas City sponsored a symposium titled "New Challenges for Monetary Policy" at Jackson Hole, Wyoming. A wide range of central bankers and academics presented papers at this meeting. Three main issues emerged at the symposium: the operation of monetary policy in a low inflation environment, the relationship between asset prices and monetary policy, and the choice of an exchange rate system. The first two of these issues clearly relate to U.S. monetary policy while the third does not. Perhaps it was included in order to attract participants from countries such as Brazil where exchange rate systems are a prominent issue. A summary of these proceedings was published in Economic Review, Fourth Quarter, FRB Kansas City.
The goal of monetary policy is expressed in a stylized statement issued after a meeting of the Federal Reserve Open Market Committee:
To promote the Committee's long-term objectives of price stability and sustainable economic growth, the Committee in the immediate future seeks conditions in reserve markets consistent with maintaining the federal funds rate at an average of around 5 3 percent. In view of the evidence currently available, the Committee believes that prospective developments are more likely to warrant an increase than a decrease in the federal funds rate operating objective during the inter-meeting period." (October 5, 1999)
The final sentence of this directive is referred to as the Committees' "bias", indicating an inclination to raise rather than lower rates. The current goal seems to stress price stability as the prime objective, but there were times in the past when economic growth or strong employment growth were emphasized.
Central to the conduct of monetary policy is the concept of bank reserves. Banks are required to keep reserves equal to a percentage of their own deposits. At present, this requirement is 3 percent of the first $46.5 million of net transaction account (checkable) balances and 10 percent of deposits over $46.5 million. Reserves can be held either in the form of vault cash or in the form of a credit balance in an account at a Federal Reserve Bank. Required reserves and maintained reserve balances are calculated over successive two-week periods, and banks that do not meet their required reserve may be subject to a penalty.
Typically, some banks will have funds in excess of their required reserve in their account while others will have a deficiency. This has led to the practice of one bank lending or selling its excess reserves to another bank that needs them. This "federal funds" market is very active and serves to channel funds from banks and areas with surplus funds to banks and areas which have a deficiency of funds. Federal funds are sold on a one-day basis, so the interest paid for them is in constant flux depending on the demand for and supply of reserves.
Monetary policy is carried out by the Federal Reserve Open Market Committee by controlling the federal funds rate. It does this through the mechanism of open market purchases or sales of U.S. Treasury or Agency securities. A purchase results in expanding the total supply of bank reserves while a sale results in a reduction of total reserves. By thus affecting the total supply of reserves, the Fed can keep the federal funds rate near its desired level.
This "shepherding" of the federal funds rate affects the economy in two ways. First, it establishes a floor under short-term interest rates in general. If a bank can sell its excess funds in a virtually risk-free federal funds market, it will have no incentive to lend at a lower rate elsewhere. In addition various interest rates (consumer, etc.) tend to maintain a relationship to one another so that when the federal funds rate changes, other rates are likely to follow. This does not apply to long-term rates, however, which respond to their own supply-demand dynamics.
The second effect on the economy pertains to the availability of credit. When the funds rate is increased, purchasers must offer higher returns before the Fed will inject any new reserves into the banking system. The supply of funds available for lending thus tends to fall, and some borrowers or potential borrowers are squeezed out of the market. It is this dampening of the future potential growth of the money supply that concerns the securities markets when rate changes are announced.
In implementing the FOMC'S goal for monetary policy, the Trading Desk at FRB-New York closely monitors a number of factors which affect the level of reserves, such as currency withdrawn or deposited in banks, check float, the Treasury balance, etc. The desk then attempts to offset the net effect of these "operating factors" through its own open market operations. By far the most important of these operating factors is currency in circulation.
During 1997 currency in circulation rose $31.3 billion while open market purchases were $40.5 bn; during 1998, currency increased $34.7 bn while open market purchases were $27.5 bn. About half of the currency withdrawn from banks now goes out of the U.S. to circulate abroad. As one consequence of this increase in currency about 14 percent of all outstanding marketable Treasury debt is now held by the Federal Reserve.
By contrast, there is little correlation between open market operations and changes in the consumer price index.
The level of required reserves has been impacted since 1994 by the spread of sweep accounts. The FR Bulletin (4/99, p 219) describes them as follows:
"Since 1994, depository institutions have used retail sweep programs to reduce the amount of balances they must hold at the Federal Reserve to meet reserve requirements. Under these programs, depository institutions shift their customers' funds from checking accounts that are reservable into special purpose money market deposit accounts that are not reservable. Thus, depository institutions can decrease the level of their deposits subject to reserve requirements and, with no change in their vault cash holdings, their total required balances on which they earn no interest."
Since 1994, about $312 billion of deposits have been affected by new or expanded sweep programs, which translates into a potential reduction of as much as $31 billion in required reserves.
The FRB symposium addressed monetary policy only in the context of controlling financial bubbles and of conducting policy in a period of low inflation rates. These discussions may prove to be prescient as our financial markets fluctuate ever more erratically.
In regard to high asset valuations, several points emerged. There was general agreement that we do not know exactly how rising asset prices affect the behavior of consumers, and hence their effect on the real economy. Some participants felt it was difficult to identify a bubble from price rises based on fundamentals such as earnings growth. Most felt that monetary policy should respond to asset price rises if they threatened to lead to inflation, and several advocated swift action if there was a major fall in asset valuations. If the current stock market crashes, these discussions will look rather specious.
Differences also emerged on the question of conducting monetary policy in a low-inflation environment. Issues raised included what information policy makers should respond to, the tradeoff between inflation and output, whether policy should be preemptive, and whether policy should be rule-based or discretionary. They also discussed whether a "liquidity trap" (meaning a drying-up of credit) could nullify the ability of monetary policy to direct the economy.
Since Japan has already experienced the conditions being discussed, it is especially pertinent to note the views of Yutaka Yamaguchi, Deputy Governor, Bank of Japan:
"The final panel presentation, by Yutaka Yamaguchi, focused on the relationship between asset market swings and the poor performance of the Japanese economy in recent years. In particular, Yamaguchi discussed whether a more preemptive tightening of monetary policy in the 1980s might have prevented the asset price bubble in Japan and led to better economic performance. According to Yamaguchi it is not clear that a preemptive tightening was a practical possibility. He noted that inflationary pressures were very late in developing and it would have been difficult to tighten policy without clear signs that inflation was picking up. Indeed, the Bank of Japan did tighten policy when inflation started to rise. He also noted that tighter policy would have been inconsistent with the view at the time among G-7 countries that low interest rates in Japan were necessary for global stability after the 1987 stock market collapse. Yamaguchi also questioned whether a more aggressive tightening would have been successful in breaking the bubble without risking the danger of a financial collapse. He also indicated that some of the structural problems in real estate markets would not have been solved by monetary policy, but rather by different regulatory and supervisory policies."
Monetary policy is a complex, rather murky process. The tools for its implementation are primarily open market operations and changes in reserve requirements. A third tool - the discount rate - has little impact on current operations.
As shown in the first chart above, open market operations - as reflected in the amount of U.S. government securities owned by the Fed - correlate closely with the amount of currency in circulation. This is almost an automatic process since currency withdrawals reduce bank reserves, and the Fed replenishes them by purchasing U.S. securities. But there is no similar direct link with inflation.
The real impact of monetary policy in the 1990s may be seen in the second chart and in the following summary:
|($ billions)||1990||1998||Percent change|
Required reserves on savings accounts were eliminated in 1990, at a time when banks were weakened by losses in the commercial real estate market. Sweep accounts for retail or non-business accounts began to spread in 1994. These two developments have reduced required reserves to the lowest level in history. Many banks now meet their entire requirement through their holdings of vault cash. Others need operating balances for clearing purposes equal to their required reserve. Consequently, required reserves are close to their lowest practical level.
As the second chart shows, bank credit has grown far faster than bank deposits, and bank deposits have grown far faster than required reserves, which are only a little higher today than in 1990.
The acceleration of bank credit growth beginning in 1988 results from the decline in required reserves. When required reserves decline, the "money multiplier" effect (see Pulse #98-3) loses its capacity to limit credit growth.
Based on the progressive reduction in required reserves during the 1990s, the Fed's monetary policy would have to be classified as "accommodative" or expansionary, not "tight" or restrictive. This has resulted in rapid growth of the M-3 money supply from a yearly rate of a little over one percent in the early 1990s to 11.0 percent in 1998. Consumer price inflation has not risen, but securities price inflation has soared. Incomes have grown steeply in the upper two-fifths of the spectrum while lagging in the other three-fifths. These developments puzzle economists since they do not accord with most models or theory. How they eventually play out will profoundly affect our future.
|GDP (% change at annual rate)|
|Industrial Prod. (1992=100)|
|Retail Sales (volume chg. 1 year)|
|Consumer Prices (1982-84=100)|
|Unemployment Rates (percent ending)|
|Interest Rates (3 months)|
|1999 (11 months)||4.87||n.a.||0.25||5.45||4.66|
|Stock Indices (ending)|
|Current Acc't Bal's ($bn) latest 12 months|
|1999 *3Q||-2.9||-18.0||107.2||-18.1 *||-338.9|
|Foreign Exchange Rates|
|Currency units per U.S. $
UK: pound in U.S. $s
U.S.: major trading partners (Jan. 1997=100)
Sources: Economist, Economic Indicators, Survey of Current Business
GDP growth in 1999 was little changed in Germany and the U.S. while Canada and the UK registered moderate gains. Japan's GDP stopped declining but did not rise. Industrial production rose most strongly in Canada and the U.S. with only slight gains in the other three economies. Retail sales picked up most in Canada and the UK and remained strong in the U.S.
Consumer prices rose approximately three percentage points in Canada, the UK, and the U.S. with only small changes in Germany and Japan. Unemployment rates trended downward except in Japan which is at a postwar high. Interest rates also trended lower, notably in the UK. Stock indices surged in all five countries with the largest gains in the U.S. and the UK.
The U.S. current account deficit reached another record at $338.94 billion, more than twice the 1997 level; even the balance on income is now $-24.8 billion. The German and British balances also deteriorated, but the Canadian balance improved. The Japanese yen rose against the U.S. dollar.
|BUSINESS ACTIVITY INDICATORS-UNITED STATES|
|Industrial Production (1992=100)||127.1||132.4||137.1|
|Capacity Utilization Rate (% total industry)||83.3||81.8||80.6|
|Manufacturers' New Orders (bns of $s)||329.3||336.1||356.6 #|
|New Construction Expenditures (bns of $s)||618.2||665.4||705.1|
|Construction Contracts (1992=100)||144||160||174|
|Real Gross Priv. Dom. Invest. (chained$s)||1,385.8||1,547.4||1,637.7|
|Business Sales - Mfg. & Trade (bns of $s)||752.1||777.8||831.3 #|
|Business Inventories (ending) (bns of $s)||1,060.3||1,094.3||1,144.5|
|Retail Sales (bns of $s)||218.0||228.8||249.5 #|
|Retail Inventories (ending) (bns of $s)||330.3||340.8||369.2|
|Per Cap. Personal Consump. Expend.'s (chained $s)||20,272||21,060||21,969|
|Nonagricultural Employment (millions)||122.7||125.8||128.6 #|
|Goods Prod.||25.0||25.3||25.2 #|
|Services Prod.||97.7||100.5||103.4 #|
# Monthly average
Real gross domestic product and real disposable personal income both increased 4.0 percent in 1999, a little less than in 1998 but higher than their average for the current expansion. Higher personal consumption expenditures contributed 3.5 percentage points to the increase in real GDP.
Industrial production continued on the steady uptrend that began in 1992, with the greatest growth in the manufacture of durables - industrial machinery and equipment, and electrical machinery. Capacity utilization declined, but strong new order growth indicated the expansion would continue in 2000.
Continued growth in new construction expenditures was due to the residential and government sectors as commercial and industrial expenditures rose only slightly. However, non residential investment in equipment and software increased strongly, helping to boost gross private investment to a new record.
With strong investment and rising income, both manufacturing sales and inventories, and retail sales and inventories continued their strong uptrends; inventory-sales ratios declined slightly.
Real per capita consumption expenditures rose even more than in 1998 - a record $909 per capita. This increase was supported by both income growth and lower saving. Employment growth was due entirely to the services sector. Construction employment was up, but this increase was more than offset by a decline of 340 thousand in manufacturing.
|FINANCIAL INDICATORS-UNITED STATES|
|National Income (billions of $s)||6,634.9||7,036.6||7,497.0|
|Per Cap. Disp. Personal Income (chained$s)||21,954||22,636||23,309|
|Avg. Real Gross Wkly Earnings (1982=100)||261.31||268.32||271.25|
|Gross Saving (billions of $s)||1,521.3||1,646.2||1,733.3|
|Personal (billions of $s)||271.1||229.9||155.6|
|Business (billions of $s)||1,091.0||1,141.4||1,214.7|
|Government (all) (billions of $s)||159.2||274.9||363.0|
|Commodity Price Index (1990=100)||104.2||86.9||88.4|
|Producer Price Index (1982=100)||131.8||130.7||133.1|
|Corp. Profits (with i.v.a.&c.c.a) (billions of $s)||837.9||846.0||894.0|
|Interest Rates - 10 year Treas.||6.35||5.26||5.65|
|Money Supply - M3 (ending) (billions of $s)||5,402.2||5,996.9||6,479.4|
|Fed. Res. Open Mkt. Operations (billions of $s)||40.5||27.5||5.4 @|
|Commercial Bank Credit (ending) (billions of $s)||4,104.2||4,547.2||4,781.2|
|Consumer Credit (ending) (billions of $s)||1,234.1||1,300.5||1,395.4|
|Credit Market Debt (ending) (billions of $s)||21,250.7||23,364.4||25,614.2|
* Annual rate
The increase in national income in 1999 was comparable to the increases in the prior two years, with all sectors contributing. Real per capita income rose 3.0 percent compared with 3.1 percent in 1998; the increases in the past two years were much higher than those in the earlier years of the 1990s. Average real weekly earnings increased 1.1 percent after increasing 2.7 percent in 1998. The discrepancy between these two series is due to the influence of non-wage components in national income as well as price changes.
The savings data reflect two interesting developments. One is the growth of government saving which has more than doubled since 1997. The other is the continuing fall in personal saving, despite rising income. Does this represent a triumph of the "indulge thyself" message of the day or something else? In either case, the economic stimulus from this source is likely to run out soon.
Commodity prices remained depressed in 1999; all categories remained in the 85 to 90 index range on a base of 1990=100 - one of the props under low inflation. The producer price index increased 2.4 points after falling in 1998. It is interesting to note that foodstuffs and feedstuffs have a reading of 98.8 in this index while consumer foods have a reading of 135.1
Corporate profits grew substantially more than in 1998 - $48 billion.
The 10 year Treasury rate was little changed for the year but had risen to over 6 percent by year-end. Rates are again falling as this is being written, reflecting mounting federal surpluses.
The M-3 money supply grew 8.0 percent in 1999, down from 11.0 percent in 1998. From December 1994 to December 1999 M-3 rose 48.8 percent, an amazing $2,125.3 billion in five years! Bank credit during this same period rose 43.9 percent. Consumer credit rose $434.7 billion or 45.2 percent. Credit market debt expanded $8,407.8 billion or 48.9 percent. If debt-money creation underlies the current economic boom, what will sustain it in the future?
|INTERNATIONAL TRANSACTIONS-UNITED STATES|
|Trade Balance on Goods & Services ($bns)||-104.7||-164.3||-267.5|
|US Owned Assets Abroad, net [inc/capital outflow(-)] ($bns)||-465.3||-292.8||-372.6|
|Foreign Assets in the US, net [inc/capital inflow(+)] ($bns)||751.7||502.6||750.8|
|Net change in US Int'l Inv. Pos'n ($bns)||286.4||209.8||378.2|
|Net change in Foreign Owned U.S. Securities|
|Treasury Securities & Cy Flows ($bns)||164.5||52.8||12.7|
|Other U.S. Securities ($bns)||200.6||227.8||347.2|
|Sources: Economic Indicators, Survey of Current Business|
The trade position is mixed. Exports of goods and services have been rising, but imports of goods and services have been rising even more. As a result, the negative balance on goods increased more than $100 billion in 1999 while the positive balance on services fell slightly. These trends are not sustainable.
The U.S. net international investment position mirrors the trade performance. Foreign investments in the U.S. exceeded U.S. investments abroad by $378 billion. Foreigners actually had net sales of U.S. Treasury securities in 1999, but these sales were more than offset by an outflow of $22.4 billion in currency. Foreign purchases of securities other than Treasuries, however, soared to a record $347.2 billion.Copyright © Andrew Caughey, 2000