Prepared by

Federal Reserve Bank of Cleveland

A moment's notice. Those of us in the monetary policy business are used to being questioned almost daily about the meaning of a data release, a Fed official's speech, or a financial market swing. Does a depreciation in the Malaysian Ringgit mean that the Federal Open Market Committee (FOMC) will hesitate to change the federal funds rate at its next meeting? If a jump in food prices can be traced to a freight car shortage in Nebraska, will the Fed look the other way? If short-order cooks now earn $9.00 per hour in Poughkeepsie, will the Fed regard this as a cause for concern?

In an era when the news media provide continuous coverage of global happenings, the demand for instant commentary is intense. Unfortunately, there is a tendency for people to get caught up in the moment, as if one piece of information could crystallize all of the preceding pieces into a defining event. Policymakers must also guard against getting pulled into this short-term mind set: Their actions at each point in time should form a continuum with their past and future decisions. Consistency with the past enables people to anticipate how policymakers will respond to incoming information, thus avoiding costly surprises. Consistency with the future forces policymakers to anticipate the consequences of their choices, thereby avoiding the need for costly corrections to cumulative mistakes.

Time frames highlight the difference between actions and policies. A policy is not just a decision; it is a high-level plan that guides the course of future decisions. Achieving maximum sustainable economic growth through price stability is the FOMC's current monetary policy. Decisions to alter the federal funds rate are the FOMC's choices made in specific circumstances in order to achieve policy success.

Economic policymakers do not always articulate their goals. In fact, there may be strong political incentives to avoid doing so. Policy changes can make certain groups worse off immediately, even though the changes gradually improve national welfare. In these instances, policymakers may avoid adopting welfare-enhancing policies because the constituency for change cannot mobilize enough supporters. During the 1960's and 1970's, most Americans thought that inflation did not inhibit economic growth. Only when it became clear that this premise was false did popular sentiment shift toward pushing the inflation rate down. By then, unfortunately, the damage proved costly to unwind.

Since those high-inflation years, the FOMC not only has publicly committed itself to a price stability policy, but has displayed a deliberateness in taking actions thought to be consistent with its success. Committee members have been engaged in a series of skirmishes with inflation since the mid- 1980's, always preventing the trend rate from reverting back to its 1970's trajectory and sometimes nudging the trend rate lower. With the exception of a brief and shallow economic downturn in 1990, this strategy has been highly successful. Currently, the unemployment rate is at a 24-year low, and real economic growth has been both balanced and strong.

As business cycle dynamics and unexpected shocks have caused market-determined interest rates to swing widely and repeatedly over the last dozen years, the FOMC has been maneuvering the federal funds rate both up and down to regulate the supply of reserves available to the banking system. No economic variable–not the unemployment rate, the pace of economic growth, or any variety of monetary indicator–has proved to be a consistently reliable signal of inflation or a guidepost for FOMC decisions. So why has inflation moderated?

The principal difference between today's monetary policy and that of the preceding era may well be the FOMC's willingness to be realistic about what is economically feasible and to risk occasional periods of temporarily slower economic growth for the benefit of a longer-lived economic expansion. No one should think that the FOMC's previous decisions have all been perfect. In hindsight, it is possible to pinpoint times when liquidity injections appeared too generous or unduly stingy, and when actions might have been taken too quickly or too late. At various times, the Committee erred on the side of ease and at other times on the side of restraint.

What seems to matter most is not the precise timing of funds rate moves or their exact magnitude, but the FOMC's capacity to stay with a course of action and to be patient until the desired results are obtained. To paraphrase former President Dwight Eisenhower, plans are useless, but planning is indispensable.

Since February 1996, the Federal Open Market Committee (FOMC) has changed the intended federal funds rate only once, raising it a modest 25 basis points at this year's March meeting. The rate's extended stability largely reflects the combination of low inflation and robust economic growth of the mid-1990's. This outcome is the product of a consistent strategy of maintaining a low-inflation environment, an objective underlying policy decisions since the early 1980's.

Among the chief benefits of persistent low inflation are the decline in long-term inflation expectations and the consequently low long-term interest rates that have characterized the 1990's. Consistent attention and prompt reaction to inflationary pressures have enhanced the FOMC's credibility, a necessary condition for declining inflation expectations. The wide swings in stock prices over recent weeks have been accompanied by lower long-term rates, suggesting investors' continued confidence that the value of fixed-income securities is not threatened by a potential surge in inflation.

Federal funds futures prices reveal many occasions since mid-year when market participants expected the FOMC to raise the funds rate before year's end. On October 21, for instance, this market anticipated an increase, possibly coming as early as the November meeting. However, following the sharp drop in stock prices, it became clear that participants had pushed out the horizon of a likely increase indefinitely.

When things appear to be working well, there's a natural reluctance to tinker. For several years now, the FOMC has conducted monetary policy within a framework that pays little attention to the growth rate of money. Since the summer of 1993, when Federal Reserve Chairman Alan Greenspan reported that the reliability of M2 as an indicator had been downgraded, economic outcomes have been quite favorable. Over the same period, output growth has accelerated to an average rate of around 3%, while inflation has fallen to around 2.1% thus far in 1997. Moreover, what is commonly called the core rate of inflation–the Consumer Price Index less food and energy–rose 2.2% over the past year, the smallest annual increase since 1966. Such results do not inspire significant changes in the way policy is implemented.

Although the FOMC specifies annual objectives for the monetary aggregates, M2 and M3, they are treated as benchmarks for price stability. For the last three years, these ranges have been 1% to 5% for M2 and 2% to 6% for M3. Market participants thus far have little reason to believe that growth outside these ranges would, in itself, motivate the FOMC to change the intended fed funds rate. Indeed, M2 and M3 have exceeded the upper limits of their specified growth ranges over much of the past two years, with only one increase (in March 1997) in the funds rate.

However, resurgence of growth in the monetary aggregates, particularly M2, has raised concern that inflation could accelerate. Evidence continues to accumulate that M2 velocity–the ratio of nominal GDP to M2–has stabilized into a pattern that is more consistent with historical experience. Thus, M2 growth may now yield more reliable information about underlying economic developments than in recent years.

Historically, M2 velocity has varied directly with M2 opportunity cost–the difference between the Treasury bill yield and the cost of holding M2. The role of M2 slowly diminished in the early 1990's as evidence accumulated that its velocity was increasing much faster than past experience would suggest. After shifting upward for several years, M2 velocity resumed a rate of increase that is more consistent with its historical relationship to opportunity cost.

When M2 growth is adjusted to account for changes in trend velocity, the resulting measure exhibits a stable, consistent long-term relationship to nominal GDP and inflation over the past inflation cycle. If evidence continues to accumulate that M2 velocity has indeed stabilized, an acceleration in M2 growth cannot be sustained without the risk of increasing trend inflation.

The yield curve has flattened since last month, with rates falling for Treasuries with maturities of one year or longer, and rising for those of less than a year. The most closely watched spreads have both dropped well below their long-run averages: The 3-year, 3-month spread declined from 91 basis points to 55 basis points, and the 10-year, 3-month spread from 110 to 72 points. Such a fall often predicts slower future economic growth. The middle of the yield curve has taken on a rather bumpy appearance because the complicated inter-play between expected rates and risk has generated some unusual movements in the wake of the stock market correction in late October.

Treasury Inflation-Protection Securities (TIPS) have declined slightly to 3.54% since last month, but real yields have not deviated much since reaching 3.6% in April. A more striking change is the drop to 2.3% in the spread between 10-year Treasury bonds and TIPS (a basis-point decrease of 28 since mid-October and 100 since March), which may indicate lower inflation expectations.

It is a truism that the only constant is change, but for interest rates the change is not constant. By one measure- month-to-month changes in the 3-month Treasury bill yield–the volatility of interest rates has varied markedly in the past several decades. Some theories ascribe these differences to monetary policy shifts, and the high volatility in 1979-82 seems to bear this out. Other theories suggest that higher volatility–perhaps because it produces a risk premium–naturally accompanies higher interest rates.

On October 27, the S&P 500 index plummeted 64.62 points, a percentage loss of 6.86%. This was the largest point drop in a single day, and the seventeenth largest percentage drop since the S&P index started in 1926. The chart showing the high, low, open, and close levels of the index reveals that the market dropped for three business days prior to October 27. The date of the correction also stands out because, in contrast to the ups and downs of the usual day, the high point was at the opening bell and the low point was insignificantly different from the close. The following day showed a large gain, despite early losses.

Daily volume on the New York Stock Exchange was high leading up to the correction; thus, October 27 does not stand out in the week, although its volume of 685 million shares exceeded both the 1987 crash and the average for 1996 (412 million). On October 28, trading volume exceeded a billion shares for the first time.

One reaction of investors was an attempt to preserve the gains built up over the past two years by entering into options. The most popular of these was the December 1997 put, with a strike price of 850. A put option gives its holders the right to sell their stock at the agreed-upon strike (or exercise price). In this case, the option would pay off only if the S&P 500 index dropped below 850. On October 27, demand for these options soared, and their price rose accordingly. More significantly, option prices remained high, partly because of increased uncertainty over stock prices, which makes the protective floor of the put more valuable.

The inflation indicators have accelerated a bit recently, although the year-to-date estimates are still quite low by historical standards. In the past three months, the Consumer Price Index (CPI) has increased at a 2.5% annual rate, an uptick from its nine-month average of 1.8% but a shade under its five-year pace of 2.7%. The median CPI, an alternative measure of the retail price trend, has moved up 2.6% over the past three months, also slightly under its five-year trend (2.9%). Similar patterns at the wholesale level are apparent in the Producer Price Index (PPI).

The recent acceleration in the price indexes does not necessarily augur a renewal of inflation. Rather, it may simply reflect the easing of transitory factors, particularly the drop in energy costs, which had a strong moderating influence earlier in the year. In fact, by some measures, the moderate behavior of prices continued into the third quarter. The GDP chain-type price index, which puts only a small weight on energy costs, rose at an extremely modest pace (less than a 1.9%) over the four quarters ended in 1997:IIIQ.

This year's moderate rate of price increase has been accompanied by speculation about the prospect of a deflationary period, which would not be unprecedented in the U.S. Prolonged periods of price decline were relatively common in the second half of the nineteenth century. Moreover, deflation occurred more often than inflation during most of the 1920's and 1930's, in contrast to the almost constant inflation of the postwar period.

Could another deflationary episode occur in this country? A number of business analysts have cautioned that the current economic environment shares many characteristics with the early 1920's, including rapid technology change, high business profitability, and wildly surging equity values. Still, the two periods differ in many important ways. For example, in the earlier one, domestic income taxes were on the rise, world trade was becoming increasingly protectionist, and monetary policy was considerably more restrictive. Between 1920 and 1930, the narrow money stock shrank, a condition that, given the period's economic expansion, put downward pressure on aggregate prices. Although growth in the monetary base has moderated over the past two years, it is still increasing at roughly a 5% annual pace.

It is difficult to cite compelling evidence that markets anticipate a period of deflation. Among a broad set of U.S. assets, only gold prices are falling relative to trend inflation, and household survey data suggest a continued expectation that prices will rise about 3% annually for the next five to 10 years.

The economy continues to show signs of vigor. Advance estimates from the Commerce Department indicate that real GDP grew at an annualized rate of 3.5% in 1997:IIIQ, following an increase of 3.3% in the previous quarter. For the four quarters just ended, GDP was up an average of 4.0%–the best showing since 1984. Strong increases in business fixed investment and consumer spending, especially on durable goods, outweighed declines in net exports and inventory investment.

Economists participating in October's Blue Chip survey expect the current pace of expansion to moderate toward its historical trend of 2.8% in 1997:IVQ. This would result in a 3.6% growth rate for the year–much stronger than 1996's 2.8% posting.

Consumer spending, which accounts for approximately three-fourths of GDP, rose 5.7% in the third quarter after a modest 0.9% uptick in 1997:IIQ. This gain, the largest in more than five years, was led by a 16.7% increase in spending on durable goods, fueled largely by a surge in auto sales that may be due to incentive programs offered by manufacturers.

While retailers hope for continued consumer spending growth, it is uncertain that this active pace will be maintained. The Michigan Survey of Consumer Sentiment decreased 0.8 point from September to October, and the Conference Board's consumer confidence index fell about seven points to 123.3. However, both indexes remain substantially higher than last year's levels, and it is too early to tell if the low October numbers are more than temporary blips.

Manufacturers are planning for continued consumer spending, with output of consumer goods rising 0.7% in September. Total industrial production advanced 0.7%, well above market expectations of a 0.3% rise. The increase in manufacturing output reflects widespread gains. Light trucks, computers, aircraft, and semiconductors all recorded substantial production increases. The capacity utilization rate, 84.4%, is the highest since February 1995.

The National Association of Purchasing Management also reported expanding activity. Its index went up to 56.0 in October, the fifteenth straight month indicating growth.

Investment in nonresidential structures increased 2.4% in the third quarter. Investment in producers' durable equipment was up 5.1%, following an even larger gain (5.3%) in the second quarter. The increased investment was led by purchases of computers and transportation equipment. With corporate profits remaining strong, business fixed investment should continue to grow.

October was characterized by wide-spread strength in the nation's labor markets, as nonfarm payrolls gained an unexpectedly high 284,000 workers. The unemployment rate hit a 24- year low (4.7%), although part of the decline came from a 106,000-person reduction in the labor force. Meanwhile, the ratio of employment to population stayed at 63.7%.

The manufacturing industry set the pace with an increase of 54,000 jobs, concentrated in durables production. This was the largest advance since February 1990 and reversed a string of weak reports. Growth in manufacturing employment was accompanied by upticks in both the length of the workweek (up 0.2 hour) and overtime (up 0.1 hour). In addition to above-average growth in manufacturing, construction posted its largest increase since May (up 20,000 jobs). Notable employment gains were also seen in health services (up 26,000) and retail trade (up 37,000).

Wages and salaries of civilian workers rose 3.4% in the year ended in September, outpacing a 2.2% rise in the CPI over the same period. Hourly earnings in October averaged $12.41–up 4.2% from a year ago and the biggest increase since July 1989. On the other hand, growth in benefit costs (which account for roughly one-third of total compensation) declined slightly.

In recent months, historically high levels of consumer debt have drawn considerable attention. Although the debt- to-income ratio has leveled off in recent months (reaching 20.76% in August), it is still virtually unchanged from its record high of 20.84% attained last April.

Some of the concern about high consumer debt levels may be misplaced, however. Credit card balances are a large component of consumer debt. Over the course of this decade, an increasing fraction of credit card balances has been paid in full every month (up from 9.8% in 1990 to 25.0% in 1996), indicating that much of the rise in these balances results from the convenience of this payment method rather than from a true increase in consumer debt levels. Indeed, after adjustment for convenience credit card use, the debt-to-income ratio shows a decline for most of the year (to 18.35% in August), never having exceeded its 1990 high of 18.78%.

Moreover, comparing households' debt levels to their total financial assets, we see that this measure of the consumer debt burden has been dropping since late 1994, and plunged sharply in the early months of 1997. Of course, much of this is likely due to the stock market's strong performance during the first half of this year.

In any event, it is worth asking whether consumer debt levels are a good predictor of upcoming economic activity. Contrary to popular belief, these levels do not seem to predict future patterns of personal consumption expenditures, which typically rise or fall well in advance of the debt-to-income ratio. As a result, personal consumption figures appear to predict future debt levels, not the other way around.

Another recent concern has been the growing number of personal bankruptcy filings and the rising delinquency rates on various types of personal loans. Over the last several years, delinquency rates on bank credit cards and installment loans have been on a steady upward track, with credit card delinquencies showing the most dramatic rise. In contrast, mortgage delinquency rates have been more stable.

Most striking, personal bankruptcies continue to reach ever-higher levels, with more than 353,000 filings in the second quarter of 1997 alone. Not surprisingly, credit card charge-off rates mirror movements in personal bankruptcy filings, reaching a high of 5.22% of outstanding balances in the second quarter of this year.

Despite these concerns, credit card lending continues to be highly profitable. Although the return on this type of lending has declined dramatically since the early 1990's, it is still well above commercial banks' overall return on assets.

The financial tremors that shook Southeast Asia this summer left the Hong Kong Dollar relatively unrattled. One cause of the October aftershock was uncertainty about Hong Kong's ability to sustain its currency peg to the U.S. Dollar following the realignments of other Southeast Asian currencies. In addition, the U.S. Dollar's nominal appreciation of nearly 50% against the Japanese Yen since April 1995 pulled the Hong Kong Dollar along with it. Last year, nearly 7% of Hong Kong's exports went to Japan.

Moreover, although the inflation differential has generally narrowed since 1994, Hong Kong's inflation rate remains higher than that of the U.S. This indicates that Hong Kong's currency has appreciated in real terms relative to the dollar. The U.S. bought almost 40% of Hong Kong's exports in 1996.

To defend the peg, Hong Kong's monetary authority reduced liquidity, thereby raising money market rates. While this move should relieve pressure on the peg from capital outflows, if maintained it could aggravate another aspect of Hong Kong's recent financial turmoil: Many analysts consider the country's property to be overvalued and worry that its banks could be exposed to a price adjustment. Sustained high interest rates could deflate property values, weakening banks' balance sheets in the process. Growth in the money stock relative to GDP since 1995, a somewhat ambiguous indicator of asset-price pressures, may have helped to sustain inflated property values.

Most industrial countries entered the last recession later than the U.S. and recovered more slowly. Except for Japan, however, they are now experiencing fairly solid growth. German economic activity grew at a 4.1% annual rate in 1997:IIQ, led by exports and personal consumption expenditures. Japan's lackluster performance persists, with real GDP declining at an 11.2% annualized rate in 1997:IIQ. Forecasters expect real economic activity among industrial countries abroad to expand 2.3% this year and 2.8% in 1998. Other things being equal, foreign economies must grow at nearly twice the U.S. pace before our trade deficit will narrow.

This year has seen an uptick in the average inflation rate among large industrial countries, but foreign inflation rates as a whole remain subdued at 1.7%. On a year-over-year basis, recent inflation rates among major European Monetary Union aspirants, whose participation depends on their rates' converging, remain below 2.0%. Forecasters anticipate little change in the foreign inflation outlook.

Faster economic growth has not translated into a universally improved labor situation. Half the countries in our sample currently have higher unemployment rates than they had in 1993, a trough year, and eight are above rates posted in 1990, before the onset of the recession. Economists attribute high foreign jobless rates to social programs that lower the costs of unemployment and to rigid real wages.

November, 1997Federal Reserve Bank of Cleveland

1455 East Sixth Street, Cleveland, Ohio

Consensus National Futures and Financial On Line Index

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