Prepared by

Federal Reserve Bank of Cleveland

Where to, EMU?...Many European nations have been working hard over the past several years to lower their inflation rates and trim public sector deficits. The success of these moves, which are beneficial in their own right, will also qualify these nations for full admission into the European Monetary Union (EMU). In May 1998, participants will form a new European central bank and introduce a new currency, the Euro. If plans go according to schedule, the European System of Central Banks will assume responsibility for monetary policy on January 1, 1999. What will make this institution unique is that it will be a central bank without a country.

Within nations, central banks are public or quasi-public institutions that perform a variety of financial services for the state and for private financial organizations. Central banks can facilitate government debt placement, disburse currency to the public through the banking system, and maintain the government's checking account. They also provide clearing and settlement for private firms that participate in the payments system. More important, central banks create their country's monetary standard of value and give the financial system the liquidity it needs to absorb adverse shocks.

Does the credit quality of a central bank's assets matter? Well, yes! First, if for no other reason, the government ordinarily receives net revenue from its central bank, and poor asset quality may diminish earnings. Second, lower asset quality may render the central bank's portfolio less liquid, leading to flexibility problems should it need to contract its balance sheet. But the principal reason to care is that asset quality gives government and private financial institutions an incentive to be concerned about their own credit quality, since it is their debt that the central bank would consider purchasing. To ensure credibility, a central bank must be designed so that it is restricted to holding assets of impeccable quality.

The European System of Central Banks (ESCB) will consist of a new European Central Bank (ECB) located in Frankfurt and the existing National Central Banks (NCBs). Monetary policy will be set by the ECB, but carried out on a decentralized basis by the NCBs. For our purposes, what is relevant about the arrangement is that the ESCB's security portfolio will contain the debt obligations of the constituent sovereign nations and perhaps also of other entities (such as credit institutions) headquartered in those nations. The ESCB will conduct both its monetary policy and liquidity-enhancing operations by taking these debt obligations onto its books. Accordingly, the Euro itself is ultimately backed by the credit of the EMU nations.

In the United States, the Federal Reserve holds nearly all of its assets in the form of U.S. government obligations–about $400 billion. Hypothetically, suppose that the federal government had little or no debt outstanding. Then the Federal Reserve would have to hold other securities in its portfolio, most likely the obligations of state, and possibly municipal, governments. Should the Fed regard the debt of various state and municipal governments as equally creditworthy? A constant worry, of course, is that the central bank could be used as a back-door device for channeling credit to “preferred” interest groups–unless the bank were legally bound to reject poor quality assets.

There is a possibility of adverse selection in open-market operations. Suppose the ESCB announced its willingness to purchase and then resell securities in the amount of 1 billion Euros at a rate of 4%. Wouldn't it receive offers of the poorer-quality assets from dealers before the better-quality instruments were offered? Will the ECB allow the NCBs to accept all eligible securities on an equal basis, or will they discount for quality? There are obvious political issues here.

Interest rates vary among the EMU countries today, even in real terms, reflecting differences in such factors as tax policies, regulations, and saving rates. Although the participating nations have converged their deficit/output ratios around the 3% Maastricht target, the ratios still vary widely. The diversity of these fiscal positions, together with many well-publicized structural economic problems in Europe (costly welfare and agricultural support programs, to name just two), further challenge the ability of EMU governments to harmonize their economic and fiscal conditions.

Establishing a supra-national central bank, the ESCB, creates an interesting, novel experience. Sovereign states relinquish their ability to issue non-interest- bearing claims on their governments–money–so they will be under even more pressure to manage their fiscal obligations prudently. Under the worst of circumstances, the ESCB may feel severe pressure to use its liquidity or monetary policy to address problems for which it is not suited. Under better circumstances, however, the ESCB can play a positive role in easing the structural changes that will be required of European nations in the years ahead.

The Federal Open Market Committee (FOMC) decided at its September 30 meeting to let the federal funds rate stand at 5.5%, marking six months since the rate was last altered. This inaction came as no surprise to the financial markets, which had widely anticipated the decision. The Committee will reconvene on November 12.

Implied yields on federal funds futures have been flattening throughout the year as expectations for future increases in the funds rate have been pushed out. Robust economic growth, coupled with continued low inflation and virtually no sign of any future acceleration, has significantly reduced the need for the FOMC to act. The market is not expecting the FOMC to change the funds rate in the near future.

Long-term interest rates fell slightly in September, continuing the downward trend that began in April. The 30-year Treasury constant maturity dropped seven basis points to 6.51%, home mortgage rates fell five basis points to 7.43%, and the 10-year Treasury moved down seven basis points to 6.23%.

Treasury Inflation-Protection Securities (TIPS) have been trading since late January 1997. Their average yield for the month of September was 3.6%, up 30 basis points from February. In theory, the spread between TIPS and traditional Treasury securities (currently 2.7%) should give some indication of the market's expectations for future inflation. However, the market for TIPS is not yet fully developed, and liquidity remains an issue. Investors generally require additional compensation for the extra risk they undertake when markets are less liquid, which affects an investment's yield. Hence, the TIPS/Treasury spread probably embodies more than just an expectation about future inflation, and investors should be cautious when attempting to use it to gauge such expectations.

M2 continues to expand at a rapid pace, exceeding the upper bound of its FOMC-determined provisional range set last July. Through August, the aggregate grew at a 5.5% annual rate, and preliminary numbers for the first half of September suggest that it will maintain that pace through the end of the month.

The M3 aggregate accelerated again in August, to an 8.4% annual rate. This is well above its specified range, and also above the growth rate of M2. The surge is attributable in part to robust demand for commercial and industrial loans financed with negotiable CDs, which are included in M3 but not in M2.

The monetary base, a narrower measure of money that includes currency held by the public plus bank reserves, expanded at a 5% rate in August. The primary contributor to base growth in recent years has been its currency component. Foreigners, rather than U.S. residents, are responsible for most of the growth in currency.

M1, another narrow measure of money, fell 1.4% in August, reflecting the continued proliferation of sweep accounts, which allow banks to “sweep” money from reservable to nonreservable accounts in order to economize on their reserves.

Why do economists look closely at money growth figures? Over long periods, there is a strong positive relationship between money growth and inflation. Countries with high rates of money growth have almost equally high inflation rates. In the U.S., the relationship is less precise, but still clear: Rapid money growth preceded periods of accelerating inflation in the 1970's, and slower money growth has accompanied our more recent moderate inflation rates.

The inflation consequences of rapid money growth might be more palatable if the pace of real output also quickened. This is not the case, however. To the extent that any long-term relationship exists between money and per capita output, it is negative. Countries with higher money growth between 1970 and 1996 tended to experience lower output growth. A similarly weak, but negative, correlation between inflation and per capita output growth reinforces this conclusion.

In September, the yield curve on government securities moved noticeably lower (about 20 basis points), but retained its general shape. The weekly average of the 3-month constant-maturity series moved below 5%. The 3-year, 3- month spread moved from 85 basis points to 91, while the other closely watched spread, the 10-year, 3-month, held steady at 110 basis points. Longer-term capital market rates also headed down, returning to the low levels seen last December, and spreads were little changed.

Two important and complementary indicators of the economy's direction are the spread between the 10-year and 3-month Treasuries, a term spread, and the spread between Baa-rated corporate bonds and the 10-year Treasury, a risk spread. The common wisdom is that term spreads predict future economic activity, signaling recessions by inverting. The risk spread serves as a more contemporaneous indicator, since corporate bonds presumably become riskier than government bonds as the economy worsens.

Certainly, these connections are not precise: No recession materialized until long after the term-spread inversion of 1966, and risk spreads in the 1980's often exceeded recession levels of even the 1950's and 1960's. Both types of spreads currently indicate a healthy economy–now and in the immediate future.

Although the stock market has risen sharply over the last three years, a casual examination indicates a bumpier path since the middle of 1996. A more structured approach looks at the standard deviation of the index, which shows a dramatic upturn starting in mid-1996 and continuing through 1997. The standard deviation, a measure of the size of market fluctuations, has increased by a factor of 10 since May 1995.

A more forward-looking approach to analyzing market volatility uses traded options. Call options, which give their owner the right (but not the obligation) to buy stock at a predetermined price, are particularly sensitive to volatility because it affects the likelihood that the option will expire “in the money;” that is, with the stock price above the strike price (the price at which the owner may buy the stock). For any given option, there is a volatility that will make the observed option price correct, termed the implied volatility. It too has generally been increasing in 1997, confirming the more backward- looking historical pattern.

Another useful measure of volatility is stock market kurtosis. A high kurtosis level means a greater probability of extreme movements–both jumps and crashes. This is clearly reflected in the large price movements of early 1997, but the market seems to have settled down since then. Coupled with the increased standard deviation, lower kurtosis implies a more variable market, but one less likely to experience big swings.

Consumer prices rose at a 2.3% annualized rate in August, a small acceleration from the year-to- date average increase of 1.6% and only a shade higher than the 12- month average of 2.2%. The median CPI, an alternative measure of inflation, also advanced 2.3% in August, below its 12-month trend increase of 2.8%. The Consumer Price Index (CPI) continues to track just under the 1997 central tendency range set by the Federal Open Market Committee (FOMC) last July, and is about half a percentage point below the group's 1998 midpoint.

While consumer prices have risen moderately this year, retail price growth has varied substantially by region. Over the most recent 12-month period, retail price increases averaged a mere 0.8% in Baltimore and 1.1% in Dallas. At the other extreme, Miami and San Francisco residents saw retail prices rise at an average rate of slightly more than 3½%.

According to survey data, households expect the average increase in retail prices to pick up to 2.8% over the next 12 months and to reach slightly more than 3% over the next five to 10 years.

Economists also foresee next year's inflation rate exceeding this year's modest rise. The Blue Chip forecast shows the CPI advancing at a 2.7% pace between this year and next. Still, this is a

much more sanguine outlook than projected at the beginning of the year. In January, nearly half of the economists surveyed believed that the CPI would reach 3% or more in 1998. Less than 30% hold that view today. Moreover, while fewer than 10% of those participating in January's survey predicted that inflation would come in under 2½% next year, more than 20% expect such a slight uptick today.

This year, economists are likely to have overestimated the growth rate of the CPI by at least half a percentage point, and almost certainly more. In fact, the Blue Chip panelists have been overly pessimistic about the inflation outlook in six of the past seven years, overpredicting the CPI's growth rate by 0.35 percentage point per year. Last year, however, they were overly optimistic about the inflation trend, which was 0.2 percentage point higher than the consensus forecast.

Although the U.S. retail price performance has been favorable relative to both our recent history and expectations, increases have tended to be 1/2 to 1½ percentage points higher, on average, than those of our major trading partners. In fact, on a trade-weighted basis, foreign retail prices have risen less than 2% per year since late 1993. Economists predict that the U.S. inflation rate will be somewhat worse than that of our foreign trading partners again in 1998. Of our largest trading partners, only the U.K. (at 2.9%) and Taiwan (3.5%) are expected to post higher retail price increases. Canada, France, Germany, and Japan are all expected to see consumer prices rise less than 2½% next year.

The Commerce Department's final estimate places second-quarter real GDP growth at 3.3%, down a bit from the preliminary estimate of 3.6%. This downward revision primarily reflects adjustments to personal consumption expenditures and net exports.

Overall, the U.S. economy remains strong, and economists participating in the Blue Chip survey now expect real GDP for 1997 to come in at about 3.6%–the fastest clip since 1988. Many analysts believe that the U.S. currently has the potential, in terms of resource availability and productivity trends, to sustain growth of about 2%, or slightly faster. Consequently, most output projections tend to revert toward this rate over the forecast horizon. The economy's strong advance since 1996:IVQ, however, has led many to suspect that current estimates of potential growth are too low.

What happens throughout the remainder of this year will depend heavily on inventories and consumer spending. Although inventory-to-sales ratios are not out of line at present, most economists expect the rate of inventory accumulation to slow. The prognosis for consumers remains favorable. Although consumer spending stalled in the second quarter, the year-over-year pace has remained brisk. The recent decline in nondurables spending may be a bit troubling, but sharp swings in outlays for durable goods are not uncommon. A 16.5% drop- off in automobile purchases led the decline in consumer durables in 1997:IIQ.

The nation continued to experience a strong capital spending boom in the second quarter. Since 1991, business fixed investment has risen from 12.3% of GDP to 15.5%. This rapid expansion is particularly welcome after the torpid pace of capital accumulation in the 1980's. Increases in capital investment should enhance labor productivity, defined as the output that each worker can produce in a given period. Over the long term, the pace of labor productivity determines the rate at which workers' real compensation grows. Moreover, prior to the mid-1970's, productivity growth accounted for the largest share of overall output growth.

Nonfarm productivity increased 2.7% in 1997:IIQ, the biggest advance since 1993. Since 1991, however, it has grown just 1.2%, below the 1.5% pace of the previous business expansion. Given the strong advances in business fixed investment, the generally slow pace of productivity growth has led many to question the accuracy of the productivity data. Many suspect that the numbers understate the contribution of services to output growth. An alternative measure that is not so susceptible to services bias–nonfinancial corporate-sector productivity–rose 3.2% in the second quarter and has averaged 1.9% over the current expansion, roughly the same pace as in the previous upturn.

During the first half of 1997, real GDP rose by $142 billion, translating into a 4.1% annual growth rate. Over this same period, real investment in business inventories totaled $141 billion, almost equaling the rise in real output. Many analysts have characterized this rate of inventory investment as excessive or unsustainable, and have consequently predicted a marked slowdown in real output growth for the remainder of the year.

Looking back at the pattern of inventory investment over the past 45 years, one finds that its recent behavior is not unusual. Inventory investment was roughly 1% of GDP in each of the first two quarters of 1997, well above its long-run average of about 0.5% but well within its historical range during economic expansions.

A high level of inventory investment is not, by itself, a clear predictor of either fast or slow output growth. However, it is generally associated with a lowdown in output growth from its current rate. This association partly reflects the fact that high levels of inventory investment are related to high rates of GDP growth in the same quarter. Thus, a slowdown of output growth to rates closer to its historical average would produce the negative association. From experiences in the mid-1980's and in 1994, we see that strong inventory investment need not be a precursor to recession.

Labor market growth in September appeared to recover from August's sluggish pace, with nonfarm payroll employment rising 215,000 nationwide. However, when one factors in the return to work of the former UPS strikers, the estimate is closer to 53,000–much lower than expected. Indeed, September was characterized by weakness in a variety of industries, eclipsing the strike effects and the difficulty of measuring education employment now that many districts have switched to year-round schooling.

The federal government trimmed 9,000 jobs last month, mainly postal workers hired during the strike. Manufacturing payrolls also shrunk (—16,000), primarily because of layoffs in the transportation equipment industry (—20,000). This reverses the 30,000 gain seen in August. Another loser was local education (a subset of local government), which pared 47,000 jobs after adding 63,000 a month before. This wide swing largely reflects seasonal variations in the data, not real effects.

The unemployment rate stood at 4.9% in September, and the employment-to-population ratio fell slightly, to 63.7%. Of those who are currently jobless, 55% are new entrants, reentrants, or workers who left their jobs voluntarily. This implies that Americans still believe job opportunities are plentiful. Average hourly earnings were up four cents–3.6% above last year's level–another indicator that some workers are realizing solid gains.

FDIC-insured commercial banks reported record profits of $14.6 billion in the second quarter, surpassing the previous high set in the first three months of the year. Net interest income and net non-interest income increased 7.9% and 8.9%, respectively.

Net interest margins, the difference between the rate earned on assets and the rate paid on liabilities, rose despite declines in 15- and 30-year fixed mortgage rates. However, margins so far in 1997 are no higher than 1996 levels. The growth rate of bank assets, on the other hand, is well above last year's posting–8.5% versus 5.4%–reflecting strong loan demand. Commercial and industrial loan growth accounted for 56% of the increase in bank assets in the second quarter.

Net interest margins were markedly lower for the nation's largest banks, reflecting both reduced yields on earning assets and higher costs of funding those assets. Second-quarter return on assets (ROA) stood at 1.24%, the fifth-highest ever for the industry. Differences among bank size categories were much less pronounced for ROA (net operating income after taxes divided by assets) than for net interest margins. Non-interest income reached 2.9% of assets for the largest banks, but only 1.4 % for the smallest, while the comparable numbers for non-interest expense were 4.1% and 3.9%.

The U.S. merchandise trade deficit jumped unexpectedly in July, rising to $10.3 billion from $8.3 billion the month before. Many economists now expect our current account deficit–a broad measure of the U.S. trade imbalance–to exceed $160 billion in 1997, up from $148 billion in 1996. To many observers, a persistent trade deficit reveals an inability to compete in world markets that inevitably threatens a nation's standard of living.

The U.S. trade deficit widened dramatically in the early 1980's, and by the end of the decade, we had become a debtor country. Nevertheless, the economy has continued to expand, and employment growth has remained brisk despite the competition from abroad.

The U.S. experience is not a fluke. A cross-country comparison of output growth with either the magnitude or the persistence of trade deficits reveals no correlation over the 1960-89 period. In other words, nations having large and ongoing deficits do not appear to grow more slowly.

The necessary counterpart of a trade deficit is an inflow of foreign savings. Deficit countries can consume beyond their present income, borrow from abroad, and repay their obligations without a diminution of growth. In Benjamin Franklin's words, “No nation was ever ruined by trade.”

October, 1997Federal Reserve Bank of Cleveland

1455 East Sixth Street, Cleveland, Ohio

Consensus National Futures and Financial On Line Index

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