Fiscal policy in the balance...Earlier this month, President Clinton signed into law two bills that collectively aim to balance the federal budget and slash the public's tax obligations by the year 2002. This legislation caps a long march toward fiscal equilibrium that began-depending on one's partisanship-sometime in the 1980s.

Many people oppose large budget deficits because they believe that fiscal imbalances soak up savings from a limited national pool-savings that would otherwise be directed toward private capital formation. Deficits have also been unpopular because they represent a federal government whose operations have expanded over time yet gone unchecked by any fiscal discipline. Now that the deficit is poised to disappear in a few years, at least some perennial budget critics may be able to sleep more soundly. Others, however, are having bad dreams over the budget deal, and economists are prominent among the insomniacs.

Most economists have long believed that national tax and spending policies affect the economy in two distinct ways: by affecting the overall level of economic activity, and by affecting the allocation of resources at any given level of activity. While most textbooks still claim that major changes in the government's fiscal position can have stimulative or contractionary effects on the level of economic activity, economists are becoming increasingly skeptical about their significance under ordinary circumstances. More and more, the profession is coming to believe that the most important budgetary effects stem from the allocative impact of fiscal policy.

Individual policies create incentives and penalties for engaging in particular kinds of activities. Activities that are heavily taxed are discouraged, while those that are subsidized become more attractive. Federal spending or credit programs also channel more resources in specific directions. Economists refer to these many and varied effects on resource utilization as allocative effects. Governments can induce allocative effects through regulation, without taxing or spending per se. The federal budget can be in balance at either high or low levels of activity, meaning that the size of the deficit says little about the size of government and its overall allocative impact.

Any set of fiscal policies gives rise to aggregate revenue and spending streams, with the difference indicating whether the government must borrow or retire outstanding debt. These streams include pure transfer programs (like Social Security) as well as direct purchases of goods and services. Deficits require the government to finance its current activities by drawing on the savings of others (through debt issuance)-savings that would have been channeled elsewhere, likely adding to private capital formation.

Fiscal policy changes enacted in 1990 and 1993 laid the foundation for a balanced budget. Indeed, the tax receipts being generated by our currently booming economy have already driven deficits as a share of GDP below 1 percent. Consequently, the 1997 budget plan required less "heavy lifting" than many realize. The macroeconomic effects of this budget plan are not very significant. The allocative effects are an entirely different matter.

The budget legislation contains hundreds of pages, setting forth a host of complex tax credits, deductions, and rate changes, along with spending caps on a variety of federal programs. Each of these changes will affect the public's behavior and lead to a sequence of other consequences. To name just one, college tuition credits will likely encourage more spending on higher education, perhaps boosting tuition for all students. They may also reduce the number of people interested in pursuing skilled trades. The legislation's allocative effects will spread slowly and will play out in complex ways that are now only dimly understood.

Clearly, the new budget package is not a step in the direction of tax simplification for individuals or corporations. Nor does it tackle the impending Social Security or Medicare shortfalls in any substantive way. Here, reform will still have to wait for the political scales to come into balance.

The semiannual Federal Reserve System monetary policy testimony to Congress, delivered by Chairman Greenspan on July 22, along with the Board of Governors' report, summarizes the Fed's view of current economic conditions and monetary policy as well as its outlook for economic performance through 1998.

Chairman Greenspan reported that "the recent performance of the economy, characterized by strong growth and low inflation, has been exceptional-and better than most anticipated." He noted that the Board, as well as many observers, have been puzzled by the combination of an economy operating at high levels of real activity and low inflation.

Since the February report on monetary policy, the central tendency of forecasts by the Board of Governors and the Reserve Bank presidents has increased to 3%-3¼% for real output growth, and has fallen to 2¼%-2½% for inflation. The central tendency forecasts for 1998 are 2%- 2½% for real GDP and 2½%-3% for inflation.

The intended federal funds rate has remained at 5½% since late March, when the Federal Open Market Committee (FOMC) raised it from 5¼% because, as the Board report explained, "the Committee was concerned about the risk that if the outsized gains in real output continued, pressures on costs and prices would emerge that could eventually undermine the expansion."

While the federal funds rate has been steady, interest rates have fallen. Since late April, the 1-year Treasury constant maturity rate has fallen more than 50 basis points, while the 3-month constant maturity rate has declined 9 basis points. Some perceive an implicit tightening of policy when market interest rates are falling and the intended federal funds rate is held constant.

At the same time that short-term rates have declined, the implied yield on federal funds futures has flattened out, indicating that earlier expectations of an increase in the federal funds rate have greatly diminished.

The Federal Reserve Board's report to Congress also provides provisional ranges for the monetary aggregates for 1997 and 1998. At its meeting in early July, the FOMC reaffirmed the 1997 growth ranges for the monetary aggregates and domestic nonfinancial debt that it had set in February. These ranges are 1%-5% for M2, 2%-6% for M3, and 3%-7% for debt. Provisional ranges for 1998 were set at the same levels.

From 1996:IVQ through June 1997, M2 grew at a 4.9% annual rate, just below the upper bound of its range, while M3 expanded at an annual rate of 7.1%, well above its upper bound. Through May, domestic nonfinancial debt increased at a 4.8% annual rate over its 1996:IVQ level, near the center of its range.

In evaluating the policy significance of growth in the monetary aggregates, the Board's report noted that "the correspondence between changes in M2 velocity and in opportunity cost during recent years may represent a return to the roughly stable relationship observed for several decades until 1990-albeit at a higher level of velocity." However, Chairman Greenspan testified that "sufficient evidence has not yet accumulated" to put more weight on such monetary quantities in conducting policy.

Finally, the Board's report noted that M1 continued to contract between 1996:IVQ and June 1997, falling at an annual rate of 2.7%. It stated that this decline is probably due to depository institutions' continuing tendency to "sweep" balances in transaction accounts, which are subject to reserve requirements, into savings accounts, which are not. The decline in the quantity of deposits held in transaction accounts led total reserves to fall at a 9.8% annual rate. But because of substantial growth in currency holdings, the monetary base (which equals currency plus reserves) increased at an annual rate of 4.5%.

The report sounded a warning about this decline in reserves, stating that "further reductions in required reserves have the potential to diminish the Federal Reserve's ability to control the federal funds rate closely on a day-to-day basis." Moreover, the report argues that "the decline in required reserves over the past several years has not created serious problems in the federal funds market, but funds- rate volatility has risen a little, and the risk of much greater volatility would increase if required reserves were to fall substantially further." It warns that additional increases in volatility could have negative consequences for the performance of the economy.

The yield curve has flattened since last month, with long rates falling and short rates rising. The often-watched 3-year, 3-month spread and 10-year, 3-month spread stand at 65 and 86 basis points, below their historical averages of 80 and 125. This flattening suggests a slowdown of real economic growth over the next year, although the yield curve is still far from an inversion (short rates above long rates), which would signal recession. A look at the very long and very short rates confirms a pattern-that long rates account for most of the change in the spread. Continuing the trend begun in April, the federal funds rate remains slightly above its target value of 5.50%.

Tracking spreads is convenient, but it fails to capture the true three-dimensional nature of the yield curve over time. Shifts in the curve are rarely parallel: They also involve twists, because maturities rise and fall at different rates. Did interest rates peak in 1981 or 1982? It depends on whether one looks at long rates or short. The inversion of 1981 occurred when all rates where rising rapidly, but the 1989 inversion saw long and short rates moving in opposite directions.

Finance experts disagree on how best to characterize the twists and turns of the yield curve. Most think that three numbers are needed: level, steepness, and curvature. This three-dimensional perspective emphasizes the relative tranquility of rates since 1994, with twists and turns that look tame compared to the gyrations of more turbulent times.

Both spot and futures prices of gold have been declining fairly steadily since March, dropping to levels not seen since the first months of 1993. While this may indicate a sanguine attitude among international investors (gold being a traditional safe-harbor asset in stormy times), it may also reflect the strength of alternatives such as dollar-denominated assets and world stock markets. The basis-the difference between spot and futures prices-remains negative, but it too has been diminishing since April.

One enduring question about any asset price (gold futures included) concerns predictability: Do prices follow a random walk? The answer boils down to two different possibilities: Price changes (or returns, which are the log of changes) may have an identical and independent distribution each period, or they may be uncorrelated over time. A chart of gold futures returns strongly discredits the first possibility, because gold returns' variability seems to have changed over time, markedly decreasing since the 1980s. One way to assess the correlation of returns is to look at the variance ratio. If returns are uncorrelated-if prices follow a random walk-yearly returns should have 12 times the variance of monthly returns, six times the variance of two-month returns, and so on. In the actual data, however, the variance of yearly returns is closer to 21 times that of monthly returns, suggesting a correlation. This evidence indicates that gold prices are at least partially predictable.

In June, the Consumer Price Index (CPI) rose at a mere 1.5% annualized rate, nearly the same pace it has followed since last December. Indeed, the six-month average rise in the CPI (1.4%) is the lowest six-month posting in almost 11 years.

Price increases further down the production chain have also been very subdued. Over the past year, the Producer Price Index has remained essentially unchanged, and reports from purchasing managers hint that little upward pressure will be coming from industry in the immediate future.

The moderate rate of price increase this year prompted the Federal Open Market Committee (FOMC) to revise downward its central tendency forecast for the 1997 CPI growth rate-from 2¾%-3% last February, to 2¼%- 2½% in July. For next year, the FOMC sees the rate of CPI increase in the 2½%-3% range.

Economists participating in the Blue Chip survey have also reduced their expectations for inflation. Last February, about 38% of them predicted that the CPI would increase more than 3% in 1998, compared to only 5% who expected growth below 2½%. In July, the share of economists projecting that 1998's CPI growth rate would exceed 3% had fallen to 26%, while the proportion expecting less than a 2½% increase had risen to about 12%.

In his July semiannual report to Congress, Federal Reserve Chairman Greenspan noted that monetary policymakers "have been puzzled about how an economy, operating at high levels and drawing into employment increasingly less experienced workers, can still produce subdued...inflation rates."

Although the relationship between the unemployment rate and the rate of compensation growth has been erratic since 1960, the jobless rate for 1996 (just above 5%) is associated with one of the lowest rates of compensation growth in the past 35 years (about 2¾%). In 1964, for example, when unemployment was also around 5%, compensation growth topped 4%. In 1970, a similar jobless rate coincided with compensation growth of more than 6%, and in 1974, 5½% unemployment was associated with a compensation growth rate of about 11%.

The Chairman noted that several factors may be helping to hold down wage and price increases. Firms appear to be profiting from unusually strong productivity gains, which may have resulted from the capital investment surge of recent years. Growth in business purchases of equipment during the past five years has exceeded 10% annually-its best performance since the 1960s.

"Certainly," he said, "changes in the health care industry and the pricing of health services have greatly contributed to holding down growth in the cost of benefits, and hence overall labor compensation." He also observed that job insecurity is probably helping to subdue wage demands and cited several indicators, including the fact that "the number of workers voluntarily leaving their jobs to seek other employment has not risen in this period of tight labor markets." The caution here is that to the extent that these forces are temporary, "cost and price pressures would tend to reemerge," a situation the Federal Reserve "plans to monitor closely" this year and next.

As expected, the pace of economic activity slowed in 1997:IIQ. Preliminary estimates show that the economy grew 2.2% in the second quarter (down from a revised 4.9% the previous quarter). Second-quarter growth was led by investment in producers' durable equipment, exports, and federal government spending. Offsetting these effects was a decline in consumer spending for motor vehicles and parts and an increase in imports. Over the four quarters ended in 1997:IIQ, the economy grew at a strong 3.1% clip.

The moderate second-quarter growth rate was in line with the consensus of economists participating in the Blue Chip survey. They foresee that a rebound in consumer spending could produce an uptick in 1997:IIIQ growth, but they expect a return to the 2% GDP growth range through 1988.

Real personal consumption expenditures were flat in the second quarter. Strong advances in services spending offset sharp declines in purchases of motor vehicles and nondurables. Labor disputes that limited supplies of popular vehicles may have affected car sales. Real disposable personal income growth was healthy in the second quarter, the employment situation stayed strong in July, and consumer sentiment remains upbeat.

Consumers continue to devote a growing share of their total spending to durables. The proportion has risen from approximately 8.5% in 1970 to more than 13% in the first half of 1997. The percentage spent on motor vehicles and parts, however, has remained fairly stationary (around 5%). The relative gain in durables has come at the expense of nondurable goods sales. Service's share of total consumer spending has also grown.

Industrial production continued to post strong gains in June, led by high-tech durables and commercial aircraft. Production of motor vehicles and parts also advanced in June, but was off sharply for the quarter. The National Association of Purchasing Management's July indexes of output and new orders continued to reveal a strong manufacturing sector. Inventory-to- sales ratios picked up in May, but are still low by historic standards.

The value of a nation's output (GDP) should equal the income paid to all who produced it (gross domestic income or GDI). Since 1995, U.S. GDI has exceeded GDP, leading some to speculate that the Commerce Department may be underestimating output. The magnitude of the recent discrepancy, however, is not unparalleled, and persistence in the signs of errors (albeit negative) is not uncommon.

The nation's labor markets showed robust growth in July, with nonfarm payrolls posting a higher-than-expected gain of 316,000 workers. The civilian unemployment rate returned to its May level of 4.8%-the lowest since November 1973-and the employment- to-population ratio edged up 0.1% over the same period, reaching 63.8%. Meanwhile, average hourly earnings remained unchanged at $12.23, and nonfarm employees' average workweek fell to 34.4 hours (down 0.3 hour). Household survey data, which are more variable than establishment data, also point to strength in the labor markets-an estimated addition of 344,000 workers.

In the goods-producing sector, manufacturing showed a net employment decline for the month (down 5,000 jobs) as durable-goods payrolls added 20,000 jobs and nondurable goods lost 25,000. Average weekly hours of work and overtime hours both continued their recent downward trends. The average manufacturing workweek stood at 41.7 hours in July, down 0.1 hour from a month earlier. Factory overtime also shortened by 0.1 hour to 4.6.

Jobs in the service-producing sector grew at a healthy clip last month. Employment in retail trade advanced 65,000, buoyed by a rise in restaurant jobs (up 35,000). Government continued to expand its payrolls, adding 56,000 workers in July.

The U.S. labor market is characterized by tremendous churning, with approximately 7 million people entering or leaving in a single month. In addition to people moving between jobs, substantial numbers of jobs are created or destroyed each month. Both kinds of changes occur during cyclical upswings as well as downturns. This suggests that at any given time, unemployed workers coexist with unfilled job vacancies.

The relationship between unemployment and job vacancies is shown in the Beveridge curve, which is useful for understanding how well the labor market matches unemployed workers with openings. The curve for the U.S. reveals several downward-sloping, counterclockwise loops. Evidently, these loops trace out a business cycle whose nadir roughly corresponds to the most southeasterly points. Since 1992, we have been moving northwest, and the past three years suggest that we may have reached the peak of the cycle.

Notice also that there seem to be many different Beveridge curves, shifting out and right until the mid-to-late 1980s and then shifting back toward the origin. As the curve shifts to the right, the unemployment rate is higher for any given level of vacancies. This may reflect a worsening job-matching process, slow adjustments to a changing mix of industries, or possibly an increase in unemployment insurance benefits. The opposite would be true of shifts toward the origin.

Deregulation, new financial products, and new competitors are some of the explanations for the significant changes that have occurred in the U.S. banking industry. These changes have altered the relative importance of industry profitability components.

The main components usually considered in evaluating banks' profits are asset yields, the cost of funding earning assets, non-interest income, and non-interest expense. These variables have shown two clear trends in the recent past: Since the early 1970s, the non-interest components of banks' profits have become more significant. Starting in 1981, the importance of the interest components-the yield on assets and the cost of funding earning assets-has been declining.

The yield on earning assets and the cost of funding earning assets have followed a common pattern, determined largely by market interest rates. The same is true of the variables' main components-the interest income on loans and leases and the interest on deposits. These variables reached their highest values in 1981, when the yield on earning assets was 14.1% and the cost of funding assets was 10.4%. By 1996, these variables had fallen to 8.2% and 4.0%, respectively.

In contrast to downward trends in the yield on assets and the cost of funding is the growing importance of the non-interest components. The ratio of non-interest income to earning assets jumped from 0.9% in 1972 to 2.5% in 1996. During the same period, the ratio of non-interest expense to earning assets rose from 3.0% to 4.3%. Note that these increases occurred despite the steadiness of the variables' main components-service charges on deposit accounts and the cost of employee salaries and benefits, respectively.

The change in the components of profits varied with the size of the bank. Between 1991 and 1996, the variation in interest components had a similar pattern for all banks. Furthermore, the value of these components did not differ significantly with institution size except in the case of the largest banks, which had a higher cost of funding earning assets throughout the entire period. The evolution of non-interest components, however, depended more heavily on bank size, as did their values at each point in time. One clear difference among banks of different sizes is that non-interest income and non- interest expense are far less important for smaller banks than for larger ones.

The U.S. trade deficit has widened since 1991. Over the first five months of this year, the shortfall was $48.1 billion. Our largest deficits are with Japan, China, and our NAFTA partners.

The deterioration in the U.S. trade balance over the current business expansion largely reflects the more rapid pace of economic growth in the U.S. than abroad. Since 1991, the major industrialized countries have seen their output climb 1.5% on a trade-weighted basis, while the U.S. economy expanded 2.5% (average annual rates). Our faster economic growth has attracted foreign savings and financed domestic investment at levels unsustainable through domestic savings alone. Other things being equal, foreign economies must grow at about twice the domestic rate in order to reverse this pattern and narrow the U.S. trade deficit. Although analysts expect foreign economic growth to accelerate to 2.3% in 1997 and 2.7% in 1998, it will not surpass projected U.S. growth (3.5% in 1997 and 2.3% in 1998) by the requisite margin.

The relationship between exchange rates and the trade deficit is even more tenuous than that between growth rates and trade, but a dollar appreciation can widen the deficit. The dollar's 14.4% real appreciation since 1995 has not favored a narrower trade deficit.

The U.S. current account deficit has increased thirteenfold since 1982, reaching $148 billion in 1996 and nearly $164 billion (annual rate) in 1997:IQ. Our nation has financed the surfeit of imports by selling assets and issuing debt instruments to foreigners. This generates an inflow of foreign capital, but it also gives the rest of the world a claim on our future output.

In the late 1980s, when the stock of foreign assets held in the U.S. exceeded our assets held abroad, we became a debtor country. The U.S. international investment position-our balance sheet with the rest of the world-reflects the history of our capital flows as well as changes in the value of our external assets and liabilities.

Nearly 25% of the assets that foreigners hold in the U.S. are direct investments, which entail some control over the management of American businesses. The biggest stakeholders are the U.K., Japan, the Netherlands, and Canada. Another 24% of foreign- held U.S. assets are in corporate stocks and bonds, which do not confer any significant degree of managerial control. This is the share that has expanded the most since 1982, but foreigners have also increased the portion of their U.S. assets held in Treasury securities.

August 1997

Federal Reserve Bank of Cleveland

1455 East Sixth Street, Cleveland, Ohio

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