I am pleased to respond to your request to share my views on monetary policy and the state of the economy in the Eleventh Federal Reserve District. The economy of the Eleventh District, which includes Texas, southern New Mexico, and northern Louisiana, has fared somewhat better than the national average during the past three years.1 In part, we have done better because the economy was rebounding from the sharp contraction that took place after 1986. Measured by employment, our region managed to avoid recession but not sluggish recovery. After the U.S. recovery began in April 1991, District employment growth weakened, and unemployment began to rise. Our employment growth slowed below trend, and our unemployment rates increased to national levels, especially in areas vulnerable to defense cuts. Even with these weaknesses, however, employment in the three states has grown by 194,000 since the trough in the national economy.
OVERVIEW OF THE ELEVENTH DISTRICT ECONOMY
The relative strength of our economy derives, in part, from trade with Mexico. Exports from Texas to Mexico rose 16.5 percent in 1991 and jumped another 22 percent in 1992. Exports in 1992 amounted to $19 billion, which represented 4.7 percent of gross state product. District industries benefiting most from increased Mexican trade include chemicals, food and kindred products, transportation equipment, electric and electronic equipment, furniture and fixtures, and apparel.
Our border cities have shown the strongest growth, both in terms of manufacturing employment and in retail sales. Geographically, San Antonio and Austin are doing better than Houston and Dallas-Fort Worth. Fort Worth has been hardest hit by defense cuts, while Houston has felt the brunt of energy cutbacks.
Restructuring away from energy continues to make our economic profile more like the nation's, but that restructuring, like similar adjustments across the nation, continues to exact a human toll. Within our District, the performance of New Mexico is similar to that of Texas, while that of Louisiana has been somewhat weaker.
Except for commercial real estate, construction has been a recent source of strength and jobs in our region. Residential permits last year were the highest since 1986, the year of the oil bust. Office vacancy rates, however, have not recovered much. One lesson from our District is that the overhang of commercial real estate lasts a long time.
The financial condition of our banks has improved over the past two years, and bank lending has stabilized for the first time since 1985. Nonetheless, the credit crunch has been very real in the Southwest. While it has eased somewhat during the past year, the credit crunch continues to impede job growth in small-and medium-sized businesses that rely on banks for credit.
A Stronger Growth Trend
With most sectors of the District's economy outperforming their national counterparts, a stronger long-term growth trend may be the principal factor contributing to employment growing faster in the District than in the nation during the recovery. Since 1970, the trend rate of growth in District employment has been 2.9 percent annually, while the trend rate of growth in U.S. employment has been 2.1 percent annually. Since the trough in March 1991, employment gains in both the District and the United States have been about equally below their long-term trends. In the District, employment has grown at a 0.9 percent annual rate since March 1991, while U.S. employment has grown at a 0.3 percent annual rate.
Several factors contribute to the District's stronger growth trend. First, the state and local fiscal policies in the District have struck a favorable balance between the provision of government services and the taxes required to finance them. Second, political and social factors in the District states are generally favorable to economic growth. Third, the populations of New Mexico and Texas are younger than the U.S. average.
A Growing Similarity to the National Economy
The changing composition of the District economy has made it more like the rest of the United States. In 1982, the District had a more prominent energy sector and less prominent service and manufacturing sectors. Since that year, the District's energy sector has contracted, its service sector has grown in importance, and its manufacturing sector has declined less than the nation's manufacturing sector.
Late in the U.S. recession, the District economy showed the effects of its growing similarity to the U.S. economy. The influence of the national recession on the District economy was most evident during the first two quarters of 1991. The national economy experienced its sharpest contractions from November 1990 through March 1991.
During the recovery, the performance of the District economy has remained similar to that of the nation's. Since March 1991, District employment has grown at an annual rate 2 percentage points below its long-term trend rate of growth, while U.S. employment has grown at an annual rate 1.8 percentage points below its long-term trend rate of growth.
As in much of the nation, one source of weakness in the growth of District employment has been continued structural change in the service sector. Although the service sector has continued to add jobs, the rate of growth has declined sharply over the past several years. The employment weakness stems from both technological change and increases in the costs of nonwage benefits. For example, the demand for accounting services has declined as many small businesses have acquired software that allows them to keep their own books. Many firms have also commented to us that the mandated nonwage costs of hiring an employee have risen so sharply over the last two or three years that it is now often cheaper to pay overtime than to hire new workers.
Reduced Defense Spending
As is the case for many areas of the country, another source of weakness in the District economy has been cuts in defense spending. Overall, the District is about as sensitive to cuts in defense spending as is the national average. Two metropolitan areas in the region, Fort Worth in particular and Dallas to a lesser extent, are more sensitive than the national average. Nonetheless, the District remains vulnerable to defense cuts aimed at specific, locally produced weapons systems.
Reduced U.S. spending on the A-12 attack plane, B-2 bomber, F-16 fighter, V-22 Osprey, and other defense contracts has rocked manufacturers in the District, particularly those in the Dallas-Fort Worth area. Since late 1990, employment at General Dynamics' Fort Worth facility has been reduced by more than 11,000 workers. Just last year, Bell Helicopter, Vought Aircraft, and Texas Instruments laid off a total of 9,400 workers in the Dallas-Fort Worth area who previously were working on defense contracts. Other defense contractors in the area also have made cuts. Multiplier effects will contribute to further job losses in the Dallas-Fort Worth area.
The District overall has been a net beneficiary of the base realignment process thus far. While bases in Austin (Bergstrom AFB), Fort Worth (Carswell AFB), and Beeville (Chase Field Naval Air Station) are in the process of closing and the Second Armored Division at Fort Hood (near Killeen, Texas) has been deactivated, the District has gained military jobs because 33,000 military personnel are being transferred to Fort Hood. Additionally, civilian uses have been found for some of the closed bases. A new round of base-closing decisions begins this month, however, and the story could change dramatically.
Oil and Gas
Declines in the oil and gas industry have been still another source of regional weakness. In the District, the concentration of employment in oil and gas extraction is seven times the national average. Although the boom days of J.R. Ewing have long since left the oil patch, oil and gas extraction is still a $40 billion industry in the District (7.8 percent of the value of output), and the industry's volatility still has considerable effects on the region's economy.
Before February 1991, higher oil prices brought about by the Persian Gulf War encouraged a modest expansion of the nation's oil and gas industry. As an energy-exporting region, the District benefited from higher energy prices, while much of the nation suffered.
After February 1991, lower oil prices and extremely low wellhead prices for natural gas brought a sharp contraction to the oil and gas extraction industry, which was exacerbated by a long-term shift of exploration and development activity overseas. The Baker Hughes rig count fell to a fifty-two-year low in April 1992. The fall resulted in major employment reductions by oil companies doing business in the District, such as ARCO, Chevron, Mobil, Marathon, Phillips, and Shell. Over the past two years, layoffs in the energy industry directly accounted for the loss of 32,000 jobs in the District. Longer term, the District has lost in excess of 200,000 jobs in oil and gas--more than 50 percent of its peak employment. Both in absolute numbers and in percentage terms, the District's job losses in energy exceed those of the auto industry nationally.
Real Estate and Construction
In the past few years, the growth of construction has been a source of strength for the District economy. Although construction jobs have declined by 196,000 nationally since March 1991, they have increased slightly in the District. Although most major office markets in the District remain overbuilt, residential construction has shown marked improvement. Permits issued for residential construction in 1992 were the highest since 1986, the year in which the construction sector began its massive decline.
Differences between District construction and real estate and the corresponding national averages result primarily from timing. The District's real estate market collapsed in 1986, the year in which oil prices plummeted and the region's economy fell into recession. By the time national real estate property values tumbled in 1990 and 1991, property values were stabilizing in the District.
During the District's recession, construction employment--which had been stimulated during the early 1980s by tax advantages, a booming regional economy, and speculative excesses--fell almost 30 percent from its peak in 1984 to its trough in early 1989. District construction then began to rise, spurred by rising occupancy rates and stabilizing property values.
More recently, rising home values, lean home inventories, and low mortgage rates made 1992 the biggest year for residential construction in the District since 1986. Weakness in office markets kept the growth of commercial construction at a near standstill. Because the District has already adjusted to the low levels of commercial construction associated with weak office markets, however, the commercial sector is not the drag it is nationally.
The District banking industry is, on average, now healthier than its national counterpart. In the District, healthy banks hold 82 percent of total assets versus 65 percent nationwide. District banks are more profitable and generally hold lower percentages of nonperforming loans than their national counterparts. District banks show a lower propensity to lend than the average U.S. bank, however, holding only 45 percent of assets as loans versus 56 percent for all banks nationwide. Lending by Eleventh District banks has not been as strong as the banks' capacity to lend would indicate, although recently, loans held at District banks have increased marginally.
Banking institutions in our region have been through very tough times. From 1982 through 1992, a total of 565 banks failed. A credit crunch and concerns about capital constraints on lending began in the Dallas District. The impact of the credit crunch on small businesses was long-lasting and severe. The dependence of small businesses on bank credit and the contraction of bank loans in recent years-partly as the unintended consequence of stricter regulatory oversight, increased deposit insurance premiums, and higher capital standards--may well explain some of the weak employment growth we have seen so far in this recovery.
Banking conditions improved slowly as insolvent institutions were closed, failing banks were resolved, and recapitalization occurred. While many factors have contributed to the credit crunch, it is clear that restoring capital to healthy levels is a necessary condition for bank lending to resume.
Many of the same factors that are holding back employment growth in the nation during this recovery have had a similar effect in the Eleventh District. These factors include business restructuring and reduced defense spending. A stronger growth trend in the District than in the nation accounts for much of the region's stronger performance in creating jobs. For now, the disadvantages of having a higher concentration in the oil and gas industry than the national average are being partially offset by increasing trade with Mexico and an expanding construction sector.
The District's banks are healthier than the national average, but they have yet to become a factor contributing to stronger growth. Having sketched recent events in my region, I turn to the national economy and the appropriateness of monetary policy.
RECENT MONETARY POLICY
With regard to monetary policy, I believe that it has been accommodative over the past four years. Certainly, by conventional measures, monetary policy was not tight heading into the third quarter of 1990, when the Iraqi invasion triggered a recession. The federal funds rate had been declining for fifteen months and was down more than 150 basis points from its March 1989 peak. In mid-1990, the M2 money supply was growing at an annual rate of more than 5 percent, near the center of its 3 percent to 7 percent target range. Nominal aggregate demand was growing even more strongly, at an annual rate of more than 6 percent. The interest rate yield curve had been positively sloped for six months, and both the Commerce Department and National Bureau of Economic Research indexes of leading indicators were signaling continued economic expansion. Indeed, contemporaneous real-time data did not clearly signal that a recession had begun until the fourth quarter of 1990, at which point the Federal Reserve promptly initiated a new sequence of easing moves. In consequence, short-term interest rates declined an additional 100 basis points by the end of 1990, and monetary base growth surged to double-digit rates.
The oft-heard charge that the Federal Reserve's actions were "too little, too late" is not supported by the evidence. We cut the federal funds rate much more (17 percent) before the July 1990 business cycle peak than before any of the five previous business cycle peaks. Despite a pause in interest rate cuts during early 1990, the decline in the federal funds rate from April 1989 (when it began its descent) until March 1991 (at the business cycle trough) comes very close. to the average percentage decline in the federal funds rate over comparable periods during other recent business cycles. The decline in long-term interest rates that accompanied the March 1989--March 1991 easing moves was also well within the range of past experience.
The total decline in the federal funds rate and the ten-year Treasury bond rate over this business cycle has now reached 70 percent and 29 percent respectively, compared with average total declines of 55 percent and 9 percent over the other five most recent cycles. Monetary policy was expansionary throughout the recession.
Late in 1990, as soon as it became apparent that the Gulf War, a spike in oil and gasoline prices, and a sharp drop in consumer confidence were dragging the economy down, the Federal Reserve took prompt action to maintain spending growth. Unfortunately, the lags between cuts in the federal funds rate and the economy's response are such that our actions were insufficient to prevent the economy from slipping into a recession.
THE SHIFTING COMPOSITION OF MONEY
In response to cuts in short-term interest rates, growth in narrow measures of money has accelerated markedly over the past four years. Growth in the M2 monetary aggregate, in contrast, has slowed.
It is not surprising that growth in the narrow monetary aggregates sped up relative to growth in broader measures of money. As short-term interest rates decline, the opportunity cost of holding funds in checking accounts or even in cash declines. The growth rate of narrow monetary aggregates then accelerates. Because banks are required to hold reserves against M1 deposits but not against M2 deposits that are not part of M1, the impact of lower interest rates on the growth rates of reserves and the monetary base can be particularly striking.
The mystery is the magnitude of the absolute slowing of M2 growth. Historically, the velocity of M2 has moved very closely with short-term interest rates. However, this relationship began to deteriorate in 1990. The velocity of M2 has been substantially higher than expected, given recent declines in short-term interest rates. Indeed, the shortfalls in M2 and M3 growth from the midpoints of their ranges were more than offset by the increase in their velocities. In other words, hitting the midpoint of the target ranges with no change in velocity would have resulted in slower growth in spending and income than actually occurred.
The close historical relationship between interest rates, M2 growth, and nominal gross domestic product (GDP) growth, to some extent, is a product of hindsight. Before 1980, M2 as we now know it did not exist. In 1980, the Federal Reserve redefined M2 to include money products that were not previously included in published money numbers. Most notable among these were money market mutual funds, which if they had remained excluded from M2, would have lowered M2 growth by 2 to 4 percentage points during the quarters just before M2's redefinition. If M2 had not been redefined, the historical M2-GDP relationship would have appeared much looser.
Just as households in the late 1970s shifted their money out of traditional bank deposits into money market mutual funds, households today are shifting out of M2 deposits at banks and thrift institutions and into higher-yielding bond and equity mutual funds. Mutual fund asset management accounts, such as those offered by Merrill Lynch or Charles Schwab, enable households readily to transfer assets from bond and stock funds to checkable money market funds when needed. While stock funds carry much investment risk, bond funds--particularly bond funds investing in government and high-rated corporate bonds--are quite substitutable for M2 deposits and have grown very rapidly the past two years.
Research at the Dallas Fed indicates that redefining M2 to include bond funds held outside Individual Retirement Accounts and Keogh accounts by households would result in a monetary aggregate more closely related to its opportunity cost (that is, competitive interest rates) and nominal GDP than is M2 as currently defined. Indeed, such an expanded aggregate has grown about 2 percentage points faster than M2 in recent years--very much in line with recent growth in nominal GDP. Furthermore, the expanded aggregate has stayed near the middle of the growth cones implied by the Federal Reserve's M2 target growth ranges. This research suggests, then, that current monetary policy is appropriately expansionary.
For some time now, I have been warning that, in today's financial environment, disintermediation from the banking system is as likely to be caused by low short-term interest rates as by high short-term interest rates. In the past, a steepening of the yield curve brought about by a decline in short-term interest rates stimulated the growth of bank deposits--as bank deposit rates, tied to interest rates on relatively long-term loans, tended not to fall as much as the rates on short-term marketable securities. Over the past two and one-half years, however, households have responded to lower deposit rates and a steepening yield curve not by shifting away from short-term securities into bank deposits but by shifting away from short-term securities and deposits into bond market mutual funds and other investment vehicles, as well as by reducing consumer debt. These effects have been so strong that it is possible that further cuts in short-term interest rates would actually shrink the M2 money supply as that supply is currently measured.
FACTORS CONTRIBUTING TO THE SLUGGISHNESS OF THE RECOVERY
Output growth during 1992 now appears to have been stronger than had been anticipated, GDP having increased at better than 3 percent. Growth during the second half of the year, at more than 4 percent, was particulary strong. Continued healthy output growth would be welcomed, particularly if accompanied by a more rapid expansion of employment. Unfortunately, as some members of this committee have noted, we have been in an output recovery but a jobs recession. My colleagues and I within the Federal Reserve System share your concern with this problem. Recent declines in initial claims for unemployment insurance and the lengthening average workweek provide reason to hope that employment growth will accelerate soon, and the unemployment rate will continue to fall.
The recovery was so slow to gain momentum, in part, because of the unusual composition of the declines in output and employment during this past recession. The overall percentage decreases in output and employment during the 1990 recession roughly match the average declines observed during other post-World War II recessions. For the industrial sector, however, the 1990 recession was the mildest downturn in more than 100 years. (Rapid growth in U.S. exports, particularly to Latin America, played an important role in moderating the downturn in manufacturing.) Research at the Federal Reserve Bank of Dallas suggests that mild downturns in industrial output are followed by weak recoveries. The weak growth in output and employment that we observed in the industrial sector during 1991 and the first half of 1992 is consistent with these findings.
We in the Eleventh District know, firsthand, what it can mean to a region to have one of its principal industries experience hard times. For us, the industry was oil. Today, for many states, especially on the East and West coasts, the industry is defense. Over the long term, lower defense spending, like lower oil prices, will be good for the nation. Over the near term, however, defense spending cuts can be expected to cause the economies of some states to shrink while acting as a drag on growth in the nation as a whole. States that are most dependent on federal defense purchases have tended also to be the states that experienced the largest employment declines from July 1990, when the economy peaked, through January 1992, when aggregate employment reached bottom.
Finally, I would like to offer an observation on the federal budget deficit. Regardless of what one thinks of the specifics of the President's budget proposals, the President is to be commended for acknowledging that the deficit problem is real and initiating a serious debate over the best way to deal with it. The debate will necessarily be highly political as the country decides how to structure the deficit reduction package between spending cuts and tax increases. As Chairman Greenspan stated in his recent Humphrey-Hawkins testimony before this committee, how the deficit is reduced is important, but that it be done is crucial.
It would not be appropriate for monetary policy-makers to get drawn into this political debate. I am sure I speak for my colleagues as well as myself when I say that whatever the ultimate fiscal outcome, we will do our best to support it with a monetary policy that is in the broad national interest. As far as I am concerned, the goals of the Humphrey-Hawkins law are our goals: "To maintain long-run growth of the monetary and credit aggregates commensurate with the economy's long-run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate, long-term interest rates." (1.) The attachment to this is available from the Federal Reserve Bank of Dallas, Dallas, TX 75222…