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Fourth Quarter 1997

Why Is Financial Stability a Goal of Public Policy?

By Andrew Crockett

A number of developments in recent years have combined to put the issue of financial stability at the top of the agenda, not just of supervisory authorities, but of public policymakers more generally. These developments include: the explosive growth in the volume of financial transactions, the increased complexity of new instruments, costly crises in national financial systems, and several high-profile mishaps at individual institutions.

Policymakers care about financial instability because of the close linkages between financial stability and the health of the real economy. Recent examples of these linkages include the banking crises in Scandinavia and Japan, the 1995 peso crisis in Mexico, and the current exchange rate and banking problems in the emerging market economies of Southeast Asia.

In remarks made before the Federal Reserve Bank of Kansas City’s 1997 symposium, “Maintaining Financial Stability in a Global Economy,” Mr. Crockett examines the role of public policy in maintaining financial stability. In particular, he addresses the following questions: What do we mean by financial stability? Why should official intervention (as opposed to reliance on market forces) be required to promote stability? And what concrete approaches can be employed?

Maintaining Financial Stability in a Global Economy: A Summary of the Bank’s 1997 Symposium

By Charles Morris and Klara Parrish

World financial markets have experienced tremendous growth in recent years. New financial instruments have emerged, transaction volumes in markets has skyrocketed, and capital flows across countries have risen dramatically. While these developments have made financial markets more efficient, they have also increased the risk that events at one institution or in one market will have immediate and wide-ranging effects on the entire global financial system.

To better understand how policymakers can keep financial systems safe, efficient, and stable, and how policymakers can respond to financial crises when they occur, the Federal Reserve Bank of Kansas City sponsored a symposium entitled “Maintaining Financial Stability in a Global Economy.” The symposium, held at Jackson Hole, Wyoming on August 28-30, 1997, brought together a distinguished group of central bankers, academics, and financial market representatives from around the world.

Morris and Parrish summarize the papers and commentaries presented at the symposium. The participants generally agreed that, to maintain financial stability, regulation of financial institutions is important and that financial regulators should focus on making regulation more consistent with market forces. In addition, financial stability requires a sound macroeconomic environment, particularly price stability and, for most countries, an exchange rate regime that does not attempt to permanently fix exchange rates. Finally, participants agreed that both domestic and international safety nets should be used cautiously in financial crises to avoid the destabilizing effects of moral hazard.

Predicting Real Growth and Inflation with the Yield Spread

By Sharon Kozicki

Analysts often use financial variables to help predict real activity and inflation. One of the most popular of these variables is the spread between yields on long-term and short-term government instruments, also known as the yield spread. Researchers have shown the spread is a good predictor of real activity. For instance, in a recent issue of the Economic Review, Bonser-Neal and Morley found that the spread helps predict real activity over the next year, the next two years, and the next three years.

Kozicki examines the predictive power of the yield spread for real growth and inflation in a collection of industrialized countries. She extends the analysis of Bonser-Neal and Morley by examining in greater detail the horizons at which the yield spread helps predict real growth and by investigating whether information on the level of yields contains additional predictive power beyond that summarized by the spread. She also adds to the existing literature by examining a broader collection of countries than has previously been analyzed and a wider array of forecast horizons. In addition, restrictions imposed in earlier studies are relaxed.

For real activity, Kozicki finds that the predictive power of the yield spread largely derives from its usefulness over horizons of a year or so and generally dominates the predictive power associated with the level of yields. For inflation, although the yield spread helps predict inflation at moderate horizons of a few years, the level of yields is a more useful predictor of inflation.

Looking Forward: The Role for Government In Regulating Electronic Cash

By Stacey L. Schreft

With the year 2000 rapidly approaching, stored-value cards are already popular in some countries and are being introduced into the United States by private companies. Stored-value cards are one form of electronic cash—electronic substitutes for paper currency. Digital cash (also known as cybercash or ecash) is the other form of electronic cash coming into use today. It consists of bits and bytes in cyberspace and substitutes for paper currency in transactions made over the Internet.

Someday privately issued electronic cash may be a common means of payment in the United States. Looking forward to that day, government policymakers need to assess the impact these new forms of currency might ultimately have on the nation’s currency stock. If privately issued electronic cash, once commonplace, could threaten the long-standing safety, uniformity, and relative stability of the U.S. currency, then policy-makers must decide what, if any, forms of government intervention are appropriate.

Schreft argues there is a limited role for government in ensuring the quality of the nation’s currency when private issuance is allowed. She first describes the emerging forms of electronic cash and how they differ from today’s paper currency. She goes on to argue that the concern for policymakers is not that electronic cash is electronic, but rather that private firms are issuing it. Looking forward from the perspectives of economic theory and economic history, she explores the impact privately issued electronic cash might have on the nation’s currency and the potential role for government. Finally, she considers some specific regulatory alternatives for ensuring that the U.S. currency remains stable, safe, and uniform.

How Will the 1996 Farm Bill Affect the Outlook for District Farmland Values?

By Russell L. Lamb

Farmland values in the states of the Tenth Federal Reserve District rose about 5.5 percent over the year ended June 30, 1997. Indeed, over the past two years prices in many parts of the country have risen sharply. The jump in farmland values comes at a time of dynamic change in the farm sector. Last year, the federal government enacted sweeping farm legislation that both lowers payments to producers and removes many government controls on farm production.

Government payments have been an important source of farm income for many years, and have likely been capitalized into farmland values. Changes in federal subsidies could have important implications for values. Since farmland is three-fourths of the asset base of the farm sector, the impact of changes in policy on farmland values is crucial to the financial health of the sector.

What effect will the new farm bill have on farmland values? Lamb argues that the final impact of program reform will depend on two forces. In isolation, the removal of government subsidies will depress farmland values. On the other hand, agriculture’s newly found freedom could further lift land values. Subsidies have come with a price attached in the form of restrictions on planting flexibility and production, limiting farmers’ ability to take advantage of expanding export markets. Freed from such restrictions, farmers may find that expanding export markets will lift farm commodity prices and farm income enough to outweigh the loss of income from declining subsidy payments.

Third Quarter 1997

What Long-Run Returns Can Investors Expect From the Stock Market?

By John E. Golob and David G. Bishop

When investors make financial plans, their strategies depend on the returns they expect from investments in the stock market. The expected returns from stocks affect how much investors save, how long they plan to work, and how they allocate their portfolios among alternative investments. Their strategies are most likely to be successful, of course, when they have realistic expectations about stock returns.

Over the past several years, stock returns have exceeded their long-run historical averages. For example, the 15 percent average annual return on stocks over the last decade is substantially higher than the 10 percent average return over the previous 100 years. Stock returns were particularly high in 1995 and 1996, averaging almost 30 percent for the S&P 500 stock index. Market observers have reacted to high stock returns in different ways. Many individual investors, for example, interpret recent market strength as the beginning of a new era, with 15 percent returns continuing into the foreseeable future. In contrast, market professionals are generally less optimistic. Indeed, some analysts interpret high stock prices as an indication that future returns will be below their historical average. Golob and Bishop analyze how macroeconomic fundamentals and high price-earnings ratios on stocks will affect long-run returns.

Social Security Privatization: Balancing Efficiency and Fairness

By C. Alan Garner

Growing public awareness of future pressures on Social Security is eroding many Americans' confidence in this key retirement program. These pressures are nearly certain in the next century, stemming from the retirement of the large baby-boom generation, longer average life spans, and lower projected fertility rates. To meet such pressures, various reforms of Social Security have been proposed, ranging from simple repairs to the current system all the way to full privatization. In this context, privatization usually means moving the public retirement system toward a set of individual accounts with the workers' funds invested partly in private securities and with workers having some measure of control over investment allocations.

Choosing among the competing reform proposals is a daunting task. Supporters of privatization believe such reforms would boost economic efficiency, resulting in higher real output per worker and helping the nation cope with the future pressures from population aging. Supporters also believe privatization would produce a retirement system that treats different generations more fairly. Critics fear, however, that the privatization of Social Security would produce a more unequal income distribution for retirees and expose them to greater investment risks.

Garner examines these fundamental issues of economic efficiency and fairness that should be weighed when considering Social Security privatization. He suggests that any decision to privatize Social Security will require balancing the likely gains of greater real output and fairer returns to younger generations with the possible adverse effects of a more unequal income distribution among retirees and greater investment risks. This balancing must occur through the political process because fairness is a matter of values rather than economic analysis.

Does the Yield Spread Predict Real Economic Activity? A Multicountry Analysis

By Catherine Bonser-Neal and Timothy R. Morley

Forecasts of real economic activity are a critical component of many decisions. Businesses rely on such forecasts in forming their production plans. Policymakers rely on such forecasts when choosing the path of monetary policy or when forming the national budget. The appropriateness of these choices depends, in large part, on the quality of the forecast.

Despite their importance, forecasts of real economic activity can be unreliable. Forecasts based on macroeconomic models are often hindered by the lack of timely and accurate data and the complexity of the forecasting model. These difficulties have led to a growing interest in using financial variables to supplement traditional model-based forecasts of real economic activity. The advantages of forecasts based on financial variables are that such forecasts are simple to implement, and the data are readily available and less prone to measurement error.

One financial variable that has been particularly successful in forecasting U.S. real economic growth is the difference between long-term and short-term interest rates, or the yield spread. While evidence on the usefulness of the yield spread as a predictor of real economic activity for the United States is now well-established, evidence outside the United States is limited. To obtain such evidence, Bonser-Neal and Morley evaluate the ability of the yield spread to forecast real economic activity in 11 industrial countries.

Changes in the Depository Industry in Tenth District States

By William R. Keeton and Anne D. McKibbin

Recent developments in Congress and the courts have focused attention on the relative roles of commercial banks, thrifts, and credit unions. As concern mounted last year about the state of the thrift deposit insurance fund, Congress required commercial banks to share the burden of recapitalizing the fund. In return, Congress promised to come up with a plan for merging the bank and thrift charters, a move the banking industry has long favored. About the same time, a federal appeals court ruled against a major source of credit union growth since the early 1980s the acceptance of new members with a common bond different from the original members. The Supreme Court later agreed to hear the case, sparking a renewed debate in Congress about the proper role of credit unions in the financial system.

These recent actions by Congress and the courts follow a decade and a half of dramatic changes in the depository industry in Tenth District states. Some of these changes have been due to shifts in laws and regulations. Others have resulted from shocks to the regional and national economy and long-run financial trends such as the growth of secondary loan markets. While the changes to the district depository industry have been many and varied, four stand out. First, there has been a significant decline in the number of district depository institutions a decline in which banks, thrifts, and credit unions have all shared. Second, total deposits have declined when adjusted for inflation or measured relative to economic activity. Third, the share of thrifts in total deposits has plummeted relative to that of banks and credit unions. And fourth, while banks, thrifts, and credit unions still specialize in different loans and investments, the three types of institution do not look as different today as at the beginning of the 1980s. Such changes are important because they affect the thousands of depository institutions in the district and the supply of credit and other financial services to district households and businesses. With those effects in mind, Keeton and McKibbon show how the district depository industry has changed since 1979, explain the factors behind each change, and suggest what further changes may lie ahead.

Second Quarter 1997

Monetary Policy Without Reserve Requirements: Case Studies and Options for the United States

By Gordon H. Sellon, Jr. and Stuart E. Weiner

Over the past decade, the level of required reserve balances held by depository institutions in the United States has declined dramatically. The decline in reserve balances has fueled a debate over the role of reserve requirements. On the one hand, proponents of reserve requirements argue that low reserve balances may complicate monetary policy operations and increase short-term interest rate volatility. On the other hand, critics of reserve requirements argue that lower reserve requirements remove a distortionary tax on depository institutions and need not complicate monetary policy operations.

In a previous article, Sellon and Weiner provided an analytical framework for thinking about these issues. That article suggested that monetary policy can be conducted in a world of low or zero reserve requirements as long as there continues to be a demand for central bank balances.

In this article, the authors examine how three countries Canada, the United Kingdom, and New Zealand conduct monetary policy without using reserve requirements. The experience of these three countries provides insight into the linkages between the payments system and monetary policy and into the connection between reserve requirements and interest rate volatility. This insight is particularly helpful in understanding the implications of a further reduction of reserve balances in the United States.

Are We Living in the Middle of an Industrial Revolution?

By Joel Mokyr

The concept of a new Industrial Revolution has recently become of great interest to general economists of all persuasions. For example, the New Growth Theory has placed renewed emphasis on the importance of technological change in modern economic growth, and a number of authors have suggested that we are entering a new period of technological advances that could profoundly affect the world economy.

In an article based on comments made at the Tenth District Monetary Policy Roundtable, Mr. Mokyr looks at the events of our time in relation to events of the British Industrial Revolution. He cautions that the temptation to look at the past to guide us in making predictions and policy recommendations should be resisted. Historical analogies often mislead as much as they instruct, and in technological progress, where change is unpredictable, cumulative, and irreversible, the analogies are more dangerous than anywhere.

Settlement Risk in Large-Value Payments Systems

By Pu Shen

The phenomenal growth of financial market and trading activities worldwide has led to tremendous growth in large-value payments systems. Large-value payments systems are the electronic systems banks use to transfer large payments among themselves. Payment orders processed in such systems in the United States, for example, are typically well above $1 million.

The tremendous growth of payments system use throughout the world has increased both the possibility of settlement failures and the potential impact of such failures. In 1996, the average turnover in a single day exceeded the combined capital of the top 100 U.S. banks. Regulators are especially concerned that payments systems might turn a local financial crisis into a global systemic crisis. Shen examines settlement risk in large-value payments systems and discusses some of the measures available to manage such risk.

Cyclical Implications of the Declining Manufacturing Employment Share

By Andrew J. Filardo

Over the last 35 years, the U.S. economy has created service sector jobs at a faster pace than manufacturing sector jobs. Not only has this trend led to a significant shift in the composition of the labor force from manufacturing to services, but it has also fundamentally changed the characteristics of the average workplace.

Some economists have argued that the ongoing structural shifts from manufacturing employment to services employment may have had the additional consequence of smoothing the business cycle. A smoother cycle would be welcomed and would yield several benefits. The economy would grow more stably and would provide a more predictable backdrop for working, saving, and investing.

Filardo investigates whether the shift from manufacturing to services employment has muted the business cycle. He concludes that the declining manufacturing employment share may have substantially changed the workplace but has had little impact on the smoothness of the business cycle.

Financing Rural America: A Conference Summary

By Mark Drabenstott and Larry Meeker

After a steep recession in the 1980s, many rural places are mounting a strong economic comeback in the 1990s. Reflecting the economic turnaround, more people are moving to rural areas. Notwithstanding the improved rural economic picture, rural leaders remain concerned about rural America's economic future. Chief among these concerns is gaining access to capital to fuel continued growth.

Many rural communities, especially those traditionally tied to agriculture, are trying to diversify their economic base, and capital is needed to finance new businesses. Housing is in short supply, and many communities are seeking to finance affordable housing. And public infrastructure, such as water and sewer systems, is in need of refurbishment in some communities and expansion in others, pointing to additional capital demands.

While capital demands mount, questions linger about the adequacy of rural capital markets to meet those demands. To address this concern, the Federal Reserve Bank of Kansas City sponsored a conference entitled Financing Rural America in Omaha on December 4-5, 1996. In this article, Drabenstott and Meeker review the importance of capital to the rural economy, discuss some apparent shortcomings in the markets, and summarize the options for improving them presented at the Omaha conference.

First Quarter 1997

Bank Regulation: Asking the Right Questions

By Thomas M. Hoenig

If we are to modernize our regulatory system and allow banks the flexibility to adapt to financial change, it is essential that we ask the right questions about the purposes of bank regulation. Currently, much of the regulatory debate focuses on the age-old question: Where do we draw the line between banks and other financial and nonfinancial institutions? As important as this question is, however, it begs a more fundamental question: Why do we regulate banks differently than other institutions? Unless we can answer this basic question, it is possible that we may never achieve consensus on fundamental reform and will continue to rely on an incremental, reactive approach to bank regulation.

In an article based on comments made at the 1996 Federal Reserve/Deloitte Touch Banking Symposium in Houston, Mr. Hoenig suggests that we need to look beyond traditional arguments for bank regulation that focus on protection of bank depositors and the federal safety net. In his view, a compelling reason for bank regulation is to maintain the integrity of the payments system. Focusing on the payments system provides us with insight into two aspects of the current debate over bank regulation. First, the payments system gives us a clear rationale for drawing lines between banks and other financial institutions. Second, focusing on the payments system may provide new ideas on how we should regulate banks as we move into the next century.

U.S. Inflation Developments in 1996

By Todd E. Clark

The primary goal of Federal Reserve monetary policy is to foster maximum long-term growth in the U.S. economy by achieving price stability over time. Price stability will be achieved, according to some definitions, when inflation ceases to be a factor in the decision-making processes of businesses and individuals. Although the Federal Reserve has made considerable progress toward price stability since the early 1980s, inflation remains above the level most analysts would associate with price stability. Because stable prices are essential to maximum long-term economic growth and living standards, the Federal Reserve seeks to contain and gradually reduce inflation until price stability is attained.

Clark reviews inflation developments in the United States during 1996 in relation to the Federal Reserve's goal of achieving price stability over time. He first examines the behavior of inflation over the past year, showing that sharp increases in food and energy prices caused most overall inflation measures to rise, while inflation in nonfood and nonenergy prices slowed. Second, he shows that expectations of future inflation held steady at about the current rate, indicating the public expects no further progress toward price stability. Finally, he evaluates some inflation measurement issues raised in 1996, concluding that problems in accurately measuring inflation will require the Federal Reserve to monitor all price trends with vigilance. Together, the inflation developments of the past year were mixed.

The Productivity Growth Slowdown: Diverging Trends in the Manufacturing and Service Sectors

By Sharon Kozicki

Continuing gains in labor productivity are essential to keep real wages and the U.S. standard of living from stagnating. After a period of strong gains in the 1960s, the average growth rate of productivity slowed substantially in the early 1970s. In the following years, productivity continued to grow slowly despite rapid technological advances in such areas as computers and digital communications. Analysts have proposed differing explanations for the productivity slowdown and for the failure of productivity growth to rebound in recent years. Most explanations focus on aggregate factors, such as overall saving and investment rates or the quality of the labor force.

Kozicki approaches the productivity growth slowdown from a different perspective. In particular, she decomposes the slowdown into contributions by broad sectors of the economy, focusing on the two largest sectors manufacturing and services. Doing this reveals that the main factor accounting for the productivity slowdown has been stagnating productivity in the service sector. An accompanying and reinforcing factor has been the strong employment growth in services relative to manufacturing.

Tenth District Economic Developments

By Tim R. Smith

The Tenth District economy grew at a moderate pace during 1996. The district economy expanded vigorously in early 1996 but slowed as the year progressed. Tight labor markets in many parts of the region appeared to limit job growth, particularly in the large trade and services sectors. A slumping cattle industry also curbed overall growth in parts of the district. Nonetheless, construction continued to post healthy gains, energy activity improved somewhat, and manufacturing across the region remained stable.

Smith reviews the district's economic performance in 1996 and explores the outlook for 1997. In the year ahead, the district economy will probably continue to grow moderately, about equal to the 1996 pace. Tight labor markets will continue to constrain growth in many parts of the district. District manufacturing will likely remain stable, while trade and services continue to expand at a more sustainable, moderate pace than in previous years. Construction activity may moderate, but the farm economy is expected to improve somewhat, reflecting relatively strong prices and an improving outlook for the cattle industry.

Will the Wild Ride for U.S. Agriculture Continue in 1997?

By Mark Drabenstott

U.S. agriculture formally entered a new era in April 1996 when a new seven-year farm bill was signed into law overturning 60 years of commodity programs. The new bill set agriculture on a new course where markets, not government programs, will determine agriculture's products and its bottom line. The new path was underscored by one of the wildest years in commodity markets in recent memory. Grain prices soared to new heights, while cattle prices sank to new lows. The market swings pointed to the variations in income that agriculture may experience under the new farm bill. Nevertheless, a new record for U.S. agricultural exports also suggested that the market trend for the industry is decidedly up.

For most of U.S. agriculture the year just past was a good one. Crop producers had a banner year, with high prices and the first year of transition payments under the new farm bill. In contrast, livestock growers had a difficult time due to high feed costs, with problems especially pronounced for cattle producers. In the end, the boost to crop producers prevailed, and U.S. farm income was up sharply, while increasing much less in the district due to the cattle situation.

Drabenstott reviews the year just past for U.S. agriculture and suggests the year ahead should be another good one, though probably not as good as 1996. A bigger than expected 1996 harvest will weigh on crop markets, keeping prices below 1996 levels. Still, the 1997 harvest will have a major bearing on prices since grain stocks remain low by historical standards. The lower crop prices will help fatten livestock profits, and the livestock industry could have its best year in the past four. Overall, farm income will probably decline in the nation but remain relatively strong. In the district, where cattle profits are particularly important, farm income will probably rise. With export markets staying strong and commodity markets more settled, agriculture will generally have smooth sailing in the new market era.