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FEDERAL RESERVE'S FIRST MONETARY
POLICY REPORT FOR 1980
HEARINGS
BEFORE THE
COMMITTEE ON
BANKING, HOUSING, AND URBAN AFFAIRS
UNITED STATES SENATE
NINETY-SIXTH CONGRESS
SECOND SESSION
ON
OVERSIGHT ON MONETARY POLICY REPORT TO CONGRESS
PURSUANT TO PUBLIC LAW 95-523
FEBRUARY 25 AND 26, 1980
Printed for the use of the Committee on Banking, Housing, and Urban Affairs
U-S. GOVERNMENT PRINTING OFFICE
WASHINGTON : 1980
COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
WILLIAM PROXMIRE, Wisconsin, Chairman
HARRISON A. WILLIAMS, JR., New Jersey
ALAN CRANSTON, California
ADLAI E. STEVENSON, Illinois
ROBERT MORGAN. North Carolina
DONALD W. RIEGLE, JR., Michigan
PAUL S. SARBANES, Maryland
DONALD W. STEWART, Alabama
PAUL E. TSONGAS, Massachusetts
JAKE GARN, Utah
JOHN TOWER, Texas
JOHN HEINZ, Pennsylvania
WILLIAM L. ARMSTRONG, Colorado
NANCY LANDON KASSEBAUM, Kansas
RICHARD G. LUGAR, Indiana
KENNETH A, McLfiAN, Staff Director
M. DANNY WALL, Minority Staff Director
STEVEN M. ROBERTS, Chief Economist
JOHN T. COLLINS, Special Counsel to the Minority
(II)
CONTENTS
MONDAY, FEBRUARY 25, 1980
Opening statement of Chairman Proxmire.
Opening statement of:
Senator Garn
WITNESS
Paul A. Volcker, Chairman, Board of Governors, Federal Reserve System
5
Prepared statement
7
Inflation and risk of recession
18
Control of Federal credit programs
20
"Automatic Pilot"
22
Business loans
24
Complementary policies
,
26
No deviation from our approach
27
Dramatic effect on interest rates
28
Setting the prime rate
30
Demand for Federal credit programs
32
Increase in defense spending
35
Financial emergency
36
Different circumstances
39
Summary of developments in certain sectors especially sensitive to interest-rate changes
40
Open Market Committee report
43
Inflation brings higher tax rates
45
Minimum wage law counterproductive
51
Housing production depressed
52
Monetary Policy Report to Congress pursuant to the Full Employment and
Balanced Growth Act of 1978:
Chapter 1. Federal Reserve Policy and the Outlook for 1980
56
Section 1. The Objectives of Monetary Policy in 1980
56
Sections. The Growth of Money and Credit in 1980
58
Section 3. The Outlook for the Economy in 1980
61
Section 4. The Administration's Short-term Economic Goals and
the Relationship of the Federal Reserve's Monetary Objectives
to those Goals
64
Chapter 2, A Review of Recent Economic and Financial Developments.
66
Section 1. Overview of Developments
66
Section 2. Economic Activity in 1979
68
Section 3. Prices, Wages, and Productivity
85
Section 4. Labor Markets
90
Section 5. Domestic Financial Developments.,..
93
Sectio.i 6. Foreign Exchange Markets and the Dollar
104
Appendix A Description of the Newly Defined Monetary Aggregates .. 107
Appendix B Description of the New Procedures for Controlling Money.. 141
Congressional Research Service, The Library of Congress:
Briefing material for monetary policy oversight by F. Jean Wells,
Roger S. White, specialists in money and banking, Economics Division
149
Listing of tables and graphs;
I. Monetary measures and Federal Reserve System targets:
Monetary and credit aggregates—actual levels and fourth
quarter growth rates, 1975-79, and Federal Reserve projected growth ranges from fourth quarter 1979 to fourth quarter
1980:
din
IV
Witness—Continued
Money supply: M-1A and M-1B (graph)
Money supply: M-2 and M-3 (graph)
Bank credit (graph)
Federal Reserve System one-year target ranges and actual
growth rates for monetary aggregates under old definitions
for money, 1975-79 (table)
II. Federal budget data:
Federal budget receipts and outlays, fiscal years 1977-81
(table)
".
Federal finances and the gross national product, 1958-83
(table)
III. Economic forecasts and economic goals:
1980 economic projections of the Board of Governors of the
Federal Reserve System (table)
1980 economic forecasts and administration goals (table)
1981 economic forecasts and administration goals (table)
Summary of administration goals consistent with the objectives of the Humphrey-Hawkins Act, 1980-85 (table)
IV. Past behavior of economic goal variables:
Employment—total civilian employment, persons aged 16 and
over, 1975-79 (graph)
Unemployment—percent of total civilian labor force, persons
aged 16 and over, 1975-79 (graph)
Production—real gross national product, rates of change
1975-79 (graph)
Real Income—real disposable income, rates of change, 1975-79
(graph)
Productivity—nonfarm business sector, rates of change,
1975-79 (graph)
Prices—consumer price index, rates of change, 1975-79
(graph).
V. Selected international statistics:
Exports, imports, trade balance and trade-weighted exchange
value of the U.S. dollar, 1975-79 (table)
VI. Financial sector:
Selected monetary, credit, and reserve aggregates, growth
rates, 1976 through fourth quarter 1979 (table)
Income velocity of money, M-1A and M-1B, rates of change,
1977-79 (graph)
Selected interest rates, 1975 through January 1980:
Graph
Table
Funds raised in U.S. credit markets, 1975 through third
quarter 1979 (table)
Reserve aggregates and monetary control by Carol A. Leisenring,
analyst in money and banking. Economics Division
Introduction
Federal Reserve operating procedures before October 6, 1979
Evaluation of the Federal fund rate approach
The Federal Reserve's new operating procedure
A description of reserve aggregates
Evaluation of the reserve aggregates approach
Implications of the new policy
The recent experience
Selected references
List of tables and charts:
Table 1, Bank reserve measures summary of definitions
Table 2. Money and bank reserves, compound annual growth
rates
Chart 1. Total and nonborrowed reserves, 1968-79
Chart 2. The Federal funds rate and the Federal funds rate
minus the discount rate, 1968-79
Chart 3. The Federal funds rate, 18 weeks before and after
October 6, 1979
Chart 4. Total and nonborrowed reserves and the Federal
funds rate minus the discount rate, 18 weeks before and
after October 6, 1979
pa e
e
152
153
154
155
157
158
159
160
161
162
163
163
164
165
166
167
168
169
170
171
172
173
174
176
176
178
182
186
190
195
197
205
189
199
201
202
203
204
V
Witness—Continued
Response to questions of Senator Stevenson
Response to questions of Senator Proxmire
Carnegie-Mellon University, letter to Senator Proxmire with recommendations
adopted by the Shadow Open Market Committee at its semiannual meeting
on Feb. 3, 1980
Fa
s"
49
212
206
TUESDAY, FEBRUARY 26, 1980
Opening statement of Chairman Proxmire
,
227
WITNESSES
William Griggs, senior vice president, J. Henry Schroder Bank & Trust Co.,
New York
Economic outlook
Economic policy
Fed policy since October 6
The new monetary aggregates
Summary
,
Kevin Hurley, director of financial forecasting, Chase Econometrics, New York
Outlook for the economy
Consistency of monetary policy with the outlook
A potential pitfall for monetary policy
A problem of implementation
Coordination of tax policy with monetary policy
Summary
.".
Tables:
1. Comparison of forecasts for 1980
2. Comparison of targets and projections
Jerry L. Jordan, senior vice president and Chief Economist, Pittsburgh National Bank
A legacy of inappropriate economic policies
Monetary policy actions in 1980
Credibility and perserverance are necessary
Fiscal developments are a problem
John Paulus, senior financial economist, Goldman Sachs, New York
Hopeful signs
Breakdown in fiscal policy ,
Prepared statement
Monetary policy and the economy
The current conduct of monetary policy
The outlook for i960
Panel discussion:
Bank credit above its target
Monetary targets
Set monetary targets lower
Danger of ignoring other variables
Long-term targets
Membership attrition
Changes in discount rate
Balancing the budget
Demand for Federal Credit Programs
Desirability of mandatory controls
Wage-related tax reduction
228
228
229
230
231
233
234
235
235
236
237
237
237
238
238
238
239
240
243
244
245
245
247
248
251
25*5
259
261
263
265
266
268
269
271
273
274
277
FEDERAL RESERVE'S FIRST MONETARY
POLICY REPORT FOR 1980
MONDAY, FEBRUARY 25, 1980
U.S. SENATE,
COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS,
Washington, D.C.
The committee met at 9:30 a.m. in room 5302, Dirksen Senate
Office Building, William Proxmire, chairman of the committee,
presiding.
Present: Senators Proxmire, Stevenson, Riegle, Garn, and Heinz.
OPENING STATEMENT OF CHAIRMAN PROXMIRE
The CHAIRMAN. The committee will come to order.
Today and tomorrow the committee will be considering the Federal Reserve's First Monetary Policy Report for 1980, pursuant to
the requirements of the Full Employment and Balanced Growth
Act of 1978. Our only witness today is Paul Volcker, Chairman of
the Board of Governors of the Federal Reserve System.
Mr. Volcker, we are pleased to have you with us today to discuss
the Federal Reserve's monetary policy plans and objectives for
1980. You have been Chairman of the Federal Reserve Board only
since last August, but policy actions you have put in place have
been aggressive and represent an important shift toward controlling bank reserves as a means to gain firmer control on the growth
of money and credit.
Our most pressing economic problem continues to be excessively
high inflation which has proven to be impervious to our efforts to
constrain it. Many people are now stressing that inflationary expectations are causing inflation to spurt ahead. If people believe
that inflation will continue, the conclusion that must be drawn is
that the policies we have in place have not been effective and are
not expected to be effective in reducing inflation.
Federal spending is too high and many informed observers feel
that the President's 1981 budget is excessive and inflationary in
the long run. There are doubts that the deficit can be held down in
1981 and the budget balanced in 1982. Monetary policy has been
effective in slowing the growth of the monetary aggregates, but
still the financial pages reveal concern that credit, especially business credit, is readily available. And, because of past experience
with the Federal Reserve, I am sure that in the minds of many
economists, businessmen, and financial experts there are continuing doubts that the Federal Reserve will continue to pursue a tight
monetary policy in a Presidential election year.
(i)
Like it or not, it is very clear to me that the bulk of the fight
against inflation has been delegated to the Federal Reserve. We do
not have a balanced budget. The administration's wage and price
guidelines look ineffective. Productivity is declining. Regulatory
reform is proceeding slowly.
So what are our options?
Wage and price controls? No. Why? Well, we know that wage
and price controls don't work. While they are in place they result
in a build-up of excess demand and then when they arerelaxed we
have a price exploson. We don't have any laws on the books that
would permit mandatory wage and price controls, so even now as
we dare to discuss them we have the strong possibility of businesses making anticipatory price increases. The legislative process
needed to enact controls would make inflation worse. Finally, mandatory controls would be used politically to provide a cover for
expansionary fiscal and monetary policy.
What about credit controls? We have the necessary law on the
books to put them in place. But Korean war type controls on
housing and automobiles wouldn't be useful. Those sectors of the
economy are already weak. Credit controls might be used to control
business credit expansion, but it is questionable if that could be
used successfully. Businesses already have learned to get around
the Fed's current attempts at restraint. Furthermore, we would not
want to restrain capital investment, which is so badly needed in
order to increase productivity. So the problem would be to attempt
to limit credit for nonproductive purposes, which I understand the
Federal Reserve has already tried to limit through moral suasion.
What about monetary policy? If inflation continues unchecked
and money and credit growth accelerates, you have little choice but
to continue to pursue restrictive policies. But the question is how?
First, you can continue to use open market operations to restrict
the availability of total reserves for member banks. A more restrictive stance would result in tighter credit and higher interest rates
across the board. Second, you can continue to raise the discount
rate in a dramatic fashion every several months. This may have its
advantages, but I think policy would be more effective if the discount rate floated with the Federal funds rate plus a slight penalty
rather than the current large subsidy. This would put banks on
notice that you really meant business. Finally, you could increase
reserve requirements for member banks, but even though this
might be desirable, I personally doubt that it would be done because of the membership problem.
My conclusion is that the Federal Reserve should avoid stop and
go policies. You should pursue a set of policies that will provide
only moderate growth in money and credit this year, with gradual
reductions continuing into future years, until significant progress
has been made in reducing both inflation and inflationary
expectations.
I might add, Mr. Chairman, last week this committee held hearings on financing the Export-Import Bank. As you know, that
Government instrumentality subsidizes exporters by providing
credit at 8.3 percent. This is far below market and well below the
cost of money to the Government. So, on the one hand, you're
limiting bank reserves and shoving up the discount rates so busi-
nesses large and small and homeowners and farmers and others in
America have to pay painfully high interest rates or in many cases
forego their borrowing—you do this to slow down business activity,
it cost jobs and put some marginal firms out of business, but it's
necessary, painful medicine. On the other hand, the Eximbank is
pushing hard and members of this committee are telling them to
push much harder to lend subsidized Government funds to exporters so we can sell goods, not in this country where the production
would satisfy our economic needs, but abroad, and the taxpayers
have to pay for it. As a result, the American businessman pays
more for this policy and our interest rates make credit less available and we have higher taxes.
Much of this anti-inflationary effect is offset by policies such as
the Eximbank lending policy such as subsidizing exporters, and I
might add this, last week we also passed a bill that could result in
$10 billion of additional credit for housing below market rates
which again contradicts precisely it seems to me what your policy,
painful and difficult as it is, is designed to do, to slow down the
economy as a whole; and yet we are proceeding with a policy which
contradicts that both in the export industry and with the home
builders and it seems to me that we are trying to move in both
directions at once.
Chairman Volcker, you are off to a solid start. If you fail to stick
with it our inflation outlook will continue to be bleak indeed. Also,
failure to continue with monetary policies to reduce inflationary
expectations would seriously jeopardize the credibility of the Federal Reserve System.
Senator Garn.
OPENING STATEMENT OF SENATOR GARN
Senator GARN. Thank you, Mr. Chairman.
Chairman Volcker, we are happy to have you with us today to
review the adoption and implementation of monetary policy by the
Federal Reserve.
During the past 6 months, the Federal Reserve has taken several
steps designed to provide it with better control over the Nation's
money supply. Last October 6, the Fed disclosed that it was altering its open market operations in order to focus on the growth of
bank reserves, thereby replacing the Federal funds rate as its
principal guidepost. Recently, the Fed announced the establishment of new definitions for the monetary aggregate categories. The
redefinition was needed because of financial developments such as
NOW accounts, Automatic Transfer Services, money market
mutual funds and a growing similarity between deposits in commercial banks and thrift institutions. These have altered the meaning and reduced the significance of the old measures. In its most
recent move, a week ago, the Fed raised the discount rate from 12
to 13 percent. Although committee members may differ with Chairman Volcker as to whether such actions have been tough enough, I
believe that at least such actions represent an awareness by the
Federal Reserve of the seriousness of our economic problems and
the resolve to do something about them..
While I am concerned about the effectiveness of the Fed's monetary policy initiatives, I have a greater concern about the lack of
resolve by this administration and this Congress to take the necessary fiscal actions to insure that the Fed's monetary policy objectives are not completely thwarted. Inflation is seriously draining
the economic strength of this country and unless everyone in this
Nation faces up to the problem and is willing to make some sacrifices, we will not solve it.
In its recent Monetary Policy Report to Congress, the Federal
Reserve summed up very well the need to deal with inflation
through a coordinated effort. The report stated the following:
Prospects for dealing with the inflation problem . . . will be materially enhanced
if other elements of government (besides the Fed) also exhibit a firm anti-inflationary commitment and if workers and management recognize that a moderation of
their wage demands and pricing policies is in their own long-range interests as well
as those of the nation as a whole.
Unfortunately, it is much easier to describe the need for a coordinated effort than it is to accomplish it.
From current economic indicators, it is apparent that the economy is still going full speed ahead, with sharp increases in the
inflation rate. In January, the producer price index rose by 1.6
percent, or an annual rate of 19.2 percent; and the Consumer Price
Index rose by 1.4 percent, an annual rate of 16.8 percent. Recently
revised real GNP figures for the fourth quarter of 1979 indicate
that the actual increase was 2.1 percent, not 1.4 percent as the
administration had originally reported. Even in light of these indexes, the administration has not developed a plan to deal with
current economic problems. Moreover, its economic projections for
1980 already appear outdated; for example, such projections include a consumer price increase of 10.4 percent, hardly realistic in
light of the January trend in producer and consumer prices.
I believe it is time that we face the problems before us and
develop a national plan to promote economic growth and stability.
In addition to actions by the administration, greater efforts must
be made by Congress to balance the Federal budget and reduce the
cumulative deficit. That will require tough choices on all appropriations items, but Congress will have to make them.
Tax reform is sorely needed to provide a better climate for capital investment. The Senate-House conference committee on the
windfall profit tax bill has agreed to a provision exempting from
taxation $200/$400 in interest and dividend income. This will provide some long overdue financial relief to small savers, as well as
promote capital expansion, but it's only a beginning.
In developing a national economic plan, I would hope that we not
forget the lessons of history in our search for solutions. For example, President Nixon's wage and price controls in the early 1970's,
all of the phases I-IV of that program, only added to the economic
distress of the past 7 years. What we need are controls on the
Federal budget, not on the private sector. The administration and
the Congress must act to implement a responsible fiscal plan which
complements the Federal Reserve's monetary policy, not competes
with it.
I would propose an economic summit be called by the President
and should be called as soon as possible. What I'm really talking
about here is not just another call for a meeting, but I think it's
time that if we're not convinced that the problem is so serious at
this point when we're talking about 18 to 20 percent that we don't
put aside partisan differences, not be concerned that this is a
Presidential election year or an election year for some of us who
have to run, quit worrying about Republicans and Democrats and
Liberals and Conservatives and get the best minds we can together—and forget all of that partisanship—the best people we can
together and say we've got such a problem that it goes far beyond
elections in 1980 and Republicans, Democrats, Conservatives, Liberals, and see what we can come up with as a coordinated policy, will
not be solved because for 5 years 1 have been making the same
speed, Mr. Chairman, every time we have had the Federal Reserve
Chairman here, that the Fed can't do it alone, that we can't have a
fiscal policy that is going in an entirely different direction than our
monetary policy and people more concerned about whether they
are elected or not or whether the Republicans or Democrats are
establishing a viable political position for themselves, it won't be
stopped. We will be back here 6 months from now listening to you.
We will be back here next January, and it will get worse. When I
say I call for an economic summit, I'm talking about trying—
maybe it's incredibly naive to think that could be done, but I think
we have reached that point where it's time the President called for
that kind of an economic summit and we put these partisan differences aside and see if we can come up with a coordinated plan,
because as long as the policies are going in different directions as
they have been for a long time, we are not going to solve it. It's
certainly apparent to me the Federal Reserve alone cannot solve
the Nation's economic problems. It's up to all of us.
Thank you, Mr. Chairman.
The CHAIRMAN. Thank you, Senator Garn. Senator Stevenson.
Senator STEVENSON. I don't have a statement now, Mr. Chairman.
The CHAIRMAN. Mr. Volcker.
STATEMENT OF PAUL A. VOLCKER, CHAIRMAN, BOARD OF
GOVERNORS, FEDERAL RESERVE SYSTEM
Mr. VOLCKER. Thank you, Mr. Chairman.
I don't think there's much for me to add at this point. You have
our report; you have the statement that I made before the House
committee which is still applicable. I'm conscious that things have
happened since we prepared the report only a week or two ago, and
that we live in a swiftly moving economy and world. We have had
some high price figures, but I don't think those figures in themselves should have been terribly surprising. They were anticipated
at this time mainly because of the effects of the oil price increase
working its way into those indices. As far as the Consumer Price
Index is concerned, it includes the mortgage rates that increased
last fall. But the figures certainly do carry the danger of inflationary expectations accelerating further, and we have seen some evidence of that in the reactions in the bond market and elsewhere.
At the same time, the business activity has been strong, as you
have pointed put. We mean to continue with the monetary policies
outlined in this report. It is a policy of restraint. We have set out
targets that we think are inconsistent with accelerating inflation,
and I'd like to emphasize that point: We need to do our level best
to keep within those ranges but I would certainly agree with practically all of what you and Senator Garn have said about the need
for other policies to accompany monetary policy if we are going to
deal with this situation in the most effective kind of way.
The CHAIRMAN. Thank you, sir, and your statement will be printed in full in the record.
[Complete statement follows:]
Statement by
Paul A. volcker
Chairman, Board of Governors of the Federal Reserve System
I welcome this opportunity —
my first —
to appear before
this Committee to discuss the Federal Reserve Board's semi-annual
report on monetary policy.
As required by the Full Employment
and Balanced Growth Act of 1978, that report presents the
objectives for rnonetary growth adopted by the Federal Open
Market Committee for the coming year and relates those objectives
to economic trends over the past year and to the outlook for the
year ahead.
In presenting the report to the Committee, I would like
to make a few more personal remarks about the direction that
monetary policy is taking and how those policies fit into a
broader framework of action to deal with the evident problems
of the economy.
The first point that I would emphasize is that the nearterm outlook for real economic activity and employment remains
highly uncertain.
It never has been easy to forecast the
direction of aggregate activity around cyclical turning points,
and, as one prediction of imminent recession after another has
gone awry, the past year has been a particularly humbling experience for economic forecasters.
Important uncertainties continue to cloud the outlook for
1980.
One of the most critical questions is whether consumers,
faced with lower real incomes and expecting higher prices, will
continue to spend an extraordinarily high proportion of their
income despite heavy debt burdens and reduced liquidity.
Purchasing
8
power is again being absorbed by sharply higher oil prices,
and there is no assurance that that process will quickly come
to an end.
The President has, of course, submitted his budget
for fiscal 1981.
But international political developments have
raised some new questions about prospects for defense spending
in the years ahead, and there are uncertainties about other
elements in the budget as it makes its way through the Congress.
In looking ahead and making judgments about these and other
questions, most members of the Federal Reserve Board have shared
the view of the Administration and most other economists that an
economic downturn will probably develop sometime this year.
However, such a result is by no means inevitable and many forecasters appear currently to be raising their sights.
Unfortunately, the range of uncertainty with respect to
inflation is one of how much prices will rise, not whether.
Price increases, at least as recorded in the most widely read
indexes, could well accelerate in the first quarter partly because
the latest round of oil price increases will be reflected in those
numbers.
The real question is how much progress can be made in
reducing the inflation rate in the latter part of the year.
In the past, at critical junctures for economic stabilization
policy, we have usually been more preoccupied with the possibility
of near-term weakness in economic activity or other objectives
than with the implications of our actions for future inflation.
To some degree, that has been true even during the long period
of expansion since 1975.
As a consequence, fiscal and monetary
policies alike too often have been prematurely or excessively
stimulative, or insufficiently restrictive.
The result has
been our now chronic inflationary problem, with a growing
conviction on the part of many that this process is likely to
continue.
Anticipations of higher prices themselves help speed
the inflationary process.
Nor can we demonstrate that the result has been beneficial
in terms of other obj ectives.
To the contrary, unemployment has
been higher in the 1970's than in earlier decades.
growth has declined.
Productivity
Capital spending has not kept up with the
needs of a growing labor force.
Financial markets have been
disturbed and depressed, and institutions responsible for a
substantial share of mortgage financing are coming under strain.
The recurrent weakness of the foreign exchange value of the dollar
has undercut our economic stability at home and our leadership
abroad.
The broad objective of policy must be to break that ominous
pattern.
That is why dealing with inflation has properly been
elevated to a position of high national priority.
Success will
require that policy be consistently and persistently oriented to
that end.
Vacillation and procrastination, out of fears of
recession or otherwise, would run grave risks.
Amid the present
uncertainties, stimulative policies could well be misdirected in
the short run; more importantly, far from assuring more growth
over time, by aggravating the inflationary process and psychology
they would threaten more instability and unemployment.
The implications for monetary policy are clear.
While there
may be legitimate debate about the impacts of monetary policy in
10
the short run, there is little doubt that inflation cannot
persist in the long run unless it is accommodated by excessive
expansion of money and credit.
Put more affirmatively, restraint
on growth in money and credit, maintained over a considerable
period of time, must be an essential part of any program to deal
with entrenched inflation and inflationary expectations.
Accordingly,
I see no alternative to a progressive slowing of growth of the
monetary aggregates to lay the base for restored stability and
growth.
The 19SO growth ranges established by the Federal Open
Market Committee for the key monetary aggregates are in line
with that basic, continuing objective.
In the short run, we
believe those targets are fully consistent with an orderly
process of economic adjustment and modest growth, provided the
inflation rate subsides as the year wears on.
We also believe
that, should inflationary pressures begin to build more strongly
in the context of strengthening demand, those same targets would
imply strong financial restraint.
In fact, the restraint implied
by the new targets would be inconsistent with higher rates of
inflation over a significant period of time.
The precise growth ranges are described in the Report that
has been distributed to you, and can be seen in the perspective
o£ recent years in an attachment to Ehis statement.
I should
emphasize that all these data are on the basis of revised definitions
for the monetary aggregates, described in detail in kppendix A of
the Report.
These definitions incorporate some of the recently
11
developed financial instruments that increasingly have been
used in place of more conventional means of payment or claims
on well established financial institutions.
Because these new
forms of "money" or "near money" generally have been expanding
rapidly in recent years, the redefined aggregates tend to have
somewhat faster growth rates over the past few years than the
comparable aggregates as previously defined.
(The aggregates
as previously defined are shown in Table II attached.)
The
FOMC's new growth ranges for 1980 should not be directly
compared with results based on the former definitions of the
aggregates.
What is significant is that the ranges for the
newly defined aggregates in 1980 are expected to result in
further slowing of monetary growth this year, following some
deceleration over the course of 1979.
As I implied earlier, the behavior of interest rates and
the degree of pressure on financial markets in the year ahead
will depend critically on the performance of the economy and
the strength of inflationary pressures and expectations.
Experience
suggests that if real activity in fact weakens, interest rates
—
particularly for short-term instruments —
could tend to decline
as demands for money and credit moderate.
As inflationary forces
tend to recede, the decline could be more pronounced, and spread
more fully into longer term markets.
In those circumstances. such
market developments would be constructive, tempering any weakness
in real activity,, and tending to support investment activity and
housing.
At the same time, persistent restraint on monetary
12
growth would be consistent with our resolve to resist inflation.
The other side of the coin is that continued strong inflationary
forces, accompanied by bulging credit demands, would tend to
keep financial markets under strong pressure —
and that pressure
should confine and dissipate those inflationary forces.
case, movements of short-term market interest rates —
the federal funds rate —
In either
such as
should not necessarily be taken as
harbingers of a fundamental change in the stance of monetary
policy; that policy will in any event continue to be directed
toward reining in excessive monetary growth.
Let there be no doubt; the Federal Reserve is determined
to make every reasonable effort to work toward reducing monetary
growth from the levels of recent years, not just in 1980, but
in the years ahead.
The policy actions taken on October 6 of last year, which
entailed changes in our operating techniques to provide better
assurance
of containing the growth in the money supply, were
one demonstration of that commitment.
And I can report that
developments since that time with respect to monetary and credit
growth have been remarkably consistent with our immediate
objectives.
We cannot conclude from those results that our procedures
ensure that money growth will always remain tightly on a narrow
path over short periods of time, or that that is necessarily
wholly desirable.
Prom weak to week or month to month, the
relationship between bank reserves and the money stock is
13
influenced by unpredictable shifts between different types of
deposits and among institutions.
There are transitory shifts in
demands for money, associated for example with tax refunds, strikes,
or the weather.
Nonetheless, our new procedures should continue
to give us better control over the monetary aggregates, and we
are studying what, if any, other aspects of our institutional
arrangements might be changed to enhance the efficacy of those
procedures.
The increase in the discount rate announced on Friday is
another reflection of our commitment to keep credit expansion
under control.
The most recent data for overall economic
activity have, as you know, been relatively strong, and the
inflation rate is currently responding to the new oil price
increases.
Stimulated in large part by international develop-
ments, indications are that inflationary anticipations have
tended to rise once again, and in combination, these developments
appear to be generating somewhat greater demands for money and
credit.
in the judgment of the Board, these developments under-
score the need to take such measures as may be required to maintain
firm control over the growth of money and credit.
Sustained monetary restraint is not an easy, automatic, and
painless solvent for our economic difficulties —
I will make is that it is essential.
the only claim
Tt works, in part, by limiting
the potential growth in nominal economic activity —
measured in current, inflated dollars.
that is, growth
If other policies are working
at cross purposes, the restraint can be blunt, uneven, and decidedly
14
uncomfortable, with too much of Che impact in the short terra
falling on employment and income rather than on prices.
Our aim must be otherwise.
What all of us would like to
achieve is as rapid a transition as we can manage to a more
stable and productive economy —
an economy in which we can have
more real growth and less unemployment because inflation is
dwindling away —
an economy in which real incomes are rising
even though nominal wages are rising less rapidly —
an economy
in which we can compete effectively abroad without a weak dollar.
That transition will be speeded to the extent all of us
show, not just in our words but in our deeds, that the fight on
inflation is in fact of the highest priority.
We cannot expect
that workers will long be restrained in their wage demands, or
businessmen in their pricing policies, if they feel the consequence
of self-restraint will be to fall behind in a race with their peers
or their costs.
We cannot simply rail at "speculators" in foreign
exchange, or gold, or commodity markets if our own policies seem
to justify their pessimism about the future course of inflation.
We cannot reasonably bemoan low savings, historically high interest
rates and congestion in credit markets so long as the return on
savings does not reflect the anticipated rate of inflation and
the Federal Government itself runs large deficits, adding to
borrowing demands.
Rising demands for wages and cost-of-living protection,
anticipatory price increases, skyrocketing gold and commodity
prices, sharply declining values in the bond markets —
all of
15
these are symptomatic of the inflationary process and undermine
the economic outlook.
But none of them are inevitable, provided
we turn around the expectations of inflation.
To achieve that essential objective will require sustained
discipline, not just in monetary policy, but in other areas of
public policy.
That discipline will certainly need to be
reflected in the budgetary decisions of this Congress.
I fully appreciate the need for structural reform and
reduction in taxation.
Partly because of inflation, the total
tax take, relative to GNP, is reaching a new peacetime high,
discouraging investment, adding to costs, and blunting incentives.
We need to reverse that process.
But the President nonetheless
•eems to me correct in emphasizing that the time has not yet
me for tax reduction.
in prospect.
Budgetary balance is neither here nor
Tax cuts, to put the point simply, need to be
earned by spending restraint.
That is where the challenge lies.
Beyond the broad decisions about monetary and fiscal policy,
there is much more that can be done here and now to speed up the
process of restoring price stability.
For instance:
We can curtail more decisively our dependence
on foreign energy, even at the expense of increased
costs in the short-run, because the alternative is
to have still higher prices imposed on us by foreign
suppliers over the indefinite future.
16
We can move to eliminate the impediments to
competition still imposed in some industries
by government regulation.
We can revise legislation that tends to ratchet
up wages at the expense of employment.
We can review the mass of environmental, safety,
and consumer regulations to make sure these worthy
objectives are reached without undue impact on costs.
We can resist pressures to protect industries from '
foreign competition, particularly those industries
with relatively high wage structures and wage settlements which have been sluggish in responding to the
changing needs of the American consumer.
The list is neither exhaustive nor new.
We have been slow
to act because so much of it seems to cut across the grain of
political sensitivities and, taken individually, many of the
measures will not have a dramatic effect.
But taken together,
the effect would be large and none of it is out of keeping with
our basic objectives in economic and social policy.
I sense we are rightly coming to the conclusion that
accelerating inflation, declining productivity, and energy
dependence are not sustainable options for the United StatesIn concept, policies to wind down inflation have wide support.
What remains is the challenge of converting intellectual consensus
into practical action.
The Federal Reserve has a key role to play in that
process.
We intend to do our part —
and to stick with it.
17
Table 1
Groath o£ the He«ly Defined Monetary Aggregates
(Percentage'change, fourth quarter Co fourth quarter)
M-1A
H-1B
M-2
1975
4.7
4.9
12.3
9.4
1976
5.5
6.0
13.7
11.4
1977
7.7
8.1
11.5
12.6
1978
7.4
8.2
8.4
11.3
8.8
9.5
1979
1980 FOMC range
[midpoint]
5.5
(6.8)*
3.5-6
[4.75]
8.0
'J.O)*
4-6.5
[5.25]
M-3
6-9
[7.5]
6.5-9.5
[8.0]
Table 2
Growth of the Old Monetary Aggregates
(Percentage change , fourth quarter to fourth quarter)
«-_!
M-2
M-3
1975
4.6
8.4
11.1
1976
5,3
10.9
12.7
1977
7.9
9.8
11.7
1973
7.2
8.7
9.5
1979
5.5
(6.8)*
8.3
8.1
1980 FOMC range**
IMldpo int]
3.5-6
14.75]
5-8
[6.5]
5-8
[6.51
*AdJusted for affects of introduction in late 1978 of HOW accounts
In New York State and automatic transfer accounts nationwide.
**St«ff ejtimataa of rang** aquivalent to thoaa specified by Federal
Open Market Comlttee for the new monetary aggragatea .
18
The CHAIRMAN. Mr. Chairman, in a speech on the west coast on
Thursday, Henry Kaufman laid out a very grim view of the economy. As you know, he's a highly respected economist. He's testified
before this committee a number of times and he's well thought of
in the financial community.
He called for emergency measures to be put in place. I'd like to
get your reaction to each part of his program. First, a sharp slowdown in the growth of nondefensive expenditures, and on that
score, should we cut spending to balance the budget for 1981?
Should we have a binding limit on the share of GNP accounted for
by Federal outlays? What's your view on that?
Mr. VOLCKER. I'm now in a position, naturally, where I would
greatly welcome all the restraint we can get on spending. The more
we can do toward reducing the deficit, the better.
So far as the question of a binding restraint on spending is
concerned, I suppose I find my thinking changing along with a
good many other people. I want to resist the idea of a constitutional amendment for this kind of purpose. I don't think that's going to
help us in the present situation; it seems very rigid. But I have
some sympathy for the idea of the Congress at this point setting an
overall limit, target—or whatever you want to call it—on spending
relative to the gross national product; this may be a very useful
device for focusing attention and maintaining discipline in this
area.
The CHAIRMAN. What's your response to the argument that if we
cut spending sharply it might precipitate a recession?
Mr. VOLCKER. In general—and this is a point that I tried to make
in my statement—we ought to appreciate the limitations of economic forecasting on this point and the great uncertainties in the
economic outlook. The tendency, historically I think, has been to
fear a recession around the corner, and this has been particularly
true in the past year. But the past year is only one dramatic
example of what has been a rather persistent approach. If we are
always fearful of recession around the corner, we tend to devise
policies to counter it. In a sense, I think we have been reaping the
whirlwind sowed by that approach over a long period of years.
INFLATION AND RISK OF RECESSION
When we look at the economy now, there are some signs of
strength. When we look at the inflationary situation, there isn't
much doubt that it is an enormously serious problem. I think we
have to focus our policies in that direction, on what I think is
virtually the certain knowledge that if inflation isn't brought
under control, the risks to the economy, the risks of unemployment, the risks of recession—in terms of their severity—increase
rather than diminish. The biggest threat to stability and for a
really serious recession over a period of time would be to fail to get
this inflation under control.
In saying that, I don't say there are no risks to the economy in
dealing forcefully with inflation in the short run. I think those
risks are less than the risk of procrastination, to the extent we
have a coordinated set of policies.
19
The CHAIRMAN. Now the second part of the Kaufman program
was a direct limitation on the creation of domestic credit by putting a lid on the growth of bank credit and imposing capital to asset
ratios or liability ratios for all major financial institutions.
Mr. VOLCKER. As you know, we deal with the problem of restraining credit and bank credit in particular all the time. We
think our policies are directed to that end.
Mr. Kaufman is fond of looking at the credit figures. I don't
know what figures he's using—I didn't read the speech and I didn't
see any of the newspaper reports. But, in fact, credit expansion in
the fourth quarter—which is the only quarter we have comprehensive figures for—did decline as we expected after our October 6
program. There are some recent indications that bank credit and
business loans in particular have been picking up again. Whether
that's a lasting change or not, I do not know, but certainly our
policies in general are directed toward restraint on that area of
credit.
I don't know that I want to comment on the particular techniques Mr. Kaufman suggests.
The CHAIRMAN. Well, let me just interrupt to point out the
problem. The Fed has raised its target ranges for bank credit in
each of the last 3 years. In 1977, the target was 7 to 10. The actual
growth was 11.3. It was above the target. In 1978 the target was 7
to 10. The actual growth was 11.4. In 1979 the target was 7.5 to 10.5
and the actual growth was 12.3. So in every year the actual credit
growth substantially exceeded not only the midpoint but even the
extreme point of the target.
Mr. VOLCKER. I think that's true in recent years; bank credit has
expanded faster than the targets set out, and the discrepancy in
general has been bigger than with the monetary aggregates. It was,
in a broad sense, concern over making sure that credit was more
corralled, so to speak, that led to some of the particular techniques
that we adopted in October, particularly the imposition of marginal
reserves.
The CHAIRMAN. Do you feel competent you're getting a grip on
that so you will be within the target?
Mr. VOLCKER. As I say, credit seemed to be coming under control
in the fourth quarter. Now the economy has certainly been stronger than most people expected in the past couple months. Remember that we're looking at a very brief period and nobody should
think we can control these things in a space of a month or two. But
there were some signs in January and the early part of February
that business loans in particular and to some extent total bank
credit had picked up. As we resist that, this partly accounts for the
pressures on the marketplace now.
The CHAIRMAN. The third part of his program is tighter and
more definitive standards for private short-term open market financing, along with limits on the assurance of debt by various
federally backed credit agencies.
Mr. VOLCKER. I don't really know what the first part of that
recommendation refers to, but the idea of controlling and
limiting
20
CONTROL OF FEDERAL CREDIT PROGRAMS
The CHAIRMAN. Well, maybe selective credit controls.
Mr. VOLCKER. Let me deal with the second part first. I fully
share and I think the administration shares the idea of getting
better control over the Federal credit programs; it has introduced
some initiatives in the budget, as you know, in that respect.
Now if we're talking about selective credit controls, I just don't
know how they would be workable. I don't have a clear idea of
what Mr. Kaufman had in mind, but I'm no enthusiast of using
direct controls in this area and think they can be counterproductive in that they lead to anticipation of inability to raise money
and thereby actually increase demand.
The CHAIRMAN. Then are you opposed to invoking the Credit
Control Act which is on the books now which the President could
of course invoke?
Mr. VOLCKER. I haven't had any enthusiasm for that.
The CHAIRMAN. So you're opposed to it?
Mr. VOLCKER. Yes.
The CHAIRMAN. Then the fourth point is limiting the role of the
dollar internationally. Would that be helpful?
Mr. VOLCKER. No. I cannot conceive of a control mechanism—if
that's what he has in mind—that would be helpful in that respect.
We have had some experience with trying to do that in the 1960's
and early 1970's, as you know. That experience leads me to believe
that it's not very practical or possible and would not have constructive results.
The CHAIRMAN. His fifth point is creation of a national commission for the revitalization of America, to formulate a series of steps
to enhance technological growth, to improve cooperation with business, labor and government, improvement in the U.S. trade position, lighter regulatory burdens and other measures that would get
us out of our current productivity entrapment.
Mr. VOLCKER. I certainly agree that he's put his finger on some
major problems that need work and assistance. Whether the particular device that he proposes is promising or not, I don't know.
The CHAIRMAN. Well, it would seem to work in with Senator
Garn's suggestion for emergency action and to step in now.
Mr. VOLCKER. I take it that Mr. Kaufman is looking at a somewhat longer term perspective than Senator Garn.
The CHAIRMAN. That's right.
Mr. VOLCKER. I would be in favor of that kind of thing, if it
promises results. I must say, in my experience in Washington I
have seen a lot of productivity commissions that were often an
excuse for not solving the problems. I suspect that when you can't
think of what to do you form a commission and put the problem off
to the side a little bit. But we can try again; I'm not opposed to it. I
fully agree those problems do exist and should be attacked. I don't
understand his proposal to be quite the same as what Senator Garn
was talking about; that is, a bipartisan effort right now to deal
with this inflationary problem. I think Senator Garn's proposal has
a tinge of urgency and potential political effectiveness that some of
these commissions historically have lacked.
21
The CHAIRMAN. My time is up but there was one final point and
I hope Senator Garn and Senator Stevenson will permit me to ask
about it too.
His final point was the most shocking of all to me and that got
the attention in the headlines—a temporary freeze on wages and
prices or a simple mandatory control program, and he says it
would be of some marginal transitional help toward a better economy. In other words, he indicates it wouldn't do much good, but it
might help a little bit.
Mr. VOLCKER. My problem with that, particularly the way he
seems to have phrased it, is that it's too easy to think up temporary programs as a substitute for fundamental solutions. You know
that's not going to work, and I would think on those grounds alone
he was not very wise to propose that; he says it's not very useful.
My fear would be that somebody might think it was very useful
and that it was an answer to the problem and in that way divert
attention from what needs to be done.
The CHAIRMAN. Senator Garn.
Senator GARN. Thank you, Mr. Chairman.
First of all, let me say as Chairman Volcker mentioned, my
proposal has nothing to do with more studies. I'm not talking" about
more commissions. I'm not talking about studying the problem. We
have studied it to death. You're absolutely right, we all tend to
create a committee. So your analyzation of what I said was correct.
I'm talking about something far beyond that that's action oriented.
It's something rolling in the longer term, not just for the immediate but the longer term, and cut this up and down as we sit in
these hearings year after year with nothing new really occurring.
Mr. Chairman, as I mentioned in my opening statement, certainly it's evident that the economy continues to go along unabated. In
your statement you talk of breaking the ominous pattern of unemployment, low productivity, inadequate capital spending, and the
weakness of the dollar in foreign exchange markets. How are you
going to solve these problems if the Federal Reserve is the only
tight money game in town?
Mr. VOLCKER. It would certainly be easier if we got some of the
complementary actions along the lines that I have talked about,
that the Chairman has talked about, and that you just mentioned.
I think that's very important.
Senator GARN. Have you had any conversations with the administration as far as coordinating their fiscal policies, their recommendations, with the actions you're taking in tight money in the
monetary system?
Mr. VOLCKER. I have some contact with the administration; we
discuss these matters from time to time.
Senator GARN. What kind of response are you getting? Are they
going to let you be out on the end of the limb just tightening
money and nobody else helping?
Mr. VOLCKER. I think there is a real appreciation of the problem,
Senator Garn. I think the difficulty is what you know it to be
implied in your own statement: Some of these actions are very
tough; they require political support. There's no use proposing
things that are going to be rejected immediately in the Congress or
by public opinion. I would hope, myself, that the sense of concern
22
that has deepened in recent weeks can help create a climate in
which effective action can be taken.
Senator GARN. Well, I'm not sure that just because Congress may
or may not reject—this is where we get into a consideration of
leadership. Do we have some leadership on this issue, somebody
that's got the political guts, regardless of elections, to come out and
say this is what we need to do and if Congress won't go along then
let's put it on their heads? Let's put it on their back. I happen to
think that that's where most of the problem is. It lies here with us.
But I just can't emphasize enough the need for putting aside political considerations and somebody being tough enough to say what
needs to be done, and the interesting thing about that, I think if
someone would do that they would find out that the best politics of
all were solving the problem and they could be elected for anything
forever if they had enough courage to do that. So with the uncertainty of current economic events, it's a little bit difficult for me to
understand, Chairman Volcker, how the Federal Reserve intends to
adjust its monetary policy if its projections about the economy
which are really fairly close to the administrations are incorrect.
The concern I have, despite the expectations that there will be a
mild recession that will occur this year and that will take some of
the steam out of the inflationary trends, we are not prepared for a
continued rise in the economy or a continued runaway inflation as
we had last year.
So specifically, what happens, for example, if consumer price
increases continue at a 16 to 18 percent annualized rate during the
next few months in light of your projections that it's only going to
be 8 to 12? What are we going to do about it?
AUTOMATIC PILOT
Mr. VOLCKER. We were not projecting 8 to 12 percent in these
next few months. I think the Board, in general, has been aware
that the price indexes are going to be high during the first quarter
in particular. But should an inflation rate of that sort and a strong
economy persist, the implication is quite strong that that kind of
monetary targets we have would put pressure on the markets
which, in turn, will be a restraining influence on the economy and
on inflation. The phrase that comes to mind—and I hate to use it
because it overstates the position by a considerable margin—is
automatic pilot. We meet these kinds of targets; that implies restraint on a bullish economy with high rates of inflation. If, indeed,
the economy softened and the inflation rate declined—as was the
typical projection, certainly until recently, and as is probably still
the projection—that implies quite different conditions in the credit
markets and conditions consistent with easing in any period of
economic adjustment.
Senator GARN. Let me follow up. The discount rate you have
raised to 13 percent but that is still well below the current inflation rate and some people as a result are simply arguing that the
discount rate increase will simply not cause banks to slow their
borrowings from the Federal Reserve.
23
With the discount rate, are you merely trying to send a signal
that tighter monetary policy will be implemented and, if not, what
effect do you anticipate this to gain?
Mr. VOLCKER. It does, of course, increase the cost of member
bank borrowing, but it is below the market borrowing rates; there's
no question about that. The change in the rate itself had some kind
of a signaling function in some circumstances. But let me say in
that connection that we are not, of course, writing on a clean piece
of paper—we never are. We are operating in an environment of a
Federal Reserve history and toward member bank borrowing which
is quite clear. As the famous Federal Reserve phrase goes, "Borrowing is a privilege and not a right." In other words, banks don't
feel free to borrow at the Federal Reserve for any period of time
regardless of what the rate is; they come under surveillance and
discipline if that is abused.
So I don't think that rate and its relationship to market rates
should be interpreted as a kind of open invitation to borrow. It's
not, and I think that's well understood in the banking community.
Senator GARN. You also state very explicitly that restraint on
growth in money and credit has to be maintained over a considerable period of time rather than just the short run. I certainly agree
with that, but in order for that to be effective and implemented
targets for monetary growth should be stated over periods of longer
than one year and it seemed to me this would then serve to
announce to all that monetary restraint is not only for the short
term but for the long term as well.
Do you agree with that approach that we ought to state that for
longer than—here we're looking at 6 months or the next year. I
think the Fed needs to say this is what we're looking for at 2, 3, 4
and 5 years to get this thing under control.
Mr. VOLCKER. We debated that issue on the Board and in the
Open Market Committee repeatedly, and I specifically and pointedly raised it and I will raise it this time around. I think the prevailing view, is that it's unwise to try to be specific for too far a period
ahead, but that should not be misconstrued as any lack of determination to get these figures down. The general philosophy of moving
ahead over the years to reduce those figures is broadly accepted;
the idea of pinning down a specific number, amid all the uncertainties in this world, is generally considered undesirable by the Board
members and the Open Market Committee members. They want to
reserve to themselves the ability to look at each year afresh, within
the context of a general philosophy of reducing the targets over a
period of time.
Senator GARN. Well, I understand it's very difficult to set a
specific figure even for 1 year, let alone beyond that, but I'm
talking about targets. I'm talking about sending signals and perceptions that we really are serious about this fight. Certainly if you
picked a particular figure for 1982 and didn't reach it, I'm not
going to be one who's going to criticize you.
Mr. VOLCKER. That's part of the concern of the committee: That
setting a specific target and then not meeting it might be counterobjective in the way you cite. The most important thing is meeting
the targets we set for the immediate period. If we can't do that,
then we're not going to have any credibility in the longer run.
24
Senator GARN. I understand that, but the point I'm trying to
make, at least my feeling, a good part of the inflation and solution
to that are perceptions of what people think and attitudes.
Mr. VOLCKER. I agree with that.
Senator GARN. We have got to change the perception. We have
got to change the attitude that the economy feels that people and
institutions are serious about solving this problem and there's no
way. As little as I know about economics, there's no way you're
going to solve it this year or look at a 12-month period just because
that happens to be the way the calendar works. Maybe we ought to
forget the calendar, specific dates or times and things like that and
talk about sending some very tough signals that over a period of
time we are going to continue to work on this, play hard ball and
not just go up and down.
Mr. VOLCKER. I fully agree with that. My only disagreement—
and the disagreement of the Committee—would be whether it
really assists that process to try to be too precise in setting these
numbers downward over a series of years. But I agree with the
general point.
Senator GARN. I understand. My time is up and I would just
close with that. I just hope—I have sat on this committee for 5
years and I haven't seen a great deal changed, and I just hope a
few years down the road there isn't some other Senator sitting
here questioning some Chairman of the Federal Reserve asking the
same questions for the next 5 or 10 years that we have been asking
for the last 5, and we are still in financial difficulty. That's why I
place so much importance on it.
Mr. VOLCKER. I understand. I expect the difference now is that
this inflationary problem has been driven home in a way that it
has not before. It is inbred in people's thinking, and once it gets
inbred in people's thinking the accelerating process begins and
therein lies the danger. It's also bad for the level of business
activity. I hope we can take advantage of that understanding and
really turn it around this time.
Senator GARN. Thank you.
The CHAIRMAN. Senator Stevenson.
BUSINESS LOANS
Senator STEVENSON. Mr. Volcker, did I understand you a moment
ago to say that business loans are picking up?
Mr. VOLCKER. The most recent evidence shows strength again in
the business loan picture, yes.
Senator STEVENSON. You're referring to bank loans?
Mr. VOLCKER. Primarily bank loans. We just don't have much upto-date information on it.
Senator STEVENSON. But with the bottom having fallen out of the
bond market, that would be expected, wouldn't it; short-term borrowing as opposed to long-term borrowing?
Mr. VoLCKER.That is a factor. I suspect it's also reflecting the
fact that the economy has been pretty strong these last few
months. Let me say this followed 3 months of rather modest
growth.
25
Senator STEVENSON. Well, it could also be a function of economic
uncertainty with industry borrowing for the short term as opposed
to the long term with a very uncertain marketplace and very
uncertain expectations.
Mr. VOLCKER. It could be that. I don't want to overinterpret
information for a few weeks figures either. These figures have a
habit of fluctuating.
Senator STEVENSON. What are the figures? What do you have?
Mr. VOLCKER. The rate of growth for business loans in January,
as I recall, was on the order of 20 percent; I guess, it's about 13
percent for bank credit generally now. That January figure was
affected by one huge takeover loan which by itself added 3 or 4
percent; that was an extraordinary occurrence. That's the latest
data we have on any comprehensive basis, and it tends to be fairly
localized among the bigger banks which account for a large part of
the banking system. The information for those banks for the first
half of February shows a pretty good increase too.
Senator STEVENSON. You have been relying on your own exhortations in the marketplace to allocate credit to productive purposes
as opposed to speculative purposes. How is that working?
Mr. VOLCKER. We need, perhaps, to do some surveys to get firmer
information, but my impression is that it's not working too badly
so far. We did try to do a special survey on how smaller borrowers
were faring; while, given the time period, I would not claim statistical precision for the survey, the general evidence seems to be that
small business loan rates, in particular, have not gone up as fast as
the prime rate, for instance, and that the rate paid by bigger
businesses is in accord with what we would have liked to see. That
evidence in a qualitative sense, seems to be reasonably good. I do
get reports that banks are reluctant, to say the least, to make
takeover loans. There was that very large exception; it was an
enormous loan. There may be some excuses for it in that this was
arranged largely before October, and there is, also the case to be
made that the result of that loan will be to increase production of
heavy oil; I think that's true from all the evidence I have seen. But
it was an enormous loan, and I myself wonder whether it couldn't
have been arranged in a somewhat different way. From what evidence I have I do think there has been a genuine effort to respect
the general principles we set out.
Senator STEVENSON. Doesn't the Fed have a system for monitoring the allocation of credit by the market and shouldn't it, if it
doesn't?
Mr. VOLCKER. I hate to use the word allocation, which implies
more precision and more detail than anything that I had in mind.
But certainly a review in the areas that you mentioned does seem
to be useful. As I said, we have attempted to review the small
business picture. We have also attempted to follow the takeover
picture, and we can do that more intensively.
Senator STEVENSON. Well, the bottom has fallen out of the bond
market, the prime rate is at 16 percent or higher, short-term loan
demand is rising as you have indicated, and there are international
constraints—many countries now are facing difficulties in financing development as well as their payments deficits, not to mention
longer term or speculative possibilities such as curtailed oil produc-
26
tion for lack of suitable instruments for the investment of OPEC
oil surpluses. Aren't we running or beginning to run, a risk of a
serious credit crunch which will decrease our capacity for the
production of goods and services and decrease our rates of productivity even farther, with higher and higher interest rates adding
more to the cost of goods and services? What about it? Are we
going to have a credit crunch?
Mr. VOLCKER. The only way I can respond to that, Senator, is by
saying that I think the greatest risk we run is of this accelerating
inflation.
Senator STEVENSON. That's what I'm concerned about.
Mr. VOLCKER. We have to move against that; that creates
pressures.
Senator STEVENSON. And increases the cost of all the goods and
services in the economy.
COMPLEMENTARY POLICIES
Mr. VOLCKER. Which in the short run, at least, can have some
blunting effects on the economy and emphasizes the importance of
complementary policies to help deal with that impasse. But I don't
think there's
Senator STEVENSON. Which, as the chairman mentioned before I
came in, helped offset your policy. We had to struggle heroically
with the one hand against what the other is doing.
Mr. VOLCKER. I was thinking of the budgetary and the other
approaches that the chairman mentioned. The question always
arises when particular areas of the economy such as housing are
severely hit—they are at the end of the whip so to speak—whether
some action is appropriate to moderate the harsh edge without
offsetting the main policy thrust. That's a matter of judgment. I
cannot sit here and say that I would oppose every action that
might be taken to moderate the sharp edges of policy; I don't. But I
think you have to recognize that puts the pressures on some other
area.
Senator STEVENSON. That's not the only purpose of these countervailing policies. The one the chairman mentioned was not to help
some adversely impacted sector. It was to help the United States
pay the oil bill and compete in a highly competitive world as Mr.
Kaufman mentioned, by supporting our exports with a policy of
exporter subsidization through the Eximbank which doesn't nearly
equal the comparable policies of other countries.
How do you feel about that as one complementary policy? That's
the problem. We all agree that a freeze makes no sense unless it's
accompanied by complementary policies, that we shouldn't be relying exclusively on monetary policy; but when it comes to complementary policies we can't agree on anything, even including something as elementary as enhancing the competitive ability of the
United States in this highly competitive world in order to pay the
oil bill and overcome the trade deficit which is one of the principal
causes of the declining dollar and inflation.
Mr. VOLCKER. I don't think any of this is easy, and I don't want
to suggest that it is for a moment. But I hope the nature of this
inflationary problem and the nature of the market problem tend to
27
focus people's minds on the importance of getting together a coherent set of policies that together stand the best chance for respecting all these priorities, I hope we recognize the primacy of dealing
with this inflationary problem, so we don't slip from one crisis into
another.
Senator STEVENSON. Well, I'm going to come back to those complementary policies, but my time is up.
The CHAIRMAN. Senator Riegle.
Senator RIEGLE. Thank you, Mr. Chairman.
I share many of the concerns that Senator Stevenson has just
been expressing. Chairman Volcker, is it your view that we've
worked ourselves into a financial emergency?
NO DEVIATION FROM OUR APPROACH
Mr. VOLCKER. I think you use inflammatory terms. I think we
have reached a point in this inflationary situation where decisive
action is necessary. As far as monetary policy is concerned, I don't
think that requires any sharp deviation at all from what we have
been doing. We have, I hope, recognized this problem; I think we
have. What is important in terms of monetary policy is basically
that we stick with our approach. Now the crunch arises in a
slightly different sense than Senator Stevenson suggested. The demands pile in, the concerns of particular sectors pile in; if we
attempt to meet all those demands we are not going to be successful in anything but building in the inflation rate. We have to stand
firm.
Senator RIEGLE. Well, the reason I pose the question that way
and I can understand your desire not to be needlessly inflammatory or to use that kind of word and I certainly don't have that
intention either. On the other hand, it seems to me you're following a monetary policy that is the kind that one follows in an
emergency. In other words, you're behaving as if a financial emergency did exist in terms of the need for really record setting
monetary restraint, and you made a case for why you think that's
necessary. My own view, and I think shared from what I hear from
my colleagues is that that can't get the job done by itself. I mean
you have a certain reach through monetary policy, but it's very
uneven and it's limited and that's why I think we may have to, at
the risk of being somewhat inflammatory, make it clear that we
are in a financial emergency so that the other things that need to
happen can start to happen.
Mr. VOLCKER. I don't disagree with that. I resist the word "emergency" a bit because I think that this current price performance
was more or less predictable after the oil price increases. That was
the emergency in a sense. But there's no question that we are at a
point—and I think it's illustrated by the conditions of the financial
markets—that action and coherent action is urgently needed. Now
I think we already have that pretty much in place at the Federal
Reserve.
I don't want to suggest, on the other hand, that we just strike
out in any direction wildly. It's the fundamental approaches that
are going to pay off over time. I touched on some of them at the
end of the statement that I submitted here. They are not new; they
28
are widely known. I think they are widely supported in theory. We
are at the point where they have to be applied in practice.
Senator RIEGLE, Let me ask you this. I come from the State of
Michigan and our unemployment rate in Michigan now is 10.3
percent. It's really a combination of two factors that are cutting
deeply. One is the cumulative effect of the higher interest rates
taking their toll on different sectors, and the other is the impact of
the problems of the automobile industry. But as I talk with small
business people throughout the State and others, I'm finding that
the monetary policy which applies very unevenly is really beginning to do some serious damage. Now I think one might, from a
national policy point of view, view that one way if it were solving
the overall problem. To the extent that it's not, to the extent that
it only by itself has a limited effect in solving the overall economic
problem of the country, I think it's a much less useful tool.
So let me ask you this question: If the President were to take the
lead and say, "Look, we are in a financial emergency and I'm
prepared to really change direction on Fiscal policy at this time and
I'm going to target for something close to a balanced budget, as
tough as that is, and I'm not going to just sneak it all into the
supplemental this fiscal year that we are finishing. I'm going to be
honest about that, too, but we are going to really shoot for something a lot closer to a balance with the thought in mind that I'm
going to enforce it with my veto power. If I have to send appropriations bills back four or five times, to fall within target levels of
spending, I will do it because I would hope to persuade the Fed for
some tradeoff, some relaxation of monetary policy in exchange for
serious and real demonstrated fiscal restraint, recognizing it's
tough, recognizing it's painful and so forth"—if the President were
to take that approach, is this something the Fed might respond to
in terms of feeling that it could afford at some point to try to work
these interest rates down somewhat?
DRAMATIC EFFECT ON INTEREST RATES
Mr. VOLCKER. Let me put it differently. The kind of thing you
suggest, with congressional support, could have a dramatic effect
on interest rates. I don't think we want to back off our policy and
shouldn't; it would be inconsistent in terms of the basic objective of
our policy included in this report. But, as those other policies are
successful, it would take the pressure off the money markets. In
other words, if we don't have that kind of persistent restraint on
monetary growth which we think is essential in terms of the long
range inflationary problem—not just in 1980 but beyond—we won't
deal with the inflationary problem.
The question is, What that does to financial markets and interest
rates. To the extent other policies are successful, you won't find the
same degree of pressure on the financial markets as you might
have had consistent with those money supply objectives. We want
to stick to those money supply objectives.
Senator RIEGLE. Let me ask you this. In a more realistic costing
out of the budget, the prospective budget would show a deficit of
somewhat closer to $25 billion.
29
If we were to use the veto power as a way to back it up for
something closer to a balance for the coming fiscal year and following the line of reasoning you've just expressed, wouldn't it then be
reasonable to assume that that would help bring the interest rates
down?
Mr. VOLCKER. I don't think there's any question about it.
Senator RIEGLE. How much might it bring them down? Are we
talking about 1 percent or maybe 2 or 3 percent?
Mr. VOLCKER. I am just not going to make a projection.
Senator RIEGLE. The direction would be toward a reduction?
Mr. VOLCKER. There's no question that the direction would be to
offset these pressures that we now see in the market. Look what's
happened overall in the bond market in recent weeks. Nothing
that drastic has happened in the economy. What has happened in
that brief period of time is that expectations have changed; there's
concern about the budget.
Senator RIEGLE. Suppose the President was to take the other tool
that he has right now and that is the credit control tool to find
some creative way to—very difficult to use that tool as we know,
but to try to find some way to intelligently apply some further
restraint in some areas. Would that also, if it were done right, help
you with your difficulties in starting a downward trend of interest
rates?
Mr. VOLCKER. It's awfully hard to judge that. I think it depends
upon a lot of dimensions that I find very difficult to appraise. That
is, in effect, another way of bringing pressure on borrowers; it can
be done through the market or done more directly. It adds to the
urgency for borrowers wanting funds. Just what effect it has on
interest rates I think would depend, perhaps, on how it was done.
It's pretty tough to guess on that direction.
Senator RIEGLE. Wouldn't it help us, though, if we could find a
way to channel more of the spending that's being done, the investment spending or the spending in the aggregate, into capital investment, things that could start to work for some improvement on
productivity?
Mr. VOLCKER. That suggests the kind of conflicts you run into.
What do we really want? Suppose, purely hypothetically, you want
to direct credit from where you sit here. You're kind, but you've
got a lot of claimants on that credit. There's been some concern
expressed here about the mortgage markets; there's been some
concern expressed about exports. What do you choose to do?
Senator RIEGLE. Suppose we took the balance-of-payments account and we took the areas where we are under water, whether
it's in energy, whether it's in motor vehicles. We've got a $10
billion deficit this year and items like that. And said let's try to
target the areas where we know we are hemorrhaging and see
what we can do to try to turn things around. Aren't there sort of
self-identifying targets it would be smart for us to concentrate on?
Mr. VOLCKER. You've got to pick out those targets for me. Take
the area of consumer credit. You noted that the housing and automobile industries are in recession. Are those areas where we want
to channel credit right now?
Senator RIEGLE. Probably not, and not just because I come from
Michigan, but the problem is if we are not generating the capital
30
for the retooling we are going to lose further ground to the Japanese. So I think you can make a strategic argument not to do it
there.
Mr. VOLCKER. I think there's a very strong and basic case for not
impeding the flow of credit to investment through the market
process any more than is necessary; the needs are very urgent. But
I find it difficult to sit here and decide in numerical terms that so
much credit should go to this area or that area, knowing also that
these controls never work very effectively and that some people
can find a way around them while other people can't.
Senator RIEGLE. Unfortunately, nothing works very effectively.
It's sort of a choice between rather——
Mr. VOLCKER. Let me say, as all of the discussion so far has
suggested, that a really satisfactory answer can be found in the
credit area, whatever tool is used. The way to take the pressure off
the credit markets and avoid some of the bluntness is by taking
some of these other kinds of actions that also go to solving the
inflationary problem, the productivity problem, the expectational
problem, the budgetary problem. If we are going to rely upon credit
and put the full weight there, by whatever technique, we are going
to run into problems and conflicts. You run into problems and
conflicts whatever you do, but I think the more we can adopt an
across-the-board approach, the better off we are going to be.
Senator RIEGLE. My time is up. Thank you.
The CHAIRMAN. Mr. Chairman, last October when the Federal
Reserve took dramatic steps to limit the growth of money and
credit you raised the discount rate from 11 percent to 12 percent
and said that the rate was to be flexible. The prime rate jumped to
15.5 percent and the discount rate stayed at 12 percent until 10
days ago when you raised it to 13. Now the major banks have
raised the prime to 16.5 percent. It looks very much like the banks
are setting the prime rate at the discount rate plus 3.5 percent.
This gives them a very big subsidy if they are borrowing from the
Federal Reserve.
Two questions. First, how is the behavior of the big banks in
setting the prime rate at the discount rate plus 3.5 percent justified?
SETTING THE PRIME RATE
Mr. VOLCKER. I don't think that's the way the banks approach it.
The prime rate tends to remain in relationship to the market rates
that they are paying for federal funds, for CD's, and all the rest.
The amount of borrrowing they do from the Federal Reserve relative to the total funding in the banking system is really quite
infinitesimal, and I don't think that decision to borrow from us
bears directly on the prime rate, although there may be some
influence.
Now that influence is worth exploring a bit. The general policy
toward bank borrowing that the Federal Reserve has had for 50
years is that it's not an open window; it's there in time of need.
But banks are expected to make adjustments when they use the
discount window. They're expected to use it for a limited period of
time, unless a bank is indeed in some kind of an emergency situation. That means that, to some extent, regardless of what the rate
31
is, the discount window is there as a restraint on member banks'
borrowing. As that rate is raised, it may affect the Federal funds
rate and other closely related rates. Therefore, it will affect the
total level of market rates and, indirectly, the prime rate.
Now we did not raise the discount rate after October of last year
because basically the the money supply was on target. Credit expansion did not seem excessive. There did not seem to be a reason,
under those conditions and given the general policy on borrowing
from the Federal Reserve anyway, to bring further pressure on
market rates under those particular circumstances. That was a
particular set of circumstances.
The CHAIRMAN. Well, I realize that the discounting is not used
commonly and is not a big source of funds for the banks, although
a substantial source. At any rate, why not tie the discount rate
slightly above the Federal funds rate and that way eliminate the
subsidy and you would increase your control over total bank reserves and make it more flexible?
Mr. VOLCKER. That is an approach that, frankly, has some appeal
to me theoretically; it's an approach we are examining, among
others. What it does involve, I think, is a rather fundamental
change in the way we treat borrowings in general and in the
liberality of our policies apart from the rate. In other words, we
say you're more or less free to borrow, but we discourage that
through a penalty rate mechanism. That's a rather revolutionary
change in the way we have managed the discount window in the
past, so we want to be pretty sure of our ground before we make
that kind of fundamental change. The immediate reaction would be
to make the discount rate a penalty rate and the market rate
might keep leapfrogging the discount rate; we wouldn't want to do
that in a way oblivious of all our other objectives.
The CHAIRMAN. Last October 6, the Federal Reserve put in place
an 8-percent supplemental reserve requirement on bank liabilities
and according to the financial press these supplemental reserves
may be having little or no effect on the ability of banks to raise
funds. The front page of the American Banker of February 11 has
a column called "Random Thoughts," by Sanford Rose. Let me just
read the first two sentences. "According to Bank of California
Chauncey Smith, there is no problem whatever in dodging the 8percent supplemental reserve requirements on managed liabilities,
says Mr. Smith. I go down to my trading floor and my people give
me at least a dozen ways of avoiding managed liabilities. The Bank
of California's experience is apparently fairly representative," the
article goes on to say.
Now on Friday when the large banks increased the prime rate to
18.5 percent, they indicated that credit demands were strong. If
your policies are designed to limit expansion of credit, they either
seem to ignore business credit or businesses don't care how much it
costs them to borrow. So I'd like your response to the claims that
the supplemental reserve requirements and managed reserves requirements are not effective, and then I've got another question.
Mr. VOLCKER. This is a matter that we obviously keep under
review. Let me say it is binding on some banks but not the majority of banks. One fundamental reason why it hasn't been more
binding is in fact because bank credit did not expand very rapidly
32
for 3 months following the imposition of the suplemental reserve.
In those circumstances, it was not unnatural that the restraints did
not bind, that they hovered below the threshold, so to speak, because credit demands were not expanding. Now in recent weeks we
are in a somewhat different situation, and if there are mechanisms
that make these requirements ineffective when credit demand is
expanding, I think that would deserve review.
The CHAIRMAN. Well, he says, "I go down to my trading floor and
my people give me a dozen different ways of avoiding exceeding the
basis of managed liabilities."
Mr. VOLCKER. That seems to me
The CHAIRMAN, Shouldn't that be looked into by the Fed?
Mr. VOLCKER. I agree. We do keep this under constant review,
but I think it needs to be tightened up. I think you can presume we
will do that.
The CHAIRMAN. I'd like to know whether you're concerned about
the ready availability of business credit and what actions you
might take to put a lid on business credit.
Mr. VoLCKER.The most general answer I can give to that is that I
think the kinds of actions that we have already taken—including
that marginal reserve requirement and a review of how effective
that is—point in a direction of restraint on business credit. Indeed,
this is something you have commented on often which I think has
elements of truth in it, but needs an appropriate interpretation;
that is, that we do not have a banking system that is easily
susceptible to the kind of restraint on availability that people have
been used to seeing in past cycles. A lot of attention has been
devoted, for instance—partly under your leadership, Mr. Chairman—to moving away from the regulation Q kind of restraint. We
have moved away from that kind of approach so now we have a
different kind of restraint that comes out more in the rate and less
in administrative ratcheting by the banks than used to be the case.
This has pluses and minuses, but I don't think you should interpret what's going on as no restraint at all. The restraint is
reflected in substantial part in the interest rate developments. As
the business loan demand expanded in the past few weeks, more
pressures come into play.
DEMAND FOR FEDERAL CREDIT PROGRAMS
The CHAIRMAN. Given the high interest rates and tight credit
situation arising from recent monetary policy measures, there's
certain to be greater demand for Federal credit programs. We have
talked about some—Export-Import Bank, Brooke-Cranston. It's true
for loans and loan guarantees from the Small Business Administration, the Farmers Home Administration, and so forth.
According to the President's fiscal year 1981 budget, the Federal
programs are projected to expand substantially in the current
fiscal year 1980 and again in 1981. For example, loan guarantees
are projected to increase 28 percent in 1980, 28 percent from $26.1
billion to $33.4 billion, and then to grow by another 24 percent in
1981 to $41.4 billion. Federal programs made up about 20 percent
of total funds advanced in the U.S. credit markets in 1979 so they
are a significant and substantial part of the picture.
33
Is this likely to make the conduct of monetary policy more
difficult to carry out and should there be a cutback in Federal
programs in 1980 and 1981 to be consistent with the monetary
policy measures?
Mr. VOLCKER. Let me note again that the administration has
taken some initiatives that I hope the Congress will respond to
toward a Federal credit program budget. There are a lot of exemptions in that proposal, and the biggest exemptions are in the housing area. I can't give you an answer in precise numerical terms,
but there's no question that, in total, the more those programs
expand, the more pressure is put on other sectors of the credit
markets, given any constant monetary policy. In that sense, that
expansion creates difficulties and creates pressures.
I think the only question that arises is the one you and Senator
Stevenson touched upon earlier; that is, that sometimes there is a
justification for, in effect, some Government assistance to one
sector or another that seems to be so disproportionately hit as to be
counterproductive in terms of the total effort. But when you do
that, you have to recognize you're just pushing the pressure off on
some other sector and making it greater there; there's no question
about it, and it complicates our problems.
The CHAIRMAN. My time is up. I might just say, as I recognize
Senator Stevenson, one problem with the Eximbank is that—although Senator Stevenson has made a devastating case and very
powerful case throughout the years—we have to recognize that
when we sell abroad we satisfy a demand in foreign economies. We
increase the pressure on prices in this country. We don't provide
any goods that are consumed here. And the result is peculiarly
inflationary in that sense. At the same time, I think Senator Stevenson is right. We have to pay for our oil. We live in a tough
world. We have to do what we can to defend the dollar, but I think
we ought to do all this with our eyes open.
Mr. VOLCKER. I have struggled with that Eximbank problem
almost as long as Senator Stevenson has, in various guises. I do
think it's an area in which, as he points out, we are dealing with
the world as it is, in the sense that other countries put their
priority on exports. We have this enormous balance-of-payments
problem, which stems in very considerable part from the oil situation. I think there is a case to be made for maintaining continuity
of support for our export effort. That leaves you with a difficult
question of degree, but as a general philosophy, continuity in that
program seems to be important. Our policies are not kind to our
exporters in many ways, as you well know, relative to the policies
of other countries. You spoke of the effect of shipping goods abroad,
helping other countries to have more goods, and in some sense
helping their inflationary problem while adding to our own because
those goods leave the American economy. While that is true analytically, we run into another analytical necessity, that of maintaining a balance in our overseas payments. You can't expect, in
effect, to live off other countries, which is what we're doing when
we run a deficit, so it's an unsustainable situation to think that we
can just maintain our imports but not do the exporting that's
necessary.
34
The CHAIRMAN. We considered the exports plus the investment
income.
Mr. VOLCKER. We were very close to balance last year. We are
going for a loss again because of this latest oil price increase, and
our exports, I must say, have been doing remarkably well for 18
months or 2 years, but that followed a long period of great sluggishness. In terms of looking at the overall equilibrium, the prospects for the future and the importance of a stable dollar, I don't
think we can rest on our laurels in that area. However, the export
performance has been quite gratifying in the past 18 months.
The CHAIRMAN. Senator Stevenson.
Senator STEVENSON. Well, it's also a means of reducing international liquidity in those currencies which have a source in the U.S.
trade deficit, but I don't disagree with much of what you said, Mr.
Chairman. I think it also can be said that if we disarm ourselves,
we are not going to be in a strong position from which to negotiate
reductions in the export subsidies.
Mr. VOLCKER. That's correct.
Senator STEVENSON. And I sense that governments are shifting to
competition partly as a result of changing from import protection
to export subsidization. We are not in a strong position to compete
and we will neglect an opportunity or at least a need to negotiate a
reduction in that competition, which if successful, would mean we
would reduce
Mr. VOLCKER. I think other countries would love us to get out of
that business; then they could do all the more. We have been in
constant negotiation on these matters extending over several years.
It is very difficult to maintain some level of sanity, if you will, on
the amount of assistance given to exports.
Senator STEVENSON. They have been unsuccessful so far.
Now, Chairman Volcker, I owe you an apology. I think I prevented you from answering my own question by jumping on you as soon
as you suggested that inflation was a greater concern than credit
crunch. I approach this from slightly different directions and I
think the Fed's monetary policy and the current credit crunch is as
much the cause as the result of inflation, but
Mr. VOLCKER. I don't agree with that, if I may interject.
Senator STEVENSON. You don't agree with it as much as I agree
with it, but I know there is, and you indicated a moment ago there
is, undeniably some truth in it. But I did prevent you from responding to the concerns that I expressed about the danger of the
credit crunch. Do you have more to say about that?
Mr. VOLCKER. I just dislike the term "credit crunch" because I
don't really know what it means. I suppose we have what some
people would call a credit crunch right now, and in that connection
I think the greatest danger to the credit markets through enormous congestion comes from the inflationary process itself. People
want to buy and borrow money in anticipation of the future. They
want to borrow money to support purchases that are made in
anticipation of price increases. That kind of thing brings on a
credit crunch.
The markets have been performing in a way such that credit is
flowing. In that sense we don't have a credit crunch. I hope that
continues to be the case, but I don't think there's any question
we're getting restraint. You could call any restraint a credit
crunch—that's the trouble with the word; I don't quite know what
the people mean by it. There's certainly restraint out there, in my
judgment, but credit continues to flow. It continues to flow even in
the housing industry and certainly to businesses and it should be
under some restraint.
Senator STEVENSON. Well, I wish you could say more than that. I
agree it's a sloppy term and my question ducks the difficulty I have
of defining what I mean, but I certainly mean to ask whether we
aren't reaching the point at which the unavailability and the cost
of credit on a long-term basis aren't becoming a serious source of
weakness for the economy? "You mentioned housing. Housing is
already in a slump. We all, I think, also agree that we need to
facilitate the formation of capital in the United States to enhance
our productivity and now the bottom has fallen out of the bond
market. It's already fallen out of the equity market except for the
gambling houses.
Mr. VOLCKER. The equity market has remained in a slough of
depression—I suppose that is the way to put it—for 10 years now;
it's not extraordinarily worse now than it was before.
Senator STEVENSON. I didn't mean to suggest that.
Mr. VOLCKER. But the real risk you're concerned about and I
would be concerned about will come if we fail to face up to this
inflationary problem, if we fail to turn the corner on these inflationary expectations. Then, sooner or later, we would run into an
impasse and that's not healthy for anybody. But there's no way you
can prevent it if you don't turn the corner on this inflationary
situation.
INCREASE IN DEFENSE SPENDING
Senator STEVENSON. All right. Then we agree next that we face
up to it by adopting—this is quotes—"complementary policy," and
the conventional wisdom which supports a restrictive monetary
policy follows by suggesting that the most important complementary policy is a restrictive fiscal policy. It's the conventional
wisdom also this year to support a real increase of about 5 percent
in defense spending, perhaps as much as $20 billion for just fiscal
1981. Now the conventional wisdom always ignores the choices. Are
we, in your opinion, to support an increase of some $20 billion, 5
percent or whatever, for defense and offset that by as large or a
larger amount in decreases for the nondefense sectors in the
budget?
Mr. VOLCKER. In a sense you're getting into an area where I'm
not sure my opinion should carry any special weight. But it seems
to me we have to spend on defense what is considered appropriate
for defense in terms of national security. I can't quarrel if the
judgment is that national security requires the 5-percent increase
in defense authorizations or appropriations. But I think that we
have to make room for that elsewhere, yes.
Senator STEVENSON. All right. Then, if those who do have the
responsibility and the information on which to make that judgment
conclude that $20 billion or whatever increase in fiscal 1980 or
1981 is necessary, do you, with the benefit of your experience and
36
from your important position of responsibility, conclude that it
ought to be offset by a $15 or $20 billion decrease in other sectors
of the budget?
Mr. VOLCKER. I would like to see as much progress as we can
make toward balancing the budget. The first thing is to defend the
President's present budget and not let that get further out of
whack.
Senator STEVENSON. It is getting out of whack. The full defense
supplement is not incorporated in that budget. Now we have embargoed food for the Soviet Union. The cost of the agricultural
supplement is not in that budget.
Mr. VOLCKER. That budget has a lot of vulnerabilities toward the
expansive side, so our No. 1 priority is to hold to that budget not
only on paper but in reality.
Senator STEVENSON. All right. That is what I am getting at.
Where would you cut it? In housing, production, management?
Mr. VOLCKER. I think you have to face those choices, and I am
not sure it is appropriate for me to try to pinpoint that. I recognize
the difficulty of the choice, but I would say the economy somehow
is going to make choices one way or another. Better to make some
of those choices deliberately by fiscal policy, than to let develop the
kind of credit market conditions you are concerned with. That may
be the choice.
Senator STEVENSON. Well, there is a purpose in this line of
questioning. The purpose is first to suggest that this conventional
wisdom is not very realistic. It ducks all the hard choices and if
Congress is true to form we will not have to make them, which
leads me to another line of questioning about
Mr. VOLCKER. I hope that's not true, Senator. I would rather take
what seems to me the more optimistic view that some of your
colleagues have expressed this morning that we can face up to
these choices. You talk about conventional wisdom; I think perhaps, if some of what you cite as conventional wisdom had been
applied earlier we would not face a problem as severe as we face
today.
Senator STEVENSON. I think that is right, but I think the problem
now and starting in 1973 is a very different one from what we
faced in the sixties. We have not said a word about energy conservation as one of the complementary policies. Do you think the
Congress will face up to a 50 cent gas tax?
Mr. VOLCKER. I hope they face up to something in that area.
Senator STEVENSON. Would you support that? As far as I know, I
am the only one in the Senate who does.
Mr. VOLCKER. I would support that personally, yes. There are
other ways of going about it. But I think that is an equally important component.
Senator STEVENSON. Thank you.
The CHAIRMAN. Senator Riegle?
Senator RIEGLE. Thank you, Mr. Chairman.
FINANCIAL EMERGENCY
Chairman Volcker, following the same line of questioning, not to
be unduly inflammatory, I think everything that has been said
37
here today illustrates the fact that we are in a financial emergency
and I think it is important that that be said because until we
honestly face the seriousness of the problem I doubt that we will
see the kind of broad-scale effort to deal with it that's required.
In your previous testimony you made it clear at least to me that
monetary policy and restraint is part of the answer but cannot
conceivably be the whole answer, that we need a much broader
anti-inflation strategy to really get at our problems. At any point
that you dissent from what I am saying please say so, but I am
leading up to the question that I want to pose to you.
It seems to me unless we acknowledge the fact that we have
somewhere along the line graduated into an emergency type situation, until we face that, we are not going to see the kind of serious
response that is needed. I would just say to Senator Stevenson, as a
member of the Senate Budget Committee, it is not easy to make
those cuts, but I think if we are in an emergency and that is the
understanding, then I think they can be made and they probably
have to be made most everywhere. In other words, every area—
there may be exceptions, but I think they have to be kept absolutely to a minimum and essentially you have to have what constitutes
some kind of an across-the-board cut. I think you back that up with
a hiring freeze and various other things that hold down spending
at least for a period of time until you are through what you
consider to be your emergency period. But that, too, added to
monetary restraint, and hopefully if you do it in a serious way and
back it by the veto, if that were to come forward, and some easing
of the monetary policy down the line which I think is necessary
and which I want to see, even those things do not do it all. I think
a lot more needs to be done in terms of additional anti-inflationary
steps.
We talked about credit controls. That is a very difficult area to
look at and I grant you that it is very tough to decide what might
be done in that area, but if you are in an emergency I think you
have to respond to it as it is. The same is true with respect to the
trade situation and energy conservation.
My concern also goes to the issue now of the degree to which the
underlying rate of inflation, the momentum inflation—most people
serious about it see it now at or about 10 percent and I do not
know how long we can tolerate it being at that level and particularly with the other factors in and out of Government multiplying
that rate.
I am wondering, Chairman Volcker, if you were not in the job
you are in, if you were, say, in Fred Kahn's job these days, and you
tried to step out of the Fed and step over into the notion of
inflation fighting generally, what more is there that might be
seriously considered in the way of anti-inflation strategy in addition to the things that I just mentioned here?
Mr. VOLCKER. Let me first observe that I did not take up your
invitation to interrupt you in your statement because I think you
have outlined the problem and the necessities quite clearly.
My own ranking of priorities would touch upon, first of all, the
energy and budgetary problems that Senator Stevenson just alluded to. I don't know which of those is most important. They are
both very important in stabilizing this situation.
What more could be done on the wage-price front than is being
done involves, I suppose, partly a question of philosophy among
those active in that area. When you look at just those guidelines
you have to be a little concerned.
On the other hand, I recognize the strong point that is made by
John Dunlop and others that we not rigidify this too much through
specific numbers but rather work on the process in as harmonious
a way as we can with the real actors who are setting the prices and
wages in the last analysis. I would not make that as high a priority
as the other two areas for the simple reason that I do not think
that kind of program is going to work very well unless actions on
energy and the budget are taken. But if you are in an atmosphere—I wish I could find a better word than emergency—let us
say of aggressive national effort focused on this problem, and you
are doing the things that are necessary not just with monetary
policy but with the budget and energy, you create a climate where
that kind of a program can have some supplementary role to play.
The danger today is quite clearly that the climate will go in the
opposite direction. You speak of the underlying rate of inflation
someplace in the neighborhood of 10 percent. But we have got the
Consumer Price Index and other indexes much above that and so
there is the momentum
Senator RTEGLE. I understand the momentum,
Mr. VOLCKER. The primary concern is that the rate will go up.
Instead, we have got to get it moving down. We are at a very
crucial juncture in that respect which adds to the urgency of
moving in all these directions so that we don't backtrack in terms
of that underlying rate but rather begin to get it moving down. The
danger is that it will move up; I think that's obvious.
Senator RIEGLE. If these other things were done, if we were to
move to reduce the deficit and restraint on the fiscal side, if we
were to move more aggressively on energy, I take it that you are
not ruling out at least a consideration of a price-wage freeze.
Mr. VOLCKER. I did not realize you were going that far. I am not
ruling out a look at that program of wage-price restraint.
Senator RIEGLE. You are not ruling it out?
Mr. VOLCKER. I am not ruling out looking at a freeze or a direct
control. I refer to reexamination of the situation which has to be
an ongoing process.
Senator RIEGLE. I know this is a sensitive area and it is sensitive
for all of us, but if we are in an emergency and we are going to
talk about doing a lot of things simultaneously and really breaking
the back of the inflation momentum, can you really leave out the
wage-price issue for very long? I know it is delicate and I know
everybody has to tip-toe when they talk about it.
Mr. VOLCKER. I would like to leave out controls. I have had a
certain amount of experience
Senator RIEGLE. I didn't say controls. The way the debate has
been phrased just within the last couple weeks by Barry Bosworth
and others is in terms of an effort to call for a freeze which would
be voluntary as a way to try to slow things down, but I'm only
raising that with you in conjunction as if these other steps—these
more basic steps were being taken at the same time.
39
Mr. VOLCKER. Let me make a comment that I may have made
before you came in this morning when there was some reference to
this matter. I have had a certain amount of direct experience with
a wage-price freeze when I was in the Treasury, as you recall. I'm
not sure the net result with that experience was entirely a happy
one. But among
DIFFERENT CIRCUMSTANCES
Senator RIEGLE. Well, the circumstances today and then are not
exactly the same either.
Mr. VOLCKER. But in some ways they were easier then. We didn't
have pressure on the economy. We thought the inflation was bad
then, but it wasn't. We could talk realistically about a freeze. Now
when you've got this much more inflation you've got another story.
But included among all the problems with controls are the administrative problems, the rigidities and so on that—talked about so
often and that I know not only from my own experience but from
the experience of other countries and from the experience of the
United States in the past—is the great danger that they are looked
upon as a means of avoiding all those other hard choices that
Senator Stevenson and others were referring to. Psychologically
I'm not sure it's healthy to think there's an answer in that area
when ultimately there isn't, certainly not without doing those
other things. Psychologically, it seems to me inconsistent to think
all we have got to do is wave a wand and impose a freeze and at
the same time take the other hard actions necessary.
Senator RIEGLE. Nobody is saying that. I hope I didn't pose the
question that way.
Mr. VOLCKER. You did not pose the question that way, Senator
Riegle. But I'm not sure the country as a whole is going to pose it
the way you posed it. The temptation is just overwhelming to think
that controls take care of the problem, that we can avoid all these
other difficult decisions that have been referred to here. If we try
to avoid those other decisions, the one thing certain is that's not
going to work; it's only going to complicate things and make them
worse. We have a lot of experience on this point. That was precisely the theory upon which I supported a freeze in 1971. What
happened? We blew it, because the other actions that were necessary to support the effectiveness of that action were not taken.
They weren't taken partly because we had that illusion of
protection.
Senator RIEGLE. What was our inflation rate at that time?
Mr. VOLCKER. Oh, 4 or 5 percent as I recall it.
Senator RIEGLE. Right. It was roaring ahead at 4 or 5 percent.
It's a lot different than 18 percent and we don't have the time now
to debate whether the fundamentals of the situation are——
Mr. VOLCKER. The problem is more urgent now. There's no question about it.
Senator RIEGLE. I think that gets back to the issue of whether if
we define the situation we're in as an emergency, whether that
may force us to have to broaden the debate. I grant you it's easy
for this debate to get politicized with coded phrases and makes it
very hard to have a serious policy discussion.
40
Mr. VOLCKER. I'm not thinking so much of political considerations in the partisan sense or the direct sense. It's just that I
think it's profoundly inconsistent to marshall the kind of public
support that's needed for these other measures and, at the same
time, say that controls are really an answer. That's my problem.
Senator RIEGLE. That's exactly right, but the difficulty is if you
do part of what's needed and not the rest, either way, if you just do
the monetary restraint and you don't do the other things that are
needed, or if you were to just do the price and wage effort and not
do the other things, you're probably destined for the same end. The
problem is you need to do a lot more than one thing at a time. You
need a comprehensive strategy right now. We don't have one.
Mr. VOLCKER. A comprehensive strategy is certainly a great assistance. Our only disagreement is whether or not holding out that
kind of a hope or prospect is damaging to putting together the kind
of comprehensive strategy that's really needed, fundamentally
needed. I think we do have a disagreement there.
Senator RIEGLE. Mr. Chairman, could I just ask if Chairman
Volcker could supply for the record any information that the Fed
has collected or analyzed with respect to areas that are being
damaged by the high interest rates at the present time? I'm thinking specifically of the housing industry, construction loans, and
small business, to the extent that that's been analyzed, if that
could be made available to the committee so we can see what your
evidence shows.
The CHAIRMAN. Very good.
Mr. VOLCKER. I'll be glad to do that.
[Chairman Volcker subsequently submitted the following information for the record of the hearing:]
SUMMARY OF DEVELOPMENTS IN CERTAIN SECTORS ESPECIALLY SENSITIVE TO
INTEREST-RATE CHANGES
Economic activity has been welt maintained since interest rates rose sharply in
the aftermath of the Federal Reserve policy announcements on October 6. Real
GNP in the fourth quarter advanced at a 2 percent annual rate. Moreover, production and spending have continued to advance in many sectors since the beginning of
the year; industrial production rose 0.3 percent in January, and there were sizable
gains in spending for consumer goods and business capital goods.
This is not to say that higher interest rates have had no impact on economic
activity—aggregate demand pressures likely would have been still stronger if the
Federal Reserve had attempted, at the cost of excessive monetary expansion, to hold
interest rates down. In response to your request, the paragraphs that follow summarize developments in certain sectors that typically are viewed as especially sensitive
to interest-rate changes.
Residential construction.—The most noticeable impact of the recent rise of interest rates has occurred in the housing sector. Interest rates on new commitments for
conventional home mortgages at savings and loan associations have increased more
than 2 percentage points, on a nationwide average basis, since October. Nonprice
terms of lending, such as downpayment requirements, also have tightened. A combination of lender caution and reduced demand for loans has been reflected in a
substantial decline in the volume of new mortgage loan commitments extended by
thrift institutions. Banks and other institutions also have tightened their terms on
construction loans, adding to the downward pressures on homebuilding activity.
While government support of various types (for example, government guarantees of
pass-through securities and Federal Home Loan Bank advances) has tended to
buttress mortgage credit availability compared to what was experienced in past
periods of monetary restraint, there has been a considerable drop in housing
demand. Sales of new and existing houses have declined, and prices have shown a
tendency to level off. Housing starts have fallen from around a 1.8 million unit
annual rate last spring and summer to a 1.4 million unit rate in January.
41
Autos.—The impact of higher interest rates on auto demand is difficult to disentangle from other forces operating on the sector—especially the 60 percent rise in
gasoline prices and concern about future fuel availability. However, total auto
sales—both imported cars and those built in North America—have been running
well below year ago levels, and credit conditions likely have played some part.
Extensions of consumer installment credit to purchase automobiles have fallen over
15 percent from the peak level of September 1979. Reflecting the higher costs of
funds to lenders, consumers have encountered higher interest rates, shorter loan
maturities, and, especially where usury ceilings are relatively low, some problems
with respect to credit availability. Dealers also have been finding it increasingly
expensive to carry their inventories.
State and local government.—In recent weeks, a number of state and local governmental units have called off bond issues as a result of the rise in interest rates. For
example, in February nearly $600 million of proposed bond issues were canceled or
postponed—about twice the average amount. In most cases, issues were withdrawn
because the offering agencies, exercising their discretion, decided that interest rates
were unattractive; in some cases, however, statutory ceilings prohibited financing at
prevailing rates. (Bonds issued by 19 states have interest rate ceilings and local
governmental units in 29 states have interest rate ceilings; not all of the ceilings are
binding at present.) Some state and local governments have removed or are planning to remove interest rate ceilings, which should increase their ability to tap the
bond market. However, historically, state and local units have frequently found
alternative means of financing planned outlays—for example, by drawing down
liquidity or through intra-governmental transactions—so that actual short-run financial impacts have been small. To date, it doesn't appear that higher interest
rates have significantly affected state and local spending.
Small businesses.—The Board's staff has made a special effort to monitor the
impact of recent interest rate increases on small businesses, focusing especially on
commercial bank business lending. The evidence suggests that high interest rates
have cut loan demand by small businesses. Although bank interest rates for larger
borrowers also have risen rapidly—indeed, apparently faster than for small firms—
the increase in rates perhaps has been more burdensome for smaller firms, since
these companies may have fewer financial resources and alternative credit sources
to fall back on. The non-rate terms of credit to small businesses also have been
tightened somewhat in recent months, but the firmer policies are about in line with
restrictions affecting large business borrowers. Many banks have instituted special
below prime base rates for small customers, and more generally banks have taken
account of the more limited flexibility small businesses typically have in their
finances and have made special allowances in setting loan terms.
The CHAIRMAN. Mr. Chairman, I have listened to you being lured
to say something nice about wage-price controls and I'm very critical of them and I must say—correct me if I'm wrong—you come
down absolutely against them under any circumstances at all,
flatly, completely? You're opposed to them? You think they have
no merit and you think if we did go the wage-price control route it
would simply be a way of avoiding taking the tough, serious, painful steps we have to take to combat inflation?
Mr. VOLCKER. That's my great fear, Mr. Chairman.
Senator RIEGLE. Pardon me? I didn't hear the answer.
Mr. VOLCKER. That is my great fear, that it would avoid taking
these other actions, Senator.
The CHAIRMAN. I want to get into that again in a minute. Before
I do that, I want to go back to the question of the Federal credit
programs. The President's budget for 1981 does contain a program
for controls on Federal credit programs, including the Eximbank.
This is the first time loan guarantees have been brought under
specific budgetary controls. However, some major activities are
excluded from this new system, including housing programs, some
agriculture and energy lending programs, and the activities of
Government sponsored agencies such as the Federal National
Mortgage Association (FNMA). It means at least half of all Federal
programs are still left outside any budgetary control system.
Do you think it's important to impose tighter controls on all
Federal credit programs? Should all of them be subject to budget
limitations in your view?
Mr. VOLCKER. Yes, but let me explain the answer. This is an area
that I also worked on for some time when I was in Treasury. I
think it's very useful and desirable and essential to have control
mechanisms in place in this area, and I think the administration
proposals are certainly a first step in that direction.
My only qualification when I say budgetary controls is that some
of these programs by their nature are in a kind of passive position
where the use of the program is demand determined. In some
cases, you may want to limit that, just be arbitrary and say you've
got to cut the program off at a certain amount; I think that's an
entirely appropriate response and the reason they should be
brought under control. There are some programs where that may
be less applicable, like the FHA.
The CHAIRMAN. Some programs should be and must be continued, regardless of any general need for credit restraint?
Mr. VOLCKER. Continuity is important to the programs. A classic
example is the FHA program: in some aspects you may control the
terms of the program and therefore control the demand, but you
don't want to cut it off in April just because they've used up all the
authorizations for the year.
The CHAIRMAN. I understand that, but my question is, Shouldn't
they all be brought under the same umbrella?
Mr. VOLCKER. They should all be brought under the same framework of control.
The CHAIRMAN. Do you think Congress should set an overall
limit on Federal credit activities as it now does on Federal spending?
Mr. VOLCKER. My answer really goes to that question. There are
some programs that are not very susceptible to an overall limit in
the same way you set a budget limit. In every program, direct
lending program where that's possible—and I think it's possible in
the Exim program for instance—it should be done. Some guarantee
programs, perhaps, are legitimately exempt, although even there
you can have targets.
The CHAIRMAN. I'm surprised at the response, because I thought
one of the great reforms we have enjoyed was the October 6 determination of limits on credit in the private sector. We are talking
about setting a limit on Federal credit programs, where I think the
case should be much stronger. Why not set an overall limit?
Mr. VOLCKER. I think we ought to do that in any area that's
susceptible to that kind of limit, which includes a good many of
those credit programs. We should also look at the other programs
and keep within reasonable bounds. All I'm saying is that we can
use the same technique of saying a program should not be above x
this year, but cutting off the program if you reach x in May, may
not be equally applicable.
The CHAIRMAN. You wouldn't let any program off the hook?
Mr. VOLCKER. No.
The CHAIRMAN. You wouldn't say ignore it and forget it?
43
Mr. VOLCKER. No. I would review them all.
The CHAIRMAN. So it would be proper to have limits on housing
programs as well as the others?
Mr. VOLCKER. Yes.
The CHAIRMAN. Now this committee will begin hearings on the
extension of the Council on Wage and Price Stability and a review
of our anti-inflationary policies, including proposals for mandatory
wage and price controls, next week. As you know, I'm opposed to
mandatory wage and price controls, but I think we need to review
our experience with controls carefully and debate them, because if
we don't they're going to be debated anyway and there may be
strong support for them on the floor of the Senate and House. I'd
like to know whether the Board has had its staff economists review
our experience with controls under President Nixon, including the
role played by the committee on interest and dividends. If such a
study is available, it would be very useful to the committee. If it
has not been done, I wonder if we could get a really serious review
from the Board in a relatively short period of time.
Mr. VOLCKER. I'm not sure what we have. Certainly we can see
what we have, but I would hate to promise you a——
The CHAIRMAN. You have an excellent economic staff and you
can give us a review even if it was fairly summary of the effect,
because there's been a lot of controversy about that. Some people
say the program under President Nixon wasn't as bad as some
people have argued it was and we'd like to get an expert, competent, dispassionate national analysis of what that program in 197173 achieved and didn't achieve.
Mr. VOLCKER. Let me see what we can do. I just hate to make
that promise if we have to start more or less from scratch and
don't have something pretty much in place already.
The CHAIRMAN. Give us what you can because we would like to
have something' in the next week or so.
OPEN MARKET COMMITTEE REPORT
The Full Employment and Balanced Growth Act of 1978 contains
detailed requirements of the Federal Reserve Monetary Policy Reports to Congress. It requires you to report your objectives and
plans with respect to the monetary and credit aggregates. Let me
emphasize that it says both monetary and credit aggregates. Yet
your report indicates that the Open Market Committee has established ranges of growth of monetary aggregates but not for any
credit aggregates. The Federal Open Market Committee only projected that bank credit expansion would be between 6 and 9 percent. That's a projection, not a range of growth adopted by the
Open Market Committee.
The question is this: The law requires that the Open Market
Committee report its plans and objectives with respect to monetary
and credit aggregates and you have only done this for monetary
aggregates. Why?
Mr. VOLCKER. The Committee prefers to focus on the monetary
aggregates, feeling that with the techniques we have that is more
directly susceptible to control. But, in doing that, we believe that
there is a relationship between those monetary aggregates and
44
credit growth. I think experience bears that out; the kind of credit
figure that you cited is felt to be consistent with the monetary
aggregates.
The CHAIRMAN. You're right about the Committee's interest and
the interest of the Congress. At the same time, the law requires the
credit aggregates and you haven't given them to us.
Mr. VOLCKER. We gave that to you in what you have interpreted
as a subsidiary way, which I suppose reflects a difference in focus.
But with those broader monetary aggregates you're just looking at
the other side of the balance sheet. You can look at the "1" figure,
for instance, where we also did not make a specific projection—or
even the M-3 figure, where you're looking at the liability side of all
the major financial institutions, so you begin to get a figure that
can't be very far out of line with the expansion of credit in the
economy too.
Now we have felt admittedly less certain about projecting a
precise credit figure, but there is a broad correlation between the
two.
The CHAIRMAN. But your inability to hit the monetary aggregates hasn't kept you from giving us the goal. In this case you
won't give us the range.
Mr. VOLCKER. I think it would be more difficult to meet a credit
target because this is less directly under our control, although
there is a close relationship between the two.
The CHAIRMAN. Well, I think you should take another look at it
because it seems to me the law is specific.
Mr. VOLCKER. We can look at it again.
The CHAIRMAN. I have one other question. I was happy to see
your economic report contains a set of economic forecasts. This
information is called the Federal Reserve's "Views About the Outlook for the Economy." It represents ranges that encompass the
judgment of the individual board members. Since the Open Market
Committee is the body that decides on the monetary policy plans
and objectives and the board members are only a subset of the full
Open Market Committee, I think it would be more useful to have
the outlook for the economy reflecting the voting membership of
the Open Market Committee, not just the board. Would it be possible to have that reported in subsequent reports?
Mr. VOLCKER. Yes. We do it this way because it was thought to
be more in accord with the language of the statute, but we can do
it either way. I would note, whichever way it were done, this year
most members of the Committee felt there was a good deal of
uncertainty in their own projections, and, as you can see, the range
of their individual projections is quite wide. It seems to me that
reflects the reality of the situation we are dealing with. There is a
of range of opinion and uncertainty about what the economy is
going to be doing. But we can do it the way that you're suggesting.
In fact, I gave the Committee that suggestion, but I was told the
law specifically asked for the view of the Board of Governors and
that's what we gave.
The CHAIRMAN. If in the future you'll give us the FOMC outlook
in addition—we would have the Board of Governors, of course,
since they're part of it.
Chairman VOLCKER. No problem.
45
The CHAIRMAN. Senator Heinz?
Senator HEINZ. Thank you, Mr. Chairman.
Chairman Volcker, I note in your testimony—and I apologize
that I wasn't here for the testimony and the questions and the
statements by my colleagues. We had an executive session of the
Select Committee on Aging, where we were defining our work
program for the year, which also met at 9:30, like so many committees.
When there's an opportunity—I note that in your statement you
suggest that now is not the time for a tax cut. This I assume you
would see as an unnecessarily stimulative reaction by the Congress
at this time. But there is something in the larger picture that
troubles me, and it is that, particularly during periods of relatively
high inflation, Government revenues, as measured as a percentage
of the gross national product, keep getting larger and larger and
larger.
We will be up to some 22¥2 percent, roughly, this year, in fiscal
1980—that is, fiscal 1981. And that does not take into account the
likely inflation rate. That's an estimate made by the administration of what seems to be an artificially low inflation rate.
And as you look into the years ahead, there are many additional
sources of Federal Government revenue. Over 10 years, the estimate of the Joint Tax Committee is that there will be roughly
three-quarters of a trillion dollars over 10 years in additional revenues from a combination of windfall profits tax, about a third of
that, and additional Federal income taxes, all of which adds up to a
pretty healthy figure, taking into account as well the inflation
reward to Government.
It seems to me that if the Government continually encroaches
into the productive capacity of the United States at an ever-increasing rate, that this in itself will pose different kinds of inflationary pressures. I'd like your thinking on how we should deal
with it, because on the one hand it's nice to say that we shouldn't
decrease taxes—actually, the question is not so much cutting taxes
as, it seems to me, how to hold the line on both spending and taxes
so we don't end up with a government that is today at 22 Va percent
of the GNP and when we wake up 5 years from now is at 32 Vk.
INFLATION BRINGS HIGHER TAX RATES
Chairman VOLCKER. My answer is very simple, Senator Heinz. I
agree with your basic analysis that inflation itself brings higher
tax rates. In terms of expanding the productive potential of the
economy, there is much that could be done and should be done in
reducing certain types of taxes anyway. That is indeed an urgent
problem.
Unfortunately, we have a deficit at this point, and all the earlier
conversation around this table has been in the direction of what
can be done to reduce the Government deficit. I think that's appropriate in terms of today's problem.
So the only conclusion I draw from your analysis, an analysis
that I share, is that it becomes even more urgent to maintain and
sustain control over expenditures. I see no escape from the proposi-
46
tion that you can only afford tax relief when the expenditures
situation permits it.
Senator HEINZ. Do you feel that there is a danger point past
which it would be a grave mistake to go in terms of Government
expenditures? Would it be possible to express that danger point in
terms of a percentage of the gross national product? Is that not a
sound way to express it, or not?
Chairman VOLCKER. It's a pretty crude way. As I suggested earlier, out of frustration in part, I would acknowledge that it may be
easier to maintain restraint when we have that overall kind of
projection in front of us. I am becoming more sympathetic to the
idea of Congress specifying as much as it can—I'm not talking
about a constitutional amendment—what that limit should be,
reaching a consensus on it, and just sticking within it.
The President, in the past I think, has talked to this point—to
some percent of the gross national product, if I recall correctly, as
being a reasonable outside limit.
What the particular figure should be—whether 20 percent or 19
percent or 21 percent or whatever—one man's judgment, I suppose,
is as good as another. One has the feeling that it's too high now, in
view of the productive problems of the country. In fact, you know
you'd like to see a figure much lower than that.
Senator HEINZ. In the hierarchy of ways to plow back what I will
call the inflation rewards to the Federal Government in increased
tax receipts, what would be, assuming that there were appropriate
limitations placed on spending, your priorities for the best way to
recirculate those tax revenues? Where would you cut taxes?
Chairman VOLCKER. Right now, given our problem at the
moment, the priority lies in reducing the deficit.
Senator HEINZ. Well, assuming
Chairman VOLCKER. Now, if you've got the budget into balance
and all the rest, I think that the priority should be measures that
do a combination of things. First, stimulate investment, which I
think has been falling behind the growth in the labor force and is
reflected in our productivity performance, which, of course, in turn
lies behind the prospects for real growth.
There is a question of what taxes might more directly impact on
costs than others. In view of our chronic inflationary process, I
think that's important to look at. And more generally and overlapping with the other two points, I think it's a question of incentives
at this point.
Senator HEINZ. Which kind of incentives?
Chairman VOLCKER. I think most urgent are incentives for investment, frankly. But I know that a more general case can be
made that high marginal tax rates for individuals affect incentives
as well. I see the question of more investment incentives the most
urgent part of that myself.
Senator HEINZ. In terms of either stimulating investment or
incentives for investment, there are a number of schools of
thought. Some people argue for a corporate rate reduction. Others
argue for capital cost recovery, 10-5-3.
What mechanism or general approach do you think is better?
Chairman VOLCKER. Frankly, I hate to get into that argument,
because I think an enemy of progress in this direction is the
47
argument about precisely which technique to take. I'd take almost
any of the ones that are discussed, if a consensus could be reached
behind it, because ultimately they all have somewhat similar impacts.
Having said that, I'm not at all allergic to the idea of concentrating, if that's where the consensus seems to lie, on depreciation
liberalization—and you can make a quite impressive case in terms
of its effectiveness.
Senator HEINZ. Now, the equation I learned in economics 101 is
savings equals investment in the national income accounts, and I
guess it hasn't changed much.
Chairman VOLCKER. I used to puzzle over that relationship for a
long time when I was studying economics. [Laughter.]
Senator HEINZ. I didn't say I understood it.
Chairman VOLCKER. I think it's true.
Senator HEINZ. How can we get more investment unless we get
more savings?
Chairman VOLCKER. What I learned not only in economics 101
but also 303, I guess, is that if you get the investment, you get the
savings, Now, that's not a full answer. But I tend to think that we
will get the investment with more certainty and swiftness if we put
the emphasis in tax reform on those things that most directly
affect investment decisions; and those actions generally produce
some increased savings in and of themselves.
But the economy will otherwise be able to generate the savings if
the investment incentive is strong enough. I tend to think this is a
matter of priority. A more diffuse measure to increase savings that
does not go directly to the investment decision itself is not as
effective. I think both kinds of measures have something to be said
for them, but as a matter of priority I'd go for the one which would
directly impact on the investment decision.
Senator HEINZ. Thank you, Chairman Volcker. I have one or two
more questions that I hope there will be time for. My time has
expired.
The CHAIRMAN. I want to recognize Senator Stevenson. I'm
through with my questioning.
Chairman Volcker very graciously agreed to come this morning.
We set a limit of 12 o'clock. That's why we scheduled it for 9:30. So
I hope that Senators Stevenson and Heinz can finish their questioning in 15 minutes.
Senator STEVENSON. Thank you, Mr. Chairman. I'll be brief. I
just have two areas.
First, to continue where Senator Heinz left off, taxes. How would
you feel about a reduction in the rates, income tax rates on unearned income, especially in view of what has happened in the
bond market?
Chairman VOLCKER. Here again, what we're talking about are
relative priorities. And we're getting into an area where I have—
recently, anyway—not sat down and tried to line up one measure
against another measure in terms of maximum effectiveness; and
that will vary depending upon the particular situation.
But my general view is the one I just expressed to Senator Heinz.
It is a matter of relative priority, no more than that. Tax action
that more directly impinges upon the investment decision is prob-
48
ably the first priority. I don't like to exclude these other kinds of
measures either. I think we've been very unkind to both our savings and investment process in our tax system for many years, so I
think that the whole gamut of measures needs a new look.
Senator STEVENSON. Well, I'm going to skip over those. In your
statement you addressed yourself to the nonmonetary, nonfiscal
complementary measures that you felt had potential. And most of
them deal with Government regulations, including policies which
protect industries from foreign competition.
We are reviewing COWPS, as Chairman Proxmire mentioned a
moment ago. One of the mandates of COWPS is to mandate Government policy, but it has never done so and it has not been
insulated from political and economic repression. You may recall,
when Barry Bosworth blew the whistle on a wage settlement, he
was promptly made a member of the five-member board of the
Council for the Coordination of Public Statements, chaired by the
Secretary of Labor. And when Fred Kahn blew the whistle on
Chrysler, which may be in one of the industries referred to in your
last category, everybody jumped all over him.
So one of the proposals has been to insulate COWPS from political and economic pressure. Give it the mandate, if it doesn't already have it, to review all Government policies and regulations,
put the spotlight of public opinion on the inflation and the consequences of those policies and, in doing so, finally put some pressure
to bear on the Congress, which otherwise goes along day-in and
day-out, yielding to every interest group and rarely to the general
interest in cost-effective regulation of the economy.
Now, I hate the institutional ways of getting to action. But in
view of our long record of nonaction, maybe we need something
like that.
How do you feel?
Chairman VOLCKER. Just hearing your view right now, I agree
with it.
Senator STEVENSON. I won't push that one further, then. [Laughter.]
One of your predecessors, Arthur Burns, perhaps in a moment of
weakness, suggested that the Council on Wage and Price Stability
also be given prenotification authority and the power to temporarily defer price and wage increases, in order to give it time to
investigate and possibly time to influence public opinion on unjustified price and wage increases.
How do you feel about those two proposals?
Chairman VOLCKER. I have not been particularly enamored of
them in the past, but I don't know as I would completely close my
mind to them. I'm not sure that that is a particularly central
problem right now.
Senator STEVENSON. Could you think about it some more before
these hearings, because there is legislation introduced that would
give COWPS prenotification authority. I'm not sure how it would
work, either. The fact of the matter is, it can demand and get
prenotification, which may be particularly important with respect
to wage increases.
Chairman VOLCKER. Let me think about it.
Senator STEVENSON. That would be helpful, plus the deferral
authority.
[The following information was subsequently received for the
record:]
49
B O A R D OF DDVEBNC.T5
OF THE:
FEDERAL RESERVE SYSTEM
W A S H I N G T O N . Q [1
JQCC
March 20, 1980
The Honorable Adlai E. Stevenson
United States Senate
Washington, D. C. 20510
Dear Senator Stevenson:
I am pleased to respond to your recent letter
requesting additional information in regard to matters
raised at the February 25 oversight hearing on monetary
policy.
With respect to the first matter you mentioned,
namely the composition of bank lending, I can report that
the Board, as part of its special credit restraint program,
has established a system of reporting that will permit us to
better assess the extent to which credit is flowing to productive uses as opposed to the financing of purely speculative
and economically unproductive undertakings. At this time,
however, we have no data that would permit any submission
for the hearing record.
Your letter also requested my views on S. 359, the
proposed "Inflation Review Board Act". It may be most useful
to comment on the proposals for prenotification and for deferral
of price and wage increases specified in the bill in the context of the voluntary standards tba!. we now have. As you know,
the President has announced that prenotification of wage and
price increases will be an integral part of the anti-inflation
effort, but the full details have yet to be worked out. In
any plan involving prenotification of price increases, there
could be benefits from informing a company in advance that it
was not complying with the standard, or from calling public
attention to the prospect of a violation. However, the value
of these benefits will be diminished somewhat by extra reporting
burdens and surveillance costs, and these costs could be substantial if companies were required to report in advance their
planned price increases for individual products and services,
50
as is proposed in S. 359. it seems to me more useful and
less burdensome to limit prenotification requirements to
the average price adjustments planned for a company's various
products--a procedure that would be consistent with the current reporting requirements specified by COWPS.
On the wage side, I might simply note that prenotification of proposed settlements in the collective bargaining
sector co-aid seriously disrupt the bargaining process. Furthermore, knowledge of the various offers and counter-offers
would provide little information of ultimate value to the
monitoring agency. Kith negotiated agreements, it seems
adequate to require immediate notilication of the details
of a tentative settlement once it is reached so that compliance could be determined prior to membership ratification,
Granting COWPS or some similar agency the authority
to establish an effective mechanism for temporarily deferring
wage or price increases would clearly be a step in the direction of mandatory controls; which the Administration has
already disavowed.
I concur in their opposition to mandatory
controls, and I am skeptical that deferring wage and price
increases would significantly reduce inflationary pressures.
Indeed, such deferrals would carry the risK of creating the
sorts of distortions and dislocations that outright controls
can cause—with the possibility of producing ultimately
greater wage/price pressures.
Sincerely,
51
Finally, you mentioned in these nonfiscal, nonmonetary subjects,
legislation that tends to ratchet up wages at the expense of employment. What did you have in mind here?
MINIMUM WAGE LAW COUNTERPRODUCTIVE
Chairman VOLCKER. I really had two kinds of things in mind,
both of which I'm sure are quite familiar to you and raise the kind
of problems you alluded to earlier. First, it does seem to me a
mistake, particularly in this kind of environment, to, in effect I
suspect, price out of the market some of the younger and less
privileged people coming into the labor force by the way we operate the minimum wage law.
Even if you think the minimum wage law is a good thing, pushing up the minimum wage as it applies to the youngest and least
experienced as fast as we have pushed it up seems to me counterproductive, both in terms of inflation and in terms of employment.
And one of the things that is rather obvious, of course, in those
unemployment figures is that more and more unemployment is
concentrated among the young and the least privileged- There are
many reasons for that, but I think we've aggravated the problem
by the policies in that area.
The other area that I think has been important is the kind of
policy incorporated in the Davis-Bacon Act, the Government Services Contract Act, and the like. It does not have the justification it
may have had in the Depression and yet continues to spread.
Senator STEVENSON. You would support an exemption for the
youth?
Chairman VOLCKER. Yes. I wish somebody would look at that
other legislation.
Senator STEVENSON. Davis-Bacon?
Chairman VOLCKER. It's an old story—Davis-Bacon and the Government Services Contract Act. These attempt to create conditions
where high-wage companies set the pattern.
Senator STEVENSON. There were efforts last fall. Once again,
there are very few of us who supported that.
Chairman VOLCKER. All I can do is bring it up again, in the spirit
in which Senator Riegle was speaking; that is, that when you're
making a comprehensive attack on many problems, you've got to
forget about some of those earlier decisions.
The CHAIRMAN. Senator Heinz?
Senator HEINZ. Yes, Mr. Chairman. I'll be brief.
Chairman Volcker, it seems to me that a major tool to combat
inflation, which we were touching on earlier, dancing around the
edges of, anyway, would be to channel some of consumer spending
into consumer saving. This would appear to be something of a
chicken and egg proposition, though, because it's hard to see how
money will flow into savings rather than spending, and particularly into savings accounts, until rates are competitive with market
yields. Therefore, until regulation Q is changed and probably
phased up and out, therefore, how can we encourage more individuals to save in financial institutions rather than spend?
Chairman VOLCKER. The obvious answer to that, by far the most
important answer, is begin to get these inflationary expectations
52
under control. The savings rate has declined to the lowest level in
history—postwar history, anyway. The only time it was lower was
in the middle of the depression and, for one quarter, I think,
during the Korean war period.
Broadly, the explanation seems to me clear enough: The lack of
productivity in the economy has been squeezing real income, which
tends to reduce the savings rate. Also, the fears of inflation decrease the savings rate. So when you're talking about increases in
savings, far more important than any specific measure that can be
taken, I think, is to attack those broad problems of inflation and
productivity.
This legislation to exempt savings from taxes does not, in contrast, seem to me to be a particularly productive approach. It loses
more revenue than we can afford at this point.
Senator HEINZ. Well, I wasn't coming around to that. I was
really examining regulation Q as the controls, in a sense, the price
controls, controls on the price of money that financial institutions
pay to savers.
You, yourself, in your statement, say we can move to eliminate
the impediments to competition still imposed in some industries by
Government regulation. Well, at least insofar as the consumer is
concerned, the biggest economic regulation that is going on in
terms of any price I'm aware of, that they face every time they
look at their passbook account, is the price controls on money that
the Fed and others set.
I mean, don't you feel you should be, if you're advocating deregulation of trucking or railroads—isn't what's good for the goose good
for the gander?
Chairman VOLCKER. Yes. My answer is that, partly at the prodding of this committee and others, we have moved a very long way
in that direction. The limiting factor on the speed of that movement is the extent to which financial institutions with an asset
structure built into their operations from earlier years can adjust.
Senator HEINZ. I think we're all aware of the difficulties many of
those institutions have, and I just want to make sure that we have
you on record as to direction, not necessarily as to pace.
Chairman VOLCKER. I think that's the only restraint on the speed
with which we're moving.
Senator HEINZ. Very good.
HOUSING PRODUCTION DEPRESSED
My last question is: As you know, housing production appears to
be becoming quite depressed, and many argue that because housing
is so interest rate sensitive, that it bears an excessive burden when
restrained monetary activity increases interest ratesDo you think it is or would be inflationary for the Federal
Government at this time to provide additional housing stimulus in
the form of purchasing or making available several billion dollars
of mortgage purchase authority at below-market interest rates, as
has been proposed by the Brooke-Cranston legislation and the
Emergency Home Purchase Assistance Act?
Chairman VOLCKER. It's all a matter of degree, timing, and
amount.
53
Senator HEINZ. Was this subject brought up at all? I didn't mean
to go over the same thing.
Chairman VOLCKER. I will just repeat very briefly my general
answer. With disproportionate effects occurring on particular sectors, I don't think I can sit here and say that no moderating action
is feasible, possible, or desirable. But, obviously, you don't want to
charge in and try to offset the whole thrust of restraint. You're just
pushing it on somebody else and it doesn't work.
But when you have an industry that may be particularly on the
end of the whip, as I expressed it earlier, I think some action to
moderate the sharpest edges can, in some circumstances, be justified and not inconsistent with the whole plan.
Senator HEINZ. How large an inflationary penalty is there for
doing that? Obviously, any intervention probably, given the state of
our economy at the present time, implies some kind of inflationary
penalty. I mean, is there a significant inflationary penalty, or is it,
in your judgment, relatively insignificant?
Chairman VOLCKER. I would think that would depend upon the
analysis of a particular situation. If housing, for instance, fell
sharply even from its present level—which is down but not down so
far as it's gone in the past—you could make an argument that to
some degree maintaining a certain level of activity in that industry
is not at all inconsistent with an attack on inflation over time.
You don't want to close down a whole industry and then have to
build it up again as soon as money becomes more freely available.
Senator HEINZ. Just one very brief comment or question, and
that is: The Federal Reserve is quite respected for its economic and
analytical capability. That doesn't necessarily mean you're that
much righter than anybody else.
Chairman VOLCKER. I agree with both comments.
Senator HEINZ. We unfortunately know it's all a low base of
comparison. But, having said that, would the Fed be in a position
to analyze a specific proposition at a specific point in time as to
whether, let's say, Brooke-Cranston, if invoked in a certain amount
at a certain time, the extent to which that would have an inflationary impact?
Chairman VOLCKER. I think we would do that in the ordinary
course of our business.
Senator HEINZ. Thank you very much, Chairman Volcker.
Thank you, Mr. Chairman.
The CHAIRMAN. Thank you.
And thank you very, very much, Chairman Volcker, for excellent
testimony. We're in your debt.
Tomorrow at 10 o'clock, we have four monetary experts who will
comment on the monetary policies of the Fed. We will meet in this
room at that time.
Thank you, Mr. Chairman.
[Whereupon, at 12 noon, the committee was recessed, to reconvene at 10 a.m. on February 26, 1980.]
[Additional material ordered inserted in the record follows:]
54
For use at 10a.m.,
February 19. 1980
Board of Governors of the Federal Reserve System
Monetary Policy Report to Congress
Pursuant to the
Full Employment and Balanced Growth Act of 1978
February 19, 1980
Letter of Transmittal
BOARD OF GOVERNORS OF THh
FEDERAL HESERVE SYSTEM
Washington, D.C , February 19, 1980
THE PRESIDENT OF THE SENATE
THE SPEAKER OF THE HOUSE OF REPRESENTATIVES
Sinci'iely.
Paul A. Volckei, Chairman
TABLE OF CONTENTS
Page
Chapter 1,
Federal Reserve Policy and the Outlook for 1980
Section 1. The Objectives of Monetary Policy in 1980
Section 2. The Growth of Money and Credit In 1980
Section 3. The Outlook for the Economy in 1980
Section 4. The Administration's Short-term Economic
Goals and the Relationship of the Federal
Reserve's Monetary Objectives to those Goals
Chapter 2.
A Review of Recent Economic and Financial Developments
Section 1. Overview of Developments
13
Section 2. Economic Activity in 1979
15
Section 3. Prices, Wages, and ProductiviCy
32
Section 4. Labor Markets
37
Section 5. Domestic Financial Developments
40
Section 6. Foreign Exchange flarkets and the Dollar
51
Appendix A
Description of the Newly Defined Monetary Aggregates
Appendix B
Description of the New Procedures for Controlling Money
56
CHAPTER 1
FEDERAL RESERVE POLICY AND THE OUTLOOK FOR 1980
SECTION 1.
THE OBJECTIVES OF JIOHETARY POLICY IK 19SO
Frequent!:, in the past Che decisions about stabilization policy
seemed—perhaps sometimes mlsleadlngly—to come down to a choice of how
strongly to encourage recovery or to retard expansion.
face a much more complicated set of circumstanc.es today.
Decision-makers
For some time now,
most forecasters have suggested that the economy Is on the verge of recession,
but the recession has not appeared.
tinued apace.
Over the same period Inflation has con-
The outlook for the economy remains obscured by major uncer-
tainties, ranging from the possible economic e f f e c t s of current International
tensions and the prospects for world oil prices and supplies to the attitudes
of investors around the world toward the dollar am' tlic threat that inflation
may bring increasing distortions of traditional spending and saving patterns.
It is not within the powers of monetary and fiscal policy ro resolve all of
these uncertainties and to ensure a fully s a t i s f a c t o r y econoraic performance.
Nonetheless, the appropriate direction for policy is clear. The
greatest contribution the monetary and fiscal authorities can make Is to impart
a sense of long-range stability in policy and In the economic environment.
In
present circumstances, that requires an approach that provides assurance that
the momentum of Inflation will be arrested.
Inflation not only represents
an imminent threat to the sustainabillty of the current business expansion,
but It also lies at the heart of many of the longer-range problems of the
economy, such as the inadequacy of business capital formation, and the related
declines in the productivity and real earnings of American workers, ard the
vulnerability of the d o l l a r in foreign exchange markets.
57
-3-
ttonetary policy clearly has a m a j o r role tn play in the restoration
of price stability.
Regardless of the source of the Initial impetus, I n f l a t i o n
can be sustained over the long run only if the resulting higher level of dollar
expenditures is accommodated through monetary expansion.
The Federal Reserve
is determined not to provide that sustenance, but will adhere Instead to a
course, in 1980 and beyond, aimed at wringing the inflation out of the economy
over time.
If recessionary tendencies should develop during 1980—as many
expect—the steady anti-inflationary policy stance represented by c o n t i n u i n g
restraint on growth in the supply of money and credit would be consistent
with an easing of conditions in financial markets, as demands for money and
credit weaken.
That would provide support for economic activity, and would
help assure the avoidance of a cumulating, deepening downswing.
If, on the
other hand, Inflationary pressures mount, a policy of restrained growth in
money and credit would lead to greater t a u t n e s s In financial markets, thereby
damping the expansion of aggregate dt?tn<inJ.
In any event, prospects
for
dealing with the inflation problea without serious economic disruption will
be materially enhanced if other elements of government also exhibit a firm
a n t i - I n f l a t i o n a r y commitment and if workers and management recognize that
a moderation of their wage! demands and pricing policies Is In their own
long-range Interests as well as those of the nation as a whole.
58
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SECTLGH 2.
THE GRO\)TR OF HONEY AND CREDIT IN 1980
At its meeting earlier this m o n t h , the Federal Open Market Committee
established
ranges of growth for the monetary aggregates that it believed,
in light of the prospects for fiscal policy and for private demands, would
impose appropriate restraint on inflationary f o r c e s in 1980.
Measured from,
the fourth q u a r t e r of 1979 to the fourth q u a r t e r of 1980, the ranges are: for
H-1A, 3-1/2 to 6 p e r c e n t ; for M-1R, 4 to 6-1/2 p e r c e n t ; for H-2, 6 to 9 perc e n t ; and for M-3, 6-1/2 to 9-1/2 percent.
These ranges are based on the
newly adopted d e f i n i t i o n s of the monetary aggregates; a d e s c r i p t i o n of t h i s
r e d e f i n i t i o n , which was announced on February 7, is i n c l u d e d in A p p e n d i x A
to this report.
The FOMC also projected that bank, credit will expand between
6 and 9 percent d u r i n g the c u r r e n t year.
The FOMC's ranges indicate the Federal Reserve's intention to seek
an appreciable slowing of monetary expansion from the rates observed in 1979,
and thus to move toward n o n - i n f l a t i o n a r y r a t e s of growth.
The deceleration
is especially marked in the case of the narrower aggregates.
The midpoint of
the range for M-1A, for instance, is 4-3/4 p e r c e n t ; in 1 9 7 9 , M-1A increased
5.5 percent.
The d i f f e r e n c e between these two f i g u r e s a c t u a l l y u n d e r s t a t e s
the degree of deceleration in economic terns, however, since Che a d j u s t m e n t
of the public to the i n t r o d u c t i o n of ATS and few York S t a t e NOW a c c o u n t s
probably reduced the growth of M-1A last year by roughly 1-1/4 percentage
points as funds were t r a n s f e r r e d out of existing demand deposits to s u c h
accounts.
In setting the range for 1980, the FOMC assumed, in the context of
present law, that the public's adjustment process is about completed, and that
such s h i f t i n g from demand deposits to ATS and HOW accounts will have little
59
-5-
f u r t h e r impact on M-JA this year.
Of course, if NOW accounts were authorized
on a nationwide basis, some downward adjustment of the present n-lA range
could he needed in order to take account of the accelerated s h i f t out of conventional demand deposits that might result.
The range for H-1B—which includes checkable interest-bearing
deposits in addition to currency and demand deposits—also implies a substantial slowing; the mid-point of the range, at 5-1/4 percent, is well
below the actual
8
percent expansion in 1979.
Of course, because ATS
and NOW accounts are included in M-1B, the expansion in 1979 was enlarged
by one-time t r a n s f e r s from regular savings deposits and probably other
assets to the newly o f f e r e d transactions accounts—the reverse of the
experience with 11-1A.
For similar reasons, enactment of nationwide NOW
account legislation would be expected to raise the growth of this money
stock measure this year, and the present range would have to be reconsidered
in that light.
M-2 likely would not he a f f e c t e d i m p o r t a n t l y by HOU account legislation, since it encompasses the major categories of assets that are close
s u b s t i t u t e s for MOW accounts.
Besides ft—IB, ?l-2 includes savings and small
denomination time deposits at commercial hanks and t h r i f t i n s t i t u t i o n s , plus
certain other highly liquid instruments—namely, money market mutual fund
shares, overnight repurchase agreements, and overnight Eurodollar deposits
at Caribbean branches of U . S . banks.
The recently introduced 2-1/2 year
c e r t i f i c a t e , which has no specified minimum denomination and carries a ceiling rate close to that on Treasury notes, should serve to bolster growth of
small time deposits.
remain popular.
Six-month money market c e r t i f i c a t e s likely also will
Nonetheless, absent a steep decline in market interest
60
rates, the total of interest-bearing deposits subject to federal rate ceilings
probably will continue in the months ahead to grow slowly by historical standards-
However, growth of M-2 should be buoyed in 1980 as in 1979 by sizable
flows into the money market funds-
On balance, the prospect is that M-2 this
year will grow at a rate somewhat below the 8.8 percent increase of 1979.
The final monetary measure, M-3, includes, in addition to M-2, large
denomination time deposits of $100,000 or more and term (more than one-day)
RPs at banks and t h r i f t institutions.
It is thus a very broad aggregate,
encompassing most of the liabilities of the depositary institutions plus money
market mutual funds.
Given the moderation of demands for credit —especially
at commercial banks — anticipated for the current year ( M-3 appears likely to
grow less than the 9.5 percent increase recorded in 1979.
It should be emphasized that, although we view these new monetary
definitions as better measures of financial behavior today than the old
definitions, the institutional framework is changing rapidly, and this Implies
an inevitable uncertainty about the behavior of any monetary aggregate.
Further
more, the Committee recognizes that other aspects of financial and economic
developments will require careful monitoring In the process of policy determination and implementation.
The ranges specified for the monetary aggregates
appear adequate to the Committee to provide the necessary degree of flexibility.
61
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SECTION 3.
THE OUTLOOK FOR THE ECONOMY IN 1980
It is never an easy matter to project the course of the economy,
but the current circumstances pose exceptional difficulties for forecasters.
Aside from the uncertainties associated with International political tensions,
we find ourselves In an economic environment characterized by historically
high rates of interest and inflation, so that past experience may provide only
a limited guide to prospective behavior.
In order, though, to give the Congress
an indication of the Federal Reserve's vlevs about the outlook for the economy,
the Board of Governors has assembled in the table, below, ranges that encompass
the Judgments of Its
Individual members about the most likely outcomes for
several key variables.
Change from fourth quarter to
fourth quarter, percent
Nominal GNP
Real GNP
Implicit price deflator
9.9
0.8
9.0
7-1/2 to 11
-2-1/2 to 1/2
9 to 11
Average level in fourth quarter
Employment (millions)
Unemployment rate (percent)
97.7
5.9
97 to 98-3/4
6-3/4 to 8
13.2
8-3/4 to 12
Annual rate of change in f o u r t h
quarter, percent
Consumer Price Index
The Board members' projections, it must be emphasized, rest on certain Important assumptions.
It IB, for example, assumed that, although the
cost of imported oil may rise moderately f u r t h e r over the coutse of this
year, there will not be a repetition of the 1979 price run-up and fuel supplies
62
will not be disrupted.
It Is also assumed that overall federal spending in 1480
will generally be in line with the Administration's current f o r e c a s t and t h a t
there is no federal tax cut.
As can be seen, even with these common assumptions, the rang^ of
probable outcomes is relatively wide.
Even so v there is recognition that,
while considered less likely, the actual outcomes could fall outside of the
indicated ranges.
Such is the nature of the uncertainties in the economic
outlook at present.
Most members of the Board believe that a downturn in activity ie
likely sometime in I960-
Production cutbacks In the auto sector and a d r o p
in residential construction a c t i v i t y already have occm r e d ; meanwhile, a
rising oil
import bill continues to act as a drag un n, <• .-,it demand.
With
these depressants on employment and income growth, r.nrisumei; sj.Aiding is
expected to slacken in the months ahead.
It is like]y thru ri.e t i g h t e r
consumer and Mortgage credit conditions now existing and the already high
debt obligations of households will encourage some recovery in the abnormally
low personal saving rate in coming quarters.
The weakening of consumer
demand would also tend to damp plant and equipment spending as s o f t e r m a r k ^ L s
tend to deter businesses from outlays that would add to excess p r o d u c t i v e
capacity.
Net exports might rise somewhat, however, owing to the impact on
import volume of the weakness in domestic spending and production.
In the labor markets, employment may be f l a t this ye^r, and c o u l d
well decline somewhat In the goods-producing sectors.
At the same time, the
growth of the labor force probably will slow, r e f l e c t i n g in part the reduced
growth of the working age population but also the usual cyclical response to
63
slA-:k detipnd fur workers. The unemployment rate, which turned upward last
mrt-n-h, I B l i v e l y to remain in an uptrend over the remainder of the year.
Evev 1 n Rnch an ?_ci?Ti-3n>ic environment, progress In reducing inflation
(.HI. 1 >i? d<? 1 .3"?d.
Indeed, in the f i r s t q u a r t e r , the rise of the Consumer Price
Ind?y r.nulrf sc.cel.err te, owing in large measure to the latest round of oil
flj-f-a *^cr^s?s t^d tf> the lagged impact on the index of the rise in mortgage
rf>t°-= i_ 3 R f f j , n .
Thr^'iRhiut the coming year, wage demands will reflect
eff-rt.s of wprk?r^ t:o catch up with past Inflation, and pressures on unit
jfihn-- -^ts vr.jy be I n t e n s i f i e d by cyclical weakness in productivity.
Energy
pTMr*-: r"MMv wi]l continue to rise rapidly, as recent increases In OPEC
pT-jr-pc orn p^^cpH t-hroupT! to consumers and as domestic gas and oil markets
are gradu^l.V' freed froii controls.
S^^l^]H a.->r;rebate demand prove relatively strong, as some think
pr%e<Hhir., -tTif.l:i?l<ina.rv pressures across the economy could prove more persistent.
For "ysTnlo, it must he recogni?. a d that any substantial Increase
jr- Alfonso Rnpri-Hno beyond what alre-'dy f s contemplated in the Administrat ' f i i ' c M-it-at: rrni]H slanificantly alter the economic outlook.
The lag between
a(..1-v.*,-* n a t i o n qpH jar-.tual federal outlay may bp quite long In the case of
mil •* tj»rv harHw^re, hut exnoc'-attonal impacts on employment, production, and
p-r-iv^t 0 ^r^^dlt'p "an pmetp^ f a l r l v nui^klv.
64
-10-
SECTION 4.
THE ADMINISTRATION'S SHORT-TERM ECONOMIC GOALS AMD THE
RELATIONSHIP OF THE FEDERAL RESERVE'S MONETARY OBJECTIVES
TO THOSE GOALS
The President's Economic Report, submitted to the Congress last
month, lays out the following short-term goals for the economy:
1980
JJ8L
Change from fourth quarter to
fourth quarter, percent
Real GNP
Consumer prices
Real disposable income
Productivity
-1.0
10.7
.5
-.3
2.8
8.7
1.1
1.3
97.8
7.5
51.7
/.3
Average level In fourth quarter
Employment (millions)
Unemployment rate (percent)
These goals, the Economic Report Indicates, should be viewed ,•-- forecasts
rather than as indications o£ the Administration's desires.
The Administra-
tion expects a raild recession, not lasting much past the middle of 1980.
recovery then begins and carries through 1981.
A
The Consumer Price Index
rises much less rapidly this year than in 1979 (when it increased 13.3 percent), largely in reflection of an expected slowing in the rise of energy
prices and of home purchase and financing costs.
A broad price measure less
affected by these special factors, the implicit GNP deflator, is projected to
rise 9 percent in 1980, the same as in 1979, and to slaw only tr> 8.6 percent
in 1981.
There is no apparent incompatibility between the Federal Reserve's
1980 monetary growth ranges and the economic forecast of the Administrntion
for 1980.
The Administration has projected a rise in nominal GNP of about
65
8 percent; this figure Is well within the capacity of the FOMC's monetary
ranges to finance.
With regard to the more distant f u t u r e , the pattern of developments
that appears likely this year would seen to be consistent with the resumption
of moderate expansion in economic activity In 1981.
However, the chances of
sustaining an advance over time would be greatly enhanced, in an environment
of continued monetary restraint, if there were greater progress in reducing
Inflationary
cast.
pressures than is suggested by the Administration's price fore-
Such progress would depend on, among other things, continued fiscal
prudence, moderate wage and price behavior hy labor and business, an improved
productivity performance, and maintenance of a strong dollar on exchange
markets.
66
CHAPTER 2
A REVIEW OF RECENt ECONOMIC AND FINANCIAL DEVELOPMENTS
SECTION 1.
O V E R V I E W O F DEVELOPMEHTS JN_1979
One year ago, the Federal Reserve reported to the Congress, as
required by the Full Employment and Balanced Growth Act, Its objectives for
1979.
The Board indicated that, In light of growing pressures on resource
availability, a moderation in the rate of economic expansion was essential
if
inflationary f o r c e s were to be contained.
The pace of price advance had
already accelerated over the preceding year, and it was recognized that if
this tendency toward f a s t e r inflation was not reversed the progress that
had been achieved by the November 1, 1478, program to b o l s t e r the dollar on
foreign exchange markets would be jeopardized and the dangers of serious
economic disruption would be heightened.
Consequently, at its
February
meeting, the Federal Open Market Committee had set growth ranges for the
majof monetary aggregates t h a t would be consistent with reasonable r e s t r a i n t
of demands for goods and services in the ecunomy.
The f i r s t half of 1979 saw a number of u n a n t i c i p a t e d , negative
developments.
Economic a c t i v i t y was depressed by inclement weather, by
labor disputes, and by gasoline shortages.
More critically, foreign oil
producers posted d r a s t i c price increases, giving added impetus to i n f l a t i o n
and draining income fvoc the U.S. economy.
In this environment, the ttoard
reported in July that there appeared a significant threat of a mila recession
in the months ahead.
slowing of inflation.
It also noted that there was little hope of a near-term
Under these circumstances, the Federal Open bucket
Committee reaffirmed the previous monetary aggregates ranges at it= July
meeting.
67
-14Aggregate demand actually proved stronger than generally expected
in the second half of 1979, largely because consumers displayed a surprising
willingness to spend, reducing their rate of sawing to an extraordinarily
low level.
Real gross national product rose moderately, and the overall
unemployment rate remained stable.
Inflation, as measured by the implicit
GNP deflator, d i d n ' t abate, but neither did it accelerate, as labor costs
and food prices behaved somewhat more favorably than anticipated.
Taking 1979 as a whole, monetary expansion was broadly consistent
with the FOMC's objectives—with the major money stock measures falling close
to or within the upper halves of the Committee's announced ranges.
Meanwhile,
real GNP growth was somewhat less rapid and i n f l a t i o n somewhat more rapid
than might hav^ been expected last February.
Energy supply and price develop-
ments provide much of the explanation for this adverse mix of output and
i n f l a t i o n ; they also represent a major peril to the satisfactory performance
of the economy in 1980.
Indeed, more secure energy supplies and control of
inflation are necessary conditions for the longer-range progress of our
economy, and must remain priority matters for public policy u n t i l they are
achieved.
68
-15SECTION 2.
ECONOMIC ACTIVITY IN 1979
Economic activity registered only a small gain last year, following
almost four years of brisk expansion.
Real gross national product increased
about one percent over the four quarters of 1979; Industrial production rose
a bit early in the year, but then edged o f f , finishing the year just marginally above the December 1978 level.
Two fundamental factors exerted.a per-
vasive damping influence on aggregate private demand: a near doubling of the
average cost of Imported oil, which drained income to foreign producers and
exacerbated underlying Inflationary pressures, and a posture of increasing
restraint on the parts of monetary and fiscal policy to contain those pressures and to prevent a worsening of long-range price trends.
While these factors were tending to moderate growth of output and
expenditure throughout the past year, quarterly movements in activity were
importantly influenced by a series of unexpected shocks.
In the winter
months, unusually severe weather in many parts of the nation depressed
activity In several sectors.
In the spring, real GKP declined appreciably
in response to strikes that disrupted production and transportation and to
shortages of gasoline.
As the strikes ended and gasoline lines disappeared
In the summer, activity snapped back smartly, especially in the retail sector where auto sales were boosted by price incentives offered by dealers and
manufacturers In an e f f o r t to cut back inventories.
Real GHP growth slowed
again in the final months of the year, as the special elements of strength
in the third quarter dissipated and the basic restraining Influences in the
economy dominated.
69
-16-
Real GNP
Change Irom previous period, annual rate, percent
1975
1976
1977
1978
1979
Real GNP and Major Sectors
Percent change, Q4 to O4
Persona)
Consumption
Expenditures
70
-17Arnong the major sectors of the economy, the greatest weakness
during 1979 was in residential construction and consumer durables.
This
pattern Is typical of periods when aggregate activity levels o f f , particularly
when there is a tightening of financial markets, ae there was last year,
in
1979, however, the softness of spending on consumer durables was exacerbated
by tne e f f e c t s of gasoline price and supply developments on the demand for
automobiles.
Consumer spending on other Items proved quite robust, and total
personal consumption expenditures rose even though real disposable income was
virtually f l a t .
Business fixed investment, which normally lags cyclical turn-
Ing points, posted, a small real gain in 1979; st the same time, perhaps because
an economic slowdown was widely anticipated, firms maintained a tight rein on
stocks, and despite the problems of the auto sector, inventory accumulation
was reduced over the year.
Governmental outlays were f l a t In 1979, reflect-
ing at least partly public sentiment for restraint on taxes and spending.
The one major area of strength was the international trade sector; In constant
dollar terms, the net export balance grew substantially as a result of the
relatively Easter expansion of foreign economies and the continuing e f f e c t s on
exports and imports of past exchange-rate changes.
Personal^ CQJISumption Ejcpendltures
Real consumer outlays grew 1-1/2 percent during 1979, compared with
a 4-1/2 percent gain during 1978.
Underlying the weakness in consumer spend-
ing vJas a still sharper deceleration In real disposable income, which rose
only 1/4 percent during 1979 a f t e r rising 4-1/4 percent In the preceding year.
Growth of nominal Income slowed s i g n i f i c a n t l y , and household buying power
was f u r t h e r eroded by accelerating Inflation and by the rise in tax burdens
71
D Real Personal Consumption Expenditures
n Real Disposable Personal Income
Change from previous period, annual rate, percenl
n
1375
1976
1977
1978
1979
Percent
197c
1976
1977
1978
Household Debt Repayment Relative to
Disposable Personal Income
1975
1976
1977
1978
Pe-cent
72
-19related to higher social security taxes and to the interaction of Inflation
and a progressive income tax.
All of the advance in real consumer spending occurred in the second
half of the year when the saving propensities of households f e l l to historically low levels.
The personal saving rate in the f o u r t h quarter was about
3-1/4 percent—one percentage point less than the previous post-Korean War
record low.
The rise in consumer spending a f t e r mid-year was to sorae extent
a rebound from the weak second q u a r t e r , when gasoline shortages had disrupted
normal spending patterns and cut demand for large fuel-inefficient cars.
In
response to falling sales and excessive inventories, domestic automobile producers instituted major sales promotion campaigns in the third quarter and
again near the end of the year.
As a result, sales were boosted noticeably;
indeed, the higher selling rates may well have involved some "borrowing" from
future periods.
Consumer sentiment, as measured by opinion surveys, began to deteriorate in 1978 and worsened in 1979, reaching levels that in the past have been
associated with recessionary periods.
Previous experience with these surveys
suggests that there should have been a cyclical downturn in consumer spending.
That such a decline did not occur appears at least partly attributable to the
strength of inflationary expectations, which encouraged a buy-in-advance mentality.
In the latter part of the year, however, consumers began to exhibit
less eagerness to purchase durable goods in anticipation of future price
increases and to show greater concern about high interest rates and lessened
credit availability.
Given the already reduced liquidity of Che household
sector associated with further heavy borrowing in 1979, a turn coward somewhat more cautious spending patterns would not be at all
surprising.
73
-20Res^tdentlal ConsEruc^cion
Expenditures for residential construction, In constant dollars, fell
about 8 percent in 1979; given the magnitude of the rise in Interest rates over
1978 and 1979, this is a modest decline by historical standards.
The demand
for housing was sustained by underlying demographic trends—including substantial population migration and rapid household formation—and by the growing interest in homes as an Investment and as an inflation hedge.
The combined
e f f e c t s of rising house prices and mortgage interest rates caused the monthly
carrying costs of homeownership to climb steeply, hut buyers were willing
to devote an increasing share of their income to housing.
At the same time,
the potentially disruptive effects of rising market interest rates on mortgage
credit availability were considerably ameliorated by such institutional developments as the Improved ability of t h r i f t Institutions to compete for lendable
funds, moat notably through Issuance of 6-raonth money market certificates,
and the Increasing use of mortgage-related securities.
Private housing starts averaged 1.8 million, at an annual rate,
during the first three quarters of .1979, down from the 2.1 million pace in
the latter part of 1978.
Starts fell to about a 1.5 million rate In November
and December, however, When the terms and availability of construction and
mortgage credit tightened dramatically in response to the October 6 monetary
actions by the Federal Reserve.
Home sales also fell in the closing months
of the year, and prices gave some sign of leveling o f f .
In contrast, though,
to the 1973 housing downturn, builders are not saddled with outsized inventories of unsold units and rental vacancy rates generally are very low.
Over the course of 1979, single family starts fell almost a third
from the very high level of the preceding year.
Starts of multl—family units
74
Private Housing Starts
Annual rate, millions ot units
Total
Multi-Family
1973
1977
1975
1979
Monthly Carrying Costs
and Personal Income
New Home Prices
and CPI
Index, 1976Q1 = 100
—1160
index 1976Ql=iQO
Monthly
Carrying Costs,
Mortgages on
New Homes
Single Family
Home
Price index
Personal Income
1976
1977
1978
1979
1976
1977
1978
1979
75
-22-
declined only 10 percent.
An Increase in starts of multi-family units built
for sale as condominiums or cooperatives Was mote than o f f s e t by a decline in
unsubsidized rental units.
Building under the Section 6 rental-subsidy pro-
gram of the Department of Housing and Urban Development accounted for
one-
quarter of all multi-family units, about the saae proportion as in X978.
Business Spending
Spending policies of businesses were generally cautious last year
as firms, anticipating some slowing of sales, attempted to avoid creating
excess capacity or accumulating unwanted inventories.
Real business fixed
investment rose only 1-3/4 percent during 1979 compared with 10-1/2 percent
In the previous year.
As has been common in the advanced stages of economic
expansions, spending increases were concentrated in structures, for which
there is a long lag between the formulation of plans and the completion of
new f a c i l t t - e s ; earlier in the expansion, capital spending had been dominated
by shorter-lived producers' durable equipment such as trucks and fleet autos.
Most of the advance in nonresidential structures during 1979 was for commercial and industrial buildings.
Investment in equipment was little changed
over the year, with gains in machinery and a i r c r a f t o f f s e t t i n g declines In
motor vehicles.
Given the continuing need for new capital to Improve productivity,
and thereby to alleviate inflationary pressures and to support rising living
standards, the level of business fixed investment last year l e f t much to be
desired.
After allowance for replacement requirements, the net addition to
the nation's capital stock was small.
At the end of 1979, the ratio of the
stock of business fixed capital to the size of the labor force
differed
l i t t l e from the 1975 level; in contrast, the capital-labor ratio increased
76
Real Business Fixed Investment
Billions of 1972 dollars
1975
1976
1977
1978
1979
Producers' Durable Equipment
Percent change, Q4 to Q4
1972 Dollars
1975
1976
1977
1978
1979
Nonrestdentlal Structures
Percent change, Q4 to Q4
1972 Dollars
15
10
1975
1976
1977
1978
1979
77
Change In Business Inventories
Annual rale, billions of dollars
1972 Dollars, N1A Basis
30
Auto Inventories
Millions of units
Domestic-type Models
1973
1975
1977
Business Inventories Relative to Sales
1972 Dollars, N1A Basis
1979
78
-25-
at an average annual rate of 2.7 percent over the decade of the 1960s, when
productivity and real income per capita grew rapidly.
Businesses generally attempted to maintain Jean inventories last
year-
Total inventory investment in constant dollars did accelerate during
t h e f i r s t half of the year, however, reflecting primarily an inventory imbalance for large domestic automobiles.
After mid-year, however, auto makers
combined production cutbacks with price incentives to bring stocks back into
line -it!; <;,iies.
Outside of the automobile industry, businesses generally
;-.,-~cc"ed in controlling inventory positions throughout 1979.
t is-ie
"pec a l l y important toward the end of the year when short-term interest
i ! ' . < - . >-ose s u b s t a n t i a l l y , increasing inventory carrying costs.
r'.';>
This goal be-
By y e a r - e r d ,
, Al stock—sales ratio for m a n u f a c t u r i n g and trade was in the normal iang<_,
^•igj;etitirtg an absence of the kir^d of inventory imbalances that f r e q u e n t l y ha^e
2ggr=tiMted recessionary t e n d e n c i e s in the past.
Coverament Sector
'"-overrraent outlays for goods and services were about unchanged
thirl-:L 1979 following a moderate rise during the previous year.
Public senti-
ment f « r sheading restraint continued to a f f e c t decision-making by all levels
of g n u f r n n e n t ; federal fiscal polity was additionally influenced by the need
co a'-. J d any aggravation of inflationary forces in the economy.
Real federal purcViases grew about one percent during 1979, as higher
•^efens.-- spending more than o f f s e t slower outlay growth In the strategic petroli>um 'e-iewe and farm price support programs.
Total federal expenditures—
inclv-H'ii? transfers—recorded a faster rate of growth in 1979 than in 1978,
owin£ ; T part to a large mid-year cost of living increase for social security
recipients and to higher Interest payments on the public d e b t .
However,
79
Federal Government
Purchases of Goods and Services
Percent change. Q4 to Q4
1972 Dollars
1975
1976
1977
1978
1979
State and Local Government
Purchases of Goods and Services
Percent change, Q4 to Q4
1975
1976
1977
1978
1979
80
-27-
inflation-Induced increases in nominal incomes and previously legislated increases in social security taxes resulted in a sizable rise In federal tax
collections, and, as a result, the federal budget deficit—-on a national
income accounts basis—declined considerably over the year.
The high employ-
ment budget surplus, an indicator of the thrust of discretionary fiscal
policy, Increased, signaling greater restraint on aggregate demand.
At the state and local level, real purchases of goods and services
declined marginally during 1979 following a sizable Increase a year earlier.
Construction spending was particularly depressed following federal cutbacks
in grants for local public works and public employment programs.
Moreover,
states and. localities also attempted to limit spending by holding down employment growth; the Increase in employment during 1979 was about the same as in
the previous year but was considerably less than the average annual gains
recorded earlier in the decade.
Despite this slowdown In the pace of spending,
the fiscal position of states and localities deteriorated in 1979 as revenue
growth fell Far short of the gains posted In the previous year.
Tax cuts by
many governmental units and lower car sales and gasoline consumption limited
the growth of income and sales tax revenues.
As a result, states and local-
ities showed th&ir first operating deficit (budget position net of social
Insurance funds) In three years.
International Trade and Fayjnents
Net exports of goods and services were the only major sector that
turned io as strong a performance in 1979 as In 1978.
net exports increased about $8 billion last year.
On a GKP basis, real
The U.S. merchandise trade
deficit, although swollen by a $18 billion Increase in the cost of Imported
oil, was $29 billion in 1979, $5 billion less than In 197B.
81
-28-
U.S. Current Account and Trade Balances
SeasonaNy adjusted billions Of dollars
Merchandise Trade Balance
International Accounts Basis
1973
1975
Nonagricultural Exports
Seasonally adjusted annual rate, billions of 1972 dollars
Seasonally adjusted annual rate, bidions of rioters
160
82
-29The volume of exports continued to expend rapidly during the past
year,
Agricultural exports jumped to record rates in the second half as
drought in. the Soviet UnJ.on and Eastern Europe boosted sales-
More impor-
tantly, the volume of nonajjrlcujtural exports rose about 12 percent in 1979;
U.S ? producers benefited from an improved competitive position brought about
by the depreciation of the dollar in 1977 and 1978 and from relatively robust
economic growth Abroad.
In contrast, U.S. import demand was damped by the sluggish performance of domestic income and industrial production.
Imports other than oil
rose only marginally in volume terms in 1979, although foreign auto producers captured a record share of the U.S. market as consumer preferences
shifted toward fuel-efficient cars.
At the same time, the volume of oil im-
ports was virtually unchanged from the 1978 level, with reduced consumption
offsetting the impact of a rebuilding of inventories.
a f t e r remaining flat for two years, jumped sharply.
barrel of imported oil
the end of 1978.
World oil prices,
The average cost per
in December, 1979, was 87 percent above the level at
By the fourth quartet, U.S. oil imports were at an annual
rate of $75 billion, compared with a $43 billion rate a year earlier.
The current account, which was in deficit by about $!& billion in
each of the two previous years, was roughly in balance in 1979.
Net receipts
from service transactions, continuing their rapid growth of recent years, o f f set the merchandise trade deficit.
The net r e t u r n on foreign direct investment
was especially atrong, reflecting continued economic expansion abroad, the
favorable effects of the 1977-78 depreciation on the dollar value of foreign
profits, and the surge in overseas earnings of U.S. oil companies.
Total
earnings on U.S. direct investments abroad were on the order of $37 billion;
83
Oil Imports
Annual rale, Diiiions ol dollars
Millions ol barrels per day
1S77
U.S. Direct Investment Receipts
Seasori&iiy adjusted annual rate, billions ot dollars
1973
1975
84
-31perhaps half of these earnings were reinvested abroad and therefore recorded
also as an outflow of U.S. private capital.
Earnings of foreign direct Invest-
ments in the United States also rose, but they are on a much smaller scale*
85
-32-
SECTIOM 3.
PRICES, WAGES, AMD PRODUCTIVITY
In 1979 prices advanced at historically higti rates, primarily as
a result of pressures from energy and labor costs.
The fixed-weighted price
index for gross domestic business product, a broad measure of aggregate prices,
rose about 10 percent during 1979, a pace more than 1-1/4 percentage points
above the previous y e a r ' s rate of increase.
Other price measures increased
ejen more: the fixed-wighted price index for personal consumption expenditures rose 10-3/4 percent while the Consumer Price Index increased 13-1/4
percent, the differences between these two indicators reflecting mainly alternative conceptual treatments of homeownership costs.
At the producer level,
prices of finished consumer goods were up about 12-1/2 percent over the course
of last year.
Rapid increases in energy prices, particularly for petroleum prod u c t s , dominated Inflation developments during the year.
Imported oil priced
under long-term contracts rose steadily, from an o f f i c i a l OPEC contract price
of $12.91 per barrel in December 1978 to prices ranging from $24 to $30 per
barrel one year later.
Moreover, the stockpiling of petroleum by some coun-
tries and production cutbacks in Iran resulted In spot market prices that
were considerably above o f f i c i a l OPEC levels.
At the same time, in the U.S.
market the Producer Price Index for crude oil was up about 50 percent during
1979, reflecting both price increases for domestic uncontrolled oil and the
I n i t i a t i o n of the Administration's decontrol program on June 1.
The large increases experienced In petroleum prices had significant direct and Indirect e f f e c t s .
Retail gasoline prices rose mote than 50
percent, and fuel oil prices advanced almost 60 percent d e s p i t e some s o f t e n i n g
86
— 33—
Labor Costs and Prices
Gross Domestic Business Product
1977
1978
1979
in demand that was attributable both to conservation and to mild weather late
in the year.
In addition, rising energy costs led to f a s t e r price incr^asus
for a number of other consumer goods, including transportation services and
residential rents.
At the producer level, prices of goods such as industrial
chemicals and plastics also reflected the steep runup in energy costs.
In contrast to energy prices, food prices increased less sharply in
1979 than in 1978.
Over the four quarters, consumer food prices rose 10-1/4
percent, following an 11-3/4 percent Increase in 1978.
Although beef remained
in relatively short supply during 1979, the greater availability of other
meats and poultry contributed to some deceleration of food prices during the
Bummer.
Inflationary pressures persisted in sectors outside energy and food.
Prices of consumer goods excluding food and energy accelerated during 1979: tlte
PCE fixed-weighted price sub-index for such items rose 7-3/4 percent in 1979
compared with 7 percent the previous year, and the corresponding CPI sub-index
rose at an even faster rate.
Prices of capital equipment and nonresidential
structures rose at a faster pace in 1979 Chan tn 1978.
Price movements in
commodity markets were quite volatile throughout the year and reflected
con-
siderable speculative activity related in part to international political and
military tensions.
Wage Increases in the nonfarm business sector moderated very slightly
to 8 percent in 1979t compared with 3-1/2 percent the year before.
Compensa-
tion per hour, which Includes fringe benefits and employer contributions for
social insurance as well ae Mages, rose almost 9 percent, just a shade less
than in 1978.
The Administration's voluntary pay standard probably restrained
the advance In compensation somewhat in the face of accelerated price I n f l a r ,
-35-
Unit Cost Indicators
Nonfarm Business Sector
Change from year earlier, annual rate, percent
Compensation per Hour
10
1975
1976
1977
1978
1979
89
-36however, sectors in which cost-of-living protection is prevalent, such as
manufacturing, generally experienced the largest gains even though demand
for labor in those sectors was relatively weak.
Labor productivity—that is,
percent in the nonfarn business sector.
output per hour worked—declined 2-1/4
As a result, despite the slowing of
compensation, the rise of unit labor costs accelerated sharply, from 8 percent
in 1978 to 11-1/2 percent in 1979.
The poor performance of productivity re-
flected in part the continuation of the weak trend of recent years, associated
with sluggish growth of the capital stock, changes in the composition o£ the
labor force, and other long-range factors.
In addition, however, there was
a cyclical element in the drop in productivity; there IB normally a tendency
for output per hour to drop when economic expansion decelerates, as employers
initially are loath to lay off trained workers for what might prove a abort
period of slack.
Many workers saw their wage gains outstripped by price Increases
during 1979.
The lack of progress In real wages Is not surprising, given the
drop In productivity and the adverse terms-of-trade Impact of the surge in
foreign oil prices.
Nonetheless, American workers have become accustomed to
an upward trend In their purchasing power, and there are likely to be strong
catch-up wage demands this year.
The Administrations's 1980 wage standards
take this f a c t Into account, permitting somewhat bigger wage hikes for those
workers who experienced relatively small gains in 1979.
90
-37-
SECTION 4,
LABOR MARKETS
The demand for Labor remained quite strong in 1979, despite the
sluggishness of output growth.
Firms experiencing gains in sales added to
their payrolls, while those encountering dtps in the demand for their products evidently tended to retain their workers—with the negative consequences
for productivity and unit labor costs noted in the preceding section.
Over
the year as whole, the number of workers on the payrolls of nonfarra establishments increased 2.1 million, less than in 1978, but nonetheless a sizable gain.
The major area of greatest strength in hiring was the service sector,
where employment rose f a i r l y steadily throughout the year.
Manufacturing pay-
rolls, in contrast, declined slightly in the second half of 1979.
This weak-
ness was concentrated among durable goods producers, especially In the motor
vehicles and steel industries-
By the end of the year, abouf j 3 0 , 0 0 0 auto
workers were on indefinite layoff.
The strength of labor demand in the service sector may help to
explain the large Increase in the number of women In the labor force last
year.
Many of the occupational groups in the service sector traditionally
have had high proportions of female workers.
Adult women have accounted for
a large percentage of labor force growth In the past several years, and this
pattern continued In 1979, when they accounted for two-thirds of the expansion In both the labor force and total employment.
The overall labor force participation rate grew less rapidl;- in
1979 so that the smaller Increase in employment was still sufficient to hold
the unemployment rate almost constant throughout the year, at about 5.8 percent.
This is a level that, given the composition of the work force and other
91
Nonlarm Payroll Employment
Change from December to December, millions
1975
1976
1977
1978
1979
Manufacturing Employment
Change from December io December, millions
1975
1976
1977
1978
Unemployment Rate
1975
1976
1977
1978
1979
92
-39characterlstics of the labor market, most analysts agree is today consistent
with relatively tight labor supplies.
Certainly, the proportion of Che popu-
lation employed remained at an all-time high during 1979, and many employers
continued to report d i f f i c u l t y in finding well q u a l i f i e d workers.
Some
statistical indicators of labor market tautness did, however, hegin to move
in the direction of greater ease as the year progressed; for example, the
share of the labor force on layoff, the unemployment rate for males 25 and
over, and the blue collar jobless rate all increased a bit after the f i r s t
quarter.
In January of this year, when the unemployment rate rose from 5.9
to 6.2 percent, the increase largely reflected layoffs of adult male, blue
collar workers.
There were no significant changes over the past year in the structure
of unemployment.
The jobless rates for nonwhites, for teenagers, and for black
teenagers have not improved relative to those for other major population groups.
This January, the nonwhlte unemployment rate was 11-3/4 percent, teenage
unemployment was 16-1/4 percent, and black teenage unemployment was 34-1/2
percent.
The unemployment rate among nonwhites has remained about twice
the level for whites, and teenage unemploynent continues to be about three
times the rate for adults.
93
-40-
SECTION 5.
DOMESTIC FINANCIAL MARKETS
jjit-cres t_ jates
Market rates of interest rose substantially during 1979, surpassing
the previous highs recorded In 1974.
As in that earlier year, sharply accel-
erated inflation created strong demands for money and credit, and correspondingly intense upward pressures on Interest rates.
These pressures were most
evident in the second half of the year, when the Federal Reserve had to adopt
an increasingly restrictive posture In order to keep the monetary aggregates
within the ranges set earlier and reported to the Congress.
On October 6,
the System took certain actions aimed at providing greater assurance that
monetary objectives would be achieved.
its
A fundamental change was made in the
System's operating procedures, shifting the day-to-day focus of open market
operations from the federal funds rate to the growth of member bank reserves. 1
At the sane time, the discount rate was raised one percentage point, to 12
percent, and an 8 percent marginal reserve requirement was applied to certain
managed liabilities of commercial banks.^
Over the course of 1979, interest rates on short-dated money market
instruments such as Treasury bills, large CDs, and commercial paper generally
rose 2-1/2 to 3 percentage points.
In long-term debt markets, taxable bond
T / A p p e n d i x S to this report describes the new operating procedures.
2/
The marginal reserve requirement applies to increases, above a base level,
in the total managed liabilities of member banks, Edge corporations, and
U.S. agencies and branches of foreign banks. These liabilities Include
large time deposits ($100,000 and over with maturities of less than a year),
Eurodollar borrowings, repurchase agreements against U . S . government and
agency securities, and federal funds borrowings from nonmeraber i n s t i t u t i o n s .
(Federal funds borrowings from member banks, Edges, and agencies and branches
are exempt to avoid double counting for reserve requirements, and a deduction
is permitted against RPs for U.S. government and agency securities held in
trading accounts.)
1*4
—41 —
Interest Kates
4-6 Montn Prime
Commtsruial Paper
Long-term
Aaa Uliiily Borid
New (ssues
yip.lds increased 1—1/2 to 2 percentage p o i n t s , and i n r e r p p t r a r p s no r.nn»»ntionsl hoi"° F-ir-tpace. loans in (•.recced a h n u t 2-1/2
DSr<-.pntagp ni-'nt-e.
chn-rt-
CPITI iratpH have? f l u r t u a t p d around t h p i r year-end levels dirrfn? rh- n^sf: c=u»r
hipp,|r.;.
hn«- hnrr" V'H.'^S hi"'p r'^**" to i i ^ w h l a h s . aD^?'^''"^^y ?*: l ^ E t i a ^ " i u i n
ref1.pr-r3.nn rif conrarnn ahont thp. conspnupncRfi of a posslhle sr.pn— nn i n H e f p n E
Sp"nrt < Ti6 on tb° f p n p r s ]
bi'di>pt and * r f 1 a f i Q r > .
Hone t^ry_ Aggregates '
Th» w a i n r niniiptary ag^ret-ates nr£w rpo^e si n«l.y in 1971 rbun thpy
p s r r l r n l a r l y ma'-lrarf in Clr? c^';'? "f M-1 .
Tils Feri^r^.l Oi)".n M-ii-kor. f:nn m < tri-°e
(FOM^I l a i r F f i h r n a r v dBr.an1.it.hpd a r?ni>p. of l.-l / 2 f n A-i./', n-i-ponf
*or q-i-.-f
of M-1 (r.iiTpnr.y and demand dp.poslts) in the year enHlng with t-hp fniirth
q U J i r t o r of T t T I : t.hl i comoarpri u l r h an Inr.rpase of 7 - 1 / 4 tiTi-p.nf
precpdloe vear.
In rhp.
As thp Hoard i n d i r a r p d to thp ConeroBR J n ir.s i n i t i a l rppo
iiirlcr t-h° Hi'mnhrpv-Hpt'kin'! Af.t , it
w n s est fir-at-p-rf th'ir. er^'-'tfi < n M~' e>i-r*<i%
137Q m i e h t ho rpdiirpd aT ntch "s f:hrpp r7arr»nfape Dnint-s by thp o h i f f i f R of
f u n ^ s from s v i c t i n ^ dpiand d R O o s J t s to n e w l y atir.h<Tl"pd ai-irnnarir
rrsncfpr
sa"ir>s fAT<;l ai-rnun t-i ^(-rnss th*1 n a t i o n and npootiahl p.-rn-Hp.r-of — H f hdra'j a l
(NOWl a c r o n n r R in N«w Yr>rk Srat.e.
of a c t u a l
T h i s inopnt. t h a t thp nbcprvo^ griM.Tth rate
pf.nnnmic .'mnact.
fi if-s
rn*'1™rr
report, th" Bna*-d sl:»*-«>d thflt th" FHMr, h = d r p a F f i -
rh". 1-1/5 tn t-l./? ppi-fonr. r a n a e , wi.l-!i thp u n d ^ r R i - a n d i n g that rhl « ran^« vio
96
Money Stock Growth
Former Concepts
M-1
Percent change, 04 to Q4
1975
'976
1977
1978
1979
1975
1970
1977
1978
19/9
1975
1976
1977
1978
1979
M-2
M-3
97
-44-
be adjusted upward to the extent that Che impact of ATS/NOW account s h i f t s
fell shore of the original three percentage point estimate.
ATS and NOW accounts falling off
With Inflows to
sharply, the FOMC employed an adjusted M-l
range of 3 to 6 percent during the remainder of the y e a r , based on an expected
ATS/NOW e f f e c t of around 1-1/2 percent.
In the event, M-l Increased 5.5 percent during 1979, and the estimated depressing e f f e c t of ATS/NOW accounts amounted to about 1-1/4
points.
The aggregate was approaching the upper bound of its
percentage
range in the
late summer, but Its growth moderated in the closing months of the year (see
chart on page 45).
This slower growth has continued into 1980.
M-2, which includes, in addition to tl-1, bank time and savings
deposits other than l a r g o negotiable CDs, increased 8.3 percent between the
f o u r t h q u a r t e r s of 1978 and 1979.
This is slightly above the FOtlC's range of
5 to 8 p e r c e n t , e s t a b l i s h e d last February and r e a f f i r m e d in July.
Expansion
of the i n t e r e s t - b e a r i n g component was strong, as small denomination time
deposits grew at a very brisk pace, o f f s e t t i n g a contraction in passbook
savings accounts.
Six-month money market c e r t i f i c a t e s (MMCs) accounted for
all of the growth in snail tine and savings accounts; inflows were especially
strong a t t e r March, when the f e d e r a l regulatory agencies eliminated (for
periods when the 6-month Treasury bill rate exceeds 9 percent) the one-quarter
percentage point interest d i f f e r e n t i a l t h a t had previously given t h r i f t Institutions a competitive advantage in the rlMC m a r k e t .
prohibited the compounding of MMC i n t e r e s t .
The agencies in March also
These actions were taken partly
to reduce cost pressures on t h r i f t institutions and partly to help moderate
the flow of f u n d s to depositary institutions so as restrain inflationary
pressures.
98
Growth of Money and Credit in 1979
M-1 Fanner concept
Billions ol dollars
-— Range AoopJefl by FOMC
lot 1978 Q4 to 1979 Q4
380
'** ^^
O
N
D
J
F
M
A
M
J
J
3%
S
A
O
N
£>
19/lJ
19/8
Former Concept
Billions ot Dollars
—- Hangt; AoopieO Dy KOMC
tor 1978U4 to 1979Q4
O
N
D
J
F
M
A
M
J
J
S
.
S
O
N
D
99
Growth of Money and Credit in 1979
M-3
Formar Concept
Billions of dollars
— Actual
—
Range Adopted by FOMC
tor 1978 O4lo 1979 Q4
1600
1978
Commercial Bank Credit
Billions of dollars
-— Range Adopted by FOMC
for )97aO4to 1979 04
O
1979
N
0
100
-47-
M-3, which is M-2 plus deposits at t h r i f t institutions, rose 8.1
percent in 1979, within the FOMC's range of 6 to 9 percent.
Deposits at
savings and loan associations, mutual savings banks, and credit unions expanded 7-3/4 percent, down from about 10-1/2 percent in 1978 but still well
above rates recorded in previous periods of high market interest rates. The
key to the sustained growth of thrift institution deposits—particularly for
S&Ls and MSBs—was the MMC; however, there was also a sizable increase in
large denomination time deposits outstanding at S&Ls.
Credit jTlows
Because market interest rates rose f u r t h e r relative to the returns
on f i x e d interest ceiling time and savings deposits at commercial banks and
t h r i f t i n s t i t u t i o n s , a large volume of funds was placed instead in inarket
debt instruments and in mutual funds or Investment trusts during 1979.
Money market mutual funds registered spectacular growth, their total assets
increasing from $10 billion to $45 billion.
(A record surge since year-end
has boosted their total assets above the $55 billion mark..)
However, the
depositary institutions, confronted with heavy credit demands, were able to
obtaltt the lendahle funds they desired through the issuance of ceiling-free
liabilities such as large CDs, RPs, federal f u n d s , and Eurodollar borrowings
and, in the case of savings and loan associations, through borrowings from
Federal Home Lnan Banks.
Consequently, depositary i n s t i t u t i o n s continued to
account for a large proportion of credit provided to nonfinancial sectors of
the economy, in contrast to the pattern observed at other times when market
interest rates have been high.
Commercial bank credit increased 12.2 per-
cent over the year ending in the fourth quarter of 1979—as compared w i t h
101
Funds Raised by Domestic Nonfinancial Sectors
Billions of doHars
State and Local
Governments
1976
1979
102
-49tha POHC's projection of 7-1/2 to 10-1/2 percent—despite a leveling off In
the fall.
The total voLuffle of funds raised by domestic nonfInanela1 sectors
of the ecottufiiy In 1979 was about the same as In 1978.
Reduced borrowing by
governcitncal units approximately offset an ln.ci.eaae In tattings Dy bu&infess
firms.
Aggregate credit expansion was greatest In the fleet three quarters
of the ye^r, ae the tightening of financial markets that accompanied the
System's October actions contributed to a steep drop In borrowing by households aad businesses in the fourth quarter.
The credit needs of the U.S. Treasury declined markedly in 1979
owing to the reduction in the federal budget deficit.
The operating buugets
of state and local governments meanwhile moved In the opposite direction,
fron surplus to deficit, but their net borrowing, too, diminished.
Although
the tax-exempt market was used much more extensively as a source at tuuds
for residential mortgage finance, restrictive IRS regulations brought a
virtual cessation of the advance refunding activity that had swelled state
and local government bond issuance in the previous year.
The strong demand for housing, both as shelter and as an investment,
and an evident desire to maintain past spending levels in the face of declining real disposable Income kept borrowing by the household tstctor at an
historically high level during 1979.
Over the first three quarters, debt
expansion exceeded income growth, and loan repayments as a percent of. dispossable income moved to a new high.
By the latter pact of 1979, signs had begun
to emerge—in data on loan delinquencies and bankruptcies—that families were
encountering some difficulty In meeting theit financial obligations.
103
-50-
Thp heavy de*>t burden? may have combined with, the higher level of
trtPfapt: rfll:=s to dfno hoti<;=ho1d crcrt.it use in the fourth ouarter.
In addltJnn,
however, credit avflilahllty became a significant factor as Insrttnr.lonH tighterve<* c."d«t_ pt:fiT».*,-i-ds
abonr. fi.natif.ial
or
cuT-r^ti^c) IptwHng in response to greater uncertainty
prospects and reduced earnings margins.
OK.SI- so"orRTy c.rt^vf.rnlr.f.a
Credit supplies were
in those parts of the country with low uiurv ceilings;
the year—«nd fflrteral legislation providing a three month override of srar.e usury
ceilings may nrov-lrte some r e H p f for borrowers In snc.h areas.
Borroi-'ing hv nonfLn^nrlnl bus'fnef's firms inf-reaspd "iiibsr.anttally tn
1979, PS the arnwrh of o u t l a y s for invent«irlps and fixed r.apit:;il outstripped
the 3t)"an-~H < n Intfn^] fnn^s ppnorated.
This "financtnft gap" wafi p a r t i c u l a r l y
large during the f i r s t Ehcpe quarters of the year; In the fourth Quarter the
oao usrrow«H somp'-Aat with the .slowing of inventory flcf.<™«jJ«»ti*»n.
InrreaspR tn business loans at banks anit in n*?t issuance of roromeiT.lpl oaivr acc.oiiifd f d r mnst of thp growth in borrowing by nonftnancial
enterp-riSPF.
Morteaee loans rone somftwhst, reflecting the strength of com-
mercial construction. bt'C corporate bond Issuance rena1n*;rf around the mortprate
l^'fl IBW*>I ?B coran^iles were reluc.tfnt to Incur 1 onE-term debts at h i s r o r l n ^ l l y
high I ^ r p r p o t r a t p s .
The relatively heavy reliance on sbr>rr»r-term borrowings
WPR r p f T p r - h p r l i n a f u > - r h p r dPteT-lorarfon of t r a d i t i o n a l neepurps of b a l a n c e
ehp.er streneth.
Indies'-'
1
Flow-of-funrls account estimates for n n n f I n a n c J a l corporations
tTiat th-'ir agerefistp r a t ^ o of short-term op.ht t.n total rfpht hss rosrh^d
a reco"-!! h i g h ftn.i t h a t the r a r J o of liquid assets to current I f a M l t t i e s has
ffpr-!•.=,•!
,; 3ou 1 p-.'i-l SPTI h p f o f e o n l v in 1974.
Perhaps p^rl'ly for f h ' s r e a n o n ,
the liroo-off in business borrowing In the fourth quarter was c o n c p n t r a t p d in
thft short-tBrm area.
104
The dollar was quite strong on foreign exchange markets in the
first five months of 1979, following the tightening of U.S. money market
conditions and the announcement by the Treasury and the Federal Reserve of.
a dollar support program on November 1, 1978.
The dollar rose more than
5 percent on a trade-weighted average basis, gaining 5-1/2 percent against
the mark, 7-1/2 percent against the Swiss franc, and 14-1/2 percent against
the yen between the end of December and the end of May. During this period,
U.S. and foreign monetary authorities entered the markets to moderate exchange rate movements, reversing In the process a large portion of their 1978
intervention purchases of dollars.
By the end of May the Federal Reserve
had repaid all its outstanding swap debts to other central banks, the Treasury
had reconstituted all of the balances it had raised through the issuance of
foreign-currency denominated notes, and the Federal Reserve and the Treasury
both completed repayment of their pre-1971 Swiss franc indebtedness.
In early summer, however, the dollar weakened, apparently mainly in
response to the failure of U.S. inflation to moderate and to the absence of
a concerted U.S. program to solve its energy problem.
The dollar's weakness
intensified in early June and continued into September, despite a series of
increases in the Federal Reserve's discount rate, a gradual rise in the
federal funds rate, and renewed heavy exchange market intervention in support
of the dollar.
By early October the dollar had retraced all of its
rebound of
earlier In the year, and selling pressures were mounting rapidly amidst
accelerating price rises in gold and other commodities and other signs of a
105
Weighted Average Exchange Value of U. S. Dollar*
Matcn 1973 = 100
1977
1978
3-Month Interest Rates
Weighted Average of
Foreign Interbank Rates'
106
-53-
woreening in expectations of inflation.
In these circumstances, the Federal
Reserve's announcement on October 6 of a series of anti-inflation measures—
described in the preceding section—was accompanied by a sharp advance of
the dollar on exchange markets.
By mid-November, -the dollar had risen about
4 percent on a weighted-average basis from its
early October lows.
Foreign
monetary authorities subsequently tightened their policies to deal with
similar inflationary
pressures abroad, and the dollar lost strength.
From
mid-November through the end of the year the dollar d r i f t e d lower In thin
markets unsettled by developments associated with the taking of American
hostages in Iran.
At year-end, the dollar stood close to its early October
lows on a weighted-average basis-
The dollar has been relatively stable
tn recent weeks, with trading rather light in an environment of heightened
international political uncertainties.
107
APPENDIX A
DESCRIPTION OF THE NEWLY DEFINED MONETARY AGGREGATES
A-l
THE REDEFINED MONETARY AGGREGATES
I.
Background
The Federal Reserve has redefined the monetary aggregates.
This
action was prompted by the many financial developments that have altered
the meaning and reduced the significance of the old measures.
Some of these
developments have been associated with the emergence In recent years of new
monetary assets—for example, HOW accounts and money market mutual fund
shares—while others have altered the basic character of standard monetary
assets—for example, the growing similarity of and the growing substitution beCween the deposits of thrift institutions and those of commercial banks.—
In the process of redefinition a set of Board staff proposals was published
2/
In January 1979.—
Coimnents on these proposals received from the public
and from invited experts, together with deliberations within the Federal
Reserve System and further research by Federal Reserve s t a f f , contributed to
the Board's selection of the newly defined measures,
Given the changes that have occurred in financial practices In
recent years, the new measures should aid both the Federal Reserve and the
public in interpreting monetary developments.
However, many of the changes in
the payments mechanism and in the character of financial assets that
have rendered such a redefinition necessary—some of which are ongoing—
have also added significantly to the complexity of the monetary system. As
_!/
2J
A discussion of many of these developments can be found in, "A Proposal
for Redefining the Monetary Aggregates," federal Reserve Bulletin (January
1979). PP. 14-17.
See "A Proposal," pp. 13-42. The potential need for redefinition, in
light of numerous financial innovations, was recognized by the Advisory Committee on Monetary Statistics. See , Improving the Monetary Aftftrejj^tes:
Rejort of the Advisory Cpimnittge on Monetary Stattstjcji (Board of Governors
of the Federal Reserve System, June 1976), pp. 5-6, 9-12.
108
A-2
a consequence, it ie recognized that no one set of monetary aggregates can
satisfy every purpose or every user.
For this reason, the principal com-
ponents of the new measures—along with several related series—will be
published regularly with the new aggregates.
In this way, users will be
able to analyze separately the components and to construct alternative
measures.
The following section, Section II, presents the new aggregates
and compares them to the old measures.
This is followed in Section
III
by a discussion of the rationale underlying the redefinition.
The histori-
cal behavior of the new aggregates is examined in Section IV.
A final section,
Section V, discusses some technical issues associated with the redefined measures:
consolidation and seasonal adjustment procedures used in constructing
the redefined aggregates and new data sources vised in the redefinition.
Three appendix tables contain annual and quarterly rates of growth of the new
measures and their old counterparts.
II.
The New Monetary Aggregates
Four newly defined monetary aggregates replace the old M-l througf.
M-5 measures.
In addition, a broad measure of liquid assets has been adopted.
The new aggregates are presented in Table 1.
Two narrow transactions
measures--M-lA and M-lB--have been adopted.
M-1A is basically the same
as the old M-l aggregate, except that it
excludes demand deposits held by
foreign commercial banks and official institutions.—
The other narrow
measure—M-1B—adds to M-1A interest-earnine checkable deposits at all
depositary iastitutions—namely negotiable order of withdrawal (KCW)
ll
The removal of demand deposits due to foreign commercial banks and o f f i c i a l
institutions follows a recommendation of the Advisory Committee on Monetary
Statistics. See Improving the Monetary A^greeates^^JRePort, pp. 15-19.
109
A-3
Table 1
New Measures of Money and Liquid Assets
Amount in billions
of dollars
(not seasonally adjusted)
November 1979
372.2
106.6
265.6
Currency
Demand deposits
3_8_7_L9
M-lB
M-1A
372.2
15.7
2
Other checkable deposits
M-lB
Overnight RPs issued by conroercial banks
Overnight Eurodollar deposits held by U . S . nonbank
residents at Caribbean branches of U . S . banks
Money market mutual fund shares
Savings deposits at all depositary institutions
-,
Small time deposits at all depositary institutionsM-2 consolidation component4/
M-3
1510.0
219.5
21.5
8.2
M-3
Other Eurodollars of U.S. residents other than banks
Bankers acceptances
Commercial paper
2123. ft
1759.1
34.5
27.6
97.1
Savings bonds
Liquid Treasury obligations
I/
2j
3/
4/
5_/
3.2
40.4
420.0
640.3
-2.7
Large time deposits at all depositary institutionsTerm RPs issued by commercial banks
Term RPs issued by savings and loan associations
M-2
Note:
1510.0
387.9
20.3
5/
80.0
125.4
Components of M - 2 , M-3 and L measures g e n e r a l l y exclude amounts held by domestic
d e p o s i t a r y institutions, foreign conmercial banks and official institutions, the
U.S. Government (including the F e d e r a l Reserve), and money market mutual funds.
Exceptions are bankers acceptances and commercial paper for which d a t a sources
permit the removal only of amounts held by money market mutual funds and, in
the case of bankers acceptances, amounts h e l d by accepting banks, the Federal
Reserve, and the Federal Home Loan Bank System,
Net of demand deposits due to foreign commercial banks and official i n s t i t u t i o n s ,
Includes NOW, ATS and credit union share d r a f t balances and demand deposits at
t h r i f t institutions.
Time deposits issued in denominations of less than $100,000.
In order to avoid double counting of some deposits in M-2, those demand deposits
owned by thrift instittitions (a component of M-lB) which are estimated to be used
for servicing their savings and small time deposit liabilities in M-2 arc removed.
Time deposits issued in denominations of $100,000 or more.
no
A-4
accounts, automatic transfer from savings (ATS) acroimts, and credit
union share draft balances—as well as a small amount of demand deposits
at thrift institutions
that cannot, ueing preswtt data sources, be. separated
from interest-earning checkable deposits.-'
The nev M-2 jw.*si-re ados f o W-1B
overnight repurchase agreements (RPs) issued by commercial banks *nd certain
21
overnight Eurodollars held by U.S. nonbank reagents,— nmn^y ptrket
mutual fund shares, and savings and small-dabomination time deposits at all^
depositary institutions,-^
Also, in order to avoid double counting of eome
deposits in this aggregate, the construction of the new M-2 involves subtraction a conRo3idotJtm component—an estl-nate of thope der>snd deposits
thrift institutions use in servicing their savings and time deposit liabilities included in this aggregate.-*
Redefined M-3 la equal to new M-2 plus
large-denonination Cine deposits at all depositary institutions (including
negotiable CDs) plus terra RPs issued by coon^rcial banks and savings and loan
I/
2/
3/
4_/
H-1B is the same as the K-l measure that was proposed by the B^ard staff
in January 1979, SPG "A Proposal," pp, 17-70.
Overnight Eurodollars in M-2 are those issued by Caribbean branches of member banks. Other overnight Eurodollars and longer-term Eurodollars of U . S .
residents are included in the hroad mpssure of liquid assets, L. Data on
overnight Eurodollars included in M-2 are available on a timely basis, but
data on ether Eurodollars—at both U.S. and, non-U.S, banks abroad—are
available only with a lengthy lag and do not permit a separation of o«eraight from term Eurodollars. As improved data sources become svallable,
adjustments may be made to the new measures. For example, the possible
inclusion of Eurodollars held by nonresidents other than hanks and cfficial
institutions could be reviewed. Moreover, with Eurodollar data on a more
timely basis, consideration could be given to including Eurodollars ot
longer than overnight maturities in a broader monetary aggregate,
r a t h f r than only in L.
Small-denomination tinte deposits are those Issued in denominations of less
than $100,OHO. Depositary institutions are commercial banks (including U . S .
agencies and branches of foreign banks, Edge Act Corporations, and foreign
investment companies), mutual savings bonks, savings and loan associations,
ard credit unions.
At present, because of the small atrount of checkable deposits at t h r i f t s ,
this M-2 consolidation adjustment removes all demand deposit holdings of
mutual savings banks and savings and loan associations. See Section IV
for a further discussion of consolidation procedures.
Ill
A-5
associations.—
Finally, the very broad measure of liquid assets—L—equals
new M-j plus ottier liquid assets consisting of otner Eurodollar holdings of
If
U.i>, nonfaank residents,—
tankers acceptances, commercial paper, savings bonds,
and niarketaDle liquid Treasury obligations.—
The relationship between tilt rede lined and the old mo.ietary aggregates
is shown In Tattle 2.
As already noted, tne new M-iA measure is very similar to
Che old W-l and d i f f e r s in excluding demand deposits owned by foreign cownercial
4/
banks and official institutions.— M-1B thus d i f f e r s from the old M-l by excluding
these deposits, on the oue hand, a n d , on tne other, by including other cueckable
deposits at both commercial banks and thrift institutions.
coacatfC
New M-2 is closer in
co old M-3, which included savings and time deposits liabilities at
all
depositary institutions (other than negotiable CDs at Large coiimeecial banks),
Chan it
is to old M-2, whicn excluded the public's holaiiigs of savings and
time deposits at
thrift institutions.
The major differences between the new
M-2 ana old M-3 measures are that new M-2 includes money market mutual
fund shares and overnight RPs and Eurodollars—none of which appeared in any
of tne old monetary aggregates--aud that it
tiiae deposits.
excludes ajll large-denomination
The only large-denomination time deposits removed from the old M-3
(and the old M-2) measure were negotiable CDs at large commercial banks--ainounting
tu $95.1* Dillion in Noveisber 1979--while, as the table shows, it contained ¥151.2
billion of other large-denomination time deposits at both commercial banks
ar.d t h r i f t institutions.
By including all
large-deaorainacion time deposits
at all depositary institutions, the new M-3 is closer in concept to the old
I/
2/
3/
4/
Large-deiiomloation time aejJOBite are triage issued In deiiaaiu&tlons ot ^100,000
or note.
See footnote 2, page it.
In general, the components of M-2, M-3, and L exclude amouata held by
depositary institutions, money market mutual funds, the Federal government (including the Federal Reserve), and foreign commercial banks and
official institutions. Marketable liquid Treasury obligations are those
with regaining maturities of 18 months or less.
The new M-1A also includes a very small amount of M-l-type balances at
certain U . S . banking offices of foreign banks outside New York City,
which ate not In the old M-l.
112
A-6
Table 2
Relationship Between New and Old Monetary Aggregates
Aggregate an^Component
Amount in billions
of dollars
(not seasonally adjusted)
November 1979
_
Old H-l
Less demand deposits of foreign commercial
banks and official Institutions
382.6
Equals:
372^2
Hew M-1A=^
10lil
Plus other checkable deposits
15.7
Euals
J
Hew M-1B
Old M-2
945.3
Plus savings and time deposits at thrift institutions
664.2
Equals-. __01d_ M-3
Plus overnight RPa and Eurodollars
Plus money market mutual fund shares
,
Plus demand deposits at mutual savings banksLess large tine deposits at all depositary institutions
in current M-3
Less demand deposits of foreign commercial banks and
official institutions
.
Lees consolidation component—
Equals,:
Nev_M-2
Plus large time deposits at all depositary institutions
Plus term KFs at commercial banks and savings and loan
institutions
Equals,;
New M-3
1609 ,j_
23.4
40.4
1.0
151.2
10.4
2.7
1510.0
219.5
29.S
1759.1
Memo:
Old M-2
945.3
Plus negotiable CDs at large commercial banks
Equals:
Old M-4
Old M-3
1609.5
Plus negotiable CDs at large commercial banks
Equals:
I/
2/
3/
95.9
1041.2
Old M-5
95.9
1705.4
Also includes a very small amount of M-l-type balances at certain U.S. banking
offices of foreign banks outside New York City which were not in the old
H-l measure.
Demand deposits at mutual savings banks were not included in any of the old
monetary aggregates.
Consists of sn estimate of demand deposits Included in M-1B that are held by
t h r i f t institutions for use in servicing their savings and small time deposits
liabilities included in the new M-2.
113
A-7
M-5 measure than to the old M-4 (both shown as memo Items on Table 2). Of
course, the new M-3 aggregate is Bore inclusive than the old M-5, since it
contains RPs, certain overnight Eurodollar deposits, and money market mutual
fund Shares.
Some of the new aggregates and their components will continue to be
published on a weekly basis while others will be available only monthly.
The
publication schedule calls for publication of weekly and monthly data on the new
M-lA and M-1B measures.-
Data on redefined M-2 and M-3 will be available only
2/
on a monthly basis, on a schedule similar to that of old M-3.— In addition,
data on the domestic corranercial bank components of the new measures, together
with currency, money market mutual fund shares, and overnight Eurodollars, will
be published on a weekly basis, while the other components will be available
only on a monthly basis.
III.
Underlying Rationale
The organizing principle underlying the redefined monetary aggre-
gates is that of combining similar kinds of monetary assets at each level
of aggregation.
This principle has the largest Impact on the newM-18,
M-2, and M-3 measures.
Thus M-lB combines checkable deposits at
thrift
instututions--NOW deposits, credit union share draft balances, and demand
deposits at mutual savings banks—with demand, NOW, and ATS balances at
I/
2_/
The Federal Reserve Intends to publish M-1A and M-lB on Fridays (except
occasionally when holiday periods are involved), for the statement week
ending nine days earlier.
Monthly data on the new M-2 and M-3 measures normally will be published
about 10 to 15 days following the end of the month. Because of lengthier
delays associated with some of the other components of L, this aggregate
will be published about 6 to 8 weeks following the end of each month.
114
A-8
commercial banks.—
Ordinary savings and small-denomination time deposits
at commercial banks and thrift institutions are included in the new M-2.
Moreover, money market mutual fund shares, whose liquidity characteristics
are most like those of savings accounts, are also Included In this measure,
as are overnight Ms and Eurodollars.
M-3 Includes large-denomination time
deposits at both commercial banks and thrift Institutions, as well as term
«P..2/
Two M^l ttfeaswtea were adopted primarily because of uncertainties
that would arise during a transition period should legislation be enacted
that permits NOW accounts to be offered nationwide.
SOW accounts have prop-
erties of both a transactions-type account and a savings-type account, and
thus newly opened NOW accounts vould tend to attract funds both from house3/
hold demand deposits and from savings accounts and other liquid assets.—
Evidence based on the SOW account experience in New England and New York
State clearly indicates that during the transition period, when the bulk
of NOW accounts was opened, growth in total MOW balances was buoyed by shifts
from savings balances and other liquid assets.
This suggests that during a
1 7 T h e Federal Reserve intends to include the volume of travelers checks of nonhank issuers at the M-l level at some future time, once all major issuers
begin submitting such data regularly to the Federal Reserve and once these
data have been thoroughly reviewed. Travelers checks likely will be added
Co the new aggregates in conjunction with a benchmark or annual revision.
2/ Available evidence Indicates that savings and loan associations are the
only thrift institutions with a significant amount of RP liabilities outstanding. Moreover, nearly all of the savings and loan RPs are believed to
be of the term variety.
3/ Turnover data on NOW accounts corroborate this point, The turnover rate of
NOW accounts at both commercial banks and thrift institutions is approximately
10 per year; for comparison, the turnover rate for ordinary savings accounts
is about 3 per year and that of consumer demand deposit accounts Is estimated
to be about 35 per year.
115
A-9
conversion period associated with nationwide HOW accounts, growth In M-1B
could significantly overstate underlying growth in Che public's transactions
balances.—
M-1A, by contrast, would tend to understate such growth, as
households converted demand deposit balances into HOH accounts.
In practice,
since the extent of shifting from demand deposits or other accounts to NOW
accounts is uncertain, the availability of both M-l measures Is expected to
help in the interpretation of narrow tooney stock growth during the transition period, should NOW accounts be offered nationwide.
Some other financial assets have been recommended
for inclusion
at the M-l level, buE for several reasons were not added In the new H-1A
or M-1B measures.
The most common recommendations have involved shares in
money market mutual funds, RPs, and certain Eurodollars owned by U.S. residents.
Each of these assets has transactions—related characteristics.
Many
money market mutual funds offer their customers check-writing privileges—
subject to a minimum amount per check which has typically oeen §500—while
balances placed in overnight Ws and in certain overnight Eurodollars are
2/
available for spending the next business day.—
1J
2J
The problem of seasonal adjustment wouid also be magnified by nationwide NOW accounts; the currency and demand deposit components of M-1A can
be seasonally adjusted using historical data but historical data on NOW
accounts and these ocher checkable balances appearing in M-1B are not
yet sufficient for reliable seasonal adjustment. Conversions ir-jin demand
deposit accounts to NOW accounts could also influence the seasonal behavior of the demand deposit component of M-lA, should the funds shifted
from demand accounts and those remaining have different characteristics.
Only Eurodollars settled in same-day or immediately available tunds m«et
this condition. By contrast, an jvernlght Eurodollar deposit arranged
in clearing house funds is not available for spending tor cwo Business
days. Because ot time 2oa<* considerations and other conveniences» it is
believed that th« bulk of overnight Eurodollars arranged in immediately
available funds is at Lariboean brunches.
116
A-10
However, these instruments also have attractive characteristics
as liquid investments and their behavior In many portfolios appears to
be influenced by such considerations."
Evidence on turnover rates indicates
that balances in money market funds turn over much like balances in ordinary
savings accounts—about three times per year—and thus on the average
are not being actively used for transactions purposes.—
Professional
opinion currently is divided over whether KPs are mainly liquid investments
or transaction-type balances.
Some observers hold that RPs are very slmila"
to demand deposits and that the unexpected weakness that has emerged
in the public's demand for M-l-type measures at times since the mid-1970s can
"be traced largely to the behavior of RPs.
Others stress that in practice
RPs are qualitatively different from demand deposits—that they are more
Like other short-term investments—and that recent weakness in the public's
demand for the narrow money stock was not mirrored in any single liquid asset,
11
including RPs.-
I/
2/
Furthermore, empirical research by the staff indicates that the addition
of money market mutual fund shares to M-1B has not on balance enhanced
the performance of this aggregate since mid-1974.
For those studies emphasizing the transactions properties of RPs, see
Peter A. Tinsley, Bonnie Garrett, and Monica Friar, "The Measurement of
Honey Demand," (Board of Governors of the Federal Reserve System, Division
of Research and Statistics, Special Studies Section, November 1978; processed); Gillian Garcia and Simon Pale, "Some Clues in the Case of the Missing Money," American Economic Review, 69 (May 1979), pp. 330-34; and John
Wenninger and Charles Sivcsind, "Changing the M-l Definition: An Empirical
Investigation" (Federal Reserve Bank of Sew York, April 1979; processed).
An alternUive interpretation can be found in Richard D. Porter, Thomas D.
Simpson, and Eileen Mauskopf, "Financial Innovation and the Monetary Aggregates
Bcookings_gapgrs_on Ki-onprnjc^^Act^ivity 1: 1979, pp. 213-29; Richard D. Porter
and E-'.een Hauskopi, "Cash Management and the Recent Shift in the Demand for
Demand Deposits" (Board of Governors of the Federal Reserve System, Division
of Research and Statistics, Econometric and Computer Applications Section,
November 1978; processed); and Thomas D. Simpson, "The Market for Federal
Funds and Repurchase Agreements," Staff Studies 106 (Board of Governors of
the Federal Reserve System, July 1979), pp. 43-58. A summary and evaluation
of some research on this subject can tie. found In John H. Kalchbrenner, "Recent Innovations in Financial Markets and Their Relationship to Money Demand,"
paper presented at the XI Meeting of Technicians of Central Banks of the
American Continent, Port-of-Spain, Trinidad, November 19-24, 1978 (Board
nf «™«»T,n.-o «.* *v,D Vo^Qi-ai RencrvH Svstem. November 1978; processed} .
117
A-ll
Nevertheless, in recognition of the increasingly prominent rolfc
played by these assets and their potential tranactions-related features,
data on overnight BPs and Eurodollars and money market mutual fund shares will
be conveniently shown in conjunction with figures for M-1A and M-1B on the
first page of the weekly money stock release containing the money stock measures,
QSso, these items will be included in the new M-2 measure, as noted above.
In addition to money market mutual funds and overnight RPs and Eurodollars, savings and small-denomination time deposits are included at the M-2
level.
Savings deposits and small-denomination time deposits have different
liquidity characteristics.—
Nevertheless, recent innovations—most importantly
the six-month money market certificate and more recently the two-and-one-half
year variable-ceiling certificate—have substantially added to the availability
of attractive alternatives Co holding savings balances, and bow led to
shifts froa savings to these new time deposits at all depositary institutions.
In addition, the six-month money market certificate has tended to reverse a
trend toward longer maturities of small-denomination time deposits and thus
to increase the overall liquidity of such deposits.
The share of small-denomination tiae deposits at commercial banks
has been affected by regulatory changes applying to the ceiling rates that
commercial banks have been able to offer on certain time accounts relative to
if
Customers can normally withdraw funds from ordinary savings accounts when
they wish, often by telephone, although depositary institutions have the
right to require a 30-day notification prior to withdrawal. Time deposits,
by contrast, are subject to a substantial penalty for withdrawal prior to
maturity.
118
A-12
ceilings applicable to thrift institutions." As a consequence, the historical
relationship between the public's demand for sraall-denoralnation time deposits
a* coflf^rrria! Hanks and at t h r i f t Institutions pas been altered in ways that
ci*T*T!"r be t"l"ly d^tensined at this time,
Beca'.iRe small-denomination time
deposits at both commercial banks and thrift Institutions are combined in the
M-? aggre^at-.f:. along w'th the savings deposit liabilities of both, shifts of
these kinds affect only the composition of M-2 and not its
growth.
siee or rate of
Sltnila*-lv, the growing availability of money market mutual fyno shares
hai tended to reduce the public's demand for savings and sBall-de.n.cmaination
tir»e deposits A f coKnp.rciJ'l banks and t h r i f t insH tvitioos, but such shifts
are cstpturnH w i t h f n the ww M-2 aggregate, inasmuch as it includes money market
21
mutual fund stores.— Furthermore, growth in new M-2 likely vould not be
afff.c.t-.f.'t
much by conversions to NOW accounts, should they become available
YWtionwi^e, because funds absorbed by these accounts would be drawn mainly
fr<nE other Icrnd"! of accounts included in this aggregate.
I/
2J
Thrift institution shares of small-denomination time deposits were augmented
follows.™* the introduction of the six-nonth c e r t i f i c g t e by a regulatory
ceiling that perrrntted them to offer the auction rate on six-oouth Treasury
bills: bv comparison, the ceiling rate on these deposits at commercial banks
was 2S b a s i s points bplov the auction rate. Howe.vpr. ITI Mar<-h 1979 the
differ^ntisl on icorpy market c e r t i f i c a t e ceiling rates; wss reiooved--for
aution r»t?s on nijt-iormth bills in excess of 9 percent—and the commercial
bank shsrp of i-.hpse deposits subservuently tendpd to expand.
Empirical an,fllysf.s by the s t a f f indicate that the behavior of new M-2 in
recent years Kas generally not departed far from what would be expected on
t h A b3<H"! ff. longer-term hi<!t:orT':al rftTafionshi.ps, in contract to nld M-2
and soi"p oehT mp.t-^'ireR of -monfy. See Dqvid J. Bennett, Flint Brayton,
Eileen Maiiskipf, Edyard K. Offenba^her, and Richard D, Porter, "Econometric
Properties of the Redefined Monetary AEgregates" (Board of Governors of the
Federal ReserT/e Systfir-. Division of Research and Statistics, Kconooetric
and Oimpitfftr Apnlicat-n'on? Section. Febru?ry 1980; procepsed).
119
A-13
By Including large-denomination time deposits, the new M-3 iu most
comparable to the old M-5 measure.
The new ti-3 aggregate also includes
tena RPs which have some similarities to large time deposits.
The new
M-3 definition is based on the view that large-denomination time deposits
and term RPs substitute for aach other in many portfolios and that these
items, especially negotiable CDs, are relatively liquid.
The liquid assets, or L, measure adds to M-3 other liquid usgets
held by the public.
Some of these are liabilities of depositary institutions—
term Eurodollars held by U.S, nonbank residents and bankers acceptances—
while others are obligations of the U.S. Treasury—savings bonds and liquid
marketable debt.
The commercial papei component consists of obligations of a
variety of issuers, both financial institutions and nonflnanclal corporations.
Some observers note such a broad measure of liquid assets is especially
meaningful because many financial innovations in recent years have altered the
public's demands for narrower measures.
They argue that these kinds of
shifts are absorbed in a very broad aggregate, such as L,
because reductions
in demands for narrower measures of money are mirrored In increases In the demands
for other components of the broadest measure, leaving demand for the total
unaffected.
Others who focus on the volume of credit view such an aggregate
aa better reflecting the amount of credit extended to the economy, both through
the commercial banking system and through other channels.
If
Eurodollar deposits of U.S. noobank residents other than those overnight
Eurodollars that are already incorporated at the M-2 level might appropriately be included In the new M-3 measure, since they share many characteristics with domestically issued, large-denomination time deposits.
However, lags, on obtaining data on such Eurodollars are much longer
than for the other components of this aggregate, and staff work suqgests
that estimations of this component based on Information that might be
available on an earlier schedule would be subject to large revisions.
120
A-14
IV. tti&toTical Behavior of the Haw Aggregates
An examination of the growth rates and velocities of the new measures
affords a better understanding of their behavior and their relationship to
the old measures.-'
Chart 1 shows gtowth rates of M-1A and M-1B in the upper
2/ All three narrow measures have
panel, and old M-l in the lower panel.—
generally moved closely together.
In recent years, though, M-1B has tended
to increase more rapidly than either M-1A or old H-l, because of growth of
NOW and ATS accounts. During 1979, for example, with shifts in monetary asset holdings in response to the availability of new deposit services,
M-1B expanded at a rate that was 2-1/2 percentage points faster than M-1A
and old M-l; this difference reflected conversions to NOW accounts in New York
3/
State and to ATS accounts nationwide.—
Average rates of growth of these
measures over two long time periods and several cycles are shown in Table 3.
The growth rates for all three have been very similar, both on a trend and a
cyclical baais, except ia the moat recent expansion when, because of adjustment
by the public to new deposit services, average annual growth in M-1B exceeded
growth in H-1A and old M-l by slightly more than 3/4 percentage points. Should NOW
account powers be extended to depositary Institutions nationwide, a more substantial differential In rstes of growth between M-1A and M-1B could persist
for some time.
T 7 F o r econometric evidence on che new aggregates, see Bennett and others,
"Econometric Properties."
2f Appendix Table 1 contains growth rates for these aggregates annually
"~
over the 1960 to 1979 period and quarterly for the yearB 1973 to 1979.
3/ A portion of this differential in growth rates can be attributed to conversions from demand deposit accounts to ATS and NOW accounts, and the
remainder represents shifts from ordinary savings accounts and other
liquid assets.
121
A-I5
Chart I
Rates of Growth of New and Old M-l Measures
(Quarterly, seasonally adjusted at annual rates)
Percent
12 'Peak Trough
Peak Trough
Peak Trough
9 —
6 —
-3
-3 I
1960
Note:
I1962I 11964I 1966
I I 1968
II 1970
I I I1972I 1974
I
I I 1978
I I
1976
Peaks and troughs as designated by the National Bureau of Economic Research.
Table 3
Trend and Cyclical Behavior of Growth Rates of Sew and Old Measure.* of Money
Average annual rates of growth in percent
Period
1960-1979
1960-1969
1970-1979
oid
Old
M-2
M-3
New
M-3
Old
M-4
Old
M-5
9 .3
6 .9
9 .6
7.6
6.2
8.9
8 .5
7 .0
9 .9
9,0
7.2
10,8
8.1
6.5
9.6
7.2
10.3
6 .5
5 .7
6 .2
5.6
7.1
7.3
7 .1
7.2
7.3
7-.0
8.7
3.2
5.7
9.8
9.7
7.2
8.9
8.8
7 .2
10 ,8
10 .6
6.7
10.1
9.1
7 ,3
11 .4
10 .3
7.5
12.9
10.6
7.0
11.8
8.1
7.5.
12.5
9.7
Hew
M-1A
New
M-lB
Old
M-l
New
4. 9
3. 7
6. 0
5.1
3.8
6.4
4.9
3.8
6.1
1. 9
4. 8
4. 2
1.9
4.8
4.3
1.9
4.8
4.4
4. 2
6. 6
6, 2
4.2
6.8
7.1
4.2
6.9
6.3
8.8
Peak to trough—
1960:2-1961:1
1969:4-1970:4
1973:4-1975:1
21
TrotiKh to peak—
1961:1-1969:4
1970;4-1973;4 .
1975:1-1979:4-'
2/
3/
Averages of annualized quarter-to-quarter rates of growth. The base quarter for each calculation is the
quarter following the peak (peak is first q u a r t e r shown).
Averages of annualized quarter-to-quarter ratea of growth. The baae quarter for each calculation is the
quarter following the trough (trough ±9 first quarter shown).
Data for 1979:4 are moat recent quarterly data available, and this quarter may not be a. cyclical peak.
123
A-17
The public's demands for these M-l measures relative to the gross
national product vary inversely with their velocities, which are shown in the
upper panel of Chart 2,
Shown in the lover panel is the Treasury bill rate,
representing the return on a money market alternative to holding M-l balances.
Since growth in all three of these aggregates has been very similar, movements
in their velocities have been very close, although the velocity of M-1B has
risen less rapidly in recent years thao the velocities of M-1A and old M-l, reflecting shifts to NOW and ATS accounts of funds held in demand deposit accounts and in
relatively inactive savings accounts.
Average rates of increase in these velocities
over longer intervals of time and over cycles are presented in the first three
columns of Table 4.
During economic expansions, the velocities of all three mea-
sures have tended to expand at annual rates in excess of 3 percentage points
while in economic contractions levels of velocities of all three measures tend
Co decline or their growth at least slackens.
Further, in more 'recent 'cycles the
velocities oC all three measures have expanded at successively more rapid rates.
Growth in the new M-2 measure is shown in Chart 3 Cupper panel),
along with growth In the old M-2 and M-3 aggregates (center panel).—
The
bottom panel displays the differential between the yield on Treasury bills
and the ceiling rate on passbook savings accounts at corniercial banks which
can be viewed as an indicator of the attractiveness of money market instruments relative to the interest-earning deposit components of these aggregates.
This chart illustrates that growth in new M-2 has tended to vary closely with
that of old M-3 and, to a lesser extent, of old M-2.
_!/
In addition, growth in
Appendix Table 2 contains annual and recent quarterly growth rates for
these measures.
124
A-18
Chart 2
Velocities of Sew and Old M-l Measures
(Quarterly, seasonally adjusted at annual rates)
Peak Trough
7.0
Peak Trough
6.5
6.0
5.5
5.0
o
I960
Note:
1962
I
I
1964
1966
I
1968 1970
1972
1974
1976
1978
Peaks and troughs as designated by the National Bureau of Economic Research.
Table 4
Trend and Cyclical Behavior of Velocities of New «nd Old Measures of Money
Average annual rates of growth in percent
Period
1960-1979
1960-1969
1970-1979
Hew
M-1A
Hew
M-lB
Old
M-l
New
M-2
Old
M-2
Old
M-3
New
M-3
Old
M-4
Old
0.5
0.4
0,6
-0 . 3
-0 . 3
-0 . 3
-0.8
-0.6
-1.1
0.1
0.1
0.0
-0.6
-0.5
-0.7
M-5
3.2
2 .9
3 .6
3.0
2.9
3.1
3.2
2.9
3.5
-0.1
-0.2
0.0
-1 .7
-0 .3
1 .5
-1.7
-0.3
1.4
-1.7
-0.3
1.3
-6.3
-1.2
-0.5
-5.3
-2.6
-1.5
-6 .8
-2 .5
-1 .4
-6.7
-4.1
-2.4
-5.5
-5.2
-3.9
-6.9
-4.3
-3.0
3 .1
3 .6
4 .9
3.1
3.5
4.1
3.1
3.5
4.9
0.1
-0.4
0.6
0.6
0.3
2.1
0.0
-1.0
0.9
-0.2
-2.4
0.6
0.3
-0.2
-2.0
1.5
Peak to trouah1960:2-1961:1
1969:4-1970:4
1973:4-1975:1
21
Trough to p«ak—
1961:1-1969:4
1970{4-1973:4,,
1975:1-1979:4l/
2/
3/
3.0
Average* of annualized qutrter-to-quarter rates of growth. The base quarter for each calculation Is the
quarter following the peak (peak Is first quarter shown) .
Average* of annualized quarter- to-querter rates of growth. The base quarter for each calculation is the
quarter following the trough (trough ia first quarter shown).
Data for 1979:4 are noet recent quarterly data available, and this quarter may not be a cyclical peak.
126
A-20
Chart 3
Rates of Growth of Sev M-2
and Old M-2 and H-3 Measures
(Quarterly, seasonally adjusted at annual rates)
Crou
Peak
^*
Trough
Peak
Trough
20
16
16
12
M-2 — 12
Old M-2 and M-3
16
12
—
4
—
tield spread
(Treasury bill rate less passbook ceiling rate)
1960
Note:
1962
1964
1966 1968
1970
1972 1974
1976 1978
Peaks and troughs as designated by the National Bureau of Economic Research.
127
A-21
new M-2, along with growth of the two other measures shown, has been sensitive to
the yield spread, tending to slow as market rates have advanced above deposit
celling rates.
The interest sensitivity of new M-2, however, can be expected
to moderate in the future, if the proportion of this aggregate accounted
for by components with yields that vary with money market conditions continues
to expand.
As shown in Chart 4, the share of new M-2 In money market certi-
ficates has risen sharply since these accounts were introduced in mid-1978
and the money market mutual fund, and overnight RP and Eurodollar shares have
also increased In recent years.
By contrast, the M-1A and ordinary savings
account shares have generally declined.
Trend and cyclical growth rates of new M-2 and old M-2 and M-3 are
shown in the middle three columns of Table 3.
Over longer periods of time,
especially during economic expansions, growth in new M-2 has been faster than old
M-2,
In comparison with old M-3, growth in new M-2 has been moderately slower,
except during the most recent economic expansion when sharp increases in money
market mutual fund shares and expansion in overnight RPa and Eurodollars contributed to somewhat more rapid growth- in new M-2.—
The velocity of new M-2, along with velocities of old M-2 and M-3,
Is shown in Chart 5.
Hew M-2 velocity has shown very little trend movement
ovet the pact two decades, although It has displayed a tendency to vary directly
with the spread between market rates of interest and regulatory ceilings.
By contrast, the velocity of old M-2 tended to increase, especially in
recent years, while the velocity of old M-3 h»a shown a very slight tendency to
decline over the 1960s and 19708.—
I/
2/
During economic contractions, new M-2 has tended to weaken relative to old
M-2 and M-3, nalnly because growth in old M-2 and M-3 was buoyed by their
large-denomination time deposit components.
Trend and cyclical rates of growth of the velocities of these three measures are shown in the middle three columns of Table 4.
128
A-22
Chart 4
Principal Components of New M-2
Aa a percent of total
(Quarterly, seasonally adjusted—I/,)
Percent
Percent
100
100
90
90
M-1A
80
80
Other checkable deposit
70
70
60
60
50
50
Savings deposits
40
30
30
Small tine deposits
(Excluding MMCs)
20
20
Honey market certificates
(MMCs)
10
10
Money market mutual fund share
.
1960
\j
1962
1964
.
1966
.
.
1968
. Overnight H
HFa
F aand.
and.
Eucodolla
EurodolJ
1970
1972 1974 1976
1978
Other checkable deposits, MMCs, money market mutual fund shares, and overnight
RPs and Eurodollars are not seasonally adjusted.
129
A-23
Chart 5
Velocities of New M-2 and Old M-2 and M-3
Measures
(Quarterly, seasonally adjusted at annual rates
Peak
Peak Trough
Trough
Peak
2.8
Trough,
2.6
2.6
Old M-2
2.4
2.4
2.2
2.2
2.0
2.0
l.E
l.t
1.6
1.6
Old M-3
1.4
Percent
9
Yield spread
(Treasury bill rate less passbook ceiling rare)
-3
1960
Note:
1962
1964
1966
1968
1970
1972
1974
1976
1978
Peaks and troughs as designated by the national Bureau of Economic Research.
130
A-24
The rate of growth of new M-3 is shown in Chart 6 (upper panel),
along with rates of growth of the old M-4 and M-5 measures (center panel).
Also shown in the upper panel of Chart 6 Is the rate of growth of L, the
broad measure of liquid assets.—
Chart 6 illustrates that growth rates of
new M-3 and old M-5, which are similar in content, have moved closely together,
although, expansion in new M-3 haa generally exceeded that of both of its old
counterpart*. The disparity between growth in new M-3 and old M-4 and M-5
widened in the late-1970s with sizable increases in SPs, money market
mutual fund shares, and overnight Eurodollars; these items are components of
the new M-3 aggregate but were not;included in the old M-4 and M-5 aggregates.
Growth in total liquid assets, L, has been similar to—although
somewhat steadier than—that of new M-3. In recent years, there has been a
tendency for L to grow more rapidly than M-3 and other broad monetary aggregates,
reflecting a growing proportion of liquid assets that is being issued outside
domestic depositary institutions.
The velocity of new M-3 is shown in Chart 7, together with velocities of L and of old H-4 and M-5.
While the velocity of the new M-3 has
generally declined over the period shown, in recent years It has displayed
some tendency to level o f f .
The responsiveness of new M-3—and the old M-4
and M-5 measures—to changes in the interest rate spread was dampened by
the removal of regulatory ceilings on some large-denomination time deposits
in 1970 and on the remainder in 1973,
The velocity of L has also declined
aver the period shown.
I/
Annual and quarterly rates of growth of nhe new M-3 and L measures and the
old M-4 and M-5 measures are presented in Appendix Table 3, along with rates
of growth of their velocities.
131
A-25
Chart 6
Rates of Growth of New M-3 and L and Old M-A and M-5 Measures
(Quarterly, seasonally adjusted at annual rates)
Percent
New M-3 and L
Peak
Trough
Peak
Trough
-4
Old M-4 and M-5
Yield spread
9
6
—
3
—
3
9
(Treasury bill rate leas passbook ceiling rate)
^\X^
|
1960
1 1 1 1 1 1 1 1
1962
1964
1966
1968
/ 6
/- 3
•/\_ /"^
v \^ ^
1 1 1 1 -3
1 I
\ /
1970
1972
1974
1976
1978
Note: Peaks and troughs as designated by the National Bureau of Economic Research.
132
A-26
Chart 7
Velocities of New M-3 and L and Old H-4 and M-5 Measures
(Quarterly, seasonally adjusted at annual rates)
Peak
Trough
Peak Trough
I
2.4 —
— 2.4
2.2
—
2.2
1.4
—
1.4
1.2 —
1.2
Yield spread
(Treasury bill rate less passbook ceiling rate)
9
6
3
I
1960
I
1962
1
I
1964
I.
I
1966
I
I
1968
v1 V"
I I
1970
1972 1974
0
-3
1976
1978
Hote: Peaks and troughs as designated by the National Bureau of Economic Research.
133
A-27
IV.
Some Technical Issues
The new aggregates incorporate consolidation and seasonal adjustments.
In addition, several new data sources are being used or tfill.be used in their
construction.
A.
Consolidation
Consolidation adjustments have been made in the construction of each
of the new measures, in order to avoid double counting of the public's monetary
assets.— A major consolidation adjustment involves the netting of deposits
held by depositary institutions with other depositary institutions.
In construc-
ting M-1A, demand deposits held by commercial banks with other conmercial banks
have been removed.
The procedure also calls for the removal from M-1B of those
demand deposit holdings of thrift institutions that are estimated to be used in
servicing their checkable deposits, although at present the amount is negligible.
Similarly, at the M-2 level all other demand deposit holdings of thrift institutions are deducted; currently that means all such demand deposits are netted from
2/
M-2,- Savings and time deposits held by depositary institutions are also appropriately netted at the M-2 and M-3 levels.
The other major kind of consolidation adjustment involves removing
the assets held by money market mutual funds from several components appear3/ These institutions issue shares to the
ing in the M-2, M-3, and L measures.—
public and use the proceeds to acquire a variety of liquid assets that are
I/ A discussion of consolidation issues can be found in Advisory Coma!ttee on
Monetary Statistics, Improving the Monetary Aggregates, pp. 12-14, 31-27, and
in "A Proposal," pp. 32, 40-41.
2/ It has been assumed that all demand deposits owned by thrift institutions are
held to service their checkable deposits and their ordinary savings deposits.
The portion of thrift institution holdings of demand deposits to be removed at
the M'lB level is determined by the ratio of checkable deposits at thrift
institutions to the sum of their checkable and savings deposit liabilities.
3/ In general, the components against which a money market autual fund adjustment
is made exclude holdings by depositary institutions, the U.S. Government
(including the Federal Reserve), and foreign commercial banks and official
Institutions.
134
A-28
components of the new M-2, M-3 and L measures.
In order to avoid first count-
ing these amounts as money market mutual fund shales and then counting them
again as money market fund holdings of HPs, CDs, commercial paper, and so forth,
holdings of each of these assets by money market funds are subtracted from the
relevant components.
Thus money market fund holdings of BPs arc deducted in
the construction of the public's overnight RPs that appear in M-2, holdings
of domestic CDs are deducted front the large time deposit component of M-3,
and holdings of each of the assets appearing in L are appropriately netted.
Each of the principal components of the new aggregates will be published
on the money stock release on. a conaolidated--and not a gross—basis, as it
appears in the new aggregates.
Thus differences between the published M-1B and
M-2 aggregates and the sura of their published components will equal the consolidation opponents associated with thrift institution demand deposits.
B,
Seasonal Adjustment
The procedure for constructing the new MMWally adjus tad aggre-
gates has been to seasonally adjust each component—wherever possible—and
then to sum each component in deriving the appropriate total.
Some components,
however, have not been seasonally adjusted because of insufficient historical
data.—
They will be seasonally adjusted once adequate data are available.
The most Important of the components that have not yet been seasonally adjusted
(and the aggregate In which they firat appear) are as follows:
I/
In some cases, even though data are available for a sufficiently long
period to technically perform a seasonal adjustment, the series are
dominated by strong trend and thus it is unlikely that actual seasonal
patterns can be measured accurately.
135
A-29
1.
Other checkable deposits (M-1B)
2.
Overnight RPs and Eurodollars (M-2)
3.
Money market mutual fund shares (M-2)
4.
Term RPs at both commercial banks and savings and loan
associations (M-3)
5.
Other Eurodollars held by U.S. residents (L).
A standard option of the Census X-ll program was used in the
seasonal adjustment of the separate cmn>onenta of the new aggregates,
following an examination of several alternative options.
However, it
should be noted that the overall Issue of seasonal adjustment of the monetary
aggregates has been under review by a panel of outside experts, The
Committee of Experts on Seasonal Adjustment Techniques, under the chairmanship of Geoffrey H. Moore, which is scheduled to report to the Board in a
few months.—
C.
New Data Sources
Several new data sources are being used in connection with the
redefined aggregates.
Most of these new sources are associated with components
that are either new or appear separately for the first time, and they have been
obtained in order to improve the accuracy and the timeliness of the redefined
measures.
It is felt that with them the quality of monetary statistics for the
new measures will be at least comparable to that of the old measures.
if
Other members of this committee are George Boz, Hyman Kaitz, James
Stephenson, and Arnold Zellner.
136
A-30
A number of new data series began around year-end 1979 and some others
are scheduled to begin in early 1980.—
are shown, in Table 5.
The n»st Important new data sources
Most of these are collected on a sample basis, and are
then benchmarked to less frequent reports of condition in order to obtain
timely estimates of Che total volume of each item.
A sample of nonmefflber
banks is being used to estimate demand deposits, other checkable deposits,
and small and large-denomination time deposits on a weekly basis.
Similarly, a
sample of mutual savings banks, which began to be surveyed in early 1980, is
being used to construct the various components of deposits at these institutions.
In 1979, the Federal Home Loan Bank Board started collecting sample data three
times a month from savings and loan associations on the various components of the new aggregates.
A new sample of credit unions is scheduled for
implementation in the spring of 1980 and should provide timely data on several
components for these institutions.
Data on money market mutual fund shares
are being collected in a new weekly survey by the Investment Company Institute.
In addition, in a monthly survey this institute collects data on the Industry's
holdings of various assets, for use in the consolidation process.
Data on
overnight Eurodollars at offices in the Caribbean are now being collected on a
daily basis from all member banks with significant amounts of these deposits.
Finally, a new daily report on selected federal funds and RP borrowings of 123
large member banks serves as the basis for the overnight and term RP series.
I / O t h e r data sources are discussed in "A Proposal," pp. 33-40.
New Data Sources Being Used or Scheduled Co be Used in
Constructing the Redefined Monetary Aggregates
Component
(Aggregate first
appearing In)
Demand deposits (M-1A)
Honoenber banks I/
Other checkable deposits (M-1B)
Member bonks (ATS & HOW)
Nonmembec banks (ATS (• SOW)
MSBs (SOW & demand deposits)
SiLa (HOW)
;,
Credit unions (share dra.fta)SavlnRs and anall- denomination time deposits (M-2)
Honaember banks
MSBB
Credit unions^
Overnight repurchase agreements (M-2S
Mealier banks
l>werniHht Eurodollars at Caribbean branches (M-2)
Meetoer hanks
Coverage
Frequency
Lag
sample
veekly (daily avg)
2-3 weeks
universe
sample
ample
B ample
sample
weekly (daily avg)
weekly (dally avg)
weekly ( Wednesday)
thrice-fconthly
veekly (Wednesday)
1 veek
2-3 weeks
2-3 veelu
1 veek
Z-3 weeks
sample
sample
sample
veekly (daily avg)
veekly (Wednesday)
thrice-monthly
weekly (Wednesday)
2-3 weeks
2-3 weeks
1 veek
2-3 veeks
125 large member banks
weekly (dally avg)
1 veek
appro*, unlvers*
weekly (daily avg)
1 vaek
1 veftk
2-3 weeks
2-3 veeks
1 veek
Money market mutual funds shares (M-2)
universe
weekly (Wednesday)
Laree-denomlnstion time deooBltB (M-3)
Nonmember banks
M3Ba
S&LB
sample
sample
sample
weekly (dally avg)
weekly (Wednesday)
thrice-monthly
1ZS large member banks
veekly (dally avg)
lerrn ceourchase aRteeoenta CM- 3)
Henber banks
V In addition, data on demand deposits of U.S. branches and agencies of Eor eign banks would be c;illected on a
regulatory report of deposits with an application of reserve requirements to these InstitutionsI under the
ay of
the month,
138
A-32
Appendix Table 1
Rates of Monetaiy and Velocity Growth for New and
Old M-l Measures
1/
Yeari'
1960
1961
1962
1963
1964
1965
1966
1967
1968
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
Rates of Monetary Growth
Hew M-1A New M-1B Old M-l
0.6
2.8
1.8
4.0
4.3
4.4
2.7
6.4
7.4
3.8
4.8
S.6
S.5
5.7
4.7
4.7
5.5
7.7
V,4
5.5
0.6
2.8
1.8
4.0
4,4
4.4
2.7
6.3
7.4
3.8
4.8
6.6
6,5
5.8
4.7
4.9
6.0
8.1
8.2
8.0
0.4
2,8
1.4
4.0
4.5
4.3
2.9
6.4
7.6
3.9
4.8
6.6
8.4
6.2
5.1
4.6
5.8
7.9
7.2
5,5
Rates of Velocitv Growth
New M-lA New K-1B Old M-l
1.7
4.3
4.02.6
1.4
5.8
5.3
-0,3
1.8
2.6
-0.3
2.7
3.0
5.2
2.4
5.1
4.2
4.2
5.6
4.2
1.7
4.3
4.0
2.6
1.4
5.8
5.3
-0.2
1.7
2.6
-0.3
1,8
4.2
4.4
2.6
1.3
5.8
5.1
-0.3
1.6
2.5
-0.3
2.8
2.7
3.0
5.1
2.4
4.9
3.7
3.9
4.8
1.6
4.6
2.0
5.2
3,9
4.0
5,8
4.2
6.5
2.4
4.5
6.6
6.4
2.2
3.8
5.9
-2.6
-3.1
5.4
5.4
1.2
4.9
4.5
1.6
-2,3
6.1
10.0
-1.3
5.4
8.1
0.8
3.8
1.8
5.2
5,3
5.0
5.6
9.2
0,7
3.6
1.9
7.0
4.8
2.9
1.1
1.4
9.0
2.6
9.6
3.1
2/
quarter—
1973—1
2
3
4
1974—1
2
3
4
1975—1
2
3
4
1976—1
2
3
4
1977—1
2
3
A
1978—1
2
3
4
1979—1
2
3
i/
2J
8,5
8.4
6.7
4.9
5.1
2,4
5.2
4.5
4.6
5.4
4.8
6.5
7,3
6.7
-2.6
4,1
3.6
5.4
4.1
5.4
3,1
4.6
1.4
5,0
2.0
2.9
-2.0
5.3
6.0
5.9
7.2
7.0
7.3
10.3
3.0
5.7
3.2
2.9
4.6
5.7
S.4
8.4
6.4
5.8
1.3
6.3
4.1
3,9
3.4
4.3
7.4
7.0
2.4
7,6
7.4
9.3
a, a
5.6
7.4
6.9
6.7
5.5
6.6
6.5
6.0
5.6
7,4
8.7
0.1
8.4
6.6
7.6
7.9
0.5
9.2
9.1
6.7
9.6
7.9
7.1
3.4
7.3
4.3
5.6
8.3
7.4
-1.3
4.8
0.2
9.9
8.1
-1.2
10.7
7,8
9.7
10.1
2.6
8.8
4
5.0
5.3
4.7
5.1
Fourth quartet over fourth quarter growth rate.
seasonally
adjusted data,
Annualized growth rates based on
8.2
4.9
4.4
4.8
6,7
3.6
3,1
4,9
2.6
5.9
-0.2
0.2
9.1
3.2
6.5
5.3
-4.0
1.3
4.6
6.2
10.0
11.6
-1.5
J..7
4.8
139
A-33
Appendix Table 2
Rates of Monetary and Velocity Growth for Has M-2
and Old M-2 and M-3 Measures
i™.-
1960
1961
1962
1963
1964
1965
1966
1967
1968
1969
1970
1971
1972
1973
1974
1975
1976
1977
197B
1979
Rates of Monetary (Jrowth
Old M-3
Old M-2
New M-2
4.6
7.1
8.0
8.6
7.9
8.0
4.9
9.3
8.0
4.2
5.8
13.5
12.9
7.3
6.0
12.3
13.7
11.5
8.4
a.e
2.6
5.4
5.9
7.0
6.7
8.6
6.0
9.9
9,0
3.2
7.2
11.3
11.2
8.8
7.7
8.4
10.9
9.8
8.7
8.3
4.8
7.1
7.7
8.7
8.3
8.6
5.4
9.7
8.1
3.6
7.2
13.5
13.3
9.0
7.1
U.I
12.7
11.7
9.5
8.1
Rat KB of. Velocity Growth
New M-2
-2.3,
0.0
-2.0
-1.8
-2.0
2.2
3.1
-2.9
1.2
2.3
-1.2
-3.5
-1.0
3.5
1-1
-2.0
-3.3
0.7
4.6
1.0
Old M-2
Old K-3
-0.3
1.7
-0.0
-0.3
-0.8
1.7
2.0
-3.4
0.3
3.2
-2.6
-1.6
C.5
2.1
-0.5
1.5
-0.9
2.2
4,3
1.4
-2.4
0.0
-1,7
-1.9
-2.2
1.7
2,7
-3.3
1.1
2.8
-2.5
-3.5
-1.3
L.9
0.1
-1.0
-2.5
0.5
3.6
1.6
5.2
-0.4
1.3
2.4
-6.1
2.1
2.4
-0.4
-5.7
2.5
7.2
1.9
3.3
4.1
-1.0
1.6
3.1
-5.3
2,6
3.3
-0.2
-7.5
-0.1
4.5
-0.7
1.9
-4.7
-3.1
-4.3
2.1
1.7
-0.2
-1.6
0.0
9,8
0.3
4.1
4.8
-1.3
0.9
2.1
2f
gugrtey—
4.7
10.3
10.9
9.8
0.4
7.7
6.9
8.3
3.0
7.4
7.7
6.0
6.0
9.0
8.2
5.4
-3.9
HK3
9.6
8.0
3.8
7.0
6.4
5.2
4.2
5.2
6.1
4.4
6.6
6.4
5,8
0.5
6.4
-7.1
7.8
a. 2
9.5
-2.7
12.4
14.9
10.0
2.8
12.8
14.6
-1.1
9.4
6.8
9.9
12.0
10.5
L3.0
0.9
-5.4
11.9
10. 0
12.7
11.0
8.9
11.3
-3,4
-5.6
13.8
12.6
4
15.2
12.4
13,7
0.9
10.9
1977—1
1.0
10.5
11.2
9.0
2
11.8
10.1
9.6
1.9
3
-1.2
10.1
7,9
9.7
4
7,0
0.6
8.1
7,5
1978—1
8.4
10.8
8.4
7.5
2
9.8
8.2
2.3
10.3
3
4.4
9.8
8.5
9,5
4
2.8
3.9
5.3
6.3
1979—1
8.8
-3.5
7.9
10.2
2
1.1
11,9
3
10.5
10.3
2.7
7.8
8.9
7.2
4
Fourth quarter over fourth growth rate.
2J Anflualized growth rates based on seasonally adjusted data.
1973—1
2
3
4
1974—1
2
3
4
1975—1
2
3
4
1976—1
2
3
-2.8
-1.1
-3.1
3.6
3.2
1.5
0.5
1.1
9.9
0.8
5.4
7.3
-2,1
-0,5
1.6
140
A-34
Appendix Table 3
Hates of Monetary and Velocity Growth for New M-3 and L
and Old M-4 and M-5 Measures
, .
iear^
Rates of Monetary Growth
Old H-5
Old M-4
Sea L
Mew M-3
1960
1961
1962
1963
1964
1965
1966
1967
1968
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
Rates of Velocity Growth
Old MOld M-4
New H-3 New L
4.8
7.7
8.3
9.5
8.9
9.2
5.2
10.4
8.7
1.5
8.9
14.8
14.0
11.7
8.7
9.4
11.4
12.6
11.3
9.5
3.5
6.2
8.0
8.4
7.3
8.1
5.5
8.5
9.5
4.4
6.5
10.4
12.9
12.3
9.6
9.8
11.0
12.6
12.3
n.a.
2.6
6.5
7.1
8.3
7.8
9.5
5.5
10.7
9.3
0.1
10.2
12.8
12,3
12.0
10.7
6.6
7.1
10.1
10.6
7.5
4.8
7.9
8.5
9,6
9.0
9.1
5.0
10.3
6.3
1.5
9.2
14.3
13.9
11.0
9.0
9.7
10.2
11.7
10. 6
7.6
-2.5
-0.5
-2.7
-2,6
-2.8
1.1
2.8
-3.9
0.6
5.0
-4.1
-4.6
-2.0
-0-5
-1.4
0.6
-1.3
-0.3
1.9
0.3
-1.2
0.9
-2.0
-1.6
-1.4
2.2
2.5
-2.2
-0,2
2.0
-1.9
-0.8
-1,0
-1.1
-2.2
0.2
-1.0
-0.3
1.0
n.a.
-0.3
0.6
-1.2
-1.6
-1.8
0.9
2.6
-4.2
0.0
6.4
-5.1
-2.9
-0.5
-0.8
-3.1
3.3
2.6
2.0
2.5
2.2
-2.4
-0.7
-2.4
-2.7
-2.9
1.2
3.0
-3.8
0.9
4.9
-4.3
-4.2
-1.9
0,1
-1.7
0.3
-0.3
0.5
2.5
2.1
14.0
11.7
11.2
8.0
10.1
10.6
7.7
5.4
7.2
9.4
10.7
9.1
9.9
11.3
10,3
12.1
12.4
11.4
11.7
12.5
10.5
11.1
10.3
11.5
7.9
8.8
10.3
9.8
14.0
12.3
11.8
9.1
11.0
11.1
8.4
6.6
7.1
9.5
10.5
10.7
10. 1
11.1
10.0
10.6
11.5
11.8
12,2
12.8
11.2
12.4
11.3
12.2
10.4
13.1
LI. 7
n.a.
14,2
13.8
11.0
7.0
11.4
12.8
9.9
6.9
7.6
13.7
12,2
9.6
7.1
10.2
10.3
7.8
6.7
8.9
9.5
10.1
8.8
9,0
9.4
9.2
11.8
11. 8
10.0
11.7
11.5
10.0
9.8
10.4
10.7
6.8
4.9
8.9
9.1
1.0
-4.3
-2.2
3.3
-5.9
-1.5
0.9
0.8
-6.4
2.6
6.5
-0.4
4.0
-4.1
-2.5
-2.6
2.2
0.8
-0.1
-3.9
-2.3
7.2
0.2
2.4
2.3
-2.2
1.1
0.1
1.1
-4.8
-2.7
2.2
-6.7
-1.9
0.1
-0.3
-6.4
2.5
6.8
-1.9
3.7
-3.9
-2.2
-1.4
3.0
0.4
-0.6
-4.2
-3.0
5.9
-0.7
1.8
-0.2
-6.3
-0.3
n.a.
0.9
-6.3
-1.9
4.4
-7.1
-3.6
-1.3
-O.J
-6.9
6.5
11.1
2.4
7.8
1.0
1.5
-0.1
4.4
3.9
1.6
-1.9
-2,1
7.6
0.6
3.8
4.7
2.9
2.2
-1.0
1.3
-4.7
-0.6
4.3
-6.0
-1.2
0.8
-0.4
-8.1
2.5
7.1
-0.1
4.8
-2.2
-1.4
-2.3
2.7
2,2
-0.1
-2.9
-1,8
8.4
0.2
3.3
3.4
1.7
2,5
0.8
2/
Juatter—
1973—1
2
3
4
1974—1
2
3
4
1975—1
2
3
4
1976—1
2
3
4
1977—1
2
3
4
1978—1
2
3
<V
1979—1
2
3
4
5.5
6.2
6.2
6.0
6.0
6.3
9.5
10.1
8.3
10.0
10.4
10.2
10.6
9.9
10.1
5.4
3.7
9.2
11. 0
n.a.—NOE available as data for December 1979 are incomplete.
I/ Fourth quarter over fourth quarter growth rates.
2J Annualized growth rates based on seasonally adjusted data.
141
APPENDIX B
DESCRIPTION OF THE NEW PROCEDURES FOR CONTROLLING MONEY
B-l
I*e Hew Federal Reserve Technical Procedures
for Controlling Money
As part of its anti-inflationary program announced on October 6,
1979,
the Federal Reserve changed open market operating procedures to place
more emphasis on controlling reserves directly so as to provide more
assurance of attaining basic money'supply objectives.
Previously, the
reserve supply had been more passively determined by what was needed to
maintain, In any given short-run period, a level of short-term interest
rates, in particular a level of the federal funds rate, that was considered consistent with longer-term money growth targets.
Thus, the new
procedures entail greater freedom for interest rates to change over the
short-run in response to market forces. —
This note describes the new technical operating procedures and
how the linkage between reserves and money involved in the procedures is
influenced by the existing institutional framework and other factors.
This
linkage is relatively complicated and variable, particularly over the shortrun, so that, for example, it does not necessarily follow that rapid
expansion of reserves would be accompanied by, or would presage, rapid
expansion of money.
The exact relationship depends on the behavior of other
factors besides money that absorb or release reserves, and consideration must
also be given to timing problems in connection with lagged reserve accounting.
In setting reserve paths to control money under existing conditions
account must be taken of: (1) the prevailing reserve requirement structure,
with varying reserve requirements by type of deposit (some of which may
not be included in targeted money measures) and by size of deposit;
(ti) the public's demand for currency relative to deposits; (iii) availability
of reserves at bank initiative from the discount window; (iv) lags in response
IJ
Consistent with this, the federal funds rate range adopted by the Federal
Open Market Consult tee for an Intermeeting period has been greatly widened.
142
B-2
on the part of the public and banks to changes in reserve supply through open
market operations; (v) the growing amount of money-supply type deposits at
institutions not subject to reserve requirements set by the Federal Reserve;
(vi) lagged reserve accounting.
To help Insure that operations are under-
taken most effectively, the Federal Reserve has the new operating technique
and related factors under continuous examination in light of experience
gained,
At present, studies are under way on such elements as lagged reserve
accounting and the role of the discount window.
Possible changes in other
elements involved with the technique would require Congressional action—such
as extending reserve requirements to nonmember Institutions and certain
aspects of simplifying reserve structure.
The principal steps in the new procedure are outlined below.
(1)
The policy process first involves a decision by the Federal
Open Market Committee on the rate o£ increase In money it wishes to achieve.
For instance, at its October 6 meeting, taking account of its longer-run
monetary targets and economic and financial conditions, the Committee
agreed upon an annual rate of growth in M-l over the 3-month period from
September to December on the order of 4% percent, and of M-2 of about
7% percent, but also agreed that somewhat slower growth was acceptable,
(2) After the objective for money supply growth is set, reserve
paths expected to achieve such growth ate established for a family of reserve
measures.
These measures consist of total reserves, the monetary base
(essentially total reserves of member banks plus currency in circulation),
and nonborrowed reserves.
Establishment of the paths involves projecting
how rauch of the targeted money growth is likely to take the form of currency,
of deposits at nonmember institutions, and of deposits at member institutions
(taking account of differential reserve requirements by size of demand deposits
aad between the demand and time sad savings deposit components of M-2).
143
B-3
Moreover, estimates are made of reserves likely to be absorbed by expansion
in other bank liabilities subject to reserve requirements, such as large
CD's, at a pace that appears consistent with money supply objectives and
also takes account of tolerable changes in bank credit.
Such estimates are
necessary because reserves that banks use to support expansion of
D ' s , for
example, would not be available to support expansion in M-l and M-2. Thus,
if the reserves required behind CD's were not provided for in the reserve,
path, expansion in M-l and M-2 would be weaker than desired.
The opposite
would be the case if the reserve path were not reduced to reflect contraction
of large C D ' s . For similar reasons, estimates are also made of the amount
of excess reserves banks are likely to hold.
(3)
The projected mix of currency and deposits, given the reserve
requirements for deposits and banks' excess reserves, yields an estimate of
the increase in total reserves and the monetary base consistent with FOMC
monetary targets.
The amount of nonborrowed reserves—that is total reserves
less member bank borrowing--ls obtained by initially assuming a level of
borrowing near that prevailing in the most recent period.
For instance,
following the October 6 decision, a level of borrowing somewhat above that
of September was initially assumed.
Following subsequent meetings, the assumed
level of borrowing for the nonborrowed path was always close to the level prevailing around the time of the FOMC meeting, tho.ugh varying a little above and
below that level.
(4)
Initial paths established for the family of reserve measures
over, say, a 3-month period are then translated into reserve levels covering
shorter periods between meetings.
These paths can be based on a constant
seasonally adjusted rate of growth of the money targets on, say, a month-bytnonth basis, or can lnv^lv> variable mcathly growth r-at^j vithln the 3-n»nth
period if that appears to facilitate achievement of the longer-run money targets
144
B-4
(5)
Total reserves provide the basis for deposits and thereby
are more closely related to the aggregates than nonborrowed reserves. Thus
total reserves represents the principal over-all reserve objective.— However, only nonborrowed reserves arc directly under control through open
market operations, though they can be adjusted in response to changes In
bank demand far reserves obtained through borrowing at the discount window.
(6)
Because fumborrowed reserves ate wore closely under control
of the System Account Manager for open market operations (though subject
to a small range of error because of the behavior of non-controlled factors
affecting reserves, such as float), he would Initially aim at a nonborrowed
reserve target (seasonally unadjusted for operating purposes) established
for the operating period between meetings. To understand how this would
lead to control of total reserves and money supply, suppose that the demand
for money ran stronger than was being targeted--ae it did in early October
of last year.
The increased demand for money and also for bank reserves
to support the money would in the first instance be accompanied by more
Intensive efforts on the part of banks to obtain reserves in the federal
funds market, thereby tending to bid up the federal funds rate, and by
increased borrowing at the Federal Reserve discount window. As a result
I/
In the control process, the monetary base in practice Is given less
weight than total reserves. This is principally for a technical reason.
If currency, the principal component of the base, is running stronger
than anticipated, achievement o£ a base target would require a dollarfor-dollar weakening in member bank reserves. But, because of fractional
reserve requirements, the weakening in reserves would have a multiple
effect on the deposit components of the monetary aggregates (it could
weaken the demand deposit component by about 6 times the decline in
reserves). Achievement of a base target in the short run could therefore lead, in this example, to a much weaker money supply than targeted.
If a total reserve target were achieved, the money supply would be
stronger than targeted, but only by the amount by which currency is
stronger than expected. Thus, the variation from a money supply target
would be less under total reserves than under a monetary base guide. Of
course, should currency persistently run stronger or weaker than expected,
compensating adjustments could be made to either a total reserves ot
monetary base target.
145
B-5
of the latter, total reserves and the monetary base would for a while run
stronger than targeted.
Whether total reserves tend to remain above target
for any sustained period .depends in part on the nature of the bulge In
reserve demand--whether or not It was transitory, for example—and In part
on the degree to which emerging market conditions reflect or induce adjustments on the part of banks and the public.
These responses on the part of
banks, for example, could include sales of securities to the public (thereby
extinguishing deposits) and changes in lending policies.
(7) Should total reserves be showing sustained strength, closer
control over them could be obtained by lowering the nonborrowed reserve
path (to attempt to offset the expansion In member bank borrowing) and/or
by raising the discount rate.
A rise in the discount rate would, for any
given supply of nonborrowed reserves, initially tend to raise market interest
rates, thereby working to speed up the adjustment process of the public and
banks and encouraging a more prompt move back to the path for total reserves
and the monetary base.
Itua, whether adjustments are made in the nonborrowed
path—the only path that can be controlled directly through open market
operations—and/or in the discount rate depends In part on emerging behavior
by banks and the public.
Under present circumstances, however, both the
timing of market response to a rise In money and reserve demand, and the
ability to control total reserves In the short run within close tolerance
146
B-6
limits, are influenced by the two-week lag betveea bank deposits and required
reserves behind these deposits.—
(8) Other interneeting adjustments can be made to the reserve
paths as a family.
These may be needed when it becomes clear that the
multiplier relationship between reserves and money has varied from expectations.. The relationship can vary when, for example, excess reserves and
non-money teaervable liabilities are clearly running higher or lower than
anticipated.
Since October 6 such adjustments during the intermeeting
period have been made infrequently.
Given the naturally large week-to-week
fluctuations in factors affecting the reserve ovltiplier, deviation from
expectations in one direction over a period of several weeks would be needed
before it would be clear that a change in trend has taken place.
A variable relationship between expansion of reserves and of
money is implicit in the description of procedures just given.
This is
illustrated by experience in the fourth quarter, as shown in the table on
the next page.
It can be seen from panel 1 that M-l increased at only a
3.1 percent annual rate (seasonally adjusted) in that period and M-2 at a
6.S percent rate.
At the same time, as shown in panel II, nonborrowed
reserves, total reserve and the monetary base rose at substantially more
rapid rates—by annual rates of about 13, 134, and 8 percent, respectively.
There were a number of reasons for the mach more rapid growth in
reserves and the base than in the monetary aggregates.
Only about 1 per-
centage point of the 13% percent annual rate of increase in total reserves
I/
Under lagged accounting, banks are not required to hold reserves against
deposits until two weeks later. With required reserves fixed at that
time, the Federal Reserve in its operations is limited in its ability
to control total reserves within a given week (since the total of
reserves is determined by required reserves and banks' excess reserves),
but can more readily determine whether the backing system satisfies its
reserve requirement through the availability of nonborrowed reserves,
or is forced to turn to the discount window (or to reduce excess reserves,
though most banks are usually close to minimal levels in that respect).
147
B-7
Changes to Reserve and Monetary Aggregates
September to December 1979
(Seasonally adjusted)
Percent , ,
Annual Rate-7
I.
Changes in Monetary Aggregates:
A.
M-l
1.
2.
3.
B.
II.
Currency outside banks
Member bank demand deposits
ffotunember bank demand deposits
M-2
3.1
2845
5.3
2.3
2.1
1400
972
473
6.8
15961
Changes in Reserves and Related Items:
A. Honborrowed reserves
B. Borrowings
C. Total reserves (A + B)
D. Currency 2/
E. Monetary base (C + D)
1309
12.9
-13.8
5.9
8.1
Percentage Points
Contributed Towards
Growth of
Total Reserves
III.
Change in
Mi11lone S
131
1430
1606
3046
Change in
Millions $
Total Reserves Absorbed by:
A.
B.
C.
D.
E.
F.
G.
Private demand deposits
Interbank demand deposits
U.S. Government demand deposits
Large, negotiable CD's
M-2 time and savings deposits
Bondeposit Items
Excess reserves
1.1
2.7
0.0
3.6
4.5
0.0
2.0
111
280
3
378
466
-3
205
Addendum:
Impact of lagged reserve accounting on:
1. Total reserves
2. Reserves against private demand
deposits
3.
4.
I/
Reserves against M-2 time and
savings deposits
All other Items subject to reserves
287-64
121
230
Growth rates of reserves adjusted for discontinuities in series that result
from changes in Regulations D and M.
2j Includes vault cash of nonmember banks.
_3/ Reflects change in total reserves during period attributable to fact that
required reserves are based on deposits two weeks earlier, rather than on
deposits contemporaneous with reserves. Thus, adjusted to a basis contemporaneous with deposit growth from September to December, total reserves
would have expanded $287 million, or 2.8 percentage points, leas than they
actually did.
148
supported growth in the member bank demand deposit component of M-l (as may
be seen from line III.A of the table).
An additional 4^ percentage points
supported the member bank interest-bearing component of M-2 (line III.E).
thus less than half of the increase la reserves supported expansion in
targeted monetary aggregates. More than half of the reserves supported
expansion In Interbank demand deposits, excess reserves, end large negotiable
CD's,
If these reserves had not been supplied, growth in M-l and M-2 would
have been much slower.
In fact, actual growth in M-l and M-2 was a bit slower
than targeted, though not less Chan the Conmittee found acceptable.—
As thla example from recent experience helps demonstrate, the
behavior of reserve measures in relation to money can be expected to vary
with shifts in the currency and deposit mix, with changes in bank demands
for excess reserves and borrowing, and with timing problems related to lagged
reserve accounting.
But even in evaluating money growth itself, which the
Federal Open Market Committee sets as a target in the policy process,
recognition has to be given to the likelihood that money growth can
vary substantially on a month-to-month basis in view of inherently large
and erratic money flows in so vast and complex an econowy as ours.
I/
Moreover, the relatively rapid expansion in reserve measures was not
associated with strength in bank credit, which in the fourth quarter grew
at only about a 3 percent annual rate, well below its earlier pace. The
slow expansion in bank credit during the fourth quarter reflected, on the
liability side, a sharp reduction in the outstanding amount of borrowing
by banks through Euro-dollars, federal funds, and repurchase agreements.
January 30, 1980
149
Congressional Research Service
The Library of Congress
by
February 21, 1980
F. Jean Wells
Roger S. White
Specialists in Honey and flanking
Economics Division
BRIEFING MATERIALS FOR MONETARY POLICY OVERSIGHT
This briefing document has been prepared to assist the Senate Committee
on Banking, Housing, and Urban Affairs in monetary policy oversight conducted
purusant to P.L. 95-523.
It presents selected indicators for the economic
setting in which monetary policy operates as well ag indicators of the
direction of monetary policy itself.
The first two sections of the report deal with monetary and fiscal policy
variables.
Several presentations relating to 1980 Federal Reserve targets for
the growth of money and credit are included in Section I of the report.
The
money growth targets are in terns of the new official definitions for measures
of the money supply.
A table showing the Federal Reserve System one-year
target ranges find actual growth rates from 1975 through 1979 for various
measures of the money supply using the old definitions is also included in
this section.
Sections III through VI of the report present forecasts for the economy
and trace past behavior of selected economic variables. This information is
provided to assist the Committee in revieving the Federal Reserve's plans
and objectives for monetary policy as they relate to prevailing economic
conditions and to short-term economic goals set forth in the Economic Report
of the President,,,
Assistance i^ preparing this report was obtained from Barbara L. Miles,
Specialist in Housing, Barry E. Molefsky, Analyst in Econometrics, Arlene E.
Wilson, Analyst in International Trade and Finance, and Philip D. Winters,
150
CRS-ii
Analyst in Regional Economics, all of the Economics Division.
Secretarial
production assistance was provided by Nancy Drexler.
Listing of tables and graphs
1.
Pag^
Monetary measures and Federal Reserve System targets:
Monetary and credit aggregates—actual levels and
fourth quarter growth rates, 1975-1979, and Federal
Reserve projected growth ranges froa fourth quarter
1979 to fourth quarter 1980:
Money supply: M-1A acid M-1B (graph)
Money supply: M-2 and M-3 (graph)
Bank credit (graph 1
1
2
3
,
Federal Reserve System one-year target ranges atid actual
growth rates for monetary aggregates under old definitious
for money, 1975-1979 (table)
II.
Federal b u d g e t d a t a :
Federal budget receipts and outlays, fiscal years 1977-1981
(table)
Federal finances and the gross national product, 1958-1983
(table)
III.
Economic forecasts and economic
goals:
1980 economic projections of the Board of Governors of the
Federal Reserve System (table)
1980 economic forecasts and Administration goals (table)
...........
1981 economic forecasts and Administration goals (table) ........ ...
9
10
Summary of Administration goals consistent with the
objectives of the Humphrey-Hawkins Act, 1980-1985
(table) .....................................................
IV.
Past behavior of economic goal variables:
Employment — total civilian employment, persons aged 16
and over, 1975-1979 (graph) ..................................... ...
Unemployment — percent of total civilian labor force,
persons aged 16 and over, 1975-1979 (graph)
1-
151
Production—real gross national product, rates of
change 1975-1979 (graph)
Real Income—real disposable income, rates of change,
1975-1979 (graph)
14
Productivity—nonfarm business sector, rates of change,
1975-1979 (graph)
15
Prices—consumer price index, r a t e s of change, 1975-1979
(graph)
16
Selected international statistics
Exports, imports, trade balance and trade-weighted
exchange value of the U.S. Dollar, 1975-1979 (table)
VI.
Financial sector:
Selected monetary, credit, and reserve aggregates,
growth rates, 1976 through fourth quarter 1979 (table)
lo
Income velocity of money, M-1A and M-1B, rates of
Change, 1977-1979 (graph)
19
Selected interest rates, 1975 through January
1980:
Graph
Table
20
21
Funds raised in U.S. credit markets, 1975 through third
quarter 1979 (table)
22
152
MONEY SUPPLY (M-1A) & (M-1B)
Actual Levels and Fourth Quarter to Fourth Quarter
Growth Rates from Fourth Quarter 1975
* Billions
450 -
400
350
300
IV
10
1975
II
111
IV
1976
IQ
'*•
II
III
IV
1977
IQ
*
II
111
IV
1978
10
"
II
111
IV
1979
tQ
II
IN
^—1980
IV
'
* Billions
450
400
IV
IQ
1975'
u
1976
III
IV
IQ
n
in
1977
iv
10
II
III
1978
IV
IQ
HI
1979
rv
10
II
1980
III
IV
153
CRS-2
MONEY SUPPLY (M-2) & (M-3)
Actual Levels and Fourth Quarter to Fourth Quarter
Growth Rates from Fourth Quarter 1975
I Billions
IV
IQ
1975
U
Jll
IV
I(J
"
1976
IL
HI
1977
IV
10
-"
II
III
IV
1Q
A
1978
II
III
IV
1979
-"
II
IV
10
II
II)
|V
'
1980
I Billions
(M-3]
2000
1800
1600
1400
1200
1000 J
IV
1975^
IQ
II
I
III
-1976-
L
IV
J
10
II
[||
-1977-
Diuilurc, Oulr
t Fiddl ftwrvt STi
L
[V
(Q
(I
III
-1978-
IV
IQ
III
-1979-
IQ
II
III
-1980-
IV
154
CRS-3
BANK CREDIT
Actual Levels and Fourth Quarter to Fourth Quarter
Growth Rates from Fourth Quarter 1975
Billions
155
CRS-4
FEDERAL RESERVE SYSTEM ONE-YEAR TARGET RANGES AND ACTUAL GROWTH RATES
FOB. MONETARY AGGREGATES UNDER OLD DEFINITIONS FOR HOUEf
(Growth rates in percent)
Ml
Period
Target
M2
Actual
Target
M3
Actual
Target
Actual
Mat. 1975 to Hat. 1976
5.0-1.5
5.3
6.5-10.5
9.7
10.0-12.0
1975: Q2 to 1976: Q2
5.0 - 7.5
5.3
8.5 - 10.5
9.6
10.0 - 12.0 12.1
1975: Q3 to 1976: Q3
5.0 - 7.5
4.6
7.5 - 10.5
9.3
9.0 - 12.0 11.5
1975: Q4 to 1976: Q4
4.5 - 7.5
5.8
7.5 - 10.5 10.9
9.0 - 12.0
12.2
12.7
1976: Ql to 1977; Ql
4.5 - 7.0
6.5
7.5 - 10.0 11.0
9.0 - 12.0 12.9
1976: Q2 to 1977: Q2
4.5 - 7.0
6.8
7.5 -
9.0 - 11.0 12.5
9.5
10.8
4.5 - 6.5
8.0
7.5 - 10.0 11.1
9.0 - 11.5 12.7
1916: Q4 to 1977: Q4
4.5 - 6.5
7.9
7.0 - 10.0
9.8
8.5 - 11.5 11.7
1977: Ql to 1978: Ql
4.5 - 6.5
7.7
7.0 -
9.5
8.8
8.5 - 11.0
10.5
1977: Q2 to 1978: Q2
4.0 - 6.5
8.2
7.0 -
9.5
8.6
8.5 - 11.0
10.0
1977: Q3 to 1978: Q3
4.0 - 6.5
8.0
6.5 -
9.0
8.5
8.0 - 10.5
9.5
1977: Q4 to 1978: Q4
4.0 - 6.5
7.2
6.5 -
9.0
8.7
7.5 - 10.0
9.5
1976: Q3 to 1977: Q3
1978: Ql to 1979: Ql
4.0 - 6.5
5.1
6.5 -
9.0
7.6
7.5 - 10.0
8.7
1978: Q2 to 1979: Q2
4.0 - 6.5
4.8
6.5 -
9.0
7.7
7.5 - 10.0
8.6
1978: Q3 to 1979: Q3
2.0 - 6.D
5.3
6.5 -
9.0
8.2
7.5 - 10.0
8.7
1978: Q4 to 1979: Q4
For notes «ee next page.
!_/
5.5
5.0 -
8.0
8.3
6.0 -
9.0
8.1
156
CRS-5
Old d e f i n i t i o n s for money:
Ml * private demand deposits plus c u r r e n c y .
K2 •= HI plus bank time and savings deposits other than large negotiable C D ' s .
M3 • M2 plus deposits at mutual savings b a n k s , savings and loan associations
and credit unions.
I/
"~
Hie Ml range i n i t i a l l y announced for this period, 1.5J to 4 . 5 K , was based
on an assumption about the rate at which the public would s h i f t balances
from bank checking accounts to new interest earning transactions a c c o u n t s .
The FRS estimated that use of new account forms would dampen Ml growth by
3 percentage points over the year. During the year, the FRS noted t h a t
use of these accounts as alternatives to Ml deposits was more moderate
than i n i t i a l l y anticipated and accordingly a d j u s t e d the growth r a n g e for
Ml u p w a r d . As of October 1979, the F R S ' s a d j u s t e d range for Ml was 3.02
to 6.OS.
Source:
A c t u a l growth d a t a are based on s e a s o n a l l y a d j u s t e d money supply
series of the Board of Governors of the Federal Reserve System as
revised in January 1980. Target ranges are those announced b e f o r e
House and Senate Banking Committees beginning in May 1975 according
to procedures developed under H. Con. Res. 133 of the 94th Congress
and later under P.L. 95-188. Beginning in 19T9, target ranges were
announced in accordance with provisions of P.L, 95-523.
157
CRS-6
FEDERAL BUDGET RECEIPTS AND OUTLAYS
(in billions of dollars) I/
Budget
surplus or
deficit
Budget
receipts
Budget
outlays
1977
357,.8
402.7
-45.0
1978
402,,0
450.8
-48.8
1979
465. .9
493.7
-27.7
Second C o n c u r r e n t R e s o l u t i o n ,
November 1979 2J
517 .8
547.6
-29.8
January Budget 3/
523..8
563.6
-39.8
600 .0
615.8
-15.8
Fiscal year 1979
99.4
123.4
-24.0
Fiscal year 1980
114.0
138.7
-24.6
Fiscal y e a r or p e r i o d
1980 ( e s t i m a t e s )
1981 ( e s t i m a t e s ) 3/
Cumulative totals, first 3 months:
I/
U n i f i e d budget basis.
II
Second C o n c u r r e n t R e s o l u t i o n on Che Budget—Fiscal Year 1980, November 28,
1979.
3/
Estimates from Budget of the United States Government, F i s c a l Year 1981.
Source:
Economic I n d i c a t o r s , January 1980.
158
FEDERAL F I N A N C E S AND THE. GROSS NATIONAL PRODUCT,
1958-1983
( D o l l a r amounts in b i l l i o n s )
taw
fa*"- r*A
Hammt •vv*/
ly-Dtalc'
fU|*h
VIDU
WHC tUpl
""'
1951
1SS9
1733
1973
son
1961
1%;
isw
5469
5763
1961
IKi . _
1566
61(2
65' 1
721 1
7)44
1299
I9«7
1KI
9037
9590
1.0192
1.1105
1969
1171
1971
1972
1ST3
1974 _ _
1975 __„
IS 16
1977
UU —
1979
1990 (Jtmal!
198 1 amuw
1912 (Sircar;
IWesaute
7SJ
9? 5
944
93!
1066
HP ;
1168
1309
1(96
1537
18)9
1937
1914
1,23) i
2086
2322
1.3592
2619
1 457 3
16; i o
lilt
3000
1.8433
3W8
1060 1
23134
j'.swa
q
,—
.. .
. .
)61 1
}.\an
3,5130
46S9
i?ss
ssoo
6911
79!!
110
167
lie
186
If?
ISi
1)1
16 1
19 i
185
201
202
18 S
lit
18!
19 S
193
its
19.4
195
201
MS
217
222
227
*""'
JI1
9? 2
9)!
It* 8
1113
USt
11M
13s '
IMS
IIS 8
1GI5
196 6
211 4
lii Q
2471
2696
3262
3664
W7
150!
4937
5636
615 S
686 3
mi
t%
—
;iS
IVunl
l!7
19 i
1! 5
192
19 i
193
!93
]SO
197
20i
215
826
S!l
922
978
106 8
1113
187
19 S
115
192
195
193
1181
192
180
117
701
21.5
201
ni
•
IWi
]M6
2111
!320
2*71
.1
!'l 1
m
2:9
205
207
2Q9
200
19.8
?24
?r s
m
1\3
22)
a220i
Ilil
1317
1SI3
I'M
i
u
11
7.3
1!
10.3
124
16!
191
lil
1?9
.6
3342
.4
i
.S
373 7
111 1
1(1 2
i
.7
7
b
'
205
20!
209
200
!31
223
22 (
MSI 319
5*OJ
230
6339
229
Wt
126
224
-""
7S!
—'
63J
609
27S7
29(19
SH
S55
539
Z9J9
3033
310!
3169
Sll
49.2
45 ?
141
W6
3232
3295
3413
369!
3671
106
399
402
394
379
351
373
390
395
379
3826
4095
(373
1)12
Mil
6319
7091
aiss
360
355
340
313
281
9391
S726
9891
nn
r n n e n c , F i s c a l tear
1981.
p.
612.
2350
2372
rat
2481
2S45
2576
2616
241-7
7675
2906
J795
21(9
301)
323!
3430
3161
3969
1803
551 !
6109
6146
(889
w
SI?
497
IJ7
463
4M
4*.2
41!
399
345
350
309
297
292
277
255
272
I9&
29 i
297
21 9
274
7220
7313
71! 5
235
205
159
1980 ECONOMIC PROJECTIONS OF THE BOARD OF GOVERNORS
OF THE FEDERAL RESERVE SYSTEM
Year
Actual
Projected
1979
Uem
1960
Level, fourth quarter
Employment (millions)
Unemployment rate (percent)
97.7
5.9
97
to 98 3/4
6 3/4 to 8
Percent change, fourth quarter to fourth quarter
Nominal gross national product
9.9
7 1/2 to 11
Real gross national product
0.8
-2 1/2 to 1/2
Implicit price deflator
9.0
9 to ll
Annual _rate__pf change in fourth guarter, percent
Consumer price index
Source:
13.2
8 3/4 to 12
Board of Governors of the Federal Reserve System, Monetary Policy
Report to Congress, February 19, 1980, p. 7.
160
CRS-9
1980 ECONOMIC FORECASTS AND ADMINISTRATION GOALS
Administration
Goa^ Forecast
CBO Current
Policy
Forecast
Current
Chase
Forecast
Current
DRI
Forecast
Humph rey-Hawking
Act Goals
LeveTlT fourtti quarter 1980 lj__
Employment
(millions)
Unemployment
rate (percent)
97,8
7.5
7.2 to 8.2
~-.~.
._.—-
__-
~~
97.6
97.7
7.9
7.4
Percent change, fourth quarter 1979 to fourth q u a r t e r 1 9 8 0
Real gross
national product
-1.0
-2.3 to -D.3
Real disposable
income
Productivity
total economy 2j
private business
private nonfarra
Consumer
prices
21
—
10.7
8.6 to
Based on total real GNP per hour worked.
Source
10.6
-1,6
-1.6
-0.5
0.3
0.0
-1.5
—
-2.0
9.9
10.6
161
CRS-10
1981 ECONOMIC FORECASTS AND ADMINISTRATION GOALS
Administration
Goal Forecast
Current
CEO Policy
Forecast
Current
Chase
Forecast
Current
DRI
Forecast
Humphrey-Hawkins
Act Goals
Level, fourth quarter 1981 I/
Employment
(millions)
99.7
Unemployment
rate (percent)
7.3
7.5 to 8.5
~__ _
^
99.5
99.8
7.6
7.3
Percent change, fourth quarter 1980 to fourth quarter 1981
Real gross
national product
2.8
Real disposable
income
1.1
Productivity
total economy 2/
private business
private nonfartn
Consumer
prices
—
8.7
8.3 to 10.3
Seasonally adjusted.
1j
Based on total real GNP per hour worked.
See preceding table.
3.3
4.8
2.4
3.7
1.4
1.1
1.7
9.2
9.1
'^
I/
Source:
2.0 to 4.0
162
CRS-II
SUMMARY OF ADMINISTRATION'S ECONOMIC GOALS CONSISTENT WITH
THE OBJECTIVES OF THE HUMPHREY-HAWKINS ACT I/
YEAR
Goal Forecasts
Item
1980
\9_6_l
Ggjil Requirements
19gl
^963
1964
1985
Level, fourth quarter 2f
Employment ( m i l l i o n s )
Unemployment ( p e r c e n t )
97.8
99.7
102.5
7.5
7.3
6.5
105.3
5.6
108.0
110.7
4,8
4.0'
Percent change, f o u r t h quarter t o f o u r t h q u a r t e r
Real gross n a t i o n a l p r o d u c t
-1.0
2.8
5.0
5.0
4.8
4,6
.5
1.1
4.7
4.7
4.6
4,4
P r o d u c t i v i t y 3/
-.3
1.3
2.3
2.5
2.5
2.5
Consumer prices
10.7
6.7
7.9
7.2
6.5
5.8
Real d i s p o s a b l e income
I/ Among the provisions of the Humphrey-Hawkins Act are those Setting an
unemployment goal of UZ among individuals aged 16 and over in the civilian laborforce by 1983 and an i n f l a t i o n race of 31 as measured by the consumer price index,
a l s o by 1983. The Act requires that beginning in the 1980 Economic Report the
President review tne numerical goals and timetables for reducing unemployment and
i n f l a t i o n and r e p o r t to the Congress on the degree of progress being made in these
a r e a s . From t h i s t i m e , if the President f i n d s it n e c e s s a r y , he may recommend modi f i c a t i o n of the t i m e t a b l e ( s } for achieving the unemployment and inflation goals.
According to the 1980 Economic Report:
. . . t h e P r e s i d e n t has used the authority provided to him in the
Humphrey-Hawkins Act to extend the t i m e t a b l e for achieving a 4 percent unemployment rate and 3 percent i n f l a t i o n . The target year
for achieving 4 p e r c e n t unemployment is now 1985, a 2-year d e f e r m e n t .
The t a r g e t y e a r for achieving 3 percent i n f l a t i o n has been postponed
u n t i l 3 y e a r s beyond t h a t . Economic goals through 1985 consistent
w i t h t h i s t i m e t a b l e are shown [in the t a b l e above].
The s h o r t - t e r m goals represent a f o r e c a s t for 1980 and 1981.
The m e d i u m - t e r m g o a l s for 1982 through 1985 are not f o r e c a s t s but
projections of the economic performance needed to achieve the unemployment r a t e and i n f l a t i o n goals w i t h i n the A d m i n i s t r a t i o n ' s
timetable...
(p. 94)
2/
Seasonally a d j u s t e d .
V
Based on t o t a l r e a l GNP per hour worked.
Source;
U . S . Council of Economic Advisers. Economic Report of the P r e s i d e n t .
W a s h i n g t o n , U . S . Govt. P r i n t . O f f . , 1980. p. 94.
163
CRS-12
EMPLOYMENT
TOTAL CIVILIAN EMPLOYMENT
Millions
1975
1979
1977
1978
Seasonally adjusted data
Data source: Bureau of Labor Statistics, Deportment of Labor
1976
1980
UNEMPLOYMENT
PERCENT OF CIVILIAN LABOR FORCE
7.5 -
6,5 -
5.5
1075
1876
1979
1677
1B78
S«o»ondly adjusted data
Data vourea: Bureau of Labor StaiiMio, Department of Labor
1960
PRODUCTION: REAL GNP
% CHANGE FROM SAME QUARTER, PREVIOUS YEAR
Annual rote of change
1975
1976
1977
1978
1979
Calculated from seasonally adjusted data expressed in 1972 dollars
Data source: Bureau of Economic Analysis, Department of Commerce
1980
REAL INCOME: DISPOSABLE PERSONAL INCOME
% CHANGE
FROM SAME QUARTER, PREVIOUS
YEAR
Annual rate of change
6 -
Cn
-1 -2
1975
1976
1977
1978
1979
Calculated from seasonally adjusted dita expressed in 1972 dollars
Data source: Bureau of Economic Analysis, Department of Commerce
1980
PRODUCTIVITY: NONFARM BUSINESS SECTOR
% CHANGE
PROW SAME QUARTER, PREVIOUS YEAR
Annual rate of change
5 -
os
Ol
1975
1976
1977
1978
1979
Based on output per hour, seasonally adjusted
Data source: Bureau of Labor Statistics, Department of Labor
I960
PRICES: CONSUMER PRICE INDEX
% CHANGE FROM SAME QUARTER, PREVIOUS YEAR
Annual rate of change
13
12
11
10
9
8
7
1975
1976
1977
1978
1979
Calculated from seasonally adjusted data
Data source: Bureau of Labor Statistics, Department of Labor
1980
EXPORTS, IMPORTS, TRADE BALANCE I/ AND TRADE-WEIGHTED EXCHANGE
VALUE OF THE U.?. DOLLAR 2/
1975
1976
197?
1978 _
1979 f
I
1979
II
111
IV p
(in billions of dollars; quarterly data seasonally adjusted)
Exports
107.1
114.7
120.8
142.1
182.4
41.3
42.7
47.3
51.1
Imports
98.0
124.0
151.7
175.8
211.5
47.4
50.5
54.6
59.0
9.0
-9.4
-30.9
-33.7
-29.1
-6.1
-7.8
-7.3
-7.9
27.Q
34.6
45.0
42.3
60.0
11.6
12.9
16.6
18.9
Trade balance
Memorandum item:
Petroleum imports
00
Index of the
weighted-average
exchange value
of the U . S . dollar
98.34
105.57
103.30
92.39
88.09
88.14
89.79
86.97
I/
Merchandise, excluding military, on balance of payments basis (adjusted from Census
data for differences in timing and coverage).
2/
Index of weighted average exchange value of U.S. dollar against currencies of other
G-10 countries (Germany, Japan, France, United Kingdom, Canada, Italy, Netherlands,
Belgium, Sweden) and Switzerland. March 1973-100. Weights are 1972-1976 global
trade of each of the 10 countries.
Sources:
87.37
Exports, imports, and trade balance - Department of Commerce, Bureau of Economic
Analysis. Trade-weighted exchange value of the U.S. Dollar - Board of Governors
of the Federal Reserve System.
GROWTH HATES FOR SELECTED MONETARY, CREDIT AND RESERVE AGGREGATES
(Seasonally adjusted compound annual 8rout^ rates)
\l
If
11
\1
1978
2!
I979~
11
III
IV
Federal Reserve
targets; 4th
quarter 1979 to
4th quarter I960
11
III
IV
[
5.5
8. 9
7. 3
5.7
0..2
8.1
9,.1
4.,8
3.5 - 6.0
8.2
7.9
9.4
7.,5
7.7
4.,9
11.1
10,,6
5.,4
4.0 - 6.5
11. 5
8.4
8.8
7. 7
a.,5
9.8
6,.4
10.6
10,.8
7,.4
6.0 - 9.0
11.4
12. 6
11.3
9.5
U.5
10.,8
12.0
3.,1
9.1
10.,7
10,,1
6.5 - 9.5
7,5
U. I
13.5
12.3
13. 5
13. 5
U. 6
14..6
11.8
14. 1
8,,7
6.0 - ?.0
1976
1977
1978
1979
M-1A
5.5
7. 7
7.4
M-1B
6.0
8. 1
M-2
13.7
M~3
Monetary aggregates:
Bank credit
OS
Reserve aggregates'.
(adjusted)
Total reserves
0.7
5. 4
6.6
2.7
6. 3
8.,9
2.2
-3.,1
-3.6
5,.2
13..0
Required reserves
0.7
5. 5
6.7
2.4
6.9
8..9
2,0
-3,.0
-3.4
4..9
12,.1
Nonborrowed reserves
0.9
3,1
6.7
0.6
0, 7
6..8
4.5
-3..6
-7,2
7,.2
6. 9
Monetary base
6,7
8.3
9.1
7.5
7. 9
9..6
a. 6
5,.7
4.9
9.,6
9..9
I/
From fourth quarter of previous year to fourth quarter of year indicated.
2/
From previous quarter.
Sources:
Calculated from data aeries of the Board of Governors of the Federal Reserve System, accessed
from data files of Data Resources, Inc. At the time the reserve aggregate data were accessed,
the Federal Reserve was in the process of making new seasonal adjustments for these series.
Data accessed reflects changes which have been made as of February 14, 1980.
170
CRS-I9
INCOME VELOCITY OF MONEY (M-1A)
% CHANGE FROM SAME QUARTER, PREVIOUS YEAR
Annuol rote of cHorrge
77
78
79
Cclculoted from seasonally adjusted dofo
Dolo sources: Federal Reserve 9oard; Deoortrrient of Commtrce
INCOME VELOCITY OF MONEY (M-1E
% CHANGE FROM SAME QUARTER, PREVIOUS YEAR
Annuol 'ole of chan
77
.
7B
79
Calculated from ceusanaily adjusted data
Data *ourca*: Federal Reserve Board; Department Of Commerce
171
SELECTED INTEREST RATES
October 1975 through January 1980
M.O -
•V"
Rate for
12.0
Conventional first Mortgages
on New Homes
10.0
XI "*"
XT fiwferaf Reserve
Discount Rate
8.0
^t=^T
6.0
4
-°h
Federal Funds Rate
( , , I. . i . , . . . i. . 1 . . ..
O N D J F M A H J J A 5 O N D 1 F H A M J J A S O N D J F M A M J J A S O N D J f M A W J J A S O \ 1) J F M A
1975-
-1976-
-1977-
-1978-
-1979
-1980
SELECTED INTEREST RATES, 1976-1980
1979
Oct.
Nov.
1980
Jan.
1976
1977
1978
1979
Sept.
3-nio. Treasury b i l l s
(new issues)
4.99
5..26
7.22
10.04
10.18
11.47
11.87
12.07
12.04
10-yr. Treasury securities
(constant maturity)
7.61
7 .,42
8.41
9.44
9.33
10.30
10.65
10-39
10.80
Corporate Aaa bonds
(Moody's)
8.43
8.. 0 2
8.73
9.63
9.44
10.13
10.76
10.74
11.09
Prime commercial paper,
4-6 mos
5.35
5 ,.60
7.99
10.91
11.60
13.23
13. 26
12.80
NA
Prime rate charged by
banks
6.84
6..82
9.06
12.67
12. 90
14. 39
15.55
15. 30
15.25
New home mortgage yields,
FHA/HUD series
9.00
9..00
9.70
10.90
11.35
12.15
12.50
12.50
NA
Federal Reserve discount
rate
5.50
5 ,,52
7.52
10.31
10.5011.00
11.0012.00
12.00
12.00
12.00 *
Federal funds rate
5.05
5.,54
7.94
11.20
11.43
13.77
13.18
13.78
* On February 15, 1980, the
Sourcee:
Federal Reserve
Dec.
13.82
discount rate was raised to 1 3 Z .
Board of Governors of the Federal Reserve System, Department of Housing and Urban Development, and
Service.
FUNDS RAISED IN U.S. CREDIT HARKETS
[In billions of dollars; quarterly data are seasonally adjusted «t annual ratea]
1975
Total funds raised,
by instrument :
Investment company shares
1976
1977
1978
1979
1978
(IV)
1979
(I)
(II)
1979
(III)
501.5
512.4
223,5
296 .0
392.5
481. 7
525. 0
453 ,3
-.1
-1 .0
-.9
-1. 0
-I. 3
it
-.6
-1.6
10.8
12 .9
4,9
4. 7
8. 6
5 .6
5.0
7.3
212.8
284 ,1
388.5
478. 0
517. 7
447 .6
497.1
506.7
U.S. Government securities
98.2
88 .1
84.3
95. 2
87. 5
72 .6
77.9
75.4
State and local obligations
16.1
15 .7
23.7
28. 3
14. 4
22 .3
12.7
23.5
Corporate and foreign bonds
36.4
37 .2
36.1
31. 6
31. 7
35 .8
38.7
29.1
Mortgages
57.2
87 .1
134.0
149. 0
158. 7
157 .4
168.9
157.6
9.7
25 .6
40.6
50. 6
53. 3
50 . 7
44.7
42.4
Bank loans, n.e.c.
-12,2
7 .0
29.8
58. 4
75. 4
34 .9
65,7
99.2
Open market paper
-l.Z
8 ,1
15.0
26. 4
40. 6
37 .7
44.9
55-4
8.7
15 .3
25.2
38. 6
46. I
36 .3
43.6
24. J
Other corporate equities
Debt instruments:
Consumer credit
Other loans
Source:
Board of Governors of the Federal Reserve System.
1979(111) baaed on incomplete data.
174
Congressional Research Service
The Library of Congress
RESERVE AGGREGATES AH& MONETARY CONTROL
Carol A. Leisenring
Analyst in Money and Ranking
Economics Division
February 29, 1980
CONTENT^
INTRODUCTION
FEDERAL RESERVE OPERATIC PROCEDURES BEFOKE OCTOBER 6, 1979
EVALUATION OF THE FEDERAL FUND RATE APPROACH
THE FEDERAL RESERVE' S NEW OPERATING PROCEDURE
7
A DESCRIPTION OF RESERVE AGGREGATES
II
•*
EVALUATION OF THE RESERVE AGGREGATES APPROACH
15
IMPLICATIONS OF THE NEW POLICY
20
THE RECENT EXPERIENCE
II
SELECTED REFERENCES
30
Prepared for the Committee
on Banking, Housing, and Urban Affairs
United States Senate
Research assistance was provided by Laura Layman.
provided by Hal Jennings.
Production assistance was
175
CRS-iii
LIST Of
TABLES AND CHARTS
Table 1.
BaiiK Reserve 'Measures
Summary o f D e f i n i t i o n s . . .
Table 2.
Money and Bank Reserves,
Compound annual Growth Races.
Chart 1 .
Tonal and froiiSorrowed Reserves, 1968-1979,...
Chart 2.
The Federal Funds Race and Che Federal
Funds Rate Minus the Discount Rate, 1968-1979.
Chart 3.
The Federal funds Rate, IS Weeks Before
and Alter October 6, 1979
Cnart 4.
Total and Nonootrowed Reserves and the
Federal Funds ftate Minus Che Discount
Rate, 18 Weeks Before and After Occober b, 1979.
176
RESERVE AGGREGATES AND MONETARY CONTROL
INTRODUCTION
As part of its new anti-inflationary monetary policy program announced
October 6, 1979, the Federal Reserve adopted a new operating procedure for implementing monetary policy.
Under Che new operating, procedure money stock, control
is implemented by following a day-to-day operating procedure in which bank reserves sre monitored and controlled with the aim of keeping the growth of bank
reserves consistent with desired money stock growth.
Previously, the Federal
Reserve's operating procedure consisted of keeping the Federal funds rate within a targeted range consistent with the desired rate of growth in the money
stock.
This paper describes Federal Reserve operating procedures under the Federal
funds approach and under the new reserve aggregates approach.
The two techniques
will be compared and the criticisms and problems associated with each one will
be discussed.
There are a number of aggregate measures of bank reserves avail-
able to the Federal Reserve for use as target variables.
These alternative
measures are defined and their roles in the monetary process are explained.
Finally, some implications of the new policy and the recent experience with it
will be discussed.
FEDERAL RESERVELOPERATING JROCEDURES BEFORE OCTOBER 6, 1979
Prior to the October 6, 1979 policy change, the Federal Reserve attempted
to control the growth of the money Stock by keeping the Federal funds rate within
177
CRS-2
a prescribed range.
The Federal funds rate is the interest rate a member bank
pays to borrow reserves from another member bank.
The Federal funds approach entailed, first, determining a desired rate of
growth in the money stock, estimated to facilitate real growth in GHP, and reduce inflationary pressure.
From a desired money growth rate, a range could
be inferred for short Cera interest rates; given the relationship between the
Federal funds rate and other short term interest rates, a range could then be
defined for the Federal funds rate, estimated to be consistent with desired
money growth.
The Federal Open Market Committee therefore in effect established two sets
of targets, one for monetary aggregate growth and one for the Federal funds rate,
that were estimated to be consistent with each other.
Daily open market opera-
tions were then designed to keep the Federal funds rate within its targeted
range, on the assumption that this goal, if met, would be conducive to desired
noninflationary money growth.
If actual money growth did not fall within the
targeted range, one of the two sets of targets had to be adjusted; either the
Federal funds rate target could be changed to achieve the money growth target
or money growth could be allowed to proceed at whatever rate followed from adherence to the federal funds targec.
Many observers agree that in this situation,
the Federal Reserve frequently failed to adjust its Federal Funds rate target
as far, or as quickly, as was needed to maintain close money stock control.
If the Federal funds rate cose above its target, because of the scarcity
of bank reserves or other upward market pressures, the Federal Reserve could
respond In one of two ways.
It could make open market purchases of Government
securities, increasing the reserves available to the banking system.
This action
would decrease the upward pressure on the Federal funds rate, allowing it to
178
CRS-3
return to its target: range; by providing toore bank, liquidity, it would also
facilitate an expansion of money and bank credit.
Or, the Federal Reserve could
decide to allow the funds rate to stay above the target range (in effect, raising the target range), instead of accommodating expansionary banking activity.
If plentiful bank reserves or other market forces lowered the Federal
funds rate below its target, the Federal Reserve could sell or reduce purchases
of government securities, reducing reserves in the banking system, and creating
enough upward pressure on interest rates to return the Federal funds rate to
its target range; this would also force banks to cut back on money and credit
expansion.
Or it could allow the funds race to remain below the target, there"
by encouraging banks to use their plentiful reserves to expand money and credit.
EVALUATION OF_THE JEDERAL FUNDS_ RATE:__APPROACH
Many have criticized the Federal Reserve's emphasis on interest rate control, charging that it leads inevitably to erratic money growth-
A large share
of the criticism comes from monetarist economists who believe instead that open
market operations should be aimed at more direct control of the money stock.
Criticism of the Federal funds target approach is based on a number of
issues, but much of the criticism focuses on the stability of Che relationship
between the quantity of money and short term interest rates.
As described in
the preceding section, controlling the rate of money growth by hitting a Federal
funds rate target assumes an ability to relate desired money growth to the level
of short term interest rates.
Many monetary economises believe that the relation-
ship between money stock growth and short term interest rates is too loose to
determine accurately the range of short term interest rates that is consistent
with desired money growth.
For example, suppose the Federal Reserve determines
179
CRS-4
that the rate of monetary growth should be slowed; using the Federal funds
operating strategy, this determination must be translated into a prescribed
change in the Federal funds rate.
By how much should the Federal funds rate
be allowed to rise, in order to achieve a specified decrease in monetary growth?
Since there is no precise way to answer such a question, critics claim
that
errors are inevitable.
Keeping the Federal funds rate within its prescribed bounds may, under
some economic circumstances, simultaneously allow desired money growth to be
achieved, but under other economic circumstances, an entirely different rate
of money stock growth may obtain.
It is this uncertainty and variability in
the monetary outcome of keeping the Federal funds rate at a specific level that,
in the opinion of y\any monetary economists, renders the procedure unreliable.
There is reason to believe that in the current economic environment, the
estimated relationship between money and interest rates may be incieasingly
imprecise.
Statistics! estimation of the correspondence between money growth
and market interest rates must necessarily be based on historical economic experience and previous public behavior; currently, however, market interest rates
are at higher levels than ever before,
The relationship may therefore be dif-
ferent than our previous experience would indicate.
In addition, financial Innovation such as monpy market mutual funds and
repurchase agreements are providing the public with new otouey-farms in which
to hold their assets.
This too raay be altering the money growth-interest rate
relationship from what has been previously recorded.
For these reasons many
economists charge that the money growth-interest rate relationship is a poor
one on which tc bast monetary control; under the most stable economic conditions,
180
CRS-5
inferences between money stock growth and market interest rates can produce large
errors.
A closely related concern is the claim that targeting the Federal funds
rate causes procyclical growth in the monetary aggregates.
Suppose, for example,
that the economy enters an expansionary phase and the demand for credit rises,
putting upward pressure on market interest rates and straining bank reserves.
If market forces threaten to push the Federal funds rate above its target range,
the Federal Reserve will, under .1 Federal funds procedure, supply reserves Co
Che banking system through open markec purchases, until the Federal funds rate
falls back within its target range.
Some increase in bank reserves is of course
appropriate in order to accommodate the business expansion.
But if market pres-
sures, such as a high demand .for credit or inflation, continue to push market
rates upward, the Federal Reserve must continue to add reserves in an attempt
to keep the Federal funds rate down within its target.
Continued increases in
reserve availability in an expanding economy vill lead to a rapid increase in
mone'y and credit growth.
Critics claim such an expansion of money and credit
does not simply accommodate the economic expansion, but exaggerates it, generating increased and continued inflationary pressure.
Following the «.me reasoning, the Federal Reserve may worsen a business
contraction by causing a rapid reduction of money and credit growth.
In general,
many economists believe that as long as the Federal Reserve follows an interest
rate target and supplies or withdraws reserves from the hanking system accordingly, it is apt to cause a procyelieal expansion of the money stock when the economy
expands and a procyclical decline in monetary growth rates when the economy contracts.
This procyclical behavior of the monetary aggregates will therefore
181
CRS-6
magnify the monetary impact of exogenous shocks to the economy and exaggerate
Che ups and downs in the economy into inflationary booms and recessions.
Critics contend that the procyclical movements of the money stock would be
less likely to occur under a Federal funds target if the Federal Reserve allowed
the Federal funds rate to deviate farther and more frequently outside its target range as economic'conditions dictate, or if the Federal Reserve adjusted
the target range more frequently and more quickly as market conditions change.
However, they believe Chat adjustments in target ranges have been made only after
considerable delay; changes in Federal funds ranges therefore would lag changing
market conditions and may be inappropriate.
Pursuance of inappropriate interest
rate targets, given market conditions, then produce cumulative and reinforcing,
procyclical expansions or contractions of money growth.
Critics also claim that basing monetary policy on interest rate targets
directs too much attention toward interest rates as indicators of current and
future monetary policy.
The level of interest rates is affected by many forces
besides monetary policy; it can therefore be misleading to link observed changes
in interest rates with actual or expected changes in monetary policy.
For
example, if market interest rates are high, there is a tendency for the public
to conclude that monetary policy has been tight and is therefore likely to beco'.ie more expansionary.
On the contrary, high market interest rates may be the
result of over-expansionary monetary policy that has fostered a high rate of
borrowing and spending and has generated inflationary pressure.
In such a case,
continued or increased monetary expansion, aimed at reducing high market Interest
rates, might succeed in doing so for a short period of time; ultimately, however,
such a policy would only lead to more inflation and even higher interest rates.
182
CRS-7
F o r t h e s e r e a s o n s , o p p o n e n t s o f t h e Federal f u n d s r a t e approach b e l i e v e
that it
r e s u l t s i n i m p r e c i s e money stock c o n t r o l , a n d , i n t h e i r v i e w , deli-berate
and p r e c i s e money s t o c k control, is e x t r e m e l y i m p o r t a n t .
Advocates of the
Fed-
e r a l f u n d s r a t e a p p r o a c h t e n d C o a t t a c h less v a l u e t o c l o s e noney stock control
and p l a c e more i m p o r t a n c e on the s t a b i l i z a t i o n , of market interest r a t e s .
They
c o n s i d e r t h e i n t e r e s t ' r a t e s t a b i l i t y t h a t i s fostered b y t h e Federal f u n d s race
approach to be a m a j o r a d v a n t a g e of. the procedure because it minimizes u n c e r t a i n ty and a l l o w s tile f i n a n c i a l markets to function smoothly.
P r o p o n e n t s o r the
F e d e r a l f u n d s a p o r o a c h a l s o poi.nt to a number ot operational, d i f f i c u l t i e s t h a t
are a s s o c i a t e d w i t h a reserve aggregate Approach which r e d u c e s the p r e c i s i o n of
m o n e y c o n t r o l under a reserve t a r g e t .
These o p e r a t i o n a l i s s u e s w i l l b e d i s c u s s e d
in a subsequent section.
THE F E D E R A L . R E S E R V E ' S M E W OPERATING PROCEDURE
I™nedi2tely p r i o r to Che Federal R e s e r v e ' s p o l i c y a n n o u n c e m e n t on O c t o b e r 6,
L 9 7 9 , t h e r e w a s g r o w i n g e v i d e n c e o f i n c r e a s i n g i n f l a t i o n a r y p r e s s u r e i n t h e economy;
intlatii:>n a n a i n f l a t i o n a r y e x p e c t a t i o n s were c o n t r i b u t i n g t o s p e c u l a t i v e be-
h a v i o r in c o m m o d i t y m a r k e t s and a d e t e r i o r a t i o n of the d o l l a r in f o r e i g n exchange
markets.
were all
I n a d d i t i o n , tlie v a r i o u s m e a s u r e s o f t h e money s t o c k a n d b a n k c r e d i t
e x p a n d i n g at
r a t e s i .1 e x c e s s of Federal Reserve t a r g e t s .
In i t s new
a n t i - i n f l a c i i i n a r y p r o s r a m , t h e F e d e r a l R e s e r v e a n n o u n c e d renewed d e d i c a t i o n t o
b r i n g i n g down t h e r a t e o f g r o w t h i n t h e m o n e t a r y a g g r e g a t e s , s t a t i n g t h a t reduced m o n e t a r y growth is essential to combat
P a r t of its
the new policy s h i f t s
primary emphasis from control of the Federal f u n d s rate
t o t h e c o n t r o l o f bank r e s e r v e s .
inflation.
new p r o g r a m is a c h a n g e in Federal keserve o p e r a t i n g p r o c e d u r e ;
This means t h a t i n d a i l y o p e n m a r k e t
operations,
183
F e d e r a l P.eserve p o l i c y i s b a s e d e n v c r i o u E - i p e e i u r e s o f b j n k r e s e r v e s , r a t h e r
Chan o r t h e F e d e r a l f ' i n d s r a t e .
ignored; Federal
prescribed
This does net mpan t h a c i n t e r e s t r a t e s a r e
R e s e r v e spckessen have i n d i c a t e d t^ar t h e r e is
s t i l l a range
f o r tLc F e d e r a l f u n d s r a t e , b u t t h a t t h & r range i- b r e a d e r a n d i s
m o n i t o r e d p r i m a r i l y w i t h respoct t o i t s relations!" i p C o ret-erve a v a i l a b i l i t y •
O p e r a t i n g procedures were apparently changed because of increasing d i f f i c u l t y
c o n t r o l l i n g t h e m o n e t a r y aggregates under t h e Federal f ' - n d s r s t f e t e c h n i q u e .
Since member b a n k s are r e q u i r e d Co hold r e s e r v e s a g a i n s t t h e i r d e p o s i t s ,
t h e r e is a b a s i c r e l a t i o n s n i p between the amount of r-.-servt-s t h a t the Federal
R e s e r v e c r e a t e s Lor the b a n k i n g system and the amount of d e p o s i t s and theref o r e t h e money s t o c k .
T h r o u g h i c s open m a r k e t o p e r a t i o n s , the Federal R e s e r v e
can s t r o n g l y i n f l u e n c e t h e level o f bank r e s e r v e s ; t h i s c o n t r o l over b a n k r e s e r v e s g i v e s t h e F e d e r a l R e s e r v e a n i n d i r e c t , a n d t o some e x t e n t i m p r e c i s e ,
a b i l i t y to c o n t r o l the money s t o c k ,
1C is t h i s r e s e r v e - d e p o s i t or r e s e r v e - m o n e y
s t o c k r e l a t i o n s h i p C h a t u n d e r l i e s t h e n e w r e s e r v e a g g r e g a t e approach t o m o n e t a r y
pul ic y .
Both the
torTiicr F e d e r a l f u n d s r a t e a p p r o a c h a n d t h e n e w r e s e r v e a g g r e g a t e
a p p r o a c h t o m o n e t a r y p o l i c y o f course t u r n o n t h e same b a s i c Federal Reserve
powers a n d m a r k e t r e l a t i o n s a n d r e a c t i o n s ;
that; d i l f j r e a t
the d i f f e r e n c e between the two is
i n t e r m e d i a t e economic v . - r i a b l e s a r e e m p h a s i s e d i n i m p l e m e n t i n g
ana monitoring monetary policy.
For e x a m p l e , s u p p o s e t h a t t h e Federal R e s e r v e d e t e r m i n e s t h a t t h e r a t e oi
money stock growth needs to be slowed.
Under the previous a p p r o a c h , the desired
slowdown in m o n e y g r o w t h would have been t r a n s l a t e d i n t o a h i g h e r t a r g e t r a n g e
for
tne Federal funds rate.
Federal
Reserve open m a r k e C sales t o r a r e d u c t i o n
i n t h e r a t e o f p u r c h a s e s ) o f G o v e r n m e n t s e c u r i t i e s would have reduced ( o r slowed
184
CRS-9
down the r a t e of increase in) the amount of reserves a v a i l a b l e to b a n k s , c a u s i n g
the Federal f u n d s r a t e to rise to w i t h i n its new t a r g e t range*
This would put
upward pressure on other m a r k e t i n t e r e s t r a t e s , and w i t h a general s c a r c i t y of
r e s e r v e s , banks w o u l d be inclined to r e d u c e money and c r e d i t expansion, bringing
the desired slowdown in monetary g r o w t h .
Open market o p e r a t i o n s , under t h i s
p o l i c y scheme, were de-signed to have a prescribed e f f e c t on the Federal funds
r a t e ; t h e i r e f f e c t s were monitored and policy a c t i o n s were then m o d i f i e d when
n e c e s s a r y , r e l y i n g p r i m a r i l y on the m a r k e t information conveyed by changes iu
the F e d e r a l f u n d s and other short t e r m r a t e s .
U n d e r tne new p o l i c y approach, the same desired slowdown in monetary growth
is t r a n s l a t e d i n t o the n e c e s s a r y r e d u c t i o n (or slowdown in the rate of g r o w t h )
in b a n k reserves.
This is a c h i e v e d , as under the previous s c h e m e , by Federal
Reserve sales ( o r reduced p u r c h a s e s ) of Government s e c u r i t i e s , w h i c h reduces
the l e v e l of b a n k r e s e r v e s , f o r c i n g b a n k s to cut back on money and c r e d i t
expansion.
Open m a r K e t o p e r a t i o n s , under t h e n e w p o l i c y scheme, h o w e v e r , a r e
designed s p e c i f i c a l l y
to have a p r e s c r i b e d e f f e c t on bank reserves; m e a s u r e s
of bank r e s e r v e s , r a t h e r t h a n i n t e r e s t r a t e s , are monitored on a d a i l y b a s i s
to assess the impact of Federal Reserve operations and to modify policy actions
when n e e d e d .
The d i f f e r e n c e between the two A p p r o a c h e s is t h e r e f o r e an ops r a t i o n a l one.
F u r t h e r m o r e , sines: u n d e r t h e o l d p o l i c y p r o c e d u r e , reserve a g g r e g a t e s were n o t
ignored, and under the new approach, interest rates w i l l not be ignored, the
p r o c e d u r a l change i s l a r g e l y o n e o f emphasis.
N e v e r t h e l e s s , many a n a l y s t s have
l a b e l l e d the p o l i c y change as a m a j o r , h i s t o r i c a l change in m o n e t a r y p o l i c y
procedures w i t h p o t e n t i a l l y f a r - r e a c h i n g i m p l i c a t i o n s a n d e f f e c t s .
185
CRS-10
More s p e c i f i c a l l y , under i t s new o p e r a t i n g procedure the Federal Reserve
f i r s t d e t e r m i n e s t h e r a t e o f money stock growth t h a t i s d e s i r a b l e d u r i n g t h e
f o l l o w i n g three month period.
I/
To t r a n s l a t e d e s i r e d money growth r a t e s i n t o
growth r a t e s f o r t h e r e s e r v e a g g r e g a t e s , t h e Federal Reserve m u s t p r o j e c t c h a n g e s
in o t h e r
f a c t o r s t h a t e f f e c t bank reserves and each of the f a c t o r s t h a t may a l t e r
the r e s e r v e - m o n e y r e l a t i o n s h i p .
A more d e t a i l e d d i s c u s s i o n of these i t e m s and
d e s c r i p t i o n s o f t h e v a r i o u s reserve a g g r e g a t e s appear i n t h e f o l l o w i n g s e c t i o n *
E s t i m a t e s of these f a c t o r s are required
reserve target
in order to a c c u r a t e l y
f o r e c a s t the
t h a t w i l l b e consistent w i t h d e s i r e d money stock g r o w t h ,
This p r o v i d e s e s t i m a t e s f o r t h e desired level f o r t o t a l r e s e r v e s a n d t h e
monetary base.
rowing;
An a s s u m p t i o n is
then made about tne level of member b a n k bor-
f r o m t h i s and the e s t i m a t e for t o t a l r e s e r v e s , a desired p a t h for non-
borrowed r e s e r v e s i s c a l c u l a t e d .
T o t a l r e s e r v e s , nonborrowed reserves and the m o n e t a r y b a s e are the t h r e e
m e a s u r e s o f r e s e r v e s t h a t t h e Federal R e s e r v e h a s chosen t o e m p h a s i z e .
Chairman
V o l c k e r h a s s t a t e d tliat t o t a l r e s e r v e s i s t h e Federal R e s e r v e ' s primary r e s e r v e
t a r g e t , because it
i s more c l o s e l y r e l a t e d
t o t h e money s t o c k t h a n n o n b o r r o w e d
reserves; nonborrowed reserves, however, is its
it
p r i m a r y o p e r a t i n g v a r i a b l e because
h a s c l o s e s t s h o r t - r u n c o n t r o l o f nonborrowed r e s e r v e s .
The monetary b a s e ,
a c c o r d i n g t o F e d e r a l R e s e r v e s p o k e s m e n , g e t s less a t t e n t i o n i n t h e c o n L r c l
pro-
cess b e c a u s e i t s h i g h l y - v a r i a b l e c u r r e n c y c o m p o n e n t c a n cause d i f f i c u l t i e s .
G i v e n t h e r e s e r v e t a r g e t s s e t a t m e e t i n g s o f t h e F e d e r a l Open M a r k e t Committ e e , the System Account Manager aims at
a nonborrowed reserve target each week
!_/
For a more d e t a i l e d d e s c r i p t i o n at the new o p e r a t i n g p r o c e d u r e s s e e ,
P a u l A , V o l c k e r , T h e N e w F e d e r a l Reserve T e c h n i c a l P r o c e d u r e s f o r C o n t r o l l i n g
Money. A t t a c h m e n t to s t a t e m e n t b e f o r e the Committee on Banking, Housing and
Urban A f f a i r s .
U . S . Senate. February 4 , 1980,
186
CRS-l1
during the period between Committee meetings.
Between meetings, it is possible
that total reserves or the monetary base will go outside of their targeted paths,
even though the nonborrowed reserve target is achieved.
If this situation per-
sists, the nonborrowed reserve target would be altered to bring total reserves
back within its target range.
Inter-meeting adjustments of all three reserve
measures may become necessary if there is an unforeseen movement
in one of the
factors that alters the reserve-money relationship; in that case, an offsetting
adjustment in reserve targets would be needed.
During the period since October
6, Chairman Volcker indicates that such adjustnents have been made infrequently.
A DESCRIPTION OF RESERVE AGGREGATES
Several measures of bank reserves are available to the Federal Reserve as
monetary control variables.
Total reserves is the sura of member banks' deposits
at the Federal Reserve plus vault cash.
The higher the level of total reserves,
or the faster total reserves grow, the greater the amount of reserves available
to tenks to facilitate deposit expansion; other things equal, greater reserve
availability will mean a higher level of monetary growth or a greater potential
for monetary growth.
Total reserves can be divided into required reserves and excess reserves.
The Federai Tteserve requires member banks to hold specified percentages of their
deposits in required reserves; reserves may be held as either vault cash or
deposits at the Federal Reserve.
Excess reserves are those that member banks
choose to hold above what is required of them; excess reserves therefore is
defined as total reserves minus required reserves.
Total reserves can also be divided into borrowed reserves and nouborrawed
reserves, where borrowed reserves equals member banks' borrowings from the
187
CRS-12
Federal. Reserve and nonborrowed reserves is those supplied by the Federal Reserve
through open market operations.
Free reserves is another measure of bank reserves that was used in the 1960's
in relation to monetary control.
Free reserves is defined to be excess reserves
minus reserves borrowed from the Federal Reserve.
IE borrowed reserves exceeds
excess reserves and free reserves is therefore negative, it is usually referred
to as net borrowed reserves.
Free reserves can be considered a measure of the potential in the banking
system for monetary expansion.
Lf free reserves is high, meaning that in the
aggregate excess reserves exceed borrowings from the Federal Reserve, there is
potential for the banking system to expand loans and deposits.
That is, the
banking system could expand money and credit at its discretion, without any
need for the Federal Reserve'to supply additional reserves.
On the other hand,
if free reserves is low or negative many member banks are in a position of
having had to borrow from the Federal Reserve to meet reserve requirements.
In
this situation the banking system possesses little or no capacity to expand
money and credic without the Federal Reserve supplying additional reserves;
banks Ln the aggregate are under pressure to reduce lending and deposit
creation in order to re-jay borrowings from the Federal Reserve.
That would
of course reduce money jrowtii.
The monetary base is defined as member bank reserves plus currency in circulation.
The monetary base is therefore closely related to bank reserves and
is also closely related to the money stock.
For control purposes, it has the
claimed advantage over bank reserve measures that, since it includes currency
in circulation, it does not vary with changes in the public's demand for currency.
For this reason, many believe that Che base can be controlled by the Federal
188
CRS-13
Reserve with considerable precision.
The relationship between the base and the
money stock is however subject to several other sources of variation also found
in the reserves-money relation; these items will be discussed in the following
section.
Table 1 provides -summary definitions of the various measures of bank reserves .
189
CRS-14
Table I
Bank Reserve Measures
Summary of D e f i n i t i o n s
Reserve Aggregate
D e f i n i t i o n or Calculation
Total Reserves-
Total amount of reserves available to
the banking system to back deposits.
Member bank deposits in Federal
Reserve Banks plus v a u l t cash.
R e q u i r e d Reserves
The amount of reserves the Federal
Reserve requires member bank to hold
behind t h e i r deposits. Required
reserves may be held on deposit at
the Federal Reserve or as v a u l t cash.
Excess Reserves
The amount of reserves that member
banks hold in excess of required r e s e r v e s .
Total reserves minus r e q u i r e d reserves.
Borrowed Reserves
Reserves that member b a n k s have borrowed
from the Federal Reserve.
Nonborrowed Reserves
Total reserves less member bank,
borrowing from the Federal Reserve.
Excess reserves minus member bank borrowing. Referred Co as net borrowed reserves
if member bank borrowing exceeds excess
reserves. A m e a s u r e of the b a n k i n g s y s t e m ' s
potential to expand m o n e y and c r e d i t .
M o n e t a r y Base
The combined net m o n e t a r y l i a b i l i t i e s of
the F e d e r a l Reserve and the U . S . T r e a s u r y ,
Total reserves plus c u r r e n c y in c i r c u l a tion .
190
cas-i5
EVALUATION OF THE RESERVE AGGREGATES APPROACH
There are a number of reasons why the Federal Reserve may not be technically c a p a b l e of closely controlling bank r e s e r v e s in the f i r s t
t i m a t e l y the money s t o c k .
i n s t a n c e , and ul-
F i r s t , there are a number of factors t h a t
influence
the level of bank reserves besides F e d e r a l Reserve open m a r k e t o p e r a t i o n s .
are commonly r e f e r r e d
to as the t e c h n i c a l
These
factors and include things such as f l o a t ,
member bank borrowing at the Federal Reserve, U . S . Treasury d e p o s i t s at
e r a l R e s e r v e and the p u b l i c ' s d e s i r e to hold currency.
the Fed-
For p r e c i s e r e s e r v e con-
t r o l , t h e technical f a c t o r s m u s t b e a c c u r a t e l y p r e d i c t e d .
Consider f i r s t the p u b l i c ' s d e s i r e to hold currency.
s t i t u t e s a p a r t of bank r e s e r v e s , if
Since v a u l t cash con-
the p u b l i c w i t h d r a w s c u r r e n c y from the
b a n k i n g s y s t e m , the level of reserves available to support bank d e p o s i t s d e c l i n e s .
Therefore a given i n j e c t i o n of reserves i n t o the b a n k i n g s y s t e m w i l l r e s u l t in
fewer r e s e r v e s a v a i l a b l e
for monetary expansion, if
the public chooses to w i t h -
d r a w cash from b a n k s . The F e d e r a l R e s e r v e can a n t i c i p a t e m a n y of the
t h a t occur in the p u b l i c ' s demand for c u r r e n c y ,
changes
and can d e s i g n open m a r k e t
operations to o f f s e t cash w i t h d r a w a l s from or d e p o s i t s i n t o the banking syetea.
But u n p r e d i c t e d changes in the p u b l i c ' s demand f o r c u r r e n c y c a u s e s u n p r e d i c t e d
v a r i a t i o n i n t h e m o n e t a r y r e s u l t s o f a given i n j e c t i o n o f bank r e s e r v e s Close c o n t r o l of the amount of reserves in the b a n k i n g s y s t e m may a l s o be
j e o p a r d i z e d b y member b a n k b o r r o w i n g a t
Suppose,
t h e Federal Reserve d i s c o u n t window.
f o r e x a m p l e , t h a t t h e Federal Reserve i s a t t e m p t i n g t o r e d u c e m o n e t a r y
expansion and is t h e r e f o r e l i m i t i n g the growth of b a n k r e s e r v e s .
reserves
By borrowing
f r o m the Federal Reserve, member banks can supplement reserves and
thereby, t o some e x t e n t , c i r c u m v e n t r e s t r i c t i v e m o n e t a r y p o l i c y .
This Leakage
is p o t e n t i a l l y most troublesome when market i n t e r e s t rates rise above the
191
discount rate, the interest rate the Federal Reserve charges for member bank
borrowings.
Under these circumstances, member banks have a cost incentive to
borrow froin the Federal Reserve.
The Federal Reserve can of course discourage borrowing' when market rates
rise by raising the discount rate.
But since changes in the discount rate
typically lag behind market interest rates and the Federal funds rate is often
above the discount rate, some economises are critical of the discount window
mechanism.
Under these circumstances, not only does the Federal Reserve sub-
sidize member bank borrowing at a below-market rate, but it also provides an
incentive for member banks to borrow and thereby reduce the precision of reserve
control.
Under tlie nev reserve aggregate procedure, unforeseen member bank
borrowing may make control of total reserves difficult, even if nonborrowed reserve targets are achieved.
Other economists and many Federal Reserve spokesmen diminish the importance
of member bank borrowing as a leakage in the reserve control process.
First,
they point out that member bank borrowing is very small relative to the total
amount of funds raised by the banking system and changes in borrowing tend to
be predicted relatively well by the Federal Reserve.
In addition, the Federal Reserve has traditionally administered the discount window on che principle, that borrowing is "a privilege, not a right," so
that member banks that borrow from the Federal Reserve have encountered some
degree of added supervision and surveillance.
Cost of borrowing, it is claimed,
is therefore only one consideration in a member bank's decision to borrow.
Given this historical treatment of the borrowing privilege, it is unlikely that
any member bank would seek to borrow a large enough amount of reserves for a
long enough period of time to threaten monetary policy, regardless of the cost
192
CRS-17
incentive to do so.
F u r t h e r m o r e , the Federal Reserve can always deny credit to
a member b a n k .
Evert i£ the Federal Reserve can c o n t r o l bank reserves p r e c i s e l y a second
set of f a c t o r s may i n t e r f e r e w i t h monetary c o n t r o l .
These are the f a c t o r s t h a t
i n f l u e n c e the correspondence between bank reserves and money.
Because of these
f a c t o r s , the Federal Reserve does not know with certainty the impact on the monetary aggregates when it engineers a given change in bank reserves; or, if the
Federal Reserve desires a given change in money growth, it is not possible to
determine p r e c i s e l y how much bank reserves need to be a l t e r e d .
Conversely, a
change in the rate of money growth may occur w i t h o u t any deliberate change in
the level of reserves.
tion include;
The f a c t o r s causing variation in the reserve-money rela-
deposits in nonmember banks, member bank excess reserves and a
number of s t r u c t u r a l a s p e c t s of Federal Reserve reserve r e q u i r e m e n t s .
Each of
these f a c t o r s w i l l be d i s c u s s e d below.
F i r s t , the d e p o s i t c r e a t i o n a c t i v i t i e s of nonrne.-nber banks can cause the
reserve-money r e l a t i o n s h i p to v a r y .
Notwiember banks are not s u b j e c t to the
reserve requirements that the Federal Reserve imposes on member b a n k s so
its
control of bank reserves has no d i r e c t impact on nonmeraber banks and t h e i r
a b i l i t y to expand loans and deposits.
!_/
A given i n j e c t i o n of reserves by the
F e d e r a l Reserve may t h e r e f o r e c o r r e s p c n d to d i f f e r e n t changes in mt'tiey growth,
d e p e n d i n g on the share of deposit expansion that occurs in nonmember banks.
Or,
v a r i a t i o n in the proportion of the n a t i o n ' s bank d e p o s i t s t h a t are in nonmember
banks will cause v a r i a t i o n in the reserve-money r e l a t i o n s h i p .
_!_/ Nonmeraber banks are i n d i r e c t l y a f f e c t e d by Federal Reserve actions
because the d e p o s i t expansion activities of nonmember and member banks are highly i n t e r - r e l a t e d . This inter-relation steras primarily from correspondent banking, i n t e r b a n k deposits and the n a t i o n w i d e check clearing n e t w o r k .
193
Several i n s t i t u t ional a r r a n g e m e n t s in the s t r u c t u r e of Federal Reserve
r e s e r v e r e q u i r e m e n t s also cause v a r i a t i o n in the reserve-money r e l a t i o n s h i p ,
F i r s t , t h e F e d e r a l Reserve r e q u i r e s member banks t o hold r e s e r v e s a g a i n s t s e v e r a l
k i n d s of d e p o s i t s t h a t are not i n c l u d e d in o f f i c i a l d e f i n i t i o n s of m o n e y .
These i n c l u d e government d e p o s i t s , i n t e r b a n k d e p o s i t s , and several types of
nondeposit l i a b i l i t i e s .
The Federal Reserve does not know w i t h c e r t a i n t y what
p r o p o r t i o n of the reserves t h e y supply to the banking system will be. vised to
b a c k t h e s e non-money d e p o s i t s , so it cannot know what proportion of t h o s e reserves w i l l be a v a i l a b l e to support money g r o w t h .
For example, if
the F e d e r a l
Reserve i n c r e a s e s the L e v e l of r e s e r v e s a v a i l a b l e to banks at the, same time
t h a t t h e r e is an u n f o r e s e e n i n c r e a s e in government d e p o s i t s , a l a r g e r p r o p o r t i o n
of b a n k r e s e r v e s w o u l d have to be used to b a c k government d e p o s i t s , and the expansion of the money stock would be Less than a n t i c i p a t e d .
S e c o n d , the Federal Reserve places di.££«rent reserve requirements on the
d i f f e r e n t types of deposits t h a t are included in Che various d e f i n i t i o n s of
m o n e y ; v a r i o u s t y p e s of savings and time d e p o s i t s and non-deposit l i a b i l i t i e s
a r e s u b j e c t t o d i f f e r e n t reserve r e q u i r e m e n t s than daraand d e p o s i t s .
In a d d i t i o n ,
r e q u i r e m e n t s on c e r t a i n t y p e s of deposits v a r y w i t h Che amount of such deposits
held by a bank or w i t h the m a t u r i t y d a t e of d e p o s i t s .
C u r r e n t l y , for example
r e s e r v e r e q u i r e m e n t s f o r demand d e p o s i t s , which a r e higher t h a n r e q u i r e m e n t s
on other types of d e p o s i t s , increase with the amount of demand d e p o s i t s held by
a bank.
T h e r e f o r e the e f f e c t s on the money s t o c k of a given increase in r e s e r v e s
w i l l d e p e n d on how t h e s e reserves are d i s t r i b u t e d among d i f f e r e n t - s i z e d member
b a n k s and u h a t p r o p o r t i o n of r e s e r v e s are used to s u p p o r t non-money d e p o s i t s .
The F e d e r a l R e s e r v e d o e s not know how reserves w i l l be d i s t r i b u t e d among member
banks or what p r o p o r t i o n w i l l be used to expand m o n e y , so it does not know prec i s e l y how money g r o w t h w i l l r e a c t to a change in bank r e s e r v e s ,
194
CRS-I9
In addition, member bank holdings of excess reserves can also cause variation
in the total reserves-money relationship.
An increase in reserves aimed at ex-
panded money growth could have no effect if member banks increase their excess
reserve holdings by the same amount.
Variability in member banks' desires to
hold excess reserves can offset or reinforce changes in reserves, causing variation in the reserve-money relationship.
Furthermore, lagged reserve requirements
cause variability in the relation between reserves and money on a week-to-week
basis.
All of these economic and institutional factors introduce variability into
the relation between reserves and money growth. This 'ueans that a specified change
in reserves can theoretically cause a variety of rates of change in the monetary
aggregates, if a shift in one of these factors occurs.
Likewise, such a shift
can causa a change in money growth that i.s not preceded by a change in reserves.
Opponents of the reserve aggregate approach to monetary policy claim that
the range of responses, in terms of money growth, resulting from a change in
reserves is wide and variable and therefore control of bank reserves does not
necessarily mean that monetary growth can be controlled precisely.
of reserve aggregate targeting, while recognizing
Advocates
that variability in the re-
serve-money relationship reduces the precision of monetary control, believe
that controlling reserves is a more precise monetary control device than targeting interest rates-
Reserves control, they believe, allows more stable,
predictable monetary growth.
Conversely, they believe that the interest rate
control procedure resulted in unpredictable, unintentional, erratic periods of
rapid monetary expansion and contraction.
JY Under lagged reserve requirements, member banks hold required reserves
based on deposit levels, two weeks earlier.
I/
195
It is generally accepted that it is not yet possible to judge whether the
new policy approach will be successful and reserve control will prove to be
a more precise monetary control device.
There are several reasons why judgements
at this time must be tenuous.
Any analysis of the effects to date of the new procedure must necessarily
be based on monetary data over a relatively short period of time.
Short-term
data on the monetary aggregates are known to contain errors and temporary
aber-
rations, and observers have frequently warned against judging monetary control
^
on the behavior of the monetary aggregates over short periods of time.
In addition, the lags in the effects of monetary policy are long enough
that the full impact of the new policy has not yet been felt.
While estimates
vary widely, it is generally believed that the lag is at least six months in
length and may be as long as two years.
While the effects of the new policy
approach may already be reflected in the behavior of some variables such as
bank reserves and interest rates, the impact on inflation cannot be expected
to appear for many raonths. Furthermore, most experts warn that inflation and
inflationary expectations may now be so deeply entrenched in our economy that
inflationary pressure is not apt to dissipate quickly, regardless of how effectively the Federal Reserve can control ,-noney growth using its new procedure.
Given the lags in monetary polity, most analysts agree that the new technique must be followed for at least a year before its effectiveness can be
assessed.
If inflationary pressures persist, some advocates of reserve control
are concerned that the procedure will be abandoned before its efficacy cen be
demonstrated.
The Federal Reserve has adopted operating procedures before that
196
CRS-21
emphasized reserve targets, but only followed them for relatively short periods
of timeThere are some monetary economists who believe that the Federal Reserve
has not chosen to emphasize the best measure of bank reserves in its control
process.
However, there is no general agreement a3 to which reserve is the
optimal policy guide. .Moat monetarists believe that monetary control would
be best achieved by controlling the monetary base, rather than nonborroued
reserves or total reserves.
This is based on the belief that, of the various
reserve aggregates, the monetary base is most closely related to the money
Stock, and that the Federal Reserve can als,o control it with considerable precision.
A possible implication of the new procedure which is potentially of great
importance is the degree of variability in market interest rates that may accompany reserves control.
Economists have generally believed for many years that
if the Federal Reserve used a money or reserve aggregate to guide daily operations, there would be more and larger fluctuations in market interest rates.
The Federal Reserve has never adhered to a reserve target long enough to determine the impact on interest rate variability.
The Federal Reserve can, of course,
still use its powers to ameliorate fluctuations in interest rates if they move
too far oLt of a desired range.
But if the Federal Reserve controls bank re-
serves on a day-to-day basis, some short-run fluctuations in interest rates
that would have been smoothed out under previous policies, can be expected.
The
disorder that may result in the financial markets and the adjustment or accommodations that may have to be made there are largely unknown at this time.
On the one hand, many financial experts believe that there will be a significant increase in interest rate variability which will be disruptive in the
197
financial markets.
They see investment dealers and brokers, commercial, banks
and other participants in the financial markets having to adjust to a financial
environment of increased uncertainty.
On the other hand, some economists dis-
count the importance of increasing interest-rate variability.
They believe that
once an initial transition period has passed and financial market participants
have adjusted to the Federal Reserve's new program and operating procedures, the
actual increase in interest-rate variability will be small; or, that whatever
increased variability does occur in the long run, can be acconiodated without
much cost to the financial markets.
THE RECEHT_EXPERIENCE
This section examines the issues of monetary control discussed above as
they apply to recent experience.
In the weeka following October 6, 1979, the
rate of expansion of the money stock and bank credit has slowed appreciably.
In the fourth quarter of 1979, MlA increased at an annual compound rate of 4-8
percent, following rates of increase exceeding 8 and 9 percent respectively
in the preceding two quarters.
Bank credit, increased at an annual compound
rate of 8.7 percent in the fourth quarter of 1979, which is the smallest quarterly increase since 1976.
In the long run however, the t.rue test of the usefulness of reserve targeting will be whether or not it allows the Federal Reserve to control money growth
more precisely than under the old operating procedure.
One of the factors that
may interfere with that precision is the variability in the relationship between
bank reserves and money.
Table 2 gives quarter-to-quarter compound annual growth
rates for MIA, total reserves, nonborrowed reserves, and the monetary base, 1968
to the present.
These figures demonstrate the lack of correlation between growth
198
CRS-23
r a t e s foe reserves and m o n e y .
F o c u s i n g on the year 1979 a l o n e , it
can be seen
t h a t , for any of the bank reserve m e a s u r e s , a wide r a n g e of r a t e s of growth for
reserves can correspond to a v a r i e t y of money growth r a t e s .
In the f o u r t h q u a r t e r
of 1979, for e x a m p l e , t o t a l reserves grew much more r a p i d l y than in the previous
two q u a r t e r s , w h i l e M I A growth slowed c o n s i d e r a b l y .
I n t h i s recent experience,
t h i s d i s c r e p a n c y can be" traced largely to increases in the level of government
deposits and c e r t i f i c a t e s of deposit, both of which must be backed by bank reserves but are not included in MlA.
In general such d i s c r e p a n c i e s are a t t r i b u -
t a b l e t o t h e v a r i o u s f a c t o r s discussed above t h a t a f f e c t t h e reserves-money
r e l a t i o n s h i p , such as nonraember banks or ribn-money d e p o s i t s .
As t a b l e 2 a l s o shows, the r e l a t i o n s h i p between the growth r a t e s of the
various reserve measures also v a r i e s w i d e l y .
This v a r i a b i l i t y demonstrates t h e
d i f f i c u l t y o f c o n t r o l l i n g several r e s e r v e t a r g e t s a t once; since open market
o p e r a t i o n s are aimed at c o n t r o l l i n g nonborrowed reserves in order to achieve
a t o t a l reserves t a r g e t , the Federal Reserve must be able to predict the f o r t h coming d i f f e r e n c e b e t w e e n nonborrowed and t o t a l r e s e r v e s , which is member bank
borrowing.
Chart 1 shows the h i s t o r i c a l p a t t e r n of nonoorrowed reserves and t o t a l
serves;
tively
it
shows that the gap between the two reserve measures has been rela-
large s i n c e the m i d d l e of 1977.
C h a r t 2 p l o t s the Federal funds r a t e
arid t h e d i f f e r e n c e b e t w e e n t h e F e d e r a l f u n d s r a t e a n d t h e Federal Reserve
count r a t e .
re-
dis-
When t h e F e d e r a l funds r a t e rises a n d t h e d i f f e r e n c e between i t
and the d i s c o u n t r a t e grows, member banks can be e x p e c t e d to increase t h e i r
borrowing at the Federal Reserve.
Comparing C h a r t s 1 and 2, it can be seen
t h a t p e r i o d s of time s i n c e 1968 when the gap between the two r a t e s widens correspond c l o s e l y to periods when the d i s c r e p a n c y between t o t a l and nonborrowed
. <j
0.1
1 7
11
6.1
) 1)
8
8 6
7.B
fl
7.3
<£>
I
b
1.6
i.9
3.5
B.9
7.3
5.7
11.2
200
CRS-25
reserves grows.
Lags in adjusting the discount rate upward as market rates rise
have therefore, by encouraging member bank borrowing! widened the difference
between nonborrowed and total reserves.
More important for monetary control
purposes, anything that makes member bank borrowing more difficult to predict,
loosens the correspondence between nonborrowed and total reserves.
Charts 3 and 4 provide information for the 18 weeks preceding and following the October 6 policy change.
Chart 3 gives the Federal funds rate;
Chart 4
gives total and nonborrowed reserves on the top panel and the difference between
the Federal funds rate and the discount rate on the bottom panel.
Using the
Federal funds rate as an indicator of shoft-term interest rate behavior, it is
clear that there has been increased variability in interest rates since October
6.
However, since this observation is based on a relatively short period of
time, niany analysts would contribute much of the increased variability to two
possible, short-term considerations.
First, much of the variability can pro-
bably be attributed to the psychological effects of the Federal Reserve announcement of increased monetary restraint.
Second, some part of the variability may
be representative of a transition period when financial market participants are
still adjusting to the Federal Reserve's new operating procedures.
If these
two factors prove to be important, the increase in interest rate variation may
'Jell prove to he a temporary phenomenon.
Weekly reserve figures, as shown in the top of Chart 4, also have varied
more since October 6; whether or not this closer control of bank reserves is
allowing more precise control of money growth cannot be determined yet.
The
gap between the Federal funds rate and the discount rate, while positive throughout the 36-week period plotted in Chart 4, has fluctuated widely since October 6.
201
CHART i
TQTRL RESERVES RND NONBORROWEO RESERVES
SERSONRLLY RDJUSTED, RVERRGES OF DRILY FIGURES
QURRTERLY, 1968-1979
CRDJUSTED FOR CHRNGES IN RESERVE REQUIREMENTS)
SB
E9
70
71
72
?3
7-f
?5
78
7?
7B
SOHRC OF GOVERNORS OF THE FCDERHL RESERVE SYSTEM.
RCCESSED FROM FILES OF DBTfl RESOURCES,
INC.
NOTC; The Federal Roservs 1» 1n tha procaaa of ravlalrig nil
ro«orv« iggrogstes -for chungm In semsanaF faotorn, but thB
rovtaad 0eriQ3 ward unavaf f aJ?Io whon thla chart ui«a propar^d.
PREPRR£0 BY THE CONGRESSIONRL RESEARCH SERVICE
79
Bfl
202
CRS-27
CtlAKT 1
THE FEDERRL FUNDS RflTC RND THE
FEDERflL FUNDS RRTE - FEDERRL RESERVE DISCOUNT RRTE
QUflRTERLY RVERRGES OF DRILY FIGURES
1368-I97S
14
-2
14
'.-' '.' U ' I ' I ' I ' I ' I ' I ' t M t ' 1 ' 1 "-' I ' I " " t ' I M-M ' '-' M '—
G8 S3 70 71 72 73 71 75 76 77 78 79 80
SOURCE:
BOHRD OF GOVERNORS OF THE FEICRBL RESERVE SYSTEM
PREPRREB BY THE CONGRESSIONBL RESEHRCH SERVICE
203
CRS-2S
CHART 3
THE FEDERRL FUNDS RRTE
18 WEEKS BEFORE RND RFTER OCTOBER 6,1379
CJUNE 6,1379 THROUGH FEBRUHRY 6,1980)
fC
^Q
IS -
JUNE JULY
SOURCE1
RUG
SEPT
OCT
NOV
DEC
BOflRD OT GOVERNORS OF THE FEDERRL RESERVE SYSTEM
PRCPRRED BY THE CONGRCSSIONRL RESERRCH SERVICE
JRN
FEB
204
CRS-29
CHART 4
IB WEEKS BEFORE: RND RFTER OCTOBER 6,1373
(JUNE 6,1979 THROUGH FEBRURRY 6,1380)
TOTRL RESERVES FIND NONBORROWED RESERVES
SERSQNRLLY RDJUSTE3, RVERRGES OF DRILY FIGURES
CflDJUSTED TOR CHHNGES IN RESERVE REQUIREMENTS)
THE: FEDERRL FUNDS RHTE MINUS
THE: FEDERHL RESERVE SISCCUNT RHTE
SOURCE!
BORRD OF GOVERNORS OF THE FEBERflL RESERVE SYSTEM,
RCCESSED FROM FILES OF BflTfl RESOURCES, INC.
NOTE: Tho Fedorsl Rti^Brvo Is fn tha pfoceae of r o v f s l n g a l l
resorvo agaroQatoe for changoe rn oonsonnl factors, but the
revised « o r l e » ware u n n v a l l a b l o uhan this chart was prepared.
PREPRRED 3V THE CWGRESSIONRL RESERRCH SERVICE
205
SELECTEDJiEFERKHCES
U.S. Congress.
Seriate.
Committee on Banking, Housing, and Urban Affairs. Fed-
eral Reserve Actions.
Hearinga.
9&th Congress, 1st Session.
Washington,
U.S. Government: Printing Office, 1979, 126 p.
Hearings held October 15, 1979,
Board of Governors of the Federal Reserve System.
Monetary Policy Report to
Congress, pursuant to the Full Employment and Balanced Growth Act of 1978,
Washington, February, 19, 1980.
95 p.
206
Carnegie -Mellon University
Graduate School of Industrial Administration
William Larimer Mellon, Founder
Schenley Park
PitlsOutgh, Pennsylvania 15213
1412)578-2283
Allan H. Meltzer
Maurice F8lk PruteSsotol
Economics and Soc-ft! St*em;e
February 8, 1980
Senator Wllliasa Proxmire
United States Senate
Senate Banking Committee
5341 Dirksen Building
Washington, D, C. 20510
Dear Senator Proxmire:
I am enclosing a copy of the recommendations adopted by the
Shadow Open Market Committee at its semi-annual meeting on
February 3j 1980. These recommendations are a program to prevent
a, very large increase in real tax burdens and to reduce inflation.
I hope you will bring our report to che attention of the
members of the Senate Banking Gomdlttee.
Sincerely,
Allan
AHM/jep
d,
207
QPEH
The Committee met from 2:00 P.M. to 8:00 P.M. on Sunday, February 3, 1980.
P^ofessor_jKarj_erumwr, Director of the Center for Research in Government Policy
and Business, Graduate School of Management, University of Rochester,
Rochester, Mew York
Prof e_ssp_r_ft1J_a_n_H^ He 1_tzer , Graduate Schoo' of Industrial Administration, CamegieMellon University, Pittsburgh, Pennsylvania
ftr_.__H_._ jrieh Hei'nemann, Vice President, Morgan Stanley i Company. Inc. New York,
New York
Dr . Homer Jo ne_s , Retired Senior Vice President and Director of Research, Federal
SeservFTJank of St. Louis, St. Louis, Missouri
Dr . J6j"rv_Jprcjan, Senior Vice President and Chief Economist, Pittsburgh national
Bank, Pittsburgh, Pennsylvania
DT\_Rudolgn_ Penner , American Enterprise Institute, Washington, DC
Prgfesjor^Robert Rasche. Department of Economics, Michioan State University, East
Lansing, Michigan
P_rofes_sgr Uilson Schmidt. Department of Economics, Virginia Polytechnic Institute,
Slacksburg, Virginia
Dr. B_erjl SPTI nke? . Executive Vice President and Economist, Harris Trust and Savings
Bank, Chicago, Illinois
Dr. ftnna Schwart;. National Bureau of Economic Research, New Vorfc, New Vork
210
In the fourth quarter of 1979, the Federal Reserve showed that it was capable of
achieving its target rates of monetary growth.
However, there is no evidence yet
that the Federal Reserve can be relied on to reach announced targets consistently.
Current procedures generate avoidable uncertainty and should be improved promptly.
A Program Jgr _ig8Q_a_nd Beyond
1.
The Federal Reserve should announce further details about its
procedures to reduce the long-run trend of money growth and
reestablish its credibility by actually achieving its announced
targets.
This would be the most effective way to eliminate the
entrenched belief that the rate of inflation will continue to
rise in the Eighties.
1.
The SOMC favors an immediate return to the 6S growth rate for
base money that was achieved in the first and second quarters
of 1979.
A 6* average rate of growth of the base in each quar-
ter of 1980 will continue the policy we advocated at our September 1979 meeting.
Base money by the end of the fourth quarter
of 1980 will reach $16Z-billion if our recommendation is followed.
The proposed policy is likely to be accompanied by a
mild recession in 1980 and a slight reduction in the rate of
inflation.
3.
Large, permanent reductions in the rate of inflation can be
achieved in 1981 and beyond only if there are further reductions
in the growth rate of the base.
We recommend reductions of
one percentage point in 7981 and 1982, so that the level of
the base will reach $170-Mllion at the end of 1981 and $177billion at the end of 1932.
211
4.
Under a monetary policy consistent with ending inflation, the
Federal Reserve will provide smaller and smaller contributions
to financing budget deficits.
Congress should remove the in-
consistency between budget projections and Federal Reserve
policy.
It should demand that the Administration provide bud-
get projections that are compatible with the Government's commitme/it to an antiinflationary policy.
5.
We propose that the ratio of government outlays to GNP be reduced
steadily.
6.
By 1985 the ratio should not exceed 20*.
We repeat our recommendation for a tax reduction in 1980.
tion has increased the real tax burden.
of the oil price increases.
Infla-
We are poorer as a result
Unless taxes and government spending
are reduced, the entire burden of the oil price increase falls on
private consumption and investment.
We call on the Congress to
enact a prompt reduction of $'5- to $2G-biJlion in government
spending and taxes.
212
BOARD DF G O V E R N O R S
FEDERAL RESERVE SYSTEM
WASHINGTON. D, C . 2OS5I
PAUL A V O L t K EH
CHAIRMAN
March 17, 1980
The Honorable William Proxmlre
Chairman
Committee on Banking, Housing
and Urban Affairs
United States Senate
Washington, D. C. 20510
Dear Mr, Chairman:
Enclosed, as requested in your February 7 letter, are
tables for recent quarters showing various measures of borrowing
£rom the Federal Reserve System "by member commercial banks in
different size categories.
As one would expect, larger banks account for a bigger
share of the overall dollar volume of borrowing from the Federal
Reserve than smaller banks; however, smaller banks regularly
borrow larger shares of their required reserves. Because borrowings
by larger banks do respresent the lion's share of the total dollar
volume of borrowing, any calculation of the value of obtaining
credit at a discount rate below the federal funds rate also sums to
a greater absolute dollar total for large banks than for small
banks. However, the value of the rate spread to large banks is
not very large when measured as a ratio to bank assets or bank
capital.
Large money market banks are expected to borrow from the
Federal Reserve only on a very temporary basis to assist in making
orderly adjustments to unexpected deposit and credit flows. For
this reason, money market banks are infrequent borrowers, and in
the weeks they do borrow, their use is typically for only one day
in the bank settlement period, either on the final day or just
before the weekend. These borrowings are repaid the following
business day.
When large banks do borrow, the dollar sums needed are
often relatively large—as is suggested by some of the numbers in
213
The Honorable William Proxmire
the accompanying tables. However, the administrative rules for
access to the discount window effectively limit this use to days
when legitimate adjustment credit needs develop. Moreover, as
you know the System has recently imposed a 3 percentage point
surcharge above the basic discount rate on borrowings by large
banks for ordinary adjustment credit when such borrowing occurs
successively in two statement weeks or more, or when the borrowin|
occurs in more than four weeks in a calendar quarter.
I hope this information satisfies your needs.
Sincerely,
1,168
I!
^/
_3/
V. jJt-T o: d=i>"5 ori v':.ich borrowing occurred in period, divided by rhe number of bsnks that borrowed.
Totnl a-inuut of rec;'jired resfitves at borrowing bank;; (in nil.Li.ons of 5 ) , divided by the number of da^s
in tl;i! q u a r t e r .
Tctal amount of borrowings at borrowing banks (in millions of $), divided by the Tiumbcr of days in the
Page 2
Reserves at
Borrowing Banks
'7?
.6
2-J
2V»
.2
26
.34
21
4
U
1
31
i6<)
S3
2U
.92
26
L4
H
14
29
674
132
IS
.82
3.;
3
10
24
1,538
237
15
i8
51
13
818
98
12
56
62
2,016
244
12
12
76
1,115
86
1,139
_!_/
y
_3/
955
Number o£ days on which borrowing occurred In period, divided by the number of banks that borrowed,
Total snount of required reserves at borcouing banks (in millions of $ ) , divided by the number of days
in the quarter,
TQCJ! amount of borrowings at borrowing banks (in millions of 5), divided by the imnbgr of days in the
quarter.
hi
23
20
3
15
57
13
1
5,539
_!/
_2/
J/
7,090
Number of ds.ys un which liOTTowing occurred in period, divided by the cumber of banks that borrowed.
Total amount of required reserves .it borrowing banks (in millions of S3 * divided by the number of days
in the gwarter,
Total MOUTIC of borrowings at borrowing banks (in millions o£ S), divided by the number of days in the
quarter.
C5
30
17
16
U
499
IOS
22
725
132
13
LOO - s^n
1,868
300
16
50? - 1,0,00
1,375
137
1,000
3,249
397
1,707
145
JU
- LOC
- 3,QO?
5,000 ai-.e Over
5,526
\l
11
^J
1,181
1,361
^u-uh^r of Jays on \.'hicti fjorrowins occurred in period, divided by the number of banks th;it borrowed.
Total anounc of required reserves at borrowing banV-s (in mil] ions of S J , divided by the nvireber of days
iii t'sics tjuartar.
TotiiL araour.t of borroTsingn at borroving banks (ia millions of S), divided by the number of (jays in the
quarter.
12
\l
2/
3/
IS
.'<(!?
91
?.3
13
572
103
18
11
1,487
226
15
i
1,266
172
14
64
3,163
377
12
SB
2,074
169
6
9,265
1,218
Kumbtr of days ori which borrowing occurred in period, divided by the nuraber of banks that borrowed.
Tot a] amount of required reserves s.t borrowins banks (lr. m i l l i o n s of S), divided by the number of days
in quarter.
Total amount of borrowings at borrowing banks <in millions of S) - divided by the nwber of days In the
t*
t-*
00
IS
16
107
19
311
17
304
15
669
15
206
1,771
_!/
2j
3_f
;Ju:r.ber of days on which borrowing occurred in period, divided by the number of banks Chat borrowed.
Total amount of required reserves at borrowing banks (in millions of S ) , divided by the number of days
in quarter.
Total araount of borrowings at borrowing banks (in millions of S), divided by the number of days in the
quarter.
of Che t a v o r a p l o ,Spi<.\ic 01 tr s c F u d Funds
Page B
Average Amount
Borrowed A>
Share of lotal
(Percent)
50 tcj "nJO i \ ] ' l i i o t i
103 EL. 5jO K i l l i c r ,
'0
6 .(,
37
10 .4
71
14..7
119
2i.. 7
500 to 1,000 M i l l i o n
53
231
13.. 7
1,000 co 5,000 Millior
56
331
20..7
5,000 a:id O.-cir
15
468
7..9
100
, divided by 365, tir.es the totral aaoutit borrowed,
Ihr. ^icd^rai f u n d ? race minus the Systre.Ti discount
tiividuc! fay ths r.uaher r>£ banl;£ that borrovred.
Total Amoinic borrowed, divj.(!c<! by the nit^ber o£ banks tlvat borrowed.
Fibres for e^ch size class in column G, times the niraV.r of brjrro«ing banks in chat class (Col, 2), divided
by the average fis^e Sor nil si?,e classes in column 6, ^iraea the cotral number of barits borrowing (Col. 2 ) ,
to
to
Page 4
Per
A
25 -c J^
M
1
.'•i-Hi.cn
247
to 100 Million
100 t o 500 M i l l i o n
pT-n
Value 1 of Spread
\',fir -nrl.'i', Tiinl ; I/
f i n D £LL\aE£l_
i^jav
.Jii n i;
Quarter
Average Amount
Borrowed 2>
(million fl)
Share o£ Total
Spread V.iluc 3/
_...CPgTj~^nl:)
40
70
^0
110
6
0 .1
90
i-jn
i-'.n
2r,o
14
1.1
450
lf-n
.; 5 o
2AO
400
330
350
730
24
.3
750
40
-, .8
7CO
1,230
64
9 .6
WO
1,4*JO
l.SCO
2,600
136
21 .6
3,600
2,340
13.,9
500 to 1,000 Million
56
1,310
5,980
303
1,000
61
2 ,270
7,930
6,070
11,700
592
29, 7
14
2 ,020
9,010
9,260
13,600
942
10, S
2,040
105
100
tn 5,000 Million
5,000 and Over
All Classes
\j
TJ
_3/
1,181
Tha federal f u n d s r a t e minus the System d i s c o u n t rate, divided by 365, tines the total amount borrowed,
divided by the number of banks that borrowed.
Total amount borrowed, divided by the number of banUs t h a t borrowed.
Figures for each size class in column 6, times the number of borrowing banks in that class (Col. 2), divided
by die average figure for all size classes in column 6, times tha total number of banV.s borrowing ( C o l . 2 ) .
to
to
CO
Average Value to Porroi-'in^ lianas, By Size
oE tV.u f a v o r a b l e S r ' « " J °^~ tin? Fi_d Furc's R a t e
Over the f u ' l c r a l :;c:,crve D i s c o u n t K a t e
Page 5
(Third; Q u a r t e r - 1979)
(Dopes _ t s in
'•i-llUc™. S)
0 0 ' .? -"illior.
- it; M i l l i e
Su:r.ber of Banks
Borrow ivi!*
27
S'
Jui v
in
J
Avc-lgft V a l u e of ?prcad
Pc-r Borrcvine TJsrilt i'
( I n Cellars)
Aug.
Pent .
Oi:arter
70
120
6
0.1
V",0
130
2SD
14
1.1
5.3
7.5
-.-•
:'.0
'.'-0
23
4(JO
350
770
38
660
620
1,260
G2
8.4
1/-01
1,240
2,470
122
18.5
2,990
5,300
285
14.2
613
2'.7
25 to 50 Million
220
50 '.c 100 Billion
150
5SO
100
169
1,210
55
2,960
:,510
^ e 500 M L 11 ion
500 to 1,000 Million
'(00
Share of Total
Spread V a l u e A
(Percent)
70
;:i^
-
Average Amount
Borrowed Z'
f T n i l . l i " " SI
30.3
1,000 =o 5,GCO Million
56
4,300
5.170
6,800
12,410
5,000 and Over
14
12,500
f,340
10,120
22,470
1,095
14.0
9/0
1,100
2,160
107
100
All Classes
_!/
I/
1,041
1,020
The federal fur.ds race ninus the System di. Jt .
tl:LViao<J by
divided
E>y tne
the nusiner
number or
of banks
DanKs cnac
tiiat borrowed
ooitowca.
Total amount faorrmred, divided by the number of banks that borrowed.
Figures for each si^e class in column 6, times the number of borrowing banks in that class (Col. 2), divided
by che average figure for all size classes in column 6, tirces che total number of banks borrowing (Col. 2 ) .
to
to
B-ink S i z e
•'^posits in
0 to 3 ::i.llir:>_
Per Borrowing Bank i/
Sumbur ol Banks
Ewm-.-infi
27
Average Amount
Eorroifed 2J
f n i U l - . n -'•)
(In D o l l a t d )
Oc i .
;::o
.Vov .
100
»ec.
J f,'J
Share of Total
Spread Value I-1
(i'crecnt)
260
G
0.1
0.9
9-4
370
2SO
320
(--'0
15
.a 2i Million
247
330
360
440
1,040
24
3.5
25 to 50 Million
231
950
620
750
1,680
38
5.3
iO to 100 Million
143
1,560
1,020
1,460
3,040
69
5.9
100 '-o 500 Million
195
3,470
2,590
3,110
6,400
147
16.9
71
10,160
5,260
S,560
17,880
393
17.2
IS, 470
38.7
'-. ~c -_C M i l l i e
530 to 1,000 Million
1,000 to 5,000 Million
62
25,610
10,910
46,040
992
5,000 and Over
15
40,210
26,080
19,340
56,740
1,262
11.5
1,035
3,870
2,170
2,930
6,800
150
100
All Classes
\l
2/
^/
Tha ledotal funds tote minus the System discount rate, divided by 3C5, times the total amount borrowed,
divided by the nuraber of banks that borrowed.
Total amount borrowed, divided by the number of bsnks that borrowed,
Figures for each size class in column 6, times the number o£ borrowing banks in that class (Col. 2), divided
by the average figure for all size classes in column 6, tines the total number of banks borrowing (Col. 2),
to
to
Ol
226
D a i l y Average I n t o r e ; > I K s t e s P a i d by Borrowing Banks
ids
Federal Usserve
Discount Rate
Spread
(basis points)
7.23
7.43
58
61
62
69
25
53
7.83
8.2G
9.50
9.aO
9.50
9.50
9.50
9.50
9.50
9,50
9.69
57
56
59
in. ;o
51
74
79
78
69
73
11.77
200
.1 2 . 00
12.00
178
10.24
lie
227
FEDERAL RESERVE'S FIRST MONETARY
POLICY REPORT FOR 1980
TUESDAY, FEBRUARY 26, 1980
U.S. SENATE,
COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS,
Washington, D.C.
The committee met at 10 a.m., in room 5302, Dirksen Senate
Office Building, Senator William Proxmire (chairman of the committee) presiding.
Present: Senators Proxmire and Stevenson.
STATEMENT OF CHAIRMAN PROXMIRE
The CHAIRMAN. The committee will come to order.
Today we are meeting to hear comments from non-Government
monetary experts on the Federal Reserve's monetary policy plans
and objectives for calendar year 1980. Yesterday we received testimony from Chairman Volcker, including the Federal Reserve's
report to Congress as required by the Full Employment and Balanced Growth Act of 1978. In that report, the Federal Reserve
indicated that its monetary targets for 1980 would be somewhat
lower than the actual money growth rates for 1979, with the largest reduction indicated for the new money stock measure M-1B,
which is currency, demand deposits, and NOW, ATS, and share
draft accounts offered by all depository institutions, including
thrift institutions.
We are fortunate to have with us today four economists with
substantial experience in monetary and financial matters. Our witnesses are: Mr. William Griggs, senior vice president at J. Henry
Schroder Bank & Trust Co., New York; Mr. Kevin Hurley, director
of financial forecasting at Chase Econometrics; Mr. Jerry Jordan,
senior vice president and chief economist at Pittsburgh National
Bank; and Mr. John Paulus, senior financial economist at Goldman, Sachs, & Co., New York.
Gentlemen, this committee must, by law, make a report to the
Senate indicating its view and recommendations with regard to the
Federal Reserve's announced monetary policy plans and objectives
for 1980. The reason why we have invited you here today is to get
your views on monetary policy and our serious inflation problem so
that we may send the Senate the best, most knowledgeable report
of monetary policy that we can. Therefore, in addition to your
prepared remarks, we will want to get your views on specific issues
of concern to committee members.
So that you might think about some of these while you are
listening to the statements of the other witnesses, let me briefly
(227)
228
mention some of the areas that I would like to hear your views on
once we get into the question and answer portion of the hearings:
First, are the objectives for monetary policy set by the Fed
consistent with the economic goals set by the administration and
will they contribute importantly to a significant slowing of inflation if the Fed is successful in hitting those targets?
Second, does the monetary policy plan place enough emphasis on
controlling the growth of credit, as opposed to money?
Third, does the set of monetary policy actions taken bythe Federal Reserve on October 6 and thereafter, and especially the new
stress on controlling bank reserves, represent a significant improvement in procedures for implementing monetary policy, and
how will the new thrust of monetary policy be affected if we fail to
deal with the Fed's membership problem in this session of Congress?
Fourth, would monetary policy be significantly improved if the
procedures now being used by the Fed to administer the discount
window were dropped, and the discount rate were pegged at a
penalty rate above market rates?
Fifth, would monetary policy be significantly improved if the
Federal Reserve took a longer run view, and established multiyear
targets for growth in the monetary and credit aggregates with
narrower ranges than is now the case?
Sixth, since monetary policy cannot be expected to stop inflation
without the help of fiscal policy, how important is it to have a
balanced budget or to reduce the share of GNP accounted for by
Federal outlays?
Seventh, should the Congress set an overall limit on Federal
credit activities, as it does on Federal spending, and would this
help to reduce inflation in the long run?
Finally, since this Committee will begin hearings next week on
anti-inflation policies in general, I'd like to have your views on
wage and price controls, credit controls, regulatory reform, a tax
on gasoline to encourage conservation, and productivity growth.
Our first witness this morning will be Mr. William Griggs, senior
vice president, J. Henry Schroder Bank & Trust Co., New York
STATEMENT OF WILLIAM GRIGGS, SENIOR VICE PRESIDENT, J.
HENRY SCHRODER BANK & TRUST CO., NEW YORK
I. ECONOMIC OUTLOOK
Mr. GRIGGS. Most observers of the U.S. economic scene spent
much of 1979 trying without success to predict when the latest
recession would begin. For the most part, they failed in this because they expected that the downturn would be of a significantly
different character or magnitude than the substantial slowdown in
economic activity which was already occurring. Real growth in
1979 at 2.3 percent was about 2 percent less than in 1978. Many of
these same observers now find themselves equally baffled about
1980. While 1980 does look harder to predict, I would be of the
opinion that the behavior of the economy this year will be much
like that of last year. That is, another 2 percent decline in real
growth. This would mean real growth in 1980 near zero minus 1
percent to plus 1 percent.
229
The factors that prevented a sharp downturn last year will do
the same for 1980. Plant and equipment spending will hold up well,
single-family housing activity will continue to slacken but not collapse and multifamily, commercial, and industrial construction will
do well. Inventories will continue to be kept under good control,
employment and personal income will hold up well, and the consumer, struggling to maintain a standard of living that has been
devastated by inflation, will reduce his savings rate further. The
Federal Government will continue to stimulate the economy
through substantial budget deficits and the easing of credit demands, associated with slowdown in economic activity, will mean
that credit will be readily available.
In this environment there is little reason to expect prices to
decline substantially. Consider if you will what, at its most basic,
we are up against on the price side. First we have unit labor costs
rising at an annual rate of 9 percent with no productivity gains to
offset this rise. Energy costs will continue to move substantially
higher—probably adding at least 3 percent to consumer prices—
even if OPEC oil price increases are well under the 1979 pace. This
is the case because domestic energy prices will be moving significantly higher. Thus, even if food prices behave relatively well, as
seems possible, it is difficult to believe that the Consumer Price
Index will rise less than 10 percent in 1980—the third year in a
row of double-digit inflation. I would like to note that while rising
energy costs are a short-term problem, they are absolutely necessary if we are to achieve energy independence in the long run. This
is the case because over time these price rises make the development of alternative energy sources feasible on a cost/return basis.
II. ECONOMIC POLICY
Fiscal policy has been an important stimulative factor for the
economy in this cycle and it will continue to be so. We are looking
for deficits of $41 billion and $44 billion in fiscal 1980 and fiscal
1981, respectively. However helpful this kind of fiscal policy might
be in adding to employment, it has almost certainly done nothing
to alleviate our inflation problems. If we are ever to have a chance
to reduce inflation, it is essential that such deficits be eliminated
by spending restraint.
The Fed has adopted a singular strategy in its attempt to deal
with inflation. The essence of that strategy has been to produce a
moderate slowdown in economic activity, risking a mild recession,
but not a substantial one. The rationale for such a strategy runs
something like this:
One. The history of the country clearly indicates that as a
Nation we have not been willing to tolerate a serious recession for
any length of time. That is, if a recession threatened, we typically
shifted to a very stimulative posture laying the groundwork for a
renewed inflationary buildup a few years later. Thus, a big recession would provide only a temporary solution to our inflation problems.
Two. Much of the upward pressure on prices comes from the
rising costs of food and fuel, pressure that would not ease in
230
response to a recession unless it were so severe in terms of output
and employment as to be unacceptable.
Three. Consumption and housing, which have provided the drive
to this expansion, should slacken steadily in response to the steady
erosion of real income, associated with an inflation rate which is
running well ahead of income growth, and the financial squeeze
associated with heavy reliance on credit to finance purchases.
Four. The impediments to monetary policy in this cycle are such
that the Fed's ability to control inflation is limited. These impediments include: A Federal budget that is persistently in heavy
deficit; a compensation per man-hour that grows at 9 percent and
productivity that does not grow at all; an inflation rate that has
led the consumer to the conclusion that if inflation is not going to
be controlled and savings are going to be penalized by taxation, one
should spend and borrow as much as possible and save as little as
possible; the absence of any effective control over energy prices; a
dollar that is no longer mighty and thus a constant concern in
shaping Fed policy; the ubiquitous threat that actions to tighten
credit could cause still other banks to leave the Federal Reserve
System in research of more tender treatment elsewhere; the fact
that various sectors of the economy have been insulated from the
effects of tight money.
The adoption of this strategy seems sensible to me, all things
considered. However, in the short run at least, this strategy has
meant a higher rate of inflation.
Finding a solution to our budget, energy, and productivity problems is critical to the long-run control of inflation. We have refused
to deal with these issues over the years and we are now paying a
high price for that neglect. Moreover, even if we begin today, it
will take years to deal with each of these problems. In the interim,
we can expect slow economic growth, unbalanced—but hopefully
reduced—Federal budgets, high inflation, high interest rates, and
more modest gains in standards of living than we have enjoyed in
the past. Sensible and timely action by the Congress, the administration, and the Fed can speed the adjustment process but there is
no avoiding the problems.
One final comment. I see nothing in the recent actions of the Fed
or in the testimony of Chairman Volcker before the Senate or
House Banking Committees to suggest that the long-run Fed strategy outlined above will change in 1980. On the contrary the Fed
apparently intends to stay with this strategy well beyond 1980.
III. FED POLICY SINCE OCTOBER G
The decision by the Fed to shift the main focus of attention in
implementing policy from the Fed funds rate to bank reserves,
bank credit and money was widely hailed as a long overdue
change. This warm reception was based on the belief that the Fed
had spent 1978 and 1979 pushing rates higher without reducing
credit availability adequately. The market's reaction to the announcement of this change in procedures was sharp. Rates rose
substantially and banks began revising their lending procedures to
take account of what they thought would be a substantial reduction in reserve availability. Unfortunately, this fear of a severe
231
squeeze lasted only a few weeks. It disappeared as the Fed permitted bank reserves to grow rapidly and banks once again became
aggressive lenders. As a result, bank lending, which had leveled off
in October and November, picked up substantially thereafter.
Moreover, the slowdown in bank lending in October and November
was more a rate phenomenon—that is, commercial paper was more
attractive than bank borrowing—than a reflection of a reduction in
overall demand for credit.
The Fed rationalized such a policy on the basis that bank credit
and the money supply were both growing at about 3 percent in the
fourth quarter and the Fed apparently expected the economy to be
considerably weaker than in fact it was. Thus, even though bank
reserves grew too rapidly—about 13 percent for both total and
nonborrowed reserves—in the fourth quarter, and even though it
was obvious that credit was readily available to all but the least
credit-worthy borrowers, the Fed, taking its cue from bank credit
and money supply, did nothing.
The response of the debt markets to the Fed's inaction in the
latter part of 1979 and early this year is interesting for what it
says about market perceptions. The short-term markets showed
little or no change for 2 months or longer—prior to the discount
rate change of February 15—while the long-term markets backed
up dramatically. The message in this is that the short markets
benefited from this liquidity, while the long markets saw this liquidity a harbinger of more inflation and/or a tighter monetary
policy.
The decision to raise the discount rate from 12 percent to 13
percent on February 15 was an interesting move because it seemed
to be an isolated event. After all, this action could have been
justified at any time in the last few months based on the disparity
between market rates and the discount rate. It is easy to understand, therefore, why analysts and the debt markets expected the
Fed to do something more and why they were disappointed when
no other overt tightening actions were immediately forthcoming.
IV. THE NEW
MONETARY AGGREGATES
The redefinition of the monetary aggregates brought these various statistical series into better line with reality and was therefore
a welcome and constructive development. It does not assure that a
better monetary policy will now be forthcoming but it will help. As
for the appropriate growth targets, I find myself of two minds. On
the one hand, the target ranges set by the Fed for 1980 seem
appropriate in some cases but too expansive in others. On the other
hand, in my judgment strict attention to targets is probably inappropriate in any case.
The target rates of monetary growth set by the Fed for 1980 and
the actual growth in 1979 are as follows:
232
1979
M-1B
4.0 ID 6.5
M-3
6.5 to 9.5
If one uses the midpoint of the Fed's target ranges for 1980 and
compares it with 1979, it suggests a significant tightening of monetary growth in 1980. If however, one compares the upper end of the
ranges for 1980 with actual growth in 1979, only the M-1B target
looks tight. The reason this upper end of the range worries me is
that I am not sure that the Fed would try to slow the growth if it
were near the high end of the range. If it did not, the growth for
all the monetary aggregates except M-1B would clearly be too
high. More generally, I am so concerned about inflation that given
the still respectable performance of the economy, the still precarious position of the dollar, the existence of considerable liquidity in
the banking system, the possibility that the seasonal adjustment
factors applied to the monetary aggregates understate their growth
and the need to demonstrate to labor that firm action is being
taken to control inflation. I would have preferred that the Fed
clearly err on the side of firmness in setting their targets.
The reason I wonder whether we should be worrying about this
whole matter at all is that targets imply too mechanical an approach to policymaking. In the fourth quarter of last year, for
example, regardless of the fact that money supply was growing at a
rate well within the target range, the realities of the marketplace
were such that the Fed was losing its grip on the banking system
and policy was simply too easy. I would have preferred to see the
Fed respond to such a situation by slowing the rapid growth of
bank reserves even at the risk of producing slower growth in the
monetary aggregates. In short, I would prefer to see more judgment and less reflex in policymaking.
It is extremely important to understand that the failure of the
Fed to control inflation does not result from the fact that the Fed
does not know what to do. The Fed knows how to withdraw reserves from the banking system and in so doing, it can reduce
inflation to more reasonable levels. The problem is that we want
more than that from the Fed. We want the Fed to control inflation
without producing sharp increases in unemployment and to do it in
a way that keeps the dollar strong. Moreover, the Fed is supposed
to accomplish this feat in a very difficult environment. The budget
deficit situation, the energy situation, the productivity situation,
the Fed membership situation are all givens for the Fed. Can
anyone really wonder that the Fed cannot achieve all that is being
asked of it? And should anyone be surprised that the debt market,
having lost all confidence in the ability or willingness of Washington to deal effectively with these problems, is in disarray?
233
V. SUMMARY
The U.S. economy has been in the process of slowing down
gradually throughout 1979 and that process will continue in 1980.
Whether this slowdown will qualify as a recession remains to be
seen but the economy will show little if any real growth. This kind
of steady slackening in the pace of economic activity is not an
accident. Rather, it is the result of a conscious policy on the part of
the Federal Reserve to produce a substantial slowdown over a
considerable period rather than the usual sharp recession. This
long-run strategy to deal with inflation makes sense given the
impediments to Fed policy—budget deficits, no productivity, unresponsive energy prices, and banks leaving the Federal Reserve
System, to name a few—but in the short run it has meant living
with more inflation. In the long run, the health of the economy can
only be insured by appropriate action to reduce Federal budget
deficits, to enhance productivity, and to expand domestic sources of
energy.
The Fed's decision to adopt an aggregate approach—announced
October 6—was welcome because the old techniques had succeeded
in raising interest rates but not in controlling credit growth. Unfortunately, the Fed permitted bank reserves to grow too rapidly
following the change in technique so that while money supply and
bank credit behaved well statistically, credit availability was excessive. Nevertheless, the Fed has stayed with this policy to the present and shows no inclination to change anything in the next year
or two. Thus, credit will be readily available to all but the least
credit-worthy borrowers through 1980.
The redefinition of the monetary aggregates will be helpful to
the Fed since the new definitions are more realistic. However, I am
not entirely comfortable with the growth rates established for this
year. While it is extremely difficult to know what growth rates are
appropriate, the ones chosen seem to me to risk too expansive a
policy. Indeed, it is this difficulty of knowing the appropriate
growth that makes me uncomfortable relying on such targets. They
imply more precision in the whole matter than I think is justified.
Finally, the Fed does not need any additional tools to control
inflation. What it does need though is the political support to do it,
It will not be easy even then because of the many impediments to
success that have been erected over the years; nor will it be done
quickly. The sad part of it is we could have avoided our current
impasse by making the tough decisions that needed to be made
along the way. We failed to do so, however, with the result that
price stability as we knew it only a few years ago will be a long
time returning.
The CHAIRMAN. Thank you very much, Mr. Griggs. I thank you
with a mixed reaction. That's certainly a gloomy analysis, but I
thank you.
Mr. Hurley.
234
STATEMENT OF KEVIN HURLEY, DIRECTOR OF FINANCIAL
FORECASTING, CHASE ECONOMETRICS, NEW YORK
Mr. HURLEY. Mr. Chairman, I am honored to have the opportunity to present my views on the outlook for the economy, the role of
monetary policy, and related matters to this committee.
OUTLOOK FOR THE ECONOMY
Chase Econometrics' forecast for the economy in 1980 is in basic
agreement with that of both the administration and the Federal
Reserve. We believe that an accumulation of underlying forces in
the economy is pulling us into a mild recession. High inflation has
eroded consumer purchasing power substantially and is continuing
to do so. In recent years, substantial increases in employment
offset the reduction in each worker's real income. Furthermore,
rising home prices gave households the intangible impression of
growing wealth and, in many cases, actual funds to continue spending despite lower incomes. Now, employment growth has slowed,
and home prices are no longer rising. Hence, growth in consumption expenditures can no longer carry the economy forward.
As in most downturns, the recession is being led by declining
residential construction. Both home prices and financing costs have
moved well beyond the reach of many potential home buyers.
Indeed, a weak year for housing is virtually certain, as evidenced
by low current levels for mortgage commitments, building permits,
and deposit inflows at thrift institutions.
Finally, fiscal policy is becoming less stimulative. Although the
budget will in fact remain in the red, the deficit is narrowing while
the economy is moving into recession. Typically, a weakening economy implies a widening deficit. The administration notes that in a
hypothetical full-employment economy, the budget would have a
$12 billion deficit in 1979, a $4 billion surplus in 1980, and a $5
billion surplus in 1981. This shift from a full-employment deficit to
surplus evidences fiscal restraint.
Although the administration's budget proposal may well be modified, we do not believe the differences will be significant enough to
change this characterization of fiscal policy. In particular, increased funding for defense does not alter the outlook appreciably,
because of the lags inherent in new spending projects and because
of the small share of GNP accounted for by defense spending.
Our outlook for inflation is not very optimistic. We do not anticipate another round of sharp bursts in the prices of energy and food
as occurred last year. But, recent oil price increases, coupled with
decontrol of domestic crude, will boost energy costs significantly
this year. And, nonagricultural factors, such as fuel and labor
costs, will push up the price of food at retail. Finally, and most
disturbingly, the underlying rate of inflation, based on accelerating
wage rates and declining productivity, is rising.
A comparison of our forecast for 1980 with those of the administration and the Federal Reserve is presented in table 1. Specifically, we expect real economic activity to decline by 1.3 percent from
the fourth quarter of 1979 to the fourth quarter of 1980. The
consumer price index is projected to rise 11.1 percent. And the
unemployment rate is seen to rise to 7.6 percent in the fourth
235
quarter. Looking ahead to 1981, our forecast agrees with the administration's in anticipating a relatively slow recovery. Real GNP
is expected to increase only 3.9 percent, leaving unemployment up
at 7.3 percent of the work force in the fourth quarter of 1981.
Inflation will remain on a high plateau, with the consumer price
index increasing 9.6 percent.
CONSISTENCY OF MONETARY POLICY WITH THE OUTLOOK
Analyzing the consistency of the Federal Reserve's target ranges
for money and credit with the economic outlook is not an easy
matter. Institutional changes in the nature of money balances have
hampered this analysis in the past. And now, the new set of money
definitions established by the Fed confuses the matter further.
One means of addressing this issue is to compare our forecasts
for the monetary aggregates, as previously defined, to ranges set
for them. Table 2 presents two sets of target ranges for the old
aggregates. The first set was established last July. The second set is
estimated by the Federal Reserve to be consistent with its ranges
for the new aggregates.
When we use our economic forecast—which agrees with the administration's and the Federal Reserve's—to project growth rates
for the monetary aggregates under the old definitions, the predicted growth rates fall within the ranges prescribed for them. These
forecasts are also shown in the table. Hence, we believe the Federal
Reserve's objectives are consistent with the economic results anticipated by the administration.
A POTENTIAL PITFALL FOR MONETARY POLICY
Given the primary objective of slowing the inflation rate, monetary policy must walk a very thin line during 1980. We agree that
the rate of price increases clearly calls for monetary restraint. But,
with the same goal in mind, we are also concerned that an overly
restrictive policy will be counterproductive.
Looking back over previous cycles, monetary policy is seen to
have a tendency toward overkill. Given downward rigidities in our
price structure, extreme monetary restraint primarily affects real
economic activity rather than inflation. This occurs most noticeably when an external force, such as an OPEC price increase,
accelerates inflation. Tight monetary policy is then aimed at forcing other prices to decline at an offset to rising energy costs. But
since other prices will not decline, the toll is taken on physical
output of goods and services.
Driving the economy into recession by tight monetary policy may
result in some shortrun improvement in inflation as producers cut
prices on manufactured goods to lower inventories. This policy is
actually counterproductive, however, to containment of longer
term inflationary forces.
Our concern here is based on our view of the inflation process.
Apart from the externally imposed increase in oil prices, we believe current inflation stems from an environment of disincentives
sapping investment, research, and development. In part, this is
fostered by inflation itself when combined with the corporate tax
structure. The regulatory maze is another source. The accumula-
236
tion of disincentives has slowed the economy's investment and
technological development, fostered the substitution of labor for
capital, and in the process lowered productivity and intensified
inflation.
Over the long haul, inflation can be slowed only by increased
investment, which increases the capital stock, raises productivity,
and lowers unit labor costs. Sharp slowing of the economy, however, slows investment for four reasons: (1) A low rate of capacity
utilization makes expansion unnecessary; (2) a low rate of business
activity reduces internally generated funds; (3) reduced production
rates slow the physical deterioration of the capital stock, lessening
replacement; (4) slower replacement schedules retard the introduction of technological advances embodied in new capital goods.
To be sure, a weakened economy may lower the interest cost of
borrowed funds. But, in our view, a reasonably healthy rate of
economic activity is a more important incentive to investment.
Hence, an effective anti-inflationary policy must damp the economy without fostering a tailspin which seriously deters investment.
A PROBLEM OF IMPLEMENTATION
If monetary policy is to go wrong in the fight against inflation, it
will not be through lack of good intentions. Rather, the error will
come from incorrect implementation. In this regard, the singleminded focus on money in the procedures adopted last October 6
give us reason for concern.
Although described as a policy directed toward attaining goals of
"money and credit," current procedures are more appropriately
described as aiming for "money not credit." Most cyclical swings in
bank credit, and business loans in particular, are financed by
banks through managed liabilities. These are certificates of deposit,
Eurodollar borrowing, security repurchase agreements, and similar
transactions. Since most of these are reservable, their changes
directly affect required reserves to control these items, and ultimately bank credit, the Fed's operating policy must resist deviations in the growth of reserves associated with these items. Current Fed policy does exactly the opposite. It concerns itself with
only that portion of reserves related to the monetary aggregates
and accommodates changes in reserves related to bank credit.
Current operating procedures are the reason why the Fed's commitment to slowing inflation has been questioned recently. Many
supporters of the Fed's October 6 changes believed that for the first
time in this cycle the availability of credit would be in doubt. With
the Fed's announced intention of restraining the provision of reserves, there could be no assurance that funds would be available
when needed. This was expected to slow demand by forcing borrowers to rethink their investment decisions. But, by supplying the
reserves associated with bank credit, the Fed has signaled the
banking system that sources of loanable funds can be readily
tapped. This has disappointed those hoping for a tight rein on
credit availability.
The Federal Reserve chairman has stated that we must keep an
eye on money to assess Fed policy, although M-l fell within its
range last year, the economic results were highly inflationary.
237
Bank credit, on the other hand, was well above its range last year.
Indeed, bank credit has been above its range for the past 3 years in
succession. This leads one to believe that bank credit is telling us
something M-l is not. Hence, we feel strongly that open market
operations should be directed toward the control of credit availability rather than the money stock.
COORDINATION OF TAX POLICY WITH MONETARY POLICY
In addition to the general posture of fiscal restraint, another
connection between fiscal and monetary policy lies in the area of
tax initiatives to counter inflation. In our economy, pollution,
health, safety, and a multitude of other regulations drastically
erode the return on capital spending projects. At the same time
recent institutional changes have greatly facilitated the access of
individuals to the capital markets. Through mortgages and credit
purchases of autos and other durables, households now compete
with corporations for funds much more effectively than in the past.
In an environment of rising prices, the return on investment is
higher on household items than on capital spending projects.
Hence, it is no wonder that a rising share of credit is going to
households and away from business investment.
To redirect financing toward increasing productive capacity, the
rate of return on capital spending must be improved. A clear
means of accomplishing this is to provide more generous depreciation allowances on capital equipment. Financial regulatory bodies
can also help redirect the flow of funds by shortening the repayment period on household credit, thereby reducing its attractiveness.
At the same time, we must be careful in assessing proposals to
cut payroll taxes as an anti-inflationary device. Some reduction
may be desirable. But too much can encourage the substitution of
employees for capital goods, lower productivity, and retard growth
in the real income of workers.
SUMMARY
We are in complete agreement with the general goal of monetary
policy to work toward a stable, noninflationary economy. We must
remain dubious, however, about prospects for success as long as
policy implementation is directed singlemindedly toward money
stock targets.
In this respect, we are grateful for the opportunity to suggest
alternatives which we consider of great importance. Through discussions such as this one, we are confident that the effective Government policy we all seek can be attained.
TABLE l.-COMPARISON OF FORECASTS FOR 1980
[In percent]
federal Reserve
-2.5 to 0.5.
8.75 to 12.0..
6.75 to BO....
Ctiase
econometrics
238
TABLE 2.—COMPARISON OF TARGETS AND PROJECTIONS
3.0 to 6,0
3.5 to 60
7.5 to 10.5
6.0 to 9.0
The CHAIRMAN. Thank you very much, Mr. Hurley.
Mr. Jordan.
STATEMENT OF JERRY L. JORDAN, SENIOR VICE PRESIDENT
AND CHIEF ECONOMIST. PITTSBURGH NATIONAL BANK
Mr. JORDAN. Mr. Chairman and members of the committee, I am
pleased to have this opportunity to present my views on the economic outlook and monetary policy. The policy actions of the Federal Reserve since last fall have been appropriate for the circumstances and provide some basis for optimism that the long upward
spiral of inflation finally may be broken. But our Nation's central
bank's reputation as an effective inflation fighting institution has
been so severely damaged by events of the past decade that I now
believe strong congressional support is essential for the Federal
Reserve to succeed with the announced policies. The fiscal stimulus
associated with the recently released 5-year budget projections is
not consistent with an anti-inflationary monetary policy, and financial market analysts generally have concluded that the expansionary thrust of fiscal policies ultimately will.dominate.
These hearings, pursuant to the Full Employment and Balanced
Growth Act of 1978, provide a useful forum for debating, and
hopefully reconciling, the longer-run impact of monetary and fiscal
policies on inflation, employment, and real growth. Clearly stated
and consistent objectives for the price level, capital formation,
productivity improvement, and real tax burdens would be a major
contribution to the functioning of the Nation's financial markets
and to the performance of the dollar in foreign exchange markets.
A LEGACY OP INAPPROPRIATE ECONOMIC POLICIES
There has been ample opportunity to learn a few lessons about
the formulation of stabilization policies in the past several years. It
is important to demonstrate that these lessons have been learned
and will serve to guide our policymakers in the future. Much of the
analysis of the effects of the first oil shock in 1974 was wrong and
the policies to deal with it were inappropriate. Yet, by the begin-
239
rung of 1979 we found ourselves vulnerable to another major oil
shock.
A substantial real wealth loss was imposed on the oil consuming
countries by OPEC. It was futile to think we could avoid this loss
by tax rebates to stimulate consumption and by easy money and
credit policies. The failure to correctly analyze and respond to the
oil shocks resulted in the major burden of the loss being borne by
private sector investment—which means that future consumption
and future standards of living were sacrificed in favor of short-run
considerations. In relative as well as absolute terms, the real Government sector has increased and real tax burdens have risen
because the private investment sector has been so adversely affected by the oil shocks. Testimony by Prof. Allan Meltzer of Carnegie
Mellon University before this committee last July clearly and carefully analyzed the effects and the appropriate policies to deal with
such external developments.
The emphasis on the GNP gap after the first oil shock was not
correct, and efforts to spend our way back to prosperity have
backfired. The locomotive or convoy theories behind recommendations for more stimulus in this and other leading industrial countries were ill-founded. The pressure on the Federal Reserve to
resist rising market interest rates in 1977 and 1978 by rapid injections of money and credit were based on fallacious conceptions of
the monetary policy process. Finally, the benign neglect of the
rapid depreciation of the value of the dollar on foreign exchange
markets before November 1, 1978 was based on incorrect analyses
of the causes of the dollar's weakness and a misunderstanding of
forces affecting a dominant international reserve currency in a
regime of floating exchange rates.
These experiences of the 1970's no doubt have some educational
value, but it has been, and continues to be, a very costly education.
Mistakes were made in the formulation and the implementation of
monetary policy in the past decade—but not all the mistakes involved monetary policy. Energy policies have been slowly evolving
into more sensible sets of incentives and disincentives, but our
major long-run energy problems will be overcome only if stabilization policies are different than they have been. Fiscal and budgetary policies also have been major problems, and monetary policies
cannot be expected to overcome the adverse effects of actions in the
fiscal arena any more than monetary policy can offset the shocks
in the area of energy. It would be naive to become highly optimistic
about the benefits of a given set of monetary policies until there
are definite signs that our national energy and fiscal policies are
moving in the same direction.
MONETARY POLICY ACTIONS IN
1980
Monetary growth in 1979 was expansionary on balance, although
somewhat less so than in 1977 and 1978. In the year ended in the
fourth quarter of 1979, the monetary base rose 8.2 percent and the
Federal Reserve's new money measure called M-1B rose 8 percent.
In the same period, nominal GNP rose 10 percent, real output rose
1 percent, and the general price index rose 9 percent.
240
For the current year, Chairman Volcker has announced that the
Federal Open Market Committee has established a target growth
range for M-1B of 4 to 6.5 percent. At its semiannual meeting on
February 3, 1980, the Shadow Open Market Committee recommended a target growth rate of the monetary base of 6 percent for
1980, which would be consistent with a growth rate of M-1B of
about 5 to 6 percent this year.
The data released thus far by the Federal Reserve suggest that
the income-velocity, or rate of turnover, of M-1B has risen at about
a 3 to 3.5 percent rate on average in recent years. The average
growth of the velocity of the monetary base has been between 1.5
and 2.5 for long periods of time. This past experience suggests that
growth of the monetary base of 6 percent and M-1B of about 5 to 6
percent in 1980 would be accompanied by a growth of total spending (nominal GNP) of about 8 percent. Given that the lagged effects
of strong monetary and fiscal stimulus in 1977 to 1979 will produce
an increase of the general price level of about 9 percent again this
year, these projections are roughly consistent with the administration's projection of a 1-percent decline in real output in 1980.
The strongly expansionary monetary and fiscal policies in 1977
and 1978 produced a temporarily rapid growth of real output of
over 5 percent on average for those 2 years, and total employment
rose by 7.3 million, or 8.3 percent, during those 2 years. Unfortunately, the expansionary policies that produced strong gains in
output and employment in 1977 and 1978 contributed to the substantial inflationary pressures in 1979 and 1980. Any recession that
does occur this year should be chalked up as part of the price that
must now be paid for the impatience that influenced policy actions
2 and 3 years ago. The new president of the Deutsche Bundesbank
characterized the problem quite well recently when he remarked
that, "inflation is like toothpaste. Once it's out, you can hardly get
it back in again. So the best thing is not to squeeze too hard on the
tube."
If a decline of output and a rise of unemployment does occur this
year as is generally expected, participants in domestic and international financial markets will be watching closely for signs that the
anti-inflationary monetary polices are being abandoned in favor of
antirecessionary polices. Such a shift of emphasis in U.S economic
policies would be a serious mistake and would have grave implications for the dollar in foreign exchange markets. It might be possible to further delay the onset of recession by a shift to quick-fix
stimulus, but such actions would only increase the probability of a
deep and long recession at some point. Nobel Prize-winning economist Fredrich A. von Hayek long ago put forth the view that, "the
only way to fight recession is during the prior expansion." Once
the economy has been overstimulated, it eventually must be allowed to cool off. Consequently, any recession that does occur this
year should not be blamed on monetary policy actions taken by the
Federal Reserve this year,
CREDIBILITY AND PERSERVERANCE ARE NECESSARY
An understanding of the rather long lags of policy actions and
the role of expectations about the future is necessary to interpret
241
economic developments this year as well as the likely effects of
policy actions this year. It would be wrong to say that the Federal
Reserve policies this year must cause a recession in order to effectively reduce inflation. Whether or not a recession occurs, and the
depth and duration of any recession that does occur, will be a
function of the credibility of the Government's commitment to
substantially reduce inflation during the next few years.
As we enter a new decade, the central issue concerning stabilization policies is not the role of the money supply versus interest
rates, and it is not the relative importance of monetary versus
fiscal policies, as was the case in the past decade. Now, the critical
issue is credibility. Declarations of a renewed commitment to
combat inflation were made with such increasing frequency during
the past 15 years, only to be abandoned before lasting progress was
made, that the Federal Reserve is no longer viewed as a solid
bastion against inflationary forces. The importance of restoring our
central bank's reputation and credibility as an inflation fighting
institution cannot be overemphasized. The ultimate total cost to
our economy in terms of lost output and reduced employment will
be greatly affected by the credibility of the Federal Reserve's announced policy actions.
If it were universally believed that the Federal Reserve would
have the total support of the legislative and the executive branches
of Government for as long as necessary to achieve price stability,
then the cost of a successful policy to eliminate inflation would be
minimal. However, if individuals in their roles as consumers, workers, labor leaders, business leaders, and Government officials do
not believe that we have the national will to persevere until inflation is eliminated, and if they base their economic decisions on the
assumption that inflation in the early 1980's will be at least as
high as in the late 1970's, then the real economic costs and the
dislocations associated with strongly anti-inflationary policies could
be considerable.
Restoring credibility of the commitment to persevere against
inflation will not be easy. Participants in financial markets suffered large losses in recent years when they prematurely anticipated a downturn of inflation and interest rates. Consumers and
homebuyers have been conditioned to believe that there is no benefit to delaying purchases based on the expectation of relative price
stability. The psychology of buy now before prices rise further is
deeply entrenched. Workers have watched average consumer goods
prices rise more rapidly than wages on average in recent years and
will not be easily convinced that their compensation for accepting
smaller wage increases now will come in the form of smaller price
increases in the future. Major corporations have been willing to
borrow long-term even at the highest interest rates in history in
the belief that high inflation will continue and they will repay
their debts with greatly depreciated dollars. If a policy of permanently reducing inflation is going to be successful, all those attitudes must be changed. The more rapidly people become convinced
that this time the anti-inflation program will not be abandoned
prematurely, the sooner the economy will return to full employment, improved productivity, lower interest rates, and high capacity utilization.
242
As a creature of Congress, it is natural that the Federal Reserve
should look to the legislative branch of Government for support of
its most recently announced commitment to pursue an anti-inflation policy. The congressional concurrent resolution of 1975 had
the potential of strengthening the central bank's reputation as an
inflation fighter, but the experience has not been satisfactory thus
far. The targets for monetary growth announced at successive hearings since 1975 were so widely and frequently exceeded that they
became irrelevant to outsiders trying to analyze Federal Reserve
policy actions. Now, after having frequently espoused laudable intentions to reduced monetary growth to undermine inflationary
forces, but failing to achieve their own targets, the Federal Reserve
is confronted with widely held skepticism, if not cynicism, about
their monetary growth targets. This is not a healthy environment
in which to implement a successful anti-inflation monetary policy.
The target growth rates for the various monetary aggregates in
1980 seem appropriate for the present circumstances. But the announced target growth rates for each of the past 4 years also
seemed appropriate. They simply were not achieved.
Now there is a new chairman at the Federal Reserve and new
operating procedures have been adopted, so I believe the chances
are greatly improved that the Federal Reserve will actually
achieve its targets. But I feel very lonely in that belief. Most other
observers view the announced target ranges as nothing more than
a wish list. I am afraid that it may take considerable time for the
Federal Reserve to demonstrate that the announced policy objectives, and ultimate benefits in terms of reduced inflation, lower
interest rates, and sustainable growth are anything more than a
wish list.
I also have a wish list. The first item on my list is, of course, that
the Federal Reserve actually achieve the announced objectives of
reducing the growth rates of the monetary aggregates in 1980 and
during several more years in the future. To minimize economic
dislocations that might accompany a sustained anti-inflationary
monetary policy, I wish that something could be done to make
people believe, and make economic decisions based on the belief,
that inflation and interest rates will decline substantially during
the next few years. Consequently, my wish list includes a declaration by all Presidential candidates that they will support the central bank's anti-inflation stance until price stability is restored, and
I wish for a joint resolution by Congress mandating that the Federal Reserve persevere for as long as necessary.
The skeptics argue that monetary policies will become highly
stimulative once again as soon as real output declines and the
unemployment rate begins to rise rapidly. These pessimists about
U.S. inflation must finally be proven wrong, or our standards of
living will continue to stagnate indefinitely. 1 will not repeat all of
the arguments as to why reduction of the trend rate of inflation is
essential. However, I am convinced it is necessary before we can:
restore the soundness of the financial system; achieve once again
higher rates of saving, investment and productivity; stabilize our
currency in foreign exchange markets; and create an environment
where high rates of employment can be sustained.
243
There should be no controversy over whether reducing inflation
is worth the cost. The notion of a stable inflation rate is an illusion. Either monetary and fiscal policies are geared toward reducing the long-run trend rate of inflation, or the average rate of
inflation can be expected to continue ratcheting upwards. I don't
see how there can be any question about the harmful effects of the
secular rise of inflation since the early sixties, and I don't see how
there can be any doubt about the benefits that would come from
eliminating inflation in the eighties.
FISCAL DEVELOPMENTS ARE A PROBLEM
The Federal budgetary program recently announced by the administration for the period 1980 to 1985 is a major obstacle to the
restoration of price stability. The economic assumptions underlying
the budget projections are very pessimistic—an average annual
rate of inflation of 7.7 percent and inflation still over 6 percent in
1985. Since private forecasters are accustomed to viewing the Government's forecasts of inflation as being on the optimistic side, the
reaction has been that if the Government admits that inflation will
average almost 8 percent for the next 5 years, then that means it
will be at least 9 or 10 percent. Furthermore, the budget also
assumes a highly optimistic real output growth of 3.5 percent on
average for the 5-year period. These inflation and real growth
assumptions are simply inconsistent, Either inflation must be
brought down sharply in order to help stimulate the more rapid
rate of capital formation and productivity growth necessary to
achieve a high rate of real output growth, or continued high inflation will further undermine the economic base of our country and
make high growth impossible.
The pursuit of a restrictive anti-inflationary monetary policy as
outlined by Chairman Volcker, in the face of the fiscal program
implied by the administration's budget projections, would mean
that private sector saving and investment would be severely
squeezed for an extended period of time. When fiscal policies are
expansionary, the impact of restrictive monetary policies falls on
saving and investment. However, the mood of Congress seems to
be, and private analysts agree it should be, one of concern over the
deterioration of our capital stock, our productivity, and our industrial competitiveness. I believe, and I think it is generally believed,
that Congress will take actions to stimulate savings and investment and to enhance the prospects for improved productivity. But
if the Government's share of national income is rising, efforts to
change the mix of the private sector's shrinking share from consumption to investment cannot be successful while the Nation's
central bank bears the sole burden of combating inflation.
I believe it was a mistake for the administration to extend the
timetable for reducing inflation to 3 percent to 1988. The monetary
growth targets announced by Chairman Volcker for 1980, together
with the promise of further reductions in monetary growth for the
next several years, would achieve a 3-percent inflation, or less, well
before 1988. The actual timetable and the associated growth of
output and employment depends on whether or not the vast majority of the people believes it actually is going to happen. It is
244
counterproductive to extend the timetable and show a lack of
determination.
It is my conclusion that if the fiscal program does not also
become strongly anti-inflationary, restrictive monetary policies will
not be sustained sufficiently long to be successful. It the Government's command over the Nation's real resources actually grows at
the rates projected in the administration's 5-year budget, there is
no reason to expect the performance of our economy to be any
better in the next 5 years than the dismal record of the past 5
years. Alternatively, a goal of limiting Government spending as a
percent of GNP to 20 percent by 1985 would reinforce the Federal
Reserve's actions which would finance less than 3 percent inflation
by 1985. I believe it can and should be done, and it will be an
enourmously positive outcome of these hearings if Congress shows
strong support for our central bank's policies.
The CHAIRMAN. Thank you, Mr. Jordan.
Mr. Paulus.
STATEMENT OF JOHN PAULUS, SENIOR FINANCIAL
ECONOMIST, GOLDMAN SACHS, NEW YORK
Mr. PAULUS. Thank you, Mr. Chairman.
Under normal circumstances the targets announced by the Fed
last week, if achieved, would I think contribute to an easing of
inflationary pressure in the United States. But these are not
normal times. Interest rates are at record levels and they provide
some rather extraordinary incentives for cash managers to alter
their cash management practices and to move funds out of banks
and into close substitutes—higher yielding close substitutes which
in turn can artificially slow the growth of the monetary aggregates.
The experience in 1974 through 1976 provides some guidance on
the possible reaction of cash managers to these record high interest
rates. From the middle of 1974 to the end of 1976 we saw a rather
significant slowdown in the rate of growth of money which in
retrospect was, I think, an artificial slowing. This was in reaction
to record high interest rates in 1974.
Federal Reserve staff studies indicate that if you had measured
money properly, if you had accounted for the leakage of funds out
of banks, money growth in the period from the middle of 1974
through end of 1976 would have averaged perhaps 8.5 percent
instead of the actual recorded 4.5 percent.
I am concerned that with interest rates today at record levels we
face another breakdown in the money demand relationship; that
we could see a year of very slow money growth but that that
slowdown may not be indicative of a relatively tight monetary
policy. So I am concerned that monetary aggregates in 1980 will
not provide a good indicator of the impact of monetary policy on
the economy.
There is no really good indicator, or no totally reliable indicator,
of monetary policy that I'm aware of. If there was, I suppose we
would all use the same thing. But one indicator that I find very
appealing is the rate of growth of private borrowing. That would be
borrowing by State and local governments, by nonfinancial businesses, and by consumers. When the Fed hikes interest rates, you
observe a couple things happening. First, if rates get above the
245
statutory and regulatory ceilings, credit availability problems can
be created and, second, higher rates, all things being equal, restrain the demand for credit. This slows the growth in credit which
slows the growth in aggregate demand which eventually contributes to the cooling of the economy.
Now empirically there's been a lag of 1 to \Vz years between the
time monetary policy is tightened according to this measurement
of policy—that is a slowdown in private borrowing—and the time
the economy cools off and inflation begins to ease up. I think the
record of the Fed through the third quarter of last year is pretty
miserable. Private borrowing proceeded at a very rapid pace
through the third quarter of 1979, despite the fact that we were
experiencing accelerating inflation. In retrospect, there was no
effort made by the Fed to really tighten up credit market conditions to make monetary policy an effective tool against inflation,
HOPEFUL SIGNS
But since the October 6 program we have seen some hopeful
signs that policy is beginning to bite. In the fourth quarter, for
example, we saw a decline in private sector borrowing to $295
billion, down from $360 billion in the previous quarter. That's a
rather extraordinary reduction in the rate of borrowing in a single
quarter, one of the largest that I can remember seeing.
In the first quarter there's some concern that commercial paper
outstanding and large bank loans to businesses have picked up and
that perhaps the Fed is caving in again. I think those developments
reflect to some extent bridge financing being done by business
firms that have pulled out of the collapsing bond market and will
be reversed should the bond market stabilize.
When I add all this up—and I would add I think that growth of
mortgage credit will slow considerably in 1980—when I add all
these things up, I would say the Fed policy is beginning to work. I
would judge Fed policy as being moderately restrictive at this time.
I don't, however, think we are going to see any miracles on the
inflation front for the next several months because of the fairly
long lag between the time Fed policy turns the corner and the time
you get the positive effects on the economy. And through the third
quarter I think we had a pretty stimulative monetary policy in this
country.
BREAKDOWN IN FISCAL POLICY
I'd like to make a final comment. I think the problem with
financial markets today and the deterioration in the inflation outlook are related more to a breakdown in fiscal policy than in
monetary policy. In 1978 and 1979 the full employment budget,
which is probably the best single measure of the impact of fiscal
policy on the economy, moved pretty steadily toward surplus, or
toward restraint. In 1980 the full employment budget balance will
basically be neutral. We have Federal Government expenditures
growing by 14 percent in fiscal 1980. So-called other income maintenance programs are up at a 26-percent annual rate. They include
food stamps, housing assistance, low income energy assistance, unemployment compensation and so on. And I would add, with the
saber rattling that we have heard coming out of the White House,
246
there's some real concern that the increase in defense spending in
the fiscal 1980 and 1981 budgets will turn out to be inadequate.
So to quickly summarize, I think the Fed has turned the corner
here but I wouldn't expect to see any major improvement in inflation for the next several months. I think the first half of 1980 will
be pretty miserable in terms of the inflation performance. Thank
you, Mr. Chairman,
[Complete statement follows:]
247
Statement by
John D. Paulus
Senior Financial Economise
Goldman, Sachs 6 Co.
I an pleased to have the opportunity to present my views to this
Committee on the outlook for the economy In 1980 and the effect of monetary policy on that outlook.
Continued double-digit inflation, surging commodities prices, the
Surprising strength of the equities market, and the collapse of the bond
market since the beginning of the year have all aroused concerns that a
generalized flight from currency is underway.
In part this concern is
hased upon a feeling that credit market conditions are not tight enough
—
that the Federal Reserve has not done its job properly.
In particular,
critics point to the absence of severe credit availability problems
as evidence of the laxity of the Fed in the conduct of monetary policy.
Rapid bank reserve growth since last fall is also cited by financial
market participants as a key indicator of what they view as a swing
toward stimulus in monetary policy.
Such criticisms seem unjustified.
The absence of credit crunch
conditions is a direct consequence of changes in regulatory and statutory interest rate ceilings implemented over the last few years, not
necessarily of an overly accommodative monetary policy,
rent system of interest rate ceilings
Under the cut-
it is unclear whether the Fed could
create a meaningful credit crunch without adopting a truly Draconian
interest rate policy.
Moreover, the usefulness of reserve growth as
an indicator of the impact of monetary policy on the economy is limited
over periods as short as a few months when simple changes in the composition of bank liabilities can produce large fluctuations in the
growth of reserves.
248
To be effective an Indicator of Federal Reserve policy should bear
a close relationship to changes in aggregate demand initiated by changes
in aotietary policy.
One measure that conveniently captures the impact
of policy changes on the credit markets and, thereby, on aggregate demand
Is the rate of growth of private borrowing in the U.S.
Since October,
when the Fed hiked short-term interest rates appreciably, private borrowing in U.S. credit markets has slowed significantly.
On this basis
it might be inferred that the Fed has finally turned the corner, that
monetary policy is beginning to work to restrain aggregate demand and
eventually to contain inflation.
But, although Fed policy may now be on the right track, it will
take several months before this policy will begin to meaningfully retard growth in the demand for goods and services and in the price level.
In the meantime inflation will continue to rage and the Fed will be subjected to frequent criticism, sometimes intense, that monetary policy
is too easy.
These circumstances will test the Fed's resolve in avoiding
overly restrictive, policies that could wreak havoc on U.S. financial markets.
Mongtary^Policy and the Economy
The problem of using bank reserve growth as an indicator of the impact
of monetary policy on the economy can be easily illustrated by examining
changes in required reserves last fall arising from fluctuations in specific
bank liabilities.
During the. fourth quarter of 1979 total Federal Reserve
member bank reserves expanded by Si.4 billion, or at a 14% annual rate.
But of this increase, $280 million was attributable to a substantial riae
in interbank demand deposits.
Such deposits, though reservable, are thought
to have essentially no impact on the aggregate demand for goods and services.
Another $470 million increase In required reserves resulted from a sizable
249
increase in outstanding bank CD's,
This increase in CD's merely offset
a reduction of several billion dollars in borrowings in the Eurodollar
market.
Thus, of the $1.4 billion increase in total reserves, more
than half can be accounted for by increases in particular bank liabilities
that were either not related to overall economic activity or, in the
case of the growth in CD's, that resulted from a substitution of one
type of bank liability for another with the former having a higher reserve requirement.
Another $200 million in total reserve growth in the
fourth quarter was due to a rise in excess reserves.
The basic thrust of monetary policy can be better gauged by an
assessment of the impact of changes in interest rates on the supply
and demand for credit.
By raising market interest rates above statutory
and regulatory ceilings on certain financial instruments, such as mortgages and bank deposits, monetary policy can restrain the supply of
credit to various sectors of the economy by making it unprofitable
to "lend" to those sectors.
Moreover, high interest rates., all things
equal, restrain the demand for credit in the sectors where credit availability is not shut down.
By slowing the growth of credit, either by
restricting credit availability or by choking off the demand for credit,
or both, monetary policy can lower the aggregate demand for goods and
services.
One concrete measure o£ credit growth chat has proved to be an
excellent leading indicator of economic activity and, I would argue, of
the degree of restraint in monetary policy, ia total borrowing by domestic private nonfinancial sectors.
Domestic private nonflnancial
sector borrowing ("private borrowing" for short) is just the sum of
250
borrowings by households, state and local governments, and nonfinancial
businesses in the mortgage and consumer credit markets, the bond and
equity markets, and the money market.
Fut another way, it is equal to
total borrowing in the U.S, credit markets excluding borrowings by the
Federal Government, financial companies, and foreigners.
In the past the ratio of private borrowing to GSP has declined
sharply in advance of each of the last five recessions (see Chart 1).
For example, after peaking at 3 little over 16X in early 1973, more chan
half a year before the onset of the 1973-1975 recession, the ratio declined steadily to 6% by the spring of 1975.
In late 1968, about a
Chart 1
Borrowing by Dome it ie PrivaU Nonltnantiat Sedan / GNP
251
year before the 1969-1970 recession began, it peaked at Just under 11%
before falling, again steadily to 8 1/2% by the summer of 1970,
This
pattern has been maintained without exception for the laat quarter of
a century.
The sharp declines in the ratio of private borrowing to GNP reflected
the restraining effects of higher interest rates on both credit availability and the demand for credit.
This restraint in financial markets
was, in turn, transmitted ultimately to the economy through a reduction
in the demand for goods and services, particularly durable goods.
The_Ciirrent_ Conduct^ of Monetary Policy
Between early 1978 and the third quarter of 1979 the ratio of
private borrowing to GNP had fluctuated narrowly around 152,
Or, what
is the same thing, growth in private indebtedness had kept pace with
growth in nominal GNP.
The stability of this key ratio at an historically
high level appears to inply that despite the sharp rise in nominal interest
rates in 1978 and the first, three quarters of 1979, Fed policy can probably
be characterized as "mildly stimulative" over that period.
This assessment seems broadly consistent with the overall performance
of the economy and with its stubborn resistance to recession in 1979.
In
retrospect, the interest rate hikes of 1978 and the first three quarters
of 1979 were inadequate to create credit availability problems.
Moreover,
the sharp rise in inflation and inflationary expectations outstripped
increases in nominal interest rates so that real borrowing costs remained
low.
As a consequence, strong credit demands continued unabated.
252
Since October, when the Federal Reserve permitted short-term
interest rates to rise some 150 basis points, private borrowing has
slowed appreciably, ftfter advancing by $361 billion in the third quarter,
private borrowing grew by only $295 billion in the fourth quarter
according to preliminary Federal Reserve flow-of-funds data.
This de-
cline chiefly reflects a significant slowing in growth of consumer
credit, bank loans, and open market paper fsee Table 1).
Since the first of the year new issues of corporate bonds have
remained light, largely in reflection of the volatile conditions in
the bond market.
A part of the deferred bond market financing was no
doubt shifted to the commercial paper market, where outstanding paper
Issued by nonfinaociol concerns rose by over $4 billion during the fitat
six weeks of 1980,
Likewise, a part of the sharp increase in lending
by large commercial banks in early 1980 probably served to fulfill temporary financing needs by business firms which had temporarily withdrawn
from the bond market.
But while business loans made by large banks have
increased sharply, It should be noted that such loans made by all banks
during January actually declined by almost $2 billion.
Table 1
Sorrowing by Domestj.c jlonfInanclail Private Sectors
(S Billions)
1979
Sector
State and Local Obligations
Corporate Bonds
Corporate Equities
Mortgages
Consumer Credit
Bank Loans
Open Market Paper
Other
Total
Memo: Ratio to GNP
I
II
III
IV
22.3
21.1
12.5
25.4
2.8
25.2
18.5
25-1
21.8
2.9
4.4
159.2
51.1
41.4
12.7
164.7
29.6
28.3
'159.6
43.0
65.7
23.0
23.1
159.5
30.0
28.6
-1.1
27.0
340.2
340,1
361,1
295.3
14.8
14.6
15.1
12.0
2.9
45,3
52.4
8.8
253
As shown in the Table, borrowing in the mortgage market, by far the
largest single sector of the U . S . debt market, was about unchanged in the
f o u r t h quarter from the third.
The level of borrowing in this market was
buoyed by takedowns of commitments made before mortgage rates began to
rise in October.
The lending pattern of savings and loan associations,
which typically supply about one-half of all the funds to the $100 billion
home mortgage market, might provide a better indicator of mortgage borrowing in the next several months.
These institutions, which had been
acquiring about $4 billion in mortgages per month, slowed their acquisition
rate to just under S3 billion in November and to SI.3 billion in December
(seasonally adjusted).
At the same time, commitments at S&L's for new
mortgages declined in December to $28 billion from $33 billion.
There is,
in fact, good reason to believe that the demand for mort-
gage credit will weaken appreciably in 1980.
Prior to the upsurge in
mortgage rates In October, the potential home buyer mede the following
calculation:
after-tax financing costs of an 11% mortgage are, say, 8%;
but home prices are expected to rise at a 12% to 15% rate.
Under these
circumstances, it made sense to enter the housing market as soon as
possible to beat future price hikes.
En effect, the real after-tax
cost of financing a home purchase was negative.
The Fed's October 6 program has changed both elements in the homebuyer's calculation.
First, mortgage rates are now higher.
The average
rate on new commitments for conventional mortgages at SSL's during the
week of January 11 was 12.90%.
For a consumer in a 3QZ tax bracket, this
254
would amount to 9% after caxes.
Second, and more Important, home price
appreciation has slowed considerably.
In part due to an initial reluc-
tance by consumers to borrow at the record high rates established last
fall, the demand for mortgages and for housing declined.
as a result (see Table 2).
Home prices fell
If potential homeowners project home price
appreciation on the basis of past price changes, it seems clear from
recent experience that expected appreciation over the next 6 to 12 months
has certainly declined, perhaps substantially.
Table 2
Percentage ^Change In Home ?rices
(Annual Rate, Not Seasonally Adjusted)
Federal Home
Loan Bank Board
(1)
New
78
78
79
79
HI
H2
HI
H2
Memo:
17.0
17.6
16.4
10.3
(2)
EKisting
18,2
28.2
1.3
9.0
Change since Sept.*
6.4
-18.6
Commerce,
HUD
(3)
Mew
17.4
13.3
20.5
Association
of Realtors
W
Existing
19.0
10.3
2.2
23.2
-1.1
-8.9
-5.6
Average of
(1), (2), (3), (4)
17.9
17.4
15.4
2.9
-6.7
* Through January for FHLBB new and existing series; through December
for others.
These twin developments have removed the urgency from, the homebuying decision.
With after-tax financing costs running 92 and with
expected appreciation over the next several months having dropped significantly, it no longer makes sense to buy now simply to beat future
price increases.
In effect, because of the Fed's October 6 program,
real interest rates in the mortgage market over the next year or so
255
have soared as nominal interest rates have risen and expectations of
home price appreciation, once thought surer than, death and Caxes, have
collapsed.
There is, in addition to the direct effect on financial markets, a possible immediate side effect on consumption of the Fed'a October 6 policy.
The decline in the rate of appreciation of home values, due in part to
the weakened demand for mortgages, could induce consumers to step up
their rate of acquisition of financial assets.
The large increase in
equity in homes has helped to push the real net worth of consumers to
successively higher levels despite the fact that the so-called "savings
rate" has plummetted since 1976. While homeowner equity had represented
about 25X of total consumer net worth in 1976, increases In home equity
have accounted for between 36!J and 522 of the growth in nominal net
worth in 1977-1979 (see column 4 of Table 3).
For example, net worth
in 1-4 family residences has advanced by about $130 billion in 1977,
$165 billion in 1978, and, through the first three quarters of 1979, by
$215 billion at an annual rate.
Because the bulk of this rise in real
net worth is related to home price appreciation, a slowdown in home
Table 3
Change in Consumers^Met^ Wprtti
<$ Billions)
(2)
(3)
(4)
Increase in Financial
Net Worth*
Increase in
Home Equity
Increase iti
Net Worth
(2) r (3)
121
236
385
133
167
217
254
404
603
.52
.41
.36
(1)
1977
1978
1979**
* Excludes mortgages.
** First three quarters, annual rate.
256
price increases will significantly retard growth in homeowners' equity
and will begin to depress real consumer net worth.
Should consumers
react to tliis decline by increasing their demand for financial assets,
the savings rate will begin to rise.
Such an increase would, of course,
lower consumer spending and contribute to a cooling in the economy,
The_ Outlook__for 1980
Many factors influence the basic course of economic activity.
But
surely the two most important over a period as long as a year are fiscal
and monetary policy.
Between the end of 1977 and mid-1979 fiscal
policy, as measured by the full employment budget balance, had moved
steadily toward restraint.
Over this period, the full employment budget
moved from a deficit of a little over 1% of GNP into basic balance.
But
with the sizable upward revision in federal government expenditures for
fiscal 1980 the Cull employment budget, Instead of moving well into
surplus as the President's 1979 budget message would have dictated, will
remain near balance over I960 if current projections are borne out.
Fis-
cal policy will thus maintain a neutral effect on Che economy in 1980,
neither si^o"iflcantly stimulating nor restraining economic activity.
Monetary policy aa now conducted might be judged as moderately restrictive.
The rate of growth in private sector borrowing has fallen
substantially since the Fed hiked interest rates last fall and the weakening in home prices, associated with the falloff in mortgage demand, has
probably begun to lower consumer net worth.
But although Federal Reserve
policy has assumed a restrictive stance, this move toward restraint beginning last fall is not likely to reduce economic activity substantially in
1980.
If history is a guide. It usually takes about a year after monetary
257
policy has been tightened before a significant slowing begins in real
economic activity.
In effect the profligacy of the Federal Reserve
prior to October 6 will help to sustain the economy during much of
1980.
Barring unforeseen major external shocks to the economy, economic
activity will likely remain flat for the year, much like in 1979.
A
major recession is unlikely, but so too is a significant upsurge in
economic activity.
On balance, it now seems appropriate to characterize
1980, like 1979, as a year of stagflation rather than recession.
Although the movement toward restraint in monetary policy will
eventually lead to an abatement in inflationary pressures, high inflation will continue to disrupt financial markets, producing record high
interest rates, and to expose the dollar to further downward pressure
on foreign exchange markets through most of 1980.
policy generally affect inflation with a lag.
Changes in monetary
Though an unanticipated
movement toward restraint would ordinarily begin immediately to lower
Inflation and cut profit margins, the major impact on inflation will come
only after the reduction in profit margins causes widespread worker layoffs and a downward revision in inflationary exnectations.
In fact, it generally has taken about a year and a half after monetary
policy has assumed a restrictive stance before inflation has peaked.
(See
Chart 2, noting that private borrowing is plotted six quarters into the
future).
The inflationary problems facing the economy in 1980 can thus
be attributed largely to the reluctance of the Federal Reserve to introduce
meaningful restraint on the economy in 1978 and during the first three
258
quarters of 1979, despite the fact that inflation accelerated quite steadily
over this period.
Chart2
Domattic Privet* Monti nanciol S*ctan / GNP and Inflation
The principal danger facing the economy in 1980 and beyond is that
the Federal Reserve will have to bear a disproportionate share of the
burden of containing Inflation.
This problem will be magnified if poll-
259
tical Instability Intensifies in the Middle East and, possibly, Southeast
Asia heightening the need to substantially increase defense spending.
In that case, if social programs are maintained near current levels, as
seems likely in an election year, soaring interest rates could reduce
private sector investment spending and further retard U.S. productivity
growth.
ReSort to wage and price controls ultimately would have equally
pernicious effects on the viability of the U.S. economy,
The CHAIRMAN. Thank you, Mr. Paulus.
Mr. Hurley, in listening to your remarks I just wondered how
the Fed can win. You say if they restrain monetary policy too
much—and they are in danger of doing that you think—they tend
to prevent investment; they slow down productivity. It can have a
perverse, serious effect on the economy.
On the other hand, Mr. Jordan says that the issue really is
credibility. He argues that it's not a matter of monetary and fiscal
policy any more. It's just a matter of convincing the American
people that the Fed means business; they are really going to fight
inflation.
I don't know how they can show they mean business and follow a
policy of restraint and continue it and stick with it without being
in very serious danger of doing what you say would be serious
damage to the economy.
What's your response to that?
BANK CREDIT ABOVE ITS TARGET
Mr. HURLEY. I guess one way in which the Fed could show it
means business is by meeting the targets that it announces, and I
would point out in that respect that last year the Fed's policies
were a success regarding meeting its target for M-l with a 5.5percent rate of growth in M-l. It came in within its target. Last
year bank credit was well above its target and in fact bank credit
has been above its target for the past 3 years in a row. I think we
all know 1979 was not a success and yet if we look at only M-l it
should have been a success. So I think we might get better credibility by meeting our bank credit targets than by simply meeting our
money targets.
The CHAIRMAN. Well, except I just wonder how many people in
the financial community, let alone the public as a whole, really
follow the targets. What they really follow is the consequences.
What happens to the price level; what happens to the availability
of capital; what happens to interest rates.
Mr. HURLEY. That's why I think following the bank credit target
is even more important, because people understand bank credit.
How many people have you ever heard say, "Well, I'm going to
spend more or less because M-l went up or down." They don't say
that. They do say, "Well, the bank is going to give me a mortgage
260
and therefore I'm going to buy a house," or "I couldn't get a loan
for a car and therefore I can't get a new car." Those are credit
items which I think ought to be paid attention to because they
have a specific meaning to the man on the street. They also have a
specific meaning to the businessman who's wondering whether to
increase his inventories or increase his plant and equipment spending.
The CHAIRMAN. I think you and I are arguing on exactly the
same side, but we're coming out in a different way somehow. My
position—and I take it your position too—is that if the Fed restrains effectively and vigorously, it restrains people from borrowing money to buy a house, small business or a business of any kind
from borrowing for expansion and so forth, farmers from borrowing, and that gives them some credibility. People feel the Fed is
fighting it.
You say the effect of that can be perverse economically because
it can prevent business from getting the funds they need to improve their efficiency and productivity and getting costs down in
the long run.
Mr. HURLEY. Let's look at the two ways in which the Fed's bank
credit goals for the year could be missed. They could be missed on
the high side by the economy being much stronger and business
loans and other consumer type borrowing being much stronger
pulling bank credit above its range. By the Fed maintaining its
range, that would provide a restraint, allow interest rates to rise to
discourage that type of borrowing, and keep the economy in a less
expansive state.
We could also err on the side of having too weak an economy.
When that happens businesses sell off their inventories, reduce the
business loans they are using to support them, and bank credit
goes below this range. This would allow the Fed to encourage an
increase of bank credit while allowing interest rates to fall and
encourage renewed borrowing.
So I'm saying that in order to stay within the narrow lines that I
say the Federal Reserve must walk, I believe it must pay very close
attention to the rates of increase in credit expansion this year so
that it keeps excessive credit expansion down, if that's how the
economy goes. We are all pretty uncertain how the economy is
going to go this year. It keeps rates of credit expansion down
within the range if the economy is strong, and it builds credit
expansion up if credit is going to go below its range if the economy
is weak this year.
The CHAIRMAN. I have a lot of trouble with that because it seems
to me you're looking for a kind of fine-tuning situation at a time
when we have overwhelming, appalling inflation. It's just getting
beyond anything that we had expected and it's becoming very, very
frightening. Inflation, both producer price and consumer price reports most recently are at a very high level and there's every
indication that something like that is going to continue for the
next year or so.
Under those circumstances, it seems to me that we are going to
have to pay a price for the weaker economy. We are going to have
to pay a price with higher unemployment. We are going to have to
pay a price with less investment, unfortunately, because the impor-
261
tant thing now is to convince the American people, convince business, that we are going to turn the corner on inflation and pay the
price that's necessary to do it, and that price is going to be painful,
tough, difficult, but it's a price we are willing to pay. What's wrong
with that?
Mr. HURLEY. Well, my intention here is to show that while there
may be some short-run benefit in fighting inflation by clamping
down on the economy, by not fine-tuning let's say, by going all out
in terms of monetary restraints, this is actually counterproductive
in the long run. I think we have emerged from the 1974-75 period
in worse shape than we started because we had a far deeper
recession than we probably needed and we discouraged the development of capital equipment and so forth during that period so we
had lower capabilities of production relative to the amount of labor
force and so forth coming out of 1974-75 than we did going into it.
And what I'm concerned about is the long-run implications for
inflation, not simply the inflation rates this year.
The CHAIRMAN. Well, the problem now is whether or not we are
going to turn inflation around at all. I think that's the big question
mark in the mind of many people. The feeling is that inflation is
inevitable, go ahead and buy regardless of the kind of price you've
got to pay for the money, in order to get the money so you can buy
real estate or whatever.
MONETARY TARGETS
Mr. Griggs, let me start with you and then I'm going to go across
the panel on the monetary targets. The growth rate ranges for
monetary aggregates are quite broad. As I indicated in my opening
statement, the upper limits of the ranges represent somewhat
lower growth than actually occurred in 1979 except for M-1B
which is quite a bit lower, 6.5 versus 8 percent, than the actual
growth in 1979.
Now I have a couple questions about these target ranges I'd like
each of you to answer. We'll go across the panel on each of these,
first Mr. Griggs. Are the upper limits of the ranges too high to
represent a meaningful reduction in money growth?
Mr. GRIGGS. I think they are. I think they are too high with the
exception of M-1B. The problem is that it is not clear with a 3- to
6-percent range that the Fed would respond if money growth came
in consistently at 6. What's very important here is visibility. Because we are following a much different monetary policy than we
have in the past. We have never seen this kind of thing before—
that is, where we are deliberately not willing to produce a recession. Before we had always seen monetary policy move in, to control inflation. By producing a recession. Therefore, the market
must be convinced that things are going to happen, and the Fed
fails in this by using targets that seem to be too expansive.
The CHAIRMAN. Did you say in the past we have taken the
posture if a recession follows, so be it; the important element is to
restrain inflation, but this time we are not saying that; we are
saying in the event a recession comes along we are going to
give
262
Mr. GRIGGS. I think the policy this time is deliberately taking the
view that it's going to try to deal with inflation over a long period
of time and not produce the recession which has been the typical
way of stopping the inflation—but only the moment. The things we
have done between recessions have not been correct, and so we
have not permanently stopped the inflation. But this time around
we are taking a much different tack and that's hard for the markets to understand. It's new to them and they don't know how it
will work.
The CHAIRMAN. All right, Mr. Hurley.
Mr. HURLEY. I believe that the upper end of those ranges is
about correct. I think, if anything, we will err probably on the high
side. So they are, in fact, restrictive. In other words, I'm saying the
aggregates, if anything, would come in above those ranges rather
than below them. I point out that if we are talking about lowering
them, since monetary policy does not have much effect on inflation
relative to GNP, if we talk about lowering the range, we are
talking about lowering real GNP; we're not talking about lowering
inflation. The range is not going to slow inflation.
The CHAIRMAN. Mr. Jordan.
Mr. JORDAN. The range of M-1B, the upper limit of it, is somewhat higher than I would
like to see. I think the midpoint that was
emphasized as being 5L/4 of that range would be about appropriate
for this year. I think in 1980 it's not so much the problem of
consistency in the ranges and what can happen to the economy and
inflation, but the problem is especially in 1981. The kind of nominal income growth projections that are built into the administration's budget projections for 1981, as well as the total spending
projections in the analysis of the Congressional Budget Office for
1981, suggest they are assuming a lot more rapid growth in total
spending than the Fed's announced monetary growth would support. This major inconsistency over the next 2 years is the problem.
I would like to see them stick with the announced range. I would
be happy to see it come in at the low end of the range, but only if
such a policy didn't result in an automatic reaction in the other
direction later on. Consistency is important here.
The CHAIRMAN. Mr. Paulus.
Mr. PAULUS. Well, I think it's important we not be too ambitious
on these targets. In the past I don't think we have been ambitious
enough, but I would agree with Jerry Jordan's opening statement
about the importance of credibility with the Federal Reserve. If
they were to lower their ranges significantly, say lower the top of
the range for M-1A to let's say 3 percent instead of 6, they would
run a serious risk that it would be almost impossible for them to
restrain money growth to that lower range. Money over periods as
short as a quarter, maybe even two quarters, in effect has a life of
its own. The Fed really can't control it over short periods of time.
I think we have a very serious credibility problem in this country
which could intensify if we were to lower the ranges too much. I
will qualify that, though, by saying as I said in my opening statement that I think there's very good chance that money will grow
very sluggishly this year, but in an artificial sense; that we will
experience another major downward shift in the demand for money
and, in that case, the ranges won't make much difference. Unfortu-
263
nately, it's very difficult to predict when a shift is beginning and to
predict the extent of it.
The CHAIRMAN. All right. Mr. Griggs, second, should the Fed aim
at the midpoint of the range as the maximum amount of money
growth which should be permitted in 1980?
SET MONETARY TARGETS LOWER
Mr. GRIGGS. Well, I think the midpoint would be better than the
high end. I would have set all the targets lower than they were set.
That is, the range I would try for would have been considerably
lower. I think I should say that I'm not really enamored with the
targets at all as meaning something that is going to be terribly
important. A number of people have already mentioned a good deal
of growth in bank credit and associated spending is going to be
produced out of things that don't show up in M-1A or M-1B. The
growth of bank credit is going to be accentuated if the capital
markets stay in the state they're in. Because corporations are going
to the banks in large numbers.
So I think if it were me, I would have set the targets lower
simply because I think it would make clear the Fed's intentions to
really deal with inflation, no matter what targets are set, however,
I would hope to see the Fed use its head in this matter, and if it
sees that bank credit is expanding rapidly but that is not affecting
the money supply, it would say, well, even though our money
supply is growing just right, our policy is too easy.
I think the targets in some ways have been a disservice because
everybody looks at the target and sees whether they're hitting
them and decides whether or not policy is going to be effective, and
I think that's unfortunate.
The CHAIRMAN. Mr. Hurley, should the Fed aim at the midpoint
of the range as the maximum amount of money growth which
should be permitted in 1980?
Mr. HURLEY. The reason why we set ranges in the first place is
that there's enough random effects on money growth that it's very
difficult to set any one particular number or one particular growth
path. So we have to have the ranges because of the random influences. If we believe the random influences are distributed normally
or in a general fashion, then it only makes sense that we should
have a midpoint. I would think one would not argue as to whether
one should hit above the midpoint or below the midpoint, but one
should ask should the rnid-point itself be lower?
The CHAIRMAN. That was pretty much what I asked. Should the
Fed aim at the midpoint of the range as the maximum amount of
money growth that should be permitted in 1980? The way I asked
that question, in fairness to Mr. Griggs who answered it this way,
and this is the way I intended it, is: are the ranges too high and
should they be lowered with the midpoint being the maximum?
Mr. HURLEY. No. I guess the ranges are appropriate at this level
and if we hit the midpoints we probably ought to be happy.
The CHAIRMAN. Mr. Jordan,
Mr. JORDAN. I would like to see them aim at the midpoint. I
would like to see them always announce their targets to you with
the understanding that it might be a half percent higher or lower.
264
The CHAIRMAN. Bless your heart. I have been trying to get the
Fed to do this for a long time. In this case, the ranges have been
ridiculous, not like they have been in the past. Sometimes they are
absurd. The top is excessive and the bottom is unrealistic.
Mr. JORDAN. In 1975, at the time they were originally setting up
the first targets announced to you, I was attending the Open
Market Committee meetings and the Committee decided that the
target should be GVi percent with a range around it; but they felt it
was awkward to say 6V* percent
plus or minus IVi percent, so they
said, we'll just call it 5 to l l /z. But, internally the emphasis was on
the center point. I think if they could get back to emphasizing the
center point with the understanding that it's one-half more or less
it would be desirable.
The Germans and the Swiss and other central banks that do
targeting look upon their target growth range as an announcement
of information to the markets, to business firms in their pricing
policies, to labor negotiations, to all kinds of inflation considerations as to what the government is willing to do. So far, the
targeting procedure in this country has not had that information
communicating aspect. I think it works very well in some other
countries, and I think making the targets less ambiguous would
help in this country too.
The CHAIRMAN. I'm very glad to get that. We'll use that and
press them for that. Mr. Paulus.
Mr. PAULUS. I think if we're going to have targets it's very
important to hit them. The reason we don't convey information to
the markets with the Fed's targets in this country is because we
have not had any success in hitting them in the past. I would aim
for the midpoint of the respective ranges but I would pay very
careful attention to the rate of growth of the private sector borrowing because I think the monetary aggregates are a little too narrow
an indicator of the impact of Fed policy in the economy. I would
repeat that I fear we face a real danger of an artificial slowing of
money growth which will not really be reflective of a tightening of
Fed policy.
The CHAIRMAN. Mr. Hurley.
Mr. HURLEY. I'd like to speak a second on the question about
hitting the targets or narrowing the ranges. I notice, for example,
in the summary of the hearings last July, the same issue came
up—can we get the ranges narrower and can we be more capable
of hitting them? I would like to suggest that we can get very
narrow ranges. We can even get a growth path if we try to target
something that the Fed in fact can legally control, something, for
example, on its own balance sheet.
What we have done by setting up monetary aggregates is ask the
Fed to target something which it has no specific control over. It has
to manipulate its actual instruments in order to hope to hit some
intermediate target that it has set a range for. Since there's far
more randomness in the intermediate target, they have to set a
range for it. I don't think we can ask them to set a specific number
for it. We could ask them to set a specific number for nonborrowed
reserves or total reserves or some other measure that is much
closer to the Fed's legal capabilities of dealing with. In fact, I
would think there would be nothing wrong with setting a specific
265
target for reserves for the year as a whole. We all know and people
that have been in this business know the Fed can easily hit that
path. When we start asking them to hit something farther out,
you've got to have ranges.
I noticed another question is should we try to ask them to do
longer term things. Certainly they can have a narrower range over
a longer period. I don't think that answers the question. You want
to have a more specific control over what the Fed is doing let's say
on a monthly, quarterly and annual basis. The way to do that is to
set the ranges on things they can more specifically control.
DANGER OF IGNORING OTHER VARIABLES
The CHAIRMAN. Mr. Griggs, given the new definition of these
aggregates, isn't M-1B the basic money supply variable for money
supply purposes and isn't there any danger in ignoring the other
variables?
Mr. GRIGGS. I think M-1B is the more important of the monetary
targets, no doubt about it. I think there is a danger in ignoring the
others, though, and particularly in the sense that I think a lot of
credit is going to be financed through CD's and other instruments
that do not show up in M-1B, So I think it would not be sensible to
ignore the other monetary aggregates or bank credit, but I think of
the monetary targets that we're talking about, M-1B is the most
important.
The CHAIRMAN. Mr. Hurley,
Mr. HURLEY. Certainly M-1B is the most important. As a simple
example of that, they do not announce the data for the higher
aggregates, M-2 and M-3 and so forth, so they are using M-1B as
their specific week-to-week policy variable. Also, I believe I agree
with Mr. Griggs that we are missing a lot by not paying attention
to some of the other factors.
The CHAIRMAN. Mr, Jordan.
Mr. JORDAN. 1 think M-1B is the aggregate that should be emphasized. There is a danger as has been demonstrated in the past,
of having too many targets so that if one of a long list of targets
comes within the range there's some degree of comfort. If you
narrow the focus and hit the target on any one of them, it would be
an improvement, but M-1B is certainly my choice.
The CHAIRMAN. Thank you. Mr. Paulus.
Mr. PAULUS. M-1B is my choice too. I don't think the old higher
aggregates were very useful and I don't believe the Fed paid a
whole lot of attention to them. They have some high-powered research that indicates that there's a much closer connection between unanticipated changes in M-l and unanticipated changes in
the economic activity than there is between changes in economic
activity and other monetary aggregates. I think there is a feeling
there that a narrow definition of money makes sense, and I would
agree with that.
The CHAIRMAN. Mr. Griggs, let me ask you about Mr. Jordan's
testimony in putting a good deal of stress on the Fed's credibility
problem. Given its record of hitting its targets over the past 4
years, there's little doubt that this concern about credibility is real,
especially in an election year.
266
Would this credibility problem be helped and the policy improved
substantially if the Federal Reserve were required to set multiyear
growth rate targets for monetary and credit aggregates as was
suggested by Senator Garn during yesterday's hearings?
Mr. GRIGGS. I don't think it would be any help at all. I think that
the problem would be that the market would be saying, "They're
having enough trouble hitting the short-run targets. There's no
way to believe that they are going to hit the longer one."
I think what would really be more helpful would be if the Fed
would simply say they are definitely committed to controlling inflation. I mean, that's the thing that people want to hear, not whether they set longer-run growth targets. I don't think that would
help.
The CHAIRMAN. Any difference of opinion on that?
Mr. JORDAN. I strongly believe it would be helpful. I think if you
can do 5-year budgeting, you must do 5-year monetary projections
and you must resolve the inconsistencies. Chairman Volcker has
implicitly announced the long-run money target by emphasizing
repeatedly in recent months that not only is he lowering the target
in 1980, but he's going to lower it in subsequent years, and that's
consistent with what's built into the budget—either projected by
the Office of Management and Budget or the Congressional Budget
Office. So 5-year projections of monetary growth would put us on
the track of reconciling the problems between fiscal and monetary
policies.
The CHAIRMAN. Any other opinions on that?
Mr, HURLEY. The attempt of these hearings and what the law is
based on is to coordinate the monetary growth ranges with the
economic reports on the economic outlook. Therefore, there is a
long term of 5 years on the economic outlook in the report.
LONG-TERM TARGETS
I would have to say, though, that the meaningfulness of longterm monetary targets can only be related to the meaningfulness
of those long-term economic targets and, in fact, there is some
uncertainty in those long-term economic projections as to whether
they are goals, whether they are things that are expected to
happen, or whether they are just numbers. As a result, I don't
think that long-term monetary aggregates would have any greater
credibility than economic forecasts themselves.
Mr. GRIGGS. If I understand it right, the economic forecast probably coming from the Council would require faster growth in the
money supply next year.
The CHAIRMAN. Would require what?
Mr. GRIGGS. Would actually require a faster growth in the money
supply next year. They are projecting a stronger situation shaping
up for 1981, so I assume it would be just the opposite from what
Chairman Volcker has suggested.
Mr. JORDAN. That's correct. The administration's forecast would
suggest that M-1B would have to go to 8 percent or more in 1981.
That's the inconsistency that I have been emphasizing. The Congressional Budget Office numbers suggest that M-1B may grow as
fast as 10 or 11 percent in 1981 to be consistent with the long-term
income projections.
267
The CHAIRMAN. If they had long-term targets, how would that
affect that kind of variability?
Mr. JORDAN. It would bring attention at least to the inconsistency between monetary and fiscal policy. Everybody in the financial
markets understands this. They look at two sets of the projections,
what the Federal Reserve Chairman says he's going to do and what
the budget projections suggest, and they know that this has to be
reconciled and they are accustomed to seeing the monetary authorities accommodate themselves to the fiscal rather than the
other way around.
The CHAIRMAN. Why wouldn't this be a good idea?
Mr. GRIGGS. I don't think that's what the markets do. They look
at these two projections and say, "Which one is right," and they
say, "The economic outlook is too optimistic next year, so therefore
Volcker's is about right."
The CHAIRMAN. Well, they have a basis for evaluating it. They
know what they're trying to do. It would be a basis for debate and
discussion and correction.
Mr. GRIGGS. I can see if what you wanted to do is to highlight
the inconsistencies in forecasting it would help you in that regard,
but I don't know how you would reconcile it. When you're sitting
here and arguing and the CEA comes in and says that's their
forecast and the Federal Reserve comes in and says that's their
forecast, then what do we do at the end?
The CHAIRMAN, The fundamental problem is you want a longterm policy in fighting inflation. I recognize this isn't something
you can do in a year or two. It's something we have to continue for
many years in the future. Therefore, we obviously can't bind future
Federal Reserve Boards, or future Congresses for that matter. Nevertheless, we can perhaps have some disciplining effect on them by
indicating our direction and requiring them therefore to justify
departure from what seems to be a disciplined course in the direction of restraining inflation.
Mr. GRIGGS. I can see that, but the problem I can see is if you
both come in and you both have had your hearings and you argued
your two sides and then you both part and you have exactly the
same forecast, what are the financial markets to conclude. That
you have agreed that there's no way we can have a consistent
monetary and fiscal policy.
Mr. HURLEY. I think another problem is as soon as you get into
long run, if we continue to have some financial innovations, any
targets we set for this year aren't going to mean anything for next
year. It certainly hasn't for the past 8 or 4 years. I'm not sure they
could be that meaningful. We can always change the targets because we redefine the aggregates.
The CHAIRMAN. It may be the technology is going to change
every 6 months the way it has but I hope it doesn't. I hope we can
get some greater degree of stability in the future. Maybe not.
Mr. Paulus, the Fed's new policy strategy stresses bank reserves
rather than short-term interest rate control. Opinion is almost
uniformly in favor of that change. Will this new stress in bank
reserves permit the Fed to achieve better control of the monetary
aggregates than in the past?
268
Mr. PAULUS. Not in the short term, but over a longer period of
time, 6 months to 1 year, if they hit their reserve targets, they will
achieve better control over the monetary aggregates. But over periods as short as a month or quarter or perhaps even two quarters,
you won't see a material improvement in the control of monetary
aggregates.
The CHAIRMAN. Mr. Hurley.
Mr. HURLEY. I believe that the move toward reserve targeting is
one which will help the Federal Reserve meet its targets. The
problem I have is that, as I mentioned in my discussion of implementation, at the present time it's only the reserve aggregates that
relate to the money stock measurements that the Federal Reserve
is trying to hit. Therefore, I think it may do OK in hitting the
money stock targets. Since it's not paying attention to reserves
related to credit aggregates I don't think we can very well say it's
going to improve its ability to hit the credit aggregates.
MEMBERSHIP ATTRITION
The CHAIRMAN. Let me ask Mr. Paulus again. Membership attrition and a decline in the reserve basis the Fed has to work with—
they are down to 70 percent as you know now. Could this undermine Federal Reserve monetary policy to a greater degree now
than it did before? Do you agree with that assessment and, in your
opinion, how important is it that the reserves question be solved
during this session of Congress?
Mr. PAULUS. I worked for the Fed when we were worrying about
membership in 1977 and I remember the arguments about the
safety and soundness of the banking system and the discount
window umbrella and monetary aggregates targeting. At that time
there really wasn't a strong need to have a lot of members because
we were targeting on Federal funds rate. I think you could now
build a stronger case for the need for Fed members, given that the
Federal Reserve is now targeting on the monetary aggregates
through the reserve aggregates. I don't think that the reduction in
the percent of deposits in the system, down to something like 70
percent of all deposits—I don't believe it's proceeding at such a
rapid pace that it's essential that the membership problem be
solved in this session of Congress. I would like to see it solved, but I
don't think it's a critical problem.
The CHAIRMAN. Mr. Jordan?
Mr. JORDAN. I think it's extremely important. I think it should
not be posed as a question of membership, because I think there
are some virtues of a dual banking system as far as chartering, but
it's a question of reserve requirements. I do believe that universal
and essentially uniform reserve requirements would greatly improve monetary control.
I think that something like S. 85 would be a very positive step to
helping in monetary control, implementation of monetary policy,
as well as removing some of the enormous competitive inequities. I
think that if it is not solved in this Congress, then the problems
that the Fed alludes to as a membership problem are going to
escalate very, very rapidly.
I don't think that a delay on this issue would be a healthy thing
at all.
269
CHANGES IN DISCOUNT RATE
The CHAIRMAN. Mr. Jordan, the Federal Reserve has used
changes in the discount rate to announce its intent to tighten
policy or defend the value of the dollar three or four times during
the past year or so.
At the same time, the discount rate has lagged behind changes in
market rates. I'd like to get your views as to whether the Fed's
discount rate policy aids or hurts its overall monetary policy objectives, and also your comment on the proposition that the discount
rate be set at a slight penalty rate relative to market rates, and
that it fluctuate from week to week with market rates, instead of
being used occasionally.
Mr. JORDAN. Most people, I think, view the discount rate and
changes in it as mainly having an announcement effect. Often it
can be a perverse announcement effect by the failure to change the
discount rate, when it is out of line with market rates; that tells
the market something that they think they know or understand
about the Fed's intentions, or the strength of the resolve on the
Federal Reserve Board to deal with inflation.
So removing this effect, allowing the discount rate to move automatically, maybe with a 3-week lag behind the Federal funds rate
or the bill rate—and my preference would be at somewhat of a
penalty—I think would be healthy.
I don't think it would impair at all the Fed's ability to formulate
and implement their monetary policy, and it would remove some
perverse effects it is now having.
The CHAIRMAN. Mr. Griggs?
Mr. GRIGGS. I would like to see a penalty rate. I would not like to
see it fluctuate. I would still like to retain it as something the Fed
could use when it wanted to indicate to the market that it had a
change in policy in mind.
My own preference would be to see it have a tiered rate, one in
which the kind of seasonal borrowings, kind of a regular access to
the window could be had at one rate, but anything over that would
have to come at a penalty rate that would be adjusted as an
indication of credit conditions.
The CHAIRMAN. Mr. Griggs, the burden of fighting inflation has
largely been delegated to the Federal Reserve because of the failure of fiscal policy, large increases in Federal spending for fiscal
year 1980, the failure to balance the budget for 1981, Many people
look at fiscal policy as contributing to inflation rather than acting
to restrain it.
Would the Fed's job reducing money and credit growth in reducing inflation be significantly helped by balancing the budget in
fiscal 1981 and by a binding commitment by Congress to reduce the
shares of the Nation's gross national product accounted for by
Federal outlays?
Mr. GRIGGS. I think there is no doubt about it, that it would do a
lot. I think myself, the balancing the budget in fiscal 1981 is going
to be very, very difficult to do, but I think what we really need is a
commitment that says the Congress and the administration have
agreed to move toward a balance.
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The CHAIRMAN. The administration thinks they have done that
with what they call a $16 billion deficit. It may be much bigger
than that, but that's less than the deficits they have had in the
past, and it is close enough so that it would seem to me the next
step that would have any support in the credibility would be an
announcement by the President that he is going to come in with a
revision in this 1981 budget, and a cut by $16 billion or more, $20
billion, $25, whatever it takes, to have a balanced budget in 1981.
Mr. GRIGGS. Well, my problem with that would be simply that I
don't think the $16 billion is realistic.
The CHAIRMAN. I agree with that.
Mr. GRIGGS. And that then it would be another problem of credibility.
The CHAIRMAN. They'd have to come in with more than $16
billion. They'd have to come in with a surplus.
Mr. GRIGGS. I think that would be spectacular, great, if he can do
it. I'd love to see it happen. I think it would do wonders for
monetary policy.
The CHAIRMAN. Mr. Hurley?
Mr. HURLEY. Well, I'd like to separate the symbolic and the real
effects of that. I think it would be very good from a symbolic point
of view. I think it should also be something that we would seek
overall as a long-term policy to stay much closer to
The CHAIRMAN. Let's stay with symbolic just for a minute, because we say symbolic, and people think, well, it's a symbol that
we'd like to look at in the paper for a day or two and forget. But
symbolic has a lot more significance than that in this case, does it
not?
Wouldn't the symbolic effect of a balanced budget in 1981, a
determination by the President coming in with a very sharp reduction in spending, mean decisions, perhaps, on the part of business
and on the part of labor and the part of others that would be more
likely to restrain inflation than simply symbolic in the notion and
the sense that it's nice to have the President do this?
Mr. HURLEY. Well, I guess that is really what we mean by that.
It is almost sort of an announcement effect where the willingness
to pull in our horns in fiscal policy would encourage the private
sector to do the same, and I believe that those implications would
be there for that.
I agree with Bill Griggs, though, that no one believes the $16
billion deficit, so we'd better move from a deficit people believe (we
are using $40 billion) and start subtracting from there as opposed
to subtracting from $16 billion.
The CHAIRMAN. I missed the last part of your remark.
Mr. HURLEY. I'm sorry. In order to have this as an effective,
credible policy, we should probably use a more credible number for
the current budget deficit estimate. We don't believe the $16 billion
deficit. We are using approximately a $40 billion deficit estimate
for the 1981 fiscal year. So we should probably be talking about a
$40 billion cut.
The CHAIRMAN. Well, that's a fascinating figure. How do you get
$40 billion? I've heard $40 billion is the estimate for 1980. But for
1981 you estimate a $40 billion deficit? If you assume a substantial
recession, obviously it's
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Mr. HURLEY. We have a recessionThe CHAIRMAN. God knows how deep the deficit will be. But on
the assumption that you have a moderate recession, if that.
Mr. HURLEY. OK, combined with that assumption of a moderate
recession is an assumption of a tax cut, which is not in the Federal
budget.
The CHAIRMAN. How big a tax cut?
Mr. HURLEY. About 25.
The CHAIRMAN. $25 billion?
Mr. HURLEY. Yes.
The CHAIRMAN. Oh, well, there it is right here.
Mr. HURLEY. Yes. But that's related to the—the specifics of it are
the depreciation thing that I mentioned earlier, and a rollback of
the rate increase on the social security tax that starts in January.
And these things become effective in October.
BALANCING THE BUDGET
The CHAIRMAN. Let me ask the other gentlemen here. How important is it to have an action by the President, by the Congress, in
making a commitment that one way or another we are going to
balance the budget in 1981?
Mr. JORDAN. I don't think that there is anything that could
possibly be more significant—have a more positive effect on inflation psychology and people's expectations about future inflation—
than showing some discipline over the budgetary process.
My own way of looking at it is Government spending as a percent of national income. It may be that the idea of balancing the
budget or creating a surplus communicates the determination
better than spending limitations, but the budget as projected shows
that tax revenue as a percent of national income in calendar 1981,
would be the highest level in any year in our history, except 1944,
and there were better reasons for it in 1944.
The CHAIRMAN. How high do you expect that to be?
Mr. JORDAN. Well, that depends on differences of projections on
nominal income. I don't think nominal income is going to grow as
much as the budget projects. I certainly hope not. I hope inflation
is not as much as what the administration projects. They still
project 8.6 percent for the deflator in 1981.
The CHAIRMAN. What's the percentage of the gross national product that Federal spending would achieve?
Mr. JORDAN. They have in there 22.3. With my projections of
nominal income growth and less inflation, if they spend as much as
they project, the percentage would be even higher than that, and I
would like
The CHAIRMAN. Would that be the highest it's been in any year
except 1944?
Mr. JORDAN. I believe except
The CHAIRMAN. As a percentage of the gross national product,
Federal spending as a percentage of GNP?
Mr. JORDAN. Yes, except for 1944.
The CHAIRMAN. Astonishing. In a year of austerity and fighting
the worst inflation we've had in our history.
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Mr. JORDAN. I would suggest a number of about 20 percent
should be set and firmly held to. I'm not in favor of sticking it in
the Constitution or anything like that, but I think a strong resolve,
a determination to limit there, would be a big help on improving
inflation psychology in this country.
The projections of the budget have spending growing to $902
billion in 1985. The amount that they project to spend in 1984, in
this year's budget, is $165 billion more than what they projected a
year ago. And to change one year's numbers by $165 billion in a
year's time is just an astounding result, and it's because of
The CHAIRMAN. Give me those figures. How do you get to $165
billion?
Mr. JORDAN. The number that they projected to spend in 1984 a
year ago, when they did their 5-year projection, and the number
that is in this year's budget projections for 1984, this year is $165
billion more than a year ago.
The CHAIRMAN. How much of that is military spending?
Mr. JORDAN. Not a lot. These numbers were put together before
the Russians rolled into Afghanistan, before the recent shift in
emphasis toward more defense.
The CHAIRMAN. What's the principal reason?
Mr. JORDAN. Nondefense expenditures as a percent of a national
income rise almost category for category.
The CHAIRMAN. Well, is it because of a different estimate of
inflation?
Mr. JORDAN. In large part. Also a higher real growth assumption,
and I don't believe the inflation and the real growth assumptions
are consistent. They are assuming that nominal income growth
over the next 5-year period is going to average about 11 percent.
It's an assumption that inflation is simply going to stay high
through the next 4 years or so, and that beginning maybe in 1985,
and beyond, real progress will be made. In the period 1985 to 1988
is where they are projecting that inflation will come down, which
to me is saying it's somebody else's problem.
The CHAIRMAN. You can say that again.
So the assumption is that we will have raging inflation through
1984?
Mr. JORDAN. Their projections through 1985 are 7.7 percent
annual rate on the deflator basis, and the deflator is running 9
percent now. That's an extremely high figure.
The CHAIRMAN. Any reason in your mind as to why it would take
4 or 5 years to turn inflation down?
Mr. JORDAN. No; in fact, I think inflation would come down
much more rapidly and without severe loss of output and high
unemployment if people believed it was going to be done.
There have been developments in other countries when it has.
The recession of 1974-1975 was severe; more severe than it really
had to be, I think. But inflation came down from 12 percent in 1974
to 4.7 percent in 1976.
I think that now, though, the inflationary psychology is so deeply
entrenched that if there are not actions that change people's perceptions about inflation and the Government's determination, then
that kind of fiscal and monetary restraint would again cause a
severe recession.
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I don't think that we have to have a very deep, sharp recession,
and very high unemployment to bring inflation down rapidly, if
people believe that it is really going to be done.
The CHAIRMAN. Mr. Paulus?
Mr. PAULUS. I would second that. I think it's very important that
the Government demonstrate a firm resolve in dealing with inflation. I think the credibility record of the Federal Reserve and the
fiscal policy is pretty low, and that's why, I think, it will take quite
a long time to wring inflation out of this economy.
Decisionmakers are expecting a continuation of past policies.
Wage decisions are being based on an expectation that inflation
will continue quite high, and if you take policy actions to remove
inflation rather quickly from the economy, you will only create a
very deep recession.
As a consequence, I believe we need to pursue a policy which is
targeted on bringing inflation down over the next 3 to 5 years, let's
say. I don't really have any specific time period in mind. But I
think we have to achieve some degree of credibility in policy before
we can make real progress against inflation.
And to that point, balancing the budget in fiscal 1981, I think
that would have a favorable effect on financial markets, on expectations of inflation, but I would point out that in fiscal 1980,
Federal Government expenditures will grow by $70 billion. Currently, in the fiscal 1981 budget, we are assuming an increase of
$50 billion. I think it's unlikely that we are going to see a $20
billion reduction in the rate of growth of Federal spending in fiscal
1981.
So I think we have the problem that Kevin Hurley pointed to,
that we have a pretty unrealistic target for fiscal 1981 on the
deficit. We have to, I think, take that into account, if we are
thinking about making an attempt to balance the budget, a meaningful attempt to balance it in fiscal 1981.
Let me say also, that limiting Federal Government expenditures
to 20 percent would have a tremendously positive effect on inflation, on inflation psychology, and eventually on business investment and productivity over a longer period of time.
DEMAND FOR FEDERAL CREDIT PROGRAMS
The CHAIRMAN. Mr. Paulus, while I have you, on the credit
markets again, given the high interest rates and the tight credit
situation arising from recent monetary policy measures, and a
growing concern about Federal spending, there is likely to be greater demand in the next several years for Federal credit programs.
We have already had pressure in this committee, the ExportImport Bank, the Brooke-Cranston housing proposals, and others.
And, of course, we had the Chrysler matter, and we are likely to
have other problems like that come before the committee, too.
So there is pressure for more direct loans and loan guarantees
than in normal times. According to the President's fiscal 1981
budget, Federal credit programs are projected to expand substantially in the current fiscal year 1980, and again in fiscal year 1981.
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For example, loan guarantees are projected to increase 28 percent in fiscal year 1980; $26.1 billion to $33.4 billion. And then to
grow by another 24 percent in 1981, up to more than $41 billion.
Federal credit programs make up about 20 percent of the total
funds advanced by U.S. credit markets in 1979, and they are going
to be a higher proportion in 1981 and subsequently, the way we are
going.
Is this likely to make the conduct of monetary policy more
difficult, and should there be a cutback in Federal credit programs
in 1980 and 1981, to be consistent with monetary policy measures?
Mr. PAULUS. It makes everything more difficult. I think it is
critically important that we get a handle on Federal credit programs. We have seen, as you noted, rapid growth in those programs, and it goes back a long time. In the past 3 or 4 years, we
have seen the rate of capital formation in the United States decline, at least from its trend level or trend growth achieved in the
1960's and the early 1970's. The Government is squeezing out private sector borrowing with loan guarantees, and with other Federal credit programs. I think it is of great importance over the longer
term to bring these programs somehow into the budgeting process,
and to get a handle on them.
The CHAIRMAN. Mr. Griggs?
Mr. GRIGGS. I agree with that. We seem to take the view they
don't cost us anything, but they often do, and I think it is appropriate for us to bring them under the scrutiny of a budget, and to
consider them that way, and I think it would be very helpful to the
financial markets to do so.
The CHAIRMAN. Now I'd like to end up with the—what do you
call it, $64,000 question, or the Armageddon, or the end of the
world—but I'd like to end up with a question on desirability of
mandatory controls, both wage and price controls and credit controls, and I'd like to hear any specific recommendations you have
on policies to .reduce inflation and the role of the Council on Wage
and Price Stability.
We'll start off with Mr. Griggs.
DESIRABILITY OF MANDATORY CONTROL
Mr. GRIGGS. Well, on the credit controls, they make
The CHAIRMAN. They're on the books now, of course.
Mr. GRIGGS. Yes, they can do it. Right. I would object to consumer credit controls or real estate credit controls.
Aside from a philosophical objection to them, I think that this is
entirely the wrong time for them. In 1978, they might have made
some sense, but I think in 1980, they don't, and particularly because it is very difficult to be sure of their impact
I mean if we were dealing with an economy that was roaring we
would not be so concerned about the risk of producing a sharp cut
back in spending. But we are not dealing with that kind of economy. We are dealing with an economy that is poised on the edge of
a big recession, and I think that is not the time to start doing
something that you really can't control, and that would be devastating to the economy. Furthermore, unless you exempted autos,
275
and housing, it would almost certainly be devastating to those
areas since they are already weak.
The idea of thorough-going wage and price controls, I find even
more objectionable. They have demonstrated over and over in the
past that they do not work and, they distort decisionmaking to the
longrun detriment of the economy.
If some move toward controls is inevitable, however, the idea of
some sort of a wage freeze makes more sense to me. It might give
monetary policy a chance to work, more slowly than in the past.
The CHAIRMAN. A wage freeze only?
Mr. GEIGGS. Well, wage and price. Just a freeze on everything for
the moment.
The CHAIRMAN. How long?
Mr. GRIGGS. I don't know how long; 6 months, something like
that. But I say I'm not really an advocate of it. I'm just saying that
if we are going to get into this area, this would be the only
approach that would have any interest for me, because it would
give monetary policy an opportunity to work and would permit the
Federal Goverment to come up with some programs, perhaps, for
reducing spending further, and that would demonstrate to the
populace in general that things are going to be done on energy and
productivity, and provide some reason to believe that inflation will
be reduced.
As I say, I wouldn't advocate it, but I think if you are going to
get into controls, that's the only thing I would be willing to do.
The CHAIRMAN. You freeze all wages and prices, energy prices?
Including the price of imports and so forth?
Mr. GRIGGS. Well, obviously, there are some things you can't
control.
The CHAIRMAN, We wouldn't let people buy them, I suppose, if
the price was higher,
Mr. GRIGGS. Well, that's right, but you'd probably have to have
some flexibility. It just seems to me it would not involve the kind
of apparatus and bureaucracy that a real wage and price control
mechanism would, and I would see that as a modest plus.
The CHAIRMAN. Well, you have to have a bureaucracy of some
kind to enforce it.
Mr. GRIGGS. You would.
The CHAIRMAN. It wouldn't be voluntary. In wage-price freeze,
you are going to have to have several thousand people to crack
down and make sure it's being followed.
Mr. GRIGGS. There's no way you can get around some bureaucracy. I'm just saying it would be of quite a different magnitude
than a more permanent control program.
The CHAIRMAN. Have we done anything of the kind that you
contemplate before? Would this be like any other experience?
Mr. GRIGGS. Well, we did freeze things initially some years ago,
and then followed them up with wage and price controls.
The CHAIRMAN. That was 1971.
Mr. GRIGGS. That proved equally ineffective, the whole program
did. I'm not saying that we go from that to controls. I'm suggesting
a freeze only. You might give yourself a chance to do the things
that need to be done.
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The CHAIRMAN. You have a difficulty in getting into that, don't
you?
Mr. GRIGGS. I do.
The CHAIRMAN. I mean mechanically you have difficulty getting
into it, because it has to be debated in this committee, the corresponding committee in the House, we have to bring it to the floor,
it has to be debated on the floor, it has to go to conference, and it
must be signed by the President.
Meanwhile, people are just letting their prices and wages go up
in anticipation of the freeze. If it's a 6-month freeze or 1 year's
freeze, it would be doubtful if you'd really inhibit inflation that
way for very long. When you take it off, there it goes.
Mr. GRIGGS. I don't think it in any sense represents a solution. I
am not suggesting that. I am suggesting all it gets you is a little bit
of time to break the psychology, if you can, by then doing the right
things in the interim.
The CHAIRMAN. Why don't you break the psychology by doing
these other things?
Mr. GRIGGS. I think that's a much better idea.
The CHAIRMAN. Break the psychology by a tough fiscal and monetary policy.
Mr. GRIGGS. Absolutely. I agree. That's the thing to do. I'm
saying you go to controls only out of desperation. Only because you
can't do the thing the other way. And that's the only thing that
takes you there.
We wouldn't be talking about controls if we were doing these
other things.
The CHAIRMAN, Would you object to a policy that did everything
else, but not the controls part of it? In other words, that emphasized the monetary fiscal policy and not the controls?
Mr. GRIGGS. I would much prefer that policy, one that addresses
the budget deficit issue, the energy issue, the productivity issue.
That's the way we should be going.
The CHAIRMAN. All right. Mr. Hurley?
Mr. HURLEY. I think this whole issue of controls now has come
up because the country is asking Washington to do something.
The CHAIRMAN. Rather popular, unfortunately. I'm against them,
but my polls indicate in my State that they are about 2 to 1. People
are in favor of it.
Mr. HURLEY. Well, what we might do is instead put up an alternative, which would be TIP, some sort of tax incentive program. It
is no more thoroughly discredited than controls. Controls are the
pits. TIPS may be above that somewhere. But given that we expect
revenues are rising relative to nominal GNP, that we can expect
that some time between now and a year or two from now, that we
are going to have some sort of tax cut, why not make that sort of a
tax cut from a
The CHAIRMAN. They just pointed out to me that you have
achieved a new kind of acronym in reverse, that TIPS are the pits
backward. [Laughter.]
So it's something we'll keep in mind.
Mr. HURLEY. Yes, see if we can get that quoted around.
The CHAIRMAN. Next time we run into Henry Wallach.
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Mr. HURLEY. Anyway, the problem, of course, now is wages are
picking up and we have been fortunate, I would say, to not have
the increases in petroleum and food get into the underlying inflation rate, but we expect with a number of labor contracts coming
up midyear, and some time after midyear, that a major problem in
inflation this year would be acceleration of wages, especially given
that productivity has been stagnant.
WAGE-RELATED TAX REDUCTION
Thus, it again presents a time or it further presents a good time
to try some sort of wage-related tax reduction that would be an
alternative to wage-price controls, attacking the same problem.
The CHAIRMAN. Well, do I understand, or do I not understand,
Mr. Hurley, that you are against wage-price controls?
Mr. HURLEY. Yes. I guess I would say I definitely find them
abhorrent, and also ineffective.
The CHAIRMAN. How about credit controls?
Mr. HURLEY. Well, there's a little more believability in credit
controls that they might work when applied to the household
sector. I don't believe they work very well applied to the business
sector, because the business sector is far too innovative.
The CHAIRMAN. What's left in the household sector?
Mr. HURLEY. Autos and houses.
The CHAIRMAN. Automobiles are obviously not very good candidates right now.
Mr. HURLEY. Right. Both of them are on the decline, so that
pushing them further down is the only alternative when you use
credit controls. It's very difficult to get controls on business borrowing. There are too many open market alternatives. So I don't think
a whole lot of credit controls, either.
The CHAIRMAN. Any other anti-inflation actions that you would
like to bring up.
Mr. HURLEY. I would reemphasize now is the time to try TIP.
The CHAIRMAN. Now is the time what?
Mr. HURLEY. Now is the time to try TIP.
The CHAIRMAN. TIP. OK.
Mr. Jordan?
Mr. JORDAN. I think that even the discussion of controls—wage,
price or credit controls—is counterproductive to doing something
about inflation psychology.
I think it demonstrates a lack of confidence, of belief or resolve
that monetary and fiscal will do the job to the public. You don't
expect the public at large to really understand how monetary and
fiscal are supposed to work, and how long the lags are.
I think the polls indicate their frustration and their desire to see
something happening, and so they will go for a magic wand approach when responding to a poll. But to the business community,
the discussions of controls says that the Government in total is not
going to impose the kind of monetary and fiscal discipline on
themselves to deal with the fundamental problem of inflation.
In 1972 in this country, the fact is that the existence of controls
meant that there was Less monetary and fiscal discipline than
there otherwise would have been, and the experience in many
other countries that have tried controls is that you don't get mone-
278
tary and fiscal discipline because you have incomes policy or controls dealing with inflation, and so you use these other policies to
lubricate the skids, to promote expansion of output and employment, and the markets understand that.
I think that it would do a lot of damage to people's belief that
the fundamental things are really going to be done. And, in fact, I
believe that the fundamental things would not be done if we have
controls, whether it's a TIP type or any other kind of type.
The CHAIRMAN. So you are against wage-price controls, credit
controls, or any other incomes policy that would try to achieve
this?
Mr. JORDAN. The whole thing, because I don't believe you would
get the monetary and fiscal discipline, if you have them. And if you
don't get the monetary and fiscal discipline, the controls aren't
going to work.
The CHAIRMAN. OK. Mr. Paulus?
Mr. PAULUS. I think both credit and wage and price controls
would be a very serious mistake. On credit controls, I don't know
who you would impose them on. I hear talk of the consumer, but
he's already reduced his borrowing in the last several months. As it
was pointed out earlier, the housing marking and auto demand
have both slackened off in recent months.
On wage and price controls, I have at least three reasons for very
strongly opposing them.
One is the point that Jerry Jordan made on the lack of followthrough in policy. The experience around the world, and certainly
in the United States, in 1971 through 1974, suggests that there is a
certain feeling of euphoria that controls brings to policy makers.
We have swept the problem under the rug, so to speak, now let's
get with the business of getting the economy going.
M-l grew at a record rate in 1972. It's never been passed since
then. There was a very large Federal budget deficit in 1972; not as
large as we have seen in the last few years, but nevertheless, both
parts of macropolicy were moved toward stimulus under the last
controls program, and I don't know of any reason why things are
any different today.
The second point is with a price controls program, you basically
lock relative prices into a fairly rigid alinement with one another.
You run the risk of creating some pretty serious bottlenecks and
shortages, as we saw in the summer and fall of 1973, when we had
certain aluminum products, and may steel products in very short
supply, We also observed chemicals and fertilizer being shipped
overseas, where prices were higher.
Without some flexibility in prices we will observe shortages eventually develop, and the economy will be hamstrung by these shortages.
The final point is that the unintended consequence of a wage and
price controls program can sometimes be the most damaging.
I would point to our current energy problem, which I think had
its origin in the 1971 through 1974 controls program, when we first
imposed controls on energy prices. We had control on natural gas
before 1971, but we put comprehensive controls on all energy prices
during that program, and we never removed them. And as a conse-
quence, we have a serious energy problem in the United States
today.
The CHAIRMAN. Gentlemen, I want to thank you very, very much
for excellent testimony. It's been one of the best panels we've had
in a long time, and I think you have made some very sound and
helpful, if painful, recommendations to us, and we are in your debt.
You made a fine record. Thank you very much,
[Whereupon, at 11:50 a.m., the hearing was adjourned.]
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