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SENATE
{
REPORT
No. 96--63
FROM THE
COMMITTEE ON BANKING, HOUSING, AND
URBAN AFFAIRS
UNITED STATES SENATE
NINETY-SIXTH CONGRESS
FIRST SESSION
A REPORT
together with
ADDITIONAL VIEWS
SUBMITTED PURSUANT TO PUBLIC LAW
~
w
APRIL 9, 1979
Printed for the use of the Committee on Banking, Housing, and
Urban Affairs
U.S. GOVERNMENT PRINTING OFFICE
39-010
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Federal Reserve Bank of St. Louis
WASHINGTON : 1979
COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
WILLIAM PROXMIRE, Wisconsin, Chairman
HARRISON A. WILLIAMS, JR., New Jersey
JAKE GARN, Utah
ALAN CRANSTON, California
JOHN TOWER, Texas
ADLAI E. STEVENSON, Illinois
JOHN HEINZ, Pennsylvania
ROBERT MORGAN, North Carolina
WILLIAM L. ARMSTRONG, Colorado
DONALD W. RIEGLE, JR., Michigan
NANCY LANDON KASSEBAUM, Kansas
PAULS. SARBANES, Maryland
RICHARD G. LUGAR, Indiana
DONALD W. STEWART, Alabama
PAULE. TSONGAS, Massachusetts
KENNETH A. McLEAN, Staff Director
M. DANNY wALL, Minority Staff Director
STEVEN M. ROBERTS, Chief Economist
ANTHONY T. CLUFF, Minoritu ProfeBBional Staff Mtmber
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Federal Reserve Bank of St. Louis
(II)
LETTER OF TRANSMITTAL
U.S. SENATE,
COMMITTEE ON BANKING, HOUSING,
AND URBAN AFFAIRS,
Washington, D.O., April 9, 1979.
Hon. WALTER F. MONDALE,
President of the U.S. Senate,
Washington, D.O.
DEAR MR. PRESIDENT: Transmitted herewith is the First Monetary
Policy Report for 1979 on the Conduct of Monetary Policy, pursuant
to Public Law 95-523 and oversight hearings held on February 20 and
23, 1979.
Sincerely yours,
WILLIAM PROXMIRE, Chairman.
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(III)
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CONTENTS
·page
I. Introduction________________________________________________
II. Federal Reserve reports to Congress pursuant to the Full Employment and Balanced Growth Act of 1978______________________
1. Statement of long-term goals to be pursued_______________
2. Monetary policy oversight procedures____________________
III. Economic background________________________________________
IV. The economic outlook for 1979________________________________
A. The economic outlook of the administration______________
B. The economic outlook of the Federal Reserve_____________
C. Economic outlook of the Congressional Budget Office______
The CBO current policy forecast____________________
Sources of uncertainty_____________________________
Reasons for a downturn in 1979____________________
Reasons for a mild downturn and recovery___________
V. The short-term economic goals for 1979 and 1980 in the President's
Economic Report _____________ ._____________________________
VI. The Federal Reserve's objectives and plans for monetary policy
and their relationship to the President's economic goals for 1979
and 1980__________________________________________________
VII. Analysis of the Federal Reserve's monetary policy objectives and
plans_____________________________________________________
VIII. Views and recommendations.---------------------------------Additional views of Senators Sarbanes and Williams___________________
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TABLES AND CHARTS
Selected employment and unemployment data________________________
Changes in productivity and related data_____________________________
Changes in price indexes____________________________________________
Selected interest rates, 1975-79______________________________________
Monetary and credit aggregates_____________________________________
Funds raised in U.S. credit markets__________________________________
Cyclical contractions in mortgage credit and housing starts, 1959-74_____
Economic outlook for 1979__________________________________________
Summary of CBO economic projections under current policy, calendar
years 1979 and 1980_ _ _ _____ ___________ __ _______ __ _ ___ _ ___ __ _ __ __
The President's economic goals______________________________________
Federal Reserve System target ranges and actual growth rates_ _ __ _ _ __ __
Summary of economic outlook for 1979_______________________________
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FIRST MONETARY POLICY REPORT FOR 1979
I. INTRODUCTION
The Senate Committee on Banking, Housing and Urban Affairs
held its first hearings on the conduct of monetary policy for 1979 on
February 20 and 23, 1979. At these hearings the Federal Reserve
conveyed to the committee its first report on monetary policy for
1979 as required by the Full Employment and Balanced Growth Act
of 1978 which was signed into law on October 27, 1978 (Public Law
95-523).
On February 20, 1979, G. William Miller, Chairman of the Board
of Governors of the Federal Reserve System reported the Board of
Governor's and the Federal Open Market Committee's objectives and
plans with respect to the ranges of growth of the monetary and credit
aggregates for calendar year 1979, and the relationship of those intended policies to the short-term economic goals set forth by President
Carter in his Economic Report.
On February 23, the committee received the testimony of Dr. Allen
Sinai, Director of Financial Economics, Data Resources, Inc.; Mr.
H. Erich Heinemann, Vice President, Morgan Stanley & Company,
Inc.; and Professor Edward J. Kane, Everett D. Reese Professor of
Banking and Monetary Economics, The Ohio State University.
II. FEDERAL RESERVE REPORTS TO CONGRESS PURSUANT TO THE FULL
EMPLOYMENT AND BALANCED GROWTH ACT OF 1978
Since March of 197 5 the Federal Reserve has reported its monetary
policy plans to the Congress each quarter, alternately to the Senate
Committee on Banking, Housing and Urban Affairs, and the House
Committee on Banking, Finance and Urban Affairs. These hearings
have been held pursuant to House Concurrent Resolution 133 passed
by Congress in March 1975 and Public Law 95-188, the Federal
Reserve Reform Act of 1977, enacted in November 1977.
The reports to the Congress by the Federal Reserve are now held
pursuant to Public Law· 95-523, The Full Employment and Balanced
Growth Act of 1978-the Humphrey-Hawkins Act-enacted in October 1978. This legislation amends the Employment Act of 1946, the
Congressional Budget and Impoundment Control Act of 1974, and the
Federal Reserve Act to more fully integrate economic policy formulation with the congressional budget process. Pursuant to Public Law
95-523 the Federal Reserve will report to the Congress by February 20
and July 20 each year, rather than four times a year as required by
Public Law 95-188.
Under the new reporting requirements there will be an expanded
discussion of monetary policy and its relationship to the achievement
of the Nation's economic goals. The economic goals of the President
are now explicitly stated in his Economic Report which must be transmitted to the Congress during the first 20 days of each regular session.
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The Congress may also explicitly state its own economic goals in the
first and second concurrent resolutions on the budget which must be
approved by May 15 and September 15 of each year.
The process of congressional review of monetary _policy is based
on the following major provisions of section 2A of the Federal Reserve
Act.
1. Statement of Long-Term Goals to be Pursued
The Federal Reserve is required to pursue monetary policiesgrowth of money and credit-consistent with the economic potential
to increase production, and to promote the goals of maximum employment, stable prices, and moderate long-term interest rates. This
provision is the same as in Public Law 95-188.
2. Monetary Policy Oversight Procedures
The Board of Governors of the Federal Reserve System is required
to submit written reports to the Congress by February 20 and July 20
of each year. These reports are to consist of four parts:
(1) a review and analysis of recent developments affecting
economic trends in the Nation;
(2) the monetary policy objectives and plans of the Federal
Reserve Board and the Federal Open Market Committee in
terms of the ranges of growth of the monetary and credit aggregates for the calendar year during which the report is transmitted (and in the July 20 report for the next calendar year).
Those plans and objectives are to take into account past and
prospective developments in employment, unemployment, production, investment, real income, productivity, international
trade and payments, and prices;
(3) the relationship of the Federal Reserve's monetary policy
plans and objectives to the numerical goals for the current and
the next calendar year as set forth by the President in the Economic Report for employment, unemployment, production, real
income, productivity, and prices or to any revisions to those
goals approved by the Congress. In explaining the relationship
of the Board's objectives and plans to the goals established by
the President and any subsequent goals established by the Congress, it is expected that the Board will provide the Congress
with a full discussion concerning the extent to which the Federal
Reserve's intended policies will help to achieve those goals; and
(4) if any changes in monetary objectives or plans are made by
the Federal Reserve between reports to the Congress, the Board
is required to include in the next report an explanation of the
reasons for those revisions to or deviations from the previously
announced objectives and plans.
After each Federal Reserve report on monetary policy to the Congress the Banking Committees are required to submit to their respective bodies a report containing their views and recommendations
with respect to the Federal Reserve's intended policies. These reports,
and the expanded reports by the Federal Reserve to the Congress, will
serve to increase public understanding of monetary policy. Emphasis
will be on the goals of economic policy-employment, unemployment, production, investment, real income, productivity, and prices,
and how the Federal Reserve monetary policies are designed to
achieve those goals. The means to achieve those goals-growth of
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money and credit-will be more meaningful in this context. Moreover,
since the reports will be made twice a year, rather than four times a
year, monetary policy will be given a longer-run focus, than is now
the case.
III. ECONOMIC BACKGROUND
The current economic upswing which began in the spring of 1975.
It ranks among the most durable in this Nation's history. The past
four years have seen sizable gains in production and employment.
Between the first quarter of 1974 and the fourth quarter of 1978,
real gross national product rose more than 20 percent and more than
10 million jobs have been created.
Real GNP increased 4.3 percent from the fourth quarter of 1977
to the fourth quarter of 1978-a bit slower than the average pace
over the earlier part of the expansion, but still well above the trend
growth of potential output in the economy. The persistent strength
of aggregate demand was demonstrated by the surge in activity during
the final quarter of last year, when GNP grew at an annual rate in
excess of 6 percent. Available indicators suggest that the economy
has remained generally strong in the opening months of 1979.
Residential construction, which provided a good deal of impetus
to the early recovery, continued at fairly high levels last year, even
the interest rates rose dramatically and building costs continued to
increase rapidly. Household demands for shelter have been bolstered
by demographic trends and by the desire of many people for a hedge
against inflation. The sustained advance in economic activity also
has been fostered in good part by strength in consumer spending.
A marked turnaround in the willingness of consumers to spend-reflected a sharp drop in the personal savings rate-provided much of
the impetus to over-all expansion in the early stages of the economic
recovery, and consumption expenditures have remained unusually
robust throughout the upswing.
In the business sector, spending on new plant and equipment has
continued to rise, but there have not as yet been the large increases
seen in some earlier cycles. Business fixed investment actually declined during the initial quarters of the economic expansion, as firms
concentrated on the repair of strained financial pos tions in an environment of low capacity utilization. Capital spending policies have continued to be characterized by considerable caution, and it was not
until mid-1978 that the previous peak level of real outlays was reattained. Firms also have exercised caution in managing their inventory
positions, and stocks generally have remained lean relative to sales.
Government purchases of goods and services rose briskly at both
the Federal and State and local levels during the second half of 1978.
The over-all budgetary position of the Government sector, including
transfer payments and revenues, has remained stimulative throughout
the expansion, albeit in diminishing degree.
An improving net export position contributed to the expansion of
GNP during the early recovery phase, but deterioration in the trade
balance was a decidedly negative factor from 1976 to early 1978.
The U.S. trade deficit did narrow over the course of 1978, however,
owing in part to the strengthening of economic expansion in other
major industrial countries.
S.R. 63--2
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The proportion of consumption in gross national product has held
at a high level over the course of this upswing. In prior cycles this
share typically fell as the expansion matured. In particular, household
spending for durable goods has hovered at around 10 percent of GNP
throughout the past three years, while during other economic expansions it accounted, on average, for about 7}~ percent. This exceptional strength in consumption and the associated rapid increase in
installment credit and low savings rates can be attributed, in part, to
the higher relative number of younger households. But it also appears
to be in some degree a reaction of households to persistently high
inflation rates-many consumers have been buying durable goods in
anticipation of price increases.
Real business fixed investment rose 8Vi percent over 1978. This was
nearly the same pace of advance as in the two previous years and
almost twice the rate of expansion in aggregate activity. Recently,
nonresidential construction activity has become an important source
of business investment growth. In 1978, real spending for such
structures increased 12¾ percent as outlays for commercial and industrial building showed particularly impressive gains. Investment in
producers' durable equipment grew about 6% percent in real terms
during 1978 compared with increases of more than 10 percent in each
of the previous two years. Demands for motor vehicles, which were
exceptionally strong earlier in the expansion, began to tail off in 1978,
while machinery outlays continued to advance at about the same
moderate pace experienced since early 1976.
Investment in business inventories was characterized by caution
in 1978, as it generally was in the three previous years. As a result,
aggregate inventory-sales ratios remained at or below historical
averages. This caution, which can be traced back to the severe
inventory cycle of 1974-75, appears to have been responsible for the
avoidance of the types of overhangs that preceded several prior
cyclical downturns.
The rate of private housing starts advanced briskly during the
1975-77 period and in 1978 they were sustained at the high annual
rate lf 12 million units. Spending for residential construction in
real terms increased at an average annual rate of 21 percent from the
1975 through the leveling off in 1978. Interest rates on both construction loans and long-term mortgages rose appreciably in 1978 and by
year-end they had reached usury ceilings in a number of states and
record postwar highs in many other areas. Even so, the variableceiling six-month money market certificates introduced in June of
last year buoyed deposit growth at thrift institutions and helped
maintain the high rate of housing construction.
Within the housing sector, the rise in single-family starts led
activity early in the recovery. More recently, multi-family startssupported by an increase in Federally subsidized rental units-have
increased while single-family starts have remainedabove their 1972-73
peak levels. Indeed, in the fourth quarter of 1978, total housing
starts averaged an annual rate of 2.1 million units, the same as a year
earlier.
After providing some initial stimulus to economic growth during
the early recovery period in 1975, the U.S. balance of trade began
deteriorating. In large part this reflected the relatively stronger rate
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of economic expansion in the United States compared with our major
trading partners. The deficit in net exports narrowed during 1978,
however, as activity abroad picked up in contrast to the moderation
in the U.S. expansion. In addition, the more favorable trade balance
reflected a 20 percent rise in agricultural exports last year, associated
with unusually poor harvests of wheat and soybeans in the Southern
Hemisphere.
Growth of purchases by the Federal Government has been uneven
in this expansion. In real terms, such purchases increased little during
1975 and 1976, rose substantially in 1977, and then-despite a surge
in the second half of the year-declined slightly in 1978. Total expenditures, however, have risen consistently, reflecting increased
grants to State and local governments and transfers to individuals for
Social Security, food stamps, and retirement benefits. Revenues have
increased even more than outlays over the past several years, so that
the Federal budget deficit has declined from $66.4 billion in fiscal year
1976 to a projected $37 billion for the current fiscal that ends next
September.
State and local government purchases also have grown irregularly
over the past four years. In real terms, outlays by this sector for
goods and services expanded at a 2}{ percent annual rate during the
second half of 1978, matching the average pace over the expansion
as a whole. This is well below the trend rate of increased experience
during the 1960's and early 1970's. The slowing of growth reflects
changing requirements for services, associated with demographic
developments, and a degree of fiscal conservatism prompted partly by
the financial difficulties encountered by some communities in recent
years. In 1978, however, a tendency toward tax relief-occasioned in
part by voter preferences expressed in California's Proposition 13 and
like measures elsewhere-outweighed the impact of spending economies on budgets. As a result, although the aggregate operating surplus
of State and local governments totaled $6 billion for the year, this
was only half the size of the 1977 surplus.
Labor demand has been strong throughout the current economic
expansion. During the three years following the cyclical trough in
early 1975, nonfarm payroll employment advanced at an average
annual rate of 3.7 percent-compared with a 2.8 percent median
rate of gain during the five previous postwar expansions. During
the past year-at a stage when in earlier cycles employment levels
had begun to ]eve] off or even fall-payroll employment has continued to advance at a 4.2 percent annual rate. Over the almost
four years of expansion, employment has increased by 12 million,
and today the ratio of employment to total civilian population aged
16 and over stands at the highest level on record.
A significant factor in the expansion of the work force has been
the continued rise in the participation rates of adult women. The
longer-run trend, which reflected low birth rates as well as changing
attitndfls and social trends, apparently was augmented in the 1970's
by a desire of families to maintain their material living standards in
the face of rapid inflation. As a result of these participation rate
patterns, the total civilian labor force grew 3 percent during 1978about the same as in 1977, but up considerably from the 2¼ percent
annual rate during preceding years of the decade.
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With the growth of employment outstripping even the large increase
in the size of the labor force, the unemployment rate fell one-half
percentage point over the course of 1978 to just under 6 percent. The
improvement in employment conditions during the current expansion
has not been uniform. Despite the gains made by many groups. unemployment rates for younger workers, minorities, and the unskilled
were still unacceptably high at the end of 1978. For example, the
unemployment rate for teenagers at the end of 1978 was 16% percent,
more than four times the rate for workers 25 to 54 years old; for
minority youth the rate was over 35 percent. Younger workers
between 16 and 24 years of age accounted for about one-half of all
joblessness in the fourth quarter of 1978.
Output per hour of work rose only slightly over the four quarters
of 1978. Much of the slowdown in productivity growth last year occurred outside the manufacturing sector; output per hour in manufacturing increased 3}; percent during 1978. This poor performance
of labor productivity continues a trencl toward slower growth evident
since the late 1960's. During the period from 1947 to 1967, productivity in the nonfarm business sector rose on average by 2% percent
per annum, and accounted for almost 70 percent of the gain in output
for this sector. Since 1967, the rise in output per hour has slowed, with
average annual gains of only 1.2 percent recorded since 1973. As a
result, less than 50 percent of output growth over the last five years
can be attributed to gains in efficiency.
The deterioration of productivity performance in recent years is a
complex phenomenon that is not completely understood. It appears,
however, that a crucial factor has been the failure to maintain an
adequate rate of capital formation. Indeed, the Nation's stock of
capital has shown little growth relative to the size of the labor force
over the past decade; in contrast, the capital-labor ratio trended upward rapidly in the preceding 20 years. Other factors that may have
contributed to reduced productivity growth in recent years are the
influence of environmental and safety regulations that divert resources to uses not measured in the National Income and Product
Accounts, and the increase in the proportion of young and inexperienced workers in the labor force.
Since the early 1960's there has been a marked trend toward slower
growth of the stock of business capital in the United States. Although
real gross business fixed investment last year surpassed the 1973
record, still stronger investment activity will be needed if there is to
be a sustained reversal of this trend. Net investment-that is, gross
investments less the depreciation of existing capital goods-ad<ls to
the capital stock, and real net investment has yet to reach its previous
peak level. Because the fraction of the capital stock in the form of
relatively short-lived equipment has been increasing in recent years,
a higher level of gross investment is now needed simply to maintain
the existing capital stock.
From the mi<l-1960's through the early 1970's, the U.S. merchandise
trade balance moved gradually from surplus to deficit. Then, during
the 1974-75 worldwide economic slowdown the United States suffered
disproportionately sharp contraction, so that-despite an enormons
increase in our outlays for imported oil-the U.S. trade balance swing
into surplus in 1975. The surplus proved temporary, however; the subsequent economic recovery was stronger here than abroad, and this
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played a major role in the steep increase of our trade deficit from 1976
through early 1978.
The trade deficit in 1978 was $34 billion, slightly larger than in 1977.
But the deficit peaked at an annual rate of $45 billion in the first
quarter of 1978 and developments in both exports and imports contributed to a narro"'ing of the imbalance to a rate of about $30 billion
in each of the subsequent quarters.
The growth of exports accelerated in the second quarter. The step-up
was partly attributable to temporary causes-for example, demand for
U.S. agricultural commodities was stimulated by poor Southern Hemisphere· harvests. :More important, however, was a strengthening of
economic activity abroad and the improved competitiveness of U.S.
goods resulting from the substantial depreciation of the U.S. dollar
that began in the fall of 1977. The real volume of non-agricultural
exports increased 6 percent in 1978, and growth picked up strongly in
the second half of the year. Prices of exports increased in line with the
general pace of domestic inflation, and the total value of merchandise
exports rose 17 percent from 1977.
The relatively moderate rise in the volume of imports in 1978, fol'"
lowing two years of very large increases, resulted primarily from a
slower increase in nonoil imports, but it was reinforced by some decline
in petroleum imports. Although total U.S. petroleum consumption is
estimated to have increased 3 percent, the higher demand was more
than met by increased Alaskan production and by a drawing down of
inventories from unusually high levels. The total value of imports
increased 16 percent in 1978 with the gnin spread over most major
commodity categories. Almost half of this increase was in volume
terms as imports responded to the continuing strength in U.S. economic activity. Prices of nonoil imports were boosted by the decline
in the international value of the dollar.
The current account deficit in 1978, estimated at $17 billion, was
slightly larger than in 1977. As in other recent years, net receipts from
service transactions provided a substantial offset to the merchandise
trade deficit. Earnings, fees, and royalties from foreign direct investments have shown a strong uptrend during the 1970's.
The dollar began to depreciate markedly against most major foreign
currencies in late September 1977 as forecasts for 1978 suggested that
the U.S. trade deficit would be no smaller than in 1977. The decline
continued through the end of 1977, despite large intervention purchases
of dollars by foreign central banks. An announcement in January 1978
that the U.S. Treasury would join the Federal Reserve in exchange
market intervention in German marks, followed by an increase in the
discount rate, improved market sentiment only temporarily, and by
early April the dollar had declined about 10 percent on a weightedaverage basis. Between early April and mid-Ma,y, a relative firming of
U.S. interest rates contributed to a recovery, but the dollar declined
fairly steadily thereafter in response to continuing concerns about the
size of the U.S. trade deficit and increasing fears that U.S. price performance was deteriorating.
Although some depreciation of the dollar was justified by the neeti
to restore external balance in the face of differential growth rates in the
United States and major foreign economies and a relative worsening of
U.S. inflation, by midsummer it was clear that the dollar's decline was
becoming excessive in trading that was increasingly disorderly. fo
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August the Federal Reserve announced a ½percentage point increase
in the discount rate and reduced to zero reserve requirements on borrowings by member banks from the Eurodollar market. The Treasury
subseq_uently announced that it would increase the size of its regular
monthly gold auctions. These measures produced a brief rally and
then a few weeks of stability for the dollar. However, the dollar's slide
soon resumed. After the President announced his wage-price program
on October 24, the decline steepened alarmingly, threatening to undercut the anti-inflation effort at home and abroad. By late October, the
dollar had fallen 21 percent from its September 1977 level.
On November 1, the Federal Reserve increased the discount rate
by 1 percentage point and imposed a 2 percentage point supplementary
reserve requirement on large time deposits. To increase the availability of foreign currencies for exchange market intervention, enlarged swap lines were arranged with the central banks of Germany,
Japan, and Switzerland. The U.S. Treasury simultaneously announced
its intention to draw on its reserve position in the IMF, to sell SD R's,
and to issue foreign currency denominated securities. In addition,
the Treasury announced a doubling in its rate of gold sales.
The aim of these measures was to correct the excessive depreciation
of the dollar and thereby to counter upward pressures on the domestic
price level. When viewed in its entirety, the policy initiative of the
Administration and the Federal Reserve System indicated that the
United States recognized the need for an integrated approach in
addressing domestic and international economic concerns. The announcement of these measures on November 1 produced a dramatic
jump in the dollar's exchange value. On that day alone the dollar
advanced by 5 percent on a weighted-average basis. Heavy cooperative central bank intervention over the following few weeks provided
support for the dollar as market participants tested the authorities'
resolve, but the need for such intervention abated in January. As of
mid-February of this year, the dollar was more than 7 percent above
its October low on a weighted-average basis.
Inflation moderated during the first stage~ of the cyclical recovery
in 1975 and 1976. The earlier extraordinary pressures associated with
the rise in oil prices, the sharp escalation m food prices, a worldwide
boom in other commodities, and domestic price decontrol subsided,
and the considerable slack in labor and product markets restrained
wages and prices. Inflation began to speed up again in 1977, however,
the prices then surged in 1978. The Consumer Price Index, the Producer Price Index, and the fixed-weight price index for gross business
product all registered increases of around 9 percent during 1978,
about 2 percentage points more than in the preceding year.
The acceleration of inflation last year reflected importantly the pressure of rising labor costs. Wage rates in the private nonfarm sector
increased 8¼ percent, compared with about 7½ percent in each of the
preceding two years. A boost in the Federal minimum wage contributed
appreciably to the accelerated rise of wages; the impact was especially
noticeable in the trade sector, which has the largest concentration of
lower-wage workers and saw average wage increases of more than 9
percent last year.
Hourly compensation, which includes, in addition to wages, the
costs to employers of social insurance contributions and of privately
negotiated fringe benefits, rose
percent-about 2 percentage points
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faster than in 1977. About one-quarter of the acceleration resulted
from increased Social Security taxes and unemployment insurance
contributions. In addition, private fringe benefits continued to rise
faster than wages.
Given the weak performance of labor productivity, the larger compensation ~ains were translated into rapid increases in unit labor costs,
the general level of prices was affected considerably in 1978 by developments in the farm and food sector. Retail food prices rose 12 percent over the year-the largest increase since 1974. The increases at
the retail level reflected a rise of almost 20 percent in farm prices
during 1978 following little change in the preceding year. Meat price
increases were particularly rapid, as beef production continued to
decline.
The decline in the foreign exchange value of the dollar also aggravated inflation. Aside from the direct impact of higher prices for imported merchandise, the price-restraining pressure of foreign competition was weakened for many domestic products. Large price increases
for domestically produced automobiles and other durable goods reflected both of these effects. The inflationary pressures associated with
the steep depreciation of the dollar that began in September 1977
appear to have accounted for about 1 percentage point of last year's
rise in the Consumer Price Index.
At the producer level, the inflation of prices of capital equipment
accelerated considerably less than that for consumer finished goods.
But crude materials prices, for both food and nonfood items, increased
sharply, and prices for construction materials also rose ra_pidly. In the
first month of this year the continuing strength of inflationary forces
was demonstrated by a 1.3 percent jump in the Producer Price Index;
although consumer foods posted an especially large increase, all of the
major groupings of finished goods and materials showed accelerated
advances.
Interest rates generally declined during the early part of the current
economic expansion. Interest rates began to move upward in the
Spring of 1977, however, as the Federal Reserve acted to restrain
accelerating growth in money and credit. Over the course of 1977,
yields on short-term market instruments generally rose about 2 percentage points, while corporate and Treasury bond yields increased
around h percentae;e point.
With inflation p1ckmg up, the margin of unutilized resources narrowing, and the dollar under downward pressure in foreign exchange
markets, the Federal Reserve applied increasing restraint to the expansion of money and credit in 1978. This was reflected in further increases
of 3 to 4 percentage points in most short-term rates over the course
of the year. The combination of rising short rates and heightened inflation expectations resulted in increases of roughly 1 percentage point
in bond yields. By year-end, a number of interest rates were near or
above the peak levels of 1974.
The monetary aggregates have exhibited some unusual patterns of
behavior during the past several years. This has been especially true
with respect to the narrow money stock, M1. During 1975 and 1976,
growth m M 1 averaged just over 5 percent per annum. Given the
concurrent decline in interest rates, the sizeable increases in M 1
velocity-that is, the ratio of GNP to Mi-were much larger than
would have been predicted on the basis of previous historical relationships among money, income, and interest rates.
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10
The moderation of the public's demand for l'v:1 1 may have reflected
to a degree an unusually strong cyclical swing in confidence and
increased willingness to spend out of existing cash balances as the
economy recovered from a severe recession. However, there is also
considerable evidence that other factors playe<l an important role.
The unprecendentedly high level reached by interest rates in 1974
stimulated the creation and adoption of new cash management techniques that permitted individuals and businesses to economize on
nonearning demand deposits. This development apparently continued
to exert a significant influence even after interest rates turned downward, and it was reinforced by several important legislative and
regulatory developments ancl innovations affecting the payments
system. These included the development of money market mutual
funds and the authorization of NOW accounts in all of N e,v England,
of savings accounts for businesses and governmental units, and of
preauthorized third party and telephone transfer privileges for personal
savings accounts.
By the beginning of 1977, the level of M 1 wa[ ,rnll below that
predicted by most standard econometric models of the demand for
money, This downward shift in money demand abated in early 1977,
however, and growth of M 1 generally conformed to historical patterns
until the final months of 1978. M 1 expanded 9 percent durmg 1977
and at about the same pace over the first three quarters of 1978;
rising interest rates and slowing economic expansion worked to moderate M 1 growth over this span, but these influences were offset by
the effect of accelerating inflation on transactions requirements.
On a quarterly average basis M 1 growth in the fourth quarter of
1978 was at a 4.4 percent annual rate, but the average level of the
money stock in January was slightly below that for October. A portion
of this ,veakness is the direct consequence of the introduction of
automatic transfer services (ATS) last November 1; many individuals
have shifted their transactions balances from checking accounts to
savings accounts from which funds are automatically transferred to
cover checks. According to the Federal Reserve these shifts appear to
have reduced M 1 growth rates by roughly :3 percentage points per
month, on average. However, growth in M 1 has been weaker than
might have been expected in light of the recent expansion of income
and spending. It may be that, as in 1974, interest rates have reached
a high threshold level at which households and businesses are induced
to seek out and adopt cash management techniques that permit major
economies in demand deposit holdings.
The behavior of the interest-bearing components of the broader
mon.eta.ry aggregates-M 2 and M 3-was generally in line with historical patterns during the first three years of the economic upswing,
but there has been u. ma,rkfd deviation since last June. Commercial
banks and thrift institutions experienced rapid growth of savings and
small denomination time deposits until the la,tter part of 1977. At
that point a gap began to dewlop between interest rates on shortand intermediate-term market securities and the rates permitted
on insured deposits by Federal regulations. As the gap grew, inflows to
savings and small time accounts gradually diminished through the
spring of 1978. Also, commercial banks found it necessary to rely more
heavily during this period on large time deposits and other managed
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Federal Reserve Bank of St. Louis
11
liabilities to fund their lending activities, an<l savings and loan associations borrowed heavily from Federal Home Loan Banks.
The Federal regulatory agencies authorized two new time deposit
categories effective June 1 in order to prevent a repetition of past
episodes when markedly reduced deposit inflows led to an abrupt
curtailment of credit to home buyers and others reliant on the depositary institutions for credit. One was an 8-year account paying up
to 7¾ percent at commercial banks and 8 percent at thrift institutions.
The other was a 6-month money market certificate whose maximum
rate varies weekly with the average yield on newly issued 6-month
Treasury bills. Given rate relationships, the 8-year certificate has not
added significantly to over-all deposit flows, but quite the contrary
is true of the 6-month certificates. During the first 5 months of 1978,
time and savings deposits subject to rate ceilings at commercial
banks, savings and loan associations, and mutual banks grew at a
7.9 percent annual rate; since the beginning of June, these deposits
have grown at a 10.3 percent rate despite substantial further increases
in market interest rates. MMC balances at the end of January totaled
about $105 billion and accounted for 7% percent of savings and small
time deposits at banks and almost 13 percent at thrift institutions.
Although accelerating inflation has tended to dampen the impact
of rising nominal interest rates on credit demands, there has been a
perceptible flattening of the overall pace of borrowing in the economy
over the past year. Total funds raised in credit markets by the private domestic nonfinancial sectors have expanded only moderately
since the second half of 1977 after having risen rapidly during the
earlier part of the economic expansion. Although the liquidity of
depositary institutions has declined over the past 2 years, the introduction of the 6-month money market certificates has prevented
the disintermediation that accompanied previous interest rate cycles
and permitted banks and thrift institutions to continue to account for
a very large share of the funds advanced to ultimate borrowers.
Households, in particular, are heavily reliant on depository institutions for credit, and their demands for funds have remained strong.
Home mortgage borrowing in 1978 was slightly larger than in 1977,
and consumer installment borrowing rose to a new record as households financed purchases of autos and other large ticket items. The
aggregate flow of credit to households in 1978, at more than $160
billion, was 15 percent greater than in 1977 and three times the
volume recorded in 197 5.
The build-up of indebtedness by households over the last 3 years
has outstripped both the growth of this sector's financial asset holdings
and of disposable income. Repayment burdens have reached record
proportions. Although loan delinquency data indicate that families
have not as yet encountered significant difficulty in meeting their
obligations for debt service, the diminished liquidity of household
financial positions suggests a greater fragility and vulnerability to any
deterioration of income flows.
The nonfinancial business sector also experienced some decline in
liquidity in the past year. The gap between corporate capital spending
and internal cash flow widened, and firms met a substantial portion
of their external financing needs through short-term borrowings-particularly from commercial banks. While commercial mortgage borrowing increased and private bond placements remained large, many of
S.R. 63-3
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Federal Reserve Bank of St. Louis
12
the big, highly rated industrial firms that have ready access to the
public bond markets evidently preferred to def er long-term financings
in the expectation that long-term rates would eventually decline. As
a consequence, the aggregate ratio of liquid assets to short-term
liabilities in the nonfinancial corporate sector declined over the course
of 1978, to a level only slightly above the 1974 low.
State and local borrowing was about the same in 1978 as in 1977.
Advance refundings again accounted for a sizable sha,re of tax-exempt
bond issuance, but such operations virtually ceased after August owing
to the combination of restrictive IRS regulations and rising interest
rates. Despite some rise in the past few months, the ratio of yields
on municipal bonds to those on taxable obligations has remained
relatively low by historical standards, reflecting in part the continued
demand for tax-exempt securities by casualty insurance companies,
commercial banks, and indivi<luals.
Borrowing by the U.S. Treasury has declined over the past year,
reflecting the diminution of the Federal budget deficit. Government
borrowing from the public totaled $59 billion in fiscal year 1978, but
is projected by the Administration at about $40 billion in the current
fiscal yea~. The preponderance of the increase in outstanding Treasury
debt durmg 1978 was absorbed by State and local governments,
which purchased a large volume of nonmarketable Treasury securities
with proceeds of advance refundings, and by foreign official institutions, which invested dollars obtained in exchange market intervention.
Commercial banks satisfied a substantial proportion of the credit
demands of households, businesses, and State and local governments
<luring 1978. Total bank credit expanded 10.9 percent over the course
of the year, with loan portfolios increasing by 14.6 percent. To meet
loan demands many banks had to liquidate holdings of Treasury
securities and to borrow either from correspondents or in the open
market through the issuance of large CD's or nondeposit liabilities
such as Federal funds and repurchase agreements. Aggregate bank
liquidity ratios declined appreciably, expecially among the smaller
and regional institutions that have experienced the strongest business
loan growth during this expansion.
Thrift institutions experienced considerable cash flow P.ressure
during the first half of 1978, but they have been able to rebmld their
liquid asset positions since the MMC's began to bolster deposit
growth. Thrift institution mortgage lending declined moderately
during 1978, although there was some upturn in the final quarter in
lagged reaction to the midyear pick-up in deposit inflows. Outstanding
loan commitments also rose during the second half, but in December
were slightly below the year-earlier level.
Life insurance companies a.nd pension funds have continued to
experience large inflows of investable funds. In 1978, as in previous
years of the economic expansion, these institutions absorbed the bulk
of the net issuance of corporate bonds. The insurance companies
also have supplied a large share of commercial mortgage credit.
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TABLE !.-SELECTED EMPLOYMENT AND UNEMPLOYMENT DATA
(Monthly data seasonally adjusted)
1978-79
1977-78
Total civilian employment (millions) _____________________________
Total civilian unemployment (millions) ___________________________
15 weeks and over (millions) _______________________________
une1g:~r~~m:~~~~-~~:~c~_n_t~
~ -- -- ____________ -- -- __ -- _____ -- __
Men 20 and over __________________________________________
Women 20 and over---------------------------------------White._
•••••••
•• - - • - - - - - - - - -- --- - - - - - - - - -- - --- - -- • • - -- Black and
other-___________________________________________
Household heads ••••••• _______________________________ ••••
Dec.
Jan.
Aug.
Sept.
Oct.
Nov.
Dec.
Jan.
91. 2
6.6
1. 8
91.4
6. 7
1. 8
92.2
6.6
1.8
92.6
6.2
1.6
93.0
6.3
6.6
94. 7
5. 9
1. 2
95.0
6.0
I. 3
95.2
5.8
1. 3
95.8
5.9
1. 2
95.9
6.0
1. 2
96.3
5.9
1.3
6.8
4. 7
6.9
6.0
13. 2
4.3
6.8
4. 9
6.8
5. 9
13. 6
4.4
6. 7
4. 7
6.9
5.8
13. 5
4.1
6.3
4. 5
6. 5
5.4
12.6
3.9
6.3
4.6
6.2
5.5
12. 8
3.9
5. 9
4.1
5. 9
5.2
11. 5
3. 7
5.9
4.1
5. 9
5.2
11.3
3.6
5.8
4.0
5.6
5.1
11. 3
3.5
5. 8
3.9
5.8
5.0
11.7
3.4
5. 9
4.1
5.8
5.2
11. 5
3.5
1978
Sept.
90.5
6. 9
1.9
94.4
6.0
1. 4
90. 9
6.8
1.8
7.0
5.2
7.0
6.2
13.1
5.4
6.0
4. 2
6.0
5.2
11. 9
3. 7
7. 0
5.1
7.0
6.1
11.4
4. 5
1976
87.5
7.3
2.3
7. 7
59
7.4
7.0
13.1
5.1
Source: Economic Indicators, January 1979 and data accessed from the files of Data Resources, Inc.
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Oct.
Nov.
Aug.
1977
5.8
4.0
5. 7
5.1
11.2
3.4
Cl)
14
TABLE IL-CHANGES IN PRODUCTIVITY AND RELATED DATA 1
[Percent change: Quarterly data at seasonally adjusted annual rate]
Output Compensation
per hour
per hour
Unit labor
costs
6. 8
8. 2
4.6
6.2
12. 5
8. 7
5.0
6.4
8.9
6.3
17. 4
6.8
6. 7
Private business sector:
1965-73 (average)•----- ______________________________________ _
1973 ________________________________________________________ _
1974________________________________________________________ _
1975______ -- • _________ -- ___ • _______ • ________________________ _
1976________________________________________________________ _
2.1
1.9
-3.0
9.1
9.9
2. 1
3. 5
1.6
1977------------------- -- -- _----- -- -- --------- --- -- -- -- ____ _
1978
________________________________________________________
1977 •
1978 · , ____ ----- _----- -- -- ----- -- ____ ---- ---- _--- ___ -- -- -- -- _
1978 · , , _____ -- ---- -- -- -- ----- -- _-- -- -- ____ ----- -- _-- -- -- -- -- _
1978 · '' '-- --- ----- -- -- _-- --- ---------- -- ------ -- ---- ------ -- _
1978· IV•---------------------------------------------------Nonfarm business sector:
1965-73 (average)•---- _______________________________________ _
1973________________________________________________________ _
1974________________________________________________________ _
1975________________________________________________________ _
1976________________________________________________________ _
,v ____________________________________________________ _
.4
.4
-4.5
1.2
3. 5
2.1
1.8
1. 7
-3.1
1.9
3.5
1.3
1977--- _-- -- -- _---- _______ -- -- -- _----- -- ------ -- ------ -- -- -- _
1977· IV_---------------------------------------------------1978· '- ___ --- -- ---- ---- -- -- ___ -- --- __ -------------- -- ------1978 · , , _____ -- -- -- -- ----- _-- -- -- -- __ -- _-- __ ----- -- -- -- _-- _--1978 · IV•---'' '--- _---- ------- -- ---------- ____ --------- _-- __ -------_
_______________________________________________
6. 5
6.6
7. 8
4.7
6.0
12.6
7.8
4. 7
9.1
9.9
8.4
8.1
9.4
7.6
.6
.5
!978___ -- --- -- --- --------- -- -- --- --- ---- -- -- -- -- -- -- -- -- -- -- -
7. 7
8.1
9.3
6. 7
12.1
8.1
10. 4
8. 7
-3.1
1.7
2.3
2.3
6. 7
8.8
7.1
15. 7
6.4
7.1
12.2
8.2
9.6
9.1
6. 7
1 Output per hour or labor productivity, measures the volume of goods and services produced per hour. Compensation per
hour includes wages and salaries of employees plus employers' contributions for social insurance and private benefit plans.
Unit labor costs measure the labor compensation cost required to produce 1 unit of output and are derived by dividing compensation per hour by output per hour.
2 Calculated from a least squares trend calculated from the logarithms of the numbers.
• Preliminary.
Sources: Economic Indicators, January 1979 and U.S. Department of Labor, Bureau of Labor Statistics.
TABLE 111.-CHANGES IN PRICE INDEXES
Consumer Price Index'-----Commodities less food ___
Services _______________
Food __ ---------------Producer Price Index finished
goods'-----------------GNP implicit price deflater
price deflator•-----------
1975
1976
1977
1978
1977:IV
1978:1
1978:11
1978:111
7. 0
6. 2
8.1
6. 5
4. 8
5.1
7. 3
.6
6. 8
4.9
7. 9
8.0
9.0
7. 7
9.3
11.8
4. 5
4. 4
5. 6
3. 6
8. 0
6.1
7.4
12. 4
10.9
6. 5
11.3
20. 0
8.6
7.4
10. 8
7.0
8.4
9. 7
8.1
6.9
6. 6
3. 3
6. 6
9. 1
5. 9
9. 5
11. 2
6. 8
10. 9
9.6
5.2
5. 9
7. 4
5. 5
7. 2
11.0
6.9
8.1
1978:IV
1 December-to-December yearly increase or quarter-to-quarter increase at seasonally adjusted compound annual
rates.
2 Year-to-year increase or quarter-to-quarter increase at seasonally adjusted compound annual rates.
Source: Economic Indicators, January 1979.
TABLE IV.-SELECTED INTEREST RATES, 1975-79
1978
March
June
September
December
1979,
January
4. 99 5. 26 7.22
6. 32
6. 71
7.84
9.12
9.35
7.61 7. 42 8. 41
8.43 8.02 8. 73
8.04
8.47
8. 46
8. 76
8.42
8.69
9. 01
9.16
9.10
9.25
5. 35 5.60 7.99
6. 84 6.82 9.06
6. 80
8.00
7. 63
8. 63
8. 44
9.41
10. 43
11.55
10.32
11.75
8.99 9. 01 9. 54
5. 50 5. 52 7. 52
5.05 5. 54 7. 93
9. 26
6. 50
6. 79
9.16
7. 00
7. 60
9. 73
7. 75-8. 00
8.45
10.02
9. 50
10. 03
(')
9. 50
10.07
1975 1976 1977 1978
3-mo treasury bills (new issues)_ 5. 84
10-yr treasury securities (constant maturity) _____________ 7.99
Corporate Aaa bonds (Moodn>- 8. 83
Prime commercial paper,
mo ________________________ 6. 33
Prime rate charged by banks ___ 7. 86
New home mortgage yields,
FHLBB series _______________ 9. 01
Federal Reserve discount rate __ 6.25
Federal funds rate ____________ 5.82
1
Not available.
Sources: Board of Governors of the Federal Reserve System, Federal Home Loan Bank Board, and Moody's Investors
Service.
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15
TABLE V.-MONETARY AND CREDIT AGGREGATES
[Percentage change, seasonally adjusted annual rates)
1977 1 19781
19751
19761
4.6
8.8
Mi+- - ------ --·-·-·······
8.4
M,_ -····- ·- -· ···-···· ·-·
11.1
Ms- - ••••• ·-·······-·····
Deposits at nonbank thrift
institutions._ •..•..•••• _ 15. 6
Bank credit• ••...•..•••••
4.1
Reserves:
Required ••........•..• ·-- -5.9
Nonborrowed ...... -·····- -2.7
7.6
Monetary base.·---···-···-·--
5.8
12. 6
10. 9
12. 7
7.9
9. 3
9. 8
11. 7
7.3
5.3
8.5
9.4
15. 6
8.1
14. 5
11.2
10.6
11. 5
.1
.2
8.4
3. 8
1. 2
8.8
11.0
11.1
9.6
Monetary aggregates:
M1- - ---- ----------------
Ill'
IV•
Federal
Reserve
targets:
3d ~uarter
978 to
3d quarter
1979
9.5 8.4
7.4 6.2
8.6 10.3
8. 7 10.8
4.4
2.5
8.0
9. 7
2.o-6.0
4.0-6.5
6. 5-9.0
7. 5-10. 0
13. 8 10. 0 8.8 11. 5 12. 2
10.1 10. 6 15. 9 11. 3 8.3
NA
8. 5-11. 5
1978
1977:
IV•
12
7.5
6.8
8.1
10. 5
6.9
5.1
7.2
8.3
112
6.4 8. 7 6. 7
3. 5 15. 4 -.1
9.3 10. 4 8.2
9.0 20.0
6. 7 23.8
9. 7 10.1
NA
NA
NA
1 From 4th guarter of previous year to 4th quarter of year indicated.
• From previous quarter.
a Total loans and investments at commercial banks.
Sources: Board of Governors of the Federal Reserve System and Federal Reserve Bank of St. Louis.
TABLE VI.-FUNDS RAISED IN U.S. CREDIT MARKETS
[In billions of dollars; quarterly data are seasonally adjusted at annual rates)
Total funds raised, by instrument. •.•• ·-··•·•Investment company shares ____ ········-·····
Other corporate equities •••• --·-···-······ •• _
Debt instruments .............. ·-·-·····-···
U.S. Government securities--·-·····-·-·······
State and local obligations....................
Corporate and foreign bonds ..•••.•.•.•••.•. _.
Mortgages..................................
Consumer credit. ••.....•..••.•.....• ·-.....
Bank loans, n.e.c .•••........•.•...•...•....•
Open market paper and Rp's.................
Other loans..·-················--···········
1975
1976
1977
1977(1V)
1978(1)
1978(11)
1978(111)
220. 2
-.1
11. 2
209.1
98. 2
15. 6
36. 4
57. 2
9. 4
-13. 9
-2. 4
8. 7
301.3
399.4
438.2
12.4
289.8
88.1
19.0
37.2
87.1
23.6
6.4
13. 3
15. 3
4.8
395.6
84.3
29.2
36.1
134. 0
35.0
32.2
19.8
25.1
6.5
430.9
491.3
-.2
1.2
498.2
105.1
22.2
29.9
137. 3
38.0
67.3
50.8
39. 7
454.5
-.9
2.1
453.3
92.9
35.8
33. 7
137.9
51.6
33.5
36. 7
31.l
428.4
-1.8
1.0
428.3
97. 5
37.6
34.2
134.2
43.4
26.6
21.4
24.5
-1.0
-1.0
.9
91. 7
25.0
40.1
152.4
36.2
30.9
15.0
39.6
Source: Board of Governors of the Federal Reserve System.
IV. THE ECONOMIC OUTLOOK FOR 1979
A. The Economic Outlook of the Administration
The following information, taken from the 1979 Annual Report of
the Council of Economic Advisers which is included in the Economic
Report of the President, indicates the outlook for 1979 according to
the CEA.
In 1979 the economy will enter its fifth consecutive year of
economic growth, making this the second largest recovery in
postwar history. As a recovery matures, sustaming a satisfactory pace of expansion becomes more difficult. Housing, in
which starts have more than doubled since early 1975, is only
one example. Given current demographic trends, a high level
of starts is sustainable, but housing could not be expected to
add much to growth even under the most favorable circumstances in financial markets. The saving rate has fallen to very
low levels by historical standards, and the rise of consumption
may consequently drop behind the growth of disposable income. In addition, business fixed investment in real terms has
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Federal Reserve Bank of St. Louis
16
alrea<ly regained its prerecession ratio to gross national product (GNP), and hence a slower growth of business capital
expenditures is likely. All these factors will combine to check
the pace of economic expansion next year.
As Chapter 2 makes clear, a reduction in economic gTowth
from the rate of the last 2 years is needed both because idle
labor and capital resources have been cut considerably and
because inflation has accelerated. The task for aggregate
demand policies will be to provide a climate in which inflationary pressures can begin moderating, but to avoid restraint
so severe as to generate a recession.
Real growth 1s projected to average about 2¼ percent for
the 4 quarters of 1979, a lower growth rate than in 1978 but
positive throughout the year. If the anti-inflation program
succeeds, as is anticipated, the rate of growth of consumer
prices should slow to less than 7}~ percent over the 4 quarters
of 1979, and to an annual rate of slightly under 7 percent by
the end of the year. According to initial indications, business
and labor groups are taking the President's voluntary standards seriously, but success cannot yet be assured. ·widespread
compliance with the anti-inflation program is esscntrnl to
maintenance of a strong and healthy economy.
In 1980, real growth is expected to rise to a rate of 3¼ percent over the 4 quarters, largely as a result of an upturn
housing, while inflation will continue to slow, droppin~ below
6.% percent. Here also success in the fight against inflation will
contribute materially to sustaining economic growth by reducing the pressures on credit markets and strengthening confidence among consumers and businesses.
Employment is expected to rise by about 2 million a year
in both 1979 and 1980. Productivity is expected to grow at
about the same rate in 1979 as in 1978, with some improvement in 1980. It is likely to remain well below its trend rate
of increase of about 1% percent. With the labor force expected
to continue growing at a rate above the long-term trend and
real growth slowing, the unemployment rate is likely to increase to 6¼ percent by the end of 1979 and remain near that
level in 1980.
The course of fiscal policy that is appropriate for 1979 and
1980 was described generally in Chapter 2. In specific terms,
Federal outlays are projected to be $493 billion m fiscal 1979,
an increase of over 9 percent from the previous year. In fiscal
1980 the President's budget calls for outlays of $532 billion,
an increase of less than 8 percent. This 1980 figure includes a
small real increase in defense spending, a constant level of real
spending for domestic programs, and restraint in or deferrals
of new spending initiatives. Because existing legislation mandates contined real growth in some programs, such as health
care and social secunty, zero real growth in domestic spending
can be achieved only through reductions in real outlays for a
number of other programs. Holding outlays to $532 billion
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Federal Reserve Bank of St. Louis
17
will require strenuous efforts by government agencies as well
as cooperation from the Congress.
The combined effects of rising inflation and efforts by the
Federal Reserve to hold down the growth of the monetary
aggregates carried interest rates last year to near record
levels. More restrained growth of the monetary and credit
aggregates is an appropriate complement to the other parts
of the anti-inflation program. It will help to moderate the
rate of economic expansion. Additionally, higher U.S. interest rates make dollar-denominated assets more attractive
than those denominated in foreign currencies and thus contribute to sustaining the value of the dollar in exchange
markets.
Many private forecasters anticipate a recession in 1979,
partly because they expect that current high interest rates
will substantially depress housing and business investment.
High interest rates are likely to dampen aggregate demand
in 1979, but to a lesser degree than one would expect from
past experience because of institutional changes in financial
markets. Our judgment that economic growth in 1979 will be
sustained reasonably well and that a recession will be
avoided depends in part on our analysis of why the effect of
monetary restraint is different from what it used to be.
During most of the postwar period, intervals of substantial
monetary restraint were followed by recessions. Curbing aggregate demand through the use of monetary restraint disrupted financial markets because the depository institutions
experienced a large outflow of deposits when interest rates on
market instruments rose above the rates these institutions
were permitted to pay to attract consumer savings. This disintermediation sharply reduced the availability of credit for
those borrowers most dependent on commercial banks and
thrift institutions for credit. These included small businesses
and some units of State and local government, but the sector
most severely hit was the mortgage market. As mortgage
credit became not merely more expensive but unavailable,
residential construction dropped precipitously-, and this sharp
drop was often important in tipping the entire economy into
recession.
Table 19 shows periods of such cyclical declines in acquisitions of mortgages by financial institutions and the associated
declines in single-family and multifamily housing starts. In
the 1965-66 period the sharp decline in residential construction contributed to a slowing of overall economic growth, but
the expansion of Federal outlays was sufficiently strong to
maintain economic expansion. The 1959-60, 1969-70, and
1972-74 episodes were all followed by recessions. Of course,
factors other than the decline in housing were also involved
in each of these recessions, but the s:r,eed with which the
decline in housing occurred had a destabilizing effect for which
it was difficult to compensate elsewhere in the economy.
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18
TABLE 19.-CYCLICAL CONTRACTIONS IN MORTGAGE CREDIT AND HOUSING STARTS, 1959-74
[Percent change at seasonally adjusted annual rate, except as noted]
Period
Interest rate 1
195911 to 1960 II..___________________
1965
1966I.._____________________
IV-------------------1969 I111toto1970
1.27
I. 35
41
1.
1972 IV to 1974 IV____________________
3.36
Housing starts
Mortgage-------acquisitions 2 Single-family
Multifamily
-12.7
-28.9
-28.2
-24.8
-17.3
-28.5
-23. l
-22.9
-16.4
-36.1
-30.l
-53.2
1 Percentage point change in the quarterly average market yield on 6-month Treasury bills from the beginning of the period to the peak reached during the period.
2 Acquisitions by financial institutions.
Sources: Department of Commerce (Bureau of the Census), Board of Governors of the Federal Reserve
System, and Federal Home Loan Bank Board,
As discussed in Chapter 1, the principal reason for this
higher growth was the new regulation that permitted the
issuance of money market certificates beginning last June.
This change followed upon similar, but much smaller, steps
taken in 1970 and 1973. In those instances interest ceilings
were raised on longer-term certificates of deJ?osit, thus reducing somewhat the vulnerability of thrift mstitutions to
deposit outflows (Passbook and shorter-term certificate
ceilings were also raised slightly in 1970 and 1973.)
Institutional changes have also occurred in other financial
markets. Commercial banks no longer depend primarily on
liquidating U.S. Government securities to obtain funds for
business lending, as they had done through the early part of
the postwar period. The advent of liability management
(exemplified by the issuance of negotiable certificates of
deposit and the use of nondeposit sources of funds) has enabled most banks to obtain the funds they want for lending,
provided they are willing to pay going rates of interest.
Moreover, large firms can increasmgly shift their borrowing
between commercial banks and open market commercial
paper, and between foreign and domestic sources, in response
to differences in the cost and availability of funds. Their
direct access to credit markets makes them less dependent
on intermediation by institutional lenders. The expansion of
trade credit provides a mechanism through which large firms
extend this benefit to smaller customers and suppliers.
The result of these institutional changes has been to smooth
the response of the economy to increased restraint in financial
markets. In place of sharp changes in availability of credit,
there is now a more gradual response of credit users to
changes in the cost of credit. Measured application of monetary restraint has become more feasible. The degree of restraint required to achieve the desired growth in private demand is difficult to judge, however, because the response of
the private sector is likely to occur more slowly and to be
diffused more widely than in the past. Moreover, the indicators showin~ the degree of restraint have changed, and
experience in rmJ>lementing monetary policy under present
circumstances will come only gradually.
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Over the near future, nominal interest rates are likely to
remain relatively high by historical standards. It will take
time to reduce the rate of inflation and the inflation premiums
contained in interest rates. As inflation recedes, the maintenance of are strained monetary policy will consistent with a
decline in nominal interest rates.
The economy is entering 1979 "-ith substantial momentum,
and economic expansion will be bolstered by the recent enacted tax bill, which will help to sustain consumer expernlitures during the first half of the year. Later in the year, as
the effect of the tax cut wears off, a slower expansion of consumer purchases is foreseen. Partly as a response to current
high interest rates, housing starts are expectetl to decline and
the growth of business fixed investment to diminish during
the year (Table 21).
TABLE 21.-ECONOMIC OUTLOOK FOR 1979
lrem
Growth rates, fourth quarter to 4th quarter (percent):
Real gross national product_ ________________________________ _
Personal consumption expenditures ______________________ _
Nonresidential fixed investment_ ________________________ _
investment_--------------------------------Residential
_____________________________________ _
Federal purchases
State and local purchases ________________________________ _
GNP implicit price deflator ______________________________ _
hour'------------------------------------per
Compensation
2 __________________________________________ _
Output per hour
Level, 4th quarter:,
Unemployment rate (percent) __ -----------------------------Housing starts (millions of units') ____ ------------------------
1978
I
4. 3
3. 8
8. 3
-.8
-.3
3. 5
8. 3
9. 8
.5
5. 8
2.1
Foremost
range
1979
2 to
l¾to
2½
2¼
4to 4½
-8½to-9½
¾to
I¼
7¼ to
2¼
7½
8¼to
8¾
l¾to
¼to
¾
6 to
l½to
6½
I¾
1 Preliminary.
2 Private business sector; all persons.
, Seasonally adjusted.
• Annual rate.
Sources: Department of Commerce (Bureau of Economic Analysis), Department of Labor (Bureau of
Labor Statistics), and Council of Economic Advisers.
Growth is likely to be stronger in the first half of the year
than in the second half. Housing starts are expected to
bottom out during the fourth quarter of 1979 and begin to
move up in 1980 as pressures in money and credit markets
ease with the decline in the rate of inflation. The upturn in
housing is a principal reason for the anticipated increase in
the rate of economic growth in 1980.
The rate of increase of the GNP deflator is expected to decline from 8.3 percent in 1978 to slightly under 77~ percent
during the 4 quarters of 1979; a further drop to just under 6%
percent is probable during 1980, partly as a result of a tightening of the pay and price standards. Inflation is likely to
remain high during the first half of 1979, however, because
of the minimum wage increase in Janua.ry, the delayed effects
on import prices of the decline in the value of the dollar, the
oil price increases by the Organization of Petroleum Exporting Countries (OPEC), and the conti:nued rise in food prices.
As the year proceeds, these factors will put less upward pressure on prices, and the effects of the President's anti-inflation
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program should be increasingly felt. Consequently the increase in consumer prices is expected to fall to an annual rate
of belmr 7 percent by late in the year.
B. The Economic Outlook of the Federal Reserve
In its report to the Congress the Federal Reserve included the following summary of their qualitative interpretation of the Economic outlook for the next year. The Federal Reserve has not made public its
quantitative forecast for 1979.
Despite the surge in real GNP during the fourth quarter,
it appears that underlying economic and financial conditions
will lead to a moderation of economic growth in the year
ahead. The absence of the sorts of distortions and imbalances
that have often precipitated economic downturns in thefast
indicates that is should be possible to slow the pace o expansion-and thereby relieve inflationary pressures-without promoting a recession. However, any further acceleration
of inflation or the occurrence of severe shortages of critical
commollities, such as oil, would imperil this outcome.
The monetary restraint applied over the past year by
the Federal Reserve is expected increasingly to affect the
residential construction sector. Higher costs of credit will
cause land developers and builders to put aside marginally
profitable projects, and the combination of higher house
prices and mortgage rates will lead some families to defer
home purchase. Nonetheless, owing to the MM Cs and
various institutional developments that have broadened
the sources of mortgage funds, as well as to the strong underlying demand for shelter, the decline in housing activity
should be moderate by comparison with past cycles.
Business fixed investment likely will continue to grow
during 1979, but at a slower rate than in 1978. There has
been some indication in the past few months of a slowing
in the steep upward trend of contracts and orders for plant
and equipment, and this is generally consistent with surveys
of capital spending plans which point to smaller gains in
outlays this year than last. On the other hand, the climate
for investment can be expected to improve as business
managers begin to perceive some progress in retarding inflation and become more confident about the sustainability
of expansion.
Government spending probably will post only a small
increase in real terms this year. Indeed, real Federal purchases could decline during the first half due partly to expected repayments of Commodity Credit Corporation loans
(which are, in effect, sales of agricultural stocks). At the
State and local level, slower growth of Federal financial aid
and the pressure for tax relief will tend to hold spending
increases to small proportions.
Foreign demand for U.S. exports should tend to strengthen
during 1979. Economic expansion abroad is generally expected to continue at its recent more rapid pace, and the
ffects of the substantial depreciation of the dollar on the
0
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U.S. trade position should become more evident as the year
progresses.
On balance, the aforementioned sectors are likely to provide a reduced impetus to income growth during the year
ahead. As a consequence, consumer spending is likely to grow
less vigorously, Moreover, the substantial debt repayment
burdens faced by many households and generally reduced
liquidity of the household sector could prompt households to
increase their recent relatively, low savings rate. The demand
for imports also should moderate this year, not only because
of the slower expansion of domestic income and production,
but also because of the lagged effects of the 1977-78 decline
in the international exchange value of the dollar. Inventory
investment is likely to be relatively flat in the projected economic environment.
·with a slower growth of activity, pressures on productive
capacity should ease a bit. Industrial capacity utilization
rates, which in the manufacturing sector are not now far
below past cyclical peaks, should decline slightly. In labor
markets, the gi:owth of employment should moderate from
its recent rapid pace. Labor force increases likely also will
diminish, as the growth of the working age population slows
slightly and as labor force participation rates-expecially for
youth-respond to the slackening in economic expansion.
Together, the prospective changes in employment and the
labor force point to a small increase in the over-all unemployment rate during 1979.
The moderation of demand pressures in labor and product
markets will tend to slow the advance of wages and prices and
thus to reduce the present, unacceptable rate of inflation.
However, uncertainties will remain as a result of highly
volatile and largely exogenous influences such as farm prices
and oil prices. It now appears that food prices will increase
somewhat less this year than last. Unfortunately, the price of
imported oil will be boosted substantially this year as a result
of the decisions taken by OPEC in December, and the unse~tle~l situation in Iran raises the possibility of even larger
price mcreases.
Setting aside these special factors, a key determinant of
the rate of inflation this year will be the performance of
unit labor costs. Although there may well be some improvement in _productivity in the next few years as the work
force tends to become, on average, somewhat older and more
experienced, there is little reason to mqiect any marked
acceleration of productivity growth durmg 1979. Consequently, if there is to be a noticeable slowing in the rise of
unit labor costs, compensation gains will have to moderate
significantly.
Toward this end, the Administration's wage-price program can play an important role. By providing a standard
for constructive behavior on the parts of both business and
labor, the program can be a vehicle for helping to brake the
wage-price spiral. Broad compliance with the Administration's standards would make a significant contribution to the
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slowing of inflation. Of course, the wage-price program can
be successful only if there is complementary restraint in
monetary and fiscal policy-to contain aggregate demand
pressures and to assure the public of the Government's commitment to the restoration of price stability.
C. Economic Outlook of Congressional Budget Office
The following material is taken from the Congressional Budget Office
report to the House and Senate Budget Committees made in January
1979.
The OBO current policy forecast
Forecasts of economic activity ancl inflation depend critically on
assumptions about fiscal ancl monetary policy. The CBO economic
projection is based upon the following policy assumptions:
Federal tax ancl spending policies in fiscal year 1979 are as
given in the budget resolution enacted last fall; the same policies
are also assumed to continue in fiscal year 1980. Current policy
outlays are estimated to total about $494 billion in fiscal year
1979 and $551 billion in fiscal year 1980.
Neither the real wage insurance proposed by the Administration
as part of its "·age/price guidelines program nor any tax changes,
other than those already enacted, are included in the forecast.
Expenditure cuts proposed by the Administration are also not
included. 1
Monetary authorities are assumed to continue in the recently
announced program to reduce inflation and prevent further depreciation of the dollar. This policy is assumed to prevent the
growth in the broadly defined money stock (M 2 ) from exceeding
Federal Reserve targets and to result in a further rise in shortterm interest rates through the second quarter of 1979.
Given those assumptions, the CBO forecast, shown in Summary
Table 1 is as follows:
Growth in constant dollar gross national product (GNP) will
slow from over 4 percent last year to a O to 2 percent range from
the fourth quarter of 1978 to the fourth quarter of 1979. During
1980, real economic growth will recover moderately, rising to a
3 to 5 percent range.
Unemployment is expected to rise from current levels to a range
of 6.2 to 7.2 percent by the last quarter of 1979, with little change
in 1980.
Prices are expected to rise by 7.0 to 9.0 percent during 1979,
moderating somewhat, to 6.5 to 8.5 percent, in 1980.
SUMMARY TABLE !.-SUMMARY OF CBO ECONOMIC PROJECTIONS UNDER CURRENT POLICY,
CA LEN DAR YEARS 1979 AND 1980
Economic variable
GNP (cunent dollars, percent change) ____________ _
GNP (1972 dollars, percent change) ______________ _
Consumer Price Index (percent change) ___________ _
Unemployment ratt, end of period (percent) _______ _
1976:4
to 1977:4
(actual)
1977:4:
to 1978:4
(actual)
11. 9
5. 5
6. 6
6. 6
12. 9
7.0-11.1
9. 7-13. 9
4.3
8.9
0 - 2.0
3.0- 5.0
6.5- 8.5
6.2- 7.2
5.8
1978:4
to 1979:4
7.0- 9.0
6. 2- 7. 2
1979:4
to 1980:4
1 A CBO forecast based upon the Administration's fiscal assumptions will af pear in the
CBO document, "An Analysis of the President's Budgetary Proposals for Fisca Year 1980"
(January 1979).
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The economy is not projected to weaken immediately. Available
data on real activity do not yet show the widespread imbalances
that typically precede a downturn. But CBO does foresee a modest
decline in real GNP beginning in the second half of 1979. 2
Sources of uncertainty
The Major Uncertainty.-The outlook for the economy in 1979 is
unusually uncertain. The critical factors in this uncertainty are the
future course of inflation and the response of monetary policy. Restrictive monetary policies already in place have increased the probability of a downturn in economic activity in the year ahead, and
most forecasters, including CBO, expect credit conditions to tighten
further in response to continuetl rapid inflation. But that outcome is
by no means assure<l. Forecasts of inflation are subject to substantial
error, and the Federal Reserve's policy response to inflation and other
developments in the coming months is also uncertain. If inflation slows
significantly in the months ahead, the Federal Reserve may be able
to avoid a prolonged period of credit restraint, which would considerably improve the prospects of avoiding a recession this year.
Other Sources of Uncertainty.-Other events that could significantly
affect the outlook include: the possibility of major strikes, in response
to business firms' efforts to comply with the Administration's wage/
price guidelines; prolongation of the current "buy-in-advance"
psychology, born of a general expectation of rising prices; fuel shortages, arising from the political disturbances in Iran or other causes;
a sharp shift in the value of the dollar in foreign exchange markets,
despite stabilization efforts; and exceptionally large or small harvests,
causing large unexpected movements in food prices.
Reasons for a downturn in 1979
Although the economy does not yet shmY significant signs of weakening, continued high rates of inflation appear to be sowing the seeds
of a downturn. The momentum of inflation is very strong and CBO
expects that the Administration's wage/price guitleline program will
not quickly slow that momentum. Thus, the Fe(leral Reserve, which
has responded to accelerating prices by tightening credit, is expected
to continue to pursue a tight moneta1·y policy. The prospect of continued high and rising interest rn.tes for many months makes a subsequent downturn in economic activity t.he most likely outcome.
Tight credit conditions are expected to slow housing activity and
business investment. But the predicted decline in housing starts
has been delayed longer than in earlier periods of high interest rates.
The availability of funds for mortgage lending has not been reduced
to the usual extent because deposit flows have been boosted by the
six-month money market savings certificate introduced by savings
institutions last spring. Virtually all analysts, however, expect a
decline in housing activity during 1979, both because of declining
demand and reduced availability of mort~rnges. Recent surveys of
business investment plans also indicate a slowdown in 1979. More_
• The CBO forecast satisfies the popular definition of a recession-two consecutive quarters of decline in real GNP-but it may not conform to the National Bureau of Economic
Research definition of recession, which takes many other factors into account.
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over, retail sales appear vulnerable. Indications of slower future
growth in consumer spending include:
High rates of inflation, which have eroded real income growth
and contributed to a buy-in-advance psychology that may have
improved recent sales at the expense of sales later in the year;
A decline in consumer confidence; and
Historically high consumer debt burdens.
Reasons for a mild downturn and recovery
Although some forecasters now expect a deep recession beginning
late this year, CBO concludes that the projected late 1979 downturn
will be neither deep nor prolonged because:
Businesses appear to have maintained relatively lean inventories; hence, any inventory adjustment should be mild;
Net exports are projected to be a source of considerable
strength, as a result of an expected improvement in the economic
growth of U.S. trading partners and because of the depreciation
of the dollar last year;
The cut in income taxes early in 1979 is expected to provide
stimulus to business and consumer spending throughout the year;
Large backlogs in orders in capital goods industries will provide support to total spending during the slowdown; and
The state and local sector is expected to continue to work
down operating surpluses.
CBO predicts a less robust recovery in 1980 than the typical postwar upswing because the downturn is expected to be mild and inflation is forecast to remain high. As a result, monetary policy is not
projected to respond as much as usual to the elevated unemployment
rates. Furthermore, federal fiscal policy (,vith current policy) "~ill
exert a drag on economic activity in 1980, as the interaction of inflation and the progressive tax structure causes effective personal
income tax rates to rise.
V. THE SHORT-TERM ECONOMIC GOALS FOR 1979 AND 1980 IN THE PRESIDENT'S ECONO:\IIC REPORT:
The Full Employment and Balanced Growth Act of 1978 required
that the President set forth in his Economic Report short-term goals
which are consistent with achieving the unemployment goals (4 percent overall and 3 percent adult) and the inflation goal (:3 percent) by
1983. The short-term goals cover the year in which the report is transmitted and the follo,Ying year, and the Federal Reserve is expected to
indicate the relationship between its own policy objectives and plans
and those goals set forth by the President.
The Economic Report indicates that the short-term goals for 1979
and 1980 represent "a forecast" of how the economy will respond over
the next two years not only to the budgetary policies proposed by the
President for fiscal policy in 1979 and 1980 but to the anti-inflation
program announced on October 24. The Full Employment and Balanced Growth Act declares that improved and coordinated fiscal and
monetary management is needed to reduce the rate of inflation. Thus,
implicitly the economic goals set forth in the Economic Report must.
also assume that monetary policy will be conducted in a manner consistent with achieving the short-term goals. For that reason, the Act
requires that the Federal Reserve explain the relationship bet,Yeen its
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25
intended policies and the economic goals. The Congress hits in the
legislative history of the Act indicated that:
In explaining the relationship of the Board's objectives and
plans to the short-term goals established by the Presi(lent in
his Economic Report and any subsequent goals established
by the Congress with a full discussion concerning the extent
to which the Federal Reserve's intended policies woul<l help
to achieve those goals.
This language was agreed to by the Federal Reserve Board.
The Administration's goals, along with the comparable figures for
1978, are summarized in the following table:
THE PRESIDENT'S ECONOMIC GOALS
Goals
Actual-----1979
1978
Item
Level, 4th quarter:
Employment (millions)________________________________________ _
Unemployment rate (percent)__________________________________ _
Percentage change, 4th quarter to 4th quarter:
prices___ _____ -- ---------- ---- -- -- -- -- ---- -- ------ -Real disposable income. _______ ·- ______________ -· __ ·--· __ ·-·--Productivity. ___ ·- __ ·- ______________________________ -· ·- ·- ·- __
~~~r~m,r
1980
95. 6
5.8
97. 5
6.2
99.5
6.2
8.9
4.3
3. 3
7. 5
2.2
2. 9
.4
6.4
3.2
2.3
1.1
.2
VI. THE FEDERAL RESERVE'S OBJECTIVES AND PLANS FOR MONETARY
POLICY AND THEIR RELATIONSHIP TO THE PRESIDEXT'S ECONO1IIC
GOALS FOR 1979 AND 1980
The Federal Reserve has informed the Congress that the objective
of monetary policy 1979 is "to foster financial conditions conducive
to a continued, but more moderate, economic expansion during 1979
that should permit a gradual winding down of inflation and the
maintenance of the stronger position of the dollar in international
exchange markets."
The Federal Reserve's monetary policy plans are summarized by
ranges of growth in monetary and credit aggregates that have been
established as targets for calendar year 1979. Those target ranges
are summarized in the following table which shows target ranges
and actual growth during similar previous periods:
FEDERAL RESERVE SYSTEM TARGET ltANGES AND ACTUAL GROWTH RATES
M,
M1
Period
1975 :Q4 to 1976 :Q4 ... ··-··1976:Q4 to 1977:Q4 ...•. -•..
1977 :Q4 to 1978:Q4 .•• ··-·-·
1978:Q4 to 1979:Q4 ..• ·---·-
Bank credit
Ma
Targtt
Actual
Target
Actual
Target
4. 5-7. 5
4. 5-6. 5
4. 0--6. 5
1. 5-4. 5
5. 8
7. 9
7. 3
NA
7. 5-10. 5
7. 0-10. 0
6. 5-9. 0
5. 0-8. 0
10.9
9.8
8. 5
NA
9. 0-12. 0
8. 5-11. 5
7. 5-10. 0
6. 0--9. 0
Actual
Target
12. 7 1 6. 0-9. 0
11. 7 7.0-10.0
9.4 7. 0--10. 0
NA 7. 5-10. 5
Actual
8.0
11. 3
11.4
NA
I
1 The credit aggregate used as a target for monetary policy was the bank credit proxy. After November 1976 the aggregate
used was total bank credit.
NA-Not applicable.
Definitions:
M1: Private demand deposits plus currency in circulation.
M,: M1 plus time and savings deposits at commercial banks other than large negotiable CD's at weekly reporting
banks.
M, : M , plus deposits at mutual savings banks, savings and loan associations, and credit unions.
Bank credit: Total loan and investments at commercial banks.
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The Fed's growth rate range for M, calls for a marked deceleration
from the pace of recent years. This reflects the expectation that there
will be significant shifting of funds to savings accounts with automatic
transfer (ATS) features and to NOW accounts recently authorized for
depository institutions in New York State. The Board's staff has
projected that such shifting of funds from demand deposits will
dampen M, growth by about 3 percentage points. This estimate is
based on data reported on ATS and NOW's over the November 1978
to January 1979 period and an analysis of the experience in the New
England States when NOW accounts were first authorized. The
Board's report to the Congress indicates that this projection carries
a broad range of uncertainty.
The Board's report also indicates that the FOMC is not fully satisfied that the recent flatness in M, relative to historical experience
among money, income, and interest rates is transitory or one that is
likely to persist. That considerable uncertainties currently exist is
indicated by the wider growth range-3 percentage points versus 2for M 1 • The Board admitted that M, may continue to be a "somewhat ambiguous" indicator of monetary policy.
The Federal Reserve indicated that there are also questions regarding the behavior of the interest bearing components of M2 •
It is expected that M2 growth will be somewhat stronger in the
months ahead, buttressed by "further sizable increases in the large
denomination time deposits included in the total and abatement of
the. recent unusually large withdrawals of funds from savings deposits."
The range for M 3 implies a continued substantial grmvth of deposits at non-bank thrift institutions, partially due to the issuance
of six-month money market certificates.
The projected range for bank credit expansion reflects an expectation that loan demand will be less intense in 1979 than in 1978.
In explaining the relationship between the Federal Reserve's
monetary policy plans and the short-term goals set forth by the President, the Board indicated that "the monetary growth ranges and the
Administration's 1979 economic goals appear reasonably consistent".
There wa.s no Federal Reserve comment in the relationship between
intended monetary policy and the economic goals for 1980. Rather,
the Board's report indicated that "considerably greater uncertainties
naturally are encountered with respect to the Administration's goals
·
for 1980 * * *".
'\Vith regard to the output-price mix, the Federal Reserve has indicated that the Administration's economic goals for 1979 implies
an expansion of nominal GNP of 9% percent from the fourth quarter
1978 to the fouth quarter 1979. In testimony before the House Banking Committee Chairman Miller indicated that his own view of the
output price mix may be a little less optimistic than that of the Administration with real GNP growing at 1.75 to 2.25 percent as compared with the Administration's 2.2 percent target and inflation of
7.5 to 8.25 percent versus the 7.5 percent target. No similar breakdown was given by Chairman Miller for 1980. However, the Administration's targets for 1980 are for 9% nominal GNP again with real
GNP growth of 3.2 percent and inflation about 6.4 percent.
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The midpoint of the Fed's target range for M 1 is adjusted for the
expected impact of shifts of funds from demand deposits to ATS and
NOW accounts. This growth in M 1 would be consistent with nominal
GNP growth of 9¾ percent :provided an increase in M 1 velocity on
the order of 3}~ percent. This 1s somewhat above M 1 velocity's longerterm trend, but the Fed believes this would be reasonable "in light
of the lagged effects of the recent substantial increases in interest
rates and the downward shift in money demand that has been occurring." The upper limit of M 1 growth of 7}~ percent after adjustment would allow for less velocity growth, while the lower bound of
4% percent would foster velocity growth.
With regard to the employment and productivity goals the Federal
Reserve has indicated that the Administration's forecasts for 1979
"appear consistent with the output goal." No further analysis was
given. The goal for unemployment-6.2 percent for the fourth quarter
1979-"seems" according to the Federal Reserve "consistent with
reasonable assumptions about labor force growth in the projected
economic environment." No further explanation was given. The 1980
unemployment goal of 6}~ percent by the fourth quarter would, however, "require considerable progress in the lowering of inflationary
expectations," again without further explanation.
The Federal Reserve's report also indicates that the Administration's 1980 forecast can serve as an appropriate goal for Congressional
budgetary planning for fiscal year 1980. They continued that if inflationary pressures subsequently should prove stronger than the 6.4
percent projected by the Administration, the prudent course would be
to exercise a substantial degree of restraint "even if it risks less real
growth in 1980 than the 3.2 percent goal."
VII. ANALYSIS OF THE FEDERAL RESERVE'S MONETARY POLICY
OBJECTIVES AND PLANS
Inflation is by any measure the Nation's most pressing economic
problem. The solution to the inflationary :(>roblem must come from
many fronts, including but not necessarily limited to more moderate
fiscal and monetary policies, moderation in the rates of increase of
prices and wages, a review and perhaps a reduction in inflationary
governmental regulations, increases in productivity, and lowering of
inflationary expectations. This process should not be expected to be
successful instantly; it will probably take several years. The Federal
Reserve's announced objective of fostering financial conditions conducive to continued but more moderate economic expansion during
1979 in order to permit a gradual unwinding of inflation is both
appropriate and necessary. However, care must be taken by the
Federal Reserve in its approach to its objective so as to moderate
economic expansion rather than to stop it completely.
At this time it is very difficult to judge the economic outlook for
1979. As the following table indicates the Administration and the
Federal Reserve are more optimistic with regard to both inflation
and economic growth than is the Congressional Budget Office which
expects a recession to develop later in the year and little improvement
on inflation. The Committee also heard testimony from outside witnesses that a recession later this year was probable.
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SUMMARY OF ECONOMIC OU1LOOK FOR 1979
Actual
1978
Nominal GNP _________________________
Real GNP(CPI)
___ ------------------------Inflation
________________________
Unemployment rat€, 4th quarter 1979 ____
12. 9
4. 3
8. 9
5. 8
1979
Administra\ration's
economic
outlook
for 1979
CBO
outlook
for 1979
9. 9
2.2
7. 5
6. 2
9. 25-10
2. 0-2. 5
7.25-7.5
6. 0-6. 5
7. 0-11. 1
0-2.0
7. 0-9. 0
6. 2-7. 2
Administ1ation's
goals for
Fede1al
Reserve
Chairman
Miller,
1979
9. 75
1. 75-2. 25
7. 5-8. 25
6. 2
The Federal Reserve's monetary policy plans are expressed in
terms of growth rate ranges for M 1 , M 2 , Ma and bank credit. Recent
financial innovations has made the interpretation of the growth
of these aggregates vis-a-vis intended monetary policy extremely
difficult. In particular growth of M, is distorted by automatic transfer
savings accounts authorized last November and transfers to NOW
accounts authorized for New York state institutions last fall, and by
the inducement high short-term interest rates has given to usage of
cash management techniques including repurchase agreements, overnight Euro-dollars, and liquid asset mutual funds. The growth of M 2
and Ma may also be distorted by these factors and by the 6-month
money market certificates introduced last June. These certificates
have now attracted over $100 billion. Thus, at least during this
transition period growth of the monetary aggregate may not give a
true indication of the Federal Reserve's monetary policy stance. A
broaller and better set of monetary policy indicators is needed. At
the Committee's hearings other indicators of policy were mentioned.
They included interest rates, the monetary base, and non-borrowed
bank reserves which is a component of the monetary base. It would
also be desirable to have an indicator or indicators of credit availability in the various financial sectors.
The intent of the new reporting requirements established by the
Humphrey-Ha"·kins Act is to gain a better understanding of just
how the Federal Reserve's monetary policy plans relate to the economic goals for the economy. The Federal Reserve has and should
place special emphasis on a reduction of inflationary pressures within
the economy. At the same time, it should explain how its policies
"·oulcl encoumge a reduction of inflation. For example, monetary
policy could be effective in a demand-pull situation if restrictive
policies worked to limit demand for credit to finance purchases of
goods and services. In a cost-push inflation with unutilized capacity
ancl unemployment, monetary policy might not be as effective in
reducing inflation. The Fed's monetary policy report would be improved if it explained the manner in which monetary policy is designed
to work toward the achievement of the specific economic goals in
more detailed and precise terms.
The actual economic performance this year and the next year will
depend on the mix of fiscal and monetary policies. Both must be more
moderate now and in the future than they have been in recent years.
Importantly, however, Chairman Miller told the Committee that in
his view it would be appropriate for monetary policy to become somewhat less restrictive should the economy enter into a recession provided
that fiscal policy maintained its current posture. This change in the
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Federal Reserve Bank of St. Louis
29
mix of fiscal and monetary policies has been advocated by the Committee in previous reports. Not only would a more restrictive and
stable fiscal policy and somewhat less restrictive monetary policy
provide for conditions conducive to the moderation of inflation, but
it would also permit the gradual reduction in interest rates. This, in
turn, could have saluatory effects on private investment and capital
formation, which would lead to increases in productivity. Increases in
productivity would help reduce both inflation and both unemployment.
The housing market has been partially protected from high and
rising interest rates during the last year by the introduction of sixmonth money market certificates available since last June. Housing
starts in January declined to 1.6 million units, about 20 percent lower
than the average of 1978. In February, total starts declined further to
1.4 million units. However, it is unclear whether these declines indicate
a significant change. They may in large part be related to seasonal and
adverse weather conditions in various parts of the country rather than
a sharp fundamental slowing of the housing sectors.
VIII. VIEWS AND RECOMMENDATIONS
Pursuant to the Full Employment and Balance Gro\\rth Act of 1978
(Public Law 95-523) the Committee on Banking, Housing and Urban
Affairs reports the following views and recommendations with respect
to the Federal Reserve's intended monetary policies for 1979.
1. The Committee believes that the slowing of inflation is our number one economic priority and that it is of fundamental importance to
the long-run economic and social well-being of the Nation. The Committee further believes that the economy is approaching the point
where excess demand pressures are beginning to increase our present inflation. Accordingly, the Committee believes that the Federal
Reserve should restrict the availability of money and credit in order
to moderate the rate of economic expansion and that this restrictive
policy should be continued until significant progress has been made in
reducing inflation.
2. Growth of the monetary and credit aggregates has become difficult
to interpret because of recent regulatory changes and financial innovations. M 1 growth has been and wi.ll continue to be difficult to predict
because of ATS, NOW accounts, and security repurchase agreements.
Gro"rth of M 2 and M 3 will depend in large part on developments
relating to six-month money market certificates. The Committee
believes that there is significant uncertainty with regard to the
meaning of recent and prospective growth of the monetary aggregates.
The monetary and credit aggregate growth rate ranges set fort~ by
the Federal O_pen Market Com1mttee have been lowered from previous
levels, which 1s appropriate; however, those ranges are far too wide to
be meaningful indicators of Federal Reserve policy. The Committee believes that the Federal Reserve should move forward quickly with its
review of the appropriate definitions for the monetary aggregates.
The Committee also believes that the Federal Reserve should consider using alternative indicators of monetary policy. Non-borrowed
reserves and the monetary base have been recommended to the Committee as possible alternatives and/or complimentary indicators of
monetary policy. Interest rates and the availability of credit in various
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Federal Reserve Bank of St. Louis
30
sectors of the financial markets are additional indicators of monetary
policy that sh~uld_be monitored closely. Since_ the eco~omy is pressing
close to capamty m many sectors the Committee believes the Board
should pay particular attention to credit availability as an indicator
of monetary policy.
3. The Committee believes that the Federal Reserve should not be
forced to carry a disporportionate share of the burden in fighting
inflation. Most importantly, the Administration and the Congress
must practice a greater degree of fiscal restraint if inflation is to be
dampened and the inflationary psychology is to be broken. Difficult as
it may be, increases in federal spending must be restrained and priorities
for spending established. The Federal Reserve's task of gradually
reducing the growth of money and credit will be made easier and more
achievable if the Federal deficit is eliminated over time and federal
credit demands are moderated. Accordingly, the Committee believes
that Federal spending should be reduced below the amounts proposed
by the President for fiscal year 1980 and beyond.
A tighter fiscal policy would permit a somewhat less restrictivemonetary policy which in turn would help hold down interest rates,
thereby stimulating more private sector mvestment. Capital investment in the private sector will help to increase productivity and to
decrease both unemployment and inflation. The pursuit of a moderate
rate of growth in money and credit would be conducive to achieving
this goal.
4. The Committee believes that coordinated fiscal and monetary
policies tq reduce inflation at the macro-economic level must be complimented by structural programs to reduce inflation and unemployment. With respect to inflation those programs should include elimination of federal government regulations that are inflationary and not
necessary; encouragement of capital formation and increased productivity, improvement in our trade balance and the maintenance of
a strong and stable clollar, and moderation in wage and price increases.
Special· programs are also needed to deal with structural unemployment and to increase youth and minority employment. The approaches
to deal with unemployment that were laid out in the Full Employment
and Balanced Growth Act of 1978 are a necessary part of our economic
strategy.
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Federal Reserve Bank of St. Louis
ADDITIONAL VIEWS OF SENATORS SARBANES AND
WILLIAMS
We share the views expressed in this Report on the necessity of
slowing the rate of inflation, for the success of such an effort is fundamental to the long-run economic and social well-being of the Nation.
We support the announced objective of the Federal Reserve Board
to foster financial conditions conducive to a continued but more moderate economic expansion during 19-79 in order to bring about a reduction in the current rate of inflation. We would reject any interpretation
of the announced Federal Reserve Board monetary and credit policies
that would countenance throwing the economy downward into a recession in the name of fighting mflation, and would oppose such a
policy.
Recent experience has amply demonstrated that economic decline
does not solve the problem of inflation. Because recession entails serious
costs-in lost production, in declining tax revenues, and in increased
public outlays to compensate for the rise in unemployment-it does
not serve to stabilize the economy but it is rather a further destabilizing
element. Moreover, the economic consequences of recession, translated
into individual, family and community terms, place a serious strain
on the social fabric of the Nation.
It is therefore important that the Federal Reserve Board pursue
an appropriate balance in its monetary and credit policies that will
facilitate the national effort to control inflation, while taking care to
ensure that a recession is not added to our list of economic problems.
We concur in the Committee's view on the need for exercising appropriate restraint in federal budget decisions. However, in putting forth
a budget level below that proposed by the President, the Committee
is premature since the well-developed Congressional budget process,
which includes both the Budget and Appropriations Committees, is
just beginning. In the end it is likely that the Congress will approve
a budget figure lower than the President's as it has in every year since
the Congressional budget system went into effect. The budget is a
complex matter, and our concern should be to arrive at budget decisions that, will contribute most effectively to strengthening the Nation's economy. The Budget and Appropriations Committees play
critical roles in enabling us to reach such decisions. In the five years
of its existence, the Congressional budget process has significantly improved not only our budget-making procedures but our understanding
of the ramifications of budget decisions. It seems advisable therefore
for an overall position on the budget to await a review of the materials
and recommendations which the Budget Committee will soon report
to the Senate, and for more specific positions on particular budget
areas to have the benefit of the Appropriations Committee's review.
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Federal Reserve Bank of St. Louis
s.
PAUL
SARBANES.
HARRISON A. WILLIA~s Jr.
0
(31)
@FedFRASER