Full text of Policy Statement and Position Papers : March 12-13, 1978

View original document

The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.

SHADOW OPEN MARKET COMMITTEE
Policy Statement and Position Papers

March 12-13,1978

SOMC Members - March 12,1978

2. Shadow Open Market Committee Policy Statement, March 13,1978
3.

Position Papers

Where Do We Go From Here? - Allan H. Meltzer, Carnegie-Mellon University
Potential Output Growth -Jerry L Jordan, Pittsburgh National Bank
Projections for the Economy-Jerry L.Jordan, Pittsburgh National Bank
Table Revisions-Jerry L Jordan, Pittsburgh National Bank
Statement before the Committee on Banking, Finance, and Urban Affairs-Jerry L Jordan,
Pittsburgh National Bank
Economic Prospects Through 1979 - Robert J. Genetski, Harris Bank
Business Outlook - Monthly Update - Robert J. Jenetski, Harris Bank
Fiscal Policy- Rudolph G. Penner, American Enterprise Institute

SHADOW OPEN MARKET COMMITTEE
The Committee met from 3:00 p.m. to 10:00 p.m. on Sunday, March 12, 1978.
Members:
Professor Karl Brunner, Director of the Center for Research in Government Policy
and Business, Graduate School of Management, University of Rochester,
Rochester, New York.
Professor Allan H. Meltzer, Graduate School of Industrial Administration,
Carnegie-Mellon University, Pittsburgh, Pennsylvania.
Mr. H. Erich Heinemann, Vice President, Morgan Stanley & Company, Inc. New York,
New York.
Dr. Homer Jones, Retired Senior Vice President and Director of Research, Federal
Reserve Bank of St. Louis, St. Louis, Missouri.
Dr. Jerry Jordan, Senior Vice President and Chief Economist, Pittsburgh National
Bank, Pittsburgh, Pennsylvania.
Dr. Rudolph Penner, American Enterprise Institute, Washington, D.C.
Professor Robert Rasche, Department of Economics, Michigan State University,
East Lansing, Michigan.
Professor Wilson Schmidt, Department of Economics, Virginia Polytechnic
Institute, Blacksburg, Virginia.
Dr. Beryl Sprinkei, Senior Vice President and Economist, Harris Trust and Savings
Bank, Chicago, Illinois
Dr. Anna Schwartz, National Bureau of Economic Research, New York, New York.

POLICY STATEMENT
SHADOW OPEN MARKET COMMITTEE
March 13, 1978
A declining dollar, a falling stock market, and rising long-term interest
rates describe the reaction by financial markets, at home and abroad, to our
government's actions. Currently the nation does not have an economic policy
to reduce inflation, balance the budget, and encourage investment growth and high
employment.
The stock market, the bond market, and the foreign exchange market shout
their disbelief at our government's statements about increasing investment,
reducing inflation, balancing the budget, or supporting the dollar. They fear
a drift to controls, a reliance on stopgaps, and increased inflation.
The Shadow Open Market Committee repeatedly has urged the Federal Reserve
and the Administration to recognize that the nation's problems are long-term
problems that cannot be solved by fine-tuning and by stopgap approaches. A
policy that looks ahead years, not weeks or quarters, is what is required. Last
year this Committee warned that the policies then proposed and subsequently
adopted would have the inflationary consequences now apparent to all. This year
we urge again that a long-term program be adopted and adhered to.
The problems the nation faces are not intractable. They seem intractable
only because the government continues to seek short-term solutions to long-term
problems and acts on the false presumption that inflation will not increase as
long as resources are counted as unemployed. Such presumptions lead the
Administration to solve eyery problem by pumping up short-term spending and to
understate the rule of incentives to output and capital formation -- not only
tax incentives, but also reduction of business uncertainty caused by accelerating
inflation.
Promises to defend the dollar, increase investment, balance the budget, and
lower inflation cannot be met if the primary aim of policy is to stimulate shortterm spending. Current policy will produce higher inflation, but not the high
level of investment the Administration seeks to restore growth of income to the
long-term potential of the U.S. economy.

-2-

What Has Been Done?
Last year the Carter Administration gave up the commitment to balance the
budget by 1981. The Federal Reserve failed to carry out its announced policy
of reducing the growth of money. The budget deficit remained high in 1977 and
continues high in 1978.
The growth of money stock -- currency and demand deposits -- exceeded 7%,
a rate last seen in 1972 and 1973, just before the major inflation began. There
is cause for alarm in the continuation of so high a growth rate. No less alarming would be an abrupt reduction of this growth rate. The policy of reducing
unemployment first and reducing inflation later has created the expected dilemma.
We cannot expect real investment to reach the growth rates of the 1960's if
large budget deficits, highly variable monetary policies, growing restrictions
on trade, and misguided policies on energy continue. We cannot expect a more
stable exchange rate for the dollar until policies become stabilizing. We cannot expect inflation to slow following a period of sustained increase in money
growth from 4.4% in 1975, to 5.6% in 1976, and to 7.4% in 1977. We cannot expect
to avoid recession in 1979 if monetary policy shifts suddenly to combating inflation.
Because of the excessive monetary growth that was permitted in 1977, anticipations of future inflation are heightened, and interest rates are rising. To
minimize the adverse effects on savings flows to thrift institutions, Federal
ceilings on interest rates on consumer deposits should be abolished or raised.
These price controls have never served a useful purpose and have done far too
much damage. We commend Chairman Miller's recent initiative in this regard.
Last year this Committee warned the Federal Reserve that monetary growth in
excess of the announced targets would be detrimental to the durability of this
economic expansion. The members of the House Banking Committee cautioned the
Federal Reserve to maintain monetary growth within its own announced target
ranges. The Federal Reserve did not heed the advice that was given. A mistake
in economic policy was made, and now a price must be paid to correct it.

-3What Should Be Done?
The policy of gradualism brought the increase in consumer prices down
from the very high rates of 1973 and 1974 to an average of 4.5% in the last six
months of 1977. The economy recovered. The dollar exchange rate remained stable.
If we had avoided the burst of government spending and excessive money growth last
year, we would have continued to receive the sustained benefits that can only be
achieved if government policies are stabilizing. Excessive stimulus last year
has continued too long to be abruptly halted.
We propose four steps:
One, the rate of monetary expansion in the past year was between 7% and 7.5%.
We urge that the rate be maintained at 6% in 1978.
Two, we recommend reductions of 1% a year in the average rate of monetary
expansion until a noninflationary rate of monetary expansion is achieved. The
Federal Reserve should commit monetary policy to this stabilizing long-term
monetary course in order to fulfill its legal responsibilities under the Federal
Reserve Reform Act of 1977.
Three, the Congress should implement the Administration's pledge to reduce
the growth of government spending below the growth of private spending during the
next three fiscal years.
Four, to encourage investment and output, the Administration and the Congress
should reduce all tax rates, individual and corporate, to offset the full effect
of inflation on taxpayers. Real taxes in future years should be no higher than
they would have been if there were no inflation.

WHERE DO WE GO FROM HERE?
by Allan H. Meltzer

A declining dollar, a falling stock market, and rising long-term interest
rates describe the reaction by financial markets, at home and abroad, to the
administration's actions.

Currently we do not have an economic policy to

reduce inflation, balance the budget, encourage investment growth and
high employment.
The financial markets see that there is no policy.

The stock market,

the bond market and the foreign exchange market shout their disbelief at
the administration's statements about increasing investment, reducing
inflation, balancing the budget, or supporting the dollar.

They sense that

the lack of policy, the drift to controls, and the reliance on stop gaps
will continue.
The Dollar Problem
Each time that Secretary Blumenthal goes abroad, the value of the
dollar plunges.

The reason is not hard to find.

Secretary Blumenthal

urges the Germans, the Japanese and others to do as we do.
rejected.

His advice is

Market participants find their worst fears about the United

States confirmed.

They see, or believe, that the U.S. intends to continue

on its present course while Germany, Switzerland, Japan and others continue
on their courses.
Secretary Blumenthal cannot

talk the dollar down11 any more than his

predecessors in the 1960fs were able to

talk the dollar up.11

The Secretary's

statements and the responses by his counterparts abroad, however, assure
market participants that their worst fears about U.S. policy are correct
or possibly understated, so they sell dollar bonds and stocks, sell the

dollars for foreign exchange and invest abroad.

By rejecting the

Secretary's

advice, foreign governments announce that they do not intend to inflate as
much as the United States, so the dollars that investors sell flow to those
countries that pursue less inflationary policies*
There is no mystery about the flight from the dollar, the decline in
the stock market or the rise in rates of interest on long-term securities.
Nor is there any mystery about the rise in the value of marks, yen, and Swiss
francs.

They are all, in large measure, a response to the differences in

anticipated rates of inflation in the United Sta ;es and other countries.
Comparisons of price levels or rates of moj/iey growth in the United
States and in Germany or Switzerland do not show why investors are shifting
from dollars to D-marks.

Price levels and rates of money growth are history.

The rate of inflation to which investors respond is the anticipated future
rate of inflation.
The investors may be wrong.

Secretary Blumenthal and his colleagues

in the administration may prove to be right.

The entire problem may be, as

they say repeatedly, that we have expanded output more than others, so that the
dollar floats down because we have a trade deficit, that as the others expand,
the trade deficit will shrink, the dollar will strengthen and the problem
will be over.

But the financial markets do not believe that this is the whole

truth, however correct it may be in part.

They sell dollars for many

reasons, but mainly because they believe the United States has no policy to
increase investment and reduce inflation.
Energy and the Dollar
President Carter seems convinced that the problem with the dollar is
that we import too much oil.

He argues that, once the

Congress passes

his energy program, the dollar will recover some of its value because oil
imports will fall. Although this explanation is popular it is wrong in
emphasizing oil imports as the main explanation of the dollar1s decline.
Germany, Switzerland and Japan import a much larger proportion of the oil
and gas they use than we do. Yet their currencies rise as ours falls.
Energy legislation and the dollar are not unrelated.

By raising taxes

on energy, the administrations energy program reduces the budget deficit and
therefore reduces the amount of securities that the Treasury must sell.

lower deficit puts less pressure on the Federal Reserve to print money to
finance the deficit, so the anticipated future rate of inflation in the
United States will fall.

But the tax on energ/y does nothing to increase the

future supply of energy.

It is a tax on the efficient use of resources

and, therefore, on growth.
The Carter energy program and the response to the program by the Congress
cannot be a source of confidence to investors. The government insisted on
making the energy problem an energy crisis by building a large bureaucracy,
by transferring decisions from markets to administrators, and by refusing
to allow prices to allocate current energy supplies efficiently and to
increase future supply.
The way in which energy policy has been discussed, the type of legislation proposed, and particularly the failure by Congress and the administration
to remove controls on prices is a message to investors at home and abroad
that is far more powerful in its implications than the statistics showing
a deficit in the current balance of trade. There is no confidence in the
U.S. policy because there is no policy for dealing with long-term problems.

There are, instead, expedients and stopgaps designed with much more concern
about the distribution of income than the production of income.
Our failure to respond rationally to the higher price of oil tells
investors in dollars and in dollar assets, both Americans and foreigners,
a great deal about the drift toward political control of markets.
Carter administration did not create the energy problem.

The

They inherited

the problem, but they failed to solve it or to offer a rational program
leading to an eventual solution.
Investment and Crowding Out
The key to future growth is higher spending on investment in durable
capital.

Everyone agrees on that.

The administration has proposed a tax cut for business and consumers
to stimulate investment by increasing consumer spending and by raising
after tax rates of return.

These proposals are in the right direction, but

they are too small to offset fully the effects of tax increases for social
security and proposed taxes on energy.

And these are not the only, or even

the most important problems faced by those who make investments.
The current and prospective future deficits are major obstacles.

The

deficits must be financed either by higher taxes, by inflation or both.
Businessmen looking into the future cannot fail to see that the Carter
administration does not have a policy that will produce a balanced budget,
lower tax rates and less inflation.
A few years ago, crowding out was widely discussed.

Some argued that

part of the saving used to finance large budget deficits would have
financed private capital spending.

Real rates of interest on long-term

bonds would have been lower and real investment higher if the deficit had

been smaller. Perhaps there would have been a little less stimulus then,
but more capital, higher productivity and more income now and later.
Others, convinced that crowding out cannot be a problem with
unemployment at 1% or 87O argued differently.

Large deficits stimulate

the economy, produce more income and therefore more saving.
saving finances the deficit.

The addition to

Crowding out can only be a problem at, or

near, full employment.
Now, looking back, we can see the outcome more clearly. Although the
economy recovered from the 1974 recession at a rate about equal to the
average for postwar recoveries, investment has lagged.

Total fixed investment

in 1972 dollars remains at the level of 1972 and well below the peak reached
in 1973.

Production of business equipment has risen more slowly than the

index of production. New orders for non-defense capital goods, adjusted
for inflation, remain well below their previous peak.

Contracts for

construction of commercial and industrial buildings, in real terms, reached
the 1966 level only recently and remain 25% below the peak reached in 1973.
None of the measures of capital spending adjust for the higher proportion
of investment in safety and pollution control equipment.

If adjustment is

made, the rate of growth of capital looks even more puny, and the loss of
future real income looks even more startling.
Financial markets repeat the story told by real investment.

Spreads

between short- and long-term rates of interest remained high during most
of the recovery and have widened recently.
None of the evidence shows that deficit spending had no effect on
output and employment.

But there is now reason for those who denied the

possibility of crowding out to re-examine their arguments.
has lagged behind and shows no sign of spurting ahead.

Investment

Employment has

increased but inflation is rising.
The capital markets sense what the government cannot admit.

We have

no policy to increase long-term investment, lower inflation,reduce unemployment,
and lower the real tax burden.

We have a series of stopgaps, a drift toward

controls, regulation, more inflation and higher real taxes.
Where Do We Go From Here?
Our problems are long-term problems.
old and will not end soon.

Inflation is more than ten years

Investment has lagged for several years.

will not soon spurt ahead and remain high.

Productivity is rising, but the

rate of increase is below average of the sixties.
None of these problems can be solved by intense concentration on next
quarter, next year or the next election.

They can only be solved by

policies that are able to achieve lower future taxes, less inflation, greater
incentive to work and save, less regulation and fewer controls.
The President and those responsible for economic policy must see that
investors and financial markets have voted no confidence in their measures.
Stopgaps and stimulants will not succeed and will not generate confidence.
Tired metaphors about freight trains accompanying pleas to Germany and
Japan for help do not inspire confidence or encourage cooperation.

of the same will not solve any long-terra problem.
If the government will not plan its own activities and make a public
commitment to policies that achieve stability, the private sector will not
expect stability.
continue to drift.

Inflation will remain high, investment low, and we will

SHADOW OPEN MARKET COMMITTEE
rROM

Jerry L. Jordan, Sr. V.P. & Economist PHONE NO. 412-355-3101

SUBJECT

POTENTIAL OUTPUT GROWTH

DATE

3/10/78

At SOMC meetings in 1974 and 1975 a continuing debate regarding
the economic effects of the sharp increase in the world price of oil on real
economic capacity was initiated. The basic argument was that the significant and unanticipated increase in the price of oil decreased the economic
value of the existing stock of capital that had been designed to be economically efficient at substantially lower energy prices. The wealth transfer
from oil consuming nations to oil exporting nations was reflected in the
decrease in the present value of long-lived productive assets (stock prices)
and a decline in actual current output in oil consuming nations.
The magnitude of the loss and the effects on future growth potential
have been debated during the past three years. Alternative assumptions are
illustrated in the attached table. The importance of the issue lies in the
implications for increased inflationary pressure that would be associated with
a given acceleration in the growth of total spending• In other words, how
much and how long can stimulus be maintained before reacceleration of
inflation becomes highly probable?
Columns I and II in the table show assumptions of potential real
output that were discussed at previous SOMC meetings. The estimates in
column one are based on the assumptions that higher energy prices and other
"real shocks 11 reduced potential output by 4.5 percent of the actual Q4/1973 level,
but the trend growth remained at 3.5 percent. vCdJaimn II shows a one-time
decrease of the Q4/1973 level of only 2 percent, and a decrease of the trend
growth to only 3 percent.
More recent estimates based on work by Rasche and Tatom are shown
in columns III and IV. Column III shows levels for 1978 based on a continuing
trend growth of 3 .5 percent and column IV is based on a trend growth of potential
of 3 percent.
The table also shows the maximum growth possible from Q4/1977 to
Q4/1978 to reach potential by 1978. Under the assumptions discussed at previous SOMC meetings and shown in columns I and II, the potential level will
be exceeded early in 1978. Under the estimates based on Raeche-Tatom, the
potential level will be reached by year's-end or in early 1979.
Policy Implications
It must be clearly emphasized that the analysis underlying these
estimates of real economic capacity do not imply that higher output levels
cannot be reached. Much of the existing physical capacity can be put into

3/10/78
Page 2
production, but it is only economically viable (profitable) to do so at
higher output prices. In spite of relatively low capacity utilization
numbers during the past three years, basic industries have continued
to meet demand increases with price increases. The data shown in the
table suggest that further acceleration of inflation should be expected
a*L least by 1979 unless a marked slowing occurs in the growth of total
spending.

JLJ
JLJ/Ip

Potential Real Output
(billions of dollars)
(Actual real output, Q4/1977 = $1360-7)

III

1977:Q1

$1361.7

$1370.5

$1390.7

$1387 .3

1978:Q1

1373.5

1380.7

1402.7

1397 .9

1385.4

1390.9

1414.8

1408 .3

1397.4

1401.2

1427.0

1418.7

1409.4

1411.6

1439.3

1429 .2

3,6%

3.7%

5.8%

5.0%

maximum
growth
in 1978
to reach
potential

column

I : 4.5% loss in Q4/1973, 3.5% growth

II : 2.0% loss in Q4/1973, 3.0% growth
III : Rasche-Tatom, 3.5% growth from Q2/77
IV : Rasche-Tatom. 3.0% growth from 02/77

PROJECTIONS FOR THE ECONOMY

Prepared for the
SHADOW OPEN MARKET COMMITTEE MEETING
March 13, 1978

by
JERRY L. JORDAN
Sr. Vice President & Economist
Pittsburgh National Bank
Pittsburgh, PA

Total demand in the economy was strong in 1977 and it is going
to be strong again in 1978. The pervasive effects of the severe winter
weather in recent months and the depressive effects of the extended strike
in the coal industry should not be allowed to obscure the underlying
conditions of very strong demand emanating from the highly stimulative
monetary and fiscal policies that were initiated in 1977.
A year ago severe winter weather caused many forecasters,
espcially those using large scale structural economy econometric models
to greatly underestimate the strength of the economy. The Congressional
Budget Office issued a report, dated January 11, 1977, entitled "The
Disappointing Recovery11 and painted a very dismal picture regarding the
outlook for 1977 in the absence of massive additional monetary and fiscal
stimulus. Specifically, they projected real output growth for 1977 in the
range of 3.5 to 5 percent, and unemployment of 7.1 to 7.8 percent.
The newly inaugurated President described economic conditions
as being the worst since the great depression of the 1930s. In retrospect,
the opening sentence of the Annual Report of the Council of Economic
Advisers for 1977, dated January 27, 1978, states "As the new administration took office at the beginning of 1977, the economy was turning up
strongly from a period of very slow real growth during the latter part of
1976."
At the meeting of the Shadow Open Market Committee on March
7, 1977 real output growth was projected to be 5.9 percent from the fourth
quarter 1976 to fourth quarter 1977. That projection was reviewed and
maintained at the September 19 meeting of this committee. Latest data
available for 1977 show a growth of real output of 5 .7 percent during the
four quarter period, only slightly less than anticipated by the SOMC and
its deliberations.
At the March 1977 meeting of the Shadow Committee it was recommended that growth of the narrowly defined money supply be held to between
4 and 4-1/2 percent during the year ending in the first quarter of 1978.
However, economic projections considered by the Shadow Committee assumed
a higher growth in money would most likely occur.
At the September 1977 meeting two very strong back-to-back quarters
of monetary growth had already occurred and the committee recommended a
sharp reduction in the money stock. Nevertheless, for purposes of economic

- 2 -

projections, it was generally assumed that monetary growth would remain*
excessive* Consequently, the expected rate of inflation for 1977 was
revised upwards. At the March meeting last year a relatively moderate
inflation of less than 5 percent had been discussed, but at the September
meeting an inflation rate for 1S77 of almost 6 percent was projected.
Latest data available show an increase in the CN? deflator of 5.8 percent
and a rise in the consumer price index of 6.7 percant in the year ending in
fourth quarter last year.
As a result of the upward revision in inflation expectations for the
year, growth of total spending in the economy, nominal GNP, was expected
to be about 12 percent for the year ending in the fourth quarter of 1S77.
Latest data show the rise to have been 11.9 percent, which is the largest
increase in nominal GNP for any year since 1950. Previous years of strong
grov/th in nominal GNP were 1973 and 1972 with rises of 11.1 and 11.7
percent respectively. During the past two years the growth of nominal total
spending in the economy was about evenly split between growth and real
output and inflation as in shown in Table I.
For 1978 it is expected that growth of total spending in the economy
will be somewhat less than in 1977; however, the composition will shift
towards approximately two-thirds inflation and only one-third in real output
growth. Table II shows projections for nominal income output prices, money,
and velocity for the current year.
It must be emphasized that these projections for the growth of the
money supply are not in any way recommendations, but are merely assumptions
as to the possible final outcome. My recommendations will be that money
growth be less than indicated in the table, but my fear is that it may actually
exceed that rise. The growth of the narrowly defined money stock, Ml,
indicated in Table II would be somewhat less than the 7.4 percent increase
actually observed for the full year 1977. It would be substantially less than
the 8.5 percent increase that occurred in the final three quarters of last year,
yet it would still be above the upper limit of the Federal Reserve1 s own
announced target limit of 6.5 percent.
The growth of velocity indicated in the table is above the long-run
historic trend rates. This is a result of the lagged effects on nominal income
growth of the acceleration in monetary growth that occurred in the last three
quarters of last year. In addition, the sharp acceleration in the growth of
government spending to a 15 percent rate in the current fiscal year suggests
a temporary acceleration in the growth of the income velocity of money.
Even if actual monetary growth this year is no more than the 6.5 percent
upper limit of the range announced by the Federal Reserve, it should be

- 3 -

expected that inflation will remain very high even in 197S.
The substantial overshoot in monetary growth that occurred
especially in the second and third quarters of iast year will have a
delayed effect on total spending and credit demands that cannot be
offset without imposing some costs in terms of reduced real output growth*
The Peoeral Reserve made some progress in 1975 and 1976 in gradually
reducing the trend growth of money, but substantial ground was lost last
year. Whether or not the acceleration of inflation this year and in 1979
turns out to be only a cylical increase within a secular downtrend, or is
the initial phase of an acceleration towards, or above, the rates experienced in 1973 and 1974 will be to a large extent determined by monetary
growth in 1978*
Last year the Federal Reserve was warned that monetary growth in excess of the announced targets would be detrimental to the durability of this
economic expansion. The Chairmen of both the Senate and House Banking
Committees cautioned the Federal Reserve to maintain monetary growth
within their own announced target ranges.. The Federal Reserve did not
heed the advice that was given. A mistake in economic policy was made,
and now a price must be paid in order to correct it. Jhe longer the delay
before corrective action is taken, the greater the cost will be in terms of
lost output and employment at some time in the next two or three years.

TA3LS I
(percent change;

Price
Inflator

Real

GNP

Output

Q4/75-Q4/76

9.7

4.7

Q4/76-Q4/77

11.9

5.7

5.8

TABLE II
(percent change)
Projections for 1978

GNP

Output

Deflator

Q4/77-Q4/78

11. 7

4.9

6.5

7.0

9.0

4 .4

2 • C.-/

1977-1978

11. 6

5.1

6.2

7.4

9.0

3.9

2 .4

MONEY GROWTH RATES
(% Change from Previous Year)
FROM:

TO:

1971/Q1

1972/Q1

6.8

10.9

MONETARY
BASE
7.1

6.3

9.7

7.2

6.7

10.4

6.9.

8.4

11.2

8.4

1972/Q1

1973/Q1

8.5

10.5

8.9

8.0

10.0

8.2

7,2

9.2

9.1

6.2

8.8

8.1

1973/Q1

1974/Q1

5.9

8.9

8.1

5.7

8.7

8.4

5.3

8.3

8.5

5.1

7.7

9.0

1974/Q1

1975/Q1

3,7

6.6

8.2

4,1

7,3

7,8

4.8

8.3

7.9

4.4

8.3

7.5

1975/Q1

1976/Q1

4.9

9.4

8.2

5.2

9.6

8.7

4.5

9.3

8.3

5.6

10.9

8.5

1976/Q1

1977/Q1

6,0

10.9

8. 2

6,0

10.6

7.8

7.3

10.9

8.5

7.4

9.6

8.9

*1977/Q1

1978/Q1

8.0

9.2

9.8

^Projected by Pittsburgh National Bank

TWO-QUARTER COMPOUNDED ANNUAL RATES OF CHANGE

MONETARY
BASE

Ql/71 - Q3/71

8.6

11.7

8.1

Q2/71 - Q4/71

9.6

8.0

6.6

Q3/71 - Ql/72

5.1

10.0

6.1

Q4/71 - Q2/72

7.9

11.4

7.8

Ql/72 - Q3/72

8.3

10.8

7.7

Q2/72 - Q4/72

8.9

11.0

9.0

Q3/72 - Ql/73

8.6

10.2

Q4/72 - Q2/73

7.0

9.0

8.8

Ql/73 - Q3/73

5.9

8.2

8.1

Q2/73 - Q4/73

5.5

8.7

7.4'

Q3/73 - Ql/74

5,8

9.7

8.2

Q4/73 - Q2/74

5.8

8.8

9.5

Ql/74 - Q3/74

4.8

7.0

8.8

Q2/74 - Q4/74

4.3

6.6

8.6

Q3/74 - Ql/75

2.5

.6.2

7.6

Q4/74 - Q2/75

3.9

8.1

7.0

Ql/75 - Q3/75

7.2

10.4

8.2

Q2/75 - Q4/75

4.9

8.6

8.0

Q3/75 - Ql/76

2.7

8.4

8.1

Q4/75 - Q2/76

5.6

10.6

9.5

Ql/76 - Q3/76

6.4

10.2

8. 5

Q2/76 - Q4/76

5.6

11.2

7.5

Q3/76 - Ql/77

5.5

11.7

7.9

Q4/76 - Q2/77

6.5

9.9

8.1

Ql/77 - Q3/77

9.2

10.1

9.1

Q2/77 - Q4/77

8.3

9.2

9.6

*Q3/77 - Ql/78

6.9

8.4

10,4

^Projected by Pittsburgh National Bank

£ - 3 L-^ w

i to -;w

-'4 n

- - •%*# u -a k si L . . ^ - * &

SHADOW OPEN MARKET COMMITTEE MEMBERS

FROM

Terry L. Tordan

SUBJECT

TABLE REVISIONS

PHONE NO.

N* I

412-355-3101
DAI

Attached are revisions to the tables I distributed at the March
meeting.
The very strong growth of business loans, in addition to continued strength in consumer and mortgage loans, is producing upward
pressure on short-term interest rates. The monetary base rose $1 billion
in the past two weeks after remaining unchanged for six weeks.
During the second and third quarters this year, the probability
that the money and interest rate pattern of the first quarter (that i s , both
short-term interest rates and money growth unchanged) is small.
The Fed apparently is attempting a form of "operation twist"
since they bought coupon issues for their own account last week while
selling Treasury bills to the Bank of Japan from their own portfolio.

JU/lp

TWO-QUARTER COMPOUNDED ANNUAL RATES OF CHANGE

Ql/71 - Q3/71

8.6

11.7

MONETARY
BASE
8.1

Q2/71 - Q4/71

9.6

8.0

6.6

Q3/71 - Ql/72

5.1

6.1

Q4/7I - Q2/72

7 Q

Ql/72 - Q3/72

8.3

Q2/72 - Q4/72
Q3/72 - Ql/73

8.9
8.6

10.0
11.4
10.8
11.0
10.2

10.2

Q4/72 - Q2/73

7.0

9.0

8,8

Ql/73 - Q3/73

5.9

8.2

8.1

Q2/73 - Q4/73

5.5

S.7

7.4

Q3/73 - Ql/74

5.S

9.7

S,2

Q4/73 - Q2/74

5.8

S.8

9.5

Ql/74 - Q3/74

4.8

7.0

8.8

Q2/74 - Q4/74

4.3

6.6

8.6

Q3/74 - Ql/75

2.5

6.2

7.6

Q4/74 - Q2/75

3.9

8.1

7,0

Ql/75 - Q3/75

6.3

10.1

8,2

Q2/75 - Q4/75

4.5

8.4

8,0

Q3/75 - Ql/76

3.7

8.9

8,1

Q4/75 - Q2/76

5.9

10.7

9.5

Ql/76 - Q3/76

5.4

9.6

8.5

Q2/76 - Q4/76

5.6

7,5

Q3/76 - Ql/77

7.3

Q4/76 - Q2/77

7,7

11.1
12.3
10.3

Ql/77 - Q3/77

8.3

9,8

9,1

Q2/77 - Q4/77

7.8

9.2

9,6

*Q3/77 - Ql/78

6.1

7.3

10 t 4

*Projected by Pittsburgh National Bank

7.8
7.7
9.0

7,9
8,1

XON£Y GROWTrl RATES
(% Change from Previous Year)
FROM:

TO:

MONETARY
BASE
7.1

1971/Q1

1972/Q1

6.8

10.9

6.3

9.7

7.2

6.7

10.4

6.9

8.4

11.2

8.4

1972/Q1

1973/Q1

8.5

10.5

8.9

8.0

10.0

8.2

7.2

9.2

9.1

6.2

8.8

8.1

1973/Q1

1974/Q1

5.9

8.9

8.1

5.7

8.7

8.4

5.3

8.3

8.5

5.1

7.7

9.0

1974/Q1

1975/Q1

3.7

6.6

8.2

4.1

7.3

7.8

4.8

8.3

7.9

4.4

8.3

7.5

1975/Q1

1976/Q1

5.0

9.5

8.2

5.2

9.5

8.7

4.5

9.3

8.3

5.7

10.9

8.5

1976/Q1

1977/Q1

6.3

10.9

8.2

6.6

10.7

7.8

11.0

8.5

7.8

9.8

8.9

*1977/Q1

1978/Q1

7.2

8.5

9.8

*l>rojccted by Pittsburgh National Bank

Statement by
JERRY L. JORDAN
Senior Vice President and Economist
Pittsburgh National Bank
before the
Committee on Banking, Finance and Urban Affairs
House of Representatives
United States Congress
March 7, 1978

Mr. Chairman and Members of the Committee:
It is indeed a pleasure to have this opportunity to present my views on
monetary policy. I would like to state at the outset that I have been very much
encouraged by the role that Congressional oversight of monetary policy has played
in recent years. In the three years since these quarterly hearings began under
Concurrent Resolution 133, the quality of the discussions concerning the issues
involved in the conduct of monetary policy has greatly improved. I think that the
process of formulation and implementation of monetary policy has been improved
by these hearings, and I am hopeful that further progress will be achieved in the
future.
The requirement that the Federal Reserve announce monetary growth targets
is potentially an important contribution to the objective of promoting economic
stability, but only if the targets can be relied upon. Decision makers in the private
sector, both management and labor leaders, would find it valuable to know in
advance the rate of inflation that will
be tolerated by the monetary authorities.
The credibility of the central banks1 stated intentions is the key to the success of
monetary policies in Germany, Switzerland, and other countries that also announce
monetary growth targets. Last year the growth of money exceeded the Federal
Reserve's targets by a significant margin, and it is widely believed that the same
will be the case this year. These hearings are the appropriate forum for seeking
from the Federal Reserve explanations for past errors and assurances that they are
serious about announced targets for the future.
In general, there is reason to be optimistic about the outlook for our
economy, and for that matter for world economies in the years ahead. There are
some unavoidable problems that must be dealt with in the next year or two, but
there is still time for a mid-course correction that will lay a foundation for strong
growth and declining inflation in the 1980Ts.
I would like to spend my time this afternoon commenting on what can and
cannot be expected from monetary policy in achieving our national objectives
regarding capital formation and job creation, while not abandoning the goal of a
gradual reduction in the trend rate of inflation. In addition, there are a few issues
concerning the measurement and implementation of monetary policy that it is
timely to deal with over the next year, and I will suggest that an appropriate role

of Congressional oversight of monetary policy is to monitor the progress towards
improving the quality of monetary data and to encourage reconsideration of the
techniques used by the Federal Reserve to achieve its monetary growth targets.
I will begin with a brief summary of my views on where we stand at the
present time and the appropriate objectives for monetary policy in 1978. On
previous occasions the Chairman and other members of this Committee, as well as
several witnesses, have emphasized the importance of lags between monetary
policy actions and observable responses of the economy. The pervasive effects of
the severe winter weather in recent months, especially in combination with an
extended strike in a major portion of the coal industry, should not cause us to lose
sight of the foundation of very strong demand that has been provided by highly
stimulative monetary and fiscal policies that began in 1977 and are continuing at
the present time. Growth of the monetary base and the narrowly defined money
supply during the last three quarters of 1977 was more rapid than at any time in
thirty years, with the exception of 1972. At the same time, the growth of
government spending at the Federal level began to accelerate in the second half of
fiscal 1977 and is scheduled to rise 15 percent in the current year. Normal lag
relationships suggest that the strong thrust from these monetary and fiscal policy
actions assure that growth of total spending in the economy will be strong this
year. In fact, the average 16 percent rate of increase of personal income in the
closing months of last year suggests that additional stimulation of final demand is
not necessary at the present time.
Total spending in the economy as measured by Gross National Product rose by
almost 12 percent last year, up significantly from the 9.7 percent increase in 1976.
That increase has been exceeded in only one year since World War II and was
accompanied by a number of other measures of economic performance that are
equally satisfying. Total new automobile sales were almost a record and new single
family housing starts of over 1.4 million were an all time record. Maybe most
important, the actual number of people employed in our economy increased by over
seven million last year to achieve both the highest total number of people employed
in our history by a significant margin, but also the largest proportion of population
of working force age employed that we have experienced other than during World
War II.
These excellent results in labor markets do not mean that we do not still have
problems with unemployment, but they do suggest that approaches other than
general stimulus to aggregate demand must be sought in order to achieve our
national objective of job opportunities for all that desire them. I am confident that
the overall rate of unemployment will be below 6 percent sometime this year.
Progress towards reducing unemployment further involves: much more selective
approaches to identifying who the unemployed are and where they are; providing
information to potential employers and perspective employees; removing some of
the obstructions and barriers to employment that are faced by many people; and
providing the kind of training and actual work experience that will enhance the
skills and productivity of the unemployed in order that they can become active
participants in our economy at acceptable wages.
At the same time that specially tailored programs are implemented to further
reduce unemployment, overall monetary and Federal budget policies should be
focused on the longer-term objective of achieving a much lower rate of inflation by
the mid-1980Ts. If we are to maintain any hope of eventually
returning to the low
average rate of inflation that prevailed in the 1950fs and early 1960Ts, aggregate
demand policies must be moving in the direction of achieving a growth of GNP

(total spending in the economy) that is less than one-half the rate that was
achieved in 1977. In the last few years Federal budget policies have been discussed
in the context of a five-year plan, and I believe that such a time horizon also would
be appropriate for discussing the monetary policy program. Over the next five
years we should be contemplating the monetary policies that would accompany a
reduction in the growth of nominal total spending to only a 7 or 8 percent rate that
would be associated with a rate of inflation of 4 percent or less and a 3 to 4
percent growth of real output. Such a program would involve a gradual reduction in
the rates of monetary growth from the upper ends of the current target ranges
announced by the Federal Reserve to no more than the low end of the current
target ranges.
It should be emphasized at this point that stability in the growth rates of the
monetary aggregates, and only gradual changes in the average growth rates, are far
more important than the exact figures that are sought or achieved. I will have
more to say about this in a few moments, in connection with some comments on
appropriate monetary policies to foster a greater rate of capital spending, but at
this point I want to caution against a "whites-of-the-eyes" approach to setting
shorter-run monetary growth targets.
A substantial amount of research effort has been devoted to demonstrating
that fluctuations in the growth of the money supply around the underlying trend
rate are reflected primarly in fluctuations of output and employment, while the
trend growth of money over a period of several years is reflected in the prevailing
average rate of inflation. The clear implication of this research is that a
significant acceleration in the growth of the money supply above the underlying
trend can have a short-run positive effect on the growth of output and employment.
However, such a policy action sows the seeds of its own failure since an
unavoidable dilemma is created wherein a choice must be made between sustaining
the new higher growth of the monetary aggregates — and accepting a rise in the
trend rate of inflation — or, alternatively, suffering the contraction in the growth
of output and employment that would be induced by a marked reduction in money
growth back towards, or below, the previous trend rate.
In the present environment this means that in 1978 a continuation of 8 to 9
percent growth in the narrowly defined money supply might be accompanied by a
somewhat higher rate of output and employment growth than would an immediate
return to the previous 6 percent trend rate. However, continuation of the high
rates of monetary growth this year would create a situation where the Federal
Reserve had no good options remaining once they began to focus on 1979. The
choice at that time would be between continuing the high rate of monetary growth
and tolerating an acceleration of inflation into the 7 to 9 percent range next year,
or administering a dose of traditional monetary restraint in order to combat the
emerging inflation and, consequently, necessitating a credit crunch and recession
next year.
If the Federal Reserve immediately returns to and maintains monetary
growth at no more than the upper ends of the announced target ranges a severe
credit crunch and major recession can be avoided. However, a continuation of the
policy actions of the past year for another six to nine months would make it less
likely that the excesses can be corrected without suffering a major economic
adjustment.

This outlook for the next year or two is influenced by an interpretation of the
"slack" or idle capacity in the economy that differs significantly from the view put
forth by others, notably the Congressional Budget Office staff. Briefly, they take
at face value the relatively low capacity utilization numbers and the data that
suggest that there still is a large "gap" between actual output and so-called
potential GNP, and they conclude that we are not in danger of "spilling-over" into a
condition of excess demand and rising inflation.
In my view their analysis might be correct only if the long and deep recession
of 1974 and 1975, and the associated decline in capacity utilization, had been
caused solely by prior restrictive monetary and fiscal policies. However, we all
know that that is not the whole story. During 1973 and 1974 we experienced a
number of major one time "real shocks", such as the quadrupling of oil prices, that
decreased the real economic capacity of much of the existing plant and equipment.
Given the much higher input prices, especially for energy, substantially higher
output prices became necessary to restore profitability. Many of the basic
industries such as steel, aluminum, rubber, paper, glass and plastics had installed
capacity that was economically efficient only at much lower energy prices than
prevail today. Some of this capacity was relatively new and modern in a physical
sense, but became economically obsolete (unprofitable to operate) at prevailing
output prices in view of the significantly higher input prices. Consequently,
demand increases in these basic industries have been met, and will continue to be
met, with output price increases long before full utilization of physical capacity is
reached. This means that the capacity utilization numbers are not a very reliable
measure of pressure for price increases in-this environment.
This analysis does not suggest that it is not possible to achieve the old
potential capacity output levels, but it does suggest that the rate of inflation
associated with the achievement of those higher output levels may be considerably
greater than a traditional "gap" analysis would suggest. On the positive side, it
should be noted that the fact that the nominal price of oil from OPEC has not risen
since the middle of last year and, therefore, the real price of oil to the United
States has declined, means that (as long as it continues) there will be less inflation
than otherwise. On the other side, the eventual resolution of our own domestic
energy policies will have a significant bearing on the outcome regarding energy
prices and availability.
I have no doubt that movements of interest rates are going to receive a lot of
attention in discussions about monetary policy this year. It obviously is tempting to
tolerate more rapid growth of money and credit in an effort to prevent increases in
interest rates in order to promote increased private investment spending and assure
a continued strong flow of funds to the housing industry. But that option carries
with it the danger of much more serious problems at a later time.
There is a view that rising short-term interest rates tend to push up longterm interest rates, and tendencies for short-term interest rates to rise must be
resisted by the monetary authorities in order to avoid rising long-term interest
rates. However, that view is not supported by recent experience nor by theoretical
analysis. Since investors pay increasing attention to the growth of the money
supply in forming their expectations about future inflation, a more rapid growth of
money for the purpose of holding down short-term interest rates would actually
cause long-term interest rates to rise more.
This is because managers of
investment funds, as well as individual savers, would attempt to avoid incurring a

capital loss that would occur when the price of long-term bonds declined as the
inflation premium in bond yields was revised upward. The only way to bring about a
permanent reduction in long-term interest rates, including mortgage rates, is to
permanently reduce inflation.
Last year short-term market interest rates rose approximately two percentage points, and some observers interpreted that as a sign of a more restrictive
monetary policy. I disagree with that view. Since the quantity of credit extended
was rising at historically very rapid rates, the only interpretation that follows from
the rise in the price of credit is that the demand for credit was rising even more
rapidly than the ample increase in credit supplied. That is a sign of a strong
economy. The rise in short-term yields last year occurred mostly in the spring and
summer, at a time when bank reserves and the money supply were growing at the
most rapid rates in over thirty years. Such a high rate of monetary growth
accompanied by a sharp rise in short-term interest rates occurred in only one other
year — 1972. Certainly the events of 1973 and 1974 suggest that the excessive
monetary growth in 1972 was a better measure of monetary stimulus than was the
rise in the price of credit.
At the present time, participants in money and capital markets seem to be
expecting that short-term market interest rates will rise one percentage point or
more this year, that inflation will be at least as rapid as last year, and that longterm interest rates will rise by one-half percentage point or more. It is generally
accepted that the money and credit markets will be much tighter this year in spite
of the somewhat slower real output growth that is generally expected. Market
participants understand that there is no reliable correlation between real growth in
the economy and movements in interest rates, as evidenced by recent experiences
such as 1973 and 1974. The dominant reason for expecting upward pressure on
interest rates this year is that the stimulative monetary and fiscal policies of last
year, and continuing into this year, have produced strong credit demands in the
private sector which are competing increasingly with the continuing large credit
demands of the government sector, all of which leads inevitably to a substantially
higher price of credit.
It is important to emphasize that a year ago the forecasts of higher interest
rates in 1977 were based on assumptions of an acceleration in the growth of the
money supply, not slower growth of money, than had occurred in the previous year.
Similarly, continued monetary growth in 1978 at the rate that occurred in the final
three quarters of last year would imply a larger rise in long-term interest rates this
year and in 1979 than if the growth of money was returned to and maintained at no
more than the upper limits at the announced targets.
I firmly belief that if market participants can rely on the Federal Reserve to
reduce monetary growth this year to no more than the upper ends of the announced
target ranges, the rise in short-term yields will be viewed as only a temporary
cyclical increase. Consequently, the rise in long-term yields will be small since
there will be no reason to revise upwards expectations about the trend rate of
inflation.
The reasons for the apparent paradox -- that slower money growth means a
smaller rise in interest rates — lie in the way market participants form
expectations about future credit demands and inflation and in their judgements
about actions that may be taken by the Federal Reserve to offset undesired

deviations of monetary growth from their targets. Even though traditional analysis
holds that faster growth of money implies lower interest rates and slower growth of
money implies higher interest rates, market participants have come to understand
that it is actually just the opposite.
Over the past few years market participants have recognized that when
faster money growth actually is observed, higher short-term interest rates can
usually be expected as the Federal Reserve raises the Federal funds intervention
target rate in order to slow reserve availability and bring money growth back down
into the target range. Conversely, when money growth persists for some time at
relatively slow rates, interest rates begin to decline as market participants begin to
expect that the Federal Reserve will increase reserve availability in order to
promote faster growth of money to maintain target growth rates. The implication
for the present environment is that the way to promote lower long-term interest
rates late this year and in 1979 is to allow the competition between government
and private sector credit demands to .raise short-term interest rates as much as
necessary while open market operations by the Federal Reserve provide reserves at
a rate that permits money growth at no more than the upper limits of the current
long-term target growth ranges.
The obvious problem with this conclusion for economic objectives in 1978 is
that tolerating further increases in short-term market interest rates will be viewed
by some to be in conflict with the desire to promote a higher rate of capital
spending and to insure continued strength in the housing industry. The argument
will be heard many times this year that rising short-term market interest rates
increase the likelihood of an outflow of savings deposits from the thrift industry,
especially of short-term maturities, and that, in turn, implies a reduced availability
of funds for construction and mortgage finance of housing. While that analysis by
itself is undeniable, the various alternative policies and their implications must be
considered.
For the Federal Reserve to merely peg short-term interest rates at near the
current levels and tolerate a marked acceleration in the growth of money and
credit would delay the occurrence of disintermediation and might assure a
continued strong flow of funds to the housing industry through this year. However,
those same actions would insure that inflation would accelerate substantially next
year and a major credit crunch and recession would become inevitable.
Cyclical movements in interest rates contribute to cyclical swings in home
construction activity, but it is also true that high secular rates of inflation have a
major adverse effect on the housing industry and people's ability to afford adequate
housing. Part of the reason that the demand for housing was so !strong last year and
residential housing prices rose so sharply was because of people s fears about future
inflation. Even though housing prices have risen sharply in the past decade, and in
1977 were substantially higher than just one year earlier in some parts of the
country, there was considerable speculative activity based on the assumption that
general inflation would be greater and new homes would become even more
expensive relative to incomes in future years. A policy of holding down interest
rates and permitting very rapid growth in money and credit is not the solution to
the problems of the housing industry and the thrift industry, if it means continued
high rates of inflation.

Even if nothing else is done and a return of monetary growth to the Federal
Reserve's announced target ranges causes increases in short-term interest rates and
some disintermediation of savings from the thrift institutions and a downturn in
home construction activity, there is no reason to believe that the downturn will be
very sharp nor very long in duration. It would be far better to suffer a mild
downturnT in the next year or so and lay a foundation for resumed healthy growth in
the 1980 s than it would be to promote vigorous activity this year and into 1979,
while risking a subsequent long and deep contraction in the industry.
Now I will turn to some comments about the role of monetary policy in
promoting an increased rate of capital spending. First, there is a view about the
way government economic policies influence capital spending plans of business that
I disagree with. It holds that monetary and fiscal policies can be used to stimulate
current consumption spending and thereby give business decision makers the
confidence to implement plans for increased productive capacity. According to
this view, the key to stimulating capital spending is to take actions that cause this
month's sales to increase and order books to fill up. My conversations with business
leaders do not support that view.
The experience of the last couple of years suggests that the traumatic events
of 1974 and 1975 have caused businessmen to be very cautious about being too
myopic in analyzing the strength of final demand for their products. The business
community is very sensitive to the possibility that monetary and fiscal policies in
the short-run will become overly stimulative and leave the government with no
alternative but to combat accelerating inflation either by administering a strong
dose of traditional monetary and fiscal restraint which would render any new
investment unprofitable during the ensuing recession, or adopting some form of
administrative controls over prices which would also render new capacity to be
unprofitable. There is a desire by business planners to see government avoid the
excesses of short-sighted "stop and go" policies in favor of more stable policies that
reflect the kind of patience necessary to promote a prolonged period of continued
economic expansion.
A review of the conditions that made possible the extended period of
sustained growth in the 1960fs suggests that moderation in the monetary and fiscal
policies pursued early in the period, especially in 1961 and 1962, dispelled the view
that alternating short periods of growth and recession were inevitable.T Another
development that contributed to the length of the expansion of the 1960 s was the
willingness of the monetary authorities to suffer a correction of some excesses
that were building up part way through the period. The 1966 credit crunch and the
mini-recession in the first quarter of 1967 were unfortunate and unpleasant, but
they were also probably unavoidable as a result of the overheating of the economy
that occurred in 1965 and early 1966. Their occurrence enabled the economic
growth to continue for three more years.
In 1978 it is still possible for capital spending to continue to strengthen and in
real terms to match or exceed the pace of last year. However, if high rates of
monetary growth are the results of policies designed to resist further increases in
short-term interest rates this year, then greater uncertainties will be generated
about the economic environment that will prevail two or three years from now
when new capacity is coming on stream. As a result, corporate planners will want
to go slow on major long-term projects until they have a better idea about the
timing, depth, and duration of the next recession and until the prospects for some
form of administrative controls over prices are assessed. I do not believe that

controls are desirable or necessary, but in business it is prudent to assume they will
be imposed.
Now I will turn to some comments about implementation and measurement of
monetary policy actions. At the hearings conducted by this Committee in July of
last year, the subject of seasonal adjustment of the monetary aggregates was
raised, yet the situation is the same today as it was at that time. Two years ago a
non-partisan committee of academic economists, commissioned by the Federal
Reserve and chaired by Professor Leland Bach, made a number of recommendations
regarding the measurement of monetary statistics. Yet no action or explanation
for failure to implement the recommendations has been forthcoming from the
Federal Reserve, and I think it would be an appropriate role for Congressional
oversight to seek some progress on these issues, or at least some reasons why the
recommendations have not been implemented.
At the mid-year review of the economy conducted last September by the
Joint Economic Committee, Congressman Ruess presented additional views with
which I concur substantially and will not repeat at this point, but will only say that
they are as relevant today as at that time. In addition, at the hearings of this
Committee last July on monetary policy, the subject of lagged reserve
requirements was raised and an analysis by the staff was included in the record. I
would like to associate myself with the analysis presented by the staff and suggest
that on this yearTs agenda for Congressional oversight the Federal Reserve should
be asked to plan a return to coincident reserve requirements or provide a detailed
defense of maintenance of the present structure of lagged reserve requirements.
Finally, I concur with the concern expressed by a number of observers
regarding the emphasis placed on the weekly money supply numbers, but I would
like to suggest that the Federal Reserved continued emphasis on the weekly
average and even daily or hourly Federal funds rate is equally cause for concern,
and frequently has been a source of past policy errors. Neither the level of the
Federal Funds rate nor the weekly Ml and M2 measures are appropriate short-term
operating targets for the Federal Reserve. Alternatively, the adoption of a reserve
aggregate, such as the monetary base, as a short-run operating target would
enhance the ability of the Federal Reserve to achieve its quarterly and annual
money supply growth targets and also to avoid wide cyclical swings of interest
rates. Again there is an apparent paradox, in that excessive preoccupation with
short-run movements in interest rates and efforts to stabilize them over weekly
averages (or even daily) may actually contribute to substantially greater swings in
interest rates over full business cycles. In order to minimize the long-run
movements in interest rates the Federal Reserve should allow them to fluctuate
over a wider range in the very short-run.
In summary, monetary policy actions in 1978 will be critical in determining
whether another major recession should be expected in the next few years.
Contrary to conventional analysis, the probability I would assign to an occurrence
of a major recession in the next two or three years would be greater, the more
stimulative are monetary policy actions this year. It is my hope that the Federal
Reserve adheres to monetary growth targets for this year that are no higher than
were announced, but greatly exceeded, last year.

y^~ HARRIS

Harris Economic Research Office Service

February 8, 1978

ECONOMIC PROSPECTS THROUGH 1979

Although monetary growth is beginning to ease from the rapid pace
which characterized much of 1977, the forecast assumes that the easing
represents a temporary adjustment which will be offset soon. As a
result, while the boom in sales which took place in late 1977 is likely
to taper off by early spring, further sharp advances in the money supply
in the months ahead are expected to foster a strong sales trend for the
year as a whole. Inflation is projected to move higher throughout the
forecast period, and fiscal and monetary stimulus is assumed to be sufficient to maintain real growth in the vicinity of 4%.
A Preliminary View of 1979
While the current forecast projects the path of business activity
through 1979, more than the usual number of caveats should be emphasized.
First, an expansion through 1979 would mark five consecutive years of
business expansion, a relatively long period in terms of historical experience. Second, and perhaps more importantly, the past two years have
witnessed an acceleration in the growth of the money supply. This acceleration means that some future economic instability is virtually inevitable in order to contain rising inflation.
The forecast assumes that tighter monetary policies will be avoided
during 1978. This view is based upon the belief that the Administration,
the Federal Reserve Board, and the developing fiscal policies will all be
geared toward stimulating the economy this year. The judgment concerning
the course of monetary policies in 1979 becomes much more difficult. Given
the 7%% - 8% inflation that is anticipated for 1979 combined with gradually
slowing real growth, policymakers will be tempted to implement one of two
extremes. The first would be to accelerate monetary growth above 9% in an
effort to maintain an acceptable increase in real growth. The second
would be to slow monetary growth in an attempt to combat rising inflation.
The second extreme would be likely to lead to a recession in late 1979 or
1980 while the first course of action might serve to postpone a recession
until after the 1980 election. At this point in time, the ability to
predict what policymakers will choose to do is extremely limited. Nonetheless, in spite of these uncertainties, decisions must be made today
regarding the probable course of business activity in 1979. The attached
forecast recognizes that problem and represents a compromise from two
extreme views by allowing monetary growth to continue throughout 1979 at
a 9% rate.
A longer term forecast, which will be distributed within the next
month, will incorporate the economic implications of both scenarios
referred to above. Irrespective of the precise pattern which develops, a
recession within one year either way of 1980 appears to be an extremely
likely prospect at the current time.

Monetary Aggregates Show Diverging Trends
Monetary growth trends have recently given widely divergent
signals on the future course of business activity. Normally, with a
six month lag personal income and GNP growth proceed at approximately
the rate of expansion in M2 or 3 percentage points faster than the
monetary base and Mi. As the table below shows, there has been a significant slowdown in M2 growth during the past year.
Monetary Growth
(Annual Rate of Change)
Jan. '77 July '77
Monetary Base (currency
plus member bank
reserves)

8.1%

Mi (currency plus
demand deposits)

8.5

July '77 Jan. '78

Oct. '77 Jan. '78

10.1%

9.7%

7.0

5.3

2 (M.l P l u s time deposits at commercial
banks other than
large CD's)

This significant slowdown in M2 growth is assumed to be related
to the sharp rise in short-term interest rates which have made savings
deposits in commercial banks less attractive than open market securities such as treasury bills. The higher interest rates are believed
to, have caused people to shift their money assets away from savings
deposits thereby resulting in a slower expansion in M2 relative to Mi.
Shifts in the preference for money assets will strongly influence
particular money measures and their relationship to the economy. In
this vein, the recent extremely rapid advance in the monetary base
probably overstates the case of monetary stimulus. During the past six
months there has been a $14 billion increase in large CD's at commercial
banks. This huge increase in CD's absorbs reserves and requires a
larger increase in the monetary base to support Mi and M2 than would
otherwise be the case. As such, the forecast assumes that in the
current environment of sharply rising interest rates, Mi is likely to
be the more appropriate measure for indicating future economic trends.
Although this measure also has been characterized by sharply slower
growth during the past three months, pressures to expand the money
supply to finance the large federal budget deficit and to satisfy the
real growth targets of the Administration are expected to lead to
extremely rapid increases in money during the months ahead.
Consumer Expenditures and Business Capital Investment
As a result of various policies already enacted or proposed, there
is more than the usual difficulty in trying to assess the direction of
the major components of total spending. For example, in viewing consumer

-3expenditures, adjustments have to be made for the higher social
security taxes, the proposed tax cut and tax reforms, the impact of
an energy policy on fuel prices and auto sales, as well as a host
of other factors. Given the overall forecast for a fairly strong pace
of spending, the net impact of various policies is expected to cause
(1) only a modest rise in auto sales during both 1978 and 1979 and
(2) relatively rapid inflation in the service area and hence rapid increases in expenditures for services, along with a relatively slow
advance in expenditures on nondurables, particularly during 1978.
The trend in business capital investment will result also from
highly diverse inputs. On the positive side, the sharp increase in
corporate profits in recent years, higher capacity utilization rates,
and the promise of further expansion argue for a strong increase in
capital expenditures. However, the combination of higher interest
rates, a negative business environment in Washington, and the negative
impact on private savings resulting from a large federal budget deficit
and higher social security payments should act as a drag on investment.
The net impact of all these factors is seen resulting in a 7% - 8% increase in real capital expenditures. This is several percentage points
above recent surveys but also represents a fairly weak performance for
capital spending at this stage of the cycle.
Government
President Carter's proposed tax plan includes cuts for individuals and business totaling $33.9 billion in 1979. These cuts are
linked with reforms that would increase taxes by $9.4 billion next year.
The forecast assumes that the cuts will be larger and the reforms fewer
after Congress overhauls the President's package. The net reduction in
income taxes, generally effective October 1, 1978, is expected to lower
individual and business taxes by $23.5 billion and $8.4 billion in 1979,
respectively. However, social security tax increases will reduce personal income and pre-tax profits in total approximately $5 billion this
year and $8 billion next year.
Fur^er^Jjacreases in Inflation
Inflation continues to rise throughout the forecast period. An
inflation rate of approximately 1% is forecast for the current year and
the rate moves up to 8% by the end of 1979. The main rationale behind
the inflation numbers is the prior trend in the growth of the money
supply. Historically, there has been a tendency for the inflation rate
in a particular year to reflect the average monetary growth over the
previous two years as indicated by M j . In the two years ending in
January of 1978, the money supply (Mi) averaged a 7.0% per year rise.
This suggests that there is strong pressure for a boost in the inflation
rate to IX during the upcoming twelve months. Furthermore, the assumption
in the forecast that monetary growth is likely to be close to 9% throughout both 1978 and 1979 suggests that inflation will eventually reach 9%
in 1980. Hence, the underlying trend is for a continued strong rise in
inflation.

—4—
Financial Markets
The upward trend in inflation for 1978 and 1979 means that interest rates will move higher. As inflationary pressures build and
credit demands tighten/ long term interest rates (new issue AA industrial bonds) are expected to rise from 8.4* in the first quarter of
1978 to approximately 9% by the fourth quarter. A further rise to
9.6% is anticipated by the end of 1979. Moreover, should monetary
growth in fact average 9% during this year and next as is anticipated
in the forecast, there will be strong pressures for further increases
in long-term rates beyond 1979.
As inflation and interest rates rise and the economy enters
its fourth and fifth years of expansion, profit gains are expected
to slow. On a pre-tax basis, profits are expected to be up just under
9% from the fourth quarter 1977 to the fourth quarter 1978 and approximately 5% during the subsequent four quarters. However, the anticipated corporate tax reductions are expected to result in a sharp rise
in after-tax profits in the fourth quarter of this year. During 1979
after-tax profits adjusted for the impact of inflation on accounting
practices are expected to be up slightly.
Summary
Business activity will continue to advance during 1978, although
at a somewhat slower pace than last year. Interest rates and inflation
will move higher as the economy moves closer to full utilization of
capacity. For 1979 developments are highly uncertain. Rising inflation, higher interest rates and slower real growth will create unstable
business conditions, and policymakers will be subject to extreme pressures in formulating policies. At any point in time a move toward containing inflation could throw the economy into a recession. While the
preliminary forecast for 1979 assumes that the thrust of economic policies continues to be geared toward expanding business activity, it is
difficult to place any high degree of confidence in the ability to
forecast policy changes 1 to 2 years before they occur. However, the
higher inflation and rising interest rates that will result from past
stimulus make the economy highly susceptible to a recession within the
next few years.

Robert J. Genetski
Economist
(312) 461-5001

2/21/1%

ECONOMIC OUTLOOK
(BILLIONS OF DOLLARS—SEASONALLY ADJUSTED ANNUAL RATES)

ACTUAL
GROSS NATL PRODUCT
%CH

FOR CAST
¥73": 4" 19 79 :TT97 9: 2 1979:3" 1979 :'4

1963.7 2016,1 2068.1 2123.6 23^3.1 12246.4 2312.0 2380.0 2450.1
11.7
12.1
12.2 12.3 12.3
*0.4
11.1
10.7
11'
h

1976

YEARS
1977
1978

1706.4 1890.1 2097.7
10.8
11.6
11.0

1979
£347.1
11.9

CONSTANT DOLLAR GNP
%CH

1360.7 1375.7 1389.0 1403.1 1417.4pi432.0 1446.4 1460.7 1474.9
4.0 . 4.5
3.9
4.1
4.1 |
4.2
4.1
4.0
3.9

1274.7 1337.5* 1396.3 |.U53.5
6.0
4.9

PRICE DEFLATOR
%CH

1.4432 1.4655 1.4889 1.5135 1.5403 (l.5687 1.5984 1.6294 1.6612
6.1
6.3
6.5
6.8
7.3; 7.6
7.8
8.0
8.0

1.3386 1.4129 lOoim L.6144
5.6^
5.3
6.3 /

1260.2 1292.3 1324.3 1356.9 1 3 9 4 . 4 . 1 4 3 4 . 8 1 4 7 7 . 2 1522.5 1569.2
14.3
10.6
10.3
10.2
11.5] 12.1
12.4
12.8
12.8

1093.9 1211.4 1342.0 1500.9 <*p *A
11.6
10.7
10.8
11.8
& o /

CONSUMPTION EXPENDITURES
%CH

\—--ilil

DURABLES
%CH

186.3
21.1

191.6
12.0

197.2
12.1

202.9
12.0

208.7
12.1

214.7
11.9

220.8
12.0

227.2
12.0

233.7
12.1

158.9
19.6

179.9
13.2

200.1
11.2

224.1
12.0

NONDURABLES
' %CH

500.0
16.0

511.0
9.1

521.7
8.7

532.7
8.7

545.5
10.0

559.6
10.7

573.9
10.7

590.4
12.0

607.4
12.0

442.8
8.2

480.7
8.6

527.7
9.8

582

SERVICES
%CH

573.9
10.7

589.7
11.5

605.4
11.0

621.4
11.0

640.2
12.7

660.6
13.3

682.5
14.0

704.9
13.8

728.1
13.8

492.3
12.3

550.8
11.9

614.2
11.5

694.

305.2

313.5
11.3

321.3
10.3

331.4
13.3

337.9
8.0

349.0
13.8

358.8
11.8

368.2
10.9

374.8
7.3

243.3
28.7

293.9
20.8

326.0
10.9

362.7

194.9
16.7

201.2
13.5

207.6
13.3

214.1
13.3

221.0
13.5

228.4
14.0

236.0
13.9

243.9
14.2

252.2
14.3

161.9
8.6

185.4
14.5

211.0
13.8

240.1
13.8

PRODUCERS DUR EQUIP
%CH

130.1
17.7

134.2
13.2

138.4
13.1

142.6
13.0

147.1
13.2

152.0
13.9

157.1
14.0

162.5
14.4

168.0
14.4

106.1
10.2

123.9
16.8

140.6
13.5

159.9
13.7

BUSINESS STRUCTURES
%CH

64.8
14.8

67.0
14.3

69.2
13.8

71.5
14.0

73.9
14.1

76.4
14.2

78.9
13.7

81.5
13.8

84.2
13.9

55.9
5.7

61.6
10.2

70.4
14.3

80.2
14.0

RES FIXED EXPEND
%CH

99.6
34.4

100.6
4.1

100.6
0.0

99.6
-3.9

97.5
-8.2

95.5
-8.0

92.5
-12.0

88.6
-15.8

83.8
-20.0

68.0
32.3

91.0
33.7

99.6
9.5

90.1
-9.5

INVENTORY CHANGE

10.7

11.7

13.1

17.7

19.4

• 25.1

30.4

35.7

38.8

13.3

17.4

15.5

32.5

NET EXPORTS

-15.1

-14.3

-13.3

-12.3

-11.3

-10.3

-8.3

-6.3

-5.3

7.8

-10.1

-12.8

-7.5

GOVT PURCHASES
%CH

413.4
13.1

424.6
11.3

435.9
11.1

447.6
11.2

462.1
13.6

473.0
9.8

484.2
9.8

495.6
9.8

511.4
13.5

361.4
6.6

394.9
9.3

442.5
12.0

491.0
11.0

FEDERAL
%CH
MILITARY
%CH
OTHER
%CH

153.8
16.3
98.5
12.7
55.3
23:1

164.9
9.8
105.6
9.6
59.3
10.0

171.3
16.5
109.7
16.4
61.6
16.5

173.8
6.0
111.2
5.6
62.6
6.7

176.4
6.1
112.8
5.9
63.6
6.6

178.9
5.8
114.3
5.4
64.6
6.4

185.7
16.1
118.7
16.3
67.0
15.7

130.1
5.5
86.8
3.4
43.3
10.0

145.4
11.8
94.3
8.7
51.2
18.1

163.7
12.5
104.8
11.2
58.9
15.0

178.7
9.2
114.2
9.0
64.59.5

STATE & LOCAL
%CH '

259.6
11.0

157.5 .161.1
9.5
10.0
100.9 1 0 3 . 2
10.1
9.4
56.6
57.9
9.8
9.5
267.1 274.8
12.0
12.1

282.7
12.0

290.8
12.0

299.2
12.1

307.8
12.0

316.7
12.1

325.f
12.Ot

231.2
7.2

249.5
7.9

278.8
11.8

312.3
12.0

INVESTMENT EXPENDITURES
%CH
NONRES FIXED EXPEND
%CH

NOTE: PERCENTAGE CHANGES AT ANNUAL KATES;

REVISED DATA FOR 1977:4

"^V

2/21/78

PRETAX PROFITS*
%CH
TAX LIABILITY
%CH
AFTER TAX PROFITS
%CH
AFT TAX PROF ADJ^
%CH

ECONOMIC OUTLOOK
(BILLIONS OF DOLLARS—SEASONALLY ADJUSTED ANNUAL RATES)
ACTUAL
1977:4

1978:1

180.5
19.1

182.3
4.0

186.7
10.0

191.3
10.2

196.0
10.2

195.4
-1.2

198.8
7.1

202.3
7.2

72.0
16.6

72.7
4.0

74.5
10.0

76.3
10.2

71.0
-25.3

69.8
-6.6

71.4
9.6

108.5
*>n 2

109.6
4.0

112.2
10.0

115.0
10.2

125.0
39.9

125.6
1.9

77.3
9.7

79.1
9.7

88.3
55.7

75.0
-21.7

75.5
2.8-

FORECAST
1978:2 ~ I 9 7 8 : 3 1 9 7 8 : 4 1979:1~T979:2"" 1979:3

1976

YEARS
1977
1978

205.8
7.1

156.8
27.0

172.3
9.8

189.1
9.8

200.6

72.6
7.2

73.9
7.1

64.8

68.9
6.3

73.6
6.9

71.9
-2.3

127.4
5.8

129.7
7.2

131.9
7.1

92.1
25.5

103.4
12.3

115.4
11.7

128.7
11.5

87.8
-2.4

88.4
2.8

89.4
4.6

90.3
3.9

63.3
29.0

71.6
13.0

80.0
11.8

89.0
11.2

1979:4

19*9"

1602.8
14.4

1647.1
11.5

1690.6
11.0

1735.3
11.0

1781.2
11.0

1828.4
11.0

1881.1
12.0

1935.3
12.0

1991.0
12.0

1382.7
10.3

1536.7
11.1

1713.5
11.5

1909.0
11.4

234.6
15.9

237.7
5.4

245.1
13.0

257.2
21.2

241.6
-22.2

249.6
14.0

258.5
15.2

267.8
15.0

277.2
14.9

196.9
16.5

227.5
15.5

245.4
7.9

263.3
7.3

1368.2
14.1

1409.4
12.6

1445.5
10.6

1478.1
9.3

1539.6
17.7

1578.8
10.6

1622.6
11.6

1667.5
11.6

1713.8
11.6

1185.8
9.4

1309.2
10.4

1468.2
12.1

1645.7
12.1

PERSONAL OUTLAYS
%CH

1293.0
14.3

1325.5
10.4

1358.1
10.2

1391.1
10.1

1429.0
11.4

1469.8
11.9

1512.3
12.1

1557.8
12.6

1605.1
12.7

1119.9
11.5

1242.1
10.9

1375.9
10.8

1536.3
11.7

PERSONAL SAVINGS
%CH

75.2
10.8

83.9
54.7

87.4
18.2

87.1
-1.8

110.6
160.7

109.0
-5.6

110.2
4.4

109.7
-1.8

108.7
-3.8

66.0
-17.7

67.1
1.7

92.2
37.5

109.4
18.6

5.5

6.0

5.9

7.2

6.9

6.8

6.6

6.3

5.6

5.1

6.3

6.7

EMPLOYMENT
%CH

92.069
5.6

92.600
2.3

93.200
2.6

93.800
2.6

94.400
2.6

94.900
2.1

95.400
2.1

96.000
2.5

96.500
2.1

87.481
3.2

90.554
3.5

93.500
3.3

95.7U0
2.4

LABOR FORCE
%CH

98.622
4.4

99.100
2.0

99.600 100.000 100.500 101.000 101.400 101.900 102.300
2.0
2.0
1.6
2.0
1.6
2.0
1.6

94.767
2.4

97.389
2.8

99.800 101.650
1.9
2.5

6.633

6.559

6.426

6.200

6.070

6.040

5.917

5.790

5.670

7.683

7.025

6.314

5.854

14.779
-1.5

14.856
2.1

14.904
1.3

14.958
1.5

15.014
1.5

15.090
2.0

15.162
1.9

15.215
1.4

15.284
1.8

14.b/0
2.7

14.769
1.4

14.933

1.1

15.188
1.7

1.393
2.4

1.410
5.2

1.426
4.6

1.443
4.9

1.460
4.8

1.478
5.0

1.496
5.0

1.513
4.6

1.531
4.8

1.298
10.1

1.371
5.6

1.435
4.7

1.505
4.9

PERSONAL INCOME
%CH
TAX & NONTAX PAYMENT
%CH
DISPOSABLE INCOME
%CH

SAVING RATE(%)

UNEMPLOYMENT RATE(%)
PRODUCTIVITY*
%CH
TNDUSTRIAL PRODUCTION
%CH
MONEY SUPPLY-(Ml)
%CH
VELOCITY OF Ml
%CH
MONEY SUPPLY-(M2)
%CH
VELOCITY OF M2
%CH

334.133 341.400 348.000 355.600 363.300 371.200 379.300 387.600 396.000
8.0
8.9
9.0
7.0
9.0
9.0
9.0
9.0
9.0
5.877
3.1

5.905

5.943
2.6

5.972
2.0

6.009
2.5

6.052
2.9

6.'095
2.9

6.140
3.0

6.187
3.1

802.933 822.300 840.200 860.500 881.200 902.400 924.200 946.500 969.300
7.8
10.0
9.0
10.0
10.0
10.0
10.0
10.0
10.0
2.446
2.4

2.452
1.0

2.461
1.6

2.468
1.0

2.477
1.6

2.489
1.9

2.502
2.0

2.515
2.1

2.528
2.1

304.192 324.525 352.075 383.525
6.7
8.9
5.1
8.5
5.609
6.2

5.957
2.3

6.119
2.7

703.833 777.583 851.050 £35.600
9.8
^9.4
9.9
10.5
2.425
1.7

NOTE: PROFITS FOR 77:4 ARE ESTIMATES; PRODUCTIVITY IS CALCULATED AS CONSTANT DOLLAR GNP PER WORKER
1) AFTER TAX PROFITS ADJUSTED TO EXCLUDE INVENTORY PROFITS AND ALLOW FOR DEPRECIATION AT REPLACEMENT COST

5.823
3.8

2.430
0.2

2.465"
1.4

2.508

1.8

2/21/78

ECONOMIC OUTLOOK
ACTUAL

1976

YEARS
TWT7
1978

HT79

FORECAST

T9T7T4 " l T T O
INTEREST RATES
NEW ISSUE AA INDUS BONDS

8.040

8.400

8.600

8.800

9.000

9.150

9.300

9.450

9.600

8.250

7.918

8.700

9.375

PRIME RATE

7.673

8.000

8.300

8.650

9.000

9.080

9.160

9.240

9.320

6.841

6.824

8.488

9.200

COMMERCIAL PAPER 4-6 MOS.

6.593

7.100

7.350

7.800

8.250

8.350

8.450

8.550

8.650

5.345

5.612

7.625

8.500

AUTO SALES 1)

11.000 11.337 11.312 11.456 11.497 11.566 11.604 11.645 11.673

10.092 11.217 11.401 11.622

DOMESTIC

8.933

9.240

9.219

9.337

9.370

9.426

9.457

9.491

9.513

8.600

9.133

9.291

9.472

IMPORTS

2.033

2.097

2.093

2.119

2.127

2.140

2.147

2.154

2.159

1.492

2.075

2.109

2.150

2.143

2.000

1.950

1.850

1.750

1.650

1.550

1.450

1.300i

1.541

1.966

1.888

1.488

HOUSING STARTS 1)

1) IN MILLIONS OF UNITS—SEASONALLY ADJUSTED ANNUAL RATES
2) IN BILLIONS OF DOLLARS—SEASONALLY ADJUSTED ANNUAL RATES

HARRIS
BANK
Harris Economic Research Office Service

February 28, 1978
Business Outlook - Monthly Update
Business activity is declining rapidly at the start of 1978
due to the combined impact of an extended coal strike and adverse
weather conditions. In addition, highly unusual monetary growth
patterns are creating some uncertainty about the prospects for business
later this year.
Sales, Output Drop Sharply
Following a strong burst of spending at year-end, the combination of severe snowstorms and the coal strike have sharply curtailed
business activity. Retail sales in January were down 3.1% from December.
Although the sales decline was fairly pervasive, the auto sector was
particularly hard hit. Sales of domestically produced autos averaged
an 8.0 million unit annual rate in January compared to an 8.9 million
rate in the fourth quarter. The retail sales decline continued into
early February, but auto sales were at an 8.6 million unit rate during
the first 20 days of the month. There is some evidence to support the
view that much of the sales decline is weather-related. A malor auto
company which analyzed its sales by region showed severe declines from
year earlier sales in those regions affected by blizzards, while sales
were up 4% from the previous year in those areas where weather was not
a factor.
Incomes and production also have shown a marked weakness. Personal income rose only 3% at an annual rate in January after increasing at
a 16.5% annual rate in the final three months of 1977. However, a detailed
analysis of special factors such as the coal strike, higher social security
contributions, etc., shows that personal income rose at about a 9h% rate in
January as well as in December after accounting for these factors.
Industrial production fell by .1% in January with cutbacks in
auto output leading the decline. Auto assemblies were cut back to an
8 million unit annual rate in response to both lower sales and weather
disruptions. Although weather-related difficulties are expected to
moderate, the impact of a continued coal strike would be a major factor
depressing business activity. The developing weakness in business
activity in the first quarter suggests that real output will be up only
slightly from the fourth quarter instead of the 4 ^ annual rate advance
that we had expected. Barring any further adverse developments, this
weakness will be offset by a more rapid advance in the second quarter.
Inflation Rates Move Higher
Wholesale price movements are beginning to show more rapid
increases. During 1976 wholesale prices for finished goods rose at a 3.3%
annual rate. In 1977 price trends were distorted by unusually rapid
increases in the spring, related to food and adverse weather conditions,

-2followed by unusually slow increases through the fall. Averaging
over the period shows that during the first nine months of 1977,
wholesale prices for finished goods increased 6.4% at an annual rate.
Between September, 1977 and January, 1978 the advance was 7.3% at an
annual rate. This speed-up in wholesale prices is even more disturbing when viewed by stage of processing. Crude materials for further
processing, a highly sensitive measure of price pressures, has registered increases of 1% or more per month since October. The performance in wholesale prices suggests that expectations of rising inflationary pressures in 1978 will be borne out. In this regard, consumer
prices in January were up 8.4% at an annual rate.
Unusual Monetary Growth Patterns Develop
Recent behavior of the monetary aggregates has been extremely unusual. The monetary base (member bank reserves plus currency) , which increased by 9% at an annual rate between February and
August of 1977, rose at a 10k% rate during the past six months and almost
12% during the past three months. A similar trend is apparent in
Federal Reserve Credit (Federal Reserve holdings of government securities and other assets). Both of these series measure the extent tc
which the Federal Reserve is providing the raw ingredients for the money
supply, and in the case of the monetary base, the growth during the past
12 months is the highest since World War II. Normally, the growth in the
narrowly defined money supply (M^, which consists of currency plus
demand deposits) closely parallels the rise in the monetary base while
M
2 (Ml plus time deposits at commercial banks other than large CD's)
rises at an even faster rate. Instead, over the past six months the
growth in M-| has slowed to approximately 5% at an annual rate while the
growth in M? has slowed to less than 7%.
If the latest data on Mj_ and M2 are not being distorted by
special factors, then a slowdown in real growth could occur this spring
or summer. Before changing the forecast to incorporate this development, several factors should be noted. First and most important, the
dramatic rise in the raw ingredients of money suggests that the potential for an expansion in M^ and M2 is tremendous and could occur at any
time. Second, the money supply figures are due to be revised within the
next month on the basis of more complete data. These revisions could
show higher growth rates than are now apparent. Finally, the dislocations in the economy associated with the coal strike and the adverse
weather patterns could be causing a temporary shift toward currency and
away from demand deposits, thus leading to a temporary weakness in
monetary growth.
In light of the recent unusual patterns in monetary growth,
there is cause for increased uncertainty with respect to future developments. If the monetary base is accurately reflecting the thrust of
monetary policy, then monetary growth rates should soon expand more
rapidly. Business activity would then soar at the end of the coal strike,
interest rates would move sharply higher, and future inflationary pressures would become more intense. However, if the recent slower expansion
of M^ and M? was to continue, the economy would be on the verge of a
recession this summer/ interest rates could then reverse their upward
trend, and prospects for future inflation would improve. Since there is

-3no historical precedent for the unusual monetary patterns observed
recently, it becomes difficult to have a high degree of certainty
with respect to future developments. Although our forecast continues
to call for an expansion in business activity through 1978 with
higher inflation and an upward trend in interest rates, the uncertainty
surrounding that forecast has increased. In the months ahead a careful
analysis of future monetary developments will be needed in order to
evaluate the impact on future business conditions.
Summary
Although the recent weakness in business activity is largely
attributable to adverse weather conditions and the coal strike, the
outlook for the spring and summer months has become clouded by unusual
patterns among the monetary aggregates. Meanwhile, inflationary pressures appear to be growing more intense.

Robert J. Genetski
Economist
(312) 461-5001

FISCAL POLICY
A Report Prepared for the Shadow Open Market Committee

Rudolph G. Penner
American Enterprise Institute

President Carter's 1979 Budget
Even though it is expected that we shall be in the fifth year of
economic expansion during fiscal 1979, the President recommended a unified budget deficit of $60.6 billion.

This is only slightly below the

level of $61.8 billion recommended for 1978 and $15.6 billion above
the actual level of $45.0 billion for 1977.

At Mhigh employment" lev-

els (defined by the Budget to imply an unemployment rate of 4.9 percent), the unified deficit rises from $10 billion in 1977 to $32 billion in 1978 and to $37 billion in 1979.

On an NIPA basis, the high

employment deficit rises from $17.9 billion in calendar 1977 to $26.9
billion in calendar 1978 and then falls slightly to $22.6 billion in
calendar 1979, assuming no policy changes in the 1980 Budget.
The President has successfully advertised his recommended outlay
level of $500.2 billion as being "lean and tight".

The basis for this

claim comes from the fact that outlays are being reduced from 22.6 to
22.0 percent of forecast GNP between fiscal 1978 and 1979.

It should,

however, be noted that recommended outlays will be 8.2 percent above
the 1978 recommended level and 1.6 percent above the level implied by
a continuation of "current services."
A net "tax cut" of $24.3 billion is recommended for fiscal 1979,
but, in the aggregate, this does little more than offset recently passed

-2social security increases and the automatic tendency for inflation
>
and real growth to increase tax burdens.

The ratio of receipts to

GNP is expected to rise from 19.4 percent in fiscal 1977 to 19.6 percent in fiscal 1978 and then to fall to 19.3 percent in fiscal 1979.
The total receipts ratio will be higher in calendar 1979 than in calendar 1977, and individual income tax receipts will rise from 10.1
to 10.5 percent of personal income over the two year period.
The few dramatic policy initiatives on the spending side, such
as welfare reform and the energy initiatives, do not have large 1979
impacts, and consequently, the changes in the .composition of the budget are not important enough to be of macroeconomic significance.
In the NIPA budget, total expenditures rise 8.7 percent; purchases,
8.3 percent; transfers, 9.6 percent; and grants, 6.0 percent.
The relatively slow rate of growth of grants in 1979 must be put
in context.

In the previous three years, from the trough of the re-

cession in fiscal 1975

through fiscal 1978, grants are expected to

grow at an annual rate exceeding 15 percent.

It is, therefore, some-

what ironic that one of the excuses for the large 1979 deficit is that
it is necessary to offset a growing state and local surplus.

There

is little doubt that that surplus is in part the result of the surge
in Federal grants (The main cause is, of course, the economic recovery).

In other words, the various "temporary11 stimulus programs,

which were largely implemented through the grant system, have, to a
significant degree, simply increased state and local surpluses at
the expense of the Federal deficit.

It would seem that a more direct

-3approach to the "problem" of state and local surpluses would be to
cut back on grants.

Even an extreme Keynesian would have to admit

that the macroeconomic

impact of such a cutback would be very small.

But, of course, this simple solution is constrained politically by
the fact that the aggregate state and local surplus masks continuing
financial difficulties in a number of cities.
Is the budget too expansionary?

If one accepts all of the fore-

casts and estimates of the Administration, it clearly is not.

The

budget forecast of real GNP in 1979 is over 3 percent below the CEA
estimate of potential GNP.

While one might be-concerned by the alloc-

tive impact of the large spending level and by the absorption of
private savings by the huge deficit, the degree of macroeconomic
stimulus measured in the Keynesian sense is modest given the Administration's estimate of the excess capacity implied by their forecast.
However, everyone would agree that any estimate of the potential
capacity of the economy is highly tenuous.
tial GNP was exceeded was in calendar 1973.

The last time that potenThe CEA estimated poten-

tial at $1,228 billion in that year and presumes that it will grow at
about 3.5 percent annually through 1979.
timated at 4.8 percent unemployment.

The 1973 potential was es-

If it had instead been estimated

at 5.5 percent unemployment, potential GNP would have been about $1,212
billion.

If, since that time, potential grew at 3.3 percent annually,

rather than the 3.5 percent assumed by the CEA, the Budget's forecast
of $1,467 billion for 1979 would be within one half of one percent of
potential.

If potential in 1973 had been estimated at a 6 percent un-

-4employment rate and if it subsequently grew at 3.4 percent annually,
the 1979 forecast of the Administration would slightly exceed potential.

In other words, the margin for error is very slim.

The Administration's use of 4.8 percent as the full-employment
unemployment rate in 1973 would be considered highly optimistic by
most experts.

There is less reason to assume that the assumption of

a 3 1/2 percent growth rate of potential GNP is biased either upward
or downward.

(After 1977, the Administration actually uses a range

of between 3.3 and 3.8 percent.)

Many also believe that the Admini-

stration's forecast of actual GNP in 1979 is somewhat optimistic.
Consequently, I would not argue that there is a high probability
of exceeding potential in 1979.

I would, however, argue that the

harm that might be done by exceeding potential,say by one percent, is
far greater than the potential harm resulting from falling short by
one percent.

Any significant acceleration of inflation is likely to

be followed quickly by a significant reduction of real growth and a
subsequent widening of the gap.

Unemployment could easily be at a

higher level in the long run than if we let the economy adjust to potential more slowly, wherever that somewhat artificial construct may
be.

In other words, the social costs of unemployment could be higher

in the long run and of course, we would have to bear the additional
resource costs of an accelerating inflation rate.

These costs may be

substantial in part because of interactions between inflation and the
tax system.

Because of the asymmetry of the risks, I,therefore, con-

clude that we should approach 1979 with more fiscal caution than is

-5manifested by this budget.

The Budget in the Short-Run and Estimating Problems
The official, quarter-by-quarter estimates of NIA Federal expenditures show the growth rate of expenditures accelerating through the
first three quarters of 1978.

Expenditures grow at an annual rate of

8.9 percent in the first quarter rising to 10.7 percent in the second
and to 14.1 in the third.

The third quarter growth rate is inflated

by the cost-of-living adjustment to social security.

The growth rate

in the fourth quarter is estimated''at 11.8 percent.

This last quarter

is impacted by the Federal pay increase.
The NIA deficit gradually falls from $54.4 billion in the first
quarter of 1978 to $48.3 billion in the third quarter.

In the fourth

quarter, it soars to $65.6 billion when the President's tax cut is
presumed to take effect.
As noted above, all of these numbers reflect "official" budget
estimates.

Unfortunately, OMB still has not been able to cure the

"shortfall11 problem.

In my last report to this committee, I described

the political constraints which tend to inflate OMB spending estimates
and it appears that they could not be overcome in the preparation of
the 1979 Budget.
In my last report, I estimated that 1978 unified outlays would be
between $455 and $456 billion rather than the $462.9 billion estimated
by OMB in July of 1977.

The 1979 Budget lowered the 1978 estimate

slightly to $462.2 billion.

However, I see no reason to change my last

-6estimate and will stick with a forecast of $455 to $456 bullion.

The

rate of growth of NIA expenditures is thus likely to fall short of 9
percent in the first three calendar quarters of 1978 as compared to
the 11 percent implied by my earlier discussion of the official estimates.

It should be noted that OMB will update its official estimates

on March 10 —

after this is written, but before our meeting.

I do

not expect those official estimates to alter my own estimate.
The effects of the bad winter and the coal strike may also lower
1978 receipts somewhat below the $400 billion in the budget, and therefore, I would not expect the 1978 deficit to fall by the entire $7 billion shortfall on the outlay side.
It is not meaningful to talk about a shortfall for 1979 until appropriations actions have been completed for that year.

However in the

unlikely event that all of the President's policies were adopted and
there were no Budget amendments offered by the Administration, outlays
would probably fall short of the $500.2 billion recommended for 1979
by about $4 billion.

This estimate also assumes that the economy be-

haves as expected by the Administration in calendar 1978 and in early
1979.
It is interesting to note that while the Administration altered
the timing of some payments to make the 1978 deficit slightly higher
than the 1979 deficit, the above analysis suggests that they may not
be able to maintain this posture very much longer.

Thus, we are like-

ly to see the deficit rise in both fiscal 1978 and in 1979 during a
fairly substantial economic recovery.

-7Possible Congressional Reaction
It is always hazardous to attempt to forecast the Congressional
reaction to a Presidential Budget, but during an election year forecasting efforts become positively foolhardy.

This year's Budget im-

poses extraordinary political pressures on the Congress and it is
quite possible that the new Congressional budget process will not survive in a meaningful form.
Pressures emanate from both the spending and receipts side of the
budget.

On the spending side, the President recommends few outright

cuts, but many of those that are proposed affect programs that have
long been elevated to "sacred cow" status by the Congress.

Like Pres-

ident Ford before him, Carter proposes savings on school lunches, social security, impact aid for education, the GI Bill, and health costs.
Like President Ford, he is very likely to see most of these proposals
rejected.

There will also be strong pressures to add to the generosity

of agriculture policies, and indeed, the budget estimate that spending
on agriculture will fall from $9.1 in 1978 to $5.4 billion in 1979
under the President's program makes optimistic assumptions regarding
market conditions, the number of natural disasters, and the effectiveness of acreage restrictions.
Since the Viet Nam War, the Congress has made some room for its
own initiatives by cutting the President's defense request.
Soviet intrusion

However,

into the Horn of Africa, the SALT talks, and the con-

tinuing increase in Soviet defense expenditures will make it unusually
difficult this year to cut the President's already-tight defense budget.

-8On the receipts side, it has already been noted that the President's tax cut does not provide significant real tax relief.

But

the President's income tax cuts are highly progressive and they do
provide real relief to lower income families.

There will be strong

pressures to provide the same relief to lower income groups while countering the growth in the real burden imposed by income and social security taxes on the middle class.

There also seems to be little chance

of the Congress passing over $5 billion in individual and business
"tax reforms11.
While all of this is going on,*I find it hard to believe that
Congressmen and Senators will be very anxious to stand up and vote
for a deficit that is significantly higher than that proposed by the
President.

As a result, it will be extremely difficult to get a First

Budget Resolution out of the Congress and it may take several tries
before one passes successfully.

On the other hand, one should not un-

derestimate the Congress' ability to compromise difficult issues.
A possible outcome could involve the following elements:

(i) Slight-

ly more generous spending policies, but with the Congress assuming
some

shortfallIf in the President's estimates to hold total spending

close to the President's ceiling; and (ii) a slightly deeper tax cut,
but effective January 1, 1979 rather than October 1, 1978 with some
payroll tax relief to aid the middle class.

With appropriately opt-

imistic economic assumptions, the deficit could then be held to the
President's level.

However, as noted in the beginning of this section,

it is foolhardy to make predictions such as those in the last two sentences.

Briefing Paper for the Shadow Open Market Committee
March 12, 1978
by Wilson E. Schmidt*
The foreign exchange market is telling us something. The continuous
decline of the dollar from the start of 1977 is not a whisper—it's a scream.
Recently released balance of payments data amplify the message. There has
been a flight from the dollar.
The dollar dropped 19% in terms of the mark, 38% in terms of the Swiss
franc, 22% in terms of the yen, and even 13% in terms of the pound since
January 20, 1977. Balance of payments data show a sharp decline in the inflow
of private foreign funds in 1977 compared with 1976. The balance on unrecorded
transactions—chiefly reflecting private capital outflows—shifted abruptly
to an outflow in the last half of the year.
The standard explanation for the decline of the dollar,; namely our largest
trade deficit ever, cannot explain its performance. True, our recovery has
outpaced that of our trade partners, stimulating our imports and restricting
foreign demand for our exports. True, our imports of petroleum rose almost
30%. But it must be noted that while the trade deficit dumped about 31 billion
dollars on the foreign exchange market, the central banks in industrialized
countries probably picked up almost as much in support of the dollar. So
something more fundamental seems to have taken place.
The Administration's response to the decline in the thermometer has been
short run. They have sought to talk up the mercury. The President made the
appropriate noises in his State of the Union address. The Fed apparently
intervened in the foreign exchange markets rather heavily in December, January,
and February. There was a finely honed statement on U.S. intervention policy
which suggested a change in strategy. An expanded swap agreement with the
Federal Republic of Germany was put in place. The cosmetics were applied
professor of Economics, Virginia Polytechnic Institute & State University

beautifully. But they still were just that—cosmetics.
The President's statement was soon lost in the realities of the market.
The rhetoric of intervention policy retreated to the old language of preventing
disorderly markets. The irrelevance of swap arrangements, no matter what
their size, became apparent. It was realized that the combined effect of
swapping dollars for foreign currencies with other central banks and their
use to buy up dollars was to leave the growth in the stock of money unchanged.
The bank reserves absorbed when the Fed bought foreign currencies were
returned as the foreign central banks lodged the dollars they gained under
the swaps in Treasury securities.
The market went back to look at future fundamentals. How long would
foreign central banks, anxious for us to support the dollar, continue their
purchases? What would Mr. Miller's policies be? And most of all, the
budget deficits that won f t go away until 1981 if then. If the Administration won't work on the fundamentals, the market reasoned that controls or
taxes on capital movements were the probable answer, despite government
denials.

The market was awash with rumors.of controls, scaring more private

capital out of the country. It is a road we have traveled before. The
thermometer that takes the temperature of the future got very, wery cold.

Full text of Policy Statement and Position Papers : March 12-13, 1978

FRASER