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THE

C HAIRM AN

C O U NC IL OF

OF THE

EC O N O M IC

ADVISERS

W A S H ! N' CTON

June 27, 1978

MEMORANDUM FOR THE PRESIDENT
From:

Charlie Schultze

Subject:

Background for the Quadriad Meeting on June 28

As I indicated to you in my June 14 overview of recent
economic developments, the disturbing inflation developments
recently and the response of the Federal Reserve to them are
causing concern that the economy could slow excessively later
this year and in 1979. Some slowing appears to us to be
both likely and desirable. But the coordination of monetary
and fiscal policy can make a critical difference between
desirable moderation and slowing down at least to the point
of ax"growth recession."
CEA and Mike Blumenthal met with the Federal Reserve
Board on June 19 to discuss these matters and to assess
their views. The impressions we gleaned are the following:
o

The Board is very concerned about inflation;

o

Some members of the Board appear to be prepared
to tighten monetary conditions still further;

o

With perhaps one exception, the members of the
Board do not see even a growth recession as
desirable to combat inflation. But they seem
willing to run some risks with tight money
because of their inflation worries.

o

Chairman Miller is under considerable pressure
from some of the more vocal and articulate
inflation-fighters on the Board. He, himself,
is very sensitive to the danger of overdoing
monetary restraint.

Attached is a proposed agenda for the Quadriad meeting.
I have not had the opportunity to discuss this with Chairman
Miller because he has been out of town. In light of the




-2-

june 19 meeting, however, he probably anticipates something
along the lines I am proposing.
The following material
provides some background on these points.
A.

The Outlook for the Next 18 Months

As I reported to you earlier and as we discussed with
the Board, our forecast calls for growth of real GNP at a
rate of 3-3/4 to 4 percent from the middle of this year through
the end of 1979.
o

A substantial slowing in the second half of this
year from the 7 percent annual rate of increase
between the first and second quarters (according
to the first, unpublished Commerce estimate) seems
already to be indicated. In May, employment, industrial
production, personal income, retail sales and housing
starts all indicated a slowing from the March-April
catch-up pace.

o

The exceptionally slow growth of productivity
recently (only 1 percent over the past year in
contrast with a "normal" trend closer to 2 percent)
makes it very difficult to forecast the movement
of unemployment that would be associated with
our GNP forecast. Our best guess is that the
unemployment rate will change little over the
remainder of this year — as productivity growth
catches up partially — and that it will decline
slightly next year.

o

Since the unemployment rate has dropped substantially
over the past year and some labor markets may have
tightened to the point of exerting upward pressure
on wages, this outlook seems an appropriate target
for the immediate future in order to avoid aggravating
the inflation problem.

A number of private (and foreign official) forecasters
are pointing to substantial uncertainties in the outlook.
There are a few extremists on Wall Street who see interest
rates skyrocketing and a real recession set in motion by
year end or early 1979. But this is not the prevailing view.
The concerns that do seem to prevail center around the following
sequence of developments:




o

Inflation has accelerated; even if food prices
stop rising as fast as this spring, the higher
price levels threaten to boost wage increases in
the near future.

-3o

The Fed will respond to these inflationary pressures
by some further increases in interest rates.

o

Higher interest rates, the substantial growth in
consumer and mortgage debt burdens that households
have already incurred, and the erosion of real growth
in personal income due to higher food and import
prices will lead, collectively, to a noticeable
slowing in consumer purchases of durable goods and
a reduction in residential construction.

o

Slowing growth of final sales and the higher cost
of funds will cause fairly slack growth of business
fixed investment.

o

Although these developments probably will not be
severe enough to cause real GNP to decline, growth
will be slow enough to let the unemployment rate
rise and to make the threat of a GNP downturn much
more significant.

This sequence of events cannot be forecasted with any
certainty; reasonable questions can be posed about many
links in the chain. There is enough precedent in the
postwar period, however, for this pattern of developments
that the possibility cannot be dismissed.
B.

The Battle Against Inflation

Inflation is the key cause of malaise at the Fed as
well as elsewhere. This spring we have had the dual
problems of inherited momentum from past inflation plus
the run-up in food prices. Measures to control oil
imports, and the energy program generally, may add another
blip to inflation later in the year but this cost will be
offset by the benefits in reduced oil imports and lessened
pressure on the dollar.
After excluding food and mortgage interest costs,
the rate of increase in consumer prices this year has
been in the 6 to 6-1/2 percent range. The rate of increase
in average hourly earnings has tended to creep up, however,
so the rise in unit labor costs (a key determinant of the
underlying rate of inflation) during the coming year may
be closer to 7 percent.




-4-

1.

Food prices — the worst may soon be over.
Following an increase of 7 to 7-1/4 percent
(
not annual rate) in food prices during the
first half of the year, we are now forecasting
an increase of 1 to 2 percent in the second half
of the year. There are signs of meat and some
vegetable prices coming down.

2. Labor settlements — although only about 25
percent of the work force is unionized, union
contract settlements have high visibility and
their costs tend to pass through quickly into
prices. Thus far, the deceleration program has
not had any visible successes with organized
labor. As you know, the two key settlements
this year, which will set the tone for next
year's major bargaining round, are the
Railroad Workers and Postal Workers.
3. The deceleration program — some successes have
been achieved in obtaining commitments from
business to decelerate the rate of increase in
their prices. Since late April, the three major
automobile manufacturers, the three major aluminum
producers, and General Electric, AT&T, W. R. Grace,
among others, have indicated some degree of cooperation
with your anti-inflation program. You may wish to
indicate to Chairman Miller that i f this momentum
_
can be maintained and if some deceleration of prices
actually becomes observable, it will help considerably
in obtaining cooperation from labor. However, he
can be expected to point out that success on the
price front cannot be extended indefinitely without
deceleration in wage costs.
C.

The Appropriate Posture for Monetary and
Fiscal Policy

As noted above, we believe that our forecast of 3-3/4
to 4 percent real growth over the next year and a half is
both a reasonable forecast and an appropriate target for
policy. This forecast is based on the following policy
assumptions:




-5o

no further increase in most interest rates. Since
the beginning of the second quarter — when inflation
and the spurt in real growth boosted the growth of
the monetary aggregates sharply (see attached charts)
— the Fed's target rate of Federal funds has been
raised a full percentage point (from 6-3/4 to 7-3/4).
The latest 1/4 point increase occurred in the middle
of last week, following last Tuesday's FOMC meeting.
Other short-term market interest rates adjust with
varying speeds to the Federal funds rate but normal
adjustments to the current target will bring these
market rates to the levels we have assumed to prevail
during the forecast period. The prime rate at
commercial banks had already risen by another 1/4
point at the end of last week, to 8-3/4 percent,
and it may rise further.

o

growth in M i above the Fed's target range (4-6-1/2
percent) and growth in M2 near the top of the range.
There is substantial uncertainty about what growth
rate in the monetary aggregates will be consistent
with our GNP, price and interest rate forecasts.
The slowdown in real output growth in the second
half of the year should substantially reduce pressure
on the growth of the aggregates and it is possible
that growth in M 2 (the broader measure) may remain
quite close to the top of the current target range.

o

a $20 billion tax cut effective next January 1.

o

unified budget expenditures of $450 billion in
FY 1978 and about $495 for FY 1979. This is
consistent with the spring budget review and
implies no further shortfall.

Can interest rates rise above our forecast without
significant effects on real growth, particularly in the
housing and business investment sectors? We think there
would be serious risks involved in further significant
interest rate increases. No one can say with certainty
because institutions change and the current inflation
rate makes historically high interest rates both inevitable
and less restrictive. Nevertheless, the increase in interest
rates over the past two years is relatively large in
comparison with corresponding periods since the mid-1950s
(excluding the 1972-74 period which is distorted by the
tremendous acceleration of inflation then). Continuation




-6e sharp increases would raise serious questions concerning
capacity of the economy to adapt. The possibilities of
sharp cutbacks in residential construction and eroding growth
in business fixed investment are real. Some forecasts would
suggest that a further increase of 1 to 2 percentage points
in interest rates by early 1979 could raise the unemployment
rate at the end of 1979 to 6-1/2 to 7 percent.

The gains on the inflation front from such a slowdown
in real growth — induced by interest rate increases —
would be visible but small. The rate of inflation, measured
by the GNP deflator, might be slowed by at most one-half
percentage point in 1979.
You may wish to explore with Chairman Miller his
perceptions of these uncertainties and the limitations
that they may impose on the course of monetary policy in
the coming months.

Attachments




June 26, 1978
Proposed Agenda for the Quadriad Meeting, June 28, 1978

1. Assessment of the outlook for real growth in the next
year
1.

Assessment of the outlook for real growth in the next
year to eighteen months:
o

o

2.

What is the appropriate growth target for fiscal
and monetary policy over the next year to eighteen
months; does Chairman Miller agree that the 3-3/4 to
4 percent range, which we are now forecasting, is
about right as a target — as a forecast?
Discuss the
forecasters
in the next
principally

Review of the battle against inflation — prospects,
problems, successes. This might include a review of
o
o
o

3.

emerging concern among some private
that economic growth may slow too sharply
year; the reasons for the concern are
rising interest rates and inflation.

the outlook for food prices,
labor settlements,
the deceleration program.

Assessment of the appropriate posture for monetaryfiscal policy. This might focus on two areas:
o

How much further can interest rates rise without
threatening to stall overall growth and jeopardizing
prospects for housing and business investment? On
the other hand, how much further increase in interest
rates is appropriate to contain inflation? Are there
conflicts between these objectives and how might they
be resolved?

o

What problems would arise if the Congressional
impasse on the tax cut persists through the end of
the Term? How could this be dealt with?




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THE

CO U NC IL

CHA 'RM A N
OF

Or

EC O N O M IC

TH=.

A DVISERS

VMS:'< TON
->o
i
June 26, 1978
proposed Agenda for the Quadriad Meeting, June 28, 1978

1.

Assessment of the outlook for real growth in the next
year to eighteen months:
o

o

2.

What is the appropriate growth target for fiscal
and monetary policy over the next year to eighteen
months? does Chairman Miller agree that the 3-3/4 to
4 percent range, which we are now forecasting, is
about right as a target — as a forecast?
Discuss the
forecasters
in the next
principally

Review of the battle against inflation — prospects,
problems, successes. This might include a review of
o
o
o

3.




emerging concern among some private
that economic growth may slow too sharply
year; the reasons for the concern are
rising interest rates and inflation.

the outlook for food prices,
labor settlements,
the deceleration program.

Assessment of the appropriate posture for monetaryfiscal policy. This might focus on two areas:
o

How much further can interest rates rise without
threatening to stall overall growth and jeopardizing
prospects for housing and business investment? On
the other hand, how much further increase in interest
rates is appropriate to contain inflation? Are there
conflicts between these objectives and how might they
be resolved?

o

What problems would arise if the Congressional
impasse on the tax cut persists through the end of
the Term? How could this be dealt with?


Federal Reserve Bank of St. Louis, One Federal Reserve Bank Plaza, St. Louis, MO 63102