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THE CHAIRMAN
COUNCIL O f

OF THE

ECONOM IC ADVISERS

WASHINGTON

February 21, 1978

MEMORANDUM FOR THE PRESIDENT
FROM:

Charlie Schultze

SUBJECT:

Meeting with Economic Advisers and Federal
Reserve Board Chairman (Quadriad)

I
am attaching to this memo a longer summary of recent
developments in the economy that I would commend to your
attention when your schedule permits.
Portions of it which
I have referenced in this cover note, may be useful to you
in preparing for the Quadriad meeting tomorrow at noon.
In
this memo I will try to d e s c n o e the issues worth discussing
at tomorrow's luncheon.
As you know, Dr. Burns remains in the chairmanship of
the Federal Reserve Board pending the confirmation of Mr.
Miller.
The meeting of the Federal Open Market Committee
previously scheduled for today has been postponed until
Tuesday, February 2 8 in the hope that Mr. Miller will be
confirmed by that time and can chair the meeting.
This
remains uncertain.
In any event, Dr. Burns will remain a
member of the Board through that meeting and his general
views and outlook will have much weight.
Discussion at the meeting on Wednesday,
might center on the following areas:
1.
2.
3.

1.

February 22

implications of recent economic data;
the general outlook for monetary policy;
deposit flows at financial institutions and possible
adjustments of regulatory ceilings on deposit
interest rates.

The Outlook and Recent Economic Data

The attached memo provides a review of recent developments
in the domestic economy.
The first 4 pages, in particular,
provide background on recent economic data relating to the
o u tlo ok .
2.

The General Outlook for Monetary Policy

The discussion commencing on page 6 of my review memorandum
outlines Federal Reserve actions to raise interest rates




-2-

early in January in a step publicly identified as intended
to support the faltering international exchange value of the
dollar.
This resulted in 0.2 to 0.3 percentage point increases
in interest rates across the board.
Growth rates in the monetary
aggregates have remained moderate and within target ranges as
shown on the attached charts.
There are a number of uncertainties impinging on monetary
developments at the current time:
(a)

fluctuations in the foreign exchange value of
the dollar which were substantial through mid-January
and erupted again last week at the time of internationa
meetings in Paris;

(b)

the puzzling January statistics;

(c)

fears of inflation, heightened by the increase in
the minimum wage and payroll taxes which went into
effect in January (see paces 5-6 of my review
memorandum).

(d)

developments pertaining to velocity of m o n e y ,
specifically:
o

During the last three quarters of 19 77
velocity growth appeared to be slowing,
in contrast to the unusually rapid growth
in the 1974-76 period.

o

So far in the first quarter of this year, however,
velocity growth appears to be somewhat on the
high side once again, although it is very
early to say.

Under the normal schedule the FOMC at next week's meeting
would decide on new target ranges for growth in the monetary
aggregates, extending from 1977-IV to 1978-IV, and those
ranges"would be announced to Congress shortly after the
meeting.
(The current ranges are shown in the heading of
each of the attached charts.)
This could be a particularly difficult time to set the
targets since the new Chairman may not yet be aboard when the
decision is taken.




-3-

Chairman Burns may argue that weakness in the dollar
and fears of inflation require targets at least as tight
or tighter than those announced last quarter.
I think there
are some counter-arguments suggesting either, (i) holding
the ranges as they are, or (ii) widening them symmetrically;
o

The volatility of the growth in velocity in recent
quarters has made it difficult to predict what
any given growth of
or M 2 will do to credit
conditions and interest rates.
A wider band for
the target ranges would give the Fed more flexibility
and reduce speculative gyrations in interest rates,
which can occur as
or
approach the upper and
lower bounds.

o

Tightening up on the monetary targets won't really
help the dollar.
There is already a wide interest
rate differential in favor of holding dollars.

o

3.

^

Most of the factors bearing on inflation this year
are institurional ones -- the higher minimum wage
and payroll taxes — which will not be significantly
affected by overall monetary and fiscal policies.
It would be most unfortunate to sacrifice real
output objectives ih~
w i t hou t, ai vi.
test.
Endorsement a m
the Chairman would be very helpful.

Deposit Flows and the Availability of Mortgage Credit

Higher interest rates on marketable securities, such as
Treasury securities, make these investments strong competitors
for funds relative to deposits at banks and thrift institutions.
As interest rates on these securities climb beyond a certain
point, flows of funds into time and savings accounts shrink.
In turn, the availability of morgage credit falls.
The interest
rates that can be offered on time and savings deposits are
limited by two factors:
(a) what these institutions can earn
on their loans and other assets, and (b) regulatory ceilings
on rates paid to depositors, which are set by the Federal
Reserve, the Home Loan Bank Board and the FDIC.
(In the case
of the Federal Reserve, the ceiling-setting regulation is
known as Regulation Q.)
Different ceilings apply to different
types of deposits and to different maturities and, by law, the
interest ceilings applying to thrift institutions (institutions
other than commercial banks) must be at least one quarter
point higher than those for commercial banks.




-4-

Currently, most depository institutions are paying the
legal ceiling rates.
The earnings on their existing mortgage
portfolios and other assets are probably such that they could
pay somewhat higher deposit rates if permitted to do so.
Yields on Government securities are now higher than the
ceiling rates on most types of deposits; the exceptions are
long-term deposits or certificates, particularly at thrift
institutions.
In view of this adverse yield spread, which developed
when interest rates rose last fall, it is not surprising
that the growth of deposits has slowed.
As noted in my
review memorandum, deposit growth at mutual savings banks
and savings and loan associations slowed from an exceptionally
rapid 15 percent annual rate in the third quarter, to 11
percent in November, 9 percent in December and just under
7 percent in January.
These are not strikingly slow rates,
but a continuation of the January rate or lower would pose
some threat to the availability of mortgage credit.
More
than half of all mortgage credit outstanding on 1-4 family
homes is held by these institutions.
In 19 7 3-74 when market
interest rates rose sharply, regulatory ceilings were eased
somewhat but financial institutions earnings were not adequate
to permit them to raise their deposit rates fast enough to
keep up with market rates.
Deposit growth at these institutions
fell to 5-1/2 percent in 197 4 and between 1972 and 197 4 the
amount of credit they extended dropped by more than 40 percent.
We do not anticipate a problem anywhere near this serious
in the near future.
In the absence of sharp further increases
in interest rates, yield spreads will not be as adverse as in
1973-74 and the earnings of the thrifts are better.
3ut the
possibility exists that some adjustments of regulatory ceilings
could become desirable in the near future in order to permit
these institutions to compete for funds and in order to permit
small savers, for whom time and saving deposits are the most
accessible investment, to obtain returns more nearly equal to
those available to the wealthy.
We might discuss with Chairman Burns the circumstances
under which an adjustment of ceilings would be desirable and
what kind of adjustments he thinks most appropriate.
He may
welcome your interest since it will be desirable for the three
regulatory agencies (Fed, FHLBB and FDIC) to move together and
the Administration could help to encourage such coordination.
(Technically, FHLBB must move if the others are to do so since




the ceilings pertaining to thrifts must be raised to preserve
the one-quarter point differential in the event of higher
ceilings for banks.)




\' v i > \

billions $

33«.»ftP«

332*3713

327.9(36

323.33S7

3 li.9 l7 i




(irowLh of m T RoIn Live Lo T;icyet Range
Tar <jo t Rancjo :

w

m

y

H>

,

<;i;owl It o l

billions $

in.mr

•♦4.C4P1

793.7399

7*1.8«4«

74M.7IIO




MA

( n T .it »|ol.

H .iih

Till i|(!l

l(nii<|<>:

jo

February 16, I9 7 \
j
Growth of M3 R e l a t i ^ ? Lo Target Range

billions $

Target Rancje

8% - 10-1/2%
MH

M3

....................

*7

"

1f«
3»

1369

M 2 plus deposits at
S&Ls and other non
bank thrift institutions

1349

1329

1399

1299




A

r

t

J

J

A
1977

S

O

N

D

J

F

n
197*

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