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THE CHAIRMAN OF THE
COUNCI L OF ECONOMIC ADVI SERS
WASHINGTON

November 9, 1977

MEMORANDUM FOR THE PRESIDENT
FROM: Charlie Schultze
Subject:

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

Discussion at the meeting on Thursday (November 10) might
center on the following areas:
—

the outlook for 1978 and its implications for
fiscal and monetary policy;

—

recent changes in the velocity of money and the
implications for monetary policy;

—

broader implications for the world economy.

The following material provides some background for this
discussion.
1.

The Outlook for 1978

Over the course of this past summer, growing uncertainties
about the prospects for business fixed investment led to a
downward revision in our forecast for next year. In September,
real GNP growth over the four quarters of 1978 was estimated
at about 4 percent.
Recent indicators of economic activity have continued to
be mixed.




Consumer spending was very weak in the second and
third quarters. In October, retail sales appear to
have strengthened. Although the personal saving
rate rose in the third quarter,it is still relatively
low; if it increases further, consumer spending
will grow somewhat less rapidly than after-tax
incomes.

-2-

Inventories remain fairly moderate in relation to
sales. Slow growth in industrial production during
the third quarter reflected a quick production
response to the slowdown in consumer spending,
avoiding an undesired inventory buildup. Cautious
inventory policies will continue, but production
should rise more strongly if consumer spending
strengthens.
The merchandise trade deficit declined substantially
in September, as exports rose faster than imports.
One month's performance does not make a trend; no
fundamental improvement can be expected in our
foreign trade balance while our economy is growing
faster than those of our trading partners, and our
oil imports continue to be so large.
Housing starts in the third quarter averaged almost
8 percent above the second quarter, and sales of new
homes have continued to rise. However, home building
is not likely to rise much further, because single
family construction is at record levels and backlogs
of demand have been filled. If interest rates were
to rise considerably further, residential construction
would probably decline late next year.
Business fixed investment has not developed the
momentum we expected. New orders for capital goods
moved erratically during the summer, and were lower,
on average, than in the second quarter. Private
surveys of business plans indicate a growth rate of
only around 5 or 6 percent next year in plant and
equipment outlays (adjusted for inflation). These
lackluster signals are not consistent with the
strength needed for a strong economy in 19 78.
There is now some risk that the rate of expansion in
1
1978 may even fall below the 4 percent figure we projected \
in September. The probability has increased that additional '
stimulative measures will be needed to keep growth at a
satisfactory pace next year.
On the fiscal side, scheduling individual income tax
cuts in your tax reform package to take effect at mid year
1978 would be one way to deal with the problem. You may
wish to explore with Chairman Burns the appropriate response of
monetary policy to a tax cut. A tax cut can keep the pace
of expansion from lagging if money and credit are permitted
to increase fast enough to keep the higher growth rate of




-3 gconomy from pushing up interest rates. A large rise
•^TTereit rates could negate some or all of the benefits of
tax reduction.

r

2.

Velocity of Money

The velocity of money is the
changes in financing the purchase
services. It is usually measured
current prices ("nominal GNP") to
money supply (M^).

speed with which money
and sale of goods and
by the ratio of GNP in
the narrowly defined

Normally velocity rises in an economic expansion. As
I have discussed with .you on previous occasions, the velocity
of money grew unusually fast during the first two years of
the current recovery.
From IQ 1975 to IQ 1977 velocity grew at an annual
rate of almost 6 percent, and interest rates actually
fell.
But since then the pattern has reversed:




Velocity grew at an annual rate of only 2 percent
between the first and third quarters of 1977, as
the rate of growth of
speeded up.
Short term interest rates rose sharply between the
first and third quarters of this year, reflecting
efforts by the Federal Reserve to curb the growth
of M jl.
Rapid growth of M, continued in October, and
short-term interest rates rose further as the
Fed sought to rein in that M^ growth.
Recently, the Federal Reserve has backed off its
efforts to raise the Federal Funds rate — the rate
used as a target by the Federal Reserve — and
securities markets have settled down.
It is not
clear, however, what the Federal Reserve intends
to do if money growth continues to be rapid.
If velocity continues to rise at a slow pace, a
relatively high growth rate of money will be needed
to accommodate satisfactory growth in output. The
target growth range for
announced today (11/9)
for the period from 1977-III to 1978-III was 4 percent
to 6-1/2 percent. To meet our growth targets, nominal
GNP will have to grow by about 11 percent from 1977
to 1978 (5 percent real growth and 6 percent inflation)

- 4 If velocity grows by 2 percent, Mi growth of 9
percent would be needed. If the Fed tries to hold
growth of M _ within its target range, and velocity
]
increases are small, interest rates will rise very
sharply and the recovery will be damaged.
You may wish to discuss with Chairman Burns the recent
slowdown in the growth of Ml velocity.
Does he expect slow
growth in velocity to continue? Can the Federal Reserve
explain why the rise in velocity has slowed? Will the
Federal Reserve modify its targets for money growth if the
slowdown persists?

\
I
'

Burns may argue that increasing the rate of money growth
would be unwise because of our inflationary problem. We
disagree. A weaker economy next year because of inadequate
growth of money and credit will affect prices very little,
and real output and employment a lot.
3. The World Setting
Economic growth in other industrial economies has lagged
badly this year, and unemployment in those countries is not
declining. The European economies have shown little growth
since the first quarter. In Japan, growth has been led by
exports; private domestic demand has been weak.
A faltering of the U. S. recovery during 1978 would deal
a heavy blow to the prospects for economic progress among
our trading partners. Continued strong expansion in the
U. S. economy is vital to the health of the world economy.
We must keep this in mind in formulating our monetary policy
as well as our fiscal policies.
In regard to the international situation, Chairman Burns
may argue that actions to stimulate domestic expansion will be
harmful to our merchandise trade balance and to the international
value of the dollar. There are strong arguments to the contrary:




Although expanding incomes generate demand for more
imports, a major source of the rise in imports this
year was oil. Actions to reduce our trade deficit
should concentrate on reducing our oil deficit.
Efforts on our part to hold down the trade deficit by
moderating the growth of our economy would intensify
the already alarming trend towards protectionism.

The decline in the value of the dollar in foreign
exchange markets has not been large — relative to the
trade-weighted average of all other currencies the
dollar declined 3 percent from last December to
today (11/9).
(It had fallen further but has recovered.)
Moreover, it is not a sign of weakness in our economy.
The decline was principally against the Japanese yen,
the German mark, and the Swiss franc, and will help
reduce inappropriate surpluses in the current account
balances of those countries.
Slower economic growth would discourage the flow of
investment funds into the U. S. The exchange value
of the dollar might respond more to this than to any
improvement in the trade deficit that resulted from
slower growth.
Finally, we have heard via the grapevine that Chairman
Burns is unhappy with the following remark attributed to you
by Time magazine.
"I think one of the major reasons for
perhaps a lowering in the stock market values has been
thex increase of fluidity of the money supply and the increase
in interest rates put on by the Federal Reserve Board." If
he brings this issue up, he will probably argue that the
principal reason why the stock market is weak is because
corporate profits are so low.
Your statement, which identifies rising interest rates as
one of the major reasons for declining stock prices is correct.
It is a major reason. Of course, there are others — including
an inadequate recovery of profits since early 1975, fears of
inflation, fears of a slowdown in the pace of economic activity,
uncertainties about government policy, and others.
Burns discussed the state of corporate profits recently
in a major address. We have looked at his arguments carefully
and conclude that he greatly overstates the deterioration in
business profits over the past decade for two reasons:
1)

his measures of profits do show the effect of
inflation in spuriously raising reported taxable
profits and thereby increasing the bax bite — but
they do not allow for the beneficial effect of
inflation in lowering the real burden of business
debt;

2)

he does not allow for the fact that profits are
low now because the economy is depressed and excess
capacity is now widespread.




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