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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.