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THE CHAIRMAN O F THE
C O U N C IL OF ECONOMIC A D VISE R S
WASHI NGTON

EYES ONLY
March 13, 1979

MEMORANDUM FOR THE ECONOMIC POLICY GROUP
From:

Charlie Schultze

Attached is a draft of a paper on overall economic
policy measures to deal with the current inflation situation.
It does not cover other elements of policy — food, price
monitoring, etc. It has only a short analysis of consumer
credit controls. We should have a more detailed Fed-CEA
analysis by tomorrow.

Attachment




I.

Economic Background

Since our economic policy for 1979 and 1980 was formulated
late last year, a number of developments have occurred that
immediately threaten the success of the anti-inflation
program and increase the chances of a recession later on.
1.
Inflation rates. While we expected high inflation
to continue in the first part of 1979, before the anti-inflation
program had time to bite, price increases in the last several
,
months have actually accelerated:
^
o

From November to January the CPI rose at a
9-1/2 percent rate compared to our internal
forecast of about 8 percent. Had the fall in
property tax rates in California not moderated
the rise in the December index, the November to
January rate of increase would have been 10-1/2
percent.

o

Although food prices played a large role in the
acceleration, nonfood prices in the CPI rose at
an annual rate of almost 9 percent (corrected for
the California property taxes, 10 percent). The
February CPI, when released later this month, will
almost surely show another large gain.

o

The annual rate of increase in producer prices
for finished goods, except food, was 11-1/2
percent from November to February.

o

OPEC scheduled a 14-1/2 percent price rise
during 1979, compared to the 8 to 9 percent
we had expected. The Iranian crisis is likely
to raise that figure substantially.
Internationally
traded raw materials prices have also been increasing
sharply.

Although price increases have been accelerating, wage
increases have not. CWPS has examined some 20 union contracts
negotiated since October. Only two of them seem to have
been above the pay standards. According to most reports,
nonunion pay increases have been kept within bounds. Average
wage increases for the economy as a whole have been moderate
in the past three to six months, after adjusting for the
minimum wage increase in January.




-2-

Some of the price inflation may have resulted from
"front-loading" of increases under the price standard. Many
small- and medium-size firms are probably not complying
with the price standard. But some of the acceleration in
prices undoubtedly resulted from the unexpected strength
in the economy discussed below.
2.
Economic growth. The GNP rose at a 6-1/2 percent
rate in the fourth quarter, and most indicators point to
continued surprising strength since the turn of the year.
Consumer spending, which rose phenomenally in the last three
months of 1978, has eased somewhat in January and February
from the December peak level.
The burst of consumer spending in late
inventories below desired levels-, and there
evidence that business firms are increasing
to replace them. Production and orders for
have been rising very sharply.

1978 reduced
is every
production
investment goods

o

Total employment rose by 800,000 persons between
December and February.

o

New orders for durable goods rose 11 percent in
the fourth quarter of 1978 and another 5 percent in
January (
not annual rates).

o

Orders for business investment goods rose 13 percent
in the fourth quarter and another 4-1/2 percent
in January.

o

Total hours worked in durable goods manufacturing
rose at an annual rate of 12 percent in the past
six months; total hours worked in the nonelectrical
machinery industry rose by 16 percent over the
same period.

Until recently the main thrust of economic growth was
led by housing and the consumer. That situation is now changing.
Housing is now in the process of turning down, and the pace
of consumer spending has slowed, at least temporarily. But
there is every indication that business firms are now scrambling
to replace and add to inventories and to order new capital
goods. A private survey, conducted monthly, shows a very
large rise in the percentage of companies reporting slower
deliveries during recent months. This is a sign of increasing




-3supply tightness. CEA has conducted an informal telephone
survey of businessmen and economists in a wide range of
industries. With some exceptions, those contacted report
rapidly swelling order books and a sense — which had not
existed earlier — of speculative inventory buying to beat
potential shortages (and, possibly, further price hikes).
In the industrial sector of the economy there is clearly a
boom underway — perhaps very temporary, but nevertheless real.
3.
Monetary conditions. Paradoxically, while economic
growth speeded up during recent months, the growth of the
monetary aggregates slowed down. In the past three months
M1 f
at an annual rate of 2.3 percent and M 2 rose at an
annual rate of only 1.3 percent.
We believe that the behavior of the monetary aggregates
does not signal a coming decline in economic activity nor
does it reflect an extremely tight monetary policy.
o

The combination of higher interest rates and
new forms of highly liquid financial instruments
have led people to economize on their use of cash.
As a consequence, the economy has been able to grow
rapidly without the injection of large new supplies
of money from the Fed.

o

Business profits have soared in recent months.
Firms have been able to moderate their demands
for credit.

o

Banks are highly liquid. Business credit has been
available without significant increases in interest
rates during the last several months.

o

Since inflation expectations have worsened, the
same nominal interest rates appear more attractive
to borrowers, who count on continued high inflation
to ease their future debt burden.

^

The interest rate increases which occurred in 1978
are clearly not deterring spending to anything like the
extent they did in earlier periods. Had the monetary
aggregates in recent months grown in a "normal" relationship
to the expansion in output and prices, the Fed would almost
surely have been tightening monetary policy further. The
abnormally low growth of the aggregates has led to a monetary




-4-

policy that is exerting only modest restraint on a surging
economy. While the 1980 budget will put more restraint on
the economy/ that restraint won't show up for another nine
months.
In summary, we think that the economy is currently
expanding at too rapid a pace. Some of the recent acceleration
in inflation is almost surely due to this fact. We are in
danger of of a speculative bubble developing. Anticipations
of future price increases have already been affecting consumer
purchases of housing and household durables. We have no
solid evidence that business firms are ordering to beat
price increases, but the dangers of inventory speculation
are very real. If that happens we could see a further
increase of inflationary pressure in the short run. At
the same time distortions could develop that would greatly
increase the likelihood of a recession later on — beginning
either late this year or in early 1980. Most outside forecasters
have been predicting a recession in late 1979. But virtually
all of them predict a mild recession. Should speculative
distortions develop early this year, the danger of a more
serious recession would mount.
II.

Options for Achieving Greater Restraint:
Risks and Gains

There are three general courses of action that could,
in principal, be used to achieve additional restraint on
aggregate demand: 1) a tightening of fiscal policy; 2) special
measures to dampen housing or consumer spending; 3) additional
monetary restraint applied generally through one or more of
the conventional tools of monetary policy. Each of these
options is discussed in turn.
Fiscal Policy
Added fiscal restraint in 1979 would be desirable if it
could be readily and quickly achieved. A tax increase is
clearly out of the question; any additional restraint will
have to come from the expenditure side. From a psychological
standpoint, it would be very desirable to include at least a
small step on the budgetary front in any package of measures
to cool off inflation. But there are serious practical
difficulties in doing so.




-5-

OMB has looked at several possible methods for holding
down the rise of outlays in fiscal 1979. The most practical
course would appear to be an across-the-board percentage
reduction in outlays from new budget authority applied to
all programs except entitlement or other fixed-cost or openended programs and possibly also defense. The Congress is
presently considering a third 1979 Resolution to raise the
outlay ceiling by $5 to $7 billion over the $487.5 billion
in the second Resolution. An across-the-board cut in
outlays from new authority (except for entitlement programs)
might hold down the increase to, say, $2-1/2 to $3 billion,
so that outlays would come in around $491 to $492 billion —
slightly below the Administration's recommended level. The
difficulties with this course of action, however, are many:




o

The amount of reduction in budget authority
necessary to achieve any given percentage
reduction in total outlays from new authority
would have to vary from one program to another.
There would be an appearance of unevenness of
treatment that would be hard to explain.

o

There would likely be great difficulties in getting
Congress to go along with such a request. Among other
things, the requirements of the Impoundment Control
Act would have to be waived to permit the cutback in
outlays, and this is a sensitive issue.

o

The effects on programs would differ from one agency
to another. Agencies whose funds have already been
heavily obligated would have greater difficulty.
The legislative authority would have to specify
exemptions for agencies whose funds are so heavily
obligated as to make it impossible to meet the
percentage reduction.

o

The actual effects on aggregate demand likely to
be achievable before late this year are small.

o

The effects of such an approach are bound to carry over
to some degree into spending levels in fiscal 1980.

o

The Administration would be in a politically embarrassing
position asking for cuts in FY '79 outlays from new
authority soon after sending to the Congress a series
of supplemental appropriation requests, including a
$2-1/2 billion supplemental for defense.

-6-

o

If defense were excluded, achieving meaningful restraint
would require deeper cuts in other programs, with
correspondingly larger disruptive effects in individual
agency budgets and greater adverse political reaction.

The problems likely to be encountered in going this route
can hardly be overestimated. Added fiscal restraint does not,
therefore, seem achievable either readily or quickly.
Special Measures to Dampen Housing or Consumer Spending
Special devices to curtail housing or to dampen the
rise of consumer spending, especially for durable goods,
are not a perfect substitute for more general measures of
restraint on aggregate demand.
In particular, such measures
would not directly reduce business demands for inventories,
which are now threatening to add a speculative element
to demands for goods and services. The economic wisdom of
using such devices under present circumstances is questionable
for other reasons. There may be strong psychological and
political attractiveness, however, in a moderate program to
restrain consumer credit.
Housing
Prospective supplies of mortgage credit have already
been curtailed by actions of the regulatory authorities to
limit the ability of commercial banks and thrift institutions,
especially the latter, to bid for 6-month money market
certificates. Further steps might take the form of encouraging
the Federal Home Loan Board to limit advances from Federal
Home Loan Banks to member associations, or asking FNMA to
reduce its forward commitments to buy mortgages.
Further steps to concentrate the effect of restraining actions
heavily on the housing industry are not attractive.
Some
decline in housing is probably already underway, although the
extent of decline — given policy actions to date — is uncertain.
Such steps might not, in any event, obviate the need for
more general measures of monetary restraint to help cool off
business inventory investment; if the Fed took action to raise
interest rates generally after steps were taken by the
Administration to reduce selectively the availability of
mortgage credit, we could easily find that housing starts
declined more than we want this year.




-7consumer Credit Controls
Using the authority of the Credit Control Act of 1969,
the President could request the Federal Reserve Board to
impose controls on consumer credit. The specific authority
open to the President under this act is presently being
reviewed by the Justice Department; a study of the practical
feasibility and the economic effects of doing so is also
being conducted, headed by the CEA. The results of that
study should be available within a day or so. The following
is a brief synopsis of the major economic considerations.
Controls over consumer credit would be most appropriate
if it were thought that consumers would continue to incur
debt aggressively in 1979, so that consumer spending would
continue to rise about as rapidly as the disposable income.
The current interagency forecast (which is nearing completion)
does not contemplate that; instead, the forecasting group
expects a rise of nearly three-fourths of a percentage point
in the saving rate, and a decline in real purchases of durable
goods by consumers after the first quarter. Current data
on consumer spending neither confirm nor negate this
expectation: retail sales in January and February are down
somewhat in real terms from a very high December level, and
auto sales have remained at about the level of the fourth
quarter. Consumer installment credit growth turned up in
the fourth quarter but has declined significantly in January.
Putting the brakes on consumer borrowing now may be closing
the barn door after the-horse got out, but we cannot be
sure.
The study of economic effects and practical feasibility,
while not yet completed, suggests the following points:
o




For auto loans, minimum downpayment requirements
could be easily evaded; maximum maturities would
be easier to enforce. Administrative costs
would likely be high. The impact on auto sales
of reducing maximum maturities to, say, 42 months
would be highly uncertain, but possibly large in the
short run. Going this direction would clearly
reduce our chances of getting a UAW settlement
in compliance with the pay standard.

-8o

For revolving credit (charge cards), the simplest
device would be to increase the minimum monthly
percentage repayment.
—

The effects on consumer debt repayments could
be most readily controlled if the higher percentage
repayment were applied retroactively to all loans
now outstanding. This may or may not be legal.
(We are getting a Justice Department opinion.)

—

If applied prospectively to new loans, the
magnitude of purchasing power drained off into
debt repayment would increase over time to levels
that are larger than desirable. Any scheme that
would have a significant impact in the short run,
would grow into an excessive impact later on.
Prospective application might also pose a significant
administrative problem for lenders.
(The
repayment schedule on currently outstanding
debt would have to be calculated at one rate
and the schedule on new debt at another.
)

o
v

Any use of consumer credit controls has to recognize
that those who are hit the most are lower-middle
income groups and individuals who are financially
unsophisticated.

o

Invoking the authority of the Credit Control Act
of 1969 in one area may lead to expectations of its
use in others, and hence to a scramble for credit.

General Measures of Monetary Restraint
Increased general monetary restraint could be effected
by any one of several steps by the Federal Reserve: openmarket policy, an increase in the discount rate, or an
increase in reserve requirements generally or on particular
market instruments (CD's, REPO's, etc.). As long as the
rise in short-term market interest rates is the same, any or
all of these steps would achieve broadly similar economic
results.
An increase of, say, one-half percentage point in
short-term market rates of interest would have its principal
effect on housing. Curtailment of mortgage credit availability
might also spill over into consumer spending as well, since
turnovers of existing houses and second mortgages typically
lead to a withdrawal of equity from the housing market
for use in consumer expenditures.




-9In the business sector, a rise in short-term interest
rates may also help to dampen business purchases for inventory
that are being stimulated, in part, by expectations of price
increases and/or shortages. A higher cost of inventory
financing would contribute directly to this result;
expectations that monetary restraint would cool off the
economy would make an indirect contribution to this end.
To achieve these expectational results, it would be
desirable to use monetary weapons (such as the discount rate
or reserve requirements) that tend to be regarded as strong
signals of the intent of the monetary authorities.
There would be some dampening effect of increased
monetary restraint on business fixed investment as well, but
this -effect is likely to be small for two reasons. First, the
volume of business fixed investment this year is likely to be
limited principally by restraints on capacity in the capital
goods industries — particularly aircraft, railroad rolling
stock, and nonelectrical machinery. Second, a rise in
short-term interest rates would be likely to increase the
cost of long-term credit relatively little, since participants
in financial markets are still generally expecting a downturn
in interest rates later this year.
Econometric models suggest that an increase of 50 basis
points in short-term interest rates would reduce real GNP over
four quarters by approximately 0.3 to 0.4 percent, and add
about one-tenth to the unemployment rate. The current
interagency forecast, which assumes a further 50 basis point
increase in short-term rates, is for a rise of real GNP of
2.1 percent over the four quarters of 1979 — or close to the
January forecast. Somewhat weaker growth in personal consumption
expenditures (due to a squeeze on real wages) and in housing
(because of higher interest rates) is largely offset by higher
business investment in both fixed capital and inventories.
(The forecast also assumes a $16.00 price for OPEC oil by
fourth quarter 1979.)
The outlook for 1980, as the group now sees it, is for
a rise of about 2-3/4 percent in real GNP, about half a
percent less than expected in January. There are clearly
still risks that the economy will be weaker next year than
we now forecast. The principal risks in that regard are:
(1) that the anti-inflation program may break down because
strong price pressures lead to an unwillingness of workers
to continue to accept 7 percent pay increases; and (2) that
inventory speculation in 1979 may lead to imbalances that
seriously weaken the economy.




-10-

The strongest arguing points for additional monetary
restraint are to reduce the prospects that business will
abandon the conservative inventory policies that have
characterized the recovery to date, and to indicate the
Administration's firm determination to make the anti-inflation
program work. There are, of course, risks in going in this
direction. Inventory policy may not respond as we hope it
will. The degree of strength we will see in personal
consumption expenditures and housing later this year is
uncertain; if developments in these sectors turn out weaker
than we anticipate, added monetary restraint now could result
in a slower economy than we anticipate. While the momentum
of business capital investment appears great enough to ward off
the threat of a recession later this year and in early 1980,
we cannot be sure.
On balance, the risks of taking firm actions now with
general monetary instruments appear greater than the risks
of doing nothing. The latter course risks the development of
speculation in inventories and additions to price pressures
that may deal a death blow to the anti-inflation program. If
distortions and imbalances develop as a consequence, a
recession will be difficult to avoid. If, on the other hand,
the economy late this year proves to be weaker than we now
expect, a return to less monetary restraint would be possible.
It is easier to take steps to stimulate a moderately weak
economy than it is to rescue one that is about to head into
recession.
Finally, if we fail to try to damp down the current
surge, and inflation is fed by speculative excesses over
the next four to six months, we will have built in an even
higher underlying rate of inflation which no feasible policy
can get rid of. In trying to slow the economy now, we
might indeed contribute to an excessive slowdown later on.
But it is far easier and quicker to reverse such a slowdown
when it occurs than it is to wring out a new increment of
inflation, once it has gained momentum.




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