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THE CHAIRM AN OF THE
COUNCIL OF ECO NO M IC ADVISERS
WASHINGTON

December 13, 1978

MEMORANDUM FOR THE PRESIDENT
FROM:

Charlie Schultze

SUBJECT:

Background for the Meeting of the Quadriad
on December 14

Economic growth will be slowing next year, as it must
to bring inflation under control. Achieving a "soft landing"
and avoiding a recession will be difficult.
It is therefore
especially important to coordinate monetary and fiscal
policies.
Chairman Miller is undoubtedly under substantial pressure
from within the Fed to tighten monetary policy further in
response to adverse news about current price developments,
or to indicators of real growth that are continuing to show
considerable near-term strength.
It is important to impress
upon him:
—

that the 1980 budget will indeed be tight, meaning
that fiscal policy will be taking more of the burden
of restraint.

—

that you are committed to the long pull in the battle
against inflation and making good progress in
implementing the voluntary program.

—

that too much monetary and fiscal restraint, and a
recession next year, would make it politically
difficult for you to persist with stringent budgetary
policies.

It should be made clear that the Administration fully
recognizes that the acceleration of inflation, and the
depreciation of the dollar required rising interest rates
during much of 1978 and that neither the domestic nor the




^ j n r i L i h N iihu

international situation will permit them to decline in the
near future. Nevertheless, adding further tightening to
that which has already occurred, particularly since
October 31, would threaten the "soft landing" we all want.
Attached is a proposed agenda for the meeting which I
have circulated to Chairman Miller and the others who are
attending. The following is an overview of economic
developments and the outlook as background for this
discussion.
I.

Recent Economic Developments and the Outlook
A.

Recent Developments —

An Overview

The revised estimates for real GNP growth in the third
quarter show it to be 3.4 percent (annual rate). It now
appears that the current quarter will be stronger — possibly
over 4 percent.
Furthermore, current indicators suggest
that this momentum will carry over into the early months
of next year.
o

In retail markets, a substantial upward revision
in retail sales for October and a further large
rise in November imply a resurgence in retail trade.
New car sales remain fairly flat, but overall
consumption spending is likely to show substantial
strength in the fourth quarter.

o

Housing starts are holding up well, remaining
on a plateau of about 2 million units through
October.
Sales of new homes began to taper off
very slightly during the third quarter.

o

New capital goods orders, excluding defense,
have risen strongly for the past three months
and are now more than a third above a year ago.
Construction contracts have also been decisively
stronger in the three months ending in October.
Consequently, the results of the Commerce Department *s
survey of spending plans, which show little or no
real growth of capital spending early next year, are
puzzling.




-3-

o

Industrial production continues to rise more rapidly
than GNP. Its rate of growth over the three months
ending in October was 6.7 percent at an annual rate;
in November, industrial production probably rose by
1 percent or perhaps more.

o

Employment has increased remarkably in the past two
months and, despite strong growth in the labor force,
the unemployment rate dipped to 5.8 percent in
October and remained there in November. The increase
in total employment in nonagricultural establishments
averaged over 400,000 persons per month during these
two months. The opposite side of the coin, however,
is the implication of relatively slow productivity
growth in the fourth quarter.

B.

The Outlook for Real Growth

The inter-agency forecast is currently in its final
stage of development.
It will probably show real growth
over the four quarters of 1979 of a little over 2 percent,
and positive in every quarter. Some modest strengthening
in 1980 is likely if inflation moderates.
Interest rates
might then decline somewhat, and confidence would strengthen.
Our general outlook for 1979 is broadly consistent with
the view of the Federal Reserve staff. However, the
Congressional Budget Office staff is now tentatively
forecasting a weaker economy, with slightly declining real
output in the second half of the year. This view is shared
by many private forecasters.
Thus, there is broad consensus that the pace of economic
activity will slow next year; the question is how much.
At the present time there is considerable momentum in the
economy which is likely to carry over into the first part
of next year. The areas clouded by uncertainty and the
possibility of weakening later in the year are:
o




business fixed investment, which we believe will
slow somewhat but remain stronger than GNP
as a whole. The signals are currently mixed.

-4-

o

consumption spending, which we believe will hold up
reasonably well relative to income. However, in view
of the current low level of the saving rate, the
substantial debt burdens of households, and the
possibility that more rapid inflation will create
concern about the real value of savings, consumer
spending could weaken more than we expect.

o

housing is likely to taper off because of the substantial
rise that has already occurred in mortgage interest
rates. We believe the continuation of deposit inflows
to thrift institutions and extensions of new mortgage
loans will protect housing from the sharp drop that has
occurred in past periods of tight money. But we are
sailing in uncharted territory.

The task of slowing the economy gradually without tipping into
recession is clearly delicate.
C.

Price Developments

Price developments continue to be discouraging< Food
prices at wholesale rose more slowly in November, but increases
in the previous two months were very large. Meat supplies
continue to be limited. We expect food prices at retail
to rise about 8 percent next year.
Outside of food, price increases at both the wholesale
and consumer levels have been running in the last six months
at an annual rate of 8 to 10 percent — somewhat faster than
the rate of rise over the past 12 months. This recent
acceleration may reflect both the growth of unit labor costs
and anticipatory or "front loading" price boosts induced by
the announcement of the anti-inflation program.
Business response to the program appears to be quite
positive and, on the basis of extensive contacts, we believe
that most businesses will abide by the price standards.
Compliance by labor will be made more difficult to achieve
if consumer prices accelerate. Private conversations with
Fitzsimmons give reason for some hope — but no certainty —
that the Teamsters settlement may come at or very close to
the pay standards. That would be a major achievement, and
it would increase greatly the chances of securing compliance
in other large collective bargaining contracts next year.




CONFIDENTIAL

Price Changes at

Annual Rates

Latest MonthLast 6 Months

Last 12 Months

Producer Prices
All finished
goods

9.4

7.4

8.7

Food

7.6

6.6

11.2

10.4

7.8

7.8

9.4

9.3

8.9

Food

9.9

9.0

11.4

Other

9.6

9.4

8.3

Other
Consumer Prices
All items

Note:




Latest month is November for producers' prices and
October for consumer prices.

In view of the strong likelihood of (a) continued
pressures on food prices through next spring, (b) increased
energy prices due to the anticipated OPEC price increase and
the implementation of our own energy policy and (c) continued
poor productivity growth which will raise labor costs, it
will be very difficult to reduce the inflation rate to 6-1/2
percent by year end. For the year as a whole, inflation is
likely to be somewhat above 7 percent, even with widespread
compliance with the pay and price standards. Such a performance
would, of course, be a substantial improvement over 1978.
The outlook for prices next year, however, cannot be
improved significantly by tightening monetary and fiscal
policy still further. Moderation of demand growth will assist
in achieving compliance with the pay and price standards.
But it cannot do the job alone. An outright recession would
contribute only marginally more to slowing inflation than
a moderate slowdown in growth. And an outright recession
would make it extremely difficult to maintain a political
consensus that fighting inflation must be the top priority
of economic policy.
II.

Financial Markets

Interest rates have risen sharply since the dollar
defense package was announced on October 31. At that time,
the discount rate was raised a full percentage point from
8-1/2 percent to 9-1/2 percent. The target for the Federal
funds rate was also raised, and that rate moved quickly from
9-1/4 to 9-3/4 percent. Most other short-term rates followed
the funds rate up. Since the November 22 meeting of the
FOMC, the Federal funds rate has moved somewhat erratically
in a 9-3/4 to 10 percent range.
Concern had been raised earlier in the fall that
despite increases in interest rates — which, even before
the October 31 move had risen by about 2 percentage points
since the beginning of the year — monetary restraint was
not "biting." This concern was the result of continued strong
growth of all of the monetary aggregates through the third
quarter.
Since the middle of October, however, growth of
Mi (the narrowly defined money supply) and of M 2 (which
includes time and saving deposits) has slowed substantially
(see charts).




-7In addition to this recent slowing of growth of the
monetary aggregates, there has been a significant slowing
of credit growth. New extensions of consumer installment
credit peaked in June and have tapered off somewhat since then.
The net increase in home mortgage debt outstanding levelled
out in the first half of the year even though the dollar value
of residential construction kept rising. Business loans
at commercial banks have continued to grow rapidly, however.
This largely reflects the fact that business investment in
both capital goods and inventories is outstripping growth
of internal funds.
Consequently, there is reason to believe that monetary
restraint is nibbling if not biting. The response is probably
occurring more gradually and with a longer lag than in
previous periods of restraint. A continuation of this
gradual restraint will be an appropriate component of
moderation in overall growth.
Pressing yet harder on
the monetary brakes could weaken the economy more than
we want later in 1979.
Recent Dollar Developments
By November 30, one month after our October 31 actions,
the dollar had risen on a weighted average basis by 10.3
percent from its October 30 low. About three-fourths of
this appreciation occurred during the first week following
the announcement.
During the month of November, U.S. intervention purchases
of dollars totaled $3.2 billion.
The Japanese bought $1.2
billion, the Germans and Swiss about a half billion each.
Total intervention purchases thus amounted to $5.6 billion.
(This is confidential information and will not be published
for some time.)
The dollar weakened somewhat in early December, and by
December 12, it had fallen 1 percent below its November 30
level.
Intervention was light during the period December 1-7,
but became heavy on Friday, December 8f and heavier on
Monday and Tuesday mornings. Markets calmed later on Tuesday
and continued calm today. Total dollar purchases during the
period December 8-12 amounted to just over $3 billion ($1.1
billion by the United States, about $1 billion by the Swiss,
the rest by Germany, the United Kingdom, and Italy; Japan
also entered the market on Tuesday).







-8We have no fully satisfactory explanation for the renewed
downward pressure on the dollar. One hypothesis is that the
appearance of data showing German reserve declines for November
suggested to the market that German commitment to the dollar
support program was half-hearted. More generally, the
turbulence may reflect a "testing" of the commitment of
the authorities to maintain support for the dollar.
U.S. intervention strategy has continued to be to
resist downward dollar movements strongly and not resist
upward movements — though small sales of dollars on rising
markets have occurred in order to acquire balances for swap
repayments.
Attachments




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Ml. 1190

JS7.KV7

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949,9979

344.9919

949*9999
11/29

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