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THE CHAIRMAN OF THE
C O U N C IL O F ECONOMIC ADVISERS
W A S H I N ---------

EYES ONLY

MEMORANDUM FOR THE PRESIDENT
FROM

Charlie Schultze

SUBJECT:

Some disturbing thoughts about the economic
outlook

Several recent and prospective developments pose some
major difficulties for our economic objectives and policies.
In the process of developing outlook material for your May
16 Budget Preview session, we have become increasingly
concerned about these developments. This note provides an
initial summary of the problem.
1.

Greater than expected fall in unemployment. Taking the
1st and 2nd quarter together, the GNP is not far from
the track we had been forecasting. But employment has
grown very strongly and unemployment has fallen by
almost 1 percentage point faster than past relationships
with GNP would have led us to expect. A small part of
this may be due to a greater than anticipated effectiveness
of public service employment. But — assuming our GNP
statistics are basically correct — most of it represents
a very low growth in productivity. This low growth may
be an aberration, or it may reflect a long-term loss in
productivity.
If it is the latter - so that the new
relationship between GNP and employment is not reversed —
two problems will face us in the immediate future:
o the lower productivity growth will give us larger
price increases, since there would be less productivity
to offset wage increases; and
o unemployment, by late 1979, might fall to the range
of 5.3 to 5.5 percent — given the GNP growth we now
forecast; this, in turn, could lead to labor market
conditions in which wage rates might well be accelerating.

2.




A monetary crunch. Economic growth in the current
quarter is very large — in the range of 8 to 10 percent
annual rate. This is combined with very large food
price increases. The combined growth in output and

-2prices is, in turn, leading to a very high growth of the
money supply (Mil), above the Fed's target range. The
Fed has already raised interest rates by 1/2 percent in
the past two weeks. Even if Bill Miller would be willing
to live with monetary growth rates above target for
awhile, the other members of the Federal Open Market
Committee are not likely to — especially when large
growth in Mi is combined with a strong second quarter
and bad news on the inflation front. It is entirely
possible that we could see a further sharp runup in
interest rates over the next three months. After some
time lag, such a development would begin to reduce
housing construction, possibly by a sizeable amount in
late 1978 and early 1979. In this eventuality, economic
growth would slow sharply, leading to a significant rise '
in unemployment. While this would dispose of the problem
discussed in ( ) above, it would do so in a way we surely
1
don't want.
3.

Wage rate increases. Average straight-time earnings in
April 1978 were 8.3 percent above a year earlier. In
early 1977 earnings had risen only 7 percent above 1976.
Some of this acceleration is due to the January increase
in the minimum wage (which added perhaps 0.3 to 0.5
percent to the recent year-over-year gains). Some of
the acceleration may be due to the direct and indirect
effects of the speed up in food price increases. And,
since labor markets have been improving rapidly in the
last year, some of it probably reflects a catching up of
unorganized and small union workers with the recent
sizeable wage gains won by large unions. Once the rate
of food price increases subsides the wage growth may fall
back somewhat. But it is likely to continue at a higher
level than last year and, indeed, the catch-up phenomenon
might push the increases up again.

I
have discussed the monetary situation with Bill Miller.
Mike Blumenthal, Bo Cutter, (for Jim) Bert Carp (for Stu)
Lyle Gramley, Bill Nordhaus and I met about the implications
of these developments on Saturday morning. We are meeting
again on Monday. We are considering strategies to reduce
the FY 1979 and 1980 budget deficits, and we will probably
be seeking an appointment with you this week to discuss the ^
situation.
I




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May 8 , 1978

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Charlie Schultze

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The attached was returned in p outing
the President's outbox.* I is
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forwarded to you for appropriate
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handling.

P

Rick Hutcheson

DISTURBING THOUGHTS ABOUT
THE ECONOMIC OUTLOOK
ADMINISTRATIVELY
CONFIDENTIAL

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