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h t U L K / A L i N u J L K > i— s* T»o— '■A D ale F ebru ary.3, 1972 to/2- 7 2-^F j Subject - Comment on Use of a Fixed . \ » jj . Chairman Burns T o___ [\c ? KTV ^ t^ Rule for Monetary Growth J. Charles Partee From. ~ y* kvave asked me for a comment on the deficiencies of adopting presoJj K' ,± ^ a fixed rule guiding monetary growth and also for a brief review of the Pro^ fa'JV fxesjuj-. ^ record as to policy flexibility at critical junctures over the postwar • • ' J period, Milton Fri edman published a column in the current issue of b r b l '<* H V t S e f o •-" v i C , ,. c atKjjr Newsweek arguing in favor of a fixed monetary rule (copy attached), so “ d ■J f L w "» 1>» «*a a r f<raat0f f r s £t^ac the subject could well come up in Congressional questioning at the o > « r5 o 4 I ' " V ® o t,< fT\je. u JL ■8 JEC hearing and in other situations. Cb*' Friedman's arguments are the ones that he and others have useJ f ? « 2 time and time again. He asserts tnAt on the basis of past Federal Resegye T3 performance and in view of the limits of our ability to predict the future s . and to specify the precise nature and timing of the lags with which morffit o tary changes affect the economy, it would be preferable to aim policy at the achievement of "a steady and moderate rate of growth of the quantity of money". This cannot be done from day to day or week to week, but "no serious student of money denies that the Fed. . .can come very close from month to month and quarter to quarter". Additional advantages cited for a steady rate of monetary growth would be that it would promote business confidence in monetary stability and neutralize the Federal Reserve from political pressure. We, of course, have always denied that monetary policy operating on a fixed rule would work as satisfactorily as a,flexible policy, although there is more s ^ ^ o r t in the System now than a long time past for achieving rates of growth over time that vary around normative valies for and H 2 relative to CNP. There have been numerous arguments advanced in favor of flexibility, but the ones that appeal most to me are as follows: ; 1) Adoption of a fixed monetary growth rule would require that all other factors affecting credit markets be ignored. * The Federal Reserve does have a responsibility to encourage appropriate credit conditions, and it also has responsibilities for Treasury finance, the viability of financial institutions and the conditions 2 i • influencing international capital flows. These considerations argues I that we cannot ignore interest rate and credit flow developments ang * 2 • that, at times, such developments will put constraints on our abil-^ ity to follow a fixed course as to monetary growth. 2) S r ; Every instinct argues that we should be capable of providjT CL ing ©ore assistance to our national economic objectives than is implied by the neutralist policy of an unchanging monetary stance. In contra-cyclical terms, particularly, we should be prepared to give more support to the economy in recession and less in boom, and ve should be able to anticipate these developments with sufficient accuracy to alter policy in advance of the needs of the economy. It seems to me that our ability to do this has improved steadily over the years, and that it would be most unfortunate to surrender to a fixed rule approach now. I would also argue that national Chairman Burns -3- priorities as to the allocation of credit might well create situations in which we should be prepared to depart somewhat for a time from our notions-as- to the appropriate rate of overall monetary growth. 3) Use of a fixed monetary-rule assumes that there is a fairly constant relationship between monetary growth and its influence on economic activity. This may be correct as a generality over time but it cannot be true in the short run. 32 The public's appetite for liquidity obviously shifts from time to time, depending on the confidence with which they view the future, changes, in ® inflationary expectations, and the like. O 2 o T If we do not provide the additional liquidity associated with an upward shift in pd ' o 3 . preferences, or absorb the liquidity released by downward shifts,t-a E r 3 constant rate of growth in money is likely to result in variable ^ rates of growth in the economy. In other words a constant monetary growth, if precautionary demands for liquidity are shifting, would be a source of economic instability. A) A monetary rule requires that the monetary variable, or the weighted combination of variables, to be controlled be specified in advance. Friedman does not specify which variable is to be controlled in the Newsweek article, but in the past he has sometimes focused on M , and sometimes on M 2 . j would be an equally good candidate, since depositers in thrift institutions surely regard these dep^^.ts as the equivalent of bank^^.me deposits in all respects. . And would also be a likely candidate, since oD].y by including CDs and other money market instruments do we incorporate a measure of corporate liquidity. move All of these, quantities do not and down at anything like the same rates in the short-run, of course, so it is not enough to use one M as a proxy for all of the o hers. Nor is expansion i . all of the Ms closely felated to the r provision of bank reserves. 5) The relationships between rates of change in the various r Ms, and between these definitions of money and economic activity, gre ' ’ ^ ’ clearly subject to a host of influences, including structural, competitive and technological change. I ^ 0 3 Thus, the postwar emergenceoof 1 the savings and loans clearly'impinged on the growth of bank time^ O Similarly, the increasing sophistification with which gpney £ 3 * is managed, partly a function of the upward trend in interest ratSs, deposits. has served to reduce idle non-interest bearing cash balances (M^) relative to total liquid assets (M^). Technological improvements, such as jet aircraft and bank automation, must have reduced the float of checks in transit on which depositers formerly counted (we measure money in terms of balances on the bank’s books, not in customer records), and future advances (such as wire transfer) clearly will reduce such float dramatically further. All of this makes it extremely difficult to measure the real impact of monetary policy y i .) /./ over time. It also strongly suggests to me that targeted growth rates in money--however defined--need to be modified in order to produce a^^nchanged secular stimulus to^^onomic activity. I would think that this need is most pronounced in the case of M p since cash balances are most subject to technological obsolescence. For the purpose of reviewing the responsiveness of flexible monetary management over the post-war period, we have developed the attachec .’ two tables--one on monetary aggregates and the second* on_ interes t rate and credit market indicators. Both show changes in the variables in the six months before and after each upper cyclical turning point and before and after the three points at which excess aggregate demand threatened ■ ? generalized inflation. (These three points were arbitrarily chosen as . § v ; =* » May 1951, when the unemployment rate had declined to 3 percent under wa§*4 9 time conditions, and June 1955 and January 1966, when the unemployment 3 £ rate in each case had dropped to 4 percent, ) My conclusions on the recgrd o 3 . of performance for each of these nine periods, taken chronologically, t3 C* T 3 as follows. . * 3 : I. November 1948 cyclical peak. The record is not good. drifted off both before and after the turning point, and M 2 showed no net growth. Net free reserves did move in the correct directions, though only slightly, but the discount rate was raised Just prior to the turning point and not reduced after. Interest rates did not show appreciable cyclical variation. 2. May 1951 period of excessive detrand. The record is r.ot good, despite the accord reached with Treasury on debt manage support in March 1951. ut M lt M 2 and bank credit all increased more rapidly a i ^ r May 1951 than before. Net W e e reserves expanded in the six months after May, following an earlier tightening, -a"dinterest rates stabilized. No change during period in the discount rate. 3. July 1953 cyclical peak. The record is not good. M^, M2 and bank credit increased less in the six months after the cyclical peak t'an in the six months befoie. Free reserves also increased less rapidly after the turn--though still substantially--and the discount rate was not changed. Both short- and long-term interest g a o v o rates did decline substantially after the peak, however, reflecting v ; * reduced credit demand. A. June 1955 period of ex,cess demand. o 3 0 The record is quite g<god, Du \ . assuming that a primary national objective was to curb aggregate 1 M^, M 2 and bank credit all increased at lower rates afterf-. c r S June 1955 than before. Free reserves declined substantially, and<3 demand. the discount rate was raised by a total of one full percentage point over the one year period. Interest rates moved upward both before and after June 1955, on balance, with a particularly sharp rise in short-term rates over the six months following that date. 5. July 1957 upper turning point. The record is quite bad. turned strongly negative in the six months following the turning point, after having shown no growth before. M^ and bank credit also grew at smaller rates after July 1957. The discount rate was raised after the turning point (it was subsequently lowered), but free reserves expanded substantially. Interest rates declined, * * being increased both before and after the turn, and the discount rate w a s ^ ^ t once, by 1/2 per cent, in 1967. Short-term rates declined substantially after January, but long-term r^tes - ^ rose following an earlier decline. In retrospect, one could argue that the easing was overdone, since tha recession movement was very mild nd relatively brief. Also it may be argued that monetary ease persisted too long into the year, producing large increases *n M (6. 77. and M 2 (107.) for .he year as a whole. ) Bui in time liness and speed, the initial policy turn seems to me to have been excellent. 9. : r November 1969 upper turning point. O 8 ' • v The record appears , g Expansion in M^, M 2 and bank credit all accelerated g O in the six months after the turn, but to rates that were still 3 » £ / O relatively moderate (perhaps a bit below normal in M, and bank ^ ^ O 3 . credit). Net free reserves increased both before and after the £7 a r quite good. S turn, again moderately, but the discount rate was not reduced. ^ Short-term interest rates declined after the turn, but again— as in 1967--long-terra rates continued upward (The major decline in long-term rates, you will recall, commenced in the summer of 1970 and continued to the early months of 1971.) In summary, I would conclude that the best performances in monetary policy, in terms of timing, were in the two most recent periods of inflation--following June 1955 and January 1966--and the two most recent periods of recession--following January 1967 and November 1969. Ihe performance in the early stages of the 1960 recession was also fair, •* but in all earlier postwar episodes it was poor. In the 1967 episode^ <r * j drop in long-term Treasuri<^^was not much greater than although the rise in the preceding 6. 6 month period. Hay 1960 upper turning point. notably better than in 1957. ' The record was fair, and. M , ll and bank credit all increased 1 2 eignificantly on an algebraic basis, though growth in was still quite nominal in the six months following the turning point. discount rate was cut twice, by a total of 1 The per cent, in the six months following the turn, and free reserves increased substantially both before and after the turn. Interest rates also were declining " O g * substantially both before and after the May 1960 cyclical peak. 7. January 1966 period of excess demand. * % 8 The record is q u i ^ cf M , M0 and bank credit all rose substantially less rapidly 3 good. 1 / ' © ft in the six months after than £fefore January 1966. The discount 2 . rate was raised 1/2 per cent in early December— a notable conflict 2. vith Administration desires. Net free reserves declined 5: s substantially in the six months after January 1966 and long-term interest rates were rising throughout. (Interestingly, the Treasury bill rate dropped slightly from January to July, following a sharp earlier increase.) 8« January 1967 informal cyclical peak. very good. The record looks As signs of economic slowing developed, the Federal Reserve turned promptly and substantially toward ease. The reaction probably was stronger because of the severe squeeze that had been promoted in 1966. M^, ^ and bank credit all expanded sharply faster in the six months after January 1967 than before, and all vere at historically high rates. Net free reserves were policy remainea easy too long into the year. growth in money (both Moreover, although the and M^)did slow in the last quarter of 1967 and in early 19681 it then accelerated sharply, producing two consecu-tive years of relatively rapid monetary growth. 'Friedman refers in the Newsweek article to this 1967-68 period as an example of too rapid jgrowth. Next page contains copyright-protected content 1 ho com panies reacted to the ctjmp la in t w ith outrage. K e lln e r, the largest producer w ith 4> \K'T cent of ih e f lfc p a l f it J ilc t . an grily noted that it h a s i^ R jc q u ir t'd another cereal c o m p an y since 19 M , a n d a \icv pti-sidcnt of C e n tr a l F<*>ds said of the a d v e rtisin g chariies: ~Thcy*re ISO drv*rtvv ulf course, an d \vc*fc £<’inc lo court t«» prove it." But the com panies were fran k ly w o riie d that the IT C ; seemed to Ik* sav in g that bigness in iiv tir is had . ’ The charges w o u ld ap p ly lo mavl>e 00 per cent <*t A m erican industry/* one c v e c u th c said. T he 1 T C has b itte n off ail en orm o u s new theory of an titiu s t la w , an d if carried out, it w o u ld re v o lu tio n ize 4 he A m e rica n econom y a n d break up all kinds of industries.*’ T hat m ay well I k * just w h a t the F T C .. ... "i ■ I teocrl u x «' T~t • V ; -- . I wi: r * * * r= \ w ^ f ** . lb.: i., | ! .... .. ^ pn' ‘ 3 roci I-\:Str *. ?fh’ ? « vy * - *. ^v- i f Ci \* -—* ■ . » . J ( n \ ^ - 'V! _ •• •/ C ereal con?unier: ?^o fa ir ch oice? h as in m in d . Prev ious an titru st cases have focused on one-com pany m onopolies, a n d last w e eks m ove ag ain st the cereal ti tans was the first tim e th at direct covem- fncut action has been taken ocam st an oligopoly, a few larce corporations d o m in a tin g an industry. T h e im p lic a tio n is ih at if such firms use th e ir pow er u n fa ir ly . they have in cifcct created a ‘shared ti»onoj>oly, even if th e v have plotted no V to n g d o m g s ~We d o n 't have to de p e n d o n an y Lind of a c o n s p ira c y ,” an acency official told N t w s w n Jam es Bishop Jr. \\v are saving that in view ot the conse quences for the m ark etplac e, it m ig h t just as well have been a conspLracv.** Still, the F T C has a lone wav to go befotc it proves that existing law can be tt*cd against shjred monopolies, if the Companies decide to fi^ht, the case could crap c>n for \ears belore ending up m* the Supreme Court. A nd it an out-ofCM ift settlement is negotiated, as is more H Iiiely. no iu%v le^al piecvdent would be C^tabhsltevi at all. February 7, 1972 A HE CASE F O R ~ MONETA#/ R U L E a n d m ost other m onetarists have lon g favored a poiicy of a steady a n d m oderate rate of gro w th of the q u a n tity of m oney. W e have strongly op pose d the Fed's trying- to fine-tune the econom y. R ecent po licy conform ed to our pre scription only in 1970. C ritics ask w h y we are so m odest. W h y not use the po w erful instrum ent o f m o n e tary policy to oflset other forces p u s h in g the econom y tow ard in flation or recession? W h y tie the h a n d s of the F ed ? W 'hv not trust their d iscretion in a d a p tin g to ch a n g in g circum stances? W ’e favor the rule of steady m o n e tary gro w th for several reasons. 1. T h e post p erform ance of the Fed. T h ro u g h o u t its history, the F ed lias p ro c la im e d that it was using its pow ers to prom ote econ om ic stability. H ut the record does not support the c la im . O n the contrary, t h e 'F e d has b e e n a m ajor source of instability. T h e F e d was responsible for con v e rtin g w h a t wou^d have been a seri ous recession after 1929 into a m ajor c atastrophe by p e rm ittin g the q u a n ti ty o f m on ey to decline by one-third fro m 1929 to 1933, even thou e h it h ad a m p le po w er to prevent the decline. In recent years, the Fed set otf the ac cele ra tin g inflation that M r. \L\on in h e rite d by ex p a nd in g the m oney s u p p ly too ra p id ly in 1967 an d 196S, th e n stepped too hard on the brake in 1969, an d too hard on the accelerator in the first seven m onths of 1971. F e d eral Reserve officials have often a d m itte d th e ir errors after the fact—as c h a irm a n Burns d id in Ju ly 1971, in te stim o n y before the Jo int E co no m ic C o m m itte e —a n d have prom ised b e t ter p e rfo rm ance in the future. But then the same forces have produced a re p e titio n of the same errors. W e c o n c lu d e t in t the urgent need is to prevent the F ed from being a source of e con om ic disturbance. 2 T h e limitations o f our knowledge. E c o n o m ic research has established tw o propositions: ( 1 ) there is a close, reg ular an d p red ictable relation b e tw e en the q u a n tity of m oney, n atio nal in c o m e an d prices over an y considera b le pe riod of years; ( 2 ) the same re la tio n is m u c h looser from m o n th to m o n th , q u arte r to quarter, or even year to \ear. In particular, m onetary changes take tim e to artect the econo m y , a n d the tim e de lay is itself h ig h ly v ariable. I . T h e first proposition m eans that a steady price level over the lo n g pi requires that the q u a rU i’y of mon* grow' at a fairly steady rate rou^r e q u a l to the average rate of grew of o u tp u t. I T h e second pro position rr.jans fh an y a tte m p t to use m onetary poti; for fine-tuning is likely sim ply to inti d u c e a d d itio n a l in stability . A n d this indeed-w hat has h ap p e n e d . ~ 3. T h e p ro m o tio n o f confidence. / a n n o u n c e d , an d ad h e re d to, policy steady m o n e tary g ro w th w o u ld pr v id e the business c o m m u n ity with firm basis for co nfidence in moneia sta b ility that no discretionary pol:< co u ld pro vide even if it h*),gper:c to p ro d u c e ro u g h ly steady nwncta g ro w th . § 4. N eu tra liza tion o f the Fee§ Aa i d e p e n d e n t F e d m ay at t im e ^ b e ti in su late d from p o litica l pressures— it was in the early ’30s—an<*| yet othe r tim es u n d u ly allected l^v poll cal pressures. If w e reallj| kne e n o u g h to use m on e tary p S ic v f fine-tuning, w e w o u ld p r o b a c y e.\ p rience a tour-year cycle, wit]} uner p lo y m e n t re a ch in g its troug lQ in ye; d iv isib le by four an d intfatiQ j reac in g its peak in the succeedmcQtear. A m on e tary rule w ouldB insuL. m o n e tary p o licy bo th f r o m ^ h e ar: trary po w er of a sm all croup of av not subject to control by the electc ate a n d from the short-run pressor o f partisan politics. Is the rule that w e have propos technically feasible? C a n the Fed cc trol the q u a n tity of m oney? N o seric stu d e n t of m o n e y —w hatever his pc cv v ie w s- d e n ie s th a t the Fed can, it wishes, control the q u a n tity of me ey. It ca n n o t, of course, achieve a p: cise rate of grow th from day to c. or w eek to week. B ut it can cc; very' close from m o n th to m o n th a, q u a rte r to quarte r. As I w rote some five years ago, the m on etary rule were follow* “other forces w o u ld still ailect t econom y, require chang e an d ad;V m e n t, an d distort the even tencr our ways. B ut steady m onetary grew w o u ld pro vide a m onetary climc favorable to the ettective operm: of those basic forces of enterprise. ; ge n u itv , in v e n tio n , hard ivork a ’ th rift that are the true s p r igs of ec n o m ic grow th. T h at is the most tr we can ask from m on etary poiicy our present stage of k n o w le d e e /i' th at m u c h - a n d it is a great dealclearly w ith in our reach/*