The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.
'1\ - http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis r •' ' 1 Collection: Paul A. Volcker Papers Call Number: MC279 Box 25 Preferred Citation: "Inflation Threat" Report, 1987; Paul A. Volcker Papers, Box 25; Public Policy Papers, Department of Rare Books and Special Collections, Princeton University Library Find it online: http://findingaids.princeton.edu/collections/MC279/c153 and https://fraser.sdouisfed.org/archival/5297 The digitization ofthis collection was made possible by the Federal Reserve Bank of St. Louis. From the collections of the Seeley G. Mudd Manuscript Library, Princeton, NJ These documents can only be used for educational and research purposes ("fair use") as per United States copyright law. By accessing this file, all users agree that their use falls within fair use as defined by the copyright law of the United States. They further agree to request permission of the Princeton University Library (and pay any fees, if applicable) if they plan to publish, broadcast, or otherwise disseminate this material. This includes all forms of electronic distribution. Copyright The copyright law of the United States (Tide 17, United States Code) governs the making of photocopies or other reproductions of copyrighted material. Under certain conditions specified in the law, libraries and archives are authorized to furnish a photocopy or other reproduction. One of these specified conditions is that the photocopy or other reproduction is not to be "used for any purpose other than private study, scholarship or research." If a user makes a request for, or later uses, a photocopy or other reproduction for purposes not permitted as fair use under the copyright law of the United States, that user may be liable for copyright infringement. Policy on Digitized Collections Digitized collections are made accessible for research purposes. Princeton University has indicated what it knows about the copyrights and rights of privacy, publicity or trademark in its finding aids. However, due to the nature of archival collections, it is not always possible to identify this information. Princeton University is eager to hear from any rights owners, so that it may provide accurate information. When a rights issue needs to be addressed, upon request Princeton University will remove the material from public view while it reviews the claim. Inquiries about this material can be directed to: Seeley G. Mudd Manuscript Library 65 Olden Street Princeton, NJ 08540 609-258-6345 609-258-3385 (fax) email@example.com http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM WASHINGTON, 0. C. 20551 PAUL A. VOLCKER CHAIRMAN August 9, 1987 The Honorable Stephen L. Neal U.S. House of Representatives Washington, D. C. 20515 Dear Steve: On my last weekend in office, you'll be delighted to know I read through your "Inflation Threat" report. It strikes me as a first class job in every respect. Whoever helped you with the drafting deserves a gold star, but more important the conclusions seem to me to strike the right note. When I look around me, it's hard to believe we've been too "tight," even though some seem to think so. Reg da,e /72v9 http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis efrt Tem Via/L_ 4(Atema.v-w-t Z.kt aait 144 /ff/ce- Cka STEPHEN L WEAL. WORTH C.AROLJNA. CNAMMAJI SILL McCOLLUM. FLORIDA JIM LEACH, IOWA K JAMES SAXTON. NEW JERSEY WALTER E FAUNTROY. DISTRICT OF COLUMBIA DOUG BARNARD. JR. GEORGIA CARROLL HuBBARD. JR , KENTUCKY BARNEY FRANK. MASSACHUSETTS 11.6. AiousSe of Atpreskntatibel SUBCOMMITTEE ON DOMESTIC MONETARY POLICY OF THE COMMITTEE ON BANKING, FINANCE AND URBAN AFFAIRS ONE HUNDREDTH CONGRESS filasbin gton, MC 20515 FOR RELEASE MONDAY, JULY 20 Contacts: Ben Crain, Carl Mintz 202-226-7315 WASHINGTON--The sharp increase in inflation this year "should be taken seriously as a warning signal" for Congress and the Federal Reserve, a House Banking Subcommittee chairman Concludes in a new report on "The Threat of Inflation." A resurgence of 1970s-style inflation "is not inevitable," the report says, but it could happen if Congress does not steadily reduce the budget deficit and if the Federal Reserve does not maintain a prudent monetary policy. The report was issued by Rep. Stephen L. Neal, D-N.C., chairman of the Domestic Monetary Policy Subcommittee of the House Committee on Banking, Finance and Urban Affairs. It summarizes and draws conclusions from recent subcommittee hearings on inflation. "The Inflation Dragon isn't dead," Neal said. "There's a lot of complacency among government officials, economists and businesspeople about the threat of serious inflation. But that complacency is not justified by the facts. Our report makes that clear, even though we state both sides of the issue." Inflation, the report says, "is not just a threat, it is a current reality." In the first five months of 1987, inflation increased at an annualized rate of 5.6%. Some increase was inevitable because of the drop in the dollar's exchange rate and a rise in oil prices, the report said, "But it should not be dismissed as purely transitory, a one-time-only adjustment..." Among the report's conclusions: * "The major threat is not rampant inflation within the next year or so. The major threat is that, without serious and sustained reductions in the budget deficit, the degree to which (the Federal Reserve's) monetary policy can err, without causing recession or inflation, will shrink to the point of disappearing...The Federal Reserve cannot always fine-tune its policies..." * Continuing the 1985-1986 pace of monetary expansion "would be exceptionally risky," but the Federal Reserve appears to recognize the danger and has modified its policies so far this year.. "Ml slowed from a rate of 16.5% in 1986 to an annualized rate of 7.6% through April of 1987. No one can be sure that this is precisely the right degree of restraint, but, given the risks at hand, it is surely the right direction for monetary policy in 1987." * The Federal Reserve shouirl -make ery eifort'i to analyze the new relationships that banking deregulation b.as created between money growth and economic activity. (Copies of the Chairman's report may be obtained from the Subcommittee office.) http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 1 g DRAFT A Report of the on Domestic Monetary Policy ttee ommi Subc ted by the This draft report has not been officially adop Committee the of cy Poli tary Mone Subcommittee on Domestic not may and irs, Affa on Banking, Finance and Urban ers. memb its of views therefore necessarily reflect the http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis THE THREAT OF INFLATION Table of Contents Page 1 INTRODUCTION 2 Forecasts of Inflation 3 A THREAT OF INFLATION ? Relative Price Adjustments 4 Production Cost Pressures 8 Commodity Prices 12 The Velocity of Money 13 16 THE THREAT OF INFLATION 1 16 The Impact of Inflation on Velocity The Impact of Interest Rates on Velocity • 17 The Impact of Portfolio Growth on Velocity • 19 • 21 The Impact of the Trade Deficit on Velocity . • 21 Velocity and the Changing Definition of Money 23 Relative Prices and Production Costs Monetary Policy and Budget Deficits CONCLUSIONS • • 26 32 OKI ItIcCOUUM. ILORIDA JIM LIAM IOWA JAILMS SAXTON. MW ANSI. STEPHEN I MAT.. NORTH CAROLINA. CHAIRMAN WALTER IL FAUNTROY. DISTRICT Of COLUMBIA • DOUGBARNARD. JR. GEORGIA CARROLL HUBBARD. JR. KENTUCKY BARNEY FRANK. MASSACHUS(rIll ji)ouVe of iteprefSentatibeci 41L, SUBCOMMITTEE ON DOMESTIC MONETARY POLICY OF THE COMMITTEE ON BANKING, FINANCE AND URBAN AFFAIRS ONE HUNDREDTH CONGRESS Maiihington. 11:1C 20515 July 15, 1987 Chairman The Honorable Fernand J. St Germain, Affairs Committee on Banking, Finance and Urban 2129 Rayburn House Office Building Washington, D.C. 20515 Dear Mr. Chairman: report on hearings I am pleased to transmit herewith a cy on The Poli tary Mone held by the Subcommittee on Domestic days of four the on based Threat of Inflation. This report is which , 1987 June in public testimony before the Subcommittee The ry. enta and comm yielded more than 200 pages of analysis n, ctio staff at my dire report, prepared by the Subcommittee d mmendations presente at summarizes the major points and reco ons that, in my opinion, these hearings, and draws the conclusi are most warranted. at of inflation is The major conclusion is that the thre ce of inflation may not be very serious indeed, though a resurgen sense that we still have apparent in the immediate future. This not, however, lull us into time to keep it under control should be to late to rein it complacency. Once it is upon us, it will in without a serious recession. ins the Monetary control over the long-run rema n. But the atio infl rol essential, indeed the only way to cont are being cy poli tary prospects of an anti-inflationary mone . Without cits defi budget seriously undermined by our massive nally ptio prove exce more disciplined fiscal policy it will tary policy to ward off difficult, perhaps impossible, for mone inflation. to Members and to I hope this report can help clarify, these conclusions. the public, the principal reasons for http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis n L. 'eatçChairma bcommit e on Domestic Monetary Policy r ! 1 INTRODUCTION Early in the 1970s President Nixon resorted to wage and price controls in a futile effort to strangle inflation -- then raging at Today, in mid-1987, it is widely accepted that we face about 4%. a rebound in inflation, comparing 1987 to a temporarily depressed 1986, but it's a rate of inflation we can live with.... Look for the CPI (consumer price index) to rise by 3 1/2 to 4 per cent this year...." In the 1970s the American economy rode an inflationary rollercoaster. (See chart 1). A fatal combination of OPEC-imposed oil price increases and excessive monetary stimulus produced two big surges in prices, each tamed by subsequent monetary tightening and recession. The first taming did not hold. The second, engineered by the Federal Reserve under the leadership of Chairman Volcker, has proven more durable. But 1987 brings warnings of a revival of inflation. prices are once again climbing. Oil The foreign exchange value of the dollar has been falling rapidly, making imported goods more expensive. Commodity prices are clearly on an upswing. Long-term interest rates, which embody inflationary expectations, have sharply reversed a two-and-a-half year decline. And money, which affects the economy with a lag, has been growing at explosive rates for the past two years. A major resurgence of inflation would be a tragedy. Taming it the for yet a third time within fifteen years would probably entail most wrenching recession in our post-war history. The relief it might bring debtors would surely be temporary, and not worth the costs to be paid when opinion eventually swings behind firm antiinflationary policies. Is there a serious threat of a revival of inflation, such that policy-makers, and above all the Federal Reserve, should act now to nip it in the bud? Or does the economy require continuing, perhaps 'Testimony of David Seiders, Chief Economist of the National Association of Home Builders, June 4, 1987. http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis II 3NP Price Deflator 4 2 even greater macroeconomic stimulus? Is monetary restraint now required. to head off the next round of inflation, or would it tip over an already sluggish economy into a world recession? weight of our recent economic past Does the -- the massive red ink of budget and trade deficits, and an exposion of money -- foreordain an inflationary future? To seek answers to these questions the Subcommittee on Domestic Monetary Policy of the Committee on Banking, Finance and Urban Affairs held four days of hearings, in June 1987, on The Threat of Inflation. Prominent economists, forecasters, and Administration officials were invited to testify.2 views was sought. A wide and balanced range of This report summarizes the main analyses and arguments put forward in these hearings, and presents the conclusions reached by the Chairman of the Subcommitee. Forecasts of Inflation The course of inflation over the past two decades, as measured by the GNP Implicit Price Deflator and the Consumer Price Index (CPI), is portrayed in chart 1. The following table summarizes forecasts for inflation presented by various prominent forecasting firms, and by the U.S. government, as of Spring 1987.3 Chart 2 projects several of these consumer price forecasts into 1987 and 2Witnesses for these hearings were: Dr. David Seiders, Chief Economist, National Association of Home Builders; Prof. Donald Ratajcvak, Economics Forecasting Center, Georgia State University; Dr. Paul Craig Roberts, Center for Strategic and International Studies, former Assistant Sec. of the Treasury for Economic Affairs; Mr. Lawrence Kudlow, Chief Economist, Bear Stearns & Co., former Chief Economist, OMB; Dr. Roger E. Brinner, Chief Economist, Data Resources; Dr. James Annable, Chief Economist, First National Bank of Chicago; Prof. William Poole, Brown University, former Member, Council of Economic Advisers; the Hon. Michael R. Darby, Assistant Sec. of the Treasury for Economic Policy; the Hon. Michael L. Mussa, Member, Council of Economic Advisers; Dr. Allen Sinai, Chief Economist, Shearson Lehman Brothers; and Dr. Jerry L. Jordan, Chief Economist, First Interstate Bancorp, former Member, Council of Economic Advisers. 3These forecasts convey a general picture of inflationary expectations. Forecasters frequently update their forecasts, so these numbers do not necessarily represent the current opinion of the forecasters. Sources: Memorandum to the Subcommittee from Congressional Research Service, May 5, 1987; Testimony before the Subcommittee on June 4, 10, 11 and 17, 1987. (GSU is the Georgia ' State University Economic Forecasting Center. The First Nat. Bk. of Chicago forecasts are for the fourth quarter of each year, at an annualized rate. Other figures are year-over-year forecasts.) http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 3 1988. the CPI, As of May 1987 the annualized rate of increase for since December 1986, stood at 5.6 percent. CONSUMER PRICES GNP DEFLATOR U.S. Government Congressional Budget Office Shearson Lehman Data Resources Townsend-Greenspan Wharton GSU Econ. Forecasting Center First Nat. Bk. of Chicago 1987 3.3 3.2 3.5 3.1 2.8 3.2 88 3.5 3.8 4.1 3.7 4.3 4.3 5.6 6.5 89 4.7 4.0 4.8 1987 3.0 3.5 3.8 3.9 88 3.6 4.3 4.3 4.6 89 4.0 5.4 5.9 4.7 5.4 7.0 5.0 4.7 4.7 was The point of the hearings on which this report is based on over not to determine who can make the best forecasts of inflati the next few years. The best analysis of the threat of inflation may not generate an impressive forecast. Policy-makers sharing or ate the reacting to that analysis might change policy so as to invalid forecast. Or the forecast might err in timing, especially in c assessing the impact of monetary policy, since money affects economi activity with uncertain lags. The point is not to pick the best short-run forecast, but to assess the strength of gathering forces which could, sooner or later, reignite substantial inflation in the American economy. The forecasts presented above simply indicate the range of inflationary expectations held in the Spring and early Summer of 1987 by some prominent forecasters. A THREAT OF INFLATION ? A plausible case for relative complacency about the threat of future inflation can be built on the testimony presented by some of the witnesses at these hearings. No one doubts that inflation would errs eventually return, with a vengeance, if monetary policy grossly in the direction of excessive stimulus. In the opinion of some witnesses, however, that is the least likely error to which the Federal Reserve will be prone. sluggish and fragile. The real economy is, in this view, Few if any of the forces that inflate prices by inflating costs are now at work. http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Nor is excessive demand in 14 - 1--CB0 2--Data Resources 3--GSU 4--First Nat. Bank of Chicago 10 - % change, annual 8 http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 70 7l 72 73 74 75 76 '77 78 79 BO 81 82 83 B4 85 86 87 88 CPI forecasts for .'1987 E 1988 4 al Reserve will Indeed, the major risk is that the Feder evidence. pitate a world recession: err toward monetary tightening and preci t enough at this I am not confident that the economy is robus ening of tight A .... point to stand monetary tightening for an need t urgen the monetary policy runs counter to ary monet for ng calli expanding world economy.... Those It is ut. fallo the all tightening had better think about uts, a bailo more dies, almost certain to produce bigger subsi it.4 weaker economy and a larger budget defic d target higher No witness argued that monetary policy shoul ry consequences • real growth with no regard for the inflationa a necessary and Conquering the inflation of the late 1970s was st the high cost of the positive achievement, even when measured again for the foreseeable recession of 1981-82. But the balance of risks side of economic future is seen to lie preponderantly on the stagnation. sion is a far All observers agree that a global growth reces n the late boom more likely prospect than an inflationary 1980s. A replay of 1972-73 is highly unlikely.D rading of the What evidence and arguments support this downg risks of inflation? Relative Price Adjustments foreign Movements in two important prices -- oil and the y put upward pressure exchange value of the dollar -- will undoubtedl on the U.S. price level throughout 1987. (See charts 3 and 4). In cting the sharp drop 1986 the price of finished energy products, refle nt. in the price of oil, fell by more than 38 perce This was largely inflation to about responsible for the deceleration of consumer price 1.1 percent in 1986. Excluding energy, the consumer price index nt, as in the (CPI) rose in 1986 at about the same rate, 3.8 perce previous three years. rebounded. http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis In 1987, however, energy prices have y products Through April 1987 the price of finished energ 4Testimony of Paul Craig Roberts, June 4, 1987. 5Testimony of Roger E. Brinner, June 10, 1987. ENERGY COSTS SOLID LINE is CPI Index of ENERGY COSTS - percent change from same month 1 year ago (LEFT SCALE) DASHED LINE IS the relative price of energy _ CPI Index of Energy Costs CPI, All Items (RIGHT SCALE) "1.62 — — 1.45 35 — INDEX OF ENERGY COSTS 1 1 1 22-' — 1.32 1 1 1 iNi — 1.1S r" 1.22 N • :2 •• —2S -.----1 73 http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 2.85 T I 74 75 76 77 I I4 1 I 1 78 .' I e2 I 81 MONTHLY DATA I 82 83 84 85 I 1 I 1 1 86 87 Trade-Weighted Real Exchange Rate for the Dollar Dallas Federal Reserve Bank - 132 130 (Index measures the value of the dollar against all 131 U.S. trading partners) 122 120 - -112 - 102 - 92 92 - 80 http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 1G77 1S7e I 1G7G I 1 I 1 1 I 1 €3t-3 1 Gel 1 Ge2 1 e5 IG€4 1 ass :Ge6 MONTHLY DATA '- 62 I 1G67 5 has jumped more than 14 percent. And the price of nonfuel imports, rose at about an 11 reflecting the depreciation of the dollar, of 1987. percent annual rate in the first quarter nd a revival of But these movements do not necessarily porte inflation. ges in the They are both relative price movements (chan goods), and they both can price of one set of goods relative to other need not put persistent be interpreted as one-time adjustments that . upward pressure on the overall price level the inflation (C)oncerns about a sustained resurgence in 3 years of the rate, above that recorded during the first t uptick of recen current expansion, are exaggerated. The le largely butab attri inflation, above the 4 percent range, is should tion Infla to temporary, supply-side disturbances. nd in rebou the slow later this year as the passthrough of energy prices is completed.6 e and maintain No witness expected OPEC to be able to impos as it did twice in quasi-monopolistic increases on the price of oil the 1970s. The present increase in oil prices corrects an bears no threat of artificially exaggerated collapse in 1986, but chronic inflation. serious The falling dollar is seen as a potentially more but in terms of the inflationary threat -- not in its own right, its significance. danger that policy-makers could misinterpret The ive prices, making decline in the dollar is an adjustment in relat American goods cheaper foreign goods more expensive to Americans and to foreigners. aps the It is, in today's world, the most potent (perh can trade deficit. only) force tending to reduce the massive Ameri It icial, and policy should should, therefore, be viewed as highly benef mental and persistent not try to "defend the dollar" against funda downward market pressures.7 Overcoming the trade deficit is a major require some increase policy objective, the attainment of which will in the U.S. price level. Such policy trade-offs are unavoidable, and 6Testimony of the Hon. Michael L Mussa, June 11, 1987. me 7Even the rebound in oil prices has its positive side. "(S)o of the price increases now working through the economy are beneficial. Higher foreign goods prices signal better sales prospects for U.S. producers and more jobs for American workers. In addition, higher energy prices more closely reflect the long-term scarcity of oil, and their arrival should ease the financial pressures on the domestic energy industry." Brinner, op. cit. http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 6 8 should be recognized as such, without complaint. sly raise the U.S. The depreciation of the dollar will unambiguou price level. ted, but The price of imported goods are directly affec so are domestic prices. Domestic producers competing against foreign e position, raise imports can, without sacrificing their competitiv their own prices in tandem with import prices. But some witnesses prices to be quite judged the direct impact of the dollar on overall s of nonoil modest: "It seems reasonable to expect rising price point to CPI growth merchandise imports to add less than a percentage in 1987."9 that Research at Data Resources supports the conclusion filter through to "only a fraction of import price inflation will domestic production and labor markets."1° r on domestic The expectation that the impact of the falling dolla evidence that prices will be quite modest stems, in part, from the exceptionally foreign profit margins widened considerably under strong dollar. Foreign producers are now able to adjust to the weak ng the dollar dollar more by reducing profit margins than by raisi price of their goods. on since The ultimate passthrough of the dollar's depreciati expected early 1985, therefore, may be less than would' be ase in incre the inly, Certa ips. from historical relationsh less is far thus red occur nonenergy import prices that has rical histo the upon than would have been expected based experience.11 is the danger of The inflationary danger posed by a falling dollar misinterpretation and policy overreaction. not The recent depreciation of the dollar probably does this at not least presage a new round of inflation, at ary time.... It would be a serious mismanagement of monet r dolla the policy for the Federal Reserve to misinterpret the nt preve adjustment pkocess as inflation and to tighten to adjustment." ving the 8"As soon as the dollar declined enough to begin impro r. A dolla low the about g trade deficit, people started complainin a nts prese s crisi country that turns every alternative into a confused face to the rest of the world." Roberts, op. cit. 9Seiders, op. cit. 1°Brinner, op. cit. 11Mussa, op. cit. 12Roberts, op.cit. http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis I 7 misread and There is also the danger that the private sector will the falling misreact to the one-time price increase touched off by dollar. The only source of worry is the possibility that management and labor will fail to recognize the nature of the inflation surge (rising prices of imported goods and oil) and then reach overly generous pay agreements, followed by aggressive price increases -- thus initiating a cost-push inflation spiral. The American business community must exercise restraint in pay and pricing to allow the new value of the U.S. dollar to mOce a genuine improvement in competitiveness.13 Essential to overcoming a trade deficit through relative price acceptance of changes (i.e., through a falling exchange rate) is the a decline in real income. When the dollar appreciated ... between 1980 and 1985, relative import prices declined and the real income of U.S. households rose. They could buy more imported goods at a smaller cost in terms of domestic goods. The real depreciation of the dollar, needed to correct the relative competitive position of U.S. industry, implies that this process must be reversed. Real living standards of U.S. residents must grow more slowly because of increases in the relative prices of imported goods. Increases in nominal effects wages and nominal incomes to offset the real income 14 of dollar depreciation would be self-defeating. If workers demand wage increases to protect their purchasing also power in the face of rising import prices, domestic prices will rise in line with import prices. Overall inflation will tend to n track the falling dollar, with no change in relative prices betwee Imports and domestically produced goods. That is, there will be no t. change in real exchange rates, and no impact on the trade defici Downward pressure on the nominal exchange rate would then likely accelerate, leading to yet higher wage demands and yet higher domestic prices -- a classic wage-price spiral that will either be accomodated by increasingly expansive monetary policy or stopped by a monetary tightening that induces a serious recession. This danger, though recognized, tends to be downplayed, primarily because it is thought that a relatively weak domestic economy, high 13Brinner, op. cit. 14Mussa, op. cit. http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 8 a lid on domestic wages unemployment and unused capacity will keep and production costs. Production Cost Pressures only if the A sustained resurgence of inflation is likely production inflationary process begins to affect domestic that firms and costs, most importantly, wage costs. Provided ive price workers recognize the nature and necessity of relat l competitive adjustments and the reality of the internationa production situation,...unjustifiable increases in domestic nary atio infl of ce sour ent costs should not be an independ pressures.15 essively in Are domestic costs likely to be pushed up aggr ght about by rising oil response to the relative price changes brou prices and the falling dollar? Witnesses who thought domestic cost ed three factors in pressures would continue to be minimal emphasiz relatively high support of their assessment: (1) the current increases over the past unemployment rate, (2) the very modest wage excess manufacturing few years, and (3) the continuing high level of capacity. by post-war Unemployment remains at rates which seem high recent months. standards, though it shows a downward trend for There between unemployment is, moreover, no obviously stable relationship and inflation. (See chart 5). Another, more comprehensive measure o of the employed to the of employment shows a steady rise in the rati total working-age population. (See chart 6). still touch off An historically high unemployment rate could Inflationary pressures. For reasons these hearings did not explore, pressures will begin the rate of unemployment at which inflationary the past two decades. to emerge has risen in the United States over could be cut to Optimists assert that the unemployment rate imists would 5.5% before such pressuv9s would exist; pess probably worry at 6.5%.lb ural rate of This concept, often referred to as the "nat employment" rate. unemployment," is not necessarily the "full 15Mussa, op. cit. 16Brinner, op. cit. http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis It is, SOLID LINE is the total Unemployment Rate DASHED LINE is the percent change in the GNP Deflator from the same period 1 year ago 12 '-12 I ' 12 • 1 1 1 1 1 1 1 1 1 1 1 1 1 1 5 1( /1 /\// 1 / 1 1 1 1 1 1 1 sJ 1 1 1 1 6 1 1 4 4 11 57, 2 58 SG 72 71 72 73 74 7E 75 77 7€ 7G 82 Cl http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis MONTHLY AVERAGE. DATA ez 85 84 85 85 €7 EMPLOYMENT RATE 64.2 SOLID LINE is total of those employed (including those in the armed forces) divided by the total population over 16 years old. 64.2 -62.8 62.8 .411. -61.6 62.4 s- 62.4 za.2 ,s9.2 I— L.K i,L.isi ; 61.6 411* G8.2 GS.2 73 http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 74 75 76 77 78 7 82 81 MONTHLY DATA 82 e3 84 es se 87 crt 9 h cannot be reduced by .further rather, the rate of unemployment whic ng inflationary pressures. macroeconomic stimulus without generati be achieved by such stimulus Furthermore, any reduction that might market, after adjusting to the would likely be shortlived, since the to move the rate of unexpected rise in inflation, would tend l. This "natural" level can unemployment back to its "natural" leve change the structure of the be lowered only through policies that blunt instruments of fiscal or labor market itself, not through the monetary policy. , though an important Witnesses agreed that this "natural" rate mate empirically. Our theoretical concept, is difficult to esti ld rule it out as an inability to pinpoint it precisely shou policy.17 At best it can serve operational target for macroeconomic the labor market. as a general indicator of the state of By mid-1987 moving toward the midpoint of the measured U.S. unemployment rate was of unemployment. Further the estimated range for the "natural" rate entail renewed inflation, but downward movement would not necessarily t beyond which would signal that we are close to the limi ation, but no lasting gains macroeconomic stimulus will generate infl in employment. t on inflation is the The most encouraging current restrain behavior of wages: has been reduced from (W)hile the civilian unemployment rate expansion, there ent curr 10.7 percent to 6.3 percent in the s that is cost r Is not the upward pressure on unit labo ess. For proc normally associated with the inflationary s in the nonfarm example, over the past year unit labor cost about 1 percent economy have risen by 2 percent and by only for nonfinancial corporations.18 the rise in Unit labor cost is measured by subtracting productivity rose as rapidly as productivity from wage inflation. If on final prices. wages, wages would exert no pressure at all Though recent years, so have productivity growth has slowed considerably in trending modestly downward wages, and unit labor costs have have been for the past two years. (See chart 7). 1987. 17 Comments by Poole, Hearing of June 10, y, June 11, 1987. 18Testimony of the Hon. Michael R. Darb http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 7 TNT. -MY SOLID LINE is the GNP Deflator, percent change from same quarter 1 year ago DASHED LINE is unit labor costs in the manufacturing sector, percent change from same quarter 1 year ago. - 16 .‘ 11 1 1 1 1 1 1 12 - 1 1 1 1 1 - 12 1 1 1 1 1 1 1 1 1 1 'I 4MNII IMMO 1— NIMNIN Li 4 2 • I 73 http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 74 7S 76 77 78 7 82 61 QUAR7ERLY DATA 8?_ L I e3 64 es se 67 10 modest, sharp rises in wages Assuming productivity gains remain Wage costs represent about twowill generate sharp rises in prices. ally produced goods and thirds of production costs for domestic ease in wages could be absorbed services. Little, if any, of the incr which constitute a much smaller by a reduction in corporate profits, r the past decade after-tax share of total production costs. (Ove of GNP.) Nor would it be corporate profits averaged 4.7 percent since investment depends, in desirable for them to be so absorbed, of healthy profits, the final analysis, on the expectation stment, and the growth of real productivity gains require robust inve income requires rising productivity. parallel wage inflation? Could we have price inflation without lagging behind, since wage Initially prices can surge with wages adjust instantaneously to rates are set at intervals, and do not all the current rate of inflation. But they will surely catch up sooner or later, and probably sooner. the inflation rate, Any sustained and substantial increase in tantial increase therefore, must involve a sustained and subs want to will ers in the rate of wage inflation.... Work ng prices. risi nst protect their real living standards agai the prices in s ease Employers, realizing or anticipating incr secure to s ease of products they sell, will grant wage incr Through this the labor they require for production. tary policy can mone nary nsio expa mechanism, an excessively wages move in a generate inflation in which prices and 19 mutually reinforcing upward spira1. forecast by Data Resources The relatively sanguine inflationary of the evolution of wages, stems from its relatively optimistic view productivity and unit labor costs. to fall to 2.5% in I expect growth of hourly compensation possibly 5.0-5.5% in and 1987, then rise to 4.5% in 1988-89, simultaneously ld 1990. Because productiviy growth shou unit of output will recover to 1.5% per year, labor costs per 3.5% per year.... only accelerate moderately.... to perhaps -- in the Prices of goods produced -- not just consumed as unit rate United States should rise at about the same price labor costs. Specifically, our forecast for the followed deflator for gross natigtnal product is 3% in 1987, by 4% in 1988 and 1989.z0 rience, since This is quite in line with recent inflationary expe 19Mussa, op. cit. 20Brinner, op. cit. http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 11 and 1984, while the the GNP deflator also rose at about 4% in 1983 and artificial lows 3.3% in 1985 and 2.3% in 1986 were temporary high dollar and lower oil attibutable to the passing influence of the prices. ng Thus the United States "is not at a critical turni point."21 capacity That conclusion is reinforced by the state of utilization in manufacturing. (See chart 8). industry (T)he capacity utilization rate for total U.S. sharply in remains below 80 percent. Utilization increased remained on the early stages of the current expansion but has lized unuti more is there al gener a plateau since 1984.... in or my econo eated overh an of capacity than is characteristic 22 tion. situa even a potentially inflationary s that it will Data Resources shares this assessment, and doubt change in the next few years. 79% and is Overall, the operating rate for manufacturing is At least an e. decad this g unlikely to rise beyond 81% durin be required would rate) 85% rate (and probably and 87% or 88% become would before aggresive price increases beyond costs widespread.2i inflation is Other factors were also cited as evidence that firmly under control. e,... and Commodity prices have not broken out on the upsid of the ion iorat the latest Fed data show a continuing deter to farm banks despite the massive federal subsidies of the farmers....Land values are still uncertain in much Midwest and the oil states.24 that there is Both these factors might be cited as indications little of no expectation of future inflation. But they may be very unreliable indictors of actual future inflation. Farm land values s. reflect expectations of future agricultural price With s supply on world agricultural products oversubsidized and in exces s to lag behind markets, it is plausible to expect agricultural price of inflation. the general price index, whatever the overall rate to an overall Nonetheless, stagnant farm land values contribute 21Ibid. 22Darby, op. cit. 23Brinner, op. cit. 24Roberts, op.cit. http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis V:7 SOLID LINE is Capacity - Utilization in Manufacturing (LEFT SCALE) DASHED LINE is the GNP Defiator, percent change from same month 1 year ago (RIGHT SCALE) r '2 A I 1 I / - 12 4 1 1 1 1 / 1 1 1 1 g GNP 1 1 1 6 1MM 72 - 4 V ,M111, CAPACITY http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 2 1111111111M: 62 €1 ea €3 e 4 ez 86 87 7Z-.7 76 77 7€ 7 UTILIZATION DATA IS MONTHLY . GNP DEFLATOR DATA IS QUARTERLY 12 tations are still quite assessment that current inflationary expec modest. Commodity Prices re. Commodity prices present an ambivalent pictu Commodity price they can serve indices are growing in popularity, on the claim that monetary policy. as reasonably reliable guides for the conduct of than it could be This claim deserves a more careful evaluation accorded in these hearings. The behavior of several such indices is charts 9 and 10. plotted, together with consumer inflation, in It is e inflation is far from clear that their record as indicators of futur tune with the two big perfect. Commodity prices generally moved in have led the movements, inflations of the 1970s, but do not appear to as policy indicators should do. The spot index for raw materials ng of 1983. gave a clearly misleading signal with its upswi out on the While commodity prices have not yet "broken appears as steep as upside," there is an unmistakable upswing that previous major upswings. has risen The Commodity Research Bureau spot price index annual rate. The 12.1% since December 31, 1986 or at a 25.8% .Raw industrial rise has accelerated in the past few months... This is a prices are up 12.7% over the past two montOs. sizeable and widespread higher inflation.2D (or any other The usefulness, if any, of commodity prices y must stem from a dominant indicator) as a guide to monetary polic warning signals. capacity to provide reasonably reliable early If a have "broken out on the policy response must wait until the indices upside," it will be too late. predominant role, If an indicator is to play a policy must be willing to respond to its early uncertain. signals, when other indicators are ambiguous and invested with such Commodity prices should not, at present, be weight in the setting of monetary policy. The upswing that commenced y reliable indicator in 1986 is certainly not, by itself, a necessaril to tighten monetary of future inflation, nor a reason, by itself, be complacent about policy. But neither does it offer any reason to 25Testimony of Allen Sinai, June 17, 1987. http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis SOLID LINE is the Producer Price Index for Industrial Commodities DASHED LINE is the Consumer Price Index for All Items (both are percent change from same month 1 year ago) 32 24 - S2 -24 1\ -16 16 •N„. 1 , I e , .▪ .,, -. iti \\ t\\ \ % \i • e NO• V I 1 1, $ ■••• 2 -e 68 6@ 72 71 http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 72 73 74 7E; 76 77 7€ 7 MDNTLY DA A 60 51 62 tp-c e4 1 1 8S 86 87 2 SOLID LINE is Spot Market Prices of Raw Materials :ndex (1967 = 100) (Commodity Research Bureau Index) DASHED LINE is the Consumer Price Index for All Items ire percent change from same month 1 year ago) (Both a 42-s - 40 22-' -'22 ••• OMNI. 00 " 'Nur 41.% 0 2 -22 1 -'-22 - 1 68 http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 1 1 1 1__ 71 72 73 74 / 76 77 7€ 7 I 2 6.1 A R.2 I 1 E4 I e7 13 the future threat of inflation. The Velocity of Money ded several big Since 1982 the American economy has absor upswings of monetary growth. (See chart 11). From about the third 1983 M1 grew at close to 13%, quarter of 1982 to the third quarter of and 1981. This spurt compared to about 6.5 % per annum over 1980 of 1982. coincided with recovery from the recession From the third growth in M1 quarter of 1983 through about the end of 1984 decelerated to about 5.6% per annum. This deceleration gave rise to the inflationary the charge that the Federal Reserve, fearing strangling the recovery. consequences of rapid economic growth, was ng to about 11-12% through But M1 growth surged once again, accelerati 1985 and about 16% through 1986. These rates compare with average the 1970s. annual growth rates of about 6.6% for M1 throughout l evidence There is an impressive body of theory and empirica ate cause which points to rapid growth in money as the ultim should of inflation.... This is not a partisan issue. It command general agreement. 26 ed, so far, to Why, then, has recent rapid monetary growth fail cause inflation? This question was widely discussed in these ocity of money". hearings, in terms of the concept of the "vel e to money. The velocity of money is the ratio of incom Since income, and of money, there are various measures and definitions of on is the ratio of there are various kinds of velocity. The most comm nominal GNP to Ml. Since money affects spending, and thus GNP, with whose denominator is a a lag, it is also useful to examine velocities d. measure of money over some previous time perio which money is In a rough way velocity indicates the rate at being spent. A velocity of 5 suggests that, on average, each dollar that gives is spent five times to generate the aggregate spending rise to the GNP. The image of velocity as money "turning over" should not be taken too literally. 26Darby, op.cit. http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Money is also spent on many transactions the •44 • CIIART 11 MONEY STOCK (Ml) IL RATIO SCALE RATIO SCALE MONTHLY AVERAGES OF DAILY FIGURES BILLIONS OF DOLLARS BILLIONS OF DOLLARS SEASONAllY ADJUSTED 800 80 i 775 77 Y 753.0_ 750 t t 75 t 4 725 016.5% 72 700 70 67 675 650 650 625 411.5I , 625 1 600 00 75 575 #5.61 550 50 525 ! 25 012.7r ! 00 500 75 475 t. !, t 4 50 1 .. f A !I 450 0 t 425 f 1982 1983 1984 f 1985 1986 1987 IIMI CONSISTS OF CURRENCY HELD BY THE NONBANK PUBLIC, DEMAND DEPOSITS, OTHER CHECKABLE DEPOSITS AT ALL DEPOSITORY INSTITUTIONS AND THAVELERS CHECKS. PERCENTAGES ARE ANNUAL RATES OF CHANGE FOR PERIODS INDICATED. LATEST DATA PLOTTED. MAY PREPARED BY FEDERAL RESERVE BANK OF ST.LOUIS http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 25 14 full value of which is not a part of GNP. Buying stock, or a used services of the car, requires money, but only the value of the GNP, not the value of stockbroker or used car dealer contribute to the stock or the car. GNP measures the value of goods and services things traded in the produced by the economy, not the value of all economy. other things, The demand for money is determined by, among those outside GNP. the transactions for which it is used, including total transactions, GNP is normally assumed to be workable proxy for since we lack a ready measure of their value. traced through The link from money growth to inflation can be the behavior of velocity. If velocity were perfectly constant, the the rate of rate of increase of the numerator (nominal GNP) and be exactly the increase of the denominator (the money stock) would same. GNP and the The numerator, nominal GNP, is the product of real price level. sum of The growth in nominal GNP is (approximately) the real growth and inflation. If velocity were constant and money grew with inflation at 10%, then GNP might, for example, grow at about 3%, at about 7%. If real GNP could not, in the short-run, grow faster would just than 3%, then increasing money growth from 10% to 20% raise inflation from 7% to about 17%. absolutely To be useful in setting policy velocity need not be just as Velocity with a constant rate of change would be constant. useful. literally. And a "constant rate of change" need not be taken even somewhat Velocity could be quite volatile quarter to quarter, y if it adhered volatile year to year, and still be useful for polic y makers could to a reasonably stable longer term trend, or if polic . confidently predict future deviations from that trend Under those lly guide conditions the expected behavior of velocity could usefu restrain policy makers in the setting of monetary targets which would growth. inflation while allowing (not ensuring) maximum real economic For much of the past three decades M1 velocity did seem reliably wedded to a long-term trend of about 3% growth per year. (See chart 12). However, beginning about 1980 it began to deviate significantly from that trend. The normal relationship between money and income broke down, and velocity declined abnormally. http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis This MONEY VELOCITY 2.2 SOLID LINE IS M1 VELOCITY DASHED LINE IS M2 VELOCITY 2.2 -vv.. LJ —J 1.2— c-) — 2.9 —2.€ ; cz) I —2.7 t— 2.6 e, ••\ 'M2 2• 4 N -4 • —2.5 " 1 [Ii m 1111111111 Uj111111 ii II Uli[III Ill! It 111111 I III I 1 11 IT IIlj 111 111 111111 11111 11Tf111 U 85 83 61 7G 77 73 75 71 5G 63 6Z 67 69 61 QUARTERLY DATA http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis IT 87 r 2• 4 15 . breakdown had two important implications for monetary policy In the much first place, the monetary tightening of 1980-82 was, in fact, more severe than the money supply figures, based on historical Given the fall in velocity, a relationships, would have suggested. given degree of monetary contraction produced a much larger the contraction in nominal income than could have been predicted from pre-1980 behavior of velocity. And, in the second instance, the a much rapid expansion of the money supply from 1983 to 1986 produced smaller rise in nominal income than could have been predicted from the pre-1980 behavior of velocity. That much smaller rise in nominal GNP, GNP, combined with a healthy, if not spectacular, rise in real 2.6% in squeezed inflation (as measured by the GNP deflator) down to 1986, the lowest in the past two decades. In common parlance one speaks of monetary tightening or contraction, monetary ease or expansion. These terms make sense only as shorthand for the relationship of the supply of money to the demand for money. Monetary tightening means the money supply is being depressed relative to demand; monetary ease means the money supply is being expanded relative to demand. supply can be observed. But only the money Money demand must be estimated on the basis as of other economic variables that are directly observable, such income, interest rates and prices. Good estimates of money demand and require a reasonably reliable relationship between money demand those directly observable variables. Significant shifts in velocity imply significant shifts in these relationships. If demand for money the money is growing much faster than anticipated, a given growth of in fact supply, which might appear to be highly expansionary, could be neutral or contractionary, in relation to the actual (but unexpected) growth in the demand for money. The collapse in velocity of the 1980s might suggest the conclusion that velocity is so unreliable (money demand so unpredictable) that monetary aggregates are useless as targets for monetary policy. It might also suggest that no scaling back of last year's torrid pace of monetary growth is required, since falling velocity will render future monetary expansion harmless. http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis These two 16 conclusions are, of course, mutually inconsistent. If velocity has future become truly random and unreliable, no prediction of its course is warranted. The task is to explain its behavior, and sing the thereby reestablish a basis, however tentative, for asses might be consequences of past monetary growth and the threat that rates. posed by its continuation at such unprecedentedly high THE THREAT OF INFLATION I money) has The collapse in velocity (or rise in the demand for ary growth with no obviously allowed the economy to absorb rapid monet contemporaneous inflationary fallout. The downward trend in velocity that the shift has persisted long enough to convince earlier sceptics was real and substantial. modated the Starting in October 1982 the Federal Reserve accom I decline in velocity by permitting money growth to rise. r highe that after there time thought at the time and for some Paul But tion. infla iting money growth ran the risk of reign Volcker called it right at the time. 27 Why did velocity collapse? explain the break in velocity: Witnesses presented five reasons to (1) the impact of inflation on ity; (3) portfolio velocity; (2) the impact of interest rates on veloc the definition of growth; (4) the trade deficit; and (5) changes in money. The Impact of Inflation on Velocity ity, and Accelerating inflation should act to increase veloc decelerating inflation to reduce velocity. With higher prices people strong incentive will need to hold more money, but will also have a to economize on their holdings of money. The components of M1 either adjust slowly to earn no interest, or earn interest at rates that changes in inflation. accelerates. Thus, M1 loses purchasing power as inflation M1 as People will need to increase their demand for ase that demand at a inflation rises, but can be expected to incre 27Testimony of William Poole, June 10, 1987. http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis `...,.... 17 of pace less than the rate of inflation, so as to minimize the loss purchasing power on the money they do hold. They will, therefore, tend to spend M1 faster and faster as inflation accelerates. Decelerating Accelerating inflation tends to raise velocity. inflation reverses these incentives, so it tends to reduce velocity. At moderately accelerating or decelerating rates of inflation the influence of these incentives may be hard to detect. They may also operate with considerable lags, especially when serious inflation is a novel experience, adjustment to which takes some time. The jump in inflation in the mid-1970s appears to have had no major impact on velocity. By the late 1970s, however, velocity clearly rose above its trend line. And, of course, the drop in inflation of the 1980s coincides with a major drop in velocity. If inflation has now come to exert an influence on velocity larger than suggested by previous estimates, "then the decline in velocity in recent years is not a puzzle but is a consequence of the decline of inflation."28 Moreover, if "inflationary concerns are reappearing, more rapid gains in velocity should be forthcoming or, at least, the rate of velocity decline should slow sharply."29 The Impact of Interest Rates on Velocity Interest rates should have a clear impact on velocity. In fact, two kinds of impact have been at work: an impact through the for traditional relationship between interest rates and the demand money, and an impact from the changes wrought by the financial deregulation of the early 1980s which permitted the payment of interest on most checkable deposits. The traditional relationship operates much like inflation on the demand for money, or on velocity. Rising interest rates induce people to minimize their holdings of money that pay no interest (or that pay rates that lag behind market rates). The higher the market rate, the stronger the inducement to shift money from sterile balances into assets that earn the market rate. To some extent, this 28Ibid. 29Testimony of Donald Ratajczak, June 4, 1987. http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 18 is simply a replay of the impact of inflation on velocity, since market rates, especially at the long end, contain an "inflation premium", which rises with inflationary expectations. This premium is necessary to compensate asset holders for their expected losses due to expected inflation. An increase in the "real" rate of interest -- the nominal rate minus the inflationary premium -- should also induce shifts from money to assets earning market rates. Since the inflationary premium is unobservable, there is no neat way to separate the impact of se, on inflation, per se, from the impact of real interest rates, per velocity. But the general conclusion is clear enough. Rising interest rates should increase velocity, falling interest rates should decrease velocity. A long-term relationship between velocity and interest rates is discernible. (See chart 13). It suggests the hypothesis that the postwar increase of velocity was due to rising interest rates, and the 1980s decline of velocity was due to falling interest rates. On this hypothesis there is a stable relationship between velocity and interest rates and we should use that relationship as an important input to monetary policy decisions.3u the The other impact of interest rates on velocity stems from st on deregulation measures which permitted the payment of intere checkable deposits. The transition from the old regime (money money bearing no interest) to the new regime (some components of bearing interest) had an important impact on velocity. Suddenly the icantly incentives for not holding some forms of money were signif icantly diminished, the incentives for holding those forms signif enhanced. After the shift in regimes some components of M1 became as temporary more attractive as assets to be held as savings, as well abodes of purchasing power awaiting the next transaction. That part of M1 in NOW and SuperNOW accounts is not of necessarily transactions-based monies, used against a flow ts nominal goods and services. The NOW and SuperNOW accoun es.31 purpos s saving or y tionar precau serve just as well for "Poole, op. cit. 31Sinai, op. cit. http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis VELOCITY AND INTEREST RATE S, 1915 - 1986 —16 8 Aaa Bond Rate (Ratio scale at right) 4 ami1 • Velocity (Ratio scale at left) iiiTir 4 1915 1925 http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 1935 1945 1 955 1 • -1 I. 441 1 • 1965 s 1 1975 1985 19 Assets held as savings are not spent as rapidly as assets held primarily to finance transactions. Incorporating more money held as savings in M1 would cause its velocity to decline. Since the magnitude and timing of the impact of this shift in regimes on velocity were difficult to estimate, the Federal Reserve had to operate in the early 1980s in fogs of uncertainly and ambiguity much more opaque than normal. After the economy adjusts to the new regime, a new relationship between velocity and interest rates should emerge, with interest rates likely to have a greater impact on velocity than in the past. The interest rate sensitivity of M1 or M2 balances is now much greater, particularly in periods of sharply lower or sharply rising interest rates.... On this factor, M1 and M2 velocity growth should be much less than trend in periods of relatively low market interest rates and rise faster than trend growth when interest rates are rising. 32 If yields on some checkable deposits tend to be "stickier" and less volatile than other short-term interest rates, funds may flow between those checkable deposits and other short-term assets much more readily than they would have flowed between non-interest-bearing demand deposits and other assets. This could happen because non- and interest-bearing deposits are primarily transactions accounts, s entails sacrificing the convenience of ready transactions account real costs. Some part of interest-bearing checkable deposits act cost, in more like savings accounts, however, so there would be less terms of the sacrifice of transactions balances, in shifting from checkable deposits to other short-term assets. As a result, velocity would be expected to fall significantly as short-term interest rates are declining and then begin rising after short-term interest rates begin to increase.33 The Impact of Portfolio Growth on Velocity Recovery from the recession of 1982 has been accompanied of all by substantial growth in the value of financial assets 32Ibid. 33Ratajczak, op. cit. http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 20 types held by the private sector. Much of this asset growth is of stocks and attributable to the rise in the market valuation money growth. bonds -- which may itself be attributable to rapid faster growth Rapid money growth can lead to expectations of asset prices. in d in future earnings, which may be capitalize appear to would The recent sharp climb in the stock market reflect this process.34 induce some Growth in the value of all financial assets will that, "to reduce risk rise in the demand for money, on the assumption stors will tend to of lost principle from interest rate changes, inve holdings of other increase their holdings of monetary aggregates as financial instruments increase."35 demand for money. Increases in wealth increase the The economy may react to an increased market sented real increases valuation of financial assets as though it repre liabilities which in wealth, ignoring any offsetting increases in trade deficits and arise from massive foreign borrowing to finance cits. from future tax liabilities to cover budget defi Normally this since assets tend to phenomenon would have little impact on velocity, grow at about the same rate as economic activity. since 1982 has outstripped economic growth. But asset growth Financial assets held by compared to a 33% rise in households, for example, have grown by 45%, GNP since 1982. 36 ain the break in As with the other factors adduced to expl opposite direction. velocity, this one can also operate in the earnings, as they When assets grow more slowly relative to turning up, money are prone to do when interest rates begin slacken as well. growth for portfolio needs will probably increase fol4owing The velocity of money should once again l assets." this one-time upward valuation of financia 34Testimony of Jerry L. Jordan, June 17, 1987. 35Ratajczak, op. cit. 36Ibid. 37Ibid. http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 21 The Impact of the Trade Deficit on Velocity Velocity is the ratio of GNP to a monetary aggregate. But GNP measures production, whereas theory would suggest that the connection is between money and spending. The es distinction is irrelevant in a closed economy, but becom and ts expor of flows ble sizea very important when there are 38 imports. total Expansive monetary and fiscal policies have stimulated annual rate of real spending in the American economy to grow at an rate of 3.2% since mid-1984, but real GNP has grown at an average only 2.5% The difference is the trade deficit. A good portion of ng to GNP. spending growth falls on imports, which contribute nothi alently, If exports, which do contribute to GNP, fail to rise equiv red velocity of GNP growth lags behind spending growth, and the measu money falls, other things being equal. An increase in exports, relative to imports, should tend to increase velocity. final Chart 14 compares normal M1 velocity with a "domestic Domestic final sales is constructed by subtracting sales" velocity. ts, to GNP. exports and changes in inventories, and adding impor It and measures spending by the American economy on final goods production of the services, wherever produced, while GNP measures the American economy. Replacing GNP with domestic final sales in the ent above, yield numerator of velocity should, according to the argum a more stable measure of velocity. However, the actual behavior of tinguishable from "domestic final sales" velocity is virtually indis that of normal velocity. Though the trade deficit increased remains quite dramatically in abosolute size in the 1980s, it still small relative to GNP. The impact of the trade deficit on velocity appears to be insignificant. Velocity and the Changing Definition of Money the payment In response to financial deregulation permitting Reserve confronted of interest on some kinds of deposits, the Federal a definitional conundrum. 38Jordan, op. cit. http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Prior to deregulation, Ml, composed Nei M1 VELOC:TY 7.3 - 7.3 SOL-D LINE is with GNP DASHED LINE is with DOM=T:C F:NAL SALES — • - 7.2 _ • - -6.7 6.4 -6.1 6.1 1 177 http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis iIIIIIiiii-T I 17€ 1S7S lase 1a€1 QUARTERLy 1 tiLlitiii,r 1 e-1- A A III 1 e6 1€7 S.8 Alm 22 was (primarily) of currency and non-interest-bearing demand deposits, the basic measure of money defined as a means of payments. After deregulation, those deposits in M1 that paid interest took on greater appeal as a savings asset in addition to their transactions function. As M1 became more heterogeneous, the economic significance of flows in and out of M1 became more difficult to interpret. What monetary aggregate, after deregulation, should be defined to capture the transactions function of money? The Federal Reserve chose to include interest-bearing deposits in Ml, but then let the aggregate grow far beyond the targets set for it in 1985 and 1986, and finally suspended it altogether as a target for monetary policy. er An alternative would be to maintain its transactions charact by excluding interest-bearing deposits from the definition of Ml. to This alternative is motivated by the desire to minimize the extent which changes in the traditional relationship between interest rates and money render M1 an unreliable target for monetary policy. But deleting interest-bearing deposits from M1 does not precisely recapture the properties of the old Ml, because those deleted deposits are also used for transactions purposes. Either definition yields a monetary aggregate different from the old Ml. then, is empirical: The question, Which emerges as a more stable and reliable aggregate, for the purposes of monetary policy? tBased on research of the behavior of M1 stripped of interes the bearing deposits, now dubbed Ml-A, the Assistant Secretary of in the Treasury for Economic Policy claims that the apparent break the velocity of M1 was, in large part, spurious, a consequence of change in definition: (P)roperly defined, the basic monetary relationship has been surprisingly stable.... (S)tructural changes appear to have disqualified M1 as a reliable monetary indicator, at least temporarily. We find, however, that on the traditional definition of money -- currency plus demand deposits or Ml-A -- there is no evidence of structural change.... Specifically, the pattern of Ml-A growth predicts the rapid recovery after late 1982 and the subsequently slower growth of the economy. In the analysis of quarterly inflation, Ml-A remains a consistently superior performer.39 39Darby, op. cit. http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 23 Chart 15 portrays velocity for Ml-A and Ml. The claim of the oneadvanced on behalf of Ml-A is that, with the exception the time shift brought about by the advent of deregulation, changed relationship of Ml-A to GNP and to inflation has not three decades. significantly from its historical record over the past ing. If that claim is borne out, the result may be quite alarm The nt of the rapid growth of Ml-A over the past two years, taking accou strongly estimated two year lag in the impact of Ml-A on inflation, suggests a sharp revival of inflation through 1989. (See chart 16). on the Why, then, does the Treasury share a "cautious optimism" outlook for inflation? Because it assumes tion in that the Federal Reserve will achieve a gradual reduc e. futur the in gates the rate of growth of the monetary aggre would one n That is perhaps the single most important reaso have for relative optimism on the longer-run inflation outlook." year or so, If Ml-A is brought down sufficiently over the next sharp drop in its recent surge could be seen as balancing out the would 1981, so that average growth of MI-A over several years coincide with only modest inflation. But, given its growth over the remain a past two years, it will be quite a feat for Ml-A to unless inflation superior performer" in the analysis of inflation, accelerates substantially. Relative Prices and Production Costs aggregated Velocity is a broad macroeconomic concept, the outcome of numerous economic activities. Many analysts try to disaggregated analyze those activities directly, using a more approach to the assessment of inflation. The more unstable and such an approach has. uncertain velocity appears, the greater appeal t of imminent Much of the case made by those who see no serious threa prices will inflation rests on the argument that changes in relative al price level, exert only minor and transitory pressure on the gener modest. and that increases in production costs will be 4°Ibid. http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Though possible, MONEY VELOCITY 2.S 2.S SOLID LINE is M1 Velocity DASHED LINE is Ml-A Velocity 2.4 7 2.4 2.3 2.3 l'"•• Omm 2.2 - \ ••••• LOG SCALE -2.2 M1-A #0 ' 2.1 - -2.1 2.2 -2.2 1.9-' -1.9 -1.8 -1.7 1 .S I.E 71 http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 72 73 74 7S 76 77 78 7G 82 81 QUARTERLY DATA 82 83 €4 es 86 87 MONEY GROWTH AND INFLATION SOLID LINE IS MI—A MONEY SUPPLY LAGGED 8 QUARTERS DASHED LINE IS THE GNP DEFLATOR DATA ARE PERCENT CHANGE FROM SAME QUATER IN PREVIOUS YEAR OF A 4—QUARTER MOVING AVERAGE OF THE ORIGINAL SERIES [12 /4 / •• 1 1 1 1 4 4 S. / GNP DEFLATOR a - -4 -4 i LI lig . .1i1 t111 T " • I 1 62 http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 64 66 6€ 72 75 78 82 82 74 72 QUARTERLY AVERAGE DATA €4 se 88 92 24 tended to this pattern would be quite unusual. Inflation has another into stage one be serially correlated, feeding from y, a polic ary monet until some intervention, either by tight The . rs... .occu disinflationary shock, or a major slowdown.. out gets genie lesson of history is that once the inflation be of the bottlq 4 it continues to persist and to perpetuated.'" Why is this danger now so acute? The impact of the decline in the dollar may be much greater than widely assumed. current Dollar-related inflation is the primary source of the an as ated estim inflation, and probably has been under ,42 inflation determinant in previous episodes... assessing This underestimation stems from the difficulty of the indirect effects of dollar depreciation. For example, almost 30% imported of the goods in the PPI-Finished Goods Index have can rise in counterparts, so the prices of these domestic goods e standing. tandem with import prices and not lose their competitiv red goods that Imported commodities and intermediate goods (manufactu the production of a go into the production of final goods) feed into in general will wide array of domestic goods, so production costs rise as import prices rise. Other, even more indirect effects can be cited.43 trade deficit Dollar depreciation will work best, reducing the if and generating only moderate inflationary pressures, domestic producers hold prices and try to recapture ding the previously lost markets....Some industries, inclu recapture to g American machinery industry appear to by tryin shows a try those lost markets. However, the automobile indus gains tendency to increase prices in line with the price pricing registered by their foreign competition. Such a from strategy leads to substantial inflationary fallout yment and emplo in gains ed limit dollar devaluation wAAh only industrial activity.'" now being The inflationary impact of dollar depreciation is compounded by rising energy costs. relative price changes, 41Sinai, op. cit. 42Ibid. 43Ibid. 44Ratajczak, op. cit. http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Both are, in principle, one-time 25 by but their effect on inflation is spread out and magnified ction produ consequent adjustments in labor costs, other overall costs, and profits. The lag from oil-price changes to lag The . inflation is relatively short (about six months)... r longe from dollar changes to inflation is significantly and (about eighteen months). The combination of the oil-price dollar changes that have already occurred with their 1986 differing lag structures generated the low inflation of in tion infla of on erati accel sharp the and made inevitable 1987.45 changes Even if the transitory impact of these relative price in the proves greater than expected, will not the general slack ic wageeconomy allow them to be absorbed without engendering a chron price spiral? What about the current stability of wages and the relatively low capacity utilization? Currently stable wages offer no buffer against future inflation: r or Wage costs always have lagged the earlier waves of highe g stron lower price inflation. Improved profit margins and t product markets from a more inflationary environment permi costs wage costs to move higher. Higher wage and unit labor e-pric -cost price the and s then are passed into final price wage-price spiral is completed." And low capacity utilization? Surely we have ample idle prices? productive capacity, ready to produce more at current necessarily. Not "Structural problems have made excess factory capacity a weak constraint on rebounding inflation."47 There may be not in an considerable excess capacity in a physical sense, but economic sense. Physically idle capacity is economically useless by production not a part of real economic capacity -- when burdened on world costs that render its potential output uncompetitive markets. systems These problems are largely rooted in inflexible wage ly asing that produce labor costs out of line with an incre competitive world economy.... Workers in steel, autos, rubber, and many other industries, in their attempt to maintain customary real wage growth during a period when global market trends were working against them, priced themselves and the products they produce out of increasingly 45Testimony of James Annable, June 10, 1987. 46Sinai, op. cit. 47Annable, op. cit. http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 26 competitive world markets.48 This uncompetitive pricing of labor in some industries is estimated to have caused about a three percent loss of usable factory capacity. Unusable capacity will not restrain inflation. Idled factories have not prevented home shelter prices from rising at a 5 percent rate during the past six months; nor have they held down price increases for medical care (6 percent), apparel (10 percent), and other goods and services (7 percent).49 Unusable capacity becomes usable only if production costs become competitive. But (t)he spate of wage concessions that followed the 1980-82 recessions have done little to correct the structural problem. In a number of industries, the wage differential (the excess of wages over their competitive levels) is no longer rising and, in some cases, has even declined somewhat. But that is not enough. If the structural problems rooted in wage disequilibrium are to be corrected, today's wag9 premiums must be sharply -- not slightly -- reduced.D° Macroeconomic policy should not be used to resolve problems of structural unemployment. Macroeconomic stimulus falling on structural unemployment and unusable capacity would be dissipated in higher inflation. Monetary Policy and Budget Deficits Whatever the initial impetus, inflation cannot persist in the face of sufficient monetary restraint: Indeed, without an accommodative monetary policy, inflation Is unli4ly to surge higher over an extended period of time....Di It is a truism that inflation is always a monetary phenomenon. The Federal Reserve can slow, stop, or reverse any infX4tion with a sufficiently tight grip on money-supply growth.34 The Federal Reserve can always err in estimating the degree of 48Ibid. 49Ibid. 5°Ibid. 51S1na1, op. cit. 52Annable, op. cit. http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis ink i 8 27 monetary restraint required to forestall or squash inflation, particularly when velocity and money growth are abnormally difficult to interpret. But errors can be corrected and monetary policy adjusted until the goal is attained -- if the commitment to controlling inflation is unyielding. The pessimists on inflation think that commitment will soon give way, or has already done so. The ultimate blame, however, will lie not on the Federal Reserve, but on a fiscal policy that presents monetary policy with no alternative but inflation. As two former members of President Reagan's Council of Economic Advisers see the problem: Besides the usual fear of recession, today there is another powerful consideration pushing monetary policy toward expansion, and that is the large federal budget deficit. Congress and the Administration, and the Fed for that matter, are horrified by the thought that a recession might push the Federal budget deficit to $300 billion or more. The fact of the matter is that current monetary policy will have the effect of inflating the deficit away, or partly away. Inflation will rise not because that outcome is the deliberate and conscious choice of the U.S. Government but because the Government is unwilling to run monetary policy without tilting toward inflation because it cannot take any risk of a recession and the larger deficit a recession would bring.53 In the final analysis, any country that is not able to control government spending in line with tax revenue is going to yield to the temptation to resort to the only unlegislated form of general tax increase -- inflation. Ultimately, monetary policy is simply another way to finance the government.54 Why will large fiscal deficits pose such a dilemma for monetary policy? The normal expectation is straightforward. Massively larger deficits will put strong upward pressure on interest rates. The Federal Reserve could choose to or refuse to "accomodate" the deficit by expanding the money supply in an effort to hold down interest rates. The first choice would eventually generate inflation, the second would eventually undermine real economic growth by allowing higher interest rates to crimp investment. The strong anti-inflation stance of the Federal Reserve was destined to clash with the rapid increase in Federal Government deficit spending that is structural, not cyclical, in nature.... The Fed has a basic choice when it comes to 53Poole, op. cit. 54Jordan, op. cit. http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis NEEL 28 dealing with a Federal deficit. It can buy the deficit, printing more money in the process, and ... generate an accelerating inflation. Or the Fed can refuse to buy the deficit, forcing it out on to the private credit markets, and drive up inflation-adjusted interest rates.55 But the dire consequences that would normally flow from massive, sustained deficits have not -- yet -- come true.56 The explanation is not subtle or elusive. Why not? It is the common staple of numerous analyses of recent macroeconomic policy.57 In the wake of the recession of 1982 the American economy could indulge in a sharp and sustained rise in spending concomitant with a sharp and sustained drop in inflation in part because much of that new spending fell on imports. We could consume significantly more than we produced because we could draw on the production of the rest of the world. That is not the whole story, since we also increased our own production. But the economic expansion since 1982 had not, through 1986, strained our productive capacity to the point of generating inflationary pressures because much of the new spending was readily dissipated on foreign goods made cheap by the soaring dollar. A large inflow of foreign capital into the United States is the financial counterpart to the inflow of foreign goods. phenomenon can be examined from two points of view. This single From the perspective of the real economy, we consume more than we produce by importing from abroad. From the financial or flow-of-funds perspective, we borrow, collectively, more than we save, 55Annable, op. cit. 56"According to conventional analysis, these massive budget deficits would result in inordinately high real interest rates as the government's demand for funds collided with private financing requirements. In the process, high real interest rates would crowd out private financing.... (But) these dire predictions did not come true. Real interest rates did rise, but consumer spending on durables increased steadily and substantially through the expansion, and housing activity was strong. A marked pickup in business plant and equipment spending occurred as well.... The economy's overall growth, too, surpassed expectations. It expanded uninterruptedly from 1983 through 1986 at a 4 percent annual rate.... Over the whole period, total employment climbed about 12 million workers. Market interest rates dropped perceptibly and inflation was subdued, averaging just over 3 percent." The Unpleasant Arithmetic of Budget Report. and Trade Deficits, Federal Reserve Bank of Minneapolis 1986 Annual 57In particular, it was the central point of The Foreign Exchange Value of the Dollar, a report of the Subcommittee on House International Finance, Investment and Monetary Policy of the Banking Committee, March 1984. http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis • 29 d. collectively, by borrowing the difference from abroa The foreign deficit. borrowing, the net inflow of funds, finances the trade The , the other two are equivalent, one measuring the flow of goods measuring the flow of funds to pay for the goods. deficit. Much attention has been given to the cause of the trade trade A common answer is that the budget deficit "caused" the deficit. The two certainly emerged, in their current dimensions, more or less simultaneously. (See chart 17). logic supports this chain of causation. And a very plausible The budget deficit put gn capital. upward pressure on interest rates, which attracted forei causing the The inflow of foreign funds drove up the exchange rate, trade deficit. The trade deficit supplied foreign goods on which budget deficit (some of) the growth in spending stimulated by the America's could fall, thereby relieving inflationary pressure on domestic productive capacity. it greatly This line of explanation is basically correct, though simplifies a more complex phenomenon. A large budget or a large entail an trade deficit need not entail the other, and neither need appreciating currency. In fact, a depreciating currency typically the dollar accompanies large deficits of either type, as it has for since 1985. st And large budget deficits can be observed to coexi . with large trade surpluses, as they have in Japan But, for reasons d States has particular to the time and circumstances, the Unite its large budget experienced large trade deficits concomitant with of the precise causedeficits. And that configuration, regardless my to increase and-effect relationship, has permitted the econo tment. consumption significantly without depressing inves The huge on to neutralizing inflow of foreign funds has made a major contributi budget deficits. the normally adverse effects of large structural ated by the That foreign inflow, when added to the savings gener nment's domestic economy, supplied ample credit to meet the gover it without the voracious demand for credit to finance the budget defic . normally expected crowding out of private investment can be seen'in The relative importance of this inflow of funds http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis SOLID LINE IS THE U.S. BUDGET DEFICIT (Billions of Current $) (Billions of Current $) DASHED LINE IS THE U.S. TRADE BALANCE 4.1%. / =Um 2 2 • 4r, ..r._. —62 — •••• —62 4 22 IWO —122 —182 —242 tit!: t Ititit: 176 177 l78 17G 12 1G-€.1 182 ae?, 1S.€4 http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis %I ! "—A t 4 4^M;:=M "Se 1 71 it ar A Im'^.0401, C` A A 111 1 1[1111i 1€7 IMMO —242 BILLIONS ev 30 the following calculations:58 (Percent of GNP) Government + Deficit Private Investment = Private Savings + Current Account Deficit 1975-84 (average) 1.9 + 16.3 = 17.8 + 0.4 1985 3.5 + 16.5 = 17.0 + 2.9 1986 3.2 16.3 = 16.2 3.3 nd for This basic macroeconomic equation relates the dema deficit and from the credit, from the government to cover the budget ly of credit, from private sector to finance investment, to the supp ent account the savings of the private sector and from the curr measure of the inflow deficit (a somewhat broader and more accurate of funds than the trade deficit per se). The average budget deficit the deficits of between 1975 and 1984 was substantially lower than y the same. 1985 and 1986, but private investment was virtuall in 1985-86, even Clearly private investment was not "crowded out" to the previous decade, though private savings did not rise, compared credit. (In fact, to satisfy the additional governmental demand for private savings fell somewhat.) Clearly the foreign inflow of funds, the gap. through the current account deficit, filled monetary policy to This configuration has made it easy for avoid painful choices. But it cannot endure. The seeds of its ar commenced a major unraveling were planted in 1985, when the doll to be the product of real depreciation. That depreciation appears and the Federal Reserve. major policy shifts by the Administration drop in the dollar, and the The Administration explicity promoted a nsive monetary policy in Federal Reserve shifted to a much more expa 1985 and 1986. the rise As chart 18 reveals, monetary growth tracks past four years. and fall of the dollar uncannily well over the shift to Why would the Administration and Federal Reserve the U.S. economy policies the explicit purpose of which is to deny needed to neutralize the the inflow of foreign funds so critically , World Economic Outlook, 58Source: International Monetary Fund exactly due to rounding. 1986 April 1987, p. 14. Totals may not add estimates are preliminary. http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Ml MONEY SUPPLY GROWTH TRADE-WEIGHTED REAL EXCHANGE RATE • -; FOR THE DOLLAR (Dallas Federal Reserve Bank) 7 SOLID LINE DASHED LINE http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis is M1 GROWTH, Percent change from same month 1 year ago (LEFT SCALE) is Trade-Weighted Real Exchange Raze for the Dollar (RIGHT SCALE) (NOTE: Scale is inverted) as - 122 • - 12E -112 1 - 1 IS 122 1.9E4 4"s 1 •• NONTHLY Di,7A 31 impact of budget deficits on our credit markets? Because that ng inflation on neutralization, combined with the impact of decelerati y sector, has the farm sector and falling oil prices on the energ created sharp regional and sectoral imbalances. The neutralization rs. appears benign in terms of the overall macroeconomic numbe But it r -- those is achieved at great cost to the "traded goods" secto industries that export and compete with imports. Pressure for to explode. protectionism from the traded goods sector threatened It the dollar. could be relieved by monetary expansion to depreciate also rising, Pressure from the agricultural and energy sectors was late the and could also be relieved by monetary expansion to reinf economy: also The uneven economic performance of the country... has who cies ituen created, in some regions of the country, const quent favor reinflation.... The dramatic increase and subse l plunge of world energy prices and, similarly, the substantia rise in the foreign exchange value of the U.S. dollar, followed by an even larger drop, have exerted highly uneven effects on the nation's regional economies.... On a national average basis, 1987 will be the fifth year of the current in expansion. However, many states, such as Alaska and those ns Regio al Centr the Rocky Mountains, Great Plains, and South of the country, are only hoping that their economies will stop shrinking during the current year. An activist fiscal of policy of the traditional type -- which would consist f for relie tax or ams progr ng reati public works or other job-c of rs secto e estat real and al, the hard-hit energy, agricultur al feder large the of view the economy -- is not possible in budget deficit. Consequently, the blunt instrument of monetary policy is being relied upon to stimulate the depressed regions of the country.... the opinion of key of policymakers in the Executive and Legislative branches c is government and at the Federal Reserve is that the publi the willing to accept somewhat higher inflation as part of 9 run.5 short the in erity prosp er price to be paid for great the trade Depreciating the dollar will eventually help shrink ce a deficit to the point where foreign funds no longer finan substantial portion of the budget deficit. What then? ing If the current account deficit had vanished in 1986, remov ion, what 3.3 percentage points from the right-hand side of this equat adjustments would have occurred to keep the equation in balance? It provide is extremely implausible to expect that private savings would much, if any, of the required adjustment. If, on the left-hand side more or less in line of the equation, the government deficit fell 59Jordan, op. cit. http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 32 and with the declining current account deficit, private savings investment could remain relatively stable. If not, however, the adjustment would come in private investment. That would require a gs over recession to depress investment so that the excess of savin investment would finance the budget deficit. so Monetary policy would then be faced with the dilemma it has, far, escaped. It could accept recession, or attempt to forestall it through inflation: The key is that the fundamental imbalance between domestic saving and domestic borrowing that has resulted from the shift in Federal fiscal policy will only be resolved by a return to Federal budget balance, a recession, or inflation - or some combination of the three. Washington has shown little resolve when it comes to reducing the deficit, and recession has been judged unacceptable, at least for now. of rekindling That leaves inflation, and the process 60 inflation in the U.S. is well underway. CONCLUSIONS nt (1) Inflation is not just a serious threat, it is a curre reality. 5.6%. of By May the CPI had risen in 1987 at an annualized rate sharp Though it might subside over the rest of the year, its ng signal. jump in early 1987 should be taken seriously as a warni (2) This jump in inflation is no surprise. Given the falling was dollar and rising oil prices, some impact on inflation inevitable. a But it should not be dismissed as purely transitory, one-time-only adjustment to the inevitable. It occurs in a context , of economic problems for which substantial inflation could ion. eventually, become the only politically acceptable solut of (3) The inevitable must be accepted, but a resurgence table and should inflation analogous to that of the 1970s is not inevi not be accepted. The time to stop inflation is before it begins. the cost of a After it develops momentum it can only be stopped at economic growth. recession or a painful, prolonged slowdown of real this cost will Undue complacency at the outset guarantees that "Annable, op. cit. http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis ' It • 33 eventually have to be paid. Current complacency about the threat of inflation is unacceptable. tion are (4) Economic buffers against an imminent surge of infla suggest they present, in today's economy, but plausible arguments ially if could prove to be weaker than generally estimated, espec momentum. inflation, however modest at the outset, develops some next (5) The major threat is not rampant inflation within the year or so. The major threat is that, without serious and sustained ary policy reductions in the budget deficit, the degree to which monet k to the can err, without causing recession or inflation, will shrin point of disappearing. It may not entirely disappear, but the ctly Federal Reserve cannot always fine-tune its policies, perfe ing estimating and taking full account of time lags and shift en velocities so as to never stray from the narrow path betwe recession and inflation. That narrow path can only be widened by substantial budget reductions. . (6) Velocity underwent a major shift in the early 1980s At that shift present the Federal Reserve appears to have navigated be But money acts with a lag, so future shocks could well adroitly. In store. no (7) Even if the money explosions of 1985 and 1986 carry ary expansion inflationary momentum into coming years, continued monet at that pace would be exceptionally risky. The factors adduced to guarantees of explain the recent downward shift in velocity imply no a continuing downward trend. They also suggest that when velocity in turns it could rise quickly, and could remain more volatile than With rising interest rates -- which will surely result the past. by a from a substantial decline in our trade deficit unaccompanied up very similar decline in our budget deficit -- velocity could turn sharply. ve To avoid an inflationary explosion the Federal Reser which could would then have to reduce monetary growth very quickly, rates. be politically difficult in the face of the rising interest (8) Monetary policy in 1987 indicates that the Federal Reserve its past pace of appreciates the inflationary danger of overdoing monetary expansion. http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis M1 growth slowed from a rate of 16.5% in 1986 to