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For release on delivery
Statement by
William McChesney Martin, Jr.
Chairman, Board of Governors of the Federal Reserve System
before the
Joint Economic Committee
February 26, 1969
I welcome the opportunity of meeting with this Committee
again to discuss some of the key economic problems facing the nation.
We are, at long last, beginning to make some headway in dealing with
a major economic problem that has plagued us for over 3years—
inflation.
Progress has been slow, but that is understandable after so much
inflationary momentum has been generated by the delay in getting the
nation's finances in order.
I am optimistic, however, that the forces
of fiscal and monetary restraint set in motion last year will gradually
bring us back to reasonable price stability.
Optimism about the ultimate success in containing inflationary
pressures should not, however, blind us to the difficulty of the task
in the months immediately ahead. We must deal with a heritage of cost
and price increases that is continuing to generate further cost and
price increases,and—importantly—
has
become deeply embedded in
business and consumer expectations. After several years of rapidly
rising prices, it is only natural that many spending decisions are
motivated now by the fear that prices will be even higher next year,
or by the conviction that inflation will bail out even the most
marginal speculation.
The price component of our national product has
advanced with increasing rapidity, from an average increase of less
than11/2per cent a year in the early 1960's, to 2 per cent in 1965,
21/2per cent in 1966, 3 per cent in 1967, and close to 4 per cent last
year.
Public skepticism about the Government's ability to "do some-
thing" about prices has its roots in this history of ever-quickening
inflation.
-2-
This skepticism has been reinforced by the initially inauspicious
results of fiscal restraint.
The immediate response to enactment of the
tax and expenditure control legislation last June was, admittedly, disappointing.
For a month or two after withholding taxes were raised,
consumers continued to increase their outlays at a rapid rate, drawing
on their savings and borrowing heavily to finance both higher taxes and
higher spending.
The ebullient behavior of consumers infected the
business community.
With retail sales booming, business plans for adding
to inventories and plant capacity were revised upward sharply, and in
this heady atmosphere, cost increases were rapidly passed on in the form
of higher prices. The pause in the spiral of prices last summer lasted
only briefly; by early fall, the price indexes were headed up again at
an accelerating pace.
Our foreign trade balance, too, has shown the effects of the last
4 years' spiraling rise in prices and costs in this country.
the U. S. merchandise trade surplus virtually disappeared.
In 1968,
Exports
increased fairly well, at least until the port shutdowns near the end
of the year.
But imports increased substantially, as aggregate demand
in the United States expanded excessively and as our prices rose.
In retrospect, I believe that the Federal Reserve was overly
hasty last summer in expecting an immediate impact from fiscal restraint.
As the published record of Board and Federal Open Market Committee
deliberations indicates, monetary policy moved promptly to an accommodative stance at mid-year, anticipating that an easing of demands and
of financial market pressures would ensue with little delay after the
-3-
enactment of the fiscal restraint legislation.
The easing in financial
markets that did occur in early summer enabled the banking system to
rebuild its liquidity rapidly.
Inflows to banks of time and savings
deposits, which had contracted during the spring, expanded rapidly
during the summer, permitting a resurgence in bank credit expansion to
finance both Federal and private borrowing.
Federal Reserve open market
operations provided the reserve base to support this expansion; while
deposits expanded rapidly, banks were able to reduce their borrowings
at the discount window.
The business statistics that emerged over the summer and early
fall indicated far less of an impact of fiscal restraint on aggregate
demands than had earlier been anticipated, and as the pace of inflation
quickened, monetary policy moved back toward a posture of restraint.
The intensification of this restraint has been gradual, rather than
abrupt, in keeping with our assessment of the economy's needs over the
longer term.
It takes some time for such a change in monetary policy to have
its full effect on financial markets and financial flows, and as the
policy is working through there are likely to be disparate movements
in key financial indicators.
Interest rates often tend to react most
quickly, because they reflect market participants' assessment of the
future of policy and its interactions with the economy.
The effects of policy changes on the general availability of
money and credit, however, typically take more time to work through.
The very flexibility that is a key attribute of our financial system
-4-
over the longer run allows some short run crosscurrents in financial
flows to occur. At times of policy tightening, institutional lenders
typically have some cushion of liquidity that they can utilize, at a
cost, to maintain loans.
Borrowers, too, have liquid resources at
their disposal and can take advantage of past arrangements to command
additional funds, at least for a time.
Individual and business hold-
ings of money balances are importantly influenced over the short run
by such technical factors as fluctuating transfers in and out of U. S.
Government deposits, as well as by the play of market uncertainties
and pressures on investors' decisions, and by underlying forces stemming
from changes in monetary policy.
Nonetheless, the effects of a policy of restraint becomes
more and more evident as these liquidity cushions are worked off and
the effects of temporary aberrations and transitional adjustments fade.
As was pointed out in our staff's report on financial developments
during the fourth quarter of 1968, submitted to this Committee earlier
in the month, the developing monetary restraint last autumn was first
indicated by a considerable slowing in the growth of the volume of
reserves supplied to banks through open market operations. As a consequence, banks were forced to increase their borrowings from the Federal
Reserve, and to bid more aggressively for certificates of deposit in
order to maintain expansion in their loans and investments.
Banks with
branches abroad had to pay relatively high interest rates even to retain
Euro-dollar deposits. With the passage of time, these adjustments of
bank sources of funds had to be supplemented by modifications of bank
-5-
lending and investing policies; banks generally began to withdraw from
active participation in the markets for U. S. and State and local
Government securities, while also stiffening lending terms to businesses and consumers.
By late November and early December, the developing pressures
on the banking system had pushed the effective offering rates on large
negotiable time certificates of deposit to Regulation Q ceiling limits.
Shortly thereafter, interest rates on competitive market instruments,
such as on Treasury bills and commercial and finance company paper,
moved above the 0 ceilings.
The result has been a steady reduction in outstanding largedenomination time certificates of deposit at banks, particularly at
large banks which account for the bulk of such deposits.
From the first
week in December through the first half of February, these deposits
declined by almost $4 billion, or about 15 per cent of the total outstanding.
In addition, there has been a slowdown in net inflows of
other time and savings deposits to banks during this period.
Although
banks with branches abroad built up Euro-dollar borrowings sharply in
January, aided by a heavy outflow of funds from Germany, outstanding
bank credit has, on balance, shown little growth over the past several
weeks.
Under these conditions, banks have had to turn increasingly
to liquidation of short-term securities to accommodate loan demands.
They have also had to cut back sharply their net purchases of other
securities. While the liquidity position of banks as a group is not
-6-
quite as strapped as it was in the spring of 1968, or in the fall 6f
1966, the ability and willingness of banks to help finance creditbased spending is clearly becoming more and more limited.
Outside the banking sector, evidences of the effect of
monetary restraint are also becoming somewhat more
rates on high grade corporate
widespread.
Interest
and State and local Government bonds
have edged up further from the advanced levels reached in December of
last year.
These high yield levels have been maintained even though
the prospective volume of bond offerings has not tended to build up,
and there is evidence that some potential borrowers have postponed
bond issues in view of tight current market conditions.
In mortgage markets, interest rates rose during the fourth
quarter of last year and have moved steadily higher in recent weeks.
Demands for mortgage credit have remained strong while the availability
of new funds has become increasingly constrained.
Net inflows of sav-
ings to thrift institutions tapered off in December, as market interest
rates rose further, and preliminary data suggest a further tapering in
January.
Net savings withdrawals at these institutions during the
reinvestment period of late December and early January were somewhat
larger than a year earlier, and it appears that the subsequent deposit
build-up was less than usual.
Currently, the mortgage market does not seem to be quite
as dependent on thrift institutions as in earlier years, nor do these
institutions themselves seem to be quite as sensitive to monetary
restraint as in, say, 1966.
The existing structure of ceiling rates
-7-
on deposits at bank and thrift institutions has contributed to a more
even-handed slowing of consumer deposit flows among the major savings
institutions.
Thus, monetary restraint has developed so far without
an excessive burden falling on the homebuilding industry, although new
supplies of funds for the housing market are becoming increasingly
restricted.
Even while credit markets were in the process of tightening
during the fourth quarter, expansion in the privately held money supply
accelerated, to a71/2per cent annual rate. A principal cause was the
larger than seasonal rundown in U. S. Treasury balances at commercial
banks during the fall. A little later, around year-end, deposit
balances were swollen by the combination of seasonal money market
pressures, large year-end international and domestic flows of money,
and market uncertainties about the intensity and course of monetary
restraint.
In the ensuing weeks of 1969, however, the money supply
contracted, while U. S. Government deposits were being rebuilt more
than seasonally.
In my judgment, monetary restraint is now fully reinforcing
fiscal restraint.
effective.
And fiscal restraint is becoming increasingly
In retrospect, it appears that while the Federal Reserve
was overly optimistic in anticipating immediate benefits from fiscal
restraint, the business community may have been overly hasty, last fall,
in writing it off as a complete failure. For just about the time that
business spending plans were being enlarged, consumers' spending
enthusiasm began to wane.
Retail sales reached a peak in August, but
-8-
have remained below that level since then. The consequence was a rapid
rise in business inventories in the fourth quarter; for some types of
merchandise, the build-up of stocks in distributors' hands became
excessive before year-end, and production of these goods has begun to
be curtailed.
Moreover, the impetus provided to consumer incomes and
business activity by rising Government spending also began to moderate
after mid-year.
In the second half of last year, the rate of Government
purchasing of goods and services rose by less than $2 billion, compared
with a rise of $61/2billion in the first half of the year.
Federal spending is scheduled to flatten out further during
the winter and spring months, and the full impact on consumer spending
of the higher taxes legislated last June is only now coming to be felt,
as retroactive personal income tax payments are made to cover surcharge
liabilities for the period before increased tax withholdings began.
Over the next few months, therefore, the economy's advance should be at
a more moderate pace, and that should provide a start on alleviating
some of the demand pressures underlying the advance in price levels.
Expectations of inflation are deeply embedded, however,
and speculative fervor is still strong.
A slowing in expansion that
is widely expected to be temporary is not likely to be enough to
eradicate such expectations. The experience of early 1967 is a lesson
in point. Moderation in economic activity at that time did indeed
produce a significant slowing in the rate at which prices advanced.
But the moderation was short-lived.
after mid-year, so did prices.
As economic activity accelerated
The rate of increase in the GNP
deflator, which had slowed to about 2 per cent by the spring of 1967,
almost doubled by the end of that year.
-9The critical test for stabilization policies in 1969 will
be their ability to keep such a rebound in activity and prices from
developing.
If we were to dissipate again the benefits derived from
a reduction in excessive demands, the credibility—at home and abroad—
of Government economic policies would be severely strained.
We have been fortunate this past year that the poor results
in the U. S. trade balance have not damaged the international standing
of the dollar.
In fact, we had a surplus in the overall balance of
payments, both on the so-called liquidity basis of calculation and as
measured by official reserve transactions.
of favorable flows of capital:
The surplus was the result
greatly enlarged foreign purchases of
U. S. equities at the same time as foreigners were acquiring a substantial volume of securities that U. S. companies were issuing abroad
in compliance with the compulsory direct investment controls; repayments by foreigners of U. S. bank loans, in accordance with the Federal
Reserve voluntary foreign credit restraint program; and, large flows
of foreign liquid funds out of other currencies into the Euro-dollar
market where they were borrowed by U. S. banks.
This year a slowing of the excessive expansion of domestic
demand should bring with it a slowing in the growth of U. S. imports,
and an improvement in the trade balance. On the other hand, capital
flows are not likely to be as favorable as in 1968, even with
relatively taut credit conditions here.
The problems of restoring international payments equilibrium
are truly international problems.
It has been recognized more and more
widely that better international balance requires positive actions by
-10-
countries in surplus as well as by those in deficit.
For our part,
whatever else we or any other country may be doing, one absolute
essential is to check the inflation in this country and to make a start
in restoring a healthy and lasting surplus in our trade with the rest
of the world.
Much of the burden of accomplishing the containment of
domestic demand pressures this year will rest on monetary policy, for
even with continuation of the 10 per cent surcharge into fiscal year
1970, fiscal policy is scheduled to become less restrictive after midyear.
Completion of the retroactive tax payments on 1968 liabilities,
the increase in pay scheduled for Federal workers, and the rise
indicated in the January Budget for other Federal expenditure programs
will reduce the Budget surplus substantially in the second half of the
year, and at the same time increase the flow of incomes available for
spending.
A sharp upturn in consumer spending would be likely to
rekindle business incentives to acquire additional inventories and to
add further to plant capacity. With pressures for additional housing
still strong, and the spending requirements of State and local Governments continuing to mount, the stage would be set for a strong
resurgence in overall demand.
Whether such a surge in demand will in fact occur cannot be
predicted with any assurance, but it would be foolhardy to increase the
risk by adding the fuel of easy credit.
In the hope that it will be
useful to your Committee, I am attaching to my statement a projection,
prepared by the Board's staff, of the monetary and credit conditions
-11-
that would be consistent with progress toward achieving the objective
of reducing inflationary pressures.
The progress envisioned would
necessarily be gradual, for an effort to "disinflate" abruptly, after
so extended a period of cumulating inflationary pressures, would risk
wrenching the economy sharply, with major dislocations in employment
and in the structure of production.
does not, of course, permitprecision—
or
The state of the economic art
too muchconfidence—
in
such
projection exercises, but they are useful in describing the general
financial environment that would be appropriate in light of prospective
private and public resource demands.
As I noted in my opening remarks, I am optimistic about the
prospects for gradual success of the stabilization policies now in
force, if we have the fortitude and patience to give them time to work.
It is essential for us to do so; at stake is not only the opportunity
of restoring a stronger base for equilibrium in our international
payments situation, but also of restoring a sound base
domestic growth.
Attachment.
for continued
STAFF PROJECTION OF ECONOMIC AND
FINANCIAL DEVELOPMENTS IN 1969
February 25, 1969
Division of Research and Statistics
Division of International Finance
* * * * * * * * * * * * * * * * *
Board of Governors of the Federal Reserve System
Economic Background
A moderation in the pace of economic expansion began to
be evident late in 1968, and has continued into 1969, largely as
a result of the fiscal restraint measures adopted in the middle of
last year.
In real terms, economic growth diminished to less than
a 4 per cent annual rate in the fourth quarter, compared with 5 per
cent in the third and 6 per cent or more in the first half.
In
current dollars the diminution in the growth rate of Gross National
Product was not as large, however, as average prices rose somewhat
faster late in the year.
The slower pace of economic expansion late in 1968 was accom
panied by a change in the structure of GNP growth.
The rise in final
sales (GNP expenditures other than for inventories) dropped from an
annual rate of 10 per cent in the third quarter to just over 6 per
cent in the fourth, and inventory investment contributed substantially
more to the GNP increase in the 4th quarter than in the third.
In retrospect,
it appears
that failure of the economy to
respond more promptly to the enactment of the Revenue and Expenditure
Control Act reflected a temporary willingness of consumers to
maintain unusually high rates of spending in the face of markedly
reduced growth of disposable income during the summer.
As a consequence,
while the effects of cutbacks in some categories of Federal expenditures
- 2 -
began to be felt shortly after midyear, the effect of the tax increase
was blunted by one of the sharpest quarterly increases of recent
years in consumer spending relative to disposable income.
Total
consumer purchases in the third quarter rose at a 10 per cent annual
rate, and this spurt appears to have been a significant factor in the
subsequent upward revision of planned expenditures by business for
plant capacity and inventories.
It is now clear that the rate of growth in consumer spending
in the fourth quarter dropped abruptly to just over a 4 per cent annual
rate.
Retail sales, in fact, began to drift downward after reaching
a peak in August of last year.
January sales picked up from the
sluggish December pace, but not quite enough to regain the November
level.
Among the major elements of consumer spending, unit auto
purchases have shown the most significant weakness, with the annual
sales rate for domestically produced cars, including Canadian imports,
dropping from a high of 9 million units in October to about 8-1/4
million in January.
Moreover, sales of nondurable goods have also
eased somewhat since last August.
Business investment in inventories, however, advanced
considerably in the fourth quarter, to a $10-1/2 billion annual rate,
partly reflecting this distinct slowdown in the growth of consumer
purchases.
There is no clear evidence that businesses, in the
aggregate, regard themselves as heavily burdened with excessive
stocks.
But it does appear that some downward adjustments have
- 3 -
occurred in production schedules for autos and other consumer lines
in response to recent inventory-sales developments.
An economic projection for 1969 must take into account,
therefore, the increasing evidence that fiscal restraint is working,
though with a somewhat longer lag than the Board staff and most
economists elsewhere had assumed.
Moreover, the pressure of fiscal
restraint will be intensified in the period just ahead.
Federal
purchases of goods and services are projected in the January Budget
document to show no further advance in the first half of this
calendar year, and the total of all Federal expenditures included
in the national income accounts should register only very modest
increases during this period.
Federal receipts, meanwhile, will be
increased sharply further by the rise in social security taxes in
the first quarter and by retroactive payments on 1968 income tax
liabilities in both the first and second quarters.
The Federal
budget on a national income accounts basis will thus be moving
to a significant surplus in the months immediately ahead.
With Federal purchases leveling out and the growth of
disposable income and consumer spending tempered by increased tax
payments, a further slowing in the overall pace of economic expansion
seems highly probable in the first half of 1969.
The rate of business
inventory accumulation may well taper off in the months ahead.
Some
recovery in consumer spending from the sluggish pace of the fourth
- 4 quarter is to be expected, and the momentum of rising housing starts
and increasing business expenditures for plant and equipment during
the last half of 1968 is likely to carry forward into the opening
months of this year.
But our assessment of the economic climate
on which our staff projection for 1969 is based starts with the
premise that the fiscal restraints adopted last summer are working
and, together with the intensification of monetary restraint since
last fall, will slow the pace of expansion further in the first half
of this year.
A second major element of the economic environment to be
taken into account in developing a projection for 1969 is the
climate of inflationary expectations that has developed over the
past 3-1/2 years.
This long period of predominantly overheated
conditions has quite clearly begun to affect private spending decisions.
Since about the middle of last year, for example, plans for business
fixed investment have strengthened measurably, despite relatively
low rates of capacity utilization in manufacturing, as businesses
have sought to find ways to hold down the pressure of rising costs
on prices and profits.
Housing starts, especially multi-family
units, have also shown exceptional buoyancy.
Interest rates as
high as 7 per cent and over have not been enough to cause deferral
of investment intentions in the climate of strongly inflationary
expectations that has prevailed.
5
Excess demand in the domestic economy during this period
has also spilled over into world markets.
U.S. imports have risen
very rapidly, and our trade surplus last year almost disappeared.
Thus, balance of payments considerations reinforce the need to
persevere with policies to combat domestic inflation.
As noted earlier, the expectation of a slowdown in the
domestic economy during the current half year is predicated mainly
on the belief that fiscal measures already adopted will become
increasingly effective in restraining spending.
After midyear,
Federal expenditures~-assuming they follow the path laid out in the
January Budget— will be rising more briskly, and the completion of
retroactive tax payments by individuals will give rise to more rapid
growth in disposable income.
Fiscal policy will become less restrictive
in the second half of 1969, therefore, even if the tax surcharge is
extended.
The strength in markets for goods and services that could
result, in an atmosphere of protracted inflation, could touch off
a new spurt of business and consumer spending, with its inevitable
effects on prices and costs.
Should the surcharge be allowed to
lapse, inflationary pressures could break out even more strongly in
the latter half of this year.
- 6 -
Policy Assumptions
It would seem apparent that the principal task of
stabilization policies this year will be to ensure that significant
progress is made in curbing the rate of inflation in the domestic
economy, and that the initial steps are taken towards restoration
of our traditional trade surplus.
It will be especially important,
if these results are to be accomplished, to adopt policies that prevent
resumption of an excessively rapid pace of spending in the second half
of the year, following the slower pace of advance expected in the
first six months.
In our projection, therefore, we assume the surcharge will
be extended, as recommended in the January Budget document, since
without that extension the prospects of cooling off the economy appear
dim indeed.
We are also assuming that the projected pattern of
Federal expenditures outlined in the January Budget will be realizedj
Of course, unforeseen developments in Vietnam or elsewhere could
alter the outlook for defense spending radically, and stabilization
policies will have to stand ready to alter course with any marked
change in those outlays.
The projections also assume a monetary policy of substantial—
but not severe— restraint, dictated by the need for a steady pressure
of stabilization policies to contain the strong inflationary pressures
in the economy.
The shift toward greater monetary restraint initiated
-
7 -
last fall has already begun to have noticeable effects in financial
markets.
Growth rates of money and bank credit have declined from
the rapid pace of the second half of 1968, while interest rates have
risen well above their average 4th quarter levels.
As the year
progresses, credit restraint should become increasingly effective
in moderating the pace of private spending.
The staff projection assumes that the growth rate of bank
credit will be reduced from the
11 per centrate of 1968 to a rate
in the range of 4 to 7 per cent
in 1969.The decline
in credit
expansion rates would reflect reduced growth in bank deposits, partic
ularly a turnaround in large-denomination negotiable CD's, from a
rapid expansion during 1968 to significant reduction in 1969.
A
decline in the growth rate of the narrowly-defined money stock
(currency plus demand deposits) should also occur, in the financial
market conditions arising from bank credit expansion at such a rate
and the projected slower growth
in GNP.
the growth, rate of the money stock
We project a reduction in
from the 6-1/2 per cent rate of
1968 to a rate in the range of 3 to 6 per cent during 1969.
The
stance of policy assumed implies a somewhat higher growth rate of bank
credit (on an end-of-month basis) than that which occurred in January
and currently seems in prospect for February.
- 8 GNP Projection
Based on these fiscal and monetary policy assumptions, as
Table 1 indicates, current dollar GNP for the year as a whole is
projected to be in a range of $918 billion to $920 billion, which
would mean an increase from 1968 of about $60 billion, or a little
less, compared with a gain of $71 billion from 1967 to 1968.
Following the moderation that began in the latter half
of last year, the reduced growth rate foreseen in this projection
should be increasingly apparent in the first half of 1969.
The most
important factors in the anticipated cooling off during the first
half are an expected leveling out and then a decline in inventory
accumulation, and a marked shift of the Federal Budget into substan
tial surplus.
Final sales during the first half of the year should
continue to expand at about the reduced $14 billion rate of the
fourth quarter of I960, reflecting some increase in the growth
of consumer spending from the exceptionally low fourth-quarter rate,
continued though diminishing strength in business investment, and a
topping out of housing starts in the first quarter.
Real growth in the
economy during the first six months is expected to drop a little more
sharply than dollar expenditures, given the prospects for continued
sizable price increases, and might average near a 2 per cent annual
growth rate if our current dollar GNP projection is realized.
For the last half of the year, the course of GNP depends
importantly on the assumption of continuing and increasingly
effective monetary restraint.
Although fiscal policy is scheduled
- 9 in the Budget to become more stimulative around mid-year— even with
continuation of the surcharge--we believe that quarterly GNP
increases in current dollars during the second half might be held
down to an average only a little higher than projected for the
first half, given sufficient monetary restraint and continuation of
the surcharge.
Real growth in GNP also would be a little larger in
the second half, as inflationary pressures diminish.
Federal Budget Outlook
The surplus in the Federal Budget, as measured in the national
income accounts, should reach an annual rate of around $6 billion during
the first half of 1969.
But as expenditures increase and receipts
level out after mid-year, this surplus may well disappear.
Thus, the
surplus for the calendar year as a whole is projected at around $2
billion to $3 billion.
A significant part of the projected growth of Federal
expenditures is due to the rise in military and civilian pay on
July 1, with the net
increase estimated at $2.8 billion (annual rate).
The January Budget calls for defense outlays, excluding the pay raise,
to continue on a plateau, with reductions in Vietnam spending offset
by increases on other military programs.
Nondefense expenditures are
scheduled in the Budget to rise somewhat in the last half of the year.
In contrast to the somewhat faster rise in Federal expendi
tures after mid-year, receipts are likely to rise sharply in the
first half and then stay on a plateau during the last half, even though
10
the surcharge is maintained.
This reflects the completion of
retroactive tax payments, together with the effect on tax receipts
of the projected slowdown in the growth of personal income and
some weakness in corporate profits.
Disposable Income and Consumer Spending
The impact of the surtax on disposable income was appreciable
in the last half of 1968, and gains in after-tax income should continue
to be limited in the first half of this year as a result of the retro
active portion of the higher tax payments and the anticipated slowing .
in economic expansion.
Therefore, we expect that growth in consumer
expenditures will continue relatively moderate, despite the prospect
of some acceleration from the small rise of $6 billion in the fourth
quarter of 1963.
Such an acceleration would require a decline in
the rate of personal savings during the first half.
That pattern
does not seem unreasonable, assuming that the fourth quarter rise
in the saving rate was due in part to special factors— such as the
flu epidemic— and given the fact that the saving rate typically
falls when a temporary slowdown occurs in the growth of disposable
income.
In the second half of 1969, faster expansion in disposable
income could again provide the potential for a renewed strong consumer
buying.
At that time, too, the effects in consumer markets of an
abrupt change in income growth should be cushioned to a degree by a
change in the saving rate.
To hold expansion within bounds, however,
we are depending importantly.on continuation of the tax surcharge and
the success of restrictive monetary policy in altering business
- 11
expectations and spending decisions.
If this restraint can be
accomplished, slower growth of nonconsumption demands should act
to offset the latent strength in consumer markets and to dampen
aggregate demands.
Housing
Higher mortgage interest rates, a slackening in the flow of
loanable funds through banks and other depositary institutions, and
an anticipated curtailment in the volume of new mortgage commitments
should limit housing starts this year.
The drop in starts in December
was followed by a large rise in January, as this series continues to
display large erratic movements.
As the year progresses, however, we
expect the policies of monetary restraint in train since late last
year to begin registering their effects on housing starts and
residential construction expenditures.
By the second half, the
annual rate of housing starts may drop somewhat from recent high
levels, but the monetary policy assumptions underlying the projection
suggest a much more moderate decline than in 1966, when the financial
crunch reduced housing starts by a third.
For the year as a whole,
therefore, housing starts are projected to average around 1.5 million
units, and the dollar volume of residential construction is expected
to register a small rise from the 1968 level.
Business Investment
The current surge of investment in plant and equipment in
the face of a relatively low rate of capacity utilization would appear
to reflect considerable business optimism about the course of the
12
economy in the neat term.
Expectations of future growth in sales,
a concern about rapidly rising prices and the heed to offset some
of the increasing pressures from labor costs are likely to produce
a continued uptrend in investment outlays.
Considerable business opti
mism also is reflected in recent surveys of business plans to spend
for new plant and equipment.
Quarterly increases in business fixed
investment are therefore expected to average somewhere around $2
billion during the first half— and would be larger but for an
anticipated sharp decline in commercial construction and in invest
ment by aircraft manufacturers.
However, once manufacturing
production begins to level off, declining capacity utilization rates
and lower profit margins— together with credit restraint— should tend
to dampen optimism.
Although plant and equipment expenditures are
projected to rise by roughly 10 per cent for the year as a whole,
we anticipate a marked slowing in these expenditures as the year
progresses, with little further dollar growth— and perhaps some decline
in real terms— after midyear.
The staff's projection also takes an optimistic view about
the prospects for cooling off investment in inventories, given our
assumption that final demands will be held in check.
Some dampening
influence should result from the imbalances which already have
developed between output and consumption.
Exactly when the accumula
tion of stocks will begin to outrun businessmen's confidence in the
prospects for higher sales and prices is problematical.
By early
- 13
spring, however, we think that downward production adjustments to
temper the inventory buildup should become more general, so that,
on average, the rate of inventory investment would decline in the
first half.
If growth in final demands is kept to a moderate pace
in the second half, the rate of inventory accumulation may decline
somewhat further, especially in view of the greater cost and difficulty
of holding large stocks when funds are tight.
Resource Utilization
If growth of real output moderates in line with the projection
to a range of 2 to 3 per cent in 1969, pressures on both physical and
manpower resources should gradually abate.
As Table 2 shows, the
rate of capacity utilization in manufacturing is expected to fall
from 84.5 per cent in 1968 to a range around 82 per cent in 1969,
reflecting both the slowing of growth in industrial production and
continuing large additions to manufacturing capacity.
At the same
time, employment gains are likely to fall short of prospective net
additions to the labor force.
The adjustment is expected to occur
mainly in manufacturing, where cutbacks in the length of the work
week may be followed by effects on employment once it becomes clear
that prospects for further growth in product demand are less ebullient.
The uptrend in employment in nonindustrial sectors will undoubtedly
continue, but probably at a slower pace than in the last several years.
As a result, the unemployment rate is projected to rise somewhat from
- 14 the exceptionally low rate of 3.3 per cent in recent months, but
the average is projected to stay under 4 per cent for the year as
a whole.
Upward pressures on wage levels should abate somewhat
in 1969 if the GNP projection is realized.
Key factors here include
a sharp reduction in the number of workers covered under collective
bargaining agreements up for renegotiation this year, the smaller
second- and third-year wage increases under earlier settlements, and
the smaller and less pervasive increase in the minimum wage scheduled
for this year.
However, the effect on costs is likely to be offset
in large part by a slowing in productivity gains as the rise in output
moderates.
As a consequence, the increase in unit labor costs could
continue at close to the recent 4 per cent rate during the first
half of 1969, and then edge down somewhat in the latter months of
the year.
Prices
With labor and other costs continuing to climb and business
demands very strong, industrial prices recently have been moving up
at a very fast pace.
But if the slowing in growth in the economy
indicated in our projections is achieved, the rise in industrial
prices should moderate, especially in the latter part of the year
after upward wage pressures ease and business expectations and
spending plans have lost their steam.
The sharp consumer price gains
witnessed during most of last year also seen likely to moderate in
196S.
Prospects are for some slowing in* consumer products prices
- 15 -
in response to smaller increases in industrial
prices, although
service prices seem certain to continue climbing at a fast pace—
perhaps around a 6 per cent annual rate— for some time to come.
On balance, if we can continue to make headway in avoiding
excessive rates of expansion in GNP, the rise in average prices
should diminish as the year progresses.
The projection implies a
steady downward drift in the GNP implicit price deflator, adjusted
for the third quarter Federal pay raise, towards something around
a 3 per cent annual rate of increase in the closing months of 1969.
Financial Projection
The GNP projection just described, together with the
assumptions about fiscal and monetary policies on which it rests,
imply a significant reduction in the rate of total credit expansion
this year, with the total volume of funds raised declining from about
$100 billion in I960 to a range of $75 to $C0 billion in 1969, as
Table 3 indicates.
We are in the process of experiencing a substantial
swing in Federal borrowing requirements, from an annual borrowing rate
of over $15 billion in the last half of ’63 to debt repayment at around
a $2 billion annual rate this half year.
Federal borrowing— measured to
include the borrowing of Federal agencies as well as the Treasuryshould pick up again in the second half, however, to register an annual
total in the $2 billion to $3 billion range, substantially less than
in 196G.
16 -
Private Borrowing
Borrowing by the private domestic nonfinancial sectors
(business, consumers, and State and local governments) is also
expected to recede a little in 1969.
This is a reflection partly
of the assumed effects of monetary restraint in reducing the
degree to which expenditures are financed by credit, but the
projected slower pace of economic activity resulting from both
monetary and fiscal restraints will also help to reduce private
credit expansion.
The projected effects of monetary restraint on private
credit expansion are perhaps best illustrated by considering the
volume of borrowing by consumers and businesses, and the relation
of borrowing to projected net investment in these two sectors
(shown at the bottom of Table 3).
Total borrowing by these two
sectors together is projected to decline in 1969, despite continued
high demands for credit.
For example, even though the rate of
inventory investment is projected to drop, business needs for external
financing will be sustained in the first half by large tax payments
and further growth in plant outlays, at a time when profits are
projected to be squeezed.
But the very essence of monetary restraint is to prevent
some credit demands from being satisfied.
Given the degree of restraint
assumed, businesses and consumers should have to dig further into their
liquid assets to realize spending plans, and--more importantly--to trim
17
these plans in areas heavily dependent on credit availability.
The ratio of borrowing to net investment is projected to fall below
90 per cent, compared with 95 per cent for 196C.
Bank Credit Expansion
This decline in private credit expansion, like the
maintenance of a more moderate pace of GNP growth during the latter
half of 1969, is predicated on the assumption that monetary restraint
is maintained during most of 1969.
Based on our judgments of the
relations between financial variables and rates of GNP expenditure,
we believe the GNP projection— and its financial counterpart in
terms of total funds raised— could be realized if bank credit growth
were limited to an annual rate in the 4 to 7 per cent range.
At
this projected growth rate, the banking system would be supplying
from about one-fifth to about one-third of total funds raised during
1969, compared with two-fifths or more during each of the past two
years.
Time and Savings Deposits
In the banking system, the effect of restraint on the growth of
deposits seems to us likely to show up mainly in time and savings
accounts, rather than in demand balances and the money stock, as Table
4 indicates.
Much of the expected reduction in growth rates of time
deposits relates to the projected outlook for large-denomination
negotiable CD's.
The rise in rates of interest on competing short
term money market instruments late last year, together with the existing
Regulation Q ceiling rates that banks may offer to attract time deposits,
- 18 -
have made it very difficult for banks to roll over maturing CD's since
early December 1968,
Consequently, the total volume of large CD's
issued began to decline after mid-December, and fell $2.3 billion
in the first six weeks of the year.
Our projection assumes that monetary conditions will remain
taut enough to keep large banks under pressure in the CD market.
It
also assumes, however, that attrition of CD's will diminish from the
very high rates of January and February; rates of decline that large
would not be consistent with growth rates of bank credit in the 4 to
7 per cent range projected for the year as a whole.
The projection also implies some reduction in growth rates
of time and savings deposits held by households.
Given prospective
interest rate relationships, we are projecting that households will
divert a larger share of their savings flows into market securities.
The annual growth rate of household time and savings deposits at
commercial banks is projected to decline to a range of about 8 to 10
per cent--les8 than the rate in the latter half of 1968.
Nonbank Savings Accounts
This divergence of household savings flows from depositary
claims to market securities is likely to affect nonbanlc intermediaries
also.
Inflows to these institutions were curbed in December and
January, and we project them to stay at a reduced pace of about 5 per
cent, only a little above the amounts that would result from interest
crediting.
The reduction in flows projected, however, is much less
severe than in 1966.
19
Money Stock
We do expect that, in addition to affecting time and savings
deposits at banks and nonbank intermediaries, the tighter monetary
conditions assumed in this projection will produce some slowing in
the rate of expansion of the narrowly defined money stock (currency
and demand deposits).
Interest rates are high enough now to induce
some further economization of cash; additionally, the moderation of
GNP growth is projected to hold down the rise in transactions demand
for money.
The overall monetary policy projected seems consistent
with an annual rate of expansion in the money stock in the 3 to 6 per
cent range.
Effects on Credit Markets
At the reduced growth rates of deposits projected, both
banks and nonbank intermediaries will find themselves under pressure
to reduce the availability of credit to private borrowers.
This restraint on funds flowing through the major depositary
institutions is the principal factor underlying the projected decline
in the rate of private credit expansion relative to spending mentioned
earlier, and the trimming of expenditures on goods and services that
is essential to moderate the rate of expansion in GNP during the
second half.
While some of the impact of reduced credit availability
will inevitably be felt by the mortgage market, and consequently
by the residential building sector, other markets for loanable funds
would also likely be affected by the restrictive credit policy assumed
-
here.
20
-
With limited supplies of funds available because of the
reduced rate of growth in their time and savings deposits, banks
would presumably cut back on new investment in municipal securities;
last year they took roughly 80 per cent of the net increase in such
debt.
The projected diversion of household savings flows into
market securities will help to fill the gap left by the banking
system*s reduced purchases, but we also are projecting some moderation
in the total of new issues during 1969, in response to the reduced
availability of funds.
More importantly, the posture of monetary
policy assumed in this projection implies that banks will have
to intensify significantly further their rationing of credit to
businesses and other customers as the year proceeds.
This is
expected to impel businesses to turn increasingly to market financing,
and we are projecting a rise in corporate security issues to about
one-fifth to one-fourth above the 1968 level.
Such an increase in
the supply of new issues would presumably raise the cost of capital
financing to large businesses which, together with the intensified
rationing by banks, would help to moderate the course of business
spending for fixed investment and inventories.
Balance of Payments
The gradual cooling off of demand pressures projected for
the domestic economy should have helpful implications for the
external balance of payments, since it would be accompanied by changes
in the structure of receipts and payments in the right direction for
- 21
getting nearer to a sustainable equilibrium.
Last year some of the
capital inflows that contributed to our overall
surplus were clearly at unsustainable rates.
balance-of-payments
While net capital
inflows in the year ahead will probably not be as large as last year*s,
the slowdown in the pace of domestic expansion should bring some
improvement in the goods and services account.
Statistical indexes of export unit values for the United
States, Germany, and Japan clearly illustrate the need for a persistent
effort to check the deterioration that has been going on since 1965
in our costs and prices compared with those of some of our dynamic
rivals in world trade.
But positive benefits for the balance of trade
from improvement in price relationships cannot be quickly achieved.
The significance for the 1969 balance of payments of the assumption
of a gradual slowing of price inflation lies mainly in the assurance
it provides against a further worsening of the trade balance and
against any general weakening of confidence in the dollar as a key
currency and reserve currency.
Improvement in the trade balance in 1969 would result from
continuing export expansion and a slowing of the rise in U.S. demand
for imports.
On the export side, it seems likely that continental
European economic activity will continue to rise strongly this year,
so that growth of world demand may bring an advance in the value of
U.S. merchandise exports by 9 or 10 per cent ($3 billion annual rate
in round terms).
Over the past several years U.S. nonagricultural ex
ports have risen about in line with total world exports of manufacturers,
- 22 -
and our percentage share has not changed significantly.
This
performance is creditable so far as it goes, though in the light
of apparent U.S, propensities to import goods and invest abroad
it seems to be inadequate.
While the strongly rising trend in U.S. imports— a major
element in the world payments disequilibrium— cannot be quickly
modified by cost and price developments, last year's import swing
above trend should be followed by a dip below trend this year, as
happened in the first three quarters of 1967 when growth of domestic
demand slowed that year.
The rise in merchandise imports in 1969
will probably be somewhat more than $1 billion.
Taking exports and
imports together, the merchandise trade surplus for the year 1969
might approach $2 billion, compared with about $100 million last
year.
When we add in flows of services, investment income, and
military expenditures abroad, net exports of goods and services may
be around $4 billion this year, about double last year's net exports.
While growth in payments for transportation may be below normal in
a year of slow import expansion, and while a renewed acceleration in
receipts from foreign travel in the United States may occur, these
and other services will not contribute much on balance to the
improvement.
Interest payments to foreigners will be larger, offsetting
much of the gain in investment income receipts.
As for military ex
penditures abroad, they are projected as leveling off now, and then
dipping slightly later this year, but on the other side of the account
military export sales also are passing their peak.
- 23
Outflows of U.S. private capital last year were apparently
near $5 billion, including the investment abroad of funds obtained
through long-term borrowings abroad by U.S.-based companies.
The net
outflow of U.S. funds after deducting such borrowings was perhaps not
much over $2 billion in 1960.
This net outflow is projected to be
greater in 1969, despite the assumed continuance of credit restraint
in the United States and the probability that financial conditions
abroad will not restrict seriously the ability of U.S. businesses to
sell securities abroad or to obtain credit from banks in Europe.
The
main reason for expecting a larger net outflow is that last year's
heavy borrowings abroad by U.S. companies built up a large target
leeway under the direct investment controls, and it is assumed that
some of this leeway will now be used.
Furthermore, there will
probably not be the net reflow of bank credit we saw in 1968.
We assume, however, that the domestic credit restraint
that is needed to bring inflation under control will help to prevent
a resumption of the trends shown in earlier years toward much greater
outflows of U.S. private capital.
For example, corporations will
still be encouraged to do some borrowing abroad.
For foreign private capital, exclusive of the flow of liquid
funds to the United States through commercial banks abroad, the in
flow last year apparently amounted to about $6 billion if bond issues
sold in Europe and bank loans obtained in Europe by U.S. companies
for direct investment financing are included, and about $3-1/2 billion
if these are netted out against U.S. capital outflows.
In 1969 the
- 24 corresponding net inflow coaid be smaller, but any projection would
be subject to much uncertainty.
While inflows are influenced by
relative financial market conditions, they also depend very heavily
on factors other than interest rates.
First, over $2 billion of
last year's inflow was to acquire U.S. stocks and to make direct in
vestments here.
A large inflow into U.S, equities is expected again
in 1969, but its magnitude is uncertain.
Second, something like
$1 billion of last year's private capital inflow was apparently in
such miscellaneous accounts as commercial credit, advance payments
for aircraft, and foreign working balances in the United States.
After taking account of transactions in goods and services,
Government loans and grants, other unilateral transfers, and all
private capital flows other than flows of liquid funds to the United
States through commercial banks abroad, there was a negative balance
last year of somewhat under $2 billion.
That was more than covered
by about $3-1/2 billion of liquid funds from U.S. bank branches and
other commercial banks abroad, so that on the official settlements
basis the balance of payments showed a surplus of $1.7 billion.
It is difficult to foresee at present whether the adverse
balance in the accounts mentioned above will be larger or smaller
than $2 billion in 1969.
The projected improvement on current account
would make it smaller, while the probable shifts in flows of private
capital (apart from liquid funds through banks) would make it larger.
- 25 -
But in any event the inflow of funds through U.S. bank branches
and foreign banks is not likely to be as large as last year's
$3-1/2 billion, in view of the very high interest rates U. S. banks
are now having to pay to attract fresh funds into the Euro-dollar
market out of assets in other currencies.
Thus a surplus on the
official settlements basis is rather unlikely in 1969.
It is
quite possible, however, that the over-all deficit to be settled
by using U.S. reserve assets or by increasing U.S. liabilities to
foreign monetary authorities may be small.
Given the assumptions we are making about the U.S. economy
and conditions abroad, the U.S. balance of payments in 1969 is not
likely to give rise to acute difficulties.
As noted earlier, the
prospective improvement in the goods and services account is a
change in the right direction.
But we have a long way to go, since
this year our net exports get the benefit of a favorable cyclical
conjuncture here and abroad; because capital controls, hoped to be
temporary, are still in force; and because interest rate relation
ships are more favorable now for the U.S. balance of payments than
they may become later.
Policy Problems in 1969
From a purely technical viewpoint, the monetary policy
assumed in this projection could be difficult to achieve.
The
projection of bank deposit and credit growth depends importantly
on the maintenance of the appropriate degree of restraint exerted
- 26 on the larger banks in the banking system, a restraint consistent
with a continued gradual decline in outstanding CD's as 1969
progresses, but at a rate more moderate than the steep descent of
January and early February,
This will not be easy to accomplish.
The response of banks and potential holders of CD's to fluctuations
in the spread between market rates and CD ceilings is neither smooth
nor easily predictable; at times a shade of difference can trigger
large inflows to or outflows from banks.
It may be necessary to
vary the intensity of restraint on bank reserve positions from time
to time in order to keep the degree of tautness needed, if this
projection is to be realized.
Given the high degree of sensitivity that exists among
banks and depositors to changing differential rates of return on
market securities and bank deposits, there may well be periods of
time in which actual rates of growth of bank credit, time deposits,
and the money stock are outside their projected ranges.
Nonetheless,
if the general direction of policy is maintained along the course
outlined, its effect should be increasingly observed in all credit
markets.
The more important substantive issue to which we must be
alert in 1969 is the possibility that the course of credit restraint
projected here, even if realized, may not produce the GNP expenditure
patterns that we presently are projecting.
The relationships
between financial variables.and GNP expenditures are not fixed; our
- 27
economic and financial history indicates very clearly that there are
wide variations in relative rates of growth of GNP and money or bank
credit, and in the relationship of GNP expenditures to interest rates.
Our judgmental projections could well have overestimated the
potency of monetary factors in slowing down the rate of expansion
in GNP— especially at the present time, when inflationary expectations
are strong.
On the other hand, the course of monetary policy assumed
here could entail greater effects on GNP growth than envisaged in the
staff projection.
Monetary policy must remain flexible, and policy
makers alert to the actual course of developments as the year progresses.
Finally, it seems appropriate to note that the staff GNP
projection, if realized, would result in economic conditions that
are still a long way from being fully satisfactory.
For example,
it seems quite clear that we cannot,and should not, hope to restore
fully our traditional trade surplus in one year.
The costs both at
home and abroad of such an abrupt change in our international trade
position would be too great.
Also, price inflation seems likely to
plague us for quite some time, even if the real economic growth rate
is reduced during 1969 in line with the projection, and some slack
begins to develop in markets for resources.
Yet, the declining rates
of resource utilization projected for 1969 are evidence that even this
modest step in the movement toward
not be without its> costs.
a noninflationary economy will
The momentum of inflationary pressures is
so great that efforts to accomplish a more rapid return to reasonable
- 28 -
price stability could result in a much heavier toll in real output
and employment.
The gradual cooling off of demand pressures embodied
in the projection, however, is an essential first step in the longerterm task of halting inflation and assuring a sustainable rate of
economic expansion.
Table 1
1969 PROJECTION OF GNP AND RELATED ITEMS
(Billions of Dollars)*
Annual Totals
Projected
I960
1969
GNP, Current $
Annual Changes
Projected
1968
1969
860.6
918-920
70.9
58-60
Personal Cons. Exp.
533.8
567-569
41.6
33-35
Gross Private Domestic
Investment
127.7
135-137
13.4
7-9
R.es. Construction
29.9
30-32
5.3
1-2
Business Fixed Inv.
90.0
98-100
6.4
8-1C
1.6
(")3 to(-)l
7.7
5-7
2.0
3.5-4.5
(-)2.8
197.2
210-212
18.8
13-15
100.0
103
9.4
3
State & Local
97.2
1C7-109
9.4
10-12
Personal Income
685.8
735-737
57.0
49-51
589.0
622-624
42.7
33-35
92.3
89-92
1G.7
(-)3 to 0
Total Federal Exp., NIA
Basis
182.2
192
18.6
10
Total Federal Receipts,
NIA Basis
176.9
194-195
25.7
Surplus (+) or
Deficit (-)
(-)5.3
2-3
Inventories
Net Exports
Gov't Purchases
Federal
Disposable Pers. Inc.
Corporate Profits Before
Tax
*
*
*
Based on an estimate for the fourth quarter of I960,
1-2
7.1
17-18
7-8
Table 2
REAL GROWTH, RESOURCE USE, AND PRICES
1968
Percentage Growth of
GNP in Constant
(1958)Dollars
5.0
GNP Implicit Price
Deflator, Annual
Percentage Change
3/8
Total Labor Force
Armed Forces
Civilian Labor Force
Unemployment Rate
Capacity Utilization in
Manufacturing
*
82.3
3.5
78.7
3.6
84.5
Projected 1969
2 - 3
3:1 -
3.5*
83.5 - 84.0
3.5
80 - 80.5
3.8 -
4.0
81.5 - 82.5
Excluding effects of the Federal pay raise in the third quarter.
Tab l e 3
FUNDS RAISED IN CREDIT MARKETS
(Billions of dollars)
Total, All Nonfinancial
Borrowers
97.5
75 to 80
Federal Government*
16.9
3
ft
o
1968
Projected
1969
3.0
2 to 3
77.7
70 to 75
29.7
24 to 27
Consumer Credit
11.0
6 to 8
Bank Loans
12.7
9 to 12
Foreign Borrowers
Private Domestic Nonfinancial sectors
Loans
Other Loans
6.0
7 to 9
22.7
23 to 26
State & Local
10.0
8 to 10
Corporate
12.7
15 to 17
Securities
to
CM
25.3
CM
CM
Mortgages
Consumer & Business Borrowing
Included in Private Domestic
Nonfinancial Sectors
Total
67.4
62 to 65
Per cent of Net Investment
96.0(7.)
86 to 90(7.)
* Includes agency issues and participation certificates. Home
Loan Banks, Land banks, and FNMA are consolidated with other govern
ment agencies in this table, which departs in this respect from new
budget concepts. Table includes net issues by these agencies but
excludes interagency transactions.
Table 4
BANKING AND MONETARY VARIABLES
ANNUAL PERCENTAGE RATES OF CHANGE
1968
Projected
1969
Total Reserves*
7.2
3 - 5
Money Supply
6.5
3 - 6
Currency
7.4
5 - 6
Demand Deposits
6.2
3 - 6
Time Deposits at
Commercial Banks
11.3
1 - 5
Total Bank Credit
11.0
4 - 7
6.4
4.5 - 5.5
Nonbank Savings Accounts
*
Adjusted for reserve requirement changes.
NOTE:
Data for reserves, money supply and time deposits at commercial banks
are on a daily average basis. Bank credit and nonbank savings
accounts are on an end-of-month basis.
@FedFRASER