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SHADOW OPEN MARKET COMMITTEE
Policy Statement and Position Papers

September 12,1975

1.

Policy Recommendation of the Shadow Open Market Committee Meeting, September 12,1975

2.

Position Papers




Monetary Policy, Economic Policy and Inflation - Karl Brunner, Universtiy of Rochester and
Universitat Bern
Implications of Possible Monetary Groth Targets - A. James Meigs, Claremont Men's College
Implications of Possible Monetary Groth Targets, Revised 9/10/75 - A . James Meigs,
Claremont Men's College
Comments on the Rate of Inflation and the Real rate of Interest from 1961 to 1975 -Allan H.
Meltzer
Fed Foreign Exchange Intervention: Some Questions-Wilson E. Schmidt, Virginia
Polytechnic Institute and State University
Comments on Future Fiscal Actions and Budget Developments- Robert H. Rasche, Michigan
State University
The Uselessness of Full Employment Budget Concepts as Indicators of Recent
Changes in Fiscal Policy and as Forecasts of Future Federal Expenditure Capacity
- Robert H. Rasche, Michigan State University

Policy Recommendations of the Shadow Open Market Committee Meeting
September 12, 1975
The economy is now poised for recovery.

At its meeting today, the

Committee considered issues affecting short-term prospects for the economy
and longer-term goals for reducing inflation: (1) the severity of the
recession-from which recovery now appears to be underway;

(2) the

appropriate size of expansionary actions required for economic recovery;
(3) the .dangers posed by the large Federal deficit; (4) international
economic policy; (5) the appropriate rate of monetary growth for longterm price stability.

Severity of the Recession:
A prevalent judgment is that the recession that has apparently
reached a trough is the most severe of the post-World War II recessions,
some even regarding it as in the same class as the 1929-33 contraction.
The data do not support such a view.

The decline from November 1973 to

September 1974 was not primarily cyclical, but a response to real shocks
that lowered real income and real wealth.

It did not generate a pattern

of sagging employment levels and weak labor markets.

A true cyclical

decline comparable to earlier postwar recessions may be dated from
September 1974, in response to a pronounced deceleration in monetary
growth.

The decline in nonfarm employment in the recent recession ranks

fourth in severity among postwar recessions, and is about one-tenth in
magnitude of the decline in 1929-33.

The decline in industrial production

with no allowance for the real shocks ranks second in severity after the




2'

1957-58 recession; with such an allowance, it would probably rank fourth
also.

The decline is about one-quarter of the magnitude of the decline

in 1929-33.
A distinction between a decline attributable to real shocks and a
decline attributable to cyclical forces is important for rational policy
making.

A cyclical decline creates an output gap.

Real shocks reduce

potential output and capacity.
A disregard of the distinction magnifies estimates of the potential
gap to be eliminated by expansionary policies.

Appropriate Size of Expansionary Policies:
Those who view the recession as exceptionally severe have urged the
Federal Reserve to produce a rapid expansion of money at an annual rate
of 10 to 15 per cent, so that a year from now the money stock would total
between $325-340 billion.

They argue that with existing high levels of

unemployment and under-utilization of resources, a large monetary expansion
will simply mop up the economic slack and draw unused resources into use
without raising the rate of inflation.

This scenario is conceivable, but

it is more likely that a rapid nominal expansion will endanger the retardation of inflation in two ways.

Should there be a rapid acceleration of

nominal income it would induce revisions of expectations concerning prices.
These revisions are likely to be reinforced by growing awareness of the
policy of rapid monetary growth.

Market participants after ten years of

rising inflation are acutely sensitive to large changes in monetary
growth rates.

Inflation is hence likely to be substantially higher by late

1976 and in 1977, with little change in real output, if this option is
chosen.




3"
We would once again face the problem of bringing the growth rate of
money from the proposed 10 to 15 per cent rate to a noninflationary rate,
with the probable result of another recession in late 1977 accompanied
by higher inflation than now exists. We reject this course and applaud the
Federal Reserve's declared opposition to it.
At the opposite extreme is a proposal to reduce the growth rate of
money quickly to a path consistent with price stability and to keep it at
this noninflationary level. A year from now the money stock would be less
than $305 billion.

At first, unemployment would increase and recovery would'

give way to a deeper recession.

By late 1976 or 1977, the economy would

begin to recover from a lower level of output with a low rate of inflation.
The cost of thus ending quickly an inflation as protracted as the one
we have experienced is too high.

The Committee has always argued that

we should consider social costs of achieving price stability, and we find
no merit in proposals that ignore the costs of restoring stability.
A third option is the one the Federal Reserve has proposed to make
money grow between 5 and 7.5 per cent over the year from the second quarter
of 1975. At the lower end of the range,the money stock a year from now would
total $309, and at the upper end of the range, $319 billion.

Whether

Federal Reserve actions will match its declared policy target remains to be
seen.
In March this Committee urged the

Federal Reserve to raise the money

stock to $290 billion by April 15, the level that would have been reached if
sharp monetary deceleration had been avoided over the preceding 9 months
and a 5.5 per cent annual growth rate had been maintained.




By the end of May,

4
1975, the Federal Reserve reached the level we recommended.

Currently, the

actual money stock is about the same as our target, and about equal to the third
quarter Federal Reserve target at the upper end of its range.

Thereafter, as

the accompanying table shows, the Federal Reserve monetary targets diverge
from ours by progressively increasing amounts.

At the low end, the Federal

Reserve target figures fall short of the Committee's by $1.9 to $3.3 billion.
At the top of the range the Federal Reserve target figures exceed the CommitteeTs
by $1.6 to- $6.4 billion.

Target Levels of Money Stock

Federal Reserve
5

Growth Rates

SOMC Growth Rate

7.5

5.5

290.3

290.3

291.6

1975 III

293.9

295.7

295.6

1975 IV

297.6

301.3

299.7

1976 I

301.3

306.9

303.8

1976 II

305.1

312.7

308.0

1976 III

308.9

318.6

312.2

Base 1975 II

Starting from the level of the money stock in August 1975, the Federal
Reserve should maintain the growth rate of money at steady 5.5 per cent annual
rate, so that the level in the first quarter of 1976 totals $304 billion.

Such

a growth rate will be adequate to support recovery but with a lower rate of
inflation than more expansionary policy will produce.

Threat of the Federal Deficit

The proportion of the stock of the Federal debt held by the Federal Reserve
was more or less constant at 11 per cent in the 1950's and the proportion doubled




5

over the 1960!s.

The ratio rose to 23.5 in 1973/4; now 22 per cent of the

Federal debt is held by the Federal Reserve.

Under circumstances, the

explosion of the Federal Deficit from the beginning of fiscal 1976
through the end of fiscal 1977 by an estimated $135 billion threatens to
undo, the policy of moderate monetary growth.

The marginal percent of

Federal debt to be acquired by the Federal Reserve over the current fiscal
year must be substantially below the average resulting from its past actions.
If monetary growth were limited to the upper end of the Federal Reserve
target range, the volume of new debt it would absorb is less than half
the amount associated with a 22 per cent ratio.
lowers the admissible ratio even more.

This Committeefs proposal

The difference between the Federal

Reserve and the Committee in this regard however, pales compared to the
massive money creation that would result if past patterns of acquisition
of Federal debt were observed.

Our differences are of a small order

relative to the dangers inherent in the growth of the Federal deficit.

We

therefore approve Chairman Burns' frequently expressed concern about the
long-run development of the budget.

The experience of most countries suggests

that longer-run budgetary control is a necessary condition for effective
monetary control.
International Economic Policy
The virtues of the floating exchange rate system are now widely
acknowledged.

We no longer experience foreign exchange crises.

Countries

that wish to pursue independent monetary policies to reduce inflation now
have that option.




6

There has been increasing intervention in the New York foreign exchange
market by the Federal Reserve since July 1973 to affect exchange rates. . It.
is not evident that the Federal Reserve accomplishes anything beneficial
by such action.
. Discussion of international economic policy, often proceeds as if
fixed exchange rates prevailed.

The price effects of grain sales to the

Soviet Union demonstrate the superiority of the flexible rate system.

Under

both floating and fixed exchange rates, the increased demand for grain
raises grain prices.

With fixed exchange rates, the sales increase foreign

exchange reserves, expand domestic money, and raise the domestic price level.
Under floating exchange rates, grain sales increase the exchange value of
the dollar and reduce the effective price we pay for imports to the United
States.

The lower cost of imports offsets all or part of the higher price

of grain.
Appropriate Rate of Monetary Growth for Long-Term Price Stability
The rate of monetary growth is a principal determinant of the rate of
price change.

The 5.5 per cent monetary growth rate that we recommend

currently is too high for long-term price stability.

If the recovery proceeds

fairly smoothly over the next half year, the next step will be to reduce
the rate of monetary growth gradually to a lower level consistent with the
long-term growth of real output.




Karl Brunner
Homer Jones
Thomas Mayer
A. James Meigs
Allan Meltzer
Robert Rasche
Wilson Schmidt
Anna Schwartz
Beryl Sprinkel
William Wolman

University of Rochester
St. Louis, Missouri
University of California
Claremont College
Carnegie-Me11on University
Michigan State University
Virginia Polytechnic Institute
National Bureau
Harris Bank 6 Trust Company
c
Business Week




MONETARY POLICY, ECONOMIC POLICY AND INFLATION

Karl Brunner
University of Rochester and
Universitat Bern

Position Paper prepared for the fifth meeting of the
Shadow Open Market Committee, September 12, 1975.

The Shadow Open Market Committee was initiated in the summer of
1973.

It was designed to offer an organized forum for a systematic

appraisal of U.S. stabilization policies. A deep concern over policies
pursued in the past ten years motivated the initiative.

The financial

policies dominantly patterned in the past years threaten, in our
judgment, the future welfare of our country.

The budgetary policies

endanger economic growth and the continued rise in our living standards.
The evolution of the budget also conditions monetary policy and the
resulting monetary growth.

This linkage between budget and money oper-

ated in the past ten years to generate a pattern of world wide inflation.
The experiences made since our first meeting in September 1973 dramatically
confirm our motivating concerns. The policies pursued over many years
contributed to the largest peace inflation observed in the U.S.A.,
followed by a substantial downswing in economic activity in 1974/75.
The heritage of past error and mismanagement affected in recent
months public awareness. Congress initiated in late winter a new approach to
monetary policy making. We certainly hope that this approach, codified
under House Concurrent Resolution 133, contributes to a comparatively
stable and less inflationary monetary growth in the future.

The financial

behavior of Congress exhibited unfortunately a pattern barely designed to
comfort our expectations.
seem to emerge.

Still, some attempts to constrain the budget

Congress also set up institutions hopefully assuring a

more systematic overview over the budget and also a more explicit
acknowledgment of responsibility with respect to the magnitude of budget
and deficit.




But the basic properties of the political process have

2.
barely been touched by these attempts and the political rewards and
penalties associated with the budget process have been little changed so
far.
The danger of long-run inflation remains and has actually been
augmented by the threat of long-run "crowding out" of private capital
formation resulting from persistent large budget deficits.

Both dangers

loom in the proposals recently advanced by the "Keynesian Establishment11
to cope with the current recession.

These proposals center on a continued

large deficit supported by a large monetary growth reaching probably well
into the two-digit range. This "activist financial policy" with the usual
overtones of "fine-tuning" confronts us after ten years with the same
basic issues already encountered in the 1960's. It is indeed remarkable
to note that the policies mostly responsible for the sorry state of the
U.S.

economy should be proposed, on a larger scale of course, as useful

means to cope with their own bad consequences.

Financial policy, and

particularly monetary policy making, thus faces in the fall of 1975 a
critical test shaping the economic affairs for many future years. The
fundamental issue will be discussed in the last section of the position
paper.

The first section summarizes recent monetary trends and the

second section examines the policy targets proposed by the monetary
authorities and advances a tentative suggestion for the SOMC.

I. Recent Monetary Trends
The broad movement of the money stock over the 1970fs can be
inferred from table I.

This pattern has been discussed in previous

position papers and is simply introduced for the current occasion to




3.
define the historical context of contemporary policy-making.

The table

presents peaks and troughs of monetary growth computed between corresponding months in successive years. We notice since the January 1969 to
January 1970 period (indicated by 1/1970) three acceleration periods and
two deceleration phases. The long deceleration from 6/1973 until 2/1975
is particularly noteworthy in this respect. We also note early this year
the initiation of a new acceleration. A comparison shows that the current
acceleration exceeds until June 1975 the average rate of the previous
accelerations.

But an interpretation of this movement should be suspended

until the next section.
Attention is directed at this stage to another aspect of the table.
The patterns of monetary growth exhibit a remarkable difference before and
after 6/1973.

The combined contributions made by the currency ratio and

the time deposit ratio (columns 5 and 6) before 6/1973 are comparatively
negligible relative to the magnitude of monetary growth.

Beyond the

middle of 1973, however, the public's behavior dominated the broader
variations in monetary growth.

The acceleration noticed in the first half

of the current calendar year was largely due to the moderation in the
negative contribution emanating from increases in the time deposit ratio.
Between 1/1970 and 2/1974 the contribution made by the currency ratio to
monetary growth was confined to the range (-1.37, + .37).

It continuously

dropped below this range after early 1974 and moved since 11/1974 between -2%
and -3%.

A comparison with the time deposit ratio in the last column in-

dicates furthermore that the break in the patterns was heavily concentrated around the public's behavior centered on the currency ratio.




4.
The data in table II cover a shorter horizon.

They show monetary

trends between successive (non-overlapping) three month periods at annual
rates.

The first row shows the monetary growth and its decomposition into

contributory components from February/March/April 1973 to May/June/July
of the same year. The table presents the peaks and troughs of the shortterm movements. We observe over the last two years two intervals with
decelerations and two accelerations.

The table confirms the prevalence of

a dominantly deflationary deceleration of substantial magnitude from the
middle of 1973 until early this year.

The acceleration over seven months

from 10/1973 until 5/1974 is however also noteworthy.

It contributed to

maintain the activity level over the first segments in last calendar year
at a substantial level, retarded the onset of the cyclic downswing and
probably maintained the inflationary momentum.

Still, the acceleration

was smaller and proceeded at a lower rate than the sharp and large deceleration in the second half of 1973. Lastly, we note again the
emergence of a new acceleration phase of pronounced magnitude early this
year. Monetary trends thus reenforced the economic retardation emerging
in 1974 and also encouraged this year a reversal in the direction of
economic activity.

The role of the public's behavior is again clearly

revealed by the decomposition.

The currency ratio and the time deposit

ratio contributed substantially to the variations in monetary growth,
particularly over the recent acceleration phase. The first acceleration
period (10/1973-5/1974) forms in this respect somewhat of an exception.
The third table summarizes the monetary trends over an even shorter
horizon since the turn of the year.




The movements describe percentage

TABLE I:

MOVEMENT OF MONETARY GROWTH OVER i:
'-MONTH PERIODS AND
CONTRIBUTIONS MADE BY PROXIMATE DETERMINANTS

12 Months
ending in

Money
Stock

Monetary
Base

Adjusted
Reserve
Ratio

Currency
Ratio

Time
Deposit
Ratio

1/1970
7/1971
5/1972
6/1973
2/1975
6/1975

3.72
7.80
5.24
8.36
3.74
4.91

2.68
8.10
6.76
7.98
7.19
6.85

.17
2.27
1.34
2.68
1.91
+1.69

-1.05
.26
- .60
- .19
-2.63
-2.39

1.92
-2.85
-2.10
-2.10
-2.92
-1.37

TABLE II: MOVEMENT OF MONETARY GROWTH BETWEEN NON-OVERLAPPING
THREE MONTH PERIODS

Middle Months
of Second 3
Month Period/
Comparison

Money
Stock

Monetary
Base

Adjusted
Reserve
Ratio

Currency
Ratio

Time
Deposit
Ratio

6/1973
10/1973
5/1974
2/1975
6/1975

9.38
2.15
7.26
1.03
9.91

7.40
6.09
8.83
4.45
7.55

2.61
.98
2.66
3.88
1.24

.45
-2.21
-1.37
-3.94
.08

-1.70
-2.76
-3.02
-3.70
1.06

Remarks:




The date 6/1973 refers to the change from (2,3,4) to (5,6,7).

TABLE III: CONTRIBUTION OF PROXIMATE DETERMINANTS TO MONETARY
GROWTH BETWEEN SUCCESSIVE NON-OVERLAPPING FOUR-WEEK
PERIODS

Date of terminal week
of terminal four week.
period in comparison
12-18-1974
1-29-1975
3-26-1975
4-30-1975
6-18-1975
8-10-1975

1)

Money
Stock

10.42
- 9.99
13.24
1.25
21.57
1.32

Monetary
Base

Adjusted
Reserve,..
Ratio

Currency
Ratio

Time
Deposit
Ratio

11. 30
- 5.87
12.38
4.36
14.32
- 1.98

1.19
13.08
- 2.17
- 1.77
1.29
5.41

-1.18
-9.07
.31
- .08
2.77
-3.01

-0.29
-8.81
2.98
- .57
3.66
.36

Remarks:
1) The numbers are percentages per annum




2) The date 12-18-1974 refers to the change in M

to the four

weeks ending at 12-18-1974 from the previous (non-overlapping)
four week period.
3) The adjusted reserve ratio contains the "liberated reserves"
per unit of total deposits.
All data are seasonally adjusted.

5.

changes at annual rates between successive four week periods.

The first

row states that the money stock increased to the four week period ending
on December 18, 1974 from the immediately previous four week period at
an annual rate of 10.4%.

The table exhibits three periods of deceleration

and two with accelerations.

It is also noteworthy that the accelerations

and decelerations of the monetary base match the general order of the
movements in monetary growth.

The contribution made by the time deposit

ratio reflects the evolution on the credit markets.

In particular,

rising short-term rates in the late summer lowered substantially the
contribution emerging from the time deposit ratio.

The large decline over

the recent months in the component defined by the currency ratio is
somewhat surprising.

It seems most probable at this stage that this

component will increase again in the near future and contribute to raise
monetary growth over the balance of the year.

It is expected moreover

that the decline in the contribution made by the time deposit ratio will
remain quite limited and not reach very deep levels over the next months.
It should be noted lastly that recent variations in monetary growth were
negligibly affected by the Treasury's management of its bank deposits.
This management actually offset the recent deceleration by a fractional
amount (less than 1%), and also offset the previous acceleration by a minor
amount.

Contrary to some allusions occasionally encountered, recent

trends of monetary growth cannot be attributed to the flow of Treasury funds.

II.

Monetary Policy Targets
The SOMC proposed at the conclusion of its last meeting a two part

target for monetary policy:



the money stock should immediately be raised

6.
to a level of $290 billion, a level it would have reached according to
our previous proposals made in March and September 1974. Once M
was brought to an appropriate level, a moderate growth path centered on
5.5% per annum was proposed.

The proposal attended thus to the two

problems confronting our economy.

The "frontloading" should contribute

to dampen the ongoing recession and contribute to the reversal of
economic trends in the second half of the current year.

The moderate

growth path following the "frontloading" on the other hand was designed
to assure a continued reduction in the average rate of inflation.
The reader finds a graphical presentation of the SOMC target in
graph I.

The targeting implicit in the SOMC proposal is summarized by a

cone starting in March 1975 at $290 billion.

The lower boundary of the

cone corresponds to a monetary growth of 5% and the upper boundary to a
growth of 6%.

The jump from February to March in comparison to the

proposed subsequent path clearly reveals the nature of the proposed
frontloading.

An inspection of the graph shows that our monetary

authorities actually attended (or permitted) a good approximation to the
frontloading.

With a delay of three months the actual money stock

touched and almost moved inside the cone.

In July and August the money

stock veered however below and to the right of the cone with an abrupt
deceleration of monetary growth.

Still, the SOMC should acknowledge

the approximate realization of its front loading proposal.
Inspection of graph II offers some interpretation of recent
movements in M1 relative to the Fed's avowed monetary target. The
beginning of the cone is centered in May 1975, in the middle month of the
second quarter.




The FOMC announced that monetary growth should proceed

7.
from 11/1975 to 11/1976 (from second quarter to second quarter) at least
by 5% p.a. and at most by 7.5% p.a.

The FOMC cone is consequently wider

than the SOMC cone. We notice that the actual May figure is quite close
to the vertex of the ccne. The July figure moved above the cone and was
brought back inside the cone in August.

The deceleration since June was

thus quite appropriate relative to the target range acknowledged by the
Federal Reserve authorities. We should also note however the wide
latitude permitted to the money stock for the second quarter of 1976.
Along the lower boundary M- would reach approximately $305 billion and
along the upper boundary approximately $313 billion.

This $8 billion

difference amounts to about 2.7% of the lower boundary value.

Such a

range of admissible monetary values seems too large and the monetary
authorities should design procedures, institutions and assessments
permitting a somewhat tighter targeting for monetary policy.
Another aspect of Federal Reserve policy requires our attention.
The official target suffered between April and July substantial shifts.
The first targeting range announced in April was based on March 1975.
The base of the target range was subsequently moved to June 1975. This
shift occurred in June itself.

The last adjustment, basing the target

on a second quarter average, occurred in July 1975. These shifts are
somewhat unsettling and one wonders unavoidably about the reliability
and quality of policy making under the circumstances.

One also wonders

to which extent the target is adjusted ex post facto to the emerging
outcome.

The reader will find some comparisons between the three

targets in graph III and IV.

The March to March target is juxtaposed to

the quarterly target in graph III. We note that the quarterly target




8.
is shifted up relative to the March target.

This shift affects foremost

the lower boundary of the range and much less the upper boundary.

A

much larger difference appears between the quarterly and the June target
The quarterly target has thus been placed between the first two attempts
at targeting and somewhat nearer to the original March target.

The last

two graphs compare the SOMC target range with the FOMC's June and quarte
target.

The reader should note in graph V that the SOMC's target range

is completely contained, beyond June, within the FOMC's June targeting.
Graph VI depicts on the other hand the comparison between the SOMC
proposal and the FOMC's quarterly target. Until October 1975 the SOMC
target remains completely above the FOMC's target range. We note however
that by January 1976 the upper boundary of the FOMC target pierces
beyond the SOMC range. The Federal Reserve authorities are thus willing
to admit beyond January 1976 monetary growth patterns deemed inadvisable
according to the SOMC's previous judgments and evaluations.
The implicit admission by the FOMC of monetary trends excluded by
our previous proposals should encourage a careful reexamination of the
issue on our part. My tentative suggestion to be submitted to the SOMC
covers three aspects. The first point is immediately directed to the
appropriate choice of a target range. The other two points address
aspects of policymaking which will require, in my judgment, the serious
attention of the Federal Reserve authorities. Neglect of these aspects
will endanger the successful execution of future monetary policies. It
is not sufficient to formulate a target range. . Suitable adjustments
of institutions and policy making procedures are necessary to create an




9.
effective framework for monetary policy making.
1.

It is proposed that the money stock M1 for September be brought

back into the target cone formulated at the SOMCfs meeting in March.

This

implies an increase of the money stock of (at least) about $2.5 billion
in September over August.

The monetary base would have to be raised by

approximately $1 bullion for this purpose. Moreover, from September
1975 to March 1976 the money stock should b«* held within the SOMC cone
exhibited in graph I.

A reexamination will be necessary next March.

If

we assume an actual development confined to our proposal we may well
judge it appropriate to lower somewhat the growth target for spring and
summer of 1976. But the proposal definitely rules out a higher range
of M- values admitted by the FOMC for the first half of 1976. This
range is too expansionary for a persistently anti-inflationary policy in
my judgment.
2.

The shifting targets and the wide range admitted by the FOMC

directs our attention to the policy making procedures. The SOMC should
emphasize in my judgment the importance of suitable modifications in the
Fed's internal procedure.

The FOMC should be made responsible for the

development of a useful targeting of monetary growth.

This involves in

particular the development of more reliable and more appropriately
defined measures of the money stock.

The Fed has recently enlarged the

number of money stock measures to eight.

One wonders of course whether

this is an attempt at obfuscation to assure a sufficient supply of
numbers.

The larger the range of possible numbers available for selection,

the greater the probability that the Fed will find a number, ex post
facto, which fits its political purpose.

This reservation associated

with the manner in which the numbers appeared should not distract us



10.
however from the fact that a serious examination of the measurement problem
is quite urgent.

Some elements of current measurements seem barely

appropriate and poorly designed to yield the analytically desired measure.
The SOMC should certainly await with great interest the findings of the
special committee instituted by the Board of Governors to review the
measurement problem.

In view of the variety of measures listed by the

Chairman of the Board and the sense of uncertainty recently conveyed
in this matter by an article in the Wall Street Journal, the SOMC should
explicitly state that the Fed be advised to assess systematically the
relative usefulness of the various measures for purposes of monetary
control and monetary policy.

I would also contend that we are not lost

in a fog of diffuse uncertainty in this matter. We do possess some information. No evidence has been submitted thus far to the profession
that any of the more inclusive measures beyond M~ offer useful information
for purposes of monetary control. The best measures still seem to center
around ML and M 7 , and I expect this situation to persist. This does not
mean that I expect the present measures of M . or M^ to be really adequate
.
for our purposes.

I suspect on the contrary definite modifications of these

measures once the Fed seriously proceeds to untangle the measurement
problem.
The targeting of monetary growth forms the basis for the F0MCrs
determination of the required growth of the monetary base. This involves
additional staff work under the FOMC's responsibility.

The required

growth path of the base should then form the centerpiece of the directive
to the account manager.

The responsibility for monetary policy is divided

in this manner in a specific way between account manager and FOMC. The
account, manager is responsible for the growth path of the monetary base




11.
over a specified interval of time. The discharge of this responsibility can
be regularly assessed by the FOMC.

The latter, on the other hand, is made

responsible for the choice of monetary growth target and its translation
into a targeting range for the monetary base.

The FOMC would also be

responsible for the proper development of facilities and procedures
necessary for its assigned task.

It appears to me that this division of

responsibilities would improve the Fed's policy making procedures.
3.

Lastly, the Federal Reserve authorities should be urged to

review the existing arrangements and examine their usefulness for
purposes of monetary control.

I suspect that numerous institutions,

including the present manner of computing required reserves, ceiling
rates, etc., lower the controllability of the money stock.

The FOMC

should immediately initiate a study systematically reviewing the institutional changes under the Board's power which can be expected to improve
monetary control.

III.

Recession, Inflation and the Keynesian Establishment.
Economic recovery and the gradual reduction of the rate of inflation

face two major and closely associated dangers. These dangers are posed
by the budget, more specifically, the large deficit, and the advice
emanating from the Keynesian Establishment centered around the Brookings
Institution.

Subsections 2 and 3 attend to the nature of the issues con-

fronting us in this respect.

The first subsection attends to a question

affecting one's view bearing on the appropriate magnitude of financial
expansion required for economic recovery.




12.
1.

Timing and Magnitude of the Recession

A prevalent judgment places the onset of the recession around
November 1973. The lower turning point may well be located in early
summer of 1975. Measured in this way the recession of 1973/75 easily
appears as the largest and longest recession since the economic downswing of 1937/38.

Some facts seem incontestable.

Real national product

and industrial production peaked in late 1973 and reached a lox* in the
summer of 1975. But a more detailed examination reveals some peculiar
patterns not usually occurring during a cyclic recession.

The behavior

of production, unemployment, employment, quit rates, the evolution of
financial markets, delivery times for manufacturing products and the
frequency of suppliers unilaterally raising prices in violation of
customer contracts, etc. suggests that the interval from November 1973
to the summer of 1975 really contains two very distinct phases with
radically different interpretations.

Industrial production fell from

November 1973 to January 1974 and then rose gradually again until
September 1974. Total employment rose continuously until the fall of
1974 and so did the market sensitive quit rates.

Similarly, unemployment

rose over this initial segment by comparatively little.
somewhat nearer to 6%.

It inched

All these patterns, and others, differ quite

substantially from the patterns usually associated with a cyclic decline.
Thg standard observations of a cyclic decline clearly prevailed on the
other hand from September 1974 until the summer 1975.
These shifting patterns are difficult to reconcile with the view
that the (hopefully and probably) now defunct cyclic decline emerged in
November 1973 and controlled over one and a half years the course of




13.
the U.S. economy.

An alternative interpretation is suggested.

The

first segment lasting from November 1973 until September 1974 reflects
the adjustment imposed by a variety of real shocks. These real shocks
(oil, agriculture, devaluation, extensive legislation bearing on pollution, safety, health hazards, etc.) lower

real income and real wealth,

but neither do they generate a pattern of sagging employment levels or
nor do they weaken the labor markets.

On the other hand, the large load

of resource reallocation imposed on the economy by such real shocks raises
the "natural" or "normal" rate of unemployment at least for some time.
The real shocks supplemented with the concurrent acceleration of monetary
growth noted in table II on previous pages also explains a portion of
the accelerating inflation observed in 1974. The cyclic decline properly
comparable to previous postwar recessions emerged around September 1974,
fostered by the simultaneous acceleration of price-levels and the pronounced deceleration of the money stock observed in table II. The
conjecture advanced here has been examined in further detail by Norman
Bowsher in the June 1975 issue of the Review published by the Federal
Reserve Bank of St. Louis.

It seems appropriate to quote the conclusions

of this study for our purposes:




"The current recession has been severe by post World War II
standards, with output contracting by a greater magnitude and for
a longer period than in any of the four previous recessions experienced since 1950. Not only has the current contraction been
deep and prolonged, but it has been, in effect, two recessions.
The first, induced largely by constraints on supply, had characteristics which differ strikingly from prior experience.




14.
Previous recessions were preceded, and accompanied for a time, by
a slow (relative to trend) rate of money growth.
money

By contrast,

expansion in the current cycle continued to be rapid,

except for a
recession.

brief period, through the first two quarters of the

However, from the second quarter of 1974 to the first

quarter of this year, the rate of money growth slowed markedly.
Fiscal actions, on the other hand, have been expansive since a
quarter before the

current cyclical peak.

Total spending for goods and services rose substantially during the
first three quarters of the current recession,-pausing only moderately
after the cyclical peak.

However, spending growth slowed significantly

after the third quarter of the contraction, causing the recession
to

enter the second stage.

Until last fall, the chief cause of the downturn came from the
supply

side.

The nation's ability to produce was reduced by

increased energy costs, unfavorable weather, costs of environmental
and safety programs,

the impact of dollar devaluation, and the

effects of price controls. The quantity of goods and services
available for consumption thus declined.

Much of the current

recession and the persistence of inflation have reflected the
process of adjustment that the economy has been making to the
constraints placed on production.
Recovery from the current recession depends on the overcoming or
removal of constraints on supply.

Elimination of wage and price

controls was a significant step in attaining greater output, since
production tends to expand when profits are enhanced.

With normal

15.
weather, agricultural production should increase, placing downward
pressures on the price of food.

While some adjustment to the

higher cost of fuel has taken place, a full adjustment will take
additional time.
Economic recovery is also dependent on a pick-up in demand growth.
In view of the projected sizable Federal deficits, and the probable
monetary creation that will occur in financing them, total demand
is likely to receive a substantial boost from fiscal and monetary
developments in the near future.
again risen sharply.

Since January the money stock has

Expansionary developments are now welcome,

because demand is inadequate.

Yet, a stimulation of demand in

excess of the ability of the economy to produce would likely
result in a re-intensification of inflationary pressures at a later
date."
The alternative interpretations bear on our current policy problem.
The distinction between a "real shock decline11 in output and a "cyclic
decline11 in output seems to me important for rational policy making.
The latter creates an "output gap" really absent from the former. A
disregard of the two distinct processes thus magnifies estimates of the
"potential gap" to be removed by expansionary policies. An inadequate
analysis of the decline in output observed since November 1973 thus
reenforces the danger of inflationary financial responses on the part of
policy-makers.

2.

The Threat of the Deficit

The history of numerous Central Banks suggests a connection between
the growth patterns of the monetary base and the magnitude of the deficit



16.
in the government's budget.
the U.S.A.

This association has also been observed for

Periods experiencing a surplus (early postwar years) generated

a pronounced retardation of the base, or periods exhibiting small increases
in public debt (as during portions of the Eisenhower Administration)
showed a small and stunted growth of the monetary base.

Phases with

larger and expanding deficits, exemplified by the experiences since
1965, were prone to produce a larger growth of the base.

The volume of

public debt held by the Fed behaved quite differently during the 1950fs
and the 1960's. The volume changed relatively little over the 1950fs
and even declined over four years in the middle 50fs.

With the turn of

the decade came an uninterrupted increase in the volume of public debt
held by the Fed.

The turn of the decade also unleashed a persistent

increase in the percentage of the public debt absorbed by the Fed.

This

percentage fluctuated between 1951 and 1960 around 11% and rose from
1960 until 1971 uninterruptedly to 22%. It held near this level for
about 2 1/2 years and shot in 1973/74 to about 23 1/2% but fell by the
summer of 1975 again to 22% of outstanding public debt. The proportion
of public debt absorbed by the Fed was more or less constant in the
1950fs and doubled over the 1960fs. The contemporary explosion of the
federal deficit seriously threatens under the circumstances the future
course of moderate monetary growth.
The problem can be usefully appraised with an enquiry into the
implications of past patterns extended to the current state. Suppose
that the recent absorption ratio (i.e. 22%) determines the proportion of
the current deficit financed by the Fed.

We also assume for our purposes

that the deficit over fiscal year 1975/76 will approximate $85 billion.




17.
This deficit and the recent absorption ratio-imply together an increase
of about 17% in the monetary base over the fiscal year.
approximately equal monetary growth over this period.

This implies an

The expectation

of a deficit for 1976/77 still around $60 billion would naturally produce
under the circumstances expectations of continued high double digit
monetary growth.

This acceleration in monetary growth with the partial

revision of inflationary expectations over the next 12 months would
generate a new wave of double digit inflation and double digit interest
rates by 1977.
With the present deficit predetermined by Congressional actions the
Fed can only operate on the absorption of public debt in its portfolio.
The marginal percentage applicable to the issues over the current fiscal
year must be held substantially below the average resulting from past
actions of the Fed.

Even with a monetary growth of 7.5% at the upper

boundary of the Fed's targeting range, the volume of new debt absorbed
by the Fed would be only about $8.5 billion.

This is less than half the

roughly $19 billion associated with * 22% absorption ratio of new debt.
The SOMC proposal lowers the admissible absorption to at most $7 billion.
The difference between the Fed's and the SOMC's admissible upper range
pales however compared to the massive financing required in accordance
with past patterns. The SOMC's position with respect to this matter
seems rather clear. We should fully support the Fed's attempt to hold a
moderate course.

I suspect that the SOMC has a natural propensity to

pre'fer its proposal over the Fed's policy target.

But we should ex-

plicitly acknowledge that our differences are of a small order relative
to the dangers inherent in the evolution of the budget. The Federal
Reserve's position in this respect deserves our full approval. Even



18.
more, we should be quite sympathetic to the Chairman's frequently expressed
concern about the longer-run development of the budget.

The experience

of most countries suggests that longer-run budgetary control is a necessary
condition for effective monetary control.

3. And the Keynesian Establishment
The monetary policy proposed in this position paper is in substantial
conflict with the views presented

by leading Keynesians (Okun and

Heller) on the policy-making agencies.
summarized their position as follows:

The New York Times of July 14
"They believe the Board has

focussed too much on controlling the nation's money supply rather than
managing interest rates.... (and) the Fed should be guaranteeing the.
country a period of flat interest rates.

(Moreover), because of the

weak economy, (there is) the lack of risk of inflation11. Andrew Brimmer,
a former Governor of the Board supports the basic Keynesian view and
adds that the Fed should keep the Federal funds rate for some time in
the range between 5% and 5.5%.
The views summarized in the New York Times present a very traditional
Keynesian conception of policymaking.

It centers on the control of

interest rates, the use of interest rate targets, as a means to guide
the policy responses of the Central Bank. Moreover, this interest
target policy occurs in the context of an activist application of financial
policies which relies (implicitly) over, one or two years on large variations
in monetary growth and explicitly on large changes in fiscal policy.
These issues confronted us already more than ten years ago and it is remarkable to observe the conservative pattern of the issues raised in the
current struggle for an economic policy assuring a recovery without
unleashing a new wave of inflation.




19.
Since Allan Meltzer and I prepared our report on Federal Reserve
Policy Making for the Committee on Currency and Banking of the U.S.
House of Representatives we have argued extensively against the use of
an interest target policy.

We argued in particular that this policy

bears a major responsibility for the emergence of both deflations and
inflations. It converts a decrease in aggregate demand into a retardation
of the money stock and unleashes in this manner a deflationary feedback.
Similarly, an expanding aggregate demand induces under an interest
target policy an acceleration of the money stock and introduces an
inflationary feedback.

This policy of interest orientation obstructed

appropriate stabilizing action in the early 1930's by the Federal Reserve
authorities, converted the federal budget surplus in 1947/48 into a
decline of the monetary base and also determined a major portion of the
acceleration of the money stock in the later 1960's. Quite generally,
the interest target policy establishes the dangerous association discussed
in the previous subsection between the deficit and the movement of the
monetary base. A Central Bank's attempt or willingness to prevent
interest rates from rising under the pressure of large financing requirements
by the government has on many occasions been a major source of inflationary
monetary growth.

It is also noteworthy that this alleged "Keynesian

policy11 is not a logical consequence of Keynesian analysis. An acceptance
of Keynesian analysis does not impose the choice of this policy.

The

proper application of an interest target policy depends on very restrictive
conditions about the relative order of underlying disturbances and
impulses operating on an economy.

We note in particular that the advocates

of an interest target policy have not made their case in this respect




20.
and did not pi>egress beyond a repetition of the old positions.

Even the

simulations from an econometric model pertaining to a specific initial
state are somewhat irrelevant in this context. We face essentially a
general strategy problem under substantial uncertainty with respect to
the precise responses and structural properties of the economic process.
It seems under the circumstances quite inappropriate to rely on the
short-run simulations of an econometric model with uncertain and frequently
untested reliability concerning short-run analysis of economic events.
The SOMC should also invite the Keynesian Establishment to present their
analytic and empirical case for the choice of an interest rate target
for the execution of monetary policy so that the public discussion may
move beyond a repetition of the old lines.
Closely associated with the currently proposed interest rate target
is the view that we require for a number of quarters a large monetary
expansion.

Several double-digit figures appeared occasionally in the

discussions over recent months. This proposal, or implication of the
interest target policy, is justified in terms of the existing high
levels of unemployment and the under-utilization of resources.

It is

argued that under these circumstances a large monetary expansion simply
mops up the economic slack, draws unused resources into renewed activity
without raising the rate of inflation.

This scenario is certainly not

impossible and could actually be true.

But we do not know and neither

do the advocates of this policy.

The activist policy of massive financial

expansion involves in my judgment a serious risk of renewed inflation.
The prevailing slack can be expected to retard inflation and should over
the next year substantially lower the inflation rate. A rapid nominal




21.
expansion endangers the anti-inflationary course in two ways.

The

initially rapid acceleration of output induces revisions of prevalent
expectations. These revisions are likely to be reenforced by growing
awareness about the policy of financial expansion.

The initial state

for the application of financial expansions differs in this respect
substantially from past experiences.

Ten years of rising inflation made

market expectations more sensitive to evolving events.

It is not necessary

for this argument that the large mass of market participants attune
their expectations to the new circumstances.

It is sufficient that a

substantial margin on output, labor, and financial markets revise their
expectations sensitively to new developments.
It is frequently stated that the proposal advanced in this position
paper shows little concern about unemployment and is apparently more
concerned about inflation.
the problem.

This is a politically useful misstatement of

Inflation per se deserves little concern.

Our concern is

surely directed to the consequences of alternative policies for human
welfare. In particular, we have become deeply concerned about the longerrun consequences of inflationary policies. We have been told that
"inflation is a zero-sum game". This view is in my judgment singularly
blind to the social, policital and economic problems created by inflationary
policies in the context of our institutional arrangements.

The disruptive

and destabilizing consequences of inflation with the serious strains
imposed on the political process suggest to me the importance of a
careful, moderate and cautious approach in our financial policies. The
proposal advanced in this paper is essentially designed to guard against
the danger of accelerating inflation and to proceed on a course assuring




22,
a gradual erosion of the inherited inflation.
The risks and uncertainties inherent in our situation and evaluations
leads me to reject emphatically Okun's assertion of (almost) perfect
knowledge. According to the New York Times "he has no worries11 about
turning the monetary faucet at the right time in order to prevent "an
addictive inflationary bias".

He assured the New York Times that he

knows when to stop the large monetary expansion.
1968 or does he know only just recently?

Did he know also in

The fact of the matter is that

nobody possesses this precise knowledge and probably never will.
remains another aspect to this matter.

There

Okun apparently speaks as if

nominal expansions can be enlarged or throttled like the flow of water
from a faucet without any serious problems.

But a substantial reduction

of monetary growth after one year of massive expansion introduces
at least temporarily a pronounced retardation of economic activity at
the very time that inflation probably accelerates.

Okun's proposal most

likely leads us to a new round of stagflation with little reduction of
unemployment in the average and probably higher levels of inflation over
the next years. This risk seems too large. The political and social
dangers inherent in this policy seem best avoided by a moderate financial
course geared to a longer-run perspective.

Policies fostering unemployment

and inflation in the future and yielding at best a temporary reduction in
current unemployment possess little virtue. These policies increasingly
dominated over the last 15 years the m^dia and the political process. It
seems time to proceed with an alternative program based on a moderate
and longer-run conception avoiding the cultivation of detailed short-run
responses without sufficient information.




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Clarernont Men's College

Bauer Center, Clarernont, California 91711
Telephone (714)626-3511

!/»»•IIB

Applied Financial Economics Center

Memo to the Shadow Open Market Committee, for Meeting of September 12, T975
From:

A. James Meigs

Re:

Implications of Possible Monetary Growth Targets
The attached tables summarize the results of simulations run on a

forecasting model developed by John Rutledge, Paul Hunt, and Jerry St. Dennis
at the Applied Financial Economics Center, Clarernont Men's College.

In order

to focus on the SOMC's problem of recommending a monetary growth target, we
tried five possible growth rates for M,, while assuming that high-employmentbudget Federal expenditures grow at rates projected by the Federal Reserve
Bank of St. Louis.
For all five simulations, we assumed that M, would have an average
value of $295,4\trirthe third quarter of this year.

This is approximately

the level M-, would reach in the third quarter if the money stock were to grow
at the FQMC's upper target rate of 7.5% per year from the first quarter of
'75 to the first quarter of ! 76. It also is slightly lower than the $295.9
billion quarterly average implied by the March 7 recommendation of the SOMC
that the money stock be raised to the growth track that it would have been on
if it had grown since last September at the 5.5% rate recommended by the
SOMC at its September, 1974 meeting.

It is already too late in the quarter

for the money stock to reach a much higher or lower quarterly average level
than the one assumed.

For the subsequent quarters through the end of 1975

we made the following money-growth assumptions:




Memo to the Shadow Open Market Committee
for Meeting of September 12, 1975

2.

1. Continuation of the recent pattern of alternation between a high
rate of M-. growth in one quarter and a much lower growth in the
next quarter.

For the fourth quarter 1975 we began with a 9% annual

rate, followed by a 0.99% rate in the first quarter of 1976, and so
on.
2.

The mean rate for'75:3 through '76:4 was 6%.

Extension of the SOMC recommendation for a steady 5.5% annual rate
of Mn growth from 75:4 through 76:4.

3. A 7.1% growth rate for Mn through 1976. This is approximately the
rate of growth that would keep the money stock on the FOMC'2 high
target rate of 7.5%, after allowing for the unusually large increase
in 75:2.
4.

A rate of growth of 10% for M, through 1976.

5. A rate of growth of 15% for M, through 1976. We picked these two
rates because they have been suggested in public discussions of
monetary policy as rates that would be required to achieve various
desired levels of interest rates, inflation rates, and rates of
growth of real 6NP.
The following table lists the quarterly levels and changes in high
employment Federal expenditures that we assumed.

The nominal changes were

used in our St. Louis-type nominal GNP equation and changes in real
expenditures were used in the inflation and interest-rate equations.

The

real expenditure assumptions therefore were conditional by the money growth
rates assumed in each simulation.




Memo to the Shadow Open Market Committee
for Meeting of September 12, 1975

H E FE

3.

% Annual Rate of Change in H E F E

1975: I I I

340.7

- 5.552

.

IV

349.0

10.107

1976 :

I

355.4

7.539

:

II

363.5

9.433

: III

379.9

19.305

:

397.0

19.305

IV

The numbers in the simulation table are un-retouched estimates taken
directly from the computer runs. To make a specific forecast for 1976, we
probably would adjust the levels in light of other information.

I believe

these estimates are helpful, however, in assessing the benefits and costs of
shifting from one monetary growth target to another.

For example, they

indicate how much higher the inflation rate would be in 1.976:4, with a 15%
money-growth rate than with a 5.5% money-growth rate, other conditions
remaining the same.
Conclusions:




There does not appear to be any payoff in the form of lower
interest rates from a policy of permitting higher growth rates
in M, than the 5.5% rate recommended by the SOMC or the FOMC
target rates.
>

From '75:4 onward, short-term rates are

substantially higher at high M-, growth rates than at low
money-growth rates. The difference in behavior of long bond
yields is not so pronounced but it is significant.

The highest

money growth assumption implies that long term bond-holders would
forfeit over twenty percent of their capital values over the next




, . «• o^en Market Committee
.
r '' :":enber 12, 1975

4,

**,•» .;^rters, as compared with what would have happened to them
.- w
,

:>z 5.5% money-growth-assumption.

*«•? r.«-her rates of monetary expansion would result in higher
;*'v*:<5 rates for nominal and real GMP through 1976 than would
V f S'^C's 5-5% rate.
" - - r i-her money-growth rates would result in a sharp
n.*K<;eleration of i n f l a t i o n in 1976, with the i n f l a t i o n rate
•ceding for new highs by the end of 1976 with the 15% money-growth
.is suction
M l of the money-growth rates tested would produce a re-acceleration
m

inflation after 76:2, which suggests the need for considering a

reaction in money-growth rates early in 1976.

INCOME, INFLATION, AND INTEREST RATE SIMULATION RESULTS
A GNP
% Annual
Rate
Assumption 1
Alternating 9.0%-0.99%
M, growth
1
75:3

4
76: 1
2
3
4

Yield on
Long AAA
Corporate
Bonds

Inflation
Rate
(Deflator)

A Real GNP
% Annual
Rate

4-6 Month
Commercial
Paper Rate

5.2
7.4
4.4
6.6
4.6
8.9

4.0
4.2
1.7
0.8
1.0
1.4

1.1
3.2
2.7
5.8
3.6
7.5

5.5
4.9
3.7
3.2
3.5
3.4

8.7
8.7
8.3
8.1
7.9
7.8

5.1
5.3
5.6
5.5
6.2
8.3

4.0
4.3
2.1
1.4
1.9
2.3

1.1
1.0
3.4
4.1
4.4
6.0

5.5
5.2
4.1
3.9
4.3
4.4

8.7
8.7
8.4
8.2
8.1
8.0

5.1
6.2
7.3
7.4
8.9

4.0
4.4
2.4
1.9
2.8
3.7

1.1
1.8
4.9
5.5
6.1
6.9

5.5
5.3
4.4
4.6
5.4
5.9

8.7
8.7
8.4
8.2
8.2
8.3

Assumption 2
Steady 5.5%
M, growth

75: 3
4
76. 1
:
2
3
:
4
Assumption 3
Steady 7.15%
M, growth
1
75 :3




:4
76 :
1
:2
:3
:4

10.7

Income, Inflation, and Interest Rate Simulation Results (continued)

4-6 Month
Commercial
Paper Rate

2.
Yield on
Long A M
Corporate
Bonds

A GNP
% Annual
Rate

Inflation
Rate
(Deflator)

5.1
8.0
9.8

4.0
4.5
2.8
2.9
4.4
6.1

1.1
3.5
7.0
8.4
8.5
9.4

5.5
5.6
5.1
5.8
7.3
8.5

8.7
8.7
8.4
8.4
8.5
8.7

1.1
6.0
11.5
13.4

5.5
5.9
6.2
7.9

21.6

4.0
4.6
3.5
4.6
7.3

13.3

10.5

23.7

10.4

13.4

13.0

8.7
8.7
8.5
8.6
8.9
9.5

A Real GNP
% Annual
Rate

Assumption 4
Steady 10%
M, growth
1

75:3

4
76: 1
2
3
:
4

11.3
13.0
16.6

Assumption 5
Steady 15%
H, growth
1




75 :
3

5.1

:4
76 :
1
:2
:3
:4

10.6
15.0
18.0

Claremont Men's Colfeae

Bauer Center, Claremont, California 91711
Telephone (714) 626-8511
Applied Financial Economics Center

Memo to the Shadow Open Market Committee, for Meeting of September 12, 1975
From:

A. James Meigs

Re:

Implications of Possible Monetary Growth Targets

Revised 9/10/75

The attached tables summarize the results of simulations run on a
forecasting model developed by John Rutledge, Paul Hunt, and Jerry St, Dennis
at the Applied Financial Economics Center, Claremont Men's College.

In order

to focus on the SOMC's problem of recommending a monetary growth target, we
tried five possible growth rates for M-,, while assuming that high-emplcymentbudget Federal expenditures grow at rates projected by the Federal Reserve
Bank of St. Louis. We also used two sets of forecasting equations. The
results reported in Column #1 for each variable were estimated from equations
fit over the period 1965:1 through 1975:2. The results reported in Column #2
for each variable were estimated from equations fit over the period 1953:1
through 1971:2, which were used to avoid some of the complications resulting
from price controls and other unusual conditions of the period 1971:3 through
1974:4.
For all ten simulations, we assumed that M-, would have an average
value of $295.4 billion in the third quarter of this year.

This is

approximately the level M. would reach in the third quarter if the money stock
were to grow at the FOMC's upper target rate of 7.5% per year from the first
quarter of '75 to the first quarter of '76.

It also is slightly lower than

the $295.9 billion third-quarter average implied by the March 7 recommendation
of the SOMC. At the March 7 meeting, the SOMC recommended that the money
stock be raised to the level it would have reached if the 5.5% growth rate




Ciaremont Men's College

Memo to the Shadow Open Market Committee
for Meeting of September 12, 1975

2.

recommended the preceding September had been achieved.

It is now too late

in the third quarter for the money stock to reach a much higher or lower
quarterly average level than the one assumed, although the $2.6 billion jump
in M, in the week ending August 27 makes our third-quarter assumption look a
little low.

For the subsequent quarters through the end of 1976 we made the

following money-growth assumptions:
1. Continuation of the recent pattern of alternation between a
high rate of M-, growth in one quarter and a much lower growth
in the next quarter.

For the fourth quarter 1975 we began with

a 9% annual rate, followed by a 0.99% rate in the first quarter
of 1976, and so on. The mean rate for
2.

75:3 through

76:4 was 6%.

Extension of the SOMC recommendation for a steady 5.5% annual
rate of M-, growth from 75:4 through 76:4.

3. A 7.1% growth rate for M, through 1976. This is approximately
the rate of growth that would keep the money stock on the
Federal Reserve's high target rate of 7.5%, after allowing for
the unusually large increase in 75:2.
4. A rate of growth of 10% for M ] through 1976.
5. A rate of growth of 15% for M-. through 1976. We picked these
two rates because they have been suggested in public discussions
of monetary policy as rates that would be required to achieve
various desired levels of interest rates, inflation rates, and
rates of growth of real 6NP.
The following table lists the quarterly levels and changes in high
unemployment Federal expenditures that we assumed.




The nominal changes were

Cfaremont Men's College

Memo to the Shadow Open Market Committee
for Meeting of September 12, 1975

3.

used in our St. Louis-type nominal GNP equation and changes in real expenditures were used in the inflation and interest-rate equations. The real
expenditure assumptions therefore were conditioned by the money growth rates
assumed in each simulation.
The first set of simulations, based on equations fit over 1965-75 gave
estimates of inflation for 1976 that seemed too low to be plausible. The
first set also indicated a much earlier and sharper reacceleration of
inflation than did the second set. We believe these differences stem from
the extraordinary increase in inflation in 1973-74 and the subsequent fallback
toward the trend rate in the first half of '75. These made money stock changes
appear more influential than they should have been and to influence prices
with shorter lags.

The second set, based on equations fit over 1953-71:1,

had prices responding with longer lags and gave more intuititively plausible
estimates of levels. However, these naturally missed any effects on expectations that might have resulted from the public's learning about inflation
between 71:2 and this year.
Despite these caveats, some conclusions can be drawn:
1. Neither set of simulations indicates that the Federal Reserve
can easily depress interest rates by increasing money-growth
rates. The higher rates of money growth produce higher interest
rates in either set of simulations, by inducing bond traders to
revise inflation forecasts.
2.




Both sets of simulations reveal the temptation to policy makers
to increase GNP growth by increasing growth of the money stock.
The higher rates of monetary expansion would result in higher

Claremont Men's College

Memo to the Shadow Open Market Committee
for Meeting of September 12, 1975

4.

growth rates for both nominal and real GNP through 1976
than would the SOMC's 5,5% rate. The short-lag model (#1)
shows a bigger payoff than does the long-lag model. But
retribution comes sooner, too, because the inflation hits
bottom during '76 and is re-accelerating before the end of
the year. The long-lag model makes it look as though a
stimulative policy does not impose any inflation cost, but
that is because the re-acceleration of inflation would not
begin to appear until 1977. Less than one-fifth of the longrun effect of money growth on inflation is experienced during
the first year. Money growth exerts its strongest influence
on inflation after approximately two years, with full adjustment taking about five years.
3. The difficulty of adjusting for the distortions caused by the
price controls, as shown by the wide differences in the two
sets of simulations, illustrates the riskiness of activist
policies.

No one should be confident in predicting the effects

of a 10%-15% money growth to be followed by a deceleration some
time later.

I believe the inflation ris k/of such a policy is

greater than suggested by the long-lag simulations, although
probably not as great as suggested by the short-lag simulation.

AJMrr
9/10/75




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Income, Inflation, and Interest Rate Simulation Results (continued)

2.

4-6 Month
Commercial
Paper Rate
#1
#2

Yield on
Long AAA
Corporate
Bonds
#1
#2

0.1

5.5

5.4

8.7

8.4

3.5

0.5

5.6

5.5

8.7

8.4

5.2

7.0

3.9

5.1

5.6

8.4

8.3

2.9

5.2

8.4

7.6

5.8

5.7

8.4

8.1

14.9

4.4

5.0

8.5

9.8

7.3

5.5

8.5

8.0

16.6

12.1

6.1

5.1

9.4

7.0

8.5

5.6

8.7

8.1

3

5.1

4.9

4.0

4.8

1.1

0.1

5.5

5.4

8.7

8.4

4

10.6

8.2

4.6

4.6

6.0

3.6

5.9

5.5

8.7

8.4

1

15.0

12.8

3.5

5.2

11.5

7.6

6.2

5.6

8.5

8.1

2

18.0

17.7

4.6

5.4

13.4

12.3

7.9

5.6

8.6

7.9

3

21.6

20.4

7.3

5.4

13.3

15.0

10.5

5.2

8.9

7.9

4

23.7

17.8

10.4

5.7

13.4

12.1

13.0

5.1

9.5

8.2

A GNP
% Annual
Rate
#1
#2

Inflation
Rate
(Deflator)
#1
#2

A Real GNP
% Annual
Rate
#1
#2

3

5.1

4.9

4.0

4.8

1.1

4

8.0

6.0

4.5

4.6

1

9.8

9.0

2.8

2

11.3

12.8

3

13.0

4

Assumption 3
Steady 10%
Mn growth

Assumption 5
Steady 15%
M-i growth




3.

FEDERAL EXPENDITURE ASSUMPTIONS

H E F E

% Annual Rate of Chanqe in H E F E

1975: III

340.7

- 5.552

IV

349.0

10.107

I

355.4

7.539

II

363.5

9.433

III

379.9

19.305

IV

397.0

19.305

1976:




Comments on the Rate of Inflation and the Real
Rate of Interest from 1961 to 1975
by Allan H. Meltzer

The relation between inflation and the growth of money is a central issue
in current policy discussions.

Some economists argue that a high rate of

monetary expansion now -- to to 15% — will have very little effect on
the price level because there is unemployment.
The table shows that for the past fifteen years the average rate of
monetary growth has provided an accurate forecast of the rate of inflation
in the following year.

The relation held during the recovery from 1961 to

1963, during the rising inflation from 1965 to 1971 and during the decline
in inflation in 1971 and 1972.
[Insert Table 1 about here]
Column (1) shows the average rate of monetary growth for the three
preceding years. (The 1961 growth rate is the average for 1958-60),
Column (2) shows the rate of change of the deflator for private
product.
Column (3) is the "anticipated rate of price change" computed by
subtracting 1% from column (1), and Column (4) shows the error made predicting
the current rate of price change, column (2), from the "anticipated rate of
price change."

The only sizeable error is in 1974, a year of shortages

induced by past price controls, food price increases; oil price rise and
other well publicized events.
Column (6) shows the result of subtracting the "anticipated rate of
inflation" from the market rate of interest on new issues of corporate bonds.




Table 1

Current
Year

Average Percent
Rate of Change
of Money

Percentage
Rate of
, i
Price Change—

for three
/
a/
previous years —

(2)

Estimated
Rate of
Price Change
Col. (1)
less 1%

Difference
Col (2)-Col (3)

Interest
Rates on
New AA
Indust. /
Bonds -'

(3)

(4)

(5)

(6)
3.3
3.3
3.4

"Expected"
Real Rate
of Interest

0.9
1.0

1.0
0.8

- 0.1

1962

2.0
1.8

0.2

4.3
4.1

1963

1.7

1.1

0.7

0.4

4.1

1964

2.7

1.7

- 0.6

4.2

1965

3.2

1.1
1.5

2.2

- 0.7

4.4

2.5
2.2

1966

4.2

2.8

3.2

5.2

2.0

1967

3.8

1968

2.8
3.4
4.5
4.8

0.3
0.2
0

5.6
6.4
7.5
8.6

2.8
3.0
3.0

1970

4.4
5.5
5.8

2.9
3.7
4.7

0.4
0.1

1971

5.7

1972

1961

1969

4.8

3.8

4.7

- 0.4

7.5

2.8

5.2

4.3
3.2

4.2

- 1.0

7.2

3.0

1973

6.8

6.3

5.8

0.5

1.7

1974

6.6
6.0

13.2

5.6
5.0

7.6
1.8

7.5
8.8

1975
Source:
*




6.8

*

BCD, Salomon Brothers

2 quarters
a/ does not include current year
b/ deflator for private product
c/ from Salomon Bros. 1965-69 is utility average AA less 0.25

3.2

2

A crude measure of the effect of government debt finance on the real
rate of interest is obtained by comparing the average "real rate of interest"
in the five years of large new issues, 3.16%, with the rate in five years
of low new issues, 2.46%.
Real rates of interest depend on many factors other than debt finance,
so the differences should not be attributed solely to the effect of debt
finance.




BRIEFING FOR SHADOW OPEN MARKET
COMMITTEE MEETING, SEPTEMBER 12, 1975
FED FOREIGN EXCHANGE INTERVENTION:
SOME QUESTIONS
by Wilson E. Schmidt*
I.

Introduction

Following on several years of international monetary turbulence,
capped by a massive international financial crises, in March 1973 the
leading nations agreed to a system of generalized floating of exchange
rates.

Under the new system, these nations agreed not to fix the value

of their currencies in terms of the dollar.

In July 1973 the Fed began

to intervene in the New York foreign exchange market to affect exchange
rates.
Fed intervention has increased sharply since then.

From July 1973

through January 1974 the Fed's gross sales of foreign currency were $517
million.

In the succeeding six months gross sales rose slightly to $527

million.

By the end of the next six months, January 1975, gross sales

grew to $724 million.

And during the succeeding three months, February

through April 1975, gross sales had jumped to $793 million, more than
twice their previous annual rate.

^Professor and Head, Economics Department, Virginia Polytechnic Institute
and State University, Blacksburg, Virginia. Deputy Assistant Secretary
of the U. S. Treasury, 1970-72.




2

The Executive Vice President of the New York Fed, Mr. Alan Holmes,
recently stated the purpose of Fed intervention:

"As far as inter-

vention policy is concerned, our current approach is to intervene solely
to maintain orderly markets and not to achieve or maintain any particular
rate,"

(June, 1975) This is quite different from Fed intervention prior

to August 15, 1971

(when the tie to gold was dropped) because that inter-

vention was chiefly designed to give foreign central banks a guarantee on
the value of the dollars they held in order to ward off their requests for
our gold.
Mr. Holmes goes on to offer one justification for intervention:
There are too many occasions in the foreign
exchange market where purely transitory events—
the bunching of exchange orders, the misinterpretation of a current news item--can cause
disproportionate movements in the exchange rate,
particularly if markets are thin or if market
participants are uncertain about national policies as to exchange rates. Such movements
are in no sense fundamental, but they can
cause a great deal of trouble if they tendas they often do--to generate other speculative
movements of the band wagon variety.
And Mr. Holmes clarifies the concept of disorderly markets and
what the Fed seeks to accomplish:




Early this year, in January and February, our
activity was all one way as we sold foreign exchange to cushion in some degree a sharp decline
in the dollar rate. At that time, as now, most
commercial and central bankers felt that the
dollar was undervalued—a view that I and my
colleagues share. But other adverse factors, real
or imagined, were enough to push the dollar down.
Our intervention helped the market find its own
footing so that reasonably good two-way trading
could resume. Since that time our market activity

3

has become more even-handed with market purchases
and sales of foreign exchange about balancing
out. While there have been occasions when sharp
temporary rate declines necessitated support
operations to maintain orderly markets, these operations were reversed at times when the dollar was
strong, providing us foreign exchange to cut back
our swap debt. While our net market purchases of
exchange in the past three months were about even,
we were able to repay swaps in a substantial amount
through foreign exchange operations with our central
bank correspondents.
II.

The Mechanics

The mechanics of Fed intervention are simple.

When the Fed wants

to intervene, say selling German marks in order to strengthen the
dollar, the New York Fed instructs one or more commercial banks to sell
a given amount of marks for it. The commercial bank may call one or
more of several brokers to place the offer; the broker then searches the
market for a willing partner to the deal.
directly with commercial banks overseas.

Or the commercial bank may deal
So far, since the float, all

the deals have been in the spot market, none in the forwards.
The New York Fed appears to have some autonomy in its interventions--

1
The commercial bank that serves as the agent has to pay the Fed in Fed funds
while the buyer pays the agent bank clearing house funds which in turn
become Fed funds a day later. The extra cost, namely one day's interest
on Fed funds is compensated in the rate of exchange charged to the Fed.




4

how much has never been told.

There is a daily, frequent telephone contact

among the New York Fed, the Board of Governors, and the Treasury.

In

fact, the New York Fed seeks to contact the other two prior to any intervention.

This occasionally introduces some lags

into the system when the

appropriate officials cannot be reached.
The Fed has two sources for foreign currencies. One is its own relatively small holdings, which have ranged from a high of $220 million to a low
of $1 million in dollar equivalent since July 1973. The second, much
larger, is a system of borrowing arrangements with foreign central banks
(called swap agreements) which in principle could permit it to obtain up
to $20 billion equivalent in foreign currencies for a period of three months.
The funds can in principle be rolled over, though the general directive
covering Fed intervention obviously seeks to limit the total length of
borrowing to twelve months.
The Fed can choose among a variety of methods or styles of intervention.

Because of the Fed's potentially large resources under the swap

agreements, a major factor determining the effect of Fed intervention is
whether and how well it is known that the Fed is intervening.
The styles range from the highly public intervention, announced by
a statement by the Chairman of the Board of Governors and/or the
Secretary of the Treasury to highly secret interventions.

Between these

extremes, the Fad las some options.
2
Intervention takes place under a directive dated January 1, 1973 which sets
out very general guidelines for intervention policy. It is published in
the Annual Report o ? the Board of Governors. It is now being revised.




5

Though the commercial banks are pledged to secrecy when dealing
on behalf of the NY Fed, the Fed may instruct the commercial bank to
undertake the operations in such a manner as to make it fairly clear
that the Fed is in the market.

This would be the case if the bank

were to spread the Fed's offers among a number of brokers in the same
amounts at the same quotes, so to speak, all over the street.

If foreign

exchange dealers see offers in round amounts of say 5-10 million marks
at repeated rates, they smell the Fed.
can cover its tracks.

By changing its rates, the Fed

On the other hand, it can caution the bank to do

the job very q u i e t s in which case the commercial bank might spread
the funds all over the world through its branches and correspondents.
Although the NY Fed appears to rotate its intervention business
among leading banks, presumably to avoid charges of favoritism, it can
fine tune the degree to which its presence is known by picking a bank
that it is known not to deal in large amounts normally in that currency
it is offering.

Alternatively, if it wants to keep it secret, it can

pick a bank that is known to deal in that currency actively.
Another factor, which again is a question of style, is whether the
Fed instructs the commercial bank to move aggressively—as telling the
commercial bank to hit every bid in the market—in which case it clearly
has tremendous power to affect the market while it is in.
it can tell the commercial bank to hit at a certain level.

Less boldly,
Finally,

it may simply tell it to sell on offer when the rate reaches a certain
point.




6

The very public approach is easy to understand.
the Fed is relying on the announcement effect.
work on occasion.

In this approach

This obviously does

For example, on May 14, 1974 it was let known that the

U.S., Germany, and Switzerland had agreed on concerted foreign exchange
operations.

By the following day, in the

,,

scramble,,--to use the Fed's

word—the mark and the Swiss franc fell 4-1/2% in respect to the dollar.
But why would the Fed want to use the secret approach?

It makes

sense if the Fed wants to invest relatively little money in an operation
and let the market believe that private market forces are driving the
rate one way or another.

Putting it another way, it the market knew it

was the Fed that was offering the small amounts, the market would not
regard the Fed as being serious in its efforts to affect the rate.

(This

does not mean that small offers are of no consequence because some of
the Fed's intervention is probably done to get the feel of the market.)
To put the explanation for secrecy or some degree of uncertainty
still another way, if the Fed becomes the dominant factor in the market
it runs the risk of having its hand called.
would determine rates.

As the dominant factor it

If the market believes the Fed is holding the

rate at a level that the market does not believe is right, the market
will take all the foreign exchange the Fed has to offer, believing that
when the Fed pulls out, the rate will change sharply, providing a handsome profit.




Foreign exchange traders with whom I talked believe that it is

7

very difficult for the Fed to hide its presence.

Certain patterns in

the quotes from brokers, such as the same quotations from several brokers
for fairly large amounts and the repetition of the same quotes, reveal
the presence of the Fed.

Some traders call the commercial bank they

suspect of intervening for the Fed and ask if they are; the tone of the
response conveys the answer even if the words do not.
Fed itself with the same results.

Others call the

But that leaves the quantities uncertain

and these are important.
Another important factor in determining the effect of Fed intervention is whether it occurs in the morning or in the afternoon.

In

the morning both the foreign exchange markets in Europe (in its afternoon)
and in New York are open—providing a very broad market.

Whereas in

the afternoon, Europe is closed and the entire market is thinner.

Thus

a given amount of Fed intervention will have a much stronger effect on
rates in the afternoon than in the morning.

The European market will

normally open the next morning at the New York closing rate.
Still another factor is how the market perceives the intervention,
which seems in part at least to be a function of the amounts the Fed is
offering as well as its persistence in the market.
be piddling sums will be disregarded.

What are thought to

If, after a small intervention, the

Fed backs away from the market, the market pays it no heed.

It is

difficult to nail down what the market perceives as small because that
in turn is complicated by the nature of the market at a particular
time.




(In a normal market, that is one undisturbed by official

8

announcements, not a Friday or a holiday, according to one trader 250
million German marks would be big, 50 million would be small.)
What is important here are the traders1 judgments as to whether
or not the Fed is right.

If a trader thinks the market is long in

dollars, he is apt to assume that foreign currency sales by the Fed
will have no effect.
From talks with traders, it is clear that there is no automatic
presumption that the Fed (or any other central bank) is right in
predicting its ability to slow or speed the movements of rates.

When

a trader senses that the Fed is in, he quickly evaluates the situation,
perhaps widening his spread to protect himself while analyzing the
market.

He may decide to help the Fed by doing what it wants in his

own interest or he may do the reverse, in effect trying to make money
off the Fed. This includes the commercial bank selected to serve as
the agent of the Fed who is in the best position to evaluate the effectiveness of the Fed action.

Even so, while the agent banks know the

Fed is in the market and while the non-agent trader may be pretty sure
the Fed is in, neither he nor the agent bank can know for sure how
much it is in for.

(The Fed feeds out foreign exchange sometimes in a

sequence of deals and through several banks and even the agent trader
will have a difficult time guessing how far the Fed will go on any
sequence or at one time.)
Finally, it may be noted that the Fed has been quite selective in
the currencies in which it deals.




It has dealt primarily in German

9

marks.

While it has dealt also in Dutch guilders, Swiss francs and

Belgian francs, these have been in smaller amounts.
III.

Some Questions

Fed intervention in the foreign exchange market raises some
interesting questions.

What is the impact on the domestic economy?

What is the Fed trying to accomplish?

Does it actually change rates?

If so, should there be rules governing its intervention?
A.

Domestic Monetary Impact
When the Fed sells foreign currency, it absorbs bank reserves

just as when it sells U.S. Government securities.

Hence, there always

is a potential impact on the U.S. stock of money.

But several things

should be said about this.
First, the amount of intervention is small compared with other
Fed operations affecting bank reserves.

For example, gross outright

purchases by the Fed of U.S. Government securities averaged well over
$1 billion per month from July 1973 through April 1975 while gross
sales of foreign exchange averaged over $100 million.
Second, the Fed, in determining its open market operations, throws
its interventions in with all the other factors affecting reserves.
Thus, the intervention transactions get lost in the formulation of
policy.

Unless th? Fed wants to take account of international events

and transactions in the formulation of its open market operations,




10

an intervention operation does not have any direct impact on the amounts
of reserves it supplies.
Third, however, intervention can have an indirect effect when the
Fed is focusing on interest rates as its target for monetary policy.
To understand this point, one must know that when the Fed draws German
marks under a swap agreement, it credits the account of the German
central bank with dollars and receives a credit of marks on the books
of the German central bank.

When the Fed sells the marks, the effect

is to reduce American bank reserves as a U.S. bank pays for the marks.
When those marks are paid, they will be transferred from the German
central bank to the commercial bank in Germany of the recipient of those
marks.

The latter raises German commercial bank reserves.

If we suppose that both central banks offset, through open market
operations, the effects of these transfers, then the Fed buys U.S.
Government securities to offset its sales of marks while the German
central bank sells government securities to offset the transfer of
marks to the German commercial bank.

As a consequence, bank reserves

and the money supply in each country remains unchanged.
The net effect is that the U.S. public has fewer U.S. government
securities and the German public has more German government securities.
As a consequence, with no change in the money supply in either country,
interest rates will tend to fall in the United States and tend to rise
in Germany.

To the extent that the Fed hones in on interest rates to

determine its policies, the decline in interest rates will signal to




11

it a smaller need for reserves and the Fed will cut down its effort
to supply reserves.

Under these circumstances, sales of marks would

contract the money supply indirectly.
This indirect effect would never, however, get started if swift
movements of private capital among markets here and abroad would prevent
the incipient interest rate changes from occurring which would lead the
Fed to misread the situation.

If securities in different markets are

perfect substitutes for one another, such swift movements will occur.
But with floating rates and the ever present possibility of increased
exchange controls securities are not likely to be perfect substitutes, and
thus the point should be watched for by the Fed.
Fourth, having said all this, it does not seem likely that over the
long pull foreign exchange intervention, as long as it merely substitutes
for domestic open market operations, that is, if it is undertaken entirely
within a target for monetary growth, has any different impact than domestic
open market operations.

Thus, the sale of dollar securities by the Fed

tends to tighten interest rates here and reduce the growth of the money
stock, which will bring in foreign capital which has the effect of
appreciating the dollar.

Similarly, the sale of marks by the Fed tends

to cause an appreciation of the dollar while reducing the growth of

Even if securities are perfect substitutes, the sale of marks by the
Fed will raise the dollar value of the mark, and Americans will enjoy
an increase in their mark denominated wealth. The rise in their wealth
will increase their demand for both foreign and domestic securities as
well as for money which also may shift interest rates.




12

the stock of money here and tightening interest rates.

In the longer

run, the price level in the United States will conform to whatever
stock of money prevails. The exchange rate will conform to that price
level.

As long as either domestic open market operations or foreign

exchange intervention have the same effects on the stock of money, as
would be the case if they occur within the framework of a given
monetary target, the price level and the exchange rate will not tend
to differ from what they otherwise would be no matter whether domestic
or foreign exchange operations are employed.
B. What Are Disorderly Markets?
This question goes to the very core of intervention policy.
At minimum, the notion of a disorderly market is one in which there
are abrupt changes in rates, where the market is only one way (supply
or demand but not both), and that there are quotes without business
being transacted.

This suggests a very short run phenomenon, prevail-

ing for minutes and intermittently over several hours and, at most, days.
I found no agreement among traders on the degree of abruptness
in changes in rates which is required to constitute a disorderly market.
Nor is there agreement that the concept is limited to the very
short run.

Some private traders conceive of it as wide swings in rates

over several months. Others see it as something that is very short
term.
It seems quite clear from the statement of Mr. Alan Holmes,
quoted earlier, that the Fed sees the concept in terms of months as




13

well as minutes.
banks agree.

And in this respect it appears that other central

For example, the German central bank explains its policy

as follows:
In its intervention policy the Bundesbank's guiding
principle is that interventions should be made only
for the purpose of maintaining "orderly market
conditions", and that fundamental trends in the
markets should not (and cannot) be counteracted. However, interventions have not only served to maintain
orderly market conditions and avoid hectic exchange
rate fluctuations from day to day. Rather, the attempt
has been made to moderate excessive fluctuations in
the Deutsche Mark rate vis-a-vis the U.S. dollar
over extended periods of time. This has been done not
least also in the interest, and with the full consent,
of the other members of the European currency bloc.
There may be still another concept.

In reading Fed reports on

intervention it is obvious that the Fed thinks it is more important
to tell the public when it sells foreign currencies than when it buys,
since the sales of foreign currencies are far easier to pinpoint in
time than the repurchases.

One wonders if the repurchases of foreign

currencies are not made in smaller amounts and spread over a longer
period of time than the sales so as to have less effect on the market.
Though the evidence is slim, one wonders if the Fed may perceive
purchases as being different from sale in respect to intervention,
i.e., that one is intervention and the other is not.

If so, perhaps

there is a third concept, namely that disorderly markets exist when
the Fed thinks the dollar needs support.




Obviously, there are rather significant differences among these

14

three concepts of disorderly markets in terms of whether or not intervention is designed to buck the trend.

It is by no means clear which

of the concepts prevail.
C. Are There Perverse Effects?
However defined, one cannot take it for granted that Fed intervention reduces disorderly markets.

The reason is that there is the

possibility of some perverse effects.
The foreign exchange market is often full of rumors, including
rumors of Fed intervention when it in fact is not intervening.

One

foreign exchange dealer reported that on numerous occasions other
dealers told him that he was intervening for the Fed when in fact he
was not.

The Reuters ticker, a major source of information in trading

rooms, often reports the rumors.
market disorderly.

Obviously, these rumors can make the

Unfortunately, there is no way to tell whether the

orderliness achieved by Fed intervention is larger or smaller than the
disorder!iness created by the rumors of intervention.
Still another perverse effect may occur when the Fed pulls out
of the market.

Once the Fed stops selling foreign exchange, for example,

those holding dollars may panic, fearing that their existing holdings
of dollars will fall in value, and therefore will sell them, driving the
price

down.

This, say the traders, does happen.

The same phenomenon

has been observed in the government securities market.




Still another problem may arise because under the swap arrangements

15

the Fed ultimately must repay the foreign exchange it borrows. In
principle, the sale of marks today by the Fed should cause the value of
the dollar in terms of marks in the forward market to fall because
the market knows the Fed has to repurchase the marks sometime in the
future.

But since the market does not know when the repurchase will

occur, it adds to the uncertainty about forward rates.
Finally, there can be some confusion over whether the Fed is intervening when it undertakes transactions for its customers such as
foreign central banks or the U.S. Government.
Whether the perverse effects outweigh the reverse effects is
extremely difficult to analyze. After experimenting with several
techniques of analysis, it is apparent that there is not enough public
information on the timing of Fed intervention and that of other central
banks to draw strong conclusions.

During the first two years of the

f^ibt, foreign exchange markets appear to have followed a random walk
with no tendency, as compared with chance, towards runs or bandwagons
in one direction or another.

But since the exchange rates have through-

out the period been influenced by central banks it is not possible to
conclude whether this result has been helped or hindered by intervention.
D.

Rules for Management?
Recently efforts have been made to set down some rules for central

bank intervention.

These rules would call for intervention when reserves,

exchange rates, or measure of the balance of payments change by a certain
amount.




16

On reflection, it is clear that the effort to establish rules is
mistaken, both theoretically and as a practical matter.
The theoretical objection lies in the fact that the only justification for central bank intervention in the foreign exchange market
is that the central bank has better information than the market.
kind of information?

What

Information about the future. The past is known

to all. Since all of the proposed rules are tied to changes from the
past, they are embedded, one way or another, in the past.

Rules requir-

ing intervention prevent the central bank from using any inside information about the future it has such as that gained about the monthly
Bank for International Settlements meetings of the leading central banks
and morning telephone calls.
The practical objection is that no rule can be written which is
automatically consistent with the market place.

If the Fed is forced

to intervene or reverse its intervention at a certain time because of
a rule, that rule will become known through experience.

If the market

does not believe that its intervention (the rule) is correct, the
market will wipe the Fed out, buying all the foreign currency it sells
in anticipation of a subsequent rise in its value.

When the Fed

repurchases the foreign exchange at a higher price to repay its borrowing under the swaps, it will suffer losses which in turn will be borne
by the American taxpayer since virtually all of the profits of the Fed
are returned to the Treasury.




Few would condone, as our bicentennial

17

approaches, such taxation without representation for the benefit of
speculators.

The substantial losses in foreign exchange transactions reported by the
Fed for 1974 were, I believe, attributable to losses endured in repaying
swaps dated before August 15, 1971.




ECONOMIC OUTLOOK
(BILLIONS OF DOLLARS—SEASONALLY ADJUSTED ANNUAL RATES)
•0 ORECAST

CTUAL
75:1
CROSS NATL PRODUCT
%CH

AUGUi

75:2

75:3

'75:4

76:1

76:2

76:3

7677"

1416.6 1433.4 1470.0 1520.0 1571.0 1623.0 1670.0 1713.01
10.6
-3.9
14-3
4.3
13.9
12.1
12. 0 |
14.1

ANNUAL
1972

AN. N UAL

1973

ANNUAL
1974

ANNUAL
1975

197o

PRICE DEFLATOR
ZCH

1294.9
11.3

1337.4
7.3

1460-0
4.5

1645.5
12.7

862.0
5.5

792.5
6-2

839-2
5-9

821.2
-2.1

783 - 6

845. 3
5. b

1.8162 1.83^0 1.8630 1.3860 1.9100 1.9350 1.9640 1.9330
C I
5.0
8.5
5.3
5.6
5.9
5.2
6.0

CONSTANT DOLLAR GNP

1158.0
9.8

1.4610
3-4

1.5429
5-6

1.7024
10.3

l.cSlO

780.0
-11.4

775.4
-0.3

789.0
5.0

805.9
8-8

322.5
8.5

333..3
7.9

350.3
5.8

— <a •

O

Z' • 4

913.2
S.O

93S.I
11.4

952.0
10.6

987.0 1010.0 1025.5 1061.C 1037.5
9.7
10-3
1C.2
10.5
10-4

729- C
9-3

805-2
1C.4

87 5- 6
8.3

950- 1

DURABLES
%CK

124.9
14.7

130.0
17.4

126.0
19.8

142.0
18.8

147.0
14.8

152.5
15.8

158.C
15.2

162.51
11.9|

113*5
14.0

130.3
10.0

127.5
-2.1

« W ~ • ti,
0
*

15 5 - 0
16.2

NONDURABLES
ICH

393.8
7.4

408.5
10.1

416.0
7.5

425.0
8.9

435.0
9.7

445.0
S.5

455-0
9.2

465.Cj
9.1!

299.7
7.5

338.0
12-3

3 30. 2

412.1
*~6.4

45:.0
9.2

SERVICES
ICii

389.5
€.4

393-6
10.8

410.0
10.8

42C.0
10.1

428.0
7.8

448.0
9.4

450.0

9.7

310.9
3.2

336-9
8-4

"5 £ C, A
w w J • w

^.5

9.7

442-5
3.6

163-1
-53.2

147.3
-33.5

160.0
39.2

179.0
56.7

199.0
52.8

214.0
33.7

225.0
22.2

234.5:
18.0

179.4
16.7

209.3
16.7

203 . 5
CO

162-3

213-1
34-4

14-7.0
-10.7

14 4 . 6

144.0
-1.5

146.0
5.7

150.0
11.4

154-0
11.1

158.0
10.8

155.0
18-3

116-8
11-7

126.7
17„1

14S.2

145.4

—0 . •»

156-7
7. c

PRODUCERS DU3. EQUIP
ICli

94.2
-12.9

94.4
0.9

95.0
2.6

97.0
3.7

100.0
13.0

103-0
12.6

106.0
12.2

110.0
16.0

75.7
n •• J c
:

89.7
13.5

37.1
8.2

95.2
-2*0

104.7

S U S I N E S S STRUCTURES
ICE

52.8
-6.5

50.2
-18.3

49,0
-3.2

49-0
CO

50.0
8.4

51.0
8.2

52.0
3.1

55.0
25.2

41-1
8.4

47.0
14.3

52.1
10.7

50.3
-3.5

25.3
-41.7

1n *

12.1

40. 0
45.8

45.0
60.2

50.0
52.4

54.0
36.0

58.0
23.1

51.5
25.4

54.0
26-0

57.2
5.0

46-0
-13.7

39.2
-14.7

55.3
4^.o

-19.2

-33.7

-24.0

•12.0

-1.0

6.0

9.0

8.0

8.6

15.4

14-2

-22-2

5.5

8.8

9-2

5* 0

6.0

4.0

4.0

4.0

4.0

-6.0

3.9

2.2

7.5

4.C

331.6
9.9

338.8
9.C

342.0
3.8

343.0
7.2

358.0
12.0

370.0
14.1

380.0
11.3

332.0 |
12.2

255.7
9.1

276.4
8-1

303.2
11.9

340-1
ICO

375.0
10-2

126.5
6.2

128-6
6-8

128.0
-1.9

129.0
3.2.

133.0
13.0

138.0
15.9

142.0
12.1

147.0
14.8

104.9
7.3

105. 6
1.6

116.9
9-7

128.0
3.5

14 w . 0
'
9.4

85.0

35.0

87.0

89.0

91.0

93.0

74 . 8

73.7

S5.0

9C. 0

54.0

20.1

32.2

38-2

43-0

50-C

245.0
12.3 1

150.3
10.4

169.8
12.6

192.3
13.3

212-1
10.2

10. b

CONSUMPTION
%CK

£X?Z:<lDX7i:R2S

INVESTMENT EXPENDITURES
SCH
NONRES FIXED ZX?!::^
ICE

RESIDENTIAL

$?ZUCV^ZS

INVENTORY CHANCE
NET EXPORTS
GOVT PURCHASES
^CK
FEDERAL

fcCH

ft O \/ • W

MILITARY

84.7

OTHER

41.8

43.2

43.0

44.0

46.0

49.0

51.0

205.1
12-2

210.2
10.3

214.0
7.4

219.0
9.7

225.0
11.4

232.0
13.0

238.0
10-3

STATS & LOCAL


http://fraser.stlouisfed.org/
Federalv - ? • Bank of : « ; Louis C~2*;r:" a ? ANNUAL RATES: PRELIMINARY DATA FOR 7 5 : 2
Reserve r v ^ ^ ^ St. r : ?

u• 4

«• O ** w . O
"

1C.H

52.0
»*. z*

(3ILLI0NS OF DOLLARS—SEASONALLY ADJUSTED ANNUAL Ri
ACTUAL

FORECAST
ANNUAL
1975

ANNUAL
1976

75:1

75:2

75:3

75:4

76:1

75:2

76:3

76:4

1972

ANNUAL
1973

ANNUAL
1974

PRETAX PROFITS* & IVA I)
%CH

94.3
•30.8

92.0
•9.4

96.0
18.6

104.0
37.7

110.0
25.2

119.0
37.0

124*0
17.9

130.C
20.8

92.2
17.2

105.1
14.0

105.6
0.5

96.6
•8.6

120.7
25.0

INV VAL ADJ (IVA)

•7.0

•7.9

-5.0

-5.0

-10.0

-10.0

-10.0

-10.0

•7.0

•17.6

•35.1

•6.2

•10.0

PRETAX PROFITS 2)
iCK

101.2

99.9
•5.0

LC1.0
4.5

109. O
35.7

120.0
46.9

129.0
33.5

134.0
16-4

140.0
19-1

99.2
18.6

122.7
23.7

140.7
14.7

102.8
•27.0

130.7
27.2

TAX LIABILITY
%CK

39.0
•68.4

37.8
•12.1

38.2
4.5

41.2
35.7

45.4
46.9

48.9
33.5

50.1
16.4

52.9
19.1

41.6
10.7

49.8
19.9

55.7
11.8

39.0
-29. 9

4$. 4
2b. 6

AFTER TAX PROFITS*
tCH

62.3
•62.3

62.1
•1.0

62.8
4.5

67.8
35.7

74.6
46.9

80.2
23.5

83.3
16.4

87.1
19.1

57.6
25.1

72.9
26.5

85.0
16.6

62.8
•25.0

81.3
27. b

1193.4 1220.8 1245.0 1281.0 1318.0 1 3 5 5 . 0 1 3 9 4 . 0 1 4 3 5 . 0
2.2
9.5
8.2
12.1
12.1
11.7
12.0
12.3

944.9
9.4

1055.0
11.7

1150.5
9.1

1235.0
7.3

1375.5

205.4
11.1

142.4
21.1

151.3
6.3

170.3
12.9

168.5
•1.4

197.7
17.2

1015.5 1073.8 1070.3 1101.6 1127.8 1160.0 1193.9 1229.6
2.7
27.4
12.2
9.9
•3.1
11.9
12.2
12.5

802.5
7.5

903.7
12.6

979.7
8.4

1066.6
S-.9

1177.g
10.4

749.9
9.3

829.3
10.6

902.8
8.9

976.8
8.2

1077.1
10.3

112.9
38.2

52.6
•13.1

74.4
41.6

77.0
3.5

39.7
16.5

100.7
12-3

9.2

6.5

8.2

7.9

o*4

8.5

PERSONAL INCOME

%ca
TAX & NONTAX PAYMENT
%H
C
DISPOSABLE INCOME
%B
C

1">8.0
•0.2

142.0
^59.5

174.7
128.9

179.4
11.2

190.2
26.4

1S5.0
10.5

200.1
10.8

PERSONAL OUTLAYS

939.5
7.7

964.1
10.9

989.2 1014.6 1038.0 1063.9 1089.8 1116.7
10.7
10.8
9.5
10.4
10.1
10.2

PERSONAL SAVINGS

76.0
•40.4

114.7
418.8

81.1
•75.0

87.0
32.3

89.8
13.5

96.1
31.1

7.5

10.6

7.6

7.9

8.0

8.3

SAVING RATE(%)

104.1
38.9
8.7

EMPLOYMENT
%H
C

8 4 . 1 4 6 8 4 . 3 1 1 £ 5 . 3 0 0 8 5 . 7 0 0 8 6 . 4 0 0 87.200 88.000 89.000
3.3
4.8
•7.2
0.8
1.9
3.8
3.7
4.6

81.671
3.2

84.408
3.4

85.971
1.9

84.864
•1.3

87.650
3.3

LA3CR FORCE
%K
C

9 1 . 8 1 0 9 2 . 5 1 4 9 3 . 5 0 0 9 3 . 8 0 0 9 4 . 3 0 0 94.800 95.400 96.000
0.1
4.3
3.1
2.1
1.3
2.1
2.6
2.5

85.50S
2.8

88.711
2.5

91.073
2.7

92.906
2.0

95.125
2.4

8.3

8.9

8.8

8.6

8.4

8.0

7.8

7.3

5.6

4.9

5.6

S.7

7.9

PRODUCTIVITY*

9.270
•4.5

9.244
-1.1

9.250
0.3

9.404
6.8

9.520
5-0

9.614
4.0

9.663
2.0

$.686
1.0

9.702
2.9

9.942
2.5

9.552
•3.9

9.292
•2.7

9.620
3.5

INDUSTRIAL PRODUCTION
tCH

1.116
•28.3

1.098
-6.3

1.110
4.3

1.155
17.2

1.200
16.5

1.240
14.0

1.270
10.0

1.290
6.4

1-.151
7.9

1.254
9.0

1.243
•0.9

1.120
•9.9

1*250
11.6

MONEY SV2BL*

283.9
1.0

290.3
9.2

296.0
8.1

301.8
8.1

308.0
8.5

314.5
8.7

320.5
7.9

326.5
7.7

245.6
6.4

263.8
7.4

278.7
5.7

293.0
5.1

317.4
8.3

.989
•4.9

4.938
•4.0

4.966
2.3

5.026
5.8
•

5.101
5.2

5.211
5.161
4.8
3.9
•;.,.. -'.. >

5.262
4*0

4.715
3.1

4.909
.4.1

5.013
2.1

4.9S3
•0.6

5.183
4.0

UNEM PLO YMENT RATE {%)

iCK

M/t***

*§§£

INCOME VELOCITY OF MONEY
%K
C

i

.. «»

'NOTE: PRODUCTIVITY I S CALCULATED AS CONSTANT DOLLAR GNP Pi R WORKER;
1 PRETAX PROFITS MINUS INVENTORY ?^0?I7S
Digitized for "" ' '" mm «*"" a ^^~rv*My>nt»y<x. -TKCoUini^a.JLNJ^SffOSX. PJ&OFJTS
—* " FRASER


PROFITS F
<

75:2 ARE ESTIMATES

ECONOMIC OUTLOOK
ACTUAL

FORECAST

ANNUAL ANNUAL ANNUAL ANNUAL ANNUAL
1972
1973
1974
2975
1976

75:1

75:2

75:3

75:4

76:1

76:2

76:3

76:4

NEW ISSUES HI-GRADE CORP 30NDS

8-69

9.06

9.00

9.00

9.50

9.50

9.50

9.50

7.16

7.65

8.96

8-94

9.50

COMMERCIAL PAPER 4-6MTS.

5.56

5.92 ( ^ 0 X 8 . 5 0

9.00

9.50

9.50

9-50J

4.73

8.15

9.84

7.12

9.33

10.1

INTEREST RATES

AUTO SALES 1)

8.3

3.1

3.9

9.3

9.6

9.9

20.2

10.5!

10.9

11.5

9.0

8.7

DOMESTIC

6.6

6.4

7.2

7.5

7.7

S.C

8.2

8.4J

9.3

9.8

7.6

6.9 fc-. 1

IMPORTS

2.7

2.7

1.7

1.8

1.9

1.9

2.0

2.1

1.6

1.8

1.4

1.7

0.995

1.C60

1.500

1.600

1.700

1.750

1.7501

2.351

2.047

1.337

1.214

1.700

RECEIPTS

284.1

247.3 282.8 293.5 310.6 321.2 330.2

342.

227.2

252.5

291.1

275.9

326.1

EXPENDITURES

333.5

355.3

3S6.7J

244.7

264.2

299.2

355.2

384.3

DEFICIT (SURPLUS)

-54.4

-103.0

- 7 7 . 3 - 7 3 . 1 - 6 1 . 8 - 5 3 . 0 - 5 3 . 5 - 5 4 . s|

-17.5

-5.6

-S.l

-73.3

-5S.2

HOUSING STARTS l)

1.300

2.0

FEDERAL BUDGET (NIA) 2)

y

35G.6 3 6 6 . 6 3 7 2 . 4 3 7 9 . 2 3 3 3 . 7
3i

p IN BILLIONS C? DOLLARS—SEASONALLY ADJUSTED ANNUAL RATES




COMMENTS ON FUTURE FISCAL ACTIONS AND
BUDGET DEVELOPMENTS
Robert H. Rasche
Michigan State University
I have been asked to attempt to provide some information on
a number of issues with respect to the Federal Government Budget
over the next few years.

Specifically, 1) how soon will the bud-

get get near balance again (presuming no additional discretionary
fiscal policy actions, and what will it look like after that; 2)
what would it look like with another tax cut; 3) should there be
another tax cut; and 4) what resources will be absorbed when we
get back to full employment?
The Tax Reform Act of 1969 was once characterized as the tax
lawyers and accountants relief act of 1969.

It might be appropriate

to characterize the Congressional Budget Act of 1974 as the Soothsayers relief act of 1974. As a result of this act, OMB is required
to submit long range projections of Federal Outlays and Receipts
with the annual budget document.

In addition, the Congressional

Budget Office is mandated to provide similar projections. Although
this law does not require implementation until 1976, for the most
part the required information has been prepared for the current year.
In addition, the two Budget Committees have held hearings on the
fiscal 1976 budget during which a number of private forecasts have
been submitted for the record, though in these cases, the forecasting
2
periods have usually been only through fiscal 1976.
Rather than provide my own projections, which necessarily would
have to be prepared with considerably less labor input than most of




-2the rest, I have decided to compile and comment on various projections from these sources which seem appropriate in light of
the current economic situation and recent fiscal policy actions.
Table 1 presents the OMB projections through 1980 which were
incorporated in the fiscal 1976 budget document, and the revisions
which were announced in the 'Mid-session review of the Budget,' as
reported in the July, 1975, Survey of Current Business.

These pro-

jections, of course incorporate the President's fiscal and energy
policy proposals initially, with allowance for the deviations of
the Tax Reducation Act of 1975 from those proposals in the revisions.
In particular, they continue to incorporate the following fiscal
policy proposals which seem unrealistic as of this date:
1)

excise taxes of $2 per barrel on domestic oil and a tax
of .37 per thousand cubic feet of natural gas (estimated
revenue of 12.3 billion)

2)

energy tax offsets in the form of changes in the minimum
standard deduction and tax credits for energy-saving home
improvements (estimated revenue loss of 12.5 billion)

3)

energy equalization payments to State and Local governments and individuals with little or no tax liability
(estimated payments of 5.8 billion)

4)

a cut in the corporate income tax rate, effective September 1, 1975 from 48 to 42 percent (estimated revenue
loss of 3.1 billion)

5)

cost-of-living 'caps' of 5% on government wages and social
security payments (except for the increase in social security benefits of 8% which became effective June 1)

6)

expiration of the temporary provisions of the Tax Reduction
Act of 1975 as scheduled on December 31, 1975

If the 'Mid-session review of the Budget1estimates for fiscal 1976
are adjusted under the assumptions that

1-4 proposals

will not go through (and assuming that the revenue and payments
changes indicated are net, then receipts go up by 3.3 billion to




TABLE 1
President's Budget Proposals

(Jan. 1975 & mid year budget review)

\<\7&

i«m
k?

±^7?

I'm

1498

1686

1896

2123

2353

2606

794

832

879

936

997

1061

11.3

7.8

6.6

5.2

4.1

4.0

8.1

7.9

7.5

6.9

6.2

5.5

Federal outlays

313.4

349.4

393.1

425.4

451.9

476.7

Federal receipts

278.8

297.5

362.5

405.8

452.3

501.7

Surplus

-34.7

-51.9

-30.6

-19.6

.4

25.0

1474

1680

1892

2108

2335

2558

Change in CPI

9.1

7.1

5.3

4.4

4.0

4.0

Unemployment rate

8.7

7.9

7.2

6.5

5.8

5.1

358.9

398

432

458

483

299.0

364

412

457

505

j -59.9

-34

-20

-1

+ 22

GNP - current $
GNP - 58 dollars
change in CPI
(percent)
unemployment rate

(+)

GNP - current $

Federal Outlays

323.6

Federal Receipts

281.0

WW

1«!30

calendar years

fiscal years

calendar years

fiscal years

i

Surplus (+)
Source:

-42.6

The Budget of the U.S. Gov't:] Fiscal 19^6 pp 41,44. Survey ofc Current jusiness, June, 1975 pp 4-5




-3302.3 billion, and payments go down by 5.8 billion to 353.1 billion,
leaving a deficit of 50.8 billion dollars for fiscal 1976. Assumption
5 seems totally unrealistic at the present, particularly since the
Congress has already passed a pay increase for government employees
before recessing in August, which pays no attention to the idea that
there should be a five percent fcapf. Finally, most other forecasters are presently assuming that the temporary provisions of the
Tax Reduction Act of 1975 will be extended beyond the present December, 1975 cutoff, at least until December, 1976.

In light of

recently published comments of Rep. Ullman of the House Ways and
Means Committee, it seems likely that proposals for extensions of
this sort will at least be reported out of committee.4 These
temporary provisions are estimated to result in a revenue loss of
approximately 7.8 billion, which suggest that the estimates of
revenues for fiscal 1976 should be reduced accordingly by about 7.8
revenues for the transition quarter reduced by about 4.0 and revenues
for fiscal 1977 by 16 billion.

Ullman's recent comments also suggest

that the two year increase in the investment tax credit to 10% might
be extended for an additional year, through 1977, which would further
reduce fiscal 1977 and 1978 revenues below projections.
All budget projections, of course, are dependent on the assumed
path of the economy, as well as the path of the economy being dependent on the assumed fiscal and monetary actions. The February projections accompanying the budget are well known: very little progress
in slowing down inflation through at least calendar 1976, and a very
slow tapering off to 5.5 percent unemployment by 1980. This is in
part the result of the assumed effects of the energy taxes and decontrol of 'old1 oil and natural gas on both the price level and




TABLE 2
Congressional Budget Committees - Fast Alternative, April, 1975

i^7*r

1^6

437?

l^tTS

&m

43 So

1460

1642

1852

2092

2323

2558

GNP - 58$

793

835

892

960

I 1023

1085

Change in CPI
(percent)

8.7

7.0

5.8

5.2

1 4.4

4.0

Unemployment rate

8.4

7.6

6.7

6.0

!

Federal Outlays

354

396

426

Federal Receipts

288

356

413

Surplus (+)

-66

-40

-13

GNP - current $




j

|

5.5

\

4.9

450
I

1

472

464

518

+14

+46

i

1

;

•

\

}

j

I

I
i
i

j
1

-4employment.
Alternative projections of the state of the budget through 1980
are provided through the Congressional Budget Committees.

One of

these projections, the so called 'faster recovery' option is indicated
in Table 2. The 'faster recovery' option is documented in 1976 Budget:
Alternatives and Analysis, prepared early last Spring.

The starting

point for the estimates prepared for the Congressional Budget Committees is the so called current services budget which purports to
measure the outlays and revenues which could be expected to accure
under existing government programs and tax laws.

The faster recovery

alternative presented in Table 2 essentially takes the position of
the current services budget on the outlays side, namely, what will
be the cost of continuing all of the existing programs in the resulting economic environment.

The major differences from the

Presidents budget proposals here are the absence of the energy proposals and the caps on the cost of living provisions. On the revenue
side the faster recovery alternative starts with the then existing
tax law provisions and assumes that certain tax law changes will be
enacted.

In particular it assumes a 12 billion dollar rebate of 1974

taxes, by the end of fiscal 1975. This conforms very closely to the
actual aggregate rebate provisions of the Tax Reduction Act of 1975.
In addition, it assumes permanent tax reductions totalling 25 billion
dollars during fiscal 1976; a 20 billion dollar reduction in personal
income taxes, and 5 billion dollars per year reduction in taxes through
the adoption of the president's proposed increase in the investment
5
tax credit (to 12%), but permanently extended through fiscal 1980.
Under a continuing extension of the temporary provisions of the Tax
Reduction Act of 1975, the faster recovery alternative would not differ




-5much from the actual tax policy over the coming years.
The question is whether the projections are likely to be realized.
Clearly, this is unlikely, if the economic environment which is projected in the top part of Table 2 is not realized.

These kind of

projections cannot be attempted without specifying the course of
monetary policy as well as the fiscal proposals. Unfortunately,
the assumptions about the course of monetary policy are rather poorly
defined.

For example, consider the Economic Report of the President,

February, 1975:
Monetary policy faces great difficult in the year ahead and
will require careful and continuous evaluation by the Federal
Reserve. The uncertainities that underlie the outlook for
1975 add to the importance of a flexible monetary policy.
Monetary policy must be conducted so as to encourage a nearterm recovery in the economy and a resumption of sustainable
economic growth. Toward this end, a reasonable growth in
money and credit will be required — growth which, one hopes,
will encourage a freer flow of credit and lower interest rates
in private credit markets.
...rapid monetary growth would run the risk that inflationary
pressures would once again be increased, later on if not in
1975, undermining the Nation's fundamental need to regain the
basis for reasonable price stability.
1976 Budget; Alternatives and Analyses, is even more vague on the
assumptions regarding monetary policy over the next five years. It
states:
Federal Reserve actions also have a major impact on the economy
and can supplement, reinforce, or even thwart fiscal policies.
The economic projections in this report assume that the Federal
Reserve will accomodate to the fiscal policies that are postulated.
I can think up several ways in which to interpret this statement (the
only reference to monetary policy that I have been able to find in
the entire report), but the interpretation that I think is most
iikely to be correct, I find rather disturbing, namely, that the
Federal Reserve will maintain interest rates at some target level




-6regardless of the fiscal policy alternative considered, and regard=
less of the resulting course of monetary aggregates.

If accomodating

monetary policy usually means interest rate targets, interest rate
targets usually means low interest rate targets.
Suppose that we interpret 'accomodating monetary policy1 as
keeping interest rates constant over the five year projection period.
If such a policy were to be pursued, then I would expect that
velocity, say of M1 money, would remain approximately constant over
the period.

Thus, the rate of growth of M, which would appear to

me to be necessary to support the projections of this faster recovery alternative is in the neighborhood of the projected growth
in nominal GNP, namely in the ten to thirteen percent range. Personally, it seems highly improbable that increases in M , sustained
.
at rates in excess of ten percent per annum for a five year period,
are consistent with an inflation rate of the order of four percent
per annum at the end of the period, and with decreasing rates of
inflation throughout the period.
I think that one of two alternatives to the Congressional Budget committee projections is likely.

In the first alternative,

monetary policy will constrain the growth of aggregates to considerably lower rates that those which I judge to be implicit in the
'faster recovery alternative'.

Under such an outcome, the inflation

rates which are indicated in Table 2 may well be realized, but the
unemployment rates are likely to be higher and rate of growth of
real output is likely to be lower over the period from 1976 through
1980 than those indicated by the projections in Table 2. Also,
interest rates are likely to be higher, at least in the earlier
years of the projections, than the rates that would be realized under




-7my interpretation of Table 2. Under these conditions, I would expect that Federal outlays would be larger than indicated in Table 2,
because of increased payments out of income maintenance programs,
and increased debt service.

On the other hand, Federal Receipts

are likely to be less than projected in Table 2, because of the
lower levels of production.

Thus, under this alternative, I would

expect that Federal deficits in 1978-1980 would be larger than indicated in Table 2, and the return to a near balance in the budget
would be delayed until late in the decade when unemployment would
return to around the five percent level. This, of course, is conditional upon the assumptions about Federal expenditure programs
which are implicit in Table 2, and the assumption that no additional
tax reductions would be instituted to speed up the reduction in the
unemployment rate.
The second alternative to the Congressional Budget Committee
projections which I consider has a good deal of credence is that
something approximating the monetary policy that I have attributed
to the Table 2 projections will be realized.

In this case, I think

that we would see a lot more inflation in the last few years of the
decade than is indicated in Table 2, though the unemployment projections might well be realized.

With this alternative, the effect

on the Federal Budget would be likely to be just the reverse of that
under the first alternative that I have proposed.

With roughly the

same unemployment as indicated in Table 2, but with higher inflation
rates, both Federal outlays and receipts are likely to be larger
than indicated there, but since tax receipts tend to have a higher
elasticity with respect to the inflation rate than do outlays, it
is likely that the budget deficits would be smaller.




Consequently,

-8we might well see larger surpluses and a quicker return to near
balance in the higher inflation regime than that postulated for the
Budget committees.
All of this meandering through the wispish world of intermediaterun projections can be summarized as follows: 1) deficits which
are large by historical standards will be with us at least through
fiscal 1977; 2) what happens after that depends crucially on how
impatient policy makers become to reflate; 3) with a policy of
moderate monetary growth, it is likely that the Federal budget
would be on the surplus side by the end of the decade.
Turning to the second question which was posed at the beginning
of this paper, the question of what the budget would look like with
another tax cut has in some sense been preempted.

Another tax cut,

at the moment, presumably means making permanent something like the
temporary changes in the tax laws which were enacted in the Tax Reduction Act of 1975. The discussion centering on the projections
provided for the Congressional Budget Committees has presumed that
this kind of 'additional tax cut1 would in fact take place. Certainly at the moment it sounds like such an action is gaining favorable support in Congress; the administration for the moment seems
to be maintaining a position that these provisions should be allowed
to expire, if we can judge by the OMB assumptions associated with
the 'Mid-session Review of the Budget', but considering that we are
approaching an election year, resistance to such extensions by the
administration is likely to evaporate.

Finally, there is considerable

support from a wide spectrum of the economics profession that something needs to be done about the distortions which have been caused
in the tax structure by the inflation of the last decade.




Consider

-9for example the testimony of Professor Fellner before the Senate
o

Committee on the Budget:
The tax structure has become badly distorted as a result
of inflation. Tax-rate adjustments should take account
of the difference that has developed between the originally
intended and the actual rate of taxation in a world in
which the general price level has been rising rapidly.
Professor Hymans, in testifying before the House Budget Committee
states:
...I interpret the Ways and Means tax bill as really involving on the household side and eight-plus billiondollar permanent tax cut. That, given the rate of inflation, given the way households have moved up in the
tax brackets, as their incomes have become inflated
through tax increases, that is a pitifully small tax cut.
Ten years ago there was a lot of discussion about
fiscal drag. I think that is what we are in there now.
We have found, due to inflation, we have had a increase in
effective tax rates for individuals which has helped hold
down the real income after taxes, and the $8 billion
permanent tax status is pitifully small.
These statements are typical of many which have been voiced by
economists in recent months.

Consequently, I think that it is

likely that we will see some sort of 'permanent1 tax reduction
enacted in the coming months, and I am pursuaded by the arguments
that have been advanced that it is appropriate to design some
sort of tax reduction to offset the shifting of the effective
rates which has come about through the past inflation.
The final question on the intitial list is how much in resources
will be absorbed when the economy gets back to full employment.
This first requires some sort of statement on what is meant by
'full employment'.

For at least fifteen years there seems to

have been general acceptance of the proposition that maximum
employment means minimum unemployment; that is 4% unemployment.
This 'goal' has been achieved in only four of the past 22 years,




-101966-1969, years which are generally viewed in retrospect as a
period in which Federal fiscal and monetary policies were overly
stimulative with serious consequences which we are still living
with.

In spite of this, some would refuse to accept even 4% un-

employment as the minimum level of unemployment.

For example the

Joint Economic Committee, in its 1975 report of the House and
Senate Budget Committees states:
The use of this concept (Potential Gross National Product)
is not meant to imply that the Joint Economic Committee
regards a 4 percent unemployment rate as 'full employment'.
The Committee has long been on record in favor of ultimately
reducing the unemployment rate to 3 percent or less.
On the other hand, many opponents of the four percent full employment concept have suggested a higher unemployment level be accepted
as 'full employment1, something like five or five and one-half
percent.

Perhaps it is time that we started considering the idea

of 'maximum employment' proposed by the Employment Act of 1946 in
terms of the resources actually used rather than those which people
report as unused under unspecified market conditions.
Actually, there seems to be less to argue about than much of
the discussion would seem to suggest, at least in terms of the
level of Federal expenditures. Whether one assumes 4 or 5 percent
as unemployment rate which is to be associated with full employment,
if one accepts the maxim that at full employment the budget should
be balanced, or should run a small surplus, then with the kind of
tax reductions that are presently being contemplated, the Current
Services projection of expenditures comes close to hitting the target of exhausting revenues at 'full employment'.

Thus, within the

constraints specified, there would seem to be little room for new
program initiatives by the Federal Government.

The President's

budget, of course, does propose an increase in real terms in defense



-11spending.

The overall budget expenditures remain close to the

Current Services budget, in his proposals, because the increases
in the defense area are offset by cuts in the income maintenance
area.

If the President's proposals for allocating more of the

budget to defence are accepted by Congress, then by the end of
the decade the recent trend toward a reduction in the purchases
of goods and services by the Federal government may be reversed.
On the other hand, defense spending is not increased in real
terms, it is likely that by the end of the decade that Federal
purchases of goods and services, in real terms (i.e. resource
absorption) will be no larger, and perhaps somewhat smaller, than
it is today.




1976 Budget: Alternatives 8^ Analyses, Report to the Committees
on the Budget of the U.S. Congress, April 6, 1975
Fiscal Year 1976 Budget and the Economy, Hearings before the
Committee on the Budget, House of Representatives, Feb 20 Mar 10, 1975 The 1976 First Concurrent Resolution on the Budget,
Hearings before the Committee on the Budget, United State Senate,
Mar 4 - Mar 10, 1975
'Survey of Current Business, June, 1975, p 5
"House Tax Chief Urges Extension of Some Reductions", Wall Street
Journal, August 27, 1975, p 3
*1976 Budget: Alternatives &_ Analyses, p 25
'Economic Report of the President, February 1975, p 26
1976 Budget; Alternatives &_ Analyses, p 3
'The 1976 First Concurrent Resolution, p 498
Fiscal Year 1976 Budget and the Economy, p 25
For a discussion of indexing the tax system to prevent future
inflation from introducing similar distortions into the structure
see B.M. Blechman, et. al., Setting National Priorities: The 1976
Budget, Brookings Institution, pp 166-175
"1975 Report of the Joint Economic Committee to the Committee on
the Budget United States Senate, and Committee on the Budget,
United States House of Representatives, p 3. reprinted in The
1976 First Concurrent Resolution on the Budget, Hearings before
the Committee on the Budget, United States Senate, March 4-10, 1975







ADDENDUM TO SHADOW OPEN MARKET COMMITTEE
BRIEFING ON FISCAL POLICY
The Uselessness of Full Employment
Budget Concepts as Indicators
of Recent Changes in
Fiscal Policy and as
Forecasts of Future
Federal Expenditure Capacity

Robert H. Rasche
Michigan State University

September 11, 1975

Consider the hypothesis of a "real shock decline" in output, caused, for example by the increase in the relative price
of crude oil by the OPEC cartel. This could be interpreted as
causing a downward shift in the aggregate production function,
so that for every given level of employment, real output is lowered.

Depending on what you postulate about the nature of the

production function this could come about with reduced, unchanged,
or increased employment.

The domestic price level will rise.

If this is the case, then, "potential output" has suffered
a shock. Also "capacity".

Note that all these measures are

typically constructed by peak-to-peak interpolation and extrapolation; recently at around 4% per annum for "potential output"
by the CEA.
Under the "real shock decline" hypothesis then "true"
potential output at every level of employment (including that
associatedwith 4% unemployment) is lower then one would get with
a naive extrapolation from the pre October 1973 experience.
"Potential output" is crucial for the full employment budget
exercises (see N. Teeters, "Estimation of the Full Employment
Surplus," R.E. Stat, August, 1965, pp 309-321).

Before any

computations of full employment revenues can be computed, GNP
in nominal terms must be imputed.

This is usually done by

computing "potential output" in real terms by the extrapolation
method, and then multiplying by a price deflator

(even the most

avid proponents of full employment budget concepts acknowledge
that there are many problems associated with the "inflation"
of the real "potential output" figures - see Okun and Teeters,




-2Brookings Papers on Economic Activity, I, 1970.)
If the inflation is correctly guessed and applied to a
real potential output that is too high, then full employment
revenues will be over estimated, as wellas the full employment
surplus.
One conclusion from this is that when we get back to
around 5% (or4%) unemployment, even if Congress manages to stay
in the range of the Current Services Budget Expenditures, we may
find that we have considerably less surplus, than is cited by
the administration and Congressional extrapolations which I
cited in my prepared paper.
A second conclusion is that attempting to judge the stance
of fiscal policy over the 1973-75 period by the behavior of
the full employment surplus just doesn't make any sense.
If potential output has suffered a negative shock by the
OPEC action, then one cannot look at the full employment surplus
from 1973 to 1974, calculated on the usual extrapolation, and
say, that since the surplus has gone down, fiscal policy, has
been contractive.

(See B. Blechman, et.al., Setting National

Priorities: The 1976 Budget)

In doing so you would be looking

at the wrong numbers.
On the other hand, suppose that one had a revelation of the
true impact of the OPEC action on potential output so that one
could correctly start extrapolating from a new base in 1974. If
one recomputed the 1974 full employment surplus on this new
base, it would still not be correct to infer the behavior of discretionary fiscal policy from the change in the full employment
surplus from 1973 to 1974, as this change, by its construction
is a function of the external shock.



-3The above statements have been directed toward OPEC and
1973-74 for illustrative purposes.

Clearly crop failures be-

cause of whether conditions cause the same kinds of problems
for the full employment surplus concept.

The only difference

here is that an addition to the impact on the production function of the non-agricultural sector of the economy, there is
the obvious direct effect on the potential output of the agricultural sector.

Similarly, the changes in the full employment

surplus are potentially confounded by any major shift in the
terms of trade, such as that following the ungluing of Bretton
Woods in August 1971.
Nor are we over our measurement troubles with this concept.
Clearly the OPEC generated effects on "potential output" have
not fully percolated through the economy, if for no other reason
then we just threw out price controls on "old oil" two days ago.
If the oil companies are really rid of the inefficiencies imposed
by the FEA,

I would expect this to have an opposite (positive)

effect on "potential output".

Or the other hand, if OPEC pushes

through anotherprice increase this October we will go through
the negative effects all over again.
Finally, everything said about "potential poutput" here
can be applied to the "capacity utilization" figures commonly
cited.

Since these are similarly constructed from extrapolations

of past peak-to-peak trends, it is highly likely that they seriously underestimate the utilization rate of presently effective
industrial capacity.




Estimates of Potential Output Growth

Period

Annual Growth

EROP, Jan, 1963 p 42

55-62

3.5%

EROP, Jan, 1964, pp 37-38

55-63

3.5%

EROP, Jan, 1965 p 81

55-62IV
62IV -

3.5%
3.75%

EROP, Jan, 1968 p 61

62IV - 65IV
65IV - 67IV

3.75%
4.00%

EROP, Jan, 1969, p 65

65IV - 68IV

4.00%

EROP, Feb, 1970, p 85

65IV
69IV
70IV
71IV

4.00%
4.30%
4.40%
4.30%

EROP, Feb, 1975

71 - 74

Source

EROP = Economic Report of the President




-

69IV
70IV
71IV
75IV

4.00%

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