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SHADOW OPEN MARKET COMMITTEE Policy Statement and Position Papers September 13, 1976 1. Shadow Open Market Committee Policy Statement, September 13, 1976 2. Position Papers Monetary Policy, Inflation and Economic Expansion – Karl Brunner, University of Rochester Notes on GNP Forecase Procedure – Jerry L. Jordan, Pittsburgh National Bank Shadow Open Market Committee Meeting -- 9/13 – Jerry L. Jordan, Pittsburgh National Bank The State of the Float – Wilson E. Schmidt, Virginia Polytechnic Institute and State University Comments on Fiscal Policy Developments – Thomas Mayer, University of California Long Run Outlook and Quarterly Update – John Rutledge, Claremont Men’s College Draft: Policy Statement Shadow Open Market Committee September 13, 1976 Recovery and sustained expansion has been achieved with policies that gradually reduce inflation. At its meeting today, the Shadow Open Market Committee considered the current position of the economy and the near-term outlook. The Committee concluded that the policy of gradually reducing the growth rate of the money stock should be continued. rate of growth of money — A 4 per cent annual currency and demand deposits -- was recommended as appropriate policy for the next six monthse A 4 per cent rate of monetary growth would bring the stock of money to an average of $310 billion in the first quarter of 1977 and an average of $316 billion in the third quarter of 1977• Most importantly, 4 per cent monetary growth would move the rate of monetary expansion closer to the range that permits sustained economic expansion without inflation. The Recent Past and the Future Evidence of a reduced rate of economic expansion and a lower reported rate of inflation during recent weeks has revived discussion of the policy appropriate for the current state of the economy. Some urge greater stimulus to employment and production and less concern for inflation on grounds that the problem of inflation has been reduced and the problem of unemployment has become more severe than expected. Substantial progress toward higher employment and lower inflation was achieved in the past year by avoiding the type of policy that is again recommended. Tax reduction, gradual reduction in the growth of money and increased stability in government policy proved more powerful than many supposed. Continuation of these stabilizing policies will, we believe, move the economy toward a lower rate of inflation and a lower rate of unemployment in 1977. A year ago, recovery and reduced inflation seemed less certain. Many economists urged a return to highly^ expansive policies of the past. The Congressional Budget Office reported that, according to their projections, an 8.57o rate of monetary growth would produce 5-6% real expansion and about 7.5% inflation in 1976. They appeared to favor a 10% rate of monetary expansion to raise the growth rate of real output at a cost of more inflation. Others favored rates of monetary expansion as high as 15% in the belief that the recession was the most severe in decades so that rapid monetary expansion would draw unused resources into production without increasing the rate of inflation. A year ago, we called attention to a misinterpretation. Rational policy, we said, requires !la distinction between a decline attributable to real shocks and a decline attributable to cyclical forces.11 shocks reduce potential output and capacity. Real Ignoring the effect of real shocks "magnifies estimates of the gap to be eliminated by expansion and policies.11 We concluded, then, that a 5.57O rate of monetary expansion would be adequate to sustain recovery and reduce inflation. In March, we lowered the recommended rate of monetary expansion to 4.5%. In reaching our conclusions, we recognized that monetary policy can contribute to cyclical recovery but can do little to replace capacity lost in the shocks of recent years. The Federal Reserve has produced a rate of monetary growth that, though variable differs little on average from the path we recommended. Reduction in the rate of monetary policy is a main reason that we can look forward to continued moderate expansion and slower inflation. But to end inflation, monetary growth must be further reduced. The Congressional Budget Office projects a 5 to 6% rate of inflation in the early 1980fs« They foresee little further progress against infla- tion in this decade and rising inflation in the eighties. A 5 to 6% rate of inflation is not inevitable. Experiences in countries that reduced monetary growth shows that monetary policy can reduce inflation. The 4% rate of monetary growth that we recommend for next year will, if maintained, bring the rate of inflation below the projections of the Congressional Budget Office long before 1980. If the economy continues to expand at the moderate pace we now anticipate, further reductions in the rate of monetary growth can and should be achieved in 1977 and later years. Congressional Resolution 133 Since the spring of 1975 the Federal Reserve has reported to the Congress on the projected annual rate of monetary expansion. Concurrent Resolution 133 requires the reports expire with the present Congress. The reports are now widely discussed in the financial press and provide information useful for private planning. A principal benefit of resolution 133 is that the Federal Reserve has been encouraged to direct more attention to the longer-term consequences of its current operating targets. Mistakes that produced excessive or deficient monetary growth have, often, been corrected. Much of the progress toward higher employment and lower inflation results from the increased attention to longer-term consequences of current policy. We urge that resolution 133 be renewed and that the reports on monetary growth be made permanent. Alternative Scenarios for S.O.M.C. Meeting FIR3T HiiTIO!i;'lL CITV liflHK MflCRQ FORECAST 3 0URRTER3 1 976: 1 THROUGH I 977: 4 (IN BILUOMS OF *) HflV 8, 1976 5% *::*** HI VR 1976 **** H HI I'." 300,34 3 04.':.-3 "SO $.2? 3.00 :.*.. 00 5.00 I 297.20 RflTE 3.43 **** ''977 :**•** X II III IU 313.05 31 >.8 V ' 3 1 9 . 7 6 323 ..69 5.00 5.0i5.00 5.00 MOM GNP 1599.41 1626.74 1654.27 163'i. ^3 1717.86 1752.3 i 1787.15 VR RflTE 7,02 7.0 1 6.94 7.64 6.04 8 . 2.' 8.19 PRICE 131.32 VR RflTE 6.32 133.17. 5.73 134.89 15.25 136.45 4.7! 137.35 4.13 REfiL GHP1217.93 1221.52 1226.40 '1234.39 1246.13 VR- RflTE 0 . 6 9 • 1.17 1.61 2.30 3.71 LJHEMP1.0V 8.03 8.25 7 1/2% 3.44 8.53 140.23 3.39 141.3-+ 3-03 1259.5. H.J.: 1273.94 4.64 1239.64 5.02 3.6b 3.63 8.53 8.65 . *:•*:* I'll VR 139. 12 3.7'« I 297.20 RflTE 3.43 1976 *.*•:*+: II III IU 302.62 303.14 3)3.76 7.50 7.50 • 7.50 ' *.***.. '977 ' **.*.+: . I II III I" 319.4:5 3 2 5 . 3 1 331.25 337.29 7.50 7.5 1 .' 7.50 7.50 NQM GUP 1599.41 1 6 3 1 . 7 7 1 6 6 6 . 0 6 1 7 1 0 . 2 4 1 7 5 6 . 0 3 1 8 0 4 . 0 ' VR RflTE 7.0 2 8.34 9.20 10.51 11.15 i1.4': PRICE 131.32 VR RflTE 6.32 V.O ' 133.1-7 5.73 RERl. GHP1217.93 1225.30 VR RflTE 0.69 d.x\d UrUIMPUOV 3. 0 3 10% • Ml VR 1822.72 8.20 3.23 134.90 5.27 13-;.. 43 4.73 140.61 3.30 141.36 3.62 1 2 3 6 . 5 5 1253.10 1 2 7 3 . 0 8 1 2 9 5 . 0 ^ 1 3 1 7 . 4 9 3.73. '5.46 6.53 7. i 7.10 1340.23 7.03 8. 32 3.31 137.94 4.33 1 8 5 2 . 4 9 1901.30 11.17 10.v6 159.3i 4.O.; 3. 20 • 8. 0 2 . . • ' " 7.31 • . - . .7. 60 ' **** 1976 •:**** • ' ' *.*** 977 **:** I - II . . Ill • IU I II III ' • IU 297.20 304.36 311.70 319.22 326.91 334.80 342.87 351.14 RRTE 3. l O 1 0.0 0 1 0 . 00 10.0 0 !0.U 0 10.0 * • ! 0.0 0 ! 1 0.0 0 NOM 6NP 1599.41 1636.30 1681.84 1735.23 1794.08 1356.1-19!3.54 1931.14 VR RRTE 7.02 9.63 11.47 13.32 ' 14.27 14.5"' 14..14 ,13.70 PRICE 131.32 VR RflTE 6.32 133.17 5.73 134.90 5.30 136.51 4.36 133.02 4.49 139.4, • 'K2-. 140.92 4.22 142.39 • 4.21 <£ 4 REhL G iP 121?. *3 1 229.07 1 2H6. 70 1271 .11 1 299. 36 1 330 . 7 ; I 361.40 1 391 . 4 0 « % ^ r VR RflTE 0 . '69 3.69 5. $6 8. 07 9. 3 > « 9. o* ' 9.52 9*11 Ul U;MPLOV. . 8.03 8.21 8.20 " C, 0 4 7 . ?r5 7. 3 V •>. 9o 6. I>M (BILLIONS OF DOLI,ARS—£ EasoNfcEr,YWXSJU STED ANN UAL RATES) ACTUAL 75: 4 GROSS NATL PRODUCT %CH AUGUST 13,1976 FORECAST 76:1 76: 2 76:3 7 6; 4 77:1 77:2 77:3 77:4 ANNUAL 1973 ANNUAL 1974 ANNUAL 1975 ANNUAL 1S76 A:ISUA 1977 1538.2 1636.2 1673.0 1708.0 1748.0 1788.0 1825.0 1864.0 1903.0 10.6 12.6 9.7 9.3 8.6 8.6 8.8 9.5 8.5 1306.6 11.6 1413.2 8.2 1515.3 7.3 1691.3 11.5 1845.0 9.1 CONSTANT DOLLAR GNP %CH 1219.2 1246.3 1259.7 1272.2 1286.5 1301.5 1314.0 1327.6 1340.4 3.3 4.7 9.2 4.6 3.9 3.9 4.2 4.4 4.0 1235.0 5.5 1214.0 -1-7 1191.7 -1.3 1266.2 6.3 1320.9 4.3 PRICE DEFLATOR %CH 1.3027 1.3129 1.3281- 1.3426 1.3587 1.3738 1.3889 1.4040 1.4197 7.1 4.7 3.2 4.9 4.5 4.5 4.5 4.4 4.4 1.0579 5.8 1.1646 .1.2721 10.1 9.2 1.3356 1.3966 4.6 1012.0 1043.7 1064.5 1087.0 1113.? 1139.0 1162.5 1186.0 1209.C 8.7 10.4 13.1 10.1 9.5 8.5 8.-0 8.2 8.3 809.8 10.5 887.5 "9.6 973.2 9.7 1077.2 10.7 1174.1 9.0 CONSUMPTION EXPENDITURES %CH DURA3LES %CH 141.8 18.2 151.4 30.0 154.1 7.3 157.-0 7.7 163.0 168.0 16.2 • 12.8 173.0 12.4 177.0 9.6 181.0 9.4 123.7 11.2 " 121-6 .-1.7 131.7 8.3 156.4 18.7 1-74.7 11.8 N0NDURA3LES %CH 421.6 6.9 429.1 7.3 434.8 5.4 444.0 8.7 453.5 • 463.0 8.8 8.6 471.0 7.1 480.0 7.9 489.0 7.7 .333.8 11.5 376.2 12.7 409.1 8.7 440.3 7..6 475.7 8.0 SERVICES %CH 448.6 11.4 463.2 13.7 475.6 11.1 486.0 9.0 497.0 9.4 508.0 9.2 518.5 8.5 529.0 8.3 539.0 7.8 352.3 9.3 389.6 10.6 432.4 11.0 480.4 11.1 523.6 9.0 201.4 9.9 229.5 68.6 23*5.2 12.2 246.0 17.7 252.0 10.1 262.0 16.8 272.0 16.2 282.0 15.5 291.0 13.4 220.0 16.9 214.9 -2.3 183.7 -14.5 24C.9 31.1 276-7 14.9 148.7 7.3 153.4 13.3 158.4 13.7 163.0 •167.0 10.2 12.1 172.5 13.8 178.0 183.0 13.4 " 11.7 188.0 11.4 136.0 16.4 149.2 9.7 147.2 -1.4 160.4 9.0 160.4 12.4 PRODUCERS DUR EQUIP 96.6 10.1 1-00.2 15,8 103.1 12.1 107.0 16.0 110.0 11.7 113.5 13.3 117.5 14.9 121.0 12.5 124.0 10.3 87.0 17.0 95.1 9.4 95.1 -0.0 105.1 10.5 11^.0 13.3 BUSINESS STRUCTURES %CH 52.1 2.3 53.2 8.7 55.3 16.7 56.0 5.2 "57.0 7.3 59.0 14.8 60.5 10.6 62.0 10.3 64.0 13.5 49.0 15.3 54.1 10.4 52.0 -3.8 55.4 6.4 61.4 10.8 RESIDENTIAL STRUCTURES %CH 57.0 37.9 61.3 33.8 64.5 22.6 69.0 31.0 74.5 35.9 80.0 33.0 84.0 21.6 86.0 9.9 88.0 9.6 66.1 6.6 55.1 -16.7 ' 51.2 -7.0 67.3 31.5 84.5 25.5 INVENTORY CHANGE -4.3 14.8 13.3 14.0 10.5 9.5 10.0 13.0 15-0 17.9 10.7 -14.6 13.2 11.9 21.0 8.4 9.1 5.0 4.0 .3.0 0.5 0.0 0.0 7.2 7.5 20.5 6.6 0.9 353.7 12.8 354.6 1.0 363.1 9.9 370.0 7.8 378.5 9.5 384.0 5-9 390.0 6.4 396.0 6.3 403.0 7.3 269.5 6.5 303.3 12.5 339.0 11.8 3 65.6 8.1 393.2 7.3 130.3 19.6 129.1 -3.6 132.3 10.3 135.5 10.0 140.0 14.0 142.0 5.8 144.0 5.8 146.0 5.7 149.0 8.5 102.2 0.0 111.7 9.3 124.4 11.4 134.2 7.9 145.2 8.2 MILITARY 87.1 86.2 88.4 89.5 92.5 94.0 95.0 96.0 98.0 73.5 77.3 84.3 89.2 95.7 OTHER 43.2 42.9 43.9 46.0 47.5 48.0 49.0 50.0 51.C 28.7 34.4 40.1 45.1 49.5 223.4 9.1 225.5 3.8 230.8, 234.5 9.7 6.6 238.5 7.0 242.0 6.0 246.0 6.8 250.0 6.7 254.0 6.6 167.3 10.8 191.6 14.5 214.5 12.0 232.3 8.3 243.0 INVrST»vIE^T EXPENDITURES NONRES FIXED EXPEND %CH NET EXPORTS GOVT PURCHASES %CH FEDERAL %CH STATE & LOCAL • %CH NOTE: PERCENTAGE CHANGES AT ANNUAL RATES; PRELIMINARY DATA FOR 76:2 6.7 ECONOMIC OUTLOOK (BILLIONS OF DOLLARS—SEASONALLY ADJUSTED ANNUAL RATES) ACTUAL PAGE 2 FORECAST ANNUAL 1973 ANNUAL 1974 ANNUAL 1975 ANNUAL 1976 ANNUAL 1977 171.5 7.3 115-8 20.4 127.6 10.2 114.5 -10.2 147.9 29.1 166.2 12.4 73.3 10.1 74.6 7.3 48.7 17.3 52.4 7.6 49.3 -6.1 64.4 30.7 72.3 12.4 95.2 10.1 96.9 7.3 67.1 22.8 75.2 12.1 65.3 -13.1 83.6 28.0 93.9 12.4 AFT. TAX PROF- ADJ. 1)48.300 53.700 52.664 53.968 57.357 60'. 183 61.442 62.702 63.397 8.6 . 8.5 4.5 27.6 • 21.2 -7.5 10.3 -16.3 52.8 %CH 50.400 -0.2 32.425 -35.7 42.375 30.7 54.422 23.4 61.931 13.3 1299.7 1331.3 1361.4 1388.0 1423.0 1456.0 1486.0 1517.0 1548.0 10.1 10.5 9.6 8.5 8.4 9.4 8.0 8.6 11.3 1052.5 11.7 1153.3 9.6 1249.7 8.4 1375.9 10.1 1501.7 9.1 226.9 11.7 150.3 6.8 170.4 13.0 168.8 -0.9 192.6 14.1 217.7 13.0 1119.9 1147.6 1171.8 1193.1 1221.1 1247.5 1271.5 1296.3 1321-1 8.7 . 9.7 7.9 7.9 8-9 8.0 7.5 10.8 10.3 901.6 12.5 982.9 9.0 1030.3 10.0 1183.4 9.5 1284.1 3.5 1036.2 1063.1 1080.2 1112.2 1139.1 1165.0 1188.9 1212.8 1236.2 8.7 7.9 10.0 9.4 8.5 8.3 8.1 10.3 12.9 831.3 10.6 910.7 9.6 996.8 9.5 1102.2 10.6 1200.7 3.9 75:4 76:1 76:2 76:3 131.3 14.6 141.1 33.4 145.6 13.4 149.5 11.2 TAX LIABILITY %CH 57.2 18.7 61.4 32.8 63.3 13.2 AFTER TAX PROFITS %CH 74.1 11.6 79.7 33.8 32.3 13.5 PRETAX PROFITS* %CH PERSONAL INCOME %CH TAX & NONTAX PAYMENT %CH DISPOSABLE INCOME %CH PERSONAL OUTLAYS %CH 17 9.5 14.0 183.8 9.2 189.6 13.2 76: 4 77: 1 77: 2 155.5 17.0 160.5 13.5 164.5 10.3 168.5 10.1 65.0 11.2 67.6 17.0 69.8 13.5 71.6 10.3 84.5 ' 11.2 37.9 17.0 90.7 13.5 92.9 10.3 194.9 11.7 201.9 • 15.2 208.5 13.7 214.5 12.0 77: 3 220.7 12.1 77:4 83.7 16.9 79.5 -18.6 82.6 16.5 80.9 -8.1 82.0 5.6 82.5 2.5 82.6 0.5 83.5 4.4 84.9 6.9 70.4 4 2.5 72.2 2.7 84.0 15.3 81.2 -3.3 83.4 2.6 7.5 6.9 7.0 6.8 6.7 6.6 6.5 6.4 6.4 7.8 7.3 7.8 6.9 6.5 EMPLOYMENT %CH 85.241 86.402 87.532 88.000 88.500 89.000 89.500 90.000 90.500 2.3 2-3 2.3 2.2 2.3 5.3 2.2 5.6 0.5 84.374 3.3 35.949 1.9 84.734 -1.4 87.608 3.3 89.750 2.4 LABOR FORCE %CH 93.153 93.553 94.546 95.200 95.600 96.000 96.500 97.000 97.400 1.7 2.1 2.8 1.7 2.1 1.7 1.7 4.3 . 0.1 88.678 2.5 91.062 2.7 92.652 1.7 94.725 2.2 96.725 2-1 7.1 4.9 5-6 8.5 7.5 7.2 14.303 14.424 14.391 14.456 14.537 14.624 14.681 14.752 14.811 2.3 3.4 -0.9 2.4 1.6 1.6 2.8 1.8 1.9 14.637 2.1 14-124 -3.5 14.054 -0.5 14.452 2.3 14.717 1.8 PERSONAL SAVINGS %CH SAVING RATE(%) UNEMPLOYMENT RATE(%) PRODUCTIVITY* %CH 8.5 7.6 7.4 7.6 7.4 7.3 7.3 7.2 INDUSTRIAL PRODUCTION %CH 1.234 9.9 1.270 12,-4 1.293 7.4 1.306 4.0 1.322 5.0 1.338 4.9 1.353 4.6 1.367 4.2 1.380 3.9 1.297 8.4 1.293 -0.3 1.178 -3.9 1.298 10.2 1.360 4.7 MONEY SUPPLY-(Ml) %CH 294.6 2.3 296.5 2.7 302.7 8..6 307.0 5.8 311.0 5.3 315.0 5.2 319.5 5.8 323.5 5.1 328-0 5.7 263.3 7.5 277.7 5.5 289.5 4.2 304.3 5.1 321.5 5.6 VELOCITY OF Ml %CH 5.391 8.1 5.518 9.7 5.527 0.7 5.564 2.7 5.621 4.2 5.675 4.0 5.712 2.6 5.762 3.5 5.302 2.8 4.962 3.8 5.089 2.6 , 5.236 2.9 5.557 6.1 5.738 3.3 MONEY SUPPLY-(M2) %CH 660.7 6.6 677.4 10.5 696.5 11.3 711.0 8.6 725.5 • 8.4 740.0 8.2 756.0 8.9 771.0 8.2 787.0! 8.6! 549.1 9.6 595.4 8.4 641.0 7.7 7C2.6 9.6' 753.5 3.7 VELOCITY OF M2 %CH 2-404 3.8 2.416 2.0 2.402 -2-2 2.402 0.0 2.409 1.2 2.416 1.1 2.414 -0.4 2.418 0.6 2-418 O.lj 2.379 1.8 2.374 -0.2 2.365 -0.4 2.407 1.3 2-415 0.4 2 A?^ ESf ; PROP IX'TTV?ITY IS CALCULATED AS CONSTANT DOLLAR GNP PER WORKER ECONOMIC OUTLOOK ACTUAL 7 5:4 76:1 PAC£ 3 FORECAST 76:2 TST3 76:4 77": 1 77:2 77": 3 ANNUAL ANNUAL 1974 7 7 : 4 1973 " " ANNUAL ANNUAL ANNUAL 1975 1976 1977 INTEREST RATES SSP COMP. AAA BONDS 8.650 8.490 8.490 8.300 8.000. 7.750 7.750 7.750 7.750 7.557 8.250 8.635 8.320 7.750 10.80 7.86 7.00 7.44 PRIME RATE 7.58 6.83 6.90 7.00 7/25 7.25 7.50 7.50 7.50 8.02 COMMERCIAL PAPER 4-6MTS. 6.12 5.29 5.57 5.75 6.25 6.40 6.50 6.60 6.70 8.15 9 . 3 4 1 1 . 511.5 - 8 . 9 AUTO SALES lj 9.1 DOMESTIC 7.7 8 . 9 8 . 7 8 . 7 . 9 . 2 9 . 4 9 . 6 9 . 8 IMPORTS 1.4 1 . 3 1 . 4 1 . 4 1 . 4 1 . 5 1 . 5 1 . 5 1 . 5 HOUSING STARTS }} 1.365 1 0 . 21 0 . 1 1 0 . 11 0 . 61 0 . 91 1 . 11 1 . 3 1.400 1.430 1.600 1.700 £] IN MILLIONS OF UNITS—SEASONALLY ADJUSTED ANNUAL RATES 1-730 1.750 1.800 1 0 . 0 1.800 6 . 3 2 5 . 7 2 8 . 7 1 0 . 3 6 . 5 5 1 1 . 2 K7 7.5 7.1 1.9 9.7 1.8 1.4 1.6 1.4 1.5 2.044 1.332 1.163 1.5321.770 Monetary Policy, Iaflation and Economic Expansion Karl Brunner University of Rochester Position paper prepared for the meeting of the Shadow Open Market Committee - September 13,1976. 1, Introduction Economic recovery, continued expansion of activity and a gradual decline in the rate of inflation distributed over a number of years are the central concern of the SOMC. The Committee proposed since its formation in 1973 a course of fiscal and monetary policy designed to restore a comparatively stable price-level over a period covering probably five to seven years. It opposed therefore in its meeting of September 1975 all suggestions for a substantial increase in the deficit or proposals involving a large monetary acceleration. The SOMC recommended that Federal Reserve policy continue on a moderate course located towards the lower end of the target range announced by the FOMC. It was the sense of the SOMC that this course would assure with sufficient likelihood a continued recovery of the economy. The SOMC reaffirmed its basic position in the meeting held in March 1976. It expected however some moderation of economic expansion during spring and summer but saw no danger of abortion or early reversal of economic recovery. The Committee recommended that monetary growth be slightly reduced and follow a path averaging 4 1/2% p.a. from the first quarter 1976 to the first quarter of 1977. This modification should assure some further retardation of inflation over the subsequent two years. The current session of the SOMC confronts the Committee with the same basic issues centered on economic expansion and inflation. Monetary policies pursued until the end of 1977 will substantially determine the direction of inflation over the next two years. The rate of inflation fell by a wide margin since its peak in 1974 and monetary policy should be carefully designed to lower the remaining rate of inflation until the end of 1978 2. to a range around 2% p.a. The SOMC should also emphasize the importance of a long-range view of financial policies moving the economy by the end of the decade to a stable price-level. The sections of the position paper cover a variety of issues associated with the central thrust of the SOMC!s goal. Section II describes the monetary evolution in the recent past and considers the Fed's performance and targeting policies. the SOMC opens Section III. The discussion of some options confronting This section attends furthermore to the Humphrey-Hawkins bill, emphasizes the importance of an independent Federal Reserve System and refers to the potential usefulness of the report on "Improving the Monetary Aggregates" recently published by the Board of Governors. H» Monetary Evolution and Monetary Policy 1. The Evolution of Monetary Patterns Tables I to III summarize longer-range, intermediate-range and shortrun patterns of monetary growth. We note in table I that M grew in three successive years at a rate between 4.1% and 5.7%, whereas the growth of M« spanned a range from 7.3% to 9.8%. Previous position papers discussed in some detail the role of the shifting time deposit ratio and currency ratio in the money supply process over the past years. A persistent in- crease in the time deposit ratio (ratio of time to demand deposits) determined the divergence between the growth rates of M and M . The problem posed for monetary policy by such divergent movements will be considered in a subsequent paragraph. Attention is directed here to the relative stability of monetary growth in the average over the past three TABLE I: Growth Rates of M , M and B Over Three Successive Years The growth rates are computed with quarterly averages of monthly data. M1 M2 B 11/1973 to 11/1974 5 ,7 8,7 7.8 11/1974 to 11/1975 4.1 7.3 7.1 11/1975 to 11/1976 5 .2 9 .8 7.2 TABLE1I: Annual Growth Rates in % of M- , M and B Over Successive Two Quarter Periods M M IV/1973 to 11/1974 l 6.0 2 8.8 B 8.8 11/1974 to IV/1974 4.2 6.6 7.9 IV/1974 to 11/1975 4.0 8.1 6.2 11/1975 to IV/1975 4.8 8.5 7.2 IV/1975 to 11/1976 5.6 11.1 7.3 3. years. Moreover, both M and M moved in the average over this period on a track well designed to lower the inherited rate of inflation. The broader aspects of monetary evolution are thus largely compatible with the general ideas advocated by the SOMC. Some aspects of intermediate run movements are presented in table II. The growth rates of M- and M over two successive (and non-overlapping) quarters span a range from 4% p.a. to 6% p.a, or from 6.6% to 11.1% respectively. We note in particular the large divergence between the two growth rates over the first half of the current year. Table III continues the description of the shortest-run patterns discussed in some detail in previous position papers. We note an increase in monetary growth since early March from 7% p.a. between successive four week periods to about 20% p.a. by early May. This acceleration was followed by a deceleration lasting until the end of June lowering monetary growth to about minus 3% p.a. July. Monetary growth emerged on a new track since early An inspection of the proximate determinants shows the important role of the public's and the banks1 behavior in the shortest-run variations in monetary growth. The contribution emanating from the adjusted reserve ratio fluctuated bewteen -9.3% and 11.5% since early March of this year. The monetary base moved within a range (-3.1% to 19.8%) of similar order, whereas the contributions produced by changes in the currency ratio and the time deposit ratio remained confined to a comparatively small range (-.4% to 4.5% for the currency ratio, and -6.1% to 4.5% for the time deposit ratio). It is noteworthy that the sum of the contributions made by the base and the adjusted reserve ratio exhibits a much smaller variability than either one TABLE III: Compound Annual Rates of Change to the Average of the Four Weeks on the Dates Showft in the Table rrom the Four-Week Average Ended Four Weeks Earlier. Date our Weeks nded 1976 Jan 7 14 21 28 Feb 4 11 18 25 Mar 3 10 17 24 31 Apr 7 14 21 28 May 5 12 19 26 June 2 9 16 23 30 July 7 14 21 28 Aug 4 Source: CD (2) CM-1) Monetary Base Money Supply - 1.31% 0.00 2.79 1.78 1.00 3.02 4.72 7.17 7.05 6.80 4.94 5,16 7.01 5.50 9.46 15.41 17.52 20.45 17.19 9.46 6.43 4.72 2.17 2.71 0.54 - 3.06 - 2.12 - 1.70 3.81 8.93 9.74 1.56% 3.27 6.12 7.82 3.93 2.43 12.33 18.52 19.83 19.68 12.87 11.51 8.24 6.00 5.98 5.56 7.35 10.28 11.15 6.89 4.81 2.91 5.88 12.83 15.41 14.88 11.12 1.73 - 1.55 - 3.56 - 3.11 - Cl-2) - 2.87% 3.27 8.91 9.60 4.92 0.59 - 7.61 -11.35 -12.78 -12.88 - 7.94 - 6.35 - 1.22 - 0.51 3.48 9.85 10.17 10.17 6.04 2.57 1.62 1.81 - 3.71 -10.11 -14.88 -17.94 -13.24 - 3.45 5.36 12.49 12.86 Morgan Stanley Research Calculations Contribution o: Contribution of the Contribution of the Contribution of the the Treasury Adjusted Reserve Ratio Currency Ratio Time Deposit Ratio Deposit Ratio 3.55% 6.98 10.16 12.80 10.34 4.57 - 0.32 - 6.26 - 8.75 - 9.29 - 3 91 2.81 1.41 3.93 4.52 8.04 7.28 4.66 2.42 78 50 68 - 0.44 - 5.31 - 6.27 - 6.33 3.66 5.83 7. 91 11.41 11.51 -3.10% -1.90 -0.94 -2.43 -3. SS -2, 82 -4, 95 -3, 41 -3, 01 -3.37 88 95 34 -3.65 -1.29 0.13 0.44 1.14 -0.14 -1.25 -1.16 -1.27 -2 18 2.17 3.76 -4 50 -2.85 -3.40 -0.40 0.51 -0.34 -2.61% -1.67 -0.60 ,11 ,73 ,03 ,86 -0.98 -0.61 -0.32 -0.34 -0.05 0.27 -0.99 -0.18 .40 1. ,32 2. 4.45 4.32 2.14 1.31 0.02 68 59 32 08 67 50 2.71 0.45 0.68 -0.71% -0.13 0.29 0.26 0.20 -0.14 -0,48 -0.70 -0.41 0.10 0.19 0.47 0.44 0.20 0.43 0.28 0.14 -0.07 -0.56 -0.09 -0.04 0.38 0.56 -0.04 -0.53 -1.04 -1.05 -0.35 0.57 1.02 1.00 TABLE III: Compound Annual Rates of Change to the Average of the Four Weeks on the Dates Shown in the Table -£rom the Four-Week Average Ended Four Weeks Earlier, Date our Weeks nded 1976 Jan 7 14 21 28 Feb 4 11 18 25 Mar 3 10 17 24 31 Apr 7 14 21 28 May 5 12 19 26 June 2 9 16 23 30 July 7 14 21 28 Aug 4 Source: (2) CD Money Supply (M-l) - 1.31%. 0.00 2,79 1.78 1.00 3.02 4.72 7.17 7.05 6.80 4.94 5.16 7.01 5.50 9.46 15.41 17.52 20.45. 17.19 9.46 6.43 4.72 2.17 2.71 0.54 - 3.06 - 2.12 - 1.70 3.81 8.93 9.74 Monetary Base 1.56% 5.27 6.12 7.82 3.93 2.43 12.33 18.52 19.83 19.68 12.87 11.51 8.24 6.00 5.98 5.56 7.35 10.28 11.15 6.89 4.81 2.91 5.88 12.83 15.41 14.88 11.12 1.73 - 1.55 - 3.56 - 3.11 - (1-2) - 2.87% 3.27 8.91 9.60 4.92 0.59 - 7.61 -11.35 -12.78 -12.88 - 7.94 - 6.35 - 1.22 - 0.51 3.48 9.85 10.17 10.17 6.04 2.57 1.62 1.81 - 3.71 -10.11 -14.88 -17.94 -13.24 - 3.45 5.36 12.49 12.86 Morgan Stanley Research Calculations Contribution of the Contribution of the Contribution of the Adjusted Reserve Ratio Currency Ratio Time Deposit Ratio 3.55% 6.98 10.16 12.80 10.34 4.57 0.32 6.26 8.75 9.29 3.91 - 2 81 1.41 3.95 4.52 8.04 7.28 4.66 2.42 1.78 1.50 2.68 - 0.44 • 5.31 . 6.27 • • 6.33 3.66 5.83 7.91 11.41 11.51 3.10% 1.90 0.94 2.43 5.88 2.82 4.95 -3.41 ,01 ,37 ,88 95 34 65 29 0.15 0.44 1.14 -0.14 25 16 27 18 17 76 50 85 40 -0.40 0.51 -0.34 -2.61% -1.67 -0.60 -1.11 -1.73 -1.03 -1.86 -0.98 -0.61 -0.32 -0.34 -0.05 ' 0.27 -0.99 -0.18 1.40 2.32 4.45 4.32 2.14 1.31 0.02 68 59 32 08 67 50 2.71 0.45 0.68 Contribution oi the Treasury Deposit Ratio -0.71% -0.13 0.29 0.26 0.20 -0.14 -0.48 -0.70 -0.41 0.10 0.19 0.47 0.44 0.20 0.43 0.28 0.14 -0.07 -0.56 -0.09 -0.04 0.38 0.56 -0.04 -^0.53 -1.04 -1.05 -0.35 0.57 1.02 1.00 4. of the component series. each other. Variations in the two series substantially offset This phenomenon and particularly the remarkable fluctuations in the contribution resulting from the adjusted reserve ratio deserves some detailed examination in the future. I suspect that the movements observed are at least partly due to the lagging of required reserves behind deposits. If this conjecture is borne out by future investigations, suitable simplifi-. cation of reserve requirements could be expected to moderate the range of shortest-run movements. A further inspection of the contributions made by the public!s currency and time deposit ratio indicates that the basic pattern discussed in the previous position paper continued. both cases with a large margin. The negative contributions prevailed in Moreover, positive contributions emerged more frequently in the case of the time deposit ratio. A period with positive contributions appeared at the time of a substantial increase in short-term interest rates in April/May. We should expect that future increases in short rates induce positive contributions in the time deposit ratio and thus lower the margin between the growth rates of M and M 9 . Tables IV and V relate monetary evolution with the trend in Gross National Product and provide some further perspective for our purposes. The table decomposes the percentage rate of increase in Gross National Product (at current prices) into monetary growth M or M , the changes in respective velocity V- or V^, the increase in government expenditures and net exports. The formula used for this purpose is GNP = M .V± + G + X where M. denotes a measure of the money stock (M or M ) , G = government expenditures and X designates net exports (= net foreign investment). term M .V The refers to total private expenditures measured as the sum of consumption and gross private domestic investment expenditures. covers the first five quarters of all postwar cyclic recoveries. The table The first recovery phase was of course substantially distorted by the temporary inflationary expectations (or "shortage" expectations) engendered by the outbreak of the Korean war. This phase should probably be omitted for useful comparisons with the present situations. The reader may note that the velocity concept used here refers to a private expenditure velocity and must be carefully distinguished from the usual GNP velocity which varies directly with government expenditures on goods and services. The large variation in the percentage change of these expenditures over the five-quarter recovery phase suggested a measure of velocity which removes the direct effect of changes in G. Indirect effects working (possibly) via a Keynesian multi- plier may still operate on V.. pendence of changes in V This would be reflected by a systematic de- on changes in G. The data drawn from postwar recovery phases yield no obvious evidence revealing the operation of such a "multiplier11. Useful judgment will require substantially more extensive examination however. Government expenditures and net exports move in sharp contrast over the recovery phase. The contribution of net exports is syste- matically negative and reveals the operation of an endogeneously induced retarding modifier of the recovery. is however quite small. The order of magnitude of this operation The large percentage changes in X are'multiplied with a small weight expressed by the proportion of X in GNP in order to yield the X-contribution in the percentage change of GNP. The percentage 6. increase in government expenditures over the recovery phases accelerated since 1954/55 by a factor of five. The last three recovery phases ex- perienced over the initial five quarters essentially the same behavior in government expenditures. We note thus that in 1954/55 government expenditures accounted directly for 0.4% of the 11.3% increase, whereas they accounted for 2.4% in the 14.6% increase observed in 1975/76. These direct contributions of increasing government expenditures to increasing GNP are obtained by multiplying the percentage increase in G with the weight w(G) of G in GNP. For obvious reasons the increase in private expenditures dominates the expansion in nominal GNP. The relative shift in the partition of private expenditures occurring between the first two post-Korean recoveries and the last two recoveries is noteworthy. The contribution of monetary growth increased for both measures relative to the contribution made by an increasing velocity. This shift was however much more pronounced in the relation between M and V than in the relation between M and V . The relative behavior of the two velocities attracted some attention recently. The interpretation of this behavior also affects appropriate decisions concerning the course of monetary policy. The FOMC and the Board of Governors elaborated in the recent past on numerous occasions on the cumulative effect of a variety of financial innovations. Some discussion of these issues, centered on the possible "leftward shift" of demand for M -balances, was presented in my previous position paper. sufficiently important to deserve the SOMCTs attention. The problem is A broad range of financial innovations resulting from the competitive adjustments of the products offered by the various financial institutions gradually changes the substitution-relation between savings or time deposits on the one side and TABLE IV: The Component Contribution to the Percentage Change of GNP Over the First Five Quarters of Postwar Recoveries The decomposition is computed according to the formula - ^ « w(MV)— + w(MV)— + w ( G ) — + w ( X ) — where w(z) is the relative weight of z, for z = MV,G,X. The relative changes were computed relative to the average of initial and terminal value of the five quarter period. GNP IV/1949-I/1951 M1 22.0 5.4 Vx M2 4.2 17.7 V2 19.2 (.837) III/1954-IV/1955 11.3 4.5 10.3 5.0 11.7 5.0 10.0 12.5 3.2 8.8 7.2 6.6 12.3 8.2 7.4 8.7 1.9 5.5 13.6 14.6 7.2 9.4 12.2 (.772) 7.2 -200 10.6 - 14.1 (.207) (.012) .1 (.777) I/1975-II/1976 2.1 - 5 (.205) (.003) (.781) IV/1970-I/1972 20.9 -100 (.194) (.005) (.792) I/1961-II/1962 X (.154) (.009) (.801) I/1958-II/1959 G 10.5 -730 (.222) (.0009) A.4 10.9 - 49.2 (.221) (.007) The sign of the last term in the decomposition, i.e. w ( x ) — is given by the sign of AX. Moreover, w(X) has been (arbitrarily) specified to be positive, and consequently AX/X has always the sign of AX (i.e. the X in 7. demand deposits on the other. These innovations imply in particular a positive trend over the foreseeable future in the time deposit ratio and thus a relative decline of the multiplier relative increase in the multiplier for M^. associated with M and a These innovations modifying the substitution relations between demand and time deposits tend to generate a positive trend for V relative to the movement of V . Some inspection of the postwar patterns may he3p us to gauge the broad perspectives confronting monetary policy xn this respect. provides some useful information for this purpose. Table V The sequence of succes- sive values at peaks (or troughs) suggests that V 9 followed since around 1957 essentially a stationary process. The earlier postwar period produced some adjustments upwards from the low levels experienced as a result of the Great Depression and war controls on prices and interest rates. velocity offers a radically different pattern. "Exclusive" Both sequences over peaks and troughs show a pronounced positive trend> interrupted for several years in the second half of the 1960!s. One suspects that the financial innovations associated with the development of the thrift institutions during the 1950*s probably induced gradual and continuous modification of substitution relations centered on demand deposits. It is noteworthy that the rising trend re- appeared with substantial strength in the 1970Ts and raised velocity V in the first half of 1976 already 7 1/2% over the previous peak reached in the second half of 1974. crease of V It should also be noted however that the rate of in- over the first five quarters in the recent upswing is quite similar to the observations made for the economic upswing 1954/55 and 1958/59. Interest rates and creditmarkets behaved however somewhat differently in TABLE V: Measures of "Inclusive" and "Exclusive11 Velocity at Peaks and Troughs (based on moving two quarter averages) Successive Peaks Successive Troughs V V II-III/1957 1 2.598 2 1.853 I-II/1958 2.503 1.728 I-II/1960 2.875 1.947 IV/60-I/1961 2.797 1.839 III-IV/1966 3.505 1.822 II-III/1967 3.448 1.732 III-IV/1969 3.546 1.885 III-IV/1970 3.538 1.851 III-IV/1974 3.995 1.861 I-II/1975 3.910 1.780 I-II/1976 4.294 1.876 V 1 2 8. the three periods. The Federal Reserve Authorities thus conjectured that the demand for M -balances has recently been substantially lowered by the new surge of financial innovations. Some econometric studies apparently executed earlier this year at the Board show a cumulative divergence between predicted and actual money stock. The equations estimated from past samples yield since 1974 increasing overpredictions of desired balances. One suspects however that this result depends sensitively on the detailed specification of the money demand function. It is particularly conjectured that mmoney demand functions using long term in lieu of short term interest rates supplemented with a measure of returns on equities produces different results. An examination of this issue prepared by Michael Hamburger for the Journal of Monetary Economics may clarify the problem somewhat further. The issue is certainly not settled and the uncertainty associated with the proper interpretation of velocity should be considered m the formulation of policy and the recommendations advanced. 2. The Federal Reserve Targeting Policy Congress passed House Concurrent Resolution 133 m early 1975. This Resolution addressed the Federal Reserve Authorities and requested attention to a non-inflationary long-run growth of the money stock and levels of interest rates compatible with non-inflationary regimes. The Federal Reserve instituted in response to the Resolution new procedures and reports regularly in the appropriate Senate or House Committee on the conduct of policy. It submits furthermore an assessment of current trends and announces 9. plans for the future course of monetary growth. These plans are stated in terms of a target cone bracketing the admissible path of the money stock. The target cone is specified with the choice of a base and two growth rates forming the upper and lower boundaries of the target cone defining the Fed!s desired policy. The new procedure and some problems associated with it were discussed in previous position papers. After one and a half years of the new targeting policy a summary appraisal seems appropriate. this purpose to graphs I to VI for M The reader is referred for and graphs VII to XII for M . Each graph traces with a black line the actual movement of the respective money stock. The M-line is supplemented with two target cones, each one projecting from a different base with possibly different slopes of the boundary lines. Graph I compares the first targeting, based on March 1975 and projected to March 1976, with the second targeting introduced m based on the average M -value observed for months m projected to the second quarter of 1976. late spring 1975 and the second quarter and Both target cones have upper boundaries defined by a 7 1/2% growth rate and lower boundaries corresponding to a growth rate of 5%. An inspection of the graph indicates that the money stock moved over an initial segment, lasting until August 1975 cSudvc both target cones, slid until December sideways across the target cones and fell below both target ranges until March 1976. It returned subsequently to the March target xange and moved since April 1976 along the lower boundary of the targeting range defined for second quarters. In the early fall the Federal Reserve Authorities introduced a new target range based on the average of observed monthly values in the third quarter of 1975. It is remarkable to note that the subsequent path of the 10. money stock M never moved into the target range. fell without exception short of this target* The exclusive money stock The procedure of tar- get shifting was further developed during the winter. The base of the cone was moved to the fourth quarter 1975 and both boundaries lowered. The upper boundary was reduced from 7 1/2% to 7% and the lower boundary from 5% to 4 1/2%. The first four months still fell below the target range, but the monetary acceleration of early spring 1976 brought the monetary path into the target range announced last winter. The fifth shift introduced at the turn of the seasons by the end of the winter yields a different pattern. The monetary path follows the upper boundary of the target cone. A sixth change occurred in the summer 1976, moving the base forward again by another quarter. The last graph for ML (i.e. graph VI) compares the initial March. 75/76 target cone with the last second quarter 76/77 target cone. Graphs VII to XII depict the situation prevailing for money stock M^. The target cones are located at the same base periods and shifted simultaneously with the base for M-. however. The boundaries for the target cone differ The March 75/76 cone has boundaries defined by growth rates 8 1/2% and 10 1/2%. Both boundaries were maintained for the target range based on the second quarter 1975. An inspection of graph VII reveals a pronounced similarity with graph I. The movement of actual M^» depicted by the black line, shows a pattern relative to the two target ranges similar to M graph I. in Some early overshooting is followed in the middle stretch by a lengthy undershooting. Since early 1976 the actual path moves closely around the lower boundaries of the two ranges. The third shift from the second to the third quarter also reduced the lower boundary from 8 1/2% 11. to 7 1/2% and broadened the target cone. successfully covered by this target. The subsequent path was more The shift to a fourth quarter base (graph IX) maintained the boundaries of the target range. But the shift in the base raised the subsequent path to the upper boundary of the new cone. The last two shifts successively lowered the upper boundary from 10 1/2% to 10% and to 9 1/2%. The range for M^-growth was thus substantially compressed by the Authorities. The targeting procedure developed by the Federal Reserve Authorities involves several aspects which require the SOMCrs attention. The authorities have accustomed public and Congress to a deliberately "flexible approach"• Every quarter the base for the target cone is redefined in terms of the most recent actual values observed. Moreover, the Fed also changes with some frequency the width or boundaries of the target range for one or the other of the aggregate measures. This procedure forms in a sense a rational response by the policy institutions to the enquiries and potential constraints emanating from Congress. It protects its operational freedom and requires com- paratively small adjustments of internal procedures. But we should also note that the adjustments actually made should be acceptable to the SOMC. The target range was lowered for both M and M^. Some doubts were expressed on previous occasions concerning the quarterly shift in the basis. This procedure may endanger the essential purpose of H.C.R. 133 designed to assure a deliberate choice and careful execution of planned monetary growth. The occurrence of random components in the proximate de- terminants of monetary growth supplemented with occasional short-run accommodations of the monetary base could produce an unsystematic or chancelike drift in the target basis used by the authorities. This possibility 12. exists and the probability of its relevant occurrence depends partly on institutional conditions affecting the random terms in the money supply process and also on the degree and frequency of short-run credit market accommodation indulged by the Fed. for M Of the five target ranges introduced subsequent to the initial target cone centered on March 1975 one basis fell below the previous target cone (fourth quarter 1975) and one (second quarter 1976) moved beyond the previous target cone. In all other cases the new basis was placed within the previously specified target cone. But even so, the width of the range is sufficient to permit potential drifts implying substantially different long-run behavior of the price-level. Some indication of a drift seems to have emerged in the case of M . . The . second (second quarter 1975) and last (second quarter 1976) choice of basis moved beyond the previous cone whereas the fourth (fourth quarter 1975) and fifth choice (first quarter 1976) dropped below the previous cone. We note also that in both cases, for M1 and ML, the last target cone is based lower end of the first (March 1975) target cone. some respect: at the They differ however in The M- central path defined in terms of the last target remains within the original cone, whereas the M central path introduced at the last policy change diverges below and away from the first target cone. The potential drift built into the Fed's policy procedures did not emerge, so far, with any major proportions. maintain a It does contribute however to pervasive uncertainty about the longer-run course of the FedTs monetary policy. In particular, intermittent accommodation of rising pressures on short term interest rates would probably push the targeting cone into a higher range. It would seem important therefore that the 13. Federal Reserve Authorities specify procedures containing this drift* Such procedures would not necessarily prohibit the quarterly or semi-annual changes in the target basis. These adjustments may actually form a sensible response to two kinds of uncertainties confronting the Federal Reserve Authorities. We are first increasingly uncertain about the relative weight to be assigned M- and M thrust operating on the economy. in assessments of the net monetary This uncertainty barely matters when M- and M ? move approximately together. It emerges however with some force in periods experiencing divergent growth patterns for M- and M~. appeared with increasing frequency in past years. Such patterns The relative movements of M1 and M^ are of course well understood in a general sense. They are domi- nated by the behavior of the public's currency and time deposit ratio. The changing substitution relation between demand and time deposits discussed in a previous paragraph generates a positive trend in the latter ratio. In- creasing short term rates tend to accelerate the change in the time deposit ratio and declining interest rates decelerate the movement of the ratio. But the general pattern is still associated with substantial uncertainties in important detail, reenforced by the behavior of the public's currency behavior. Changes in the target basis for M.. and M seem in this context quite appropriate whenever unanticipated changes in the time deposit ratio modify the relative growth rates of M- and M . A rigid adherence to an initial target basis in cases of unexpected increases in the time deposit ratio very likely violates one or the other of the two target paths. The shifts between M- and ML occurring in this example are voluntary demand responses to changing market conditions. It follows that the retardation 14. of M- exaggerates probably the incipient excess demand for M- and the acceleration of M ? overindicates the incipient excess supply of M^. relative uncertainty of the relative role of M and M The suggests under the circumstances a sequential adjustment of the target basis to new information with essentially no change in the target basis and target range for the monetary base. The latter condition is crucial in this context. It pre- vents an unsystematic drift in the net monetary thrust whenever the growth patterns of VL and M diverge (or converge) as a result of substantial variations in the time deposit ratio. This conclusion holds of course with appropriate changes in the argument for periods with unanticipated declines in the time deposit ratio. Unexpected changes in the currency ratio determine on the other hand a different policy response• the target range violates Sequential adjustments of the original intentions. currency ratio accelerates both M- and M o . A falling (rising) Quarterly adjustments of the target basis would consecutively raise (lower) the target range and impose expansionary (contractive) constraints on the monetary base whenever the movement of the currency ratio slackens. Movements of the currency ratio thus require suitable offsetting by changing growth rates in the monetary base without any short-run adjustments of the target cone. It appears that in either case the Federal Reserve Authorities should supplement their procedures with appropriately targeting the monetary base and relate the base with the two monetary measures ML and M^. I refer in this context to the proposals advanced in the two previous position papers. 15. III. On the Course of Policy 1. The Current Situation and the Policy Recommendation The SOMC recommended last March that policy be adjusted to establish a growth rate of 4.5% for M quarter of 1977. from the first quarter of 1976 to the first The M- stock was estimated at the time at $297,5 billion for the first quarter 1976. The SOMC target would have yielded thus an M stock of about $311 billion for the first quarter of 1977. actual value of M However, the for the first quarter of 1976 turned out to be somewhat below the level desired by the SOMC. average of $296.5 billion. The observations settled on a quarterly Inspite of this lower basis, the third quarter figure for 1976 probably moves the M- stock more than halfway to the original target of $311 for the first quarter of 1977. The figure for July stands so far at $305.0 billion, the preliminary figure for August, based on the average of published weekly data, appears to be around $306.5 billion. Without any further increase in September, $8.5 billion of the proposed $13.5 billion increase in M (relative to the initial basis) would thus have been realized within two quarters. ations the M According to the S0MCTs initial evalu- stock would have to be raised over the next two quarters (i.e. from HI/1976 to 1/1977) by about $5 billion. implies The required growth in dollars a percentage growth of about 3.2% at an annual rate over the next two quarters. This compares with a growth rate of 6.8% p.a. for the first half of the period covering the first to the third quarter 1976. The SOMC's recommendation from last March implies thus in the context of the actual path emerging over the first 8 months a very substantial deceleration of monetary growth to the first quarter of 1977. With further increases in September over August the deceleration required over the next two quarters 16. would be even larger. Such a retardation of monetary growth by more than 50% over a six month period is not innocuous and should be carefully weighed. It has become standard practice to discount shorter-run varia- bilities in monetary growth with the argument that monetary accelerations (or decelerations) not exceeding two quarters are most unlikely to modify the pace of economic activity or the rate of inflation. But our knowledge of the timing relations is not sufficiently reliable or secure to discount monetary decelerations with the magnitude and length indicated above. Moreover, the credibility of Federal Reserve policy still forms a major issue. Such credibility is a crucial factor inducing a longer-run adjustment of price and wage setting to a foreseeable stable pattern of monetary policy. Substantial short-run variability involving large accelerations or decelerations over several quarters are poorly designed to produce such credibility. These difficulties and uncertainties associated with the shortrun course of monetary policy suggest that we examine a longer horizon reaching to the last quarter of 1977. It seems also useful for our purposes to consider the relative magnitude of the potential gap in output still to be covered by future expansion. Previous position papers directed attention to some aspects of the real shocks generally acknowledged to have affected the U.S.economy in 1973/74. It is widely recognized that these real shocks raised the price-level and thus temporarily raised the rate of inflation. But little attention was directed to the further consequences of these real shocks with respect to our measures of potential output, to our real wealth, or achievable real income, and the measured rate of unemployment. The argument in the previous position papers emphasized that 17. real shocks are also bound to affect potential output. In particular, it was argued that potential output was lowered and the output gap produced by the recession probably substantially lower than generally conceived in the policy discussions assessing the need for a large monetary or fiscal expansion. Moreover, the cumulative effect of legislation introduced in the 1970fs designed to protect the environment, to raise standards of health and safety, reenforced by \ the increasing uncertainties about the rules of the game confronting business and larger attending to investment of resources regulatory or bureaucratic requirements of the government sector, all tend to lower the trend growth in potential output. attracted recently more attention. These issues Denis Karnosky presented in ' the June issue of the Review published by the Federal Reserve Bank of St. Louis an article exploring the magnitude of the effect exerted by emerging real shocks on potential output. His examination establishes that the USA suffered in late 1973 a loss of about 4% in potential output. Haberler estimated on the other hand a reduction of about 2% in potential output. It is now instructive to reflect on the magnitude of the potential gap to be closed by an expanding real output. I compute for this purpose a level of potential output for the last quarter 1977. This estimate is based on two different assumptions, one pertaining to the magnitude of the reduction in potential output experienced in 1973 and the other referring to the prevailing trend rate of growth in potential outputTable VI. The results are summarized in The level of potential output spans a range between $1314 billion (in constant dollars) associated with a reduction of 4% in potential output and a trend rate of 2.5%, and $1389 billion associated with a loss of potential output of 2% and a trend rate of 3.5%. A decline in potential 18. output of 2% seems to me somewhat more likely than 4%. But 1 am quite unsure on this point and would only insist that potential output did fall in 1973/74. I also contend that population trends, the trend in the compo- sition of output favoring gorwth in components with smaller productivity increases, and the cumulative effects of recent legislation and regulatory patterns, gradually lowers the trend rate below past performances. I select thus the combination of a 2% loss with a trend rate of 3% as a general guide line. This combination yields a potential output of $1364 billion for the fourth quarter of 1977. We note that this level is only surpassed by the trend rate of 3.5% based on a 2% loss. The guide line selected requires an average real growth of 6»6% p.a. from 11/1976 to IV11911 in order to bring actual output up to potential output by the last quarter of 1977. Table VII presents the growth rates required to close the gap until late 1977 on the various assumptions pertaining to potential output. The considerations introduced In the previous paragraphs affect the choice among the options available to the SOMC. Three options are submitted to the members' attention. i) Monetary policy should adjust monetary growth in order to reach the level of $311 billion originally projected and recommended at the occasion of the last meeting in March 1976. should be held between 4% and 4.5% for M Moreover, monetary growth and probably 7 1/2% to 8 1/2% for M 2 from 1/1977 to 1/1978. ii) Monetary growth should be held on a growtu pauu « o - < >«w 4.5% for M CttAN* from HI/1976 to HI/1911 based on the average realized level for the third quarter 1976. The growth for M^ would correspondingly be maintained around 8% p.a. over this period. -T/O 19. iii) Monetary policy should be defined for the period 111/1976 to IV/1911, spanning one and a half years. This longer horizon should be used to implement a policy of longer-run real expansion with a simultaneous and gradual decline in the rate of inflation. This option proposes that M. grow over the six quarters indicated at 4% to 4.5% and M around 8%. It was already noted in a previous paragraph that option i calls for a substantial deceleration of monetary growth from III/1976 to 1/1977. It seems to me inappropriate for the SOMC to "correct" (sequentially) substantial accelerations or decelerations which actually evolved relative to our previous proposal, I suggest therefore at this stage that our proposals do not inject further waves of acceleration or deceleration into the process. We did propose on previous occasions some measure of "frontloading" in monetary growth. But these measures would not involve sustained acceler- ations, but were designed as once and for all measures to move within a month the money stock to the neighborhood of the accepted growth path. The average growth of M from Hi/1976 to TV/1917 proceeding under option i) would settle around 3.9% p.a. This is indeed no radical difference with re- spect to 4.2%, the central path between 4% and 4.5%. But it reenforces the deceleration sustained over two quarters with an average shaded somewhat on the low side with respect to the desired rate of expansion in nominal GNP required for a real growth of about 5.5% to 6% over five quarters. I suggest therefore that option i) be discarded in favor of option ii) or iii)> with particular emphasis on option iii). Using past patterns bearing on velocities V- and V. and the relative motion of M growth rate of M and M~, an average around 4.5% can be expected to be associated with a rate 20. of increase in nominal GNP of around 9 f p*a. ^ This nominal expansion is partitioned approximately into a real growth of about 5,5% p.a. and a rate of inflation not exceeding 4.5% on this track. The output gap would be gradually closed under this program without engendering a new wave of inflation. Moreover, the program seems appropriate to establish the re- quired credibility in the Fed's long-run anti-inflationary policies. An increasing credibility accelerates over time the decline of the remaining rate of inflation as price and wage setting practices are suitably readjusted to the firming expectations of a persistent anti-inflationary policy. The partition of the nominal expansion into real and price effects thus gradually shifts under the circumstances in favor of real effects. The expected decline of the rate of inflation will be a major force maintaining the economy's real expansion and lowering the output gap. For the reasons indicated I recommend to the SOMC's attention the option iii), with the possible proviso of course, that the growth rates for M (and implicitly for M ) need be reexamined by the end of the winter in order to assure closer approximation by 1978 to the SOMC's long-run objectives. 2. Some Further Aspects The Federal Reserve Authorities still accept a range of 4.5% to 7% for the growth rate of M- and 7.5% to 9.5% for the growth rate of M . This range permits a substantial acceleration of monetary growth. An increase in the growth rate of M- to the upper boundary of the target cone accompanied by a corresponding increase in growth of M ? generates probably a nominal expansion incompatible with a persistent decline in the rate of inflation. The simultaneous acceleration of both monetary measures requires TABLE VI: Potential Output in the Fourth Quarter 1977 Potential output level Assumptions made Loss of Potential Output 4% Trend rate in billions of constant dollars 3.5% 1360 4% 2.5% 1314 2% 3.5% 1389 2% 3 % 1364 2% 2.5% 1340 TABLE VII: Implicit Annual Growth Rate of Real Output from 11/1976 to Assuring Closure of the Gap Until IV/1977. Assumptions made Loss in potential output Trend rate of growth Potential Gap in billions of constant dollars Required annual growth rate 4% 3.5% 100 6.0% 4% 2.5% 54 3.4% 2% 3.5% 129 8.2% 2% 3 % 104 6.6% 2% 2.5% 80 4.9% 21. either a reversal of the negative currency effect operating over the past two years not offset by the authorities or an acceleration of the monetary base beyond the rate of around 7% maintained approximately in the recent past. A proper control of the base according to the suggestions made in a previous paragraph would effectively prevent such occurrences. On the other hand, an acceleration of M- towards the upper boundary accompanied by a lower M growth converging towards the growth rate of M involves com- paratively small dangers of nominal acceleration under the present circumstances. Such convergent motions would be consistent with stable growth patterns in the base. Under the current uncertainty pertaining to the relative weight assignable to M and M pertaining to their respective economic effects the movement of the base may offer a crude but useful approximation to the properly weighted mixture of M a. and M . Another Chapter in the Keynesian Tradition A protracted problem deserves the SOMCTs continued attention. The position paper prepared for the meeting of September 1975 discussed the fundamental issue posed by the Keynesian tradition. Stabilization policies expressing a determination to "fine-tune" the economy and advocating a permanent financial expansionism are still very influential. The SOMC cautioned in its meetings of September 1975 and March 1976 against such policies and strongly supported the basically moderate and cautious stance of the Federal Reserve Authorities. The Keynesian tradition reappeared this year in "The Full Employment and Balanced Growth Act 1976" proposed by Senator Humphrey. The SOMC should explicitly acknowledge the decisive and forthright argument against this proposed legislation advanced by the Federal Reserve Authorities. Governor I. Charles Partee presented the 22. Fed's case against the proposed bill at the Hearings in the House of Representatives in April 1976. The Governor warned that the Board "was gravely concerned that the net effect of "the bill" would be to add substantially to the inflationary bias..." He also argues that "a principle flaw in the 1946 Act is its failure to identify clearly price stability as a long-run economic goal". The new bill "shares and extends this shortcoming...The bill has many provisions that would contribute further to conditions and practices that would likely result in an intensification of upward price pressures". The SOMC should fully support the Fedfs concern and position on this issue. The Humphrey-Hawkins bill is excellently designed to generate an accelerating inflation and retard our future real growth. An explicit obligation imposed on financial authorities to push the measured unemployment rate in the context of our current institution to 3% is the safest and quickest way to raise the rate of inflation over the next ten years to levels never experienced in the USA (outside the old Confederacy). These obligations introduce powerful incentives operating on labor unions and producers to anticipate the expected rise in the price-level with appropriate price and wage setting of their own. The legislation converts the financial authorities into an agency confined to full accommodation of these evolving price and wage setting practices. Unions and producers will realize that their real benefits in the process depend on staying ahead of the crowd in the game of raising prices and wages. The assurance of full validation under the obligation imposed by the Humphrey-Hawkins bill thus surrenders monetary policy, and financial policy in general, to the labor unions. 23. The bill would also perpetuate the budget expansion experienced over the past ten years and assure a permanently large deficit. likely encourage continued growth of the government sector. It would very The SOMC noted in previous meetings the dangers of a long-run "crowding-out" process resulting from a persistent deficit and expansion of the government sector. The various channels conveying the crowding-out process lower the growth of private output per capita and threaten the economy with stagnation. It appears thus that the Humphrey-Hawkins bill should be properly relabelled as "The Inflation and Unbalanced Stagnation Act 1976". The SOMC should therefore strongly oppose such legislation. b. Fiscal Policy and General Government Policy Chairman Burns addressed himself in the Hearings of March 22, 1976 to the adjustments in government and fiscal policy required for a sustained real gorwth without inflation. His admonitions not to block incentives to invest, his warnings about the social cost of environmental and safety legislation, his plea to reconsider regulatory arrangements or governmental policies fostering restraint of trade and his suggestion to revise labor market institutions are well grounded and deserve the fullest support of the SOMC. The only hesitation applies to the Chairman's advocacy of a "limited income policy". Income policies are generally quite useless beyond a short interval whenever they are executed independently of financial policies, or in contexts of a permanent financial expansionism. One may hope that a "limited income policy" can be used to shift financial policies to a more pronounced anti-inflationary track. The rationale of income policy is then based on the assumption that it accelerates the downward revision of inflationary expectations. This seems to me a dubious case indeed. Moreover, 24. income policies require an institutional apparatus and the political process will barely abandon such an apparatus once it is installed. Vested interests will arise in the economy, among politicians and in the bureaucracies which tend to protect the established institution. c. Comments on Interest Target Policies Another protracted issue over many years centered on the role of interest rates in policymaking. Many Central Banks relied traditionally on some interest rates to guide adjustment and execution of monetary policy. It was argued on the other side that monetary policy should not be specified or implemented in terms of interest rate levels but in terms of monetary growth. The debate erupted during the 1960's and a resolution seems gradually to emerge. An increasing number of Central Banks reexamined the traditional procedures and develop new approaches to the formulation and implementation of monetary policy. One usually refers to the German Bundesbank in this context as the leader in a new trend. appropriate. This seems upon closer inspection not quite The Swiss National Bank and the Banco de Espana developed procedures of monetary control with a much more explicit conceptual underpinning. Still, the German Bundesbank operated in some relevant aspects with comparative success. T'le S?MC -honld note at this stage with parti^ul^r interest the views bearing on this subject and expressed by Governor I. Charles Partee in a statement presented to the House Committee on Banking Currency and Housing on June 10, 1976: 25. M In the Congressional deliberations leading to the present wording of House Concurrent Resolution 133, and in further discussions since then, a recurring issue has been the question of whether monetary policy intentions should be specified in terms of interest rates as well as monetary aggregates. The Resolution does of course require that the Board specify 12-month growth ranges for the various monetary aggregates, and it provides ample leeway for adjustment of such ranges as conditions change. In my view, this approach is far preferable to any attempt to specify interest rate objectives. While it is theoretically possible to specify the course of monetary policy in terms of interest rate levels as well as the monetary aggregates, it must be recognized that interest rates are particularly exposed to the influence of many variables external to the scope of monetary policy, and that there is thus a large risk of specification error. The announcement of interest rate intentions or expectations could lead borrowers and lenders to believe that the Federal Reserve could—and m rates. practice would—guarantee particular levels of interest But the system does not have the power to do so, for interest rates are influenced not only by the interaction of demands for credit with the available supply of funds, but also by the strength of the economy and the public's willingness to defer current consumption order to save for the future. m Interest rates are also importantly affected by the expectations of both borrowers and lenders about the rate of inflation. If the Federal Reserve did nevertheless attempt to maintain selected interest rates at some predetermined level, the effort could well lead to inappropriate rates of growth in bank reserves and the money stock. If interest rates came under upward pressure because of rising demands for funds, for example, System efforts to prevent interest rate increases would inevitably generate more rapid monetary expansion, thereby feeding new inflationary pressures. If, on the other hand, interest rates came under downward pressure because of slackening business activity and declining demands for funds, System efforts to prevent the decline rates would inevitably retard monetary growth rates, quite possibly exacerbating the recessionary problem. m 26. Thus, any serious effort to specify monetary policy aims in terms of interest rate intentions or expectations could well prove inconsistent with stated objectives for growth rates in the monetary aggregates. Of course, the central bank might attempt to hold to the interest rate objectives, regardless of the performance of the monetary aggregates. But even in this extreme case the result would very likely be self-defeating as lenders and borrowers moved to protect themselves against the prospect of accelerating inflation or deepening recession, foreshadowed by what might be very high or very low monetary growth rates. Needless to say, these effects would be quite perverse from the standpoint of economic stabilization." d. The Board!s Report on "Improving the Monetary Aggregates11 The last event submitted to the SOMC!s attention refers to the report on "Improving Monetary Aggregates" published some months ago. This report was prepared by an advisory committee on monetary statistics under the chairmanship of Professor L. Bach. The members of the Committee were mostly academic economists or statisticians invited for this purpose. The SOMC supported at the time the constitution of this committee and expressed its hope that some useful work would be accomplished. A detailed examination of the Committee's work supplemented by the staff work prepared at the Board of Governors will be presented for a general discussion at the November meeting of the Carnegie-Rochester Conference. evaluation of the report will occur at this occasion. A full and detailed A preliminary reading certainly establishes the professional competence of the Report. offers a useful survey of the problems associated with the data published and the existing measurement procedures. The report submits moreover a numberof important recommendations to improve the measurement procedures. These recommendations pertain in particular to the measurement of the deposit component in the money stock and the seasonal adjustment of the It 27. data. 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"LT " -A \ - \ 1 ' -^-r 1TT : .XX 3 1 : .iT:^ ~ •~t-.~ n• r » l ( i m lav* IB" IH: xr ... :4 r"; E- -*" z\.\rrz V rr- - r -rf\ • 1 , - • * L- - C M C C M 0) 03 (0 O *J •U 0J • rir r :1 ,1. : •*- m O rH 00 I; * _ ~ 00 -••» iill iiU I i - r i rH -i 7ti o ill! 4 M 43 D. cd O - rz— „• e 5% to 7 1 - $ " rang _- r -1 i j *V 4 rr. r :prr -R - ter 19 targ .-{j - - - "IF" s^ TTTJ i J: 3? et base: Ma ^ o o O cr- o- V t t WM«« "^ ^ B 1 H 3 N I SI X Ot " 7 - VI H O N I aHXTMi oe x or 3k11 K" Lt *3H3N» SI X 01 ar.VJ HON1 3H1 OX OS X OZ - * r l • V V I A Mi )«»K S 3 H 3 N I Gl X O l HONI 1 H 1 OX OS X OX oo watts m • a. target base: March 1975 range b. 8 1/2% to 10 1/2% target base: range 2nd quarter 197S 8 1/2% to 10 1/2% M M AV>N H A ' a. target base: range JUJorfS target base: range 2nd quarter 1975 8 1/2% to 10 1/2% 3rd quarter 1975 7 1/2% to 10 1/2% Graph IX: a. target base: range b. 7 1/2% to 10 1/2% target base: range 3rd quarter 1975 rth quarter 1975 7 1/2% to 10 1/2% OS WISH « ilddMH » • rt HI I«VN 53HONI St X Ot LV H3Ni I H I 01 oi x or File FROM Jerry L . Jordan SUBJECT NOTES ON GNP FORECAST PROCEDURE PHONE Mo DATE September 3, 1976 Begin the analysis with IV/73. Assume that at that time there was full utilization of economic capacity and that the aftereffects of the wage and price control program and decontrol and the changes in relative prices associated with the devaluations of the dollar were fully adjusted for. In other words, the economic system was largely in equilibrium. Second, assume that in the fourth quarter of '73 the oil embargo and subsequent quadrupling of oil prices resulted in a decrease in real economic capacity of 4.5 percent. Currently, real GNP in 1972 prices is reported to be $1,242.6 billion in IV/73. Decreasing that number by 4.5 percent gives $1,186.7 billion in 1972 prices. Next, assume that from that point real economic capacity grows at 3.5 percent annual rate which is slightly less than the historic trend rate. That growth would produce the following levels of real economic capacity at the end of each respective year: IV/74 IV/75 IV/76 IV/77 $1,228.2 billion 1,271.2 1,315.7 1,361.7 In 11/76 real GNP is reported currently as being $1,259.4 billion. For the sixth quarter period from 11/7 6 to IV/77 real GNP would have to grow at only a 5 .3 percent rate to be equal to the potential GNP level for IV/77 arrived at by the above means. Assuming that industrial capacity suffered the same 4.5 percent loss as overall real output and that the industrial production index coula also be decreased in IV/73 by 4.5 percent to obtain an index of industrial production capacity, the following numbers would be obtained: IV/73 IV/74 IV/75 IV/76 IV/77 127.25 132.34 137.63 143.14 148.90 Given the final number of IV/77 and given the approximate 129.5 that actually prevailed in the 11/76, the industrial production could grow at a 9.8 percent rate for the six quarter period before reaching capacity. The above exercise produces some interesting implications for inflation, given the Fed's announced money growth targets. Growth rates of Ml andv M2 respectively from IV/73 to 11/76 have been at 4.9 percent and 8.6 percter^t annual rates. Growth of money in each of the successive four quarter periods has been: Ml M2 Percent change 4-quarters ending: IV/74 5.0 7.7 IV/75 4.4 8.3 11/76 5.2 9.8 111/76 4.5e 9.7S For the longer period from IV/73 to 11/76, M2 velocity has risen only a 0.2 percent annual rate while Ml velocity rose at a 3.7 percent annual rate. For the next year and a half there's no reason to assume that either measure of money velocity should exceed the past rates; consequently, the growth of M2 itself sets an upper bound of the growth rate of nominal GNP that should be expected from 11/76 to IV/77, while Ml growth rate plus 3.5 percent would set a similar upward bound. Therefore, if the Fed increased Ml and M2 at the upper end of the currently announced targets, in other words 7 percent and 9-1/2 percent for Ml and M2, respectively, then growth of nominal GNP in the range of 9-1/2 percent to 10-1/2 percent for the period n/76 to IV/77 could be expected. Similarly if Ml and M2 grew at the lower end of the announced ranges, that is 4.5 percent and 7.5 percent, then nominal GNP growth of 7-1/2 percent to 8 percent would be expected. If real GNP grew at the 5 .3 percent rate consistent with exactly achieving assumed full capacity by IV/77, then prices over the six quarter period would rise in the range of only 2.7 percent to 4.7 percent annual rate. These results would mean that output was growing at a 1.8 percent faster rate than economic potential and that would seem to be consistent with the decline in the unemployment rate to about 6 percent by the end of 1977, assuming that an approximate 7 percent rate of unemployment is achieved by the end of 1976. JLJ/nl 9/3/76 GNP PROJECTIONS (FOMC Money Growth Targets) Nominal GNP Actual II/75-II/76 Real Output 12.9% Prices Implied Velocity Ml M2 5.6% 7.3% 7.0% 2.8% B Projections II/76-II/77 9% 10.5% 5.2% 6.1% 3.8% 4.4% 3.5% 3.5% 1.5% 1.0% A Alternative: Ml = 4.5%; M2 = 7.5% B Alternative: Ml = 7%; M2 » 9.5% Projections Ml M2 GNP Real Output Prices Uneraployment Rate II/76-IV/77 4.0 7.0 8.0 5.3 3.7 6.0 PITTSBURGH NRTiGNEL BP.NK TO. File FROM Jerry L> Jordan SUBJECT SHADOW OPEN MARKET COMMITTEE MEETING--9/13 . PHONL No DATE September 3, 1976 At the March, 197 6 meeting, the SOMC recommended growth of Ml * at a rate of 4.5 percent from 1/1976 to 1/1977, At that time it was assumed, that Ml would average $300 billion in the month of March, 1976 and $297.5 billion for 1/1976. Assuming these base figures, the recommended rate of growth would imply HI/1976 Ml=$304 billion and 1/1977 $311 billion. The actual level of M l , 1/1976 was $296.5, one billion less than assumed. It currently appears that the level of Ml for HI/1976 will be about $2 billion greater than recommended by the SOMC last March. Retaining the target level of Ml for 3/1977 of $311 billion would imply a growth of 4.9 percent from the actual level 1/1976, but a rate of only 3.2 percent from currently estimated HI/1976. Subsequent to the SOMC meeting, the Federal Reserve announced on May 3 , 1976 that their own target for 1/1976 to 1/1977 for Ml was 4.5 percent to 7 percent. Thus the lower end of the FOMC's target range for Ml was the same as the SOMC's recommended growth rate. In July, 1976 the FOMC announced that target , growth rates for 11/1976 to IT/1977 for Ml and M2 respectively were 4.5 percent to 7 percent and 7,5 percent to 9.5 percent. It is a good bet, based on the discussion in the Record of Policy Actions for the July FOMC meeting, that the FOMC will set a lower limit for Ml when the targets are moved to HI/1976. Lowering the M2 lower-end also should not be ruled out. Best guess at this time would be that the FOMC will set targets for 113/1976 to III/1977 for Ml and M2 respectively of 4 percent to 7 percent and 7 percent to 9.5 percent. Note: Since the actual level in 11/1976 for Ml was considerably above the Fed's target and more than consistent with the SOMC recommendation, the lower growth rates now indicated by the FOMC still imply more rapid money growth since they begin with a higher b a s e . The SOMC recommendation of 4.5 percent (based on an assumed 1/1976 level of $297.5) would give a level $314.3 for 11/1977. The current FOMC range for 11/1977 is $316.3 to $323.9. Consequently, there has been an upward rachet in the FOMC's money targets. In the first five quarters of economic expansion from I/i975 to 11/1976, Ml grew at a 5.7 percent annual rate while M2 grew at a 10 percent annual rate. Even the non-monetarists agree that a slower growth of money is appropriate in the second year of expansion and there is no basis for recommending higher growth in the year ahead than occurred in the past year. Nonetheless, Professor Modigliani / in an article in the Boston Fed Review, argued for higher growth and the Congressional Budget Office, in its August 3 7 1976 report Sustaining A Balanced Expansion, argued for an 11 percent growth in M2 11/1976 to IV/1977. Their prescription is less extreme than a year ago, but there is no reason to expect that they are any more correct now than they were a year ago. As a tentative recommendation I would suggest a target growth of Ml for the period in/1976 to III/1977 of 4 percent. The level of money for 1/1977 set at the March 8, 1976 SOMC meeting was $311 billion; I recommend raising that to $312, whichj//ould be a 5.2 percent increase over actual 1/1976, and a 5.3 percent rate of increase over estimated III/1976, JLj/nl THE TREND OF OUTPUT Ratio Scale Billions of Dollars 1400 •nnf Ratio Scale Billions of Dollars 1400 Quarterly Totals at Annual Rates Seasonally Adjusted 1 i , i 1 s i y I 1 1300 i 1300 t\ 1 i • ! , s f f ! ! • • 1200 i' 1 • 1200 / y • 1 II ! i 1 1100 A 1 • i 1000 i r !' i |! I1 \ t 1000 \ I 1 I 900 •i! / i 1! H i 900 • 1 ;• 1 800 / f 1 1 j i !• ! 1 ' i ,| 1 !i ' i ( i 800 i 1' | i y i !, I / i J r : ii ' 'i , !• iii!;!1 iiii I |!- I ' I 1 'li 1959 ' i ' V 1 lij :ii;i | |,|l| ;|. i Ii!1, 'ill' I J i iii1 I* 'in i •" ; • • •I!- Il ' iti'i 1957 t ; i 1 ''! 1955 ' 700 1l 1 1 I, 1 i !l , 1 i I'1' •il ! , 1 ' ' 1 1 ! r i ' • ' 600 j 1 t 1 700 1100 •; '.'.'lib! 1961 1963 1965 1967 1969 ! 1971 1973 1975 600 1977 PITTSBURGH NRTIONRL BflNK M odigl ian a^ ja nd_ Lucas. Brookings Papers on Economic Activity I — 1975 - Page 163 (from Conference, April 24 & 25, 1975) "If the Federal Reserve should fail to accommodate the recovery in money income and insist on containing the growth of monetary aggregates within some historical average range, as in 1974, one can confidently predict short-term market interest rates will again escalate into the two-digit range, taking the wind out of the sail of recovery and possibly causing a new recession, much as in 1974. This time, however, the episode would start from an unemployment of 8 percent or more, and the consequences would be far more tragic." II From an article printed in the Boston Fed New England Economic Review reprinted in the Money Manager, April 12, 1976 - Page 15 " . . . .the best judgment one can make from historical experience as to the rate of growth of money needed to hold interest rates around current levels over the next 2 to 3 quarters is around 9% - 10%, but we would not be too surprised if that number turned out to be as high as 12 or instead to fall short of the current target range. l f "This is a large margin of uncertainty, but fortunately there is no need to be concerned about it, since our policy target is stated in terms of interest r a t e s , not in terms of money supply," "Indeed, the great uncertainty about the demand for money is one major reason why, at the present time, the target of monetary policy is best stated in terms of interest rates rather in terms of growth of money. " "The large margin of uncertainty and the wide range of possible outcomes for the growth rate of money further imply that neither Federal Reserve nor the public need panic if the maintenance of the current level of interest rates for the next 2 to 3 quarters were to require in some quarters a rise in the money supply, well about 10%." "There is no danger that such a growth rate of the next 2 or 3 quarters would lead to increasing inflation contemporaneously or even at some later date, as long as it resulted from maintaining current interest rates, rather than from a policy of forcing them down. " JLJ/Ip A/23/76 THE STATE OF THE FLOAT BRIEFING FOR SHADOW OPEN MARKET COMMITTEE MEETING SEPTEMBER 13, 1976 by WILSON E. SCHMIDT 1 As is well known, floating exchange rates are no longer sinful. This was agreed in Jamaica in January by the Interim Committee of the International Monetary Fund. The tedious process of getting formal parliamentary approval of this is well on its way, with the real possibility that the United States may have approval in hand by the Manila meetings of the Fund early in October. Hie rhetoric about par values, central rates, and most ether vestiges of the Bretton Woods system has shifted almost completely. The Bank for International Settlements writes "•..experience has now taught us that relative stability of exchange rates cannot be achieved merely by market 2 intervention, even on a massive scale.ff national Monetary Fund said in June: The Managing Director of the Inter- fT No par value system could have been sustained with the large imbalances and the wide variations in inflation we 3 have seen in recent years." But if the rhetoric about floating is moving in the right direction, it is not at all clear that the facts about floating are also moving the same way. The amount of foreign exchange market intervention by central banks and Professor and Head, Department of Economics, Virginia Polytechnic Institute and State University, Blacksburg, Virginia 2 Forty-Sixth Annual Report, Basle, June 14, 1976, p. 138. 3 IMF Survey, June 21, 1976, p. 182. Treasuries through sales and purchases of foreign exchange appears to be increasing, perhaps substantially. The Organization for Economic Cooperation and Development stated in June that "Over the past several months, official interventions have been substantial, probably the largest since the 4 generalizing of floating in early 1973. n Recent press reports relying on Fed sources indicate that intervention by major central banks averaged $7 c billion.in February through p i ? (a record high since March, 1973 when the April } float began) and $7.5 billion in Hay and July. And the Federal Reserve-Treasury operations in our foreign exchange market during February-April 1976 increased, measured at an annual rate, by 4 % over the preceding year. 5 Not counted in those operations is the massive $5.3 billion bundle for Britain, of which our share was $2 b i l l i o n , on June 7. was drawn under that facility Recent press reports indicate that $400 million from the United States in M y and June and that a the Italians repaid $550 million under their swap arrangements with us in the same period. O an average monthly basis, this suggests at minimum (because we n don't know as yet a l l of the transactions that occurred) a 5 % increase in 7 Fed-Treasury intervention over the year prior to February. constitutes intervention is a matter of dispute. (Exactly what I have taken a broad definition namely the sum of the sales and purchases identified by the Fed in i t s official frequent reports and the activation of swaps with the U.S. by other countries since the l a t t e r requires the approval of the U.S. Government. A much narrower definition would be to count only those sales of foreign exchange by the Fed. Provisionally, I reject this because i t seems that purchases of 4 Economic Outlook, Paris, July, 1976, p. 47. The Journal of Commerce, September 2, 1976. 6 Ibid. foreign exchange affect rates as well.) There is, however, some good news. Various reports indicate that drawings under our swap arrangements will be more conditional than ever before, less automatic than they seemed to be in the 1960 *s, and less likely to be rolled over after their six month life. Also, while there was a pronounced increase in restrictions on current (as distinguished from capital) transactions in 1975 and through the first four months of 1976, "...in only a few instances were they applied as a major instrument of balance of payments management.11 To some extent perhaps exchange rate changes are being allowed to replace controls that otherwise might have been imposed. The other piece of good news is that the United States Government has abolished the concept of an overall balance of payments surplus or deficit, a decision which will properly distract attention from the condition of our balance of payments, which is no longer a problem. It is much too early to tell if we shall be turning to a system of de facto par values, created out of a system of de facto targets for exchange rates. hints are there. The An Alternate Executive Director of the Fund recently wrote that the "majority of policymakers" . . . "dream of 'advancing1 again step by step to a par value system." And the mechanism is in place because under the reform agreed upon at Jamaica, the Fund "...shall exercise firm surveillance over the exchange rate policies of its members, and shall adopt specific principles for the guidance of all members with respect to those policies." (Italics added) Only time will tell how far the Fund will go in its exercise World Financial Markets (Morgan Guaranty Trust, June, 1976). Q Statistical Reporter, June, 1976. g Tom de Vries, "International Monetary System." p. 591. Foreign Affairs (April, 1976) of responding to this mandate which began last week. And if guidelines are established, only time will tell how much power the Fund will have to enforce them. Dr. Guido Carli, long-time Governor of Italy's central bank, recently reminded us that "...as originally conceived, the Fund's prescriptive powers derived from its ability to exclude refractory countries from access to conditional credit.!! He sees the private banking system, particularly U.S. banks, as having taken over the function of providing international liquidity, thereby diminishing the ability of the Fund to enforce its rules of conduct. On the other hand, the Managing Director of the Fund seems to see enhanced effectiveness of the Fund under the float in dealing with exchange rates. Under the par value system, it was virtually impossible to discuss changes in exchange rates among countries in advance in the Fund because of the effects of ensuing leaks and rumors on capital flows. He now reports "...we have already seen a greater willingness on the part of the Fund members to engage in effective discussion of their exchange rate policies." Curiously, the Managing Director seems to complain that the reform agreement provides no arrangements for the control of international reserve creation. principles to be adopted will do that. 12 Clearly, the exchange rate If the guidelines require central banks to support foreign currencies, under any circumstances, reserves are apt to be created; if the guidelines prohibit it, then reserves are not likely to be created. Whether or not the Fund will have more power (and how much international reserves are created) depends in part on how many favors it has to dish out. 10 U IMF Survey, July 19, 1976, p. 212. I M F Survey, June 21, 1976, p. 182. 12 Ibid.» p. 179. ("Favors" is the right word, since it starts its lending at 4.5%). These clearly have been increased by a little noted part of the reform agreed upon at Jamaica. Quotas of the members have been raised from 29 billion SDRs to 39 billion SDKs. The actual increase in Fund resources is "considerably greater" than one third because the existing resources of the Fund contributed by some nations were not available in practice before the Jamaica agreement was negotiated but now 13 presumably will be* Pending approval of the quota increase, a decision was made to increase the credit tranches of the Fund by 45% which has approximately the same effect. In a fundamental sense, this mandate for exchange rate principles and surveillance puts the cart before the horse. A new perception of how the world could obtain exchange rate stability was worked out at Rambouillet and Jamaica. It says that if countries stabilize their underlying economic conditions, stable exchange rates will be the derivative. To this end, increased consultation among the leading countries has been achieved which hopefully will lead to better coordination of national economic policies. If one were to dream about the ideal form of coordination, one might ask the members of the Fund to set a target for the growth in the world money stock. The members would then divide that target among themselves. (This would not be unlike the Congressional Budget Resolution exercise.) By setting a world target, world inflation might be stopped. And since floating does not always provide perfect independence from foreign events for a floating nation, internal inflationary pressures within the more sober floating 13 Testimony of Jack F. Bennett, International Finance Subcommittee, Senate Committee on Banking, Housing and Urban Affairs, August 27, 1976. nations might ease. And the world target might help put pressure on the inflationary-hippies of the world to come to their senses which, while probably good in i t s e l f , would help the more restrained nations and the world as a whole indirectly by reducing the uncertainties created by inflation. If the members divide up the world money target in a manner which stabilizes their underlying economic conditions, stable exchange rates are likely to ensue because their relative postions are not likely to change. (Paradoxically, i t is then that the greatest dangers for pressures to return to fixed rates will prevail.) In such circumstances, over the longer pull, there is no need for specific principles of exchange rate management. For example, if the Federal Republic of Germany's appropriate target is 8 , then i t doesn't matter whether the % German central bank achieves that objective by buying foreign exchange (thus adding to world international reserves) or by internal measures to expand the monetary base. The German price level will be the same in either case and the exchange rate will have to conform to i t relative to prices in other countries in the longer run no matter whether the central bank intervenes in the market place or not. In effect the level of world reserves has nothing to do with the world price level and world economic activity for the l a t t e r are determined by the world target for monetary growth. or too l i t t l e ) drops out. The so-called liquidity problem (too much If a l l the countries of the world by some coincidence sought to achieve their proper target by buying foreign exchange, the difference would be that a l l central banks would be holding far more reserves and far fewer assets of domestic origin. In this scheme, one starts from the top - a world monetary growth target and, if that target is properly divided among nations, stable exchange rates ensue and the issue of the proper amount of international liquidity drops out of sight. Of course, this is a dream, but perhaps one worth thinking about. It is a dream because floating rates probably do not conform in the short-run to relative price levels as quickly as politicians would like. As Secretary of the Treasury Simon warned the OECD last June, in those inflation-prone countries with floating rates the downward pressures on their exchange rates may tempt their governments to restrict trade to the detriment of their more sober neighbors. And it is a dream for another reason. With the inherent desire of politicians in power to pursue expansive policies before elections and tighto n e ^ after victories (the political business cycle), it will be hard if not impossible to get the appropriate division of the world target among nations simply because elections are scheduled at different times among nations. While it is not clear that the Fund will enjoy an increase in its power to influence its member's exchange rate policies, it is rather clear that if the Fund uses the carrot of lending rather than the stick of withholding its resources, the result could be more world inflation without a world monetary growth target. There are two reasons for this. First, when the Fund lends the currency it has of Country X to Country Y, then when Country Y uses the X currency to pay Country Z, Country Z then enjoys an increase in its reserves if the central bank of Z chooses to buy the X currency. There is a direct increase in the monetary base of Country Z. 14 Statement, June 22, 1976. Second, when the Fund lends the currency of Country X, that country, under Fund procedures, enjoys an increase in its net reserve position at the Fund, which is a balance guaranteed in terms of SDKs. Country X can draw an equivalent amount of foreign exchange from the Fund virtually automatically. While there is no necessary direct impact on the monetary base of Country X, the monetary authorities may well feel less constrained in their domestic monetary policies by their increased holdings of international reserves, While it is impossible to foretell what the Fund lending policy will be, it is not difficult to make some rough estimates of the possible impact on world inflation of this increase in quotas under various assumptions. By mid-19 76, net lending by the Fund to its members equalled almost half of the quotas of its members. If we assume that the same ratio prevails for the increment of 10 billion SDRs and the increment in lending is divided equally over three years, recent econometric research by H. Robert Heller suggests that by 1980 the world price level would be almost two-thirds of 1% higher than it otherwise would be. (This probably exaggerates the effect of Fund lending because the Fund often imposes conditions on borrowers to perform better internally. To the extent that the Fund is successful in this respect, and experience suggests that it is, this effect tends to offset the inflationary effect of Fund lending elsewhere in the world, i.e., in the country ultimately receiving the foreign exchange and in the country enjoying a net increase in its reserve position. On the other hand, 10 billion SDRs understates the effective increase in the Fund's resources as noted above. But there is at present no way to sort these things out.) To achieve a IMF Staff Papers (March, 1976). For a critique of this model see a forthcoming paper by Richard Sweeney and Thomas Willett, "Eurodollars, Petrodollars and Inflation." zero rate of world inflation, the internally generated growth of the stock of money in the world as a whole, given the Fund generation, will, according to Heller's equations, have to be held to 3.2% in the period 1978-80. Formulated in that manner, these calculations reveal the fundamental question which underlies (or at least should underly) the discussions of guidelines for exchange rates. That question is how much should the world rely on adjustment through exchange rate changes versus financing of balance of payments disequilibria (as throug\ the IMF) ? The answer to that question rests in part on what ratio of world trade to world output one thinks is optimal because, the more financing of disequilibria, the larger the volume of world trade and the smaller the portion of the money stock that can be generated internally. While this question is too complicated to try to answer here, one might start with a presumption against financing instead of adjustment on the grounds that the Fund loans are at non-market rates. Comments on Fiscal Policy Developments for Shadow Open Market Committee Meeting April 13, 1976 Thomas Mayer University of California, Davis In this memo I will follow the format set out by Bob Rasche in his memo at our last meeting. Much new information has become available in the last six month, but, as discussed below, some new problems have arisen which increase the range of uncertainty about any fiscal forecasts. Previous Developments Table 1 is an update of Bob Rasche!s Table 1 from our last meeting. I have added the data for two quarters and revised the data for the other quarters in accordance with the revisions of the NIA data. The figures in the first five columns are taken from the NIA budget and are seasonally adjusted quarterly rates. The data for 1975 IV and 1976 I show a continuation of the trends pointed out by Bob Rasche at our last meeting. Real government purchases of goods and services are up only slightly, but transfers are up much more. The NIA deficit is still very substantial. The other data in Table 1 are from the unified budget and indicate the financing requirement. They are not strictly comparable with the NIA data shown in the first five rows so that the last column is somewhat inaccurate. There are definitional differences; for example, governmental sales (e.g., oil leases) are included in the unified budget, but excluded from the NIA budget. In addi- tion, the unified budget, unlike the NIA budget counts outlays when payments are actually made, rather than on an accrual or delivery basis. can be quite large. These differences TABLE 3 DEFICITS AND hORROWING REQUIREMENTS, 1975 1-1976 I 1975 1976 I II III IV (Billions of Dollars) A. 1. 2. 3. 4. 5. NATIONAL INCOME ACCOUNT CONCEPTS-S.A. QUARTERLY RATES Fed. Gov. Purch. of Goods § Services (1) in 1972 $ Transfers Receipts Deficit ( ) - C. CHANGES IN CASH ACCOUNTS 10. F.R. 11. T+L Accounts 12. Other D. BORROWING 13. F.R. 14. Public 29.8 23.1 56.5 62.5 -23.8 31.0 23.7 58.2 73.3 -15.9 32.5 24.0 59.3 75.5 -16.3 32.8 24.0 61.2 78.2 -15.8 83.120 65.129 17.991 18.281 88.083 76.061 -12.022 -14.477 90.805 72.274 -18.531 -21.701 93.618 67.056 -26.562 -27.760 89.612 66.910 -22.701 -24.847 "Xl58 -.603 .622 1.502 -.667 1.294 2.301 .687 -1.004 -.788 -1.003 -.312 -.141 -.295 -.299 .917 18.541 B. UNIFIED BUDGET CONCEPTS 6. Outlays 7. Receipts 8. Deficit ( ) 9. Financing 29.8 23.4 52.9 70.9 11.8 3.331 13.275 2.249 21.436 ,936 24.721 1.819 22.293 Sources: col. 1- 5: col. 6- 8: col. 9: col. 10-11: col. 12: col. 13: col. 14: National Income and Product Accounts, Survey of Current Business, Tables. Federal Fiscal Operations: Summary, Federal Reserve Bulletin, p. A32. Federal Fiscal Operations: Summary, Federal Reserve Bulletin, p. A32: US Budget Surplus or Deficit Plus Other Means of Financing. Federal Fiscal Operations: Summary, Federal Reserve Bulletin, p. A32: Selected Balances (End of Quarter-Beginning of Quarter). Federal Fiscal Operations: Summary, Federal Reserve Bulletin, p. A32: Selected Balances - Other Depositories (End of QuarterBeginning of Quarter) + Other Cash and Monetary Assets. Consolidated Condition Statement of all Federal Reserve Banks, Federal Reserve Bulletin, p. A10, Total U.S. Gov't. Securities (End of Quarter-Beginning of Quarter). (Col. 10 + Col. 11 + Col. 12 - Col. 9 - Col. 13). As Bob Rasche pointed out at our last meeting, since 1971 the Federal Government has required approximately $115 billion of new financing. In the two quarters I have added this has risen by about $50 billion of which the Fed picked up $2.76 billion, i.e., 5.5 percent. This contrasts with the 20 percent the Fed picked up on an average over the 1971 1-1975 III period covered by Bob Rasche at our last meeting. The Treasury financed $2.8 billion of the deficit by running down its cash balances over these two quarters. The Previous Fiscal Year The final figures for FY 1976 are now available, and show the following pattern: Actual Receipts Outlays 300.0 365.6 Deficit ( ) - -65.6 Previous Estimates Jan. 1976 Mid-session Review (July 1976) (Billions of Dollars) 297.5 299.4 375.5 369.1 -76.0 -69.6 Thus the deficit was $10.4 billion (14 percent) less than was expected in January 1976. And even the mid-session review, two weeks prior to the end of the fiscal year was $4 billion off, due to an overestimate of expenditures. However, some of these expenditures were merely deferred. Since Congress authorized the carry-over of appropriations into the current transition quarter, the usual last minute rush to spend funds did not occur. However, some of these expenditures will occur during the transition quarter since funds cannot be carried over beyond that to fiscal 1977. Compared to the January estimate, actual expenditures were $7,9 billion less. Some, but not all of this, will therefore be made up in the current transition quarter; glancing at some of the specific items involved I would guess that perhaps $2.5 billion or so will be permanently "lost." Transition Quarter The July Mid-Year Review lists the following estimates for the transition quarter: Receipts Outlays Deficit ( ) - $ 82.1 billion $ 102.1 billion $ "-20.0 billion It is worth noting, however, that these estimates, while they include congressional actions through June, assume that Congress will follow the President's program subsequently. However, the C.B.O.'s expenditure estimate is lower, $98.6 billion. According to OMB if one combines FY 1976 and the transition quarter, the error in estimating expenditures is greatly reduced, a reflection of the shift of expenditures into the transition quarter. The figures are as follows: July estimate January estimate (Billions of Dollars) Difference Receipts Expenditures 381.6 471.2 379.4 471.5 2,2 -0.3 Deficit ( ) - -89.6 -92.1 -2.5 Projections Before looking at the projections for FY 1977 and beyond, two warnings are in order. One is that uncertainties about the strength of the current expansion make it hard to predict both revenues and expenditures. C.B.O. projections assume a continuing expansion, Both the O.M.B. and I have not tried to adjust them for a possible slowdown, because I am guessing that a healthy expansion will continue, and that the current signs of a slowdown are only the hesitancy frequently seen part-way through an expansion, what at one time was referred to as a stage in a "Mack cycle.11 Second, it is hard to know how the new congressional budgeting system will work. Expenditures have been set on the assumption that taxes would be raised by $2 billion. This seems unlikely as of today (Aug. 30) though this may change before our meeting. The alternatives one can play with here are numerous. I do not know which one of the many alternatives to choose, and have therefore not made any adjustments to the figures. The reader may want to lower receipts by $x billion and add $x billion to the deficit. With these two provisos, here are figures for FY 1977 as obtained from the staff of the C.B.O. and from the O.M.B.!s Mid-Session Review of the Budget. FY 1977l C.B.O. O.M.B. (Billions of Dollars) Receipts Outpay 362.5 413.3 352.5 400.0 Deficit ( ) - -50.8 -47,5 The C.B.O. and O.M.B. estimates differ for two reasons. One is that the O.M.B. expenditure figures are based on the assumption that Congress will enact the President's program, though it does, of course, take account of Congressional actions prior to July when it was issued. is based on congressional proposals. The C.B.O. budget, on the other hand, In this respect the C.B.O. figures are probably the more realistic. O.M.B. figures are from Mid-Year Review, p. 8. C.B.O. figures are unpublished estimates supplied through the courtesy of the C.B.O. Another difference is in the underlying economic assumptions which are as follows: Calendar Years 1976 1977 OMB Real GNP growth Inflation Rate (CPI) Unemployment Rate CBO OMB CBO 6.8% 5.7 7.3 5.0% 5,0 7.3 5.7% 5.6 6.4 5.0% 5.5 6.4 It is hard to choose between these estimates. Fortunately, such a choice is not really necessary because both the O.M.B. and C.B.O. deficit projections are not very far apart; we are dealing he:£p with a difference of $3.3 billion. This is not very large in view of the other uncertainties that are involved. To illustrate with just one example, estimated FY 1977 interest payments on the Federal debt are about $40 billion. If the average interest rate on the debt is 10 percent lower than is assumed in this $40 billion estimate, then, even after making some allowance for the resulting reduction in tax receipts, the deficit could be, say $2 billion lower. And given the recent peculiar behavior of interest rates, a 10 percent error is far from unlikely. This illustrates an important point; although the new Congressional budget system is an immense step forward, there is still a great deal of uncertainty about what next year's deficit will be. This is an example of the familiar statistical point that if one tries to estimate a small residual it is a good idea to have an unlisted phone number. Longer Run Projections Table 2 shows the O.M.B.fs economic assumptions as given in its July 1976 Mid-Session Review. These differ from the ones given in the January Budget discussed by Bob Rasche at our last meeting. The estimate for GNP in current dollars has been lowered by $3 billion for 1978, $6 billion for 1979, $61 billion in 1980 and $130 billion for 1981. The real growth rate has been changed as follows: July estimate 1977-78 1978-79 1979-80 1980-81 January estimate 5.9% 6.3 4.4 3.7 5.9% 6.5 6.5 4.9 The assumptions about the unemployment rate are now uniformly more optimistic. The inflation rate expected for some years has gone up, and for others down. The most notable difference is that the new projections have sharply reduced the inflation rate projected for 1^)81, to less than 3 percent in what seems like an act of faith. One can well sympathize with O.M.B. in trying to forecast the inflation rate that far ahead. the tools needed to make such a forecast. Economics simply does not provide All the same, I would be surprised if the inflation rate would actually be below 3 percent in 1981. And given the high inflation-elasticity of revenues, I suspect that 1981 revenue is probably understated, and the same may well be true for 1980 as well. Table 3 shows the C.B.O. assumptions. These assumptions, which are un- published updates of the ones published in March, no longer use the format of Path A and Path B projections. The real growth rate is assumed to be 5 percent until we return to a 4.5 percent unemployment rate when it will fall to 3.5 percent. It is instructive to compare the old Path B with the new estimates in terms of unemployment and inflation rates: TABLE 2 O.M.B.!S LONG RANGE ECONOMIC ASSUMPTIONS (Calendar Years; dollar amounts in billions) Assumed for Purposes of Budget Projections 1978 1979 1980 1981 Gross national product Current dollars: Amount Percent change Constant (1972) dollars: Amount Percent change Incomes (current dollars): Personel income . ^... • Wages and salaries....* Corporate profits Prices (percent change) GNP deflator: Year over year Fourth quarter over fourth quarter CPI: Year over year •••••••.. December over December .....••••.. Unemployment rates (percent): Total Insured 1/ .v ". Federal pay raise, October (percent) .. Interest rate, 91-day Treasury bills (percent) 2/ 2,121 12.2 2,370 11.7 2,575 1,418 5.9 l;508 6.3, 1,575 1,720 1,121 201 1,920 1,252 2,083 1,361 223 242 2,220 1^452 258 6.0 5.7 5.1 4.7 4.0 3J6 2.9 2.5 5.6 5.4 5.1 4.1 4.7 3.5 2.9 2.4 5.7 4.1 7.0 5.1 3.2 6.5 4.8 3.2 • 5.75 4.7 3.2 5.0 5.4 5.4 5.4 5.4 8.6 4.4 2,747 6.7 1,634 3.7 1/ Insured unemployment as a percentage of covered employment; includes unemployed workers receiving extended benefits. 2/ Because of the difficulty of forecasting interest rates, the budget has generally followed the convention of assuming that interest rates remain constant at the level prevailing at the time that interest outlays are estimated. The rates shown above for calendar years 1978 through 1981 were those prevailing at the end of June. Source: O.M.B. Special Analyses of the Budget of the United States Government, Fiscal Year 1977, p. 47. TABLE 3 ECONOMIC ASSUMPTIONS OF C.B.O. Calendar Growth Rate Year of Real GNP 1976 1977 1978 1979 1980 1981 1982 5.0 5.0 5.0 5.0 5.0 3.5 3.5 Unemployment; Rate 7.3 6.4 5.8 5.3 4.8 4.5 4.5 Increase in W.P.I. 4.97 5.91 5.50 5.40 5.55 5.78 5.96 a Increase in c.p.i. a Treasury Bill Rate 4.98 5.52 5.52 5.39 5.59 5.88 6.13 4th quarter to 4th quarter. Source: unpublished estimates provided through the courtesy of C.B.O. 5.29 6.59 7.13 7.13 7.13 7.13 7.13 C-B.O. Growth rate of CPI Unemployment Rate Path B New estimate Path B New estimate 1977 1978 1979 1980 1981 O.M.B. Growth rate of CPI Unemployment Rate 6.9% 5.5% 7.5% 6.4% 5.7% 6.4% 5.9 5.6 4.8 5.0 5.5 5.4 5.6 5.9 7.1 6.7 6.3 5.9 5.8 5.3 4.8 4.5 5.4 4.7 3.5 5.7 5.1 4.8 4.7 2.4 These new estimates seem a substantial improvement over Path B, not to speak of Path A which Bob Rasche pointed out at our last meeting is quite unrealistic. Compared to the estimates of O.M.B., also shown above, the price path indicated by C.B.O. seems more plausible. In particular, it avoids O.M.B.!s very optimistic assumption that we can get the inflation rate down below 3 percent in 1981. For 1977 C.B.O. is a shade more optimistic than O.M.B., which I also find plausible. and 1979. C.B.O. is also a shade less optimistic about unemployment for 1978 I am a bit uneasy about both the C.B.O. and O.M.B. unemployment estimates for the last two years. Unless manpower policy becomes much more effec- tive, the natural rate of unemployment may well be high enough to make the unemployment and price projections, particularly O.M.B.fs, inconsistent, if one allows for the possibility that once we fall below the natural rate, memories of the current inflation will be revived very quickly. The revenue and outlay projections that follow from these economic assumptions are shown in Table 4. Unfortunately, the only figures available are in calendar year terms for the O.M.B. estimates and in fiscal year terms for the C.B.O. estimates, though for the new fiscal year this does not matter quite so much. Despite this the differences between the two estimates are relatively modest for both outlays and receipts, but again the residual item, surplus or deficit, shows a relatively much larger difference. TABLE 4 LONG RUN PROJECTIONS OF REVENUES, OUTLAYS AND DEFICITS (Billions of Dollars) 1978 O.M.B.a C.B.O.b 1979 O.M.B.S C.B.O.b Outlays Receipts 433.3 405.2 442.1 406.3 461.5 462.6 Deficit (-) " 28<1 ~35"8 1A 1980 O.M.B.a C.B.O.b 468.8 453.7 492.2 513.9 "l5A 21 7 ' 498.6 507.4 8 8 ' 1981 O.M.B.a C.B.O.b 522.2 558.3 36 1 ' 529.6 565.1 35 5 - applies to calendar years applies to fiscal years Source: O.M.B., Mid-Session Review of the 1977 Budget, p. 29, C.B.O. unpublished estimates. In this connection it is worth noting that a fairly small difference in estimates of the deficit can have unpleasant consequences for monetary policy. For example, if one assumes that the Fed picks up, at the margin, a quarter of the deficit, and that the M money multiplier is 2, then a $8 billion difference in the deficit translates into very roughly a one percent difference in the growth rate of M . For 1979 the difference between the estimates is about $16 billion, though much of this could be due to the fact that one set of estimates is for calendar years and the other for fiscal years. It is worth noting that the outlay figures are meant to show different things. The C.B.O. outlay projections tell us what expenditures will be if current programs are maintainted in real terms, while the O.M.B. outlays are projections of expenditures if transfer programs remain fixed in nominal terms, except where current legislation or legislation proposed by the President has an escalator clause (e.g., Social Security). Actuality probably lies somewhere between the two. It is therefore not surprising that O.M.B. shows smaller deficits, or larger surpluses, than C.B.O. The deficits shown by both projections for 1978 represent substantial declines from the current year's and the previous year's level, but are still large in absolute terms. O.M.B. then shows surpluses starting in calendar year 1979, while C.B.O. shows a surplus starting in FY 1980. pluses. For 1981 both show substantial sur- But I would be most surprised if anything beyond a modest surplus actually materializes. Continued deficits seem much more likely. Both projections assume no new programs, and this is hardly likely to happen, particularly if there is a surplus. In summary then, it is reasonable to expect a deficit in the $30 billion plus range in calendar year 1978, and a considerably smaller deficit the following year-assuming that few, if any, new costly programs are introduced. For the period beyond that, the existence of a deficit, and its size, will be determined by the size of new spending programs that are likely to be introduced by 1980. Financing Requirements in FY 1977 As previously discussed the C.B.O. projects the deficit for FY 1977 at 50.8 Table 5 shows the O.M.B.!s January billion, while O.M.B. estimates 47.5 billion. projection of how the deficit will be financed. have to be borrowed from the public and the Fed. It shows that $53.5 billion will But the O.M.B.fs July estimate puts the deficit $6.5 billion below the January estimate, which suggests that borrowing from the Fed and the public will be $47 billion. this borrowing will be close to $50 billion. by foreigners. Using the C.B.O. estimate Some of this debt may be picked up Foreigners, mostly foreign central banks, increased their holdings by $10.2 billion in FY 1973, -$2.5 billion in FY 1974 and $9.1 billion in FY 1975. Hence, foreign central banks could potentially reduce the strain the deficit imposes on the American capital market, but since their purchases are erratic, I know of no way to predict whether they will oblige. Fortunately, as Table 6 shows, the agen- cies (including the off-budget ones) will not exacerbate the problem. I have not located any estimates of the FY 1978 borrowing requirement, but the previously discussed projections of the deficit for that year suggest that there will again be a substantial, albeit a declining, public borrowing requirement, even in the unlikely event that no new programs are started. However, Conrail's problems will probably raise agency borrowing beyond the budget estimate. TABLE 5 PROJECTED MEANS OF FINANCING THE FEDERAL DEFICIT Description 1975 actual • Budget surplus or deficit ( - ) -43.604 Surplus or deficit ( - ) of oF-budget Federal agencies *. Total, surplus of deficit ( - ) -9,544 -53,149 Means of financing other than borrowing from the public: ^ Decrease or increase (—) in cash and monetary * > mets Increas; c decrease ( —) in liabilities for Checks outstanding etc 2 Deposit fund balances Seigniorage on COJIS 1976 t$U - 7 6 00! - 9 342 -85,343 —273 167 -1,585 - 1 6 077 - 4 2 975 -4,040 -11,060 -20.117 -54.035 131 -182 626 672 2,295 -2.157 Total, requirements for borrowing from the public -50.853 Rcdassincation of securities3 -87.500 -20.000 87.500 20.000 Total, means of financing other than borrowing from the public Change in debt held by the public 1977 cat. -1.411 1 362 579 TQ cit 50.853 422 -591 168 704 117 535 - 5 3 500 —340 53.8^0 1 The off budget Federal agencie* c o n i n t of the Rural Electrification and Telephone revolving fund Rural Telephone B i n k H o j u n g for the Elderly or Handicapped f^nd 'as of Septemb-r I 19?*) P e n n o n Benefit Guaranty Corporation Feoeral Financing tian*. Export I i i o o r t Bank urt 1 Octooer I. 1976) Pottal Service certain activitie* of the United States Railway Anociatton and Energy Independence Authority * Betide* checks o j t i t a n d m g include* military p a y m e n t certificate* accrjed »ntere»t ( l e u unamortized ducount) payable on Trea»ury debt and at an o d i e t t m g change in atteti certain collections in transit 1 On October 1 1976 Federal debt he'd by the public is e»timated t o mcres»e by $340 million due t o & red&uification of Export Import Bank certificate* of benehual interest from loan a»*ct «al:» t o debt Source: O.M.B. Special Analyses of the Budget of the United States Government, Fiscal Year 1977, p. 48. TABLE 6 AGENCY BORROWING (millions of dollars) Borrowing or repayment (—) of debt Description 1975 actual 1976 estimate Debt out TQ ettimtte end 197*7 ettimttc Borrowing from the public* Agriculture Farmers Home Admii ' Defense Health, Education and Welfare : Housing <md Urban Development College housing loans 2 3 Pubhcfacil tyloans 2 3 Federal Hojsmg Administration Housing for the elderly 2 .. . Gov National Mortgage Association 2 . Revolving fund (liquidating programs) 28 Veterans Administration 2 Export-Import Bank4 Postal Sen.ce Small Business Administration 2 Tennessee Valle> Authority _ All other Total, borrowing from the public 4 ... Borrowing from other funds: Agriculture Farrrcs Home Admin2 Defense Health, Educaticr and Welfare 2 Housing and Urban De\ elopment Collegehoiking loans" 3 Public facility loans" 3 Federal Housing Administration Housing for the cldcly 2 . Gov National Mortgage Association : . Rewlvmg fund (liquidating programs) 23 Veterans Adrmnistrat'on 2 Export-Import Bank Small Business Administration * Tennessee Valley Authority -1 -25 -92 -25 90 19 50 "-41 -17 -44 -295 -39 4 -18 "-99 -4 -55 -789 -1 -570 -11 -100 _* -1,023 -178 -41 -15 -2 -87 61 _* _ -73 1 -19 1 -98 -4 -55 -1,079^ 291 900 125 576 64 545 391 553 2,144 250 227 1.975 2 8,042 -21 -14 -3 156 128 65 -62 67 33 442 1 "io -4 4 -6 1 -51 -4 2U 549 -46 * 117 Total, borrowing from other funds.. Total, agency borrowing included in gross Federal debt 4 MEMORANDUM Borrowing from Federal Financing Bank: Tennessee Valley Authority Export-Import Bank Postal Service__ _ United States Railway Association. 1.435 4.049 1,000 34 1.100 1,437 1.280 -5 300 393 500 -1 1.000 2.028 1.398 -2 3.835 7.508 Total, agency borrowing from Federal Financing Bank 6,518 3,812 1,192 ',424 16,447 4.678 26 • L e u than $500 thousand * Exclude* agency borrowing from Tre**ury * Certificate of participation in loan* t»»ued by the Government National Mortgage A»»oci*tiot» on behalf of several agenciei ' T h e debt of the Public facility loan fund (5143 million) w t i tran«ferred to the Revolving fund (liquidating program*) on April I 1975 and the debt of the College housing fund ($467 million) is scheduled to be transferred on October I 1976 n « Borrowing in 1977 doe* not include the recia»»incation on October 1. 1976 of an estimated $340 miHioc of Export import Bank certificate* of beneficial interest as debt t m U a d of loan s»»ct tales Source: O.M.B. Special Analyses of the Budget of the United States Government, Fiscal Year 1977, p. 54. June-July Report rterly Update June 30 1976 In this issue John Rutledge combines the quarterly update of the AFEC forecasts with a look at the economic and financial environment over the next five years The key ingredient in AFEC forecasts of real output, prices and interest rates over the next five years is the likely path of the monetary aggregates Given our appreciation of the powers which an administration can bring to bear on a reluctant Federal Reserve system, and the current odds on the Presidential election, Rutledge advises our Associates to be prepared to react to the consequences of an overly expansionary monetary policy over the next five years The big question in everyone*s mind, of course, is that no one knows just what type of demand management policies a Carter administration would pursue, if elected That uncertainty itself together with an almost certain swing to more expansionary policies, has already had and will continue to have adverse effects on asset markets We should look fot a rise in short-term rates and a cooling of the performance of stock prices over the remainder of the year The main message in this issue, then, is that in the short term we can expect the recovery to proceed as in our earher forecasts, with inflationary pressures moderating sonuu hat Planning oier a longer horizon, however, is much more difficult, because of massive uncertainties surrounding the outcome of the Presidential election We would advise investor* and executives to take steps tu maintain their flexibility oier the two-to-five-yeai horizon until we are more certain about the poht ics which will he adopted by the new administration THE OUTLOOK FOR THE NEXT T\\O YE4JRS We currently face a situation which is not too rare in an election >ear We can be fanlv confident about the economic outlook for the next \ ear or t\v o, because the policies which influence near-term economic and financial beha\ior a*e either aheadv in the books or are unhkeK to change substantially m the next year Even if there is a change in the Presidency it will take some amount of time for the new team to get assembled, to put together a pohev package, and to implement its policy choices When we try to look past that period to forecast the economic and financial em ironment, sa\ two to five years from now, the policies adopted by the winning party in this fall's elections will make a tiemendous amount of difference Although we have analyzed the statements of Governor Carter and of his advisor^ to form out assumptions of possible policies the plain fact is that no one knows ioi sure what macroeconomic policies would be followed under a Carter administration The longer term All Rights Reserved, Claremont Men's College n outlook, theiefore, is clouded by great uncertainties at this time For these reasons, we have decided to combine our quarterly update issue with a discussion of the factors which will determine the course ot the economy over the next five >ears The first section of this issue discusses forecasts of output, employment, prices and interest rates ever the next eight quarters The second section, assesses the effects of longer term uncertainty on the behavior of the economy and places bounds on the hkeh time paths of prices and interest rates over the next five yeais SHIFT TOWARDS MORE EXPANSIONARY POLICIES In the AFEC forecasting model, the behavioi of the economy over time depends in a direct and important way on the monetary policies conducted by the Federal Reserve Board and on the taxing and spending decisions of federal, state and local governments A large increase in the rate of growth of the money stock will lead to a temporary business expansion or boom fairly quickly, as individuals use their increased monev balances to finance higher spending on goods and services The gains in output and employment are only temporary, however, and are followed after a v ear or more by higher rates of inflation Anticipation of the higher inflation rate that eventually results from increased money growth leads investors and issuers in the bond markets to bid up market interest rates to protect the real value of loans, which would otherwise be eroded by the inflation An increase in the rate oi real government spending, on the other hand, can have several different effects, depending on how it is financed A£ James Meigs argued in the Mav report, higher spending financed through increased taxes raises the price level and real interest rates, and transfers control of resources from the pnvate sector to the professional buieaucrats Extra spending financed by borrowing from the public raises interest rates and makes it more difficult for business to raise capital for expansion Increased spending financed by money creation brings inflation on two counts fewer goods and services are available for those in the private sector to buy. and they have more money to buy them with Therefore the behavior of the economy can be radically different depending on the set of monetary and fiscal policies adopted by a particular administration. An administration which opts fot large scale public works and social programs, which is not worried by enormous budget deficits, and u>hich is committed to a "go-go growth" platform will produce more inflation and higher interest rates and, in the longer run, lower profits, investment, and real growth than a more conservative administration with an emphasis on controlling inflation This makes the outcome of this fall's Presidential race critical when evaluating the likely performance of the economy over the next several years The economic policies which would be follow ed by a Ford or Reagan administration are fairly well known Both place great emphasis on the role of free markets in the economy, and on the dangers of too much government interference in people's economic affairs They diffei on relative emphasis in public spending decisions, to be sure, but both basically side with fiscal and monetary restraint, * placing control over domestic inflation as a top priority Either a Ford or Reagan White House, then, would strongly support Chairman Burns' announced intention of gradually purging the economy of inflation over the next few years This would mean rates of money growth slowly and steadily declining from their current values to about 1% or 2% annual rates over the next few years On the fiscal side, we believe that either a Ford or Reagan administration would push to limit growth in the fedeial budget, with defense spending rising at the expense of social programs This set of policies — in the absence of embargoes and crop failures — would produce gradually decreasing inflation and interest rates, and would allow a smooth transition between recovery and normal growth of the economy. A Carter administration, however, is much more difficult to predict at this point We have few statements and little experience to go by when trying to nail down the policies which Carter would support if elected President The information that we do have, however, suggests that Carter would try to pursue strongly expansionary monetary and fiscal policies during '77 and '78 His proposal "to give highest priority to achieving a steady reduction of unemployment and achieving full employment -a job for everyone who wishes one - as rapidly as possible, while reducing inflation" together with his endorsement of the Humphrey-Hawkins Bill, indicates that Governor Carter would urge the Federal Reserve Board to increase the rate of monetary expansion and would not balk at proposed public works spending projects But wouldn't such policies leignite the inflation that we have worked so hard to subdue^ Governor Carter says no, that we need not worry about infla- tion while the economv has so much excess capacity Besides, even if there did occur a resurgence of inflation, it could be treated "directlv" via standb> wage and price controls At the rootof Go\ernor Carter's statements is his acceptance of the concept embodied in the Phillips curve, that inflation and unemployment are inversely ielated in a regular, predictable way In fact Professor Lawrence Klein — Go\ernor Carter's chief economic advisor — was one of the fust economists to apply computers to estimating laigescale models of the economy, built around the Phillips curve framework We believe that the experience of the past decade and the results of recent economic research have discredited the idea that there is a useable tradeoff between inflation and unemployment, and that the uncritical acceptance of the tiadeoff was one of the major factors leading country after country to opt for the "quick-fix" of inflation, rather than the more responsible approach of maintaining a stable economy without inflation The results were devastating, steadily mcieasing inflation rates, and steadily rising interest rates We at AFEC reject the notion that there is a stable tradeoff between inflation and unemployment We are convinced that a monetary expansion wtll provide only a temporary - two or three quarters -stimulus to output and employment, and will leave both inflation and interest rates on a higher plateau Those who remember Phase I during the Nixon years will certainly agree that — except for all the nice people you meet while standing in lines — price and wage controls are not a serious alternative to sound economic policies The policy assumptions underlying the forecasts discussed in this issue obviously cannot represent the full range of outcomes which could emerge after November. They will provide our Associates with a benchmark, however, and serve as an estimate of the central tendency of the likely policies As I mentioned above, the stage is largely set for the determination of inflation and, to a lesser extent, interest rates over the next year or two Differences between our policy assumptions and actual policies will, however, be very important for the longer-term outlook, as I will discuss later in this report On the monetary side, we have assumed what we feel is the least inflationary policy which would be followed under a Carter administration We assume that the money stock grows at a steady 5% annual rate, after expanding rapidly during the second and thud quart*. *s * f this \ ear This scenario > could arise with a reluctant Chairman Bums being pressured by an expansion-minded White House With a Republican President, monev growth would likely be lowei, with a Carter White House, it could veiy well be higher Finally, we have assumed that fiscal policy will not be a major pioblem, leal government spending giows at a low annual late Most of the diffeiences m fiscal policy will hkelv be in the budgetaiy mix, with defense spending taking high pnoritv with a Republican President and public works lecemng emphasis under a Democratic President With these assumptions, w e w ill now outline the likely economic and financial environment which our Associates will face ovei the next eight quarters THE FR4GILE TRANSITION FROM RECOVERY TO STEADY GROWTH The AFEC forecasts for output and employ ment under the assumption that the Fed regain^ control over the money supply by the fourth quarter of this year and then holds a steadv course at 5% monev growth are presented in Tables 1 and 2 As we can see from the growth rates of both nominal and real output in Table 2 the 5% growth assumption would allow the economy to complete a strong recovery and make the transition between recovery and steady growth in output during the middle of'77 Rates of real output growth then would settle down on the longrun rate of capacitv grow th of about 2V2% per year Nominal income, of course, grows at a much higher rate in the steadv growth stage because the 5% money growth generates an inflation rate of about 4*/2% per year Earlv '77, then, should mark the end of an era in U S economic history that we could well have done w ithout The U S suffered a drastic fall in real output, the worst inflation of the century, and a severe slump in asset prices Perhaps the only blessing of the period is that it serves as evidence that the market economy has the resiliency to recover from even the most severe blows dealt out by erratic and often irrational economic policies The principal danger with the steady growth scenario which emerges from our steady money growth assumptions is that it is not glamorous enough for campaigning politicians The prospect of returning to a steady growth rate of only 2xh% per year does not make for fiery speeches when compared with the high growth rates we have observed over the past year There is a great temptation, then, for the policy makers to make promises that they can keep the economy growing at such phenomenal rates for long periods of time In the past this has led to overexpansion and subsequent recession time and time again As the great Trillion Dollars Chart 1 Over-Stimulating GNP Growth Would Mean Trouble Later LEGEND 2 4 21- GNP in Current Dollars GNP in 72 Dollars Trend Lines 73 American economist, Irving Fisher, argued at the turn of the century, a business expansion which is created by artificiallv stimulative monetary policies contains the seeds of its own destruction Over long periods of time, the economy cannot grow faster than the rate of giowth of the resources, including labor, raw matenals, capital, and technology, which are the basis for production A careful examination of Chart 1 gives a sobering example of the dangers of overly stimulative fiscal and monetary policies Chait 1 plots levels of real output since 1970 together with the \ F E C forecasts of future real output based on the assumed steady 5% rate of change in the mone> stock The trend line in Chart 1 indicates roughly the ! 74 75 76 77 78 79 - 80 81 long-run normal growth path for the economy It represents what the economy could have been expected to produce over this period in the absence of abrupt changes in government policies, assuming no major external shocks to production — like crop failure and embargoes Its purpose is to s e n e as a benchmark for evaluating the actual performance of the economy since 1970 It does not take a magnifying glass to see that the U S economy did not follow the long-run normal growth path veiy closely over the past six vears The two obvious detour^ aie the penod of lapid growth which accompanied the lapidiv growing monev stock in *72 and '73 and the subsequent — and now infamous — recession of '74 and '75 As we have Men's College ivjued in previous reports, the recession was the )int outcome of seveial factors Nevertheless, I >^heve that it was in great part attributable to the wer-zealous monetary expansion of the two previnis years The rapid money growth rates of'72 and /3 combined with the tightening grip of the wage >nd price controls, produced an expansion of leal utput which was simpl> not sustainable over any substantial period of time The predictable result of increasing demand while prices aie fixed by direct ontrols is an economy chaiactenzed by shortages, production bottlenecks, black markets, and uneeiamty These factors, together with the slowdown m ^ioney growth in the third quartei of'73, generated f he early signs of a recession bv fourth quarter '73 ! o make matters worse, the recession was aggra\ ated and prolonged by the oil embargo and the iccompanymg confusion about energv costs and nohcies A careful anah sis w ill show, however, that 1 he recession had already set in at the time of the embargo, and that the unsustainable growth of the H\o previous years and the slowdown in money nowth both pla\ed major roles in this episode This analysis is ample justification for the close watch we try to keep over de\ elopments in Federal Reserve policies It is not hard to imagine the whole succession of inflationary and recessionary shocks repeating itself if the Fed weie to gi\e in to those who call for more expansion For the reasons we have discussed already, however, we do not think that this is likely to happen within the next \ear Chairman Burns has repeatedly issued strong warnings about the dangers of too much monetary expansion Of course, it is possible that the new administration might be so dissatisfied with Chairman Burns* conservative course of monetary vohcy that he would step doan to let the Ptesident select a new chairman Again, however, this shift in Federal Reserve leadership and objectives would take time, so we believe a major change in monetary policy within the next year to 18 months is unlikely. In the longer term, however, there is nothing to prevent a resumption of the willy-nilly policies which brought on the debacle of the past six years The forecasts plotted in Chart 1 for the 77-'8O period, remember, weie made under the assumption of steady money growth rates at 5% per year over that period Theie ate two quite distinguishable characteristics to that policy assumption First, we have assumed that the average rate of growth of J V mone\ stock *s 5T — this is wh.it would set the eeneral environment foi inflation and inteiest rates over the period, higher monev giowth would produce both moie inflation and higher interest rates 1975 I 1434 1458 1159 II III IV 1461 1490 1168 1529 1531 1202 1573 1575 1216 124 125 127 129 Personal Consumption Spending Durable Goods Nondurable Goods Services 926 950 124 405 422 977 1001 132 416 429 13S 424 440 Private Domestic Investment Fixed Private Investment ^onresidenlMl Structures J£esidenfutl Structures Change in Inventories 169 194 149 44 -25 161 195 197 205 207 146 50 _2 152 55 2 17 24 22 22 Total Government Purchases Federal Purchases Defense Olber State and Local 321 119 81 325 119 82 37 345 130 87 206 334 124 S5 39 210 43 215 Money Stock (Mi =cuirencv + dem dep ) 283 288 293 295 60 67 79 SO Ind Prod Index 19G7 - 100 112 110 114 118 Unemployment Rate 81 87 86 85 Gross National Product Total Final Fxpenditures GNP in 1972 $ GNP Deflitor Net Exports Corp Profits After Taxes 119 394 413 38 202 19i 146 45 -30 Incidentally, if we had a choice, we would prefer Arthur Burns' plan of graduallv reducing money growth rates ov er the ne\t several > ears in order to reduce the inflation late to zero Our inflation estimates for a Burns-tvpe policy aie shown on the bottom line of Chart 2 Second, and in many ways more important, we have assumed that the money stock will grow smoothly at 5% pei vear This would provide a stable financial environment in which to conduct business, because it would enhance the predictability of pi ices and inteiest rates to investor and executives \ monev giowth pattern chaiactenzed b> iits and starts, bv unfoieseen mcieascb and decieases in money growth rates, would upset the normal flow of information through the price sv stem TABLE 1 AFKC FORECASTS OF AGGREGATE ECONOMIC ACTIVITY (seasonally adjusted, billions of dollars at annual rates) June 30, 1976 •Forecast 1978 II* III* IV I * II* 1620 1605 1242 1662 1645 1702 1258 1685 1274 1741 1723 1288 1778 1760 1300 1813 1794 1310 131 132 134 135 137 138 1030 1051 1074 1095 1116 1136 146 431 453 150 439 462 154 449 472 157 458 480 161 466 489 232 254 237 173 64 17 264 247 180 67 18 1979* 1980* 2098 2076 1382 152 2257 2234 1423 158 1223 179 509 535 1305 193 542 570 1397 209 5~9 609 281 262 191 71 19 299 279 203 75 20 323 301 220 81 22 353 330 241 89 24 1978* 1977* Ueraces \nnual 1S29 1958 193S 1810 1347 1314 140 145 1975 1976* 1942 1922 1343 145 1499 1514 1186 126 16S1 1655 1265 133 1194 174 497 523 1213 177 505 531 964 128 410 426 1063 152 444 468 11-46 166 478 502 288 269 196 73 19 292 273 199 74 20 296 276 202 75 ^0 1S3 198 149 49 15 248 232 169 63 17 1977 1976 I III* 1846 1828 1319 140 IV I * II* 1879 1S60 1327 142 1911 1891 13-35 143 164 474 498 1156 168 482 506 1175 171 490 515 272 254 186 69 18 279 260 190 70 19 284 265 193 72 19 | 59 1 1 6 242 226 165 61 16 9 10 10 10 1 1 11 11 11 12 12 21 10 11 12 13 14 349 131 87 44 218 359 136 91 45 223 365 139 93 45 226 372 142 96 46 230 3S0 146 99 47 234 3S8 150 102 47 240 397 153 105 48 244 405 156 107 50 250 414 160 110 51 254 422 164 114 51 258 a3i 123 84 39 208 361 137 92 44 224 392 151 103 48 241 426 166 115 51 260 458 181 126 55 277 494 198 139 59 296 297 303 308 312 316 320 324 32S 332 336 290 305 322 338 355 372 86 89 93 96 98 100 102 104 105 107 71 91 101 107 114 122 121 123 125 127 129 130 131 132 133 134 114 124 131 134 137 140 76 75 7 1 68 67 65 63 62 62 85 7 ~> 62 60 56 217 1 158 64 which enables the economy to function efficiently A steady rate of inflation \\ ould be costl>, a variable rate of inflation would be even more damaging We could imagine several scenarios, then, which would make our pohcv assumptions o\eily optimistic First, if Go\ernor Carter moves into the White House in January, he and his advisors may feel that the economy is mo\ ing too slowly Assume that they are successful, by one route or another, in convincing the Fed to raise its money growth target to 10% per yeai, but still at a steadv rate The result would be a tempoiary boost to real output, inflation rates rising to about the 9% to 10% lange, and rapidly rising interest rates Later, the \niencan people would pay the price for the "quickhx" either through living with the permanently higher infla- 65 tion and interest rates, or through suffering the unemployment and business losses of the next recession, when pohc\ makers finalh decide to wring the inflation out of the svstem again More hkel>, policy makeis would be tempted to deal with the inflation by the cosmetic remed> of wage and price controls Governor Cartel has already endorsed their use on a standbs basis In that case, the inflationary piessures would be augmented b\ the falling output of goods and services which accompanies the shortages and ad hoc rationing schemes of price and wage controls Worse yet, there is a very real possibility that the new udmmistia l 'on n"n Tht foil > monetai\ policies v which ai'j not onl\ nillationan {\i\si\\ tiend rates oi money growth) but also eiratio (variable and unpre- CHART 2 The Inflation Rate Will Be Determined by Money Growth, 1976-81. Rising Money Growth LEGEND AFEC Assumption (5%) Declining Money Growth Actual TABLE COMPOUND ANNU4JL R *Foreca 1975 I Gross National Pioduct GNP m 1972 S GNP Deflator Consumei Pnces Wholesale Prices Peisonal Consumption Spending Private Domestic Imestment Federal Puichases State and Local Govt Pnrch C()lp Piofits \tt(M l a u ^ Industiial Production Index Monev Stock (Mi = cunency + dem dep ) -2 2 -9 2 78 75 -2 1 82 -1058 41 119 o9 5 -35 9 06 1976 II 78 33 43 64 33 10 7 -18 5 III 19 9 119 71 88 79 11 9 20 8 IV 12 1 50 68 65 92 10 0 23 4 I 12 6 87 36 39 -0 7 119 63 3 II* 10 6 54 49 49 47 84 18 4 IIP 10 0 50 48 43 36 91 20 4 IV* 96 46 49 45 38 82 -0 7 73 55 9 -4 7 76 17 9 88 96 0 14 6 72 19 7 97 57 123 23 38 13 8 76 17 2 90 91 94 69 97 67 169 63 70 13 5 63 S2 4 110 29 17 5 65 50 Claremont Men's Co! servative monetary and fiscal policies that we have had foi the pa> tu o u < i ^ 1 lit plain tiuth is the>t no one knows for sure what policies would be pursued by a Carter administration For that reason, the statements and press leleases of Governor Carter, and the polls indicating his chances for winning the Presidency, will be very important in the behavior of financial markets in the near future. dictable money growth rates) This is the behavior we might expect from a new chairman who was a policy activist, committed to the idea that the Government can "fine-tune" the economy We have plenty of experience from the '60's to make us wary of policy makers who say they can use the cumbersome tools of monetaiy and fiscal policy to smooth out the minor wrinkles in economic activity For my part, I would sooner take the minor wrinkles than the type of economic and financial environment we have had over the past several years For these reasons, we must advise our Associates that, although the stage is set for a smooth transition from recovery to growth, and although the economy will be strong over the next two years, that transition mav not be allowed to happen The uncertainties over the development of monetary policies over the hvo-to-five-vear horizon are so great that we believe it will be prudent to adopt management strategies which allow relatively great flexibility over the longer period It is not unlikely that inflation could accelerate sharply two or three vears from now, and that interest rates will climb to record levels INFLATION IN THE 4 - 5% RANGE THROUGH 7 7 The rate of increase in the puce level is largely determined bv the rate of increase in the money stock relative to the rate of pioduction of goods and services Faster money growth at a given rate of real output increases inflation rates Factors which inhibit production — like crop failures, shortages, and price controls — also increase the price level In certain situations these supply restrictions can be verv important for explaining inflation The U.S inflation rate in '74 was substantially worsened by the effects of the oil embargo and by the dislocations resulting from the price control period The overwhelming majontv of inflationary episodes, however, can be traced to previous high rates of We mav be worn ing too much It is possible that a Carter administration could follow the same con- 2 \TES OF CHANGE st June 30, 1976 II* 81 10 9 79 86 54 50 10 2 89 83 44 50 33 47 44 38 74 99 1975 1978 1977 Is" 88 38 48 42 38 77 13 1 III* 76 28 47 45 38 71 76 92 8S 79 36 50 73 25 46 45 38 70 60 Ix 69 23 45 46 36 67 53 II* 67 23 43 46 34 65 56 96 84 76 29 50 10 4 83 68 23 50 98 67 6 \ 19 IV* 50 1976"* 65 -2 0 88 91 92 12 2 67 51 52 42 10 3 35 9 88 -110 10 0 98 -10 7 -8 5 \ 7 114 76 27 5 83 53 1977* 1978* Vnnual \verages 71 88 25 39 45 48 45 42 36 38 68 78 13 2 63 10 1 78 10 8 54 55 99 96 66 25 50 1979* 1980* 71 26 44 43 34 67 80 - 76 30 45 41 35 70 95 90 67 60 19 50 93 69 70 28 50 TABLE AFEC INTEREST R V I (percent per year, quai *Foreca$ 1975 1976 I SHORT TERM RVTES Four to Six Month Prime Commercial Paper Federal Funds Rate Prime Rate Three Month Treasury Bills 90 Da> CD, New York Secondary Market 90 Da> Euro-Dollar Rate LONG TERM RATES AAA Corporate Bonds AA Corporate Bonds Long-Term Government Bonds New Home FHA Mortgages Bond Bu\er20 Municipals ioney expansion Our assumption about the beiVior of monetary pohcv over the next few years, icrefore, fonns the base of the AFEC inflation • ecasts Chart 2 illustrates the inflation consequences of lee alternative monetary policies b> plotting acil rates of change in the implicit price deflator er the past few years together with the AFEC iecasts of inflation rates based on three money owlh assumptions The series labelled AFEC piesents the inflation forecasts of Table 2 based i the assumption that the money stock grows at a _ddy 5% annual rate through 1980 Chart 2 shows u a 5% monev growth rate would result in an ation late which fluctuates in the 4 - bL/c range the next live vears Thus, with a 5°c monev \\i\\ rate inflation would not get any worse, but II III IV I II III* IV* 6 56 6 30 8 98 5 92 5 42 7 32 6 67 6 16 7 56 6 12 541 7 58 5 29 4 83 6 83 5 47 5 23 6 92 5 75 5 54 7 17 611 5 94 7 49 5 75 5 39 6 33 5 63 4 92 5 30 5 55 5 88 6 73 5 96 6 81 6 28 5 18 5 52 5 81 6 20 7 58 6 47 7 26 6 78 5 51 5 88 6 20 6 62 8 71 8 87 8 91 8 81 8 56 8 53 8 62 8 64 9 16 961 9 72 9 54 8 80 9 10 9 20 9 22 6 67 6 96 7 08 7 22 6 91 6 88 6 94 6 96 8 84 9 05 9 40 9 42 9 01 9 05 9 12 9 13 6 65 6 95 7 23 7 38 6 96 6 77 6 83 6 85 CHART 3 Interest Rates Would Stabilize with a Steady 5% Rate of Money Growth * LEGEND FHA Mortgage Rates m u m AAA Corporate Bond Yields mmmmmmm 4 - 6 — Month Commercial Paper Rates ' ' Actual —7— 3 E FORECASTS t^erly averages) t June 30, 1976 1977 1978 1975 1976* 5 66 5 39 8 10 6 32 5 82 7 86 6 54 6 51 6 92 6 97 7 34 741 8 71 8 73 9 26 9 30 6 98 I * II* III* IV* V II* 641 6 27 7 75 6 62 6 50 7 93 6 74 664 8 04 6 80 6 70 8 09 684 6 75 8 13 6 81 6 15 6 34 6 45 6 50 6 51 6 73 6 86 6 97 7 20 • 8 67 1977* 1978* Annual \\erages 1979* 1980* 6 16 5 99 7 53 6 71 6 60 7 10 6 64 6 53 7 95 801 6 18 6 01 7 54 5 53 5 41 6 36 6 42 5 94 5 92 6 98 6 44 *5 65 6 76 6 83 6 24 6 25 7 46 7 43 7 02 6 05 721 7 31 6 69 6 68 8 74 8 79 8 85 8 83 8 59 871 8 74 8 64 8 52 9 32 9 33 9 39 9 45 951 9 08 9 30 9 44 9 22 9 09 701 7 02 7 03 7 07 7 10 6 98 6 92 7 01 7 10 6 96 6 87 9 16 9 19 921 9 22 9 26 931 9 18 9 08 9 20 9 30 9 14 9 04 6 88 6 90 6 92 6 92 6 96 7 00 7 05 6 85 691 6 99 6 85 6 76 M1 I ' 6 72 Per Cent 120 105- 9 0- 7 5- 6 0- 45 . i ' ' I ' I T I " ' I V neither would it get any better This assumption would simply maintain the underlying inflationary pressures m the. economv at this time v hich resulted fiom the loughly 5% annual rate of money expansion over the past two veais The lower line represents the path of inflation if the Fed were to stick to Chairman Burns' announced intention of gradually decieasing the annual rate of growth of the mone\ stock to 29c o\er the next two years, and then hold a steadv 2% annual growth rate After hovering for awhile in the 4 - 4V2% range, inflation would drop steadily to about 2V2% b> 1980 In fact, a 29c mone\ grow th rate would eventually result in prices which were either stable oi growing at onl\ 1% per yeai The senes which is heading uphill represents futuie inflation rates assuming that the annual rate of growth in the monev stock is steadih increased to 8% o\ er the next tw o y ears, then held at 89t through 1980 This represents an e\pansionai\ pohcv which could emerge either as the result of White House pressure on the Federal Reserve Boaid, or of futile Fed attempts to hold down the rising interest rates which w ould accompam large deficit-financed public works projects Under this pohc\, inflation would rise fiom about \lh°7c per \ear to about 6V2% per yeai by 1980, and would e\entually settle down on an annual rate of about 79c Because money giowth determines inflation rates with a substantial lag -between one and two years for the USthere is not much room for variation in inflation forecasts through '77 Inflation should stay in the 4% to 59c range over the next 18 months under a fairly wide range of likely monetary policies Fiom '78 on, however, the story has not yet been written, and inflation rates can differ widely depending on the particular policies adopted by the Fed over the next few years This, of couise, is the policy makers' dilemma Politicians know that by sharph increasing the rate of money7 growth, they can get a temporary surge of real output and a temporary dip in the unemployment late The inflationary consequences of their folly, however, won't be felt for one to two y eais As long as elections can be "just aiound the corner" and as long as politicians behe\e votes will be cast according to the state of the economy on election day, we can be quite confident about the choice which policy makers will make Controlling infla- tion thus reduces to controlling the policy makers, a much more complex and unmanageable, problem INTEREST RATES RESPOND QU1CKIA TO CHANGING MONETARY POLICIES As we have argued in previous reports, short-term mteiest rates aie extremeh sensitive to changes in monetary policy Changes in money growth aie quicklv tianslated bv market traders into inflation forecasts which have immediate effects on market interest rates The AFEC forecasts of both short- and long-term interest rates are presented in Table 3 The forecasts, like those of output and prices presented above, are based on the assumption of a steady 5% annual rate of monev growth through 1980 Chart 3 illustrates the AFEC forecasts for selected interest rates We expect a fairly sharp rise in short-term interest rates and a somewhat more moderate rise in long-term rates over the next year The 5% money growth assumption does not result in a return to the interest rate peaks of'74, but does leave interest rates at histoncallv high levels Commercial paper rates should rise to about 79c in the next year, then decline to the 6V2°c level This would leave a return to short-term investors after inflation of about IVi^o The factors causing the interest rate rise are the renval in business loan demand during the next two quarters, and the increased uncertainty about the economic policies of the new administration Treasury borrowing will also add pressure to both short and long rates as it swallows up more and more capital to finance the continuing budget deficits If the new administration follows a much more inflationary course than the one underlving our forecasts, however, interest rates will rise more rapidly than indicated in Table 3 and depicted m Chart 3 Higher money growth rates mean more inflation, and our research has shown that market traders are well aware of the relationship between money and prices The result is that a sharp increase in money growth rates would increase inflationary expectations, raising market interest rates Conversely, a policy like that advocated by Chairman Burns, of slowly reducing the rate of money growth, would result in declining market interest rates 140 CHART 4 Unemployment Falls as Production Rises 79 John Rut ledge \sso(i(ite Duettoi. Applied Financial Fconomic? Center Claremoni Mois College Bauer Center Chnemont, CA 91711 (714) 626-8511 ext 2523