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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.

The SOMC should urge the Board of governors to pursue the

recommendations and suggestions advanced by the advisory committee.




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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

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1300

i

1300

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•
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1200
i'

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•

1200

/

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II

!

i

1

1100

A

1

•
i

1000
i

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i
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1000
\

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1

I

900

•i!

/

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1!

H i

900

•
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1

800

/

f

1

1
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1
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800

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I

J
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1957

t

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1955

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600

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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

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