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Policy Statement and Position Papers

September 14,1973


Minutes of the Meeting of the Shadow Open Market Committee, September 17,1973


Remarks Prepared for Annual Meeting of National Associaton of Business Economists - A. James
Meigs, Argus Research Corporation


Prepared Statement for Hearing on Recurring Monetary and Credit Crises before the Committee
on Banking and Currency, U. S. House of Representatives - A. James Meigs, Argus Research

September 14, 1973 - Argus Research Corporation
New York
The meeting was called to order at 10 A.M.
of Argus Research, welcomed us to Argus0

Joseph Dorsey, President

He expressed the hope that the

meeting would have a useful influence on economic policy in the United
States, and he indicated personal enthusiasm for the idea0

He noted,

particularly, the benefits to be obtained by a combination of business
and academic economists interacting on issues of economic policy and
making statements about appropriate policy. Mr. Dorsey then left the
Allan Meltzer made a brief statement welcoming the members of the
committee and the members of the press who had been invited to attend*
He noted that recent economic policy had produced some of the poorest
results in many years,, Inflation is at the highest rate in peacetime
history and shows no sign of ending*

There is no inclination to discuss

current policy or to deal with current problems*
of alternative policies*

There are no discussions

Instead, the Federal Reserve^ members of Congress,

and members of the Administration try one ad hoc measure after another.
Members of the group had discussed, on many occasions, ways in which
economists from business and academic life could try to improve the making
of policy.

Efforts have been made by members of the group to issue statements.

The problem was, often, the statements were issued after the policies
had been adopted. Many of us believe that by issuing statements in advance,
repeatedly^ we may have greater influence on the types of policies pursued.

Minutes of SOMC Meeting
September 14, 1973
Meltzer commented that the idea had been greeted enthusiastically by
everyone approached.

Only one person had declined an invitation to

participate or be associated with the group.
Prior to the meeting members of the committee had been asked to
prepare statements on aspects of interest to the entire committee.
James Ford had prepared a forecast of economic policy. Wilson Schmidt
had prepared a discussion of international and exchange rate influences
on domestic economic activity*

Robert Rasche had prepared an analysis

of fiscal policy with some indications of future fiscal policy. Karl
Brunner had prepared a discussion of monetary policy* James Meigs had prepared
a discussion of money market conditions and interest rates. Allan Meltzer
had prepared a first draft of the policy statement.
James Ford presented a forecast for the next six to twelve months.
He indicated that 2-1/2% real growth and 4-1/2% rate of inflation seemed
a reasonable prospect for 1974. He discussed some of the components of
the forecast and some of the policy assumptions underlying the forecast.
The money supply was expected to grow at approximately 6 o during the period
relative for the forecast. Price and wage controls were expected to remain
for lai;ge corporations but, severe shortages were not anticipated.
A general discussion of the forecast followed.

There was general

agreement that real economic activity would decelerate in 1974. No one
expected a recession, using the National Bureau definition of recession.
Mr. Rasche indicated that the forecast coincided, approximately, with the
Michigan and Wharton econometric models, although there was some disagreement
about the rate of inflation. Mr. Wolman commented on the Argus forecast.

Minutes of SOMC Meeting
September 14, 1973


The committee agreed that deceleration from the results of the first
half of 1973 would continue and that inflation could be expected to
continue at the rate of 4 to 5% on the GNP deflator basis.
Wilson Schmidt discussed the balance of payments and the exchange
rate problems. He indicated that from a monetary point of view, the balance
of payments could not be expected to have any sizeable effect on the
domestic economy during the next year. The most likely effect would be
on the term structure of interest rates, if, as was expected, the dollar
continued to rise in the exchange markets relative to other major currencies,
Mr* Schmidt then discussed the balance of payments composition.from
a structural or Keynesian point of view©

He indicated some of the problems

of forecasting the individual items and their interaction*

He could not

find any substantial contradiction with his overall view by looking at the
structure of the balance of payments, so he concluded that the balance of
payments would not play a large role in the domestic activity next year.
Mr. Schmidt expressed some doubts that any important new agreements would
be reached at the Nairobi meeting of the International Monetary Fund*
The committee discussed the general implications of Mr. Schmidtfs
presentation. Most agreed on the general nature of the outlook. They
complimented Mr. Schmidt on the quality of his presentation in a difficult
A consensus emerged that with the current floating exchange rate, the
international sector would not have a substantial impact on domestic
economic policy in 1974.

Minutes of SOMC Meeting
September 14, 1973


Mr* Robert Rasche discussed fiscal policy. He gave a history of the
past fiscal policy and some indications of the size of the deficits over
the last few years0

In the current fiscal year, the budget would be

approximately in balance. Most of the studies that he had seen came to
this conclusion.

Several econometric models were in agreement on the

general point, although not in agreement on the specific details. His
best guess was that there would be a deficit of approximately 2.7 billion
in the full employment budget for fiscal 1974 and a small deficit in
the unified and national income accounts budgets. After July 1^ 1974, there
is to be an increase in social security benefits of 6%©

In 1975 there

will be a consumer price index accelerator on the social security payments.
These will constitute large items at current rates of inflation.
The near-term outlook indicated that the Federal Reserve would not have
to face the problem of financing large deficits.
Most members of the committee expressed a view similar to Mr* Rasche1s.
The committee then turned to a discussion of what might be done if
fiscal policy were changed.

There was talk in the press of suggestions by

Arthur Burns and others of a tax increase being requested of Congress.
The precise form of a tax increase was not discussed, but the committee
attempted to resolve the question of what should be done if fiscal policy
became more or less expansive. No general conclusion was reached. A
subcommittee consisting of Anna Schwartz, Robert Rasche and Tom Mayer was
asked to discuss the question at lunch and to return with some statement.
The meeting adjourned for lunch at 12:10 p.m0

Minutes of SOMC Meeting
September 14, 1973


At 1:30 p.m., the meeting resumed.

The subcommittee returned a

statement expressing the view that monetary policy should not be
adjusted if there is a change in the expected fiscal budget deficit or

The committee did not discuss the recommendation at this time.

Mr. William Wolman now chaired the meeting. He called on Karl Brunner
to discuss monetary policy. Mr. Brunner delivered some tables showing
regressions between money and the monetary base for different time

He also included some relations between the monetary base and

the money multiplier and between the money stock and the money multiplier.
His regressions showed a close relation between the monetary
base and the money stock using three month moving averages of percentage
changes in the money stock and percentage changes in the base. No similar
relationship between the base and the money multiplier was found.
Mr. Brunner commented that there was no problem, as had been reported
from the Board of Governors, of gaining control of the money supply.


control of the money supply was not in question, and it had not been in
question during the entire post-war period.

Mr. Brunner then

discussed prospects for the future. He indicated that there were now
signs of a deceleration in the money stock.

The money stock was growing

somewhat less than the 6-l/27Q average rate that had been maintained for
the past two or three years. A general discussion of the recent performance
of the Federal Reserve followed.

Several members expressed the view that

it was premature to conclude that the money stock deceleration would have
a substantial effect on the real economy, an effect requiring modification
of the forecast presented earlier in the day.

Minutes of SOMC Meeting
September 14, 1973
The committee then moved to a discussion of conditions in the
money market*

Mr* Meigs described the recent position of the money

market and commented on the behavior of interest rates* He distributed
a forecast prepared by Argus Research on short- and long-term rates„
general discussion of the interest rate forecast followed.


Several members

noted that a precise, detailed forecast of interest rates was not essential
to our policy decision.

The contrast to the Federal Reserve!s procedures

was mentioned.
The committee then moved to discuss a draft policy statement that had been
prepared after telephone discussions with many of those at the meeting.
Several comments and suggestions were made about the reorganization of the

A drafting committee consisting of Homer Jones, Anna Schwarts,

Robert Rasche, James Ford, William Wolman and Allan Meltzer was given
responsibility for carrying out the instructions of the committee.
The subcommittee prepared the following directive:
Many economists in business and in universities believe that economic
policies could have been better in the past and can be better now. Almost as
important, more accurate information can be given to the public about what can
be —

and what cannot be —

achieved by current policies during the next six

months and over longer periods*
A small group from banking, industry, and the universities who share these
views plans to meet every six months to consider the same range of issues as the
Federal Reserve's Open Market Committee and to issue statements on monetary policy*
We also hope to encourage discussion of alternative policies, the likely
consequences of current and alternative policies, the risks to be faced and the
potential benefits*
At its first meeting, the group issued the following statement on Monetary

Market interest rates are currently at the highest levels in 100
years as a result of high rates of monetary expansion maintained
for several years. Only by reducing the rate of inflation can we
expect to reduce interest rates permanently.

We believe that the objective of monetary policy over the next
year should be to reduce the rate of inflation. To accomplish this,
the growth rate of money for the next six months should be at a
steady rate of about 5%%. Because inflation will continue, laws
and regulations that delay or prevent adjustment to inflation should
be removed.

In the current circumstances, we have considered four options:
(1) Reduce the growth rate of money sharply until unemployment
starts to rise, then revert to a high growth rate in an attempt to
promote a quick recovery; (2) Reduce the growth rate of money sharply,
to three percent or less, and then maintain it until inflation ends;
(3) Maintain the 6^% growth rate of money that has prevailed for three
years; and (4) Reduce the growth rate of money gradually to a less
inflationary or non-inflationary range.


If monetary expansion were sharply reduced until inflation ended
or fell substantially below current levels, we would experience
the most severe recession of the postwar period. This policy, if
maintained, would reduce inflation rapidly but at high short-term
cost in real output and employment and high business failure rates.

Moreover, we are skeptical that inflation could be ended in
the next: twelve months even by a policy of zero monetary growth.
Inflation has been maintained too long at current rates to be ended
quickly* Unemployment would rise substantially* Monetary growth
policy would be reversed and high rates of monetary expansion and
inflation would ensue.


Some urge a repetition of the monetary policies of 1966-67 and
1969-70. After a sharp reduction in monetary growth, a very low
growth rate would be maintained until the inflation rate fell and
unemployment rose. Then monetary growth would be restored to
bring the recession to an end.

Such a policy would be an attempt at **fine tuning.** Past
attempts were followed, within a year, by rates of inflation as
high or higher than before the attempt was made. We have no reason
to believe that a policy of this kind would be more successful
now. On the contrary, past failures make the attempt less likely
to succeed because the belief that inflation will continue is more
firmly held.


Restoring or maintaining the growth rate of money at 6 . would
mean accepting an inflation rate of about 4^% -- the average rate
of the past five years --as the norm. Labor rates, market rates
of interest, rental prices and other contracts are now based on this

• 9
norm. Some of the cost of adjusting to this rate of inflation has
been paid. The longer inflation continues at this rate, the more
deeply rooted and more widespread becomes the belief that this rate
has become the norm. The burden of trying to reduce or end inflation

This option appeals to many. We have rejected this policy because
it is based on a false presumption. The chances of achieving the
goal of a steady rate of inflation are no better at 4^2% than at
lower rates. The long-term consequences for employment and
prosperity are not improved by high rates of inflation.


A policy of gradually reducing inflation can be initiated by
lowering the average growth rate of money to 5^% for the next six
months. In March, a further reduction in the growth rate may be
appropriate. The amount of additional reduction would depend on the
economic conditions prevailing in March and expected to prevail

A policy of gradually reducing inflation runs the risk that the
policy might be abandoned. Yet, looking back, it seems clear that
had this policy been adopted and maintained in 1967 or in 1969,
inflation would be lower and less well entrenched. Real growth would
have been as good or better. Interest rates would be lower now.

There are costs of maintaining inflation and costs of ending


inflation, but there is no way to end inflation easily or without cost.
Sharp and sudden swings between extremes, attempts to break expectations,
false promises, ringing statements of commitment to anti-inflationary
policy and controls have not succeeded during the past eight years©


dramatic policies will cost less and will, perhaps, be more effective©
They are unlikely to be less effective©

The vote on the directive was as follows:
Voting Yes:
Karl Brunner
Peter Crawford
James Ford
Homer Jones
Tom Mayer
A. James Meigs
Allan Meltzer
Robert Rasche
Wilson Schmidt
Anna Schwartz
William Wolman
Absent, but not voting:

Be^yl Sprinkel.

The meeting adjourned at 5:15 p<>m©

A. J a m e s M e i g s , Vice P r e s i d e n t and Economist
Argus Research Corporation
R e m a r k s P r e p a r e d for
September 13, 1973

Because this is to be a m o n e t a r i s t view I plan to b a s e m y
r e m a r k s m a i n l y on two of the contributions to the a r t of f o r e c a s t i n g that
can m o s t fairly be a t t r i b u t e d to m o n e t a r i s t s .

The f i r s t of t h e s e is the

p r o p o s i t i o n that substantial changes in the r a t e of growth of the money
stock c a u s e fluctuations in b u s i n e s s activity and changes in the p r i c e

In fact, I will base m y views on a m o r e dogmatic v e r s i o n of

the m o n e t a r i s t c r e d o : Substantial changes of inflation r a t e s and r e c e s s i o n s i m p o r t a n t enough to win the National B u r e a u of R e s e a r c h
seal of approval will not o c c u r u n l e s s t h e r e a r e e a r l i e r changes in
the r a t e of growth of the money stock in a p p r o p r i a t e amounts and d i r e c t i o n s .
The second key m o n e t a r i s t p r o p o s i t i o n I plan to u s e is
that anticipations of changes in the p r i c e level have i m p o r t a n t effects on
market interest rates.

We owe this one l a r g e l y to Irving F i s h e r , who

was a half century or m o r e ahead of m o s t of the Economics p r o f e s s i o n for
m o s t of his life.
The m o n e t a r i s t view, it s e e m s to m e should be be m o s t
useful on t h e following t h r e e q u e s t i o n s :

- Will t h e r e be a r e c e s s i o n in 1974?
- How m u c h inflation will t h e r e be?
- What will i n t e r e s t r a t e s do?

The c r i t i c a l signal of impending r e c e s s i o n in the m o n e t a r i s t s '
book is a s h a r p reduction in r a t e of growth of the m o n e y stock o v e r a p e r i o d
of two or t h r e e c a l e n d a r q u a r t e r s ,

A r e c e s s i o n would begin two or t h r e e

q u a r t e r s after such a d e c e l e r a t i o n in money growth b e g i n s .

To p r o d u c e

a r e c e s s i o n for '74, t h e r e f o r e , the F e d e r a l R e s e r v e would have to s t a r t
working on it right away.

In July and August the F e d did have s o m e

s u c e e s s in slowing growth of the m o n e y stock.

So the t h i r d q u a r t e r m a y

show c o n s i d e r a b l y slower growth than did the second.

This would be

c o n s i s t e n t with a F e d e r a l R e s e r v e a t t e m p t to get back on a 6% y e a r - t o - y e a r
growth t r a c k after overshooting badly in the second q u a r t e r .


I do not believe the m o n e t a r y a u t h o r i t i e s want to r i s k pushing the economy
into r e c e s s i o n .

T h e i r f o r e c a s t i n g m o d e l s p r o b a b l y a l r e a d y a r e sounding

caution s i g n a l s .
I a s s u m e the a u t h o r i t i e s will be aiming for a 6% growth r a t e
for M l , p e r h a p s a little l e s s , and that they will t r y to avoid running u n d e r
that for l o n g e r than t h r e e or f o u r m o n t h s at a t i m e .

Their own r e s e a r c h

t e l l s t h e m that they can u n d e r s h o o t , or o v e r s h o o t , t h e i r a g g r e g a t e t a r g e t s
for a s 1-ong a s two q u a r t e r s without having a significant i m p a c t on the growth
of GNP.

Given the w i d e s p r e a d opinion in the land that the economy is now in

a s e n s i t i v e s t a t e , it s e e m s unlikely to m e that they would take a chance of
using up all of the leeway for undershooting that t h e i r e c o n o m e t r i c i a n s
t e l l t h e m they h a v e .

F u r t h e r m o r e , they have d e m o n s t r a t e d since they took

conscious control of the money supply in 1970 that it is e a s i e r for t h e m to
p u s h on a string than to pull it.

That i s , they have found t h a t it i s e a s i e r

- 3 -

to get the money supply to grow than to slow it down, with their
control m e t h o d s .

Consequently, they m a y a i m for about 6%, but I

think they will get about a 7% a v e r a g e growth r a t e in Mj over the
next s e v e r a l q u a r t e r s .

That should be enough to a v e r t r e c e s s i o n

in '74.
T h e r e a r e two a r g u m e n t s against that conclusion, both of which
have been u s e d r e c e n t l y by Milton F r i e d m a n .

The f i r s t of t h e s e is

that b u s i n e s s m e n and c o n s u m e r s will be so confused by P h a s e IV
that they will want to b e c o m e m o r e liquid.

The slowing of velocity,

a s they t r y to build up money b a l a n c e s , will then offset enough of
the growth in the money stock to cause a r e c e s s i o n .

T h e r e was such

a slowing of velocity for a short t i m e after the f i r s t f r e e z e was d e c r e e d
in August 1971. However, b u s i n e s s m e n and the public a r e m o r e
sophisticated about c o n t r o l s now.

Although P h a s e IV will cost the

economy some output through encouraging inefficiency, I believe we
can count on the ingenuity of the A m e r i c a n public and the f l i m s i n e s s
of the c o n t r o l s m a c h i n e r y to hold the d a m a g e below the c r i t i c a l point.
The second a r g u m e n t is b a s e d on the difference between nominal
money b a l a n c e s - - book d o l l a r s , u n c o r r e c t e d for the effects of inflation
on t h e i r p u r c h a s i n g power - - and r e a l b a l a n c e s - - nominal b a l a n c e s
adjusted for anticipated inflation.

It can be argued that a 6% growth

r a t e for nominal M-^, with a 4% inflation r a t e , is equivalent to a 2%
growth r a t e of M-. when the p r i c e level is stable, or is expected to be

- 4 -


This a r g u m e n t flows from the quantity t h e o r y of money, which

is a t h e o r y of the demand for r e a l b a l a n c e s .

The t h e o r y says that

people want to hold a p a r t i c u l a r amount of r e a l p u r c h a s i n g power in
the f o r m of money and that how m u c h they want to hold is r e l a t e d
to t h e i r i n c o m e s , i n t e r e s t r a t e s , p r i c e anticipations and t h e i r holdings
of other f o r m s of wealth.

A r i s e in the inflation r a t e , with nominal

Ml- growing at steady 6%-7% r a t e , t h e r e f o r e , would reduce the r a t e
of growth of t h e r e a l m o n e y stock.

Again, D r . F r i e d m a n b e l i e v e s , the

slowing of velocity, a s people t r y to m a i n t a i n t h e i r d e s i r e d r e a l b a l a n c e s
in the face of a r i s i n g inflation r a t e , might be enough to c a u s e a r e c e s s i o n .
T h e r e is little e m p i r i c a l evidence to go on in a s s e s s i n g
this argument.

What m a t t e r s i s how m u c h inflation people expect.

However, we have had only a brief e x p e r i e n c e with A m e r i c a n s behaving
a s if they expect inflation to continue.
since 1965.

Most of that e x p e r i e n c e has been

The r e a l - b a l a n c e a r g u m e n t justifies expecting a slowing

down in the r a t e of growth of r e a l GNP next y e a r , a s m y colleagues at
A r g u s and I do.

But t h e r e a r e p o s s i b l e offsets t h a t I expect will combine

to keep the slowdown from r e a c h i n g t h e r e c e s s i o n stage:


Anticipated inflation m a y r e d u c e the demand for
r e a l b a l a n c e s , encouraging people to get out of
money and into other a s s e t s .


The devaluation of the dollar has i n c r e a s e d d o m e s t i c
and foreign demand for U. S. produced goods, s e r v i c e s
and capital a s s e t s .

- 5 -


After having grown at an a b n o r m a l l y slow, 1.1%, annual
r a t e between 1966 and 1971, income velocity a c c e l e r a t e d
in 1972. If velocity grows m o r e n e a r l y at its 3. 5%
1950/1966 a v e r a g e annual r a t e in 1974, a 6% money growth
r a t e would prove to be considerably m o r e expansive than m o s t
money models now indicate*


The F e d e r a l R e s e r v e is so sensitive to the r i s k of r e c e s s i o n
that I believe any p e r c e p t i b l e slowing in growth of r e a l GNP
will bring an i n c r e a s e in the growth r a t e of the money stock.
T h i s , I admit, violates my original money supply a s s u m p t i o n ,
but I believe money growth is m o r e likely to r i s e above the
a s s u m e d t a r g e t then to fall below it.

In forecasting the inflation r a t e for 1973, many f o r e c a s t e r s ,
including those in government, w e r e m u c h i m p r e s s e d with special f a c t o r s ,
such as the devaluation of the dollar, and the R u s s i a n wheat deal.


w e r e expected to contribute to a s h o r t upward sprint in p r i c e s , after
which the inflation r a t e would settle back about to the 2 1/2% to 3% that
was the A d m i n i s t r a t i o n ' s goal.

T h e r e a l s o was c o n s i d e r a b l e o p t i m i s m

about the p r i c e - d e p r e s s i n g effects of productivity growth and unused

At A r g u s , we a c c e p t e d the t e m p o r a r y spurt t h e s i s , but

expected the inflation r a t e to settle back to a new higher t r e n d r a t e
of 3 1/2% to 4%.

We thought an i n c r e a s e in the inflation rate was

inevitable, given a 6% a v e r a g e m o n e t a r y growth r a t e for f 7 1 , '72,
and ' 7 3 .
The t r e n d r a t e of growth of the money stock now a p p e a r s
to be c l o s e r to 7% than to 6%.

During 1974, t h e r e f o r e , we expect the

c o n s u m e r p r i c e index to be moving toward a 5% to 5 1/2% t r e n d r a t e of

- 6 -

inflation, after the effects of the dollar devaluation and the world
food s h o r t a g e fade away,

i m p r o v e m e n t in the food supply outlook m a y

slow the r a t e of r i s e of the C . P . I , for a while, but its effects on t h e
o v e r a l l index will be t e m p o r a r y .
The f a m i l i a r MV=PT equation of exchange r e f e r s to
equilibrium s i t u a t i o n s .

We have m u c h to l e a r n about the dynamics

of adjustment of p r i c e s a s r a t e s of growth of the money stock change.
N e v e r t h e l e s s , s i m p l e o b s e r v a t i o n s of changes in annual a v e r a g e s of the
money stock and p r i c e s can be i n s t r u c t i v e .

F r o m 1953 through 1964,

for example, the money stock grew at a 2. 0% annual r a t e and the
CPI r o s e at a 1. 4% r a t e .

F r o m 1964 through 1972 the money stock

grew at a 5. 5% annual r a t e , while the CPI r o s e at a 3. 8% r a t e .


3. 5 p e r c e n t a g e - p o i n t r i s e in the r a t e of m o n e t a r y expansion was
a c c o m p a n i e d by a 2. 4 p e r c e n t a g e - p o i n t i n c r e a s e in the inflation r a t e .
However, t h e r e is no r e a s o n to suppose that the inflation r a t e had
fully adjusted

by 1972 to the higher t r e n d r a t e of m o n e t a r y expansion.

The 1970 r e c e s s i o n had t e m p o r a r i l y r e v e r s e d the a c c e l e r a t i o n of p r i c e

F r o m 1969 to 1970, which was roughly five y e a r s after the

a c c e l e r a t i o n of money growth began, the CPI r o s e 5. 9%.

A 3. 5

p e r c e n t a g e - p o i n t upward shift in the t r e n d r a t e of money growth,
thus was followed five y e a r s l a t e r by a 3. 5 p e r c e n t a g e - p o i n t

Since then, m o n e t a r y expansion has a c c e l e r a t e d again.


- 7 -

To those who believe a 5% to 5 1/2% inflation r a t e is too high,
I suggest considering a few additional p o s s i b i l i t i e s :
The F e d e r a l R e s e r v e m a y have shifted to a higher t r e n d r a t e
of money growth after the 1970 r e c e s s i o n than the 5. 5% p r e vailing over the e n t i r e 1964-72 period- M e a s u r e d by
q u a r t e r l y a v e r a g e s , the money stock grew at about a 7%
annual r a t e between the fourth q u a r t e r of 1970 and the
second q u a r t e r of 1973. A 7% money growth r a t e i s 5
p e r c e n t a g e points higher than the 2% that e a r l i e r a p p e a r e d
consistent with a 1. 4% a v e r a g e r a t e of r i s e in the CPI.
That a r g u e s for a 6% inflation r a t e eventually, u n l e s s the
F e d slows down its money m a c h i n e .

Some of the upward p r e s s u r e on output and p r i c e s between
1965 and 1971 was dampened by a slowing of velocity.
Velocity showed signs of r e t u r n i n g to its old growth t r e n d
in 1972.


Sorae U. S. inflation was exported to other c o u n t r i e s between
1964 and 1971, a s they a b s o r b e d d o l l a r s r a t h e r than letting
their exchange r a t e s change. The new r e g i m e of floating
exchange r a t e s , in effect, bottles up U. S. inflation in the
United S t a t e s .
Not even a 1974 r e c e s s i o n would m a k e much difference to
1974 p r i c e s , although it would slow inflation in l a t e r y e a r s .
Controls have taught b u s i n e s s m e n n e v e r , or a l m o s t n e v e r ,
to reduce l i s t p r i c e s , The 1967 and 1971 t u r n a r o u n d s in
m o n e t a r y policy have taught the g e n e r a l public that a n t i inflation policies a r e bad politics and hence will not be
followed v e r y long. To achieve a s much d e c e l e r a t i o n in
the inflation r a t e a s was achieved between between 1970
and 1972, I b e l i e v e , would r e q u i r e a m o r e s e v e r e , or
longer, r e c e s s i o n than the one of 1970.

F i n a l l y , I do not believe d i r e c t c o n t r o l s will r e d u c e inflation
in 1974.

In my opinion, the net r e s u l t of adopting w a g e - p r i c e controls

in 1971 was to m a k e p r i c e s higher in 1974 than they would o t h e r w i s e have

- 8 -

The m o n e t a r y influences d i s c u s s e d thus far suggest both
downward and upward f o r c e s on i n t e r e s t r a t e s in ! 7 4 .

F i r s t , the

downward f o r c e s : A slowing in the r a t e of growth of r e a l GNP will
tend to r e d u c e demand for c r e d i t .

This should pull short r a t e s , as

r e p r e s e n t e d by the-90-day T r e a s u r y bill r a t e , down to about 7. 0% on
a q u a r t e r l y a v e r a g e b a s i s in the f i r s t and second q u a r t e r s .

The effects

on long r a t e s will be m u c h s m a l l e r , with the n e w - i s s u e yield on Aa
u t i l t i t i e s coming down to about 8. 1% in the s a m e q u a r t e r .
I do not include an easing of m o n e t a r y policy among the downw a r d f o r c e s , for the s i m p l e r e a s o n that it was not tight F e d p o l i c i e s
that drove r a t e s up so high in 1973.

The effort to slow growth of t h e

m o n e y supply probably added s e v e r a l b a s i s points to short r a t e s in
t h e t h i r d q u a r t e r , but the b u s i n e s s boom, the r e s u r g e n c e of inflation,
and t h e i l l - s t a r r e d effort to hold bank p r i m e r a t e s down w e r e far
m o r e important.
Now the upward f o r c e s :

The developing s u r g e in b u s i n e s s

spending for plant and equipment and continuing strong demands for
c o n s u m e r d u r a b l e goods and housing will be exerting a l o n g - t e r m upward
force on the r e a l r a t e , despite the t e m p o r a r y downward force of a busme
slowdown in e a r l y 1974.

M o r e i m p o r t a n t , l e n d e r s and b o r r o w e r s

p r o b a b l y be r e v i s i n g upward t h e i r expectaticns of p r i c e inflation.


will l i m i t the decline in s h o r t - t e r m r a t e s and could push l o n g - t e r m r a t e s

- 9 -

higher than they w e r e in 1973. Anyone who doubts the power of inflation
expectations to push long r a t e s up in the face of a b u s i n e s s slowdown
should r e m e m b e r 1970.

Long r a t e s peaked in the middle of that

recession year.
To sum up, 1974 should be a good y e a r in many r e s p e c t s .
Output and employment will be high, in spite of a slowing in t h e i r
r a t e s of growth.

C o r p o r a t e profits will grow instead of collapsing as

many f o r e c a s t e r s now f e a r .
will adjust to inflation.

Although agonizing over it, the public

A 'continuing u n c e r t a i n t y should support the

demand for b u s i n e s s e c o n o m i s t s .

Prepared Statement of A. James Meigs,
Vice President and Economist, Argus Research Corporation
Hearings on Recurring Monetary and Credit Crises
before the
Committee on Banking and Currency
U.S. House of Representatives
September 11, 1973
Reforms in the structure and regulation of
financial institutions would be highly desirable.
Financial institutions have been massively overregulated since the 1930's. Consequently, relaxation of regulatory restraints that now limit competition among the various types of financial institutions should yield substantial benefits to the
However, the draft Staff Report of the
Subcommittee on Domestic Finance is correct in
saying that unless the Federal Reserve System is
somehow induced to maintain a more stable
monetary framework for the U.S. economy,
financial reform cannot assure the flows of
funds into housing, priority state and local government projects, and new and small businesses
that this Committee and others would like to
see. Nor can financial reform alone ameliorate
the costs of instability in other important sectors of the economy. I believe that the current
disarray and confusion in the securities markets,
for example, also reflect the damaging effects of
extraordinary and unnecessary instability of
monetary policy, especially since 1964.
In this statement and in the appended exhibits, therefore, I plan to concentrate on the
problem of improving monetary policy. As
Chapter 4 of the draft Subcommittee Report
presents a well-balanced and competent analysis
of the problems and evidence involved, I shall
confine my remarks to points that seem to me
to be especially important.

misunderstanding of the interaction of monetary
policy and interest rates has been, in my opinion, the most important source of error in the
conduct of monetary policy, not only in the
United States but in most other countries as
well. Misguided efforts of central banks and governments to stabilize interest rates have caused
economic instability and inflation the world
over. The effects on interest rates, moreover,
have been perverse; interest rates are higher and
certainly less stable than they would otherwise
have been.
Attempts to insulate homebuilding from
the effects of interest-rate instability - as, for
example, through requiring institutions to purchase prescribed amounts of mortgages or
through the variable investment-tax credit recommended by the Board of Governors of the
Federal Reserve System - would, I believe, redistribute some of the costs of instability without
significantly benefiting homebuilding. Aggravating instability in business spending for new
plant and equipment by varying investment-tax
credits, in particular, seems unlikely to foster
the confidence in employment and income prospects that would encourage people to undertake the burdens and pleasures of homeownership.

Money and Interest Rates

The only effective way to attain lower
and more stable interest rates is through maintaining lower and more stable rates of growth of
the money stock than those of recent years.
Under our current institutional arrangements,
only the Federal Reserve can do that.

The first of the two exhibits discusses the
influence of money-supply changes on interest
rates. I include it with this statement because

When I wrote the first exhibit on money
and interest rates in early 1971,1 was more optimistic about the outlook for interest rates than I

-2am today. The slowing of inflation that was
underway at that time and the declarations of
good intentions from the monetary authorities
made lower and more stable interest rates seem
highly probable. The subsequent swing to hyperexpansive fiscal and monetary policies and the
resort to wage-price controls can perhaps best be
described as wringing defeat from the jaws of
victory. The effects of the resurgent inflation on
interest rates need no elaboration here.

upward. The new inflation began in 1965, when
money-growth rates approached or exceeded the
5% and 6% maximum guidelines. Inflation was
strongly accelerated from 1967 through the
second quarter of 1973, when money-growth exceeded both the 5% and 6% maximum guidelines
in many quarters. This suggests that if moneygrowth had been checked at either of the JEC
maximum guidelines, the economy would be
suffering much less from inflation today - and
interest rates would be lower.

Instability and Inflation
The second exhibit, "Conflicting Targets
of Monetary Policy," discusses some evidence on
effects of money-supply changes and contains
my recommendations for improving the conduct
of monetary policy. Chart 18.1 shows changes in
quarterly averages of the narrowly defined
money stock (Mj) from 1947 through the
second quarter of 1973. Two sets of guidelines
that have been recommended by the Joint Economic Committee have been added to provide
an idea of what might have happened had they
been in effect over the whole period.
Two characteristics of that record strike
me as being overwhelmingly obvious. The first is
the great volatility in rates of change in the
money stock. Every major reduction in the rate
of growth except the one of 1971 was followed
by a recession or a mini-recession (1967). Every
time the rate of growth of the money stock fell
below either the 3% or 2% minimum guidelines
of the Joint Economic Committee, except in
1962 and 1971, a recession or mini-recession
followed. This suggests that if monetary decelerations had been checked at either of the minimum guidelines, the subsequent recessions or
mini-recession would have been avoided or reduced in severity.
The second important characteristic is the
change in trend in the rates of growth of the
money stock. From early 1952 through early
1960, the trend was downward. It was in this
period that the World War II and Korean War
inflations were painfully, but effectively, wrung
out of the economy. From early 1960 through
the second quarter of 1973, the trend has been

Federal Reserve spokesmen undoubtedly
will express reservations about this ultra-simple
evidence. But their own research and statements
support two of its main implications:
1. Econometric models in use at the Board
of Governors and elsewhere in the System
would forecast a reduction in the rate of
growth of Gross National Product if the
rate of growth of the money stock were to
fall significantly below its prevailing trend
and remain there for more than two calendar quarters.
2. Dr. Arthur F. Burns, Chairman of the
Board of Governors, has testified, as he did
before the Joint Economic Committee in
February 1971, " . . . while a high rate of
growth of narrowly defined money may
well be appropriate for brief periods, rates
of increase above the 5 or 6 percent range if continued for a long period of time have typically intensified inflationary pressures."
It may well be asked why the monetary
a u t h o r i t i e s , who have acknowledged that
changes in the money stock influence income,
employment and prices, have not kept these
changes within narrower bounds.
The Mechanics of Controlling the Money Supply
One of the defenses of the Federal Reserve is that there are defects in the machinery.
From the early 1920's to this day, however, the
principal weakness has been in the Federal Reserve's own conception of the processes it is sup-

posed to control. My own research, Free Reserves and the Money Supply, which was distributed within the System in 1960 and published
by the University of Chicago Press in 1962,
demonstrated the fallacy of the Federal Reserve's reserve-position doctrine. A three-part
study done for this Committee by Karl Brunner
and Allan H. Meltzer in 1964 carried the criticism much farther along and proposed an alternative approach to the monetary mechanism.
Many other researchers inside and outside the
System have contributed to the discussion since
then. Yet, the same old discredited ideas still
have a strong hold on System thinking. They are
dressed up now in the language of modern
macroeconomics and econometrics, but they
still give a misleading impression of the difficulties involved in controlling the money supply.
More important, they lead to operations that
cause the money stock to behave in ways that
the Open Market Committee itself considers inappropriate.
I will simply assert here that the Federal
Reserve could exert much more effective control
over the money supply than it now does, and
that it will, whenever the Members of the Board
of Governors decide that it is in their best interest to try. Changes in the machinery that have
been initiated by the Board in recent years, however, have often been in the direction of making
their job more difficult. I have particularly in
mind the proliferation of reserve requirements
on various categories of bank liabilities.
My own suggestions for improving monetary policy are:
1. Develop better measurements of the
money supply and other monetary aggregates.
2. Renounce attempts to control interest
rates, "money-market conditions," or the
supply of credit.
3. Adopt a steady-growth rule for the
money supply, so that money-supply
changes would no longer cause instability

and inflation and no longer amplify disturbances originating elsewhere in the economy.
I would also suggest, as I have in the past,
that the transition to a system of controlling the
money stock be done gradually, through reducing
the tolerated range of variation in money-growth
rates while increasing the tolerated range of variation in short-term interest rates. This, it seems
to me, would be consistent with the Joint Economic Committee's recommendation for specifying a range of variation in money-growth rates.
I would certainly endorse, also, the suggestion in
the draft Subcommittee Report that a target
rate of growth for the money stock be set
The Politics of Monetary Policy
When I speak of the politics of monetary
policy, I use the word "politics" in its finest
sense. Economic policy seems to me legitimately
and necessarily subject to political decision and
accountability. Considering the enormous costs
of inflation and economic instability, therefore,
it seems no more logical to have monetary policy determined by an independent monetary
authority than to have all uses of military power
determined by an independent Defense Department.
To explain why the Federal Reserve does
not now do better than it does would carry me
far beyond the boundaries of my professional
competence. But I believe monetary policy
would be enormously improved if the President
were to set money-supply growth guidelines in
his Economic Reports to the Congress and require the Federal Reserve to operate within
these guidelines. This would focus the attention
of the Federal Reserve on something they could
do, rather than permitting them to intervene in
so many different markets in so many different
ways that they can never be held responsible for
the results.
I have only one additional suggestion to
make regarding other ways of making the Fed-

-4eral Reserve more responsive to the wishes of
the President and the Congress. These are, after
all, matters of organizational structure and procedure that the Members of this Committee are
far more competent to judge than I am.
My one additional suggestion is to eliminate the secrecy that now cloaks the processes
and decisions of the Board of Governors and the

Open Market Committee. I see no reason why
Policy Directives of the Open Market Committee
should not be publicly announced immediately
after each meeting of the Committee, preferably
with a discussion of the reasons for policy decisions. Ending the secrecy would not only facilitate the monitoring of System actions by the
President and the Congress, but it would greatly
reduce uncertainty among the general public.

7 - 1

Exhibit submitted to Committee on Banking
and Currency, House of Representatives, 93rd
Congress, First Session, Hearings on Recurring
Monetary and Credit Crises, September 11, 1973,
by A. James Meigs, Vice President and Economist
Argus Research Corporation.

. . . in order to estimate the possible variation in the rate
of interest, we may, broadly speaking, take account of
the following three groups of causes: (1) the thrift,
foresight, self-control, and love of offspring which exist
in a community; (2) the progress of inventions; (3) the
changes in the purchasing power of money. The first
cause tends to lower the rate of interest; the second, to
raise it at first and later to lower it; and the third, to
affect the nominal rate of interest in one direction and
the real rate of interest in the opposite direction.
Irving Fisher, The Theory of Interest, 1930

order to get $105 next year, he gives up $100
worth of goods and services for what he hopes
will be $105 worth of goods and services next
year. We have no direct measure of this real rate.
The money rate is the one we can see in the
markets, where loans are measured in dollars,
not goods.

The Real Rate and the Money Rate

If lenders and borrowers all believed that
the purchasing power of money would remain
constant, the real rate and the nominal rate
would be the same. But people seldom, if ever,
do believe that the purchasing power of money
will remain constant. Therefore, the money rate
of interest will be higher than the real rate if
people believe prices will rise; and it will be
lower than the real rate if people believe prices
will fall. With prices expected to rise 5 percent
per year, lenders will demand the real rate plus 5
percent so that they will be protected against
the expected loss in the purchasing power of
money. Borrowers will be willing to pay this 5
percent inflation premium because they expect
to repay their loans with dollars worth 5 percent
less than the dollars they borrow.

As Fisher explained it, we should distinguish between two kinds of interest rates: real
rates and money (or nominal) rates. The real
rate is the interest rate measured in terms of
goods. When someone lends $100 this year in

The revived Fisherian emphasis on the
purchasing power of money directly contradicted a central proposition of the conventional
approach to interest-rate forecasting used before
1965 because it implied that an easy-money

Of Irving Fisher's three causes, monetarists have learned to concentrate on the third the changes in the purchasing power of money.
But the educational process has not stopped
with monetarists. People who earn their bread
by lending in the capital markets have rediscovered in an excruciatingly painful way a truth
that Irving Fisher had clearly explained in 1896.
This truth is that changes in the purchasing
power of money have powerful effects on
market interest rates - the nominal rates to
which Fisher referred.

Chapter 7 of A. James Meigs' Money Matters:
Economics, Markets, Politics (New York: Harper
& Row, Publishers, 1972)
Reprinted by Argus Research Corporation with
permission of publisher.

7 - 2
policy would cause interest rates to rise. Most
forecasters and money-market practitioners cQnsidered it an obvious fact instead that an
easy-money policy would cause interest rates to
fall. They accepted the traditional view that
central banks could control interest rates
through increasing or decreasing the supplies of
credit and money and by changing the central
banks' own discount rates.
The business cycle was important, in the
conventional view, for two reasons: it influenced
the demand for credit and it influenced credit
policy and thereby influenced credit supply. The
first step in anyone's interest-rate forecast,
therefore, was a forecast of economic activity or
GNP. After the introduction of the Federal
Reserve's Flow-of-Funds Accounts in the midfifties, many forecasters in the United States
began to project supplies of credit and demands
for credit that they believed were implied by
their own or other GNP forecasts. Expected
federal budget deficits or surpluses played a key
role in the flow-of-funds projections as well as in
the GNP forecasts. The interest-rate forecasts
would then depend largely on how the Federal
Reserve was expected to react to the projected
economic and credit-market conditions. Would
the Federal Reserve allow a projected gap
between credit demand and credit supply to be
filled with bank credit? Or would it not? As a
matter of fact, this flow-of-funds approach is
still widely used.
The conventional approach to interestrate forecasting had two parts of the problem
right. That is, it was correct in expecting
business fluctuations to push interest rates up or
down. In the United States after World War II,
interest-rate peaks roughly coincided with
business-cycle peaks and interest-rate lows followed recession troughs by two to five months
(see Chart 7-1). And the approach was correct in
assuming that efforts of the Federal Reserve to
counteract recessions and expansions would also
push interest rates down or up, at least for a
time. But even those few economists who were
aware of the effects of price expectations on
interest rates thought they worked so slowly

that they could be safely overlooked in forecasting.
As we saw earlier, however, the Federal
Reserve and other central banks struggled mightily but unsuccessfully to curb the rise of interest
rates in the second half of the sixties. Interestrate forecasts of all types, therefore, proved to
be spectacularly wrong.
In 1965, on the very eve of the inflation
that still bedevils the United States, prudent,
farseeing portfolio managers of financial institutions bought long-term corporate bonds yielding
AVi percent or less. Investors were glad to get
them because corporations were so well supplied
at the time with retained earnings and depreciation allowances that they were not borrowing
much. Little did these expert portfolio managers
know that by mid-1970 their actual return on
these bonds would prove to be less than zero
because of a depreciation in the purchasing
power of money that they had not foreseen.
Viewed in the glaring light of hindsight, lending
decisions of banks and other institutions were
also costly.
It is, of course, an ill wind that blows
nobody good; the corporations that had the
prescience or the good luck to borrow in 1965
were handsomely rewarded for the care they
took of the institutions' money over the next
five years. The same thing could be said of the
homeowners who had bought houses in 1965
with mortgages yielding less than 6 percent to
lenders. The government borrowed well, too.
Fisher had anticipated just such a possibility when he pointed out that the influence of
changes in the purchasing power of money on
the money rate of interest will depend on
whether or not the changes are foreseen. "If it is
not clearly foreseen," he said, "a change in the
purchasing power of money will not, at first,
greatly affect the rate of interest expressed in
terms of money."
One of the most remarkable aspects of
capital-market behavior in the period since 1965

7 - 3

is that the inflation that was not foreseen in
1965 was very quickly reflected in market
interest rates. In mid-1970, shortly after the rate
of rise of prices approached 5Vi percent, (as measured by the GNP deflator), long-term bond
yields hit 8Vi percent. A 4 percentage-point
increase in the rate of price inflation had been
roughly matched by a 4 percentage-point rise in
corporate bond yields. This was a more rapid
adjustment than Fisher would have expected.
Reverent Fisherians, conse4uently, underestimated the rise of rates along with nearly
everyone else.
From Theory to Dogma
For more than sixty years, Fisher's idea
about the effects of inflation on interest rates
had been an esoteric proposition familiar only to
a few economists. The painful experience of
lenders in the 1960s, however, made it a matter
of dogma in the capital markets in less than five
years. Now, everyone knows that price inflation
means high interest rates. This suggests that the
grading system used in the markets must be
quite effective in eliminating slow learners.
By 1971, however, forecasters were in
some danger of forgetting that changes in the
purchasing power of money affect market interest rates in both directions. Most of the
people who were courageous enough, or foolhardy enough, to publish their views on the
future of interest rates in early 1971 agreed that
inflation had much to do with pushing rates to
the peaks reached in 1969 and 1970. From there
on they seemed to me to divide into four main
camps. One group expected rates to remain high
because inflation would never be curbed.
Another expected rates to remain high even if
inflation were to slow down - because of real
forces, such as an expected capital shortage and
a decline in the propensity to save. The third
group expected rates to come down because of a
slowing in the inflation rate. And a fourth
expected rates to be driven down by the Federal
Reserve. Membership of this group grew considerably during 1970.

We should not expect to keep these
forecasters confined to the camps I just mentioned. There were certain to be migrations from
camp to camp. For example, the forecasters who
expected rates to be driven down by the Federal
Reserve were likely to join the perpetualinflation group in expecting high and rising rates
after 1972. As a matter of fact, if the Federal
Reserve were to try very hard to do what they
expected in 1971, we might all join those who
expect perpetual inflation and high rates.
The views of all these forecasters, and of
the people who inhabit the markets as well,
incorporated in various ways expectations about
future prices, what determines future prices, and
the effects of price changes. Fisher believed that
people's expectations about prices were drawn
from their own experience. Furthermore, in his
day most people could remember periods in
which prices fell as well as periods in which
prices rose. Consequently, they did not jump
quickly to the conclusion that a year of rising
prices meant perpetual inflation or that a short
period of falling prices meant perpetual deflation.
" . . . when prices are rising," Fisher said,
"the rate of interest tends to be high but not so
high as it should be to compensate for the rise;
and when prices are falling, the rate of interest
tends to be low, but not so low as it should be
to compensate for the fall." Between 1965 and
mid-1970, however, long rates rose higher and
more quickly than can be explained by Fisher's
view that price expectations and money interest
rates are adjusted slowly in the light of actual
price behavior.
One possible explanation for the apparent
speeding up of interest-rate reactions to price
inflation is that a long and accelerating rise of
prices has a more powerful impact on expectations than an inflation that moves at varying
speeds. We all must admit that the price rise
from 1964 on was strong and convincing.
Another is that expectations are influenced by
other information than the actual past behavior

7 - 4
of prices. The new ingredient is economic policy
or, rather, expectations about economic policy.
Instead of looking just at prices, people analyze
the speeches of the monetary authorities and
read the election returns to decide whether or
not inflation will continue.
Whatever caused the change, the lags in
interest-rate reactions to changes in prices have
shortened since Fisher's day. I should amend
that to say the lags in reaction to a speeding up
of inflation have shortened. We cannot be sure
that the lag in reaction to a slowing of inflation
has shortened as much, for in 1971 we had not
yet had much opportunity to observe the effects
of a slowing in the rate of inflation.
Lessons for the Seventies
The outlook for U.S. interest rates in the
seventies, therefore, depends upon what policies
the Administration and the Federal Reserve will
follow, how soon and how much those policies
will influence the rate of inflation, and finally,
how soon and how much the change of inflation
rates will influence price expectations and interest rates. To take these possibilities in turn, if
the Administration and the Federal Reserve stay
on the 1970-early 1971 strategy of moderation
in fiscal and monetary policies, the slowing of
price inflation, which had been so elusive,
should become more noticeable in 1972, unless
the monetary explosion of 1971 causes inflation
to reaccelerate.
By 1975 the purchasing power of money
could be approximately stable, as it was in the
early 1960s. After all, four years of extraordinarily expansive monetary and fiscal policies were
required to get the inflation started. In the
absence of such policies, inflation will not
continue indefinitely. Even if the price stability
of the early sixties is not regained, however, the
inflation rate should be considerably lower than
it was when interest rates reached their peaksin
1969 and 1970.
I have already indicated that interest rates
should react to a slowing of inflation by drifting

gradually downward after 1971. Whatever investors may say about inflation, many have been
acting for some time as though they at least do
not expect the inflation rate to increase. Judging
by the tremendous volume of bonds purchased
by households and institutions in 1970 and
1971, the inflation premium in bond yields
seemed to have eased investors' fears of future
injury from inflation. If they were to see
inflation actually slowing down, therefore, their
appetite for fixed-income securities might increase even more.
The painful lesson to lenders in the 1960s
was that unforeseen inflation brings depreciation
in the bond account. The more pleasant lesson
of the 1970s may be that unforeseen slowing-of
inflation brings capital gains for the bond buyer.
Either way, the slow learners are penalized,
which may account in part for the shortening of
the lags that I mentioned earlier.
The Financial Research Center of Princeton University found in a survey of 137 large
institutional investors in 1971 that they expected an average annual inflation rate of nearly 4
percent for the next decade. A bond yielding 8
percent or more at the time of the survey would,
therefore, provide them a real rate of return of 4
percent or more, if they correctly predicted the
rate of inflation. If the inflation rate were to fall
below 4 percent, as I expect it will, the 8
percent bond of 1971 would produce more than
a 4 percent real rate of return.
If inflation were to go well above 4
percent per year, however, the investors who
bought 8 percent bonds would suffer capital
losses, as did those who bought 41/2S in 1965. It
is no wonder then that American investors have
learned to keep one ear or both on Washington
at all times. In interest-rate forecasting, as in
forecasting the GNP, the most difficult problem
is to forecast what the government and the
central bank will do. In early 1971 an alarming
upsurge in money supply raised the odds on
another acceleration of price inflation that
would drive rates higher.

7 - 5
Before escaping into the euphoric, less
inflationary, long run, interest-rate forecasters in
early 1971 had some troublesome details to
clear up about the rest of the year. The U.S.
economy had been below par for more than a
year. Interest rates had fallen since June, 1970,
as they always do in recessions. As economic
activity improved in 1971, therefore, rates could
be expected to rise. Nevertheless, the downward
influence of the slowdown in price inflation on
rates should tend to counteract the upward
influence of the increase in activity. This suggested that although rates would rise again
during 1971, the rises would stop far short of
the previous peaks.
Another widely held view at the time,
however, was that the recovery from recession
would be slow, in fact, so slow that interest rates
would continue to decline for much or all of
1971. The continuing decline of rates in this
view, would result from weakness of credit
demand and from efforts of the Federal Reserve
to get the economy moving again by expanding
bank credit and the money supply.
Economic stagnation was the least likely
outcome of the Administration's policies of
curbing inflation and ending the Vietnam War.
Both of these policies had contributed to unemployment by reducing demand for the products
of some of this country's most important
industries, including durable goods manufacturing in general and the aerospace industry in
But it should not have been forgotten that
the war and the space program had diverted
enormous amounts of manpower and other
resources from the production of many other
things that Americans wanted, and still want including millions of new houses and the community facilities required for a high-quality life.
Inflation was one of the ways in which the U.S.
government had extracted from an unenthusiastic
electorate the real resources for the Vietnam
War and the phenomenal expansion of nondefense programs that accompanied the war
from 1965 through 1968. High interest rates

also played a part in the diversion of capital
resources from home building and from state
and local governments.
The resilience and flexibility of the economy could be counted on to complete the
difficult transition from war to peace speedily.
Unfilled demands would not long be neglected
after resources became available for filling them.
There was good reason to expect a recovery that
would be a revelation to those forecasters who
had allowed the pressing problems of the day to
rob them of historical perspective. But there was
a danger that the Federal Reserve might help
that recovery with too much zeal and reawaken
the sleeping dragon of inflation.
The Monetarists' Kit for InterestRate Forecasting
The revival of Fisher's view of interestrate determination certainly improved the forecasting of interest rates but did not make it
simple or foolproof. His contribution was the
emphasis on the influence of price expectations,
which had been a glaring oversight on the part of
most forecasters. The new monetarists have
added the improvements in forecasting fluctuations in business activity that were covered in
the preceding chapter.
Monetarists' forecasting models now try
to capture three different effects of moneysupply changes on interest rates. The first is the
familiar liquidity effect, the short-run tendency
of an increase in money-supply growth to reduce
interest rates. This one turns out to be surprisingly weak as compared with the others.
The second is the income effect, the
tendency of an increase in money-supply growth
to increase income six to nine months later and
thereby to increase demands for credit and
money and to raise rates. The projections of a
GNP model like the one in the preceding chapter
are used by some forecasters as the income
variable in interest forecasting equations.
Some forecasters, myself included, were

7 - 6
so pleased to have discovered the tendency of
the income effect of money-supply changes on
interest rates to offset the liquidity effect that
they were led to forecast too early a turnaround
of interest rates in 1969, when monetary policy
became restrictive. Earlier periods of monetary
restraint in the United States, such as 1959 and
1966, had resulted in slowdowns of economic
activity and declines in interest rates well before
the monetary authorities relaxed the restraints.

The most plausible explanation for expecting the interest-rate turnaround in 1969 too
early was that expectations of price inflation
continued to carry rates on upward even after
the 1969-1970 business recession had begun.
The monetarist forecasters were correct in forecasting a recession that would cause rates to fall.
But they made two mistakes. The first was to
underestimate the amount and persistence of
inflation from 1965 through 1970 and the
second was to underestimate the impact of the
inflation and possible other factors upon expectations and rates. As I said earlier, the
1965-1970 adjustment of interest rates to price
inflation was in the direction predicted by Irving
Fisher but was much more rapid than he would
have expected. Needless to say, forecasters have
been working feverishly since 1969 to improve
their ability to forecast price-inflation rates and
to learn more about how price expectations are
formed. Although we believe major improvements have been made, we will not know for
sure until we have observed more cycles of
inflation and recession.
What causes the stability of the anticipated real interest rate is still, to me, largely a
mystery. The real rate seems to be influenced by
slow-moving forces of population changes, technological changes, and the willingness of people
to defer consumption today for greater consumption in the future. Some economists who
study the determinants of economic growth
argue that the real rate is equal to the long-run
rate of growth of real output, for it is the yield
of the total stock of real capital in all forms. In
any case, forecasters probably will not be too
badly misled if they assume the real rate to be
nearly stable while they focus on the forces that
make nominal rates fluctuate around it.

From early 1969 on, therefore, monetarist forecasters watched and waited for a downturn in interest rates that did not come. Shortterm interest rates peaked in December of 1969
and long-term rates did not peak until the
following June. When interest rates finally did
fall, however, the decline was greater than
everyone expected.

The forecaster's problem is compounded
also by the obvious fact that there is no such
thing as "the" interest rate, whether real or
nominal. What he faces is a vast array of
particular market rates on short-term and longterm instruments ranging from commercial
paper to home mortgages. Demand-supply an-

7 - 7
alyses, such as the flow-of-funds approach, will
still be necessary for moving to the rates for
particular instruments from the forecast levels of
a few key rates that can be provided by
monetarist models.
There is no danger of a collapse in the real
rate, in my opinion. The world economy is
certainly not heading into another depression
that would paralyze saving and investment. Nor
do we have much reason to expect the real rate
to be substantially higher than it has been in the
past decade, despite the fears of a capital
shortage. The real rate on high-quality corporate
bonds should remain around 3 or 4 percent in
the United States, as it has for many years. The
more difficult questions concern how large an
inflation premium will be included in the money
rates that we can see in the markets and how
savers and investors will react to the economic
policies of governments.
The most damaging feature of the inflationary environment in which the capital markets labored after 1965 was not price inflation,
although that was damaging enough. Given time,
money interest rates could adjust to a steady
rate of price inflation, as Fisher predicted, so
that interest rates and the markets could do
their work of allocating capital resources
smoothly and efficiently. Far more damaging
was the uncertainty about how much inflation
there would be and what, if anything, would be
done about it.
Fears of direct credit controls in the
United States surely made interest rates higher
in the sixties than they would otherwise have
been. Fearing they might at some time be cut
off from credit suppliers, especially banks, corporations borrowed more than they needed and
were willing to pay commitment fees for funds

they had not yet borrowed. Lenders, furthermore, were more reluctant to lend than they
would have been if the monetary authorities had
not been so determined to reduce bank lending
to businesses. Large banks, effectively cut off
from domestic time-deposit funds by Regulation
Q ceilings on the rates they were allowed to pay,
were afraid they would eventually be cut off
from their alternative sources in the Eurodollar
market. After Regulation Q was suspended on
large negotiable certificates of deposit in June,
1970, the fears of borrowers and lenders were
quickly dispelled and interest rates fell. Nevertheless, the interest-rate effects of controls
imposed by governments in capital markets are
extremely difficult to forecast.
The lingering uncertainty about economic
policies delayed recognition in wage and price
decisions of a movement toward price stability
that should not be, but could be, aborted. Most
helpful in dispelling uncertainty about the
future purchasing power of money in the United
States was the announced determination of the
Administration and the Federal Reserve to avoid
after 1968 the wide swings in fiscal and monetary policies that had brought confusion and
disorder to the capital markets in the first place.
The swing to highly expansionary monetary
policy in early 1971 was disconcerting evidence
that monetary instability had not yet been
eliminated. But it was not yet too late to bring
money under control. If the Federal Reserve
eventually demonstrates through its actions that
the prospect for stability can become more
widely accepted, interest rates and the markets
will behave as Fisher would say they should.
Thrift, foresight, self-control, love of offsrping,
and the progress of inventions will replace
changes in the purchasing power of money as
the key determinants of money interest rates.

18 - 1

Exhibit submitted to Committee on Banking
and Currency, House of Representatives, 93rd
Congress, First Session, Hearings on Recurring
Monetary and Credit Crises, September 11, 1973,
by A. James Meigs, Vice President and Economist
Argus Research Corporation.

In the discount market, the Bank's stress on the desirability of steadiness in the Treasury bill rate compromises its control over the cash base; in the bond market,
the more it cares about the price of bonds, the less control it has over the liquid assets basis of the clearing
R.S. Sayers, Modern Banking, 1964
Because monetary policies affect the
economy with long time lags, the monetary
authorities cannot immediately see the effects of
their actions upon such key variables as national
income, employment, and prices. Therefore,
they must use intermediate guides for their dayby-day operations to tell them if they are exerting their influence in the right direction and in
appropriate amounts.
The current world debate over standards
for guiding monetary policy focuses on two
main possible guides, or groups of guides. On
one side are interest rates, which are price
measures. On the other side are the monetary
aggregates, such as money supply, bank reserves,
the monetary base, or total bank credit; these
are quantity measures. Although central banks
generally strive for a compromise between the
two, both guides cannot be followed at the same
time. If a central bank attempts to control interest rates, it must allow money supply to
fluctuate. If it controls money supply, it must
allow interest rates to fluctuate.

A good guide should have two main characteristics. First, it should be closely under the
control of the central bank, so that the central
bank can interpret a change in the guide as the
result of its own actions rather than the result of
outside forces. Second, changes in the guide
should have a strong and predictable relationship
to changes in ultimate policy variables, such as
income, employment, and the price level.
Although no guide may be considered
ideal, some meet the practical requirements of
the policy makers better than others. Money
supply is far superior to interest rates, which
have traditionally been the preferred guide of
c e n t r a l b a n k s . Monetarists have compiled
abundant evidence on this point for the United
States and have recently begun to do the same
thing for other countries. In fact, the timehonored practice of trying to control interest
rates while allowing the money supply to
wander as it will can result in extremely serious
and costly mistakes. It has fostered economic
instability, price inflation, and large fluctuations
of interest rates.
The Interest-Rate Guide
In most popular textbooks today, changes
in the rate of growth of money supply are
assumed to influence the economy mainly

Chapter 18 of A. James Meigs' Money Matters:
Economics, Markets, Politics (New York: Harper
& Row, Publishers, 1972)
Reprinted by Argus Research Corporation with
permission of publisher.

18 - 2
through changing interest rates, which in turn
influence business investment spending, and,
finally, consumer-spending. This orthodox, although perhaps oversimplified, Keynesian doctrine would justify the use of interest rates as
monetary policy guides. A central bank might,
therefore, try to stabilize the economy by
changing interest rates.
In practice, however, central bankers seldom apply a consistently Keynesian approach to
interest rates in the United States or anywhere
else, although their explanations of their actions
might suggest that they do. Most of the time the
Federal Reserve and other central banks have
been more concerned with stabilizing interest
rates and money-market conditions than with
manipulating them for contracyclical purposes.
The practice of trying to minimize short-run
changes in interest rates and availability of credit
amounts to adding stability of financial markets
and institutions as a fourth ultimate policy objective to the usual three - price stability, high
employment, and balance-of-payments equilibrium. The market-stability objective, moreover,
conflicts with the others.
Nearly everywhere it is assumed that the
central bank is "called upon to keep the financial structure on an even keel." Those words
are borrowed from Britain's Macmillan Committee Report, written in 1931, not from the
more recent discussion of Federal Reserve operations in the United States. Stability in moneymarket conditions, or an even keel, is an elusive
concept; but it has a high place among the goals
of central bankers. It would probably be highly
valued by most commercial bankers and other
members of the financial community as well. At
least they have become so accustomed to the
daily presence of the central bank in the market
that they find it difficult to imagine operating
without it.
Central-bank pursuit of the widely extolled ideal of financial stability may now be a
more important, though more subtle, threat to
stability of income, prices, and interest rates
than is the alleged propensity of governments to

use their central banks as "engines of inflation."
It is a more subtle danger precisely because it
meets such widespread approval; official pressure on central banks to finance deficits is openly endorsed by almost no one.
A plausible rationalization for centralbank emphasis on interest rates and creditmarket conditions is a belief that financial markets and institutions work better if interest rates
are stable than if they fluctuate. Central banks,
therefore, try to cushion money markets from
sudden rate changes that might somehow impair
market performance.
In the United States the Federal Reserve
helps the Treasury to issue new securities or to
refund existing ones by attempting to keep interest rates stable during Treasury financing
operations. These so-called even-keel operations
are especially important when budget deficits
are large, as they were in 1967 and 1968. Evenkeel operations during such periods can produce
extremely large increases of money supply. Consequently, it is often assumed that the Federal
Reserve is yielding to political expediency in
helping the government to borrow on more
favorable terms than it could otherwise. Although perhaps partly true, this is too simple an
Because the government is generally the
largest and most disturbing borrower in the markets, it is the one most likely to trigger stabilizing operations by the central bank. Therefore,
the borrowing of governments tends to be accommodated automatically by central banks.
The Federal Reserve's solicitude, however, is intended more for the market than for the
A Stable Money Market or
A Stable Economy?
The principal objection to the practice of
stabilizing interest rates is that supplies of bank
credit and money will then be determined largely by changes in the demand for them. When the
central bank intervenes in the markets, it uses

18 - 3
high-powered money. This means that there will
be changes in money supply several times as
large as the central bank's purchases or sales,
unless these operations are almost immediately
cancelled out by offsetting sales and purchases.
The paradoxical result of stabilizing interest rates or retarding their movement is that
the central bank automatically becomes expansive when the government runs a deficit, instead of acting as a counterweight in the way
indicated by most discussions of the appropriate
fiscal-monetary policy mix. Because changes in
money supply are induced also by increases or
decreases in private demands for credit and
m o n e y , a rate-stabilizing policy results in
money-supply changes that amplify business
fluctuations instead of countering them. This
directly contradicts the usual textbook view that
the central bank is a stabilizing influence in the
Although fluctuations in the rate of
growth of U.S. money supply since World War II
- even those after 1964 - have been much more
moderate than those before the war, they have
been enough, in the opinion of monetarists, to
have caused each of the postwar recessions and
the minirecession of 1967. To have kept money
supply growing at a steady rate, therefore,
would at least have removed a source of disturbance and thus would have increased the stability of income and employment.
Central banks are so sensitive to the possibility of economic recession today that they are
not likely to be misled by falling interest rates
into being too restrictive. A much more likely
mistake is the one of resisting a rise of rates and
thus causing price inflation. In the summer of
1965, for example, the Vietnam War buildup
and an already booming private economy caused
U.S. interest rates to begin rising. The Federal
Reserve System's efforts to keep rates from rising led to an enormous expansion of money
supply that contributed to the inflation that
plagued the country for years afterward.

In effect, price inflation was part of the
cost of attempting to moderate the rise of interest rates. The interest-rate policy, moreover,
was unsuccessful, for interest rates soared in
spite of the Federal Reserve's efforts. Again, a
simple policy of keeping the money supply
growing at a steady rate would have done more
to maintain stability than what was actually
The monetarist view of how interest rates
are influenced by money-supply changes makes
it clear that a policy of stabilizing interest rates
in the short run makes them less stable in the
longer run. Contrary to common belief, a restrictive monetary policy means lower rates and an
expansive policy means higher rates. This view
of interest-rate determination has truly ironic
implications for central bankers because it
demolishes the principal justification for their
preoccupation with interest rates.
The bitter fruits of years of central-bank
solicitude for investors can be seen in two representative long-term government bonds, one
British and one American. British Treasury 2Vzs,
redeemable after 1975, traded at less than 30 in
1970, or, in real terms, about 10 percent of their
value at issue in 1946. U.S. Treasury 3s of 1995
traded as low as 60 in 1970, or at less than half
their real value when they were issued in 1955.
Holders of mortgages, long-term corporate
bonds, and state-and-local government issues
have similar capital losses to mull over.
It may seem that the deficiencies of the
interest-rate guide are not in interest rates themselves but rather in the way the guide has been
used by the central banks. It could be argued
that if central banks aggressively changed interest rates in pursuit of more stable income and
prices instead of stabilizing the rates, the results
would be better. However, this argument is weak
on two points: (1) central banks, as we have
seen, have very little control over interest rates;
and (2) the effects of changes in market interest
rates on incomes and the price level are not eas-

18 - 4
ily predicted. Recognition of the effects of price
expectations on market interest rates has weakened confidence in interest rates as a guide for
both of these reasons.
The central bank has only a tenuous and
temporary influence on market interest rates.
Therefore, the monetary authorities cannot
know whether a change of interest rates is a
result of something they have just done, or a
delayed result of actions taken many months
earlier, or the result of forces completely out of
their control.
Levels of market interest rates can be
disastrously misinterpreted. In the thirties, for
example, low interest rates were interpreted as
evidence that U.S. monetary policy was expansive when, in fact, money supply was contracting. In the sixties high interest rates were interpreted as evidence that U.S. monetary policy
was restrictive when, in fact, money supply was
growing at an inflationary rate.
In Keynesian theory the rate that is important for influencing investment and saving is
the real rate. Because Keynes assumed that
prices were fixed over the period analyzed, market interest rates could be used as proxies for
the real rate. Furthermore, money-supply
changes could be used to manipulate interest
rates without fear of inflationary consequences.
But in the real world over-expansion of money
supply does raise prices; and price expectations
drive a wedge between the real rate that influences saving and investment and the nominal
rates, or market rates, that we can measure.
Therefore, changes in market rates cannot be
assumed to be equivalent to changes in real
rates. In fact, effects of central-bank actions on
the real rate, if there are any, probably will be in
exactly the opposite directions from the effects
the central bank is trying to achieve on nominal
market rates. Interest rates, therefore, are
neither a reliable guide nor a policy instrument
for the monetary authorities.

Which Monetary Aggregate?
When a central bank turns from interest
rates to the monetary aggregates as guides it is
confronted with a bewildering number and
variety of aggregates from which to choose. Indeed, critics of the monetary aggregates point to
this variety as a major problem. I believe this
criticism is a red herring.
The U.S. Federal Reserve System still
attempts to follow several guides at once, although this can be confusing. The confusion is
avoidable, however, because one guide would be
enough. Each of the candidates can be tested
with regard to two criteria: (1) controllability
by the central bank and (2) predictability of the
relationship between the aggregate and the ultimate policy goals, such as income and prices.
The following list covers some of the
monetary aggregates proposed as monetarypolicy guides in the United States and suggests
the shortcomings and advantages of each. Not all
of them have close counterparts in other
* 1. Free reserves, excess reserves less borrowings of member banks. This old favorite of
the Federal Reserve and of many money-market
practitioners is by all odds the least useful and
most misleading guide that has ever been proposed. It is neither controlled by the Federal
Reserve nor dependably related to any important ultimate policy goal.
2. Credit proxy, total liabilities of U.S.
member banks. This measure has the advantage
of being available to the Federal Reserve on a
weekly basis as an approximation for total bank
credit. However, it has all the weaknesses of
total credit in explaining changes of income and
prices. The apparent closeness of its relationship
to income stems from the fact that it closely
approximates changes in broadly defined money
supply (M2) because total member-bank depos-

18 - 5
its are a large part of total M2.
3. Non borrowed reserves of member
banks - probably the purest measure of what
the Federal Reserve is doing to reserves of member banks. Looked at from the standpoint of the
member banks, these are the reserves over which
the banks have no control, but which the banks
can supplement by borrowing from Reserve
banks. Although closely controllable by the Federal Reserve through open-market operations,
nonborrowed reserves are less closely related to
income and prices than are other monetary
4. Total reserves of member banks. More
comprehensive than nonborrowed reserves, they
are more closely related to income and prices;
but they are a little more difficult for the Federal Reserve to control.
5. High-powered money, or monetary
base, total member-bank reserves plus currency
in the hands of the public. This is a key variable
in determining the money supply. Because it is
determined partly by decisions of the public,
however, it is not a pure measure of central-bank
actions. Furthermore, it is less closely related to
income and prices than is money supply. In
some other countries, however, this may well be
the best operating guide available.
6. Money supply (Mj, M2, M x ). Money
supply, in any of its variants, is the most closely
related to income and prices of all the monetary
aggregates and, on this account, is the best
guide. Ordinarily, narrowly defined money (Mj)
and money including time deposits (M2) perform about equally well in models for forecasting gross national product. But the Federal
Reserve's use of Regulation Q ceiling rates on
time deposits has so badly distorted M2 in recent years that it is not safe to rely on predictions made from relationships between M2 and
income that were estimated before Regulation Q
was an important influence. Other versions of
money supply, represented here as M x , incorporate other variables, such as savings and
loan shares or other liquid assets, or attempt to

adjust for the distorting effects of Regulation Q
by excluding negotiable certificates of deposit
(CDs), for example. These are interesting refinements, but they are not essential for practical
The main objection to the use of money
supply is that it is not completely within the
control of the central bank. How important this
objection is must be weighed against the alternatives available to the monetary authorities.
Perhaps the most extreme alternative to
money supply as a guide for monetary policy
was suggested by the Radcliffe Committee, an
official body established to "inquire into the
working of the monetary and credit system" of
Britain in the late fifties. In its 1959 Report, the
Radcliffe Committee concluded that the quantity of money was virtually irrelevant because the
velocity of circulation was unstable. The key
variable, instead, was "total liquidity," to which
money supply was only one of a great many
Because total liquidity was never clearly
defined and because the relationships between it
and the ultimate goals of income, prices, and the
balance of payments were never empirically
demonstrated, this concept could not serve as an
operational guide. The Committee's endorsement of it did have the negative effect, however,
of encouraging the Bank of England and other
central banks to neglect the behavior of the
money supply for a few years more.
At a tenth anniversary celebration of the
Radcliffe Report, Professor A. A. Walters of the
London School of Economics administered a
less-than-merciful coup de grace to the totalliquidity concept.
"Liquidity" [he said] . . . is an eternally elusive
concept - a will-o'-the-wisp of monetary economics.
Liquidity is "the amount of money which people think
they can get hold of. .." (para. 390) or "the lending
behavior of an indefinitely wide range of financial institutions " (para. 394). It is impossible to grasp such a
concept. Liquidity is a state of mind relative to an indefinite range of institutions. But even if one's intuition

18 - 6
were to penetrate the mists to meaning it is clearly quite
impossible in principle to measure 'liquidity. "No refutable theoretical propositions can be formulated in terms
of liquidity. The pure Radcliffe theory can never be

A related criticism of money, the
"Gurley-Shaw Thesis," became popular in the
United States at about the time of the Radcliffe
Report. In the course of an original treatment of
the role of financial intermediaries, Professors
John G. Gurley and Edward S. Shaw of Stanford
University argued that savings and loan shares
and other liabilities of nonbank financial intermediaries were close substitutes for money. One
implication, therefore, was that if the central
bank restricted growth of the money supply,
other financial intermediaries would create more
liabilities for the public to hold and the central
bank would be frustrated. With nonbank intermediaries growing faster than commercial banks,
furthermore, central banks would have to find
ways to extend their powers to the nonbank intermediaries or resign themselves to impotence.
Like many other initially promising ideas,
however, both of these propositions foundered
when confronted with facts. Although the
"near-moneys" are substitutes for money in the
long run, the bank intermediaries do not have
the power to frustrate the monetary authorities
in the short run by issuing more of their liabilities when the central bank restricts growth of
money. On the contrary, when growth of money
supply is restricted, the nonbank intermediaries
suffer a prompt and painful "disintermediation," as we saw in 1966 and 1969. Rather than
viewing the nonbank intermediaries as a threat,
the Federal Reserve System has been worried
about how they can be shielded from the restrictive effects of its policies.
Still another vestige of the Radcliffe
total-liquidity idea lingers in the "new view" of
money that is associated with James Tobin and
some of his students at Yale University. The
"new view" emphasizes the role of portfolio
management by economic units, an idea with
which monetarists are quite at home, as we saw

earlier. It differs from the monetarist view, however, in arguing the necessity "to regard the
structure of interest rates, asset yields, and
credit availabilities rather than the quantity of
money as the linkage between monetary and financial institutions on the one hand and the real
economy on the other." The quantity of money,
moreover, is not an autonomous variable controlled by the monetary authorities but an
endogenous or "inside" quantity determined by
the banks and other economic units. Effective
policies, in the "new view," would require a
tremendous investment in measurement and
analytical efforts by the authorities and intervention at many points in financial markets.
These may seem like minor differences in
emphasis, but they are of the sort that can keep
controversies among the experts alive for a
generation or more. And they can cause doubts
about the efficacy of monetary policy, especially when put forward by such an eminent
and distinguished economist as James Tobin.
Nevertheless, I find myself, as a monetary practitioner rather than a theoretician, in agreement with Professor Harry Johnson's comment:
.. . the "new view" is long on elegant analysis of theoretical possibilities, but remarkably short on testable or
tested theoretical propositions about the way the
economy works, and specifically how it responds to
monetary impulses, when the interaction of the monetary and real sectors is taken into account.

The performance of the economy would
be improved, I believe, if central banks merely
avoided gross changes in rates of money-supply
growth. Fine tuning of the money supply day by
day or week by week is not required. The monetary authorities have been overly sanguine about
the consequences of the money-supply changes
they produce while following guides they consider to be more important. But it is now clear
that money matters. As I argued earlier, tolerance of large money-supply changes has increased economic instability, caused inflation,
and made interest rates less stable in many countries. Worst of all, neglect of money supply has
nourished beliefs that monetary policy is either
impotent in the face of price inflation or too

18 - 7
harsh in its effects on certain sectors of the
economy. One result has been a proliferation of
governmental intrusions in the marketplace.

market operators who will have to acquire new
reflexes and new rules of thumb.
The Federal Reserve can make a gradual
shift of emphasis between interest rates and the
monetary aggregates within the framework of its
present operating procedures through changing
the Open Market Committee's directive. The
directive formerly emphasized avoidance of
short-run interest-rate fluctuations by instructing the manager of the Open Market Account to
conduct open-market operations with a view to
maintaining a particular set of money-market
conditions. A proviso clause, added for the first
time in 1966, was intended to guard against excessive fluctuations of bank credit and money
supply. That is, if money supply or bank credit
appeared to be increasing, or contracting, too
much, the manager of the Open Market Account
had authority to depart from the interest-rate

What Should be Done?
Although it is unlikely that money supply
will continue much longer to be neglected as a
monetary-policy guide, increasing the emphasis
on money supply does present some adjustment
problems for the central banks and for market
institutions. The Joint Economic Committee of
the U.S. Congress recommended for several
years that the Federal Reserve should keep
money-supply growth within limits shown on
Chart 18-1. The System followed such a policy
for a while in 1970. The International Monetary
Fund made somewhat similar recommendations
to the Bank of England in 1969. In both countries, the monetary authorities thus made a start
toward more direct control of the money
supply. However, the traditional central-bank
concern with money-market conditions was not
entirely abandoned in either country.

With the new ordering of the guides after
January, 1970, the Federal Open Market Committee instructed the manager of the Open Market Account to try to achieve some desired
change in money supply and other monetary
aggregates. The proviso clause then called for
modifying operations if short-run changes in interest rates exceeded some specified range. If

Given the fact that financial institutions
are so much accustomed to the old regime in
which the central bank continually attempted to
moderate interest-rate fluctuations, any change
is likely to be gradual and will stir protests from
Chart 18-1
15 1








6% annual rate
maximum J.E.C. guideline
5% annual rate



l A 3 % annual
A f
[:; \
p*y \ |

A / V
\ 1

NOTES: Money stock -- quarterly
changes at annual rates of money supply
(demand deposits and currency). Shaded
areas are recessions. Chart by Argus
Research Corporation.

I f f
1 1


1 11.;
2% annual rate
I f m i n i m u m J.E.C. guideline

















18 - 8
wide fluctuations of interest rates would impose
costs and structural changes on the economy,
the proviso clause could be a safety valve.

Bank's earlier decision to increase its emphasis
on controlling monetary aggregates.
Measure, Control, Simplify

We actually do not know much about the
costs of fluctuating rates or how wide the
fluctuations would be if the Federal Reserve
attempted to keep money-supply growth within
narrow bounds. These characteristics of the
system must be determined through experiment.
I believe these potential costs of greater, shortrun variability of interest rates have been vastly
overestimated for the United States.
Simulation experiments with the FRBMIT econometric model reported by James
Pierce, an economist at the Board of Governors,
indicate that stability of the U.S. economy
would increase as the bounds on money-supply
growth are narrowed and the permissible range
of variation of interest rates is widened. This is
in line with the expectations of monetarists.
As experience with the new techniques
and new strategies accumulates, the range of
fluctuation permitted in money supply should
be narrowed while the range of fluctuation of
interest rates is broadened. By making the
changes gradually, central banks can permit
money-market institutions to adjust their practices with minimum strain.
However, I would urge the central bankers
of the world not to be too kind to their moneymarket friends. It would be far better to inconvenience securities dealers and banks with
fluctuating interest rates than to risk instability
in income, employment, and prices for whole
countries, and their neighbors, as some central
banks have done in the past. Financial institutions are flexible and have strong incentives for
adapting to whatever operating guides the central banks follow. The key step in improving
monetary policy will be for central banks to
renounce attempts to control interest rates, once
and for all. The Bank of England came close to
this in announcing in May, 1971, that it would
restrict the extent of its operations in the giltedged market. This step was in line with the

Advice to central bankers about using
money supply as a guide can be summed up in
three words: measure, control, simplify.
Measurement is the essential first step.
When the Federal Reserve System was not much
interested in the money supply, it devoted very
little effort to measuring it. Until the late 1950s
the published money-supply series of the Federal Reserve was based on a one-day-per-month
estimate. Because demand deposits in the United
States sometimes fluctuate by several hundred
million dollars per day, a one-day-per-month
measure could be, and was, seriously misleading
at times.
When the Federal Reserve Bank of St.
Louis took on its now-legendary concern for the
money supply around 1958, William J. Abbott,
senior economic adviser, and his research assistant, Marie Wahlig, personally reconstructed the
Federal Reserve's entire money-supply series.
They based their new series on daily-average
deposit data for the member banks that the
System had gathered for years in the course of
enforcing reserve requirements but had not used
in the money-supply series. This one project
immensely improved the quality of U.S. moneysupply data and was a significant step toward
improving U.S. monetary policy. Their project
has since been followed by other improvements
in U.S. money-supply data by the staff of the
Board of Governors.
Nevertheless, the U.S. money-supply data
still had serious flaws in 1969 and 1970, years in
which the Federal Reserve was trying to curb
inflation and to facilitate a recovery from recession which, in my opinion, was caused by too
sharp a deceleration in money-supply growth in
1969. That error, however, should not be charged to faulty money-supply data, although there
were substantial revisions of prior estimates during the year. In 1969 the Federal Reserve had

18 - 9
not yet adopted money supply as a guide. Therefore, I would attribute the overly severe restrictiveness of that year's policies to Federal Reserve attempts to curb business investment
spending while overlooking what was happening
to the money supply.
But in 1970 the Federal Reserve was trying to learn how to control the money supply.
Errors in the statistics did not make that task
easier. Large upward revisions of the data after
the fact revealed that money-supply growth
between February and October had been
appreciably greater than the Fed had intended.
In his Newsweek
Friedman said in March, 1971:


The explanation of the major errors of the past
two years is highly technical and cannot be spelled out
here. I can only report my judgement that the errors
would not have been anything like so large, and might
not have occured at all, if years ago, the Fed had devoted to improving its measures of the money supply
anything like the attention and research effort it has
lavished on its index of industrial production, let alone
on its surveys of liquid assets.
The Fed neglected monetary statistics for years
because it took interest rates rather than monetary
aggregates as its criterion of policy. It has corrected the
mistake in policy. But it has not corrected the mistake in
statistics. As a result, its present estimates of monetary
aggregates are still defective.

Other central banks, like the Federal Reserve System, lavish resources on gathering and
reporting financial and economic data of many
kinds. Yet most of them lack good moneysupply series. Obviously, this is something that
can and will be corrected when they become
serious about attempting to control the money
There is still much to be learned about
methods of money-supply control. The difficulty, however, stems mainly from attempting
to do other things at the same time. The U.S.
Federal Reserve System was still trying in early
1971 to control several monetary aggregates and
interest rates simultaneously. The Federal Re-

serve was attempting to control money supply
through controlling interest rates (money-market conditions), possibly the most difficult
approach that could be found.
In the first half of 1971 this method of
trying to control money-supply growth by controlling interest rates led to serious embarrassment for the Federal Reserve. The virtual explosion of monetary growth in that period revived fears of inflation that had been quieting
down. It seemed to confirm press reports that
the Nixon Administration had persuaded the
Fed to abandon the fight against inflation.
Long-term interest rates began to rise at once,
despite the declared hopes of Administration
and Federal Reserve spokesmen that they would
continue to decline. Furthermore, it confirmed
the fears of Europeans that the United States
was indifferent to their problems of coping with
large dollar inflows. Although the international
monetary crisis of May, 1971, had many roots,
there is no question that the upsurge of moneysupply growth in the United States was one of
As we saw in 1959-1960, 1965, 1967,
1968, 1970, and 1971, the use of the "moneymarket strategy," or reserve-position doctrine, in
guiding Federal Reserve open-market operations
leads to changes in bank credit and money
supply that the Federal Open Market Committee
did not intend. And these inadvertent departures
from the Committee's intentions have come at
the most awkward times - at the onset of recessionary or inflationary swings in the economy.
More direct, more effective, methods for
controlling the money supply will surely be
developed. The key requirement is the will to do
it. The will of the Federal Reserve should have
been strongly reinforced by the furor stirred up
by the monetary accident of early 1971.
A possible new procedure has been
suggested by economists of the Federal Reserve
Bank of St. Louis, which is an elaboration of the
classic high-powered money and moneymultiplier framework. In essence, the suggested

18 - 10
procedure requires the Open Market Committee
to express a target in terms of a growth rate of
money. This growth rate of money is then translated into a growth of "net source base" - nonborrowed reserves of the member banks plus
currency held by the public plus vault cash of
nonmember banks - that the trading desk is to
achieve through open-market operations over
the control period of a month or quarter at a
To determine the growth of monetary
base needed to reach the money-supply target
would require a forecast of the multiplier. There
is good reason to believe this can be done well
enough to keep money supply under much
better control than is attainable with the
money-market conditions approach.
Finally, there is a good need for simplifying central-bank techniques. In viewing themselves as required to intervene in a great many
ways in a great many markets in pursuit of a
great many objectives, central bankers have
made it extremely difficult for anyone to
appraise the effectiveness of their actions. By
narrowing down to a single guide, money
supply, they would concentrate on something
they can do and they would be able to determine the relationships between their actions and
the behavior of ultimate objectives, such as income, employment, and prices. It would be especially helpful to drop the traditional preoccupation with interest rates.
The Bank of England, the "mother of
central banks," has led the way by announcing
its withdrawal from the hallowed practice of
supporting the gilt-edge market. In a truly remarkable effort, the Bank also has simplified
and improved its procedures and regulations.
The Federal Reserve has been retrogressing in
recent years. The number and variety of reserve
requirements have been increased. Furthermore,
the proposals for the so-called reform of the discount mechanism would make it more difficult
for the System to control the issue of highpowered money. The number of reserve require-

ments should be cut to one, or none. The discount window could be abolished in the United
States, for it has been rendered an anachronism
by the development of open-market operations
and the Federal Funds (interbank) market for
rapidly transferring reserves within the System.
The most important, and currently most
widely misunderstood', simplification would be
to adopt a steady-growth rule for the money
supply. A not untypical example of the misunderstanding about monetarists' arguments for
steady growth in the money supply was a 1970
statement of Alfred Hayes, president of the Federal Reserve Bank of New York:
/ am applying that term ["monetarist"] to those
who believe in a virtually assured mechanical relationship of a casual character between the money supply and
economic activity\ and who therefore tend to favor a
very steady increase in the money supply and a minimum resort to discretionary policy by the central bank.

Monetarists argue that it is precisely
because there is not a "mechanical" one-to-one
correspondence between changes in the money
and changes in income that they favor a steady
growth-rate for money supply. Because of the
slippage, we do not know how to do better than
to maintain a steady growth-rate. This does not
rule out the possibility of adopting some other
rule later when the linkages are better understood.
The wielders of discretionary powers
seldom want to give them up. But the Federal
Reserve and other central banks have treated the
world economy as a "free-fire zone" in launching their discretionary measures at many visible
and invisible targets. Among the unintended results of their discretionary measures have been
economic instability, price inflation, and a growing uneasiness about the viability of the international monetary system. This is not a criticism
of their intentions but is instead recognition of
how limited is our knowledge of the linkages
between actions and results. I believe it would
be possible to do better by attempting less.

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