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SHADOW OPEN MARKET COMMITTEE
Policy Statement and Position Papers

September 10-11,1978

1.

SOMC Members - September 10,1978

2.

Shadow Open Market Committee Policy Statement, September 11,1977

3.

Position Papers




Economic Projections-Jerry L.Jordan, Pittsbufgh National Bank
Economic Prospects Through 1979 - Robert Genetski, Harris Bank
The Dilemma of U.S. Monetary Policy and the "Commitment" to Permanent Inflation - Karl
Brunner, University of Rochester
Fiscal Policy-Rudolph G. Penner, American Enterprise Institute
Worksheets- Robert Rasche, Michigan State University

SHADOW OPEN MARKET COMMITTEE

The Committee met from 1:30 p.m. to 8:00 p.m. on Sunday, September
10, 1978.
Members:
Professor Karl Brunner, Director of the Center for Research in Government Policy
and Business, Graduate School of Management, University of Rochester,
Rochester, New York
Professor Allan H. Meltzer, Graduate School of Industrial Administration, CarnegieMellon University, Pittsburgh, Pennsylvania
Mr. H. Erich Heinemann, Vice President, Morgan Stanley & Company, Inc. New York,
New York
Dr. Homer Jones, Retired Senior Vice President and Director of Research, Federal
Reserve Bank of St. Louis, St. Louis, Missouri
Dr. Jerry Jordan, Senior Vice President and Chief Economist, Pittsburgh National
Bank, Pittsburgh, Pennsylvania
Dr> Rudolph Peiiner, American Enterprise Institute, Washington, DC
Professor Robert Rasche, Department of Economics, Michigan State University, East
Lansing, Michigan
Professor Wilson Schmidt, Department of Economics, Virginia Polytechnic Institute,
Blacksburg, Virginia
Dr. Beryl Sprinkel, Executive Vice President and Economist, Harris Trust and Savings
Bank, Chicago, Illinois
Dr. Anna Schwartz, National Bureau of Economic Research, New York, Mew York




POLICY STATEMENT
Shadow Open Market Committee
September 11, 1978
The government's economic policy has produced the results we predicted.
Inflation has risen from \ 3/4% in 1976 to between 7% and 8% this year. The
increase in the rate of inflation is now reflected in higher interest rates, a
sinking dollar and increased demands by labor for compensatory wage increases.
Long-term interest rates are near the highest levels in a century.
Neither the Administration nor the Federal Reserve has developed a policy
capable of slowing the rate of inflation. The Administration proposes or adopts
one stopgap after another. None of their programs or proposals to limit price
or wage increases has more than a temporary effect on the measured rate of inflation. The Federal Reserve continues to chase interest rates to higher levels
by rapidly creating money. The Federal Reserve and the Administration confuse
public discussion by misinterpretinq the rise in interest rates as evidence of
restrictive monetary policy and by opposing policies to reduce monetary growth.
Figure 1 records the results of Federal Reserve monetary policy since 1960.
Measures to "defend the dollar11 by selling gold, drawing on IMF balances,
using swap arrangements, or encouraging foreign borrowing by domestic banks
at best, buy time. But time that has been bought has been squandered. The
Administration and the Federal Reserve have not developed any effective policy
to lower the rate of inflation permanently and to prevent further acceleration.
We are drifting without a program or a goal. One month, the Administration
wants tax reduction to stimulate spending; the next month, increases in spending
in fiscal 1980 are to be held to the lowest level in decades. One month, the U.S,
is a tugboat pulling the rest of the world onto the seas of higher growth; the
next month, there is talk of 'defending the dollar" and restricting imports from




the economies we intended to stimulate. One month, the Federal Reserve announces
a target rate of growth of money; the next month, the target is exceeded and
ignored.
The experience of the past several years should remove any remaining belief that the government can fine tune the economy. The risk of recession has
increased and the threat to economic freedom has grown. Inflation has risen and
the long-term growth rate has fallen.
The Past Five Years
The Shadow Open Market Committee first met in the fall of 1973. We were
concerned then by the lack of consistent direction in government policy, the
resort to controls, the high growth rate of money and the failure of government
to develop a long-range program to reduce instability and inflation. Now, five
years later, we find again the same high growth rate of money, a renewed drift
toward controls, a much larger budget deficit and higher inflation.
At our first meeting and many subsequent meetings, we warned that inflation
would not be reduced if we continued to follow stop and go policies. We predicted as early as 1975 that continued large federal deficits financed by debt
would "crowd out" private spending and reduce the rate of investment and the
growth of real income. In the fall of 1975, we recognized that economic capacity
had been reduced by the oil price rise and challenged the then standard view
that the economy was in a deep depression comparable to the depressions of the
thirties. We argued then that the standard measurement of the output gap -- the
gap between actual and potential output — was misleading and that policies that
relied on published measures of idle capacity would produce excessive stimulus
and higher inflation. In March 1977, we warned against the return to fine tuning,
predicted that the increase in money growth would bring increased inflation in




1978 and 1979, and pointed out, again, that there would be no large increase in
investment spending if the government budget deficit averaged $50-bil1 ion or
more in 1977 and 1978 as then seemed likely. Our recommendations for monetary
policy are shown in Figure 2.
Our predictions regrettably have come true. Investment has remained relatively low. Policies to stimulate consumption did not produce an investment
boom. The government was not able to increase output first and slow inflation
later. The economy, as we predicted, has come close to economic capacity with a
large budget deficit, a rising rate of inflation and slow growth of productivity.
The Next Five Years
The policy of gradualism in reducing the growth rate of money in 1974 and
1975 brought the increase in consumer prices down from about 11% in 1974 to
an average of 5 3/4% in 1976. The economy recovered. The dollar exchange rate
remained stable. If we had avoided the burst of government spending and excessive money growth in the last two years, we would have continued to receive
the sustained benefits that could have been achieved only if government policies
had been stabilizing. The monetary expansion of the past year and a half renewed excessive stimulus. These policies have continued too long to be abruptly
halted.
We propose four steps to end inflation and restore stability within the next
five years.
One, the rate of monetary expansion in the past year has been 7.75%. We urge
that the rate be reduced to an annual rate of 6% over the next year. The stock
of M-l — currency and demand deposits -- will average $376-billion in.the third
quarter of 1979 if the 6% growth rate is attained.
Two, we recommend reduction in the average rate of monetary expansion by 1%
a year until a noninflationary rate of monetary expansion is achieved. The Federal Reserve should publicly commit monetary policy to this stabilizing long-term




course in order to fulfill its legal responsibilities under the Federal
Reserve Reform Act of 1977. Abandoning interest rate targets and controlling
the monetary base ~ currency and bank reserves — is the single most important
step the Federal Reserve must take to meet those responsibilities. This change
in Federal Reserve procedure should be adopted forthwith.
The Federal Reserve proposes to permit transfers between consumer-type
time and demand deposits on November 1. If the change occurs, the reported
short-term growth of M-l will fall. This fall should not be interpreted as
part of the reduction in M-l growth that we recommend and should not be an
excuse for acceleration of the growth rate of the monetary base. No misinterpretation wH*; res'jit if the Federal Reserve shifts its procedure to control
the monetary base.
Threes the Congress should implement the Administration's pledge to reduce the growth of government spending below the growth of private spending
during the next three fiscal years. Growth of government spending should be
reduced enough to produce a steadily declining absolute deficit.
Four, to encourage investment and output, the Administration and the Congress
should reduce all tax rates, individual and corporate, to offset the full effect
of inflation on all taxpayers. Real taxes in future years should be no higher
than they would have been if there were no inflation.




Figure 1
The Record of Federal Reserve Monetary Policy

Rate of Change in the Money Supply (M-1)
9.0%'

7.0

CO

6
s

5.0 -

0)

3
CO

3.0

0)




1.0 *

-1.0

F

1960

I

1962

1964

1966

1963

1970

1972

1974

1976

1978

Shaded areas represent periods of recession as designated by the National Bureau of Economic
Research except for the mini-recession of 1966-1967.
Sources: Chase Econometric Associates Data Base; Morgan Stanley Research

Figure 2
Targets for the Money Supply
The 'Underlying' Rate of Growth in M-1 and the Recommendations of the Shadow Open Market Committee

— - • - Rate of Change in M-1
_ . . * . SOMC Recommendations

9.0%-

6.6 -

o

5.4 -

\

V

y

(Year

-Year Changes)

7.8 -




/

XT.
4.2 -

3.0 1974

1975

1976

1977

Sources: Chase Econometric Associates Data Base; Morgan Stanley Research

1978

TO.

FROM
SL3JECT

Shadow Open Market Committee
Jerry L. Jordan

.PHONE No.

ECONOMIC PROJECTIONS

I,

DATE

Sept. 1, 1978

Below are two tables showing summary projections for 1978 as presented

in March this year (I) and as now appears likely (II).

TABLE I
(percent changes)
Projections for 1978 as of March 78 SOMC Meeting

Deflator

Output

GNP

M

V

M

Q4/77-Q4/78

11.7

4.9

6.5

7.0

9.0

4.4

2.5

1977-1978

11.6

5,1

6.2

7.4

9.0

3.9

2.4

TABLE II
(percent changes)
Projections for 1978 as of September 78 SOMC Meeting

GNP

Output

Q4/77-Q4/78

12.1

4.1

'7.7

7.6

1977-1978

11.4

4.0

7.2

7.7

Growth of both M

Deflator

V

8.1

4.2

3.8

8.4

3.5

2.8

and GNP are going to be higher than projected at the

March meeting, even though the growth of M
2
to be undesirably high.
quite a bit greater.

V

M

Growth of M

Growth of V

projected at that time was considered
2

will be somewhat less, but V

will be

will be close to the estimate at quite a high

rate for this stage of the economic expansion, as was assumed at the March
meeting.
Inflation is going to be much greater than has been projected in March,
although the rates yet to be reported for Q3 and Q4/1978 are likely to be
close to the rate that had been projected for the full year.




- 2 -

At the March meeting, the levels of economically efficient potential
real output under four alternative assumptions were discussed.

The lowest

level projected for Q4/78 was $1409 billion and the highest level was
$1439 billion.

It now appears the level of real output at year-end will

be at the lower figure, or about $1410 billion. The question of whether
real output in 1979 is likely to grow at a more rapid rate than the
long-run trend rate can still be usefully discussed within the context of
the analysis of the loss of real economic capacity that occurred in the past
few years.

II.

Projections for 1979 are shown in Table III.

Again it must be emphasized

that the growth rates shown, especially for the money stock, are assumptions
about what will occur, and are not recommendations about desired trends.

TABLE III

(percent changes)
Projections for 1979
GNP
Q4/78-Q4/79
1978-79

Output

Deflator

M1

M

2

V

1

v2

10-12

2-3

8-9

8.0

9 .0

3 .0

2.0

11.6

3.4

8.0

7.9

8 .8

3 .5

2.6

The unemployment rate is expected to remain in the 5.5 to 6.5 percent
range in the next year, and the growth of employment, as well as the labor
force, are likely to be slower than in 1978.
Both short- and long-term market interest rates are expected to rise,
at least through mid-1979.

The rise of high quality corporate bond yields

will be about one-half percentage point while yields on short-term market
securities will rise by 75 to 100 basis points.
Residential construction activity next year will be down 10 to 15
percent compared with 1978, but non-residential construction will exceed
this year.

Real capital spending will still rise next year, but by a smaller

amount than in 1978.




Automobile sales can be expected to decline about 10

- 3 -

percent for the full year, with a somewhat larger decline occurring in
foreign cars and a smaller decline in sales of domestically built cars.
Export volume will continue to rise in 1979 and will be accompanied
by a smaller increase in import volume so the trade deficit is expected to
be smaller.

Government spending in nominal terms is projected to rise 11

percent, about the same as nominal GX?.

III. Monetary policy has become more firmly wedged between the rock and the
hard place.

Growth of Ml has averaged between 7.5 and 8 percent during the

past two years.

Unfortunately, it appears that a third year of money growth

in this historically high range is likely, and a "trend" of inflation of
around 8 percent will be established.

The ease with which the "acceptable"

rate of inflation rose from 2 percent in che early 1960 f s, to 4 percent in
the late 1960 f s, and to 6 percent in the mid-1970 f s, suggests that policymakers may conclude that it is easier to live with an 8 percent continuing
inflation than it would be to reduce it.
Institutional changes in the banking system —

especially the prospects

of "automatic transfer accounts" on November 1, 1978 —

are likely to present

problems for the monetary authorities in interpreting short-run movements
in the monetary aggregates.

Typically,

the FOMC has decided to emphasize

"money market conditions" during such periods.

That usually means

they accomodate credit demands by providing sufficient reserves to
"moderate tendencies for interest rates to rise".

The SOMC may wish to

consider recommending that the Fed make full disclosure of the data it is
collecting, and will be collecting, such as on NOW accounts, share drafts,
automatic transfer accounts, and others.




SOMC 9/11/78

TWO-QUARTER COMPOUNDED ANNUAL RATES OF CHANGE
MONETARY
BASE

Ml

M2

01/71- -Q3/71

8.2

11.5

8.1

Q2/71- -Q4/71

4.8

8.1

6.6

Q3/71- -Ql/72

5.4

10.2

6.1

Q4/71- -Q2/72

7.8

11.3

7.8

Ql/72 -Q3/72

8.1

1.0.7

7.7

Q2/72 -Q4/72

9.0

11.0

9.0

Q3/72 -Ql/73

9.0

10.4

10.2

Q4/72'-Q2/73

7.1

9.0

8.8

Ql/73 -Q3/73

5.5

8.0

8.1

Q2/73 -Q4/73

5.3

8.6

7.4

Q3/73 -Ql/74

6.3

10.0

8.2

Q4/73- -Q2/74

6.1

8.9

9.5

Ql/74- -Q3/74

4.2

6.7

8.8

Q2/74- -Q4/74

4.0

6.4

8.6

Q3/74- -Ql/75

3.3

6.6

7.6

Q4/74'-Q2/75

4.2

8.2

7.0

Ql/75- -Q3/75

6.3

10.0

8.2

Q2/75- -Q4/75

4.5

8.4

8.0

Q3/75 -Ql/76

3.7

8.9

8.1

Q4/75 -Q2/76

5.9

10.7

9.5

Ql/76 -Q3/76

5.4

9.6

8.5

Q2/76 -Q4/76

5.6

11.1

7.5

Q3/76 -Ql/77

7.3

12.3

7.9

Q4/76 -Q2/77

7.7

10.3

8.1

Ql/77 -Q3/77

8.3

9.8

9.1

Q2/77 -Q4/77

8.0

9.3

9.6

Q3/77 -Ql/78

6.7

7.8

9.8

Q4/77 -Q2/78

7.8

7.8

9.3




SOMC

MONEY GROWTH RATES
( Change from Previous Year)
%

FROM:

TO.

1971/Ql

MONETARY
3ASE

Ml

M2

1972/QI

6.8

10.9

7.1

Q2

Q2

6.3

9.7

7.2

Q3
Q4

Q3

6.7

10.4

6.9

Q4

8.4

11.2

8.4

1972/Qi

1973/Q1

8.5

10.5

8.9

Q2

Q2

8.0

10.0

8.9

Q3
Q4

Q3

7.2

9.2

9.1

Q4

6.2

8.8

8.1

1973/Q1

1974/Q1

5.9

9.0

8.1

Q2

Q2

5.7

8.8

8.4

Q3
Q4

Q3
Q4

5.3

8.3

8.5

5.1

7.7

9.0

1974/Q1

1975/Q1

3.8

6.7

8.2

Q2

Q2

4.1

7.3

7.8

Q3
Q4

Q3
Q4

4.8

7.9

4.3

8,3
8.3

7.5

1975/Q1

1976/Q1

5.0

9.5

8.2

Q2

Q2

5.2

9.5

8.7

Q3

Q3

4.5

9.3

8.3

Q4

Q4

5.7

10.9

8.5

1976/Q1

1977/Q1

6.3

10.9

8.2

Q2

Q2

6.6

10.7

7.8

Q3

Q3

7.8

11.0

8.5

Q4

Q4

7.9

9.8

8.9

1977/Q1

1978/Q1

7.5

8.8

9.5

1977/Q2

1978/Q2

7.9

8.6

9.5




9/11/73

I
Harris Lconom.c Research Office Service

May 5, 1978
ECONOMIC PROSPECTS THROUGH 1979
After a difficult winter, business activity is once again rising
rapidly at the start of the second quarter. However, much of the
recent .strength in the economy- reflects a rebound from adverse weather
and coal-induced cutbacks rather than fundamental strenath. The econon;v
suffers from low productivity gains and rising inflation brought about *
by extensive government regulation and highly expansive monetary and
fiscal policies. These policies have created an unstable economic environment which is highly.vulnerable to recession.
It has now become painfully obvious to many policymakers that at
some point in the current cycle monetary and fiscal restraint will have
to be applied in an effort to contain rising inflation. The precise
timing of such restraint is difficult to forecast with any high degree
of confidence. At one extreme, the restraint may have already begun
in the sense that monetary growth, which has slowed since last October,
may continue to iroderate in the months immediately ahead. In this ccise, a
recession would begin later this year.. At the other extreme, there
may be no effective restraint until after the 1980 election in which
case inflation will rise close to the double digit range by 1980
creating the potential for a major downturn in the early eighties.
•
While the precise timing of a policy move remains unknown,
the present forecast is based on the assumption that effective monetary
restraint is applied late this year (after the Congressional elections)
when public furor over the inflation rate becomes intense. As a result
of this restraint, the economy is seen entering a recession in the
spring of 1979.
Inflation - A Case for Monetary Restraint
There have been two notable developments since the beginning of
the year which make a recession in 1979 more likely. The first of these
is the boost in the underlying inflation rate. On a year-to-year basis,
both consumer and wholesale prices are up 6%%. However, in the first
three months of this year, both indices were rising in the vicinity of
8-9% annual rates, and in April wholesale prices jumped 16% at an annual
rate. More significant in the. eyes of some policymakers is the sharp
rise in wages. The year-to-year increase in average hourly earnings
reached 8% in March compared to 7% in the twelve months ending in March*,
1977• Moreover, in the past three months, average hourly earnings rose
9*2% at an annual rate.




-2By virtually any measure, inflation is accelerating. The
Administration view that stimulative monetary and fiscal policies
would not lead to higher inflation because of excess capacity is being
proved wrong. In the past few mdnths, both the public and policymakers
have become more concerned about rising inflation and this raises the
odds that some effective action will be taken to slow monetary growth.
Chairman Miller - Another Case for Monetary Restraint
The most pleasant surprise on the monetary front has been the
policy pronouncements and the actions of the new Chairman of the Federal
Reserve, G. William Miller. He has verbally come Sown as hard as possible
against inflation and for a policy of monetary and fiscal restraint. In
addition to the words, there have been some signs of action. The federal
funds rate has been moved from 6 3/4% in early April to 1%% by early
May in an effort to contain a rapid rise in bank reserves and hence,
money. As a result of these moves, the growth in the raw ingredients of
money (federal reserve credit and the monetary base) has slowed moderately
since January. In addition, the growth in the narrowly defined money
supply, M-, was under 6% at an annual rate in the six months endina in
April.
Putting the Squeeze on the Economy - When?
A squeeze on the economy in terms of a significant tightening
in the money supply could come at any time. The recent upward move
in inflation rates is providing some pressure for an immediate move
tov/ard tighter money. However, there are some reasons to believe that
the squeeze could be put off until -he fourth quarter. First, from a
political perspective, both Congress and the Administration would find
it extremely undesirable for unemployment to be moving higher prior
to the elections this fall. As a result, Congressional pressure to
increase the money supply in the upcoming months will be intense.
Second, from a technical perspective, the Federal Reserve may be reluctant to continue to raise interest rates to the heights that may be
necessary to contain monetary expansion. With each upward move in rates,
the Federal Reserve will be subject to unrelenting criticism that it
is contributing to both inflation and recession.
While there is no way to know for certain how long the Federal
Reserve can withstand such criticism, the current forecast assumes
that a further slowdown in monetary growth is still some months away.
Once the Congressional elections are over, some increase in the unemployment
rate will.be more acceptable as a trade-off for containing inflation.
Interest Rates to Move Higher
Interest rates are expected to move higher throughout the balance
of this year even with the relatively large increase in money anticipated
for the second and third quarters. By year-end and early 197S, when monetary restraint is applied, short-term rates are expected to move sharply
higher with the 4-to-6 month commercial paper rate rising to 9% by
the first quarter of 1979. As a result of political jawboning, the




prime rate is forecast to peak in the vicinity of 9%. Once the
recession begins, short-term rates are expected to decline rapidly.
Long-term rates follow the same general pattern as short rates, but
the magnitude of change is much smaller.
Predicting the timing of a business cycle is crucial for
forecasting interest rate developments* If tighter money were to
develop over the next six nionthn (inntond of near yoar-end as the forecast
assumes) interest rates would go up very rapidly in coming months and
then would decline later this year. Since there is no way to know for
certain when monetary growth will slow, the precise timing of interest
rate changes cannot be forecast with a high degree of confidence.
Fiscal Policy
A net tax cut of close to $25 billion is assumed to take place
in the first quarter of 1979.- Only a third of the revenue-raising reforn
elements recommended by President Carter are assumed to be passed while
individuals and business receive approximately $271$ billion in tax
relief. Since social security contributions are scheduled to increase
taxes by $9Jj billion and inflation will raise personal tax receipts by
moving ^individuals into higher tax.brackets, the true reduction in
taxes is much lower than the $25 billion figure. The growth in the federal deficit as the economy slows early next year will put further upward
pressure on financial markets and help to prevent a larger tax reduction.
Corporate Profits
Corporate profits are expected to move sharply higher in the
present quarter following a steep decline during the first quarter.
However, from this point on profits are expected to trend downward with
the sharpest declines occurring v/hen the economy turns dov/n next year.
The anticipated cut in corporate profit taxes in the first quarter of
1979 helps to modify the decline in after-tax profits. In the past,
when real output has been in. the vicinity that is projected, profit
performance has been extremely volatile. Kence, although it is fairly
certain that a decline in economic activity will be accompanied by a
sharp drop in profits, the magnitude of the profit decline is highly
uncertain.
SUMMARY
The prospects concerning future economic developments are changing
rapidly. Inflation remains strong and may be reaching the point where
policies of restraint will be applied. Given the vulnerability of the
economy in the fourth year of an economic expansion, a recession appears
to be a likely development. In light of political pressures, the recession is forecast to occur in 1979 and is tentatively assumed to be
relatively mild* Although inflationary pressures should start to recede
by the end of the next year as a result of the recession, it is doubtful
that policymakers will be willing to incur the costs that are necessary
to significantly lower inflation in future years.
Robert Genetski
Vice President and Economist




5/2/78

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

ACTUAL
1977:4 1978:1

197b:2 1978:3

1961.8
9.9

1992.9
6.5

2057.5 2109.4 2159.6 2203.4 2230.1 2252.7 2303.8
10.5
13.6
9.9
8.4
4.9
4.1
9.4

1706.4 1889.6 20"9.8 2247.5
11.6
8.1
10.7
10.1

CONSTANT DOLLAR GNP
%CH

1360.2
3.9

1353.3
-0.6

137b.2 1387.7 1394.9 1397.4 1390.0 1381.6 1391.8
2.8
6.0
-2.4
2.1
0.7 - 2 . 1
3.0

1274.7 1337.3 1379.8 1390.2
C.S
6.0
4.9
3.2

P R I C E DEFLATOR
ICll

1.4423
5.9

1.4673
7.1

1.4929 1.5200 1.5432 1.5768 1.6044 1.6305 1.6553
7.2
6.7
7.5
7.6
7.6
7.2
6.2

1.3386 1.4127 1.5071 1.6167.3
5.3
5.5
6.7

1259.5
14.0

1284.0
8.0

1321.0 1354.0 1387.0 1418.2 1443.5 1464.4 1494.1
10.4
12.0
10.1
9.3
7.3
5.9
8.4

1093.9 1211.2 1336.5 1455.1
11.6
3.9
10.7
10.3

DURABLES
%CH

186.0

184.0

199.7
13.4

204.9
10.8

208.6
7.4

208.8
0.4

207.4
-2.7

210.0
5.1

158.9
19.6

195.5

-4.2

193.5
22.3

179.8

20.3

13.2

8.7

208.7
6.7

NONDURABLES
%CH

499.9
15.9

505.8
4.8

517.0
9.2

528.1
8.9

539.7
9.1

551.2 561.9
8.8
8.0

571.2
6.6

582.3
8.0

442.8
8.2

480.7
8.6

522.6
8.7

566.6
8.4

SERVICES
%CH

573.7
10.5

594.3
15.2

610.5
11.4

626.2
10.7

642.4
10.8

658.4
10.3

672.8
9.0

685.8
8.0

701.8
9.7

• 492.3
12.3

550.8
11.9

618.4" 679. T
9.9
12.3

306.7 314.4
4.1
10.4

326.8
16.7

330.0
4.0

330.6
0.7

329.0 320.4
-1.9 -10.1

311.1
-11.1

321.2
13.6

243.3
28.7

294.3
20.9

325.5 320.4
10.6_ - 1 . 5

193.5 197.7
13.4
9.0

204.6
14.7

210.0
11.0

214.5
8.9

217.9
6.5

220.1
4.1

221.1
1.8

222.0
1.6

161.9
8.6

185.1
14.3

206.7
11.7

220.3
6.6

129.0 132.6
13.8
11.6

136.2
11.3

139.1
8.8

141.0
5.6

143.0
5.8

143.7
2.0

143.7
0.0

144.0
0.8

106.1
10.2

123.6
16.5

137.2
11.C

143.6
4.6

65.1
3.8

68.4
21.9

70.9
15.4

73.5
15.5

74.9
7.0

76.4
8.3

77.4
5.3

78.0
3.1

55.9
• 5.7

61.5
10.1

69.5
13.0

76.7
10.4

. 9 9 . 7 100.2
35.0 • 2.0

102.0
7.4

99.5
-9.4

97.0
93.0
-9.7 -15.5

93.5
2.2

95.0
6.6

97.0

68.0
32.3

91.0
33.7

99.7
9.5

94.6
-5.1

20.2

20.5

19.1

18.1

6.8

-5.0

13.3

18.1

19.1

5.5

-10.0

-3.0

-2.0

0.0

7.8

-10.9

-16.1

-1.5
473.5
9.1
176.5
10.2
110.1

2*.<7. C
8.4

GROSS NATL PRODUCT
%CH

CONSUMPTION EXPENDITURES
%H
C

INVESTMENT EXPENDITURES
* %H
C
NONRES FIXED EXPEND
%H
C
PRODUCERS DUR EQUIP
%H
C
BUSINESS STRUCTURES
%H
C
RES FIXED EXPEND
%CH
INVENTORY CHANGE
NET EXPORTS

64.5
12.7

13.5

16.5

-18.2 -22.6

-18.0

-13.6

1978:4

FORECAST
1979:1 1979:2

YEARS
1979:3

GOVT PURCHASES
%H
C

413.8 417.1
13.5
3.2

427.8
10.7

438.9
10.8

452.0
12.5

459.2
6.5

460.1
8.0

477.1
7.9

FEDERAL
%H
C
MILITARY
%H
C
OTIIKR

153.8 153.1
16.3
-1.8
98.5
99.2
12.7
2.9
55.2
53.8
22.2
-9.8

157.0
10.6
100.0
3.3
57.0
26.0

161.3
11.4
100.8
3.2
60.5
26.9

169.0
20.5
104.0
U.3
65.0
3).2

174.0
4.1 • 0.0
106.2 100.5
8.9
fi.7
65.5
64.5
-3.0
6.3

177.3
7.8

260.0 264.1
11.7
6.5

270.8
10.5

277.6
10.1

233.0
8.0

208.5
0.0

%CH

STATK & LOCAL




PERCENTAGE CHANGES AT ANNUAL R A T E S ;

PPPI.TMTNAPY DA'I

170.7

A T 7Q:

291.1
0.0

110.7
8.4
66.6
6.9
290.8

e.o

1979:4

8.7

2.2
-1.1
489.6
10.9

1978

1976

361.4
6.6

184.0
16.0
115.0
16. S
69.0

130.1
5.5
06.8
3.4
43.3
I CO

395.0 433.9
9.3
9.8
145.4 160.1
11.3
10.1
94.3 101.0
8."
7.1
51.2
59.1
18.C
IS.5

305.6
b.O

231.2
7.2

240.6
8.0

2-3.9
9.7

1979

66.4
12.4

M Lu s* • . till) ^ .1 ^/ ^
.
H a m s Economic Research Office SOIVICO

August 22, 1978
EconaTVic Forecast - Revised Second Quarter K\r±ers
One month after it issues- preliminary quarterly GNP r/crters/ the
Department of Ccxm^rce releases revised figures. Sore of our custcrrers have
requested to see these revised nurrbers as well as the implications they have for
our forecast. The attached tables show cur previous eccnaric fcrecast (catcc
July 28, 1978) with the latest revised GNP nurrters for the seccr.c quarter.
The forecast is the same as that released last rronth in the ser.se that, where
applicable, the percent changes for each itcn are the scire as they were at
that tirce. The only difference is that the percent charges are new ^rpliec":
to updated second quarter nurters. This has the effect of charging rrar.y of the
annual figures by a srrali amount.
Since there is no essential difference between this forecast end the
one of July 28, it is suggested that these nunxers be attached to the KERCS
write-up entitled ECXLKCMIC PROSPECTS TKRCUGH 1979 which was railed a p p r i
a month ago.
Robert J. Genetski
Vice President and Economist
(312) 461-5001




8/21/78

ECONOMIC OUTLOOK
(BILLIONS OF OOLLARS--SEASONALLY ADJUSTED ANNUAL

1977:4
GROSS NATL PRODUCT

CONSTANT DOLLAR GNP
%CH
PRICK DEFLATOR
%CI1
CONSUMPTION

EXPENDITURES

ten

ACTUAL
FORECAST
197(3 :1 1970:2 1978:3 1978:4 197S :l 1979:2 1979 :3 1979 :4;

1958 .1 1992 .0 2083.2 2138.3 2193.3 224 7 .8 2295.1 2320 .0 2351 .8 '
8 .9

%cn

RATES)

7 .1

19.6

11.0

10.7

10 .3

8.7

5 .5

4 .5

!

197C-

YGASS
1977
197«

197 9

1700.1 1887 .2 2101.7 2305 .2
11.4
9 .7
.2
11 .0

n

?9

>
1354 .5 1354 - 1380.5 1391.2 1400.2 .1407 .3 1409.5 ll401 .1 1389 .8
.4
8.0
3 .2
0.6
2 .0
-0 • 4.
.2
2.0
3.1
.1
1.4456 1,4710 1.5090 1.5369 1.5064 1.5972 1.6283 1.6601 1.6922
10.7
8.1
7.9
8.1
8.0
7.9
7.2
7.6
5.5

1271 .0 1332 .7 138J.S( 1401
3.7> S,
4 .9
1 .5
.7

1514 .3
1255 .2 1276 .7 1324.9 1357.9 1392.9 1428 .5 1401.9 1488
9.7
14 .1
7 .1
7 .5
16.0
7 .0
10 .6
10.3
1.0.7

1090 .3 1206 .5 1333.1 1473 .3
10 .1
10.9
10 .7
11 . *

I"

2

1.3373 1.41 58 1.5208
7.4
5 .9
5.2

i?3?u
8 .1

187 .2
24 .0

183 .5
_^ .7

198.0
35.6

203.2
11.0

200.6
11.1

213 .2
8 .9

216.2
5.0

215
-0 \*

214 .5
-2 .f

156
18 • X

178 .4
13 .9

198.3
11.2

214 .9
8 .4

NONDURABLES
%CH

496 .9
15 .1

501 .4
3 .7

519.8
15.5

531.4
9.3

543.9
9.7

556 .7
9• 8

569.5
9.5

581 .7
8 .9

50 3 <
8 .6

442
8

479 .0
8 .2

524.1
9.4

575 .5
'J.8

SERVICES
%CI!

571 .1
10 .1

591 .8
15 .3

607.1
10.7

623.3
11.1

640.4
11.5

658 .6
11 .8

676.2
11.1

690 .9
9 .0

7or> # o
9 .0

491 .0
12

549 .1
11 .«

015.7
12.1

682 .9
10 .9

313 .5
5 .0

322 .7
12 .3

344.0.
29.1

349.9
7.0

354.6
. 5.5

359 .4
5 .5

360.6
1.4

355 .1
-6 .0

341 .1
-14 .8

243
27 .3

297 . 8
22 . 6

342.0
15.1

35-1, 1
3, 3

200 .3
14 .8

205 .6
11 .0

219.8
30.6

226.1
11.9

232.3
11.4

238 .3
10 .7

243.7
9.3

246, 5
4. 7

240 .4
3 .2

164 .6
9. 6

190 . 4
15 . 7

220.9
10.0

24 4. 2
10. 5

PRODUCERS DUR EQUIP
ICII

132. 8
15. 5

137, 1
13. 6

143.7
20.7

147.8
12.0

151.7
10.8

135 .3
9 .9

150.3
0.0

.160, 2
4. 9

101 .4
1
3.

107. S
11. 3

120 . 5
17 . 9

145.1
14.7

ir>d. 0
9. 5

BUSINESS STRUCTURES

67. 4
12. 8

68. 5
6. 7

76.1
52.3

78.3
11.8

80.6
12.0

83. 0
12. 2

85.3
11.9

86. 3
4. 4

87, 0
3. 4

57. 3
6. 5

63. 9
11, 5

75.9
IB. 8

Pr>. 4
12. 5

100. 2
27. 5

100. 3
0. 4

105.3
21.5

107.7
9.5

107.5
-0.7

105. 5
-7. 3

103.5
-7.4

10 3. r,
0. 0

105. 5
8. 0

68.
32.

91. 9
34. 8

1^5.2
14.5

ltM. 5
-0. 7

n.1

16. 7

18,9

10.1

14. 8

15. 0

13.5

10.

15. 6

16.0

5.4

NET EXPORTS

-23. 2

-24. 1

-10.2

-0.3

-6.3

- t .3

1.7

,
1.r

3. 7

7.

-11. 2

-12.2

I. 4

GOVT PURCHASES
%CII

412. 5
13. 7

416. 7
4. 1

424.5
7.7

4 33.6
14.0

4M.9
12.7

4 01. I8. 4

470.8
8.7

4 80. 5
}
8. *

497. 4
10. 3

359.
0.

432.9
9
9 m ft
9.9

470. 2
10. U

152. 2
15. 5
97. I
It. 9
55. 1
22. 3

151. 5
-1. 8
97. 9
3. 3
53. 6
-10. 5

147.2
-10.9
90. f.
2.9
40.6
-32.4

155.5
24.6
99. 0
4.9
55.7
72.7

163.3
2i.r,
103.2
M.3
60. 1
30.0

K,C>. 9
9. I
104. 9
6. 7
02. 0
U. 3

170.9
9.9
100.6
0.0
64.3

174. n
9. 4
I0H. 3
(>.r»
00. r
14.

1H0. ft
13. 9
112. 2
lr>.2
f»«. 4
1
1 I.•

129.
5.
80.
3.
43.
9. b

145. I
7
1 1.
04. 3
n. 0
so. 0
17. 9

134.4
0.4
?9.9
0.9
34.5
7.3

173.
12.
li'S.
«.

31). H
ft. ?. !

,
229. r
ft.

24 H. 9
4

::?.o

3<»2.
8.

DURABLES

%cn

INVESTMENT
%CH

EXPENDITURES

NONRES FIXED EXPEND
%CH

ten
RES FIXED EXPEND

ten
INVENTORY CHANGE

FEDERAL

ten
MILITARY

ten
OTHER
HCII
STATE * LOCAL

*cn
MOTH:




260. 3
12. 6

265. 2
7. 7

PERCENTAGE CHANGES AT ANNUAL RATES

277.3
19.S

2B3.1
K.O

H.O

2<M. 2
M. 0

r>.7
299.9
H.O

r

>.1

r

3o >.

;

-12.

n

r>
c

11.9

3
3
•
j

1
3

n.

i
/

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

8/21/78

1977:4
PRETAX PROFITS
%CH
TAX LIABILITY
%CH

-ACTUAL
1978:1~ 1978:1

E.OKECAST

1§78.:3 "197874

1979:1

1979:2

1979:3
188.6
-10.8

172.1
-.13.2

178,3
1.8
73.9
6.2,

201.6
88.3

200.0
-3.1

200.0
0.0

195.7
-8.4

194.0
-3.3.

70.0
-19.5

84.2
109.3

81.7
-11.4

81.7
0.0

75.6
-26.6

75.0
-3.3

1979:4

1976

1977

197U

1979

182.8
-11.7!

155.9
29.5

173.9
11.5

193.4
11.2

190.3
-1.6

72.9 . 70.71
-10.8
-11.7*

64.3
29.0

71.8
11.8

79.4
10.5

73.5
-7.4

AFTER TAX PROFITS
%CH

104.4
-1.5

102.1
-8.5

117.3
74.2

118.3
3.4

113.3
0.0

120.1
6.1

119.0
-3.3

115.7
-10.8

112.2
-11.7

91.7
30.0

102.1
11.4

114.0
11.6

116.7
2.4

AFT TAX PROF ADJ
%CH

74.3
-32.9

62.6
-49.6

75.3
109.4

77.7
13.4

78.0
1.6.

79.5
7.7

77.9
-7.4

74.0
-18.8

69.4
-22.8

62.8
36.2

72.3
15.3

73.4
1.5

75.2
2.4

1628.9 1682.2 1727.6 1777.6 1817.6 1855.6 1880.6
1900.6
9.3
13.7 1 1 . 2 12.1
9.3
8.6
5.5
4.3

1380.9
10.0

PERSONAL INCOME

1593.0
13.4

1529.0 1704.1 1863.6
10.7
11.5
9.4

233.3
16.4

237.3
7.0

248 .9
21 .0

260.2
19.4

270.4
16.7

267.3
-4.5

273 .7
9 .9

276.8
4.6

280.0
4.7

196 .5
16 .4

1359.6
12.9

1391.6
9.8

1433 .3
12 .5

1467.4
9.8

1507.2
11.3

1550.3
11.9

1581 .9
8 .4

1603.8
5.7

1620.6
4.3

1104.3
9.0

1303.0 1449.9
10.0 11.3

PERSONAL OUTLAYS

1285.9
13.9

1309.2
7.4

1358 .7
16 .0

1394.1
10.8

1430.2
10.8

1466.3
10.5

1500 .6
9 .7

1528.2
7.6

1554.8
7.1

1116.3
11.3

1236.1 1373.1 1512.4
10.7
11.1 10.2

PERSONAL SAVINGS
%CH

73.7
-3.2

82.4
56.3

74.6
-32.8

73.2
-7.1

77.0
22.1

84.1
42.3

81.4
-12.2

75.7
-25.2

65.9
- 4 2.6

68.1
-18.6

66.9
-1.7

14.8

-J.I

5.4

5.9

5.2

5.0

5.1

5.4

5.1

4.7

4.1

5.8

5.1

5.3

4.B

TAX & NONTAX PAYMENT
%CH
DISPOSABLE INCOME
%Cfl

SAVING RATB(%)

226 .0
15 .0

254. 2
12. 5

274 .4
a.0

EMPLOYMENT
%CH

92.069
5.6

93.050 94.244 95.000 95.700 96.400 97.000 97.246
97.000
4.3
5.2
3.2
3.0
3.0
2.5
1.0 - 1 . 0

87.481
3.2

90.554 94.498 96.912
3.5
4.4
2.6

LABOR FORCE
%CII

98.622
4.4

99.205 100.206 101.000 101.700 102.400 103.100•103.600 104.100
2.8
2.4
4.1
3.2
2.0
2.8
2.0
1.9

9.4.767
2.4

97.3H9 100.528 103.300
2.8
3.2
2.b

UNEMPLOYMENT RATE(%)

6 .633

6 .200

5 .933

5 .941

5.900

5.U59

5.917

6.133

6.820

7.683

7.025

5.993

PRODUCTIVITY*

1 .164

1.154
-3.4

1 .156
0.7

1 .159

1.0

1.163
1.4

1.166
1.0

1.167
0.3

1.162
-1.7

1.150
-2.0

1.140
3.3

1.150
1.5

1.158
0.1

1 .393
2.5

1.396

1 .439
12.8

1 .457
5.1

1.467
2.8

1.47J
1.6

1.469
-l.l

1.442
-7.2

1.409
-0.9

1.298
10.1

1.371
5.6

1.440
5.0

335 .600 340 .300 34U .400 356 .000
5.7
7.7
9.9
9.0

S3.COO
—-d.l

.6

6 .006
1.0

6.042
2.A

INDUSTRIAL PRODUCTION
MONEY SUPPLY-(Ml)
VELOCITY OF Ml

ten
MOHKY S U P P L Y - ( M 2 )

riTY OF M2
!
i

5 .835
l.l
804.300
8.4

2 .435
0.4

1.0

5 .854
1.3

1.0

6.100
4.4

370.000 370.000 372.000
2.7
0.0
^ ?
6.2U7
5.5

326.10S 351.V20
7.2
7.9

6.322
2.3

5.587
5.U

8 1 8 . 2 0 0 8 3 5 . 1 0 0 858.SOU 8 7 9 . 4 0 0 8 9 5 . 7 0 0 9 0 0 . 0 0 0 9 0 0 . 5 0 0 91H.8U0
7.1
8.5
11.7
K . I
7.0
4.2
2.0
A.Z

703.770
9.8

2 .435
0.0

5 .979
8.9

2.490
10.2.

2.4 •
n
-0 .6

>.4 »t
U.C

2 . ' ; 10
2.5

6.203
6.4

2 . 0 30
4.3

.V>7
3.4

2 . SOU
O.3

2 . 4 10
1.3

P R O F I T S F O R 7 B f 2 A R K P R E L I M I N A R Y : P R O D U C T ! V I I'Y I S .•" M W I M i D ?»r, O U T P U T VVM I I O f J N — f l O U P A P . ' t MUST•;*::;.•>
,, . j . , . , , , , , , r r r : • • • t n r , T ! : i ) TO K X n . n i ) ' : I N V ! : I I T * - * % Y I " " ) ! I T • ; • • M . J . < \ . ; J- >J> o r p ! : i V | M M « * N A T ••'••! I . V ! !',\:UT t'O




6.162

5.7UC

5.970
3.2

77U.4»-»7 IJ47.SOO 9
1 «J. 6
8.9

0. j

2. 3

2.Ml

8/21/78
ECONOMIC OUTLOOK
ACTUAL
FORECAST
1977:4 1978:1 1978:2 1978:3 1978:4 1979:1 1979:2 1979:3 1979:

1976

_

YEARS
1977
1978

.m .
1979

INTEREST RATES
NEW ISSUE AA INDUS BONDS

8.040

8.480

8.730

9.100

9.300

9.600 10.000 10.000

9.801

8.250

7.918

8.902

9.850

PRIME RATE

7.673

7.977

8.300

9.200

9.500 10.000 10.500 10.000

9.000

6.841

6.824

8.744

9.875

COMMERCIAL PAPER 4-6 MOS.

6.593

6.797

7.200

8.300

8.700

8.001

5.345

5.612

7.749

9.075

9.300 10.000

9.000

10.984 10.815 12.039 11.943 12.042 11.700 11.4G0 10.800 10.001

AUTO SALES 1)

10.114 11.185 11.710 10.990

DOMESTIC

8.978

8.748

9.972

9.794

9.874

9.600

9.400

8.900

8.200

8.612

9.119

9.597

9.025

IMPORTS

2.006

2.067

2.067

2.149

2.168

2.100

2.060

1.900

1.800

1.502

2.066

2.113

1.965

2.146

1.721

2.114

2.049

1.820

1.804

1.734

1.692

1.729

1.533

1.967

1.926

1.740

HOUSING STARTS 1)

1)




* UNITS—SEASONALLY ADJUSTED ANNUAL RATES




THE DILEMMA OF U.S. MONETARY POLICY AND
THE "COMMITMENT" TO PERMANENT INFLATION

Karl Brunner
University of Rochester and Universitat Bern

Lecture presented at a luncheon
sponsored by the Swiss National Bank
Bern, June 15, 1978

THE DILEMMA OF U.S. MONETARY POLICY
Karl Brunner

I. Some Background
The Federal Reserve System enjoyed over many decades a remarkable
esteem. The media reflected without probing questions the views
offered by the "proper authorities". Textbooks in "Money and Banking" uncritically accepted

the official interpretations of mone-

tary events or of "policies" pursued. These golden days of the
Federal Reserve System vanished with its 50th anniversary in 1964.
The monumental work on the History of the US Monetary System published in 1953 by Milton Friedman and Anna Schwartz described in substantial detail the tragic failure of the Federal Reserve during the
Great Depression. The Banking and Currency Committee of the US
House of Representatives published moreover shortly afterwards
an extensive and critical examination of Federal Reserve policymaking. This examination demonstrated the systematic misinterpretation of monetary events in the councils of the Federal Reserve.
This misinterpretation was essentially caused by a money market
conception centered on free reserves and short-term interest rates guiding the formulation and implementation of monetary policy
over many decades.
The public debate unleashed by the scholarly critique produced
some hesitant changes in the Federal Reserve's procedures. The
free reserve doctrine gradually disappeared by the end of the
1960*5. It was replaced by a money market conception emphasizing
the role of an unstable money demand operating within a Keynesian
perspective. There also emerged over a period of ten years major
changes in the rhetoric and the general language used to express
"policies". The format of the directive addressed by the Federal
Open Market Committee (FOMC) to the account manager at the Federal



Reserve Bank of New York experienced intermittend adjustments. The
crucial procedures used by the FOMC and the "account manager" in
order to implement policies remained however substantially unchanged.
The account manager continued to adjust open market operations according to the position of the Federal funds rate relative to a
target range prescribed by the FOMC. A decline of the Federal
funds rate below the target range encourages open market sales
and increases beyond the range foster purchases. The target range
operates in this manner similar to a control band in a feedback
system. This pattern assures systematic accommodation of money
market pressures. Variations in these pressures are converted into monetary accelerations or decelerations. The basic policy pattern
of the 1930's or 1950*5 thus persists into the 1970's. It was enunciated, justified and elaborated with a different language, conveying the impression of a major shift in policy-making.

• Congress and the Federal Reserve
The public debate initiated by the work published in 1963 and 1964
attracted within a few years occasional attention by some members
of Congress and some Congressional Committee. The Joint Economic
Committee recommended in 1968 that monetary growth be maintained
between 2 % and 6 % per annum. The recommendation reflected the
Committee's concern about the Federal Reserve's perfomance between 1965 and 1966. But Congressional interest waned rapidly and
the recommendation receded to a shadow of political irrelevance.
The large variation of inflation suffered over the first half of
the 1970Fs and the recession suffered in the winter of 1974/75
motivated the most significant incursion by Congress into monetary
affairs since 1932. House Concurrent Resolution 133 was explicitly
addressed in March 1975 to the Federal Reserve Authorities. The Resolution instructed the Federal Reserve to develop longer-range
targets of monetary growth compatible with a stable price-level.



It recognized that lower inflation was the most effective means
to reduce interest rates. It finally provided that the Federal
Reserve publicly announce
to

targets for monetary growth applicable

the subsequent four quarters. This information must be sub-

mitted at quarterly Hearings on monetary policy before Congressional Committees in the House of Representatives and the Senate.
The legal status of the Resolution was eventually changed in the
fall of 1977. Its intent was incorporated into the Federal Reserve
Act.

Ill. The Response of the Federal Reserve
The Federal Reserve initially opposed the Resolution and negotiated behind the scenes for changes in the formulation. After Congress accepted the Resolution the Federal Reserve adjusted quickly
to the new circumstances. The first Hearings were held at the end
of April 1975 and followed each other in quarterly succession. On
each occasion the Federal Reserve presented a target zone for
planned monetary growth of M1 and M2. The target zones presented
in each quarter for the following four quarters were moreover
based on the average volume of the money stock actually observed
in the previous quarter. This procedure assures that all errors
made in the past are carried forward and unavoidably affect the
level of the future target zones. Members of the FOMC seemed to
interpret moreover the procedure in a variety of ways. The Shadow
Open Market Committee cautioned since 1976 repeatedly against
this procedure and warned about the potential drift built into
monetary growth. The quarterly revision of the target zone offers
opportunities to evade the sense of the Congressional Resolution.
The Shadow Open Market Committee emphasized that the procedure
evolved by the Federal Reserve Authorities in response to the
Congressional Resolution was essentially restricted to the formulation and adjustments of monetary targets. The implementation
guiding the execution of policy remained centered on money market
conditions and was never adjusted to the requirement of monetary



control. The Shadow Open Market Committee offered on several occasions specific proposals for an effective translation of monetary targets into appropriate actions by the account manager.

IV. The Discrepancy between Words and Action
The persistence of the traditional implementation implies that the
actions of the account manager are poorly related to the policy
goals announced to Congress and public. The actions are based on
instructions from the FOMC couched in terms of a target range for
the Federal funds rate. The problems associated with this traditional procedure could thus be expected to continue. They result
from a singularly volatile and unreliable connection between the
control band on the Federal funds rate governing open market operations and the longer-range monetary growth targets. This approach
to policy-making is demonstrably faulty and unsuccessful. "Keynesian"
and "monetarist" members of a panel evaluating the role of Congessional Supervision of monetary policy at last December's annual
meeting of the American Economic Association concluded that the
substance of Federal Reserve policy-making hardly changed at all
over recent years. The correlation between rhetoric and substance
persists at a low level. Comparatively low rates of interest and
a low demand for credit from the private sector produced in the
context of traditional implementation a moderate rate of monetary growth during the early recovery phase following the last
recession. The monetary control intended by Congress and publicly
announced by the Federal Reserve seemed to work. But the year
1975 offered no real test of Federal Reserve performance.
A gradual change in underlying conditions increasingly tested the
Federal Reserve during 1976 and particularly during 1977. The announced policies still cultivated an anti-inflationary tone. There
was hardly a Hearing at which the Federal Reserve Authorities did
not lower an upper or lower boundary of the target zone for M1 and




M2. Since the initiation of Congressional supervision the target
zones confining monetary growth were gradually lowered. "Policy"
clearly conveyed throughout this period the Federal Reserve's determined anti-inflationary

concern. This impression was reenforced

by Chairman Burns with numerous and excellent speeches.
Unfortunately, "policy" was not reflected by the actual behavior
of monetary growth. The tabulation
Growth of M1
in Percentages p.a.

Period
1/1976 - H I / 1 9 7 6

5.4

11/1976 -

IV/1976

5.6

HI/1976 -

1/1977

7.3

IV/1976 -

11/1977

7.7

1/1977 - H I / 1 9 7 7

6.3

11/1977 -

IV/1977

7.6

HI/1977 -

1/1976

6.2

of relevant data reveals a remarkable increase of monetary growth
beginning in early 1976. The growth rates actually achieved in
1977 substantially exceeded the target zone. In contrast to the
official line of "policy" signalling a continued committment to
an anti-inflationary track the monetary acceleration

actually

observed indicates the very opposite.
It is important to understand the full responsability of the Federal Reserve Authorities for this development. Some financial
analysts adduced some tortured explanations for this excessive
monetary growth. The decline of the dollar, liquidity traps and
other exotic events were made responsible. But all these explanations possess no basis and are moreover simply irrelevant with
respect to our issue. Three proximate determinants pushed monetary growth over the past one and a half years: An acceleration
of the monetary base supplemented by increasing

contributions

emanating from movements of the public's currency and time deposit
ratio (i.e. the public's desired holdings of currency and time



deposits relative to demand deposits). The movements of the monetary base are completely controlled by the"Central Bank. The currency ratio and the time deposit ratio exhibit on the other hand
systematic patterns which could be exploited for suitable adjustments in the monetary base in order to approximate the desired
rate of monetary growth. The Federal Reserve's implicit refusal
to develop and institute effective procedures of monetary control
assures the likelihood of "uncontrollable" monetary acceleration.

V. The Dilemma of Current Monetary Policy
The Federal Reserve's tacit abondonment of an anti-inflationary
policy produced some visible consequences. Inflation reached a
low value of 4.7 % p.a. in the last quarter of 1976 (expressed
by the GNP deflator). A monetary growth maintained along the
lower boundary of the official target zone would have slightly
reduced the rate of inflation over the period 1976/77. The very
opposite happened under the impetus of a new monetary acceleration. A new surge of inflation appeared in the USA pushing the
expected rate of inflation for 1976 (relative to 1977) to around
7.5 %. And, of course, the price of US-dollars fell on foreign
exchange markets suffering under renewed uncertainties about
the course of US financial policies.
The inheritance determined by the Federal Reserve's behavior over
the past two years confronts our policy-makers with an unfortunate dilemma. They may continue the course initiated in 1976 and
maintain a monetary growth of around 6 % p.a. over the next one
and a half years. Or they may accept the monetary deceleration
observed during the past winter and use this opportunity to reaffirm the official committment to an anti-inflationary line.




What are the consequences of these two scenarios? Under the first
option the rate of inflation drifts to hig-her levels and settles
in 197S eventually arou-nd B % p.a. Real growth would move around
3.5 % - 4 % p.a. between the summer of 197B and the end of 1979
and thus approximate the growth rate of full output. The likelihood of a recession within the next one and a half years would
remain quite low under the circumstances. But interest rates
tend to rise and the prime rate would reach a level of about 9.5 %
(or more) by late summer of 1979."The Presidential Campaign opens
thus under the first scenario with the political liability of
high rates of inflation and high levels of interest rates.
The second scenario produces a monetary growth of about 5 % p.a.
This pattern continues the trend initiated last winter. But the
deceleration observed early this winter is not sufficiently significant per se to affect inflation and real growth this year. An
expansionary course emerging beyond the first quarter would overwhelm the minor effect of a single quarter's retardation. The
second scenario introduces however a persistent decline of monetary growth. A retardation of output in the second half of 1976
appears unavoidable under the circumstances. A recession is quite
unlikely, but real growth may be expected to remain very low for
several quarters reaching into 1979. The rate of inflation on the
other hand would fall this y¥ar"'very little, "if "at all." Inflation and interest rates may gradually respond during 1979. A persistent monetary growth of about 5 % p.a. lowers eventually the
inflation rate from 7 % - 7.5 % p.a. in 197B to around 5 % p.a.
in 19B0. Real growth would rise gradually in 1979 under the second
scenario and move towards the 5 % level. Lastly, market rates of
interest eventually fall by 1980 at least two percentage points
below the level established along the first scenario.
The second option, expressed by an immediate return of actual
monetary growth to the official target zone, offers President
Carter probably a better basis for his reelection campaign. Still,
an approximation to the first scenario appears more probable. I



may be wrong and I hope that I will be wrong. Fortunately (or unfortunately) this issue is easily settled by the time I return to
Switzerland next year.
Somebody may suggest that my assessment seems already refuted by
recent Federal Reserve actions initiated earlier in the second
quarter of 19 7 6. The media conveyed to the world in April and May
that the Federal Reserve has shifted to a substantially restrictive stance. But this message involved the traditional misinterpretation of monetary events. Short-term interest rates rose rapidly beyond the middle of April. Banks raised in early May the
prime rate, and the Federal Reserve Banks boosted the discount
rate. What should be noted however is the rapid increase by about
11 % p.a. in the monetary base from the middle of March to early
May. We also note the remarkable acceleration of monetary growth
from late March to the first week of May. Market pressures pushed
interest rates to higher levels and the Federal Reserve Banks
adjusted the discount rate in the usual manner in order to maintain some balance with the market rates. The acceleration of the
base reveals moreover the Federal Reserve's attempt to moderate
the rise in interest rates with suitably enlarged injections of
base money. An examination of the situation which evolved in
April/May actually indicates therefore just the opposite of a
move to a more restrictive policy. The provisional data for the
second quarter resemble so far more closely the pattern associated with the first scenario.
Other considerations reenforce the conjecture favoring the first
scenario. The Carter Administration exhibits a pronounced disposition towards "Mondalean economists". Many advisers, staff
members and members of the Cabinet apparently prefer a "pressure
cooker" approach to macro-policy. The economy should proceed according to this view under full steam with the necessary dosage
of expansionary fiscal and monetary policies. Any spillover of
demand pressures to prices must be contained with the aid of
"voluntary restraint" in price-wage setting. Some vague allusions ("or else") usually refer to the eventual threat of co ercive


measures involving the government's police power.

The various groups associated with the Carter Administration's
macro-pel icy determinedly argue moreover at every passing

decline

of the quarterly growth rate in output the need for immediate
monetary-fiscal expansion. They argue in particular that the
economy could never expand on its own. Persistent economic growth
requires in their view intermittend
budget supported

boosts from an expanding

by an accelerated monetary growth. We also

hear at this stage that another expansionary boost need be
applied this year.
The Carter Administration's anti-inflation program offers little
solace for our anxieties. It is a mixture of rhetorical

exercises

shifting responsibility to business or labor supplemented

with

symbolic gestures about the budget. The program never referred
to monetary policy and offers little hope that the growth of
government expenditures can be contained or the deficit substantially lowered over the next years. Even more disturbing is Chairman Miller's statement that he prefers to use other methods than
monetary policy to curb inflation. The context made

sufficiently

clear that "other methods" involve some more or less

"coercively

voluntary" price-wage restraints. Chairman Miller expresses himself volubly and usefully on matters bearing on the budget, fiscal
policy and the effect of inflation on interest rates. He remains
in contrast remarkably quiet in all matters concerning monetary
policy. The Chairman of the Federal Reserve Board appears reticent
to commit himself in affairs involving his direct
Lastly, the Administration

is

responsibility.

imbued with an attitude that anti-

inflationary policies should never lead to [temporarily)
employment and output. This attitude removes the only
instruments of anti-inflationary

policies from the

lower

effective

"admissible

range" of political action. It unavoidably fosters a permanent
drift to higher inflation.
The pattern of conceptions and attitudes surveyed above lowers the
likelihood

of the second scenario in my judgment and renders the

first scenario more probable. But such assessments could of course
be wrong and we could experience a shift to the second option during



June and the third quarter. But this move would accelerate the increase in short-term rates of interest over the next four months.
It also induces a substantial retardation of economic activity
with an increase of the'unemployment rate towards the 7 % level.
Dn all these counts we could reasonably expect therefore a major
political assault on the Federal Reserve in the media, from the
Carter Administration and particularly also from Congress. The
record of past behavior, and especially the abortion of repeated
anti-inflationary attempts in the past 12 years, suggests that
the Federal Reserve Authorities would most probably abandon by
next winter the newest endeavor at anti-inflationary policies.
The reversal into renewed monetary acceleration could be safely
expected to initiate, as in 1967, 1972, 1976, another and probably
larger surge of inflation than previously experienced.

VI. The Drift into Permanent Inflation
In 1969 I published an article advancing the thesis of a rapid
drift into a state of permanent inflation in the Latin American
tradition. The events evolving over the seventies strengthen my
conjecture. The Carter Administration reveals no signs beyond
rhetorical exercises to implement any meaningful and effective
anti-inflationary policy. Monetary policy will most probably drift
over the next years along an erratic course producing an average
rate of inflation in the range of 6 % to 9 % p.a. This development
will be accompanied with varying styles and procedures modifying
private wage-price setting by political actions. Other countries
face under the circumstances an unfortunate choice. They may adjust to the "financial leadership" offered by the United States
and suffer the inflationary consequences. They may on the other
hand explore alternative policies and experience volatile exchange
rates superimposed on a long-run drift reflecting their deviation
from the "leader's" financial style. In any event we will continue
to live in a troubled and uncertain world suffering from the policies of permanent inflation pursued in the United States.




A Report Prepared for the Shadow Open Market Committee

The deficit outlook for both fiscal 1978 and 1979 is now
slightly less pessimistic than I indicated in my last report
to this committee.
A,

Fiscal 1978

Outlajys-

Last March, I estimated final 1978 outlays at $455-456

billion.

Since that time, outlays have been redefined to include

refunds of the earned income credit and receipts estimates have
been raised accordingly.

Consequently, my estimate was equiva-

lent to $456-457 billion given the new definition.

I purposely

chose an outlay figure higher than the £454.4 billion which
would subsequently appear in the OMB, March 1978 estimates because
of my judgment that OMB had finally overestimated the outlay
"shortfall."

The fact that it now appears that outlays will

come in about $450 billion indicates that the shortfall problem
remains with us.

Given the numerous procedural changes under-

taken by OMB to eliminate the problem, I must confess to total
puzzlement.
The severity of the shortfall problem is indicated by the
fact that between January and July, the official outlay estimates
had to be lowered by $10.8 billion or by 2.3 percent.

Now, T

am suggesting another 0.5 percent reduction for a total error
of 2.8 percent.

There were no significant budget policy changes

over the period and adjustments in the economic forecasts of
inflation and unemployment should have largely offset each other,




[2)

Needless to say, errors of this magnitude, after appropriations
actions are virtually completed, make it extremely difficult to
operate a rational fiscal policy.
Receipts-

In contrast to OMB's outlay estimates, Treasury's

receipts estimates (adjusted for definitional chanqes) have been
miraculously accurate.
were:

The forecasts made at various times

January, $401.3 billion; March $401.4 billion; and July

$401.2 billion.

It now appears as though the actual number will

be very close to the July estimate.
Deficit-

The implied deficit is:
Outlays
Receipts
Deficit

B.

$450
401
"$4 9

billion
billion
billion

Fiscal 1979

Outlays-

Appropriations actions are not yet completed for fis-

cal 197 9, and. the Second Budget Resolution is waiting to go to
conference.

However, the outlook for 1979 outlays is considerably

brighter than it was last March.
the shortfall discussed above.
into 1979.

Part of the chance is due to
It is expected to carry forward

In addition, the Congress is showing very little in-

terest in certain expensive Carter spending initiatives such as
the urban program and welfare reform.

(Welfare reform had very

little impact on 1979 outlays but the Administration's optimistic
cost estimates suggested that the reforms would increase outlays
by $13 billion by fiscal 1983.)




There are also across-the-board

cuts in the House version of the Labor-HEW and the HUD appropriations bills.
While it is too early to say that the public mood, which
brought us Proposition 13 is having a profound impact on Congressional behavior, it has at least altered the tone of the
debate.

Whether or not it will alter the substance of the de-

bate may depend on what members of Congress heard at home durinq
the Labor Day weekend.
I do not, however, expect any dramatic chang;e in the outlook for 1979 outlays.
billion for 197 9.

I would suggest usinq a figure of $490

Note that while I have lowered my estimate

for outlays by $5 billion since our last meeting, my estimate for
the rate of increase of spending between 1978 and 1979 has actually gone up slightly from 8.7 to 8.9 percent.
It is conceivable that outlays will be a bit lower than
S490 billion.

I believe that the outcome of the debate on the

re-authorization of CETA and on the President's proposal for
fiscal assistance to cities will be a aood indicator of whether
there is, in fact, a new mood in the Congress.

If CETA, ^itle

VI (public service employment) is cut back and if countercyclical
revenue sharing is extended as a substitute for the Presidents
more expensive fiscal assistance program, there will, at least,
be a hint that the Proposition 13 phenomenon is havina a real
impact.

There will be little effect on 197 9 outlays, but the

implications could be more dramatic for 1980.




(4)

Receipts-

In July, the Administration estimated 1979 receipts

at $448.2 billion.

This figure assumed a $20 billion tax cut

for calendar 1979.

The House has passed a $16 billion cut and

the Senate Finance Committee will be starting to mark up a tax
bill around Seotember 10.

It is generally believed that the

Senate will provide a larger tax cut than that, in the House Bill,
but the situation is sufficiently unstable that anything could
happen.
I am inclined to adopt the Administration's receipts estimate on the basis of the following assumptions:
1.

The eventual tax cut will be between $16 and $20 billion;

2.

A worsening inflation outlook does not quite offset a
worsening real growth outlook and money GNP will therefore be slightly lower in calendar 1979 than the 52,330
billion assumed by the Administration in July;

3.

Although the 197 9 money GNP is assumed to be lower, GNP
revisions suggest that the current share of corporate
profits in money GNP is somewhat higher than believed
earlier and it seems reasonable to raise the profit
share forecast for 1979.

A higher profit share, of

course, means that revenues will be higher for any
given money GNP.
In summary, I assume that the revenue increasing impact of
the first and last assumptions offset the revenue reducing impact of the second assumption.




Needless to say, considerable

(5)

political and economic uncertainty surround the receipts forecast,
Deficit-

The outlay and receipts estimates made above imply a

1979 deficit of:
Outlays
Receipts
Deficit
c

•

$490
448
$ 42

billion
billion
billion

The Longer Run
The July, Mid-Session Review of the 197 9Budget estimated

that an extension of current policies plus Presidential recommendations, already announced, implied outlay levels of $549.4
billion in 1980 and $591.3 billion in 1981.

The 1981 figure

was $15.2 billion higher than had been estimated in January
only six months earlier.

—

These projections clearly frightened

the Administration, and in a most unusual footnote for a budget
document they said, "The Administration regards the current
estimates of 1980 outlays -- and the deficit that results -- as
unacceptably high.

The President's budqet for 1980 will, there-

fore, reflect a fiscal program that will lead to substantially
lower outlay levels.^ Reductions in 1980 spendina will also
reduce the current estimates of 1981 spending."
Various press reports suggested that the Administration
was using a planning ceiling of $537-538 billion for 1980.

With

a current policy estimate of $549.4 billion this implied a
truly Draconian budget by the standards of the recent past.
deed, it was fair to say that OMB was working on the most




In-

(6:

Republican budget of the last 30 years.
But the $549.4 billion current policy estimate for 1980
was based on a 1979 outlay estimate of $496.6 billion.

Although

it is now reasonable to assume a 1979 outlay level of $490
billion there is no indication that the Administration has made
a comparable reduction in its planning ceilina for 1980.

The

implied rate of increase in outlays for 1980 has gone from 8.8
percent to 9.7 percent.

More important, the reduction from cur-

rent policy plus Presidential initiatives has gone from over 2
percent to about one percent.

This may seem like a tiny change,

but it is immensely important politically in terms of the number
of special interest groups that will be antagonized by cuts in
their programs.

It must be remembered that, for all practical

purposes, cuts have to be concentrated on that 25 percent of the
budget that is defined as being "relatively controllable."
In attempting to achieve their goal the Administration will
be hurt by the worsening inflation and real growth outlook and
by the Congressional rejection of their health price controls.
On the other hand, they will be aided by the lack of Congressional
action on welfare reform and urban initiatives.
early to say how this will all come out.

It is far too

TAjhile it appears as

though the 1980 Budget will be stringent, it is only safe to say
that it will not be as stringent as it appeared last July nor
as stringent as the Administration and the special interest
groups will claim next January,




TO:
FROM:

Members of the Shadow Open Market Committee
Bob Rasche

Attached are copies of my worksheets on the sources of financing of
the Federal Government deficit for the first five months of 1978.
To save you the task of going through the detailed numbers, I have
constructed the following summary:
(to date) (to date)
Total Financing Required
FY 1977
CY 1977
FY 1978
CY 1978
(millions)
53,720
26,164
61,431
56,246
Borrowing from private
capital markets
Monetization (Change
in Net Source Base)
Borrowing from foreign
official institutions
Other sources of financing

23,450
(.44)

19,390
(.32)

19,771
(.35)

10,894
(.42)

5,260
(.10)

11,396
(.19)

5,852
(.10)

3,995
(.15)

20,274
(.38)

29,381
(.48)

20,583
(.37)

8,141
(.31)

4,736
(.09)

1,264
(.02)

10,040
(.18)

3,134
(.12)

I would interpret this summary as indicating little change since the
beginning of the year from the patterns that we saw established in
1977, Foreign Official institutions continue to be a major, if not
the major source of funding for the continuing large deficits. The
data for June, July and August are not yet available, but judging
from the newspaper reports over the summer, it would seem that at
least the Japanese have been a major contributor during this period*
It seems likely that when the fiscal year comes to an end, these
institutions will have contributed at least the 40-50 percent of the
financing requirements that they did last year. If my notes and memory
serve me correctly, this is a higher rate than we anticipated last
March,




The behavior of the Fed is also running essentially unchanged from
the past several years. It appears that it is difficult, if not
impossible for the Fed to reduce the expansion of the net source
base below say a range of 10-20 percent of the total financing
requirements of the Federal Government, given their concerns about
resisting upward pressure on short-term interest rates. If we take
this as a very rough forecasting rule of the minimum expansion of
the net source base (they have managed to get below ten percent
once in the past 6 years, to-eight percent in calendar 1975),
combined with the long-term projections of the federal deficit
such as those constructed by the Congressional Budget Office,
the results for monetary expansion over the next few years are
not at all optimistic.
FY 78

Off-budget agency deficit
Total

2

FY 79

FY 80

FY 81

FY 82

61.25

Federal Budget Deficit
Projections^

67.0

61.0

49.0

39.0

7.5

7.5

7.5

7.5

74.5

68.5

56.5

46.5

7.5
68.75

Change in Base at .10
monetization:

6.9

7.5

6.9

5.7

4.6

% change from 9/30/77

(5.7)

(5.9)

(5.1)

(4.0)

(3.1)

Change in Base at .20
monetization

13.8

15.0

13.8

11.4

% change from 9/30/77

(11.4)

(11.1)

(9.2)

(7.0)

(5.3)

Congressional Budget Office; Five Year Budget Projections:
Years 1979-83, December 1977, pp. xii.

Fiscal

9.2

My arbitrary assumption based on deficits in last several fiscal years.




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