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SHADOW OPEN MARKET COMMITTEE
Policy Statement and Position Papers

February 3-4, 1980
PPS-80-2

CENTER FOR
RESEARCH IN
GOVERNMENT
POLICY
& BUSINESS

Graduate School of Management
University of Rochester




SHADOW OPEN MARKET COMMITTEE
Policy Statement and Position Papers

February 3-4, 1980
PPS-80-2

Shadow Open Market Committee Members - February 3, 1980
SOMC Policy Statement, February 3, 1980
Position Papers prepared for the February 1980 meeting
FISCAL POLICY Rudolph G. Penner, American Enterprise Institute




SHADOW OPEN MARKET COMMITTEE POSITION PAPER - Karl Brunner,
University of Rochester
MONEY MULTIPLIER FORECASTS - James M. Johannes and Robert H.
Rasche, Michigan State University
THE GOLDEN OPTION - Wilson E. Schmidt, Virginia Polytechnic Institute
ECONOMIC PROJECTIONS - Jerry L. Jordan, Pittsburgh National Bank
ECONOMIC OUTLOOK - Beryl W. Sprinkel, Harris Trust and Savings Bank




SHADOW OPEN MARKET COMMITTEE

The Committee met from 2s00 p.m. to 8s00 p.m. on Sunday, February 3, 1980.
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
Carnegie-Mellon University, Pittsburgh, Pennsylvania

Administration,

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 Penner, American Enterprise Institute, Washington, DC
Professor Robert Rasche, Department of Economics, Michigan State University,
East Lansing, Michigan
Professor Wilson Schmidt, Department
Institute, Blacksburg, Virginia

of

Economics,

Virginia

Polytechnic

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, New York




3




POLICY STATEMENT
Shadow Open Market Committee
February 4, 1980

Economic performance in the Eighties will be even worse than the deplorable
economic performance in the Seventies, unless the Administration, Congress, and
the Federal Reserve begin now to slow the growth of government spending and
money. There is an urgent need for clearly stated fiscal and monetary policies to
reduce the size of the public sector, to reduce real tax burdens, to reduce the
crowding out of private capital formulation, and to reduce the rate of money
growth.
In the Seventies, higher oil prices, low aftertax returns to capital, large
public sector deficits and high inflation contributed to reduced investment, lower
growth of labor productivity, and reduced growth of actual and potential output.
Recent increases in oil prices and projected increases in government spending
threaten to produce the same pattern in the Eighties. Increased spending for
defense, if not paired with reductions elsewhere, will result in an increase in the
size of the public sector. Higher oil prices and further growth of the public sector
depress the growth of the private sector by crowding out private capital and
reducing productivity growth.
Fiscal Policy
The major issue regarding the budget is the continued surge in real tax
burdens, both current and projected, to 1985. The ratio of total budget receipts to
GNP reaehes 21.7% in 1981 — a level that has been exceeded only once before in
our history and never in peacetime. To bring the average tax burden down to the
level prevailing in 1976 would require an $88 billion cut in taxes.
Taxes are scheduled to increase in 1980-1981 as follows:
* $15 billion owing to Social Security tax increases;
* $20.6 billion owing to the windfall profit tax;
* $11- to $13 billion in personal income taxes owing to the shift of taxpayers to higher brackets;
* The effects of inflation on income from capital;




5

* Plus other small tax increases resulting from proposed changes in the
timing of payments:
These tax increases are but the beginning of the massive rise in taxes
required to finance the inordinate growth of the public sector.
One year ago the Administration projected 1984 outlays at $674 billion. Now
these 1984 outlays are projected to reach $839 billion — a rise of $165 billion,
nearly 25%, in one calendar year. We believe that the true increase is understated
because the Administration has used optimistic assumptions about real growth, the
inflation rate, and cyclical developments.
The Administration's spending program is a recipe for low economic growth.
Higher government spending will bring higher levels of taxation, more debt, more
crowding out of private capital formation, and more inflation.
Monetary Policy
The Administration's budget projections assume the failure of the October 6,
1979, Federal Reserve program of monetary restraint.
These projections
presuppose a rate of inflation for 1979-85 of 7.7%, as measured by the GNP
deflator, and of 8.2% as measured by the CPI.
The October 6 Federal Reserve statement accepted one part of the program
that this Committee has recommended for the past six years. We applaud the Fed's
move toward monetary control exercised through the control of monetary
aggregates.
In the fourth quarter of 1979, the Federal Reserve showed that it was capable
of achieving its target rates of monetary growth. However, there is no evidence
yet that the Federal Reserve can be relied on to reach announced targets
consistently. Current procedures generate avoidable uncertainty and should be
improved promptly.
A Program for 1980 and Beyond
1.
The Federal Reserve should announce further details about its procedures to reduce the long-run trend of money growth and reestablish
its credibility by actually achieving its announced targets. This would
be the most effective way to eliminate the entrenched belief that the
rate of inflation will continue to rise in the Eighties.
2.
The SOMC favors an immediate return to the 6% growth rate for base
money that was achieved in the first and second quarters of 1979. A




6

6% average rate of growth of the base in each quarter of 1980 will
continue the policy we advocated at our September 1979 meeting.
Base money by the end of the fourth quarter of 1980 will reach $162
billion if our recommendation is followed. The proposed policy is
likely to be accompanied by a mild recession in 1980 and a slight
reduction in the rate of inflation.
Large, permanent reductions in the rate of inflation can be achieved in
1981 and beyond only if there are further reductions in the growth rate
of the base. We recommend reductions of one percentage point in
1981 and 1982, so that the level of the base will reach $170 billion at
the end of 1981 and $177 billion at the end of 1982.
Under a monetary policy consistent with ending inflation, the Federal
Reserve will provide smaller and smaller contributions to financing
budget deficits. Congress should remove the inconsistency between
budget projections and Federal Reserve policy. It should demand that
the Administration provide budget projections that are compatible
with the Government's commitment to an anti-inflationary policy.
We propose that the ratio of government outlays to GNP be reduced
steadily. By 1985 the ratio should not exceed 20%.
We repeat our recommendation for a tax reduction in 1980. Inflation
has increased the real tax burden. We are poorer as a result of the oil
price increases. Unless taxes and government spending are reduced,
the entire burden of the oil price increase falls on private consumption
and investment. We call on the Congress to enact a prompt reduction
of $15- to $20 billion in government spending and taxes.




7




Fiscal Policy
A Report to the Shadow Open Market Committee
Rudolph G. Penner
American Enterprise Institute

The 1981 Budget
Outlays - Given raging inflation and the need to increase defense spending, one
would have expected an austere non-defense budget if this were not an election
year. Unfortunately, the election intervened and "austerity" is hot a word that can
be used to describe the 1981 budget.
A year ago, when President Carter presented his 1980 Budget, he could
legitimately claim to be a fiscal conservative. With recommended outlays at
$531.6 billion, the original 1980 Budget was $12.5 billion below the level necessary
to keep all programs functioning at real levels prescribed by 1979 law. Essentially,
all of this "cut" came out of non-defense programs. The estimate of 1980 outlays
has now been raised to $563.6 billion, an increase of 6 percent over the original
estimate as an unexpectedly high inflation rate and new program initiatives (some
of which are related to the crisis in Iran and Afghanistan) destroyed the restraint
inherent in the original budget.
Instead of cutting from "current policy" levels as did the original 1980
Budget, the new budget adds about $3 billion to the newly inflated current policy
levels inherent in the new 1980 estimates. The increase all goes to defense with
non-defense held at roughly "current policy" levels. The resulting outlay level of
$615.8 is 9.3 percent above 1980 in nominal terms and 0.2 percent higher in real
terms.
At first sight, this appears pretty stringent, but the aggregate figures hide a
lot. First, there is some artificial shuffling of outlays from 1981 into 1980. Onbudget net lending is shown at $5.5 billion in 1980 and $-0.6 billion in 1981. Simply
smoothing out this net lending would raise the rate of growth of outlays from 9.3 to
10.4 percent. I do not wish to predict that this will necessarily happen, but only
wish to illustrate how sensitive the appearance of restraint is to small timing




9

differences. Second, there are numerous proposals for cuts that have been rejected
often by the Congress in the past. Among them are cuts involving hospital cost
containment, impact aid, school lunches, and veteran's educational benefits. I do
not criticize the President for making these recommendations, because there is
always a small chance that some sacred cows will be slaughtered. But the fact that
the budget rises significantly even with such unlikely cuts provides an indication of
the President's generosity toward other programs. In fact, there is sufficient
generosity that I would not rule out Congressional cuts in a number of Presidential
recommendations, even though it is an election year. Revenue sharing for states
and targeted fiscal assistance are likely candidates for the ax.
Receipts and Macro Considerations - Though relatively generous on the spending
side, the budget contains such massive tax increases that the budget is highly
restrictive from either a Keynesian or fiscal supply siaer point of view. The actual
deficit falls even though forecast unemployment rises as a result of a forecast
recession in 1980. On a unified budget basis the high employment surplus swings
from $-12 billion in 1979 to $+57 billion in 1981.
The ratio of total receipts to GNP reaches 21.7 percent in 1981 — a level that
has been exceeded only once before in our history and that was in fiscal 1944 when
the ratio attained 21.9 percent. For most of World War II the overall tax burden
was actually lower than the budget recommends for 1981! Putting the matter
another way, it would take a tax cut of $88 billion to return the ratio to the 18.5
percent prevailing in 1976 and a $44 billion cut to return it to the 1979 level.
Among the 1981 tax increases are:
1. Social security tax increases - The 1980 increase adds $4.3 billion to 1981
receipts while the 1981 increase adds $10.7 billion;
2. The windfall tax adds $6.2 billion in fiscal 1980 and $14.4 billion in 1981;
3. Growing money incomes will add roughly $11 to $13 billion to the personal
tax burden between fiscal 1980 and 1981 because of people being pushed into higher
brackets;
4. The interaction between inflation and the taxation of capital income will
add an additional significant amount though this is difficult to compute;
5. There are numerous other subtle small tax increases resulting from
proposed changes in the timing of payments.




10

Summary of budget totals
Fiscal years
Actual 1979

Outlays
Receipts
Unified deficit
Off-budget deficit
Total deficit

Proposed 1980

Proposed 1981

493.7
465.9

563.6
523.8

615.8
600.0

27.7
12.4

39.8
16.8

15.8
18.1

40.1

56.6

33.9

Economic assumptions - The actual outcomes for fiscal 1980 and fiscal 1981 will be
significantly affected by paths of inflation, unemployment, and interest rates over
the next 18 months. The Administration has been quite candid about the dismal
outlook and while it is possible to find more pessimistic forecasts, it is quite
remarkable to see an Administration forecasting a rise in the unemployment rate to
7.5 percent for the fourth quarter of an election year.
For the relevant calendar years, the Administration's economic assumptions
are as follows:
1979
Real GNP (% change)
GNP deflator (% change)
Unemployment (average rate)
Interest rate (91 day bills)

1980

1981

2.3

-0.6

1.7

8.9

8.9

8.8

5.8

7.0

7.4

10.0

10.5

9.0

Possible changes in the budget totals
I shall accept the Administration's economic assumptions for the purposes of
the discussion which follows.
The most likely changes in the President's budget will come on the tax side.
It is hard to believe that the 1981 social security tax increase will be allowed to
stand. If it does go into effect is is likely to be offset by personal tax reductions or
some sort of a tax credit. As already noted that is worth almost $11 billion in
fiscal 1981.
There will be strong demands for tax changes providing investment incentives
and some less strong demands for general income tax reductions. At the time of




11

the last SOMC meeting I was virtually certain that such cuts would occur and that
they would retroactively affect 1980 liabilities. This seems less likely now though
it is still possible. The failure of the recession to arrive on time and heightened
concern over the deficit because of inflation has dampened enthusiasm for tax cuts
and much will depend on the course of the economy over the next few months.
However, any cut will certainly come too late to have much impact on the fiscal
1980 deficit unless we are foolish enough to enact a temporary rebate.
Some action on 1981 liabilities seems virtually inevitable, but that is what I
said last time about 1980 liabilities. Nevertheless, it would be foolish to rule out
the possibility that the fiscal 1981 deficit could be $20 billion or so larger because
of a tax cut enacted for calendar 1981.
Still accepting the Administration's economic assumptions, I find it hard to
identify any major changes in the Administration's outlay figures. Many of the
President's proposed cuts will be rejected as will some of his increases. Generally,
I think it fair to say that the budget is aimed at the middle of the Democratic party
because of the nomination battle and is somewhat more liberal than the Congress
or the general populace. The Congress may allow many "controllable" programs to
erode more with inflation than the President desires and may cut some of the grant
programs now designed to get the President the organizational support of governors
and mayors in the nomination battle. In addition, the rapid changes in defense
policies are conducive to conditions that tend to create a shortfall. On the other
side, many of the sacred cows attacked by the President will remain alive and well,
and some of his estimates for things like disaster aid and agriculture could turn out
to be low. It is not unreasonable to assume that all of these things will largely
cancel out. A recession that is more serious than that forecast could, of course,
result in significant discretionary and endogenous spending. Some say that defense
is likely to be increased significantly, but it must be noted that only hawks are
speaking out now and the doves have hunkered down. They may reapper before
defense appropriations are passed.
The Long-Run Budget Outlook
We face many severe budget pressures over the 1980s.

Over one-half of

Federal payments for individuals go to the elderly and that population will grow
more than twice as fast as the working population over the next decade. Moreover,
current programs promise that rapidly growing population a growing real standard
of living. Earlier growth in such programs was largely financed by reducing defense




12

relative to the GNP and by an upward trend in the deficit. Until recently,
increased taxes have played a very minor role. Now it seems quite clear that
defense will command a growing share of GNP over the next five years. The
significance of this shift for future budget pressures is hard to overemphasize.
These pressures are obscured by the Administration's long-run budget
projections which are based on the unrealistic economic assumption that the
Humphrey-Hawkins goal of 4 percent unemployment is achieved in 1985. The
achievement of the Act's 3 percent inflation goal is postponed to 1988. As a result,
the assumed rate of inflation over the 1979-85 period is 7.7 percent, as measured
by the GNP deflator, and 8.2 percent, as measured by the CPI. The average
assumed rate of real growth is an implausible 3.3 percent.
The combination of high inflation and high real growth results in a strong
downward bias in the projection of the outlay-GNP ratio, because there is obvious
understatement of spending on programs affected by unemployment while the high
inflation erodes the real value of those programs affected by an explicit policy
decision to keep them constant in money terms for the 1980-83 period, e.g., general
revenue sharing. It should also be emphasized that the projections allow for no new
spending initiatives other than those already announced by the Administration, e.g.,
national health insurance.
Despite all of this, the budget projections do not show a rapid decline of
spending relative to GNP.
Before discussing these official projections, it is useful to emphasize the
ephemeral nature of budget projections.
One year ago, the Administration
projected 1984 outlays at $673.7 billion. Changes in the economic assumptions
(still unrealistically optimistic) and defense, energy and health initiatives have nowraised the 1984 projection to $838.9 billion — a rise of $165.2 billion or almost 25
percent in 12 short months!.
Neither time nor space allow a detailed program-by-program discussion of
these projections, but a few simple calculations reveal the nature of the budget
pressures likely to be faced in the early 1980s. If we do nothing more than replace
the official 3.3 percent annual real GNP growth assumption with a more realistic
2.5 percent growth rate, the projected outlay-GNP ratio rises to 21.6 percent
before making any adjustment for higher expenditures on programs affected by
employment.




13

Official Budget Projections
(Dollar amounts in billions)
Actual 1979

Projected 1985

Amount

% of GNP

Amount

% of GNP

117.7

5.1

229.7

5.2

International affairs

6.1

0.3

13.0

0.3

Gen. science, space &
technology

5.0

0.2

6.6

0.2

Energy

6.9

0.3

11.8

0.3

12.1

0.5

14.7

0.3

Agriculture

6.2

0.3

5.2

0.1

Commerce & housing credit

2.6

0.1

2.7

0.1

17.5

0.8

24.9

0.6

9.5

0.4

10.3

0.2

Education, training, employment & social services

29.7

1.3

40.6

0.9

Health

49.6

2.1

100.3

2.3

160.2

6.9

307.9

7.0

(Social security)

(102.6)

(4.4)

(208.3)

(4.7)

Veterans benefits & services

19.9

0.9

26.9

0.6

Administration of justice

4.2

0.2

5.3

0.1

General government

4.2

0.2

5.3

0.1

General purpose fiscal
assistance

8.4

0.4

8.9

0.2

Interest

52.6

2.3

70.0

1.6

Allowances

—

—

49.6

1.1

-18.5

-0.8

-31.1

-0.7

493.7

21.3

902.6

20.6

Function
National defense

Natural resources &
environment

Transportation
Community and regional
development

Income security

Undistributed offsetting
receipts
Total




14

A highly tentative, but conservative list of adjustments to the outlay
estimate follows;
1. Add $12 billion as a modest estimate of the cost of higher unemployment!
2. The projections assume rapid real cuts of 3.5 percent per year on a long
list of functions shown in the appendix. Holding the real decline to one percent per
year adds $24 billion;
3. Add $3 billion to reflect the failure of the hospital cost containment
program. Other Presidential cuts are almost certain to fail, but no adjustment will
be made;
4. The Administration assumes that its national health insurance proposal
will cost $30 billion in 1985. Assume that it is rejected, but replaced with other
health initiatives costing $15 billion. Thus $15 billion is deducted from the total.
The net add-on from this list totals $24 billion and brings total outlays to 22.1
percent of the GNP. The modest nature of this adjustment must be reemphasized.
Some would also question the defense projection which assumes real growth of
about 3.7 percent per year. I do not, because I would suggest that the Pentagon
will be subject to intense scrutiny once the present enthusiasm for defense cools
down. This, of course, assumes that the Soviets will not continue to misbehave —
perhaps a foolish assumption. The interest projection is perhaps more suspect since
it assumes a balanced budget from 1982 onwards.
Even with the modest adjustments made above, a tax increase of about 10
percent above 1979 levels would be required for a balanced budget in 1985. (Of
course, present law plus the windfall tax imply much greater increases.)
Whatever the budget pressures of the 1980s, they pale beside the problem to
be faced at the beginning of the 21st century when members of the baby boom of
the 1940s and 1950s begins to retire. The problem must be confronted very soon to
allow ample time for private adjustments to any change in promised public
benefits. Adjustments in the retirement age and in the indexing formulae which
now promise rapidly growing real benefits should be contemplated. If we do not
adjust, the future is bleak. The real danger may not be higher tax burdens or
deficits, but an intense budget squeeze which reduces vital spending on defense and
other budget functions.




15

Appendix
The official budget projections assume that total real spending on the
following functions declines at about 3 1/2 percent per year between 1979 and
1985:
General science, space and technology (-2.9 percent per year);
Natural resources and environment (-4.2 percent);
Agriculture (-10.0 percent);
Commerce and housing credit (-6.7 percent);
Transportation (-1.7 percent);
Community and regional development (-6.0 percent);
Education, training, employment and social services (-2.3 percent);
Veterans benefits and services (-2.5 percent);
Administration of justice (-3.6 percent);
General government (-3.6 percent);
General purpose fiscal assistance (-6.4 percent).
Items were deflated by the GNP deflator.
The decline is somewhat
exaggerated since future pay increases are not included in these functions, but are
instead put into the "allowances" category.




16

SHADOW OPEN MARKET COMMITTEE
POSITION PAPER
Karl Brunner
University of Rochester
February 3, 1980
PPS-80-1

Position Paper prepared for the 14th Session of the Shadow Open Market Committee,
February 3, 1980.




Shadow Open Market Committee Position Paper

Karl Brunner
University of Rochester

"Our policy, taken in a long perspective, rests on a simple
premise - one documented by centuries of experience - that the
inflationary process is ultimately related to excessive growth in money
and credit."
Paul A. Volcker, January 2, 1980

I. The Political Cycle of Anti-Inflationary Policies
On October 24 and November 1, 1978, President Carter announced a program
allegedly designed to protect the domestic and international value of the dollar.
My position paper prepared for the meeting of the Shadow Open Market Committee
in March 1979 examined the proposals advanced. It was noted at the time that they
contained some useful but vague suggestions bearing on our future welfare (real
income per capita) but offered otherwise no relevant specific action designed to
lower inflation or to provide for a sustained improvement of the dollar's international position. The President revealed no comprehension concerning the nature
of the inflation problem. The program submitted to the public's attention offered
in particular no useful instructions for the Federal Reserve Authorities. President
Carter's view of the world assigns no role to monetary policy as a major component
in a program addressed to lower the rate of inflation.
As it happened, the Federal Reserve Authorities lowered over six months
(October 197 8-April 1979) the growth rate of the monetary base. We observed at
the time, so it appeared, another move to control monetary growth. But our
monetary authorities failed once more. They reversed the course in April, as so
often before, after a short devotion to anti-inflationary exercises. The return to an
inflationary policy, expressed by a growth rate of almost 11% p.a. in the monetary
base from the middle of April to the middle of October, induced new doubts and
uncertainties. The dollar declined again in terms of major currencies.




18

The international repercussions of the falling dollar alerted the Federal
Reserve Authorities, operating with a new chairman, to the failure of the inherited
course. Almost one year after President Carter's useless exercise at "leadership' in
the fight against inflation Chairman Volcker announced on October 6, 1979, a new
policy promising a determined effort to cope with inflation. Chairman Volcker
presented a package with three measures: (a) the discount rate confronting
member banks was raised by one percentage point; (b) reserve requirements on
major categories of bank liabilities were raised and the cost of their supply
correspondingly increased; and lastly (c) we were informed that the Fed would
proceed with the formulation and execution of monetary policy more directly
addressing the control over monetary growth with less concern and attention to
short-term interest rates.
The Chairman's general intentions were quite clear. His announcement
prepared the public for the sixth attempt in 15 years to hold monetary policy to an
anti-inflationary course. The recent intentions were articulated with remarkable
forthrightness in numerous interviews or press statements with admirably sensible
economic interpretations supplied by the Chairman. No Chairman of the Board of
Governors ever elaborated so explicitly and without obfuscation the crucial role of
monetary expansion with respect to our experience of inflation and high interest
rates.
The sense of the Chairman's general thrust was however blurred by the nature
of the announcement and the confusing elaborations added by several Federal
Reserve officials. The first two items of the agenda presented by Chairman
Volcker can hardly be justified as relevant and separate measures of an antiinflation program. The increase in reserve requirements lowers both the monetary
and the asset multiplier of the banking system. They involve thus a once and for all
reduction in the stock of money and the volume of bank credit (banks' total earning
assets) relative to the monetary base. Such once and for all reductions in the two
aggregate measures, apart from their small magnitude, induce no relevant effects
on the ongoing rate of inflation. The latter is dominated over time by the excess of
persistent monetary expansion over the non-inflationary benchmark level. And the
persistent monetary expansion is not affected by the change in reserve
requirements applied in October. This action, however irrelevant in terms of
inflation, raised the banks' costs of supplying selected liability categories. This rise
in costs expresses the relative decline in bank credit and produces consequently




lb

some minor increase in the real rate on bank loans combined with a minor decline
in the real rate offered on the bank liabilities affected. But these shifts in relative
interest rates may induce some allocative changes on the credit markets but exert
no significant effect on aggregate demand and the rate of inflation. The raise in
reserve requirements imposed essentially a new tax on the banks with the revenues
acquired by the U.S. Treasury with the Federal Reserve Authorities acting as a
collecting agency.
The first item is by itself similarly irrelevant with respect to the ongoing
inflation. A negligible fraction of the outstanding base money has been issued via
the discount window. A change in the discount rate relative to prevailing market
rates contributes by itself alone at most to determine the relative magnitude of
base money supplied via the discount window without much effect on the total
monetary base driving the monetary aggregates. An increase in the discount rate
may have a useful function however in the context of a completely specified and
properly executed anti-inflation program. A monetary retardation induces initially
a substantial increase of bank borrowing at the Fed. In contrast to some ancient
folklore around the Fed and Wall Street this fact does not induce a reduction in
bank credit due to some "inherent reluctance of banks to borrow". Extensive bank
borrowing actually attenuates somewhat the impact of tightened open market
operations. An increase in the discount rate raises under the circumstances the
short-run impact of a retardation in open market operations and conveys the full
effect more rapidly to the monetary aggregates. But I repeat that raising the
discount rate without attention to the crucial aspects of the context is a pointless
and futile gesture in terms of our real problem.
So the issue centers on the third strand presented in the agenda. The
Chairman committed the Federal Reserve Authorities at this point to a policy more
explicitly geared to monetary control. This monetary control should moreover be
deliberately adjusted to lower, over time, the rate of inflation. The statement
remained however silent with respect to the nature of the implementation. The
statements made subsequently by other Federal Reserve officials increased the
uncertainty about the meaning of the promised change in policy. Still, we should
acknowledge that Chairman Volcker offered the most explicit and clearest
recognition ever presented by a high official of the Federal Reserve Board that
monetary control is a necessary instrument of an anti-inflationary policy. The
program of October 6 thus addresses directly the controllability of monetary
growth and the selection of appropriate control techniques.




20

D. Controllability and the Choice of Control Procedures
1. Controllability of Monetary Growth
Controllability of the money stock or monetary growth has often been denied.
Professor Lawrence Klein (University of Pennsylvania) recently argued that the
"money supply is hard to control".
He notes first that the data contain
measurement errors and approximations. The data are moreover subject to regular
revisions. This is indeed true and applies of course to all the data used for any
rational evaluation of economic policies. But Professor Klein does not evaluate the
order of significance of the "noise" built into the measurement of the monetary
aggregates. The corrections noted by Klein modified the growth rate of the money
stock in general by comparatively small amounts. In particular, these corrections
exerted no relevant influence on the rational evaluation of the prevailing state. An
error of 1% p.a. at a time of a measured growth rate of 8% p.a. with an
accelerating inflation hardly changes the nature of the problem. We know,
independently of the measurement error, that monetary policy should lower
monetary growth by at least five percentage points (in case of IVL). The discussion
of measurement errors presented by Professor Klein neglects the context of the
errors and overstates suggestively the practical importances, at this state, of their
occurrence and relative magnitude. There is also no recognition that the frequency
and magnitude of measurement errors is not pre-ordained nor is it just the result of
a process beyond rational attention. The measurement procedures are improvable
and useful suggestions have been submitted in the past years to the Federal
Reserve Authorities.
Professor Klein challenges moreover the significance of the data and the
controllability of the "more significant broader measures". He emphasizes the
range of measures reaching from ML to M„. This is of course a favorite game of all
those opposed to monetary control.
This game motivated most likely the
development of this array under Chairman Burns. The fact is that there is hardly
any evidence supporting Klein's contention that the "economic significance" of the
measures increases with their inclusiveness. The relevant measures are still
confined at this stage to M- and M„ and the crucial issue is the Fed's obligation to
develop useful measurement procedures designed to encompass all assets held by
the domestic public and regularly used for transaction purposes.
The variability of monetary velocity is also introduced in Klein's argument in
order to suggest that monetary targets cannot be translated into spending targets.




21

But variability of a variable is not the relevant aspect for our purposes. Even a
highly variable magnitude may be reliably predictable. In particular, velocity
exhibits patterns of systematic behavior exploitable by monetary control for
purposes of an anti-inflationary policy. The predictability of velocity has been
explored by Brunner-Meltzer more than ten years ago. The Shadow Open Market
Committee's assessments of expected developments based on Jordan's work and
presented in recent years supplies additional evidence in support of the
predictability of a variable velocity.
All the objections advanced by Klein centered on measurement errors,
shifting significance, poor controllability of monetary aggregates or spending can
be safely rejected with the aid of an examination of the monetary base. It may be
useful to repeat that this magnitude expresses the total amount of money directly
issued by the monetary authorities. It occurs on the liability side of a consolidated
balance sheet covering all Federal Reserve Banks and the Treasury's monetary
account. Variations in the base thus reflect actions of the authorities concerning
the volume of assets or non-money liabilities on this consolidated account. Any
action of the authorities affecting assets or non-money liabilities modifies the
monetary base by a corresponding amount. The Federal Reserve Authorities
control thus via their actions and arrangements completely the behavior of the
monetary base. The monetary base is not determined, as Governor Wallich
suggests, by the public's demand for currency. Whatever the proportion of currency
may be, base money is issued and withdrawn by actions of the Fed changing assets
and non-money liabilities of the consolidated balance sheet. Whenever asset
purchases are accelerated the monetary base accelerates, and whenever asset
purchases are retarded, the monetary base decelerates. The public's behavior does
not determine the magnitude of the base; it determines the distribution of the total
between currency holdings and bank reserves.
The complete dependence of the monetary base on the Fed's actions should
not be so difficult to understand. The second point follows closely. The monetary
base can be accurately measured with little delay. It requires only knowledge of
the balance sheet, and this knowledge is available with substantial precision.
Consider now the relation between the monetary base and total spending expressed
by nominal Gross National Product. This relation is formulated in terms of a basevelocity V (Vj indicates the velocity of I L and V„ of M„). The velocity V is of
Y
course the product of the monetary multiplier m. linking the base with M.. with the




22

velocity V, (also V = m - . V j . Two important implications follows first, the
measurement problems resulting from financial innovations concerning transaction
accounts and time deposit accounts hardly affect the behavior of base velocity V .
The errors associated with traditional measures of M1 and M„ produced by such
innovations affect V- and m- (or V„ and m J in opposite directions. These changes
essentially offset each other. This is revealed by the fact that the base velocity V
neither exhibited any particular acceleration over the period dominated by
innovations in transaction accounts nor any noteworthy volatility.
The persistence of behavior patterns exhibited by V also concerns the second
point to be considered. Trend and cyclic movement of V hardly changed during
the 1970's when compared to the 1950's. Financial innovations beyond components
properly included in M„ modify the substitution relations of IVL and M„ over a
widening range of assets.
This process operates gradually over time and
contributes to the trend rate of growth (2.5% p.a.) observed for V . We find
moreover that in the absence of any run on the banks raising the currency ratio in
the public's money holding, accelerations or decelerations of the base are not offset
beyond one or two quarters by movements of V in the opposite direction. Beyond
two quarters persistent and major changes in the growth rate of the monetary base
are transmitted via velocity to the level of total spending. Professor Klein's
objection thus fails to conform with relevant observations produced by the world
we actually live in.
2. Implementation of Monetary Control and Control Techniques
We still need to consider however the control procedures applicable to the
control of monetary growth. This issue has been repeatedly discussed in some
detail in previous position papers. The Fed's prevailing method centered on
targeting a Federal funds rate on the assumption of a stable relation linking the
targeted interest rate with a targeted monetary growth has been examined and
criticized on various occasions. The procedure essentially failed to produce an
adequate control over monetary growth. This failure resulted from the instability
and unreliability of the central relation anchoring the Fed's conception. The
announcement of October 6, 1979 suggested that the traditional implementation of
monetary policy would be suspended but no information was supplied allowing any
useful inferences concerning the nature of the new control procedures. It emerged
subsequently that the staff of the Board of Governors appeared to develop a




23

procedure centered on a targeting of bank reserves. A desired target path of
monetary growth is translated into a corresponding path for bank reserves. The
account manager would then be instructed to adjust the volume of net open market
operations in order to produce the targeted level of bank reserves.
The Shadow Open Market Committee proposed since its beginnings in 1973
that the Fed proceed according to the following program! (a) determine the target
rate of monetary growth for one year ahead in accordance with an anti-inflationary
policy, (b) use an expected profile of the monetary multiplier in order to translate
the targeted monetary growth into a target for the monetary base applicable for
the next one or two months; (c) assess the movements in the various source
components of the base in order to determine the net volume of open market
operations to be executed over the next month by the account manager; (d) with
new information accruing every month the FOMC should reexamine steps (b) and
(c), with new instructions about net operations to the account manager covering the
subsequent month. We may note that the control procedure developed quite
independently by the Swiss National Bank coincides with this proposal. Its
suspension in the fall of 1978 was not due to any serious technical problems with
the procedure or its failure to control monetary growth. It resulted from a
political decision influenced by rising pressures to link the Swiss franc with the Dmark. This linking required that open market operations, concentrated in the Swiss
case on the exchange market, be governed by the movement of the D-mark rate
and not by the goal of a non-inflationary monetary growth.
The change in implementation to a reserve targeting procedure should be
welcomed by the Shadow Open Market Committee, but we should express our hope
that the staff may not lock itself into a new procedure without systematic
exploration of alternative modes of implementing the goal of monetary control.
We invite the Board of Governors to instruct the staff to compare their reserve
targeting with the control procedure proposed by the Shadow Open Market
Committee. The general nature of the examination required for the purpose of
assessing alternative procedures has been tentatively explored by Robert Rasche, a
member of the Shadow Open Market Committee. His basic statistical work coauthored with James Johannes was published in the July 1979 issue of the Journal
of Monetary Economics. The two authors applied their statistical study bearing on
the behavior of the monetary multiplier to an investigation of the comparative
performance of a reserve targeting and a base targeting procedure. The relative
performance of the two procedures depends crucially on the quality of the




24

respective links with monetary growth expressed by the monetary or base
multipliers (linking base with money stock) and a reserve multiplier (linking bank
reserves with the money stock). The relative predictability of the course of the
two multipliers determines the comparative performance of the alternative
procedure. Rasche and Johannes estimated thus the predictive errors of the two
multipliers over selected recent periods. The detailed discussion of procedure and
results can be found in the authors' contribution to a symposium on Monetary Policy
to be published by the Center for Research in Government Policy and Business
(University of Rochester).
The most important aspects are summarized for our purpose in the following
table. We note quite immediately that the average forecast error measured as a
mean or a root mean square is substantially smaller for the multiplier associated
with the monetary base. This pattern holds for both multipliers associated with the
exclusive and the inclusive measure of the money stock. The results obtained
provisionally suggest that a more reliable targeting of monetary growth is achieved
by manipulating the monetary base than by controlling a new reserve measure.
This issue of adequate control procedures appears to us sufficiently important for
the Fed to invest some attention and resources in order to improve its
implementation of monetary policy.
One last point need be covered in this context. An inspection of the data
emerging since October 6 may suggest that the Fed already abandoned the antiinflationary policy announced on October 6. The monetary base substantially
accelerated again since early December. The reader should be cautioned however
not to read too much into the data at this stage. We need to remember that the
data published were "corrected" with a seasonal factor looming quite large over
this time of the year. But the seasonals in the movement of the money stock,
monetary base and bank credit are not the product of nature. They are produced by
the prevailing policy regime. The current seasonal factors used to adjust data
express a seasonal pattern resulting from a policy designed to smooth out the
seasonal movement of interest rates. The underlying seasonal was thus transmitted
into a seasonal pattern exhibited by monetary aggregates. It follows therefore that
a change in policy regime from Federal funds targeting to a targeting of net
reserves radically modifies the seasonal patterns.
The inherited seasonal
correction factors based on past seasonal movements of monetary aggregates
associated with the previous policy regime are inappropriate under the new policy




25

Forecast Errors of Base and Net Reserve Multiplier
Covering the Period 1/1978-10/1979
A. The base multiplier
m

mean error
root mean square
error

m.

l

1
-.0012

2
-.0004

.0026

.0009

.0131

.0168

,0229

0342

1

2

B. The reserve multiplier
r

mean error
root mean square
error
Note:

r

l

2

1
-.0059

2
-.0116

1
-.0101

2
-.0134

.0877

.1097

.01853

.2262

m..: base multiplier for M.; m„ for M„
r.,: reserve multiplier for M-; r„ for M2
Column 1 describes one month ahead forecast error and Column 2 a
two month ahead forecast error.




26

regime. In particular they would produce an overestimate of the actual growth
rate of monetary base or money stock during January and February under the
prevailing circumstances. We suffer at the moment a substantial uncertainty in
evaluating the course of the Federal Reserve Authorities. We will need a period
sufficiently long to include substantial variations of the inherited seasonal
correction factors (probably the first six months of this year) before a reliable
judgment about the Federal Reserve Authorities' anti-inflationary policy can be
advanced. This problem reveals that a change in policy regime should really be
accompanied by a deliberate choice and public announcement of seasonal factors
expressing the design of the new regime.
III. Another View at Fashionable Fallacies
The need for control over monetary growth is of course predicated on the
assumption that inflation is essentially a "monetary phenomenon". This does not
mean that every short-run movement in the price level is systematically caused by
corresponding short-run movements in monetary growth.
Short-run price
movements contain substantial noise and reflect many unsystematic forces
unrelated to monetary growth. Persistent increases of the price-level are hardly
likely to occur however without a similarly persistent monetary growth.
Alternatively, in the absence of persistent and excessive monetary growth we will
not experience any persistent inflation. Moreover, any persistent acceleration of
the money stock unleashes eventually a rising inflation. On the other side no
inflation was ever terminated without lowering monetary growth to the relevant
benchmark level. The evidence bearing on these matters is remarkably uniform and
strong and covers many different countries and historical episodes.
These patterns are however disregarded and denied by President Carter and
Professor Klein. Both maintain that our inflation is at least partly, if not mostly,
the result of our energy problem. But this assertion violates the best established
part of economic analysis and is also contradicted by a host of crucial observations
mentioned in the previous paragraph. Other observations may be adduced which
cannot be reconciled with an explantion of inflation in terms of OPEC pricing
policies and an energy crisis. Inflation accelerated in this country since 1965 in the
context of a cheap and massive supply of energy. Inflation accelerated during 1973
in the U.S.A. many months before the first OPEC shock admitted to the world
economy in the fall of 1973. Most revealing however is a comparison of price




27

movements observed in various countries beyond 1972. Ihspite of a total
dependence on imported oil West Germany and Switzerland experienced in contrast
to the U.S.A. throughout 1973-1975 a decline in the rate of inflation. According to
the Carter-Klein hypothesis they should have experienced substantially more
inflation than the U.S.A. But this implication of the Carter-Klein hypothesis was
thoroughly falsified by events. The crucial difference must be recognized in
different monetary policies pursued in the various countries. Switzerland moved in
February 1973 to a hard control over monetary growth at a low level and West
Germany held to a comparatively modest course of monetary growth (relative to
the relevant benchmark level). It is occasionally contended that special factors
prevented the inflationary impact of the energy problem in the two countries
mentioned. The "virtuous cycle" affecting the international position of the t ss
franc and D-mark is occasionally emphasized in this context. But "virtuous" and
"vicious" cycles are neither blessings of heaven nor gifts of hell. They are
consequences of the monetary policies pursued in different countries. Most
attempts to invoke "special factors" reveal however the classic gesture of
protecting a falsified hypothesis and to immunize it against critical observations.
But such attitudes and evasive exercises essentially abandoned science and forfeit
the claim to relevant analysis.
One more aspect need be considered in this context. Much of the public
appeal of an explanation of inflation in terms of the energy problem follows from
the widespread confusion between once and for all price level effects and
persistent inflation effects. Large increases in the oil price lowered normal output
of all countries outside OPEC. Associated with this reduction in normal output,
measuring probably 596-7% in the U.S.A. is a corresponding increase in the price
level as of any prevailing money stock. This once and for all increase appears of
course as a temporary bulge in the rate of price movements. Inflation on the other
hand operates as a persistent increase in the price-level expressing continuous
adjustments in the price-level imposed by a persistent rate of excessive monetary
growth. Suppose that OPEC miraculously decides to lower the price of oil to the
marginal cost of producing oil. Normal output would increase in the U.S.A. and the
price-level fall by a corresponding amount with a given money stock. Whatever the
ongoing rate of inflation produced by a persistent rate of excessive monetary
growth may be, the reduction in the price-level would appear as a temporary
decline in the rate of price change below the maintained underlying rate of
inflation.




28

We may usefully explore another example of pervasive misconceptions. On
January 19, 1979 Walter W. Heller presented an explanation of inflation in
essentially sociological terms unrelated to persistent patterns of monetary
evolutions. He accuses the monetarists that "they fail to explain... (a) how it can
be that three years of slack in the economy from early 1975 to early 1978...failed
to dent the underlying rate of inflation; (b) how it is in the face of careful studies
that it takes a $200 billion loss of GNP to knock one percentage point off the
inflation rate, that Spartan policies of tight money that they advocate could subdue
inflation without a deep, deep recession or years of economic slack; and (c) how it
is that Germ any...could achieve much lower inflation rates than the United States
with both a faster growth in its money supply in the past four years and bigger
deficits...".
It is indeed remarkable to note that these issues have been dealt with in
recent monetary analysis on a variety of occasions by diverse groups of
researchers. They were also dealt with in recent years by the Shadow Open Market
Committee and the Shadow European Economic Policy Committee. Walter Heller
reveals on this occasion a noteworthy ignorance of the literature and the relevant
discussions in the field of monetary analysis.
The first point covers a standard argument of explanations more or less
implictly abandoning economic analysis. It expresses astonishment about the
negligible impact of "gaps and slacks" on the rate of inflation. This observation
offers a serious challenge to their understanding of economic processes which they
promptly attribute to their intellectual adversaries. Heller argues as if the fall in
actual output observed over the period 1973 to 1975 occurred relative to an
unchanged normal output. We already noted however that the actual decline in
output consisted of two components. One component measures the decline in
normal output and the other, smaller component, measures the decline in actual
output relative to normal output. The second component expresses the magnitude
of the recession and the gap.
Heller disregards the first component and
systematically overestimates thus the magnitude of the "gap and slack".
This overestimate involves one aspect of the fallacy embedded in Heller's
point (a). The other aspect bears on a faulty analysis of the significance of "gaps
and slacks". We are told that properly functioning markets should convert a gap
into falling prices or at least a falling rate of inflation. This view misses however
crucial aspects of price-wage setting behavior in the context of market




29

mechanisms. Price-wage setting does not evolve in passive response to past
evolutions. It responds to the best assessments on the basis of all available
information bearing on the dominant policy regime to be expected over the future
horizon. A monetary retardation generally deemed to be quite temporary hardly
induces substantial revisions in prevailing price-wage setting patterns. A gap
emerges under the circumstances with little consequence for price behavior.
Price-wage setting remains geared to the more permanent patterns of monetary
growth and disregards the transitory variations. A well established feedback which
induces a monetary acceleration in response to any evolving slack actually
encourages price-wage setters to disregard the current gap in view of accelerating
demand in the near future. Neither gaps nor slacks operate per se with any
particular force lowering the rate of inflation. Such lowering depends not on the
gaps, it depends on prevalent beliefs that the monetary authorities are fully and
unwaveringly determined to curb excessive monetary growth. This does not require
any major or long lasting "gap and slack". A dominant conviction by market
participants that the Federal Reserve Authorities truly, unwaveringly and
persistently lower monetary growth produces a decline in the rate of inflation with
comparatively small and rapidly eroding gap. Emergence and magnitude of a gap in
the context of an anti-inflationary policy depends foremost on the credibility of the
policy. A low level of credibility with a diffuse uncertainty produces a large gap
with a lasting slack. But this circumstance is not the unavoidable consequence of
anti-inflationary monetary policy. It is the result of the low credibility attached to
an anti-inflationary policy after a long period of activist expansionism of the kind
advocated by Walter Heller. This issue is closely connected with a prevalent faulty
perception expressed by the assertion that in order to lower the rate of inflation we
need (unavoidably to produce a recession. This characterization distorts the crucial
issues. Lower inflation does not require a recession, it requires a lower rate of
monetary growth. Whether or not a gap emerges is essentially determined under
the circumstances by the agents' assessment of the permanent or transitory nature
of the announced policy or of the observed movements.
This discusison already covered Heller's assertion in the second point about a
"deep, deep recession" following from an anti-inflationary monetary policy. Some
additional considerations need be added however. The credibility of an antiinflationary policy determines to a large extent the speed at which monetary
deceleration should proceed. A large deceleration against the background of a low




3C

credibility on the basis of accumulated experience produces indeed a large and
protracted gap. In order to minimize the social cost of transition to a stable pricelevel monetary growth should be lowered gradually over a number of years
according to a pre-announced plan. A long inflationary experience creates in the
economy a contractual structure which reflects to a major part the inflationary
trend. This holds in particular for price-wage setting patterns. The inherited
contractual structure will be modified in response to an anti-inflationary monetary
policy provided economic agents become sufficiently convinced that the antiinflationary stance involves a permanent shift and not just a transitory deviation
from a long-run inflationary course. Such conviction is not easily created against
the background of broken promises, empty rhetoric or demogagic distortions
responsbile for the current low level of credibility. It will require substantial
information beyond a few quarters that the Fed is really determined to hold on to
its anti-inflationary course.
Heller also refers to "careful studies" showing the huge social cost associated
with an anti-inflationary monetary policy. These studies, mostly executed around
the Brookings Institution, may indeed be carefully done. The crucial issue is
however what the studies were carefully done about. They inform us essentially
about price-wage-price (or wage-price-wege) processes in the context of rising
inflationary trends and increasing inflationary expectations. This important
context affects the structure of these processes. An application of these estimated
relations to evaluate the loss in output and employment associated with any given
anti-inflationary regime yields indeed an answer, but it is an answer to an
irrelevant question. The careful studies inform us about the social loss of an antiinflationary policy in a world composed of agents unable to learn and unwilling to
assess competitively new information. In other words agents proceed with the
belief of total incredibility about the anti-inflationary regime even in the face of
expanding information raising the rational level of credibility. The implicit
description of man in these studies seems more nearly to fit biologically preprogrammed organisms than conscious and inherently problem solving agents.
Lastly, Heller finds the simultaneous occurrence in West Germany of a larger
monetary growth, larger deficit and lower rate of inflation than in the U.S.A. an
unsolvable puzzle for monetary analysis. The puzzle has been resolved a long time
ago, one component even by Keynesian analysis. The latter implies quite clearly
that the level of deficits, large and small, exert per se (i.e. irrespective from the




31

feedback via money creation) no effect on the rate of inflation. They affect the
price-level. This is good Keynesian analysis confirmed by monetary analysis.
There remains thus only to note that the non-inflationary benchmark level of
monetary growth differs between countries. This benchmark level depends on the
trend in velocity and the rate of growth of normal output. Countries with normal
growth rate larger and velocity trends smaller than the U.S.A. exhibit a
substantially higher benchmark level of monetary growth. Both conditions held for
West Germany over many years. It is of course an interesting question to explore
the underlying determinants of the differences. This task has not been neglected
by economic analysis, but the answer leads us beyond a position paper for the
Shadow.




32

Money Multiplier Forecasts
James M. Johannes
and
Robert H. Rasche
Michigan State University

For the third time, we are prepared to put our models of the multiplier
components on record with forecasts of various multipliers. The models that we
are using are the same as we have used during the past year; that is the sample
period ends in March of 1978, and the only adjustment that has been performed in
the post-sample period is a one time shift for the introduction of ATS accounts,
imposed consistently across equations in January, 1979 and held constant ever
since. The data base for these forecasts is the period through December, 1979, and
includes the revisions to account for the call report benchmarks of December,
1978, and March, 1979, that were released by the Board of Governors within the
past month.
Our extensive analysis of the forecasting performance of the models, (some
of which is documented in the enclosed paper that we prepared for the AEA
meetings in Atlanta), suggests that over the 78-79 period the forecasts from the
models were unbiased over at least a six month horizon, and that the root-meansquared forecast error cumulates very gradually as the forecasting horizon is
lengthened. We still do not have enough experience to determine the maximum
horizon over which the forecasts hold up reasonably well.
Forecasts of these multipliers at the present time may be something of an
exercise in futility, since we are not sure exactly what measures of the money
stock will be featured in policy discussions in the near future. It seems likely that
whatever measures are introduced, the corresponding multipliers will contain
components for which we do not presently have working models. Assuming that a
reasonable history is made available for all the components of these new concepts,
we foresee no difficulty in extending our modeling techniques to the components of
the appropriately defined multipliers.
Table 1 contains forecasts over the next eight months for the M. through Madjusted monetary base multipliers on a not seasonally adjusted basis. These are




33

the actual output of our component models. We have also tabulated forecasts of
the seasonally adjusted multipliers using the non seasonally adjusted components
and the seasonal factors for the money stock components published in the February,
1979 Federal Reserve Bulletin. These seasonals are subject to revision in the near
future, so these latter forecasts could prove erroneous because of an inappropriate
seasonal, even though the component models might prove accurate. It should be
noted that the published seasonal factors are the product of X-11, and may not be
consistent with the seasonals implicit in our time series estimates. We are
presently investigating this issue. In Table 2, the forecasts of the adjusted net (of
member bank borrowing) monetary base multipliers are presented for the same
money stock measures.
We would interpret these forecasts as suggesting that there will be no distinct
trend in the M- multiplier (seasonally adjusted) over the period until the next
meeting of this committee. In contrast, the M„ multiplier (seasonally adjusted) is
forecast to drift upward by 1/3 to 1/2 percent over the eight month period. (1/2 3/4 percent at annual rates.)
This contrasts with our previous forecasting
experiments where the multipliers were correctly forecast to drift slowly
downward.




34




Table 1
Money Multiplier Forecasts
Gross Monetary Base Basis
Not Seasonally Adjusted

Seasonally Adjusted

l

M2

M3

M4

l

M2

2.50450

6.15184

10.45170

6.77661

11.07647

2.49503

6.18984

2.46150

6.21846

10.61435

6.82658

11.22247

2.47345

6.17042

2.46939

6.24707

10.66206

6.84551

11.26050

2.47811

6.18826

2.52297

6.27622

10.65777

6.87471

11.25627

2.48909

6.19393

2.45264

6.20677

10.55588

6.77763

11.12674

2.48174

6.19490

2.48355

6.22452

10.56163

6.78949

11.12659

2.48616

6.20480

2.48523

6.19478

10.49538

6.75654

11.05713

2.48742

6.20807

2.46484

6.20535

10.50833

6.76633

11.06932

2.47993

6.22419

M

M

5

M




Table 2
Money Multiplier Forecasts
Net Monetary Base Basis
Not Seasonally Adjusted
M

l

M

2

M3

Seasonally Adjusted
M

4

M

5

M

l

M2

2.52823

6.21013

10.55072

6.84081

11.18141

2.51867

6.24848

2.48490

6.27758

10.71526

6.89149

11.32916

2.49696

6.22909

2.49290

6.30656

10.76359

6.91070

11.36773

2.50171

6.24719

2.54710

6.33625

10.75971

6.94047

11.36393

2.51289

6.25317

2.47575

6.26524

10.65532

6.84148

11.23156

2.50512

6.25326

2.50706

6.28344

10.66159

6.85374

11.23190

2.50969

6.26352

2.50860

6.25304

10.59408

6.82008

11.16111

2.51081

6.26645

2.48799

6.26364

10.60704

6.82989

11.17329

2.50322

6.28266

The Golden Option
Wilson E. Schmidt
Virginia Polytechnic Institute

If American resources are strained in the near future by rising government
expenditures, will foreigners add to our available real resources and in particular
will they help finance a rising Federal budget deficit?
In the recent past, foreigners have been of considerable help. In 1977 and
1978, we ran annual current account deficits — the balance on exports of goods and
services less imports and grants — of about $15 billion which added to the real
resources available to us. These deficits were more than financed by foreign
official purchases of U.S. Government securities. In fact, foreigners bought about
three quarters of the increase in the publicly-held U.S. public debt.
It seems that this favorable experience is not likely to be repeated soon. We
probably were in current account balance in 1979 and the most recent Treasury
forecast for 1980 suggests little change from that outcome. The deterioration in
our terms of trade, or the decline in the amount of U.S. imports that American
exports will buy, knocked perhaps one percentage point off our real income in 1979.
The partial suspension of grain exports suggests further deterioration in our terms
of trade.
Foreigners sold off U.S. public debt in 1979. Definitive data through October
show a decline in foreign holdings of $13 billion, and foreign official holdings
through mid-January of both marketable and non-marketable government securities
have been stable since then. If correct, this will be the first, year-long decline in
foreign holdings of U.S. public debt in the 1970's. One might hope for substantial
OPEC purchases of U.S. Government securities in 1980 because of the enormous
surpluses they will enjoy, but, as these have not increased foreign official holdings
of government securities since September, the situation is not reassuring. If
foreign official institutions are reluctant to hold more dollars, an incipient
worsening of our current account as a reuslt of pressures at home may not be
financed; instead the dollar will depreciate, denying us the extra resources, as the
current account balance is maintained.




37

The U.S. Treasury has an inventory of a potential export product of
considerable value. As of the end of November, it held 263 million ounces of gold,
and these are larger now because of the restitution of the International Monetary
Fund's gold to its members in January. This hoard is worth, at the recent high of
$850 per ounce, about $225 billion, roughly equal to a year's worth of U.S. exports
of goods and services. (At the pre-hostage price, it is worth somewhat more than
$100 billion.) If we sold that gold to foreigners, it would permit larger imports or
reduced exports of other goods, raising the goods and services available at home.
By raising Treasury cash balances, it would reduce the need for tax increases or
government debt issues, increasing the resources available to the private sector.
In 1978, the Treasury auctioned about 4 million ounces of gold and another 12
million ounces in 1979. But in December of last year it quit, and recently the
Secretary of the Treasury indicated uncertainty over the renewal of the sales. No
explanation was offered except a vague reference to volatility of the market.
Public discussion has suggested that there is no need for such sales because
the dollar has been stable. This is true, for the effective rate of the dollar has
been barely changed since we last met in September. But this puts exchange rate
stability before our resource requirements, which is an odd selection of priorities.
Furthermore, the economics is fairly clear. We have a new comparative advantage:
for the first half of 1977, the price of gold was relatively stable in terms of dollars
and then, until the Fall of 1978, it rose with the dollar price of strong foreign
currencies, changing little in their terms; thereafter it achieved a life of its own,
rising in terms of both dollar and foreign currencies (except sterling). This new
comparative advantage is an opportunity to raise our gains from trade. Furthermore, an appreciation of the dollar has been seen in Washington as a restraint on
measured inflation.
1)

Curiously, Treasury sales are likely to worsen the measured U.S. trade
balance. Gold exports are included in merchandise exports only if they are
sales of non-monetary gold and the method of determining whether or not
gold is non-monetary provides no assurance that such sales will be included.
Despite this statistical fluke, gold sales improve the balance of payments and
thus strengthen the dollar which in turn is likely to weaken the measured
trade balance to the extent that it excludes the gold exports. Hence, the
surprising statement at the outset. Should Treasury expand its sales, the
proponents should not be necessarily upset if the trade balance does not
improve. For the domestic monetary effects, see St. Louis Federal Reserve
Review, January, 1975.




38

The economics of the international politics is also fairly clear (and should not
be forgotten in these difficult times)? a rising dollar adds respect to the United
States Government abroad; it opens markets to foreigners who become more
dependent upon us? it facilitates appropriations for foreign aid with which to
persuade foreign governments. When the United States ruled the world after the
Second World War, the dollar shortage was one of the reasons.
The obvious question is how much the Treasury should sell, and for this there
is no neat answer. One public view is that central bank sales would raise the price
by adding to speculative fever; if correct without limit, the Treasury should sell it
all for the value of its assets and sales would rise until it ran out. Another view
believes that the dollar price of gold might fall sharply. Obviously, a greater
supply has this effect in principle. But experience suggests that in the face of a
bull market this effect need not be great. For example, official sales from the gold
pool in 1967-1968 did not restrain prices. In 1979, the total supply of gold was
undoubtedly significantly larger than in the previous year, but the near tripling of
Treasury sales did not prevent the price from rising.
It seems difficult to reconcile the Treasury's uncertainty over selling gold
with its push for the creation of a substitution account which would permit foreign
central banks to exchange dollars for SDRs in large amounts. Gold sales would also
absorb dollars and need not wait on the outcome of extended negotiations.
Seemingly, gold sales would not enhance the role of the SDR as a reserve
settlement asset as the substitution account would. But gold sales reduce the role
of the dollar relative to SDRs to the extent that they directly or indirectly take
dollars out of the hands of central banks, and they reduce the role of gold relative
to SDRs in the international financial system to the extent bought by the private
sector. Thus, gold sales serve Treasury's larger purpose.
It is also difficult to reconcile the Treasury's apparent posture on gold sales
with its sales of U.S. Government securities to private holders abroad denominated
in foreign currencies, e.g., the two recent bond sales in the Federal Republic of
Germany. Not only do we have to pay interest to foreigners, but we take the
exchange rate risk as well. The sale of gold for Deutschemarks would avoid the
interest charge and reverse the exchange rate risk we take.
Clearly, the Treasury has a major asset which it should exploit, unless, of
course, it thinks the price of gold is going higher still.




39




Economic Projections

Jerry L. Jordan
Pittsburgh National Bank

Tables I and II show the projections for 1979 as of the September 1979
meeting and the actual resutls for 1979.
TABLE I
(percent change)
Projections for 1979 as of September 16, 1979 meeting
GNP

Output

Deflator

M1

V1

M2

V^_

MB

VB

Q4/78Q4/79

9.1

-0.3

9.4

5.1

3.8

7.6

1.4

7.2

1.8

19781979

11.0

1.8

9.1

4.8

5.9

7.3

3.5

7.9

2.9

TABLE II
(percent change)
Actual 1979 Preliminary Results
GNP

Output

Deflator

M1

V1

M2

V^

MB

VB

Q4/78Q4/79

9.9

+0.8

9.0

5.5

4.2

8.3

1.4

8.2

1.6

19781979

11.3

2.3

8.9

5.5

5.9

7.9

3.2

8.2

2.9

On an annual average basis growth of nominal income and real output were
slightly greater than expected at our last meeting while inflation was slightly less
than projected. On a fourth quarter to fourth quarter basis the actual results for
the growth of nominal income and output were even larger compared to projections




41

and the actual of the deflator was smaller than projected. This is primarily the
result of a larger increase in spending and output in the fourth quarter of last year,
as currently indicated by the preliminary data, and a smaller rise in the deflator
than had been expected. The growth of Ml, M2 and the Monetary Base were all
greater last year than was projected at the September meeting, which is also a
result of the failure of the aggregates to decelerate as much as has been expected
during the fourth quarter of last year.
In reviewing the developments for 1979, it is important to emphasize the
sharp acceleration of the growth of the monetary aggregates in the second and
third quarters of 1979 as illustrated in the tables and charts at the end of this
memo. The annual average and year-over-year growth rates shown in Tables I and
n mask the roller coaster pattern of monetary growth that occurred during the last
year. Yet these accelerations and decelerations of monetary growth do have some
impact on economic activity. At the previous meeting it was generally agreed that
the sharp acceleration of monetary growth that had occurred in the second and
third quarters could not be expected to continue. The pressures on the U.S. dollar
on foreign exchange markets and rising expectations about the trend rate of
inflation would cause the Federal Reserve to tolerate sharp increases in short-term
interest rates in order to slow the growth of bank reserves, monetary base, the
money supply and bank credit. Shortly after the last meeting the Federal Reserve
announced a program designed to strengthen the currencies on foreign markets
while also sharply restricting the growth of the monetary aggregates. The key
announcement in the Federal Reserve's new program was the deemphasis of the use
of the Federal funds rate as an operating target and the increased emphasis on
reserve aggregates, although the specific nature of the Federal Reserve policy
change could not have been anticipated. Our assumption of a shift to a more
restrictive stance by the Federal Reserve was validated shortly after our last
meeting. It was expected that at the end of 1979 housing starts would be down
about 25 percent from the end of 1979 and that new residential construction
activity would contract further during the first half of 1980. Our assumptions
about various industries and sectors such as automobiles, as well as housing and
non-residential construction, have been reinforced by subsequent events.
Table HI shows projections for 1980 as of the September meeting, and Table
IV shows current projections for 1980.




42

TABLE III
(percent changes)
Projections for 1980 as of September 16, 1979 meeting
GNP

Output

Deflator

Mi

Xi_ Mf_

V^_ MB

Q4/79Q4/80

8.0

-0.4

8.4

4.0

3.9

7.0

0.9

6.2

1.7

19791980

8.1

-0.8

8.9

4.9

3.1

7.6

0.4

6.5

1.5

VB

TABLE IV
(percent changes)
Projections for 1980 as of February 3, 1980 meeting
GNP

Output

Deflator

_ ^
M_

V^_

M^_

V2

MB

VB

Q4/79Q4/80

7.4

-1.1

8.6

4.4

2.9

7.2

0.1

6.0

1.3

19791980

7.9

-0.8

8.9

5.2

2.3

8.1

-0.2

7.3

0.6

On an annual average basis the decline of output and rise of prices is
unchanged from the earlier projections while on a fourth quarter to fourth quarter
basis a larger decline in output and a somewhat greater rise in prices is now
projected. The primary reason for this difference is the higher level of output and
somewhat lower level of the price indexes at the end of 1979 than had been
projected at the meeting last September. On balance it is not expected that the
level of economic activity nor the ongoing rate of inflation at the end of this year
will be substantially different than what was projected at our last meeting.
However, the current projections in Table IV show a somewhat greater procyclical
decline of velocity growth than had previously been assumed, coupled with
somewhat greater growth of Ml and M2 than have been projected earlier. The
growth of the monetary base continued to be very high at a 9.8 percent annual rate
in the fourth quarter of last year, while the growth rates of Ml and M2 decelerated
sharply compared with the second and third quarters. The available data on the
monetary base show a growth of only 6 percent annual rate for the first and second




43

quarters of 1979 followed by an average growth of over 10 percent in the third and
fourth quarters. The difference in the growth patterns for Ml and M2, compared to
the monetary base, may be nothing more than the reflection of differences in the
seasonal adjustment procedures used for the money supply measures and the
monetary base. The growth of the monetary base is projected to be 6 percent from
the fourth quarter of 1979 to the fourth quarter of 1980, however the year over
year percentage change will still be 7 percent in the third quarter of 1980 as a
result of the sharp acceleration in base growth in the third and fourth quarters of
1979. On an annual average basis, the projections reflect a 1 percentage point
decline in the growth of the monetary base, but very little decline in the growth
rates of Ml and a slight increase in the growth rate of M2. On a fourth quarter to
fourth quarter basis the growth rates of Ml and M2 decelerate by 1 percentage
point, while the growth rate of the monetary base declines by 2 percentage points.
Most of the decline of real output in the economy is expected to occur during the
first half of 1980 and it is expected that the level of economic activity in the
fourth quarter of this year wiL be below the level at the end of 1979, although it
will be beginning to improve somewhat. The rate of inflation, as measured by the
GNP price deflator, is expected to be somewhat higher in the first half of 1980
than in the second half of 1979, and then decelerate to about an 8 percent annual
rate in the second half of this year. The unemployment rate is expected to rise
about 2 full percentage points by year-end and would continue to rise somewhat
further during the first half of 1981. It is expected that most regions and sectors
of the economy will be effected by the decline of economic activity and no explicit
assumptions have been made for 1980 as a result of the prospects for increased
expenditures by the government for military purposes. It is assumed that other
than increased outlays for research and development, and some shorting of delivery
schedules of previously ordered defense goods, there will be little effect on
aggregate economic activity during this calendar year.




44

Two-Quarter Compounded Annual Rates of Change

Ml

M2

Monetary
Base

Q2/73-Q4/73

5.4

8.6

7.4

Q3/73-Q1/74

6.5

10.0

8.1

Q4/73-Q2/74

5.9

8.9

9.5

Q1/74-Q3/74

4.1

6.7

8.8

Q2/74-Q4/74

4.3

6.5

8.5

Q3/74-Q1/75

3.3

6.7

7.7

Q4/74-Q2/75

4.0

8.2

7.1

Q1/75-Q3/75

6.7

10.1

8.3

Q2/75-Q4/75

5.2

8.7

8.2

Q3/75-Q1/76

3.8

8.9

7.8

Q4/75-Q2/76

5.6

10.6

9.2

Q1/76-Q3/76

5.4

9.7

8.7

Q2/76-Q4/76

5.9

11.1

7.7

Q3/76-Q1/77

7.6

12.3

7.9

Q4/76-Q2/77

7.6

10.4

8.1

Q1/77-Q3/77

8.3

9.9

9.2

Q2/77-Q4/77

8.2

9.3

9.5

Q3/77-Q1/78

7.2

7.7

9.8

Q4/77-Q2/78

8.2

7.9

.9.3

Q1/78-Q3/78

8.8

9.4

9.0

Q2/78-Q4/78

6.2

9.0

9.9

Q3/78-Q1/79

1.5

5.8

7.9

Q4/78-Q2/79

3.4

5.9

6.0

Q1/79-Q3/79

9.2

10.8

8.4

Q2/79-Q4/79

7.6

10.8

10.4

Q3/79-Q1/80

4.1*

7.6*

7.9*

Q4/79-Q2/80

3.7*

6.5*

6.0*

*Projected by Pittsburgh National Bank




45

Money Growth Rates
(% Change from Previous Year)

From:

To:

Ml

M2

Monetary
Base

1972/Q4

1973/Q4

6.2

8.8

8.1

1973/Q1

1974/Q1

5.9

9.0

8.1

Q2

Q2

5.6

8.8

8.4

Q3

Q3

5.3

8.3

8.4

Q4

Q4

5.1

7.7

9.0

1974/Q1

1975/Q1

3.7

6.7

8.2

Q2

Q2

4.2

7.3

7.8

Q3

Q3

5.0

8.4

8.0

Q4

Q4

4.6

8.4

7.6

1975/Q1

1976/Q1

5.3

9.5

8.0

Q2

Q2

5.4

9.6

8.7

Q3

Q3

4.6

9.3

8.3

Q4

Q4

5.8

10.9

8.4

1976/Q1

1977/Q1

6.5

11.0

8.3

Q2

Q2

6.8

10.8

7.9

Q3

Q3

8.0

11.1

8.5

Q4

Q4

7.9

9.8

8.8

1977/Q1

1978/Q1

7.7

8.8

9.5

Q2

Q2

8.2

8.6

9.4

Q3

Q3

8.0

8.5

9.4

Q4

Q4

7.2

8.7

9.6

1978/Q1

1979/Q1

5.1

7.6

8.4

Q2

Q2

4.8

7.7

7.9

Q3

Q3

5.3

8.2

8.2

1978/Q4

1979/Q4

5.5

8.3

8.2




46

TRENDS AND FLUCTUATIONS OF MONEY GROWTH

1957

1957

1959

1959

1961

1963

1965

1967

1969

1961

1963

1965

1967

1969

1971

1971

1973

1975

1973

1975

1977

1977

1979

1979

The shaded areas represent periods of business recessions as defined by the National Bureau of Economic Research.

Latest data plotted:

4th Quarter

1. Short-Run: Two-quarter rates of change.
2. Trend: Twenty-quarter rates of change.

' P r o j e c t e d by P i t t s b u r g h N a t i o n a l Bank



47

PITTSBURGH NRTiONRL BONK

Money Stock
Ratio Scale
Billions of Dollars
1000

Ratio Scale
Billions of Dollars
100C
'95C

Monthly Averages of Daily Figures
Seasonally Adjusted

90C
85C
80C

640
,59C
54C

42C

37C

32C

27C

J

1972 '

1973

1974

1975

1976

Percentages are annual rates of change for periods indicated.
Latest date plotted: December



48

1977'

w

1978

1979

.PITTSBURGH NOTIONAL BRNtt

22C

Moneta_ryjga_se and Fed.Jffeserve Creu*j
Monthly Averages of Daily Figures

Ratio Scale ,
Billions of Dollars

_

_

§gQg0j^yjy

. Ratio Scale,
Billions of Dollars
n 160

^j,jstecj

s
,

+8.2% y
—

•

150

v

'

140

"i

•^9.4% /

J<^
+

9-A%/

130
v

120
/S^^tir

+8J%

.Monetary Base

•

^-kt/jf

y
^r

110

y/f^

1

+8.2%

S

1 f
f
y ^ \ / ^

^

100
+8.6%

Ay

y / . j r

\

XJ0^

.

i

/ r
+8.9%

j^
yH>^

-

f e d . Reserve Credit

90

i

/ j r

i

80

1

-

J
1972

1973

1974

t
1975

'qtr.

2nd

A

to

1st qtr.

%

I

cr

1st' qtr.

*i
2nd

70

\

1976

•4r

A

f

1977

1978

1979

1. Uses of the monetary base are member bank reserves and currency held by the public and nonmember banks.
Adjustments are made for reserve requirement changes and shifts in deposits among classes of banks.
Latest data plotted:




December
1

49

^9jf
,f

' PITTSBURG NtfrtOHAL t3RNK
-

60

8

Trends and. Fluctuations of .Money,_ Prtos^jOutput, and Unemployment.

1956 '

' 1958

1860 '

1982

J968

1084

1988

1970

''?72

1974

197J

197?.

General Price Index
Twenty-Quarter Rates of Change
R

1t

li 1
'II

>w
—ll 1
I'.

1

fi

h-l

!

P'

!!

1

1

r*^

. <S* S

-

1 ' 1 ^

'

i
III" ' J l

inliiiiii
yuiniij

III!

fi'iiiii

ill *«r

1

2l

i

f

flUINl

;l

'I 1

i
,

' !i

i1

!',

i

1 w

i

!n,ii:!!ti

1

i ,

1

Real Output
Two-Quarter Rates of Change
\<L

1

1\

y\

L 'ii"'

1 VIV

"•

1

\,

0

j:

y |„

|"f

hj

-4

i

i

/ \ '

f

J

1

*l

i

!

!|,
li

IJI'
i P"

'i

i

k
i'

1

i
\

'i

I

i

¥

i\

i

i

;

«

i

'

i
M
,

> If

j

ill

I!

!

12

f

1

j

j

Ii' l'
*

ii,

i ;
\''

iii

if j
III''

iji'i1

|..

.:'
'i t"""l T'

M

i

-8

i 1
A / \ !:
j

1
iii i ' -

i|j

'

i

I, „

J

f \ R' 'I

J

1

il

A

_8.
4

r

' ™ "!
1

r"! - i *H

I

Employment & Unemployment Rates

1956

1958

1960

1962

1964

1966

1988

1970

1972

1974

1976

1978

The shaded areas represent periods of business recessions as defined by the National Bureau of Economic Research.
Latest data plotted: i 4 t h



Quarter

""3~

50

PITTSBURGH NATIONAL BRNK

Selected Interest Rates
Rati© Scale
of Yields

1964
'

Ratio ScSIe
of Yields
15

Monthly Averages of Daily Figures

1965

Latest data p l o t t e d :




1966

1967

December

1968

1969

1970

1971

1972

1973

1974

1975

T

1976

1977

1978 . 1979

PITTSBURGH NRTIONRL BANK

Inflation and Interest Rates
Percent

;f%rcent

1964

1965

1966

1967

1968

1969

1970

1971

1972

1973

1974

1975

1976

1977

1978

1979

1. Rate of change of Consumer Price Index over five-year periods.
CPI for 1974 was adjusted for estimated effect of the oil price increase.
Latest date plotted:



Aaa-

Deceraber

^5r

PITTSBURGH N^TIONHL BFSNK'

Inflation and Short-Term interest Rates

1972

1973

1974

1975

1976

1977

1978

1979 '

1. Yields on 4- to 6-Month Prime Commercial Paper.
2. Rates of change in Consumer Prices over the previous six months.
Latest date plotted: CP Rate- December
——
InflationDecember




WOMBS'

53

PITTSBURGH NOTIONAL BRNK




Shadow Open Market Committee
Beryl W. Sprinkel
Harris Trust and Savings Bank

Economic Outlook
(Annual Rates of Change)

79:4 A

80:1

80:2

80:3

Quarters
80:4

81:1

81:2

81:3

81:4

79

80

81

2455.8
10.3

2508.2
8.8

2550.6
6.9

2589.2
6.2

2628.4
6.2

2677.3
7.7

2736.8
9.2

2798.4
9.3

2860.4
9.2

2368.6
11.3

2569.1
8.5

2768.2
7.7

Constant Dollar GNP (72$) 1438.4
%Change
1.4

1437.7
-0.2

1430.1
-2.1

1421.4
-2.4

1413.9
-2.1

1412.1
-0.5

1416.0
1.1

1420.6
1.3

1425.9
1.5

1431.2
2.3

1425.8
-0.4

1418.7
-0.5

Price Deflator
% Change

1.7074
8.7

1.7446
9.0

1.7835
9.2

1.8216
8.8

1.8590
8.5

1.8960
8.2

1.9328
8.0

1.9699
7.9

2.006
7.5

1.6549
8.9

1.8022
8.9

1.9512
8.3

CPI-A11 Urban
% Change

2.277
13.2

2.345
12.5

2.407
11.0

2.462
9.5

2.516
9.1

2.568
8.5

2.619
8.2

2.670
8.0

2.721
7.9

2.175
11.3

2.433
11.9

2.645
8.7

5.9

6.1

6.6

7.1

7.5

8.0

8.3

8.6

8.9

5.8

6.8

8.5

Money
% Change

380.9
5.2

384.6
4.0

387.9
3.5

391.7
4.0

397.0
5.5

402.8
6.0

408.7
6.0

413.7
5.0

418.8
5.0

371.0
5.2

390.3
5.2

411.0
5.3

Money-2
% Change

948.1
9.2

963.1
6.5

977.2
6.0

992.7
6.5

1012.0
8.0

1032.9
8.5

1054.2
8.5

1073.4
7.5

1093.0
7.5

914.4
8.0

986.3
7.9

1063.4
7.8

Gross National Product
% Change

Unemployment Rate (%)

Actual




Yams

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