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SHADOW OPEN MARKET COMMITTEE
Policy Statement and Position Papers

September 13-14, 1981

PPS-81-8

Graduate School of Management
University of Rochester

SHADOW OPEN MARKET COMMITTEE
Policy Statement and Position Papers

September 13-14, 1981

PPS-81-8

Shadow Open Market Committee Members - September 1981
SOMC Policy Statement, September 14, 1981
Position Papers prepared for the September 1981 meeting:
TRANSITION TO A NEW REGIME - Karl Brunner, University of Rochester
FISCAL POLICY OUTLOOK; A REPORT TO THE SHADOW OPEN MARKET COMMITTEE - Rudolph G. Penner, American Enterprise Institute
RISK and FEDERAL RESERVE ACTION AND MONETARY GROWTH - H. Erich
Heinemann, Morgan Stanley & Co., Incorporated
FORECASTING MULTIPLIERS FOR THE "NEW-NEW" MONETARY AGGREGATES James M. Johannes and Robert H. Rasche, Michigan State University
FEDERAL BUDGET OUTLOOK and ECONOMIC PROSPECTS THROUGH 1982 Robert R. Davis and Robert J. Genetski, Harris Trust and Savings Bank
ECONOMIC PROJECTIONS - Burton Zwick, Prudential Insurance Company of America




SHADOW OPEN MARKET COMMITTEE
The Committee met from 2;00 p.m. to 8:00 p.m. on Sunday, September 13, 1981.
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.
DR. ROBERT J. GENETSKI, Vice President and Chief Economist, Harris Trust and Savings
Bank, Chicago, Illinois.
MR. H. ERICH HEINEMANN, Vice President, Morgan Stanley & Co., Incorporated, 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. RUDOLPH G. PENNER, American Enterprise Institute, Washington, D.C.
PROFESSOR ROBERT H. RASCHE, Department of Economics, Michigan State University,
East Lansing, Michigan.
DR. ANNA J. SCHWARTZ, National Bureau of Economic Research, New York, New York.
DR. BURTON ZWICK, Vice President, Economic Research, Prudential Insurance Company of
America, Newark, New Jersey.

The Committee notes with great sadness the death in a tragic accident of its former
member, PROFESSOR WILSON SCHMIDT of the Virginia Polytechnic Institute. At the time
of his death. Professor Schmidt was on leave of absence, pending his appointment by
President Reagan as United States Executive Director of the International Bank for
Reconstruction and Development. Wil was a fine economist and a good friend. We shall
miss him.




POLICY STATEMENT
Shadow Open Market Committee
September 14, 1981

Economic policies do not work instantly. Reductions in the growth of government
spending that shift resources to more efficient uses do not immediately trigger equal or
greater increases in private spending. Tax cuts that encourage saving and effort do not
generate instant responses. Reductions of monetary growth do not instantly reduce
inflation. All these policies have their expected lasting effects only if people believe the
policies will remain in effect.
An immediate problem the administration faces is to enhance the credibility of its
commitment to its economic program. This cannot be done by the quick fixes suggested
recently. Credibility can be enhanced only by making the administration's and the Federal
Reserve's commitment firmer. Greater certainty about the continuation of these policies is
more likely to lower nominal interest rates than reinstitution of credit controls, ceilings on
interest rates, and similar discredited remedies. Other options, which hold far greater
promise, are suggested in this statement.
For many years, this Committee has advocated policies similar to those that have now
been adopted. We said that, if the size of the government were reduced, sustained higher
productivity growth, increased employment, and lower inflation would follow within two
years. We have emphasized that a more rapid response could be achieved only if the policies
remained credible and commitment to the policies were sustained through the difficult
months following their adoption.
The policies we have advocated are now in place. Currently, the most reliable
indicators of money growth are substantially below their past peak rates of increase. The
growth of government spending is slower, and tax rates will be lower.
A widespread belief persists that the administration and the Federal Reserve will not
sustain these policies. Projected growth rates of defense spending, Social Security outlays
and Medicare costs appear to many observers to be incompatible with the projected real
growth of the economy at lower rates of inflation. The conflict between the budget and the
economic forecasts has stimulated daily discussion about the prospects for a budget deficit
instead of a small surplus in 1984. Cries of failure are rising.




Intense concentration on a particular value of the budget surplus or deficit for 1984
misplaces attention. We wrote in our March statement:
"Doubts about the size of the deficit will not be removed even if Congress
approves the entire program. The administration's forecast of the growth of
nominal income for 1982-1986 appears to us inconsistent with its assumptions
about monetary and fiscal policies and the historical record of performance of
the American economy. The estimates of real growth are more optimistic and
estimates of the slowing of inflation more pessimistic than we believe the
administration's policies will achieve."
There is a growing conflict between the policies pursued and the forecasts of their
effects. The problem is that presently no one knows which course the administration will
follow. The conflict heightens current uncertainty and sustains those who believe that the
lower rates of inflation we now observe are a temporary pause in the long uptrend.
TWO OPTIONS
The members of the administration have two options. They can choose to realize their
budget forecasts for 1983 and 1984 by inflating the economy in line with their forecasts of
nominal income growth. Or, they can continue present policies. This option requires
additional spending cuts to achieve a falling share of government.
The first option is to maintain the current forecasts — that the average growth of
nominal and real GNP remain at 12 percent and 4.5 percent, respectively, for the next three
years. This forecast of real growth is well above the historical average achieved by the U.S.
economy, and the projected nominal growth is inconsistent with a continued and sustained
decline in the rate of inflation. The projected rate of nominal income growth cannot be
achieved with the monetary policies that the President, leading members of his
administration — and we — have urged the Federal Reserve to follow. The forecasts fail to
recognize the considerable progress toward lower inflation that has been achieved this year.
Under the second option, the administration can reduce the burden of regulation and
the growth of government spending to stimulate real growth while supporting the Federal
Reserve's announced policies of sustained, gradual reduction of money growth. This option
discards the administration's February and July forecasts and thereby reduces uncertainty
about the administration's intentions as to future policy.
We prefer option two. A substantial reduction in the measured rate of inflation has
been made. The reduction in inflation lowers the nominal growth of GNP and increases the
size of the deficit. This result should not be scorned but should be followed by further




2

reductions in spending. The additional reductions in spending should be made to enhance
efficiency — not solely for the purpose of achieving a particular value for the budget surplus
or deficit on a given date. We believe that more efficient use of resources, including
resources devoted to defense, can be achieved by shifting resources from public to private
hands.
ENHANCING CREDIBILITY
Years of failed promises have engendered skepticism about the durability of current
policies. Skepticism is the principal reason that financial markets continue in disarray and
interest rates, after adjustment for current inflation, remain at extraordinary levels.
Decisive actions are required now to deal with the dilemma.
In addition to consideration now being given to the restoration of some type of
commodity standard for money, government should consider one or more of the following
actions;
(1)
(2)
(3)
(4)
(5)

legislative limits for monetary expansion;
a requirement that Federal Reserve governors offer their resignations if
monetary targets are not achieved within reasonable tolerances;
endorsement of a constitutional limit on the size and growth of government;
budgetary projections constrained by historical experience of the economy,
instead of political fancy;
flexibility in Treasury debt management techniques perhaps including:
(a) the issue of inflation-indexed bonds and advance refunding of existing
long-term debt into the indexed bonds;
(b) greater use of call provisions;
(c) less reliance on the sale of long-term debt;
(d) publication of a long-term Treasury financing calendar;

(6)
(7)

removal of all limits on the payment of interest on financial assets;
adoption of a simple and uniform system of reserve requirements applicable
to all competing financial institutions; and

(8)

immediate outright repeal of the Credit Control Act of 1969.
BUDGET POLICY

The administration has made substantial progress toward a more effective fiscal policy
by reducing the growth of government spending and by reducing tax rates. The reductions
were offered as first steps toward a long-term solution of neglected economic problems.




3

Yet, within a few weeks of Congressional passage of the budget resolution, and before the
program is to take effect, it has frequently and incorrectly been described as a failure.
The administration should not allow current, excessive emphasis on the size of the
deficit, temporary changes in stock prices, or forecasts of the future deficit to dominate
current concerns or obscure the goals of economic policy. A balanced budget in 1984«is not
a goal of policy — and should not be made a goal of policy. A balanced budget should be
achieved in 1984 only, if at all, by following policies that lead to accepted goals of more
employment, less inflation, higher productivity growth, and greater freedom and efficiency.
Budget reductions should be made in any category of spending that permits the administration's defense and nondefense programs to be achieved in ways that are consistent with
these long-term goals. The administration's July projections show an increase of $118-billion
in defense outlays, a rise of 17 percent a year from 1980 to 1984. It seems likely that a
more efficient use of resources can be achieved at a slower rate of increase.
The administration should make clear that a budget deficit resulting from slower
inflation is preferred to a budget that is balanced by high or rising inflation. The recent
experience of Japan shows that deficits do not prevent the central bank from controlling
money growth and reducing inflation. However, reduced inflation lowers tax receipts and so
prevents the deficit from falling as a percentage of GNP. In Japan, deficits as a fraction of
GNP are about twice U.S. deficits. Nevertheless, money growth has been lowered from
more than 12 percent in 1978 to minus 2 percent in 1980. Inflation has been reduced as the
economy has expanded.
Inflation is caused by excessive monetary expansion, not by Federal deficits p_er se. So
long as the Federal Reserve conducts its operations to achieve noninflationary rates of
monetary growth — and does not set targets for interest rates — Federal deficits will not
cause inflation.
MONETARY POLICY
The Federal Reserve repeats frequently that it is committed to sustained gradual
reductions of money growth, the policies we have advocated. In its recent statement, the
Federal Open Market Committee (FOMC) indicated a preference for growth of M-1B —
currency and checkable deposits — in the range of 6 percent to 8 1/2 percent from fourth
quarter 1980 to fourth quarter 1981 and a further reduction to the range of 2 1/2 percent to
5 1/2 percent in the following four quarters. These targets would permit M-1B to average




4

more than $450-billion in the fourth quarter of 1981 and make $463-biUion the midpoint of
the range reached by the fourth quarter of 1982.
The FOMC's proposed rate of monetary growth for the remaining months of 1981 would
reaccelerate money growth. This would be undesirable. Progress in reducing money growth
this year has made the Federal Reserve's current targets too high.
For 1982, we urge the Federal Reserve to increase the monetary base, as reported by
the Federal Reserve Bank of St. Louis, by no more than 5 percent. Our targets bring the
level of the monetary base to $171-billion in fourth quarter 1981 and $180-billion in fourth
quarter 1982.
PROGRESS AGAINST INFLATION
Greater progress has been made toward price stability than we, or others, anticipated
six months ago. The lower-than-anticipated rate of inflation reported for 1981 means that
growth of nominal GNP is lower than anticipated because inflation is lower.
The
unemployment rate is now lower than at the start of the year, and a larger fraction of the
population is employed. To date, the costs of disinflation have been much lower than anyone
anticipated.
Slower inflation in 1981 is a response to firmer and better policies. Decontrol of oil
prices, the decision to allow the exchange rate to appreciate without intervention, and
tighter monetary policies have helped to lower the measured rate of inflation this year.
These gains must not be thrown away.
The cost of ending inflation can be reduced dramatically if the public becomes
convinced that inflation has fallen and will continue to fall. Anticipation of slower inflation
means that real wage demands can be achieved with smaller increases in current wages. So
far this year, the rate of increase of hourly earnings has generally fallen from late 1980.
Simultaneous reductions in rates of change of wages, as well as other costs and prices, lower
the costs we pay to reduce inflation.
No country can costlessly end fifteen years of inflation and low productivity growth.
What is needed now is a strong commitment to continue and strengthen the policies to which
the administration is pledged. The administration should not back away from policies that
are working better than anyone anticipated. The costs we are experiencing now are
transitory. The benefits of persistence will be permanent.




5




TRANSITION TO A NEW REGIME
Karl Brunner
University of Rochester

I
.

THE LEGACY AND THE REAGAN PROGRAM

Erratic stagnation, inflation and volatile interest rates characterize the recent state
of the US economy. This state is neither preordained nor the random product of a
mysterious stochastic process unfolding over history. It was conditioned to a major extent
by the pattern of policies, and administrative and court decisions evolving over the past
twenty years. A reversal of the trend experienced during the last decade requires under the
circumstances a radical ehange in basic policy conceptions and the nature of policymaking.
The Reagan Administration's program. offers a new direction with a different thrust.
Its objectives are clear enough and well known. Inflation should be lowered with the
expectation of eventually achieving a stable price level. Normal output and the rate of
growth need both be raised. The strategy addressed to the pursuit of these objectives has
also been well presented to the public. Monetary policy need be adjusted to a systematic
control over monetary growth. This control should moreover be used to produce a precommitted and publicly announced decline in monetary growth. The reliable and recognized
performance of this new approach in monetary policy is also expected to lower the level and
volatility of interest rates. Stimulation of output and growth is expected to result on the
other hand from a "lower level of government". Lowering the level of government involves
two dimensions: it bears on the execution of budget powers and the application of police
powers.
A reduction of marginal tax rates with a corresponding containment and
restructuring of expenditure programs raises the incentives to work, save and invest. The
redirection in fiscal policy should also eliminate over four years the entrenched budget
deficit. The stimulation of output and growth requires however more than a new approach
to the use of budgetary powers. An overregulated economy impairs the efficient use of our
resources and obstructs innovative developments of new resources. A new approach will also
be required in our regulatory policies. This redirection ought to attend with greater care
and explicit awareness to the social costs (i.e. the human values forfeited) by any kind of
existing or intended regulatory activity.




7

H.

SOUND AND CONFUSION OF A TRANSITION PERIOD: MONETARY POLICY

A familiarity with objectives and general strategy seems hardly sufficient to assure a
smooth transition to a new regime characterized by a new policy conception and a different
pattern of policymaking. The erratic behavior of our financial markets, so generally
commented upon, dramatically reveals the difficult problems encountered over the
transition period produced by a radical change in policy conceptions. The tactical execution
of the general strategy unavoidably produces in the context of the inherited problems diffuse
uncertainties and shifting apprehensions. The "sound and confusion" produced by the
markets' efforts to absorb the new information becomes amplified by the media process.
Changing uncertainties about the detail of the tactical course or about its path over time,
anxieties about the reliability and commitment to the strategy, or an unstable spectrum of
apprehensive and confused interpretations of current events and conditions affect all
markets, but most visibly the financial markets.
Much of the "sound and confusion" reflects a sense of disorientation and doubtful
reservations. Some of this disorientation expresses persistent ignorance, confusion or uncertainty bearing on monetary matters. The market for words and interpretations abounds with
assertions that we hardly know what money is, or that for one or the other reason it is really
impossible to control its magnitude or rate of growth within any useful tolerance band. Both
groups of claims possess however no relevant foundation or justification. The first group
frequently confuses the definition of money in terms of its crucial behavior characteristics
(generally used means of making payment, i.e. comprising any object used with dominant
frequency as a means of settling transactions) with the specification and procedures required
for its adequate measurement. The behavior of peasants, retailers, workers and of most any
other agents unmistakeably reveals that they do systematically distinguish between "money"
and "non-money credit", or between money and bonds or many other assets. The agents' skill
at differentiation between market objects with distinctive characteristics does not resolve
however the measurement problem. Attention to this problem forms an essential strand of
the responsibility assigned to monetary authorities. The Federal Reserve Authorities
increasingly recognized this obligation in recent years. The specification and procedures
have been repeatedly adjusted to represent the innovations produced by the financial
markets. There still remain some problems requiring future attention. But the emergence
of major problems would be signalled by significant breaks in the behavior pattern of the
respective monetary velocity as expressed by trend and variance around trend (or .more




8

generally by the nature of its time series structure). We may note that no significant breaks
in the patterns have been observed so far. The controllability of monetary growth seems
sufficiently assured in this context relative to the magnitude of the problem to be addressed.
The other denials of effective monetary control made in the public arena fare no
better. Their suppliers hardly ever appear to know the accumulated scholarly work
analyzing the structure of the money supply process and the major determinants of observed
money stock behavior. The denials involve usually no more than sweeping impressions
unsupported by any analysis or evidence. The reader may examine in contrast the empirical
investigations prepared over the past three years on behalf of the SOMC by James Johannes
and Robert Rasche. We also note that the examination of the control problem prepared by
the staff of the Board of Governors essentially confirms the contention advanced over many
years by the SOMC in this matter.
Controllability does not assure its exercise by the authorities. Some Central Banks,
fully recognize the technical feasibility of monetary control but find it politically difficult,
for some reason, to pursue such control. The behavior of financial markets suggests that
this political question probably governs the erratic skepticism expressed by agents on the
market place. The behavior of the Fed still encourages doubts about its commitment to a
longer-run anti-inflationary monetary policy. This doubt is nurtured by a tactical procedure
and by arrangements under the control of the Fed lowering the reliable delivery of an
effective monetary control strategy. These reservations are reenforeed by apparently
conflicting statements made by various officials over the past two years. Ultimately, there
is only one solution to this problem; the Fed needs to institutionalize more definitely its
acknowledged strategy of monetary control. In particular, the doubts and reservations
addressed to the Fed will vanish with the increasing length of time that the Fed adheres to
an effective anti-inflationary commitment of monetary control.
HI.

SOUND AND CONFUSION OF A TRANSITION PERIOD: FISCAL POLICY

The behavior of the financial markets and the related discussions in the public arena
directs our attention however beyond the Fed and the immediate prospects of monetary
policy. Doubts and apprehension about the course of the Federal budget and budgetary
policies appear to dominate the market's erratic drift at the high level of interest rates.
The current phase emerged in a difficult transition to a state with a lower real magnitude of
a balanced budget (relative to national income).
These objectives of the Reagan




9

Administration are not ends in themselves. They are designed to shift resources from the
public to the private sector and encourage a more efficient use. They will also lower
consumption and encourage private investment in productive capital. This change in the use
of our resources with the resulting effects on normal output and normal rate of growth
essentially determines the Reagan Administration's fiscal strategy. But the strategy
requires some tactical procedures and the tactical aspects with their public discussion seem
to have obscured the ultimate strategy and its purpose in the public arena. The "supply side
story" dramatized by the media market contributed most particularly to general confusions
ana irrelevant expectations. It concentrated public attention on tax policies and neglected
expenditure policies. It conveyed thus a false sense about the real tax burden imposed by
government. It also neglected the consequences of a persistent large deficit, or promised
miraculous effects on output growth to be expected just only from lowered marginal income
tax rates.
IV.

ALTERNATIVE TACTICAL PROCEDURES OF FISCAL ADJUSTMENTS

The hesitations and reservations were reenforced by the disjointed set of forecasts
published by the Reagan Administration earlier this year. This incoherence between the
forecasts for output, price-level and the monetary evolution was explicitly noted at the
occasion of the meeting held by the SOMC last March. The Shadow decided at the time to
disregard this set of essentially irrelevant data and invited all interested parties to direct
their attention to the program itself and its consequences. The irreconcilable forecast
patterns supplied by the Administration appeared to emerge from a compromise between
two alternative tactical conceptions submitted to the Reagan Administration's attention.
One conception argued that nominal gross national pruduct shoulc continue to grow for
this and (at least?) the next year at a rate well beyond 10 percent p.a. The rate should be
sufficiently high in order to prevent recessionary effects imposed by a restrictive monetarypolicy. A figure of 13 percent p.a. was mentioned in this context. Monetary policy need be
geared to accommodate this target. Substantial tax reductions would stimulate a large
increase in real growth according to the supply side story. Output experiences under the
circumstances an unobstructed opportunity to grow into the range provided by the nominal
expansion assured by an accommodating monetary policy. The accelerated rise in output is
expected moreover to depress the inflation rate point for point. This strategy would also
assure that the "supply side policies" can be executed without endangering the goal of a
balanced budget.




10

The alternative conception emphasizes a simultaneous attack on tax rates ana
expenditure programs combined with an anti-inflationary monetary policy systematically
lowering monetary growth over four years. This proposal recognizes that it probably
involves a recession. The magnitude and duration of this recession is essentially determined
by the degree of credibility attributed by the market at this stage to the policymakers. A
larger degree of credibility induces more rapid revisions of price-wage setting in response to
the announced anti-inflationary policy.
And a more rapid revision lowers both the
magnitude and duration of the temporary retardation of output and employment. Whatever
the retardation may be, it does not obstruct the gradual emergence of the longer-term
supply side responses induced by the reversal in fiscal and regulatory policies. An imbalance
of the budget could persist however for some time under the second approach. Its magnitude
and duration depends on the recession and the nature of the revision procedure in fiscal
policy. A larger recession combined with a concentration of political effort on taxreductions could create for some time a substantial deficit. This result does not endanger
the eventually dominating effect of a maintained anti-inflationary monetary policy.
The first procedure essentially assures approximate balance in the budget by
suspending or postponing for years any serious anti-inflationary policy. Budget balance is
achieved by offsetting the nominal reduction in tax rates with the inflation induced "bracket
creep". But this implies that the reduction in nominal tax rates would not produce a
corresponding real rate reduction. The intended incentives ano the corresponding stimulus
would hardly materialize under the circumstances. The prevalent skepticism expressed by
the behavior of credit markets with respect to the future course of monetary policy would
moreover be substantially confirmed by this approach. Interest rates would continue in this
case to move erratically for a long time along a high level.
The Administration may have settled for some compromise of the alternative
proposals. It certainly determined quite early in its operation to work with the Federal
Reserve Authorities in order to develop an anti-inflationary course of monetary policy. The
required retardation of monetary growth is well under way at this stage. It has also
managed successfully the major tax reductions bearing on personal income and business
investments of various kinds. The approach to the expenditure side has been substantially
less sweeping though certainly commendable. This compromise may well have been
unavoidable under the circumstances. It would appear very difficult, if not politically
impossible, to launch a total revision of the budget all at once in one single package. But




11

the compromise produces its own problems which the Administration needs to consider. It
yields in particular a large deficit encouraging a variety of fears about the future course of
our financial policies. Some of these fears are poorly founded and somewhat exaggerated.
But the fears do include a relevant core. Without a determined effort to contain the
expenditure programs we will experience either a reversal of monetary policy or a
"crowding-out" of the private sector from the capital market of major magnitude. The
objectives of the Reagan Administration are best servea under the circumstances by
maintaining the anti-inflationary stance in monetary policy and forcefully addressing the
expenditure side of the budget. This need not involve a "social dismantling", but does
require a resourceful reexamination of the social programs and eventually a substantial
restructuring of their operation.
V.

THE CHOICE OF A MONETARY STANDARD

A Presidential Commission was appointed earlier this year in order to appraise the
merits of a gold standard. The advocates of a gold standard argued their case over recent
years with an increasing intensity. Their program frequently combined the Kemp-Roth
fiscal strategy with a return to the gold standard. This program was motivated by the
erratic social cost increasingly imposed by the government's fiscal and monetary policy. The
Great Depression of the 1930's and the permanent inflation generated over the past 16 years
by our monetary authorities reveal a fundamental flaw in our monetary arrangements.
These major social failures of our policy agency were not prevented under the existing
institution of an "independent Central Bank". This institution emerged in response to
pervasive experiences with the political misuse of the Central Banks' money creating
potential. Central Banks offer opportunities to finance expenditures in circumvention of
parliamentary revenue approvals. An independent monetary authority separated from the
government's fiscal operation was supposed to pursue policies in the best long-run interest of
the nation. This independence provided however little guidance to the Central Bank. It
failed moreover to constrain an extended political interaction between an "independent
monetary agency" and a broader political market place. "Independence" could ultimately not
separate a Central Bank from some political interaction so long as the policy agency was
assured any range of discretionary action. It only modified the nature of the political
interaction.




12

The lessons from past centuries combined with the social failures in our monetary
policymaking in this century direct our attention once again to the social role of a monetary
standard. The Shadow Open Market Committee should thus acknowledge the importance of
such reexamination. It would seem useful at this stage to clarify first the social role of a
monetary standard and secondly to evaluate the performance of alternative standards in the
contexts of the pattern of underlying shocks typically affecting our economic life.
A standard constrains the "double temptation" encountered by a monetary agency in
the political process. It obstructs the exploitation of money creating potential by the
government for convenient financing of its expenditures. It also constrains on the other side
the "discretionary exploitation" of its powers by the monetary agency. This second
constraint appears at this stage at least as important as the first bearing on the fiscal
temptation of government. The social failures of our century remind us that we can hardly
expect a policy institution to behave in accordance with our favored social welfare function.
The choice between alternative standards should of course rely on a systematic assessment of their respective performance characteristics. Such assessment may increasingly
attract the profession's interest in the near future. This interest would certainly be
welcomed by the Shadow Open Market Committee. A rough eomparision between three
standards is outlined for our purposes at this stage. This sketch should really be understood
in the nature of a research program. A fixed exchange rate standard (CEX) is juxtaposed to
a constant monetary growth standard (CMG) and a domestic commodity reserve standard.
The gold standard may appear in this context as a particularly important form of the first
and the third standard, depending on whether the gold standard is an international or an
isolated national arrangement.
The various standards differ most particularly in terms of their respective risk
combinations and the determinacy of the long-run price-level. Under a CMG standard the
generally perceived strategy prevents the emergence of fluctuations in real variables due to
misperceived monetary shocks. This statement holds irrespective of short run deviations of
monetary growth from target path, provided the general public firmly expects the long-run
maintenance of the CMG standard. This standard involves on the other side the risk of
fluctuations in real exchange rates with corresponding effects on domestic economic
conditions. The CEX standard lowers the risk of real exchange rate movements with their
specific real consequences. It accepts in contrast a large risk of substantial variations in
misperceived or unanticipated short-run monetary growth inducing fluctuations in output,




13

employment and the price-level. Under a CMG standard foreign real shocks will be absorbed
by the exchange rate. The same real (and nominal) foreign shocks will be converted under a
CEX standard into accelerations (and decelerations) of the domestic money stock. It follows
under the circumstances that fluctuations in output and employment proceeding in the
context of the CMG standard essentially result from domestic real shocks, not amplifiea by
monetary responses, and adjustments in the allocation of resources imposed by variations in
the real exchange rates induced by foreign shocks. Under the CEX standard, variations in
output and employment are produced by domestic real shocks and the accelerations of
monetary growth, yielding misperceived or unanticipated components of the monetary
evolution, attributable to foreign nominal and real shocks.
Another major difference between the two standards should be noted. The CEX
standard provides no anchor for the price level. Its rules impose a constraint on the inflation
rates within the system but not on the system's price level. The inflation rates may deviate
over time only in response to the operation of real shocks modifying the real rates of
exchange within the CEX system. The CMG standard on the other hand can be explicitly
designed to stabilize the price-level. This opportunity to anchor the price-level, built into
the CMG standard, can be used to determine the benchmark level of monetary growth
characterizing the standard. We note lastly that the CMG standard is not incompatible with
the persistence of pegged exchange rates over wider areas. The reliable adherence to a
CMG standard by a "Central economy", e.g. the USA, offers strong inducements to other
countries to peg their currencies to the US dollar. An implicit division of responsibilities
will spontaneously emerge under the circumstances. The "central economy" assumes
responsibility for a non-inflationary monetary growth and the "participating nations" accept
responsibility for their respective exchange rates. The formation of such a cluster will
hardly encompass all nations. There may also emerge various regional currency areas
committed to different levels of inflation policies. The important aspect to be emphasized
in this context however is the compatibility of a CMG standard with a system of pegged, or
intermittently fixed exchange rates.
Our attention turns lastly to a purely domestic gold (or commodity reserve) standard
supplemented with a floating exchange rate. Whatever the specific form of the arrangement
consistent with the general idea it would involve a relation between the value of the gold
stock and the monetary base. This relation will control money stock and monetary growth in
terms of the evolving behavior of the gold stock and its valuation. This valuation and the




14

reserve ratio against base money can be used as a policy variable. The base moves under the
circumstances in response to these policy variables and the underlying shocks modifying the
real cost of producing (or acquiring) gold. In order to ensure longer-range stability in the
price-level and minimize unanticipated or misperceived monetary movements affecting
output and employment this domestic version of the gold standard would appear as a clumsy
and expensive version of the CMG standard.




15




FISCAL POLICY OUTLOOK:
A REPORT TO THE SHADOW OPEN MARKET COMMITTEE
Rudolph G. Penner
American Enterprise Institute

INTRODUCTION
This report is written more than a month before the SOMC's September 13 meeting.
Neither the reconciliation bill nor the tax bill have been completed, and the Administration
may update its own budget estimates prior to the completion of the Second Congressional
Budget Resolution. The analysis in this report is based on the Administration's Mid-Session
Review of the 1982 Budget issued on July 15, 1981.
ADMINISTRATION ESTIMATES FOR 1981 AND 1982
The July estimates assume that the "bipartisan" tax bill passed by the Senate is
enacted and that with a few minor exceptions, the Administration will be successful in
obtaining all the budget cuts advocated in March plus the social security cuts advocated in
May.
The economic assumptions underlying the estimates are provided in Table 1.
The resulting estimates are as follows:

Receipts
Outlays
Budget deficit

1981
$605.6 billion
661.2
55.6

1982
$662.4 billion
704.8
42.4

Off-budget deficit
Total financing requirement

24.0
$079.6

18.J
$060.6

ADJUSTING THE ESTIMATES
1981 - Because of higher than expected interest rates, and because I think it wise to
assume a somewhat weaker economy than in the Administration forecast, I think it




17

Table 1 .—SHORT-RANGE ECONOMIC FORECAST
(calendar years; dollar amounts in billions)
Actual
1980

Forecast
1^981
1982

Major Economic Indicators
Gross national product (percent change,
4th quarter over 4th quarter):
Current dollars..........................
Constant (1972) dollars
GNP deflator (percent change,
4th quarter over 4th quarter)
Consumer Price Index (percent change,
4th quarter over 4th quarter)
Unemployment rate (percent, 4th quarter)....

9.4
-0.3

11.8
2.5

12.9
5.2

9.8

9.1

7.3

12.6
7.5

8.6
7.7

6.2
7.0

2 , 626 2,951
12.4
8.8

3,296
11.7

X,481
—0.2

1,519

1,570
3.4

a£, . O U
246

2,401
1,495
252

2,677
1.668
281

177.4
9.0

194.3
9.6

209.9
8.0

247.0
13.5

d. 1 X o J

9.9

290.2
7.0

7.2
3.8

7.5
3.7

7.3
3.9

11.7

4.8
14.3

7.0
8.9

11.5

13.6

10.5

Annual Economic Assumptions
Gross national product:
Current dollars:
Amount
Percent change, year over year
Constant (1972) dollars:
Amount................................
Percent change, year over year
Incomes:
^er@Onai

inCOme ..aaaa.eeeeaaaeoaeaeaa.ee.

Wages and salaries ...........a....a......
COrpOrate

prOfitS

1/a...

a.aaaaaaaaaa

Price levels
GNP deflators
Level (1972™100), annual average
Percent change, year over year
Consumer Price Index 2/s
Level (1967»100), annual average
Percent change, year over year
Unemployment rates:
Total, annual average...•aa.B.aa.aaaaaa..
Insured, annual average 3/
Federal pay raise, October Tpercent) 4/:
Military
Interest rate, 91-day Treasury
bills (percent) 5/

1,344

1/
Excludes
the
direct
accounting
effect
of the
Administration's depreciation proposal on
business
income,
although all categories of economic assumptions do reflect the
economic impact of this proposal.
2/ Two versions of the CPI are now publisheds one measures
the cost of living for urban wage earners and clerical workers in
urban
areas; the other, more recently developed, is more
comprehensive, covering all urban dwellers. The index shown here
is the CPI for urban wage earners and clerical workers, which is
the one used, as required by law, in calculating automatic costof-living increases for indexed Federal programs.
3/ This indicator measures unemployment under State regular
unemployment insurance as a percentage of covered employment
under that program. It does not include recipients of extended
benefits under that program.
4/ Pay raises become effective in October of each year —
the first month of the new fiscal year. Thus, the October 1981
pay raise will set new pay scales that will be in effect during
fiscal year 1982.
Sj Average rate on new i««ues within period.
These
projections assume, by convention, that interest rates are linked
to the rats o£ inflation. They are not forecasts of interest
c^t^s.




18

reasonable to add at least $5 billion to the above deficit estimate. This yields a unified
budget deficit of something over $60 billion and total financing requirements close to a
record breaking $85 billion.
1982 - Despite the Administration's magnificent success in the Congress thus far, it
would be unwise to assume that they will get all of the budget cuts that they hope for. The
entire $3.8 billion proposed cut in social security faces a particularly difficult time though
minor cuts are possible. It is also possible that some already enacted cuts will be reversed
as the 1982 election approaches. 1 would add $10 billion to outlays because of such changes
in policy.
There are a number of areas in which Administration estimates seem overly optimistic
given their economic assumptions. I would add $2 billion for the cost of current agricultural
programs and $4 billion for unanticipated national disasters and outflows from the FHLBB,
FSLIC, and FDIC, resulting from the problems of the thrift institutions. Most outside budget
analysts also believe that the Administration's requested appropriations will be spent at a
faster rate than they anticipate. Estimates of as much as a $15 billion overrun can be found,
but I suspect that the amount will be much less than that. In fact, I would not completely
rule out the possibility of a major under-run in defense. However, I shall add $4 billion to
the estimates as a best guess of the net overrun. Thus, my guesses regarding factors
unrelated to the economic assumptions add $20 billion to 1982 outlays.
Note from table 1 that the Administration assumes nominal GNP growth of 12.4
percent in 1981 and 11.7 percent in 1982. Given Fed money growth targets, the assumptions
imply an extraordinary increase in velocity. If instead the middle of the Fed's own July
forecast range for real growth and inflation is used, the net effects of lower growth and
lower inflation adds about $2 billion to outlays and reduces receipts by $12 billion. The
Administration's assumptions are compared with the mid-points of the Fed's ranges below:
1982

1981

Real GNP growth

Admin.
12.4%
02.6%

Implicit deflator
Unemployment rate

09.6%
07.5%

Nominal GNP growth




Fed.
10.75%
02.25%
08.75%
07.90%

19

Admin.
11.7%
03.4%
08.0%
07.3%

Fed.
10.88%
02.50%
07.50%
07.75%

There was a lot of controversy regarding the Administration's March interest rate
assumptions. For the purpose of the July update they raised the 1982 average 91-day bill
rate from March's 8.9 percent to 10.5 percent. In adjusting Administration estimates to the
Fed forecast, I assumed that the 10.5 percent bill rate prevailed even though the inflation
forecast was lowered slightly.
After all of the adjustments discussed above, the resulting totals are:

Outlays
Receipts
Unified deficit
Off-budget
Total financing requirement

1982
$727 B.
650 B.
$ 77 B.
18 B.
$ 95 B.

The resulting estimate of the financing requirement may be overly pessimistic, since
this Administration has already exceeded everyone's expectations in their ability to control
outlays. Nevertheless, it is clear that they have a good chance to exceed 1981's record
financing requirement which I am guessing will be $85 billion. (The previous record of $73.8
billion was set in 1980 marginally edging out 1976's $73.7 billion.)
For those who would like to make their own budget forecast using a different economic
assumption, I have added tables 2 and 3 which illustrate the sensitivity of the budget to the
economy.
THE LONGER RUN
It is the Administration's goal to balance the unified budget in 1984. The July
estimates project a surplus of $0.5 billion in that year.
Two factors play a crucially important role in attaining that tiny surplus. First,
nominal GNP is assumed to grow at 11.5 percent per year in 1983 and 1984 after growing
more than 12 percent per year in 1981 and 1982. Second, the Congress must pass yet
unspecified program cuts totalling $30 billion in 1983 and $44 billion in 1984.
Nominal GNP growth of the assumed magnitude is not likely if the Administration
achieves its monetary targets. Also, a large portion of the unspecified cuts will have to be
voted before the 1982 election, which is no easy task. Without going into elaborate detail
regarding assumptions, it is my own judgment that the current policy stance is moving us
toward unified deficits in the range of 2 to 2 1/2 percent of GNP for the 1983-84 period.




20

TABLE 2
SENSITIVITY OF FY 1982 BUDGET OUTLAYS TO ECONOMIC ASSUMPTIONS
(in billions of dollars)
1982
Outlays
Prices (effect on indexed programs only)
One percent increase in CPI level bys
Third

M

0

\& IL

JL i* O

&

M [ *-i cEJT C. O XT $

s»» J
>

J . 5 ' O ^ S a Q 0 O 0

X X «

U

U

CE J> ( - c5 M,
L

l i t

o

o

e

0

o

@

0

o

0 0 o o

o

@

@

0

@

@

0

0 0 0 0 0 0

O

0

0

0

o

0

@

0

0

s

0 0 0 0 0

0

0

0

0

0

0

0

0

0

0

0

0

0

0

^

0

0

0

9

0

0

0

0

0

0

0

0

0

0

0

0

0

0

0

0

0

0

0

0

O

S

0

O

0

O

0

O

0

D

0

O

0

O

0

O

0

S

0

O

Q

0

0 0

%J 0 /
vl 0

^

«•§• 9

^

Interest Rates
One percentage point increase in interest rates bys
%J O l I V I C l il» J f
6j> 1LS j l _ J f

-S. §

JL Q

JLZS

' L J ' C - f L > C J U c 2 JUT
W

V

0

0

0

^

7

O

J

L

0

O

X

-

•&» #

J&. $

L

Cj X

JLg

O O M C I J T Jf'

6-1 U i

JL ^ ? £ 5 J

X
a

y

^
0

/
^

O
£

@
S

«
0

0

0

0

&

O

O

0

0

©

S

0

0

O

0
O

0

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©

0
0

0

0

O
-

&
0

0

0

0
0

0
0

0

0

O
0

&
O

O
0

0

0
0

&

0

0

O
O

0

0
0

0

0
0

0

0
0

0

0

9

0

0

0

&

0

0

0

0

0

0

0

0

0

0

0

0

0

0

0

0

0

0

0

0

0

0

0

0

0

0

0

0

e

0

0

0

0

0

O

0

0

0

0

0

0

0

0

0

0

0

0

0

o

0

0

0

0

0

0

0

0

0

0

0

0

0

0

0

0

0

e

o

0

o

e

o

0

0

@

@

&

0

0

0

0

0

0

0

0

0

0

0

0

0

0

0

e

0

0

0

S

0

0

0

0

0

0

0

0

0

O

0

@

0

©

0

0

0

0

e

0

0

0

0

0

&

0

0

0

Q

0

O

0

0

0

0

©

0

0

0

0

0

0

O

0

e

0

0

0

0
0

0

0
0

0
0

O

0

0

0

0

0

0

0

0
0

0

0
0

0

0
0

Q

0
Q

0

S

0

0

O

O

O

©

0

@

0

o

0

e
©

&

O
0

0

O
0

0

0

0

&

0

0

0

0

0

0

Q

O

0

0

0

0

0

0

0

0

0

«S 0 . 3

e

0

0

0

0

e

O

0

0

0

4& 0 O

0
0
o

0

©
0

0
0

0
Q

0
0

0
0

0
Q

0
0

0

S

0

Q

Q

Q

JL 0 O
U

Q «J

Unemployment Rate
One percentage point increase in average rate for FY 1982i
0 0 ©

l U O i L O Jf I n S O C»

^J" !•• IB W JL 0

O

0

0

B

0

o

D c H O i l L O
O

O

O

a

0

0

O

0

0

01 O
0

0

0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0
©

0

0

O

0

O

0

0

0

O

0

0

0

O

0

O

O

0

0

O

O

O

O

O

0

©

O

O

O

O

O

O

O

O

O

O

O

O

0

0

o

o

o

0

0

©

a

0

0

©

O

O

0

0

J) 0
_| „

J
j

Civilian and Military October 1981 Vay Raises
One

p e r c e n t a g e

p o i n t

I n c r e a s e < > < < < » » » < » < • < ° » s * « « • • ° •>,<> « * ° * • < < » < < ® < < • » •»<> <• * » < » D » o ® »
>>>
> > >
> » >> >>
>
_ i

_

NOTEs For changes in economic assumptions in the opposite direction, outlay decreases
would be of similar magnitude with the opposite sign.

Sources




Office of Management and Budget

0< 7
>

TABLE3
SENSITIVITY OF THE DUDGET TO ECONOMIC ASSUMPTIONS
(fiscal years? in bllliona of dollars)

Outlays

1901
Receipts"

^_^
Deficit

Outlays

1982
Receipts"

Deficit

Effect of one percentage point
higher annual rate of
inflation beginning l/i

-1

6
+2

11
3

-5
-1

4
1

-13
-3

1?
4

Effect of one percentage point
lower annual rate of real
growth beginnings
fc>3

&J III"! * l l iTy
-c

I /Ul

O O Q O Q O G Q & Q O O O I

aj 3 Si ll O &^ j^

X^?Cj^e

o o o @ Q o o e e o o @ (

_3

1/ Includes the effect of higher inflation on Indexed programs, interest outlays, and
tnedicare/medicaidj excludes effects on discretionary programs.
NOTEs If the rate,of inflation were lower or the rate of real growth higher by one
percentage point, the changes in outlays and receipts would be of the opposite sign but of
similar magnitude to the figures shown above.
Sources




Office of Management and Budget

That, of course, assumes that the Administration sticks with its monetary targets and
does not use inflation to balance the budget. Indeed, about one-third of my projected deficit
is the result of inflation being lower in the 1980-1984 period than the 7.6 percent annual rate
assumed by the Administration. In other words, it is not assumed to be an inflationary
deficit. It is a deficit caused, in part, by a lack of inflation.
In searching for future budget cuts, it is interesting to note that under the Administration's July projections, the total budget rises from $579.6 billion in 1980 to $802.7
billion in 1984 (before subtracting the $44.2 billion in unspecified cuts for 1984) or by $223.1
billion. The increase in three functions — defense, health, and social security — is $206.1
billion, an amount equal to 92.4 percent of the total increase. This already presumes major
cuts in health and social security which are not very popular to say the least. The absolute
increase in defense is $118.3 billion or 17 percent per year. Even the most devoted hawk has
to feel uneasy about that increase and it is essential to examine it critically.
ADJUSTMENT FOR A PESSIMISTIC FORECAST
I was asked to provide an alternative budget forecast for a more pessimistic outlook
than that assumed by the Fed. That forecast is compared to the Administration's below.
1981
11.8

10.2

9.1

7.3

8.2

7.1

Z oO

Admin.
Pessim.
Unemployment (4th q average)
Admin.

12.9

8.2

Nominal GNP (4th q over 4th q)
Admin.
Pessim.
Deflator (4th q over 4th q)
Admin.
Pessim.
Real GNP (4th q over 4th q)

1982

ODZ

-0.1

£t«2/

7.7
8.2

Pessim.

7.0
8.0

Assuming the same policy changes and non-economic estimating adjustments assumed
before, the fiscal 1981 deficit would only be increased marginally. The 1982 totals would be:




23




Outlays
Receipts
Budget deficit
Off-budget deficit
Total financing requirement

24

$733 B.
632
$101
18
$119 B.

RISK and FEDERAL RESERVE ACTION AND MONETARY GROWTH
H. Erich Heinemann
Morgan Stanley & Co., Incorporated

Background paper prepared for the September 13-14, 1981 meeting of the Shadow Open
Market Committee and distributed earlier by Morgan Stanley







^^^^^^^^^^^^^^:^5^^'^^^^<^s^T^^s^^^^^^S^^^^^^^B^^^^^^^^^^^^^^^^^^^^^^^^^^^^^y^^^^^^^^^^^S

UiM:--V^2v4M

"
. - vft^_ •*'!u vast*-'' -VsSSfW'-^—"^as^--*** •> -j-• •

MONEY AM) THE ECONOMY

August 24, 1981

RISK
The risk premium has risen sharply in the nation's financial markets.
This is the message to be drawn from the significant rise in interest
rates in recent days — notwithstanding a stagnant economy, slowing
inflation, and credit demands which, overall, are only moderate. The
economy is clearly moving sideways. Inventories are, indeed, too high
in some sectors and are being reduced. But this does not seem likely
to trigger a sustained and substantial contraction in real business
activity. In large part, this is so because final demand, buoyed by a
sharp increase in transfer payments in July, is holding up reasonably
well. Weekly indicators of production, employment, and prices suggest
a lateral pattern, not a sharp decline (see page 4). The inflation
news, meanwhile, is good. Our estimates suggest that the rate of increase in consumer prices through July this year was about 8.25%,
down considerably from the 12.3% rate of gain in the comparable period
last year. Moreover, it seems likely that the reduction in inflation
represents a systematic response to prior monetary restraint and is
not simply the result of essentially random movements in food and fuel
prices. In financial markets, the expansion of total credit outstanding has not been particularly rapid, despite the strong demand for
funds from large corporations and the U.S. Treasury. For example,
total bank credit rose at an annual rate of less than 6% in July, even
though business loans at large banks rose at a rate in excess of 30%.
We expect that the Federal Reserve's latest estimates of the overall
flow of funds — which are due to be published later on this week —
will show only modest changes in the second quarter.
Nevertheless, interest rates are
rising, especially in long-term
markets. The proximate cause of
this most recent episode appears to
have been the significant easing in
monetary policy that developed
during July and the first part of
August. The authorities have
sought to offset the effect of what
they regarded as an unacceptable
shortfall in money growth in the
second quarter. The actual growth
rate of the money supply, adjusted
for shifts into NOW accounts, was
5.4% in the April-June period. As
policy has eased, the short-run
growth rate of the monetary base
and bank reserves has jumped up
into double digits. For portfolio
managers, the appropriate question

THIS MEMORANDUM


CONTENTS
A Lateral Pattern, Not a
Sharp Decline

1

Pumping Up the Reserve Base
Has Backfired

3

Crisis Options for the
Administration

5

Federal Reserve Action and
Monetary Growth

. 6

A Shift into Currency Lies
Behind the Monetary Slowdown 6
"Decomposing" Monetary Growth 10

27
IS BASED UPON INFORMATION AVAILABLE TO THE PUBUC. NO REPRESENTATION IS MADE THAT IT IS ACCURATE OR COMPLETE

MORGAN STANLEY & CO

MORGAN STANLEY

-2-

i s not whether the Federal Reserve intends to ease i t s policy stance,
but r a t h e r whether the easing t h a t has already occurred i s excessive.
Unfortunately, i t appears t h a t the answer to the l a t t e r question i s
"Yes."

MONETARY DATA
(Weekly Averages of Daily Figures in Millions of Dollars)

Rates of Change Over
3 Months 6 Months
1 Year

Latest Week

Change From
Previous Week

Mone\ SuppK (M-1A)*(1)

$364,300

$+

300

-

4.9%

-

4.1%

-

4.6%

Money SuppK (M-1B)*(1)

434,700

+

800

-

2.6

+

6.0

+

7.1

Expanded Monev *( 1)

546,400

+

700

+

9.8

+20.4

+ 14.4

Adjusted Monetary Base*(2)

168,900

+

300

+

5.4

+

7.1

+

6.5

Adjusted Federal Reserve
Credit*(2)

147,200

+

700

+

5.4

+

7.6

+

7.7

Total Adjusted Reserves*(l)

47,500

+

600

+

4.4

+

6.7

+

5.4

Member Bank Borrovnnjr(2)

1,457

+

186

NA

NA

NA

Wednesday Figu res

Short-Term Business Credit*(l)

334,308

+ 1,783

+ 34.3

+ 20.4

+ 17.9

Total Commercial Paper
Outstanding*) 1)

157,099

+ 1,917

+ 62.0

+41.5

+26.0

Business Loans
All Large Banks*(l)

184,480

-

305

+ 22.5

+ 12.9

+ 14.4

New York Cm Banks* **(1)

52,621

-

385

+13.8

+

9.3

+ 14.4

Chicago Banks*) 1)

19,952

+ 31.1

+ 15.1

+ 15.7

•Seasonally Adjusted

—

66

'Excludes bankers' acceptances and commercial paper

NA = Not Applicable

Rates of change are compound annual rates. Expanded money consists of M-1B plus overnight RPs and Eurodollars, and 50% of
money market mutual fund shares. Short-term business credit includes commercial and industrial loans at large banks plus
loans sold to affiliates less bankers' acceptances and commercial paper held in portfolio plus loans at large banks to finance
companies and nonbank Financial institutions plus nonbank commercial paper.
(1)

August

12


THIS W£ MORA \DL Vf
UPON
http://fraser.stlouisfed.org/IS BASED — ._. INFORMATION
Federal Reserve Bank of St. Louis

(2)

August

19

28
AVAILABLE TO THE PUBLIC SO REPRESENTATION IS MADE THAT IT IS AI.CLRATE OR (. OMPLETE UORG A V STA \LEi & CO
„ .. .. „ „ , t t r c r z - T T B i i n r r m i t i\ km PITIK: nr r o « P j \ ; f \ \4F\TIOSED HEREIN 4\D VA>

MORGAN STANLEY

„3_

By pumping up the reserve base of the banking system, the Federal
Reserve has introduced a new and significant element of risk into the
near-term outlook for the valuation of financial assets. In effect,
the increase in short-run inflationary expectations that has resulted
from the acceleration in growth of the monetary base and bank reserves
(the high-powered raw materials that form the basis for expansion in
the money stock) has offset, and then some, whatever "beneficial"
effect might have been anticipated from the increased availability of
funds in credit markets.
These conclusions, and the irony they imply, are amply supported by
the minutes of the Federal Open Market Committee's meeting that was
held in early July. Here are some key points from the summary of the
FOMC's debate:
•

"The members were in agreement on the need to maintain a
policy of restraint." However, the summary suggests that
there was a consensus that a "significantly more rapid increase in narrowly defined money would be required to meet
the Committee's objective for the year [1981]."

•

To implement this judgment, the FOMC decided to aim for monetary growth during the summer months that would "promote
achievement of the monetary objectives for the year as a
whole." The FOMC said it wanted expansion of M-1B to be fast
enough to "permit growth of this monetary aggregate toward
the lower end of its range for the year [3.5%, from fourthquarter 1980 to fourth-quarter 1981]." At the same time,
however, the committee decided to "avoid generating an excessively rapid rebound in growth of M-1B, both because the pace
would need to be sharply reduced later and because such a
rebound might tend to raise the growth of M-2 above the upper
end of its range for the year."

•

The committee debate plainly recognized the risks in seeking
faster monetary expansion and the benefits in keeping growth
in the money stock under tight control. FOMC members argued
that the "present situation provided a critical opportunity
that could be lost if monetary growth in the months ahead
became too rapid. Even if rapid monetary expansion should
lower interest rates, which was debatable, such effects would
likely be temporary, and latent demands for goods and services
would be released at the potential cost of a still more difficult period of high interest rates and financial strains later.
The point was made that lasting declines in nominal interest
rates and a solid base for sustained growth would depend on
convincing progress in reducing inflation."

The risks implied in this commentary seem to have surfaced rather more
quickly than most members of the FOMC would have imagined at their
meeting in early July. The question then becomes critical; What
happens if sentiment in the financial markets continues to deteriorate?
29
THIS MEMORA NDVM IS BASED UPON INFORMATION AVAILABLE TO THE PUBUC NO REPRESENTATION IS MADE THAT FT IS ACCURATE OR COMPLETE MORGAN STANLE) & CO
„

INCORPORATED AND OTHERS ASSOCIATED WITH IT MAY HAVE POSITIONS IN AND MAY EFFECT TRANSACTIONS IN. SECURITIES OF COMPANIES MENTIONED HEREIK AND MA)

ALSO PERFORM OR SEEK TO PERFORM INVESTMENT BANKING SERVICES FOR THOSE COMPANIES


MORGAN STANLEY

-4-

ECONOMIC DATA

Latest Week

Change From
Previous Week

Hates of Change Over
3 Months 6 Months 1 Year

Date

OUTPUT
Goods Production:
Auto* (Units)
Truck* (Units)
Lumber ** (Millions of Board Feet)
Paper* (Thousands of Tons)
Paperboard* (Thousands of Tons)
Raw Steel* (Thousands of Short Tons)
Energy Production:
Bituminous Coal* (Thousands of Short Tons)
Crude Oil Refinery Runs*
(Daily Average; Thousands of BBLs)
Electric Output Index* (1967=100)

180,400
27,720
314.315

591

47
54
28
7
6
15

+53,031
+12,668
- 6.813

32
3.3

594.0
2,329

+

12

5
3
4
2
8
3

+65 3
-46 9
-17 3
+ 13 5
- 3 7
-10 8

+ 27.9
+ 1.9
+ 6.5
+ 8.4
+ 2.6
+44.2

8/15
8/15
8/ 8
8/ 8
8/ 8
8/15

604

+2,503.3

-10.5

+21.8

8/ 1

286
7

4.7
7.5

-10.0
+ 2.9

0.2
3.5

8/15
8/8

17.7

0.3

80.5

-20.7

+4.6

8/8

271.6
248.0
289.2

3.0
5.3
0.9

5.3
13.6
0.1

+ 1.0
- 4.1
+ 4.8

- 3.4
- 9.9
+ 1.3

8/18
8/18
8/18

421.2
2,900.9

+
3.4
+ 138.1

16.6
16.2

+ 2.9
- 5.0

-19.0
-25.1

8/15
8/ 8

17,345
12,843
192

+
+

TRANSPORTATION
Revenue Ton-Miles, Class I Railroads* (Billions)
PRICES
Spot Price Index (1967=100)
AH Commodities
Foodstuffs
Raw Industrials

+
+

EMPLOYMENT
Initial Unemployment Claims* (Thousands)
Claimant Level* (Thousands)

•Seasonally Adjusted

••Data subject to final revision

All data are reported for the week ending Saturday except price data which are for the week ending on Tuesday.
Sources: Chase Econometric Associates Data Base; Morgan Stanley Research

30

 BASED LPOS I.NFORMATION AVAILABLE TOTHEPLBUC SO REPRESENTATION IS MADE
THIS,MEMOR.ANDL MIS
INCORPORATED AND OTHERS ASSOC! ATED HITH IT M At H Al I POSITIONS IN AND MAY EFFECT TRANSACTIONS
http://fraser.stlouisfed.org/
/v I'Firur^T u i t-i\ r- ?[ Dt-ir-L < IT/ID r u n c m ) w p ^ \ ; f <;
Federal Reserve Bank of St. Louis

THAT IT IS ACCLRATE OR COMPLETE MORGAN STANLEY & CO
IN SECL RITIES OF COMPANIES MENTIONED HEREIN AND MAY

MORGAN STANLEY

_5_

In particular, how would the Administration respond? Moves in four
major areas seem promising (not necessarily listed in order of
importance);
•

Technical reforms in the implementation of monetary policy
— floating discount rate, contemporaneous reserve accounting,
and monetary base targeting (among others) — could be
instituted to minimize the risk of unintended spurts in
monetary growth. The Federal Reserve would have to adopt
such changes, but the Administration could increase sharply
its pressure to do so.

•

A dramatic limitation could be put on current Federal spending to reduce sharply the Treasury's borrowing needs. This
would be difficult politically, but is probably technically
possible.

•

A formal link of the dollar to gold could be reestablished
to eliminate much of the uncertainty in the current conduct
of monetary policy. Such an approach, which Barton Biggs has
discussed at length elsewhere this week, is plainly being
considered. It would represent, in effect, a "super-monetarist"
approach to the problem of getting interest rates down, promising lower and more stable rates of growth in the money stock
than most monetarists (myself included) believe would be feasible. In any event, there are major technical and political
difficulties involved in any reopening of the gold window
which may make an approach of this sort impractical. On the
technical side, presumably the price of gold in the open market would have to be stabilized somehow; on the political side,
if a renewed gold standard were deflationary in the short run
(which is quite possible) it might be hard to sell.

•

Finally, there is always a possibility — remote as it might be
— that the Administration could seek to reimpose direct credit
controls, as President Carter did last spring. This would also
carry huge problems — philosophical, political, and practical.
Widespread Government intervention in private decision-making
is foreign to President Reagan, The President promised to move
away from techniques of this sort in his quest for the White
House. Lastly, credit controls don!t work to produce sustained
improvements in the performance of financial markets. They
didn't work in 1980, and they won't work in 1981 or 1982.
Even so, however improbable, portfolio managers should not
dismiss a decision to move in this direction as impossible.

31


THIS MEMORANDUM IS BASED UPON INFORMATION AVAILABLE TO THE PUBUC NO REPRESENTATION IS MADE THAT IT IS ACCURATE OR COMPLETE MORC1N STANLEY & CO
http://fraser.stlouisfed.org/
ivr-nBenBATFn A Kn nTHFtK A <;<;OCIATED WITH IT MAY HAVE POSITIONS IN. AND MAY EFFECT TRANSACTIONS IN. SECURITIES OF COMPANIES MENTIONED HEREIN A VD MAY
Federal Reserve Bank of St. Louis

MORGAN STANLEY

-6-

Figure \
A Retreat I n t o Cash Lies Behind the Slowdown in Monetary Growth

Data are four-week moving averages.
Sources: EconaJyst Data Base, Morgan Stanley Research

FEDERAL RESERVE ACTION AND MONETARY GROWTH
Over the past one and one-half years, the short-run growth rate of the
money supply (defined as M-1B, not adjusted for shifts into NOW
accounts) has averaged within about one percentage point of that of
the monetary base. Moreover, the bulk of the variance in the linkage
between these key variables is accounted for by transitory shifts in
the relationship between the public's holdings of cash and its holdings of demand deposits. These are the key findings to emerge from
Morgan Stanley's most recent analysis of actions by the Federal Reserve
(measured by changes in the monetary base) and movements in the money
supply.
Figure 1 on page 6 shows the contrasting movements of the money multiplier (the ratio of the money supply to the monetary base) and the
currency ratio (the ratio of the public's holdings of currency to its
holdings of demand deposits). Parts I, II, and III of Table 1
trace the quantitative relationships between the Federal Reserve's'
management of its own balance sheet (the monetary base) and the subsequent movements of the money supply. Extensive research has shown
(1) that the growth of the monetary base bears a stable and predictable
association with total spending in the economy (more stable, in fact,
32

http://fraser.stlouisfed.org//<; BASED UPON INFORMATION AVAILABLE TOTHE
THI\ uf wnmvnr
W
Federal Reserve Bank of St. Louis

PUBLIC SO REPRESENTATION IS MADE THAT IT IS ACCURATE OR COMPLETE MORGAN STAM.t} * CO

MORGAN STANLEY

-7-

TABLE 1 - PART I
FEDERAL RESERVE ACTION AND MONETARY GROWTH
(S BILLIONS)

(D

(2)

(3)

(4)

(5)

(6)

(7)

(8)

(9)

(10)

DATE
FOUR
WEEKS
ENDED

MONETARY
BASE
CURRENCY

TOTAL
SAVINGS
NONADJUSTED
& SMALL
LARGE
DEPOSIT
BANK
DEMAND
TIME
TIME
RESERVES DEPOSITS DEPOSITS DEPOSITS LIAB.

TREASURY FOREIGN
TOTAL
DEPOSITS DEPOSITS DEPOSITS*

1981

JAN

FEB

MAR

APR

MAY

JUN

JUL

AUG

7
14
21
2t
f
4
11
18
25
4
11
18
25
1
8
15
22
29
6
13
20
27
3
10
17
24
1
8
15
22
29
5

162.80
162.80
162.80
162.70
162.40
162.40
162.60
163.10
163.60
163.80
164.00
164.10
164.20
164.50
164.80
165.10
165.30
165.70
166.00
166.20
'166.50
166.40
166.60
166.50
166.60
166.70
166.70
167.00
167.30
167.70
168.00

116.40
116.50
116.60
116.60
116.60
116.70
116.90
117.10
117.30
117.50
117.60
117.60
117.90
118.10
118.30
118.60
118.90
119.10
119.30
119.40
119.70
119.60
119.70
119.70
119.60
119.90
120.20
120.40
120.60
120.90
121.00

46.10
46.10
46.20
46.10
45.80
45.60
45.70
45.90
46.20
46.30
46.30
46.30
46.30
46.30
46.40
46.30
46.40
46.50
46.50
46.80
46.70
46.80
46.90
46.SO
47.00
46.80
46.50
46.60
46.70
46.80
47.10

296.00
296.60
298.10
299.60
298.30
298.10
298.00
298.10
299.60
300.80
301.30
302.10
302.80
304.80
307.10
310.20
310.90
310.80
310.00
308.00
307.00
305.60
305.00
305.20
305.40
305.00
306.30
306.20
306.10
306.00
305.60

478.00
478.50
479.10
479.60
480.00
480.10
480.30
480.40
480.80
481.30
482.00
482.60
483.10
483.60
483.90
483.80
483.90
484.00
484.20
484.80
485.50
486.20
487.00
487.60
488.00
488.20
488.50
489.00
489.70
490.60
491.50

216.20
219.00
220.60
222.00
223.60
225.00
226.50
227.50
227.40
226.40
226.00
225.00
224.40
223.80
223.00
222.50
222.70
223.40
225.30
227.50
229.60
232.70
234.60
236.00
237.00
238.50
239.50
240.70
242.10
242.60
244.40

61.60
61.70
62.90
63.70
64.10
63.70
62.80
62.10
62.10
62.40
62.10
61.20
61.10
60.40
60.70
61.40
62.20
64.00
64.80
66.10
66.50
67.20
68.70
69.90
70.50
69.90
68.90
68.00
67.50
68.00
68.50

13.20
13.10
11.90
10.80
11.70
12.00
11.50
11.60
11.20
10.90
11.80
12.90
13.50
14.60
13.80
13.90
15.20
17.30
19.40
18.70
16.80
13.60
11.50
11.50
13.60
16.10
17.50
17.10
15.40
13.80
13.20

6.30
6.20
6.00
5.50
5.40
6.00
6.40
16.50
16.50
16.10
!5.50
15.20
15.60
15.50
15.90
6.30
6.30
6.40
6.00
5.70
5.60
5.80
6.10
6.60
6.60
6.50
6.40
16.50
16.00
16.00
15.90

1081 . 10
1085.10
1088.60
1091.20
1093.00
1094.80
1095.50
1096.30
1097.50
1097.90
1098.60
1099.00
1100.50
1102.60
1104.30
1108.10
1111.10
1115.70
1119.70
1120.70
1121.00
1121.10
1122.90
1126.70
1131.00
1134.10
1137.10
1137.50
1136.80
1137.00
1139.10

NOTE: DEMAND DEPOSITS DO NOT INCLUDE OUTSTANDING TRAVELERS CHECKS OF NONRANK ISSUERS.
THE OMISSION DOES NOT AFFECT THE ANALYSIS.

* 4+5+6+74-8+9

SOURCES: ECONALYST DATA BASE;

MORGAN STANLEY RESEARCH

33


THIS MEMORANDUM IS BASED UPON INFORMATION AVAILABLE TO THE PUBUC NO REPRESENTATION IS MADE THAT IT IS ACCURATE OR COMPLETE MORCA \ STANLE) & CO
http://fraser.stlouisfed.org/
INCORPORATED AND OTHERS ASSOCIATED WITH IT MAY HAVE POSITIONS IN AND MAY EFFECT TRA H^ACTIOKK IN SECURITIES OF COMPANIES MENTIONED HEREIN AND MA)
Federal Reserve Bank of St. Louis

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MORGAN STANLEY

-9-

TABLF

1 -

PART

m

FEDERAL RESERVE ACTION AND MONETARY

BQLICY

COMPOUND ANNUAL RATES OF CHANGE TO TOE AVERAGE OP THE POUR WF.FKS ENDED ON THE DATES SHOWN IN THE TABLE FRO", THE
WEEK AVERAGE FOR THE PERIOD ENDED FOUR WEEKS E A R L I E R .

THIS

FOUR
WEEKS
ENDEr

MONETARY
GROWTH
(M-1B) (LESS)

IS

CONTRIFEDERAL
BUTION
RESERVE
OF THE
ACTIONS
MONEY
ADJUSTED
(MONETARY
MULTIRESERVE CURRENCY
BASE)
(EQUALS) PLIER
RATIO
RATIO

ACCOUNTED FOR BY CHANGES

SAVINGS
S SMALL
TIME
DEPOSIT
RA^IO

LARGP
TIMF
DEPOSIT
RAmIO

NONDEPOSIT
LIABILITY
RATIO

tOUR-

IN T U P

TREASURY
DEPOSIT
RATIO

^REIGN
DEPOSIT
RATIO

1981
JAN

FEB

MAR

APR

MAY

JUN

JUL

7
14
21
28
4
1 1
18
25
4
11
18
25
1
8
15
22
29
6
13
20
27
3
10
17
24
1

8
15
22
29
AUG
5

- 9 ,. 0 "
- 5 ..01
4 ,. 3 8
16., 3 1
10,. 2 3
9,. 1 9
5,. 5 8
2 .. 6 7
1 1 . ,T>
1 4 .. 7 2
15.. 7 6
15,. 1 1
10,, 6 4
13,. 3 4
1 7 ., 1 5
2 5 ,. 4 4
2 7 ,. 1 9
2 2 .. 0 3
15.. 2 8
0.. 9 1
- 3 . .76
- 1 0 ..59
- 1 2 ,.86
- 1 0 ..22
- 1 0 ..57
- 6 ,.16
0,. 6 1
1 .. 6 8
3.. 3 9
5,. 0 4
- 0 .,08

0.20
0.80
0.60
1.00
-2. 76
-3. 34
-1. 39
2.83
9.83
12.25
11.35
8.49
5 29
5 91
6 53
8 01
9 07
9.91
89
66
22
63
01
17
1.18
2.37
18
57
60
67
10.62

-9.27

14.37

-11.78

-5.81
3.78

15.41
8.23
5.73
9.43
11 . 5 6
15.«4
0.12
1.28
NM
-10.23
-2.72
0.01
0.98
1.00
2.53
2.64
2.72
7.07
0.54
0.52
-0.18
-1.79
2.22

-9.33
-0.25
8.93
4.98
3.27
-3.18
-0.18
0.76
NM
7.28
5.26
2.89
3.72
5.68
9.20
9.88
6.58
1.10
-4.87
-7.75
-9.49
-9.64

15.31
12.99
12.53
6.97
-0.17
1.94
2.46
4.41
6.62
5.35
7.43
10.62
17.43
18.12
12.12
5.39
-8.76
•12.97
•16.23
•17.87
•12.39
•11.75
-8.53
-0.57
-1.89
-2.21
-2.62
•10.70

1.91
9.57
-0.95
-5.44
NM
2.74
-3.88

-8.08
-4.81
-6.09
0.02
1.25
NM
-6.26
-5.20

-2.84
-2.20

-6.08
-6.88
-3.32
-2.10
-2.53
-2.61
-4.83
-0.0">
0.71

0.05
2.22
0.83
0.3P
-1.03
-0.04
-0.33
NM
2.94
1.44
0.79
1.13
1.88
3.29
3.64
2.98
2.54
-0.96
-1.84
-2.83
-3.24

NM
2.45
1.91
1.53
1.57
1.89
2.36
2.27
1.53
-0.09
-1.41
-2.34
-3.55
-3.97

-2.93
-2.85
-2.33
-0.03
-0.10
NM
-0.55
-1.43

-4.31
-4.73
-4.89
0.15
1.29
NM
-2.59
-1.88

-0.29
0.01
-0.40
-0.46
-0.91
-0.91
0.01
0.01
-0.60
NM
1.19
0.61
0.45
0.78
0.66
0.40
0.16
-0.74
-2.09
-1.10
-1.23
-1.20
-1.53
-1.82
-2.44
-2.22
-0.00
-0.71
NM
1.70
0.08

-2.36
-2.48
-0.55
0.50
0.73
0.68
0.35

-o.ni
-0.15
Nw
-0.15
-0.40
-0.63
-0.95
-0.44
-0.16
-0.39
-0.77
-3.22
-1.06
-0.43
0.95
2.43
2.95
1.73
-2.02
0.23
1.86
NM
1.91
1.46

-0.28
-0.34
0.02
0.49
0.45
0.16
-0.29
-0.01
0.26
)JV

0.92
0.52
0.30
0.21
-0.04
-0.18
-0.08
-0.17
0.07
0.10
0.11
0.08
-0.13
-0.42
-0.56
-0.56
0.01
-0.05
NM
0.44
0.16

NOT MEANINGFUL
SOURCES: ECONALYST DATA BASE; MORGAN STANLEY RESEARCH

35

MEMORANDUM IN BASED L PON INFORMATION AVAILABLE TO THE PUBUC NO REPRESENTATION IS MADE THAT IT IS ACCURATE OR COMPLETE MORGAN STANLE) S CO
THIS
INCORPORATED ANDOTHIRS ASSOCIATED HITH ITMAY HAVE POSITION'S IN AND MAY EFFECT TRANSACTION'S IN SECURITIES OF COMPANIES MENTIONED HEREIN AND MA)
http://fraser.stlouisfed.org/
ALSO PtRtDRMORSELk
TO PERFORM INVESTMENT HANk-INC, SFRV1CFS FOR THOSE COMPANIES
Federal Reserve Bank of St. Louis

MORGAN STANLEY

-10-

than any other monetary aggregate), and (2) unless and until the
Federal Reserve decides to manage the monetary base explicitly (and
not as an accidental residual), it will continue to produce unstable
results in monetary policy. Indeed, international experience has
shown that those central banks which seek directly to control their
monetary bases (the Germans and the Swiss in particular) generally do
a better job in controlling monetary expansion.
The purpose of this analysis is to separate, or "decompose," monetary
change into those components for which the Federal Reserve is responsible directly and those components which can be traced to actions by
the public over which the authorities have no direct control — at
least over short periods of time. This is not to argue that these two
"components" of monetary change are in any meaningful sense independent
one of the other. Obviously, actions the Federal Reserve takes influence the public's choices as to the form in which money assets are
held, and likewise changing public desires will have an important
bearing on the central bank's decisions. Nonetheless, I have found
the decomposition analysis to be very helpful in understanding temporary
movements in the monetary aggregates. (Long-run, most of the change
in the money supply is a function of the rate of increase in the monetary base.)
The focus, as I have already indicated, is the behavior of the monetary
base, which in effect represents the raw material for monetary expansion. The base is a double-entry concept -- not unlike a corporate
balance sheet — whose sources (assets) and uses (liabilities) are
defined as being equal. The principal sources of the monetary base
are the Federal Reserve System's portfolio of securities, the monetary
gold stock, loans by the Federal Reserve to depository institutions,
miscellaneous items including the Treasury's deposit balance at the
Federal Reserve banks and Federal Reserve float, and finally a statistical adjustment for changes in bank reserve requirements. The monetary base, as published, assumes a constant reserve ratio. The two
uses of the monetary base are bank reserves and currency. Thus, my
assumption is that the Federal Reserve can manage the size of its own
balance sheet, and in particular the size of its portfolio of securities, which accounts for almost four-fifths of the total monetary
base. Put another way, these totals can be controlled explicitly
(since all Federal Reserve policy actions, by definition, affect the
monetary base), provided those responsible for policy have the will to
do so.

36


THIS yF.VORA.SDLU IS BASED LPOS ISFORUlTIOS
AtAILABLF TO THE PI HUC SO REPRESESTATIOS IS VtADE TH AT IT IS ACCC RATF OR COMPUTE
MORljAS ^TASLEY & CO
http://fraser.stlouisfed.org/
u r n w r n u r H i JsnnTHIRS
ASSOCIATED H/7W IT MAi HAl k POSITION IS ASDUA) h FF f CT TRASS ACTIOS-, IS SEC I RITIESOf C OMPASIES UESTIOSLD HERE IS ASD MAi
Federal Reserve Bank of St. Louis

MORGAN STANLEY

-11-

The interest rates regularly monitored by the Federal Reserve were as
follows:
Daily Average Week Ended
August 12
August 19

Rate

Change in
Basis Points

Federal Funds

18.29%

18.19%

-10

90-Day Treasury Bills

15.23

15.61

+ 38

90-Day Commercial Paper

17.23

17.36

+13

90-Day CDs (Secondary Market)

17.91

18.01

+10

90-Day Eurodollars

18.78

18.73

- 5

20-Year Governments

14.23

14.24

+ 1

H. Erich Heinemann
(212) 974-4410
August 24, 1981

37
 MEMORANDUM IS BASED UPO.N INFORMATION AVAILABLE TO THE PUBLIC SO REPRESENTATION IS MADE THAT FT IS ACCURATE OR COMPLETE MORGAN STANLE) i CO
THIS
INCORPORATED AND OTHERS ASSOCIATED KITH IT MAY HAVE POSITIONS l,N AND MA) EFFECT TRANSACTIONS IN. SECURITIES OF COMPANIES MENTIONED HEREIN AND MA)
http://fraser.stlouisfed.org/
AIWi! UtRPnilKA OR SPFk-TO PERFORM IVVFSTMFK'T u A K'ftK r- cjroi'J^rc r / l B T l i r t r r
mtMBA^itc
Federal Reserve Bank of St. Louis




FORECASTING MULTIPLIERS FOR THE "NEW-NEW"
MONETARY AGGREGATES
James M. Johannes and Robert H. Rasche
Michigan State University

About the only certainty in dealing with monetary aggregates these days is that
something will change every time one's back is turned. Recent experience is no exception.
In the last few months we have seen (1) the adjustment of monetary data to new bench
marks, (2) a conceptual revision to include traveler's checks issued by nonbank institutions in
the various measures of money and (3) the construction of shift adjustments to abstract from
the effect of portfolio shifts subsequent to the extension of NOW accounts nationwide. All
of these changes could be a source of difficulty for the prediction, control and interpretation
of monetary growth rates. Our concern here is the significance of recent changes for the
first two of these issues.
I.

BENCHMARK REVISIONS

A year ago we reported the results of the reestimation of our money multiplier
component models after the introduction of the "new money stock" concepts. Those results
are reported in table 1 for purposes of comparison. Our sample at that time was truncated
at 1978.12, because we observed some drift in our parameter estimates when 1979 data were
added that we felt might have been caused in part by "unseasoned" data. We have now
reestimated our models through 1979.12 on the most recently available (July, 1981) data.
These estimates appear in table 2. It should be noted that recent revisions have introduced
changes in the checkable deposits series all the way back to January, 1959. In spite of the
revisions, the models demonstrate a remarkable stability as more data are added to the
sample period. All the properties which led us to the choice of the particular models
initially are preserved in the new estimates. Indeed, the structure of 4 of 6 original
component models (Johannes and Rasche, 1979) has remained unchanged for three years in
spite of all the conceptual change and financial innovations that have been introduced over
that time.




39

Table 1 Component Models

k

(1-B)(1-B3)(1-B12) Ink = (1 - .70581B3)(1 - .66907B12)a
.556 x 10~ 2

X2 = 37.8 df = 28 S.E.E.

g

(1-B)(1-B12) lng = (1 - .38067B)(1 - .21252B2)(1 - .50131B12)a
(.0675)
(.0734)
(.0632)
X2 = 31.6 df = 27 S.E.E.

z

t*

.181

(1-B)(1-B3)(1-B12)

lnt* = (1 - .64701B3)(1 - .61528B12)a
(.0531)
(.0587)
.549 x 10~2

(.0133)
1

= (1 - .53840B"
(.0617)
X2 = 31.0 df = 28 S.E.E.




(.0168)

(1 - .65984B12)a
(.0565)
.298 x 10 _ 1

SAMPLE 61.1 - 78.12

(1-B)(1-B12) ln(r+l) = (1 - .61654B + .21149B2 - .41122B12)a
(.0887)
(.0885)
(.0757)
X 2 = 31.0 df = 27 S.E.E.

r+l-v

SAMPLE: 59.1 - 78.12

(1-B )[(1-B) lnt* + .00224D* + .4750D2 - .08269D ]
(.0186)

r+1

SAMPLE: 59.1 - 78.12

12
12
(1 - .36188B)(1-B)(1-B ) lnz = (1 - .69992B )a
(.0640)
(.0501)
X2 = 36.5 df = 28 S.E.E. .273 x 10 _ 1
SAMPLE: 59.1 - 78.12

X2 = 29.9 df = 28 S.E.E.

t*

SAMPLE: 59.1 - 78.12

(1-B)(1-B12)

SAMPLE: 68.10 - 78.12

ln(r+l-v) = (1 - .23795B - .51541B12)a
(.0841) (.0891)

X2 = 21.4 df = 28 S.E.E.
(1-B)

.887 x 10~ 2

.704 x 10 _ 2

SAMPLE: 68.10 - 78.12

.460

SAMPLE: 68.10 - 78.12

lnb = a

X2 = 35.6 df = 30 S.E.E.

D» is a dummy for the period 1966.7 to 1966.12, D„ is a dummy for
the period 1968.12 to 1970.6 and D. is a dummy for the periods
1967sl-2 and 1970s7-8.

40

Table 2 Component Models
June 1981 Revisions

k

(1-B)(1-B3)(1-B12) Ink = (1 - .7396B3)(1 - .6239B12)a
(.0460)
(.0598)
X 2 = 36.21 df = 28 S.E.E. = .566 x 10~ 2

g

(1-B)(1-B12)
X2 = 34.28

z

t*

lng = (1 - .4134B)(1 - .1322B2)(1 - .6311B12)a
(.0655)
(.0742)
(.0544)
df = 27 S.E.E. = .200

(1-B) (1-B 3 ) (1-B 1 2 ) l n t * = (1 - .6761B 3 H1 - .5738B 1 2 )a
(.0494)
(.0603)
df = 28 S.E.E. = .551 x 10 _ 2

(1-B12)[(1-B) lnt* + .00232D

+ .0474D

(.0159)

(.0130r
1

= (1 - .5369B)"
X
r+£

SAMPLE: 59.1 - 79.12

12
12
(1 - .3484B)(1-B)(1-B ) l n z = (1 - .6912B )a
t
(.0627)
(.0497)
2
1
X = 34.53 df = 28 S.E.E. = .269 x l O "
SAMPLE: 5 9 . 1 - 79.12

X2 = 33.82
t*

2

= 30.65

(.0164)




'

12

(1 - .6597B )a

df = 28 S.E.E. = .292 x lO"1

SAMPLE: 61.1 - 79.12

(1-B)(1-B12) ln(r+£) = (1 - .6748B + .2449B2 - .3713B12)a
(.0823) (.0834) (.0702)
SAMPLE: 68.10 - 79.12

(1-B)(1-B12) ln(r+£-v) = ((1 - .3114B - .5220B12)a
(.0734) (.0745) t
X2 = 27.93

tc

SAMPLE: 59.1 - 79.12

- .0828D ]

X2 = 35.13 df = 27 S.E.E. = .952 x 10 _ 2

r+£-v

SAMPLE: 59.1 - 79.12

df = 28 S.E.E. = .712 x 10~ 2

SAMPLE: 68.10 - 79.12

12
3
9
12
(1-B)(1-B ) lntc = (1 - .5432B - .1730B + .1770B - .6038B )a
(.0540) (.0490)
(.0405)
(.0507) Z
2
-1
SAMPLE: 69.1 - 79.12
X = 39.27 df = 26 S.E.E. = .330 x lO

41

H.

CONCEPTUAL REDEFINITIONS

The current definitions add a new component to the M R money stock: travelers
checks. On first glance it is tempting to lump these with one of the two original
components, probably currency, redefine component ratios, and hide the problem in the
traditional symbols. Some reflection suggests that this is not appropriate. Travelers checks,
at least those issued by non banks, differ from deposits in that they are not subject to
reserve requirements. Alternatively, travelers checks differ from currency in that they are
not a use of the monetary base. We have chosen to model the problem with a new
component ratio, tc, defined as the ratio of travelers checks to the currency component of
M R . With this definition, a typical M R multiplier can be written as
IB

1+(1 + tc) k
(r-b)(l + t* + t* + g + z) + k

The most casual examination of the time series for tc reveals a distinct change in the
behavior of the series around 1968-69. We have not tracked down an explanation for this,
but feel that it is likely that part or all of it can be attributed to changes in the quality of
the data sources. Whatever the cause, we concluded that it would be futile to model the
history of the series from 1959 to the present as a stable ARIMA process, and have
concentrated our efforts on the 1969.1 - 1979.12 sample. Our current model for this
component ratio is given at the bottom of table 2. Judged by the usual standards for ARIMA
models, these estimates appear quite acceptable. The model has a very simple structure,
though it requires more parameters than our other models, and the residuals pass the usual
o
X test. Two cautions should be observed. First, there are several individual "spikes" in the
autocorrelation function that appear quite large even though the overall test statistic for
autocorrelation is acceptable. Second, we have not had the opportunity to subject this
specification to the stability tests that have been applied to the other component models in
the past. Thus, we do not have any information on the robustness of the specification to
sample changes or data revisions.
HI.

NOW ACCOUNT SHIFTS

An important question for the stability of our forecasting models, as well as for the
interpretation of monetary policy in general, is the nature and extent of portfolio shifts that
occurred subsequent to the authorization of NOW accounts nationwide on January 1, 1981.




42

We discussed this in our report to the last meeting of the Shadow Committee, though the
experience available under the new regime was minimal at that time. The important
question is the extent to which the public shifts from assets that are excluded from M R
(presumably savings deposits for the most part) into checkable deposits. Shifts from demand
deposits into other checkables would have no impact as far as the performance of our models
is concerned, since the components that we use include only the sum of demand deposits and
other checkable deposits.
Since the last Shadow meeting, the Staff of the Board of Governors has produced (and
released) a measure for "shift adjustment M " that reflects their estimate on the size of
the portfolio shift into other checkable deposits from non demand deposit sources. These
estimates reflect the assumption that 77.5 percent of net inflows to other checkable
deposits in January, 1981 came from demand deposits and 72.5 percent of new inflows into
OCD in the remainder of the first half of 81 came from demand deposits. 2) These estimates
were constructed from information from several sample surveys (including some very small
samples) and information from cross section regressions on deposit flows.
It is interesting to examine the magnitude and pattern of the computed shift
adjustment. Let D be the demand deposit component of M R (as measured), T be the
difference between M_ and M, D , and S be the different between M, D (as measured) and
l

n\

ID

"shift adjusted M " all not seasonally adjusted.
pattern of the estimated S as shown below:
January 1981
February
March
April
May
June
July

io

Particularly interesting is the time

3.7
6.2
7.7
9.8 •
9.3
9.7
10.3

D
T+S
The l n ( f r ^ ) and ln(-7jr- ) are plotted as the solid lines in the two halves of figure 1. Note
that in both eases, the In of the adjustment is basically a constant starting in April, 1981.
We have estimated two linear regressions on the January, 1981 - April, 1981 sample (4
observations) as;
(1) I n ( g ^ ) = .0071 + .0063t




43

FIGURE 1

.03
D = Checkable deposit component
° f M1B
S = Shift adjustment (Board of- Gov)
toM1B

Actual
in

02

0.0 before 1/81
.0071 + .0063t 1/81-4/81
.0071 + .0063*4 5/81 and subsequently
t=l in 1/81

,01 -

Jan

Feb

Mar

Apr

May

Jun

Jul

1981

.006
Shift adjustment (Board of
Governors) to M-

±

.004

Computed as

0.0 before 1/81
.00161 + .00148t 1/81-4/81
.00161 + .00148*4 5/81 and
subsequently

.002

Jan




Feb

Apr

Mar
1981
44

May

Jun

Jul

(2)

l n ( ~ ) = .00161 + 00148t

The predicted values from these regressions are plotted as the broken lines in figure 1. Our
conclusion is that the shift adjustment as measured by the Board of Governors is very close
to an exponential trend over the four month period January-April, at which point the
portfolio adjustment for all practical purposes can be regarded as completed.
Given the simple formulation in time of the shift adjustment, represented by (1) and
(2), we are able to use our models to attempt to independently verify the nature of the
portfolio shift into NOW accounts. First, given a portfolio shift such as that in (1) and (2)
our models should tend to overpredict the measured component ratios (without shift
adjustment) for k, t*, t*, g and z during the first half of 1981, and consequently we should
consistently underpredict the measured M R multipliers during this period. If, however, a
portfolio shift such as that in (1) and (2) actually occurred, then forecasts from our
component models for k, t*, t*, g and z, supplemented by an intervention in the form of (1)
for k, t*, g and z and in the form of (2) for t*, should eliminate the bias from the M R
forecasts. We have constructed one month forecasts over the period January-June, 1981,
under both of these assumptions. The results are tabulated below for the monetary base
multiplier (the results for other multiplier concepts are consistent with these).-4)
'
Actual M
Multiplied
January, 1981
February
March
April
MayJune

2.5609
2.5276
2.5541
2.6270
2.5446
2.5528

Forecast M 1R
Multiplier115
(No Intervention)

Forecast M R
Multiplier115
(With Intervention)

2.5379
2.5151
2.5129

2.5626
2.5257

L « 0OO<7

2.5643
2.5813

£t o 0 £ t 0 < J

2.5938
2.5609
2.5783

The results of the forecasts are consistent with a portfolio shift such as that
hypothesized by the Board's staff. Forecasts from our component models consistently
underestimate the observed monetary base multiplier from January through April. The mean
error over the entire first half of 1981 is .0111, or about .4 percent. Much of this bias is
eliminated by using the intervention variable derived from the Board of Governors shift
adjustment. Under these conditions the mean error of the one month forecasts over the first
half of 1981 is only .0035, or about .1 percent of the monetary base multiplier, and the
standard deviation of the forecast errors is about .9 percent. Both of these results are quite




45

consistent with the forecasting experience of the models since October, 1979. (See Johannes
and Rasehe, 1981, table 4, p. 307.)
We constructed a second test of the Board of Governors shift adjustment using time
series techniques. First we assumed an intervention variable of the form described above.
Rather than constraining the coefficient of this variable to -1.0, we estimated the
coefficient along with the parameters of the ARIMA models for each of the five component
models. In each case we fail to reject the hypothesis that the coefficient on the
intervention variable is -1.0; however in no case is the estimate very precise and in several
cases the point estimate is quite far from -1.0 (in one case it is even positive). In summary
all the evidence we have examined appears consistent with the shift adjustment published by
the Board of Governors. 5) Therefore we have assumed the intervention consistent with this
shift adjustment in the forecasts below.
IV.

FORECASTS

Our forecasts through June, 1982, for the net monetary base and adjusted unborrowed
reserves multipliers are given in tables 3 and 4, respectively. These forecasts are for the
current M „ concept including travelers cheeks. The tables follow the same presentation as
last time in presenting year over year predicted percentage changes to abstract from month
to month seasonal changes. These forecasts suggest a slight increase in both multipliers
during the third quarter of 81 (attributable in large part to the observed increase in July,
1981) but then diverging behavior for the two concepts. The net base multiplier is forecast
to decline during the fourth quarter of 81 and the first quarter of 82. The adjusted
unborrowed reserves multiplier on the other hand is forecast to increase slightly over this
period. The forecasts of substantial decline for both multipliers for second quarter of 82 is
so far in the future that it should not be treated seriously at this point.




46

Table 3
M, „ Net Monetary Base Multipliers (N'SA)
i—c
(Forecasts Based on Information Through July, 1981)

Actual
1980

Predicted
1981

July

2.5594

2.6037*

August

2.5727

2.5891

.64

September

2.6124

2.6044

-.31

October

2.6254

2.6104

-.57

November

2.6080

2.5834

-.95

December

2.5973

2.5946

-.10

1981

1982

January

2.6064

2.5895

-.65

February

2.5715

2.5438

-1.08

March

2.5942

2.5416

-2.05

April

2.6731

2.5829

-3.43

May

2.6021

2.5076

-3.70

June

2.6096

2.5269

-3.22

Actual




47

% Change

1.72*
.68

34

">-i.2e

>-3.45

Table 4
Mn

Adjusted Unborrowed Reserve Multipliers (NSA)

(Forecasts Based on Information Through July, 1981)

Actual
1980

Predicted
1981

9.9923

10.3153*

3.18*

August

10.1383

10.3185

1.76

September

10.2864

10.3243

.36

October

10.3275

10.2950

-.32

November

10.2925

10.2136

-.77

December

10.0790

10.2360

1.55

1982

1982

January

9.7363

9.S664

1.33

February

9.9922

10.0520

.60

March

10.0600

10.0912

.31

April

10.4329

10.2556

-1.71

May

10.3218

9.9962

-3.21
-3.21

June

10.4302

10.1736

July

Actual




48

% Change

>

>

> -2

-2.42 j

FOOTNOTES

1)

This is not necessarily an overwhelming reason for dealing with them separately. As
we mentioned last year, we resorted to expediency in defining our t* and t* ratios as
they appear in the denominator of our multiplier expressions to include all items in the
difference between M

and M R or M„ and ML, respectively, even though many of

these items are not reservable.
2)

See T.D. Simpson and others, "Recent Revisions in the Money Stock:
Seasonal Adjustment, and Calculation of Shift-Adjusted M R ."

3)

Our source for these numbers is the H.6 release for August 14, 1981, Table la.

4)

These multipliers are constructed for the "old-new" M R concept, that is they exclude
the travelers check component. This was done in order to provide comparability to our
previous forecasting results.

5)

A third approach to verifying the shift adjustment is to estimate all parameters in a
2
3
coefficient of an intervention variable of the form w + w-B + w«B + w„B in each of
the five component models and check for consistency across equations as well as
consistency with the estimated parameters in figure 1. We have not yet completed
this test.




49

Benchmark,




FEDERAL BUDGET OUTLOOK
and
ECONOMIC PROSPECTS THROUGH 1982
Robert R. Davis
and
Robert J. Genetski
Harris Trust and Savings Bank

Background paper prepared for the September 13-14, 1981 meeting of the Shadow Open
Market Committee and distributed earlier by Harris Trust and Savings Bank







?^s BANKs

Harris

I l l s Dmii\

W^^.

Chicago, Illinois

J l J l t J I U P I 1 ^ # 1i

_

• —
H W t a P

August 28, 1981

FEDERAL BUDGET OUTLOOK
The federal budget deficit for fiscal 1982 is expected to expand to a record of $77
billion. However, comparisons indicate that by some measures the deficit will be smaller
than others experienced during the last decade. The deficit is not expected to interfere
with the conduct of monetary policy, and while anticipation of the deficit may have
contributed to record high interest rates, the deficit should not significantly alter the
course of interest rate declines projected for this year and next.
A Larger Budget Deficit for Fiscal 1982
Before the end of the year, the Administration is likely to announce an expected
budget deficit for fiscal 1982 (FY 1982) that is significantly larger than the $41 billion
national income account figure released with the July Midsession budget. The expenditure
side of the new budget will remain unchanged for the most part, but projected tax
receipts will fall as the government abandons the hopelessly optimistic growth
assumptions that were part of the Administration's early euphoria. Moreover, budget
revisions apparently are being hampered by bureaucratic techniques which prevent the
rapid adjustment of budget projections, and political gamesmanship probably demanded
that such adjustments be delayed until passage of the tax cut bill was assured.
The government's revised deficit for FY 1982 should exceed $60 billion. Even this
substantial increase would fail to capture the full effects of the expected economic
slowdown. If constant dollar GNP continues to fall in the second half of 1981 at a 2.8
percent annual rate and inflation slows in 1982 to 7.5 percent, as forecast by the Harris
Economic Reseach Office, tax receipts in FY 1982 will grow by 6 percent to $644 billion.
In spite of the recent budget reductions, expenditures are set to increase 8 percent to
$721 billion. Without further outlay reductions, the FY 1982 budget deficit will set a new
record of $77 billion (Table 3).
Federal tax receipts will decline by 2 percent in real terms in FY 1982. Of the four
major components of receipts, only social insurance contributions will show an inflation
adjusted increase. Personal taxes, corporate taxes, and indirect business taxes will
decline in real terms, with corporate taxes declining in nominal terms as well.
Budgeted federal expenditures will increase by 8 percent in FY 1982, roughly
unchanged after adjusting for inflation. Of the different expenditure categories, national
defense, transfer payments, and net interest payments will increase in real terms.
Because net interest payments depend on a combination of current portfolio costs and
future interest rate changes over which the government has no control, national defense
and transfer payments appear to be the only growth areas in which further budget cuts are
feasible. These areas represent 66 percent of total budgeted expenditures. If it were
possible to hold defense and transfer spending constant in real terms through further
legislation, the projected FY 1982 deficit would drop from $77 billion to $58 billion.




53

The Deficit and Monetary Policy
The large deficit for the next fiscal year can be financed by issuing government debt
to the private sector s by issuing government debt which is absorbed by the Federal
Reserve through open market purchases, or by a combination of the two. To the extent
that debt is issued and held by the public, less creditworthy or productive borrowers will
be crowded out of the debt market. If the Federal Reserve purchases debt, the deficit
will be monetized, monetary reserves will expand more rapidly, money supply growth will
accelerate, and inflationary pressures will build.
A fear is frequently expressed that the Fed will have little choice in the decision to
monetize the deficit. In this scenario the large budget deficit is expected to put intense
pressure on credit markets. The Fed would be "required" to buy government debt to
accommodate credit demands in an attempt to ease interest rates, money supply growth
would soar, and rising inflationary expectations would raise interest rates regardless of
Fed intentions. The economy would thus be caught in a vicious cycle from which no
escape is possible unless the deficit is reduced.
TABLE 1
FEDERAL DEFICITS AND MONETARY POLICY
(IN BILLIONS OF DOLLARS)
Fiscal
Year
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981 (Harris est.)

Budgeted
Federal Outlavs*

Budget
Deficit*

212.9
232.7
255.7
278.2
328.8
370.7
411.7
450.5
494.7
578.2
668.2

-20.5
X S o &*

-14.9
-6.6
-45.4
-55.8
-45.8
-36.3
-14.0
-50.9
-58.6

Federal Debt
Purchased by
Federal Reserve
7.6
7.5
4.5
7.5
8.4
3.6
8.4
13.6
0.9
7.8
3eu

Percentage
of Deficit
Monetized
37%
39%
30%
114%
19%
6%
18%
37%
6%
15%
9%

•National income account basis
An examination of the evidence quickly dispels the notion that expansion of the
money supply has been dictated by Federal deficits. Table 1 indicates that the Fed has
enjoyed great discretion in the conduct of monetary policy over the last decade, choosing
to monetize as much as 114 percent of the deficit in 1974 and as little as 6 percent in
1976 and 1979. Moreover, there has been no tendency to monetize increasing portions ©f
the deficit during years that had greater red ink. The Fed chose to monetize only 6
pereent of the deficit in 1976 when the government experienced the largest deficit to
date.
The Federal Reserve has monetized 22 pereent of budget deficits on average over
the last 11 years (excluding 1974, when 114 pereent of a small deficit was purchased by
the Fed). Given this track record and evidence that the monetary authority has great
diseretion In choosing what amount of the deficit to monetize, there is no reason to
believe that the large FY1982 deficit should prevent the Fed from achieving its 1982
money supply growth targets. In fact, for Ml-B to reach the upper end of the 1982 target
range of 5.5 percent, the Fed should be expected to purchase about 14 pereent of the
projected $77 billion deficit. This percentage is somewhat below the Fed's past average,
but is well within the demonstrated range of discretionary action.



54

The Deficit and the Economy
Even if the FY 1982 budget deficit does not unduly hamper the conduct of monetary
policy, many observers fear that demands on private credit markets will be severe,
insuring continued high interest rates and economic chaos. Although evidence suggests
that these fears are largely unfounded, the climate of uncertainty surrounding the impact
of the budget deficit and the Administration's economic program has had a pronounced
effect on interest rates. Interest rates are currently at their highest levels relative to
inflation in 50 years, and the sizable real return can only be explained by incorporating a
premium for perceived financial risk.
The marketplace is uncomfortable with a budget deficit that is correctly anticipated
to set a new record in nominal terms. There is certainly no reason to be complacent with
the deficit, because it means that government continues to overspend its means, erode
capital formation, and jeopardize future economic growth. However, the specific effects
of the FY 1982 deficit should be analyzed by comparison to other periods of major deficit
financing. Only in this manner is an objective opinion likely to be generated.
The $77 billion deficit forecast for the next fiscal year is much less ominous when
compared with the deficit of FY 1976. As indicated in Table 2, the FY 1976 deficit
exceeded the projected deficit for FY 1982 as a percentage of GNP, as a percentage of
personal saving, as a percentage of government spending, and after adjusting for
inflation. These comparisons suggest that the markets should handle the upcoming
government financing with no more difficulty than occurred in FY1976. Moreover, the
FY 1976 financing was hampered by a real' economic growth rebound of 6 percent which
tended to raise credit demands. Even so, interest rates in FY 1976 posted moderate
declines as inflation rates felL
TABLE 2
COMPARISON OF FISCAL 1976 AND 1982 BUDGET DEFICITS
1976
Deficit/GNP
Deficit/Personal Saving "
Deficit/Government Outlay
Deficit in 1982 dollars

3.4%
66.1%
15.1%
$88.2 billion

1982
2.5%
56.9%
10.7%
$77.0 billion

In conclusion, the budget deficit expected for FY 1982 is not likely to pose an
insurmountable problem. The Federal Reserve has sufficient flexibility and discretion to
meet its money growth targets, and the deficit, though large, is relatively less than other
deficits which the economy has taken in stride. Uncertainty surrounding the size and
impact of the deficit has resulted in a risk premium that partially explains the current
record interest rate levels. However, if the fourth quarter financing proceeds in an
orderly manner as expected, the risk premium should fall, contributing to a general
interest rate decline.

Robert R. Davis
Vice President and Economist




55

TABLE 3
NATIONAL INCOME ACCOUNT BUDGET
FEDERAL GOVERNMENT RECEIPTS AND EXPENDITURES
{in billions of dollars—fiscal years)

Actual
1980

Midsession Budget

Harris Estimates

1981

1982

1981

1982

S26.0

S20.8
18.0

f?8.3

809.6
15.9

643.9
5.6

251.4

291.5
16.0

309.9
6.3

288.5
14.8

299.2
3.7

Corporate Profits Tax
% Ch

70.6

74.0
4.8

80.6
8.9

§7.8
-4.0

59.8
-11.8

Indirect Business Tax
% Ch

35.3

S7.2
58.8

61.3

58.0
62.0

61.3
5.7

168.3

198.1
17.7

226.5
14.3

195.4
16.1

14.5

576.4

S67.3
15.8

?XS*3
7.8

868.2

720.9
7.9

190.4

219.3
15.2

247.4
12,8

219.5
15.3

247.6

126.0

147.0
16.7

171.7
16.8

146.9
16.6.

171.8
17.0

64.5

72.3
12.1

75.7
4.7

72.6
12.6

75.8
4.4

233.0

278.4
17.0

S01.4
S.3

278.3
16.9

303.7
9.1

Grants-in-Aid to S&L Govt.
% Ch

86.3

89.7
3.9

82.1
-8.5

89.8
4.1

82.2
-8.5

Net Interest Paid
% Ch

10.7

17.4

77.0
14«2

S7.4

76.0

Subsidies Less Curr Surplus
% Ch

J.J.oX

Receipts
% Ch
Personal Tax
% Ch

Social Insur. Contributions
% Ch

Expenditures
% Ch
Pureh of Goods & Services
% Ch
National Defense
% Ch
Nondefense
% Ch

Transfer Pavments
% Ch

Deficit

11.4
-8.8

19.8

-46.5

-41.0

-58.6

0
-10.4

Preliminary Estimates from Bureau of Eeonomie Analysis




12.4

12*6

Wage Accruals Less Dis&.

Jnfe*0

56

-77.0

1 3 BANK5
!Sr=-

Karris .
Economies
August 28, 1981
ECONOMIC PROSPECTS THROUGH 1982

Although the economy turned down in the second quarter, various pockets of
strength continue to bolster business activity. Still, downward pressure is building,
and recessionary signals will become clearer in the months ahead. The Fed's
latest decision to promote faster growth in the narrowly defined money supply
(Ml-B) raises the prospects of a recovery next year. However, this decision,
supported by the Administration, represents the first sign that political forces
may keep the Administration from meeting its anti-inflation goals.
The Economy—Down But Not Yet Out
While second quarter real GNP was reported down 2.4%- at an annual rate,
industrial production was actually up 2.4% at an annual rate. Moreover, in the
period since the second quarter, no clear trend has emerged. Auto sales are up,
interest rates are higher, and personal income is showing surprising strength. In
contrast, the index of leading indicators fell 2*/2% from April to June, and while
the index is expected to have been essentially flat in July, seven of the eight
measures available pointed toward weakness. Furthermore, in August two reliable
leading indicators—stock prices and commodity prices—were down sharply. On
balance, in spite of some areas of strength, the economy remains under extensive
recessionary pressure.
Money, the Economy, and Inflation—What's Happening?
Some efforts to explain the strength in the economy and the high interest
rates have focused on the broader measure of money, M2, which has grown at a
8V2% annual rate since November. However, the behavior of M2 does not explain
the slow 4% annual pace of spending in the second quarter, nor the sharp downtrend
in commodity prices and stock prices. These developments are consistent with
the type of highly restrictive monetary policy reflected in the performance of
Ml-B.
While the economy and inflation appear to be responding to monetary growth,
interest rates are not. This time it has taken significantly higher rates relative
to inflation to induce slower spending. The public refuses to believe that a
prolonged period of sluggish spending and lower inflation lies ahead. Many businessmen
have apparently decided not to make the same mistake that they made in 1980
and lay off workers in response to the economic weakness, only to find sales and
orders picking up several months later. In addition, the tax cut makes immediate
layoffs less compelling than they would otherwise have been. The decision to
maintain production and employment for a longer period of time suggests that
profits will be worse and the downturn more severe than previously had been
anticipated.




57

A Sustained Fight Against Inflation?
Indications have emerged that the fight against inflation may be temporarily
ending. The two-year annual average of money (Ml-B) has gone from 8V2% in
August, 1979 to 6%. Now, both the Administration and the Fed have agreed to
boost money growth to reach the bottom of the targeted range. If the Fed is to
reach the bottom of its range for Ml-B, growth between June and December
would have to average 7.3% at an annual rate. Some argue that the reasoning
behind this proposed acceleration is tied to hitting the Fed's money targets, while
others are concerned with the prospects of a Federal deficit that may exceed
$75 billion. Still others argue that an acceleration in money is necessary to
prevent a sharp rise in unemployment as the Administration fights for further
budget cuts.
While all of the above arguments have merit, none represents a valid reason
for once again embarking on a course of monetary stimulus. After two years of
monetary growth averaging 6% per year, the economy has fully adjusted to this
rate. Any acceleration from this rate, regardless of the justification, will create
greater problems for policymakers in the future. Furthermore, if political pressure
leads to stimulus at this point in time, it is almost certain to prevent a slowdown
in money as the 1982 Congressional elections move closer.
The recent calls for faster money growth suggest that market participants
may have been correct in their skepticism concerning a sustained anti-inflation
program. The latest move on the part of the Fed and the Administration marks
a major setback in the effort to alter inflationary expectations. By justifying
greater monetary stimulus, both the Fed and the Administration are needlessly
encouraging a greater premium on interest rates. In order for this premium to
be reduced substantially in the immediate future, it may be necessary to remove
the political discretion over future monetary growth. In this regard, speculation
over the return to a gold standard is likely to intensify. Although moving toward
an effective gold standard would have considerable drawbacks, it may be the only
practical way to contain future money creation and to convince the public that
inflationary policies will not be pursued in the decade ahead.

Robert J. Genetski
Vice President and Economist




58

8/21/81

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

ACTUAL
1980:1

YEARS

rOBECftST

1979

1980

1981

1982

1981:1

1981:2

1981:3

1981:1 1982:1

1982:2

1982:3

1982:<«

2730.6 2853.0
11.9
19.2

2881.6
1.1

2915.5
1.8

295*1.9
5.5

3010.1
7.7

3095.7
11.8

3179.6
11.3

3258.5
10.3

2113.9 2626.1 2901.3 3136.0
12.0
8.8
10.5
8.1

CONSTANT DOLLAt ONP
SCB

1185.6
3.8

»
1507. 1 1196. < 1185.8
-2.1
-2.9
-2.8

1189.0
0.8

1505.1
1.1

1520.0
1.0

1529.2
2.1

1183.0 1180.7 1501.5 1510.8
3.2
-0.2
1.1
0.6

M I C E DEFLATOi
SCH

1.8381 1.8811 1.9117 1.9181 1.9887 2.0218 2.0568 2.0919 2.1309
10.7
9.8
6.6
7.9
8.5
6.8
7.1
7.0
7.7

1.6276 1.7738 1.9326 2.0753
8,5
9.0
9.0
7.1

1751.0 1810.1 1831.0 1877.0 1907.1 1911.1 1990.1 2017.5 2095.0
17.1
11.2
1.7
10.1
6.6
7.3
10.1
12.0
9.6

1510.9 1672.7 1856.1 2018.5

0 0 0 3 3 tJATi

flODUCT

ten

COISUHPTlOJi
SCH

EKPEHD1TUIES

1516.1
8.6

12.0

10.7

11.0

8.7

DURABLES
8CH

238;3
29.7

227.0
-17.6

238.0
20.8

238.0
0.0

219.6
21.0

263.6
21.1

277.2
22. 3

287.3
15.1

212.3
6.5

211.9
-0.2

235.3
11.1

269.1
11.5

iOHDURABLES
SCH

703.5
18.5

726.0
13.1

731.6
1. 8

715.3
6.0

756. 1
5.9

763.5
1.0

775.6
6.5

792.9
9.2

806.8
7.2

602.2
13.7

675.7
12.2

710.5
9.6

781.7
6.0

SERfICES
8CH

CO

223.3
30.9

821.2
13.1

815.8
10.9

869.1
1 1.6

893.7
11.7

913.3
9.1

928.3
6.7

950.9
10.1

977.1
11.6

1000.9
10.0

696.3
12.1

785.2
12.8

880.6
12.1

961.1
9.5

397.7
23.7

137.1
15.9

155.8
18.2

137.7
-15.0

130.1
-6.5

137.1
6.7

156.7
18.9

173.7
15.7

190.0
11.5

115.8
10.8

395.3
-1.9

110.3
11.1

161.1
5.5

302.1
11.5

315.9
19.6

323.3
9.7

327.5
5.3

327. 1
-0.5

321.3
-3.1

327.2
3.6

332.3
6.1

337.1
6.3

279.7

295.9

323.1

330.3

15.6

5.8

9.3

2.1

208.8
9. 1

213.6
9.5

183.1
12.3

187.1
2.0

201.1
7.6

207.2
2.9

IRTfESTNEttT
SCH
HOMES
fCH

EXPEiDITURES

F I X E D EXPEND

FttODUCERS DOB EQUIP
SCH

190.7
8.7

198.7
18.0

200.7
1.0

203.7
6.2

202.7
-1.9

202.2
-1.0

201.3
1.2

B U S I I E S S STRUCTURES
(CH

111.5
16.5

117.2
22.3

122.7
19.9

123.8
3.8

121.1
2.0

122.1
-7.2

122.9
2.6

123.5
2.0

123.8
1.0

96.3
22.1

108.8
13.0

122.0
12.1

123.1
0.9

RES FSRED EXPEttD
SCH

113.0
68.1

116.7
13.8

111.3
-17.3

100.0
-31.8

96.8
-12.2

105.9
13.2

119.2
60.5

130.8
15.0

110.8
31.3

118.6

105.3

106.2

121.2

6.6

-11.2

0.9

16.9

IMEtJTOttf

-17.1

1.5

21.2

10.2

6.5

7.2

10.3

10.6

11.8

17.5

-5.9

10.6

10.0

23.3

29.2

17.7

12.0-

8.0

6.3

8.7

3.5

-2.1

13.1

23.3

16.7

1.0

«JOV¥ PUICHA9ES
SCH

558.6
20.2

576.5
13.1

577.1
0. 1

588.8
8.1

609. 1
11.5

625. 3
11.1

610.2
9.9

651.9
9.5

675.9
13.5

173.8
9.5

531.7
12.9

587.9
9.9

619.1
10.1

FEDERAL
SCH
HILITAIY

212.0
10.0
111.6

221.6
19.1
115.2

219.1
-3.9
118. 1

221.9
10.1
15?.5

236.8
22.9
163.0

211.7
11.0
168.8

251. 1
10.9
171.6

257.6
10.8
180.6

269.9
20.5
190.7

225.7
13.5
152.2
15.6

255.8
13.1
178.7
17.1

71 . 3

72.1

73.8

75.9

76.5

77.0

198.9
18.5
131.7
18.1

70.1

76.1

167.9
9.5
111.2
11.3

79.2

56.7

67.2

73.5

77.2

316.6
9.8

351.9
9.9

357.7
3.2

J63.9
7.1

372.3
9.6

380.6
9.2

389. 1
9.2

397.3
8.7

106.0
9.1

305.9
9.6

335.8
9.8

362.2
7.9

IET

CHANGE

EXP01TS

ten
OTHEI

STATE •
ICH

UOTE:



LOCAL

PERCENTAGE CHANGES AT ANNUAL RATI--",

393.3
8.6

8/21/81

ECOtlOHIC OUTLOOK
(BILLIONS OF DOLLARS—SEASONALLY ADJUSTED AMHUAL RATES)

FORECAST .

ACTUAL

YEARS

1980:4 1981:1 1981:2 1981:3 1981:4 1982:1 1982:2 1982:3 1982:4

1979

1980

1981

1982

PIETftl P10FITS
SCH

2"»9.5
21.6

256.9
12.*

22*.9
-11.3

212.7
-20.0

206.7
-10.8

209.3
5.1

220.9
21.1

231.3
20.2

237. *
11.1

255.3
11.1

215.5
-3.8

225.3
-8.2

22*.7
-0.3

flETtl PROFITS »0J 11
tCH

181.3
12.7

203.0
50.1

187.0
-28.0

177.9
-18.1

173.7
-9.1

177.7
9.5

190.8
32.9

203.1
28.1

211.7
18.0

196.•
6.1

182.7
-7.2

185.%
1.5

195.•
5.6

85.2
38.8

§7.7
12.3

71.8
-17.1

71.2
-17.7

69.0
-11.8

68.0
-5.8

71.6
22.6

71.7
18.7

76.2
8.3

87.6
5.6

82.1
-6.0

75.7
-8.1

72.6
-1.1

161.3
13.7

169.2
12.5

150.1
-38.1

111 .1
-21.2

137.7
-10.2

111.3
10.8

119. 3 156.6
21.8
20.9

161.2
12.1

167.•
19.5

163.2
-2.7

119.6
-8.3

152.1
1.7

98.1
-5.5

115.3
90.8

112.2
-10.3

106.7
-18.1

101.7
-7.3

109.7
20.6

1 19.2
39.6

128.1
31.5

135.5
21.0

109.2
6.5

100.3
-8.1

109.7
9.3

123.2
12,3

TAX LIABILITY
fCII
IFTEt TAX P1QFITS
SCH
AFT Til PIOF &DJ 1)
SCU
PERSONAL INCOHE
SCH
TAE * ifOiTAX PAYMENT
SCH
OS

DISPOSABLE INCOME
SCH

o

PERSOUAL OUTLAYS
SCH

2256,2 2319.8 2368.9 2133.8 2*75,3 2521.6 2582.5 2613.5 2701.2
7.0
10.0
9.8
11.8
11.1
9.5
7.7
8.7
11.3
359.2
22.1

372.0
15.0

382.7
12.0

397.3
16.2

390.8
-6.1

396.8
6.3

126.1
79.7

131.8
19.3

5.1

1.6

5.3

5.3

6.0

6.2

97.3
0.9

98.0
3.1

98.9
3.5

99.1
2.2

99.3
-0.1

99.1
0.1

105.2
0.7

105.8
2.1

106.8
3.7

107.3
2.0

107.7
1.5

108.0
1.1

I6T£<8)

7.5

7.3

7.1

7.1

7.8

8.0

PRODUCTIVITY-NONFARH
SCH

0.990
0.0

1.000
1.1

0.998
-0.8

0.992
-2.1

0.986
-2.1

MDUSTSIAL
SCH

1.191
21.2

1.518
7.1

1.527
2.1

1.520
-1.8

1.159
-15.1

LABON fORCE
SCH
UiEHPLOYHEiT

II

PIODUCTlOi

PROFITS ABE AOJUSTE0 TO EHCLUDE




338.5
12.1

385.7
13.9

398.3
3.3

1555.5 1720.3 1906.5 2072.0
12.2
10.6
10.8
8.7

108.9
11.8

EMPLOYHEBT
SCH

302.0
16.7

1799.1 1858.9 1881.0 1927.6 1958.1 1993.0 2013.0 2101.8 2150.1
10.1
12.0
9.6
6.5
7.3
10.3
13.9
17.3
1.8
105.2
96.1

1»TE<S)

398.7
11.1

1611.7 1821.7 2013.8 2211.7
10.0
11.0
12.2
10.5

88.9
-31.2

SIfltJG

388. 1
-19.3

1897.0 1917.8 1906.2 2036.5 2081.5 2121.8 2173.0 2255.1 2305.5
8.0
16.1
9.8
10.5
12.8
11.1
8. 1
9.1
9.2

97.6
-11.1

PEISONAL SAVINGS
SCH

109.5
13.1

1913.8 2160.3 2399.5 2613.0
12.9
11.1
8.9
11.1

INVENTORY

130.0
-5. 1

153.6
91.8

155.1
3.9

86.2
12.9

101.1
17.6

107.3
5.8

112.6
33.0

6.8

6.7

5.3

5.6

5.3

6.1

100.1
2.8

100.5
1.6

100.9
1.6

96.9
2.7

97.3
0.3

98.9
1.7

100.2
1,3

108.1
1.5

108.8
1.5

109.3
1.9

102.9
2.5

101.0
1.8

106.9
2.0

108.6
1.6

7.7

7.6

7.7

5.8

7.1

7.5

7.7

0.986
0.0

0.990
1.6

0.991
1.6

0.996
0.8

0.991
-0.7

0.988
-0.3

0.991
0.6

0.992
-0.3

1.156
-0.8

1.179
6.5

1.500
5.8

1.509
2.1

1.525
1.1

1.171
-3.6

1.506
2.1

1.186
-1.3

6.0

PROFITS AMD ALLOM FOR DEPRECIATION AT REPLACEMEIT

COST.

ECONOMIC PROJECTIONS
Burton Zwick*
Prudential Insurance Company of America

Over the years, monetarists on this Committee and elsewhere have emphasized and
documented a familiar Federal Reserve behavior pattern — official statements about
controlling inflation followed by rapid acceleration of money. It is somewhat ironic that a
major forecasting error of many of these same monetarists occurred in October 1979 when
they interpreted an official Federal Reserve policy statement about controlling inflation as
evidence of the Fed's determination to control money growth. Contributing to the optimism
of monetarists and many other economists at that time was a Federal Reserve
announcement concerning operating procedures, namely that policy operations would
henceforth be directed at controlling money rather than interest rates.
As we of course know,the Fed followed anything but a monetarist operating approach
in 1980, with the money supply declining early in the second quarter and then soaring at a 15
percent annual rate from May to November. Part of the acceleration presumably reflected
Carter administration concern about rising rates before the election. But part of the
acceleration — as well as the earlier decline — was probably an unintended consequence of
operating procedures that continue to limit the movement of rates. Whatever the cause of
the monetary fluctuations in 1980, they have reinforced skepticism about the Federal
Reserve's commitment to controlling money and inflation on a long-term basis.
Since the election, the Federal Reserve has moved aggressively, as in late 1979, to
control money. From the fourth quarter of 1980 through mid-August, a nine month period,
annual growth of the monetary base has declined to about 5 1/2 percent, M1B to about 4
percent, and adjusted M1B to less than 1 percent (see chart 1). Relative to previous 3 year
growth rates, these represent the sharpest declines in several decades (see table 1). The
economy has responded somewhat to this monetary deceleration, with final sales though not
production and employment declining since January. In line with moderate slowing in longer
term money growth, the inflation rate has also begun to drop into single digits.
*The projections presented here reflect my own personal views and should not be interpreted
as the offical view of Prudential. I appreciate the comments of J. Robert Ferrari and
Michael J 8 Hamburger.




63

CHART 1

ANNUAL TARGETS

175,

MONETARY BASE AND MiB
S75

ANNUAL GROWTH
I975-79" 8 . 5 %
1977-79
8.6%

170
4 1/2 %

165

H 160

MONETARY BASE

155
Bill.
$430
3 1/2 %

420

420

410

400

ANNUAL GROWTH
1975-79 7 . 0 %
1977-79 8.0 %
1980
7.2 %

390

380 I

410

SHIFT ADJUSTED

I I I g j - | I j I B l i l B8I I I I I j l H B l i I I j l 1 I gl i l l g t I I j l l I j i I I I | l I I j l I I [ 1 1 1 I

1979




1980

400

390

380
1981

TABLE 1
HONETARY GROWTH RATES 1 9 5 1 - 8 0
(4TH QUARTER TO 4TH QUARTER)

Monetary Base

ILL
Current
Growth
1951
1952
1953
1954
1955
1956
1957
1958
1959
1960
1961
1962
1963
1964
1965

Ol

5.1
4.2
1.3
2.5
2.4
1.1
-0.3

1971
1972
1973
1974
1975
1976
1977
1978
1979
1980

3.3
2.1
0.6
2.7
1.8
4.0
4.4
4.4
2.8
6.3
7.4
3.9
5.0
6.7
8.5
5.8
4.8
5.1
6.2
8.2
8.2
7.5
7.3

1981
1981

4.5*
2.1**

1966
1967
1968
1969
1970

Annual Growth
in 3
Previous Years

Current Less
Lagged
3 Year Growth

0.8
2.9
4.6
3.6
2.7
2.1
2.0
1.1
1.4
1.7
2.0
1.8
1.7
2.9
3.4
4.3
3.8
4.5
5.5
5.8
5.4
5.2
6.7
7.0
6.3
5.2
5.3
6.5
7.5
8.0
7.7
7.7

4.3
1.3
-3.3
-1.1
-0.3
-1.0
-2.3

2.2
0.7
-1.1

0.7
0.0
2.3
1.5
1.0
-1.5

2.5
2.9
-1.6
-0.8

1.3
. 3.3
-0.9
-2.2
-1.2

1.0
2.9
1.7
0.0
-0.7
-3.2
-5.6

Current
Growth__

Annual Growth
in 3
Previous Years

4.0
5.0
1.3
1.2
0.9
0.6
0.9
1.9
1.8
1.1
2.4
3.3
4.9
5.5
5.6
4.4
6.5
7.1
4.0
6.3
7.7
8.0
7.7
8.8
7.2
7.7
8.6
9.2
8.1
8.4

-0.1

5.7

8.6

1.8
4.0
3.4
2.5
1.1
0.9
0.8
1.1
1.5
1.6
1.8
2.3
3.5
4.6
5.3
5.2
5.5
6.0
5.8
5.8
6.0
7.3
7.8
8.2
7.9
7.9
7.8
8.5
8.6

Current Less
Lagged
3 Year Growth

4.1
3.2
-2.7
<-2.2
-1.6
-0.5

0.0
1.1
0.7
-0.4

0.8
1.5
2.6
2.0
1.0
-0.9

1.3
1.6
-2.0

1.5
1.9
2.0
0.4
1.0
-1.0
-0.2

0.7
1.4
-0.4
-0.2
-2.9

^Reported MIB, assuming 4 1/2% annual growth from June to December.
"Adjusted MIB, assuming 4 1/2% annual growth in reported MIB from June to December and no further shift of savings
accounts into NOW accounts.




TABLE 3
ANNUAL GROWTH RATES OF GNP, M1B,
AND MONETARY BASE
(4TH QUARTER TO 4TH QUARTER)
Growth Rate of
Nominal GNP
1960
1961
1962
1963
1964
1965
1966
1967
1968
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1960-80
1960- 70
1971- 80
1971- 75
1976- 80




Growth Rate of

2.0

0.5
2.8
1.8
4.0
4.4
4.4
2.7
6.3
7.4
3.8
4.8
6.7
8.5
5.8
4.7
4.9
6.0
81
.
8.2
7.7
7.3

7.5
5.8
6.6
5.9
10.5

8.0
6.2
9.4
6.9
4.9
9.6
11.5
11.6

71
.
10.0

9.3
12.2
14.2

9.9
9.4
8.5
6.7
10.5
10.0
11.0

M1B

5.3
3.9
6.8
61
.
7.5

v

Growth Rate
of Velocity
of M1B

1.5
4.6
3.9
2.6
1.5
5.9
5.2

=

Growth Rate o f
Monetary Base

1.8
2.9
0.0
2.8
2.8
5.5
2.3
4.9
31
.
3.8
5.6
21
.
1.9

11
.
2.4
3.3
4.9
5.5
5.6
4.4
6.5
71
.
4.0
6.3
7.7
8.0
7.7
8.8
7.2
7.7
8.6
9.2
8.2
8.3

31
.
2.7
3.5
3.7
3.3

6.3
4.6
81
.
7.9
8.4

-0.1

TABLE 4

INFLATION RATE OF GNP DEFLATOR
(4TH QUARTER TO 4TH QUARTER)

As Predicted Using 3-Year
Laqqed Growth of:
Actual

M1B (error)

Mo netary Base (error)

1963
1964
1965

1.5
1.4
2.5

0.9 (0.6
1.6 (0.2
2.6 (0.1

0.5 (1.0)
2.2 (0.8)
3.1 (0.6)

1966
1967
1968
1969
1970

3.7
3.1
4.8
5.5
5.0

3.7
3.9
4.2
5.4
6.8

(0.0
(0.8
(0.6]
(0.1,
(1.8]

4.0
3.5
4.3
4.4
4.4

(0.3)
(0.4)
(0.5)
(1.1)
(0.6)

1971
1972
1973
1974
1975

4.7
4.3
7.0
10.1
7.7

5.4
5.2
7.8
7.9
6.7

(0.7)
(0.9)
(0.8)
(2.2)
(1.0)

5.0
5.4
7.4
7.4
7.6

(0.3)
(1.1)
(0.4)
(2.7)
(0.1)

1976
1977
1978
1979
1980

4.7
6.1
8.5
8.1
9.8

4.8
5.6
7.4
9.0
9.0

(0.1)
(0.5)
(1.1)
(0.9)
(0.8)

7.4
7.2
8.0
8.3
8.4

(2.7)
(1.1)
(0.5)
(0.2)
(1.4)

FORECASTED INFLATION RATE OF GNP DEFLATOR
(4TH QUARTER TO 4TH QUARTER)
Assume; Growth of:
i
Monetary Base
MTB.
1981
1982
1983




4.5
5.0
5.0

5.5
6.0
6.0

Inflation ]mplied by Growth of:
Monetary Base
M1B
8.4
7.0
5.9

69

7.3
6.1
4.8

1983. The major reason to believe that the Reagan administration will adhere to a program
of monetary restraint is that voters may in fact be willing to accept relatively high
unemployment for a while if the inflation and interest rates decline as much as in the table 2
projections. Also, any move toward stimulus would almost inevitably lead to further
weakness in the financial markets.
Another risk to the forecast is that the Fed may remain too tight over the next few
weeks. While the Federal Reserve does not target the funds rate as explicitly as before
November 1979, the weekly average of the funds rate has remained between 18.21 percent
and 19.33 percent for 14 of the past 16 weeks. (This tendency to keep the weekly average
within narrow limits for several months at a time occurred in 1980 as well.) The funds rate
pattern suggests that the new operating procedures may still not be sufficiently flexible to
permit the rate decline that may be needed in the next few months if the monetary restraint
since last November causes the economy to weaken. A grudging decline in the funds rate
would represent yet another instance of procyclieal monetary policy, in this ease causing a
moderately severe recession extending into early 1982. Such a policy would increase the
pressures on the Reagan administration to stimulate in 1982.
A final word about budget deficits. Deficits are going to be in the $75-$100 billion
range in 1982 and 1983, particularly if the economy is as sluggish as projected in table 2.
While skepticism about the Reagan administration's willingness to accept protracted
economic weakness accounts for much of the weakness in the bond market, at least some of
this weakness reflects concern about budget deficits, particularly if follow up budget cuts
are not forthcoming or if defense spending increases are permitted to offset the nondefense
budget cuts. At present levels of inflation and nominal rates, market rates are presumably
affected more by money and inflation than by the effects of deficits on the level of real
rates. Even so, because many believe that budget deficits encourgae faster money growth,
efforts to reduce budget deficits would be extremely helpful to Administration efforts to
change inflationary expectations.




70

a/2»/8i

ECONOMIC

OUTLOOK

YEARS

f
1980:R 1981:1 1981:2 1981:3 1981:1 1982:1 1982:2 1982: 3 1982 «
liTEREST

1979

1980

1981

1982

RATES

13.3

13.9

11.8

15.9

1».3

12.7

11.7

1 12

10 5

9.7

12.3

11.7

11.5

1V. 4

15.1

15.9

17. 1

15.5

13.7

12.7

12 2

11 5

10.3

13.3

15.9

12.5

16.7

19.2

18.9

19.8

16.5

1 3.0

11.0

9 7

9 5

12.7

15.3

18.6

10.8

15.0

15. 1

15.9

16.3

13.5

10.5

9.0

8 2

8 0

11.0

12.6

15.2

8.9

3 noma T-BILLS

13.6

11. R

11.9

15.3

12.5

9.7

8.5

7 7

7 5

10. 1

11.1

11.3

8.3

PRIHARf

15.6

15.8

16.6

17.2

11.2

10.9

9.3

8

8 2

11.1

12.9

15.9

9.2

161.9
9.8

163.3
3.6

166.2
7.1

168.5
5.6

171.8
8.1

171.7
6.9

177.7
7.0

183.8
7.0

1HH.9
8.3

156.6
8.1

167.5
6.9

179.2
7.0

17.689 18.0U2 17.802 17.85* 17.776 17.866 18.019 18.200 18.337
8.1
8.2
-5.2
1.2
-1.7
2.0
3.5
1.1
3-0

17.322
2.9

17.113 17.868
2.1
0.7

1 8 . 106
1.3

MEW ISSUE

AA INDUS

REM ISSUE M
PHIME

UTIL

BONDS
BOtfDS

BITE

COMMERCIAL

PAPER

R HOS

90 DA? CDS

1)

i)

HONE? AND VELOCITY
NONETfttT

BASE-(HB)

ten
fELOCITS
ilCU

OF MB 0

180.7
6.9

•117.0
11.3

122.1
1.9

«31.3
9.1

133.3
1.8

110.6
6.9

«t«7.1
6.0

H53.6
5.9

160.3
6.0

167.0
6.0

378.9
7.8

102.7
6.3

131.8
7.2

157.0
5.8

H1-B»

6.959
18.5

7.027
1.0

6.910
-6.5

6.908
-0.2

6.851
-3-3

6.918
5.8

7.026
1.6

7.112
5.0

7.181
U.I

6.616
3.6

6.729
1.7

6.921
2.9

7.067
2.1

HOMEf S U P P L f - ( H 2 )
5SCH

1661.0
8.1

1698.1
8.5

1713.6
11.1

1765.1
5.0

1803.5
9.0

1838.5
8.0

1871.3
8.0

1910.7
8.0

1917.8
8.0

1173.0
8.9

1603.9 1752.6
9.3
8.9

1892.8

1.739
9.2

1.719
2.5

1.732
-».0

1.717
-3.U

1.695
-5.0

1.706
2.6

1.716
2.6

1.729
3-1

1.739
2.1

1.712
3.2

1.712
0.0

1.723
0.6

1.722
0.0

2.569
12.9

2.636
10.8

2.68*
7.5

2.751
10.3

2.BOH
7.9

2.8«5
6.0

2.891 . 2.913
7.1
6.9

2.995
7.3

2.176
11.3

2.170
13.5

2.719
10. 1

2.919
7.«

9.065

10.100

7.800

8.630

8.219

8.796

9.301

9.615

9.820

10.559

8.978

8.687

9.390

DOMESTIC

6.581

7.100

5.567

6.300

6.000

6.597

6.976

7.330

7.163

8.230

6.58«

6.317

7.092

IMPORTS

2.181

2.667

2.233

2.330

2.219

2.199

2.325

2.315

2.357

2.332

2.39»

2.362

2.299

1.535

1.391

1.170

1.000

1.100

1.300

1.000

1.500

1.600

1.716

1.303

1 . 165

1 . 150

HOME?
gCH

SUPPL¥-(H1-B)

WLOClTf

OF

yen

m

VELOCIT? OF
»CH
CPI-ALL

m

URBAN

yen
AUTO SALES

2)

HOUSING STARTS

2)

MOTE:
VELOCITY I S HEASURED AS GHP D I V I D E D BY MONEY S E R I E S
1) PRIOR TO NOVEMBER 1 9 7 9 , COMMERCIAL PAPER 1-6 MOS
2 ) I N M I L L I O N S OF UNTTS-SEASOMALLY ADJUSTED ANNUAL RATES




LAGGED TWO QUARTERS

8.0

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