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FRBSF WEEKLY LETTER
August 29, 1986
In Dubious Battle
New economic developments made a turbulent
decade of the 1970s, presenting problems and
sometimes conflicting objectives to both fiscal
and monetary policy and leading Congress to
mandate significant changes in the Fed's responsibilities, goals and structure.
In the summer of 1973, a price freeze was again
imposed, except on unprocessed farm products,
while wages, interest, and dividends remained
subject to guidelines. Sharp OPEC oil price hikes
in late 1973 and subsequent embargoes early in
1974 exacerbated cost pressures.
"New Economic Policy"
When President Nixon announced his New Economic Policy (NEP) in August 1971, prices had
been rising at a 5 percent average annual rate
over the preceding two years, unemployment
had more than doubled to 6 percent, and the
nation's foreign trade and balance of payments
had deteriorated sharply. To cope with the problem of inflation, the program imposed an initial
freeze in prices and wages followed by successive phases of more flexible controls designed to
reduce inflation to no more than a 2.3 percent
annual rate by the end of 1972. Interest and
dividend payments also were subject to limits
and guidelines.
But the public had become disenchanted with
the NEP. The President's Council of Economic
Advisers concluded that the track record of the
controls was "poor," and the NEP came to an
end with the lapse of Congressional authority in
the Spring of 1974.
At the same time, the program embraced
broadly stimulative fiscal and monetary policies,
including various measures designed to promote
productivity and employment, such as an investment tax credit. To correct the deteriorating balance of payments, the NEP called for a
temporary 10 percent import tax, successive
devaluations of the dollar amounting to about
20 percent, the end of convertibility of foreign
official holdings of dollars into gold, and abandonment of the system of fixed exchange rates
that had prevailed since 1946 in favor of one of
flexible rates.
The immediate results appeared favorable as
real growth (and exports) picked up, and unemployment, interest rates and the rate of inflation
all receded. Controls consequently were relaxed
in the direction of voluntary compliance under
the scrutiny of the Cost of Living Council.
However, prices subsequently rose sharply,
partly in response to worldwide crop failures
and large sales of u.s. grain to the Soviet Union.
A fistful of dollars
In spite of periods of transitory abatement, the
problems that afflicted the nation's economyinflation and high unemployment (spawning the
term "stagflation") - continued to confront policymakers throughout the decade. Between
1974 and 1978, prices rose at over a 7 percent
annual rate and unemployment averaged over 7
percent.
In 1978, President Carter called for an all-out
war on inflation and late that year imposed
wage and price guidelines of 7 and 6112 percent,
respectively, along with a package of measures
again designed to prop up a sagging dollar.
However, subsequent wage increases were
accompanied by net declines in productivity,
with the result that unit labor costs and prices in
1979 continued to soar.
In its 1979 Annual Report, the Federal Reserve
Bank of San Francisco noted that "the decade of
the 1970s experienced some notable achievements - and some notable failures." On the
"plus" side, real GNP increased by 36 percent
and aggregate real personal income by 26 percent in response to the creation of 21 million
jobs. But on the "minus" side, unemployment,
although down from 7-8 percent in 1975-76,
remained high at 6 percent at the end of the
decade, and the price level almost doubled,
leaving some groups (including the average production and nonsupervisory workers) with a net
loss of purchasing power.
FRBSF
Nominal market interest rates reached doubledigit levels by the end of the decade, while rate
ceilings imposed on the deposits of banks and
thrift institutions - a selective form of price
control- periodically resulted in substantial
savings outflows in favor of higher yielding
market instruments.
Atlas winced
A host of factors interacted to make the 1970s
the worst decade of inflation in the nation's history. They included a 15-fold increase inOPEC
oil prices, a tripling of raw material prices in
response to economic booms in most of the
industrial countries, and widespread crop
failures that contributed to a doubling of food
prices.
Domestic government spending also contributed
heavily. America's involvement in the Viet Nam
war wound down in 1972, but total federal outlays, pri~arily to expand entitlement programs,
nearly tnpled over the decade. The increase far
outpaced revenues, which were constrained by
tax reductions in 1971, 1975, and 1977. The
results were deficits aggregating $365 billion exceeding the net total of all deficits incurred in
the nation's previous 193-year history.
In 1974, CEA Chairman Alan Greenspan noted
that inflation ultimately reflected pressure on the
Federal Reserve to accommodate much larger
increases in the money supply than it normally
would sanction. Pressure came from heavy government demands in the credit markets which
were pre-empting a steadily increasing 'portion
of savings. Inflation, in turn, contributed to enormous private demands for credit. Both consumer
and mortgage debt about tripled over the entire
decade, partly in response to expectations of
continuing inflation, which, alongwith interest
tax deductibility, sharply reduced "real" borrowing costs.
For his part, Arthur Burns, Fed Chairman from
early 1970 to early 1978, repeatedly urged upon
the Congress the need for greater fiscal restraint
("deficits in the Federal budget must be scrupulously watched and gradually reduced"). In
1977, he added that the speed with which the
Fed could decelerate the growth of money and
credit without severely disrupting economic
activity "is limited by the degree to which inflation has become embedded."
Policy debate
At the heart of the debate over the appropriate
role of monetary policy were the differing views
and prescriptions of Keynesians and Monetarists,
although neither of their "textbooks" could adequately explain the phenomenon of stagflation.
As reflected in the views of the staff of the Congressional Joint Economic Committee in 1977
for example, Keynesians concluded that mon~
tary policy had been extremely tight over the
preceding five years inasmuch as the real money
supply (the nominal money supply adjusted for
inflation) had shown a net decline. Many in the
Congress argued that increasing production by
reducing high unemployment and excess capacity were the keys to reducing inflation. They
consequently favored a stimulative fiscal policy
and a monetary policy that focused on keeping
interest rates low rather than on limiting
increases in the money supply.
Monetarists argued that strict control over the
money supply was the key to controlling inflation, and that the lack of "real" growth was itself
the end-product of the rapid growth of nominal
money and the resulting inflation.
Various market and technological innovations
also were altering the historical relationship
between M1, interest rates, and income. In the
meantime, the Fed was being roundly criticized
by both sides in the policy debate - by Keynesians for being too restrictive, and by monetarists
for being too expansive.
Congress generally accepted the Keynesian view
although early in 1975 it also gave tacit recognition to the importance of the monetary "aggregates" when it adopted Concurrent Resolution
133. The economy was in a recession that had
started in 1974, and Resolution 133 expressed
Congress' "resolve" that the Federal Open Market Committee (which makes monetary policy)
pursue policies in the first half of the year to
enCourage lower long-term interest rates and
expansion of the monetary and credit aggregates
"appropriate to facilitating prompt economic
recovery."
In fact, ,interest rates already had started to drop
and the money supply to expand. Two years of
substantial real growth and falling unemployment and interest rates would follow - together
with accelerating inflation and, inevitably,
record high interest rates.
Structural reforms, increased responsibilities
The decade of the 1970s also witnessed substantial changes in the structure of the Fed and the
MONETARY POLICY OBJECTIVES FOR 1986 AND 1987
On July 23, Federal Reserve Board Chairman Paul Volcker presented a mid-year report to the Congress on the
Federal Reserve's monetary policy objectives for the remainder of 1986 and its proposals for 1987. The report
reviews economic and financial developments in 1986 and presents the economic outlook heading into 1987.
For single or multiple copies of the report, write to the Public Information Department, Federal Reserve Bank of
San Francisco, P.O. Box 7702, San Francisco, CA 94120, or phone (415) 974-2246.
scope of its responsibilities. In 1976, the House
Banking Committee made a number of recommendations to help the System deal more effectively with the increasingly complex problems
that characterized the economy, and also to
make it more "accountable" to the Congress
and the public.
Subsequently, the Congress vastly expanded the
Fed's responsibilities in the field of supervision
and regulation, including its authority over bank
holding companies and its rule-writing and
enforcement authority under a dozen major consumer protection laws enacted during the
decade (such as the Equal Credit Opportunity
and the Community Reinvestment Acts).
The Federal Reserve Reform Act of 1977 substantially broadened the criteria for selecting
Reserve Bank directors to give due consideration
to the interests of services, labor and consumers,
as well as agriculture, industry and commerce,
without discrimination as to race, creed, color,
sex or national origin.
In addition, the Act called on the Board to report
semi-annually to the House and Senate Banking
Committees on its goals and "targets" for the
monetary and credit aggregates (e.g., M1 and
M2) over the ensuing twelve months, and to
maintain long-term growth of the aggregates "to
foster increased production, maximum employment, stable prices and moderate long-term
interest rates." During mark-up of the bill, the
House Banking Committee responded to Chairman Burns' objections that it would trigger speculation by narrowly rejecting a provision that
would have required the Fed to provide forecasts of interest rates.
Congress passed the Humphrey-Hawkins "Balanced Growth and Full Employment Act" in
1978. The Act required the Board specifically to
discuss its plans and "targets" for the monetary
and credit aggregates in relation to the short-
term (two-year) economic goals (of GNP, employment, prices, etc.) specified by the President
in his annual Economic Report. After fierce
debate, the Act also stipulated adult unemployment and inflation goals of 3 percent by 1983
(and zero inflation by 1985) provided that policies and programs for reducing inflation do not
impede the goals and timetable for reducing
unemployment.
Crossing the Rubicon?
During the 1970s, the Fed continued to attempt
to influence the growth of deposits and the
money supply indirectly by influencing the Fed
funds rate (the rate at which banks borrow from
one another) and the cost of the reserves that
support deposit growth, rather than directly by
influencing the quantity of reserves by buying
and selling government obligations in the market. This procedure was flawed by a bias to react
too late in a climate of rising prices and interest
rates. Under the impact of soaring budget deficits and an enormous demand for credit from
the private sector, it had pro-cyclical effects, that
is, it amplified swings in the business cycle.
On balance, M1 about doubled, and M2 far
more than doubled during the decade. Consequently, on October 6, 1979 - two months
after Paul Volcker was appointed Chairman by
President Carter - the System announced a
series of steps to "assume better control over the
expansion of money and bank credit." The steps
included an increase in the discount rate (to a
record 12 percent), additional reserve requirements on various "managed liabilities," and,
most important, procedures for controlling
reserves directly rather than indirectly through
the Fed funds rate.
These steps ushered in the transition to the Brave
New World of the 1980s, which will be the subject of a future Letter.
Verle B. Johnston
Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of San
Francisco, or of the Board of Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor (Gregory Tong) or to the author .... Free copies of Federal Reserve publications
can be obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco
94120. Phone (415) 974-2246.
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BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT
(Dollar amounts in millions)
Selected Assets and liabilities
Large Commercial Banks
Loans, Leases and Investments 1 2
Loans and Leases 1 6
Commercial and Industrial
Real estate
Loans to Individuals
Leases
U. S. Treasu ry and Agency Secu rities 2
Other Securities 2
Total Deposits
Demand Deposits
Demand Deposits Adjusted 3
Other Transaction Balances4
Total Non-Transaction Balances6
Money Market Deposit
Accounts-Total
Time Deposits in Amounts of
$100,000 or more
Other Liabilities for Borrowed MoneyS
Two Week Averages
of Daily Figures
Reserve Position, All Reporting Banks
Excess Reserves (+ )/Deficiency (-)
Borrowings
Net free reserves ( + )/Net borrowed( - )
1
2
3
4
5
6
7
Amount
Outstanding
8/6/86
200,067
182,039
50,801
67,146
39,351
5,516
10,436
7,592
206,549
52,697
36,414
17,173
136,679
Change from 8/7/85
Dollar
Percentl
Change
from
7/30/86
46,752
"35,206
21,625
-
182
-
-
-
-
31
-1,309
-
-
5,294
5,824
718
3,095
2,737
120
1,182
651
7,751
5,330
6,711
2,881
459
2.7
3.3
1.3
4.8
7.4
2.2
-10.1
9.3
3.8
11.2
-15.5
20.1
- 0.3
1,760
380
156
6
182
157
6
71
153
2,496
1,626
1,368
879
8
3.9
2,627
433
- 6.9
- 1.9
Period ended
Period ended
7/28/86
7/14/86
79
35
43
6
23
17
Includes loss reserves, unearned income, excludes interbank loans
Excludes trading account securities
Excludes U.s. government and depository institution deposits and cash items
ATS, NOW, Super NOW and savings accounts with telephone transfers
Includes borrowing via FRB, TT&L notes, Fed Funds, RPs and other sources
Includes items not shown separately
Annualized percent change
@FedFRASER