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ill)@,lIT\lk\ Jl CD) '(\\ lS':rVJ WJ "S' 11 I f I f February 15, 1 980 The Foreign Dimension Over the past year, the "foreign dimension" of u.s. economic policy has become increasingly prominent. In November 1 978 and again last October, the Federal Reserve took dramatic steps to reduce money growth and slow inflation, spurred in part by the adverse verdict rendered by the foreignexchange markets on u.S. economic policies. While safeguarding the soundness of the dollar has always been a u.S. policy objective, recent events have made it a matter of more explicit and immediate concern. In this situation, U.S. policymakers are likely to give more weight to foreign economic policies in formulating their own. After all, the foreign-exchange value of the dollar depends upon policies taken abroad as well as those pu rsued here at home. Ten-percent inflation in the u.s. need not mean a falling dollar if foreign inflation is the same-but a fall can scarcely be avoided if the foreign inflation rate is only five percent. This consideration looms particularly large as pol icymakers attempt to deal with the latest round of oil price increases. The consequences for the dollar of u. S. policies will depend critically upon how foreign governments choose to deal with that price surgesuperficially, whether they choose to fight its inflationary effects or whether they try to combat its adverse impact on real growth. Past record To a large extent, cu rrent and futu re macroeconomic policies abroad reflect the reverberating impact of 1 974's quadrupling of oil prices. This increase led to a sharp rise in inflation rates in japan and Europe in 1 974 and ,1975, accompanied by the most severe recession of the post-war period. As in the U.S., foreign governments at first reacted to the increased inflation by tightening monetary policy, even while applying fiscal stimulusto raise real growth. Their fiscal measures were largely unsuccessful, however, and so they eased monetary policy later in 1975 in a further attempt to alleviate the recession. Thereafter, economic policies here and abroad diverged somewhat. In the U.s., money growth continued to accelerate while real output recovered fairly steadily from its 1975 trough. Increased money growth in turn led to a fairly steady acceleration in U.s. inflation following its 1 976 trough. In contrast, foreign monetary policy remained cautious, with money growth actlJally slowing in 1 976 in most Europea'n countries and in 1 977 in japan. By 1978, these policies had generally succeeded in reducing foreign inflation rates well below 1 974-75 levels. (Indeed, in Germany and japan, consumerprice inflation fell to 3.5 and 2.5 percent, respectively, in 1978.) Partly as a result of these policies, foreign economies remained relatively sluggish: after a strong but abortive recovery in 1976, real growth slowed substantially in 1977, leaving unemployment rates very high by pre-1973 standards., Road to '79 ... Apparently successful in lowering inflation but faced with continued high unemployment, foreign governments eased policy in late 1 977 and 1 978 in an attemptto stimulate output. All of the major foreign industrial nations increased their government budget deficits followi ng the adoption of tax cuts and other stimulus measures. In japan, for example, the budget deficit reached 5 percent of G N P in 1 978-this in a country that had not experienced any significant budget deficits until the early 1970's. (In contrast, the budget deficit in the 1 970's generally remained under 3 percent of G N P-and never exceeded 4 percent.) Except in the U.K. and Canada, fiscal stimulus was accompanied in 1 978 by an acceleration of money growth, although for external as well as domestic reasons. German, japanese and Swiss central banks in particu lar made heavy pu rchases of dollars in u.s. Opinions expressed in this newsletter do not nc:cessariiy the views of the rnanagernent of the Federal Resf'::rve Bank of Sail francisco, nor of the Board of of the F'edera! Reserve Organization for Economic Cooperation and Development (OECD), real GN P in 1 980 was expected to grow by 2.25 percent in Germany and by 4.75 percent in Japan (considerably below their 1 979 performance of 4.25 and 6.00 percent, respectively), and was expected to fall by about one percent in 'the U.S. Even those unfavorable forecasts assumed thatoil prices would rise by no more than 1 0 percent over those prevai ling at the end of 1 979. order to support the dollar's sagging value on the foreign exchanges. As a resuIt, money growth in these countries in 1 978 substantially exceeded official targets or (Japan) projections. Whatever the reasons, the results of these pol icies were largely the same. Real growth averaged 3.3 percent in the ten majorforeign industrial countries in 1 978-compared to 2.9 percent the previous year-and apparently was about the same in 1 979. This improvement in real growth led to significant reductions in unemployment, but the accompanying easing of policy left governmentdeficits bloated in several countries and rekindled inflationary pressures. This expected slowdown could halt, and in some cases partially reverse, the recent progress in lowering unemployment and excess capacity. Nonetheless, foreign governments seem unlikely to relent from their stance of restraining inflation tighter monetary and fiscal policies. As in the U.s., their concentration on fighting inflation appears to reflect a public consensus that inflation is the number-one economic problem. In 1 979, foreign industrial countries experienced sharply accelerating inflation, traceable to their previous monetary expansion but also to sharp price increases for oil and other basic commodities. Consumer prices rose nearly 8.0 percent (on average) in the 10 major foreign industrial nations, compared to 1978's SA-percent average increase. Mindful of their earlier success in containing inflation, governments generally responded quickly and decisively to this acceleration by slowing money growth and raising domestic interest rates. For example, Japan raised its central-bank discount rate three times last year, from 3.5 percent to 6.25 percent, while Germany raised its central-bank rate from 3 to 6 percent over the same period. Foreign money-market rates increased apace (see,chart). Indeed, interest rates in Germany and Japan have increased more in real terms (relative to inflation) than they have in the U.S. Largely as a result, money growth abroad has slowed over the last year, while some foreign governments also have moved to tighten fiscal policy. To what extent are these prospects now altered by the oil price increases of the past several months? With oil prices rising this year, not by 10 perce.nt, but by nearly 30 percent, the outcome is likely to be even lower growth and higher inflation than previously anticipated. Whether governments now ease policy is likely to depend crucially upon how those price increases affect real growth throughout the industrial world. According to recent OECD estimates, the latest oil-price hikes could reduce real GN P in the industrial countries by an average of about one percent in 1980. This could mean stagnation or worse, especially in view of the fact that real GN P was already expected to grow very little in most foreign countries. Still, any downturn would probably not beas sharp as that occurring in 1 974 and 1 975, when real output fell sharply in most major industrial countries. Furthermore, estimates of the growth effects of these oil-price increases may be overstated, because they are based on past reactions of industrial economies to such shocks. In light of the experience gained by the oil-'importing ... and1980 Until the latest round of oil price hikes, last year's policy tightening promised some reduction in 1 980 inflation-but at the cost of lower real growth. According to the December 1 979 EconomicOutlook of the 2 ultimately to reduce inflation. Given the move toward more restrictive policies abroad, and given the lower average levels of foreign inflation rates, continued stability of the dollar is likely to depend upon a public perception that policy remains on its announced course of checking inflation. In other words, America's room to "accommodate" the oil price increases will be constrai ned by pol icy decisions made abroad if further pressure on the dollar is to be avoided. The foreign dimension of policy thus seems likely to remain prominent for some time to come. nations over the past six years, the disruptive effects of further price increases may be smaller and less protracted now than in the past. On balance, then, it seems Iikely that unemployment abroad will remain at painful but probably not intolerable levels during 1980. If so-and in view of the inflation impact of the latest oil-price increasespolicies abroad may continue to be directed toward containment of inflation. u.s. u.s. This prognosis, if correct, has important implications for policy. In the last fifteen months, the has twice succeeded in relieving pressure on the dollar by taking steps to restrain money growth-and hence u.s. u.s. CharlesPigott Percent 15 Money Market Rates U. K. 12 9 Germany 6 3 1918 1919 3 l SI:II:I !!eM1?H • lj1?ln • 1?! UJoJ!leJ • • 1?pei\aN• oljepi 1?UOZ!N • 1?>jS1?IV CG)24I Z:Sl'ON 1IWM:ld OIVd @l\\JJ@<§@CQ[ 's'n ll VW SSV1) 1SMI:I BANKING DATA-TWELfTH FEDERAL RESERVE DISTRICT (Dollar amounts in millions) Amount Outstanding 1/30/80 Change from 1/23/80 Loans(gross,adjusted)and investments* Loans(gross,adjusted)- total# Commercial and industrial Realestate Loansto individuals Securitiesloans U.S.Treasurysecurities* Other securities* Demand deposits- total# Demand deposits adjusted Savingsdeposits total Time deposits total# Individuals, part. & corp. (LargenegotiableCD's) .137,161 114,423 32,765 44,145 24,700 1,303 7,199 15,539 43,346 32,111 28,130 59,100 50,272 21,323 + 151 + 101 92 + + 129 + 121 68 32 + 18 + + 352 + 520 248 223 188 - 319 Weekly Averages of Daily Figures Weekended 1/30/80 SelectedAssetsand liabilities large Commercial Banks Member Bank ReservePosition Excess Reserves+ )/Deficiency (- ) ( Borrowings Net free reserves + )/Net borrowed(- ) ( Federal Funds- Sevenlarge Banks Net interbank transactions [Purchases (+)/Sales(-)] Net, U.S. Securitiesdealer transactions [Loans(+ )/Borrowings(-)] Changefrom year ago Dollar Percent + 16,637 + 16,043 + 3,965 + 8,648 + 4,206 304 391 985 + + 2,872 + 2,573 1,670 + 7,970 + 8,814 + 2,344 Weekended 1/23/80 + + + + + + + + + + + 13.80 16.30 13.80 24.40 20.50 18.90 5.20 6.80 7.10 8.70 5.60 15.60 21.30 12.40 Comparable year-agoperiod 5 336 341 0 69 69 77 56 21 + 1,526 +1,139 +1,363 - - + - 436 306 616 * Excludestrading account securities. # Includes items not shown separately. Editorial comments may be addressedto the editor (William Burke) or to the author .... Freecopiesof this and other FederalReservepublications can be obtained by calling or writing the Public Infonnation Section, Federal ReserveBank of SanFrancisco,P.O. Box 7702, SanFrancisco94120. Phone(415) 544-2184.
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