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October 11,1974 Potential causes of the world's ab normal rates of inflation are easier to come by than potential cures. Still, part of the problem of devis ing solutions stems from the difficul ties of diagnosis. Dozens of com peting explanations have been advanced in the recent past, ranging from the workings of the interna tional oil cartel to the now-famous disappearance of the Peruvian an chovies. However, an increasing amount of research is now being devoted to monetary explanations of the worldwide upsurge in prices. Expansion of monetary base Monetary analysts link the domestic inflation since the late 1960's with the rapid growth of the U.S. mone tary base and thus the U.S. money supply. These analysts also argue that the expansion of the U.S. mone tary base has been an important determinant in inflation rates in foreign countries because it led to expansion in the monetary bases of these countries. The rapid growth of the U.S. monetary base has tended to increase U.S. prices and diminish the value of the dollar on foreign-exchange markets. To maintain dollar exchange rates within predetermined bands, for eign central banks had entered ex change markets periodically to purchase dollars. These dollar pur chase operations had the same effect as domestic Federal Reserve open market operations, leading to increasing the monetary bases of foreign countries and thereby their domestic money supplies. 1 The liabilities of foreign central banks (another name for the mone tary base) are matched by both domestic government debt and for eign-exchange reserves. In fact, changes in foreign-exchange re serves have dominated the move ments of the monetary base in most industrial countries during the period of fixed exchange rates. Under a fixed exchange-rate system surplus countries (other than the U.S.) had an undesirable choice— either revalue the currency, thereby hampering the export sector by making export goods more expen sive, or accept the impact of the reserve inflow on the monetary base, adding further to money growth and inflationary pressure. Central banks can sterilize such reserve inflows in the short-run if they are relatively small. However, if the inflows are large or continue for a long period of time, they will affect the domestic money supply. Given that in each country domestic currency growth determines domes tic prices, it follows that the course of world prices depends closely on the rate of growth of the world money supply. However, they now have to face the question of whether floating exchange rates— albeit managed to some degree by central banks— will diminish the inflation ary pressures on world prices. This question is related to the fixedvs- floating exchange-rate controversy. (continued on page 2) Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of San Francisco, nor of the Board of Governors of the Federal Reserve System. Expanding world base Monetarists contend that control over the money supply, interna tionally as well as domestically, de pends on control over the monetary base. Consequently, they are now giving close attention to alternative measures ot a world monetary base. One such measure is published in the annual report of the Italian cen tral bank, Banca d'ltalia, and is called the international liquidity base. The sources of the world liquidity base include monetary gold, IMF ordinary and special draw ing rights, unused credit lines at the IMF and the Federal Reserve Bank of New York— and most im portantly, U.S. and U.K. liquid liabili ties to official holders. (The total does not include domestic assets held by central banks.) The world liquidity base has grown spectacularly since the late 1960's, and has supported the vast increase in the world money supply. The sharpest growth— almost $22 billion — came in 1971, when it expanded more than in the preceding three years put together. Two-thirds of that 1971 upsurge was due to a sharp increase in foreign official holdings of dollars, associated 2 mainly with the severe monetary crisis which culminated in the de valuation of the dollar. Official foreign-exchange reserves — a primary component of the world liquidity base— have soared from $32 billion in 1969 to almost $138 billion in mid-1974. At the same time, a sharp discrepancy— $7 billion in 1969, but $48 billion in 1973 — has appeared between this total and U.S. -U.K. liabilities to official foreign institutions. The discrepancy indi cates that foreign-exchange reserves are being “ created" without an off setting U.S. or U.K. official liability. The source of this unexpected inter national-reserve creation is the Eurocurrency market. In that market, the funds deposited by foreign cen tral banks expand through Eurocur rency loans and later reappear as official foreign-exchange reserves. The process has been noted re cently, of course, in connection with the placement of the flood of dol lars from the oil-exporting countries. In its annual review of the Euro currency market, the Bank for Inter national Settlements noted the ex pansionary influence in 1973 of $8 10 billion in deposits by official monetary authorities, mainly attrib utable to the "fairly sharp expansion of the reserves of the developing countries." That influence will bur geon in 1974 and later years. Dollars and floating rates The future of the dollar in foreignexchange markets will depend not only on the supply of dollars, but also on official and private demands. Some analysts contend that the sys tem of floating exchange rates will affect official and private demands differently. The official demand for dollars should decline under this re gime, but private demands could in crease, because other currencies would then be less perfect substi tutes for dollars, the primary inter national-trading currency. The system of floating rates allows countries to insulate their domestic money supplies from outside mone tary movements, by permitting ex change rates to appreciate or depre ciate. The question still remains, however, how much countries will allow their exchange rates to move in order to secure control of domes tic money growth and their domes tic rates of inflation. Nor will it be costless for monetary authorities to pursue policies to reduce rates of money growth. While flexible exchange rates may provide the mechanism for coun tries to determine to some extent their domestic rates of inflation, money growth still has a large short-run impact on output and employment. Coincident reductions in money growth across the globe will possibly mean a reduction in the rate of growth of world output. But apparently, little choice remains if inflation is to be curtailed to any significant degree. C = 3 o Joseph Bisignano Business Review The current (September) issue of the Business Review carries the recent testimony of John J. Balles, President of the Federal Reserve Bank of San Francisco, before the House Banking and Currency Committee. In his testimony, Mr. Balles presents four major policy recommendations concerning ways of fighting inflation and high interest rates. Another feature of this issue is an analysis of the inflation-unemployment trade-off by Larry Butler, entitled "The Relation Between Income Growth and Unemployment." See page 4 for information on obtaining copies of this issue. 3 m o c= 3 uo;Su!i]se/v\ • q e ifi • uo S a jo • ppBAafsj . oqepi H E M EH • E jU J O p | E 3 * EU O ZU y BANKING DATA—TWELFTH FEDERAL RESERVE DISTRICT (Dollar amounts in millions) Amount Outstanding 9/25/74 Change from 9/18/74 Change from year ago Dollar Percent Loans (gross) adjusted and investments* Loans gross adjusted— Securities loans Commercial and industrial Real estate Consumer instalment U.S. Treasury securities Other Securities Deposits (less cash items)— total* Demand deposits adjusted U.S. Government deposits Time deposits— total* Savings Other time I.P.C. State and political subdivisions (Large negotiable CD's) 83,472 66,990 1,583 23,955 19,914 9,557 3,965 12,517 80,444 22,146 899 55,936 17,697 28,814 5,984 15,600 918 848 731 — 90 + 36 + 40 — 65 — 5 654 — 510 + 58 + 363 + 24 + 157 + 39 + 335 +7,783 +8,516 + 428 +3,490 +2,298 + 716 Weekly Averages of Daily Figures Week ended 9/25/74 Selected Assets and Liabilities Large Commercial Banks - - - + + + + + + 1,164 — + 431 +6,436 +1,029 — + + + 182 — +5,280 + 51 +5,018 — + + + 201 — +3,295 Week ended 9/18/74 + 10.29 14.56 37.06 17.05 13.04 8.10 22.69 3.59 8.77 4.87 16.84 10.42 0.29 21.09 3.25 26.78 Comparable year-ago period Member Bank Reserve Position Excess Reserves Borrowings Net free ( + ) / Net borrowed ( —) - 102 147 45 54 204 -2 5 8 - + 521 + 1,362 -9 9 6 + 945 + 1,064 + 150 - 23 88 65 Federal Funds— Seven Large Banks Interbank Federal fund transactions Net purchases ( + ) / Net sales ( - ) Transactions: U.S. securities dealers Net loans ( + ) / Net borrowings ( —) * Includes items not shown separately. Information on this and other publications can be obtained by calling or writing the Administrative Services Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco, California 94120. Phone (415) 397-1137. . E>|SE|V
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