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July 4,1 980 Money,Prices, InterestRates and Monetary policy is currently at a critical juncture, since it must deal simultaneously with the twin problems of continuing high inflation and a developing recession. Some observers suggest that the Federal Reserve has given up the battle against inflation, because it has allowed a sharp drop in interest rates without first finding substantial evidence of any moderation in price behavior. Others worry that the Fed is contributing to a more severe recession, because the growth of the monetary aggregates has lagged below the lower bounds of their annual target ranges. Putting these concerns into proper perspective requires a realistic assessmentof 1) the tightness of current monetary policy, 2) the lags between money, output, and prices, and 3) the relationship between money and interest rates. The Federal Reserve has taken a strong antiinflation stance by attempting to reduce money-supply growth -specifically, by choosing a 5 %-percent midpoint for the target rate of growth of M- 1B, and associated targets for the other monetary aggregates. (M-1 B equals currency plus bank demand deposits plus other check-like deposits at banks and other financial institutions.) These targets represent a marked deceleration from the money-growth rates experienced previously, such as M-1 B's 8-percent annual growth rate over the 1977-79 period. Thus, according to this monetarist approach, the underlying inflation rate eventually should respond to the slowdown in money growth -although this development may be masked attimes by sudden price movements, such as occurred in the consumer-price acceleration of first-quarter 1980. lags and the long view Past experience would suggest that a 5Y4-percent rate of growth of M-1 B will, in the long run, tend to produce about a 7Y4-percent rate of growth of nominal GNP. That 7%-percent nominal growth in turn cou Id be divided into a 3-percent real growth rate (the long-term trend) and an inflation rate of around 4 % percent. But past experience again would suggest that this effect of monetary deceleration wi II be felt on Iy after a substantial lag, lasting four to five years for the final effects to occur. Thus, if current money-growth targets were to be hit consistently -and were to remain unchanged for several years' time -the inflation rate (measured by the GN P deflator) should decline from the 91f2-percent of early 1980 to perhaps 6Y2percent in 1982 and (finally) 4 % percent in early 1984 (see chart). However, the Federal Reserve has expressed its intention to reduce money growth gradually over time, which would imply an even lower inflation rate by the mid-1980's. Wh i Ie not perfect, the close association between inflation and lagged money growth vividly demonstrates the importance of taking a long view in the battle against inflation. That relationship also suggests an important related point -the substantial lag between the trough in economic activity and the low point in inflation. Following the 1970 recession, the inflation rate did not bottom out until the third quarter of 1 972; and after the 1974-75 recession, the low point in inflation was not reached until the third quarter of 1976. Similarly, even if the current recession is of normal duration and ends early in 1981, the trough in inflation generated by the current rate of monetary growth may not occur until over a year later. Interest-ratecontroversy Deceleration in inflation implies a prior deceleration in money growth -yet some analysts argue that the Federal Reserve has already given up in the fight against inflation by allowing a sharp drop in interest rates before seeing any tangible evidence of a moderation in price behavior. This point of view assumes, however, that interest rates are a good measure of current monetary policy, TI § JFrr CC CC li (G) Opinioil S expressed in this liewsletter do not necessarily rI.::,f\ect the vievvs of the management of the Federal Reserve Bank of San Francisco, nor of the Board of Govern()rs of the Federal Reserve System. which simply is not the case. Interest rates reflect current policy only to the extent that they reflect the liquidity effects of monetary acceleration or deceleration -that is, by faIling in a period of rapid money growth or rising in a period of slow money growth. But such liquidity effects often tend to be swamped in practice by changes in the demand for money and credit resulting from past policy changes and other influences. For example, in recession periods such as the present, interest rates fall because of a decline in the real demand for money and creditand also because of a decline in expected inflation, and hence in inflation premiums that become built into interest rates. come under pressure in a severe recession to abandon its current monetary-growth targets -i n effect, to abandon its antiinflationary policy. Policymakers thus see the wisdom of bringing the monetary aggregates back on path in coming months. That course of action, by providing the economy with sufficient liquidity, helps to moderate the severity of the recession -and also enhances the credibility of the Fed's policy stance. In contrast, excessively slow money growth would not be helpful, because in view of the lags involved, it would not bring any substantial improvement in prices until after the advent of double-digit unemployment, which presumably cou Id lead in tu rn to pressu res for excessively stimulatory public policies. Of these several factors operating on interest rates, expected inflation historically has generally been dominant But in the past two recessions, real demand effects have also been significant, leading to a fall in interest rates prior to the decline in the inflation rate. As in past cycles, current declines in interest rates are entirely consistent with a future moderation in the inflation rate, despite what some observers now contend. These individuals mistakenly believe that they are seeing the I iqu id ity effects created by a monetary acceleration, when in fact they are witnessing a fall in the real demand for money and credit flowing from a weak economy. A procyclical pattern of money growth (i.e., one that accentuates instead of dampens the business cycle) can be avoided, provided that all sectors of the economy recognize that cu rrent interest-rate decl i nes stem from a decline in the demand for money and credit generated by a weakening economy, rather than from the liquidity effects of a monetary acceleration. Current monetary-growth targets wi II contribute substantially to a moderation of inflation after a period determined by the usual lags, and a stable rate of monetary growth consistent with these targets is the best guaranty against a severe recession. A more stable pattern of business activity, in turn, will provide the best environment for making further progress against inflation in the future. Overly slow growth? If anything, liquidity effects are currently tending to raise, rather than lower, interest rates. Recently the narrowly defined monetary aggregates have lagged below the lower bounds of their target ranges. A prolonged undershoot of current monetary targets would constitute unwarranted tightness, and could be counter-productive in achieving both inflation and real-output goals. Adrian W. Throop The recession could be aggravated, with higher-than-expected unemployment, if the Federal Reserve consistently failed to meet its money-growth targets. However, that situation could also set the stage for future accelerated inflation, because the Fed would 2 Percent 12 10 8 6 4 2 o 1962 1965 1975 Shaded areas indicaterecessions 3 1980 1984 SS,",10 ! Sl:Il:I !!eMeH • • 4eln • e!uJoJ!le:::> • \illW;>d I \VJW;>CS ell (G) 4I\illW;>cgr 'J!It':>'O)SpUt'J::I ut'S ZSl 'ON 11WlHd GIVd :l9V1 S0d 's'n 11VW SSV1:> 1SHI::I @1 \\ell@<§@CQI ell@U:»@dI ITW;> :lJ. BAN KING DATA-TWELFTH FEDERAL RESERVE DISTRICT (Dollar amounts in millions) Selected Assetsand Liabilities Large Commercial Banks 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. (Largenegotiable CD's) Weekly Averages of Daily Figures Member Bank ReservePosition ExcessReserves +)/Deficiency (- ) ( Borrowings Net free reserves(+)/Net borrowed(-) • epei\aN • o4epi euoz! JY • e>jselV Amount Outstanding 6/18/80 136,176 114,693 33,202 46,439 23,699 1,014 6,323 15,160 42,919 30,508 27,407 63,583 54,722 22,533 Weekended 6/18/80 73 1 73 Changefrom year ago Dollar Percent Change from 6/11/80 - - - - 142 76 149 75 9 21 50 16 504 732 224 504 401 361 - - - Weekended 6/11/80 110 1 109 8,081 9,281 2,137 8,270 1,325 666 1,368 168 218 61 2,609 13,174 13,128 5,276 - - 6.3 8.8 6.9 21.7 5.9 39.6 17.8 1.1 0.5 0.2 8.7 26.1 31.6 30.6 Comparable year-agoperiod 9 16 25 * Excludestrading account securities. # Includes items not shown separately. Editorial comments may beaddressed the editor (William Burke) or to the author .... Freecopiesof this to andother Federal Reservepublications can beobtained 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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