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O cto b e r 8,1976 Policy in a Weak Recovery In a speech last May to the Institu tional Investors Institute, Federal Reserve Governor Wallich set forth a useful rule-of-thumb of monetary policy: “ When there are disturb ances on the side of the real sector, monetary policy should focus on the (monetary) aggregates and al low interest rates to move up or down in order to counter the dis turbance. Conversely, when there are disturbances on the monetary side, monetary policy should focus on interest rates in order to avoid transmitting these disturbances to the real sector." His remarks may provide some background for ex amining the recent “ summer lull"—the unexpected slowdown in the expansion pace of the real economy, as exemplified by an ap parent lag in GNP growth and by a decline in the leading indicators of future business activity. Then: monetary disturbance Actually, Governor Wallich's re marks were made in the context of what was seen at the time as “ a disturbance on the monetary side— the less predictable demand for M i." He was referring to the fact that during late 1974 and 1975, con ventional money-demand equa tions had persistently (and increas ingly) overpredicted the amount of money demanded by the public to finance transactions. By the last quarter of 1975, the over-prediction had cumulated to $19 billion— about 6 percent of the actual level of the narrowly defined money supply. Digitized for F R A S E R The Federal Open Market Commit tee responded to this monetary disturbance—the apparent instabil ity in money demand—in a way consistent with Governor Wallich's rule-of-thumb. For example, the Record of Policy Actions for the January 20th meeting stated, “ In view of the current uncertainties regarding the behavior of the monetary aggregates, many mem bers advocated that the Committee continue to give greater weight than usual to money-market condi tions in the period until the next meeting, and that it specify twomonth ranges of tolerance for growth in the monetary aggregates that were wider than usual." The FOMC thus decided to shift the short-run ranges of tolerance it had previously used for its policy vari ables. For the Mi money supply, it widened the range to five percent age points—somewhat greater than the average range of three percen tage points it had used in earlier months. But for its interest-rate variable (the Federal-funds rate), it narrowed the range of tolerance to 14 percentage point, down from the 1-114 percentage-point range of the immediately preceding months. A good deal of recent research has attempted to explain the large er rors produced by standard moneydemand equations. Enzler, Johnson and Paulus, in a recent article in the Brookings Papers, identified several factors which reduced the error but still left a relatively large amount to (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. be explained. However, we should note one important point: since the fourth quarter of 1975, the error in the money-demand estimates has become relatively stable, in the sense that it has stopped its upward climb and levelled off. Conse quently, for the past three quarters, changes in the demand for money have been in line with their past behavior, in relation to changes in aggregate demand, interest rates and prices. Now: real disturbance Today the emphasis has shifted, with more uncertainty in the real sector than in the monetary sector, in the form of the “ summer lull.” One of the most striking features of the summer lull was the succession of three straight increases in the unemployment rate, to 7.9 percent in August. This was the first time since 1959 that unemployment had risen in such a fashion in the midst of a business expansion—and the 1959 episode was explained by a major steel strike which forced lay offs in other industries. According to the Bureau of Labor Statistics, most of the recent upsurge in the Digitized for F R A S E R jobless rate reflected an unexpect edly large increase in the civilian labor force, especially in the num ber of women jobseekers. In Au gust, however, the labor force grew only modestly and still the jobless rate continued to rise. Another element in the summer lull was the lag in business plantequipment spending, relative to the pace projected in the preceding survey of business spending plans. This was the fifth consecutive quar ter in which actual outlays trailed projections. In addition, new orders for non-defense capital goods fell by a steep 12 percent in August after a seven-month string of in creases. There was some encouraging news as well. Retail sales, which had fall en in July, rose more than 2 percent in August. Capital appropriations, which lead spending plans for plant and equipment, were up substan tially in the second quarter. And although the August survey of spending plans indicated little ad vance over the previous (April) sur vey, real outlays may be higher than indicated because of the easing of capital-goods prices between the two survey dates. Different choice of variables Given the present concern over the state of the real economy, some importance attaches to the variable that is emphasized in policy delib erations. Past experience indicates (as does our rule-of-thumb) that when aggregate demand is weaker than expected, targeting interest rates closely would tend to keep rates higher than otherwise would have been the case. Such an action in turn would tend to reinforce the weakness in the underlying econo my. Testifying before the House Bank ing Committee last February, Con gressional Budget Director Rivlin presented an argument against em phasizing interest-rate variables rather than monetary-growth vari ables. “ If an unexpected economic weakness were to develop, for ex ample. . .it would have the effect, because of the fall-off in loan de mands, of reducing monetary growth and lowering interest rates. Following an interest-rate target at such a time would mean taking steps to raise interest rates back to target levels, and these steps would further reduce demands and hence further weaken the economy. “ Following a monetary target, on the other hand, would mean taking steps to raise the money supply back to its target level, and these steps would tend to strengthen de mands and counteract the unex pected economic weakness." In her view, whenever unexpected strength or weakness has occurred during past business cycles, “ it seems clear in retrospect that fol lowing monetary-growth targets would have promoted economic stability." Current cyclical indicators suggest that we are now faced with relative ly greater uncertainty regarding the real sector than regarding the monetary sector. Although fore casts of both real and monetary variables are subject to error, the future course of real-sector behav ior may be the more crucial factor for policymakers to watch. Rose McElhattan Digitized for F R A S E R 0 U O j8 u it )S B / V \ • I J E i n . U O § 0 J O • B p B A |s| . O L jB p i M EM EH • B |U J O p |E 3 • E U O Z jjy . E > )S E |V • J ! | E J 'O 3 S I0 U E J J U B S ZSL ON HWi!3d OlVd a o v is o d s n HVW SSV1D lSJlId ILjpjng©§3>^[ BANKING DATA—TWELFTH FEDERAL RESERVE DISTRICT (Dollar amounts in millions) Selected Assets and Liabilities Large Commercial Banks Amount Outstanding 9/22/76 Loans (gross, adjusted) and investments* Loans (gross, adjusted)—total Security 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* States and political subdivisions Savings deposits Other time deposits^ Large negotiable C D ’s 89,747 68,022 1,534 22,033 20,760 11,454 9,219 12,506 88,743 25,125 486 61,806 5,290 27,225 26,822 11,127 Weekly Averages of Daily Figures W eeken d ed 9/22/76 Member Bank Reserve Position Excess Reserves Borrowings Net free(+)/Net borrowed (-) Federal Funds—Seven Large Banks Interbank Federal fund transactions Net purchases (+)/Net sales (-) Transactions of U.S. security dealers Net loans (+)/Net borrowings (-) - Change from 9/15/76 - + + - + + - + - + + + - 14 0 14 + + 325 381 461 138 124 3 43 13 469 511 139 511 38 137 359 381 Change from year ago Dollar Percent + 3,905 + 3,693 + 518 719 + 1,120 + 1,223 + 384 172 + 2,288 + 1,213 + 170 + 944 549 + 6,329 3,421 - 5,292 W eeken ded 9/15/76 + + + + + + + + + + + - 4.55 5.74 50.98 3.16 5.70 11.95 4.35 1.36 2.65 5.07 53.80 1.55 9.40 30.29 11.31 32.23 Comparable year-ago period + 26 3 23 + 35 19 16 297 + 280 + 981 405 + 1,255 + 668 in c lu d e s items not shown separately. ^Individuals, partnerships and corporations. Editorial comments may be addressed to the editor (William Burke) or to the author. . . . Information on this and other publications can be obtained by calling or writing the Public Information Section, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco 94120. Phone (415) 544-2184. Digitized for F R A S E R