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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.
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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

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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

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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.
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