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The W orld and the C ycle This has been an unusual business cycle. We were pleasantly surprised in early 1976 by the strength of the recovery in income and employ ment and by the significant fall in inflation and interest rates. This was the other side of the coin of the unpleasant surprise we encoun tered in 1974 and early 1975 with the unexpectedly severe decline in income and employment associat ed with historically high inflation and interest rates. There may be a common explana tion for the good news of early 1976 and the bad news of 1974-75. The explanation is not that the standard laws of supply and demand have been repealed—but rather that a worldwide business cycle phe nomenon has affected the U.S. in recent years, in contrast to the more domestic nature of the cycle in earlier decades. Worldwide cycle International influences, although by no means unimportant, had not been crucial influences on the U.S. economy until fairly recently, when the major industrial countries found themselves in a synchronized business cycle. In earlier periods, when one country was in a rising phase, other countries generally were in the falling phase of the cycle. As a result, world demand for internationally traded goods tended to grow at a steady rate, and international prices either re mained stable or, as in 1968-72, increased at only a moderate pace. But then an inflationary boom 1 developed, and industrial-export prices of major industrial nations more than doubled by mid-1975. A number of factors helped explain this phenomenon, but they could be summarized by a single statistic—international liquidity or world money, measured by the major industrial countries’ holdings of dollars and other international financial reserves. International liq uidity grew at a 3 percent annual rate between 1954 and 1968, and at about 7 percent annually between 1968 and 1971, but it more than doubled between 1971 and the abandoning of fixed exchange rates in early 1973 before tapering off. While special factors—such as the oil cartel and crop failures—played a role, one of the dominant factors in world inflation during that peri od was the growth of world liquid ity. It helped explain both the sharp price acceleration in mid-1972 and the sharp deceleration in mid-1975. Liquidity and prices International reserves are a compo nent of each country’s monetary base, against which the domestic money supply is created. A central bank’s purchase of a dollar of inter national reserves affects the mone tary base in the same way as the purchase of a dollar of Treasury bills by the Federal Reserve’s Open Market Account. From 1970 through March 1973, the world’s major industrial countries accepted an unprecedented inflow of international reserves in the form (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. of dollars. They did this in order to maintain fixed exchange rates in a period when many private investors were switching out of dollars into other currencies. At the time, poli cymakers recognized the develop ment of the "dollar overhang" problem—the sharp buildup of in ternational reserve holdings. But many of them failed to realize that the counterpart of the dollar over hang was a simultaneous expansion in the domestic money supplies of the major industrial countries, which led to double-digit money growth in most of those countries. Thus, worldwide "monetary ease" led to a simultaneous businesscycle expansion, which placed great pressure on prices of internationally-traded goods as well as prices of purely domesticallytraded goods. With a lag of two to three years, the sharp buildup of international liquidity exerted a se vere impact on the prices of internationally-traded goods. Domestic consequences World inflation has had a major impact on a wide range of U.S. goods—predominantly petroleum products, but other commodities as well. This is especially evident in the wholesale price index, in which about half of all prices are deter mined by international markets. Although world prices in the past 2 normally moved independently of WPI movements, this was not true during the 1973-74 inflation, nor was it true during our recent happi er experience. Because of the rise in world prices, U.S. inflation in 1973,1974 and early 1975 was higher than would have been the case for strictly domestic reasons—and be cause of the fall in world prices, domestic inflation in early 1976 was below what strictly domestic condi tions would have dictated. These world developments have affected domestic financial mar kets, at least indirectly. The effect of inflation expectations on long-term bonds is well understood, but the effect on short-term securities is less apparent. Flowever, the ob served market interest rate can be considered made up of two ele ments: the "real rate" (or real cost of funds) and an inflation premium. The inflation premium for short term securities, such as the commercial-paper rate, tends to reflect the most recent rate of infla tion. On this basis, most of the historically high interest rates in 1974 were due to the high rates of domestic inflation, while the rela tively low short-term rates recorded in early 1976 reflected the sharp deceleration of inflation. Because U.S. inflation has been dominated by foreign as well as domestic influences over the last three years, the inflation has not (as in the past) followed the U.S. busi ness cycle. As a result, short-term interest rates, which generally fol low the inflation rate, have failed to move in line with U.S. cyclical movements. Future implications What does this evidence suggest for the future? First, it suggests that we are living in a highly interdepend ent world, where domestic mone tary and fiscal policies no longer reign supreme in influencing each country's economic health. Even the U.S. can no longer be consid ered a closed economy. While only 6 percent of our GNP is imported, 20 to 30 percent of our consumer prices—and 50 percent of our wholesale prices—are determined in world rather than purely domes tic markets. This point was not clearly appreciat ed in the past because the world at that time did not follow a synchro nized business-cycle path. The situ ation has changed significantly in the 1970's, however. The critical question for the future is, will we continue to follow a worldwide boom-and-bust scenario or will we return to the more uncoordinated patterns of the 1950's and 1960's? The answer to that question de pends on government policy deci 3 sions in the U.S., Europe and Japan, as evidenced by the trends in world liquidity. At present, most industrial countries face high unemployment levels, and are thus following easymoney policies towards recovery. If they adopt relatively moderate pol icies, as the U.S. is doing, we may avoid a repeat of the last three years. However, if governments fol low aggressively easy policies in order to return quickly to full em ployment, the story may be differ ent. Some observers fear a resumption of the earlier inflationary experi ence. In seven of ten major indus trial nations, the 1975 monetary expansion exceeded that which oc curred in the previous inflationary boom. Only Japan, the U.S. and Switzerland (and possibly Germany) have been following moderate money-growth paths. Given the interdependence of world econo mies, continued monetary expan sion of this type could stimulate inflationary pressures and prevent the U.S. from achieving the amount of price stability that our current policy actions would warrant. Ac cording to this analysis, the effects may not show up immediately, especially in view of the long lags involved in this type of process, but problems could be encountered some time in 1977. Michael W. Reran u o i § u il |SBm HBM BH . . qEin • uo§3JO • epe^aN . oqepi E IU J O J !|B 3 • B U O Z jjy . B>)SB| V • J ! | B 3 'O D S p U B J J U B S ZS£ ON llWlttd aivd aovisod s n HVW SSV1D ISBId p r a r a p i s d f o Q upjng®§®^[ BANKING DATA—TWELFTH FEDERAL RESERVE DISTRICT (Dollar amounts in millions) Selected Assets and Liabilities Large Commercial Banks Amount Outstanding 5/19/76 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 87,372 65,864 1,357 22,374 19,857 11,025 9,250 12,258 86,634 23,485 638 61,115 6,658 26,147 26,174 11,027 Weekly Averages of Daily Figures Week ended 5/19/76 Member Bank Reserve Position Excess Reserves Borrowings Net free(+)/Net borrowed (-) Federal Funds—Seven Large Banks Irrterbank Federal fund transactions Net purchases (+)/Net sales (-) Transactions of U.S. security dealers Net loans (+)/Net borrowings (-) Change from 5/12/76 Change from year ago Dollar Percent + + + + 1,877 + 928 + 18 1,320 + 209 + 1,157 + 1,272 323 + 1,948 + 837 + 256 + 712 995 + 6,250 3,111 - 4,796 - + + - + - + - + - - 50 223 163 48 12 17 220 47 459 817 193 24 9 0 48 92 Week ended 5/12/76 - + + + + + + + + + + + - 2.20 1.43 1.34 5.57 1.06 11.72 15.94 2.57 2.30 3.70 67.02 1.18 13.00 31.41 10.62 30.31 Comparable year-ago period + + + 47 16 31 - 7 0 7 + - 244 + 145 + 1,718 + 153 + 558 + + 29 0 29 476 ♦Includes 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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