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Review and outlook: 1978-79

fO M T F M T ^

In late 1978, predictions of a
recession were common. Increases in
employment, retail sales, and output
seemed to be slowing down. But with
the accumulation of more data, the
picture looks brighter. So far, the
economy has withstood extremely
high interest rates and rapid price
inflation. Under such conditions, true
economic stability is impossible, so
the nation is girding to reverse this
trend.
B u sin e ss: a tim e o f test a h e a d
A g r ic u ltu r e : farm in c o m e r e c o v e r s
E c o n o m ic e v e n ts in 1978 —a c h r o n o lo g y

January/February 1979, Volume III, Issue 1

ECONOMIC PERSPECTIVES
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G o v e r n m e n t : th e fe d e ra l g o v e rn m e n t
shifts gears
F in a n c e : restrain t w ith o u t im b a la n c e
F u tu re u n c e rta in

Review and outlook:
1978-79
Business: a time of test ahead
Large gains were made in 1978 for the third
consecutive year in employment, output,
income, and retail sales. Momentum was so
strong at year-end that some forecasters were
modifying their predictions that a recession
was imminent. Again, the economy had
shown unexpected staying power in the face
of adversity.
If activity continues to increase through
March, as most observers expect, the expan­
sion will have passed its fourth anniversary—
remarkable longevity compared with past ex­
pansions. But a critical period of testing is cer­
tain in the coming months. Signs of strain can
be seen in several areas.•

All of these problems arise from the fact
that effective demand exceeds the nation's
resources. The excessiveness of demand is
reflected in continued inflation, the inter­
national trade deficit, and pressures on
available facilities, materials, and labor. A start
toward resolution of the problem of excess
demand requires moderation of competing,
and therefore conflicting, demands.
A broad perspective

The gross national product reached $2.1
trillion in 1978. That was an increase of almost
12 percent, compared with 11 percent in both
1976 and 1977. Forecasts made early in the

• Interest rates are at (or near) historical
highs and credit markets are
taut.
More inflation and less growth expected for 1979
• Consumer debt burdens
percent change, year to year
have climbed to an un­
precedented level.
• Pressures have mounted
to restrict government taxing
and spending.
• A huge deficit persists in
the balance of trade.
• The adequacy of oil
supplies is again in question.
• Efforts to curb inflation
through guidelines and
budget stringency suggest
disruptive conflicts among
powerful sectors.

Federal R e se rv e Ba n k o f Chicago




‘ Estimated.

3

year proved optimistic. Price inflation was
significantly underestimated, and real growth
was overestimated. Inflation at about 7.5 per­
cent was well above price increases of 5 per­
cent in 1976 and 6 percent in 1977. Probably
less than 4 percent, the real gain in output was
well below the 6 percent reached in 1976 and
5 percent in 1977.
Two developments early in the year
helped account for the year's performance
being poorer than expected. One was the
severe cold, high winds, and heavy snows that
hampered transportation and production.
The other was a 111-day strike by Eastern coal
miners that sharply reduced coal supplies,
forcing some utilities and steel mills to curtail
output.
As in early 1977, when severe weather
and natural gas shortages slowed activity, the
economy snapped back as soon as normal
conditions returned. Lack of growth in real
GNP in the first quarter, nevertheless, in­
terrupted a procession of 11 consecutive
quarterly increases. The rate of price increase
accelerated sharply in the second quarter but
moderated after midyear.
Consumer outlays rose 11 percent, about
in line with the rise in after-tax income and
somewhat less than the rise in nominal GNP.
Construction and spending on business
equipment increased significantly faster than
GNP. Government expenditures increased
less than GNP, mainly because federal outlays
fell short of the spending budgeted.
A recession is usually defined as a signifi­
cant decline in real GNP for at least two con­
secutive quarters. The declines usually center
in plant and equipment, inventory invest­
ment, housing, and consumer durable goods.
Governm ent spending and consumer
purchases of nondurables and services usual­
ly rise even in a general slump.
Plant and equipment spending seems
headed for a good year. Inventories are
generally well balanced but could be
vulnerable if final sales falter. Housing, which
was still strong in 1978, is almost certain to
decline in 1979. Consumer purchases of
durables, which were at a high level in 1977
and 1978, are generally expected to soften.
4




Consumer spending remains strong

Despite surveys suggesting widespread
apprehension, consumers continue to spend
at a high rate. Total consumption spending
rose about 11 percent last year. That was the
same rate of increase as in 1976 and 1977.
Outlays on goods—both durables and
nondurables—rose 10 percent. Outlays for
services—including medical care, rent, and
recreation—rose about 12 percent, marking
continuation of a trend for services to account
for a growing share of consumption. In 1978,
15 percent of consum ption spending w ent for

durables, 39 percent for nondurables, and 46
percent for services. Ten years before, less
was spent on services than on nondurables.
Disposable personal income (DPI), in­
come from all sources less taxes, rose more
than 11 percent last year. That was the biggest
rise since 1973. Savings (DPI less consump­
tion) advanced in step, but as a proportion of
DPI, held at about 5 percent. Though roughly
the same as in 1977, that was down from
almost 6 percent in 1976 and an average of 7.6
percent for 1972-75.
Reflected in the comparatively low rate
of savings was continued heavy use of instal­
ment credit. Gross extensions of instalment
credit totaled $300 billion lastyear,18 percent
more than in 1977, when extensions increased

Consumers borrowed heavily
billion dollars

Ec o n o m ic Persp ectives

20 percent. Credit outstanding at year-end
totaled $273 billion, $42 billion more than a
year before and only slightly less than the rate
of rise in 1977.
For the past two years, the rise in out­
standing instalment credit has been more
than half as much as personal savings. That has
been unprecedented since World War II.
Consumers have also been using mortgage
credit increasingly to finance consumption
spending.
Total car sales of 11.3 million, including 2
million imports, were only slightly below the
1973 record. Including trucks, vehicle pur­
chases reached a new high. About 70 percent
of all sales were financed. More than half of
the new car loans last year were for more than
36 months. They were mostly for 42 or 48
months, but some carried even longer ma­
turities. Car loans for more than 36 months
were rare as recently as 1974.
Of the various types of instalment credit,
use of bank cards, a handy substitute for cash,
has increased fastest. About $40 billion was
extended on bank card credit last year, 30 per­
cent more than in 1977. Outstandings at yearend approached $18 billion, again an increase
of about 30 percent.
New debt instruments, changes in
consumer attitudes, and the structure of

Consumer prices accelerated
index, 1967 = 100, middle month of quarter

Federal R e se rv e B a n k o f Chicago




household income cast doubt on assertions of
some analysts that consumers generally are
over-extended. The Survey Research Center
at Ann Arbor has stated that analysis of con­
sumer opinions reveals that fears of inflation,
which once caused consumers to hold back
on nonessentials, now seem to be stimulating
spending.
More couples now have two incomes
and no children or old folks to provide for.
Most people expect their income to rise yearby-year, often through automatic indexation,
and retirement income to be provided. They
are often well protected against the con­
tingencies of sickness and disability. Under
these circumstances, the concept of dis­
cretionary income takes on new dimensions.
Consumer prices

The Consumer Price Index (CPI) aver­
aged 7.7 percent higher in 1978, following in­
creases of 5.8 percent in 1976 and 6.5 percent
in 1977. After the record 11 percent rise in
1974, the rate of increase slowed in 1975 and
1976, giving unfounded hope that inflation
was on the wane.
Monthly trends show an even darker in­
flation picture. In December, the CPI was up 9
percent from a year before. That was for all
types of consumer purchases. But prices of
food for use at home were up 12 percent,
home ownership up 12 percent, medical care
up 9 percent, fuel up 8 percent, and trans­
portation up 8 percent. Apparel prices, which
have been held down by a heavy influx of
foreign clothes, were up 3 percent.
Part of the record rise in the CPI in 1974
could be attributed to special factors—the
sharp increase in energy prices after OPEC
boosted oil prices, poor crops, and the end of
price controls. No special factors can be
blamed for the acceleration of prices in 1978.
A multitude of forces are working either to in­
crease money income, reduce supply, or
both. These include, for example, automatic
cost-of-living adjustments (COLA), more
liberal unemployment compensation pol­
icies, environmental regulations, government
farm programs, restrictions on imports, the

5

higher minimum wage, higher Social Security
taxes, the depreciating value of the dollar
abroad, and subsidies for rent, food, medical
care, and transportation.

proposals as unfair. Major tests will come in
the months ahead. The trucking industry
pacts expiring in March are deemed par­
ticularly significant.

Wage and price guidelines

Labor negotiations ahead

The Administration has insisted it does
not favor mandatory wage and price controls.
The program in effect from August 1971 to
April 1974 is generally believed to have done
more harm than good. Many observers have
pointed out that interference with the func­
tioning of the market system leads to misallocation of resources, shortages, black
markets, and over the long run, more infla­
tion than if controls had not been imposed.
On October 24, the President announced
a program of voluntary guidelines to slow in­
flation. He urged that increases in compensa­
tion, including fringe benefits, be held to 7
percent, not for every individual, but on
average for groups of workers. He also urged
that price increases—here, too, the average
for all products of a company—be held to half
a percent less than the average annual in­
crease for 1976-77. The guidelines do notapply to farm products or imports. A profit mar­
gin test will be applied, however, to food
processors and retailers and others with
special problems.
Under this program, the Council on
Wage and Price Stability will require reports
from large corporations, especially the 500
largest with annual sales of more than $500
million, for use in determining whether the
companies are complying with the guide­
lines. Companies believed not to be comply­
ing will be barred from government contracts
if the goods or services they provide can be
obtained elsewhere. This holds even if the
companies are potentially low bidders.
Various large companies have an­
nounced they will cooperate with the
guidelines. In most cases, they say the pro­
posed regulations are flexible enough for
them to comply without undue interference
with their operations.
Some labor leaders have said their unions
will cooperate. Others have denounced the

6




In the first five months last year, first-year
wage increases negotiated in major labor
contracts averaged 7.7 percent, about the
same as in 1977. First-year increases in total
compensation, including pensions, health in­
surance, and other supplements, averaged 8.8
percent, somewhat less than in 1977 but clear­
ly well above the guideline.
Some labor unions, those representing
coal miners, railroad workers, and machinists,
for example, have recently negotiated con­
tracts for increases of 30 percent or more over
a th re e -ye a r period. Adm inistration
spokesmen say no effort will be made to
challenge contracts already negotiated for
fixed future increases. Moreover, new con­
tracts will not be opposed if they match in­
creases in other contracts, provided there is a
traditionally "tandem" relationship between
the workers.
The labor bargaining calendar was light
in 1978, both in terms of the number of
workers covered (1.8 million) and the types of
unions involved. This year, the "heavy
hitters" will come up to bat. Altogether, over
3.7 million workers are involved, including
those in the oil industry (January), trucking
(March), rubber (April), electrical equipment
(June), and autos, farm and construction
equipment (September). Most of these
groups had increases in compensation in 1976
in excess of the average in contracts
negotiated in that year.
Labor costs and productivity

Hourly compensation per worker in the
private economy, including employer con­
tributions for Social Security, rose over 9 per­
cent last year, somewhat above the average
for the previous five years. In the late 1960s
and early 1970s, increases had averaged about
6.5 percent, up from 4 percent in the early
1960s.
Ec o no m ic Persp ectives

Improved efficiency reflected in in­
creased productivity (output per worker
hour) helps hold down prices. If increases in
productivity matched increases in worker
compensation, unit labor costs—the main
element in total costs—would be stable.
Pressures on prices would be minimized.
In the 25 years 1947 through 1972,
productivity for the entire private economy
rose an average of 3 percent a year. Since
1972, increases have averaged only about 1
percent. Last year, there was little or no rise in
productivity.
With compensation rising 9 percent a
year for the past five years and productivity in­
creasing only 1 percent, labor costs per unit of
output have increased about 8 percent a year.
Prices in the nonfarm economy increased
about the same pace.
The reasons for the sluggish trend in
productivity are not entirely clear. The 197475 recession, increased government regula­
tion, unusually severe weather, an inade­
quate level of investment in modern laborsaving equipment, inadequate training of
younger workers, and a rise in the proportion
of total output originating in the service in­
dustries (where productivity is lower than in
the goods-producing industries)—all these
have played a part. But one thing is certain.
The gap between increases in compensation
and increases in productivity will have to
narrow before progress can be made against
inflation.
Employment and unemployment

One of the salient features of the
business expansion that began in the spring of
1975 has been the rapid rise in employment.
Employment totaled almost 96 million in
December, up 3.3 million from a year earlier
and 10 million from the cyclical peak of 1974.
The rise has been unprecedented.
Except for agriculture, where the trend is
still downward, all major types of employ­
ment have increased substantially in the past
three and a half years. Proportionately, the
biggest gains have been in the trade and ser­
vice industries. All five states of the Seventh

Federal R e se rv e Ba n k o f Chicago




Employment rise has been
unprecedented
million workers

Federal Reserve District report large gains in
employment, though only in Wisconsin has
the pace matched the national surge in
employment led by the fast-growing states of
the South and West.
Unemployment remained at the 6 million
mark last year. That was slightly less than 6
percent of the civilian labor force, which was
almost 102 million in December. Unemploy­
ment tends to be concentrated among young
workers and minority workers.
Over 59 percent of the population over
16 years old held jobs in December. That was a
record proportion, up from 58 percent in
December 1977 and 56 percent in December
1976. Reflected mainly in the higher job-topopulation ratio was the increase in the
number of women workers. Women now
make up 41 percent of the labor force, com­
pared with 36 percent a decade ago.
Manufacturing leads GNP

While real GNP rose 4 percent last year,
manufacturing output increased about 6 per­
cent, the same as in 1977. After a drop in
January associated with bad weather, man­
ufacturing output rose steadily throughout
the rest of the year. Large order backlogs for
durable goods suggest that the uptrend could
continue well into 1979.
In December, the Federal Reserve's in­
dex of manufacturing output, measured in
physical units, passed 151 (1967=100), rising to
7

a level 8 percent higher than a year earlier.
Nearly all types of manufacturing participated
in the rise, but business equipment was the
star performer. Output of business equip­
ment was 10 percent higher than in
December 1977, compared with an increase
of 3 percent for the production of consumer
goods.
The motor vehicle industry turned in
another strong performance. It produced 9.2
million passenger cars, about the same
number as in 1977. The record was set in 1973,
when 9.7 million cars were produced. The in­
dustry produced 3.7 million trucks. Thatwasa
new record, 7 percent more than the previous
high set in 1977. Many of the smaller trucks
were bought for personal use. Plants pro­
ducing trucks operated close to capacity all
year. Demand for four-wheel drive vehicles
and heavy-duty trucks was especially strong.
Demand for farm equipment was weak
early in the year, when farm prices were low
and farm income depressed. But sales began
improving rapidly in the spring, and produc­
tion schedules were stepped up. Inventories
of farm equipment were low in December,
compared with a year earlier.
Steel shipments from domestic mills
totaled 98 million tons last year, up from 91
million a year earlier but still well below the
record 111 million tons shipped in 1973.

With the government moving to dis­
courage below-cost sales of foreign steel
here, imports had been expected to decline
from the 19.3 million ton record set in 1977.
Instead, they rose to a new high of 21.6 million
tons. That was 18.4 percent of domestic
supplies last year, another new high.
Housing surprisingly strong

Because of high interest rates and a pro­
jected reduction in the availability of
mortgage funds, housing starts had been
generally expected to decline in 1978, drop­
ping probably 10 percent or more. But about 2
million units were started, the same as in 1977
and a total substantially exceeded only in
1972, when there were 2.4 million starts. Sales
of existing homes rose 9 percent from the
previous record set in 1977 to a new high of 3.9
million. Prices rose 12 to 14 percent.
Starts and sales stayed high because
mortgage credit remained available. Savings
and loans, the main lenders on residential
property, continued to receive large net in­
flows of funds. In previous periods of tight
money, such as 1973-74, interest rate ceilings
imposed by regulatory authorities prevented
savings institutions from competing effective­
ly for funds. The result was disintermediation,
meaning investors turned to higher-yielding
m o n e y - m a r k e t instru­
ments, such as Treasury
bills.
Business equipment production outgained
Several factors helped
total manufacturing
support the flo w of
ind ex,1967 = 100
mortgage funds in 1978.
Beginning in June, S&Ls
were allowed to offer sixmonth certificates of de­
posit in amounts of $10,000
or more at yields as high as
Va percent above the latest
auction yield on six-month
Treasury bills. Sales of these
money-market certificates
enabled S&Ls to maintain a
large volume of funds to
m e e t lo a n d e m a n d .
Another factor was the sale

8




Ec o no m ic Pe rsp e c tive s

of bonds secured by mortgages, mostly under
federal guarantees. Still another was an easing
up on usury ceilings. Various states, including
Illinois and Iowa, had raised ceilings or made
them more flexible in recent years.
At 1.4 million, single-family starts last year
approached the 1.45 million record set in
1977. Construction of apartments was much
more volatile, as it has been in recent years.
About 600,000 multifamily units were started
in 1978, 12 percent more than in 1977. But
while the rate of multifamily starts was twice
the depressed rate in 1975, it was still 40 per­
cent less than in the boom from 1971 to 1973.
A major factor in the undertaking of mul­
tifamily projects has been the availability of
federal subsidies. Subsidized multifamily
starts reached about 200,000 in 1978, more
than four times the starts in 1975. Despite low
vacancy rates, unsubsidized apartment con­
struction has been held back by rents that
while rising, have not kept up with costs of
construction and operation. Starts on con­
dominiums and conversions of existing
apartments to condominiums have picked up
in the past two years. This has been mainly
because of tax advantages to both buyers and
sellers.
After holding near 9 percent from 1975
through 1977, interest rates on new
mortgages averaged about 10 percent by late
1978. Buyers were willing to pay these rates
because real estate has proven to be the best
hedge against inflation available to most
households. To acquire an equity interest in
their house or apartment, people have been
willing to devote more of their income to
mortgage payments. The trend has been en­
couraged by the growing number of families
with two incomes and often no children.
High rates on mortgate and construction
loans, combined with slower growth in family
income, are likely to dampen residential con­
struction this year. But with the continued
availability of credit and a strong rate of
household formation, the decline can
probably be held to no more than 10 to 20
percent this year, which is not nearly so steep
as in past housing cycles.

Fe d e ra l R e se rv e B a n k o f Chicago




Capital expenditures and capacity

Business outlays on new plant and equip­
ment have increased rapidly for three years.
Spending increased 16 percent lastyear. After
adjustment for inflation, the increase was
about 8 percent. Capital outlays were 10.6
percent of GNP last year, a ratio surpassed
only in 1966 and 1974 and then only slightly.
Surveys show business capital outlays are
expected to rise again in 1979. Though the in­
crease is apt to be somewhat less than in 1978,
prospects for continued expansion in control
spending are supported by large backlogs of
orders reported by producers of capital
equipment and by the heavy volume of con­
tracts for nonresidential construction.
Orders have been particularly strong for
machine tools, construction equipment,
heavy trucks and trailers, railroad equipment,
and com m ercial aircraft. F.W. Dodge
reported that contracts for commercial
buildings last year were 50 percent higher
than in 1977. Contracts for manufacturing
buildings were up 60 percent. Similar in­
creases were reported for the Midwestern
region. Much of this work will be put in place
in 1979.
If the nation is to have a comfortable,
prosperous future, capital outlays will have to

Housing maintained high plateau
million units

1971

1972

1973

1974 1975 1976 1977

1978

9

rise further. A large part of business outlays is
going to alleviate pollution, promote health
and safety, and comply with other state and
federal regulations, rather than to improve

Spending on business structures
and equipment surged
billions of 1972dollars

efficiency or add to the capacity to produce
goods and services. Large additional outlays
are also going to ensure adequate supplies of
increasingly expensive energy and to con­
serve use of energy.
Demands on productive facilities, raw
materials, and the experienced people in the
workforce kept the nation's economy
operating close to its effective capacity in
1978. Margins of unused resources are un­
comfortably narrow in such important sectors
as energy, transportation, steel, nonferrous
metals, and building materials, including
cement, brick, sheetrock, and insulation.
Demand for technical and scientific skills sub­
stantially exceeds the number of trained peo­
ple available for work.
Until the capital stock and pool of trained
workers are raised appreciably, additional
buying power created by higher incomes and
expanding credit will not raise total output.
Rather, it will be dissipated in higher prices. A
healthy atmosphere for private capital forma­
tion is an essential ingredient for material
progress.

1978 Annual Report
Limited copies of the 1978 Annual Report of the Federal Reserve
Bank of Chicago are now available. The publication includes
statements of condition and earnings and a summary of this
bank's operations for 1978. Send requests to:
Public Information Center
Federal Reserve Bank of Chicago
P.O. Box 834
Chicago, Illinois 60690

70



Ec o n o m ic Pe rsp e c tive s

Agriculture: farm income recovers
Farm earnings rose substantially last year,
breaking a four-year slide. The index of prices
received by farmers averaged a record 209
(1967=100). That was 14 percent over the
previous year and 9 percent over the previous
high in 1974.
Livestock led the upturn as smaller
supplies of meat and milk and decidedly
stronger demand pushed prices of livestock
23 percent higher than in 1977.
Crop prices contributed to the rise, but
with increases that averaged only 6 percent.
Crop production surpassed the record 1977
harvest, providing abundant grain supplies
throughout last year. But with record foreign
purchases and the new grain reserve pro­
grams, grain and soybean stocks were not as
burdensome as expected.
Higher prices and higher government
payments boosted gross farm income to
about $125 billion. Despite another substan­
tial rise in production expenses, gross returns
were enough to boost net farm income about

two-fifths higher than the depressed $20
billion in 1977.
This strong performance contrasted
sharply with initial forecasts of another year of
low earnings. It also belied much of the con­
cern that had prompted the American
Agricultural Movement to mount one of the
strongest farm lobbying efforts ever seen.

Strong livestock markets boosted
farm prices to a new high in 1978 . . .

. . . ending the 4-year slide in
net farm income per farm

index, 1967 = 100

Land values and capital spending rose

Improved farm earnings led to a strong
recovery in capital spending and aggressive
bidding for farmland. It is estimated that
farmland values rose a tenth last year, marking
a threefold increase since the beginning of
the 1970s. Even bigger increases were seen in
the Midwest, where surveys by the Federal
Reserve Bank of Chicago showed farmland
values rose about 17 p ercent. For many

farmers that own their land, the unrealized
gain from appreciation in land values again
surpassed the net operating returns to land.

thousand dollars

12 f
current dollars
1967 Hollars

1968 '69

70

71

72

73

74

75

76

77

78*

•Prelim inary.

Fe d e ra l R e se rv e Bank o f Chicago




11

With the remarkable appreciation in land
values has come concern that nonfarmer in­
vestors may be a stronger component in the
demand for land. Concern focused last year
on foreign investors, partly because of the
bidding advantages that accrued to some
foreign buyers from the decline in the value
of the dollar. Although it is generally believed
that foreign ownership of land is at most
nominal, the facts are not known. To provide
information for an objective assessment of
the situation, Congress passed the Agri­
cultural Foreign Investment Disclosure Act
late last year. The act set up a nationwide
system for keeping track of the amount of
land foreigners own and theamountthey buy
in the future.
The recovery in capital expenditures
showed up particularly in purchases of
machinery and equipment and construction
of grain storage facilities. In the first 11
months of the year, unit retail sales of farm
tractors were 6 percent higher than in the cor­
responding period a year earlier. Sales of
combines were up 9 percent. These increases
were in sharp contrast to the sluggish sales
forecast in early 1978 that led to layoffs and
caused some manufacturers to shut down
plants for a while.
Information on expenditures for new
grain storage facilities is sketchy. It is clear,
however, that substantially more was spent
than in other recent years. A liberalized
government loan program helped finance
over 750 million bushels in new on-farm
storage capacity in fiscal 1978. That was
equivalent to nearly a third of the storage
facilities built under the loan program during
the previous 29 years it had been in existence.
Other facilities were built, no doubt, with
private financing. Overall, farmers probably
expanded their storage capacity about a tenth
last year.
The reason for the surge in construction
of on-farm storage facilities was the new grain
reserve program authorized in late 1977. The
program is designed to withhold grain from
the market for three years or until prices at the
farm rise up to established trigger levels. By
late December, 33 million metric tons of grain

12



The buildup in carryover stocks
of grain is expected to continue
into next year
million metric tons

1965

'67

'69

percent of utilization

'71

'73

'75

77

’79*

grain marketing year ending in
•U SD A projection.

had been accumulated under the program,
including 410 million bushels of wheat and
720 million bushels of corn. That represents
about half of the projected carryover stocks of
grain.
Agriculture and the rest of the economy

Improved farm earnings reflected
strength in both domestic and foreign
markets but left divergent implications for
two measures of the economy overall. The
value of agricultural exports rose to a new
high in fiscal 1978, helping offset the balloon­
ing deficit in nonagricultural trade. But there
was also an ominous development in agri­
culture's contribution to the rekindling of in­
flationary pressures.
Nearly 122 million metric tons of farm
commodities were shipped abroad in the
fiscal year that ended in September. That was
nearly a fifth more than the shipments in fiscal
1977 and a seventh more than the previous
high in fiscal 1976. The increase was made
despite transportation snarls during the
winter and shortages of rail cars during the
spring and summer, when grain and soybean
shipments were exceptionally high.
With feed grain and soybean prices down

Ec o n o m ic Pe rsp e c tive s

from the year before, not all the increase in
shipments was reflected in the value of ex­
ports. The value of farm exports, nevertheless,
rose to $27.3 billion in fiscal 1978—14 percent
more than the previous year. Imports of
agricultural products, on the other hand,
were up only nominally, leaving an agri­
cultural trade surplus of $13.4 billion.
Despite the declining value of the dollar,
exports to such strong currency countries as
Japan and those in Western Europe increased
little in fiscal 1978. At a combined $13 billion,
farm exports to Japan and Western Europe
were up only 4 percent.
By contrast, exports to the Soviet Union
increased about three-fourths, nearly equal­
ing the $2 billion in 1976. Mainland China,
after three years of virtual absence from
American farm markets, imported over $350
million in agricultural products from here last
year. Agricultural exports to Latin America in­
creased nearly a third, to $2.8 billion. Exports
to African countries were up about a fifth, and
exports to Asian countries—excluding Japan
and mainland China—were up a sixth.
Food prices soared

Retail food prices soared at an annual
rate of 18 percent in the first half but slowed to
an annual rate of 5 percent in the second half.
For the whole year, food prices averaged a
tenth higher, twice the increase forecast a
year ago. H igher prices for raw food materials
accounted for about half of the rise. Higher
costs for processing and distribution ac­
counted for two-fifths.
Prices for red meats, poultry, fish, and
eggs averaged 15 percent higher last year,
largely because of the pronounced recovery
in demand. Per capita supplies of all meat,
although less than expected, were down only
1 percent from the 1977 record. The mix in
meat production shifted, however, resulting
in more poultry and less beef. Pork produc­
tion was virtually unchanged.
Retail prices of fruits and vegetables
averaged 11 percent higher lastyear. Much of
the rise was related to weather. For the sec­
ond winter in a row, produce in Florida was
Federal R e se rv e Ba n k o f Chicago




Consumers ate more poultry
than pork in 1978
pounds per capita*

trimmed by a freeze. And in California, an un­
usually warm winter coupled with high winds
and excessive rain in the spring and summer
reduced the production of several different
fruits and vegetables.
Government programs also put pressure
on food prices last year. The ratcheting up in
dairy supports, for instance, contributed to an
average rise of 7 percent in retail dairy
product prices. Likewise, changes in govern­
ment programs that boosted wheat prices
helped push average retail prices of cereals
and bakery products 9 percent higher. And
government actions to support domestic
sugar producers led to a 12 percent average
rise in retail prices of sugars and sweets. This
was despite the most burdensome world
sugar surplus in years.
Review and outlook by commodities

One of the surprises in 1978 was the lack
of an increase in pork production. The con­
sensus a year ago was that pork production
would increase at least a tenth, causing hog
prices to plunge. Instead, pork production
was virtually unchanged. And hog prices,
reflecting smaller supplies of beef and a
pronounced recovery in demand, rose nearly
a fifth to average $48.50 per hundredweight.

13

The failure of pork production to res­
pond to the strongest incentives for expan­
sion in decades is not fully understood. The
harsh winter was a contributing factor,
however. And many analysts believe the shift
in recent years to more capital-intensive
production facilities may have lengthened
the production-response cycle.
Whatever the reason for the perfor­
mance last year,conditionsstill pointtoasubstantial rise in pork production. A December
survey of recent and prospective actions by
hog farmers showed that pork production
could rise a tenth in 1979. An increase of that
size would push hog prices lower and offset
much of the expected decline in beef produc­
tion. With the further likelihood of substan­
tially larger poultry production, per capita
consumption of all meats could increase
slightly this year.
The mix in cattle slaughter last year
moved closer to the norm of the early 1970s as
the liquidation phase of the cattle cycle
wound down. The movement of cattle
through feedlots rose to a near-record level,
boosting fed cattle slaughter 7 percent. But
nonfed steer and heifer slaughter was cut in
half and cow slaughter was reduced 13 per­
cent, resulting in a 4 percent decline in total
beef production. The decline, buttressed by
strong demand, pushed choice steer prices to
a record average of $52.25 per hundred­
weight, nearly 30 percent higher than the
year before.
Factors underlying the past two years of
decline in beef production are tied to the
cattle cycle. The huge financial losses that
staggered cattlemen from 1974 to 1977
triggered a massive liquidation of the
breeding herd, temporarily swelling beef
supplies. The liquidation, however, has
reduced the inventory of beef cows (net of
additions through replacement heifers) near­
ly a fifth over the past four years. With fewer
cows, calf crops have gotten smaller. Es­
timates show the 1978 calf crop was the
smallest in 11 years. And the crop could be
smaller in 1979.
Implications of the sharp reduction in the
cow herd are not encouraging for near-term
14



The downturn in the cattle cycle is
the most pronounced since the 1920s
million head

beef supplies. Calf crops are not large enough
to maintain past levels of beef production and
accommodate the herd rebuilding that is
needed for future growth in consumption.
If market forces encourage herd
rebuilding, beef production will trend lower
for the next two or three years. Per capita beef
consumption could drop to the levels of the
late 1960s. And cattle prices could rise to new
heights. The extent of the rise in prices will
depend mostly on the availability of pork and
poultry and the willingness of consumers to
switch to these other meats while beef
supplies are tight.
Dairy farmers received higher prices and
earned more in 1978, and their prospects
seem equally bright for 1979. Prices farmers
received for milk averaged 9 percent higher
than in 1977. The increase came largely as a
result of the statutory semiannual increases in
dairy support prices. Milk production de­
clined nominally but still exceeded the record
amount utilized commercially. The better
balance between production and utilization
allowed government purchases of manufac­
tured dairy products (the mechanism for sup­
porting prices) to decline more than a half
from the high level a year earlier.
Higher support prices will contribute to
another rise in earnings of dairy farmers this
year. Milk production may edge up a little,

Ec o no m ic Pe rsp e c tive s

Corn and soybeans pulled all crop
production to a new high in 1978
index, 1967=100

but high cow prices will probably encourage
further culling of the dairy herd. Barring a
downturn in the general economy, demand is
expected to remain strong, fueled in part by a
rebuilding in the low commercial stocks of
dairy products.
Grain and soybean prices were sup­
ported throughout m uch of last year by the

drouth-reduced harvests in the Southern
Hemisphere. The combined Australian and
Argentinian wheat harvest was cut a third last
winter. In Brazil, the soybean harvest last
spring was a fourth less than expected. These
reductions in competing supplies overseas—
and transportation problems in Canada—
gave U.S. exporters a decided edge in
meeting the strong world demand for grains
and oilseeds.
Prices drifted slightly lower in the second
half as it became apparent that grain crops in
the Northern Hemisphere would be very
large. Final estimates show the United States,
Western Europe, and the Soviet Union all
brought in record harvests.

Federal R e se rv e Bank o f Chicago




In the United States, reduced plantings
cut wheat production 12 percent. But corn
production rose a tenth, to a record 7.1 billion
bushels. Per-acre corn yields exceeded 101
bushels, ten bushels above the previous year
and four bushels above the previous high in
1972. The soybean harvest, at a record 1.8
billion bushels, was up 5 percent. These levels
were reached despite late plantings and the
first use of voluntary acreage controls since
1973.
Large crop harvests the past two years
have provided more than adequate supplies
of grain. Domestic carryover stocks rose to 74
million metric tons in 1978, up a fifth from the
year before. Projections show the carryover
rising to a 15-year high of 86 million metric
tons in 1979. Equal to a third of the expected
utilization, that will be the largest stock
relative to utilization since early in the
decade. Corn accounts for all of the projected
increase in carryover stocks of grain.
The relative accumulation of soybean
carryover has been far more modest. Projec­
tions are the soybean carryover this year will
still be less than a tenth of utilization.
Prices of grains and soybeans w ill be
strongly influenced this year by foreign de­
mand and growing conditions around the
world. Mainland China will import large
amounts of grain from the United States. But
exports to other countries may be somewhat
eroded by the large world supplies, par­
ticularly if wheat and soybean production in
the Southern Hemisphere returns to the
record levels expected this winter and spring.
Domestic crop production in 1979 will
likely reflect larger plantings. Wheat acreage
will be up substantially. In the Midwest,
farmers will likely substitute soybeans for
some corn acreage. Final production pros­
pects, of course, will hinge largely on the
vagaries of weather.

75

Economic events in1978—a chronology
Jan 1 Minimum wage rises from $2.30 to $2.65. (On January 1,

Apr 18 Senate approves treaty transferring Panama Canal to

1979, it rises to $2.90.)

Panama by year 2000.

Jan 1 Pay base for Social Security rises from $16,500 to $17,700,

Apr 20 Treasury announces additional sale of gold to stabilize

and tax rate rises from 5.85 to 6.05 percent. (On January 1,
1979, base rises to $22,900 and rate rises to 6.13 percent.)

the dollar.

Jan 4 Treasury and Federal Reserve intervene in foreign ex­

M-1, M-2, and M-3.

change markets to moderate fluctuations in the dollar.

Jan 6 Prime rate rises from 7.75 to 8 percent.
Jan 9 Discount rate rises from 6 to 6.5 percent.
Jan 13 Arthur Burns resigns from Federal Reserve Board,
effective M arch 31.

A p r 25 F O M C announces retention of growth ranges for
May1 Federal

Reserve Board approves plan to allow
automatic transfers from savings to checking accounts (ATS),
starting November 1.

May 5 Prime rate rises to 8.25 percent.
May 7 Saudi Arabia and Iran overrule other O P EC nations

Jan 23 President Carter proposes $34 billion tax cut.

that want to boost oil prices.

Jan27 Blizzard hampers industry and trade in Midwest.

May 11 Federal Reserve discount rate rises to 7 percent.

Feb 6 Major blizzard hits Midwest and East.

May 25 Prime rate rises to 8.5 percent.

Feb 14 President approves sale of advanced fighters to Egypt,

Jun 1 Change in Regulation Q permits banks and S&Ls to tie

Israel, and Saudi Arabia.

rates paid on C D s to Treasury Bill rates.

Feb 20 Indiana orders cutback in electricity usage to con­

Jun 7 California voters overwhelm ingly approve Proposition J

serve coal supplies depleted by strike in eastern mines.

13, sharply limiting property taxes.

Feb 22 Supreme Court rules employees can demand jury trial

Jun 16 Prime rate rises to 8.75 percent.

in age discrimination cases.

Jun28 Supreme Court issues Bakke decision, apparently

Feb 27 IC C orders railroads to allocate freight cars to speed

limiting use of racial quotas for “ affirmative action.”

grain shipments.

Jun 30 Prime rate rises to 9 percent.

Feb 28 Dow stock average closes at 742, low for the year.

Jul 3 Federal Reserve discount rate rises to 7.25.

Mar 4 Chicago Daily News ceases publication after 102 years.

Jul7 Federal

Mar 8 G . William M iller (named D ecem ber 28) is sworn in as

Reserve Board sends Congress proposed
changes in rules for membership in the System.

chairman of Federal Reserve Board.

Jul 16 Economic summit meeting convenes in Bonn to dis­

Mar 9 Federal O p en Market Com m ittee (FO M C) announces

cuss measures for dealing with world econom ic problems.

retention of M-1 and M-2 growth ranges, but reduces limits
of M-3 range.

Jul 28 FO M C announces retention of growth ranges for M-1,

Mar13 Treasury and Federal Reserve announce com m it­

Aug 4 Agricultural Credit Act permits Farmer’s Hom e A d ­

ment of additional resources to stabilize the dollar.

ministration to aid farmers facing foreclosure.

Mar 27 Coal strike ends after 111 days with three-year pact
boosting compensation 39 percent.

Apr 1 Majority of member nations ratify changes in the ar­
ticles of agreement of the IMF.

Apr 6 Amendment to Age Discrim ination Act ends man­
datory retirement age in federal jobs and raises age from 65
to 70 for private companies.

Apr 11 President urges 5.5 percent ceiling for price and wage

M-2, and M-3.

Aug 21 Federal Reserve discount rate rises to 7.75 percent.
Aug 24 Treasury announces increased gold sales.
Aug28 Federal

Reserve Board eliminates
quirements on foreign borrowings.

reserve

re­

Aug 30 Prime rate rises to 9.25 percent.
Sep 7 House upholds President's veto of $37 billion arms bill.
Sep 8 Dow industrial average closes at 908, high for year.

hikes.

(Identical peak is reached again on September 11.)

Apr 11 Volkswagen produces its first U.S.-built car at New

Sep 15 Prime rate rises to 9.5 percent.

Station, Pennsylvania.

Sep 15 International M achine Tool show closes in Chicago,

Apr 12 FJouse rejects Emergency Farm Aid Bill.

with reports of booming business.

Apr 14 Federal Hom e Loan Bank Board (FHLBB) reduces

Sep 17 International Banking Act provides for federal regula­

liquidity requirement for S&Ls from 7 to 6.5 percent.

tion and supervision of foreign banks in the United States.

16




Economic Perspectives

Sep 18 Nancy Teeters sworn in as first woman on Federal

Nov 5 Iranian prime minister resigns as riots and strikes

Reserve Board.

disrupt economy and reduce oil output.

Sep 20 Energy Departm ent officials report adequate natural

Nov6 New

gas supplies for winter.

York
88-day strike.

Sep 20 Congress adopts Second Budget Resolution setting

Nov 6 Com m unity Reinvestment Act regulations become

fiscal 1979 outlays at $487.5 billion and deficit at $38.8 billion.

e ffe ctiv e , re q u irin g fin a n cia l
neighborhood credit needs.

Sep 22 Federal Reserve discount rate rises to 8 percent.
Sept 28 Prime rate rises to 9.75 percent.
Sep 29 Nationwide rail strike ends by court order after four
days.

Oct 1 General pay increase boosts pay of federal workers by
5.5 percent in addition to usual “ step” increases.

O ct 4 Council on W age and Price Stability (CWPS) says un4 derlying inflation rate is 7 percent, against 6 percent in 1977.

, O ct 12 Prime rate rises to 10 percent.
3
Oct 15 Congress passes $18.7 billion tax-cut bill.
*
*

newspapers

Nov 7 E le ctio n s

somewhat
majorities in Congress.

resume

publication

institutions

reduce

large

to

after

meet

Democratic

Nov 9 Department of Agriculture reports record corn and
soybean harvests.
Nov 10 Financial Institutions Regulatory Act
supervisory power over financial institutions.

increases

Nov 13 Prime rate rises to 11 percent.
Nov 16 F O M C announces retention of growth ranges for
M-2, M-3 but reduces limits for M-1 range.

Nov 17 Federal Reserve Board issues tentative schedule for

O ct 15 Congress passes major energy legislation.

pricing check collection, clearing, and settlement services.

O ct 16 Discount rate rises to 8.5 percent, all-time high.

Nov 19 Death of Vice Chairm an Stephen G ardner creates
second vacancy on Federal Reserve Board.

Oct17 Agricultural

Foreign Investment Disclosure Act
creates system to monitor foreign purchases of farmland.

Nov 24 Prime rate rises to 11.5 percent.

Oct 18 Philip Jackson resigns from Federal Reserve Board,

Dec 1 Shell announces plan to ration gasoline to dealers.

effective November 17.

O ct 23 Prime rate rises to 10.25 percent.
O ct 24 O SH A drops 928 job-safety rules.
.

Oct 24 President announces voluntary guidelines for wage
and price boosts.

O ct 27 Full

Employment and Balanced Growth Act
(“ Hum phrey-Hawkins” ) calls for achievement of 4 percent
employment and 3 percent inflation by 1983.

Dec 11 Supreme Court affirms Federal Reserve Board's
power to set capital requirements for bank subsidiaries of
bank holding companies.

Dec 12 FHLBB reduces liquidity requirement for S&Ls from
6.5 to 6 percent.
Dec 13 Production of Susan B. Anthony dollar begins.
Dec 15 President announces formal recognition of China,
effective January 1, 1979.

Dec 16 Cleveland defaults on bank loans.
O ct 30 Treasury sells notes yielding a record 9.25 percent.
*

Oct31 Am endm ent to Civil Rights Act of 1964 requires
employers to treat pregnancy as an illness.

Nov 1 Com m ercial banks begin offering ATS accounts.
Nov 1 President announces plan to support sagging dollar.

*
-

Plan includes larger gold sales and increased market in­
tervention through acquisition of foreign currencies. In
coordinating actions, Federal Reserve raises discount rate
from 8.5 to 9.5 percent and increases reserve requirements
on large CDs.

Nov 1 Prime rate rises to 10.5 percent.

Dec 17 O P EC announces three-stage 14.5 percent boost in
crude oil prices for 1979.

Dec 20 Prime rate rises to 11.75 percent.
Dec 22 Consum er price index for November
9 percent above year-earlier level.

reported

Dec 27 FNMA auctions commitments to buy governmentbacked mortgages at record 10.6 percent.

Dec 31 Heavy snows hit M idwest, followed by severe cold.
Dec 31 Year ends with widespread forecasts of a recession,
but with employment, output, and retail trade still vigorous.

Nov 2 Under Treasury tax and loan investment program
banks pay interest on Treasury note balances and receive
fees for services.
►

Nov 3 Prime rate rises to 10.75 percent.

Federal Reserve Bank of Chicago



17

Government: the federal government
shifts gears
This time a year ago, the government was ex­
pecting a deficit for fiscal 1978 (October 1,
1977, to September 30, 1978) of $62 billion.
The Administration presented Congress with
a budget proposal for fiscal 1979 that implied
essentially no change in the deficit that year.
Nowhere in the President's Budget
Message last January was the word inflation
used. The focus was on the need for a fiscal
policy that provided continuing economic
recovery. Over the course of the year,
however, the Administration shifted its atten­
tion from stimulating further growth of the
economy to reducing inflation.
The change had little effect on fiscal 1978.
But it was largely responsible for differences
in the planning for fiscal 1979 and 1980.
Fiscal 1978— the outcome

Federal outlays totaled $450.8 billion in
fiscal 1978. With receipts at $402 billion, the
deficit was $48.8 billion. The final figure for
receipts is remarkably close to the January es­
timate of $400.4 billion, particularly as that
figure would have been about $800 million
higher if it had been estimated by the
bookkeeping procedures used now. Outlays
were almost $11 billion less than expected in
January and $2 billion less than the forecast in
July—mainly for a reason that has plagued
budget authorities for years.
Government departments consistently
overestimate their needs, during both
preparation of the budget and later quarterly
reviews. This year a substantial portion of the
shortfall came from lower-than-expected
defense spending and slowness in building
the petroleum reserve. The Office of
Management and Budget has tried to im­
prove estimates of spending, but considering
the large proportion of spending going to
entitlement programs, errors in estimates of
total outlays are apt to recur.

18




The tax cut—smaller, later, restyled

The budget proposal presented last
January for fiscal 1979 included a tax cut over
and above those previously passed but
scheduled to expire at the end of calendar
1978. The cut, about two-thirds for individuals
and a third for businesses, was planned to take
effect October 1.
As proposed, the cut in personal income
taxes was skewed toward low incomes. A tax
credit would replace the personal exemption.
Some deductions taken by individuals that
itemize deductions would be eliminated or
reduced, and use of other deductions would
be restricted. Treatment of capital gains and
some other tax preferences under the min­
imum tax would be tightened.
A similar approach was taken toward cor­
porate income taxes. Rates would be re­
duced, but so would the allowable deduc­
tions. The investment tax credit would be
made permanent and even liberalized. But
the liberal treatment of domestic inter­
national sales corporations, income of foreign
subsidiaries, and deductions for business
meals, entertainment, and first-class air travel
were items scheduled to be phased out, limit­
ed, or eliminated immediately.
About three and a half months after the
President made his tax proposal, however, the
Administration and Congress agreed that
with inflation worsening, the tax cut would
have to be smaller than originally proposed.
The change was made primarily by shifting
the effective date for most provisions forward
to January 1979.
In addition to reducing the size of the tax
cut, moreover, Congress drastically changed
its form. Two concepts seem to have been un­
derlying the thinking in Congress. One was
that the combined effects of inflation and the
progressiveness of the tax structure required
that more relief be given to middle-income

Ec o n o m ic Pe rsp e c tive s

groups than to low-income groups. The other
was that taxes on capital gains, which had
been raised in several recent tax bills, were
discouraging the investment now needed to
increase the potential growth of the
economy.
The bill that finally passed raises personal
exemptions from $750 to $1,000. It reduces the
progressiveness of the personal income tax by
reducing the rates and widening the tax
brackets. Tax rates on capital gains are
generally reduced, the maximum effective
rate dropping from 49 percent to 28 percent.
Taxpayers that itemize lose their deductions
for state and local gasoline taxes.
Corporations get less reduction in in­
come taxes than originally proposed. Broader
use can be made of the investment tax credit,
however, and like individuals, corporations
pay lower taxes on capital gains. Some deduc­
tions for entertainment expenses are no
longer allowed.
The bill, identified as the Revenue Act of
1978 (PL 95-600), is long and complicated. It
changes the treatment of partnerships, some
tax shelters, deferred income, and unemploy­
ment compensation. These are special
changes, however, and while they may impact
heavily on some taxpayers, they will have little
effect on the size or shape of the tax reduc­
tions in the bill overall.
Fiscal 1979— the outlook

The budget picture for fiscal 1979 is now
completely different from the way it was
originally proposed last January, particularly
for revenues. Expenditure estimates have
been reduced from $501 billion to about $492
billion, but this lower estimate comes almost
entirely from the lower-than-expected
spending in fiscal 1978. Increases in spending
in fiscal 1979 over those of 1978 are expected
to be about the same as originally forecast.
Revenues are now estimated at about $453
billion, up sharply from the original estimate
of $441 billion, primarily because of the
smaller tax cut.
As a result, instead of a deficit in excess of
$60 billion, as was originally forecast, the es­
Federal Reserve Bank of Chicago



timate is now down to $39 billion. Receipts
and expenditures during the first quarter of
the fiscal year (last quarter of calendar 1978)
were consistent with these forecasts.
This shift is a major change from the fiscal
policy underlying the budget presented a
year ago. There is clearly less fiscal stimulus.
Moreover, the most recent budget statement
for fiscal 1980, with a proposed deficit of $29
billion, suggests that a policy of progressively
lowered deficits is to continue at least another
year. The deficit for fiscal 1980 could,
however, grow substantially if the economy
weakens as much as some private forecasters
are suggesting. Lower incomes than the ad­
ministration has estimated would reduce
receipts, and higher unemployment would
increase spending.
Holding the deficit to this figure, without
raising taxes, will take a tight rein on spend­
ing. Social Security pensions, government
retirement pay, veterans' pensions, and
payments covered by similar programs go up
automatically with the inflation rate. For
budget objectives for 1980 to be met, spend­
ing on other programs—those legislated
every year—will have to be constrained or
even reduced from the levels of fiscal 1979.
A partial energy program

A year and a half after the President
presented his proposals for a comprehensive
energy program, Congress passed a bill that
dealt primarily with the pricing and use of
natural gas. Problems with the oil aspects of
the energy program were left to the new Con­
gress. Unless Congress acts, existing controls
on oil will expire in May.
Legislation as passed has two main
features: the gradual phasing out of price
controls on new natural gas by 1985 (with
some standby authority through 1988) and the
imposing of controls on intrastate gas, which
has been free of federal controls.
Price ceilings with escalator clauses tied
to the inflation rate were established for
various classifications of gas, depending on
such factors as dates of discovery and terms of
contract. The escalators seem generous

19

enough for market conditions to keep prices
below legal ceilings until controls end.
Under certain circumstances, the Energy
Department can order industrial boilers con­
verted to coal and require use of coal on new
facilities. Use of coal, however, is still con­
strained by environmental requirements.
Similarly, utilities burning natural gas in
existing plants are expected to convert by
1990. New power plants cannot be built to use
natural gas, nor can existing plants be con­
verted to gas.
Other provisions of the program require
state regulators to hold hearings over the next
two years on the feasibility of introducing rate
structures designed to encourage energy
conservation.
A "gas-guzzler" tax was introduced,
beginning with 1980 models. The tax gets
progressively higher and the mileage rating to
which it applies gets progressively lower
every year through 1985. For 1980, perfor­
mance better than 17 mpg is not taxed. But a
tax as much as $650 is imposed on cars (and
light vans) getting no more than 13 mpg. By
1985, the levy begins at $400 for performance
less than 23.5 mpg and rises to $3,850 for
vehicles getting no more than 12.5 mpg.
These penalties are, naturally, to be passed
through to buyers.
State and local government

Last year has been called the year of the
taxpayers' revolt. The rallying point of the
revolt was California's Proposition 13, which
sharply rolled back property taxes and limited
the ability of the state legislature and local
taxing authorities to raise other taxes. The
proposition was originally thought to be
another attempt at an issue that had been
defeated in 1968 and 1972. This time,
how ever, C alifo rnia voters surprised
everybody by passing the proposition
decisively. The California vote in June was a
catalyst for discontent in other states. Some
form of tax limitation issue was on the ballot in
16 states in November.
Issues were generally less restrictive than
the proposition in California. Only Nevada

20




passed a constitutional amendment directly
modeled on Proposition 13. And the law there
requires that before the amendment can take
effect, it must be voted on again in 1980.
Voters in 11 other states took some kind of ac­
tion bearing on taxes. Outcomes ranged from
Illinois's advisory referendum that said taxes
and spending were too high, and should be
limited, to North Dakota's direct reduction of
individual income tax rates. Several states put
limits on spending by tying outlays to per­
sonal income.
The limit placed on California's property
tax is believed to have reduced local tax
receipts there by about $7 billion. Much of
that was made up by dividing the state's $5
billion surplus with local governments. It is es­
timated that the federal government will
collect about $2 billion more in California
than it would have. This is because both in­
dividuals and businesses will have smaller
deductions for local taxes.
While the financial conditions of most
state and local governments have improved
with growth in the general economy, there
are exceptions. Even with the federal govern­
ment guaranteeing loans up to $1 .6 billion,
New York City has still not convinced some
observers that it can cut spending fast enough
to bring its budget into balance in the near
future. Detroit has been able to recover after
substantial austerity, but Newark continues to
experience financial problems.
The newest addition to the list of cities
with severe problems is Cleveland. When it
could not pay notes due December 15,
Cleveland became the first city to default
since the Great Depression.
Despite these problems, state and local
governments have operated, on the whole,
with a surplus, as measured in National In­
come Accounts. In the aggregate, the sur­
plus declined quarter by quarter over the
year. And given the sharp decline in revenue
in California, the sudden limitations on taxing
authority in other states, and outright reduc­
tion in federal assistance that can be expected
in 1979, the number of total governments with
financing problems could increase this year.

Economic Perspectives

Finance: restraint without imbalance
Expansion in economic activity combined
with accelerated price inflation last year to
sustain the strong demands for credit and
money that characterized 1977. Credit flows,
spurred by growth in businessand household
borrowings, reached a new high, although
the rate of increase was sharply less than in the
two previous years.
In an effort to reduce inflationary
pressures from excessive expansion in money
and credit and stabilize the dollar in the inter­
national exchange markets, the Federal
Reserve was less accommodative in providing
reserves to the banking system. Moreover,
the discount rate was raised to the highest
level in its history.
In this environment, money-market in­
terest rates rose sharply but held well below
the peaks reached in 1974. Rates on Treasury
co u p o n o b lig a tio n s and residential
mortgages, however, rose to new highs,
reflecting the heavy credit demands, rising
costs of funds to lenders, and investor expec­
tations of continued inflation.
While the cost of borrowing rose sharply,
those willing to pay the higher rates had little
difficulty obtaining financing. Moreover,
because of actions taken to sustain the supply
of funds available to finance residential con­
struction, effects of restraint were spread
more evenly over the economy than in
p re v io u s p e rio d s of tig h t money.
Nevertheless, growth in the credit and money
aggregates slowed late in the year. If this
moderation continues, it should have a
favorable effect on inflation in the months
ahead.

financial institutions totaled $362 billion in
1978. While a record, this represented only a 6
percent increase over 1977. In the two
previous years, increases ranged from 25 to 30
percent. More of the financing needs also
reflected rising prices. Total funds raised
amounted to 17 percent of nominal GNP
compared with 18 percent in 1977.
All of the increase in funds raised in 1978
can be attributed to the private sector. Its
combined net borrowing and equity sales in­
creased $28 billion, to $274 billion. Treasury
borrowing decreased somewhat. At $54
billion, federal borrowing accounted for 15
percent of the funds raised in credit markets.
That is a historically high proportion for this
stage of an economic expansion. State and
local governments issued a large amount of
securities during the year but invested much
of the proceeds in Treasury securities.
Nonfinancial businesses raised $123
billion in 1978—16 percent more than in 1977.

Record credit flows were paced
by private sector borrowing
funds raised by:
state and local —
governments and
foreign

dollar amounts in billions
$362 (100%)

$341 (10 0 %)
iimmiiniiiiiiiiiiiiiiiiii1

$38 (11%)
........ .

$34 (9%)
$54 (15%)

$57 (17%)

U.S. Treasury
and agencies
$123 (34%)
$106 (31%)

nonfinancial
business

$140 (41%)

Record credit flows

$151 (42%)

households

Funds raised in the equity and credit
markets by economic sectors other than

Federal Reserve Bank of Chicago



1977

1978*

•Prelim inary.

21

Business mortgages, which accounted for
more than 35 percent of the total funds raised
by businesses, rose 27 percent more than in
1977. Demand for nonmortgage business
credit rose even faster. The $30 billion in­
crease in bank loans was one-third greater
than in 1977 but slightly lower than the
previous record set in 1973. Business borrow­
ing in the commercial paper market also
accelerated.
Households continued to raise more
funds than any other sector, though the in­
crease over 1977 was only about 7 percent.
Home mortgages rose $94 billion, which,
even with record-high mortgage interest
rates, was slightly above 1977. Strong housing
demand, combined with rapid appreciation
in home prices, the general rate of inflation,
and the tax advantages of home ownership,
have largely offset the dampening effects of
high nominal mortgage rates on home
buying.
The supply of mortgage funds was
sustained mainly by two factors. First, S&Ls,
the main suppliers of household mortgage
credit, increased their borrowings from the
Federal Home Loan Banks by $12 billion.
Second, beginning June 1, savings and loan
associations were allowed to offer $1 0 ,0 0 0
minimum-denomination, six-month maturity
time certificates at maximum issuing rates 25
basis points above the average weekly issuing
rate on six-month Treasury bills with the same
maturity. Through these money-market cer­
tificates (MMCs), S&Ls were able to compete
more effectively for savings than in previous
periods of high market interest rates. By late
November, total outstanding MMCs at S&Ls
were estimated at $37 billion.
Another factor helping sustain the
availability of mortgages was the sale by some
larger financing institutions of mortgages or
mortgage-backed securities to supplement
deposit flows.
Other household credit, led by a rapid
rise in automobile loans, surged ahead by $57
billion. That was about 22 percent more than
in 1977.
Lenders and investors supplied funds
only at rising interest rates. Net credit ad­

22




vanced by commercial banks and their af­
filiates was $94 billion—16 percent more than
the 1977 increase.
Nonbank financial institutions—S&Ls,
savings banks, and credit unions—were again
the biggest source of credit. Their net lending
did not increase as fast as in 1977, however,
reflecting a marked slowdown in deposit in­
flows early in 1978. Through the first half of
the year, households stepped up their
purchases of Treasury securities in response
to rising yields on frequent offerings. Later,
savings institutions' lending picked up again
as M M Cs attracted funds—though at
comparatively high costs to the issuers.
Nevertheless, the net increase in direct ac­
quisition of credit-market instruments by
households was close to twice as much as in
1977.
Funds advanced by foreign sources slow­
ed to $31 billion from a record $42 billion in
1977. Foreign central banks purchased large
amounts of U.S. government securities during
the first quarter of 1978 and again in the fall.
These were periods when the dollar was
under extreme pressure in foreign exchange
m a rk e ts. Foreigners liquidated U.S.
Governments in the second quarter.
Sharply higher interest rates

As a result of record credit demands,
increased inflationary expectations, and
Federal Reserve policy actions designed to
temper undesirably rapid growth in monetary
aggregates, interest rates rose at an
accelerated pace in 1978. Federal Reserve
policy actions were manifested in a fed funds
rate around 10 percent at the end of the
year—about 350 basis points higher than at
the beginning of the year—and discount rate
of a record 9 V2 percent.
The year also saw the re-emergence of an
inverted yield curve—short-term interest
rates higher than long-term rates. In the past,
inverted yield curves had usually come late in
an interest rate cycle. In the previous cycle,
yields on Treasury securities inverted in mid1973 and remained so through late 1974.
Over the year, representative short-term
Economic Perspectives

Rising long-term interest rates. . .
percent

. . . were surpassed by sharply
higher short-term rates
percent

interest rates increased between 300 basis
points on six-month Treasury bills and 400
basis points on 90 to 119-day commercial
paper and the bank prime loan rate. Reflected
in the increases were both the surge in
business demands for short-term credit and
monetary policy actions which usually have
their initial impact on the money market.
Rates on long-term securities other than
Treasury issues rose about 100 basis points
over the year. Despite a record volume of new
issues of state and local government
securities, average yields on municipals
remained well below the peak reached in the
previous cycle. Strong demand for taxexempt securities—by individuals and by
property and casualty insurance com­
panies— attenuated yield increases on
these securities. Corporate bond yields, as
measured by the new issue Aaa utility bond
Federal Reserve Bank of Chicago



rate of 9.28 percent at yearend, were still about 1 0 0 basis
points short of 1974 highs.
By contrast, yields on in­
term ediate and long-term
Treasury securities exceeded
the peaks reached in the
previous cycle. Twenty-year
government bonds closed out
the year at 8.90 percent—30
basis p o in ts above the
previous record high in 1974.
These record-high Treasury
bond yields reflected both the
coincidence of heavy net
borrowing by the federal
governm ent with record
private credit demands and
the Treasury's continued ef­
forts to lengthen the maturity
structure of its debt.
Individuals that obtained
home mortgage loans in 1978
also paid record-high interest
rates. The conventional home
mortgage rate average finish­
ed the year at 1 0 .1 0 percent—
30 basis points above its
previous high established in
1974. However, without the
new six-month certificates and record Federal
Home Loan Bank advances, which enabled
S&Ls to maintain loanable funds, even higher
mortgage rates—or some nonrate rationing
of mortgage credit—would have been likely.

Monetary aggregates and
monetary policy actions

Domestic monetary policy was directed
to the achievement of financial conditions
consistent with reduced inflationary
pressures and an improved international
payments position while being supportive of
moderate economic expansion. Given that
excessive monetary growth is likely to induce
expectations of increasing inflation, the
Federal Open Market Committee responded
to the strong demand for money and credit by
23

supplying reserves only at a higher cost to the
banking system. The increase in the discount
rate, coming in early January in the wake of
growing disorders in foreign exchange
markets, signaled the added emphasis the
Federal Reserve would put on international
considerations in 1978.
Since 1975 the Federal Reserve's quarter­
ly reports to Congress have specified annual
ranges of monetary growth expected to be
consistent with economic objectives.1 Projec­
tions are made for M-1, (currency and de­
mand deposits held by the public), M-2 (M-1
plus commercial bank savings and time
deposits other than large CDs), and M-3 (M-2
plus mutual savings bank deposits and shares
at S&Ls and credit unions).
The year began with growth in M-1 run­
ning well above the range specified for 1977
and M-2 and M-3 at the top of their ranges.
Growth in each of these aggregates,
measured from the fourth quarter of 1977 to
the fourth quarter of 1978, was slower than in
1977.
Growth in M-1 was about 7 percent, com­
pared with nearly 8 percent in 1977—but still
above the 4 to 6 I/2 percent range specified for
the period QIV-77 to QIV-78. Growth in M-2
and M-3 was near the midpoints of their
specified ranges. The increase in M-2 was
about 8 percent, down from 9.8 percent in
1977 and well within its 6 I/2 to 9 percent target
range. The increase in M-3 was about 9 per­
cent, down from 11.7 percent in 1977 and also
within its 7 V2 to 10 percent range. As usual,
however, there was considerable variation in
growth rates over the year, which made it dif­
ficult to discern underlying trends as the year
progressed. Growth in M-1 did not slow
significantly until the last quarter.
Policy actions were aimed at reducing in­
flation and strengthening the dollar while
seeking to sustain moderate economic
growth. The year began with the Board of
1From 1975 through 1977, quarterly reports to C o n ­
gress were in response to House Congressional Resolu­
tion 133 passed M arch 24, 1975. The Federal Reserve
Reform Act of 1977, approved November 16, 1977,
amended the Federal Reserve Act to require such
reports.

24



Governors approving an increase in the dis­
count rate from 6 to 6 V2 percent. The rate
Federal Reserve banks charge on loans to
member banks was increased because the
Federal Reserve believed “ the recent dis­
order in the foreign exchange market con­
stitutes a threat to orderly expansion of the
domestic and international economy."
In support of this action, the FOMC
became less accommodating in supplying
reserves to the banking system and allowed
the fed funds rate (the market price of
reserves) to move up from 6 V2 percent to 6 3
A
percent. Weather and strikes, however,
reduced both economic activity and the need
for transaction balances through the rest of
the first quarter and the fed funds rate leveled
off.
With the economy rebounding in the
second quarter, transaction balances surged.
To restrain monetary growth without choking
off financing needed to sustain real activity,
the FOMC moved gradually to increase the
cost of deposit-supporting reserves. By midAugust, the fed funds rate was near 8 percent.
Increases in the discount rate were ap­
proved in May (to 7 percent) and July (to "PA
percent) to bring the discount rate into closer
alignment with other short-term interest rates
and thus reduce the incentive for banks to
borrow reserves at the discount window.
With foreign exchange markets still dis­
orderly and domestic inflation serious, the
discount rate was raised another 50 basis
points in August (to 73 percent), and the
A
Board of Governors announced that reserve
requirements on foreign borrowings were
being reduced to zero.
The persistence of inflation and
problems with the dollar combined with
another surge in monetary aggregates in late
summer to prompt the FOMC to tighten
money-market conditions further. By late
October, the fed funds rate was around 91A
percent. Another increase in the discount
rate (to 8 percent) had already been approved
in September, and in October it was raised to
8 V2 percent.
The package of policy actions announced
in support of the dollar on November 1 in-

Ec o n o m ic Pe rsp e c tive s

Monetary growth in 1978 slowed from previous year

was believed to have been
shifted out of demand
M-2
M-3
M-1
deposits.
Projected
Projected
Projected
Recognizing the un­
range
Actual
range
Actual
range
Actual
certainty of effects of ATS
(percent, seasonally adjusted annual rates)
on M -1 , the FOM C
lowered and widened the
Annual*
9.0
M-1 target range for the
8.8
6.2
1973
7.1
7.7
5.1
1974
year ending with the third
11.1
8.4
4.6
1975
quarter of 1979— 2 to 6
to
12.8
9.0-12.0
10.9
7.5-10.5
5.8
4.5-7.5
1976
p e rc e n t— and placed
11.7
8.5-11.5
9.8
7.0-10.0
7.9
4.5-6.5
1977
more emphasis on M-2 in
9.1
7.5-10.0
8.0
6.5- 9.0
7.2
4.0-6.5
1978
7.5-10.0
assessing the behavior of
6.5- 9.0
2.0-6.0
1979**
the aggregates. M-2 was
Quarterly
largely unaffected by ATS7.7
6.9
6.2
1978-1
related shifts. The attrac­
7.8
7.9
9.9
2
tiveness of savings and
10.1
8.9
7.6
3
sm all tim e deposits,
9.7
7.5
4.4
4
however, including bank
M M Cs with maximum
♦Annual data based on fourth-quarter averages.
rates 25 basis points less
♦♦Ranges in effect at the end of 1978 applying to the third-quarter 1978 to
than S&Ls could pay,
third-quarter 1979 period.
declined relative to other
outlets available for savings. Some investors, giving increased weight
cluded an increase of a full percentage point
to the probability that interest rates were
in the discount rate to a record 9Vi percent
nearing their peaks, acted to extend currently
and a supplementary 2 percent reserve re­
high returns by lengthening maturities.
quirement on large time deposits at member
banks. At the same time, open market
operations were designed to supply reserves
Bank loans and liquidity
consistent with a fed funds rate between 9V
2
and 9Va percent. The FOMC agreed before
Commercial banks feel pressures from
year-end to aim for a fed funds rate of 10
restrictive monetary policy from two sides.
percent.
Because of rising prices and the growing
Despite the momentum of the economy,
need for working capital—plus an un­
growth in both M-1 and M-2 slowed ap­
willingness to issue long-term debt at current
preciably in the last two months of the year. In
interest rates—business demand for bank
addition to earlier policy measures, another
credit increases. At the same time, loanable
factor weakening M-1 in the last few weeks of
funds become less available and more
the year was the introduction of automatic
expensive.
transfers. Effective November 1, an amend­
Both elements were at work in 1978.
While the expansion of total funds raised in
ment to Federal Reserve Regulation D
permitted banks, on preauthorization by
credit markets slowed, outstanding loans and
customers, to cover overdrafts by transferring
investments of commercial banks rose at
funds automatically from savings to checking
about the same pace as in 1977—11 percent.
Loans accounted for most of the rise. Bank
accounts (ATS). By year-end, balances in
savings accounts authorized for transfer
holdings of state and local securities con­
tinued to expand, but the expansion was
under ATS arrangements were estimated at
largely offset by a decline in Treasury issues.
more than $3 billion. Of that, 50 to 60 percent

Federal Reserve Bank of Chicago




25

Liquidity ratios weakened at
all banks in 1978
percent

*Last W ednesday of the month except for June and
Decem ber Call dates. Total loans exclu de loans to banks and
total deposits exclude cash items in process of collection.
**R atio of liquid assets to liabilities. M onthly averagesof
W ednesday figures. Liquid assets include Treasury and other
securities m aturing in one year or less, loans to brokers and
dealers and dom estic com m ercial banks, holdings of bankers’
acceptances and gross sales of fed funds. Liabilities are total
liabilities less capital accounts, valuation reserves, and demand
deposits due to banks.

Total bank loans increased 15 percent, also
about the same as in 1977.
Loan growth and smaller savings inflows
reduced bank liquidity significantly. This did
not result in any appreciable tightening in
loan policies of large banks, since many were
still below desired loan levels. Nor was there
any evidence of severe constraint on the
availability of credit overall. By year-end,
however, even large banks were screening
applications more carefully, and there were
signs that some potential applicants were
discouraged by the high costs of borrowing.
Real estate and consumer loans were
again the strongest elements of growth in
bank credit last year. Both rose more than 18
percent, matching the record 1977 gains.
Loans to business rose rapidly in the first half,
but later slowed. For the year as a whole, com­
mercial and industrial loans rose $27 billion.
That was an increase of 13 percent, compared
with 12 percent in 1977 and 20 percent in 1973.

26



Business lending picked up at the very largest
banks, however, while moderating at smaller
banks where demands had been strong in
1976 and 1977.
Aggressive competition for loan business
and the purchase of participations from
regional banks that were loaned up helped
bolster loans at large banks. There were other
elements, however, holding them down.
Outstanding commercial paper issued by
large nonfinancial firms rose by almosta third
last year. Business loans at U.S. branches and
agencies of foreign banks were also up sharp­
ly. The cost of funds from these sources was
generally less than charges based on the bank
prime loan rate.
Despite the competition by large
domestic banks for loan business, the prime
rate was increased 14 times last year, rising to
within a quarter-point of its historic 1 2 per­
cent peak reached in mid-1974. Late in the
year, some banks adopted a “ two-tier" prime.
Under this arrangement, when the prime rate
set for large borrowers rose above a specified
level, the base rate for small companies was
set at some margin (such as 125 basis points)
below the prime. While this arrangement
mitigated to some extent the heavy interest
burden on small businesses, by keeping the
rates on most of their lending closely aligned
with the marginal cost of loanable funds,
the major banks tempered loan volume
and avoided the squeeze on earnings they
had experienced in 1973.
Growth in demand deposits continued
strong throughout most of 1978, but as market
interest rates rose, savings inflows dwindled.
Savings and small-denomination time
deposits, which had supplied almost $32
billion of loanable funds in 1977, rose only $16
billion in 1978, with most of the gain at­
tributable to the new MMCs. While MMCs
helped stem outflows into direct market in­
vestments, because of the better return on
identical obligations offered by S&Ls, they did
not produce a great deal of new money for
banks.
With consumer-type savings flows weak
and the need for loanable funds rising, banks
increased their reliance on certificates of
Economic Perspectives

deposit of $1 0 0 ,0 0 0 or more, which are ex­
empt from rate ceilings. Altogether, large CDs
increased about $47 billion last year, financing
roughly half the growth in total bank credit.
Negotiable CDs issued by large banks ac­
counted for half this gain. Outstandings at
year-end were at a record $ 1 0 0 billion.
Rates paid for these funds ranged from
101/2 to 111 percent in the last two months of
/2
the year, and their cost was increased even
more by the imposition of the 2 percent
marginal reserve requirement in early
November.
As banks found deposits insufficient to
meet credit demands, they also tapped
"nondeposit" sources of funds. These
sources—which include fed funds and securi­
ty repurchase agreements with nonbanks,
borrowings from foreign branches, and sales
of loans to nonbank affiliates—rose about
$15 billion.

loans and investments of member banks in
the district, exclusive of interbank loans, rose
10.5 percent, compared with 8 .8 percent in
1977.
Nearly all the expansion was accounted
for by loans, which rose more than $ 1 0 billion.
That was an increase of 15.7 percent. Holdings
of Treasury securities declined almost $1.2
billion, more than offsetting the dollar gain in
holdings of municipals, agencies, and other
securities. Portfolios of non-Treasury
securities rose only 3.9 percent, compared
with 7 percent in 1977.
In contrast to the two previous years,
loans expanded faster at large banks than at
small and medium-sized banks. Loans at large
banks submitting weekly condition reports
increased 16.5 percent. Gains were especially
strong in Chicago. Loan growth at the large
banks was broadly based. Gains in all three of
the main loan categories—consumer instal­
ment, real estate, and commercial and
District banking
industrial—were more than 15 percent. Loans
to nonbank financial institutions also rose,
Credit growth at banks in the Seventh
while loans on securities declined from a year
earlier.
Federal Reserve District kept pace with the
expansion of bank credit nationwide. Total
Loans at small banks—for which a
breakdown by type is
not yet available —
Strong loan demand set pattern for district banking
rose 13 percent,
(Nov. 30, 7977 to Nov. 29, 1978)
down from 17 per­
__________________Deposits
cent in 1977. While
loan demand was
Negotiable
O ther time
C D s2
and savings
Loans1
Securities
Demand
reportedly strong,
(percent change)
many of these banks
had to tighten their
Large banks*
3
*
le n d in g p o lic ie s
-12.4
-0.8
Chicago
19.3
2.5
28.9
because of greatly
15.2
1.7
1.4
Detroit
-6.9
64.9
reduced liquidity.
4.1
Indianapolis
9.5
- 7.2
8.6
22.8
16.7
M ilwaukee
21.6
1.2
8.9
0.6
Aggregate de­
Des M oines
16.6
2.8
187.5
8.6
12.6
mand deposits for all
member banks in the
O ther member banks
district were virtually
Illinois
13.7
1.5
2.9
6.5
unchanged over the
M ichigan
13.8
4.5
5.3
10.2
6.7
Indiana
15.0
3.1
4.3
year, leaving net
11.4
W isconsin
1.5
-2.3
5.0
growth in loans to be
7.1
9.2
Iowa
11.1
3.2
financed by interestbearing funds. Total
E xclu d e s fed funds sold.
time and savings
2Data not available on negotiable C D s at smaller member banks.
3Large weekly reporting member banks.
d e p o s it s at a ll

Federal R e se rv e Ba n k o f Chicago




27

member banks in the district increased 8 .2
percent—11.6 percent at large banks and 7.8
percent at other banks. Excluding large
negotiable CDs, time and savings deposits at
large banks rose less than 1 percent.
Gains in time and savings deposits at
money-center banks in Chicago and Detroit
included an increase of more than $600
million in MMCs after June 1. After
November 1, all banks in the district with
$1 billion or more in deposits offered their
customers automatic transfer service. By yearend, savings balances authorized for transfer
at these banks totaled more than $170 million
in about 19,000 accounts.
Bank holding company
developments

Eighty-five bank holding company
applications were decided on from the
Seventh District last year compared with 98 in
1977. Two of the sixty one-bank holding com­
pany formations were denied, while only one
of the twenty multibank acquisitions and
proposals for additional shares was denied.
Three applications for acquisition of existing
nonbank activities were approved as were
two bank holding company mergers.
Nationwide, 523 applications were com­
pleted last year, compared with 428 in 1977.
The record was set in 1973, when 723
applications were completed.
The Supreme Court has found that the
Board of Governors has authority under the
Bank Holding Company Act of 1956 to deny
the formation of a bank holding company
solely on grounds of financial or managerial
unsoundness. The decision, in Board of
Governors of the Federal Reserve System v.
First Lincolnwood Corporation, was delivered
December 11.
The court found that the Board’s authori­
ty is not limited to situations where the forma­
tion of a holding company would cause a
bank to be unsound or where it would ex­
acerbate the unsoundness of a bank. The
court, therefore, affirmed authority of the
Board of Governors to require that a bank's

28




financial position meet Board standards
before a bank holding company application is
approved. This is regardless of the agency that
is the bank's primary regulator.
Newly enacted legislation

Two fairly new pieces of legislation will
have a direct effect on banks and bank
holding companies. One is the Community
Reinvestment Act of 1977. The other is the
Financial Institutions Regulatory and Interest
Rate Control Act of 1978.
The major purpose of the Community
Reinvestment Act (CRA) is to encourage sub­
ject financial institutions—banks, savings and
loan associations, and mutual savings banks—
to meet the credit needs of their com­
munities, including low- and moderateincome neighborhoods. This has to be done,
of course, in accordance with safe and sound
operations.
When applications for branches,
mergers, charters, deposit insurance, and
bank holding company acquisitions are filed,
the regulatory agency will assess the in­
stitution's past performance to determine if
the credit needs of the entire community are
being met.
Financial institutions had to have CRA
statements delineating their local lending
community and the types of credit available
on file by February 4,1979. The statement and
all correspondence regarding the institution's
CRA compliance must be available to the
public. The availability of this information had
to be announced in a public notice posted in
the lender's lobby by the deadline. The pur­
pose of the information is to improve public
awareness of the organization's obligation to
the com m unity, especially low- and
moderate-income neighborhoods.
Several sections of the Financial In­
stitutions Regulatory and Interest Rate Con­
trol Act (FIRA) relate specifically to banks and
bank holding companies. Under this act, the
Board of Governors can require a holding
company to divest itself of a nonbank sub­
sidiary or cease a nonbanking activity when

Economic Perspectives

there is reason to believe the financial safety
of a subsidiary bank is at stake.
The act also deals with insider transac­
tions. Aggregate total loans of more than
$25,000 to an officer, director, or 10-percent
shareholder require advance approval of a
majority of the directors, not including the in­
terested party. These loans have to be made
on essentially the same terms as comparable
loans made at the same time. Overdraft
payments on the accounts of officers and
directors are prohibited. The act also
authorizes the Board of Governors to assess
civil penalties of $1 ,0 0 0 a day against banks
and individuals for violations of the Bank
Holding Company Act. Cease and desist
orders can be brought against individuals as
well as banks and bank holding companies.
Regulatory agencies can remove officers,
directors, or others involved with a bank for
violating a final cease and desist order. In­
dividuals that have engaged in unsafe or un­
sound banking practices that might cause a
bank to suffer financial loss or that have gain­
ed financially as a result of personal dis­
honesty or willful disregard for a bank's safety
and soundness can also be removed.
Banking structure will be affected by Title
II of FIRA, which deals with management and
director interlocks in all types of depository
institutions. Interlocks between banks (or
thrift institutions) in the same SMSA—or the
same, contiguous, or adjacent city, town, or
village—are prohibited. The SMSA test does
not apply to financial institutions with assets

Federal Reserve Bank of Chicago



less than $20 million. Interlocks are also
prohibited, regardless of geographic limits,
where one institution has assets of more than
$1 billion and the other institution has assets
exceeding $500 million. Existing interlocks
that would otherwise be legal are grand­
fathered for ten years.
Title VI of FIRA, also called theChangein
Bank Control Act of 1978, gives regulatory
agencies authority to disapprove an in­
dividual's acquisition of control of a bank
holding company or an insured bank. An in­
dividual has to give to the agency 60 days prior
written notification of the proposed acquisi­
tion. The applicant must furnish personal,
financial, and legal history, as well as plans for
the organization to be controlled. The
proposed acquisition can be denied on either
competitive or managerial grounds. Under
Title VI, insured banks are required to report
any loans secured by as much as 25 percent of
the stock of another insured bank.
Another significant change brought on
by FIRA is the establishment of a new federal
financial institution examination council. The
council will consist of a governor of the
Federal Reserve System, the Comptroller of
the Currency, and chairmen of the Federal
Deposit Insurance Corporation, the Federal
Home Loan Bank Board, and the National
Credit Union Administration. The council will
make recommendations for the development
of uniform reporting and examination stan­
dards for financial institutions supervised by
federal agencies.

29

Future uncertain
In late 1976 and in late 1977, various
professional forecasters concluded an end to
the business expansion was at hand. But all
major sectors continued to make major gains.
Dips in indicators of activity that were pointed
to as heralding a general decline proved to be
temporary or even illusory as statistical series
were later revised upward.
Again in late 1978, predictions of a re­
cession were common. Increases in employ­
ment, retail sales, and output seemed to be
slowing down. But as more data has ac­
cumulated, the picture looks brighter.
Growth in real GNP, in fact, appears to have
accelerated in the fourth quarter. Personal
income, farm income, and corporate profits
were all sharply higher than a year before.
A substantial majority of the forecasters
this January were still calling for a recession,
saying it would begin sometime this year.
Others, however, thought a decline would
not occur, and a surprising number admitted
that they were baffled. One of the most
threatening new developments has been the
long drawn-out turmoil in Iran, which has
shut off that country's important contribution
to world oil supplies.
So far, the economy has withstood ex­
tremely high interest rates and rapid price
inflation—to an extent once thought impossi­
ble. Credit conditions tightened significantly
throughout 1978, but unlike other such
periods, credit remained available to those
willing to pay the price. Mortgage credit grew
more than in 1977. Banks continued to seek

30



out new business. And capital markets ac­
commodated a large volume of new issues.
The rapid rise in prices is viewed with
alarm, even anger. But most incomes have
been rising almost as fast, and some much
faster. Consumers protest but buy anyway. So
do businesses and farmers. Rising purchasing
power from income and debt is one of the
main factors propelling inflation.
The Administration and the Federal
Reserve System are committed to slowing in­
flation. The Administration's wage-price
guidelines were unveiled October 24. And on
November 1, the Administration and the
Federal Reserve jointly announced moves to
support the dollar in international money
markets and further restrict growth of
domestic credit. Then on January 22, the
President presented a “ lean and austere"
budget that forecasts a reduced deficit, even
at the cost of restricted spending on programs
interested groups consider highly desirable.
By and large, all these measures have been
widely supported.
Inflation of 1 to 2 percentwasconsidered
intolerable 20 years ago. By 1974, an underly­
ing inflation rate of 5 percent was generally
viewed as “ imbedded.” More recently, the
concensus has raised the expected rate to 6
percent, then 7 percent, and now 8 percent.
True economic stability is impossible un­
der such conditions. The nation is girding to
reverse this trend. The road to faster price in­
creases was easy. The return to slower rates of
inflation will be long and hard.

Ec o no m ic Persp ectives