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FEDERAL RESERVE BANK OF RICHMOND MONTHLY REVIEW E conom etric M od els: The M onetarist and N on -M on etarist V iew s Compared F orecasts 1973 Financial F oreca sts: 1973 T he M o n t h l y R e v i e w is produced by the Research D epartm ent of the F ederal R eserv e Bank of Richm ond. Subscriptions are available to the public w ithout charge. A d d ress inquiries to Bank and Public R elations, F ed eral R eserv e B ank of R ichm ond, P . O. B o x 2 7 622, Richm ond, Virginia 23261. A rticles may be reproduced if sou rce is given. P lease provide the B ank’s Research D epartm ent with a copy of any publication in which an article is used. 2 MONTHLY REVIEW, FEBRUARY 1973 ECONOMETRIC MODELS: THE MONETARIST AND NON-MONETARIST VIEWS COMPARED In recent years a grow in g number o f Government agencies and private business firm s have turned to the events of the 1930's redirected econom ic thinking tow ard problem s o f the econom y-in-the-large, i.e., large com puter-solved econom etric models as aids in toward forecasting future business conditions or in analyzing the effects o f alternative econom ic policies. E co n o metric models are statistical representations of the fram ew ork established by John M aynard K eynes in structure, or w orkings, of the econom y. in use today. T hey usu ally take the form of systems of equations, represent ing their structure. m odel-builder’s view o f the econ om y’s Since economists differ in their view s 011 m acroeconom ics. F ollow in g the general the 1930’s, m acroeconom ics developed rapidly, fo rm ing the basis for the large-scale econom etric models In statistics, the early w ork o f K arl Pearson p ro vided a method o f estimating statistical relationships and laid the foundation fo r the science of econ o the nature of the econom y, different types of econ o metrics. metric m odels are to be expected. One m ajor way in which econom etric models differ is in the role they assign to financial variables in passing the influence lands and Ragnar Frisch o f N orw ay began exp eri of policy changes to the real sectors of the econom y. T w o m ajor schools of thought may be identified. In the 1930’s, Jan T inbergen of the N ether menting with models o f their national econom ies. F or this w ork they received the 1969 N obel Prize in E conom ics. In the 1940’s, T . H aavelm o and A . First, the M onetarist position generally argues that W a ld restructured econom etrics as a problem in statistical inference. T his w ork was extended and policy influences on econom ic activity are routed consolidated by the Cowles Com m ission in the 1940’ s primarily through changes in the m oney supply; the importance of fiscal policy is generally downgraded. and 1950’s. By the early 1950’s, econom etrics was generally recognized as a separate and distinct sci Second, the non-M onetarist, or neo-Keynesian, p osi ence.1 tion argues that monetary policy influences econom ic activity primarily through changes in interest ra te s; the need for an appropriate m ix of monetary and Law rence R. Klein in the early 1940’s. fiscal policy is emphasized. T his article com pares the Monetarist and n eo-K ey nesian views by exam ining tw o representative e con o metric models. First, the general development and the nature of econom etrics are summarized. A simple model illustrates the problem s of constructing and specifying econom etric models. Then, typical neo-Keynesian and M onetarist models are surveyed. Both the underlying theoretical position and the logical structure of these models are studied. T he first model of the U . S. econom y was built by T his was follow ed by the very successful K lein-G oldberger model in 1950 and by the W h arton forecasting model in 1960. T od ay the W h arton model has a substan tial forecasting record and a clientele of over a hundred large corporations using its forecasts. A number o f other models are similarly being used, including those of Chase E conom etric Associates and Data Resources, Inc. L arge structural models have also been produced by the B rookings Institution, the Department of Com m erce, and the Board of G ov ernors of the Federal R eserve System. T he F e d eral R eserve model is one of the tools used for policy I. ECONOMETRICS analysis and forecasting by a number of District Econom etrics is a unified collection of statistical techniques used to express econom ic relationships as single equations or as systems of simultaneous equa tions. This definition implies that the subject matter of econom etrics is drawn from the two closely related fields of econom ics and statistics. Recently, the Federal R eserve Bank of St. Louis has developed a small model conform ing to the M onetarist view of the econom y. A number of other models, for exam ple the R C A forecasting Developments in both of these fields have converged to make possible the m odern science of econom etrics. Banks of the Federal Reserve System as well as by the Board itself. In econom ics. 1 For a summary of these developments and appropriate references, see Lawrence R. Klein, “ Wither Econometrics,” Journal of the American Statistical Association, 66 (June 1971), 415-21; and “ ’Figuring the Future,” Wall Street Journal, August 23, 1972, pp. 1, 6. FEDERAL RESERVE BA N K OF RIC H M O N D 3 m odel, also follow the M onetarist approach. T he rent time period, Y t is national income, Ct—i is last Federal R eserve Board model and the St. Louis model will serve as the representative models ana lyzed in this article.2 period’s consum ption, representing habitual consum p tion patterns, and f i ( ) means “ is a function o f.” Econometric Model-Building Several types o f variables appear in econom etric models. T hose variables that are explained within the context o f the m odel are termed endogenous variables; those taken as given (determ ined outside the m od el) are said to be exogen ous. W hether a variable is treated as exogenous or endogenous is determined by the m odel-builder himself in light of the analytical purpose o f the model. F or example, population w ould likely be treated as exogenous in a short-term m odel but endogenous in a long-term model o f econom ic grow th, since population trends interact with long swings in econom ic activity. A lso, variables whose influence is felt in the current period, but observed in past periods, are known as lagged, or predetermined, variables. Finally, instrum ent vari ables, which derive their value from policy decisions, are usually treated as exogenous in econom etric models. A Simple Model Investment may be explained, at first a p p rox i mation, as a function of expected profits and the existing level of capital stock. Since measuring e x pectations is difficult, it can be further hypothesized that current period profits are a p r o x y fo r expected profits. Sym bolically, I t= f 2 ( P t ,K t _ i ) , where It is investment expenditures, Pt is profits (o r nonw age in com e), and K t_ i is the nation’s capital stock at the end o f the previous period. National incom e is distributed between wage and nonwage income. W a g e income, W t, may be e x plained as a function of the level of econom ic activity, measured by Y t, and a measure o f time, t, taken as a p rox y for increasing productivity, price changes, and other changes that generally proceed at a fairly uni form rate over time. Sym bolically, W t = f a ( Y t,t). N on wage incom e is then determined by subtracting wage payments from national income. In addition to the three behavioral equations dis cussed above, the model is made com plete by three identities. First, national incom e is simply the sum o f consum ption, investment, and Governm ent e x penditures. That is, Y t = C t + I t + G t . Second, non T his m odel is d e wage incom e is national incom e less wage p a ym en ts: P t = Y t — W t. Finally, the capital stock at the end signed to determine measures of the broad com p on of the current period is identical to capital stock at ents of national in co m e : the beginning of the period plus net investment e x penditures during the current period. Sym bolically, T hese concepts may be illustrated by exam ining a simple model of the econom y.3 consum ption, investment, and Governm ent expenditures. It also determines the distribution of incom e between wage payments and nonwage, i.e., profit, payments. T he first step in m odel-building is to hypothesize the relationships am ong the variables. T here are generally tw o types of relationships to be defined. First, a number of behavioral equations set forth the m odel-builder’s hypotheses concerning the determinants of the be havior o f certain endogenous variables. Second, a number of variables are linked together by identities, which are simply econom ic or accounting definitions. T he follow in g hypothesized. behavioral relationships may be Consum ption is dependent upon, i.e., is a function of, income. A lso, people have a ten dency to maintain past consum ption patterns. bolically, we could state: S ym C t = f i ( Y t,Ct—1 ) , where Ct represents consum ption expenditures in the cu r K t = K t _ i + I t - T he model therefore consists o f six equations, each of which explains a corresponding endogenous variable. O f the tw o remaining vari ables, time is exogenous, and Governm ent expen di tures are policy determined. T he second step in m odel-building consists of specifying the behavioral hypotheses in precise mathematical form . A n y one o f several alternative form s may be appropriate. F or example, consum p tion may be linearly changes related to income, that is, in consum ption changes in income. may be proportional to Alternatively, consum ption may be related to the change in income, the logarithm of income, etc. F or simplicity, all equations o f this illustrative model are assumed to be linear. The complete model is presented in E xhibit 1. Estimation Problems 2 Frank de Leeuw and Edward M. Gramlich, “ The Channels of Monetary Policy: A Further Report on the Federal Reserve-MIT Model,” Journal of Finance, 24 (May 1969), 265-90; and Leonall C. Andersen and Keith M. Carlson, “ A Monetarist Model for Economic Stabilization,” Review, Federal Reserve Bank of St. Louis, 52 (April 1970), 7-25. 3 This model is similar to the small illustrative model presented in M. Liebenberg, A. Hirsch, and J. Popkin, “ A Quarterly Econo metric Model of the United States: A Progress Report,” Survey of Current Business, 46 (May 1966), 13-16. 4 An important step in building an econom etric model is to specify numerically the coefficients of relationship am ong the variables in the behavioral equations. A s presented in E xhibit 1, the equations of the m odel contain nine coefficients, the a’ s, b ’s, and MONTHLY REVIEW, FEBRUARY 1973 c ’s, that must be given numerical values if the m odel is to be mathematically operational. These coefficients are determined statistically by exam ining past data. T here can conceivably be a large number o f esti mating equations relating, fo r example, consum ption to incom e and past consum ption. A statistical tech Exhibit 1 AN ILLUSTRATIVE MODEL (1) C t = a 0 - f - a iY t - f a 2 C f_, nique known as regression analysis selects the set of coefficients that minimizes the variation o f observed consum ption values from the corresponding values (2) l t = b Q + b , P t + b 2 K t_, estimated by the equation. (3) W t = c0 + C lYt + c 2 t (4) Yt = C t + I t + G t (5) Pt = Y t - W t (6) K t = K t_, + l t T his “ best fitting” equa tion is adopted for use in the model. O nce these coefficients are specified, the model is complete in the sense that it can be solved mathematically. Clearly, how ever, perfect estimates or predictions are not to be expected. First, these statistical equa tion systems produce solutions that are essentially a verages; no such system can reproduce reality in full detail. Second, the model may be misspecified because errors in the data may provide incorrect estimates o f the coefficien ts; or because the hypothe where C = sized structure may include incorrect variables, or Y == income exclude significant variables, or specify an incorrect mathematical form for an equation. W = F or example, A lso, it may be that net investment K = capital stock at end of period G = Finally, several sources o f error relate to the statistical method o f regression. nonw age income I = credit conditions and other financial considerations, which are not included in the m odel, help to explain consum ption. w age income P = consum ption may be m ore properly related to after tax incom e than to total income. consumption government expenditures on goods and services t = time F o r example, if several explanatory variables m ove through time in similar patterns, it is difficult to measure their sepa rate influence on the dependent variable being e x plained. A lso, the coefficients may be biased when the equations are part of a simultaneous system.4 Source: Adapted from a similar model presented in M. Liebenberg, A. Hirsch, and J. Popkin, " A Q u a r terly Econometric M odel of the United States: A Progress Report," Survey of Current Business, 46 (M ay 1966), 13-16. M uch recent theoretical w ork in econom etrics has been directed tow ard finding methods to minimize such errors. A lthough these sources o f error exist, econom etric models have a number of clear advantages over alter native methods of analysis and prediction. Such models provide a logically consistent fram ew ork within which the interrelations o f all variables in the model may be studied. Forecasts are provided that meet all accounting identities, as well as the requirements o f the behavioral equations. A lso, econom etric models may be used to simulate the econom y under alternative time paths for policy variables or different time paths fo r exogenous vari estimates for the exogenous variables in the period being forecast. H ow ever, the prim ary advantage of econom etric forecasting over judgm ental methods is the potential for perfecting forecasting as econom etric models im prove in perform ance.5 The Logical Flow Chart Large-scale econom etric models may be extrem ely com plex in structure. A clear understanding o f their logical structure may be difficult to acquire from studying their equation systems. Perhaps a better approach is to study each m odel’s flow chart. To M oreover, while the assumptions underlying illustrate this, E xhibit 2 charts the flow o f econom ic traditional judgmental forecasts are often unstated, interaction am ong the variables o f the model pre the assumptions built into an econom etric forecast are necessarily explicit, taking the form of numerical m axim um advantage by tracing the effects o f a given ables. l Ibid., p. 16. sented in E xhibit 1. T his flow chart may be used to 5 “ Bad Year for Econometrics,” Business Week, December 10, 1969, p. 40. FEDERAL RESERVE B A N K OF R IC H M O N D 5 change step-by-step through the chart. In this simple case the equation system is given and can be co m pared directly with the flow chart. A rise in G ov Depression. T he development of an alternative theory o f m oney, interest, and output was initiated by the British econom ist John M aynard Keynes. ernment expenditures, for example, causes national incom e to rise. T his is shown in equation creased profits (equation 5 ) , and increased wages (equation 3 ) . Consum ption then feeds back into national incom e (equation 4 ) and, after a one period lag, induces further increased consum ption. R ising profits induce increased investment expenditures (equation 2 ) , resulting in a further rise in national incom e (equation 4 ) . Increased investment is also reflected, at the end o f the period, in a higher level of capital stock (equation 6 ) . Changes in wages and profits are generally offsetting, as national in com e is distributed between these tw o com ponents (equation 5 ). T his procedure of tracing through the logical flow chart of a model provides a method for presenting and studying even the m ost com plex econom etric models in a manner that can be under stood by nonmathematicians. This procedure will be follow ed below in studying the M onetarist and neo-Keynesian approaches to econom etric model building. II. Neo-Keynesian Theory 4, where G is a com ponent of Y . R ising national in com e induces higher consum ption (equation 1 ), in THE NON-MONETARIST VIEW T w o fundamentally different views of the role of m oney in econom ic activity underlie current econ o metric models. T he M onetarist view is form ulated as an econom etric model by the Federal R eserve Bank of St. Louis. T h e non-M onetarist view , based largely on a disaggregated Keynesian approach to monetary analysis, has given rise to several largescale econom etric models containing up to several hundred equations. T he approach is illustrated in this article by the so-called F R B -M I T m odel.6 T h e approach to m acroeconom ics developed by Keynes and those w ho refined his w ork is know n as the incom e-expenditure approach. Its basic char acteristics may be summarized briefly. First, the econom y is viewed as consisting of a num ber of sectors, e.g., the consum ption, investment, and g o v ernment sectors. Dem and in each sector is deter mined by factors peculiar to the sector. Then, all sectoral demands are added together to determine aggregate demand, measured by gross national p ro d uct, G N P . T his process is illustrated in E xhibit 1, where equations 1 and 2 determine consum ption and investment d em a n d ; governm ent demand is e x o genous. A ggregate demand is added together in equation 4. W ith larger, m ore com plex m odels, each of these m ajor com ponents of aggregate demand is disaggregated. Consum ption may be divided into expenditures for durables, nondurables, and serv ices; in some cases, automobile demand is explained sepa rately. Investment may be broken dow n into e x penditures for producers’ equipment, p rodu cers’ structures, residential construction, and inventory changes. Governm ent spending may be classified as Federal or state and local, with Federal expenditures further subdivided as defense or nondefense. T his disaggregation procedure can be carried to any p rac tical degree of detail, limited, o f course, by the avail ability o f appropriate data. A second characteristic of neo-K eynesian models is a built-in policy transmission mechanism that deemphasizes the role of money. F o r the m ost part, this mechanism involves the indirect linkage of m oney with aggregate demand via interest rates. In its simplest form , it may be stated sym bolically as : The Historical Setting P rior to the D epression o f the 1930’s, conventional econom ic theory considered the econom y basically O M O ----- - R ----- - M ----- - i ----- - I ----- - G N P . stable over the long run and tending tow ard full A n open market purchase o f Governm ent securities employment. T he main theme of theoretical analysis by the Federal Reserve, O M O , increases com m ercial was tow ard long-run equilibrium relationships, with bank reserves, R , and raises the banks’ reserves- little attention earning assets ratio. devoted to the short-run process Banks operate to restore their through which long-run equilibrium was attained. desired ratios by extending new loans or by expan d In this context, the quantity of money, together with ing bank credit in other ways. the level o f output, was view ed as determining the new demand deposits, thereby increasing the m oney level of prices, but having little to do with long-run supply, M . real productive grow th. a rising money supply causes the general level o f T his quantity theory was was brought into serious question as a result o f the N ew loans create Given the public’s liquidity preferences, interest rates, i, to decline. Given businessmen’ s “ expected profits,” expressed by Keynes as the m ar e See de Leeuw and Gramlich, loc. cit., and Andersen and Carlson, loc. cit. 6 ginal efficiency of investm ent, falling interest rates, MONTHLY REVIEW, FEBRUARY 1973 are important as points o f com parison with M on e tarist models. First, the m oney supply, in the p roc ess described above, is an endogenous variable, whereas M onetarists consider it exogenous. Second, the basic Keynesian model treats the price level as independent o f monetary forces. Large-scale neoKeynesian econom etric models, which generally en compass non-m onetary theories of price level deter mination, are consistent with this treatment. These tw o points will be clarified at appropriate points in the discussion below. The FRB-MIT Model T he generalized neo-Keynesian approach to m odelbuilding may be illustrated by the F R B -M I T model, which is a large-scale model of the U . S. econom y constructed by the B oard of G overnors of the Federal Reserve System and the E conom ics Department o f the Massachusetts Institute of T echnology. Its stated purpose is to quantify the monetary policy process and its impact on the econom y.9 T he model consists of 10 sectors, the most important o f which i.e., reduced capital costs, induce expanded invest ment expenditures, I. Finally, increased investment are the financial, investment, and con su m ption /in ventory sectors. T he financial sector is displayed in E xhibit 3 and the real sector in E xhibit 4. spending causes successive rounds of new final d e mand spending, causing G N P to rise by a multiple of The Financial Sector the initial change in investment.7 A number of refinements to this process have been cial sector is to establish the linkage between the instruments of monetary policy and the financial made by later economists. variables that are important in the real sector of the F or example, this trans T h e p u rp o s e o f the fin a n mission process involves K eyn es’s liquidity prefer ence trade-off of m oney and financial assets. In econom y. more sophisticated versions, this trade-off is general ized to better approxim ate a real w orld o f “ numerous financial assets, hence num erous interest rates on . . . are nonborrow ed reserves and the Federal R eserve different securities. Different types o f investment spending are most sensitive to particular interest rates, e.g., plant and equipment investment to the corporate bond rate, residential construction to the m ortgage rate, and inventory investment to the bankloan rate.” 8 Policy-induced changes in bank reserves cause portfolio adjustm ents over a wide range of financial and real assets, eventually influencing the com ponents of final demand spending. In further refinement o f the Keynesian theory, a sector. Several types o f variables appear in this First, the instruments of monetary policy discount rate. N on borrow ed reserves serve as a p rox y for open market operations. Second, demands for short-term financial assets are explained. These assets include free reserves, demand deposits, cu r rency, com m ercial loans, and time deposits held by banks, savings and loan associations, and mutual savings banks. Supply, i.e., rate setting, equations explain interest rates on T reasury bills, com m ercial loans, com m ercial paper, m ortgages, industrial bonds, and state and local bonds. Other rate setting equa tions determine the stock market yield and rates on time deposits held by banks, savings and loan asso number of writers now argue that changes in the ciations, and mutual savings banks. m oney supply have direct wealth effects on co n ture equation relates the corporate bond rate to the A term struc sumption spending, in addition to the indirect wealth com m ercial paper rate. effects operating via interest rate changes, described T h e workings o f the financial sector may be illu above. T w o other characteristics of neo-Keynesian models strated by tracing the effects o f a Federal Reserve purchase of Governm ent securities, represented in the model as an increase in n onborrow ed reserves, R U . 7 William L. Silber, “ Monetary Channels and the Relative Importance of Money Supply and Bank Portfolios,” Journal of Finance, 24 (March 1969), 81-2. A s shown in E xhibit 3, this purchase causes a rise 8 Ibid., pp. 84-5. 9 See de Leeuw and Gramlich, op. cit., p. 2G6. FEDERAL RESERVE BA N K OF RIC H M O N D 7 in free reserves, R F , and a rise in the price o f T reas ury bills, represented by a fall in the bill rate, R T B . Com m ercial banks are assumed to have, under given market conditions, a desired proportion o f earning to non-earning assets (reserv es). A n increase in nonborrow ed reserves low ers the proportion o f earn ing assets in the banks’ portfolios below the desired level. In attempting to restore this ratio, banks attempt to purchase similar fixed cou pon short-term financial assets, increase their loan offerings, and increase their demands for com m ercial paper. T he declining T reasury bill rate represents not only a decline in the yield on short-term Governm ent se curities but also a decline in short rates generally, for which R T B is a p rox y . Other short rates, the co m mercial paper rate, R C P , and the rate on com m ercial loans, R C L , follow R T B downw ard. T here follow s a com plex adjustm ent process serving to restore portfolio balance to the com m ercial banking market. T his process is expressed prim arily in the equations that determine the time deposit rate and the com mercial loan rate.10 Part of the adjustm ent involves acquisition of longer-term financial assets, represented by a term structure relationship linking the com m ercial paper rate and the corporate bond rate, R C . T he corporate bond rate influences other long-term rates, the m ort gage rate, R M , and the stock market yield, R D . T hese rates pass the m onetary stimulus to the real sector by way of the industrial bond rate, R C B I ; the state and local governm ent bond rate, R S L ; and the deposit rates of nonbank savings institutions, R S L A and R M S B . The Financial-Real Sector Linkage M o n e ta ry effects spread through the econom y by way o f three separate ch ann els: the cost o f capital, the net w orth of households, and the availability of credit to the household sector. Continuing the above illustration, the impact of low er interest rates may be traced in E xhibit 4. T he cost-of-capital channel captures the effect of three long-term interest rates— the c o r porate bond rate, the m ortgage rate, and the stock expenditures for single and multiple fam ily housing, and state and local governm ent construction spend ing.11 market yield —on investment expenditures for plant The net worth channel passes the effect o f chang and equipment, expenditures for consum er durables. ing rates o f return on bonds to the stock yield, to equity values in the net worth of households, and to 1 This process is simplified in two ways for presentation in Ex 0 hibit 3. First, the portfolio balance terms are commercial loan-todeposit ratios, which serve as measures of portfolio composition in determining each financial institution’s desired deposit or loan rate. The actual market rate is a function of the discrepancy between the lagged actual rate and the desired rate. For simplicity, in Exhibit 3 each separate component of these ratios is shown rather than the CL full ratio. For example, rather than showing the ratio: --------------, D D+DT each component— commercial loans, CL; demand deposits, DD; and time deposits, DT— is shown separately. Second, in order to simplify the chart and to emphasize financial market interaction, no real sector feed-back variables appear. These variables, such as GNP or net worth, enter the several asset demand equations as transactions or scaling variables. For further discussion of these points, see de Leeuw and Gramlich, op. cit., pp. 267-80. 8 consumption expenditures. Finally, credit rationing, the third channel, is found to be important in the housing sector. Savings in stitutions experience large fluctuations in their de posit flows, because of the sluggishness of their lending and deposit rates. In addition, their p ort 1 For a more detailed description of the cost-of-capital channel, see 1 de Leeuw and Gramlich, loc. cit. MONTHLY REVIEW, FEBRUARY 1973 Exhibit 4 FIRST-ROUND EFFECTS OF MONETARY POLICY IN THE FRB-MIT MODEL B A S IC IN T ER E ST RAT E Source: IN V E S T M E N T R A T E S O F RE T U R N C O S T O F C A P IT A L O N T A N G IB L E C A P IT A L VALUE OF NET W ORTH R A T IO N IN G V A R IA B L E E X P E N D IT U R E D E C IS IO N V A R IA B L E S F IN A L E X P E N D IT U R E S de Leeuw and Gramlich, "The Channels of Monetary Policy/' Journal of Finance, May 1969, p. 281. folios usually include a high proportion o f long-term , size o f this markup include a productivity low turnover m ortgages. In times of rising interest rates, these institutions are forced to restrict m ort gage lending. T h is non-price rationing o f credit variable, which allows producers to maintain profit shares even though wages rise faster than prices. Dem and shifts and non-labor cost-push forces are influences the residential construction com ponent o f final demand. other factors involved in this essentially non-m onetary theory o f the price level. trend T he F R B -M I T m odel thus illustrates tw o basic characteristics of neo-Keynesian m od els: (1 ) a highly detailed sector-by-sector buildup of aggregate demand and ( 2 ) a detailed specification o f the p ort folio adjustm ent process that attaches a central role to interest rates as an indirect link between m onetary policy and final demand. A s a point of com parison with M onetarist models, one further characteristic o f the F R B -M I T model should be mentioned. Prices are determined in this model by real sector forces, that is, by a variable markup over wage costs.12 Factors influencing the III. THE MONETARIST VIEW A lthough the quantity theory was in eclipse during the period of neo-K eynesian preeminence, a group of economists, led by P rofessor M ilton Friedm an at the U niversity of Chicago, continued to develop the M onetarist approach, restructuring the theory and gathering supporting statistical evidence. W ith the problem s of increasing inflation in the late 1960’s and the questionable effectiveness o f the 1968 tax surcharge in dampening inflationary pressures, the policy prescriptions and forecasts o f neo-K eynesian 12 See de Leeuw and Gramlich, op. cit., Appendix, pp. A15-16. economists became increasingly subject to question.13 FEDERAL RESERVE BA N K OF R IC H M O N D 9 T h e M onetarist view gained increased respect am ong academic econom ists and policymakers. Monetarist Theory M odern Monetarists consider the econom y basic ally stable, with m ost elements of instability the product o f faulty monetary arrangements or im proper policy. T he reasoning behind this may be briefly summarized. First, there is a stable, but not precise, relationship between the grow th rates o f m oney and nominal, i.e., current dollar, national incom e or G N P . If m oney balances g ro w m ore rapidly in relation to incom e than people wish, they will attempt to spend the excess, causing prices to rise. O n the other hand, if m oney grow s too slow ly in relation to income, people w ill try to build up their cash balances by reducing spending, which w ould result in a slow ing of incom e grow th and rising unem ployment.14 Changes in m oney and incom e do not occur simultaneously. O n the average, a change in monetary grow th will result in a change in real output grow th six to nine months later, follow ed by changes in prices in another six to nine months, according to Friedm an’s esti mates.15 Carrying this logic further, the M onetarists co n sider fiscal policy, when not accom panied by changes in the m oney supply, to be an unlikely source ot econom ic change. F o r example, increased G overn ment spending, if not accompanied by m onetary e x pansion, will tend to “ crow d out” som e private spending and have minimal impact on aggregate dem and.16 Fiscal policy distributes incom e between the private and public sectors but has little impact on price level changes.17 Thus, short-run variations in prices, output, and employm ent are thought to be dominated by movements in a policy-determ ined m oney supply.18 L on g-ru n real econom ic grow th, on the other hand, is thought to be independent of monetary change, being determined by basic grow th factors such as expanding productive capacity, population grow th, advancing technology, and natural resources. In the long run, m onetary change affects only the price 1 There is some debate concerning the effectiveness of the 1968 tax 3 surcharge. See, for example, Robert Eisner, “ Fiscal and Monetary Policy Reconsidered,” American Economic Review, 59 (December 1969), 897-905; and the subsequent comments and reply in American Economic Review, 61 (June 1971), 444-61. See also, Milton Fried man, “ The Counter-Revolution in Monetary Theory,” Occasional Paper No. 33 (London: The Institute of Economic Affairs, 1970 f, pp. 19-20 and Arthur M. Okun, “ The Personal Tax Surcharge and Consumer Demand, 1968-70,” Brookings Papers on Economic A c tivity (January 1971), pp. 167-213. 1 William N. Cox, III, “ The Money Supply Controversy,” Monthly 4 Review, Federal Reserve Bank of Atlanta, 54 (June 1969), 73. 15 Friedman, op. cit., p. 22. 1 Andersen and Carlson, op. cit., p. 8. 6 17 Friedman, op. cit., p. 24. 1 Ronald L. Teigen, “ A Critical Look at Monetarist Economics,” 8 Review, Federal Reserve Bank of St. Louis, 54 (January 1972), 13. 10 level. A ccordin gly, policy is to “ prevent source o f econom ic stabilization policy the basic objective o f m onetary m oney itself from being a m ajor disturbance.” 19 It follow s that should seek a grow th rate o f money that closely approxim ates the long-term rate of grow th of real productive capacity. T he M onetarist view o f the role o f interest rates in the policy transmission process may be summarized in the follow in g w a y : . . . Monetary impulses are . . . transmitted by the play of interest rates over a vast array of assets. Variations in interest rates change rela tive prices of existing assets, relative to both yields and the supply prices of new production. Acceleration or deceleration of monetary im pulses are thus converted by the variation of relative prices, or interest rates, into increased or reduced production, and subsequent revisions in supply prices of current output.20 Further, while interest rates serve to facilitate real and financial asset adjustm ents, “ the impact o f changes in m oney on any specific interest rate is both too brief and too weak to be either captured statistically or identified as a strategic variable in the transmission process.” 21 Therefore, the M onetarists view the m on ey supply as the strategic variable, affecting incom e directly. T his view may be repre sented schematically a s : O M O ----- - M ----- - S P E N D I N G — - G N P . A com parison o f this description with the general ized neo-Keynesian portfolio adjustm ent process, as illustrated by the F R B -M I T m odel, focuses on tw o crucial points at issu e : the range o f assets involved in the adjustm ent process and the response patterns o f interest rates and prices. Concerning the form er, Friedm an argues that the spectrum o f assets and rates o f return influenced by m onetary action is e x tremely broad, including many im plicit rates, which are not recorded.22 Friedm an further argues that recorded rates do not reflect the real cost o f capital but rather include anticipated rates of inflation. M oreover, m onetary policy may be routed through as yet undiscovered channels. In short, the transmission process is too complicated to be captured by statistical models. T he standard practice of using recorded interest rates both 1 Milton Friedman, “ The Role of Monetary 9 Economic Review, 58 (March 1968), 12. Policy,” American 2 Karl Brunner, "The Role of Money and Monetary Policy,” Review, 0 Federal Reserve Bank of St. Louis, 50 (July 1969), 18. 2 W . E. Gibson and G. C- Kaufman, “ The Relative Impact of Money 1 and Income on Interest Rates: An Empirical Investigation,” Staff Economic Studies (Washington, D. C. : Board of Governors of the Federal Reserve System, 1966), p. 3. 22 Friedman, Occasional Paper No. 33, p. 25. M ONTHLY REVIEW, FEBRUARY 1973 Exhibit 5 FLOW DIAG RAM OF THE ST. LOUIS MODEL Source: Andersen and Carlson, " A Monetarist M odel for Economic Stabilization," Review, Federal Reserve Bank of St. Louis, April 1970, p. 10. underestimates the full impact of monetary actions effect.24 Thus, changes in interest rates may be only and narrows the scope of the transmission process to a result o f the adjustm ent process, rather than a only a relatively few channels. crucial lin k; and may be directly, rather than in Therefore, Friedm an concludes, even the most com plex econom etric model versely, related to changes in money. cannot adequately represent the monetary process.23 Prices, in this process, are a function o f “ demand Monetarists also question the response patterns o f interest rates and prices in neo-Kevnesian models. T h ey regard the fall in interest rates in response to pressure” — determined by h ow close to full em ploy ment the econom y is operating. In addition, an accumulation o f price changes over time tends to monetary expansion as a tem porary effect. In a lon ger view , monetary expansion, whether via inter incom e and expenditures. T he M onetarists are care ful to distinguish nominal from real changes. W hen generate “ price expectations,” which serve as a sepa rate influence in future price movements. Thus, the long-run insensitivity o f real variables to changes in the m oney supply and the predom inant short-run in fluence of m oney on real output and em ploym ent are the econom y is operating below the full-em ploym ent consistent. est rate effects or direct spending effects, causes rising level, changes in nominal m oney may significantly The St. Louis Model affect real econom ic variables— output and em ploy ment— rather than raising prices. A s the econom y T h e process described above has recently been in approaches full employm ent, however, quantities be corporated into an econom etric model by the Federal com e less responsive, and prices begin to rise. Reserve Bank of St. L ouis.25 T he real value of money balances grow s more slow ly, or T h e m odel makes no declines, causing a reversal of the initial interest rate 2 For similar, but more detailed, expositions see Friedman, “ The 4 Role of Monetary Policy,” American Economic Review, 58 (March 1968), 6; and David I. Fand, “A Monetarist Model of the Monetary Process,” Journal of Finance, 25 (May 1970), 279-83. 2 Yung C. Park, “ Some Current Issues on the Transmission Process 3 of Monetary Policy,” IM F Staff Papers, 19 (March 1972), 24-6. 2 For a more detailed development, see Andersen and 5 op. cit., pp. 8-11. FEDERAL RESERVE BA N K OF R IC H M O N D Carlson, 11 attempt to specify the structure of the eco n o m y ; rather, it explains such broad measures as total spending, prices, and unem ployment in terms of changes in money, Governm ent expenditures, poten In sum, the St. L ouis model is a direct form ulation of the M onetarist view that m onetary changes p re dominate short-run changes in the real econom y, while in the long run m oney affects only nominal tial output, and price expectations. quantities. T h e process by which monetary action predom i This model also reflects the contention that the full transmission mechanism cannot be cap nates short-run changes in total spending can be tured by econom etric models. seen by tracing through the flow chart, E xhibit 5. found between m oney and total spending becom es the T he responses in the actual model accumulate over a basis fo r a small, simple model that explains changes in broad econom ic aggregates in terms o f changes in the m oney supply. number of periods, but no lags except price changes appear in the chart. GNP, responds T otal spending, measured by m ore strongly to m oney T he stable relationship supply IV. SUMMARY changes than to changes in the full-em ploym ent bud get. T h e latter actually has a negative impact after three quarters, reflecting the M onetarist’s “ crow ding econom etrics and has exam ined the econom etric im out” hypothesis. plications o f tw o alternative theories o f the monetary Potential output is determined by underlying fa c tors such as grow th o f natural resources, technology, labor force, and productive capacity. T otal spending process. Both the neo-Keynesians and the Mone-i tarists see a general portfolio balance mechanism at w ork in the econom y, but agreement seems to stop there. T heir divergent views concerning the im p or and potential output together determine the amount T his article has presented a summary view o f o f “ demand pressure” existing in the econom y in the tance o f interest rates, the direction of effect o f m oney short-run. Dem and pressure, a measure of short-run on interest rates, the nature o f price determination, market conditions, com bines with long-run price e x pectations to determine the current change in the price level. P rice expectations, measured by a five and the feasibility of representing the adjustm ent quarter weighted average of past price level changes, enter price determination as a separate influence. T he model thus determines changes in total spend ing and prices separately. Short-run changes in real output are then calculated as a residual by process econom etrically have been discussed above. A lthough the tw o m odels presented here are repre sentative o f current thinking, som e preliminary m ov e ment tow ard synthesis is evident. R ecent analytical w ork has introduced prices into Keynesian m odels as endogenous variables.26 Later unpublished v e r sions of the F R B -M I T model are structured so that subtracting the price factor from changes in total either the m oney supply or reserves may be used as a spending. policy variable.27 Recent unpublished M onetarist w ork specifies structural detail m ore than in the Changes in output are subtracted from changes in potential output to determine the G N P gap, a meas ure of productive slack in the econom y. T h e unem ploym ent rate is directly related to current and past levels of the G N P gap. Changes in output com bine with changes in the m oney supply, current and past changes in price levels, and price expectations to determine the level of interest rates. Market interest rates are a result of market interaction, not a crucial link in the transmission process as in the Keynesian view. 12 past.28 T he problem o f im plicit interest rates re mains unresolved. T he resolution o f this problem and the thrust o f current research point in the d irec tion of larger, m ore detailed econom etric m odels. Joseph M . C rew s “ Arthur Benavie, “ Prices and Wages in the Complete Keynesian Model,” Southern Economic Journal, 38 (April 1972), 468-77; Teigen, op. cit., p. 15 and footnote 27. 2 “ FRB-M IT-PEN N Econometric Model,” unpublished staff paper, 7 Federal Reserve Board of Governors, July 13, 1971. 2 Leonall C. Andersen, “ Influence of Monetary and Financial 8 Actions in a Financially Constrained Economy,” unpublished paper. May 1971, p. 40. MONTHLY REVIEW, FEBRUARY 1973 ew J>urpnses in j>tore . . . FORECASTS 1973 T h e forecasters this year expect the econom y to m ove ahead at about the same rate as in 1972 in consum ption expenditures. Indications, now , seem to be that the inventory accumulation will proceed but with gradually decelerating quarter-by-quarter m ore rapidly in 1973. growth. T he rate o f un M ost o f the forecasters included in the consensus, none o f w hom anticipated the President’s Phase I II employment, however, is expected to fall somewhat program , thought that wage and price controls would m ore than in 1972. continue at least until A pril. T hey also expect the rate of inflation to remain about the same as in 1972. In general, this year’s crop of T hey expected Federal forecasters foresee few m ajor surprises in store for G overnm ent expenditures to increase only modestly, us. but state and local expenditures to rise m ore than Last year’s consensus forecast fell short of the G N P gain realized in 1972 and also underestimated the im provem ent in the inflation rate. But it over stated the amount of decline in the unemployment rate. T his year’s forecasts might have been influ enced by these 1972 misses. In any case they, in general, call for g ood econom ic grow th, moderate last year’s 10.1 percent because of revenue sharing. T h e 1973 forecasts summarized here represent the best efforts of business and academic economists during the autumn and early winter of 1972 to pre dict the perform ance o f the U . S. econom y in 1973. This article attempts to convey the general tone and pattern of some 50 forecasts reviewed by the Research price increases, and a modest decline in the unem Department of this Bank. ployment rate. com prehensive forecasts, and some incorporate esti M any forecasters expect to see substantial in N ot all o f them are mates o f the future behavior o f only a few key e co creases in consum er expenditures, particularly for nom ic indicators. durable goods. T he durable g ood s expenditures will be buoyed by large, in many cases unexpected, F ed than individual efforts. eral tax refunds brought about by over-w ithholding during 1972. Significantly increased social security benefits are also expected to boost consumer outlays. T he surge in consum ption is expected to be especially Several represent group rather T he vietvs and opinions set forth in this article arc those of various forecasters. No agreem ent or endorsem ent by this Bank is im plied. heavy during the first and second quarters o f the year. M any forecasters predict that automobile sales, in particular, will turn in an excellent perform ance in 1973. 1972 FORECASTS IN PERSPECTIVE T he consensus forecast fo r 1972 G N P published O n the other hand, some believe that because in last F ebruary’s M on th ly R ev iew was $1,141.0 o f an expected slow ing in residential construction, billion, a projected increase of 9 percent over 1971. sales o f household durables will increase at a slower T he collection of forecasts ranged from a low of $1,135.0 billion to a high of $1,155.0 billion. A fter allowing for expected price rises, the grow th of real rate than in 1972. Business investment is expected to increase at about the same rate as in 1972, but most of the 1973 G N P was predicted to account for slightly over tw o- increase is expected in inventory accumulation and thirds o f the 9 percent rise. in expenditures for business plant. The predicted in Department of C om m erce indicate a 1972 G N P total creases in plant expenditures are attributed to an of $1,152.1 billion, which is over $11 billion higher Latest estimates by the expected availability of long-term funds at only m od than the consensus forecast of the business and aca estly higher interest rates, com bined with a stronger demic economists. demand for increased plant capacity. seers overestimated the G N P by only $3 billion, the Com pared to 1971, when the Business inventories are expected to be a leading 1972 forecasting perform ance seems to leave som e source of grow th in 1973 as businesses respond to increases in sales. M any forecasters were surprised thing to be desired, at least so far as current dollar G N P is concerned. that inventory investment increased by such a small In late 1971 and early 1972, forecasters were an amount in 1972 in the face o f an 8.5 percent increase ticipating an increase in the implicit price deflator FEDERAL RESERVE BA N K OF R IC H M O N D 13 RESULTS FOR 1972 A N D T YPICA L FO RECAST FOR 1973 Unit or Base Preliminary 1972 Gross national product ________________ ___________ $ billions Forecast 1973* Percentage Change 1972/ 1971/ 1972 1973 1,152.1 1,261.5 9.7 9.5 Personal consum ption expenditures .___________ Durables _________________________ ___________ N ondurables _____________________ ___________ Services __________________________ ___________ $ $ $ $ billions billions billions billions 721.1 116.3 299.5 305.4 784.6 127.5 323.8 332.6 8.5 12.4 7.7 7.8 8.8 9.6 8.1 8.9 ___________ G ross private domestic investment Business fixed ____________________ ___________ Residential structures _____________ ___________ Change in business inventories ______________ $ $ $ $ billions billions billions billions 180.2 120.4 53.9 5.9 201.5 135.5 54.0 10.5 18.6 13.8 26.5 11.8 12.5 0.1 — — Governm ent expenditures __________ ___________ $ billions N et exports _________________________ ___________ $ billions 254.9 -4 .1 276.8 -0 .6 9.5 — 8.6 Gross national product (1958 dollars) _ .___________ $ billions Plant and equipment expenditures ______________ $ billions Corporate profits before taxes _______ ___________ $ billions 789.7 88.49 93.9 837.1 99.46 105.9 6.5 9.0 12.7 6.0 12.4 12.8 Private housing starts ________________ ___________ A utom obile sales _______________________ ___________ millions millions 2.38 10.76 2.10 11.01 16.1 6.2 11.7 2.3 Rate of unemployment ________________ ___________ percent 5.6 5.0 — — Industrial production i n d e x _______________________ W holesale price index ____________________________ Consumer price in d e x _________________ ___________ Im plicit price d e fla to r _____________________________ 1967=100 1967=100 1967=100 1958=100 114.1 118.7 125.1 145.9 122.1 122.5 129.4 150.7 6.8 4.2 3.1 3.0 7.0 3.2 3.4 3.3 * Figures are constructed from the typical percentage change forecast for 1973. for G N P of around 3.2 percent. Compared to their billion in the second, $25.8 billion in the third, and perform ance during the past tw o years, the forecast ers came remarkably close to predicting the rate of $25.6 billion in the fourth. T he realized increases com e to $31.0 billion, $30.3 billion, $24.6 billion, and increase in this price index, which actually rose 3.0 percent during the year. Thus, the consensus was for a rate of grow th of real G N P of slightly under 6 percent for 1972. Real G N P in 1972 increased 6.5 percent, com pared with the 1972 consensus forecast of slightly under 6 percent. The predictions for real G N P were closer to the mark than the predictions for current dollar G N P because of the offsetting $31.8 billion for the four quarters, respectively. The quarterly predictions of the implicit G N P deflator were 3.4 percent, 3.0 percent, 3.3 percent, and 3.3 percent. F or the four 1972 quarters, the implicit deflator rose at annual rates of 5.1 percent, 1.8 p er cent, 2.4 percent, and 2.7 percent during the year. The consensus consum ption 1972 forecast projected personal expenditures fo r the year at $717.8 errors in the predictions o f current dollar G N P and billion. Current estimates place the figure at $721.1 prices. billion. Gross private dom estic investment was also A pparently, the wage and price control p ro gram w orked even better than our forecasters e x underestimated and by a substantial $12.7 billion pected. margin. A lthough the forecasters came close to That account was predicted to reach $167.5 predicting the actual amount of increase in the im billion, but it actually totaled $180.2 billion. plicit deflator, it is of interest that their error was on underestimate was characteristic of all three com p on the high side. In past years, forecasters exhibited ents of gross private dom estic investment T he (in v en a definite tendency to underestimate the rate o f price tories, business investment, and residential con stru c increase. The consensus of quarter-by-quarter forecasts for tio n ), but much of it was attributable to the greater- 1972 was for current dollar G N P to rise by ap p rox i struction. mately $26.5 billion during the first quarter, $25.4 had private housing starts totaling 2.07 m illion in 14 than-expected continuing upsurge in residential co n MONTHLY REVIEW, FEBRUARY 1973 A year ago, the consensus of forecasters 1972. T h e realized figure was 2.36 million, a new record. W ith respect to the public sector of the econom y, governm ent purchases of g ood s and services were predicted relatively accurately. The consensus of forecasters projected outlays of $252.7 billion on a National Incom e A ccoun ts basis. T he figure amounted to $254.9 billion. Sum m ing the errors in predicting consum ption e x penditures, gross private dom estic investment, and governm ent purchases of g ood s and services, it Personal consum ption expenditures are expected to total $785.2 billion in 1973, up 8.8 percent from 1972. Forecasters estimate that expenditures for durable good s will increase at a faster rate than those for either nondurables or services. Governm ent purchases o f g ood s and services are projected to total $276.6 billion. T his estimate repre sents an 8.6 percent increase, somewhat less than the 9.4 percent gain o f 1972. T he largest share o f this year’s increase will occur am ong state and local governm ents, w hose finances will benefit substan seems that the forecasters were $18.2 billion too low . tially from If the one remaining com ponent o f G N P , net exports sharing program s. of good s and services, had not been considerably overestimated, they would have been much further from the mark than the $11 billion mentioned earlier. rise about 11.8 percent to $201.1 billion. This esti mated increase is considerably smaller than the sub Net exports, predicted to show a surplus o f $3.0 billion, actually were $4.7 billion in deficit. business fixed investment is projected to show ap A lthough the forecasters underestimated the grow th of real G N P , which is presumably a deter minant of the unemployment rate, they expected the unemployment rate to fall somewhat m ore than it funds obtained through new revenue- Gross private domestic investment is expected to stantial 18.4 percent gain registered for 1972. WTiile proxim ately the same rate o f increase in 1973 as it did in 1972, expenditures fo r residential structures are expected to show only a slight gain this year. A s a matter o f fact, virtually every T h e forecasters were far from unanimous about esti mates for the residential construction sector— p ro je c observer o f the econom ic scene expected a greater recovery in unemployment than materialized. T he tions ranged from an increase of 8.8 percent to a d e cline o f 7.6 percent— but m ore than half projected unemployment rate, forecast to average 5.4 percent fo r 1972, actually averaged 5.6 percent. forecasters, however, did indicate declines from the In other areas, the 1972 forecasters underestimated, record-high grow th characterizing the construction actually did. by a slight margin, the recovery o f industrial p rod u c tion. T he industrial production index rose 6.8 per cent for the year, against a forecast of a 6.5 percent gain. T he recovery in profits, however, was over estimated. Corporate profits before taxes were p re dicted to increase 15 percent but in fact rose only 12.7 percent. T he Price C om m ission’s profit margin ruling may have figured in the miss. T he forecasters were on target with their prediction for a 3.12 p er F o re ca sts fo r 1973 c u r rent dollar G N P center around $1,261.7 billion. This typical forecast represents an approxim ate 9.5 per cent yearly gain, which is slightly less than the 9.7 Price increases are expected to amount to 3.3 percent and thus to account for about a third of the rise in G N P this year. Estimates for G N P T he consensus prediction, in fact, Inventory investment is expected to increase around $4.9 billion for 1973. Industrial Production T h e m edian fo re ca st for the Federal R eserve index o f industrial production (1 9 6 7 = 1 0 0 ) is 122.1, which indicates an increase of Anticipated gains are greatest in steel, automobile, and consum er household durables production. 1973 FORECASTS IN BRIEF percent increase registered in 1972. industry in 1972. indicates an actual decline in real (constant dollar) residential construction spending from its 1972 level. 7.0 percent, only slightly greater than that of 1972. cent increase in consumer prices. Gross National Product within a range of — 2.0 percent to — 2.0 percent. A ll 1 — range from a low $1,250.0 billion to a high o f $1,269.7 billion. of The typical quarterly estimates indicate that G N P should increase almost $30.0 billion in the first quarter 1973. Increases are expected to decline steadily thereafter Housing T h e c o n str u c tio n in d u stry is e x p e cte d to experience some slow ing from its record 1972 pace. T he consensus forecast calls fo r a total of 2.10 million private housing starts, around 280,000 less than the 1972 total. Forecasters are impressed with the grow in g vacancy rates for apartments and seem to believe that pent-up housing demand has been largely accom m odated by houses built in the 1970-72 housing boom . Residential construction expenditures are expected to total $54.0 billion for 1973, ap p rox i mately the same as in 1972. and to dip to approxim ately $24.0 billion by the Corporate Profits fourth quarter. cates that this year should be slightly m ore profitable FEDERAL RESERVE BA N K OF RIC H M O N D T h e co n se n su s fo r e c a s t in d i 15 Quarter-by-Quarter Forecasts T w e n t y fo r e c a s t ers made quarter-by-quarter predictions fo r 1972. A s indicated by the accom panying table, these fo re T Y P IC A L* Q U ARTERLY FO RECAST FOR 1973 Q uarter-by-Q uarter C hanges in Billions of Dollars Unless Otherwise Noted casters generally foresee an increase in G N P fo r the first quarter of around $30.0 billion, with gradually declining quarterly gains over the rest o f the year. I Personal Consumption Expenditures Gross Private Domestic Investment Net Exports III IV 29.9 26.2 24.5 23.9 16.2 16.5 15.4 14.9 5.7 4.9 5.1 4.0 quarter forecast called for an increase o f $99.1 billion over the fourth quarter 1972 total. T h e highest predicted an increase o f $121.8 billion. Prices, as -1 .7 -1 .3 -0 .5 Gross National Product II 0.0 measured by the im plicit price deflator, are expected T o illustrate the diversity in their estimates o f the expansion path fo r G N P , how ever, the low est fourth 7.0 4.8 5.8 6.2 to increase to 4.1 percent in the first quarter, then Implicit Price Deflatorf 4.1 3.2 3.5 3.7 Rate of Unemployment(%) 5.2 5.0 5.0 4.9 slow to a rate o f 3.2 percent in the second, then grad ually rise again in the third and fourth. N et exports Government Purchases are anticipated to continue to im prove until im ports and exports balance in the fourth quarter. T h e un * Median. employm ent rate, on the other hand, is expected by f Percentage changes at annual rates. m ost to decline by 0.4 of a percentage point to 4.9 percent by the fourth quarter o f 1973. T h e fourth for business than 1972, with pretax corporate profits quarter unemployment estimates ranged from 4.7 percent to 5.2 percent, so none o f the seers is looking for a sharply declining unemployment rate during the expected to rise 12.8 percent to $105.9 billion. year. P re dictions for grow th in profits ranged from around 11.0 percent to 16.0 percent. Unemployment M o s t fo re ca ste rs are p re d ictin g Summary F o re ca ste rs g e n e ra lly u n d erestim a ted the prim e econom ic indicators fo r 1972. P relim in ary estimates for 1972 indicate that the typical a decline in the rate of unemployment in 1973. M any forecast for G N P was som e $11 billion low er than predict the rate will dip below the 5.0 percent mark by the end o f the year. T he median forecast for the the actual amount. O veroptim ism , on the other hand, was reflected in the areas of inventory accumulation, year is around 5.0 percent, well below the 5.6 percent unemployment, profits, and especially in the U . S. average for 1972. Since the unemployment rate aver aged 5.2 percent in N ovem ber and Decem ber, h ow ever, the expected fall in the unemployment rate is trade position. T he typical forecast for net exports was $3.0 billion ; in actuality, net exports declined $4.1 billion. P rojections fo r expenditures fo r n on durable good s and the percentage increase in the rather small. consum er price index, however, were right on target. Forecasters seem to be in substantial agreement Prices T h is y ea r the co n se n su s fo re ca st in d ica tes some increase in the rate of advance o f prices. T he implicit G N P deflator, which rose 3.0 percent in concerning the 1973 outlook and, as the consensus 1972, is expected to increase 3.3 percent. favorable econom ic activity. A cco rd in g to m ost p ro T he co n sumer price index is also expected to increase m ore rapidly, 3.4 percent com pared to 3.1 percent in 1972. T he wholesale price index, on the other hand, is e x pected to rise at a slower rate than it did in 1972. N et Exports forecast indicates, are anticipating another year o f jections, the 1973 econom y will be characterized by a declining unem ployment rate, an im proving trade position, and a healthy expansion that will gradually slow to m ore “ norm al” grow th. T h e n a tio n ’s trade p o s itio n , w h ich Som e forecasters expressed concern over the possi showed a deficit o f over $4 billion in 1972 was of bility of excessive grow th exem plified by overspend prim ary interest to forecasters this year. T he seers were unanimous in p rojectin g an im provem ent in however, believe that the challenge o f prom oting a net exports with estimates ranging from a deficit of $3.4 billion to a surplus of $2.0 billion. M ost fore casters projected net exports around — $0.6 billion for 1973, a considerable im provem ent over this year’s hefty deficit. 16 ing that could lead to a new burst o f inflation. M ost, continued expansion w ithout a rekindling o f infla tionary fires will be met and that the result w ill be a healthy and stable econom y fo r the new year. W illiam E . Cullison and Carla R . G regory M ONTHLY REVIEW, FEBRUARY 1973 FINANCIAL FORECASTS: 1973 F or 1973, most econom ists are predicting another T he view s and opinions set forth in this article year of rapid econom ic grow th and financial stability are those o f the various forecasters. similar in m ost respects to 1972. ment or endorsem ent by this Bank or by the Gross national product is again expected to increase by about 10 N o a gree author is implied. percent, with personal consum ption expenditures and other G N P com ponents g row in g accordingly. Unlike the latter 1960’s when rapid econom ic grow th was accompanied by sharp increases in prices and interest rates, 1972 was characterized by ready availability of credit and, by com parison with other recent years, relatively stable prices and interest rates. A lthough short-term interest rates advanced noticeably during the fourth quarter of 1972, they remained well below the levels recorded during the tight money periods of the latter 1960’s. Thus, 1973 com m ences with inter est rates at relatively moderate levels com pared to recent years. Furtherm ore, most observers see little evidence to suggest that the U . S. econom y will be incapable of generating sufficient funds to finance the growth projected for 1973. Certain developments in 1972 are responsible for this sanguine view of the econom ic and financial scenes. A s the pace of econom ic activity im proved sharply during 1972, it became evident that the econ om y was experiencing an expansion o f considerable breadth, orderliness, and sustainability. N early all sectors of the econom y were sharing in the growth, and no serious bottlenecks seemed to be developing. A lso, toward the end of the year, investor (and co n sum er) confidence was largely restored after many months o f anxiety and indecision. T he decisiveness of the presidential election, the apparent breakthrough in the Vietnam peace talks in October, and contin ually im proving econom ic statistics contributed to investor confidence. F or some time, investors in long-term markets have been particularly sensitive to the rate of inflation, which has an important impact on securities prices. Increases in the general price Short-Term Financial Markets A s the e c o n o m y continues to expand, the demand for short-term funds is expected to grow rapidly. In the absence o f a comparable grow th in the supply o f short-term funds, upward pressure on short-term interest rates similar to that experienced in the fourth quarter of 1972 will continue. T he supply o f short-term funds hinges heavily on the reserve positions o f com m ercial banks and the cash positions o f nonbank businesses and state and local governm ents. D uring 1972, banks and non bank corporations registered substantial improvement in their liquidity. A t the same time the financial positions o f state and local governm ents took a dra matic turn for the better. A ll this helped to keep interest rates relatively low during the first three quarters of the year. In 1973 there will be three important short-term borrow ers w hose demands for funds are likely to increase over 1972— businesses, consum ers, and the U. S. Treasury. T he demand for funds by businesses is expected to show the sharpest increase. F or most o f 1972 several forces were at w ork to hold dow n the amount o f short-term borrow in g undertaken by the business com m unity. In general, m ost firm s were able to accom m odate the increased demand for output without greatly enlarging their inventories o f raw materials and finished goods. Inventory-to-sales ratios were much low er than most analysts expected. F or several reasons many corporations, especially the large ones, en joyed highly favorable liquidity posi tions and internal cash flows. Corporate treasurers had undertaken a massive program to rebuild liquid level have been quickly translated into interest rate ity during 1971 by replacing maturing short-term increases in recent years, causing large price declines debt with freshly-issued long-term debt. and capital losses on long-term security issues. Thus, was unusually g o o d during 1972 as aggregate c o r a reduction in inflation and inflationary expectations, porate profits increased by 15 percent and the effects Cash flow which occurred in 1972, makes for an im proved cli of the investment tax credit and accelerated depreci mate of expectations, especially in bond markets. ation allowances were felt. T he financial forecasts for 1973 presented in this article represent the efforts o f several well known economists. T heir forecasts have been aggregated into a consensus view as shown in Tables I and II. A lso, the limitation on dividend payouts established under the wage and price controls helped corporations conserve cash. M any o f the factors lim iting the need fo r b o r rowed funds in 1972 are likely to be altered during FEDERAL RESERVE BA N K OF RIC H M O N D 17 1973. Continued grow th in the demand for output will almost certainly force greater spending on in ventories and other form s of short-term assets. Typically, such assets are financed with short-term debt. Profits are not expected to g row as rapidly in 1973, and some uncertainty has developed re lion unit level rather than at the 9-10 million level. In 1973 consumers are expected to purchase larger cars with m ore optional equipment, which should result in m ore installment borrow ing. A lso, the record num bers o f new houses being built need to be furnished with assorted consum er durables. F or these reasons garding the continuance of the investment tax credit and other tax benefits. Som e analysts are even predicting a corporate tax increase sometime in consumers are expected to continue purchasing and 1973. have an important impact on money market b o rro w ings o f finance companies and on efforts o f com m er cial banks to raise funds through sales of C D ’s. A ll of this adds up to a grow in g need for short-term funds by businesses, as shown in Table I. T his demand will most likely be manifested in in creased use of bank loans, sales of com m ercial paper, and business finance com pany borrow ing. A s banks experience greater loan demand, they will bid more aggressively for certificates of deposit and may sell off some tem porary investments such as Treasury securities and short-term municipal securities. M any corporations will also be selling short-term securities acquired earlier when their liquidity positions were m ore favorable. Each o f these actions tends to put upward pressure on short-term interest rates. M ost analysts, how ever, as is evident from their predictions of short-term rates for 1973 shown in Table II, do not expect increased borrow in g by businesses to re sult in an unusually sharp upward shift in short-term rates. Consumers are also expected to increase their b o r row ings in 1973. A s personal income continues to expand, consum ers will en joy a larger cash flow , which can be used to pay off increased installment borrow ing. F or some time in the recent business slow dow n, consum ers saved at historically high rates, presumably as a reaction to fears o f unemployment and to continued inflation. N ow that consum er co n fidence has im proved, the saving rate has retreated somewhat, and consumers are spending m ore freely. F or example, it appears that beginning with 1972 a good year for automobile sales will be at the 11 mil- borrow ing at a very substantial rate in 1973. T heir demands, while not exactly of a short-term nature, Treasury Borrowing M o s t o b s e rv e rs feel that the T re a s u r y w ill h ave to b o r r o w a la rg er q u a n tity o f fu n d s in 1973 than it did in 1972. Som e of the most important factors affecting Treasury b o r rowing, however, remain clouded with uncertainty. In 1972 the T reasu ry’s cash position was larger than expected on several occasions because o f purchases of securities by foreign central banks, overw ithholding of income taxes by individuals, and delays in expendi tures. Traditionally, the T reasury has conducted most of its financing activities in the second half o f the year, with the first half characterized by debt repayment. T his year, however, it is reasonably certain that the Treasury will be borrow ing, perhaps substantial amounts, in the first half. A n y large amount of contraseasonal borrow in g by the Treasury this spring would tend to push up interest rates. A lthough the A dm inistration has vow ed to limit Federal expenditures in the com ing year, the high level of expenditures built into the Federal budget will produce a sizable deficit. Thus, new borrow in g from the public will probably increase, as shown in T able I. N ow that long-term interest rates are low er than they were in 1968-1970, the Treasury has been trying to lengthen the maturity of its outstanding debt by selling m ore long-term securities. Notwithstand ing this effort, most o f the financing is still carried out in the short-term markets because of the greater Table I breadth and depth o f these markets. CONSENSUS FUNDS FORECASTS* A lthough it is difficult to be at all precise in forecasting the ($ Billions) T reasury’ s need for funds in 1973, most factors point 197 2 f Business Credit Consum er Credit U. S. Treasury Securities Corporate Bonds State and Local Debt Residential M ortgages Corporate Stock 1973 19 15 15 18 16 53 12 22 17 20 17 15 53 11 to an increase that will tend to put some upward pressure on short-term interest rates. L ong-Term Financial Markets M o s t o b se rv e rs see the balance between supply and demand in lon g term markets as m ore favorable than in short-term markets. A s a result they expect very little upward pressure on long-term interest rates. Several ana * These numbers represent an estimation of the consensus forecasts of many well known economists. lysts, in fact, dare to hazard a prediction that long f Estimated. rates may decline slightly. 18 MONTHLY REVIEW, FEBRUARY 1973 These forecasters base Table II did in 1972. C O N S E N S U S INTEREST RATE FO R EC A ST S* Year end 1972 Certificates of D epositf Treasury Billsf Commercial Pa pe rf Prime Rate A a a Corporate Bonds Bond Buyer Municipal Index Long-Term Treasuries 5.50% 5.10% 5.50% 6 .00% 7.10% 5.10% 5.70% M idyear 1973 6 .00% 5.60% 6 .00% 6.25% 7.25% 5.20% 6 .00% Year end 1973 6.60% 6 .20% 6.60% 6.50% 7.35% 5.30% 6.25% O n balance, how ever, no serious up ward pressures on interest rates are expected to emerge in the tax-exem pt market. T he demand fo r residential m ortgage funds will probably be about the same in 1973 as in 1972. H ou sin g starts are expected to decline somewhat in 1973, but because o f the lag between the time build ing begins and permanent financing is obtained, m ortgage demand is not expected to show a com mensurate decline. T he m ajor sources of m ortgage funds are the thrift institutions, which experienced * These numbers represent an estimation of the consensus fore casts of m any well known economists. f Three-month maturity. record deposit inflow s in 1972. T his process may taper o ff somewhat in 1973, but the available supply o f m ortgage credit is generally view ed as adequate to satisfy demand without much upward pressure on their predictions not only on the flow s of funds that develop in the econom y, but also on the willingness of investors to com m it funds to the long-term markets. N ow that investor confidence has im proved, lon g term investors w ho earlier were driven by inflation fears into short-term markets are expected to m ove in greater numbers back into longer commitments. The m ajor purchasers of long-term debt, led by life insurance companies and pension funds, are expected interest rates. S to c k M a r k e t M o s t a n a lysts a p p ear to b e c a u tiously bullish on the prospects fo r the stock market in 1973. T he rapid rate o f expansion in the econom y should produce another year of im provem ent in c o r porate earnings, with much of the increase being attributable to increased productivity and output rather than to inflation. In terms of earnings p ro spects, many stocks are conservatively valued. F or to have substantial cash flow s in 1973. L ife insur ance companies, in particular, have im proved their example, the price-earnings ratio for Standard and liquidity positions since 1969-1970. recent bull market periods. P o o r ’s 500 Stocks is n ow much low er than in other T he stocks of those in A lso contributing to the behavior o f long-term dustries whose perform ance is closely tied to cyclical markets will be the smaller demands of m ost lon g A lthough the short-term movements in the econom y should also begin to rise in value as econom ic expansion continues. borrow in g needs o f business are expected to in crease in 1973, their need for long-term funds may M arket analysts expect institutional investors to continue to participate on a broad scale. Som e ana register a slight decline, as shown in Table I. In historical terms, however, corporations will be lysts also see evidence that the small investor, w ho issuing new long-term debt at rather high rates. O nly in the very early 1970’s during the period of massive liquidity rebuilding, did corporations sell m ore debt securities than they probably will in 1973. Thus, corporations will be expanding plant and equipment during 1973 at a healthy rate, but they will not be financing an unusually large proportion years, is returning to the marketplace in greater force. of these expenditures externally. vestors w ho entered the market in 1972 are expected term borrow ers in 1973. State and local governm ent financing needs are has been relatively inactive in the market in recent M ost analysts believe that substantial im provem ent in econom ic conditions and the strong market perform ance in recent months should allay the fear o f the stock market acquired by many individuals during the bear markets o f 1969-1970. A lso, many foreign in to continue to invest in stocks in 1973. T he volum e also expected to decline slightly in 1973 from 1972 of new equity issues, shown in Table I, is expected rates. to be relatively large in 1973. Funds acquired from the Federal G overn In the 1970’s new ment under revenue sharing will augment the spend issue volum e has grow n sharply com pared to the ing capacity of most municipalities and presumably 1960’s. reduce borrow ing requirements. Nevertheless, like Stock prices reflect expectations o f future earn corporations, state and local governm ents will record ings perform ance, and indexes o f their movement are one o f their highest rates o f borrow in g ever in 1973. widely T he supply of funds in the tax-exem pt market may be H ence, as analysts suggest, the perform ance of the cut back somewhat in 1973 as comm ercial banks stock market in 1973 depends in part on expectations channel more of their resources into loans than they regarding the econ om y’s perform ance in 1974. regarded FEDERAL RESERVE BA N K OF R IC H M O N D as leading econom ic indicators. 19 T h e co u rse o f m o n e ta ry p o lic y expansion is not excessive, that sufficient funds will always plays an important role in shaping conditions be generated in the process of econom ic grow th to in financial markets. finance the current expansion, and that the Federal M o n e t a r y P o lic y M ost investors now appear to believe that the chief problem facing the Federal R eserve will be careful to avoid the extrem es o f Reserve System is that o f preventing an overheating o f the econom y. Thus, many analysts are predicting overheating or tight money. that the Federal R eserve will attempt to moderate the recent relatively rapid rate of grow th o f the m oney supply in the months ahead. A t one time, such thinking prom pted talk of a credit crunch in 1973. O n balance, the co n sensus o f forecasters is that the econom y will co n tinue to expand in 1973 and that there will be suffi cient credit available to avoid any sharp upward movement o f interest rates. M ost analysts, however, feel that the current Philip H . Davidson F E D E R A L R E S E R V E B O A R D P U B L IC A T IO N IN D U ST R IA L P R O D U C T IO N : 1971 E D IT IO N The publication, I n d u s t r i a l P r o d u c t i o n : 1971 E d i t i o n , is available fo r distribution by the Board of G overnors of the Federal R eserv e S ystem . This book provides detailed descriptive material and statistical tables on the revision of the industrial production index, the results of which w ere sum marised in the July 1971 issue of the F e d e r a l R e s e r v e B u l l e t i n . C opies are available at a charge of $4.00 fo r single copies and $3.50 each for copies of ten or m ore sent in a single shipment. P lease address all requests to Publications S ervices, D ivision of A dm inistrative S ervices, B oard of G overn ors of the F ederal R eserv e S ystem , W ashington, D . C. 20551. F E D E R A L R E S E R V E B A N K O F R IC H M O N D P U B L IC A T IO N B U SIN E SS FO RECASTS FOR 1973 The F ederal R eserv e Bank of R ichm ond is pleased to announce the publication of B u s i n e s s F o r e 1973. B u s i n e s s F o r e c a s t s , which is a compilation of representative business forecasts ■ —with names and details of estimates— for the com ing year, is available free o f charge from this Bank. P lease address requests to Bank and Public R elations D epartm ent, F ederal R eserv e Bank of R ich m on d , P . O. B o x 27622, R ichm ond, Virginia 23261. c a sts fo r 20 MONTHLY REVIEW, FEBRUARY 1973