Full text of Economic Quarterly (Federal Reserve Bank of Richmond) : January-February 1976, Vol. 62

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FOREIGN BANKING IN THE
UNITED STATES:
Mouemen t Toward Federal Regulation
Bruce 1. Summers
For at least a decade now, there has been much
discussion about bringin, (+ foreign bank operations in
this country under some form of Federal control.
Recommendations
that the scope of Federal regulatory authority be extended to cover foreign banks
operating in the U. S. have come from several different quarters, both within and outside government. In
response to this discussion, a number of bills directed
toward foreign banking have been introduced in Congress, although none has been enacted to date. Today
a new sense of urgency surrounds the issue, largely as
a result of the dramatic growth in the foreign banking
presence that has occurred during the past several
years. Since January 1973, for example, the number
of separately chartered and licensed foreign banking
facilities has increased from 111 to 180, and the
combined assets of these facilities have more than
doubled to $57 billion.
Consequently, Congress is
now closer than ever to acting on the question, and
it seems likely that a foreign banking bill will be enacted in 1976. Foreign banking legislation will probably follow one of two basic scenarios: the Federal
Reserve framework, embodied in its proposed legislation known as the Foreign Bank Act of 1975,l or
the House Banking Committee framework, outlined
in the FINE (Financial Institutions and the Nation’s
Economy) study discussion principles.
The character of the eventual legislation is a
matter of interest to all bankers, not just those who
themselves engage in international operations or who
have direct dealings with foreign banks.
Foreign
banking operations have grown to such an extent
(over 6 percent of total bank assets in the U. S.
are now under foreign control) that they now have
an important effect on credit market conditions generally. This article reviews the background that has
influenced the movement toward Federal regulation
of foreign bank operations and outlines the major
ideas contained in the two legislative proposals active
today.
‘The Federal Reserve’s draft bill will have to be resubmitted again
in 1976.

The Nature of Foreign Banking Operations
The
U. S. activities of foreign banks have been conducted
through four basic organizational forms : representative offices, agencies, branches, and subsidiary banks.
Representative
offices, which have no real banking
powers per se, constitute the most primitive form of
activity. They serve as customer information centers
and business generating facilities, much as do the
so-called loan production offices opened in various
parts of the country by large domestic banks. Of
the states that allow foreign banking, only California
requires licenses for representative
offices.
As a
practical matter, the traveling representatives of foreign banks have unlimited access to customers across
the nation, so the information and assistance function
is virtually free of constraints.
Agencies engage in various types of lending and
investment activity, are not empowered to receive
deposits, and in all cases must be licensed. They-are
particularly active in financing trade and investment
between the U. S. and their home nation and also
participate heavily as lenders and borrowers in the
interbank credit markets and Eurocurrency
markets.
As primary sources of funds, agencies rely on balances placed with them by affiliated institutions (e.g.,
parent banks in their home country) and short-termborrowings from other banks.
The U. S. branches of foreign banks conduct a
general banking business including, in most cases,
solicitation of demand and time deposits. They have
an essentially wholesale orientation, and most of their
loans are of a business and commercial nature. Their
loans have traditionally been made to the U. S. subsidiaries of home-based corporate customers, but they
are becoming more and more interested in penetrating
the U. S. corporate banking market. Foreign trade
financing and lending in the market for interbank
funds remain important activities.
A few branches
have successfully entered the market for retail deposits, but corporate deposits, both domestic and
foreign, and interbank borrowings represent their
llrimary sources of funds.

FEDERAL RESERVE BANK OF RICHMOND

3

Foreign-owned
subsidiaries, almost all of which
are state-chartered, engage in a general banking business, as do branches.
Unlike branches, however,
their business is much more heavily oriented to the
domestic market for loans and deposits, including
retail deposits.
Foreign subsidiary banks are required by the Bank Holding Company Act to carr)
FDIC insurance.
They are eligible for membership
in the Federal Reserve System and are on an equal
competitive footin, u with domestic banks in the states
Although only about one-fifth
where they operate.
as large as agencies and branches in terms of total
footings, subsidiaries are nonetheless very important,
especially in certain markets.” Q7hile the subsidiary
form of organization provides the most complete set
of banking powers to foreign entrants, it also has
certain drawbacks.
Perhaps the most significant
drawback is the fact that subsidiary banks must be
independently capitalized, making them an expensive
investment relative to the branch alternative.
The Regulation
and Development
of Foreign
Banking
Operations
The particular
organizational form adopted by a foreign bank is determined
to some extent by the intended function of its operation but more importantly by the laws of the individual states governing foreign banking activities.
With only a few exceptions, foreign banking activities
are regulated by the states. 3 Thus, foreign banks that
desire to begin business here are faced with an array
of different legal requirements and must adapt their
organization to conform to the local laws under which
they operate.
Some of the laws that determine the
structure of foreign banking in states where it is
especially important will be reviewed in the discussion that follows.”
The first instance of direct entry in the U. S. by
foreign banking interests dates back to the 19th
century, when Xew York-based agencies of Canadian
2 The importance of the subsidiary form of organization was reeentl~
highlighted when European-American Bank and Trust Company,
owned by a ~onsort/um of six large. European banks, acquired the
faufadbFrankhn Natronal Bank and ~ta extensive network of retail
“The FDIC examines state-chartered subsidiaries of foreign banks.
Foreign-owned banks with a national charter would be regulated by
The requirement that all national
the Comptroller of the Currencu.
bank directors must
be U. S. citizens, however, has effectively
limited this form of organization to domestic banks only. The Board
of Governors
of the Federal Reserve System
supervises,
through
Regulation Y, the banking-related activities of foreign-owned bank
It also baa jurisdiction, impIemented through
holding companies.
Regulation K, over Edge Corporations, in which foreigners are
allowed to hold a minority interest.
4 New York laws applying to foreign bank operations and important
differences between New York laws and the laws of other states
are cataloged in Franklin R. Edwards, Regulation
of Foreign
Banking
in the United States: International
Reciprocity
and FederalSt&s Conflicts,
Columbia University Graduate School of Business
Research Paper No. 64 (New York: Columbia University, Graduate
School of Business, 1974).

4

ECONOMIC

REVIEW,

banks managed the mcney positions of their parent
organizations.
Dollar balances held with New York
correspondent
banks and call loans made to New
York securities dealers and brokers were the primary
types of secondary reserves maintained by the Canadian banks.
When the volume of international
capital and trade transactions increased after World
War I,, a more general interest in direct U. S. representation arose among banks of various nations, including Canada. Thus, in the early 19.20’s?a number
of foreign branches were opened in several western
states and in Illinois.
Legislation prohibiting these
operations was soon adopted across the nation, putting an end to the incipient expansion.
The biggest
blow to the expansion plans of foreign banks came
in 1923, when a bill that would have permitted foreign branching was defeated in the Xew York legislature.
Subsequently,
the Great Depression
and
World War II reduced foreign bank interest in
opening offices here.
Since World War II, the internationalization
of
business, supported by increased freedom in international capital movements, has provided a strong;
impetus to the development of foreign banking networks. This has been equally true for banks headquartered in other countries and for U. S. banks.
Much of the liberalization in state laws to allow
foreign bank operations has occurred out of recognition of this mutual interest.
The leading U. S.
banks, having encountered resistance to their strong
foreign expansion programs in the 1950’s, brought
the need for reciprocal treatment to the attention of
their state governments.
Their efforts led to changes
in state laws that have had far-reaching effects on
the foreign banking presence in the U. S. The mos,t
notable changes in state regulations are those involving the financial centers.
In 1961, for example,
Kew York law was amended to permit branches of
foreign banks to conduct a general banking business.
And, most recently, a change in Illinois law effective
in 1973 permits branches of foreign banks to operate
in Chicago.
Ten states have enacted legislation that explicitly
allows foreign banks to operate within their jurisdictions.
In addition to the two mentioned above,
this group includes Alaska, ‘California, Georgia,
Hawaii, Massachusetts, Oregon: Utah, and WashSixteen states explicitly prohibit foreign
ington.
banking operations of any kind, and laws of the
remaining twenty-four
are silent on the subject.
There are no foreign banking facilities located in fhe
JANUARY/FEBRUARY

1976

Fifth Federal Reserve District, and most of the
states have laws designed to discourage entry. Virginia law prohibits all types of foreign banking activity, while Maryland and North Carolina disallow
foreign branching.
The banking statutes of South
Carolina are silent on the issue. West Virginia law
establishes application procedures for foreign corporations to follow in requesting a banking license,
but state officials are candidly ill-disposed toward
approving such applications.
Branches and agencies
are prohibited in the District of Columbia.
What are the motives that have encouraged foreign
banks to enter the U. S. and to accelerate their rate
of entry in recent years ? Originally, the U. S.-based
facilities of foreign banks had a narrowly specified
Their primary purpose was to
set of objectives.
provide continuous service to home-based customers
who themselves had established U. S. operations.
Their sense of purpose has broadened, however, and
they have now become more active competitors for
the loan and deposit business of U. S. corporations.
The U. S. financial markets have been a traditional
source of attraction for foreign banks, and they reIn a few instances, furthermore,
main so today.
foreign banks have seen an opportunity to capture a
share of the retail banking market.”
Currently, the
European nations and Japan are lagging the U. S. in
recovery from world-wide recession ; business alternatives in this country, therefore, seem especially
attractive to foreign banks.
Foreign bankers are
bullish on their business prospects here and evidently
intend to step up their efforts to play a fuller role in
the financial aspects of recovery.6
In fact, the investment opportunities provided by the U. S. economy probably account for an important part of the
This is
recent spate in foreign banking activity.
illustrated by the fact that the combined operations
of foreign banking interests have caused a net inflow
of capital into the U. S. This sum has increased from
$3.6 billion in 1972 to $7.6 billion in 1975.
The wide representation
of foreign banks in the
nation’s financial centers has contributed to the continued preeminence of this country as the world’s
financial center. Foreign banks have made available
a wider and fuller range of financial services and
AThese motives are more fully described in Fred H. Klopstock,
“Foreign Banks in the United States: Scope and Growth of Operations,” Monthly
Review, Federal Reserve Bank of New York.
Vol. 55, No. 6 (1973). 140-54.
~“Foreign Banks Like U.
(1975). 40-4.

S. Market,”

BanIcing. Vol.

67. No. 11

have done much to encourage foreign trade. At a
time of widesr>read concern about capital shortages,
they have channeled more investment funds into the
country than T-hey have transferred out. These are
important contributions that must not be lost sight
of in the debate over foreign banking regulation.
The Movement Toward Federal Regulation
The
essence of the debate over Federal regulation is
whether or no: regulation of foreign banking activities should be centralized at the national level. Two
major arguments have been advanced in support of
centraIized regulation.
The first argument contends
that current institutional arrangements make it difficult for the central bank to achieve its monetary
policy objecti\-es, particularly with regard to credit
market conditions. Foreign banks have an important
effect on credir market flows and, so the argument
runs, must be subject to national policy. Until now,
foreign bank compliance with Federal policies designed to control these areas has been voluntary.
Since June 1973, for example, foreign banks operating in the TJ. S. have been asked to maintain
reserves against increases in their negotiable CD’s
and Eurodollar borrowings.
This request was made
by the Federai Reserve as part of its anti-inflation
program.
Although the record of compliance is
admirable, it nonetheless remains true that the U. S.
Government’s iormal power to regulate foreign banks
is almost nil.
The second argument encouraging the movement
toward Federal regulation of foreign banks centers
around the idea that the foreign institutions operating
here enjoy greater privileges than do domestic banks.
Accordingly, some feel that foreign banks should
have their activities restricted to the same extent as
are those of U. S. banks. The major advantage held
by foreign banks is their ability to operate branches
and agencies ir. more than one state, a privilege they
enjoy due to the acquiescence of the states themselves.?
Since about 1966, the debate over these issues has
intensified. In July of that year the Joint Economic
Committee published a research paper on foreign
banking activities.8
The study concluded that the
7 This position faiJx to recognize the issue of international reciprocity, for in most ioreign countries no limits are placed on the
branching privileges of U. S. banks.
See Anthony Favill Tuke.
“Proposed Limits on Foreign Banks in U. S. Criticized,” American
Banke7. May 31, 1974. p. 7.
*U. S.. Congress, Joint Economic Committee, Foreign Banking
in
the United
States.
Economic Policies and Practices Paper No. 9,
by Jack Zwick (Washington, D. C.. 1966).

FEDERAL RESERVE BANK OF RICHMOND

5

public interest would be served if legislation providing for Federal supervision of foreign banking
activities were passed.
It also suggested that the
option of Federal chartering should be made available to foreign banks.
Shortly after the JEC study was released, the
first bill aimed at bringing foreign banking under
Federal control was introduced in the Senate.g It
designated the Comptroller of the Currency as the
sole chartering and supervising authority for foreign
banking activities and made foreign banks subject to
roughly the same rules as national banks, with the
exception that they would be able to operate across
state lines. The Comptroller’s powers included the
ability to impose upon banks from a particular nation
the same set of regulations applied to U. S. banks
operating in the foreign country, should they be more
restrictive than those here.
In this way, it was
thought, equal treatment for U. S. banks operating
abroad could be guaranteed.
This bill languished but still achieved its sponsor’s
primary aim of arousing Congressional interest. Interest in foreign banking legislation was further
spurred by the October 1966 collapse of Intra Bank,
a world-wide financial institution headquartered
in
Lebanon. Intra Bank had a New York branch that,
although holding only a small amount of U. S. deposits, caused quite a sensation when it closed. Further, several U. S. banks incurred losses as a result
of the closing of Intra Bank offices in other countries.r” A number of other bills were introduced in
the House and Senate over the next several years,
and their thrust seemed to change somewhat.
The
idea of unfair competition became increasingly prominent, supplementing the argument based on the need
for greater control to implement economic policy.ll
Over the past several years, the Federal Reserve
has attached a high priority to dealing with the question of appropriate foreign banking legislation.
It
recognized the importance of having detailed information on the financial activities of U. S.-based foreign banks and instituted a data collection program.
A body of monthly balance sheet information for
foreign banking offices in the U. S. is now available
from late 1972.” In addition, the Federal Reserve
r’ S. 3765,

The basic principle underlying the Foreign Bank:
Act of 1975 is one of nondiscrimination
between
domestic and foreign banks. In other words, foreign
banks would have the same privileges, and be subject
to the same restrictions, as domestic banks.
From
this standpoint, the most important feature of the
,4ct is the section extending the Bank Holding Corn,pany Act to cover branches and agencies of foreign
banks, not just their subsidiaries, as is now the case.14
The result would be to eliminate any further branch
and agency expansion across state borders. A grandfathering provision in the Act, however, would allow
foreign banks to retain interstate facilities operating
prior to December 3, 19i4, the date when the proposed legislation was first released.
Entry alternatives available to foreign banks would
be increased under the Foreign Bank Act of 197:;.
Foreign ownership of national banks would be facilitated by giving to the Comptroller of the Currency
authority to allow up to one-third of the directors of a
Also, foreign
national bank to be foreign citizens.
banks and their state and Federally-chartered
U. S.
subsidiaries would be permitted to own controlling
interests in Edge Corporations, an arrangement that
is currently prohibited.
All foreign banking facilities, whether organized
under state or Federal charter, would be required to
obtain licenses from the Comptroller of the Currency.
National control of all foreign banks, even those
organized under state laws, would thereby be provided for. The requirement of FDIC insurance now
applicable to foreign subsidiaries would be extended
to branches and agencies.
And Federal Reserve

89th Con&, 2nd Sess. (1966).

10H. Erich Heinemann, “Foreign Banking In U. S. Is At Issue,”
The New York Times. February 12, 1967. sec. 3. P. 1.
11See, for example, H.R. 11440, 93rd Cow.,

1st Sess. (1973).

12 “Data Series On Foreign Owned U. S. Ranks.” Feded
Culletin. Vol. 60. No. 10 (1974), 741-2.

6

set up in February 1973 a System Steering Committee to review the regulatory aspects of interAs a result of this Committee’s
national banking.
work, the Board sent to Congress on December 3,
1974, a draft bill known as the Foreign Bank Act
of 1974. The intent of this proposed legislation was
the establishment of a national policy toward foreign
banks operating in the U. S. It was subsequently
amended with a number of technical changes and
resubmitted on March 4, 1975, under the title Foreign
Bank Act of 1975. This bill has been introduced in
the Senate.13

ECONOMIC

Resmw

REVIEW,

US. 958, 94th Cow.,

1st Sess. (1976).

*two
organizational forms would remain exempt from the provisions of the Bank Holding Company Act: New York State Invest
ment Companies, of which there are only a handful in operation:
and foreign consortia in which none of the parent companies owns
25 percent or mote of the bank’s stock.

JANUARY/FEBRUARY

1976

membership would be required of all foreign banking
operations in the IJ. S. whose parent organizations
had world-wide assets in excess of $500 million.

abolished, with the entire supervisory function transferred to a newly-created Federal agency, The Federal Depository
Institutions
Commission.16
The
underwriting
and equity investment activities currently permitted foreign banking organizations under
some state laws would also be forbidden.

The House Banking Committee, several of whose
members have been very active in drafting foreign
banking legislation over the years, has also generated
a position on the question. Its position is incorporated
as part of the overall FINE study process, which is
leading up to an omnibus bill on financial structure
and regulation.rj
Hearings on this section of the
FINE study have already begun, and it is probable
that action on foreign banking regulation will precede
action on the other parts of the study.
The emphasis of the House Banking Committee
proposal is on the relative competitive aspects of
foreign and domestic banking, rather than on national
economic policy areas.
The proposal achieves essentially the same result so far as national policy control is concerned but is significantly more restrictive
with regard to definition of an appropriate structure
and range of activity for foreign banks. Under the
FINE framework, all foreign banking entities in the
U. S. that accept domestic deposits would be required
to function under the subsidiary form of organization.
Grandfathering would not be permitted, thus implying large-scale closings of foreign branches and
agencies and conversions to subsidiary banks. State
chartering of foreign banking activities would be
‘ju.
s., Congrew. House. Committee on Banking, Currency and
Housing, Fi?uzncial Iwtitutions and the Nation’s
Eccnwmy (FINE)Discusmm Printipk8. 94th Gong., 1st Sess.. Title VI (1975).

Conclusion
There is a widely-held
belief that
the time for closer Federal supervision of foreign
banking activities in the U. S. has arrived. The sheer
magnitude of the foreign banking presence, and its
consequent influence on financial market conditions,
argue for legislation designed to centralize supervision at the Federal level. According to one view,
this would help in the attainment of national monetary policies aimed at the credit markets. Additionally, some see a need to equalize the competitive positions of foreign-owned and domestic banking organizations. These views are reflected in two legislative
proposals active today.
The Federal Reserve and
House Banking Committee proposals are similar in
several respects, but the latter is considerably more
restrictive in its treatment of permissible foreign
banking activities.
Legislative action based on one
or the other of these proposals, or on some combination of their different features, is likely this year.
lo The supervisory activities of the Comptroller of the Currency, the
Federal Reserve System, the Federal Deposit Insurance Corporation
the Federal Home Loan Bank Board, and the National Credit Union
Administration would all be consolidated under the Federal Depository Institutions Commission.
The new FDIC would then be responsible for the chartering and examination of al2 Federallychartered depository institutions, foreign and domestic.

FEDERAL RESERVE BANK

OF RICHMOND

7

FORECASTS 1976
Recovery But No Bicen temial Boom
William E. Cullison
Recovery, led by strong consumer spending, will
continue throughout
197& but the recovery
will
not be at as rapid a pace as has been the case
following past recessions.
Such, at least, is the
general conclusion
reached by leading business
and academic
economists
who have published
forecasts for the 1976 economy.
This general conclusion, as is the case with all
forecasts, is not really an attempt to foresee the
future. Professional
forecasters can only evaluate
the implications
of certain trends, and-given
certain assumptions
about future events-extend
these trends into the future. If unforeseen
events
occur, the “prediction”
does not come about.
Each year the Federal Reserve Bank of Richmond compiles various forecasts of the economy’s
performance
for the coming year. This year the
forecasters
based their forecasts on the following
assumptions:
(1) extension
of the 1975 tax cut
without
President
Ford’s
proposed
spending
limit, (2) little, if any, increase in oil prices (revocation of the $2 per barrel oil tariff will offset the
rise in OPEC prices), (3) a good crop year, (4)
sluggish recovery abroad? and (5) continued difficulties for many municipalities
in selling their
bonds.
On the basis of these assumptions,
the
forecasters
expect approximately
a 6 percent rate
of real growth for GNP.
This higher rate of
growth is expected
to be accompanied
by a 6
percent rate of inflation.
Last year the consensus
prediction
overestimated the actual GNP total by approximately
$34
billion.
Real GNP, or GNP measured
in 1958
dollars, likewise was overestimated,
and by $23$24 billion.
Forecasters
had expected real GNP
to decline 0.6 percent;
it actually
fell approximately
2.9 percent.
Much of the difficulty
stemmed
from their mistaken
appraisal
of the
Although
almost all of the forefirst quarter.
casters who made quarterly
forecasts
expected
first quarter
real GKP,
measured
at annual
rates, to decline, none anticipated
a decline as
large as $24 billion. The most pessimistic anticipated a decline of only about half that amount.
8

tjCONOMlC

REVIEW!

In any event, and perhaps as a result of their
misstep on the first quarter, most forecasters were
expecting real GNP to bottom out in the second
quarter and recover slowly in the second half. As
is common knowledge now, real GNP in 1975 hit its
low point in the first quarter and showed a good
rate of recovery in the second half of the year.
This year the forecasters expect a steady, although
not ebullient, rate of recovery throughout 1976. Personal consumption spending, particularly for durables, is expected to be strong and to exhibit its
greatest growth in the first half of the year. The
experts also expect the economy to benefit from inventory rebuilding and a pickup in the construction
Business spending for
of single-family dwellings.
plant and equipment is expected to increase only
modestly in the first half of the year, but as the recovery continues and as production increases, businessmen are expected to reactivate previously postponed capital spending plans. Thus, plant and equipment spending is expected to accelerate in the second
half of the year.
This article attempts to convey the general tone
and pattern of some 40 forecasts received by the
Research Department of this Bank. Not all of these
forecasts are comprehensive, and some incorporate
estimates of future behavior of only a few key economic indicators. The consensus of the annual forecasts may differ from the consensus drawn from the
quarterly forecasts, since different forecasters were
applying their skills. Also, since there were varying
assumptions in the individual forecasts regarding
events in 1976, the general tone and pattern may not
necessarily be based upon the more realistic assumptions, but only those most prevalent.
This Bank also publishes the booklet BUSINESS
FORECASTS
1976, which is a compilation of representative business forecasts with names and details
of the various estimates.
No summary article can
begin to be as informative as the actual forecasts
themselves. Serious readers are urged to look at the
individual forecasts in more detail in BUSINESS
FORECASTS
1976.
JANUARY/FEBRUARY

1976

The views and opinions set forth in this article
are those of the various forecasters. No agreement or endorsement by this Bank is implied.
1975 FORECASTS

IN PERSPECTIVE

The consensus forecast for 1975 GNP, published
in last year’s January/February
Economic Review,
called for an increase of 8.2 percent over 1974. The
forecasts for increases in GNP ranged from a low of
5.1 percent to a high of 10.8 percent.
Using the
revised 1974 GNP figure of $1,397.3 billion, the consensus forecast for 1975 GKP would have been
$1,512.0 billion and the range from $1,468.2 billion
to $1,54&Z billion. Increasing prices were predicted
to account for all of the 8.2 percent gain in GNP,
and slightly more. GNP measured in constant dollars,
or real GNP, was expected to fall 0.6 percent.

RESULTS

All of the forecasts that have been collected were
made before the revised GNP figures were released.
Since it would be of little use to evaluate the 1975
forecasts on the basis of the new revisions, the Research Department of this Bank estimated fourth
quarter 1975 on the old basis. The fourth quarter
estimates were made by determining a consensus of
the forecasts published in December 1975 and early
January 1976.
Including these fourth quarter estimates, a 1975
current dollar annual GNP total of $1,477.1 billion is
indicated ; that figure is almost $34 billion short of
last year’s consensus forecast. Only one of last year’s
forecasters predicted a current dollar GNP total less
than what now seems to have been the actual figure.
Prices increased somewhat more slowly than predicted, 8.8 percent versus 9.0 percent, but even so,
real GNP appears to have been overestimated by all

FOR 1975 AND TYPICAL

FORECAST

FOR 1976
Percentage
Change

Unit or

Base

Estimated
1975:

Gross national product _______-_______---____________________
$ billions
1,477.l
953.6
$ billions
Personal consumption expenditures ________________
i 34.2
$ billions
Durables __________________
- ___________I______________
416.2
$ billions
Nondurables _______-________________
-__-___-___-_-_____________________________________I__--------403.2
$ billions
Services ____
i70.3
$ billions
Gross private domestic investment ___________________
144.6
Business fixed _____________________________I_________
--__ $ billions
39.7
$ billions
Residential structures ______________________________________
-14.0
$ billions
Change in business inventories ___________________
341.0
$ billions
Government purchases ___________________________________
- _____________
12.2
$ billions
Net exports ________________________________________797.6
$ billions
Gross national product (1958 dollars) __________________
113.5
$ billions
Plant and equipment expenditures ______________________
123.8
$
billions
Corporate profits before taxes _____________________________
___________
____________
Private housing starts __________
1.2
millions
-_8.6
millions
Automobile sales _______
- ______________
-___-___- ________percent
- ___________________________I
8.5
Rate of unemployment ______-__
113.4
1967=100
- ___________________________
Industrial production index ______
174.9
1967= 100
Wholesale price index ___-____________________________________---161.2
1%7=100
Consumer price index _______________________________________
185.2
Implicit price deflator _________________________
--_- __________1958=100

F;;x-t

1,653.S
1,057.8
153.2
460.7
443.9
220.0
159.5
52.9
7.6
370.7
5.0
845.4
121.7
151.7
1.6
9.5
7.8
123.9
187.1
171.7
195.6

:97&/
--

l:V$/

5.7
8.8
5.2
9.4
9.2
-18.7
-3.1
-13.7
10.3
-2.9
1.0
-12.0
-13.0
-2.7
-9.1
9.2
9.1
8.8

12.0
11.0
15.0
10.7
10.1
28.4
10.3
33.3
8.7
6.0
7.2
22.5
35.0
11.5
9.3
7.0
6.5
5.6

iBecause of revisions in the national income and product accounts, the fourth quarter published GNP data
are not comparable with the unrevised earlier figures. Thus, comparable GNP totals for the fourth quarter
had to be estimated.
See the discussion in the text for a description of the estimating procedure.
*Figures

are constructed

from the typical percentage

change forecast

FEDERAL RESERVE BANK

OF RICHMOND

for 1976.

forecasters save one. Real GNP in 1975, expected
to fall 0.6 percent, declined approximately
2.9 percent, from $821.2 billion in 1958 dollars to $797.6
billion. The one pessimist thought real GNP would
fall 3.6 percent, to $791 billion. As might be expected from their underestimate of the extent of the
recession, the majority of the experts also underestimated the unemployment rate for the year. The
rate of unemployment in 1975, which averaged 8.5
percent, was predicted at 7.3 percent.
For the past few years, forecasters seemed to have
erred more in predicting the rate of price increase
than in estimating the performance of the GNP accounts in real terms. Last year, however, was different, and the large errors were made in estimating the
components of real GNP.
There were particularly
large errors in predicting investment and net exports.
Business fixed investment, forecast to increase 8.2
percent to $161.2 billion, is estimated to have actually
fallen by 3.1 percent to $144.6 billion.
Inventory
investment, which was expected to rise $3 billion, is
thought to have actually fallen $14.0 billion.
The net exports account total, which the forecasters
missed badly, actually provided the forecasters with
an offsetting error within their GNP estimate. Net
exports, predicted to be -$5 billion, was the only
account to do better than the forecasters expected. It
totaled somewhere around +$12.2 billion, thus helping out the consensus forecast for GNP with a $17
billion offsetting error.
The forecasters, as usual,
were close to the mark for government purchases of
goods and services, missing the actual figure by less
than $1.0 billion.
The consensus of quarter-by-quarter
forecasts for
197.5 was for current dollar GNP to rise $26.0 billion
in the first quarter, $31.0 billion in the second quarter, $38.0 billion in the third quarter, and $40.0 billion in the fourth. The realized changes in quarterly
GNP were -$14.0 billion, +$24.3 billion, +$62.7
billion, and (approximately)
+$46.2 billion for the
four quarters, respectively. The quarterly projections
for real GNP were for changes of -$l.O
billion,
+$3.0 billion, +$7.0 billion, and +$9.0 billion. For
the four 1975 quarters respectively, however, GNP
in constant dollars actually fell by $24.0 billion, then
rose $3.6 billion, $24.7 billion, and what appears to
have been $9.6 billion.
The forecasters were thus
correct in predicting a stronger second half for the
year and reasonably close to the increases registered
for the second and fourth quarters. They went wrong
in underestimating the depth of the economic decline
in the first quarter and the vigor of the “bounceback” in the third quarter.
Even the one forecaster
who predicted a lower annual figure for real GNP
10

ECONOMIC

REVIEW,

than the actual missed on the quarterly changes. He
expected real GNP to decline in both the first and
second quarters and to recover very slowly in the
second half.
The consensus 1975 forecast projected personal
consumption expenditures for the year to increase
9.S percent to $963.1 billion. Current estimates place
personal consumption expenditures almost $10 billion
lower, at $953.6 billion, an increase of only 8.8 percent.
Gross private domestic investment, forecast
to increase 1.4 percent to $212.2 billion, accounted
for the largest error among the GNP components.
It actually fell approximately
18.7 percent to $170.3
billion. In addition to the overestimates for inventories and business fixed investment
mentioned
earlier, the forecasters had predicted a recovery for
residential construction in the second half of the year
with the result that outlays for residential structures
for the year were expected to total $43.8 billion, a.
decline of $2.1 billion from the 1974 level.
The
actual total, however, fell approximately
$6 billion.
All in all, it would appear that last year’s forecasts were off the mark by an unusually large margin.
Much of the inaccuracy, moreover, was attributable
to errors in forecasting the first quarter, surprisingly
not the more distant fourth quarter.
Turning
points are always difficult to forecast, however, and
past attempts have not usually been spectacularl:y
successful. Also, for the past several years, the fore:casters have tended to predict a better performance
for the economy than the one that actually materialized.
In other areas, the 1974 forecasters also overestimated the strength of economic activity. The index
of industrial production fell 9.1 percent, against a
forecast of a 0.3 percent decline. Corporate profits
before taxes were predicted to fall 9.7 percent to
$127.3 billion; they actually fell 12.0 percent to
$123.8 billion. The consumer price index, like the
implicit price deflator, was predicted fairly accurately.
Consumer prices were expected to increase 9.5 percent ; they actually rose 9.1 percent.
1976 FORECASTS

IN BRIEF

NOTE: None of the forecasts for 1976 reflect
the revisions in the national income and product
accounts released in January 1976.
Gross National Product
Forecasts
for 1976 cnrrent dollar GNP center around $1,653.5 billion. This
consensus forecast represents an approximate
12.0
percent yearly gain, which is considerably more than
the 5.7 percent increase apparently registered in 1975.
JANUARY/FEBRUARY

1976

Prices are expected to increase only 5.6 percent.
GNP measured in constant dollars, or real GNP, is
expected to rise 6 percent in 1976, which is indicative of the modest recovery expected for the economy, but which is a considerable improvement over
the almost 3 percent decline in 1975. Estimates
for increases in current dollar GNP range from a low
of 9.0 percent to a high of 13.4 percent, but the great
majority are close to 12 percent.
The consensus of
quarterly estimates indicates that recovery will continue at about the same rate throughout the year. It
projects increases of $41.8 billion in the first quarter
of 1976, $46.7 billion in the second, $46.0 billion in
the third, and $50.5 billion in the fourth.
Personal consumption expenditures are expected
to total $1,057.8 billion for 1976, up 11.0 percent
from 1975. Forecasters estimate that expenditures
for durable goods will show an increase of 15 percent
for the year, while expenditures for nondurables and
services will rise 10.7 percent and 10.1 percent, respectively.
The faster rate of expansion of durable
goods expenditures
is expected to stem primarily
from recovering automobile sales, but sales of large
appliances and furniture are also expected to pick up
as a result of generally higher levels of consumer
confidence and a moderate housing recovery.
The
forecasters a.ssume that consumers are now in a good
financial position and are predicting that the saving
rate will fall unless inflation strikes again.
Government purchases of goods and services are
projected
to total $370.7 billion.
This estimate
represents an 8.7 percent increase over 1975, considerably smaller than the 10.3 percent gain of the
previous year. The 1976 forecasts for government
purchases range from increases of 7.1 to 10.4 percent.
Gross private domestic investment is expected to
rise substantially, by 28.4 percent in 1976. This
estimate represents dramatic evidence that recovery
is expected, since investment in 1975 registered an
approximate
18.7 percent decline.
Inventory
rebuilding, heading the investment recovery, is expected to add $20 billion to the economy. Residential
construction is not far behind, increasing by $13.2
billion or 33 percent over 1975. Business fixed investment, a more moderate source of strength, is
expected to increase 10.3 percent.
The forecasts,
as is usually the case, cluster less closely around
the consensus in predicting investment than in any
other prediction.
The increases predicted for residential structures range from 12.6 percent to 50.0
percent.
For business fixed investment, estimated
increases
range from 6.5 percent
to 15.3 percent.
And forecasts for gains in investment in business

TYPICAL*

QUARTERLY

Quarter-by-Quarter

Unless

FORECAST

Otherwise

Noted

----I
Gross

II

III

IV

Product

41.8

46.7

46.0

50.5

Personal Consumption
Expenditures

24.4

27.0

28.0

27.3

Gross Private
Investment

11.3

12.8

11.0

11.0

8.4

6.3

5.7

6.6

7.0

8.2

7.0

10.8

11.3

11.2

11.8

10.9

5.2

5.6

5.2

5.6

8.1

7.9

7.6

7.4

Net

National

FOR 1976

Changes in Billions of Dollars

Domestic

Exportsf

Government

Purchases

Gross National Product
(19.58 dollars)
Implicit

Price Deflator*

Rate of Unemployment
*Median.
$Actual estimate.
+Percentage changes

(%)$

at annual rates.

inventories, for which the consensus was $7.6 billion,
range from $3.5 billion to $16.0 billion.
Industrial
Production
The typical forecast for
the Federal Reserve index of industrial production
(1967 = 100) is 123.7, an increase of 9.3 percent.
If realized, this performance
will be much better
than the decline of 9.1 percent in 1975. The projected increase for 1976 would still leave this index
below its 1974 level of 124.7. The 1976 recovery is
expected to be attributable mainly to gains in the
production of automobiles and construction-related
items.
Housing
The construction
industry is expected
to register a moderate recovery from the very low
levels of 1974 and 1975. But activity in this sector
is expected to remain low relative to 1971, 1972, and
1973. Private housing starts, which totaled over 2
million in 1971, 1972, and 1973, 1.3 million in 1974,
and 1.2 million in 1975, are expected to total 1.6
million units in 1976.
Considering that housing
starts closed the year 1975 at about a 1.3 million unit
annual rate, 1.6 million units in 1976 represents only
a modest expectation for improvement.
Forecasters
expect the recovery to be limited mainly to singlefamily dwellings. While home financing is expected
to be easier, forecasters note important negative factors in housing markets, chiefly (1) the large inventory of unsold houses on hand, (2) high current
prices for new homes, and (3) the distressed financial conditions

FEDERAL RESERVE BANK

OF RICHMOND

of many

builders.
11

I

Corporate
Profits
The consensus forecast indicates that this year should be much more profitable
for corporations than 1975, with pretax corporate
profits expected to increase 22.5 percent to $151.7
billion.
This compares with an approximate
12.0
percent decline registered last year.
The projected 22.5 percent increase in corporate
profits may seem inordinately large at first glance.
However, the corporate profit situation has been
generally poor over the past few years. In an inflationary period, firms can show profit on the book
value of inventories held, but the profit is largely
illusory because firms must pay higher prices to
If one adjusts profit figures
replace the inventory.
for changes in inventory valuation and measures the
adjusted profit figure in constant dollars, the projected 1976 figure for corporate profits turns out to
be lower than the profits earned ten years ago. All
of the forecasters expect a much better pretax profit
figure than was realized last year. The most pessimistic forecaster expects a 14.7 percent profit increase ; the most optimistic a 32.5 percent rise.
Most forecasters
are predicting
Unemployment
only a modest decline in the rate of unemployment
during 1976. The typical forecast for the year’s average is around 7.5 percent, only 0.7 percentage points
Considering that the unbelow the 1975 average.
employment rate at year-end 1975 stood around 8.3
percent, a 7.8 percent average

for 1976 indicates that

employment growth is expected to outpace
force expansion by only a small amount.

labor

Prices This year the forecast indicates a general
improvement in the outlook for prices. The implicit
GNP deflator, which rose 10.2 percent in 1974 and
an estimated 8.S percent in 197.5, is expected to increase only 5.6 percent in 1976. The consumer price
index is also expected to increase much less rapidly,
6.5 percent compared to last year’s 9.1 percent. The
wholesale price index is expected to increase at a

higher rate than the other indexes, 7.0 percent, but
considerably slower than the 9.2 percent rate of advance registered in 1975 and far better than 1974’s
18.9 percent wholesale price increase.
Net Exports
The nation’s trade position, which
was approximately $12.2 billion in surplus in 1975,
is expected to continue in surplus in 1976, but at a
lower $5 billion level. The forecasters expect imports to continue to increase as consumer spending
picks up, but they foresee a smaller rate of increase
for exports, since the recovery abroad is expected to
be slower than the U. S. recovery. The estimates for
net exports varied between +$2.0 billion and +$lO.O
billion.
Quarter-by-Quarter
Forecasts
Twelve forecasters made quarter-by-quarter
forecasts for 1976. As
indicated by the accompanying table, these forecasters
generally expected about the same rates of growth in,
the first half of the year as in the second. While the
quarterly estimates generally clustered rather closely
around the median, one forecaster expected a different pattern of recovery-a
slow first quarter, moderate second and third quarters, and a rapid fourth
quarter.
With this one exception, the forecasters are pre-,
dieting that by the fourth quarter of the year real!
growth will range from $9.7 billion to $13.9 billion.
The quarterly consensus for the unemployment rate
shows a pattern that is consistent with the consensus
GNP forecast-the
rate declines by about the same
amount throughout the year.
If the forecasts are realized, the 7.4 percent unemployment rate at year-end 1976 will mean that
finding work will have become somewhat easier in
the bicentennial year than in 1975. But it will also
mean that the bicentennial was not a particularly
happy year for almost 7 million others.
The forecasts for the unemployment
rate at year-end 1976
ranged from 7.0 to 7.9 percent.

BUSINESS FORECASTS 1976
The Federal Reserve Bank of Richmond is pleased to announce the publication
of Business Forecasts 1976, a compilation of representative business forecasts with
names and details of estimates for the coming year. The booklet is available free of
charge from this Bank. Please address requests to Bank and Public Relations,
Federal Reserve Bank of Richmond, P. 0. Box 27622, Richmond, Virginia 23261.

12

ECONOMIC

REVIEW,

JANUARY/FEBRUARY

1976

PREDICTING THE RATE OF INFLATION
IN 1976
Robert L. Hetzel”
There is currently much interest in predicting the
rate of inflation for 1976. In recent years a number
of ad hoc explanations of inflation have attributed
price rises to special factors prevailing in the economy
at the time. According to this approach, inflation is a
process whereby the price effects of special factors in
one sector of the economy are pushed along to other
sectors and spread throughout the economy to affect
the general price level. As an alternative, the monetarist view sees inflation as strictly a monetary phenomenon-excessive
increases in the money supply
induce individuals to increase their spending in an
attempt to restore their real money balances to the
desired level. In the aggregate, this increased spending forces the general price level upward. The purpose of this article is to explain the monetarist view
of inflation, to use this view to evaluate the need for
special factors arguments to explain recent inflation,
and to evaluate the outlook for prices in 1976.
Although special factors explanations of inflation
have existed for many years, such theories have been
given much attention in discussions of spiraling prices
since 1973.i Chart 1 displays the percentage contribution of the major components of the Consumer
Price Index (CPI) to the total increase in the CPI.
Such a chart is often used as the starting point for a
special factors explanation of inflati0n.a
Chart 1
shows that in 1973 food and energy prices accounted
for 62.8 percent of the increase in the CPI. The rise
in food and energy prices, and by inference a major
part of the rise in the CPI, is then commonly accounted for by two special factors : the devaluation of
the dollar and international commodity inflation. The
first factor, the devaluation of the dollar, is considered inflationary for two reasons.
The price of

imported items such as oil is raised directly, and the
price of exported items such as grain is raised indirectly via increases in foreign demand for our exports. The second factor, the international commodity
inflation, involves rising prices of internationallytraded goods such as oil and grain. Underlying this
phenomenon are high levels of world output, poor
weather and the resulting below-average harvests,
and the OPEC oil cartel. In addition, special factors
theories of inflation often attribute inflation to a
variety of other causes such as the extent of unused
industrial
capacity, the unemployment
rate, the
growth of wages, increases in monopoly power, etc.
Using a special factors approach, if one wants to
predict the growth in the CPI he would analyze
conditions in various sectors of the economy and
aggregate all these forces into an overall inflationary
impact. For example, a study of crop forecasts and
anticipated demand would reveal the outlook for food
prices, a study of the oil sector would reveal the
outlook for fuel prices, etc.

*The author is a staff economist. Federal Reserve Bank of Richmond. The views expressed herein are solely those of the author
and do not necessarily represent the views of the Federal Reserve
Bank of Richmond.
‘For a survey of pre-World War I special factors theories of inflation and comments on this literature by early economists, see
Thomas M. Humphrey, “On Cast-Push Theories of Inflation in the
Pre-War Monetary Literature.” Banca Nazion&
de1 Lavoro
Qua+
terlv Review (forthcoming, March lSi6).
? The chart is contained in U. S., Congress. Senate, Committee on
Banking, Housing and Urban Sffairs,
Ovessipht on Econonaic
StubiIizatia,
Heatings, John T. Dunlop, statement before the Sub
committee on Production and Stabilization of the Senate Banking,
Housing and Urban Affairs Committee, Feb. 6, 1974, p. 523.

FEDERAL RESERVE BANK

OF RICHMOND

13

The monetarists
present
An Alternative
View
an alternative point of view regarding the cause of
inflation.
This view defines inflation as the change
in the rate of exchange, or terms of trade, between
dollars and the aggregate basket of goods and services
produced.
Inflation means that a dollar depreciates
when measured in terms of the goods and services for
which it will exchange. What is of economic significance to individuals is not simply the number of
dollars they hold (their nominal cash balances) but
rather the purchasing power of these dollars measured in terms of the aggregate basket of goods and
services (their real cash balances).
Real cash balances depend on the number of dollars individuals
hold and the rate of exchange between dollars and
the aggregate basket of goods and services. Assuming
the total number of dollars all individuals hold is
determined by the government, the only way individuals taken collectively have of adjusting to a situation
in which their actual holdings of real cash balances
are greater than their desired holdings of real cash
balances is by a depreciation in terms of dollars in
this rate of exchange, that is by inflation.
A single individual will attempt to adjust to such a
discrepancy by reducing the nominal amount of his
cash balances, that is by increasing his spending rate ;
however, one person’s reduction in nominal cash balances is another person’s addition, since the total
amount of dollars is fixed for the aggregate of individuals. The result is to increase aggregate spending
on the basket of goods and services. The increase in
spending in turn causes a general rise in the price
level as producers of goods and services raise prices
when they find that demand for their products exceeds supply.
This rise in the price level reduces
actual aggregate real cash balances (the real purchasing power of the nominal money stock) to the
desired level. Equilibrium is restored by a depreciation of the dollar against the basket of goods and
services.
Why, then, do actual holdings of real cash balances in the aggregate exceed the amount that people
desire to hold ? To explain this phenomenon, the
monetarists employ the empirical generalization that
changes in desired real cash balances occur only
gradually or as a result of the consequences of an
earlier change in money balances from the supply
side. For example, estimates by individuals of their
long-term income are assumed to be a significant
determinant of their demand for real cash balances,
but factors highly variable in the short run, such as
money market interest rates, are not assumed to be
significant determinants.
The implication then is that
14

ECONOMIC

REVIEW,

large fluctuations from one year to the next in the
rate of inflation derive from the supply side. They
derive from large fluctuations in the supply of nominal money.
Some Theoretical
Considerations
A critical question separating those who rely on special factors
explanations of inflation and those who do not is
whether an increase in a particular price can lead to a
rise in the general price level.
While recognizing that in the short run an increase
in the relative price of a key input such as oil could
lead to a temporary increase in the general price
level, critics of special factors explanations of inflation see an equilibrating mechanism at work in tlie
long run. They argue that individuals, because of
their wealth, the amount of uncertainty in the world,
etc. want to hold in the aggregate a given amount of
money measured in terms of its purchasing power.
A price rise for a particular commodity will cause
actual real cash balances to be less than desired real
cash balances as the weighted average of all prices
rises initially. Individuals will then hold less money
in real terms than they desire and will reduce their
expenditures until prices of other goods subsequently
fall enough to offset the original rise in the price level,
and equality is restored between actual and desired
real cash balances.3
The special factors and monetarist explanations of
inflation also imply a different impact on prices of an
Some proponents of special
increase in exports.
factors theories of inflation argue that, in general,
Inhigh levels of grain exports are inflationary.
creased exports entail reduced amounts of grain
available domestically, higher grain prices, and a
higher average price level. However, unless grain
exports are subsidized by the government, grain is
exported by sellers who do so only because they are
able to exchange it for goods that have more value to
them than the grain. Exchanging grain exports for
more highly valued imports makes people as a whole
wealthier; therefore, they desire to hold greater real
For a given nominal quantity of
cash balances.
money the price level must fall, and grain exports are
deflationary, not inflationary.
As a matter of general
theory, therefore, it is invalid to link domestic inflation causally with increased exports.
“A slightly more sophisticated theory wherein changes in relative
prices lead to a general price rise involves the assumption of an
accommodative monetary policy. If in the adjustment to changes
in relative prices unemployment is created, a central bank committed to a policy of full employment would be induced to expand
the money supply at a faster pace. In this case a change in an
individual price leads to a general prioc rise via accommodative
monetary policy.

JANUARY/FEBRUARY

1976

Money affects prices only with a long lag. As the
rate of growth of money increases, individuals find
that their real cash balances exceed the desired level ;
however, it takes time for them to realize that the
increase is permanent and not a temporary fluctuation. Individuals then try to reduce their cash balances by spending more. Producers at first reduce
their inventories rather than raise prices, since they
do not know if the increased demand is permanent
Given the persistence of inor only temporary.
creased demand, employers try to increase production. As the demand for productive resources increases, the prices of these resources increase. Labor
will work longer hours only if their wage rates are
increased, for example. Employers then raise prices
in response to increased costs, and finally the CPI
rises. The whole process is lengthened by the existence of contracts in nominal terms, both explicit and
implicit, which are renegotiated only infrequently.
Incidentally, the time sequence of the above series of
events explains the popular appeal of cost- or wagepush theories of inflation. Employers appear to raise
prices, and cause inflation, in response to rising
wages and other costs.
Money Growth and Prices
How well has monetary growth explained inflation recently in the United
States? Chart 2 shows the percentage rate of change
of the consumer price index and of the money supply
lagged 21 months. Changes for both series are on
an annual basis, and money is the sum of currency in
circulation and demand deposits (Mi).
The series
are smoothed by usin,m successive percentage changes

between the value for the current
value for six months previous.4

month

and the

In order to determine the number of months to lag
money (Ml) in Chart 2, the percentage changes in
the CPI and Mr were correlated for the period from
January 1955 to August 1971, with the latter lagged
at values ranging from 12 to 30 months. The lag of
21 months was chosen as the correlations rose and
then fell as the lag progressed from 12 to 30 with
21 as the peak value.
Percentage changes in M1 have a higher trend
value than those in the CPI. From 1952 to 1970 the
average annual rate of change in the CPI was 2.1
percent.
Keeping the Zl-month lag of Chart 2 for
the period that corresponds to 1952 to 1970, the
average annual rate of change in Mr was 2.8 percent.
The trend value for M1 is then 0.7 percentage points
above the CPI for this period. The CPI is also a
more stable series than the Mr series.
The behavior of the money supply affects the behavior of prices over a period of many years and with
a variable lag, so that the CPI and Ml as shown in
Chart 2 are not expected to move together ; nevertheless, from June 1962 to August 1971 their movements are similar. There is one significant drop in
the money series that does not correspond to a fall
in the CPI. This decline reaches a trough in July
1968 and reflects the lowering of the rate of growth
* For the CPI we use 2 x [ln CPI(O) - In CPlt-6)
1 where In is
the natural logarithm and the values in parentheses. the 0 and -6.
refer to the values of the CPI that occurred in the current month
and six months earlier.
The factor 2 converts the percentage
change to an annual basis.
The values for MI are calculated
similarly, then lagged by 21 months.

FEDERAL RESERVE BANK

OF RICHMOND

15

of money in 1966. The rate of growth in the percentage changes of the CPI, however, does diminish
in this period.

illustration, consider a statement from a representative of the grocery industry made in hearings before
Congress on whether to extend controls after their
scheduled expiration date, April 1974 :

Recent Experience
Proponents
of special factors
theories of inflation argue that the rate of change in
the CPI that began in 1973 cannot be explained
satisfactorily as a monetary phenomenon.
How well
does the money stock series predict the price series,
particularly the rise in the CPI beginning in the
spring of 1973? In examining this question, it is
useful to refer to the two consecutive ZO-month
periods starting in August 19T1, the date when wage
and price controls were instituted. These two periods
are marked by downward-pointing
arrows in Chart 2.

. . . in Phase II, the Price Commission was able to
control prices effectively for bread and other baked
goods by limiting the prices of the three largest
firms in the industry. These firms were precluded
from implementing any cost justified price increases
because their profit margins would have
exceeded the level of their margins during an arbitrarily selected base period. Smaller bakers, on the
other hand, with reduced profits, when not constrained by the profit margin test, were permitted
to pass on their increased costs under price control
regulations. They were, however, in reality, simply
unable to raise their prices to recover increased
costs because if they did their products would be
more costly to consumers than the controlled larger
firms, and they would have been chased off
the grocery store shelves.
As a result, many
smaller bakers have been subjected to severe and
critical financial hardships, resulting in numerous
closings.7

As illustrated in the chart, there is a ZO-month
period from August 1971 to April 1973 when the
rate of change of the CPI is lower than would be
predicted given the underIying pressure on prices
represented by lagged rates of change of the money
supply.5 The rate of change of the CPI for this
period is 3.7 percent ; the rate of change of M1 lagged
21 months is 6.0 percent.6 (The percentages are on
an annual basis.)
As the trend rate of growth of
lagged M1 exceeds that of the CPI by 0.7 percent
for the period 1952 to 1970, a simple.way of predicting the rate of growth of the CPI is to take the rate
of growth of M1 lagged 21 months and subtract 0.7
percent from it.
For the ZO-month period from
August 1971 to April 1973 the actual rate of growth
of the CPI then fell short of the predicted rate of
growth by 1.6 percentage points, i.e.,
3.7 -

(6.0 -

0.7) = -1.6.

This result suggests that initially the wage and
price controls did succeed in making the CPI rise
more slowly than it would have risen in the absence
of controls. Contracts in nominal terms contain implicit assumptions about future rates of inflation, and
a lowering of inflationary expectations will temporarily cause the prices negotiated in contracts to be
lower than otherwise. Also, 47.7 percent of the items
in the CPI were covered by controls in Phase II
(November 14, 1971, to January 11, 1973).
The
prices of these items must have risen more slowly
than in the absence of controls.
Finally, the price
behavior in the uncontrolled sector is not independent
of price behavior in the controlled sector.
As an
5The period actually includes 21 months.
The reference to 20
months refers to the number of monthly percentage changes in
this period.
6The calculations use a six-month average of the CPI ending in
August 1971 for the initial observation and ending in April 1973 for
the final observation.
Ml is calculated similarly except that the
values precede those of the CPI by 21 months.

16

ECONOMIC

REVIEW,

The above quotation suggests that controls on
prices in one part of the economy may retard price
rises in the exempted part of the economy, but only
In the case referred to above, some
temporarily.
firms in the exempted sector were driven out of
business.
More generally, however, prices must be
driven up in the exempted sector by enough more
than they wouId have been in the absence of controls,
to cause the average price IeveI for the entire output.
of the economy, exempt and nonexempt, to reduce
real cash balances to the level desired by individuals.
This reasoning suggests that over the long run price

controls could not have been expected to slow the
rate of inflation,
Furthermore,
it suggests that a
period when the growth rate of the CPI has been
reduced by the imposition of price controls wilI be
followed by a period of more rapid than normal
growth in the CPI. If this compensatory rise in the
CPI plus lagged rates of growth of money account
for the bulge in prices in 1973 and 1974, then onle
can explain inflation even in recent times in terms o’f
monetary phenomena, and there is no need for re:course in the explanation to special factors.
For the ZO-month period starting April 1973 and
ending December 1974, the rate of growth in the CPI
is 10.6 percent.
The corresponding rate of growth
of lagged M1 for this period is 6.8 percent.8 Was
the excess of price growth over lagged M1 growth
5 U. S., Congress, Senate, Committee on Banking, Housing and
Urban Affairs,
Oversight on Economic
Stabilization. Rearinys,
George W. Koch, statement. before the Subcommittee on Production
and Stabilization of the Senate Banking, Housing and Urban Affairs
Committee, p. 390.
SThe computation is performed as before with the base observation
being the previous final observation and the new final observaticon
being the six-month average ending December 1974.
Again, the
percentages are on an annual basis. and the percentage change in
MI referred to below is esIeulsted similarly using values 21 mont.hs
earlier.

JANUARY/FEBRUARY

1976

more than could be expected with a monetary explanation of inflation ?
One method of predicting the expected rate of
price rise is to adjust the growth rate of lagged %I1
for (1) the difference in trend rates of growth between M1 and the CPI and (2) the shortfall of the
actual rise in the CPI from the predicted rise in the
CPI in the period of price controls.
The difference
in trend growth rates of Ml and CPI is 0.7 percent.
The shortfall of the actual from the predicted rise in
the CPI in the preceding period, as calculated above.
was 1.6 percent.
Adding these to the 6% percent
lagged M1 growth rate (6.S - 0.7 + 1.6)) the predicted growth rate for the CPI in the period from
April 1973 to December 1974 is 7.7 percent.
-4s
the actual rate of growth in the CPI was 10.6 percent,
the actual value was greater than the predicted value
by 2.9 percentage points.
-4s a percentage of the
actual rate of inflation, the prediction error is 27
percent.
The question now becomes (1) whether an error
of this magnitude is large enough to justify looking
for a special factors explanation as opposed to a
monetarist explanation of inflation on the grounds
that new forces are present or (2) whether given the
length and variability of the lags involved an error
of this magnitude is what could be expected from past
experience.
This question might be approached by
calculating discrepancies between actual and predicted rates of inflation as a percentage of the actual
rate of inflation for the three preceding 20-month
periods and comparin, (+ those errors with the above
error.
-4gain predicting the rate of growth of the
CPI using lagged, trend adjusted growth in MLI1,
these errors are calculated to be -25, 30, and -10
percent for the periods August 1966 to April 196S1
April 1968 to December 1969, and December 1969 to
August 1971, respectively.
The errors are comparable to the error for the 1973-1974 period.
Furthermore,
there have been periods in the past
when the rate of growth of the CPI has significantly
exceeded that of the lagged money supply. Chart 3
is for the period January 1950 to December 1956 and
is calculated in exactly the same way as Chart 2, escept that the 311 series is lowered by 0.7 percent so
that it may be used to predict the CPI series directly
without adjusting for differing trends. As shown in
Chart 3, during the Korean War period prices rose
significantly faster than would be indicated 1)). lagged
rates of growth of M1. Intli~idu;& espectetl a reFEDERAL

RESERVE

‘.
Chart3:

CONStiMER
‘,’ .hND

TREND

$: jl ‘i:_
“’ .- _,_: >,;‘I

PI&

ADJlkTEd

INDEX

“‘I’

,.I,‘:;”

:

hUi&h~Y.~Sl&Kf

’ CiiANGE OVER S”CCESS+ix
‘_
Percentage Change
16.0
!‘:

MOb&l
./’
>

PERIOQS ‘1: ‘:
i’

,’

-Ccpl

,, _’
I

-8.O*
1950

1952

*Money Supply
Source:

I
1954.

; ;

; 1956

,’

(MI) figures

ore lagged ‘21 ,manihs:-,., ,:
_sBeard of Governoks of th&Feberil
J,&&i$&
System, Federal Resirve Bulletin.,~ ,’ ‘),‘, ;:‘I ‘::r
I
,:
,:.,,
s : 5,’

currence of the inflation of World War II and an
erosion in the value of their cash balances. There
was, therefore, :i decrease in the demand for real
cash balances, an increase in aggregate spending, and
a rise in the price level. It is interesting to note
that while the actual rate of growth of the CPI was
greater than the predicted growth during the Korean
War for the reasons just mentioned, this discrepancy
was offset in the period following the War by a rate
of growth of the CPI below the predicted growth.
For the period of the price bulge in 1973 and 1974,
the actual exceeded the predicted rate of growth of
the CPI by 2.9 percentage points. There have been
periods other than wartime when errors of similar
magnitude occurred. For the 20-month period January 1957 to September 195S, making predictions as
before, the actual rate of growth of the CPI was 2.4
percentage points above the predicted rate.
It is
interesting to note that special factors theories of
inflation, in parscular cost-push inflation caused by
unions, were especially popular during this period.
Some final general observations are useful. There
are reasons for especting that the actual would exceed the predicted changes in the CPI for the 19731974 period even after adjusting for the retardation
in the growth oi the CPI caused by the initial imposition of wage and price controls in the earlier
period. Before -+x-i1 1974, the date wage and price
controls expired. l~lsinessmen thought that controls
nlight I)e estendrd.
After April 1974, businessmen

BANK

OF RICHMOND

17

thought the controls might be reimposed. As allowable price increases under controls depend on base
prices, businessmen probably kept prices up instead
of lowering them or raised them more than they
might have ordinarily as a way of not getting caught
with a low base price. Second, the real cash balances
people desire to hold depend on the cost of holding
the balances. Inflation is a cost or tax on these balances, since in order to maintain real balances at a
given level the individual must add to his nominal
cash balances every year to compensate for their
depreciation in value. In response to the increase in
the rate of inflation starting in the last half of 1972,
caused by previous high rates of growth in M1,
people may have tried to reduce their real cash balantes relative to previous holdings. Such an attempt
would cause an overshooting in prices for a while, or
put otherwise, for a while lagged money stock data
would temporarily under-predict
prices.
Finally, a
monetarist explanation of inflation suggests that the
rapid price rises of 1973 and 1974 were unsustainable.
Over a long period of time, the rate of rise of prices
must be in line with the rate of growth of the money
supply. The period considered ends December 1974.
A decrease in the rate of change of the CPI after
that date is shown in Chart 2.
The forecasts presented in the following section
aye those of the author and in no way represent
the views of the Federal Reserve Bank of Richmond.
Predicting
Price Movements
This type of analysis does not disprove special factors explanations of
inflation or show the superiority of monetary theories of inflation.
It does suggest, however, that in
the recent past it has been reasonable to use lagged
rates of growth of money to predict prices and that
the last few years do not represent a departure from
past experience in this respect.

18

ECONOMIC

REVIEW,

Table

PREDICTED

I

RATES OF CHANGE IN THE CPI

April

1976

6.2

May 1976

4.6

June 1976

3.3

July 1976
August 1976
Average

3.6
4.1

Table I shows rates of change in the CPI for next
year that are predicted using the very simple tech-,
nique of extrapolating from past rates of growth of
the money stock suggested above. The figures are:
rates of change of the CPI on an annual basis for
the six-month period ending with the date shown.
They are the actual annualized percentage rates of
change of M1 for the corresponding six-month period
21 months earlier minus 0.7 percent.
The figures
may be read off Chart 2 by lowering the M1 series
0.7 percent.
As the M1 series is more erratic than
the CPI series, probably the average figure of 4.l
percent is a better predictor of price behavior thi:s
year.
This article has developed the monetarist explanation of inflation.
It has also presented a simplle
method of forecasting inflation based on the observed
lags between rates of change of money and prices.
The lags, as shown, are not only long but also variable. The actual rate of inflation may be significantly
above or below 4.1 percent in 1976. If the overshooting effect described above did occur in 197%
1974, its actual rate of growth may be lower as the
reverse process occurs this year. In any case, this
monetarist forecast may be compared with those
using different frameworks as the events unfold over
the coming months.

JANUARY/FEBRUARY

1976

OUTLOOK
FORAGRICULTURE
OPTIMISTIC
Sada L. Clarke
Agriculture’s prospects for the first half of 1976 were outlined by top level economists of the
U. S. Department of Agriculture at the National Agricultural Outlook Conference
in mid-November. The following is a digest of the outlook as they see it.

Optimism pervaded the outlook for U. S. agriculture through the first half of 1976 when speakers
presented their views at the National Agricultural
Outlook Conference in mid-November.
Farmers’
returns are expected to be maintained at the improved price and income levels realized during the
second half of last year. Moreover, consumers should
notice a slowdown in the rise in retail food prices.
Major factors generating these improvements
are
the bumper grain harvests last fall, strong foreign
demand that will maintain a record pace for exports,
the economic recovery now underway, and the beginning upturn in livestock production.
There are a number of uncertainties in the outlook,
however.
Among them, two stand out: (1) The
strength in the turnaround in livestock production
will depend to a great extent on the impact of developments in foreign markets on the supply and
cost of feed. (2) Gains in consumer buying power,
believed by many to be the key to sustaining general
economic growth, could be limited by continued inflation and rising costs of energy.
Farm Income, Fiscal Year 1975-76 Total cash
receipts from farm marketings in 1975-76 are expected to add up to around $101 billion-around
$10
billion more than in 1974-75.
Higher prices will
help to bring about much larger receipts from livestock and livestock products, whereas a greater volume of marketings will be the primary factor behind
Rising, albeit
a modest increase in crop receipts.
moderating, farm production expenses are likely to
offset much of the gain in gross income. Even so, a
sizable rise in realized net income is indicated, perhaps running well above the $25 billion-third
largest
of record-estimated
for calendar 1975.
Supplies and Costs of Farm Inputs With farmers
planning for all-out production again in 1976, demand for farm inputs is expected to be strong.
lMoreover, the farm supply shortages of the past
several years have eased. Xs a result, supplies of
items such as fertilizer, fuels,, and pesticides are saitl

to be adequate for this year’s farming operations.
Most petroleum fuels reportedly are plentiful, in
fact, and supplies of many types of farm machinery
seem to be catching up with demand. Feed supplies
are larger, and prices are easier.
Farm costs in general are expected to continue
upward in 19i6 but not at the leaping pace of recent
years. Actually, fertilizer prices are declining. But
farm wage rates will probably jump S to 11 percent
over 1975 levels because of the January 1 increase
in the Federal minimum wage for farm workers.
Agricultural Exports Heavy world demand for
U. S. farm products is setting the stage for another
record export year in fiscal 1976. Expectations are
that the value

of farm

product

exports

may reach

as high as $22.7 billion, about $1 billion more than
in fiscal 1975. Unlike a year earlier, the increased
value this year will result from a larger volume of
exports rather than higher prices.
Shipments of grains, oilseeds and products, cotton!
and tobacco-the
principal commodities-could
exceed 103 million metric tons. Such a level would be
about 19 million tons over last year’s volume and
would set a new record. An especially strong export
year is foreseen for wheat and feed grains.
By destination, shipments to the USSR and Eastern Europe will show the biggest gain over last year.
But larger exports to North Africa, South Asia,
Southeast and East Asia, and Japan are also expected.
Lower prices will reduce the value of exports to Western Europe and Latin America even
though export volume will likely hold up well.
Retail Food Prices Grocery shoppers can take
heart!
The slowdown in spiraling food prices that
began in 1975 promises to continue during the first
half of 1976. Moreover, supplies of fresh and processed fruits, tree nuts, and canned and frozen vegetables are large. And larger supplies of poultry and
red meats seem highly probable.
Retail food prices, under conditions that now ap1)ear most likely, will probably edge upward at an

FEDERAL RESERVE BANK

OF RICHMOND

19

annual rate of 4 to 5 percent during the first six
months of the year-about
one-half of the 9 percent
rate of advance in calendar 1975. Such an increase
would mean an average annual rate of slightly more
than 1 percent per quarter. First quarter prices may
rise at a somewhat faster pace. But a slower rate of
increase is seen as likely for the second quarter as
production of fed beef, pork, and poultry expands.
Food marketing costs will of course continue to
play a major role in the level of retail food prices.
Marketing spreads- the difference between the retail
price and farm value of foods-will
likely advance
further during the first half of the year. But gains
rnay slow relative to a year earlier, probably rising
only about 5 percent compared with an 11 percent
increase during the same period in 1975.
Commodity
Reviews
The digests that follow
are highlights of the Department
of Agriculture’s
expectations for major commodities produced in the
Fifth District.
Tobacco: Larger supplies, both at home and overseas, highlight the outlook for tobacco in 1976. U. S.
cigarette consumption
(total and per capita) may
advance further this year. But smokers are not expected to smoke as many per capita as they did
during the record year 1963. Exports of unmanufactured tobacco fell about 10 percent last year, and
leaf exports in 1976 may do well to hold near recent
levels. The high prices of U. S. leaf are adversely
affecting tobacco exports even though worldwide
preference for cigarettes containing flue-cured and
burley tobaccos has risen sharply. With last year’s
large crop, carryover stocks can be expected to increase.
The basic flue-cured tobacco marketing quota for
1976 has been cut 15 percent in an effort to keep
supplies in line with demand.
But the addition of
net undermarketings
from 1975 leaves the effective
quota only 10 percent below last season’s level. The
basic quota for burley may remain about the same
as in 1975. Price support levels for eligible 1976crop tobaccos will be 13% percent higher than in
1975.
Cotton: Smaller supplies and larger disappearance
characterize the 1975-76 outlook for cotton.
Wit11
the sharply reduced 1975 crop, current season supplies are expected to drop to the lowest level since
1923-24. On the demand side, combined domestic
mill use and exports probably will range from 9.8 to
10.8 million bales versus 9.8 million last year. Carry20

ECONOMIC

REVIEW,

over stocks next July 31 thus may total around 3.5
to 4.5 million bales, down from 5.7 million at the
end of 1974-75.
Domestic mill use holds promise of bouncing back
in 1975-76, consuming an estimated 6.S to 7.3 million
bales in contrast with last season’s 5.9 millionsmallest since the 1930’s.
How strong domestic
demand will be will depend to a great extent on the
general economic and textile activity during the next
few months and on the competition from manmade
fibers. Not to be overlooked, however, is the significant role that fashion’s ‘icasual natural look” is playing in cotton’s comeback. The natural look has now
increased demand not only for the popular all-cotton.
denim and corduroy materials but also for other
coarse cotton fabrics, such as brushed sateens, twills,,
sheetings, and the like.
Foreign demand for cotton is weak, and U. S.
cotton prices are not competitive in world markets.
So, much uncertainty surrounds export prospects for
the 1975-76 season. Current indications point to a
moderate recovery in foreign cotton demand in early
1976, with exports for the marketing year ranging
from 3.0 to 3.5 million bales, well below last season’s
level.
Soybeans and Peanuts:
Record large supplies,
significantly expanded utilization, a sharp buildup in
carryover stocks next fall, and lower average farm
prices

are the main features

of the soybean outlook

for 1975-76. Soybean plantings in 1976 could fall
below last year’s levels if the current soybean/corn
price ratio of 2 to 1 continues.
Even though soybean usage is expected to increase, it may well not
equal the record use in 1973-74. Moreover, total
soybean utilization may fall below production for the
third consecutive year.
Soybean exports are expected to increase sharply but face increased competition and may fall short of the record shipments of
1973-74. The lower prices and large supplies should
spur exports of soybeans, however.
Peanut production continues to outstrip consumption, and supplies are at record levels. Use of peanuts in edible products this season is expected to
rise by some 6 percent to about 9 pounds per capita.
But despite the likely increase in consumption, peanut supplies are well in excess of requirements for
food and farm use. About one-third of the crop will
be acquired by the Commodity Credit Corporation
under the price support program, and crushings ,to
dispose of the surplus peanuts will increase sharpIy.
Under existing law, 1976 acreage allotments have
been set at the minimum level.
JANUARY/FEBRUARY

1976

Poultry and Eggs: More poultry and eggs are in
prospect for the first half of 1976. Egg output may
gain slightly early in the year but could fall to
around year-earlier levels in the spring. The outlook
for broilers and turkeys calls for substantial production increases over a year ago, however.
Egg prices may well remain sluggish, averaging
near or below year-ago prices during the first half of
the year unless consumer demand picks up more
than is now anticipated.
Moderate expansion in
broiler consumption, small red meat supplies, and
higher consumer incomes should more than offset
the expected increase in broiler supplies and hold
average broiler prices this winter near the mid-40
cent per pound range. Turkey prices, likely to decline seasonally after the holidays, may remain above
a year earlier into 1976 in spite of indicated production gains.
With larger supplies and lower prices of most feed
ingredients likely, the cost of producing poultry and
eggs in the coming months is expected to average
below levels a year ago.
Meat Aninaals: Pork output may continue below
1975’s reduced level through mid-1976, keeping hog
prices relatively strong through the winter.
More
pork is indicated for the second half, however, starting with small gains around midyear and then becoming larger toward the end of the year. With the
outlook for reduced feeding costs and the recent
record high hog prices, producers seem likely to
keep farrowings up through most of the year. Should
hog slaughter for all of 1976 total around 3 to 5

percent above 1973, as now seems probable, the price
of hogs could move generally lower during the summer and fall.
More fed beef and less nonfed steer and heifer
slaughter are in prospect for 1976. With feeding
costs more favorable and feeder cattle available,
cattle producers have already begun to place significantly more cattle on feed. Fed cattle marketings
will probably begin to show increases over year-ago
levels in the first quarter, with larger gains following
in the second. If placements continue to rise, nonfed
slaughter is espected to decline significantly, with
most of the reduction occurring in the second half.
Should the feed situation, including pasture conditions this summer ~ remain favorable, cattle slaughter
for the year could be from 2 to 4 percent above a
year earlier. Fed cattle slaughter would comprise all
of the increase.
Assuming that consumer demand
holds up, it now looks as if fed cattle prices in 1976
might average close to, or just above, the 1975 price
range of $44 to $-lS.
Milk output during the first
Dairy Products:
half of 1976 may increase slightly if gains in production per cow offset comparatively small declines in
cow numbers as is now expected. Farm milk prices
are likely to continue well above year-earlier levels
early in 1976. But should increasing milk production
and consumer resistance to higher retail dairy prices
materialize, milk prices at the farm level may show
sharper-than-normal
seasonal price declines.
The
recent increase in price support levels will likely hold
farm milk prices above those a year ago, however.

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21