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/ m n l‘ c/em /and ECONOMIC REVIEW Additional copies of the ECONOMIC REVIEW may be obtained from the Research Department, Federal Reserve Bank of Cleveland, P. O. Box 6387, Cleve land, Ohio 44101. Permission is granted to reproduce any material in this publication providing credit is given. THE FEDERAL FUNDS MARKET REVISITED A number o f major changes to o k place in financial markets during the 1960's. One very im p o rta n t develop ment was the increased willingness o f commercial banks to develop new sources o f funds, often nondeposit sources IN THIS ISSUE sources. generally The funds represented obtained borrowed by tapping fro m these money. One example o f the increased bank use o f borrowed funds was the grow th in purchases o f Federal funds. The Federal Funds Market Revisited The Federal funds market has existed fo r many years, .... 3 are those commercial banks th a t are members o f the In fla tio n : Problems o f the 1960's and Im plications fo r th e 1 9 7 0 's .............. p rim a rily as a bank market. T hat is, the m ajor participants Federal Reserve System. However, Federal funds are also 14 com m only used in connection w ith payments in the U. S. Government securities market. In both functions, Federal funds have come to be accepted as an im p o rta n t money m arket instrum ent. 3 ECONOMIC REVIEW O R IG IN OF FEDERAL FUNDS achieve a w eekly Basically, Federal funds represent money th a t is imm ediately settlem ent or balance. (The banks' reserve week begins on Thursday and ends available. A n y check drawn on a at the close o f business on the fo llo w in g Wednes deposit at a Federal Reserve bank is payable day.) im m ediately, in contrast to checks drawn Because member banks do n o t receive on interest on reserves held w ith the Federal Reserve individuals, banks, or businesses. The latter checks banks, the banks prefer to keep excess balances at are payable through a clearinghouse on the fo llo w a m inim um and tr y to fin d other uses fo r the ing business day at the earliest and are d iffe re n ti funds, such as the extension o f new loans. Conse ated fro m Federal funds in the money m arket by quently, being called clearinghouse funds. positions carefully in order to achieve an optim um most banks watch th e ir d a ily reserve weekly reserve balance as well as the most e ffic ie n t The major suppliers o f Federal funds are banks 1 holding excess reserves. Commercial banks th a t use o f nonearning assets. Since September 12, are members o f the Federal Reserve System are member banks to subm it reports on daily deposit required to hold a pro p o rtion o f th e ir deposits as and vault cash balances. 1968, the Federal Reserve System has required all reserves. In any reserve week, required reserves are computed on the basis o f the average level o f a On any day, some banks may have surplus or bank's deposits (at the close o f business) in the excess reserves, w hile other banks may be deficient reserve period tw o weeks prio r to the reporting in required reserves. Frequently, a bank may have week. Member banks may hold th e ir required excess reserves fo r o n ly one or tw o days before the reserves in the form o f vault cash and nonearning reserves are absorbed by an expected change in deposits w ith Federal Reserve banks. On any given deposits. S im ilarly, unexpected shifts in deposits day, the volume o f funds actually held as reserves may produce tem porary demands fo r reserves. The may be more or less than the required volume Federal funds m arket evolved as a means o f selling because the excess reserves o f "su rp lu s” banks to banks of short-run flu ctu a tio n s in deposits. Those reserves over and above the am ount re w ith quired to be held against deposits are called excess manner, Federal funds transactions represent an reserves, and membership in the Federal Reserve additional use o f existing bank reserves, rather System carries w ith it the a b ility to w rite checks than the creation o f new funds. against excess balances at the Federal tem porary reserve deficiencies. In this Reserve In most cases, a telephone call is the o n ly step banks. necessary to arrange a Federal funds transaction. Member banks do not have to m aintain their No physical transfer o f funds occurs, although required reserves on each business day; instead, some types o f Federal funds transactions involve they the exchange o f collateral in the fo rm o f U. S. must manage th e ir reserve positions to Government securities. ^Federal funds also arise fro m checks w ritte n in payment fo r Federal Reserve purchases o f U. S. Government securi ties and fro m checks drawn on the U. S. Treasury or foreign balances held at Federal Reserve banks. 4 NATURE OF THE M ARKET Federal funds transactions were firs t arranged FEB R UA RY 1970 in 1921 in New Y o rk C ity .2 Trading in funds member banks, reflecting changes in Federal spread q u ickly to banks in the large money centers Reserve Regulations D and Q th a t became effec throughout the nation. The participation o f U. S. tive February 12, 1970.3 Government securities dealers and the investment A lthough the to ta l number o f banks through frenzy o f the era stim ulated growth o f the m arket out the nation th a t have entered the Federal funds during the 1920's. The stock m arket crash o f market at one tim e or another is not know n, there 1929, however, preceded a long period o f low is considerable interest rates and substantial amounts o f unused participating banks increased sharply during the evidence bank reserves; as a result, demand fo r and trading 1960's. As shown in Federal funds was depressed u n til the postwar Federal in th a t Chart the number o f 1, in the Fourth Reserve D is tric t alone, the number o f years when excess reserves again became relatively banks trading in Federal funds has skyrocketed scarce. During the postwar period, and particularly since 1948, w ith most o f the newer entrants being since 1955, Federal funds a c tivity has increased relatively smaller banks th a t have deposits o f less substantially; recently, the average d a ily volume o f than $100 m illio n . Such banks are usually sellers Federal funds transactions in the nation has ranged o f Federal funds, often over fa irly long periods o f from an tim e, because o f th e ir preference fo r holding some estimated average daily volume o f less than $2 excess reserves to cushion deposit fluctuations. $13 to $18 b illio n , compared w ith 1955. In the 1960's alone, the net Each trading bank is n o t active in the m arket every volume o f funds purchased daily increased more day; on the contrary, some banks trade in Federal b illio n in than five fo ld , reflecting increased bank participa funds o n ly a few times in a three-m onth period, tio n in and use o f the market. w hile others are inactive fo r as much as a year at a The m arket fo r Federal funds has widened time. perceptibly, w ith more in stitu tio n s in more cities The growing p a rticipation o f smaller banks has becoming active. For example, agencies o f foreign been due in part to the rise in interest rates as well banks have joined U nited States commercial banks as to an increasing awareness o f the o pportunities and U. S. Government securities dealers as p a rtici afforded by trading in Federal funds. The chart pants in the market. (Federal funds transactions suggests th a t these determ inants have been very w ith securities dealers are usually in the form o f im portant since 1963, a period characterized by bank loans th a t are used to carry inventories of rapidly rising interest rates and a sharp increase in U. S. Government securities.) The d o lla r volume o f the number o f active banks. Correspondent rela transactions involving other in stitutions, such as tionships have also con trib u te d to increased bank mutual savings banks and foreign banks, is rela tively small, am ounting to about $1 b illio n , and is concentrated in New Y o rk C ity. This discussion concentrates on flow s o f Federal funds among 2 The regulation changes had the effect o f narrowing the d e fin itio n o f Federal funds transactions to those short term transfers o f im m ediately available funds among banks and th e ir subsidiaries, various Governmental in s titu For a more complete discussion o f the early phases of the market, see Parker B. W illis, The Federal Funds M arket—Its Origin and Development, Bank o f Boston, T h ird E d itio n , 1968. Federal Reserve tions, or in certain cases, securities dealers. In tu rn , "banks” include domestic and foreign commercial banks, savings banks, savings and loan associations, and the E x p o rt-lm p o rt Bank o f the United States. 5 ECONOMIC REVIEW fo r most o f the purchases is relatively stable and C h a rt 1. relatively sm a ll."4 That is, purchases are concen N U M B ER of M E M B E R B A N K S T RADIN G trated at the aggressive money m arket banks th a t in FEDERAL FUNDS manage th e ir balance sheet positions very closely Four t h F e d e r a l R e s e r v e D i s t r i c t (as of S e l ec t ed M i d - y e a r s ) Number and try to balance th e ir excess reserve positions 360 ---------------------------------------------- close to zero. As a result, the Federal Reserve System confines its collection o f daily data on Federal funds transactions to 46 large banks in the United States, w ith six o f these banks located in the Fourth D istrict. The national reporting sample now accounts fo r an estimated one-third o f the total volume o f funds transactions (see A ppendix). TYPES OF TRANSACTIONS In the 1959-1962 survey, several d iffe re n t types 1948 l a s t ent r y : ’53 '58 '63 6 8 ’69 * 1969 S o u r c e of d a t a : o f Federal funds transactions were revealed, w ith substantial differences in the relative usage o f each F e d e r a l R e s e r v e B a n k of C l e v e l a n d type. Probably the most frequently used trans action involved the sale o f Federal funds fo r one day w ith repayment being made on the fo llo w in g participation in the Federal funds market, because day. In these so-called straight transactions, the some o f the smaller banks have been drawn into exchange is made by debiting the selling bank's the market by th e ir larger correspondent banks. In the Fourth reserve balance at its Federal Reserve bank and D istrict, most o f the dollar crediting the buyer's balance at its Federal Reserve volume o f trading in Federal funds is carried out bank. On the fo llo w in g day, the bookkeeping is by banks located in the larger cities. In fact, there reversed, w ith the buyer usually paying the about 30 banks in the D istrict th a t interest in a separate transfer. Custom arily, Fed regularly buy and sell Federal funds in the same eral funds are traded in standard units o f $1 are o n ly week. These banks account fo r about 95 percent m illio n , although the standard denom ination fo r of all purchases and 65 percent o f all sales o f smaller banks seems to be $200,000, and sales as Federal funds in the D istrict. This market concen small as $10,000 have been reported.5 tra tio n seems to be true fo r the nation as a whole. These transactions are essentially one-day unse A three-year study o f 258 banks active in the cured loans, and there are at least tw o constraints Federal funds market, conducted by the Federal Reserve System in 1959-1962, led to the conclu 4 sion th a t tin, Board o f Governors o f the Federal Reserve System, "w h ile a substantial and fluctuating number o f banks around the co un try may enter "N e w Series on Federal Funds," Federal Reserve Bulle August 1964, pp. 944-953. the Federal funds m arket on the selling side o f any particular day, the group o f banks th a t accounts ^W illis, op. c it., p. 91. FEB R UA RY 1970 on lending Federal funds. First, banks have tra d i were secured by U. S. Government securities th a t tio n a lly been reluctant to make unsecured loans. were to mature w ith in 18 months. Secured Federal There are indications th a t the jum p in participa funds transactions th a t were not repurchase agree tio n in the Federal funds market by the smaller ments came to be used fre q u e n tly by smaller (and less know n) banks has led to some insistence banks, not o n ly because they could sell ten times on collateralized Federal funds loans. Second, the am ount o f funds to a single borrow er as national banks are forbidden under the provisions compared w ith a straight sale, b u t also because o f the National Bank A c t from making an unse neither the cost nor the inconvenience o f trans cured loan to a single borrow er in excess o f 10 ferring securities and title s was increased between percent o f the lending bank's capital and surplus. the buyer and the seller. Instead, in a transaction A national bank is also prohibited fro m borrow ing o f this type, the bank purchasing Federal funds in excess o f its capital stock plus 50 percent o f its places U. S. Government securities in a custody surplus. In June 1963, the C om ptroller o f the account fo r the seller fo r one day u n til the funds Currency ruled th a t Federal funds transactions o f are repaid. national banks were exem pt from these restric tions, although sim ilar rules still apply to many D uring the 1959-1962 Federal funds study, a d iffe re n tia tio n was made between one-day funds state banks. Second in dollar im portance in Federal funds transactions and those outstanding fo r more than trading are one-day secured transactions. Before one day. The p ro p o rtio n o f longer term purchases 1958, most secured transactions were in the form and sales to the to ta l gross volume o f Federal of repurchase agreements in w hich the bank selling funds transactions proved to be q uite small (only 3 Federal funds did so by buying U. S. Government percent in the F ourth D istrict). In addition, most securities (actually taking title to the securities) o f these transactions were secured and had been from the borrow er fo r immediate cash delivery. extended during Treasury financing operations. Sim ultaneously, the borrow er made a com m itm ent Consequently, it was decided th a t this type o f to repurchase the securities the next day at the in fo rm a tio n w ould no longer be collected because same price plus a predetermined rate o f interest. the data were n o t needed fo r current money among market analysis. Moreover, it was clear from the smaller banks before 1958 because such agree study th a t Federal funds were most im p o rta n t to ments were n ot controlled by the 10 percent loan banks as a means fo r making short-term adjust lim ita tio n . ments in th e ir reserve positions. In fact, statistics Repurchase agreements were popular In A p ril 1958, however, the C om ptroller o f the fo r Federal funds transactions arranged by banks Currency ruled th a t the lim ita tio n on loans to as a service to th e ir customers, plus transactions single borrowers w ould be removed if the loan w ith foreign bank agencies and mutual savings banks, are not included in the Federal funds data For a discussion o f repurchase agreements in the money market, see "Repurchase Agreements: T he ir Role in Dealer Financing and in M onetary P olicy,” Econom ic now published by the Federal Reserve System. The interbank nature o f the Federal funds Review, Federal Reserve Bank of Cleveland, November- market was revealed in the F ourth D is tric t data December 1969. gathered in the 1959-1962 study. Less than 10 7 ECONOMIC REVIEW percent o f the dollar am ount o f D is tric t trans deficiencies in reserve positions. The m o b ility o f actions was made w ith U. S. Government securities existing reserves is increased, thus conserving the dealers, corporations, and others, whereas more use o f Federal Reserve bank credit by decreasing than 90 percent o f the purchases and sales was the am ount o f borrowed reserves th a t banks w ould made w ith other banks. As mentioned earlier, otherwise have pulled in to the money market. most o f the nonbank participants concentrate Generally, banks outside the money m arket th e ir Federal funds a c tiv ity in New Y o rk C ity. centers o f the U nited States hold the bulk o f There are several Federal funds brokers in New excess reserves th a t can be loaned to the large c ity Y ork C ity operating to bring together the suppliers banks. Because o f the preponderance o f relatively and users o f funds. It has been the general Fourth small banks in the F ourth D istrict, the volume o f D istrict experience, however, fo r banks to deal Fourth D is tric t sales o f funds has generally tended d ire ctly w ith buyers and sellers, w o rkin g from lists to o f approved borrowers or in the con te xt o f a example, D is tric t sales averaged $6.2 m illio n a correspondent bank netw ork. week, w hile purchases averaged $5.7 m illio n . FLOWS OF FEDERAL FUNDS actions in the exceed purchases. In December 1969, fo r A substantial p o rtio n o f Federal funds trans nation move to and fro m San A large fraction o f Federal funds purchases and Francisco and other West Coast cities, due in part sales move to and from New Y o rk C ity, which is to the financial structure o f th a t area. S pecifically, not surprising since New Y o rk is the money center the im portance o f branch banking in the West, o f the nation. The major New Y o rk banks are not plus only more sensitive to the factors th a t affect bank increased volume o f transactions. Some o f the reserves but are also known larger banks in the San Francisco D is tric t act as to manage th e ir the tim e d iffe re n tia l, c o n trib u te to the money positions very closely. That is, these banks clearinghouses adjust th eir reserve positions continuously and, as branch banks in th a t area as well as fro m banks in a result, have a substantial short-term demand fo r the Dallas, Kansas C ity, and Minneapolis Federal and use fo r Federal funds. The New Y o rk banks Reserve Districts. As a result, banks in the San fo r funds fro m the numerous are p rim a rily borrowers or purchasers o f Federal Francisco D is tric t can often be counted on to have funds, drawing on supplies o f surplus reserves a supply o f Federal funds to sell, or to be able to owned by banks in other parts o f the country. In absorb or distrib u te purchases o f funds after banks the second half o f 1969, eight New Y o rk banks in the East are closed. accounted fo r about 30 percent o f the dollar am ount o f the Federal funds purchases made by the 46 banks from w hich daily data are collected. In the A d d itio n a l flow s o f Federal funds crisscross the nation. Again, using the F ourth D is tric t banks as 1959-1962 survey period, nearly 60 an example, transactions have been made w ith percent o f the dollar volume o f Federal funds banks in as many as 50 cities outside the major traded by banks in the Fourth D is tric t flow ed to money centers o f the nation. Over and above the banks in New Y o rk C ity. Such flow s o f Federal large volume o f funds moving to New Y o rk C ity funds illustrate the use o f the m arket in redistrib and the West Coast, a relatively large share o f uting bank reserves to locations where banks have D istrict purchases and sales is directed to Chicago, 8 FEB R UA RY 1970 Minneapolis, Philadelphia, and Boston. The pat subtracted fro m the to ta l am ount o f gross pur terns o f d istrib u tio n change over tim e, as shifts in chases and sales. For example, a bank reporting the supply o f and the demand fo r Federal funds $10 m illio n in average purchases and $8 m illio n in occur w ith in each area. Because needs fo r addi sales in one week w ould have net purchases o f $2 tional reserves are revealed in the overall volume m illio n . W ith o u t this adjustm ent, it is believed th a t and number o f banks reporting net Federal funds figures fo r gross purchases and sales do not reveal purchases, however, the Federal Reserve System shifts in reserve needs or in the availability o f has discontinued collecting in fo rm a tio n on the reserves fo r reporting banks.7 In the short run, because o f the use o f the location o f the second party to each Federal funds Federal transaction. A sizable am ount o f Federal funds purchases and sales Federal is carried o u t w ith in an individual Reserve d is tric t, as opposed to funds positions, m arket it should to adjust bank reserve be possible to distinguish certain patterns and trends in funds transactions as those related to bank reserves.8 Because a money m arket transactions between banks w idely separated geo bank w orks tow ard a balance over the reserve graphically. In fact, there is evidence th a t in tra period, a bank th a t may experience a surplus in d istrict transactions have increased substantially in reserves early in the reserve week w ould try to size and number, probably because o f the growing reverse its position in the Federal funds m arket participation o f smaller banks in the Federal funds tow ard the end o f the week, selling funds in a large market. Correspondent bank relationships have enough am ount to bring its average excess reserve played an im p o rta n t part in the expansion o f this position fo r the week close to zero. Because o f the aspect o f the market. Many large banks buy and intraweek pattern, the cost o f obtaining Federal sell funds from smaller banks as a correspondent funds tends to decline as the week progresses, service; such transactions are made w ith o u t con providing the o p p o rtu n ity fo r banks to play the cern about the reserve position o f the large banks yield curve. Most published data on Federal funds themselves b u t e ntirely as an accomm odation to are cu rre n tly expressed as w eekly averages o f daily the smaller banks. In addition, when Federal funds figures. The Federal Reserve System also publishes have been relatively scarce, the major banks have statistics on outstanding relied on their correspondent systems to draw new commercial banks as o f each Wednesday. or additional supplies o f funds in to the market. Federal funds at large Over a longer period, the patterns in Federal funds trading are more d iffic u lt to isolate. Several USES OF FEDERAL FUNDS major influences are said to be evident: the costs A ccom m odating transactions make it d iffic u lt o f alternative sources o f funds; changes in bank to evaluate current developments in the Federal funds m arket, when analysis o f bank reserve adjustments is the prim ary concern. To overcome 7"l\le w Series on Federal Funds," op. cit., p. 951. this d iffic u lty , the Federal Reserve System in tro duced a ne t Federal funds concept, in which the O am ount o f each reporting bank's purchases and Funds—Findings o f a Three-Year Survey, Board o f Gov sales th a t offset each other in the same week is ernors o f the Federal Reserve System, 1965. See also D o roth y M. Nichols, Trading in Federal 9 ECONOMIC REVIEW C h a r t 2. FEDERAL FU N D S and NET BAN K R E S E R V E S Percent NOTE: D a t a a r e m o n t hl y a v e r a g e s of d a i l y f i g u r e s . Las t entry: D e c e m b e r 1969 S o ur c e of da ta: loan demand B o a r d o f G o v e r n o r s o f t he F e d e r a l R e s e r v e S y s t e m and deposit levels; seasonal and W ithin any m onth, net Federal funds trans cyclical factors; changes in m onetary policy; and actions are affected strongly by changes in market random elements. These influences combined to factors that influence bank reserves. A relationship cause w ide fluctuations in net purchases and sales is particularly apparent between increases in the fo r the 1960-1969 period (see Chart 2). volume o f flo a t and net Federal funds purchases. As the Federal Reserve B u lle tin states: There are several separate seasonal movements. One cause o f short-run sim ilarity...m ay For one, the volume o f net purchases tends to fall be th a t System actions taken to offset o ff in January-February (and to a lesser extent, at increases in flo a t in itia lly affect U. S. mid-year), because the banks accumulated reserves Government securities dealers and the at the end o f their accounting years and m arket banks, ch ie fly those in New Y ork C ity, factors, such as the post-holiday return o f cur providing them w ith marginal finan rency in circulation to the banks, increase their cing. These actions cause banks lend reserves. These influences reduce the need and the ing to dealers to need reserves and, demand fo r Federal funds. The funds m arket also therefore, to increase th e ir purchases responds to seasonal money m arket pressures th a t o f Federal funds.9 usually have the effect o f increasing net purchases in the second half o f the calendar year. 10 g "N e w Series on Federal F u n d s/' op. cit., p. 948. FEB R UA RY 1970 Some o f the other m arket factors affecting bank purchases o f Federal funds as a longer term source trading in Federal funds include financing opera o f funds fo r loans and investments, rather than tions o f the United States Treasury, w ithdraw als only as a means o f tem porary reserve adjustment. by the United States Government from its tax and In other words, when convenient, some banks now loan accounts, and deposit shifts due to payments made by tax borrow Federal funds continuously, at any reason businesses and individuals. able cost, to maintain th e ir balance sheet posi These flow s o f funds affect bank loan demands tions. The change in demand has had tw o im plica and deposit levels, as well as other short-term tions fo r economic analysis: it freed the Federal interest rates. m arket factors funds rate from its form er ceiling o f the Federal influence the cost o f and the demand fo r Federal Reserve discount rate, and it had the effect o f funds. broadening bank reserve and asset analysis to a Cyclical In other words, influences on Federal funds and study o f all the sources and uses o f commercial changes in m onetary policy are generally associ bank funds, including Eurodollars and CDs, among ated. Using net reserves as a rough indicator o f others. bank reserve pressures, it is evident fro m Chart 2 that monetary policy allowed a build-up in reserves in 1960 and early 1961, coincident w ith the business recession. In succeeding months, net free reserves declined steadily (net borrowed FEDERAL FUNDS RATE One major facet o f the Federal funds m arket remains to be discussed. T hat is the interest cost of reserves increased) un til the end o f 1966. A fte r an a typical easing Federal funds is estimated each day by the Federal in both m onetary policy and business transaction. The "e ffe c tiv e " rate on conditions during 1967, net bank reserves once Reserve Bank o f New Y o rk on the basis o f direct again reports from trading banks and brokers about the turned tightening increasingly negative, because o f m onetary policy. There is some volume of trading and quotes on rates. The evidence in the chart tha t net purchases o f Federal effective rate is a modal or representative rate o f funds increase as the level of economic a c tivity the interest costs o f Federal funds transactions rises and as free reserves decline. Conversely, net throughout the co u n try on th a t day. The rate is sales decrease w ith the level of economic a ctivity; determined i.e., net purchases and net sales tend to move in demand fo r Federal funds, but it is also highly opposite directions. (The dollar volume o f pur responsive to changes in the cost o f alternative chases exceeds sales in the chart because the daily form s o f bank borrow ing, such as the Federal p rim a rily rate, by the the supply of Treasury b ill and reporting sample o f 46 banks includes a greater Reserve discount number o f large borrow ing banks than lending (representing the cost of obtaining reserves from rate banks.) the sale o f U. S. Government securities to other banks or th e ir depositors), and the E urodollar rate, More recently, the association between a bank's as well as to the financing needs o f Government Federal funds a ctivity and its reserve position has securities dealers. The Federal funds rate does not become less precise. In late 1964, a large New include commissions paid to brokers or accommo Y o rk C ity bank announced that it planned to use dating banks. A lthough these agents may charge a 11 ECONOMIC REVIEW commission o f 1/16 to 1/8 o f 1 percent, they are variance is the greatest on Wednesday. This pattern usually compensated by th e ir correspondent rela may be explained in part by the bank reserve tionships or the referral o f other business. adjustments described earlier. Because o f the There is a tendency fo r the Federal funds rate v o la tility o f the Federal funds rate and because the to rise w ith the volume o f net purchases (see Chart supply o f and demand fo r bank reserves have a 2). That is, as purchases are increased by the 46 strong banks in the sample, the rate is pushed up tow ard sensitive indicator o f money m arket conditions. e ffe ct on it, the rate is considered a a p o in t at w hich it may become cheaper fo r the In summary, analysis o f Federal funds trading is banks to obtain funds fro m other sources. The useful in discerning pressures th a t are evolving on effective rate can fluctuate w idely fro m hour to bank reserve positions. In tu rn , the pressures may hour and day to day, reflecting changes in supply indicate developments such as the changing need and demand conditions. This has been p articularly fo r funds by U. S. Government securities dealers true since the Federal Reserve discount rate ceased and the possibility o f changes in other money to act as a ceiling on the Federal funds rate. W ith in m arket interest rates. Thus, the a reserve settlem ent period, the funds rate tends to market not o nly reflects e ffic ie n t use o f bank be higher on Thursday and Friday b u t lower on reserves, b u t also shifting patterns in the money Wednesday. m arket as a whole. On the other hand, the intraday Federal funds APPEND IX SOME L IM IT A T IO N S OF TH E F O R T Y -S IX B A N K F E D E R A L FUNDS SERIES There are at least three shortcomings o f the example, over the December 31, 1965 to June 29, Federal funds series as a 1968 period, the share o f to ta l purchases reported measure o f the tota l use o f Federal funds in the by the 46 banks on call report days fell from 55 reserve adjustm ent process. percent to around 35 percent. This decline in cu rren tly published First, the biannual call report summaries o f all commercial Deposit banks published by the Federal Insurance Corporation since December p ro p o rtion must be interpreted w ith caution. The total volume o f trading falls sharply on call dates, due to the reluctance o f banks to report an 1965 indicate th a t the share o f total trading done indebted position, and the one day figures, there by the 46 fore, banks has been d im in ish in g .1 For may not be representative. Further, the transactions reported on the 1965 call report did not include purchases in the fo rm o f repurchase 1 Assets, L iabilities, and Capital Accounts, Commercial and M utu a l Savings Banks, R eport o f Call, Federal agreements. Thus, to ta l purchases were under Deposit Insurance C orporation, Washington, D. C., begin stated, w hich had the effect o f increasing the ning w ith December 31, 1965. computed share o f the 46 banks. 12 FEB R UA RY 1970 o f to ta l counting, it overstates the use o f Federal funds in purchases carried o u t by the 46 banks is c o rro b o r the reserve adjustm ent process. One can use net ated by the Federal funds reports o f a p proxi purchases (gross purchases minus gross sales) as a The 1968 estimate of the share mately 340 w eekly reporting banks. This series, substitute fo r gross measures o f purchases and w hich began June 25, 1969, shows recent daily sales. A lthough to ta l gross purchases must equal funds purchases, including repurchase agreements, total sales fo r the entire market, fo r a sub-group o f between $13 b illio n and $18 b illio n , or about tw o banks, such as the 46 reporters, net purchases and a half to three times the gross purchases show the combined use o f the m arket by th a t set reported by the smaller sample o f 46 banks. The o f banks fo r reserve adjustment. Net figures, on 46-bank series may, therefore, increasingly under the other hand, may hide great differences in the state the total volume o f funds traded as the use o f the funds m arket by individual members of number o f trading banks grows. the group. Second, the series includes an unknown am ount A th ird shortcom ing is introduced in to the data of double-counting. This results fro m inter-bank by the inclusion o f transactions involving im m edi trading among the 46. Double-counting occurs, fo r ately available correspondent balances in reports instance, as Bank I purchases funds from Bank II o f Federal funds traded. The reporting banks are and report asked to include these amounts even though title purchases, w hile I and II report sales, even though to Federal Reserve bank balances does not change I was an interm ediary rather than a principal. To hands. The fra ctio n o f reported the extent th a t the series contains such double made up o f correspondent balances is not known. sells to Bank III. Both I and III Federal funds 13 ECONOMIC REVIEW INFLATION: PROBLEMS OF THE 1960's AND IMPLICATIONS FOR THE 1970's In fla tio n was one o f the major domestic eco resolved are: is it possible fo r stabilization policies nomic issues in the United States during most of to restrain the forces o f in fla tio n w ith o u t genera the latter half o f the 1960's, and there is w ide ting an intolerable level o f unem ploym ent; w hat is spread sentim ent th a t in fla tio na ry pressures w ill the tim e path of the reduction in the rate o f continue be an im portant factor in public in fla tio n ; and w hat magnitude o f a reduction can economic policy decisions in the early 1970's. In to reasonably be expected. Obviously, the answers to addition to personal inequities and hardships, the these questions involve judgments about the effec inflationary situation has caused serious disloca tiveness and tim in g o f public policy measures th a t tions and imbalances in the flo w o f domestic are designed to reduce upward price pressures and economic activity, and it has been an im p o rta n t to elim inate in fla tio na ry expectations. Judgments factor in the deterioration o f the United States about such matters are usually controversial. foreign trade balance. Furthermore, persistent and This article examines some o f the fundam ental widespread price increases over such an extended aspects o f in fla tio n in the United States during the period have generated an in fla tio na ry psychology 1960's w ith in the generally accepted economic th a t has hampered the effectiveness o f monetary theories. The analysis involves a review o f alterna and fiscal policies. tive causes o f in fla tio n and in fla tio n a ry psychol In view o f economic developments during the ogy and considers the various public policy tools 1960's, it w ould seem th a t properly form ulated th a t are available to a tte m p t to stabilize prices in m onetary and fiscal policies can be im p o rta n t an in fla tio n a ry situation. Finally, some im plica factors in directing the economy onto a long-run tions fo r price behavior in the early 1970's are growth discussed. path, where increases in spending are consistent w ith the expansion of productive capac ity. In a ddition, it is apparent th a t the manage ment o f high-em ploym ent prosperity in an envi D E F IN IT IO N AND MEASUREMENT OF IN FLA TIO N ronm ent o f stable prices presents some d iffic u lt The predom inant view o f economists is th a t choices in the determ ination o f appropriate public in fla tio n means a persistant and appreciable rise in economic policies. Therefore, as the 1970's begin, the general level o f prices. some of the key economic issues th a t must be d iffe r about the meaning o f the general price level 14 However, opinions FEB R U A R Y 1970 as well as w hat the magnitude and duration o f an increase in some index o f prices must be to w arrant the label o f in fla tio n. One index th a t attem pts to measure the general price level is the im p lic it price d e fla to r fo r Gross National Product. The d e fla to r is m ainly derived As a practical matter, there is no perfect price from components o f the CPI, WPI, construction index curre ntly available to measure the general and transportation cost indexes, and certain earn price level. (Even at the theoretical level, econo ings indexes. A lthough mists do not always agree on w hat they w ant a d efla to r is the most comprehensive indicator o f price the general price level th a t is available, it measures index to measure.) The w idely follow ed the overall GNP price Consumer Price Index (CPI) and the Wholesale only prices o f the cu rre n t production o f goods and Price Index (WPI) have lim ita tio n s when they are services, not prices o f existing assets (tangible or used to analyze price developments. A lthough the intangible). CPI is n o t a perfect cost o f living index, it is the The entire increase in the overall GNP price best available measure o f retail prices. In addition, deflator, however, should not be regarded as a true the behavior o f the CPI (especially in a period price rise, because o f the measurement techniques when the index is rising rapidly) is an im p o rta n t utilized fo r the government sector and fo r the consideration in many wage and salary negotia construction industry. Increases in wage and salary tions. Frequently the CPI is used in labor contracts scales fo r government employees (Federal, state, to and local) are treated as price increases, and no provide autom atic wage adjustments (com m only called “ escalator clauses” ). allowance is made fo r p ro d u c tiv ity gains. Today, The WPI, in contrast, does not relate to any many government employees w o rk w ith greater particular sector o f the economy, nor to any amounts o f physical capital, or technologically special group o f buyers or sellers. However, com improved capital, compared w ith ten or tw e n ty ponents o f the WPI can be used to gauge price years ago. This should result in an upward trend in developments in many industries, or at various 1 stages o f the productive process. some " o u tp u t” per government employee. attem pts at measuring A lthough p ro d u c tiv ity in lim ited areas o f government have been made, the overall problem o f measuring physical o u tp u t o f 1 measures average price the many and diverse activities o f the public sector changes o f approxim ately 400 goods and services bought remains unsolved. Therefore, it is assumed th a t The Consumer Price Index by urban wage earners and clerical workers. The "m a rke t basket" remains essentially unchanged between decennial surveys o f consumer buying patterns; thus, current pricing there are no p ro d u c tiv ity increases in this sector of the economy. The price d e fla to r fo r GNP origina techniques used to construct the CPI do not allow fo r the ting in the general government sector is actually an practice o f consumers to reallocate th e ir expenditures earnings towards those com m odities whose prices may have risen relatively less than others. The Wholesale Price Index index and movements in this index conform closely to changes in the Bureau o f Labor measures average price changes of approxim ately 2,300 Statistics' index o f compensation per manhour in items (farm products, processed foods, and industrial the private economy. comm odities) at the firs t significant stage o f commercial transaction. Because the index is based largely on pro In view o f the upward bias attrib u ta b le to the ducers' prices, it is not representative o f price changes at treatm ent o f the government sector, many analysts the wholesale m arket level. believe th a t the price d e fla to r fo r GNP originating 15 ECONOMIC REVIEW in the private sector is a better measure o f the explaining in fla tio n w ill probably never be com general price level. The private GNP price deflator, pletely satisfactory. Indeed, some economists have however, is also generally thought to have some argued th a t a single-cause theory upward bias. The goods p o rtio n o f this d e fla to r is w ould not be in accord w ith actual developments thoug ht to be reasonably accurate because e fforts in the economic system. are made to adjust fo r price increases associated co u n try of in fla tio n In a highly developed as the U nited States, the in fla tio n a ry w ith q u a lity im provem ent. No allowance is made process is extrem ely com plex. There is general fo r q u a lity im provem ent (or deterioration) in the agreement th a t the mechanism of in fla tio n prices o f services. If, in fact, prices o f services are involves the not biased upward, such prices have an inherent demand and cost (or supply). However, there is tendency to rise because, unlike the goods sector, much many service industries are characterized by low demand and cost in the determ ination o f prices. p ro d u c tiv ity grow th. The price d e fla to r fo r the The conventional view is th a t the greater the structures p o rtio n o f GNP is m ainly based on the economy's unused resources, the more lik e ly it is costs o f materials and labor, w ith little allowance th a t increases in aggregate demand w ill lead to interaction o f tw o debate concerning the basic forces— relative roles o f fo r p ro d u c tiv ity gains and, therefore, tends to increases in o u tp u t rather than to increases in costs overstate the true price increase in construction. and prices. The closer the economy is to fu ll Data fo r the behavior o f the various GNP price em ploym ent, the more lik e ly it is th a t fu rth e r deflators during the 1960's are summarized in increases in aggregate demand w ill be translated Tables I and II. In Table I, changes in the price into b oth increased o u tp u t and higher costs and d eflator fo r private GNP are the weighted summa prices. Demand tio n o f changes in the price deflators fo r GNP Inflation. T heoretically, of the pure originating in private nonfarm businesses, farms, demand-pull version in fla tio n states th a t if households and institu tio n s, and in the rest o f the aggregate demand exceeds aggregate supply at fu ll w orld. In effect, the price defla to r fo r households em ploym ent, prices w ill rise. In practice, it is and in stitu tio n s is an earnings index. The price recognized th a t at some stage before the economy deflator fo r the farm sector has been extrem ely has achieved fu ll u tiliz a tio n o f human and physical volatile in recent years and has significantly resources, bottlenecks occur in certain markets influenced short-run changes in the d e fla to r fo r and the general price level w ill have already begun private to rise. GNP. A ccordingly, some price analysts prefer the price de fla to r fo r GNP originating in The cause o f excess aggregate demand can be private non farm business. viewed in several ways. In some circumstances, CAUSES OF IN FLA TIO N large increases in private consum ption or private There is some disagreement about the principal cause 2 of rising prices.2 The various analyses M artin Bronfenbrenner and Franklyn D. Holzman, "S u r investment may be the major factors th a t lead to excess demand. Such increases may be induced 3 Paul A. Samuelson and Robert M. Solow, "A n a ly tic a l vey o f In fla tio n T h e o ry ," Am erican Econom ic Review, Aspects o f A n ti-In fla tio n a ry P olicy/'A m e ric a n Econom ic LI 1 (September 1963). 1 Review, L (May 1960). 16 FEB R UA RY 1970 T A B LE I Change in Gross National Product Price Deflators By Sector 1 9 6 0 -1 9 6 9 Year Total GNP (100.0% )* General Government (8.5% )* 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1.7% 1.3 1.1 1.3 1.5 1.9 2.7 3.2 4.0 4.7 4.2% 4.6 2.6 4.2 5.7 4.0 5.1 5.6 7.6 7.0 Private Nonfarm Business (85.4% )* Private (91.6%) 1.4% 0.9 1.0 1.1 1.1 1.7 2.6 2.9 3.6 4.5 Households and In stitu tio n (2.2% )* Farm (3.3% )* 0.5% 0.5 0.5 - 1.7 - 2.4 8.0 11.5 - 7.5 3.8 7.4 1.3% 0.9 0.9 1.0 1.1 1.4 2.0 3.2 3.5 4.3 4.6% 3.2 3.5 4.0 4.5 4.2 4.9 6.6 7.7 4.2 NOTE: D eflators fo r the sector, "rest o f w o rld ' ' (0.6% o f GNP) are not published, m ainly because constant dollar GNP originating in ' 'rest o f w o rld " is computed by means o f the somewhat unreliable u n it value export and im p ort price indexes. * Shares o f 1968 GNP, measured in constant 1958 dollars. Source: U. S. Departm ent o f Commerce through previous changes in income or profits, or through expectations of favorable could tend to be in fla tio n a ry if the method o f changes in financing involves the creation o f new money; the income or profits. As an alternative, changes in d e fic it w ould n o t tend to be in fla tio n a ry if it is consumer or business spending may largely be financed by borrow ing fro m the nonbank private independent o f income or profits, such as the sector, w hich is, in fact, a reallocation o f existing consumer credit.) buying spree th a t occurred at the outbreak o f the Korean War. In other circum stances, increases in spending fo r A growing number o f economists hold the view goods and th a t m onetary and cre d it conditions can be one o f services by the government sector may generate the in itia l cause o f excess demand, or at least excess demands th a t could, in the absence o f an perm it o ffsetting increase in taxes, result in additional private sectors against potential excess claims of the government and d e ficit financing. (Many economists, however, do exercised. not consider a Government d e fic it in fla tio n a ry —as price, and interest rate levels, there is to o much o u tp u t to be If, fo r example, at existing income, d istin ct from stim ulative—if the economy is opera money in the hands o f spending units, they w ill ting w ith a substantial margin o f unused resources. a tte m p t to decrease th e ir cash balances by pur On the other hand, additions to the Government chasing d e ficit incurred at or close to fu ll em ploym ent process, expenditures, income, and prices should securities, goods, or services. In the 17 ECONOMIC REVIEW TABLE II United States in the post-W orld War II period Change in Gross National Product Price Deflators By Major Type o f Product 1 9 6 0 -1 9 6 9 War, the mid-1950's, and the late 1960's). There Year Goods (49.8%) * Services (40.1% )* Structures (10.1% )* 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 0.8% 0.5 0.7 0.4 0.5 1.5 2.3 2.3 2.8 3.6 3.1% 2.2 1.6 2.3 2.8 2.3 3.2 4.0 5.1 5.6 1.1% 1.1 1.9 2.2 2.7 2.8 4.0 4.4 5.3 6.9 * Shares o f 1968 GNP, measured in constant 1958 dollars. Source: U. S. Departm ent o f Commerce (during the im mediate postwar period, the Korean is, however, considerable disagreement about the role o f the money supply as a causal fa c to r during those in fla tio n a ry periods. Regardless of the source o f excess demand, both the monetarists and those w ho emphasize the incom e-expenditure approach agree th a t in fla tio n w ould not, in all like lih o o d , be initiated or sustained at fu ll em ploy ment unless validated by the m onetary authorities through an increase in the supply o f money; unless, o f course, there is an o ffse ttin g increase in velocity. However, the income ve lo city o f money (GNP/m oney supply) usually rises during business expansions and declines during business contrac tions. When m onetary authorities atte m p t to rise u n til the real value o f cash balances is reduced reduce excess demand by sharply restricting the to the p o in t at which the public is satisfied to hold growth o f the money supply, or by p e rm ittin g no the existing supply o f dollars. Professor M ilto n growth at all, the income ve lo city o f money tends Friedman, one o f the leading proponents o f the to accelerate—fo r a tim e. For example, during the "m one tary school," succinctly described the posi most o f 1966 and again in the latter half o f 1969 tio n o f the monetarists: (periods when the money supply v irtu a lly leveled Infla tio n is always and everywhere a o ff), a faster turnover o f the existing money stock m onetary phenomenon, resulting from enabled GNP and prices to continue rising. and accompanied q u a n tity by a rise in the o f m oney relative to o u t Partly because o f the unpredictable behavior o f p u t...It follow s th a t the o n ly effective velocity (w hich is to say, uncertainties concerning way to stop in fla tio n is to restrain the the rate o f grow th changes thereof, actually determ ine income, o u t o f the q u a n tity o f m oney.4 (Italics supplied) put, e xtent to and w hich prices), the money supply, and incom e-expenditure theorists Empirical studies seem to indicate th a t excess w ould supplement tra d itio n a l tools o f m onetary aggregate demand played a major role in the initial policy w ith fiscal measures to curb excess demand. stages o f each o f the fo u r waves o f in fla tio n in the Decreases in Government expenditures and in creases in taxes clearly have a d ire ct im pact on 4 income and, in tu rn , induce cutbacks in private M ilto n Friedman, "W hat Price G uideposts?" Guidelines, In fo rm a l Controls, and the M arket Place, ed. G. P. Schultz spending (in the absence o f a decrease in the saving and R. Z. A libe r (Chicago: The U niversity o f Chicago rate). However, just as an increase in the income Press, 1966). velocity 18 of money can te m p o ra rily offse t the FEB R UA RY 1970 impact o f m onetary restraint on spending, so also thereby raising u n it labor costs. can a decrease in the saving rate offset or retard tim in g sequence o f the However, the movements o f p ro fits fo r a tim e the restrictive impact o f fiscal actions. norm ally rising firs t, follow ed by price increases, Because there are practical short-run lim its on the and fin a lly upward pressures on u n it labor costs magnitude o f changes in the income ve lo city of does not necessarily prove anything w ith regard to money, as well as the saving rate, causal roles in the in fla tio n a ry process. monetary and fiscal policies—if restrictive pursued long Because o f the cyclical nature o f economic enough—u ltim a te ly register their im pact on aggre a ctivity, the relative magnitudes o f changes in key gate demand. In practice, once excess demand has variables, such as p ro fits, prices, wages, and u n it been elim inated through restrictive public policy labor costs, depend upon the a rb itra ry choice o f measures, in fla tio n is u n like ly to end im m ediately, w hich stage in the business cycle the measure however, reflecting the undetermined lag effects o f ments begin. Furtherm ore, it may not be correct policy actions on prices as well as various cost- to measure changes in all variables from the same p o in t in tim e because there is never a wage level or price rigidities in some areas o f the economy. a price level to w hich everyone has fu lly adjusted. of By the same token, a rise in wages or compensa infla tio n stresses the influence o f spending actions tio n per m anhour in excess o f the p ro d u c tiv ity Cost Inflation. The demand-pull th e o ry prices. The alternative approach is usually gain per se may not necessarily be evidence o f labeled cost-push or supply in fla tio n ,5 which tends cost-push in fla tio n .7 Increases in u n it labor costs on to focus on cost increases as the principal sustain can ing source o f in fla tio n. U nlike demand-pull in fla employers bidding up prices o f productive inputs. tio n , cost-push in fla tio n reflect impersonal m arket forces—th a t is, is not generally con Indeed, under conditions o f actual (or anticipated) sidered to exert a significant in itia tin g role in the excess demand, it m ight be expected th a t wage in fla tio na ry process, although cost pressures are increases w ould tend to exceed p ro d u c tiv ity gains, w idely thought to play a reinforcing or sustaining even if all markets were perfectly com petitive. A ll role once prices have started to rise. The reason is markets are not, in fact, perfectly com petitive. that in the early stages o f a business recovery, pro fits and p ro fit margins begin to improve as ^This typical sequence o f events is the rationale fo r the p ro d u ctivity rises faster than wages, and overhead classification by the National Bureau o f Econom ic Re costs are spread over a larger volume. As aggregate search o f corporate p ro fits and p ro fit margins as “ lead demand rises relative to supply (or as capacity in g " economic indicators, wholesale prices o f industrial com m odities and o f m anufactured goods as "c o in c id e n t" ceilings are approached), price increases tend to economic indicators, and u n it labor costs in m anufactur fo llo w p ro fit gains. Finally, in the later stages o f ing and in the corporate sector as "la g gin g " economic the expansion, p ro d u c tiv ity gains become harder to achieve and wage increases become larger, indicators. See the m o n th ly publication. Business Condi tions Digest, U. S. Departm ent o f Commerce. ^Samuelson and Solow, op. cit., and F ritz Machlup, 5 "A n o th e r View o f Cost-Push and Demand-Pull In fla tio n ," Variations o f cost in fla tio n include terms such as sellers' in fla tio n , administered in fla tio n , and structural in fla tio n . The Review o f Economics and Statistics, X L II (May 1960). 19 ECONOMIC REVIEW Thus, increases in u n it labor costs also can be the The apparent 'in fla tio n a ry bias' in our result o f unions negotiating wage increases larger wage-making and price-making in s titu than tions has been o f almost continuous those th a t w ould occur under perfectly com petitive m arket conditions. concern fo r the Council o f Economic O Advisers fo r many years. Whatever the cause, increases in u n it labor costs exert essentially sim ilar upward pressures on prices The in fla tio n a ry bias (im perfect co m p e titio n or as do natural or a rtificia l constraints on supply. discretionary m arket power) also tends to obscure The latter w ould include lim ita tio n s on agricul the d istin ctio n between cost-push and demand-pull tural production , im p o rt quotas, power o f certain in fla tio n . firm s to control o u tp u t, and power o f certain demand, m arket im perfections can cause the over trade and professional groups to lim it membership. all price level to rise. For example, it is perfectly A ccordingly, economists generally a ttrib u te cost normal in fla tio n , and many o f its variants, to im perfect sectors th a t experience excess demand. In some Even w ith o u t generalized excess fo r prices to rise in those markets or co m pe titio n in labor and product markets. As a industries, a decrease in demand or a decrease in general matter, fo r any given rate o f in fla tio n , the u n it costs o f production norm ally leads to a price greater the margin o f unused resources in the decline. Failure o f prices to decline under such economy, the greater the role o f cost-push ele circumstances usually suggests elements o f im per ments. (F or example, a 4 percent rate o f in fla tio n fect is more like ly to reflect cost pressures if the in fla tio n may be lack o f su fficie n t fle x ib ility in economy is operating w ith a 7 percent rate o f wages or prices in the demand deficient, excess unem ploym ent as compared w ith a 31 percent /2 capacity sectors.9 At rate o f unem ploym ent.) In co m p e titio n . 1966, the Council o f Economic Advisers commented on the problem o f rising prices during present, Thus, one m ajor source o f there are no perfect tests to distinguish the tim in g o f the effects o f excess demand and cost factors in the in fla tio n a ry years when there was no general excess demand or process. Many economic studies have, however, when demand was clearly inadequate. suggested th a t certain symptoms may be indicative The exact diagnosis remains a m atter o f one or the other sources o f in fla tio n . Signs o f a o f some disagreement among econo demand in fla tio n , fo r example, w ould include a mists. B ut almost all agree th a t an im p ortant part o f the explanation lies in the fact that, in many industries, unions possess or managements considerable or both discretionary O Econom ic Report o f the President, together w ith the A n nual R eport o f the Council o f Econom ic Advisers, 1966. q This power to set wages and prices, and special demand-shift version in fla tio n ) of in fla tio n (com m only called was developed to explain the th a t in to o many instances they have problem o f rising prices during the late 1950's, when used th a t power to raise wages and aggregate demand was not considered excessive. See prices in ways not consistent w ith Charles L. Schultze, "R ecent In fla tio n in the United States,” S tudy Paper No. 1, Jo in t Econom ic Com m ittee, basic supply and demand forces in the S tu d y m arket. (Washington, D. C.: Governm ent Printing O ffice, 1959). 20 of E m p lo y m e n t, G row th and Price Levels FEB R UA RY 1970 tig h t labor m arket (low or declining unem ploy Accordingly, most explanations o f in fla tio n incor m ent rates and high or rising overtime payments) porate a number o f economic variables, such as and rapidly increasing p ro fit margins and p ro fit p ro d u c tiv ity , labor compensation, p ro fits, and the share o f national income, A cost-based in fla tio n , scale o f o u tp u t as a w hole (com m only gauged by which can reflect increased nonlabor costs as well the unem ploym ent rate or the ratio o f actual GNP, as collective bargaining settlements or employers in 1958 prices, to potential GNP, in 1958 prices). bidding up wage rates because o f demand consider ations, w ould tend to cu t into p ro fits or p ro fit margins, and w ould labor's share o f national income 10 Signs o f a pure cost-push increase. THE GENERAL PRICE LEVEL DURING THE 1960's This section reviews the behavior o f prices in fla tio n, according to some economists, w ould be during the past decade in lig h t o f the foregoing a rise in both the unem ploym ent rate and prices in theoretical considerations. the face o f declining physical ou tp u t. Chart 1 reveals the pattern o f quarterly changes, at annual rates, in Instead o f emphasizing either o f the extreme tw o measures of the general price level—the positions o f demand-pull and cost-push, it seems im p lic it price d e fla to r fo r more reasonable to take an eclectic view o f the private GNP. The generally higher and more erratic in flationary rate o f increase in the d e fla to r fo r total GNP process and to recognize th a t the general price level depends upon a number o f reflects pay interrelated factors, some o f w hich were recog to ta l GNP and fo r increases fo r general government employees. nized by the British economist, John Maynard Keynes. Chert The general price-level depends partly on the rate o f rem uneration o f the factors o f production which enter in to 1 IMPLICIT PRICE DEFLATORS TOTAL GNP and PRIVATE GNP Q u a r t e r to Q u a r t e r C h a n g e at A n n u a l Rate marginal cost and p a rtly on the scale o f o u tp u t as a whole, i.e. (taking equipm ent and technique as given) on the volume o f em ploym ent.11 E quipm ent and technique do n o t remain un changed in an economy th a t is growing. Produc tiv ity , therefore, generally increases and provides a cushion 10 against upward cost-price pressures. The process o f various factors of production a tte m p t ing to increase th e ir respective shares o f national income is sometimes referred to as income claims in fla tio n . 11 John Maynard Keynes, The General Theory o f E m ploy m ent, Interest, and M oney (New Y ork: Harcourt, Brace, and Co., 1936), Ch. 21. 21 ECONOMIC REVIEW W hether or n o t the wage-price performance in A fte r the 1960-1961 recession, the President's Council o f Economic Advisers established guide- the U nited States during the early and m id-1960's posts fo r n o n infla tio n a ry wage and price behavior. w ould have been less satisfactory in the absence o f The rate o f grow th o f p ro d u c tiv ity (o u tp u t per the widespread p u b lic ity given to the guideposts is manhour in the private economy) over a period of a m atter still subject to debate among econo several years was to serve as the benchmark fo r mists.12 There is little disagreement, however, th a t appropriate the most im p o rta n t restraining force on wages and wage and price performance. The Council suggested th a t if compensation per man- prices during the firs t half o f the 1960's was the hour (including fringe benefits) were to increase in considerable margin o f unused resources in the line w ith the trend rate o f p ro d u c tiv ity improve economy. ment, stable prices w ould be warranted in those 1960-1964, the rate o f unem ploym ent fo r the industries where the p ro d u c tiv ity gain was average; civilian labor force averaged 5.7 percent and the price declines w ould be desirable in those indus real tries where p ro d u c tiv ity gains were above average; below its potential ou tp u t. As shown in Table III, during o u tp u t o f the economy was substantially and price increases w ould be appropriate in indus In an atte m p t to reduce unem ploym ent and tries where p ro d u c tiv ity gains were below average. raise the nation's grow th rate. President Kennedy The proposed guidelines were not com pulsory and did reductions in personal and corporate include in the inform al specifications exceptions income tax fo r wage and price behavior in certain industries capital investment, Congress enacted the invest rates in 1962. To encourage new th a t w ould otherwise be unable to attra ct the ment resources needed fo r expansion. The assumption allowances in 1962. In 1964, Congress legislated was th a t compliance w ith the guideposts w ould the tax cuts, w hich were an im p o rta n t stim ulus to result in relative cost-price sta b ility fo r the entire aggregate demand, p a rticu la rly capital spending. economy and, at the same tim e, w ould preserve a During 1964, there was a significant improvem ent tax cre d it and accelerated depreciation degree o f price fle x ib ility necessary fo r the alloca in the ratio o f actual to potential GNP and in the tio n o f resources. rate o f unem ploym ent, although the la tte r was still at an undesirable level o f 5.2 percent. (The Indeed, the wage-price guideposts apparently A d m in istra tio n wanted to attain the interim goal were successful—fo r a tim e. From the beginning o f o f a 4 percent rate o f unem ploym ent.) Upward 1962 u n til the latter half o f 1964, the quarter-toquarter annual rate o f change in the price d eflator fo r private GNP hovered around 1 percent (see Chart 1). Because o f the upward biases in the data 12 The con trib u tio n s in Schultz and A libe r, op. cit., pro vide a well balanced discussion o f the pros and cons o f the guideposts. Because the w o rk o f George L. Perry is fre used to construct the defla to r fo r private GNP, quently cited as evidence to support the efficacy o f the most guideposts, see also Paul S. Anderson, "Wages and the economists considered th a t prices were nearly stable in this period. If, in fact, there was any in fla tio n , it did not exceed a range o f a 1 Guideposts: C om m ent"; Michael L. Wachter, "Wages and the Guideposts: C om m e n t"; Adrian W. Throop, "Wages and the Guideposts: C om m e n t"; and George L. Perry, percent annual rate o f increase in prices, w hich "Wages and the Guideposts: R e p ly," Am erican Econom ic was tolerable. Review, L IX (June 1966). 22 FEB R UA RY 1970 T A B L E III Selected Economic Data 1 9 6 0 -1 9 6 9 Private Economy Year Percent Change in O u tp u t per Manhour 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 Percent Change in Compensation per Manhour 1.5% 3.4 4.8 3.6 3.9 3.3 4.0 2.0 3.3 0.9 3.9% 3.7 4.5 3.9 5.1 4.1 6.9 5.8 7.6 7.3 Percent Change in U n it Labor Costs 2.3% 0.3 -0 .3 0.4 1.1 0.7 2.8 3.8 4.2 6.3 Percent Change in Im p lic it Price D eflator Percent Change in Corporate Profits, A fte r Taxes 1.4% 0.9 1.0 1.1 1.1 1.7 2.6 2.9 3.6 4.5 Corporate P ro fit Margins* (percent) - 6.3% 1.9 14.7 6.1 16.0 21.1 7.3 - 5.2 5.3 - 4 .1 1 Unem ployment Rate Ratio: A ctual GNP to Potential GNP 5.5% 6.7 5.5 5.7 5.2 4.5 3.8 3.8 3.6 3.5 10.6% 10.4 11.2 11.3 12.1 13.5 13.2 11.9 11.4 11.0$ 93.8% 92.4 95.1 95.4 96.9 99.2 101.7 100.2 101.1 100.0 * Ratio o f p ro fits, after taxes, to income originating in all corporate industries, t Annual rate o f change, firs t three quarters o f 1969. $ Average, firs t three quarters o f 1969. Sources: U. S. Departm ent of Commerce; U. S. Departm ent o f Labor; Council o f Econom ic Advisers price pressures began to accumulate in 1964, as actually declined in 1965, w h ile the corporate the d e fla to r fo r private GNP accelerated from a p ro fit share rose fu rth e r. Corporate p ro fits after rate o f 1.1 percent during the firs t half o f the year taxes and p ro fit margins continued to rise sharply to a rate o f 1.8 percent by yearend. Because o f a during the period. In 1965, corporate p ro fit somewhat tig h te r labor market, compensation per margins reached 13.5 percent and were at the manhour rose faster and u n it labor costs, w hich highest level since 1955, when they had reached had been relatively steady during the preceding 13.6 percent. three years, rose moderately. As a result o f the Economic a c tiv ity was reinforced during 1965, higher level o f aggregate demand, there was a large as production in the defense industries was increase in corporate p ro fits after taxes and p ro fit stepped up. A ctual defense expenditures (as mea margins in 1964. The corporate p ro fit share o f sured national income also began to rise in 1964 (see accounts) did not rise sig n ifica n tly u n til the latter Table IV ). half o f 1965. The increase in Federal outlays, in the national income and product In 1965, despite a fu rth e r significant decline in superimposed on the capital goods boom th a t had the unem ploym ent rate and the virtual closing o f been underway fo r some tim e, was the prim ary the gap between potential and actual GNP, com reason fo r the overheating th a t occurred. A lthough pensation per m anhour and u n it labor costs in the there was a tem porary private in fla tio n economy rose at slower rates. The employee compensation share o f national income easing in the rate o f during the second half o f 1965, the year-to-year increase in the price d e fla to r fo r 23 ECONOMIC REVIEW T A B L E IV D istrib u tio n o f National Income 1 9 6 0 -1 9 6 9 1960 1962 1963 1964 1965 1966 1967 1968 71.0% 70.8% 70.7% 70.8% 70.6% 69.8% 70.2% 71.5% 71.9% 73.0% 8.3 2.9 3.8 2.0 12.0 100.0% Employee compensation Business and professional income Farm income Rental income Net interest Corporate p ro fits Total 1961 8.3 3.0 3.7 2.3 11.8 100.0% 8.1 2.8 3.6 2.5 12.2 100.0% 7.9 2.7 3.6 2.9 12.2 100.0% 7.8 2.3 3.5 3.0 12.8 100.0% 7.5 2.6 3.4 3.2 13.5 100.0% 7.3 2.6 3.2 3.4 13.3 100.0% 7.2 2.2 3.2 3.8 12.1 100.0% 6.9 2.0 3.0 3.9 12.3 100.0% 6.5 2.1 2.8 4.0 11.7 100.0% 1969* NOTE: Details may n o t add to totals because o f rounding. * First three quarters. Source: U. S. Departm ent o f Commerce private GNP accelerated. The evidence strongly 1966, it remained below the average o f the early suggests th a t the economy experienced classical 1960's. The rate o f increase in the d e fla to r fo r symptoms o f excess demand-induced in fla tio n . private GNP was at an in te rim peak in m id-1966 In 1966, wage demands and wage settlements and then decelerated fo r about a year (see Chart grew larger, w hich is n o t surprising in view o f the 1). The easing in the price d e fla to r reflected, in extrem ely good p ro fit performance o f earlier years part, tig h t m onetary and credit conditions during and the stepped up increase in the cost o f living. most o f 1966 and was accompanied by some Much o f the stim ulus to the rise in retail prices reduction o f demand pressures. between 1964 and 1966 stemmed fro m a sharp increase in wholesale prices o f farm products and In 1967, the Council o f Economic Advisers processed foods, w hich o rd in a rily are largely inde conceded pendent o f general business conditions. The coin proven to be less effective than the Council had cidence o f a significant upswing in agricultural originally prices and rapid expansion in business a c tivity were orig in a lly form ulated to tem per the discre between 1964 and 1966 intensified the cyclical tio n a ry economic power o f unions and businesses th a t the wage-price guideposts had expected. The guideposts, o f course, elements o f in fla tio n a ry pressures. As corporate under conditions o f less than fu ll em ploym ent. As p ro fits continued to increase in 1966 (and p ro fit stated by one o f the proponents o f the guideposts, margins remained at a relatively high rate), the ...if to ta l economy's resources became overburdened, and exceeds the a b ility o f the economy to compensation produce per manhour began to o u tstrip demand goods in the economy and services w ith p ro d u c tiv ity gains significantly. U n it labor costs reasonably fu ll accelerated available resources, then in fla tio n in 1966 (see Table III). A lthough labor's share o f national income rose slightly in 24 em ploym ent o f the is inevitable. Under such circumstances F EB R U A R Y 1970 o f generally excess demand, guideposts Congress enacted the surtax in m id-1968. A l can play no significant part in avoiding though the rate o f real economic grow th began to in fla tio n .13 slow during the second half o f 1968, there was In 1967, labor had recouped its depressed share little im pact on prices. In fact, the rate o f increase o f national income, w hile corporate p ro fits after in the price d e fla to r fo r private GNP began to taxes, p ro fit margins, and the p ro fit share o f accelerate in late 1968 and reached a new high fo r national income all declined. Pressures on u n it the decade in 1969 (see Chart 1). D uring the la tte r labor costs intensified, and the year-to-year rise in half o f the price d eflator continued to accelerate. Those variables (fo r example, bank cre d it and the money were symptoms, b u t by 1968, some of the m ajor m onetary no means conclusive supply) expanded at rates greater than intended by evidence, o f cost in fla tio n . Aggregate demand was the Federal Reserve authorities. A lthough mone still ta ry p o licy turned tow ard restraint in December very strong fo r 1967 as a w hole; the unem ploym ent rate averaged less than 4 percent; 1968, some observers a ttrib u te d the succeeding and actual GNP remained above potential GNP. acceleration in prices to the lagged e ffe ct o f an The labor m arket generally remained tig h t in the overly expansionary m onetary p o licy during the face o f a tem porary decline in real o u tp u t during latter half o f 1968. early 1967. It now seems clear th a t anticip atio n o f the During resum ption o f strong demand helped to sustain attem pted 1969, to m onetary stem and in fla tio n a ry fiscal p o licy pressures. A l high em ploym ent, large wage increases, and in fla though some progress was made in reducing excess tio n . Employers were reluctant to lay o ff workers demand (as measured by a reduction in the ratio because they anticipated a b rie f slowdown and o f actual GNP to potential GNP), the unem ploy expected th a t the economy w ould resume a strong m ent rate edged down to a new low fo r the growth path in the latte r part o f 1967. By the decade. The very small gain in p ro d u c tiv ity in the second half o f 1967, the rate o f in fla tio n began to private sector resulted in a substantial increase in accelerate again and the price d e fla to r continued u n it labor costs. Prices did n o t rise as fast as did to advance at an intolerable rate the fo llo w in g u n it labor costs. In short, business firm s were in a year. cost-price squeeze, w hich resulted in declining p ro fit margins and corporate p ro fits a fte r taxes Renewed pressures on resource u tiliz a tio n were (see Table III). As shown in Table IV , the p ro fit evident in 1968. The unem ploym ent rate resumed share o f national income in 1969 was depressed to its decline and the ratio o f actual GNP to potential the lowest level o f the decade. GNP began to rise again. Fiscal restraint was necessary to help cool an overheated economy, to Inflationary Psychology. D uring the la tte r half relieve pressures in financial markets, and to help o f the 1960's, p a rticu la rly in 1969, in fla tio n a ry strengthen international confidence in the dollar. psychology hampered the effectiveness o f anti- 13 widespread a ttitu d e among businessmen o f "o rd e r in fla tio na ry Gardner A ckley, "T h e C o n trib u tio n o f the Guidelines,” p o licy actions. For example, the in Schultz and A libe r, op. cit. new plant and equipm ent now, because costs and 25 ECONOMIC REVIEW prices w ill rise enough to ju s tify today's invest 1969, and the expectations were realized, thereby ment d ecision" has obviously helped to sustain a placing a heavier burden on public policy. high rate o f in fla tio n . A decade ago, economists were reminded o f the role o f expectations w ith regard to in fla tio n and IMPLICATIONS FOR THE 1970's The consensus o f business analysts is th a t the restrictive public policies th a t were pursued in public policy. ...We th in k it im p o rta n t to realize th a t 1969 w ill have a substantial im pact on economic the more the recent past is dominated a ctiv ity during 1970. W ith little , if any, grow th in by in fla tio n , by high em ploym ent, and physical o u tp u t expected over the near term , the by the belief th a t both w ill continue, economy w ill be operating below its potential the more like ly it is th a t the process o f o u tp u t fo r the firs t sustained period since the firs t in fla tio n w ill persever or even increase half o f the real demand, or the more heavily the increase in prices is also expected to occur in view monetary and fiscal authorities may of the suppression o f excess aggregate demand. have to bear down on demand in the Based on historical experience, prices may con interests o f price stabilization. tinue to rise, although at a reduced rate, despite 1960's. A slowing in the rate o f the absence o f excess aggregate demand. The more slower reaction o f prices probably reflects various deeply imbued w ith an in fla tio na ry psychology as U nfortun ately, businessmen became in stitu tio n a l rigidities and in fle x ib ilitie s as well as the 1960's drew to a close. The sharp rise in the fa ct th a t many firm s adjust slow ly to reduced in fla tio n a ry sentim ent since 1965 is reflected in wage-price-cost pressures. the Dun & Bradstreet quarterly survey o f a p proxi In recent months, spokesmen fo r the A dm inis m ately 1,500 businessmen. Am ong other items, tra tio n have conveyed the opinion th a t the eco businessmen are asked w hether they expect th e ir nomic o u tlo o k contains a number o f uncertainties selling prices during the next quarter to be higher, and th a t these uncertainties may n o t be consistent lower, or unchanged fro m the comparable year- w ith wage and price increases o f the magnitude earlier quarter. The net result (that is, the percent experienced during the late 1960's. A t present, expecting an increase minus the percent expecting public policy is attem pting to dissipate the in fla a decrease) is shown in Chart 2 tio n a ry psychology th a t has become so deeply actual changes in the together w ith price d e fla to r fo r GNP originating in private nonfarm business. D uring 1969, when monetary and fiscal policies entrenched in to the th in k in g o f businessmen and consumers and gradually to reduce the rate o f price increases to a "to le ra b le " level w ith o u t were restrictive, businessmen apparently were not generating an "in to le ra b le " rate o f unem ploym ent. convinced th a t the slowdown in real economic What is tolerable or intolerable is subject to debate grow th (then in progress) w ould be o f su fficie n t and magnitude to dampen the rate o f in fla tio n . Busi among nessmen expected prices to rise at a faster rate in unem ploym ent rate in the early 1960's was in to l is a m atter o f individual value judgments policymakers. It does seem th a t the erable and th a t the price performance in the late 14 Samuelson and Solow, op. cit. 26 1960's was also intolerable. FEB R U A R Y 1970 C h a r t 2. BU S IN E S S M E N 'S PRICE EXPECTATIONS vs. ACTUAL PRICE CHANGES Last entry: Sour ces copyright of 4Q data: '69 U. S. Department of Commer ce; data on price expectati ons used w i t h special permission from D u n 's Review , 1969 If there is a tapering in the rate o f in fla tio n in In the coming years, a number o f factors w ill 1970, and if fu rth e r progress is made in 1971, the influence prices, including increased emphasis on magnitude o f reduction th a t can be reasonably the service industries where p ro d u c tiv ity grow th expected is open to question. In view o f recent tends to be lower than in other industries; the price developments, it seems somewhat u n like ly need to remain concerned about high em ploy that the stable price environm ent o f the early ment; and the increasing demands fo r government 1960's (when major price indexes such as the spending in areas such as housing and urban d eflator fo r private GNP and the CPI rose approxi redevelopment, air and w ater p o llu tio n control, mately 1 percent a year) can be achieved im m edi transportation, and health, education, and welfare. ately. In such an environm ent, it seems almost inevitable The economic clim ate in the 1970's should be somewhat d iffe re n t from th a t of the early 1960's. that in fla tio n a ry pressures w ill remain an im p o r ta n t factor in public economic decisions. 27
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