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MONETARY POLICY
GOALS AND CONDUCT FOR THE 1980's
HEARINGS
BEFORE THE
SUBCOMMITTEE ON
DOMESTIC MONETARY POLICY
AND THE
SUBCOMMITTEE ON INTERNATIONAL TRADE,
INVESTMENT AND MONETARY POLICY
OP THE
COMMITTEE ON
BANKING, FINANCE AND URBAN AFFAIRS
HOUSE OF REPRESENTATIVES
N IN E T Y -S IX T H CONGRESS
FIRST SESSION
NOVEMBER 13; 27; AND DECEMBER 4, 1979
Serial No. 96-38
Printed for the use of the
Committee on Banking, Finance and Urban Affairs
U.S. GOVERNMENT PRINTING OFFICE
55-123 0
WASHINGTON : 1980
HOUSE COM M ITTEE ON BANKING, FINANCE AN D U RBAN A F F A IR S
H ENR Y S. REUSS, Wisconsin,
THOMAS L. ASHLEY, Ohio
WILLIAM S. MOORHEAD, Pennsylvania
FERNAND J. ST GERMAIN, Rhode Island
HENR Y B. GONZALEZ, Texas
JOSEPH G. MINISH, New Jersey
FRANK ANNUNZIO, Illinois
JAMES M. HANLEY, New York
PARREN J. MITCHELL, Maryland
WALTER E. FAUNTROY,
District of Columbia
STEPHEN L. NEAL, North Carolina
JERRY M. PATTERSON, California
JAMES J. BLANCHARD, Michigan
CARROLL HUBBARD, Jr., Kentucky
JOHN J. La FALCE, New York
GLADYS NOON SPELLMAN, Maryland
LES AuCOIN, Oregon
DAVID W. EVANS, Indiana
NORMAN E. D ’AMOURS, New Hampshire
STANLEY N. LUNDINE, New York
JOHN J. CAVANAUGH, Nebraska
MARY ROSE OAKAR, Ohio
JIM MATTOX, Texas
BRUCE F. VENTO, Minnesota
DOUG BARNARD, Georgia
WES WATKINS, Oklahoma
ROBERT GARCIA, New York
MIKE LOWRY, Washington
Chairman
J. WILLIAM STANTON, Ohio
CHALMERS P. WYLIE, Ohio
STEWART B. McKINNEY, Connecticut
GEORGE HANSEN, Idaho
H ENR Y J. HYDE, Illinois
RICHARD KELLY, Florida
JIM LEACH, Iowa
THOMAS B. EVANS, Jr., Delaware
S. WILLIAM GREEN, New York
RON PAUL, Texas
ED BETHUNE, Arkansas
NORMAN D. SHUMWAY, California
CARROLL A. CAMPBELL, Jr.,
South Carolina
DON RITTER, Pennsylvania
JON HINSON, Mississippi
ClerkandStaffDirector
General Counsel
Minority StaffDirector
P aul N elson,
M ichael P. F laherty ,
M ercer L. Jackson,
S u b c o m m it t e e o n D o m e stic M o n e ta r y P o lic y
PARREN J. MITCHELL, Maryland,
STEPHEN L. NEAL, North Carolina
NORMAN E. D'AMOURS, New Hampshire
DOUG BARNARD, Georgia
JIM MATTOX, Texas
JOHN J. CAVANAUGH, Nebraska
Chairman
GEORGE HANSEN, Idaho
RON PAUL, Texas
DON RITTER, Pennsylvania
SUBCOMMITTEE ON INTERNATIONAL TRADE, INVESTMENT AND MONETARY POLICY
STEPHEN L. NEAL, North Carolina,
LES AuCOIN, Oregon
JOHN J. CAVANAUGH, Nebraska
JAMES J. BLANCHARD, Michigan
DAVID W. EVANS, Indiana
STANLEY N. LUNDINE, New York
DOUG BARNARD, Georgia
M ARY ROSE OAKAR, Ohio
JERRY M. PATTERSON, California
JOHN J. L a FALCE, New York
JIM MATTOX, Texas
MIKE LOWRY, Washington
Chairman
JIM LEACH, Iowa
H ENR Y J. H YDE, Illinois
GEORGE HANSEN, Idaho
CARROLL A. CAMPBELL, JR.,
South Carolina
NORMAN D. SHUMWAY, California
J. WILLIAM STANTON, Ohio
(II)
CONTENTS
Hearings held on—
November 13, 1979_____________________________________________
November 27, 1979_____________________________________________
December 4, 1979_______________________________________________
Pw
1
49
101
Statements
Berman, Dr. Peter I., Bank of America_______________________________
Brunner, Prof. Karl, University of Rochester and University of Bern,
Switzerland_______________________________________________________
Fand, Prof. David I., professor of economics, Wayne State University___
Frenkel, Prof. Jacob A., professor of economics, University of Chicago__
Friedman, Benjamin M., associate professor of economics, Harvard
University________________________________________________________
Hamburger, Prof. Michael, New York University_____________________
Meigs, Dr. A. James, chairman of the board, Claremont Economics In
stitute, professor of economics, Claremont Men’s College_______________
Parkin, Michael, professor of economics, University of Western Ontario,
Canada_________________________ _________________________________
Volcker, Hon. Paul A., Chairman, Board of Governors of the Federal
Reserve System___________________________________________________
Additional I nformation Submitted
for the
103
165
183
51
138
60
84
22
R ecord
Berman, Dr. Peter I., prepared statement--------------------------------;________
“ Briefing Materials,” prepared by the staffs of the subcommitteer re recent
developments in monetary policy___________________________________
Brunner, Prof. Karl, prepared statement entitled “ The Choice and Imple
mentation of Monetary Policy” ____________________________________
Bryant, Ralph C., senior fellow, Brookings Institution, statement---------Fand, Prof. David I., prepared statement_____________________________
Frenkel, Prof. Jacob A., prepared statement__________________________
Hamburger, Dr. Michael J., prepared statement----------------------------------Letter to witnesses testifying at hearing re assessment of the merits of two
alternative monetary policy strategies for the 1980’s, dated October 11,
1979_____________________________________________________________
Meigs, Dr. A. James, prepared statement______________________________
Taub, Leon W., vice president, Chase Econometric Associates, Bala
Cynwyd, Pa., letter dated November 6, 1979_______________________
Tracy Ronald L., and Paul B. Trescott, respectively assistant professor and
professor, department of economics, Southern Illinois University, Carbondale, 111., statement entitled “ Monetary Policy and Inflation in the
United States, 1912-1977” ________________________________________
Trescott, Paul B., visiting professor of economics, Southern Illinois Univer
sity, Carbondale, 111., letter dated December 5, 1978_________________
(in)
124
126
7
108
218
170
187
142
5
66
216
246
242
MONETARY POLICY
Goals and Conduct for the 1980’s
TUESDAY, NOVEMBER 13, 1979
H o u s e o f R e p r e s e n t a t i v e s , S u b c o m m itte e o n D o
m e s tic M o n e t a r y P o l i c y , a n d S u b c o m m itte e o n
I n te r n a tio n a l T r a d e , In v e stm e n t and M o n e ta r y
P o l i c y o f t h e C o m m it te e o n B a n k i n g , F i n a n c e a n d
U rban A ffa ir s,
Washington, D.C.
The subcommittees met at 9 :30 a.m., in room 2220, of the Rayburn
House Office Building, Hon. Parren J. Mitchell, chairman of the Sub
committee on Domestic Monetary Policy, presiding.
Present: Representatives Mitchell, Neal, LaFalce, AuCoin, Hyde,
Leach, and Ritter.
Chairman M it c h e l l . Good morning. This hearing will now come
to order. Today the Subcommittee on Domestic Monetary Policy
joins with the Subcommittee on International Trade, Investment, and
Monetary Policy in beginning 3 days of hearings on the recent dra
matic, to say the least, historic changes in the strategy and focus of
monetary policy. These changes were announced by the Federal
Reserve Board Chairman Paul A. Yolcker on October 6.
We had planned to have the second and third days of hearings to
morrow and the next day. However, they will be held on November 27
and December 4. W e have to reschedule those hearings because the
full Committee of Banking, Finance, and Urban Affairs will mark up
the Chrysler guarantee loan legislation tomorrow and the next day.
Our witness today is Chairman Paul A. Volcker of the Federal
Reserve Board. Before we hear from you, Mr. Chairman, I have a
very short opening statement, and Chairman Neal also has an opening
statement that he wants to make, and then I will call on other mem
bers of the subcommittee for any opening statements that they may
want to make.
Twice before in the last 10 years inflation and recession have joined
together to hammer the American economy and people. Today they
threaten to join together again. Some would blame our recurring bouts
with what has come to be called “stagflation” on OPEC, bad weather,
and the like. However, we are not entirely blameless, not even for
OPEC’s price behavior. Between the second quarter of 1974 and the
fourth quarter of 1978, prices here in the United States rose consid
erably faster than the price of the oil which we import from abroad.
It is not surprising, therefore, that OPCE raised its price in 1979.
(l)
2
In the long view, we have only ourselves to blame for our current
predicament and only we can change it. I think we will all agree that
monetary policy has been part of the problem. More importantly,
it is my opinion— and I think all the members of the subcommittee
share my opinion— that monetary policy can be a part of the cure.
Soon after I assumed the chairmanship of this subcommittee in
January of 1977, I warned, and have repeatedly warned, that the
acceleration of money growth which had begun shortly before the
1976 Presidential election would, if continued, fuel inflation and
bring us to the brink of another recession just about around this time.
Unhappily, I think I was right in my warning. Powered by faster
money growth, the so-called “underlying” or “base rate” of inflation
rose from below 5 percent in the latter part of 1976 through 6, 7, and
8 percent, and on up to the 9 to 10 percent area. W ith each uptick in
underlying monetary inflation, interest rates have risen, the dollar
has dropped on the foreign exchange market, and the economy’s
stability has become more and more difficult to maintain.
The task we now face is to reduce this basic monetary inflation
without inducing or worsening recession. Now, I am generally sup
portive of the Federal Reserve’s newly announced resolve to do this
slowly but surely, decreasing money growth presumably down to a
rate “ commensurate with the economy’s long run potential to in
crease production.” This is required by the Humphrey-Hawkins Act
which was passed by this Congress.
Let me digress from my prepared statement to say that in addition
to those requirements of Hawkins-Humphrey, the Federal Reserve
sets money growth ranges each year. Unfortunately each year the
ranges for M xthat have been given to the Congress have been violated.
M y initial posture is, if we can stay within those ranges for now,
we will begin the very significant process of getting monetary growth
and inflation under control.
Although I generally approve of what has been done up to this
point, I am concerned that the high interest rates which have resulted
since October 6 will trigger another recession. Chairman Volcker,
to put the matter concisely: Can we pull it off? Can we reduce the
rates of monetary growth without inducing a recession? How do you
assess the responses to date to your October 6 policy initiatives in
the U.S. money, capital and commodity markets? How have the
foreign exchange markets been affected?
What are the longer-term implications for unemployment— which
is an albatross, it seems to me, around the neck of America, the
long-term implications for inflation, interest rates, and the value of
the dollar in exchange markets? Can we unwind inflation without a
substantial rise in unemployment? And as most of yon in this room
know, the predictions are that unemployment will rise, some econo
mists say to 7 percent in the beginning of 1980; others suggest that
we will have an 8 percent rate of national unemployment by June
1980; still others suggest an astronomical 9 percent rate of unemploy
ment by September 1980.
Before I welcome you officially, Chairman Volcker, I would like
to call on Chairman Neal for his opening statement.
Chairman N e a l . Thank y o u , M r . Chairman.
3
This morning we begin hearings on a very important topic: The
longrun strategy for monetary policy through the 1980’s. I am especi
ally pleased that the Subcommittees on Domestic Monetary Policy
and on International Trade, Investment and Monetary Policy are
once again joining forces to conduct these hearings.
This past summer we met together for a very fruitful set of hearings
on control of the Eurocurrency markets. That we meet again for
joint hearings is evidence of our recognition of the important re
lationships between U.S. monetary policy and the international
economy.
I am delighted to welcome Chairman Volcker of the Board of
Governors of the Federal Reserve System. No one is better qualified
to help us assess the relationship between U.S. monetary policy and
the world around us.
There are two broad questions I hope these hearings will help us
answer. The first relates to the basic nature of money management.
Is it a tool that can be effectively employed to steer the economy
from month to month, quarter to quarter, or year to year?
Does the record suggest that we have been very successful in trying
to flex monetary policy first one way and then the other to combat
whatever economic problem seems temporarily most pressing?
Economists have long debated the wisdom of trying to “fine-tune”
the economy in that fashion. The recognition has been growing that
such a strategy is very likely to fail.
It is time to try a different approach— one that adopts and adheres
to an appropriate long-term target path for the growth of the monetary
aggregate. To that end, I have introduced legislation specifying such a
path, and mandating the Federal Reserve to follow it.
It is most encouraging that the Federal Reserve, under Chairman
Volcker's leadership, has switched its operating techniques away from
control of the Federal funds rate to more direct control of member
bank reserves. That switch was a practical prerequisite for a long-term
strategy aimed at controlling and stabilizing the growth of the
monetary aggregates.
If fully exploited to that end, this switch in technique could prove
truly revolutionary, one of the most profound and promising economic
policy initiatives in recent years.
Nonetheless, though our capacity to control the money supply has
been greatly enhanced by this switch in technique, the task remains to
use it to the best advantage. A technique is just a “ technique” whose
ultimate usefulness depends on the basic monetary strategy in whose
service it is employed.
The second basic question which we will try to explore deals with
the impact of international forces on the choice and conduct of a
monetary strategy. Is there an inherent conflict between domestic
and international objectives?
The Federal Reserve has in the past been criticized from both sides
as it tried to maneuver between domestic and international objectives.
Some charge that in defense of the fore:gn exchange value of the dollar
it has raised interest rates to high, damaging the domestic economy.
Others— particularly foreign officials— have blamed the Federal
Reserve and the administration for not doing enough to bolster a
chronically weak dollar.
4
A commitment to a long-term strategy for stabilizing the growth
of the monetary aggregates would, in my opinion, help reconcile the
domestic and international objectives of monetary policy. If that com
mitment were credible to the world’s financial markets, it would help
stabilize the foreign exchange value of the dollar around some rational,
justifiable trend. Not every problem would be resolved— the inter
national economy would still be vulnerable to severe shocks and ex
change rates would still be sensitive to changes in the major econo
mies— but an important source of stability would be introduced into
the behavior of exchange rates, provided the foreign exchange markets
came to believe that the U.S. monetary aggregates were under control
and tilted on a stable path that promised to rid us of excessive inflation
in the 1980’s.
In my opinion, no matter what other weapons we use in our war
on inflation— increased productivity, decreased budget deficits, more
sensible regulatory policies, and so on, all of which are things we cer
tainly need to do— we are not going to win this war on inflation until
the Fed gradually brings down the rate of growth in the money supply.
Mr. Chairman, nothing would be worse for our economy and the
value of the dollar abroad than for the Federal Reserve System to
continue an erratic, on-again-off-again monetary policy.
I hope we can get a commitment from you, Mr. Chairman, this
morning for a long-term money policy which will mean health for our
economy.
Chairman M i t c h e l l . Thank you very much, Chairman Neal.
Mr. Leach, do you have an opening statement?
M r. L e a c h . I have just a few comments, Mr. Chairman.
I would like to welcome Chairman Volcker on behalf of the Republi
cans. I particularly enjoyed your opening comments, Chairman
Mitchell, and agree with you that monetary policy is part of the
problem and part of the cure, but so is fiscal policy.
The Fed is independent of Congress and the Executive only to the
point that it must work within the constraints established in the fiscal
arena. In that regard, it seems to me that responsibility for the current
debilitating high interest rates must be shouldered squarely By Con
gress and the President and not simply by the Federal Reserve
Chairman.
So it would be my hope today, Chairman Volcker, that you will
comment on your expectations m the monetary arena, but also on
what you think we in Congress can best do to underscore and bolster
the Fed’s policy, and in particular to move in a direction where fiscal
and monetary policy work together rather than at odds.
Thank you.
Chairman M i t c h e l l . Thank you.
A t this point in the record, without objection, I would like to insert
the letter of October 11, 1979, which was sent to each witness testi
fying at the hearing and also “Briefing Materials” prepared by the
joint staffs of the subcommittees re recent developments in monetary
policy:
5
GEORGE HANSEN IDAHO
RON PAUL. TEX.
PON RITTER, PA.
PARREN J. MITCHELL. MO. CHAIRMAN
NORMAN E. DAMOURS. N.H.
DOUG BARNARD. GA.
JIM MATTOX. TEX.
JOHN J.
U .S. HOUSE OF R E P R E SE N T A T IV E S
SUBCOMMITTEE ON DOMESTIC MONETARY POLICY
OF THE
COMMITTEE ON BANKING. FINANCE AND URBAN AFFAIRS
N IN ETY -SIX TH CO N G RESS
W ASHINGTON, D.C.
20515
October 11, 1979
Dear
On November 13, 14 and 15, the Subcommittee on Domestic Monetary Policy
and the Subcoirmittee on International Trade, Investment and Monetary Policy
will hold joint oversight hearings on "Monetary Policy ~ Goals and Conduct
for the 1980's." We would appreciate hearing your views on this subject and
invite you to testify on November 15 at 9:30 a.m. in Room 2128 Rayburn House
Office Building.
Although we do not want to limit your testimony in any way, we would
like to hear your assessment of the merits of two alternative monetary policy
strategies for the 1*980's.
Strategy 1 places top priority on halting the decline in the value of
the dollar on the foreign exchange markets, and proposes to do sc by keeping
money "tight11 at home and resisting speculative attacks against the dollar
abroad until the decline is halted. Under this strategy, in the months
immediately ahead, the Federal Reserve would raise the Federal funds rate
substantially above the current level. The purpose would be to raise U.S.
short term interest rates and slow U.S. money growth so as to provide
incentives for money managers around the world to buy dollars and hold
dollar denominated securities. Simultaneously, the Federal Reserve and the
Treasury would intervene vigorously on the foreign exchange markets, in
cooperation with other central banks, to combat any excessive fluctuations
in exchange rates that might arise from speculation against the dollar even
in the face of high interest rates. After the dollar had been stabilized,
primarily against the German mark, sufficiently long to convince foreign
exchange traders that further precipitous declines would not be tolerated,
monetary policy could be gradually re-oriented toward the domestic goals
of full employment and price level stability.
What risks would this strategy entail? Can such a policy succeed without
the cooperation of foreign central banks? That is, would our raising interest
rates not invite retaliation by foreign central banks, and hence a spiraling
upward of interest rates worldwide without noticeable effect on the foreign
exchange value of the dollar? Even assuming a policy of cooperation by foreign
6
Page Two
October 11, 1979
central banks, would not maintaining the funds rate at a higher level than
currently prevails precipitate a sharp deceleration of money growth and
consequent recession? Would not fighting that recession, and even the
expectation of fighting it, again destabilize exchange rate markets?
Strategy 2 would ignore movements in interest rates and concentrate
instead on establishing and remaining on or near a long run disinflationary
monetary growth target path. (See, for example, the Banking Committee's
recommendations of July 27, 1979 (Report No. 96-396) and H.R. 5476* recently
introduced by Mr. Neal.
Can this strategy be followed independently of the monetary policies
pursued by other central banks? Would it help to promote achievement of
the 1983 Hawkins-Humphrey Act goals of 4 percent unemployment and 3 percent
inflation and at the same time to stabilize the value of the dollar on
foreign exchange markets? What risks does it involve? Should it be adhered
to in the face of increases in interest rates and unemployment? If the
strategy is not binding, how can we convince investors and traders around
the world that we are serious about reducing inflation and that the exchange
rate risk from holding dollar denominated assets will diminish?
Further in this regard, is there reason to believe that adhering to
an announced long run disinflationary monetary growth target path would
lead to higher interest rates and higher unemployment than would a policy
that accelerated mone^ growth when interest rates and unemployment moved
higher? Would it not’
be wiser to hold fast to the announced monetary
growth target path even in the face of temporary increases in unemployment,
which could be dealt with by pinpointed fiscal policies?
Finally, we note that recently the Federal Reserve raised its discount
rate from 11 to 12 percent and at the same time announced that the Open
Market Committee will try to control monetary growth by metering the flow
of reserves instead of manipulating the Federal funds rate. The discount
rate rise would appear consistent with Strategy 1 while the change in
operating procedure seems consistent with Strategy 2. We would appreciate
your comments on the meanings of these recent changes in policy and tactics
by the Federal Reserve.
We look forward to hearing your views on these and other questions you
may want to address on November 15.
Sincerely
Stephen L. Neal, M.C.
Chairman, Subcommittee on
International Trade, Investment
and Monetary Policy
Parren J. Mitchell, M.C.
Chairman, Subconmittee on
Domestic Monetary Policy
7
BRIEFING MATERIALS
PREPARED FOR HEARINGS ON
RECENT DEVELOPMENTS IN MONETARY POLICY
HELD JOINTLY BEFORE THE SUBCOMMITTEES ON
Domestic Monetary Policy
&
In t e r n a t i o n a l T r a d e , In v e s t m e n t & M o n e t a r y Po l i c y
of
Co m m i t t e e
on
November
THE
Ba n k i n g , F i n a n c e & Ur b a n A f f a i r s
13 & 27, a
December
4, 1979
8
CHART 1 .
Exhibit 1 breaks the 1954-1977 period into eight
consecutive 3-year periods: 1954-1956, 1957-1959, etc.
For
each 3-year period, Chart 1A relates average Ml growth to
the average rate of rise in the Consumer Price Index
(inflation)?
Chart IB relates average Ml growth to the
average rate of interest on.3-month Treasury bills;
Chart
1C relates average Ml growth to the average rate of
unemployment.
The exhibit shows that there is a close positive relationship
it
between money growth and inflation (chart 1A) and between
money growth and the rate of interest (chart IB).
It shows
that as money growth increases, so do both inflation and the
rate of interest.
However, it also shows that there is no
relationship between the rate of money growth and the rate
of unemployment (chart 1C).
This belies the Phillips Curve
theory that inflation is inversely correlated with unemployment.
The closeness of these relationships is denoted by the lines
which were fitted in between the points on the graphs.
Note
the straight lines which were easily drawn in charts 1A and
IB.
It was impossible to fit one line into chart 1C.
9
10
CHART 2 .
Last March, the Committee recommended that money growth
be established at 6 percent between the 4th quarter of 1978 and the
4th quarter of 1979, then reduced one percentage point each year
until year-over-year money growth, defined as Ml + ATS accounts, is
established at 3 percent in 1982, where it would be maintained in 1983.
In the fourth quarter of 1978 and the first quarter of 1979, the
growth rate of the money supply was substantially less than 6 per
cent per annum.
As a result, the outstanding stock or volume of
money fell short of the volume projected by the Committee as nec
essary if we are to avoid a recession while unwinding inflation.
However, in the April - September, 1979 period, money supply
growth soared to an annual rate in excess of 10 percent.
The shortfall in money growth late last year and early this year
generated strong downside pressures on economic activity, so it
is not surprising that the economy's momentum changed from up to
down during the first half of this year.
In the same way, the upsurge in money growth that began in the
second quarter provided strong upward impulses, so it is not sur
prising that the economy's slide was halted this summer-during
the third quarter.
The sensitivity of the economy to money supply changes warns us
of the necessity of avoiding sharp changes.
Such changes are
inevitable if the Federal Reserve focuses on hitting interest rate
targets.
Under that strategy, money growth is whipsawed by uncon
trollable changes in credit and foreign exchange markets.
The
Federal Reserve's new resolve to focus directly on controlling
money growth should avoid the destabilizing sharp changes which
have affected our economy in the past.
CHART 2
ACTUAL MONEY SUPPLY
VERSUS
HOUSE BANKING COMMITTEE'S RECOMMENDATION
of
M a r c h 1979
420
BILLIONS
OF
$
BILLIONS OF $
400
380
360
340
MONTHLY DATA
(t h r u
Se p t e m
ber
,
1979)
12
CHART 3. Ml growth, measured between the same months of adjacent
years (for example, January 1947 to January 1948) , cycled down and
up seven times between the end of World War II and 1978.
in late 1978 it appeared to start down once again.
Beginning
However, the
slide was reversed in April 1979.
Our economy's performance in the post World War II period is mirrored
in this chart of money growth.
Inflation was broken after World War
II and again after the Korean War by sustained low money growth.
It was rekindled after 1964 by upsurges in money growth in the late
1960s, 1971-1973, and 1977-1978.
Recessions, which are delineated
by the vertical lines on the time axis, occurred in the wake of
sharp prolonged decelerations in Ml growth, as the chart shows.
Last March, based on data through February, we stated: "The chart
indicates that we are now headed for another recession.”
Then, in
July, observing that the slide in money growth had reversed in April,
we stated: "How deep and long the recession becomes depends on how
the Federal Reserve manages the growth of Ml (adjusted to include
ATS accounts) from now on."
Now, in November 1979, it is clear that
the economy definitely slowed and dipped in the first half of 1979,
although perhaps not enough to be labelled a recession; and that in
the wake of the upsurge in money growth that began in April, the
economy reversed in the summer or third quarter.
Barring either (a) another sharp prolonged deceleration in Ml growth,
inclusive of ATS accounts, or (b) disruption in the flow of foreign
oil, we do not foresee a major recession developing in 1980.
Further
in this regard, the Federal Reserve's new strategy of focusing on
controlling money growth, should rule out another sharp prolonged
deceleration of money growth.
However, the flow of foreign oil is
now an unknown which could cause future problems.
PERCENT
14
EXHIBIT 4 .
Charts 4A and 4B map year-over-year percentage changes
in the CPI and Gross National Product deflator, respectively,
against year-over-year percentage changes in Ml (money supply)
lagged two years.
These charts show that the rate of inflation
follows Ml growth of two years earlier fairly closely.
15
16
CHART 4
(continued).
Charts 4C and 4D map percentage changes
measured between the same quarters from one year to the next in
the Consumer Price Index (CPI) and the Gross National Product
deflator, respectively, on percentage changes in the quarterly
average in Ml, also measured between the same quarters from one
year to the next but lagged 8 quarters.
These charts also show
that the rate of inflation follows Ml growth of two years earlier
fairly closely.
Together, the several exhibits of chart 4 provide hope that
inflation will begin to subside no later that 1981.
17
------------------------------------------------------ 1
CHART HC
YEAR TO YEAR PERCENT CHANGE
LINE IS CPI
CHART 4D
YEAR TO YEAR PERCENT CHANGE
i
I
18
CHART 5 .
This chart plots the monthly average of the Federal
funds rate— the overnight inter-bank interest rate, and percentage
changes in the Consumer Price Index (CPI) from twelve (12) months
ago.
It shows that monthly movements in the Federal funds rate
occur very closely together with changes in the inflation rate
measured from the same month a year ago.
This indicates that
even short-term interest rates are very powerfully affected by
immediate past inflation.
PERCENT
20
CHART 6 .
This chart graphs year over year inflation (vertical
axis) against yearly unemployment averages (horizontal axis).
The top panel graphs the two concurrently,
the middle panel
lags unemployment 1 year, and the bottom panel lags inflation
one year.
The concurrent panel (6A) reveals that the so-called Phillips
curve is unstable.
On average, the trade-off was highly
favorable from 1954 to 1965 but has worsened significantly
since then.
The middle panel (6B) reveals much the same story.
Specifically,
for an arbitrarily selected unemployment rate, the rate of
inflation the following year is much higher today than it was
in the 1950s and early 1960s.
Finally, the evidence plotted in the lower panel (6C) reinforces
this story.
As indicated here, there is even some tendency for
accelerating inflation to be followed by higher unemployment.
Viewed together with Chart 1, these three panels show that un
employment cannot be reduced by accelerating money growth and
inflation.
The only enduring result of faster money growth is
higher inflation..
21
CHART 6fl
INFLATION vs
UNEMPLOYMENT (n e i t h e r
lagged)
UNEMPLOYMENT RATE
CHART. 6B
INFLATION
vs
UNEMPLOYMENT (l a g g e d 1
__________________________________ UNE M P L O Y M E N T R A T E
CHART .6C
SCATTER DIAGRAM
U N E M P LOYMENT R A T E
year)
22
Chairman M i t c h e l l . I anticipate, Chairman Volcker, that other
members of the subcommittee will be joining us. The full committee
is in another day of hearings on the Chrysler bill, called by the Re
publican members.
I welcome you. I am very, very pleased that you could take time
out from what must be an absolutely frenetic schedule, to be with us
this morning. We anxiously await your words of wisdom.
STATEMENT OF HON. PAUL A. VOLCKER, CHAIRMAN, FEDERAL
RESERVE BOARD
Mr. V o l c k e r . I think perhaps the best way for me to proceed, Mr.
Chairman, is to read my statement, which addresses itself to at least
some of the questions that have been raised in your opening statement
and those of Mr. Neal and Mr. Leach.
I am pleased to participate in these hearings on the goals and con
duct of monetary policy. As you know, this is a subject that has been
the focus of considerable public attention and debate recently. That
attention is symptomatic of the widespread concern and uneasiness
about the performance and prospects of our economy.
All of us—members of the committees, members of the Federal
Reserve Board, and citizens generally—would no doubt prefer more
equable economic conditions, with the performance of financial policies
relegated to the back pages of the newspapers. But conditions being
what they are, I can only welcome this opportunity to contribute to
general understanding ot the problems we face and the approaches
we are taking to their soution.
I would like to set the stage for a dialog this morning by reviewing
briefly the decisions taken by the Federal Reserve on October 6,
indicating both the circumstances that prompted those decisions and
the objectives of our actions. In the process, it should be possible to
address in a fairly concrete way some of the broader issues of monetary
strategy that you have indicated you wish to examine.
Viewed from virtually any vantage point, economic developments
in the weeks and months immediately preceding the Federal Reserve’s
October 6 announcement were disturbing. The level of business
activity had dropped in the second quarter, and virtually all econo
mists were either predicting a recession or felt a recession had already
started.
As the summer ended, however, signs began to emerge of a sur
prising degree of strength in spending. Subsequently available infor
mation, such as the 2)k percent annual rate of increase in real GNP
for the third quarter, the large increase in retail sales in August and
September, and the record increase in consumer installment credit
for September has in fact confirmed this assessment.
In retrospect, the suspicion that the second quarter performance
was heavily affected by the shortage of gasoline seemed confirmed,
but the subsequent burst in spending was troubling because it seemed
to reflect in considerable part a “ buy now” attitude spurred by an
intensification of inflationary expectations.
Savings dropped to historically low levels, and some inventory
imbalances seemed to be developing. Such a pattern could temporarily
provide some strength to business activity, but if extended the clear
threat was that the ultimate result would be to deepen and prolong
23
anticipated adjustments in production and employment—adjust
ments that in part are related to the oil price shock.
These unsettling developments were plainly related to the inflation
ary situation. The most widely watched price indices had advanced to
a range of 13 to 14 percent increase at an annual rate. Many Americans,
as they struggled to balance their family budgets and suffered a con
tinuing erosion in the value of their savings, began to doubt the
prospects for a return to greater stability. While the acceleration of
inflation this year has in large part been a reflection of a surge in
energy prices, the question remained as to whether the higher rate of
inflation would not be built into wage and other cost elements in the
economy, defeating the prospects for some relaxation in price pressures
as the bulge in energy prices passed.
Consequently, in the absence of firm action to deal with inflation
and inflationary expectations, there was a clear risk that the runup in
energy prices would work its way into wages and prices generally,
thereby raising the Nation’s underlying inflation rate ana, among
other things, contributing to pressures on oil prices.
That risk was underscored by an apparent buildup of speculative
pressures in commodity markets in September, carrying with it the
potential of aggravating economic instability. Rapid price movements
in gold and silver markets, while not of critical importance in them
selves, seemed to reflect discouragement over our ability to deal with
inflation, and the atmosphere began to affect movements in the prices
of other metals. The danger was that the bidding up of prices in com
modity markets not only would in itself reinforce the inflationary
trends, but that it would lead to a brief and unsustainable surge of
buying.
These same expectational forces were reflected in an atmosphere of
increasing uncertainty in foreign exchange markets, and in September
the dollar weakened against a number of major currencies. The external
value of the dollar is sensitive to perceptions and expectations about
our economic prospects and policies, and especially to concern about
our ability to deal with inflation. And, given the central position of
the dollar in international financial markets, as well as the
impact of a decline in the value of the dollar on the prices of imports
renewed instability in foreign exchange markets could undercut pros
pects for dealing with inflation generally and for achieving moderation
in oil prices in particular.
Under these circumstances, there was in early October no conflict
or meaningful “ tradeoff” between the domestic and international
objectives of economic policy. Nor was there any real tradeoff between
inflation and unemployment. The clear and present danger was that
failure to deal with inflation and inflationary expectations would in
time produce more—not less—economic instability, ultimately with
higher prices and greater unemployment.
In that setting, the priority for policy was decisive action to deal
with inflationary pressures and to defuse the dangerous expectational
forces that were jeopardizing the orderly functioning of financial and
commodity markets. The Federal Reserve clearly had a key role to
play in this situation. Although the solution to the problem of inflation
should not reside with monetary policy alone, control over money
and credit is an essential part of the overall policy framework. In the
long run, inflation can continue only if it is nourished by excessive
24
monetary expansion. In the short run, it was clear by early fall that
the growth in money and credit was threatening too exceed our own
targets for the year, and was nourishing inflationary expectations.
Efforts had been made during the summer to slow this excessive rate
of money and credit expansion, largely by permitting money market
interest rates to rise, a process accompanied by several increases in
the discount rate. The October 6 actions involved a change in instru
ments and tactics to reinforce and underscore our intention to achieve
moderation in the growth of money and bank credit.
The new steps taken did not reflect any change in our basic targets
for the various monetary aggregates for 1979; they did provide added
assurance that those objectives will be achieved. In doing so, the new
measures should make abundantly clear our unwillingness to finance
an accelerating inflationary process and our desire to “wind down”
inflationary pressures.
One component of the October 6 package was a change in our
operating procedures. In recent years, with the support of this com
mittee and others, explicit targets for the growth of money have been
a central feature of our approach toward monetary policy. However,
the operational guide from day to day in conducting open market
operations has typically been the so-called Federal funds rate—the
rate established in interbank trading of reserve balances. Translation
of money stock objectives into day-to-day management of the Federal
funds rate is effective if the relationship between the public’s demand
for cash balances and short-term market interest rates is relatively
stable and predictable. But in an environment of high and relatively
volatile inflation rates, the relationship between interest rates and
money—or, for that matter, between interest rates and economic
activity—is more difficult to appraise. Moreover, the operating tech
niques over time may have contributed to excessive supplies of credit
by encouraging a view by banks or others that they could count on
access to liquidity at interest rates reasonably close to whatever levels
were currently prevailing.
Consequently, we are now placing more emphasis on controlling
the provision of reserves to the banking system—which ultimately
governs the supply of deposits and money—to keep monetary growth
within our established targets. In changing that emphasis, we neces
sarily must be less concerned with day-to-day or week-to-week fluctua
tions in interest rates, because those interest rates will respond to
shifts in demand for money and reserves. I would emphasize that, in
an important sense, our objective has remained the same: to achieve
the growth of money that we believe suitable to the Nation’s economic
goals. What is involved is a tactical change in the approach to control
of the money supply. We did not before, as we do not now, attempt
to maintain a fixed or predetermined pattern of interest rates over
time. But changes in interest rates will necessarily be observed and
evaluated over time, along with the entire array of economic and
financial variables, in reaching policy judgments.
We took two other actions on October 6. The Board approved a
1-percent increase in the discount rate so that restraint on bank
reserves would not be offset by excessive borrowing from the Federal
Reserve banks. And we placed a special marginal reserve requirement
of 8 percent on increases m managed liabilities of larger banks—includ
ing the U.S. agencies and branches of foreign banks—because that
25
source of funds, which is not included in the usual definition of the
money supply, has financed much of the recent excessive buildup in
bank credit.
Let me highlight a few points about our current approach, parti
cularly as they bear on the broad issues of monetary strategy raised in
Chairmen Mitchell and Neal's letter of invitation.
First, the effort to restrain monetary expansion in the face of strong
credit demands and rising levels of economic activity has initially
entailed increases in market rates of interest. Whether those increases
persist, or whether they subside rather promptly, will in the end be
determined largely by the course of the economy and inflation. Con
trol of the money supply is not synonymous with rising interest rates;
it all depends upon the performance of the economy itself. In the long
run, only the prospect of a lower inflation rate can create the environ
ment for a sustained and substantial reduction in interest rates.
Second, some other important industrialized countries have recently
experienced increases in their interest rates. These events have been
interpreted by some observers as implying the existence of an “ interest
rate war” in the pursuit of conflicting exchange rate objectives. That
interpretation seems to me unwarranted in circumstances where those
countries are responding reasonably to inflationary pressures in their
own economies.
There is, of course, always the possibility that national economic
goals and policies will not mesh. I know of no protection against that
possibility other than working continuously with our partners abroad to
insure that policies take into account our mutual interdependencies
and don't move in mutually damaging directions. Within limits, all
major industrial countries have several tools of economic policy at
their disposal, and particular elements can be emphasized or deem
phasized at particular times. Intervention in foreign exchange markets
can sometimes be helpful—although experience illustrates clearly that
intervention alone cannot substitute for more fundamental actions
over time if stability in exchange markets is to be maintained. We
continue, on a day-to-day basis, to monitor developments in foreign
exchange markets, and I am satisfied that if and when intervention is
necessary, our actions can be closely coordinated with those of key
monetary authorities abroad to maximize their effectiveness. Mean
while, we shall continue to consult with our trading partners to assure
mutual clarification of our policy objectives and decisions.
In that connection, I do not anticipate, in practice, the sharp
dichotomy between “foreign exchange” and “money supply” ori
ented monetary policy strategies outlmed in your recent letter. The
fact is that for the foreseeable future, a policy looking toward attain
ing and maintaining a noninflationary growth in money at home
would appear broadly compatible with our concern about the inter
national position of the dollar. I do not in any event view our domestic
and international problems as distinct and separable. Recent ex
perience has shown all too clearly that weakness in the value of the
dollar internationally is symptomatic of basic problems here at home.
It is fundamentally inflation that raises questions about the sta
bility of holdings of dollar-denominated assets or the outlook for our
balance of payments, thereby prompting recurrent downward pressures
on the dollar in exchange markets. And it is inflation and the distor
tions it creates that constitute a major impediment to the resumption
26
of balanced, sustainable economic expansion at home. In that sense,
the problems confronting us on the domestic and international fronts
demand a common response, and an essential element in that re
sponse must be a firm and credible monetary policy, seeking and
attaining appropriate restraint on growth in money and credit over
time.
The suggestion has been made that this process could be speeded
by setting out a specific target path for growth in the money stock
over a number of years ahead. Chairman Neal’s bill would incorporate
such a strategy in law. In examining this question, members of the
Federal Reserve Board remain of the view that there are decisive
drawbacks to setting out so precise a growth target over so many
years ahead.
We recognize that approach is rooted in a central element of truth:
that a return to price stability will require over time a substantially
reduced rate of monetary and credit growth. Indeed, the Federal
Reserve has often reiterated in the past the need to reduce growth
in money over time if we are to deal with inflation.
Moreover, some observers would go further, arguing that by clari
fying our intentions in a numerically precise and simply way, we
could more decisively change expectations about inflation, assist in
achieving a national concensus, and thus change behavior in a con
structive way.
However, experience shows that many forces can affect the financial
requirements 01 the economy at any time. Other governmental policies,
institutional changes, exogenous shocks to the economy—emanatmg
from both domestic and foreign sources—and changes in the public’s
money preferences can alter the relationship between money and
economic performance. Rigid adherence to a fixed money stock path
set for years ahead might therefore turn out to be inappropriate,
sometimes needlessly wrenching financial markets or unduly con
stricting our flexibility in responding to some cyclical or other dis
turbances. If, on the other hand, the targets are changed or interpreted
more flexibly, unnecessary confusion could arise and the basic rationale
would then be undermined.
Furthermore, even though we hope that our new operating proce
dures will bring some improvement, we must recognize that monetary
control will always be imprecise. Recent events indicate quite clearly
that even the problem of specifying precisely the monetary variable
that should be controlled over a period of years is a very knotty one;
what serves as “ money” in our rapidly changing financial system is far
from a constant.
For all of these reasons—and despite the underlying element of
truth in the broad proposition relating inflation to excessive monetary
growth—I think it would be a mistake to attempt to set rigid ana
narrow long-range monetary targets. A legislative approach—even
one with some built-in leeway—would raise the further basic question
as to whether the Congress would want to inject itself so directly into
these judgments filled with technical complexity and doctrinal con
troversy. It does not seem to be consistent with the approach taken
by the Congress in establishing the Federal Reserve System 65 years
ago, and consistently adhered to since, that these decisions should
emerge from a dispassionate, professional, deliberative process and be
shielded from partisan pressures.
27
I would strongly suggest that the present system under which the
Federal Reserve reports its intentions and its targets to the Congress
within the framework of the Humphrey-Hawkins Act is a much more
promising approach. It preserves a necessary degree of flexibility in
monetary management while providing a good basis for communica
tion. While our experience has been limited, the present arrangement
seems to be working well. The line of responsibility and accountability
is clear.
I am sure other members of the Board, as myself, have profited
from your attention to these important issues of monetary policy. We
particularly welcome your concern with developing policies appropri
ate to the longer term future, and look forward to working with you
as we develop and announce new monetary targets.
Chairman M i t c h e l l . Thank you, Mr. Volcker. That was a very
comprehensive statement indeed.
There are some questions that still remain in my mind, and I am
certain in the minds of the other members of the subcommittees.
Ordinarily on the subcommittee, Mr. Volcker, we operate in a very
informal fashion. However, today I think we will operate under the
5-minute rule to allow all members to put questions to you. I will
lead off and I will take my 5 minutes first.
Recently there have been a number of press reports concerning the
earnings and liquidity squeeze in some thrift institutions. I assume
that these press reports are correct. Will the Federal Reserve Board
be prepared to extend advances or other credit to any of these insti
tutions should the current problem become aggravated?
Mr. V o l c k e r . Y o u may recall, Mr. Chairman, that plans along
that line were developed m 1974, the previous period of this sort.
We have reviewed those plans. I am satisfied that we have the ability
to deal with any extraordinary liquidity problems that may arise, as
part of our role as lender-of-last-resort.
Chairman M i t c h e l l . Could you enlighten me just a little bit more
on the details of those plans?
Mr. V o l c k e r . The plans, fortunately, never needed to be imple
mented before. We do have authority to lend to non-member banks
in extraordinary circumstances; or, we can, potentially, lend to a
member bank and the member bank in turn could lend the funds to
another institution. Plans were developed in 1974 to take advantage
of either of those avenues in the case of a soundly managed institution
that ran into extraordinary liquidity problems. We have reviewed
those plans, and I think they could be used to deal with the kind of
situation that you envisage.
Chairman M i t c h e l l . Certainly interest rates have gone up since
October 6, and I assume that this was not a total surprise to you. I
want to ask, first, whether there have been any developments in recent
days, which give you any hope at all that interest rates may begin to
drift down a bit—at least short term rates?
Mr. V o l c k e r . In the most recent days there has been quite a sharp
drop in interest rates. Interest rates, under the operating procedures
that we are now following, should reflect, as I indicated in my state
ment, changes in demand in the marketplace for credit and money;
over a period of time they should reflect economic activity, and partic
ularly both the facts and expectations about inflation.
28
I think it is too brief a period to draw any very profound conclusions
about what is going on. But we had a period in October when interest
rates went up quite sharply, as you know, and in part that reflected
the fact that business activity was indeed stronger and inflationary
pressures were probably stronger than almost anyone had anticipated.
Whether this change in trend m the last few days is meaningful or not,
I think only time can tell.
Chairman M i t c h e l l . I think the members of the subcommittees
were very wise and prudent in waiting about a month before we started
look'ng into this issue. Unfortunately, a number of the committees
of the Congress immediately jumped on the Fed:----Mr. V o l c k e r . I agree w i t h y o u .
Chairman M i t c h e l l (continuing). Though there is no way in the
world we could determine what the impact was, or would be. We
thought we would wait at least 30 days.
Concerning the impact of the policy changes instituted on October 6,
you mentioned in your testimony some of the more encouraging signs
related to those policy changes. Let me ask: What, if any, develop
ments do you find discouraging as a result of the policy changes you
instituted?
Mr. V o l c k e r . I am not discouraged by any of the results I see. I
have noted, as other people have noted, that the strength of infla
tionary forces in the economy is at least as great as we anticipated at
the time that we took those measures. Ana there is a good deal of
uncertainty about the oil price situation, in particular, I think that is
going to have a large bearing on the way the economy develops in
coming months, the way inflation develops in coming months, and
therefore the way the credit markets respond to our initiative.
But basically, while we have had a good deal of turbulence in
financial markets—or did earlier in October at least—and while no
one ever likes to see that degree of turbulence, as we have gained a
little perspective, as you suggest—with a month or so having passed
—I feel somewhat encouraged by the results of the initiative.
Chairman M i t c h e l l . My time is up. We are dealing with such a
thorny and complex area. Do you find it at all discouraging that there
has been no impact on the rate of inflation—or is that simply because of
the time factor.
Mr. V o l c k e r . In my judgment, it is clearly too early to see that
kind of an impact, Mr. Chairman. It will take months literally before
we could really expect to see any concrete evidence of this action on the
rate of inflation. The near-term inflation figures are going to be im
portantly impacted by whatever decision is made on oil prices in
December.
Chairman M i t c h e l l . Chairman Neal?
Chairman N e a l . Thank you, Mr. Chairman.
Mr. Volcker, you say on page 12 that the present system whereby
the Federal Reserve reports its intentions and its targets regarding
money growth is a much more promising approach than the Neal
bill, which legislates a path for money growth from now through 1984.
I find that somewhat puzzling, in view of the fact that from late
1977 until now the Federal Reserve’s money growth intentions haven’t
been lived up to, and its targets haven’t been hit. Why then, in your
opinion, is the present system more promising?
29
Mr. V o l c k e r . I hope that we will hit those targets in 1979; that is
part of the rationale of the recent actions we took. Again, there is no
certainty in this area, and the money supply on a month-to-month
basis can be elusive, as some of your statements suggested.
But I would point out in that connection, Chairman Neal, that it
was only in the beginning of 1979, as I recall it, that we really adopted
the full Humphrey-Hawkins approach—where we had a target for
a year which we reviewed in mid-year for the same time period and
then, on a tentative basis, extended that target out 1 year beyond, to
1980 in this case.
Earlier, as you recall, we had been reviewing these targets quarter
by quarter and had fallen into the habit—not a very good one, in
my opinion—of using the previous quarter as a base, so whatever had
happened up until the time we announced a new target was incor
porated as a base for the new projection.
The Humphrey-Hawkins procedure, I think, has provided a little
clearer base for the formulation and announcement of these targets,
and we have really only had 1 year’s experience with it.
Chairman N e a l . Well, we would be doing essentially the same
thing by House Congressional Resolution 133.
Mr. V o l c k e r . It is a modification of the earlier procedure, but it
is a modification that happens to make it a little easier, I think, for
you and others to hold our feet to the fire as to whether we hit a
target during a particular year. The previous procedure involved a kind
of rolling target, and it was always a question of whether we hit or
whether we didn’t hit it.
Chairman N e a l . Well, just looking at the targets set out in that
bill and subject to the assumption that background conditions would
remain essentially constant, would that target path for monetary
policy, would you find that a sensible one?
Mr. V o l c k e r . My main reaction to the bill, I think Chairman Neal,
is that it required quite a narrow path I can’t complain that it did not
move quickly enough toward a level more consistent with price
stability, but I react to the narrowness of the ranges, the implied
rigidity. While you gave the Federal Reserye a little bit of leeway in
altering the target—aiming at a 1 percent band, as I recall, with room
changing that by only 1 percent—that really isn’t enough room to
recognize the uncertainties of the situation, the difficulties of even
defining the money supply that closely, of allowing for the variety of
influences which really can alter the money/economic relationship.
And, I think that is the kind of problem you get into if you try to
legislate so definite a path that far ahead. But I very much welcome
and agree with the notion that we have got to follow that kind of a
broadly declining trend if we are going to restore price stability.
Chairman N e a l . Where, in your opinion, should we be say 5 years
from now?
Mr. V o l c k e r . Five years from now I would like to be around that
level that you suggest in your bill. I think experience shows that using a
kind of present Mi concept, the increase in that particular figure should
be very small if, indeed we are serious about price stability.
Chairman N e a l . Well, I would say we are in general agreement.
Let me say also that I really do not want to see us have to pass a bill.
That isn’t really what I want.
5 5 - 1 2 3 0 - 8
0 - 3
30
Mr. V o l c k e r . Right. I understand.
Chairman N e a l . It was only introduced out of a sense of frustra
tion-----Mr. V o l c k e r . T o illustrate the point.
Chairman N e a l [continuing]. That we were seeing the money
supply go up and down, keeping the economy on a roller coaster kind
of pattern. It just seems so important to me that if you at this point
could announce, even if not in absolutely rigid terms, a strong commit
ment on the part of the Board to follow-----Mr. V o l c k e r . T o bring it down gradually.
Chairman N e a l [continuing]. To bring it down gradually over a
period of about 5 or 6 years, and make some kind of very strong
commitment to this course, recognizing that there could be some
exogenous shock that could cause us some problem, and leaving
yourself a little leeway, that this more than any other single action
could remove the uncertainties surrounding financial conditions in
our own contry. It would bring down the rate of inflation; you would
see the stock market soar; you would see the value of the dollar
stabilize. I think you .would see employment go up and interest rates
come down.
So I just cannot think of any single thing that the Fed could do that
would be more beneficial to this economy, and I just don’t understand
your hesitancy.
Mr. V o l c k e r . In broad terms I have great sympathy with that.
The difficulty and hesitancy in my mind—and certainly m the minds
of many members of the Board—is that as you try to make the path
more and more explicit, the greater these reservations and questions
and difficulties arising out of what might happen in particular circum
stances in the future, what institutional changes might take place,
what outside shocks might arise. The more definite you become then,
if you do have to change, the more you raise the question of how firm
your intentions were in the first place. It is a difficult balancing decision.
In concept, I agree with you, and I welcome the emphasis that the
subcommittees put on the necessity, over a period of time, to reduce
monetary growth because I think that emphasis is correct. We can
argue about how precisely to state that, with what degree of rigidity
and narrowness, but broadly I think it is necessary to bring down
those increases in the money supply; I don’t have any quarrel with that.
Chairman M i t c h e l l . Tne Chair would like to observe, before calling
on Congressman Leach, that I too face an enormous frustration in
terms of the implementation of the Hawkins-Humphrey Act. While it
is clear that this subcommittee, or indeed both these subcommittees,
are supportive of moving monetary policy in the direction of 3-percent
inflation per year, there is no discernible purposive action taking place
right now to bring unemployment down to the 4-percent goal suggested
by the Hawkins-Humphrey Act. Indeed, we are moving in the opposite
direction. Both the Congress and the President have set forth policies
which, I suspect, will inevitably result in an increase in unemployment
to be borne disproportionately by blacks and Hispanics. Though that
is really not under your control, I must share with you my sense of
frustration in implementing just one-half of the Hawkins-Humphrey
legislation.
Mr. V o l c k e r . If I can just comment briefly on that, Chairman
Mitchell, I think there is a good deal of evidence that the kinds of
31
level of unemployment that we reached in the aggregate in this
country in the past couple of years may be about as far as we can go
through aggregate demand measures without creating severe infla
tionary problems.
Now that leaves us with an intolerable unemployment problem, as
you suggest, centered particularly in cities ana urban areas, among
minority groups. But it does seem to me that the great challenge in
that direction is developing actions and programs that can deal with
that very great unemployment challenge, particularly in our cities.
You live in Baltimore; I live in New York City. You go around
those cities and see, on the one hand, a great need for things to be
done and, on the other hand, great numbers of unemployed people.
You have to recognize that something is the matter; how do we get
those needs together with the people?
I feel very frustrated about our ability to do that through national
monetary policy or national fiscal policy, but there certainly must be
methods by which that problem can be met and it must be met more
effectively than we have been doing.
Chairman M i t c h e l l . I will return to that later, but I am encroach
ing on Congressman Leach’s time.
1 recognize Congressman Leach for 5 minutes.
Mr. L e a c h . Mr. Volcker, you point out that monetary policy is
always going to be imprecise because what serves as “ money” is not
always constant. Would you welcome legislation authorizing the
Federal Reserve Board to establish reserve requirements in non
banking areas where near-banking functions are performed?
Mr. V o l c k e r . We have a piece of legislation that goes some dis
tance in that direction, Congressman Leach, in the form of H.R. 7 in
the House or Senator Proxmire’s proposal in the Senate, and I very
much hope that the Congress will act on that legislation in this session.
It does adopt as its basic point of departure that institutions doing
comparable business—and particularly doing money-supply business,
so to speak, holding transactions balances—should be subject to the
same reserve requirements. The bills also provide that they would be
subject to the same reserve requirement on their time-deposit business,
to the extent they are covered at all.
Mr. L e a c h . What about, for example, money market and travelers
checks?
Mr. V o l c k e r . Travelers checks, yes. But money market funds are
a prime example of relatively new innovations that have come along,
“new” in the sense of having any sizable quantitative impact.
I think it does raise some questions, while it is very new particularly,
as to whether it is in effect a transactions account business and whether
as to whether it is in effect a transactions account business and
whether, over any period of time, institutions can have it both ways—
do a transactions account business, but not be subject to, let’s say, the
reserve requirements applied on other institutions doing a transac
tions account business.
Mr. L e a c h . Y o u also point out in your testimony that the third
feature of your October 6 announcement was placement of an 8-percent
marginal reserve requirement on certain managed liabilities of the
larger banks.
This strikes me as a bit of an anomaly because effectively it expands
the Eurodollar market while at the same time creating a disincentive
32
for bringing some of these funds back here; therefore, it increases dol
lar availability abroad rather than at home.
Is this a policy that you expect to maintain?
Mr. V o l c k e r . N o .
Mr. L e a c h . Is it only for the short term?
Mr. V o l c k e r . The first answer I would give you is that these were
measures taken to deal with a particular situation, at a particular time,
and they do inevitably have some anomalies attached to them. They
put impediments on the functioning of markets that create some dis
tortions, and I would like to dispense with them as soon as practical,
as soon as the credit expansion that has heen fed by these instruments
comes under control and as soon as I think there is a strong and clear
signal that they have outlived their usefulness.
I don't expect the effects on the Euromarket, viewed in this kind of
temporary context at least, to become really significant. There are
some anomalies in that we do put on an inhibition—quite deliberately,
as you suggest—on the use of Eurodollars back in the United States,
while there is no similar inhibition on the flow of money from the
American market into the Eurodollar market.
Now the smaller demand on the Eurodollar market for transmittal
of those funds back to the United States will, in effect, have some
influence on the incentives for the money to flow out, so I do not
expect that to become a major problem in the time period we are
talking about. But there are anomalies in the situation.
Mr. L e a c h . Obviously higher interest rates impact differently
across the economy, and most of us know the construction industry
particularly housing, is hit the hardest.
Mr. V o l c k e r . Right.
Mr. L e a c h . Do you have any advice about how we might cope with
this situation which in effect the Federal Reserve has, if not created,
at least exacerbated?
Mr. V o l c k e r . Let me start with one general comment just to p>ut
it in perspective. I myself believe that by attempting to deal with in
flation more effectively over not so long a period of time, homebuilding and construction will be maybe less impacted than if we had just
let the situation drift, because eventually they would have been sub
jected to a squeeze in these circumstances anyway, without any clear
termination point.
But, given the situation that does exist, I think the question does
arise as to whether some selected measures can't be taken, or should
not be taken, to relieve some of the impact on the homebuilding in
dustry if this period turns out to be at all prolonged.
There are a variety of techniques that have been used in the past,
some of which require legislation and some of which do not. The
Federal Home Loan Banks reduced their liquidity requirements
some weeks ago; they have undertaken some additional borrowings
of their own so that they can expand the level of advances to the
savings and loans. In the legislative area, some special mortgage
>rograms were developed in the 1974-75 period which I think are at
east worth review at this point to see whether the time might have
come where some of those programs might be triggered.
Mr. L e a c h . But you d o think interest rates will remain high?
Mr. V o l c k e r . I w o u l d h o p e , i d e a l l y , t h e y w i l l n o t b e , b u t w e j u s t
f
w ill h a v e t o w a it a n d see. I w o u ld lik e t o see th e s itu a tio n r e s o lv e
33
itself and interest rates move in the other direction as soon as they
can, but that will depend upon economic developments that can’t
be predicted with absolute certainty at this point.
One of the advantages that many people see in our new technique
is that, should the economy move lower, there is some sense in which
the credit markets ought to respond almost automatically—to use
that word—more quickly toward the visible signs of declining interest
rates and easier credit availability than might have been the case
with the techniques that we were following earlier.
Mr. L e a c h . Thank y o u , Mr. Chairman.
Chairman M i t c h e l l . Congressman LaFalce?
Mr. L a F a l c e . Thank you very much.
Mr. Volcker, it is a pleasure having you with us. I believe this marks
your first appearance before any subcommittee of the House Banking
Committee, at least as the chairman-----Mr. V o l c k e r . In this particular incarnation.
Mr. L a F a l c e . I wanted to just ask you a broad question first.
That is, how do you conceive of your role as Chairman of the Federal
Reserve Board? And that is a difficult question to answer, but is it
one primarily as the determiner of the monetary policy? Do you see
yourself also as an outspoken advocate regarding not just the monetary
policy but perhaps the fiscal policy, because they must mesh?
Do you see yourself as an independent spokesman on issues such
as tax matters, spending matters, et cetera? Should you have a voice
when it comes to issues such as rollback of social security taxes,
tax incentives to spur savings and investment to help productivity?
How do you view your role?
Mr. V o l c k e r . Let me say first of all, Mr. LaFalce, that I think
the day when a central banker could be entirely in the background
and disappear into the mist of some arcane traditions of central
banking—seldom appearing in public, and if appearing in public
only to make delphic statements—are probably gone. They are gone
because whatever his personal predilections may be, that is not
consistent with life in this particular democracy anyway and re
quirements to appear before the Congress and so on. But basically
Mr. L a F a l c e . Are you drawing a distinction between a chairman
who smokes a pipe and one who smokes a cigar?
Mr. V o l c k e r . N o , not at all. All the smoking chairmen have been
out in public, I am afraid, one way or another, whatever they smoked,
and I think it is probably a good thing-----[Laughter.]
Mr. L a F a l c e . Y o u are not suggesting-----Mr. V o l c k e r . N o , no-----[Laughter.]
Mr. V o l c k e r [continuing]. There was nothing devious about that
suggestion.
And I think it is probably a good thing. You have to be out; you
have to be a spokesman and defend your policy and explain what
you are doing because the success of the policy depends upon under
standing. That is why I value so much the dialog with these sub
committees and the emphasis that you have placed upon this basic
relationship between money and inflation over a period of time.
34
Now the degree to which a chairman wants to get outside the
monetary policy area is another question. It seems to me, in general
terms, a chairman can’t help but refer to key elements in economic
policy that impinge upon his own job and impinge upon the outlook
for the economy. At the same time, there is some vague dividing line,
in my judgment, as to avoiding issues that are a matter of great
political and social debate. Economic repercussions of such issues are
one thing, but one’s own competence in dealing with the political and
social aspects of an issue I think is properly limited and should not
be a matter of public discussion.
Mr. L a F a l c e . Well, leaving you discretion to act with what I
erceive as an expansive role, but exercised prudence, I have a numer of concerns and I would ask for your opinions on these concerns.
First, I really think that our legal regulatory framework, as it has
historically evolved, has created incentives for consumption and dis
incentives for savings, to a certain extent; and your new monetary
policy, if I can call it that, certainly strives to curb, in part, specula
tive consumption. I am wondering what else we ought to be doing,
both in the fiscal and monetary policy, to encourage savings and
investment with an appropriate balance.
Mr. V o l c k e r . I have no hesitancy about speaking in very general
terms about the need for tax programs that do address the balance of
investment and consumption. It seems to me the tax structure that
we have lived with during the postwar period—that we inherited in
good part in World War II, and modified through the years—is
almost peculiarly designed to impinge upon investment. Investment
has been heavily taxed.
As we find it possible to make tax reductions—and we hope that
that becomes possible, even though the time is not now—I hope
that increased emphasis will be put on investment incentives m
particular. I tend to think the savings will flow if the investment
incentive is there, and I put the emphasis on the “ investment incen
tive” side, rather than the “ savings” side.
Mr. L a F a l c e . Well, I appreciate that, and I think that is probably
something that most Congressmen could and would assent to with no
pain whatsoever, to give incentives to someone, but I don’t want it to
affect one side of the equation. But what about doing something that
would affect consumption by way of addressing ourselves to tax policies
that presently give an incentive to consume, and perhaps limiting that.
Mr. V o l c k e r . Are you thinking o f the “ value added” tax?
Mr. L a F a l c e . Well, no. I am talking about the fact that we now
can deduct every penny of interest on borrowed money, and certainly
we are having government subsidy of debt, and private debt has in
creased tremendously, as has corporate debt, which could not be
altered, corporate debt would be written off as a business expense-----Mr. V o l c k e r . Correct.
Mr. L a F a l c e . But is it desirable to do something about the private
debt? What is your position as to the import of that?
Mr. V o l c k e r . Y o u are really getting into an area where perhaps I
should not comment in detail, but I would not think the deductibility
of interest on the Federal personal income tax is a major problem in
this connection. Indeed, I think it is rather difficult to deal with
interest in any other way, because clearly borrowings that are under
taken in an effort to increase income, as by a business, should be
E
35
deductible. But where can one draw the line between what is properly
deductible and what is not?
I suppose a tax reformer would tell you that the proper way to
approach that problem might be to impute the income on an owneroccupied house, as some foreign countries do, but that is an area where
I am just really not competent to draw up a tax reform program at
this stage.
Mr. L a F a l c e . I ask the question only because it seems to me that
we must do something on a fiscal basis insofar as our legal framework
is concerned to mesh with what you are attempting to do with your
monetary policy.
Mr. V o l c k e r . Yes, I agree with that, but I have not myself ap
preciated the problem so much as one of a specific exemption or incen
tive that is given to consumption through the income tax, as one of
the general balance between various types of taxes; and taxes that are
placed on investment seem to me pretty heavy.
Chairman M i t c h e l l . Congressman feitter?
Mr. R i t t e r . Thank y o u , Mr. Chairman.
I would like to thank Mr. Volcker for coming before our subcom
mittees today. I know a lot of my constituents all of a sudden are
very interested in interest rates who probably didn’t understand too
much about-----Mr. V o l c k e r . Certainly.
Mr. R i t t e r [continuing]. Interest rates, since the October 6 act
went into effect. Many people consider that the Fed’s restraining
actions, however, are only part of the picture. Many of my constit
uents are more and more coming to the opinion that the Govern
ment spending and the deficits arrived at are root causes of inflation,
and that the Fed’s measures wouldn’t be so harsh, or considered to
be so harsh, if the Congress itself was doing its share and restraining
itself fiscally.
I am just wondering what you think about the relationship be
tween what you are doing now and what Congress has done or has
not done in the recent past, and whether or not—the second part
of the question is: Should the Fed treat monetary policy in some way
divorced from the fiscal responsibility of others are you not in a sense
covering up for the past mistakes of the Congress in simply spending
well beyond its means and achieving deficits of a national debt worth
$900 million?
Mr. V o l c k e r . I am not sure I agree with the words “ covering up.”
In some sense-----Mr. R i t t e r . No; “ covering up” is the wrong phrase.
Mr. V o l c k e r . We have to deal with the situation-----Mr. R i t t e r . It is “ compensating for.”
Mr. V o l c k e r . To some degree, I think that is true. In that sense
we are at the end of the line; we have to evaluate everything else that
has gone on that impinges very much on inflation and the performance
of the economy including, most importantly, fiscal policy. I mean,
there is no question in my mind that a more restrained budget over
the years, smaller deficits over the years and maybe some occasional
surpluses at least, would have made our job easier and resulted in
less of an inflationary problem than we now have.
I just want to draw a distinction between what has happened over a
large number of years and what is happening currently. In a sense,
36
fiscal policy also inherits the past, as we inherit fiscal policy. In the
past year or two, I think a good deal of progress has been made in
restraining inexorable growth in government spending and reducing
the size of the deficit. We started from a very unsatisfactory situation,
but if you ask me whether, as a practical matter, a great deal of prog
ress can be made right now toward balancing the budget or indeed
reducing expenditures in a 1-year time period, I would have to say I
doubt if anything dramatically different could be done. But it is very
important, over a period of years, that we keep at this and, as with
the money supply figures, hold out that target of getting the deficit
down toward zero; I think we have to hold that target out in front of
us in fiscal policy, too.
Mr. R i t t e r . Being a new Member and watching the way the
Congress authorizes, appropriates, and then votes on legislation
requiring that Government spend money, it really seems to me that
what we are talking about is needing more congressional discipline
because of rampant double-digit inflation. I haven’t seen it. I may be
missing something, not having been here over the years, but it seems
that the kind of free-spending ways of Congress—I hate to use a
cliche—but if there is a perceived need, then Congress will come along
and spend that kind of money. We’ve just gone through this in a num
ber of areas—energy being one, fuel stamps another—nobody even
talked about where these funds were coming from. It’s as if they were
there in some unlimited sinkhole of money.
Mr. V o l c k e r . I suppose it depends upon one’s personal perspective.
I suspect you might have been even more discouraged 5, 10 years ago.
Congress has gone through this process of establishing the budgetary
committees and bringing together a budgetary resolution. It’s always
hard to identify concrete results, but I feel somewhat encouraged, on
balance, by the sense of concern that I think I have observed in the
Congress about spending and about the deficit in general relative to
earlier periods perhaps; I have been encouraged by the budgetary
process.
Mr. R i t t e r . I know my time is up, but I have one other observation.
Is it possible that by the Federal Reserve taking its actions which deal
essentially with borrowing and credit in the private sector, we further
overburden the mix between private and Federal toward the Federal?
In other words, the Federal continues more or less unabated or at
a very, very different rate of expansion, and the private gets-----Mr. V o l c k e r . If that happens, I think it is bad. If you had to persist
with this kind of pressure on the private credit markets for a long
period of time, I think that danger would exist and only reinforces
your basic point of the need for restraint on the governmental side.
Mr. R i t t e r . Should the Federal Reserve be telling the Congress in
no uncertain terms to put its own house in order fiscally?
Mr. V o l c k e r . There is no question that the more responsible the
Congress and the Executive are on the fiscal side—in very concrete
terms, the less money that you spend for the Government, the smaller
the deficits are—the easier our job will be in dealing with inflation
and the more ample the supply of funds will be in the private markets.
I think this has consequences over a period of time for the productivity
of the American economy-----Mr. R i t t e r . Absolutely, and I think it has had consequences in the
past 10 years as we have seen declining rates of productivity.
37
Mr. V o l c k e r . And, in a sense, the most serious manifestation of
the problems that we have had in recent years is the fact that pro
ductivity seems to be declining so inexorably; in the past 12 months
or so, it has actually been negative.
Now I hope that is a temporary phenomenon, but unfortunately-----Mr. R i t t e r . I think you should voice this in both Houses of the
Congress on this matter.
Thank you, Mr. Chairman.
Chairman M i t c h e l l . Thank you, and I think past Chairmen, or
Chairpersons, of the Federal Reserve have indeed spoken to the Con
gress issuing admonitions and warnings in terms of how we conduct
fiscal policy, but this morning’s hearings are primarily centered on
monetary policy.
Mr. Volcker, it is clear that you are suffering from a cold. Could
you stay for one more round of questions?
Mr. V o l c k e r . I will stay as long as you like. Just ignore the occa
sional cough, Mr. Chairman.
Chairman M i t c h e l l . I would suggest that we just take one more
round of questioning, and then after that we can reduce our questions
to writing and submit them to you for the record.
Mr. V o l c k e r . I am feeling perfectly well—I may not sound that
way, but I am—so don’t.
[Laughter.]
Chairman M i t c h e l l . Let me assure you it is just the compassionate
side of Chairman Mitchell that has demonstrated itself this morning.
[Laughter.]
Chairman M i t c h e l l . Let me get back to monetary policy. I have
two questions—one with reference to unemployment; the other with
reference to whether you have room to maneuver in regard to Mi
growth between now and the end of the year.
I recall when Mr. Miller was in your spot, and I also recall when Mr.
Blumenthal was the Secretary of the Treasury; they both appeared
before this subcommittee in hearings and I posed the question to them
that I am going to pose to you this morning: If indeed unemployment
should reach 7% percent, or 8 percent, or 9 percent at the extreme, in
1980, what would you do? Do you anticipate any increase in your
money growth targets? In your open advocacy role with few restraints
on it, would you suggest to the Congress that we pinpoint programs to
directly employ the unemployed? More specifically, would you support
a countercyclical fiscal program if we reached those astronomical rates
of unemployment?
Mr. V o l c k e r . It is always difficult, as you will appreciate Mr. Chair
man, t o try t o answer a q u e s t i o n of that s o r t , t r i g g 3 re d only by a
single number, because another part of the question that immediately
occurs to me is: unemployment is at 7% or 8 percent—whatever
number you use—but what is the outlook? And my response to the
question would be quite different if I thought that 8 percent were the
bottom and it was immediately going to begin rising, or whether there
was a big question about whether that was the case. I think you can
recognize that it is almost impossible to answer, in a fully satisfactory
way, that kind of a hypothetical question.
Let me say, so far as monetary policy is concerned, under those kinds
of conditions you would expect, quite naturally, a free flow of credit,
lower interest rates, significantly lower than we have now without
38
artificially increasing the money supply—maybe “ artificial” isn't the
right word—but without consciously increasing the money supply at a
greater trajectory than had been planned.
I would suspect that monetary policy would have made its best
contribution by encouraging the thought that over a period of time we
could achieve these lower rates of monetary growth that are neces
sary—as we were discussing earlier—while permitting the easier
market conditions to show through and to influence spending in the
economy.
Now whether or not, on the fiscal side, programs would become
necessary, it seems to me terribly important—in line with a conversa
tion I just had with Mr. Ritter—that we be extremely cautious about
programs that add to spending over a period of time and that may not
even be cranked up, so to speak, until the most urgent time has passed,
but rather leave us with a new trajectory of Government spending or a
new level of Government spending that would create difficulties in the
future.
On the other hand, going back to the earlier conversation with Mr.
LaFalce, if it is true that we need programs—either spending or tax
programs, although one tends to think of tax programs perhaps as
being larger—that can contribute to the productivity of the economy
over a period of time, can contribute to needed investment activity,
can contribute over a period of time to solving some of those structural
problems which you and I were addressing earlier on the unemploy
ment side, there is obviously more opportunity to do that kind of
thing if the particular timing makes sense in the overall cyclical
situation.
So I think you would think about programs that have their own
justification in the long run, that have a high payoff in the long run,
and therefore have their own rationale as being the kinds of programs
that you could think about if their particular timing makes sense
for the economy generally in adverse cyclical circumstances.
Chairman M i t c h e l l . Thank you very much for that answer. I
must confess that I was somewhat perturbed by the responses that
Mr. Miller and Mr. Blumenthal gave last year and the year before.
They appeared to say that no matter what happens we are going to
stonewall it. I believe that kind of rigidity was not desirable.
Mr. V o l c k e r . It depends on what you are stonewalling, I suppose.
There are tilings that I would like to stonewall, too; but my caveat
is that programs considered be truly constructive for the long term.
Chairman M i t c h e l l . I understood you loud and clear—“ and
targeted.”
Mr. V o l c k e r . Right.
Chairman M i t c h e l l . Many politicians, as well as economists, are
saying that as a result of the policies that you instituted on October 6,
there really is relatively little maneuvering room for M x growth
between now and the end of the year. As a result they fear a credit
crunch. I am inclined to disagree with that. Your target range this
year for Mxgrowth has a 6-percent ceiling. True?
Mr. V o l c k e r . Right.
Chairman M i t c h e l l . Now it would appear to me that even if you
achieve 5.5 percent Mx growth in 1979, the volume or stock of Mx
money could average $381 billion in November, and around $383
billion in December. In October it averaged $379 billion. Thus it
39
seems to me that you have ample maneuvering room for Mx to grow
to prevent a credit crunch. Is that a correct assumption on my part?
Mr. V o l c k e r . I do not have those precise numbers in my head
at the moment, Mr. Chairman, but we obviously thought it was
possible to meet these targets without a crunch. Even acting as we did
m October, which didn’t leave us much room before the end of the
year, we were not for the year as a whole appreciably above our
target. The trajectory was moving very rapidly above the target, but
we didn’t face the problem of actually having to curtail the growth
of money to meet the target this year. We still had room for growth
in the 4- to 5-percent area on a monthly basis from September to
December, as I recall the numbers, which seemed feasible and I still
think is feasible.
Now what we don’t know right now—and perhaps will never know
perfectly—is how closely we can really control the money supply on
a month-to-month basis. We certainly can’t do it on a week-to-week
basis. I am sure we can’t do it at all perfectly on a month-to-month
basis. We have a quarter to work with here; we expect we can get
somewhat better control over the quarter. The figures we have are
consistent with our objective, but it is certainly too early to tell.
But, basically, I think it is reasonable to expect we can meet that
objective. In this uncertain world, I won’t say it is 100 percent cer
tain; it is not. We will see what November and December bring, but
I think we have a reasonable chance of reaching it.
Chairman M i t c h e l l . Thank y o u . M y time has expired.
Mr. V o l c k e r . Particularly for M1# I might say, the M2 number
has been running further above the target than-----Chairman M i t c h e l l . And let me say, I don’t think there would
be a great deal of hue and cry in Congress if you got up to 6.5 percent.
Mr. V o l c k e r . The 6 percent itself is based upon a particular
estimate of NOW accounts and ATS, and is going to have to be re
viewed again; so that figure may vary a little bit, but it would not be
very- much.
Chairman M i t c h e l l . Thank y o u . Chairman Neal?
Chairman N e a l . Mr. Volcker, what relationship do you see be
tween the value of the dollar on exchange markets and U.S. interest
rates? What has happened to the dollar exchange market since Oc
tober 6? And what would you expect for the future?
Mr. V o l c k e r . Since we took our actions—more explicitly, since a
few days before we took the actions when they were widely antici
pated—the dollar was up 3 or 4 percent across the board, as I recall
the numbers. That reaction has certainly been satisfactory. The dol
lar has been quite steady in the markets; it hasn’t required any
intervention.
In general, as I suggested in my statement, I don’t see that much
difference between our so-called international objectives and our
domestic objectives, because they are both very much related to the
inflationary problem.
Now all other things being equal, a change in relative interest
rates—in this case, higher interest rates in the United States relative
to abroad—will help the dollar, but that is only one of a number of
influences; it can be swamped by negative influences, or it can be
unnecessary if other influences are strongly positive.
40
In this case, what I think is most crucially important, is whether
there is some confidence that we can deal with this inflationary problem
over a period of times and whether our balance of payments will get
better. And, so long as there is confidence in those two developments—
I don’t think there was much confidence in the summer, but as con
fidence can be restored—the dollar in the exchange markets, in my
judgment, will not be terribly sensitive to small changes in the abso
lute interest rate differentials, because these other factors can well be
more important or more constructive in terms of the outlook for the
dollar.
[Chairman Volcker subsequently submitted the following informa
tion for inclusion in the record of the hearing:]
Looked at another way, the dollar might strengthen as our inflation rate
declines. With lower U.S. inflation, U.S. interest rates may decline relative to
those abroad, consistent with a strong dollar.
Chairman N e a l . On another subject, if I can, I understand that
you played an instrumental role in setting up United States and
international monetary policy during the period in the early 1970’s
when we left the fixed exchange rate system and changed the rules of
the IMF to permit floating exchange rates.
Many economists and officials, particularly in Europe, have come
to the conclusion that floating exchange rates don’t work. Within
Europe, they are trying once again to establish the fixed exchange rate
regime, and many voices are calling for a more tightly managed ex
change rate system between Europe, the United States, and Japan.
Have floating exchange rates failed?
Are there specific reforms we should pursue in the international
monetary system in addition to domestic—well, to make floating
exchange rates more stable?
Mr. V o l c k e r . Let me give you a general answer to that very
important question—which we could go on discussing for hours.
The major difficulty, in my judgment, with the floating rate system
was not “ floating rates” in and of themselves. We are living with
floating rates; they have worked in a very real sense. But it does seem
to me that many people interpreted them as a kind of license, as
meaning that all international constraints were eliminated. It seems
to me that is patently untrue. If you are going to live in an inter
dependent world and a highly integrated world, you cannot escape
the consequences of living in that world, and some of those consequences
come to you, if you ignore this fact, through highly volatile exchange
rates, which in turn feed back on the behavior of your own economy.
I think that basic truth was pretty much ignored for a period of
time. We were in a floating exchange rate system and that was true
of some other countries; we felt a wonderful sense of freedom at having
eliminated an international constraint. It affected our behavior, but
we found out in the end that the snake came back and bit us when the
exchange rates got highly volatile and began undermining what we
were trying to do at home and undermining, I think, the position of
the United States in the world at large.
I think the floating exchange rate system, as a technical matter, can
work well. It probably worked during this period better than any other
system we could have conceived. I think it could work well in the
future, but I don’t think it implies that we can ignore signals from the
41
international side that seem to indicate there are problems either in
the domestic economy or arising elsewhere that need attention. If
those problems aren’t given attention, we will find that this system
turns out to be highly volatile and will give us more problems.
Chairman N e a l . Mr. Volcker, did you have a chance to look at
the hearings record, or are you familiar with the hearings record that
our two subcommittees had earlier in the year on the Eurocurrency
question?
Mr. V o l c k e r . I don’t believe I have looked at that specific record.
Chairman N e a l . I commend it to you, as something you may be
interested in, and I would have a question, which I will try to phrase
as broadly as I can:
Would you see the growth of the Eurocurrency markets as being
threatening in general terms to our domestic rate of inflation? Or do
you see any problem there that we are losing so much control that the
system might just fly apart?
This is a vague kind of concern.
Mr. V o l c k e r . Let me give you a general sort of answer to a vague
kind of concern. I don’t think it is an acute problem, but I do have
reservations and concern about the growth in the Eurocurrency
markets over a period of time.
We still tend to think, rightly, that the Eurocurrency market is
kind of the tail on the dog; that the Eurocurrency market—or the
Eurodollar market, specifically—reflects pretty accurately conditions
in the U.S. dollar market; that the markets are very closely linked
and the conditions prevailing are comparable. In that sense, it is not
a matter of a major escape valve for the effects of all our policies, for
instance.
But, as the markets get bigger and bigger, you wonder if some day
the tail will become the dog, rather than the reverse.
The analogy that in my mind is appropriate to the Eurodollar
market is to think of it as a very large nonmember bank or group of
nonmember banks. That presents the same kind of problems that non
member banks present, m my judgment: They are outside our direct
framework of monetary control. It doesn’t mean they’re not influenced
by it, but as the area of direct control gets smaller and smaller relative
to the total, it does over time, I think, create some problems.
Chairman N e a l . What would be your primary concern? Its in
fluence on our domestic rate of inflation?
Mr. V o l c k e r . There are two general types of concerns. I was really
addressing myself mostly to the concern that it may make our control
over money, quite specifically, less precise than it would otherwise be.
Here is a big area of money creation—potentially, and to some degree,
actually—that escapes our direct influence—not our indirect in
fluence, but our direct influence—and therefore may inadvertently
lead to either an expansion or, conceivably, under some other con
ditions, to a contraction of a sort that really had not been contem
plated or easily controlled.
The other area of concern is what tends to be called by central
bankers the “ prudential concern” : How safe and sound are the in
stitutions in the Eurodollar market—and, of course, mainly branch
offices or subsidiaries of American banks.
42
We tend to look at those Eurodollar entities as part of the bank
itself. We examine them, exercise surveillance over them on the same
basis as we do over domestic institutions. That has not been the
practice with all other countries, and there has been a good deal of
discussion recently about the need for more systematic appraisal of
all the institutions in those markets—all the major institutions—as,
in effect, arms of their home office wherever that may be. More sys
tematic efforts are now being made by virtually all countries to deal
with that safety and soundness issue in the Eurodollar market.
Chairman N e a l . Thank you. My time has expired.
Chairman M i t c h e l l . Congressman Leach?
Mr. L e a c h . This was a concern I intended to pursue, and I would
be happy to yield my time if you care to pursue it.
Chairman N e a l . Well, one brief comment. I would be most grate
ful. During the series of hearings we were specifically holding on Con
gressman Leach’s bill, which would impose reserve requirements on
Eurocurrency banks, and I came to think that would be very dif
ficult, if not impossible, for us to do. But I don’t know that the solu
tion to a serious problem occurs to me. Do you have some thoughts
on that?
Mr. V o l c k e r . This is a matter which has been under discussion
among central banks. It is under discussion currently. I think it is,
if not impossible in a technical sense, futile for us to think about doing
it for our banks alone, because the business will just go elsewhere.
Reserve requirements are a kind of tax in their impact on banks,
and by putting that kind of competitive impediment on our banks-----Chairman N e a l . I think that his idea was broader than that.
Mr. V o l c k e r . That involves getting the agreement of a large
number of other countries, and there have been at least exploratory
conversations along that line. There is a good deal of resistance to
that approach among some other countries, and it is a matter which,
in my judgment, will remain under some discussion, but I do not
foresee an early resolution.
Chairman N e a l . If that approach won’t work, what would you
recommend?
Mr. V o l c k e r . There are alternative methods of going about this
which have surfaced in the course of these discussions. Some coun
tries, for instance, are quite interested in the idea of establishing fairly
definite—just how rigid or precise remains a question—but fairly
definite capital requirements which would, for their banks, encom
pass their operations in he Euromarket, as well as their operations
domestically. That fits in with the banking traditions of some coun
tries, and one can imagine approaches along that line that would
have a grossly equivalent impact in terms of limiting the growth of
the market over time. It might have a different result in any par
ticular cyclical situation, or in terms of achieving a policy objective
in a limited period of time, but it certainly could be a very effective
method of limiting growth over a period of time.
There are other concerns about the liquidity policies and measures
taken by institutions within that market and about whether addi
tional official surveillance over liquidity might not be desirable. Now
that is an area that kind of overlaps the issues of the prudential
concern—the safety and soundness of the institutions—and the
monetary control concern.
43
I cannot go much beyond that, frankly, because these discussions
are at a point where some studies have been developed that I have
not seen, much less absorbed, at this point. I think these will be useful,
and light will be thrown on these issues, as we have a chance to eval
uate some of the analytic and statistical work that was dene in ex
ploring these different approaches—reserve requirements, capital
ratios, liquidity ratios, and so on.
Chairman N e a l . I thank the gentleman for yielding.
Chairman M i t c h e l l . The gentleman’s time has expired.
Chairman N e a l . I thank my chairman for yielding.
Chairman M i t c h e l l . The Chair generously will recognize Congress
man Leach for 5 minutes.
Mr. L e a c h . I appreciate that, Mr. Chairman.
You aptly make a “ the tail wags the dog” analogy. One of the
points which almost everyone who appeared last summer before these
subcommittees made was that, as you have noted, the problem is
extraordinarily acute. The Euromarket has grown at an annual rate
of 25 percent since 1970 to the point where in gross terms its size is
presently around $1 trillion. If that growth rate is maintained, and it
could well increase, the Euromarket will enlarge to $8 trillion within a
decade.
Under those circumstances, is there a point in your judgment when
action is mandatory? In particular, one aspect of the overall discussion
in which the Federal Reserve Board has taken the lead, is the apparent
certainty that some time period is going to elapse before any type
of new controls take effect. Do we have sufficient time to deal with
this problem area? At what point, in your judgment, do you think
controls will be needed, if they are not today?
Mr. V o l c k e r . I don’t think there is any trigger point that makes
this go from a manageable situation to a crisis, and I don’t anticipate
that kind of crisis or emergency.
Let me say, in terms of the growth of the market over time—and
I think it would be unfortunate if these extremely high rates of growth
relative to the domestic markets continue—that we should not be
looking just at the Euromarket. I think a relevant question is: What
are we doing to our domestic banking system that makes it com
petitively so desirable to operate abroad? We ought to at least look
at that side of the equation; maybe that is where the problem arises.
Now I don’t think that is wholly true, but there may be some truth to
the suggestion that we overregulate or place too high reserve require
ments at home and thereby drive that business abroad. That is the
way many foreign countries look at it. They say: “ Look, you want to
do something about the Euromarket? It seems to us sensible you do
something about your home market, because you are driving the
business abroad, before you ask us to take all these distasteful meas
ures, not only against your banks but our own banks.”
Now I do not think that is the whole truth, either. But the problem,
as I see it, is that we create competitive advantages to doing banking
business abroad. We do it both by not applying some regulations on
the Eurobanks, but also maybe by applying too many regulations on
our domestic banks.
We can look at both sides of the problem; it doesn’t make sense to
me, over a long period of years, to continue to stimulate the growth
of the Euromarkets artificially at the expense of our domestic market.
44
Mr. L e a c h . Let me just ask one other question in this vein. On
the other side of the ledger is the prudential concern and certainly
the Federal Reserve and the other central banks are looking much
more carefully at this issue. When you consider the currency amounts,
primarily dollars, involved, currencies are being directed, and the real
possibility of an international recession, does it strike you that, even
with greater central bank scrutiny, other countries, probably more so
than the United States, may have very real difficulties in the next 2
or 3 years with their banking systems, and that there may be some
spillover effect in this country? Or do you think that scenario is very
unlikely?
Mr. v o l c k e r . It seems to me remote. The central function of central
banks, whether they are in the United States or elsewhere, is to deal
with this kind of ultimate liquidity pressure that I suppose you’re
foreseeing here; and overall, I think we are equipped to do that job
now.
Mr. L e a c h . Thank y o u , Mr. Chairman.
Chairman M i t c h e l l . Congressman LaFalce?
Mr. L a F a l c e . Thank y o u , Mr. Chairman.
Mr. Volcker, I have three questions.
First, I am very concerned with the disintermediation that has taken
place in our thrift institutions in the United States, particularly in
the Northeast—and the Northeast, which is really New York and
Massachusetts. Another reason for this of course is the higher interest
rates, available money market certificates, but most especially the
geometric increase, as opposed to the arithmetic increase which has
taken place in money market funds.
In your letter to the chief executive officers of October 23, you
warned—the chief executive officers of the financial institutions—you
warned them against speculative lending. And I can think of fewer
locations for speculative sources of funds than Merrill Lynch or
Bache, or what-have-you, money market funds. One possibility you
discussed was the imposition of reserves on transaction accounts, and
the defining of money market funds as “ transaction accounts”—and
the difficulty there is they immediately get out of the so-called trans
action account business, which is almost exclusively a marketing device
rather than anything else.
So while I am in favor of deregulation of regulation Q, phased in
over a period of time and in an appropriate manner, I don’t know that
we would have any recourse if we are going to do something about this
effectively—both to curb speculative usages of money, and to prevent
the disintermediation to take place—other than to bring money market
funds under a legal regulatory framework, perhaps similar to regulation
Q. Your opinion?
Mr. V o l c k e r . Let me say first that I agree with the comment you
made about the transactions account side of this. I think that approach
might have some sense as a basic regulatory, structural approach, but
I don’t think it is going to end the problem you referred to as the
“ money market fund” problem in terms of its attractiveness at the
moment.
I would be reluctant to take measures that were not justified in
terms of the longer term structure of the financial industry and longer
term trends in dealing with this situation at this point.
45
The only real solution, as you know, is getting into an environment
in which interest rates can come clown again, and the thrift institututions can again become competitive, and the mortgage lending instru
ment becomes an attractive vehicle for them to put funds into the
market. There is no other easy solution, it seems to me, of trying to
manipulate these funds, partly because it does run against the grain
of what we would like to see in terms of freeing the market and permit
ting competitive forces to work.
So at this stage at least, I don't think we are able to go in that
direction.
Mr. L a F a l c e . The difficulty I have is that, while I favor the long
term goal, any phaseout plan is usually conceived of in approximately
a 10-year period, perhaps given appropriate economic circumstances,
left. And what do we do about the disruptive effects-----Mr. V o l c k e r . In the short tun.
Mr. L a F a l c e [continuing]. In that short run? And the short run is
not all that short. We are talking about a 10-year period, and it seems
to me we must address ourselves to it.
Mr. V o l c k e r . It is not necessarily 5 or 10 years; that all depends.
If you assume for this 5- or 10-year period we are going to have in
creasing inflationary pressures, then we will have the problem for 5
or 10 years. I don't make that assumption. I would like to think that
we are going to have 5 or 10 years of lower interest rates than we have
just experienced, in which case this problem will be a negligible one.
Mr. L a F a l c e . Well, let us switch to another problem which certainly
concerns that.
Yesterday the President decided that we would not purchase any
more Iranian oil. About an hour later, Iran said they wouldn't sell us
any more Iranian oil. I would query the effect of what that is going to
be—but whether it does or doesn't have an effect, certainly there is
going to be a meeting in December of the OPEC nations, and I think
it is safe to assume that we will have a minimum increase of 10 to 15
percent and probably, in my judgment, higher.
Now if my judgment of “ probably higher increases" is accurate—
and I hope it is not—so that we have a 25- to 30-percent increase, we
certainly are going to get a higher increase from Saudi Arabia that
has been behind in its price schedules; it seems to me that Iran will
probably be selling a lot of its oil in the spot market—I don't know—
but what is going to happen insofar as the U.S. monetary policy, come
December, should there be a 25- or 30-percent increase in the OPEC
oil prices?
Mr. V o l c k e r . Let me say, first, that I think this oil-pricing decision
and the behavior of oil markets in coming months is a very crucial
determinant of the outlook for the economy—not just next year, but
for a period of time, and not just the American economy.
We seem to be in a situation where there has not been any shortage
of oil in the markets, in the sense that production is up to consump
tion; as nearly as one can tell, it seems to be in excess of consumption
by a limited margin. But there is a great desire for stockpiling out of
fear of higher prices or interruptions m supply, and my concern is that
that stockpiling, which keeps the spot price very high, brings about the
very conditions that people fear—that is, the pressures on prices,
whether in the form of that OPEC decision in December or the deci
sions the countries have been making on an ad hoc basis.
55-123
0 - 8 0 - 4
46
We have set up a situation here, inadvertently, where oil prices may
rise higher than the underlying market over a period of time would
justify. That distorts and hampers what we are trying to achieve in
this country, puts additional burdens on developing countries in a
severe way, and undermines the chances of reaching an orderly
economic adjustment and a fairly prompt turnaround of the in
flationary situation.
I am not in a position to speak with any precision at this point
about just how it affects monetary policy. I hope the large price
increase does not come about.
I think that is one reason why we were perhaps fortunate to have
taken the measures that we have already taken, which hopefully to
some degree minimize the chances of a large increase happening at all,
but also put us in a little better posture for absorbing what price
increase there might be.
All things equal, the bigger the oil price increase, the more pressure
there is, obviously, on the inflationary front, and the more need there
is for money to finance the normal turnover of business activity. This
would therefore, to some degree, impinge upon the judgment that we
have to make about, let’s say, the target for the money supply next
year—if the decision really were outside the framework in which
people have been thinking.
It would be extremely unfortunate in my judgment—and not just
for the monetary policy reason—to have a very large increase in oil
prices on top of the 60- or 70-percent increase we have already had
this year. I am not sure there’s enough appreciation in this country
of the risks and dangers in that situation, whether one is worried
about unemployment, inflation, the vitality of the world economy, the
prospects for the developing world, or other issues. There is a point
when these prices have gone up rapidly enough, and far enough, so
that enough is enough.
Chairman M i t c h e l l . Congressman Ritter?
Mr. R i t t e r . Thank you very much, Mr. Chairman.
This is a kind of short-term approach to my first question. Ap
parently the Treasury will have a difficult task over the next several
months—I understand some $30 billion in money would have to be
borrowed—that this is in addition to drawing down present cash
balances. This is going to put additional pressure on interest rates.
Can the Fed stay on course in the face of these things?
M r. V
olcker.
Y es.
Mr. R i t t e r . These credit demands and still hold the interest rates
in moderation?
Mr. V o l c k e r . I think “yes” to both sides of that question. The
Treasury is facing some large seasonal needs for funds—of course,
it is related to the deficit, but there are seasonal needs on top of
that—but I do think that those demands are manageable.
Now, if you present me with a couple of hypotheses that say business
activity at home is going to continue to expand, and we will have the
kind of oil price increase that Mr. LaFalce was worried about, then
we are going to have problems; those problems are not solely traceable
to that Treasury financing, but that would be a further complication.
Mr. R i t t e r . But you don’t think that the-----Mr. V o l c k e r . I am hopeful that-----Mr. R i t t e r , [continuing]. Pressures to be to that extent.
47
Mr. V o l c k e r . I am hopeful that we will not have those kinds of
pressures.
Mr. R i t t e r . Thank you.
Chairman M i t c h e l l . M r . Volcker, at the end of my last question
to you, you talked about the area of maneuverability that you would
have with money growth between now and the end of the year. I
want to pursue that a bit further.
If we include ATS accounts as “money,” that changes your ceiling,
does it not, from 6 to IY2 percent growth for this year, or roughly that?
Mr. V o l c k e r . I am trying to think of the right way to phrase this.
We have ATS and NOW accounts coming out of traditional measure
of Mi. We would have had a ceiling of 7){ percent had we not had
ATS and NOW accounts. But that is not quite the same as saying:
put ATS and NOW accounts back in Mi. You get a higher number if
you do that.
We only estimated the amount of ATS and NOW accounts that
came out of demand deposits, and some of them from out of savings
accounts. If you put that whole total back in the money supply, you
get a bigger number than the 7% percent.
Chairman M i t c h e l l . The point I am trying to get at is that, even
if you have a larger number than 7H, you still have maneuvering room
between now and the end of the year, do you not?
Mr. V o l c k e r . We have maneuvering room in the sense that the
current money supply is less than it would have to be in December to
still be within our targets.
Now when you speak of “maneuvering room,” it makes me a little
nervous, because I picture your having an image of a situation where
we could maneuver from week to week and month to month and hit a
money supply figure; I don’t think we can do that. We can influence
it on a monthly basis, but we don’t know how closely we can hit that.
So we have room, yes. I don’t like to call what we are doing “maneu
vering.” We are “ aiming” at some gradual growth during this quarter.
We have room for that. Just what happens on a month-to-month
basis-----Chairman M i t c h e l l . That is the only point I was trying to make.
Mr. V o l c k e r . Right.
Chairman M i t c h e l l . If you need to grow, then there is room.
Mr. V o l c k e r . We have room for some growth between now and the
end of the year; that is right.
Chairman M i t c h e l l . Chairman Neal?
Chairman N e a l . Yes, I just have one closing comment.
Throughout your testimony, and your responses to my questions
about bringing down the rate of growth in the money supply, you over
and over again agree that this is an essential element of your policy.
You say that in crystal clear terms-----Mr. V o l c k e r . It is an essential element of a noninflationary policy.
Chairman N e a l . That is right. I think I am convinced that you
are sincere in this and I think it is critically important—but it also
seems to me that it would be so beneficial if you would make a very
strong statement about your dedication to pursuing such a policy in
your own way. In other words, if you have to qualify it by saying,
“ except under certain conditions,” or something.
Mr. V o l c k e r . I suppose it is the qualifications that get you, in
trouble.
48
Chairman N e a l . I understand that, but just leaving yourself a
little room to maneuver, but the strongest possible statement that
would put the American public, the Congress, the central bankers
around the world, everyone who has an interest in this, that you do
mean business and you do intend to pursue this policy.
We will be following it closely from this side, and if the policy is
not pursued, we will be making some noises about it, but you know
that is not nearly as important as what you are doing and saying.
Mr. V o l c k e r . But it is terribly important that there be an under
standing of the basis of these policies, because you don’t carry forward
these policies in this country without the kind of support that the
subcommittees have been willing to give.
Chairman N e a l . Well, I wish you would give that some thought.
Mr. V o l c k e r . I will indeed, and certainly this is a matter which
you can be assured is discussed and will be discussed very closely in
the Open Market Committee, because we have to adopt these tar
gets—if not for the 4 years that you are talking about, for 1980; and
the middle of 1980, we are going to have to adopt a target for 1981.
That is part of the procedure. We usually have a little debate about
what we say about targets beyond that: There are those who say
precisely what you are saying, maybe even stronger; and then there
are those who say, “ But there are all these contingencies, and what
will it do to our credibility if we don’t meet the target next year,”
and so on.
Chairman N e a l . I understand those considerations, and I just want
to say that my only problem is that I have sat here now for 5 years
and listened to wonderful men—Dr. Burns, Mr. Miller—say essen
tially the same things that you say about the economy and the need
for restraint and so on, and yet not see that reflected in policy.
Mr. V o l c k e r . I understand.
Chaiiman N e a l . I know it was ongoing before I got here, and I
deeply appreciate your efforts. I don’t think that the President could
have found a better man in the world for the job, and I certainly wish
you every success. We will try to support these kind of sensible antiinflationary policies from this end.
Mr. V o l c k e r . I do very much appreciate this opportunity to be
here this morning, Chairman Mitchell and Chaiiman Neal, and I look
forward to coming back.
Chairman M i t c h e l l . Let me just indicate that the degree of par
ticipation on the part of the members, and the number of questions
we raised, should be demonstrable evidence of our intense interest in
this area. We have worked very well with the Federal Reserve over
the past couple of years, and we certainly anticipate that continued
good harmonious woiking relationship.
M r . V o l c k e r . I v e r y m u c h l o o k f o r w a r d t o it .
Chairman M i t c h e l l . Thank you so very much for being here with
us.
[Whereupon, at 11:30 a.m., the hearing was adjourned.]
MONETARY POLICY
GOALS AND CONDUCT FOR THE 1980’s
TUESDAY, NOVEMBER 27, 1979
H
S u b c o m m i t t e e o n D o
and
S u b c o m m it t e e o n
I n t e r n a t io n a l T r a d e , I n v e s t m e n t a n d M o n e t a r y
P o l ic y o f t h e C o m m it t e e o n B a n k in g , F in a n c e a n b >
U r b a n A f f a ir s ,
ouse
R
of
m e s t ic
M
e p r e s e n t a t iv e s ,
onetary
P
o l ic y ,
Washington, D.C.
The subcommittees met, pursuant to notice, at 9:30 a.m. in room
2128, Rayburn House Office Building, Hon. Stephen L. Neal (chair
man of the Subcommittee on International Trade, Investment and
Monetary Policy) presiding.
Present: Representatives Neal, D’Amours, Cavanaugh, and Evans.
Chairman N e a l . The subcommittees will come to order.
Because of the situation in Iran, the chairman of the full committee
has called a caucus of Democratic members. I think members will be
coming in a little later on in our hearing, but we will go ahead and
begin the hearing at this point, anyway.
Today we continue joint hearings of the Subcommittees on Domestic
Monetary Policy and International Trade, Investment and Monetary
Policy on “ Monetary Policy—Goals and Conduct for the 1980’s.”
It has been nearly 8 weeks since Federal Reserve Board Chairman
Paul Volcker announced on October 6:
A change in method used to conduct monetary policy to support the objective
of containing growth in the monetary aggregates over the remainder of this >ear
within the ranges previously adopted by the Federal Reserve . . . . This action in
volves placing greater emphasis in day-to-day operations on the supply of bank
reserves and less emphasis on confining short-term fluctuations in the federal
funds rate.
From October 6 until now there has been a definite slowdown in
money growth. The stock or volume of Mx, in fact, was actually lower
during the latest statement week, the week ending November 14,
than it was the week ending October 3.
So, although I have some concern about the details of the new
method, the results so far are encouraging. They show that growth in
the aggregates, for the present at least, is being contained.
I am hopeful that money growth will continue to be contained, and
gradually reduced over the years ahead. Unless this is done, I see no
hope of containing and reducing inflation, or of limiting the frequency
and magni ide of future episodes of recession.
(49)
50
I was especially pleased, therefore, when Chairman Volcker, re
sponding to a question which I put to him about reducing money
growth around a percentage point a year over the next 5 years, said:
I very much welcome and agree with the notion that we have got to follow the
kind of a broadly declining trend if we are going to restore price stability . . . five
years from now I would like to be around that level you suggest in your bill (3
per centum for Mi inclusive of ATS and NOW accounts). I think experience
shows that using a kind of present Mx concept, the increase. . . should be very
small if, indeed, we are serious about price stability.
I am also encouraged by developments since October 6 in foreign
exchange and commodity markets, and since late October in credit
markets. From the beginning the dollar has firmed. The speculative
interest in metals has, at least for now, ended. The sharp rise m interest
rates which followed the October 6 announcement now appears to
have been checked.
Since late October interest rates have fallen on a wide front. The
keystone Federal funds rate has dropped from over 15% percent at
the end of October to under 13 percent, the Treasury bill rate has
fallen from nearly 13 percent back under 12 percent, the 3-month CD
rate is off over a percentage point. In California, some mortgage rates
have been reduced and yesterday a major New York bank reduced
its prime loan rate.
At the opening of these hearings my colleague Parren J. Mitchell,
who unfortunately cannot be here today, asked: “ Can we pull it off?
Can we reduce rates of monetary growth without inducing a re ses
sion?” I believe we can, if the Federal Reserve acts carefully and well.
The dramatic turnaround in interest rates since late October indi
cates that if the Federal Reserve doesn’t let money growth collapse,
as it has so often in the past, reducing money growth won’t precipitate
a major recession.
The Nation’s credit markets are flexible enough to prevent a credit
crunch, provided only that money growth is slowed and not allowed
to collapse.
We can reduce inflation without causing a recession. However, I
have two gnawing doubts about our doing so.
First, I am disturbed about the caveat in Chairman Volcker’s
October 6 statement that the change in the Federal Reserve’s method
was “ * * * to support the objective of containing growth in the
monetary aggregates only over the remainder of this year.”
If the new method works, as it can, why go back to the old one which
definitely didn’t work?
Second, I am concerned because the Federal Reserve’s commitment
to the new method of focusing on the input of reserves, instead of on
the Federal funds rate, in managing monetary growth is far from
complete.
Witness that at its meeting on October 6 the Federal Open Market
Committee stated that it would try “ * * * to restrain expansion of
reserve aggregates to a pace consistent with deceleration in growth of
Mi, M2 and M3 * * * provided that in the period before the next reg
ular meeting the weekly average Federal funds rate remains within a
range of 11% to 15K percent.”
Frankly, I am puzzled. Is it enough to change only the focus of
monetary policy, placing, as Chairman Volcker stated on October 6,
“ greater emphasis in day-to-day operations on the supply of bank
51
reserves and less emphasis on confining short-term fluctuations in the
Federal funds rate” ?
Since October 6 it has been enough, and that is encouraging. How
ever, maybe we have benefited from a happy accident. In the future
we may find that even a 4 percentage point funds rate target band is
not wide enough to prevent the same rollercoaster money growth
which has so terribly afflicted our economy, causing repeating waves
of inflation and recession, in the past.
Can we afford to subject our monetary growth plans to provisos on
the Federal funds rate in the 1980’s? I am sure that our witnesses
today and next week will shed light on this and other questions about
the course and conduct of monetary policy in the years ahead.
Before calling on today’s witnesses, I will ask if any of my colleagues
has an opening statement.
Our witnesses are Dr. Benjamin M. Friedman of Harvard Uni
versity; Dr. A. James Meigs, who is chairman of the board of the
Claremont Economics Institute and professor of economics at Clare
mont Men’s College; and Dr. Michael Parkin, who is professor of
economics at the University of Western Ontario in Canada, originally
from England and currently on leave of absence with the Hoover
Institute.
Gentlemen, I thank you for being here today. We will now hear
from you, Dr. Friedman.
STATEMENT OF DR. BENJAMIN M. FRIEDMAN, ASSOCIATE PROFES
SOR OF ECONOMICS, HARVARD UNIVERSITY
Dr. F r i e d m a n . Mr. Chairman, I am honored to have the oppor
tunity to present my views to this meeting of the two subcommittees
on the occasion of their joint oversight hearings on “ Monetary Policy—
Goals and Conduct for the 1980’s.” The subject of these hearings is of
crucial importance, and I commend the members of this committee
for their continuing interest not only in the current posture of mone
tary policy but also in the fundamental underlying structure of the
monetary policy process. Too often attention is devoted entirely to
current events, rather than to the evolution of the monetary policy
process—which, in the long run, may be even more important. The
work of this committee has been a notable, and laudable, exception.
As we are all aware, on October 6 the Federal Reserve System
announced a number of monetary policy measures, including a change
in the method of conducting open market operations to implement its
monetary growth target strategy. Since then there has been substantial
uncertainty about just what this new method for open market opera
tions will involve. In addition, there has been much speculation about
the implications of this new operating method, and the apparent
tightening of monetary policy that has accompanied it, for the U.S.
economy’s prospects for 1980 and thereafter.
In light of these recent developments, in my testimony this morning
I will address three questions: (1) What is the best method of imple
menting a monetary growth target strategy for monetary policy?
More specifically, is adoption of the new method announced last
month likely to improve the Federal Reserve’s ability to induce mone
tary growth within a desiginated target range? (2) At a more funda
mental level, should the Federal Reserve gear its operating strategy
52
for monetary policy to the pursuit of monetary growth targets in the
first place? If so, are there general guidelines for the implementation
of a monetary growth target strategy beyond the somewhat mechanical
choice of technique for setting day-to-day open market operations?
(3) Finally, is the current stance of monetary policy, including the
posture of monetary policy since the October 6 measures, appropriate
for the circumstances confronting the U.S. economy at the opening
of the 1980’s?
1. HOW TO PURSUE MONETARY AGGREGATE TARGETS
Since 1970, the Federal Reserve has generally structured its mone
tary policy around the pursuit of targets set in advance for aggregate
measures of either money or bank reserves. Moreover, since the passage
of H. Res. 133 in 1975, the Federal Reserve has reported in advance to
the Congress, several times per year, the rates of monetary expansion
that it is seeking over successive forthcoming 12-month periods.
At the outset, before even considering the best method of imple
menting monetary aggregate targets, it is necessary to deal with two
preliminary issues. The first is whether the Federal Reserve can
control the rate of monetary growth if it so chooses. The answer is
that the Federal Reserve can indeed control the rate of monetary
growth with moderate accuracy over the medium to longer run—say,
over a time horizon of a year or so. By contrast, within shorter time
horizons the Federal Reserve can exert substantial influence on the
rate of monetary growth, but it is unlikely to be able to achieve any
specific monetary growth target with exact precision. The vagaries
of uncertain behavior on the part of both the commercial banks and
the nonbank public simply preclude precise short-run monetary con
trol in a fractional reserve banking system like ours in the United
States. This perhaps troublesome fact does not mean that the Federal
Reserve should not try to influence monetary growth in the short run.
It does mean, however, that we should not expect precise achievement
of monetary growth targets over timespans like one month, or even
one calendar quarter. Moreover, we should not infer, simply on the
basis of whatever deviations of monetary growth away from the an
nounced targets occur over such timespans, that the Federal Reserve
is not attempting to achieve its targets.
Second, some critics of recent monetary policy have recently alleged
just that—that the Federal Reserve’s announced monetary growth
targets are no more than announcements. In other words, critics have
claimed that the announced monetary growth targets are merely
rhetorical, and that they play no role in determining th,e monetary
policy that the Federal Reserve actually implements. It is important
to understand that this allegation is false. A growing accumulation
of empirical evidence has now shown clearly that the contrary is true.
Work by Paul DeRosa and Gary Stem at the Federal Reserve Bank
of New York, by James Diggins at Harvard University, by Edjar
Feige and Robert McGee at the University of Wisconsin, and most
recently by Raymond Lombra and Michael Moran at Pennsylvania
State University, in each case shows clearly that since 1970 monetary
growth targets have in fact played an important role in actual—not
just announced—monetary policy. The evidence produced by Lombra
and Moran in particular shows that by far the largest single factor
53
in accounting for the Federal Reserve’s adjustment of the Federal
funds rate, its main operating instrument during the 1970’s, has been
the observed deviation of monetary growth from the targeted range.
When monetary growth has been higher than targeted, the Federal
Reserve has adjusted the Federal funds rate upward; conversely,
when monetary growth has fallen short of the targeted range, the
Federal Reserve has lowered the Federal funds rate. While there is
ample room to debate whether these responses should have come
quicker, or whether they should have gone further, the evidence is
clear that such responses have consistently taken place.
As is now familiar, the innovation announced by the Federal Re
serve on October 6 is to replace the operating method that manipulates
the rate of monetary growth by setting the Federal funds rate with
an alternative method that manipulates the rate of monetary growth
by setting the growth of bank reserves. Instead of relying on relation
ships that describe how much money the banking system and the nonbank public will produce under a given interest rate, therefoie, the
new approach relies on relationships describing how much money they
will produce for a given amount of reserves to back it.
In principle, either method could work better than the other. There
is simply no way of knowing a priori which of the two methods will
provide the better lever with which to control the rate of monetary
growth. On one side, the looseness of the relationships connecting
monetary growth and interest rates is now well known from the ex
perience of the 1970’s. It is important to realize, however, that the
analogous relationships connecting monetary growth to the growth
of bank reserves are also loose and not necessarily very reliable. Banks
can create a great deal of money for a given amount of reserves by
using those reserves to back low-reserve liabilities like passbook
savings accounts; or, alternatively, they can create a small amount
of money for the same amount of reserves by using those reserves to
back high-reserve liabilities like demand deposits. In addition, the
uncertainties of deposit shifts between city banks and country banks,
between large banks and small banks, between Federal Reserve mem
ber banks and nonmember banks, and between domestic banks and
off-shore branches, all preclude any exact relationship between the
quantity of reserves and the quantity of money created from those
reserves.
Two years ago I attempted, in a paper published in the Brookings
Papers on Economic Activity, to assess which of these two methods
of open market operations—one keying on a short-term interest rate
like the Federal funds rate, and the other on the growth of bank
reserves—would achieve the more precise control over monetary
growth within a time horizon of one calendar quarter. The statistical
analysis that I carried out suggested that the two methods did not
differ much on this account but that, of the two, the interest rate
method was actually modestly superior. Specifically, I found that,
under the interest rate method, two-thirds of the time the Federal
Reserve should be able to come within 2.4 percent per annum of
achieving its monetary growth target while, under the reserves method,
two-thirds of the time it should be able to come only within 3.7 percent
per annum. I hasten to say that I do not regard this evidence as in
any way conclusive. My own conclusion from this analysis is that, on
the basis of the statistical evidence that we have to date, we simply
54
cannot tell the difference between the likely performance of the two
methods as scored by the precision of monetary control that either
can deliver. The two may well be different, in that one may be able to
achieve better monetary control than the other. On the basis of the
available evidence to date, however, it is impossible to determine
whether that is so—or, if it is, which method would turn out to be
better.
Where does that leave us with regard to the recent change announced
by the Federal Reserve? In my judgment it will
be useful
to go ahead to experiment with the new method. There is no hard
evidence to suggest that the new method will do worse, and it is
entirely possible that, for reasons not captured in statistical investiga
tions, the new method may do better. Hence I welcome the adoption
of the new- reserves method on an experimental basis.
Nevertheless, it is important to keep several caveats in mind. One is
that we should not expect any great improvement in the precision of
monetary control. Hence we should not conclude that the Federal
Reserve is somehow “not trying very hard” if it turns out that the
new method yields only about the same precision of monetary control
as did the old method. Moreover, we should be prepared to resume
the old method of operation if it turns out that the new method,
instead of being an improvement, delivers substantially worse mone
tary control or somehow suffers from other unanticipated drawbacks.
probably
2. THE ROLE OF MONETARY GROWTH TARGETS IN MONETARY POLICY
Unfortunately, a substantial amount of confusion has surrounded
the nature of the Federal Reserve’s new policy measures. A reading of
the financial press indicates that many observers of monetary policy
believe that the new policy amounts to adopting a monetary growth
target strategy for monetary policy where none existed before. I do
not believe that that is what the Federal Reserve has done. Instead,
as I have indicated already, the Federal Reserve has changed the
method of using open market operations to implement the monetary
growth target strategy that it has had throughout most of the past
decade. The general policy of pursuing monetary growth targets re
mains. What is different is merely the method of seeking to achieve
these targets.
In this context, it is important to ask whether placing primary
reliance on monetary growth targets is the appropriate way to design
monetary policy in the first instance. Monetary growth targets can in
fact play a useiul role in the design and implementation of monetary
policy, but it is important not to place too much emphasis on precise
control over monetary aggregates in the short run. In the paper that I
mentioned earlier, I also showed that the monetary targets operating
strategy, as recently implemented by the Federal Reserve, suffers from
at least two principal shortcomings.
First, the monetary targets strategy is a useful but in general an
inefficient way of exploiting the valuable information about the
economy contained in near-term observations of the money stock.
Except under the highly restrictive conditions that the demand for
money is both interest insensitive and perfectly stable—neither of
which receives support from empircical investigations—the monetary
targets strategy is inferior to an alternative, more general, procedure
55
for adjusting monetary policy in light of the relevant information con
tained in observed money stock values. At the empirical level my paper
provided some limited evaluation of this criticism. Results based on a
compact macroeconometric model indicated that the monetary targets
strategy exploits the information in money stock observations with
substantial inefficiency. This strategy, which involves responding to
observed deviations of the money stock from the targeted growth path
so as to restore the money stock to that path, calls for a monetary policy
response that differs markedly from that which a correct processing of
the information contained in the observed deviations would
warrant—regardless of whether the direct operating instrument of
monetary policy is a short-term interest rate or bank reserves. In
addition, as the events of past years have dramatically illustrated,
the short-run relationship between the money stock and economic
activity is sufficiently unreliable that at least some of the information
provided by money stock movements is itself often highly misleading.
Hence reacting sharply to shortrun deviations of the money stock
from prior growth targets is not a sound strategy.
Second, the monetary targets strategy suffers from the further—and
potentially more damaging—shortcoming of hindering monetary
policy from exploiting the near-term flow of information about the
economy contained in observations of variables other than the money
stock. With information as scarce as it is, any that nonmonetary
sources offer should be exploited; and the use of the monetary targets
strategy leads to a mistaken emphasis on exploiting only those vari
ables that are not only observable but also largely “ controllable” in
the short run. Empirical evidence showed that several nonmonetary
financial aggregates—including bank credit, bank loans, total credit,
and total ]:quid assets, each of which is readily observable on a current
basis, just like the money stock—contain information about income
that is not already contained in the monetary aggregates. The fact that
monetary policy cannot exert even reasonably close shortrun control
over some of these aggregates—especially total credit and total liquid
assets—as direct target variable in no way precludes their use as “ in
formation” variables for keying monetary policy operations.
The basic implication of these analytical and empirical results is
that in the short run the Federal Reserve should not seek to control
the money stock closely as the direct target of monetary policy. Even
if on a near-term basis policy were to focus only on the money stock,
its response to observed movements should still be different from that
indicated by the monetary targets strategy. Perhaps more important,
policy should focus not just on the money stock but rather, at the
very least, on an index of monetary and credit aggregates. In addition,
the Federal Reserve should seek better ways of incorporating into its
analysis the near-term flow of information from financial variables
other than financial aggregates, and from nonfinancial sources too.
The fundamental point is not that near-term observations of the
money stock contain no useful information for monetary policy, but
only that they do not contain all such useful information. While
money should not be the direct target of monetary policy, therefore,
it should be a useful and probably an important variable—but not
the only one.
For these reasons I find disturbing the Federal Reserve’s continued
emphasis on the “money” side of the banking system’s activity, to
56
the near exclusion of attention to the “ credit” side. The formulation
and implementation of monetary policy must depend on a broad
range of measures both of the performance of the nonfinancial economy
and of the effect of monetary policy more specifically. In light of
recent shifts in portfolio behavior, narrowly keying on one or two
monetary aggregates would be especially unfortunate at this point.
For this reason I applaud the Federal Reserve’s apparent close atten
tion to developments in the nonfinancial economy, but I also urge
increased attention to credit measures in addition to money measures.
In this context I commend the Senate Banking Committee for also
recommending, in its “ Second Monetary Policy Report for 1979” —
issued on August 9—that the Federal Reserve place more emphasis
on credit targets along with money targets.
The point of this recommendation is not that money measures
contain no influence or information relevant to monetary policy, but
rather that money measures and credit measures both bear such
relevant influence and information. The relative importance of the
two is an open question, which recent developments have rendered
even less easily resolved than it may once have appeared. Economics
provides no a priori reason to acknowledge the influence and informa
tion provided by the public's money holdings but not its credit lia
bilities. For a given short-term interest rate, or a given growth in the
monetary base, the behavior of the banking system as well as of the
nonbank public determines the growth of both money and credit, and
does so jointly with the determination of nonfinancial economic ac
tivity. There is no justification for paying attention to the “money”
side of this process while disregarding the “ credit” side.
Moreover, the importance of paying explicit attention to bank credit
will be all the greater if the Federal Reserve adopts the new definitions
of the monetary aggregates proposed earlier this year by the Federal
Reserve Board staff. In brief, the primary aim of the proposed new
definitions is to eliminate some of the arbitrariness inherent in the
current definitions by emphasizing, within the universe of liabilities ( f
deposit-issuing institutions, the question “ what kind of deposit?” in
stead of “ what kind of institution?” The primary beneficiary of this
change will be the middle measure, M2. Despite the attention it has
received in recent years as the aggregate with the stablest “ velocity”
relation to income, the current M? has never made sense as a summary
measure of anyone's deposit-holding behavior. The proposed new M?,
which will add to M2 savings deposits at both banks and thrift insti
tutions, will avoid the anomaly of arbitrarily distinguishing large
quantities of essentially identical consumer-held deposits that are often
accessed from similar looking buildings across the street from one an
other. Hence the new measure will provide an improved guide to the
asset-holding behavior of the nonbank public including both individ
uals and businesses.
The price that the proposed new definitions will pay for this
rationalization of the representation of the public’s asset-holding
behavior, however, will be a sharp loss of ability to represent the
public's liability-issuing behavior. Fittingly enough, the main winner
on the asset-holding side, M 2, will also be the chief loser on the liabilityissuing side.
57
An often troubling question is why the current M2, which is such a
profoundly arbitrary measure of deposit-holding behavior, should
exhibit such a close relationship to aggregate economic activity. One
part of an explanation is that movements in the current M2, although
they are measured from the liability side of the commercial banking
system’s balance sheet, in reality capture much of what is happening
on the asset side. With the subtraction of some $100 billion of currency
and the addition of some $100 billion of negotiable certificates—plus
an adjustment for capital accounts less reserves, and some other
liabilities—M2 is approximately equivalent to bank credit. Indeed,
historically there has been a very high correlation between the re
spective growth rates of M2 and bank credit. It is my impression that
this close relationship between the current M2 measure and bank
credit is widely recognized though seldom explicitly discussed. In
stead, M2 has served as a tacit neutral ground on which people with
divergent views about how monetary policy works can hold a mutually
understandable conversation and even concur on a mutually agreeable
policy. Using M 2 as the monetary growth target to guide monetary
policy, or simply as a variable to relate to income, in effect captures
much of whatever influence or information is associated with bank
credit in the complex process connecting financial and nonfinancial
economic activity.
The proposed redefinition of M2, by excluding time deposits at
commercial banks and including savings deposits at nonbank thrift
institutions, will sever the relationship to bank credit. The historical
correlation between bank credit and the proposed new M2 measure
is only about half that between bank credit and the current M2.
The new definition will therefore achieve an improved representation
of “money” at the expense of the representation of “ credit” behavior.
If the Federal Reserve adopts the proposed redefinitions, it will
therefore be all the more important to rely explicitly on bank credit
measures as well as the monetary aggregates in formulating and
implementing monetary policy.
3. MONETARY POLICY TODAY AND THE U.S. ECONOMY IN 198D
The sharply contradictory forces now affecting the U.S. economy
have created substantial confusion about near-term economic
prospects. It is now widely recognized that price inflation is our
Nation’s most threatening macroeconomic problem, but there is no
sign yet of any improvement or even nearterm likelihood of improve
ment on this front. At the same time, signs of recession ahead con
tinue to accumulate, despite the absence of much hard evidence
of weakness to date. The economy’s surprisingly strong rebound in
the July-September quarter almost exactly offset the decline in the
preceding quarter, leaving total output essentially back at its earlier
peak after adjustment for inflation. Moreover, it was primarily final
sales, rather than an unintended build-up of inventories, that ac
counted for most of this strength. Still further, the expansion of final
sales itself came entirely from sources other than the Federal
Government.
58
Nevertheless, two powerful factors suggest that the current business
expansion, which passed its fourth birthday last spring, will falter
soon. First, the strong dependence of this expansion on consumer
spending, which has been evident almost from the beginning, became
even more pronounced in the most recent quarter when the economy’s
personal saving rate dipped to an astonishing 4.1 percent. If the saving
rate had merely remained at the already low 5.2 percent average
maintained during the first half of this year, final sales after adjust
ment for inflation would have grown by only 1.7 percent per annum
instead of the 4.8 percent per annum gain actually recorded. Although
it is impossible to say with precision just when this consumer spending
splurge will end, mounting consumer debt burdens and weakeningpersonal incomes suggest that its time is sharply limited. Without the
strong boost from the consumer, there will be little momentum left
in the expansion.
The second major factor indicating economic weakness ahead is the
Federal Reserve’s new monetary policy. Until this past month, it was
impossible to make a convincing case that U.S. monetary policy had
been restrictive at any time since the current business expansion began
more than 4 years ago, regardless of which policy indicator one chose to
emphasize. Now the situation is different. In large part because of new
reserve actions that have raised commercial banks’ marginal cost of
funds far above their average cost, short-term borrowing rates are
now well in excess of meaningful rates of inflation, and long-term
yields have adjusted sharply upward as well. Banks have begun to
liquidate their securities portfolios for the first time in this business
cycle, and reports of credit rationing are widespread.
In conjunction with a fiscal policy that has been tight for 2 years,
as Federal nondefense spending has consistently fallen below budget
and the Federal Government’s deficit has been smaller than the com
bined net surplus of State and local governments, a tight monetary
policy is now likely to bring on the long anticipated downturn.
Reduced availability of consumer credit will help to slow consumer
spending, even if consumers themselves remain impervious to their
record debt service burdens. The surprising resilience of the homebuilding industry thus far finally appears about to fade, although
probably only to the extent of reducing new housing starts by some
25 percent from their relatively high level of the past year or so.
Similarly, the financial pressures associated with high energy prices,
falling profits, the high cost of external credit, and limited availability
of credit for some borrowers, will probably cause businesses’ invest
ment in new plant and equipment to falter by the second half of next
year. In sum, the combination of tight fiscal policy and tight monetary
policy will probably prove too powerful a drag for the current expan
sion to persist much longer.
How do these prospects for a weak economy in 1980 relate to the
subject of this hearing—the goals and conduct of monetary policy for
the 1980’s? The principal challenge that monetary policy—and fiscal
policy too—faces at the outset of the 1980’s is the stabilization, and
then the deceleration, of the ongoing rate of inflation. To be sure, there
are other pressing macroeconomic problems as well, including such
examples as our country’s inadequate capital formation rate and exces
sive dependence on increasingly unreliable foreign supplies of energy.
59
In addition, efforts to solve any or all of these problems may tempo
rarily lead to hardships for some, through higher fuel prices or loss of
jobs or other unfortunate events. Nevertheless, other more focused
policies are better suited to dealing with these other problems than
are relatively blunt instruments like monetary and fiscal policies.
The best use of monetary and fiscal policy at this time is to promote
stable growth and decelerating inflation, leaving other problems to
other policy measures.
It is important to realize that no one policy error or unlucky acci
dent created the environment of high inflation in which we live today.
Instead, the surprise is that price inflation in the United States has
accelerated so slowly. It has taken more than a decade to move our
economy from an environment of approximate price stability to one
of near double-digit inflation—and well into double digits for some
inflation indices—in which we live today. During this period of a decade
and a half, we have of course had some “bad luck” in the areas of
energy prices and, at times, food prices. Nevertheless, it is impossible
to ascribe all of the increase in inflation to these factors. A substantial
part of the unhappy story is that, over the bulk of this period, on
balance the U.S. economy operated too close to its effective ceiling
of full employment of resources. The continual pressure to use more
plant and equipment, to employ more labor, to extract or import more
raw materials, and to use more energy, all combined to generate a
consistent and quickening upward pressure on prices.
Realizing that the increase of the inflation rate from a relatively
stable range to the near double-digit range has been a slow process is
an important first step in assessing prospects for the future. It suggests
that there is no magic cure that will undo in a year, or even two, what
it has taken a decade or more to do. Moreover, it is highly unlikely
that the adverse inflationary effects of energy prices will turn around
any time soon. Instead, most people knowledgeable about the subject
fear that the relative price of energy will continue to rise throughout
the 1980’s, so that progress in reducing inflation will have to come
against the ongoing pressure of at least one of its initial causes.
What can monetary and fiscal policies do under these circumstances?
Over the foreseeable future, the best way in which U.S. monetary and
fiscal policies can help to reduce price inflation is to aim at a modestly
lesser utilization of resources—again, including plant and equipment,
labor, raw materials, and energy—than has been the case during the
last decade and a half. Moreover, they should attempt to take a some
what different set of risks than they did during the past two decades,
when most policy errors were on the side of too much expansion. We
never try to make policy mistakes, but we know—even though we
may not enjoy admitting it—that we will inevitably make some. Over
the next decade, monetary and fiscal policies should adopt an overall
posture such that on balance, when mistakes do occur, they are more
often in the direction which temporarily reduces utilization of the
economy’s resources than that which temporarily causes excess utiliza
tion. A sustained policy of aiming at a modestly lower utilization level,
and of having mistakes on balance be in the lower utilization direction,
should begin to make a substantial difference for our inflation rate
before too long.
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Finally, what about the prospects for 1980 in particular? In the
context of the current inflation problem, a weak economy in 1980
has probably become an unfortunate necessity. It would at least make
a start on the road to halting the rise of inflation, and then subsequently
to producing a deceleration of inflation. Nevertheless, it is important
not to expect inflation to fall rapidly, even if a short and mild recession
occurs next year, because building up unrealistic expectations of prog
ress would probably only lead to the abandonment of a responsible
anti-inflation policy after it emerged that that policy could not pay
off with enormous gains in the short run. Instead, the right strategy
is to pursue a gradual attempt to reduce inflation over a longer period
of time. A weak economy in 1980 is a regrettable but probably neces
sary way to begin.
Mr. Chairman, thank you for the opportunity to present my views
to the committee.
Chairman N e a l . Thank you, Dr. Friedman, for your very excellent
testimony.
I would like to know what the will of the subcommittees are,
whether we would like to hear from all the witnesses and then ask
questions or to ask questions of each witness.
Mr. D ’ A m o u r s . Mr. Chairman, I would suggest maybe we suspend
the questioning. It is 3 minutes of 10. We have a caucus at 10.
Chairman N e a l . The caucus will be meeting in another room. We
are going to continue.
Mr. D’ A m o u r s . I am sorry. I understood you were going to suspend.
I apologize. I have no preference.
Chairman N e a l . We could suspend the hearings for 15 minutes or
so and see if the caucus would be a relatively brief one, and return to
the hearings.
I am wondering about the time constraints of our witnesses. Would
that be a problem for anyone? If it would not, I believe we might get
broader participation in the hearings, and I think that that might be
beneficial.
If there is no objection, we will suspend the hearings for about
15 minutes. We will return sooner if we can.
[Brief recess.l
Chairman N e a l . I apologize to our witnesses for this long delay.
The caucus is still meeting. I think it won’t last too much longer.
There will be some other members up in a very short time.
At this time we would like to hear from Professor Meigs.
STATEMENT 0E DR. A. JAMES MEIGS, CHAIRMAN OF THE BOARD,
CLAREMONT ECONOMICS INSTITUTE, PROFESSOR OF ECONOMICS,
CLAREMONT MEN’S COLLEGE
Dr. M e i g s . First I want to say it is a great honor for me to par
ticipate in your hearings. Like Professor Friedman, I think your in
vestigations of the monetary policy process have been very helpful
by explaining to the public how monetary policy works.
I believe that your hearings and reports will help to restore stability
in prices, bring lower interest rates, a more stable dollar in exchange
markets, and put this country back on track toward more and better
jobs and a rising standard of living.
61
You can do this by increasing public understanding of what mone
tary policy can do and should do.
Now, I believe the Federal Reserve deserves very strong support
for the policies announced on October 6, and especially for the policy
of controlling growth of the money stock, and giving less emphasis
to attempting to control interest rates.
I believe that the Federal Reserve can control any monetary
aggregate it selects within a small and tolerable range of error. It is a
matter of wanting to do it.
I think they could hardly do worse than they have done in the past.
So a change to a new procedure should yield benefits in improved per
formance.
I think it is very unfortunate that the early reactions of the U.S.
financial markets were apparently based on a misinterpretation of
Federal Reserve policy. I think many people believed that the Federal
Reserve planned to drive interest rates higher in order to support the
dollar on exchange markets.
That is essentially the strategy No. 1, that you outlined in your
letter of invitation. But in fact the announcement of these new policies
should have meant less inflation in the future, and less inflation in the
future should mean lower interest rates, not higher interest rates.
In recent days, the sharp fall of interest rates indicates that the mar
kets are recovering from the shock that they suffered in October.
Trying to keep interest rates high would not help the dollar on
exchange markets if inflation is not checked at the same time. So if
money growth is reduced, expectations of inflation will fall, and we
should see lower interest rates at home and a stronger dollar or more
stable dollar abroad. So, there is no ccnflict between domestic and
international monetary policy goals at this time.
The key to the whole thing is expectations; that is, it seems to me,
where you can help the most. Because if Americans expect more infla
tion, this will cause them to buy real estate, commodities, gold, and
other inflation hedges. They will hesitate to put money in savings
accounts in banks and thrift institutions or to buy bonds. Therefore,
this hesitation tends to drive interest rates up in the United States.
If exchange traders and investors expect more inflation in the United
States, they will buy other currencies, which drives the dollar down on
exchange markets. OPEC is more likely to raise the price of oil if
they believe that we are going to have more inflation m the United
States because, after all, they want goods and services for their oil,
not dollars. We saw all of these effects of rising inflation expectations
in 1979.
In preparing for these hearings, we tested various monetary policies
and the results are shown on the charts that are part of my prepared
statement.
The first experiment we did was to contrast a policy of cutting Mx
growth to a 3-percent annual rate and holding it there through 1984.
Then we contrasted this with a policy of reducing Mi growth gradually
in stages as prescribed in your H.R. 5476. For this first experiment,
we assumed there would not be a major oil price shock. So the first
chart you see shows two courses for monetary expansion—one steady
3 percent, one gradually declining.
On the second page, we show effects of the two policies on real GNP
growth. If money supply growth were to drop immediately to 3 percent
55-123
0 - 8 0 - 5
62
and stay there, this would hold output in 1980 and 1981 a little bit
below what it would be with the gradual money supply reduction
strategy. Actually, though, it would mean that with the 3-percent
steady money growth rate the economy would reach its potential
output growth rate a little sooner than with the gradually declining
Mi growth rate.
The effects on inflation are that an immediate drop to a steady 3
percent would bring inflation down a little faster than the gradual
reduction, but both of them get inflation down to a very low level by
the end of 1984.
So by either course, reduction of the money growth rate would
bring inflation down. We would have a temporary period of instability
in 1980, which is really a legacy of the unstable monetary policies and
oil shocks of last year, and then get back to a high growth rate by 1982.
Both of these strategies of reducing money growth rates would, as
you see on the next page, reduce interest rates. You can see we use
commercial paper rates for our short-term rate. By either policy, we
would expect a sharp* drop in short-term rates in 1980. In fact, I think
that decline is already underway.
With the steady 3-percent Mi growth, which is a sharper reduction
policy, interest rates would fall sooner than with the gradual. Both of
them would get to the same point by 1984. Long-term rates, too,
would come down under both policies. They would come down a little
faster with the steady 3-percent Mi growth.
But the essential point is that reducing the money growth rate
instead of raising interest rates, as many people fear, would bring
interest rates down. So that would seem to me a very desirable impli
cation of these policies.
Now, the next question we looked into is to suppose that the Federal
Reserve is on a policy of gradually reducing money growth rates by
stages over the next several years, and then in 1980 we have a major
oil price increase comparable to the one that we had last year. What
should be the policy, what should the Federal Reserve do, in response
to this?
We analyzed two possibilities, One possibility is that they don't
respond to this in any way—just stay on course, controlling the growth
rate of the money stock, gradually reducing it.
The other one is a suggestion some economists have made that the
Federal Reserve could ease the adjustment cost by departing from
their monetary growth strategy and letting the money growth rate rise
temporarily. We show both possibilities on the chart, showing what
we call accommodative monetary policy for an oil price shock, and one
of just sticking on course.
But when you look at the effects of the policies on the next page,
page 5, the accommodative monetary policy to cushion the shock of an
oil price increase would mean a little bit higher growth in real GNP
in 1980, immediately after the shock, and in 1981. But we would pay
for that with lower growth of real output later on, in 1982, when the
Federal Reserve would be attempting to get back on its disinflationary
or anti-inflationary track. So there is really no net gain in output over
the period, following an accommodative monetary policy, when we
have an oil price shock.
But if you look at the effects on inflation, the accommodative policy
would mean a sharp rise in inflation rate within 1980, and then it
63
would mean that inflation would be substantially higher for a long
time to come than it would have been if the Federal Reserve had just
stayed on a monetary growth strategy, of reducing monetary growth.
Accommodative policy would mean higher inflation.
The next page, page 6, shows the effects of these two policy choices
on interest rates. A lot of people would expect that if we had an oil
price shock and the Federal Reserve followed an accommodative
policy by letting money growth accelerate, interest rates would be
lower.
It doesn’t appear to be so. The policy would actually not make in
terest rates perceptibly lower in 1980 than they would be otherwise,
but it would make interest rates much higher later than they would
otherwise be. As you can see, both short-term and long-term rates
would be higher for a long time.
So, the policy of trying to cushion an oil price increase would mean
higher inflation, and would mean higher interest rates than we would
otherwise have. That in effect means there is no way to adjust to the
oil price shock with monetary policy. The Federal Reserve cannot
create oil with its money printing press.
Those results might seem implausible until we reflect that in 1979
the Federal Reserve did effectively cushion or accommodate an oil
price increase.
When we had the oil price increase in 1979, soon thereafter the
effects on prices raised inflation expectations, which raised or tended
to raise interest rates. With the Federal Reserve’s procedure of con
trolling the monetary aggregates by pegging the Federal funds rate,
this meant an automatic acceleration in growth of the money stock.
That automatic acceleration of the money stock had all of the unfor
tunate effects that we have shown with this experiment, as a hypo
thetical possibility in the future. A policy of cushioning an oil price
increase by more expansive monetary policy would mean higher inter
est rates than we would otherwise have. We already have seen that
happen.
The third set of experiments that we did was to see what happens,
what difference does it make, if the public believes in the policy
announcement or if it does not believe. We have two possibilities.
One is that the Federal Reserve policies are believed, the announce
ments are believed by the public. We have precedents in other coun
tries, I think, in the Bundesbank and the Bank of Japan. When they
make a policy announcement, the public believes and begins to adjust
to the expected new policies rather promptly. In our country, let us
say the public is much more skeptical of policy announcements, and
so the only way we know now is for the public to observe good behavior
on the part of the Federal Reserve for a long time.
So in the two courses we looked at, one is if they believe immediately,
we would have a somewhat smaller cost of adjustment in terms of
lost output, real GNP, to an anti-inflationary policy. If the public is
skeptical for about 2 years, the cost in terms of lost output and em
ployment is somewhat greater. But eventually, if the people believe
that the Fed is on a steady anti-inflation policy and intends to remain
so, real GNP growth accelerates.
These effects show very clearly on inflation rates. The inflation rate
would come down much sooner if people believed that the Federal
Reserve was on an anti-inflationary policy and intended to stay on
that policy.
64
So these effects carry on into interest rates. If the people fail to
believe that the Federal Reserve is serious, interest rates will be higher
than they would be if the public believes that the Federal Reserve is
oing to control inflation, it is going to stay on the policy. This is true
oth for short-term rates and long-term rates, which are of great con
cern to all of us.
In conclusion, I would say that from our experiments and from
many years of history, a lot of which is very clearly portrayed in the
briefing materials prepared by your staff before these hearings, it is
clear that if the Federal Reserve stays on a steady monetary policy
track—that is, either a constant rate of growth of money stock or a
steadily declining rate of growth of money stock—inflation and interest
rates will come down, and the U.S. economy could go back to full
potential growth rates within 3 years.
I think the adjustment could be done within a 3-year period. But
a deviation from this policy track for any reason—for example, to
accommodate an oil price increase—would make inflation and interest
rates higher for a long time than they would otherwise be, and would
not really increase the growth rate of real output or employment.
Another deviation which I did not illustrate would be one of acci
dentally undershooting the money growth target. That is a danger in
a period of falling interest rates, if the Federal Reserve targets on a
Federal funds rate. They may make the growth of eonmy supply less
than would be desirable, in which case we could have for a time a more
serious recession than we would otherwise have, which raises the danger
that the public will demand a shift back to an inflationary policy. We
hope that would not happen. Deviation from the track in either direc
tion would have dangerous or unpleasant consequences.
Therefore, I would say that announcing a money growth target is
extremely important; the announcement itself is important, letting
people know ahead of time what the Federal Reserve has in mind.
So then consumers, businesses, investors can plan because they would
have more information about future economic conditions. At the
>resent time, the record of great instability in monetary policy over a
ong period makes people very uncertain about what the Federal
Reserve will do next. Even though they have already announced that
they intend to have an anti-inflationary policy, they have not spelled
out for us yet just what kind of growth rates they project for next year
or the years thereafter.
I think it would be very, very helpful if your committee would ask
the Federal Reserve to explam its new procedures, explain them
frankly and fully, as soon as possible. One of the reasons for the tre
mendous rise in interest rates m October was that people in the finan
cial markets were so puzzled by what the new procedures were going
to be. They knew that procedures would be different than in the past.
Many of them believed that the Federal Reserve had been stabilizing
interest rates, which actually it had not been doing.
So for a while they were in such great uncertainty that, in effect, a
big risk premium was added to interest rates, on bonds and all sorts of
financial assets. So that simply explaining the procedures, something
your committee has been working on for a long time, would help calm
down the markets and make it possible for people to plan more
realistically.
f
1
65
A strategy for reducing inflation and stabilizing the dollar on
exchange markets would work faster and cost less if people at home
and abroad could be convinced that the Federal Reserve won’t give
up. I am afraid that many people here and in other countries are very
cynical about these recent announcements. They say, “Well, they will
be on track for a short time and then very soon they will go back to
their old habits.” That would be very damaging. I think it is one of
the reasons why inflation rates and interest rates are not coming down
even more rapidly than they are.
So, helping to keep the Federal Reserve on track and convincing
the public that the Federal Reserve will stay on track would be a
great service that you can perform. It is very important that these
announcements be carried out by the Federal Reserve. Whatever the
announced policy is, it is important that it be carried out.
I would say that probably the most convincing ultimate announce
ment that there could be is something like your legislation, H.R. 5476.
Thank you.
[Dr. Meigs prepared statement follows:]
Claremont Economics Institute
201 W. Bonita Avenue
Claremont, California
Statement by
A* James Meigs, Chairman of the Board of Claremont Economics Institute
Professor of Economics, Claremont Men's College
before the
Subcommittee on Domestic Monetary Policy
and
Subcommittee on International Trade, Investment and Monetary Policy
of the
Committee on Banking, Finance and Urban Affairs
House of Representatives
November 27, 1979
It is a great privilege for me and for the institutions I represent to
be asked by you to take part in these hearings on the goais and conduct of
monetary policy.
By increasing public understanding, your hearings and your
reports will increase the effectiveness of policies designed to reduce
inflation, to stabilize the value of the dollar on exchange markets, and to
facilitate growth in employment and real income in this country and in the
rest of the world.
67
I
plan first to comment on the policy strategies outlined in your
invitations Strategy 1, which would place top priority on halting the
decline of the dollar on exchange markets by keeping interest rates high,
and Strategy 2, which would ignore movements in interest rates and concen
trate instead on establishing and remaining on or near a long-run disinfla
tionary monetary growth target path.
Then I will comment on the results of
the simulations which are presented in the charts attached to my written
statement. These simulations were run at the Claremont Economics Institute
as a way to test implications of various monetary-policy courses for infla
tion, economic activity, and interest rates.
It is extremely unfortunate that the policy measures announced by the
Federal Reserve on October 6 were misinterpreted by many people as measures
designed to raise interest rates in this country in order to halt the
decline of the dollar on world exchange markets, as in the Strategy 1
outlined in your questions.
This fundamental misinterpretation of both the
intent and the probable effects of the new Federal Reserve policies
accounts, I believe, for much of the extraordinary, indeed shocking, losses
in current market value of stocks, bonds, and other financial assets in
U.S. securities markets following the Federal Reserve's announcements.
The
announced policies, if adhered to, should reduce interest rates, not raise
them, and thus should increase market prices of stocks, bonds, and other
financial assets in U.S. securities markets in coming months.
A strategy of trying to keep interest rates high, in order to support the
dollar on exchange markets, would be neither feasible nor necessary.
It would
68
not be feasible because the only way the Federal Reserve can raise interest
rates for more than a very brief period is by increasing inflation and
raising inflation expectations.
Volcker has testified:
The converse is also true, as Chairman
The only way the Federal Reserve can reduce interest
rates is by reducing growth of bank credit and the money supply and thus
reducing inflation and inflation expectations.
The relationship between
inflation and interest rates is very clearly shown in the briefing materials
prepared by your staff and in the simulations to be discussed later.
There is a danger, as your questions suggest, that a strategy of sharply
reducing growth of bank credit and the money supply in an attempt to raise
interest rates would cause a recession, which would then lead participants in
financial markets and exchange markets here and abroad to expect a resumption
of inflationary policies*
This expectation of inflationary policies would
soon depress the value of the dollar on exchange markets.
A strategy of trying to keep interest rates high in order to support the
dollar would not be necessary because a policy of reducing inflation through
reducing monetary expansion rates would be far more effective.
2 —
Thus Strategy
ignoring interest rates and concentrating on following a longrun dis
inflationary monetary growth target path —
Strategy 1*
is much more desirable than
There is, as Chairman Volcker testified on November 13, "no
conflict or meaningful 'trade-off' between the domestic and international
objectives of economic policy•"
If the Federal Reserve concentrates on
controlling the provision of reserves to the baulking system in the future,
rather than attempting to control interest rates, the prospects for achieving
both domestic and international objectives of policy will be vastly improved.
69
Expectations are the key.
If people at home and abroad believe that U.S.
fiscal and monetary policies will lead to more inflation in the future they
will not wait to see the inflation before they act to protect themselves.
They will try to reduce their holdings of dollar financial assets, such as
savings accounts in U.S. banks and thrift institutions and U.S. bonds and
stocks, in order to buy real assets, such as houses, gold and other commodi
ties, thus raising U.S. interest rates.
Many also will shift into assets
in countries whose governments are expected to do a better job of protect
ing the purchasing power of their currencies, This shift will reduce the value
of the dollar on exchange markets.
The members of OPEC, too, are more likely
to raise oil prices if they believe the dollars they take in payment will
continue to lose purchasing power in terms of the goods and services they
can buy in this country and other countries.
We have seen all of these effects
of inflation expectations on U.S. interest rates, exchange rates, and OPEC
oil prices this year.
A strategy of following a disinflationary monetary growth strategy while
ignoring interest rates would not require cooperation of other central banks
and governments to be successful in stabilizing the value of the dollar on
exchange markets.
In fact, such a policy strategy in the world's largest
national economy should be welcomed by other governments which are concerned
with maintaining price stability and high employment in their countries.
Their efforts to offset effects of instability in the exchange value of the
dollar through direct intervention in exchange markets merely spread infla
tion and economic instability from the United States to their countries.
70
They understand that very well*
Countries, such as West Germany, which have
taken the lead in advocating and applying monetary growth stategies, would
enjoy greater success in achieving their domestic stability objectives when
instability in economic activities and prices is reduced in the United
States.
Other countries would have increasing incentive to adopt comparable
policy strategies, in order to enjoy the benefits of more stable exchange
rates with the United States and other countries.
In the simulations reported on the charts, my colleagues and I at the
Claremont Economics Institute tried to see how various proposed monetary
policy strategies would work.
In the first set, we contrasted a strategy
of reducing the growth rate of Ml to a 3% annual rate immediately and
holding it there through 1984, with the strategy proposed in H.R 5476 of
gradually reducing M1 growth from a 6% annual rate in 1980 in successive
stages to a 3% annual rate in 1983 and following years.
We did not try to
adjust M1 for the introduction of Automatic Transfer Services, believing
that such adjustments, if necessary, could be made in the Federal Reserve's
actual operating targets as they go along.
We started with assuming a 3% growth rate for the fourth quarter of this
year, as a rough estimate of what actual money growth will be in the current
quarter.
We also assumed that oil prices will rise at a 3% real annual rate,
(after adjustment of dollar prices for U.S. inflation) but that there would
not be a major oil-price shock, such as those of 1973-74 and 1979.
The most interesting implication is that inflation would decline substan
tially under both strategies, with the gradual strategy taking longer, as would
be expected.
There would be considerable instability in growth rates of real
71
GNP in 1980 under either strategy, as a legacy of the extreme instability in
monetary growth rates and the oil price shock during 1979.
The first-year
cost in lower economic activity would be greater with an immediate reduction
to a 3% growth rate for M1 than under the gradual-reduction strategy, but
output would return sooner to longrun potential growth rates under the
constant 3% strategy than under the other.
Both short-term and long-term
interest rates would begin to decline in 1980, and would fall most rapidly
with the steady 3% M1 strategy.
The second set explores the implications of another oil-price shock in 1980
comparable to the one in 1979.
We were most interested in the question of
what would happen if the Federal Reserve were to attempt to cushion the shock
by departing from a strategy of gradually reducing monetary expansion.
Under
the gradual reduction strategy, a major oil-price increase would mean higher
inflation and lower output growth for approximately three or four quarters than
would have occurred without the oil-price shock.
There is no way to avoid these
consequences of large, sudden increases in oil prices.
If the Federal Reserve were to try to accommodate effects of the oil-price
shock by temporarily abandoning its monetary growth targets, our simulations
indicate that it would stimulate higher growth rates of real output in 1980
and early 1981 than if it stayed on its announced monetary growth path.
But
this gain in output in 1980 and 1981 would be paid for by lower growth in
real output in late 1981 and 1982.
In effect, accommodative monetary policy
in 1980 would merely delay and increase the real costs of adjusting to the
oil-price increase*
Furthermore, an attempt to accommodate the oil-price
72
increase with greater monetary expansion would sharply increase the inflation
rate and keep it much higher for a long time than it would have been without
an attempt at monetary accommodation.
An oil-price increase also would make interest rates higher for a time than
they would otherwise be.
The attempt to accommodate the oil-price increase
with monetary expansion, however, would make short-term rates almost imper
ceptibly lower for one quarter than they would be without monetary acconraodation.
But rates would be considerably higher for the next four years as a
result of the accommodative monetary policy than they would have been if the
Federal Reserve were to igrnore the oil-price increases in setting Monetary
growth targets.
These results gain plausibility if we remember that the Federal Reserve
accomodated the 1979 oil-price increase with a sharp acceleration in
monetary expansion, by accident if not by intention*
When the oil-price
increase began to raise inflation expectations and interest rates, the
Federal Reserve's practice of attempting to control monetary expansion
throwgh pursuing Federal funds rate targets led to am acceleration in
growth of Federal Reserve credit, member bank reserves, monetary base,
total bank credit, and all of the various measures of the money stock.
The
recessionary effects of the oil-price increase on real GNP may have been
softened or delayed in the third quarter, but inflation rates and interest
rates soared upward.
The Federal Reserve's announced new practice of
controlling monetary expansion through metering out bank reserves, instead
of pegging Federal funds rates, should make such accidents much less likely
in the future.
73
The final question we examined in our simulations was the influence of
differing degrees of public confidence in Federal Reserve policy announce
ments*
For these tests we assumed that the Federal Reserve would follow
the strategy of gradually reducing the growth rate of M1 as prescribed in
H.R* 5476 (first chart) and that OPEC would not make any sudden, large
increases in oil prices.
It is well recognized that the Bundesbank in West Germany and the Bank
of Japan get prompt results from policy announcements, because they have
established reputations with the people of their countries for following
through (except when pushed off track by pressure to intervene in exchange
markets to stabilize their exchange rates)•
of government policy announcements
Americans are more skeptical
and so the Federal Reserve has the
very difficult problem today of reducing inflation expectations.
If we
assume, as we have for the lines labeled "Public Confidence", that the
public expects money growth to be on the announced growth path, inflation
would cone down more rapidly than it would if the people have to be shown
by several years of good behavior by the Federal Reserve.
The costs in
real output of reducing inflation also would be much less if the public had
confidence that announced policies would be followed. Both short-term and
long-term interest rates would decline more rapidly if the American people
were confident that the monetary growth targets would be followed.
Although we did not simulate effects of the proposed monetary policy
strategies on exchange rates, the effects surely would be very similar.
If
foreign exchange traders were to believe that the Federal Reserve will stay
74
with a steady or gradually declining growth rate for the money stock, the
dollar would rise promptly.
We can see this from the behavior of exchange
rates after both the November 1, 1978 policy change and the October 6, 1979
change.
But exchange traders remember the record of instability in U.S.
monetary growth rates since the early 1960s.
They will require convincing
evidence in the form of a record of responsible control of monetary aggre
gates that the Federal Reserve is really serious this time, before commit
ting themselves as fully as they would if they had more confidence in
U.S. policies.
The monetary authorities, as Chairman Volcker testified, argue that it
would be a mistake to set rigid and narrow long-range monetary targets . They
naturally want to retain as large a degree of discretion in setting policies
as they can.
But the long record of extreme dinstability of monetary growth
rates under discretionary policies will make it difficult for them to achieve
their policy objectives as rapidly, or at as low a cost in reed, output and
employment, as they, and the public, would prefer.
Therefore, there is much
to be said for announcing targets for as far ahead as possible and then
hitting them.
I have no doubt of the Federal Reserve's technical ability to
maintain any desired growth rate for any monetary aggregate they select,
within a small, tolerable range of error.
Stabilizing the growth rate of
almost any monetary aggregate would be a far more effective way to achieve
domestic and international monetary policy objectives than would the policies
and procedures applied in the past.
75
The Subcommittee on Domestic Monetary Policy and the Subcommittee on
International Trade, Investment and Monetary Policy can play a major role in
enlightening the public on the costs and benefits of pursuing steady dis
inflationary monetary policies.
This should make the Federal Reserve's
task easier by reducing the public's fears that the Congress or the Admini
stration may compel the monetary authorities to repeat the errors of
excessive monetary expansion and excessive variability in monetary growth
rates that have caused so much trouble in the past.
Perhaps the most
convincing evidence of the determination of the Congress to support sound
monetary policies would be legislation, such as H.R. 5476, which would
determine a long-range monetary policy strategy.
76
Claremont Economics Institute
ALTERNATE COURSES FOR REDUCING MONEY GROWTH
MONEY GROWTH ASSUMPTIONS
A ll
ch a rts
p lo tte d
q u a r te r ly
at
(M l)
annual
ra tes
77
EFFECTS OF LOWER MONEY GROWTH ON REAL GNP GROWTH
RATES OF GROWTH OF REAL GNP
EFFECTS OF LOWER MONEY GROWTH ON IN F LA T IO N
RATES OF CHANGE OF GNP DEFLATOR
78
EFFECTS OF LOWER MONEY GROWTH ON
SHORT-TERM IN TEREST RATES
COMMERCIAL PAPER RATES
1979
1980
1981
1982
1983
EFFECTS OF LOWER MONEY GROWTH ON
LONG-TERM Y IE L D S
P ercen t
LONG-TERM AAA CORPORATE BOND Y IE L D S
1984
79
ALTERNATIVE COURSES FOR MONETARY POLICY
WITH A 1980 OIL-PRICE SHOCK
MONEY-GROWTH ASSUMPTIONS (Ml)
80
EFFECTS OF A 1 9 8 0 O I L -P R I C E
REAL GNP GROWTH
SHOCK ON
RATES OF GROWTH OF REAL GNP
EFFECTS OF A 1 9 8 0 O I L -P R I C E
IN FLA TIO N
SHOCK ON
RATES OF CHANGE OF GNP DEFLATOR
81
EFFECTS OF A 1 9 8 0 O I L -P R I C E SHOCK ON
SHORT-TERM IN TER E ST RATES
PRIME COMMERCIAL PAPER RATES
Percent
EFFECTS OF A 1 9 8 0 O I L -P R I C E
LONG-TERM Y IE L D S
SHOCK ON
LONG-TERM AAA CORPORATE BOND Y IE L D S
P ercen t
82
MEASURES TO INCREASE CONFIDENCE IN ANNOUNCED
MONETARY P O L IC IE S REDUCE ADJUSTMENT C O S T S :
REAL GNP GROWTH
RATES OF GROWTH OF REAL GNP
% C hange
MEASURES TO INCREASE CONFIDENCE IN ANNOUNCED
MONETARY P O L IC IE S REDUCE ADJUSTMENT C O S T S ;
IN F LA T IO N
% C hange
RATES OF CHANGE OF GNP DEFLATOR
83
MEASURES TO INCREASE CONFIDENCE IN ANNOUNCED
MONETARY P O L IC IE S REDUCE ADJUSTMENT C O S T S :
SHORT-TERM IN TEREST RATES
P ercen t
COMMERCIAL PAPER RATES
MEASURES TO INCREASE CONFIDENCE IN ANNOUNCED
MONETARY P O L IC IE S REDUCE ADJUSTMENT C O $ T S :
LONG-TERM Y IE L D S
LONG-TERM AAA CORPORATE BOND Y IE L D S
P ercen t
84
Chairman N e a l . Thank y o u , Professor.
I just want to say at this point, we tried, when Chairman Volcker
was here, we urged him in the strongest terms that I know how to use
to pursue the policy that was announced and to make an announce
ment that he intended to pursue a policy as outlined in our bill, al
though I frankly, even though I am the author of the bill, would rather
see the Fed announce that and stick to it than to see the bill passed.
He agreed that it was his intent to follow this policy and agreed to
bring to the further consideration of the Board of Governors a dis
cussion of this matter. I hope that that will result in just such an
announcement.
As I listen to your testimony on this subject, I thought that I might
send him a copy of it and urge him again to do this. I know
he is thinking along these very same lines, and I think he has some
reservations that probably make a lot of sense from his point of view.
I agree with you that if we can get better public understanding that
this policy will benefit the American public in terms of lower inflation,
lower interest rates, stabilized value of the dollar, more employment,
that we can get more support for it.
But that is not an easy task because there are all sorts of conflicting
voices in our society, many with a great deal of influence which will
argue against this kind of policy. It is going to be most difficult in this
next year, a political year, not to hear a lot of that.
I thank you for your testimony. We will get back with some more
questions a little later on.
Professor Parkin?
STATEMENT OF DR. MICHAEL PARKIN, PROFESSOR OF ECONOMICS,
UNIVERSITY OF WESTERN ONTARIO, CANADA
Professor P a r k i n . Thank you, Mr. Chairman.
It is a great honor and privilege for someone from an island that is
almost sunk under much more inflation that you have yet had to be
able to help you in what I think are some of the most important in
novations in monetary policy; that is, these very oversight hearings
which you are conducting.
I would like to begin by apologizing that I don’t yet have a pre
pared statement, but would ask that I might submit that after the
event.
In your letter of invitation you asked me to address two matters—
first of all, to assess two alternative strategies for monetary policy anc1,
secondly, to comment on the October 6 policy changes.
I propose to speak to both those points in that order.
First, I would like to examine and offer my own evaluation and
assessment of the two strategies outlined in your invitation letter.
Strategy No. 1, which initially calls for placing full priority on
stabilizing the foreign exchange value of the U.S. dollar, and after,
but only after achieving a stabilization in the foreign exchange market,
turning attention to domestic goals of price stability and high
employment.
I
would in a sense define that policy strategy as a variation on the
status quo theme; that is, it is doing what we have been doing in the
past, only with a slight variation in that the foreign exchange rate
85
becomes one of the central initial approximate targets for monetary
policy.
I want to try to evaluate what I think would happen if this policy
strategy, strategy 1, was followed.
The first thing that is fairly certain would happen is that the U.S.
economy would go through either a recession or at the very least a
very marked slowdown of real output of growth and a marked rise in
unemployment.
W hy clo I say that? I say that because what is implied by such a
strategy is an initial sharp contraction of money supply growth and
an initial, perhaps even sharper than we have seen in the past few
weeks, rise in short-term rates of interest for a period.
Why do I say this would lead to a recession? Simply because every
time that has been done in the past it has led to a recession. The
historical evidence is not mixed. This is not something about which
there is some uncertainty. It is absolutely for sure that there would
be a rise in unemployment.
Just as a matter of interest, on the five occasions since World War
II when money supply growth has been cut back for 2 successive years,
the unemployment rate has risen in the subsequent year or year and
a half by an average of 2 full percentage points.
So that is the sort of thing which we know happens when we indulge
in sharp monetary contraction or sharp deceleration of money supply
growth rates.
The second thing that we are fairly sure, I think, would happen
following strategy 1 is that inflation would abate temporarily, but
only temporarily, and thereafter would be succeeded by yet a bigger
wave of inflation.
Why would that happen? Well, it would happen primarily because
the very sharp contraction of money supply growth that would be
implied by strategy 1 would generate an unemployment rate which
would then itself trigger an overreaction, subsequent expansion of
money growth supply.
Again, the historical record on this is very strong. Every time in
the past when unemployment has increased sharply following a decel
eration of money supply growth, there has been a subsequent increase
in money supply growth and usually and certainly in the case of the
last decade of American history, to even higher rates of money supply
growth in the new upturn than there had been experienced in the
previous upturn.
Now, this is something which we have seen very, very important
evidence on. We have seen that countries that have pursued this kind
of shortrun monetary policy, trying to beat inflation or trying to sta
bilize the exchange value of the currency in the short run, thereafter
trying to stabilize the employment rate, we see this has uniformly led
to accelerating inflation.
The most gross example I suppose is that from my own country,
the United Kingdom, which in 1969 through 1972 put itself through
the disinflationary wringer and wound up with inflation of about 12
percent down to 8 percent, and thereafter increased money supply
growth, so that inflation increased to the middle twenties by 1975-76.
So here is a previous rerun of what that kind of policy would be
likely to produce.
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Worse than all this, it would be a policy that would insure that
interest rates would remain high because there wouldn’t be a long
term expectation of inflation reduction. So there would be none of the
forces that Professor Meigs talked about would be at work to bring
the general level of interest rates down.
Yet, worse than all this, as if this is not bad enough, would be con
siderable uncertainty on foreign exchange markets themselves. The
reason for this is to pursue strategy 1, to pursue a policy of initially
targeting on the exchange rate and then subsequently switching tracks
to domestic targets would give zero information to market participants
in all markets, foreign exchange markets included, concerning what
the even medium-term actual policy course of the Federal Reserve
system would be.
This conclusion arises from consideration of the virtual impossibility
of making accurate predictions of what foreign central bank reactions
would be to a sharp deceleration of monetary growth and a sharp rise
in interest rates in the United States.
One possible reaction would be to follow suit. One other reaction
of the foreigners would be to just let the United States run ahead
with its policy and not attempt to retaliate with its own higher rates
of interest and slower money supply growth rates.
So until one saw what the foreigner was going to do, one wouldn’t
know what the Fed was going to do, and there would be a lack of
information, and foreign exchange market expectations would be
extremely vague and hazy, and the foreign exchange rates would
reflect a great deal of instability, short-term ups and downs as a
consequence.
In summary, the consequences of following strategy 2 seem to
me to be more and worse of the things that we have had in the recent
past. It would make the decade of the eighties to the seventies like
the seventies were to the sixties; that is, it would be a continuation of
the deteriorating trends in monetary stability, not just in the United
States but throughout the world.
Let me come to strategy 2, which is to establish and maintain
money supply growth targets similar to those— together with a range
for money supply growth, not just a point, but a range of money
supply growth similar to those set out in your draft bill, H .R . 5476.
I want to evaluate this under three headings— what are the main
positive effects that would occur as a result of such a strategy, what
are the risks, and are there any extra requirements required to make
such a strategy really successful?
First, the positive effects. It seems to me that one very important
positive effect is that this is a strategy that the Federal Reserve could
follow independently of what is done in Japan and Germany and the
rest of the world.
It is a policy, in other words, which can be declared ahead of time
and pursued regardless of foreign monetary policy developments. In
that sense, it is a policy that gives maximum information to market
participants and is likely in and of itself to produce much more order
liness in the foreign exchange market than would strategy 1.
It might not initially produce as large a rise or reduction in the rate
of decline of the dollar, but it would certainly produce a more orderly
and less perturbed foreign exchange market.
87
Second, it is a monetary policy which it seems to me at least does
as much as monetary policy can do to achieve the unemplo} msnt
targets of the Humphrey-Hawkins Act by helping to move the unem
ployment rate by 1982-83 to the lowest conceivable level.
That is not to say that it can achieve the Humphrey-Hawkins
target. I don’t know whether that target is achievable. Certainly
monetary policy alone is not something which can move the unem
ployment rate permanently very far.
But there is stratistical evidence from some recent studies that the
amount of monetary uncertainty, the amount of uncertainty from
variableness in monetary policy, does add to the unemployment rate.
This evidence I think has to be taken somewhat seriously.
The third and most important positive effect of strategy 2 is
that it is the only policy that we as a profession of economists know
that is capable of moving the inflation rate toward the HumphreyHawkins target of about 3 percent by the early eighties.
We know of no other way of doing it. So, for that reason alone it is
an exceedingly important strategy proposal.
Now, what are the risks of this strategy? The first possible risk that
ought to be recognized is that it could conceivably cause a rise in the
unemployment rate.
However, on the basis of the historical evidence it seems to be the
case that the rise in the unemployment rate that will occur, or that
might occur, if strategy 2 is followed is less than what would arise
under strategy 1; that is, there may be a temporary rise in unem
ployment, but it will not be as large as the rise would be under a
policy of sharp deceleration of money now to achieve quickly some
foreign exchange or even inflation objectives.
The second possible objection to strategy 2 is that it would
produce high interest rates. Well, Professor Meigs pointed out, with
the aid of some very interesting charts and tables, that that is not
foreseen in his scenario, and I want to agree with that.
Indeed, it sound paradoxical, but strategy 2 is the low-interestrate strategy, it is the low unemployment/low-interest-rate strategy.
It is not the converse, which it sometimes is branded as being.
Now, what are the extra requirements that have to be fulfilled
in order to make strategy 2, the gradualist strategy, really do the
best it can? It seems to me there are two things that matter.
First, it is important that the strategy be adhered to even in the
face of temporarily higher unemployment or interest rates than
politicians feel comfortable with. Perhaps one should say it is not
necessary to stick to it even then, but especially then. That is when
most impact would be made on public perception of what future
policy is going to be.
The second extra ingredient that seems to me to be required is there
needs to be some kind of binding, perhaps legislative commitment,
perhaps an H.R. 5476 as an act rather than a bill, which in fact ties
the hands somewhat for policy discretion.
Now I say ties the hands somewhat because that draft bill is the
most cleverly worded document in this area that I have seen, in the
sense that it constrains the Federal Reserve to a trend rate of growth
of money supply which is anti-inflationary, and at the same time it
gives the Federal Reserve as much flexibility as it has historically
88
shown itself to need in order to cope with cyclical fluctuations in the
economy.
You will recall, Mr. Chairman, that that draft bill provides for a
band for money supply growth of 3 percent. That is a target plus or
minus 1 }i percentage points on either side, the extra extension of
which is subject to some additional restrictions, but nevertheless avail
able for the Federal Open Market Committee to pursue.
Now I looked at the actual behavior of money supply growth over
the past decade and I noted that the average growth rate of money
supply has been exceeded by more than l){ percentage points on just
one occasion—in 1978. That has produced the two-digit inflation that
we are now experiencing.
I also noted that the Federal Reserve produced money supply
growth more than 1 percentage points below the average for the last
decade on one occasion only. That was in 1975 when the Federal
Reserve helped along with O PEC and others to generate the most
serious recession that this economy has had to experience in recent
years.
In short, Mr. Chairman, I note that when the Federal Reserve has
on two rare occasions gone outside the range that your draft bill
would restrict it to remain within, problems have arisen.
For the rest of the time the Federal Reserve has managed to stay
within that range. So I would summarize strategy 2 as saying if it is
bolstered with seme kind of more long-term binding requirement to
achieve the money supply growth path and target range envisioned in
it, then it is a policy that will deliver lower inflation, more stable and
higher employment, and lower rates of interest than any other policy
that we could devise.
Finally, and briefly, let me say that I think the October 6 policy
changes do represent a bolstered step in the right direction. I agree,
though, with Professor Friedman that controlling the money supply
as a technical operation is not the central issue.
It is the will to achieve a particular path for the money supply
rather than the particular technique chosen for achieving it. Although
I am extremely sympathetic to the new moves and to the general
approach by Chairman Volcker, I would like to see the two missing
ingredients that I have already referred to put into place quite soon—
one, some lengthening of the term of the commitment; two, some
binding of the commitment somehow.
Whether that simply requires the Chairman of the Fed to say I will
do it and for us to believe him, or whether it requires the Congress to
put some legislative restrictions on the Fed is a matter for your
committee to decide.
I personally would favor a legislative approach because it would
give more assurance to the market participants, to the general public,
that this is for real.
Thank you, Mr. Chairman.
Chairman N e a l . Thank you very much, Dr. Parkin.
Dr. Meigs, you looked at the relationships between a rapid decline
in the money supply growth in terms of its impact on rates of inflation.
Do you look at those relationships in terms of the relationship to
unemployment?
Dr. M e i g s . Well, the more rapid reduction would mean slower
growth in real output, which would mean higher unemployment. The
89
gradual reduction strategy would mean, I believe, less unemployment
than the sudden adjustment to a fixed rate.
Chairman N e a l . Considerably less unemployment, I would think.
Dr. M e i g s . Oh, yes, but for a year or two— then the question is
what price would the public be willing to pay to reduce inflation. That
is a matter of-----Chairman N e a l . It is essentially a political question.
Dr. M e i g s . Exactly. A lot of economists say it would be better to
have a shock treatment, get it over with, and maybe the longrun costs
would be less. M y personal preference is for the gradual strategy.
Chairman N e a l . It is certainly mine, also. I believe, as your charts
indicate, we reach the same goal at about the same time. In the overall
picture there is not very much difference in the time we reach the ulti
mate goal. It would come at a much lesser cost in unemployment.
I think that the country— it would be my political judgment that
the country would not support any rapid escalation in the rate of
employment. It would be unnecessary if we would follow the more
gradual approach.
I just wanted to get on the record whether or not you would be
more likely to endorse the gradual approach over the more rapid
approach, and I see that you do.
Dr. Parkin, some recent statistics regarding the relationship of
monetary policy to unemployment. I wonder if you could tell us what
it was that you referred to.
Dr. P a r k i n . There is a study by Prof. Paul Evans of Stanford
University, which is currently in mimeographed form, being circulated
around to economists— I am not sure whether any of my colleagues
have had an opportunity of seeing this, but it has been widely
circulated.
What it does is to calculate a statistical series called monetary un
certainty that runs from the 1920,s through the 1970,s, together with
some other relevant series, and then explains the movements of the
unemployment rate in the United States all the way from the middle
twenties through to the present time.
It even helps to explain some of the persistently high unemployment
in that Great Depression period which previously had puzzled econo
mists and defied explanation.
The theoretical idea is simple enough and is contained in Milton
Friedman’s Nobel lecture, sort of the theory of the reversed slope
Phillips curve, the idea that higher inflation makes for higher unem
ployment because it increases the amount of monetary uncertainty
and makes it necessary for market participants to invest a greater
amount of time in search activity than they would otherwise do.
Whether these statistical ideas would stand up to full scrutiny is too
early to say, but here is a piece of carefully conducted statistical work
by a very careful scholar that points in that direction.
Chairman N e a l . I am certainly glad to know about it. It makes
commonsense to me.
On this question of whether we ought to pursue a legislative ap
proach as opposed to an announcement by the Fed, of course the first
step I think under any conditions would be for the Fed to make some
sort of strong public statement to the effect that they are going to
pursue this policy over a long period of time.
90
I believe all three witnesses agreed that that is an important ele
ment, and whatever influence you have with Chairman Volcker I wish
you would let it be known to him you feel that way, and we might
forward him your testimony to this effect.
I think it would be hard to quantify, but I would think that would
make the process of bringing down the rate of inflation go much more
rapidly, and it would have beneficial effects on the dollar, employment
and so on, as I think all of your have indicated. I certainly agree.
On the question of legislation, would any of you see any
disadvantages to the legislative approach? I have real questions about
it.
In my own mind, in the absence of a strong commitment to a longrange policy, I think the legislation would be very desirable. If we could
get a long-range commitment from the Fed that meant something—
and I don’t know quite what that means— what would be your thought
on the two approaches?
Dr. M e i g s . One point I think implicit in your statement about what
the disadvantages would be— and all of us would agree— is that it
would be undesirable for the Congress each year to legislate a rate of
growth for the money stock for that particular year. It is not the ap
propriate forum for doing that.
Chairman N e a l . Absolutely.
Dr. M e i g s . The key point is to get this binding commitment to a
long-term strategy of reducing inflation, which would then reduce
uncertainty among market participants in financial markets, labor
markets, consumer markets, exchange markets.
So, the key point is getting a commitment to a stable policy defined
in terms of, preferably, some monetary aggregate. It doesn’t matter too
much which one is selected— just so something is stabilized over a
long period. The markets would be relieved of the fear of sudden
unannounced reversals in policy, such as those we have had so many
times in the past.
Dr. F r ie d m a n . Mr. Chairman, I agree the Congress is not the
right place to take decisions about the year-to-year rate of growth of
the money supply, in part because of well-known reasons for insulating
this decision as much as possible from the short-term realities of the
political process.
I think there is another, more technical, reason for this conclusion
that to me is equally important. In you opening remarks this morning
you included A T S accounts along with the usual components of the
M! money stock, and I agreed with you earlier on doing so. A T S
accounts, however, constitute a development that is very recent. If
we had participated in these hearings 2 years ago, it would not have
occurred to us to include such an item as A T S accounts.
The problem here is that our financial institutions are not unchang
ing, and the public’s preferences with respect to its money balance
holdings are not unchanging. I can just cite one example for the future.
There is a substantial movement under way to exempt from the per
sonal income tax the interest received on certain kinds of consumer
deposit balances. It is very difficult to believe that the consuming
public’s choices about how to hold its financial assets would be un
changed if the Congress were to pass such a measure. Nevertheless,
if the public’s preferences about how to hold its cash balances did
91
change because Congress exempted from income tax savings account
interest someone would have to decide the technical issue of how to ad
just the targets of money growth at which the Federal Reserve should
be aiming. It is clear that the target which is appropriate when savings
account interest is taxed would not be the target that would be
appropriate under a different tax regime.
The issue, then, is who is best suited—not just by technical exper
tise, but as a forum for discussion of such issues—for the technical
problem of deciding how to adjust monetary targets in the face of
whatever shifts of consumer deposit balance preferences emerge. Again
I suggest that, on a year-to-year basis, the Congress is not a very
good forum for working out these technical matters. This is yet a
second reason for being cautious about implementing the legislative
approach on a short-term basis.
Chairman N e a l . Of course, what we had in mind, a temporary
definition of money supply— what we are talking about is whatever
is in a bank and checkable, from now on. We don’t care how that
changes.
Would you like to comment on that point?
Professor P a r k i n . Yes, thank you, Mr. Chairman. Legislating the
money supply growth rate is not a business that would yield very
high returns.
Chairman N e a l . We certainly don’t envision that. Let me assure
you of that.
Professor P a r k i n . The real question is how can we best achieve
credibility for medium- to long-term commitments to a steady dis
inflationary money supply growth pattern.
Certainly for the central bank—in this case the Federal Reserve
Board— to announce a path for monetary supply growth such as that
set out in your own draft bill would be a remarkable step forward and
would in and of itself help considerably to reduce uncertainty about
medium-term inflation ana interest rates and would improve the work
ing of markets. It does, however, leave itself open to the problem that
a subsequent Governor or a subsequent Board of the Federal Reserve
could do something different.
A law similar to your own bill, which as it were provides a sort of
background of stability within which the Federal Reserve can exercise
its discretion, would seem to me to be yet another reinforcement of
the credibility of the system. So, I would see it as not an either/or
matter. For the Fed to commit itself is better than nothing; for the
Congress to reinforce the Fed would be better still. Just how much
better and how much we would gain, of course, we can only speculate
because we have not seen anything like this. This is very new and
totally untried.
M ay I just very briefly finally say that of course Professor Friedman
is right to point out that there is a problem about how one defines the
money supply. But once a definition or a criterion for defining the
money supply— in your case, Mr. Chairman, it is a criterion for saying
what would be included— then all that seems to me to matter is to
insure the target growth rate for that aggregate, whatever it is, is such
that once account has been taken of the predicted change and its
velocity of circulation, and once account has been taken of the best
prediction that you can make of the trend growth rate of real income,
92
the desired trend rate of inflation emerges. It is inconceivable to me
that whichever aggregate we picked we could make inflationary
mistakes— that is produces inflations that we didn’t intend to occur—
that were bigger than 1 or 2 percent per annum. I would have thought
that we would all agree that that would be success. If we could have
the inflation bouncing around between 0 and 3 percent, that would
be all right. It would not be heaven, but it would certainly be better
than what we have been achieving in the recent past.
Chairman N e a l . I would like to ask you to comment on one other
thing and then yield to my colleagues.
In trying to deal with the broad question of inflation with my
constituents at home, I ordinarily say something like in my own
opinion, if you looked at the long range—by long range I mean in
this case 50 years, 100 years, 200 years— that you could argue that
all inflation is probably caused by excessive money growth.
If you look at the short range— and by that I mean 1 year, 2 years,
3 years, 4, 5 years, some relatively short period of time— then it
seems to me to be useful to try to look at what we might call monetary
inflation and something we might call price inflation, which I guess
are sort of arbitrary, imprecise terms.
Then I go on to say I think in the short term we could say that
probably 50 or 60 percent of the inflation today is monetary inflation,
and the other 40 or 50 percent would be divided between oil price
increases and other structural elements of our economy, such as mini
mum wage, cost of living increases in labor contracts, regulatory
costs— the whole range of other themes like this.
Then I go on to say if we are going to do something about the basic
cause of inflation we have got to bring down the rate of growth in the
money supply, and if we want to deal with these other elements of
inflation, we have to look at them one by one and see if we think their
inflationary impact, their cost, is worth their benefit.
In some cases I personally think that it is. In other words, I vote
for increases in veterans’ benefits and social security and so on, even
though I know they have an inflationary impact. I think that it is
worth the cost in these specific cases because I think the costs are
relatively minor.
I would like to have all of you just briefly comment on this kind of
understanding and see if you think it is accurate or not, or how would
you improve upon it, trying to understand the situation in which we
find ourselves today.
Dr. F r ie d m a n . I am sympathetic to what you said, Mr. Chairman,
with the exception of the notion that the inflationary costs imposed
by such matters as the minimum wage and a lcn •, long list of other
measures is minor. The evidence is counter to that, in a sense that is
somewhat subtle and therefore warrants clarifying.
Too often we simply assume that the longrun rate of growth of the
money stock is determined by some magic process that has nothing
to do with the political realities of the time. I think that that is not
correct. Instead, the economy generates pressures, and then the Fedeial Reserve must make what is often a very difficult choice about
whether or not to accommodate those pressures.
If we had continual increases in payroll taxes, and in certain kinds
of benefits, and in sugar price supports, and in minimum wage levels,
and in other similar items, and if the Federal Reserve were able or
93
willing to resist the pressure to accommodate those increases, then
over long periods of time the Federal Reserve’s policy would de
termine the longrun inflation rate.
Nevertheless, the accumulation of these inflationary measures builds
up pressures which, more often than not, the Federal Reserve is forced
to accommodate. If it doesn’t, it risks a rise of unemployment or a fall
of real incomes, which will lead to an even greater inflationary pres
sure after the next political go-round.
In fact, therefore, all of these measures have a longrun and lasting
and very major inflationary impact that operates because they are not
independent of the way in which the money stock is allowed to grow
over the long term.
With the exception of that distinction, I believe that I support
what you said, Mr. Chairman.
Chairman N e a l . H o w would you quantify, in your own mind, the
short-range elements of inflation? I said something like 50 or 60 per
cent monetary. To try to be more precise, I might try to say 60 percent
monetary inflation, maybe 25 percent oil prices, 15 percent for every
thing else.
Would that seem like a reasonable sort of division?
Dr. F r ie d m a n . I see no reason to differ with that breakdown. M y
point, however, is that the 60 percent that you attribute to the rate
of monetary growth in fact is an indirect reflection of many of the
other things that have been taking place earlier on. For example, had
the O PEC prices not gone up, and had the minimum wage not in
creased, and had sugar prices not been supported, and had payroll
taxes not been increased, the pressures on the Federal Reserve to
allow the money stock to grow by the amount that accounts for what
we can agree is 60 percent of the inflation would not have been nearly
so great. Hence that 60-percent factor would itself have been much
smaller. Drawing fine distinctions between the monetary part and that
due to the institutional measures, without acknowledging that today’s
monetary part reflects yesterday’s institutional measures, may be quite
somewhat misleading.
Chairman N e a l . Thank you.
Dr. M e ig s . Some of this was involved in the little experiment we
did on whether the Fed should accommodate an oil price shock. Some
economists argue that if one important price rises, if you are going to
keep the average constant, some other price has to go down, and we
all know, so it is said, no price ever comes down.
That is a fallacy. Prices do adjust in relative terms, but adjustment
is not always short and pleasant. That generates some of the pressures
that Professor Friedman is talking about.
There are two components to these pressures on policy. One is the
sort of pressure on the Federal Reserve to do something about unem
ployment. That is a direct policy response. I think a more subtle one,
and perhaps more important as an explanation of some of the trouble
we have got into, is that by pegging interest rates, the Federal Reserve
has made itself accident prone. That is, most of the major accelera
tions and decelerations in money growth in recent years have been,
I would say, accidents. If they would stop pegging interest rates, then
we would have fewer accidents.
There are two kinds of accidents. The oil price increase, which gen
erated increases in some prices and raised inflation expectations, tended
55-123
0
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8 0 - 7
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to raise interest rates. The Federal Reserve then amplified this real
disturbance by increasing the growth of money stock.
There could be an accident on the other side. If, for some reason
we don’t understand, the economy tends to go into recession, interest
rates tend to fall, then an interest rate targeting approach by the Fed,
assuming they are slow to adjust the interest rate targets, means a
deceleration, a slowing down in money growth. Then the Fed would
give the economy a downward push which has already been induced
by some real disturbance.
Over the long record, I think you can find many instances in which
Federal Reserve policy, rather than resisting pressures, has amplified
disturbances in the real sector of the sort you point out.
In going back over the record it is very hard to disentangle these.
But I think the kinds of disturbances you point out probably cost us in
real output, income, employment over time, but are not in themselves
a cause of inflation.
Chairman N e a l . Would you find this kind of analysis that I used
with my constituents helpful, accurate enough to be helpful?
Dr. M e i g s . Well, I personally would be cautious about going that
way because it is very popular to blame inflation on whichever price
is going up at the moment.
When we have inflation and unions come in with wage settlements,
people say the unions are causing inflation. If farmers happen to be
getting very good prices for livestock, then it is farmers causing
inflation. If later on it is the auto industry that raises prices, they are
causing inflation. These are not explanations of the inflation. They are
explanations of changes of relative prices. It would be a service to
the public to differentiate those a little more carefully.
Confusion is rampant. So I think I would just keep holding them to
the monetary explanation, to say we have centuries of experience,
observations in many countries, many different kinds of monetary
systems, which show that if the money stock, whatever it is, grows
more rapidly than potential output, you have inflation and that there
are many, many instances of reductions of inflation coming when you
reduce the growth of the money stock. Keep their attention on the
the longer run implications of current policy and not let them be too
inuch diverted by the immediate situation.
Professor P a r k i n . I think I would go along somewhat with my
colleague, Professor Meigs. I would be somewhat hesitant to feel
comfortable with your characterization of some fraction of inflation
being as it were caused by prices being pushed up and some other
fraction being caused by money. I think I would wrant to say that
inflation, to quote a famous passage, “ is always and everywhere
a monetary phenomenon arising from too rapid a growth rate in the
money supply,” a statement that is attributable to Milton Friedman
many years ago.
To underline this, let me, if I may, point out some recent statistical
features, not of this country, but of two other countries, which in
1973 suffered exactly the same oil shock as this country did, only
worse, because they, unlike this country, relied 100 percent on imported
oil from the O PEC countries.
I refer to two countries in Europe, Switzerland, and Germany. In
the face of that same oil price shock, those countries permitted domes
tic oil prices to rise much more quickly and to much higher levels than
96
you did in the United States. A t the same time, the Bundesbank and
the Swiss National Bank pursued tight monetary policies. The inflation
rate in Switzerland in 1974, the year following the OPEC price rise,
was 9.7 percent; by 1975 6.7 percent; by 1976 1.7 percent; 1977 1.3
percent; 1978 1.1 percent. This is the result of monetary policy.
Germany’s inflation in 1974 was 7 percent, and then in each succes
sive year, 5.9 percent, 4.5 percent, 3.9 percent, 2.6 percent respectively.
Inflation was squeezed out as a result of pursuing tight monetary
policy.
So what we observe is that variations in inflation rates either over
time or across countries can be explained by variations in money
supply growth rates, not by all the other thousand and one things that
can push prices here and there. So, if I was telling your story, Mr.
Chairman, I would tend to put 100 percent on the monetary and zero
percent on the price push. Although that is an exaggeration it is in the
right direction. I could be persuaded that 90 to 10 or somewhere around
there is perhaps correct.
But the central factor that comes across when one looks at the in
ternational as well as national evidence is that it is monetary policy
that is the key variable factor. More importantly, it is the one and only
variable factor that is manipulable by policy.
To be told that a thousand and one prices have increased for a
thousand and one reasons is not to be told what you can do about in
flation. But to be told that it is caused in the main by monetary ex
pansion is to be told what can be done to stop it. So for two reasons—
one because I think it is a more important variable and two because it
is controllable— I would place the emphasis on money.
Chairman N e a l . Thank you .
Mr. Cavanaugh?
Mr. C a v a n a u g h . Thank you, Mr. Chairman.
Dr. Friedman, I am interested in your discussion concerning the lack
of emphasis on credit by the Federal Reserve, and I wonder if you
might give us a little more detail as to how, first of all, you might de
fine credit, and then how you feel that the Fed might be more ac
countable in taking credit into account in the development of policy.
Dr. F r ie d m a n . Yes, sir. Let me focus initially on the second part of
your question, and then go back to the first.
Under House Resolution 133 passed and also under the HumphreyHawkins Act, the Federal Reserve is required to state in advance and
to report to the Congress not only targets for the monetary aggregates
but in addition targets for credit. To a certain extent, my suggestion
is already in the legislation.
The fact, however, is that the experience of the Federal Reserve in
meeting the targets that it has set during the past several years has
been very different with respect to credit than with respect to money.
B y and large, despite all of the discussions of the failure of the Federal
Reserve to hit the money targets, until the last 18 months or so the
Federal Reserve has done pretty well in hitting its four-quarter-ahead
monetary targets. B y contrast, it has done much worse in hitting its
credit targets, and not only in the sense that, on a simple numerical
counting exercise, it has missed the credit target more often than it
has missed the money targets. In addition, it has typically missed the
credit target by greater margins than it has missed the money targets.
Last summer, for example, the rate of expansion of bank credit on an
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annual basis was approaching 20 percent for several quarters. As to
what measure of credit one might use, the first part of your question,
I have no very fixed views. In the same way that it is important to
establish a monetary target, but then much less important to work out
exactly which monetary target we have on the credit side also, much
more important than exactly which credit measure we use is simply to
have some measure from the other side of the balance sheet; that is,
some measure of banks’ or other lenders’ assets as well as their
liabilities.
For the same reason that we usually prefer to look at either Mi or
M 2— namely, because under current institutional arrangements they
are measured more accurately and more rapidly than M 3 or any other
broader monetary aggregates— I suspect that some credit measure
relating primarily to banks, or maybe to banks plus the commercial
paper market, would be the easiest to implement. Which credit
measure we use, however, is a second-order problem compared to the
importance of having some measure drawn from the other side of the
balance sheet.
.
M y point was simply that both sides of the balance sheet contain
information that is important to economic activity. If the public
is borrowing in great volume, and if the banks are lending in great
volume but financing that extension of credit out of liabilities that
do not happen to be included in whatever definition of the money
stock we are using at the moment, that is information we want to
use and not throw away.
Mr. C a v a n a u g h . To what do you attribute the Fed’s lack of success
of hitting the credit target?
Dr. F r ie d m a n . M y sense is that it has not tried. I think it is quite
clear that the dominant variable that the Federal Reserve has used
over recent years has been Mi. To the extent that it has used some
thing different from Mi, they have looked at M 2. Anything like bank
credit— or the credit proxy, which is really total bank liability—has
been awarded third place at best.
Mr. C a v a n a u g h . Y o u are saying that they do nothing now?
Dr. F r ie d m a n . I hesitate to be that extreme, but my sense from read
ing the policy records is that, if credit is outside the range of the credit
target, that is deemed to be less of a cause for action than if M 2 is
outside of its range and far less than if Mi is outside of its range.
Mr. C a v a n a u g h . What is your understanding of what policy they
adopt to hit their credit targets, what methods do they employ?
Dr. F r ie d m a n . The same ones that they use for the money targets.
When monetary expansion was too great, under the previous regime,
the response was typically to raise the Federal funds rate.
M y understanding of now the new policy will work is that, if the
Federal Reserve is implementing a certain rate of growth of bank
reserves in the expectation that that will lead to a certain growth of
M u M 2, and bank credit, then if, for example, Mi is growing too
rapidly, it will cut back on the rate of growth of bank reserves and
expect that to lead to M x growth falling back into the targeted range.
The real issue is what happens if, for example, M x is about on target,
and M 2 is slightly above the range, and bank credit is very much
above its targeted range.
Mr. C a v a n a u g h . Which has been the recent experience.
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Dr. F r ie d m a n . Yes, sir. M y understanding is that, in such a circum
stance, the Federal Reserve has been inclined not to respond. This is
not something that has to do with the tactical issue of whether the
response mechanism keys off interest rates or off reserves. It could
just as easily happen under a reserve targeting mechanism, too.
Mr. C a v a n a u g h . We have talked about monetary policy. Have you
any comments on fiscal policy?
Dr. M e ig s . In terms of fiscal policy, I would like to have as stable
a fiscal policy as possible, as well as a stable monetary policy. I believe
the history of this country demonstrates that instability in monetary
policy probably has done more to cause shortrun changes in fiscal
policy than the other way around.
So that if you were to stabilize monetary policy, have a more stable
>rice level to have more stability in the economy, you would have
ewer swings in the budget. That would make it possible for fiscal
policy decisions to be concentrated more on allocation questions, such
as how big a Defense Establishment do we want, how big a Govern
ment, and much less on trying to adjust the budget year by year to
try to offset changes in the economy.
That has not worked well in any country I know of. So that fiscal
policy question is to me less important in shorturn swings in the
economy. Fiscal policy is terribly important in determining what kind
of economy we have, what kind of country we have over long periods,
and should not be confused with trying to stabilize the economy in the
short run.
Professor P a r k i n . If I may add to that, I would like to suggest
that while I don’t think you have a shortrun cyclical fiscal policy
problem I do believe that you have a longrun trend fiscal policy
problem, in the sense that the overall scale of the deficit that has to
be financed is uncomfortably large and cannot be maintained in the
long run. A deficit as large as currently being experienced is probably
going to be financed with some inflation despite the best will in the
world to avoid it. So I would see a need to get that deficit down. I
would have thought that a gradualist policy on this would be the only
way to go. I don’t see how you can sensibly cut public spending over
night, and I don’t see how you can sensibly raise taxes overnight.
These are actions which are best taken gradually and with some help
from the real growth of the economy.
Dr. F r ie d m a n . Congressman, I would adopt a different perspective.
I do not believe that the Federal deficit is very large right now. The
fact is-----Mr. C a v a n a u g h . Y ou are awfully lonesome.
Mr. F r ie d m a n . I agree, but the fact is that, adjusted for the Federal
Government’s lending activities, the deficit has averaged $10 billion
per annum in the first three quarters of 1979. That is a deficit of less
than one-half of 1 percent of the GNP. I would just as soon that
$10 billion were zero, but I find it difficult to get upset about the
Federal Government running a deficit of $10 billion per annum at
this time. I would also point out that State and local governments,
collectively, are now running a surplus in excess of $30 billion a year,
so that the Government sector as a whole is running a surplus of
approximately 1 percent of the GNP.
I think that that is about appropriate under the current circum
stances. A net surplus for the Government sector is a good idea at
{
98
this point, not only because of our inflation problem, but also as a
way of helping to spur capital formation, which is a major problem
that lies perhaps outside the scope of this hearing but is an important
subject for congressional action nonetheless.
Hence, I do not believe that the size Government deficit that we
have right now is a problem.
Mr. C a v a n a u g h . I don’t want to take time from my colleague. But
your $10 billion figure, you are not projecting that that is going to
reflect the aggregate deficit for this year. The CBO is in excess of $20
billion. The fourth quarter is---- Dr. F r ie d m a n . I think the difference is somewhat different, Con
gressman. The usual number that is used is for the unified Federal
deficit, which includes certain lending activities of the Federal
Government.
B y contrast, what I used is the one that economists are more
familiar with; namely, the national income accounts deficit, which
excludes the lending. From a fiscal policy perspective, if the Federal
Government borrows in the credit market and then relends to some
one else in the credit market, that is not fiscal policy. It is a reallocation
of credit. It is the Federal Government acting as an intermediary. We
would not want to include that in the Federal budget any more than we
would include Fannie Mae or the Home Loan Bank Board, which are
conventionally excluded from the Federal deficit. When you take out
the Federal Government’s borrowing for the purpose of relending,
some minority of which takes place directly through the Treasury
rather than through these off-budget agencies, it is then that you get
this figure of $10 billion.
The answer, finally, is, yes, I would expect that approximately to
reflect the total for this fiscal year.
Mr. C a v a n a u g h . Thank y o u , Mr. Chairman.
Chairman N e a l . Mr. Evans?
Mr. E v a n s . I have no questions, Mr. Chairman.
Chairman N e a l . On the question of credit, isn’t there a relatively
consistent relationship between money and credit, and shouldn’t our
focus essentially be on money rather than credit?
Isn’t credit limited in effect by the amount of money available, and
wouldn’t it be a mistake in effect to pay too much attention to the
levels of credit over any very short term because they are influenced
very greatly by short-term factors?
Dr. F r ie d m a n . On the assumption that that was directed to me,
M r. Chairman, I believe that there is much in what you said. In the
first instance, if the relationship between money and credit growth
were perfect— if an increase in one always meant an exact increase in
the other, and vice versa— then of course it would make no difference
which one we used. They would simply be identical.
The fact, however, is that the two are not perfectly related, for
reasons having to do with the regulatory structure of the banking
business. The most outstanding example, again, would have been
what was happening a year ago. Reserves against demand deposits
were as usual, but reserves against Eurodollar borrowing were zero.
From last August until this October, therefore, banks had an over
whelming incentive to finance their lending activities and their
securities purchases not by issuing ordinary money liabilities, but in
the Eurodollar market.
99
It is not surprising that banks responded to that incentive, so that
we had a very weak rate of money growth but a very strong rate of
credit growth. Until a month ago, this was the first business cycle in
U.S. postwar history in which, at this stage of the cycle, banks were
not only making a large amount of loans but not having to liquidate
their securities portfolios in order to finance those loans. Banks were
not only lending great amounts of money but also able to increase
their securities holdings all through this period.
Chairman N e a l . But business was in decline, business was weak.
Dr. F r ie d m a n . Yes, sir. For the precise nature of the relationship,
the answer is that the correlation between the Mi measure and bank
credit over the postwar period has been approximately 0.6. That is the
simple correlation. So, yes, there is substantial correlation, but the cor
relation is far from perfect.
Finally, you asked if it would be a mistake to place too much em
phasis on bank credit. Of course it would be a mistake to place too
much emphasis on anything. It would also be a mistake to place too
little emphasis on bank credit. There is substantial evidence showing
that the right amount of emphasis to be placed on bank credit is
probably not the same as the amount of evidence to be placed on
money. The evidence favors placing more reliance on money than on
credit, the right amount of emphasis to place on credit is not zero—
which, at a first approximation, is what we do now.
Chairman N e a l . That 0.6 ratio that you mentioned, is that fourquarter basis or year on year? What would it be year on year?
Dr. F r ie d m a n . I don't know, but what is generally true is that, re
gardless of which pair of aggregates we look at, whether it is the rela
tionship of Mi to M 2 or Mi to bank credit or M ? to bank credit, over a
longer and longer period of time the relationship between any two of
them always gets greater. M y assumption without knowing the fact is
that, if the Mi to bank credit relationship is 0.6 quarterly, over a
1-year time span it would be significantly greater than that, and over
5-year time span I think it would be pretty close to perfect.
Chairman N e a l . S o looking at the long term, if I am following you,
it is relatively unimportant.
Dr. F r ie d m a n . Yes, sir.
Chairman N e a l . S o that would be my conclusion.
Dr. F r ie d m a n . Yes, sir, I am agreeing with that. If what we were
talking about were what the Federal Reserve should do on average
over the next 5 years, I don't think that the money versus credit dis
tinction is of any importance at all.
If the issue is what the target should be over the next 1 year,
however, I think that the issue is of some importance. If the issue is
how the Federal Reserve should respond if after one quarter of a year
the aggregates seem to be moving away from their 1-year targets— that
is to say, we set targets from now until a year from now, and in
February we discover that the aggregates are not moving the way we
wanted them to do, so after 3 months of things not happening the
way we wanted, we then do something different in the reserves
market— I would say that for gaging the response after 3 months, the
difference between money and credit is definitely large enough to be
substantial, and worth paying attention to.
Chairman N e a l . Thank you.
Would either of the others like to comment?
100
Dr. M e ig s . I would say there is a lot of virtue in keeping things
simple. If the Federal Reserve has too many targets to follow, that
makes it more difficult for you to make them accountable. As a fore
caster, I have not found a way to improve my forecasts by paying
more attention to credit than to money supply. That is just one small
bit of evidence.
I do remember quite a few instances in which the Federal Reserve
became very much concerned about what they thought was over
expansion of a particular form of credit; for example, business loans of
large banks to corporations. In 1966 they became so preoccupied with
trying to hold down bank lending to corporations that they acci
dentally caused a very sharp reduction in growth of the money stock.
There was a conflict of targets there, which did bring on a minirecession; 1969 was a similar story.
I think we have some danger currently, or recently, of the same
kind of confusion. It is just a fact that near peaks of business cycles
corporate borrowing from banks increases. That doesn’t mean that
the banking system or the Federal Reserve is doing something that is
contrary to policy. I would rather have them concentrate on controlling
the monetary aggregates.
If I make a loan to one of my children, the supply of credit in the
country increases. That doesn’t necessarily mean that total spending
increases, because their spending power is increased and mine is
reduced.
You could assume, of course, that my children would spend the
money faster than I would. That is the only effect I can see from paying
attention to credit as compared to paying attention to the monetary
aggregates.
Professor P a r k i n . I have nothing of substance to add. Mr. Chair
man, other than to underline what Dr. Meigs has said. I agree with
him.
Chairman N e a l . I am just sorry that more members of the subcom
mittees couldn’t be here to hear what I think has been excellent,
fascinating, very helpful testimony. I just want to thank you all for
appearing. I want to thank you as deeply as I can.
Any advice that you have for us as we move along in this area we
would welcome at any time. Thank you again for being with us.
The subcommittees are adjourned.
[Whereupon, at 12:30 p.m. the joint subcommittees adjourned.]
MONETARY POLICY
Goals and Conduct for the 1980’s
TUESDAY, DECEMBER 4, 1979
R e p r e s e n t a t i v e s , S u b c o m m it t e e on D o
M o n e t a r y P o l ic y , a n d S u b c o m m it t e e on
I n t e r n a t io n a l T r a d e , I n v e s t m e n t a n d M o n e t a r y
P o l i c y o f t h e C o m m it t e e o n B a n k i n g , F i n a n c e a n d
U r b a n A f f a ir s ,
H o u se
of
m e s t ic
Washington, D.C.
The subcommittees met jointly at 10:05 a.m. in room 2128, Rayburn
House Office Building, Hon. Parren J. Mitchell (chairman of the
Subcommittee on Domestic Monetary Policy) presiding.
Present from the Subcommittee on Domestic Monetary Policy:
Chairman Mitchell, Representatives Neal and Hansen.
Present from the Subcommittee on International Trade, Invest
ment and Monetary Policy: Chairman Neal, Representatives Oakar,
Lowry, Campbell, and Shumway.
Chairman M i t c h e l l . This hearing will now come to order.
Today, ladies and gentlemen, we conclude our joint hearings on
“ Monetary Policy, Goals, and Conduct for the 1980’s.” The principal
question which must be answered is whether the Federal Reserve’s
new policy will be able to wind down inflation without causing or
contributing to recession. As I asked in my statement on November 13,
when these hearings began, “ Can we pull it off? Can we reduce rates
of monetary growth without inducing a recession?”
Other questions, such as the impact of the Federal Reserve’s new
policy on foreign exchange rates and interest rates, can be subsumed
under this question.
Developments since October 6, when the new policy was announced,
have been mixed. A t first, the dollar firmed on exchange markets—
a positive development, but interest rates soared— a negative and
somewhat perplexing development. Since late October, interest rates
have dropped but the dollar has weakened on exchange markets.
However, the recent weakening of the dollar on foreign exchange
markets may reflect events in Iran more than the fundamental
economic trends.
I am sure our witnesses today will help to enlighten us about de
velopments in foreign exchange, money, and commodity markets,
as well as about our chances of unwinding inflation without inducing a
recession.
(101)
102
Before introducing the members of the panel, I would turn to my
distinguished colleague Stephen L. Neal of North Carolina, who has
been gracious enough to share these joint hearings with us.
Chairman Neal, do you have an opening statement?
Chairman N e a l . Yes. Thank yo u .
Mr. Chairman, as you pointed out, this is the third and final day
of this set of hearings on conduct of monetary policy in the 1980’s.
The first 2 days of hearings have been very enlightening. I would like
to offer a brief summary of some of the conclusions we could draw from
testimony given during those days.
The witnesses we have heard from so far all support the major
policy initiated by the Federal Reserve, on October 6, the decision to
try to control bank reserves directly instead of the Federal funds
rates.
They agree that this switch in the technique of monetary policy
should enable the Federal Reserve to achieve better control over the
money supply. One witness, Professor Friedman, from Harvard, was
uncertain that the switch would actually lead to better control, but
supported the effort to try on the ground that there is no reason to
expect it to be worse, and our past failures to achieve control should
encourage us to experiment with new methods.
All witnesses agree that stabilizing growth of the monetary aggre
gates around a noninflationary trend was the most important single
objective of monetary policy. Professor Friedman was concerned that
monetary policy should also pay attention to the behavior of credit
aggregates in the short run, though he admitted that the choice be
tween money and credit was not important for a longrun strategy.
All agreed that excessive monetary expansion was the single most
important— indeed, the overwhelmingly most important— cause of
inflation in the long run. This interpretation does not neglect the in
flationary pressures generated by other factors— oil prices, payroll
taxes, budget deficits, and so forth—but stresses that the ultimate
impact of those factors on the rate of inflation depends upon the
Federal Reserve.
That is, it depends on the Federal Reserve’s willingness to accom
modate those pressures by creating more money, or resist them by
adhering to a noninflationary path for the money supply.
Professor Parkin pointed out that Germany and Switzerland both
suffered a greater inflationary shock from the 1974 increase in oil
prices than did we, and both experienced an immediate sharp jump
m inflation. But monetary policies in those countries succeeded in
bringing inflation down to the 1- to 3-percent range within a couple
of years.
Finally, two of our witnesses— Professor Meigs and Professor
Parkin— strongly supported my efforts to get the Federal Reserve to
commit itself to a strategy for controlling the money supply over a
long period into the future, not just a year at a time.
The legislation I have introduced, H .R. 5476, is designed to make
it clear that inflation will be arrested and gradually reduced over the
next few years. If we could get a credible commitment from the Federal
Reserve to pursue such a strategy, inflationary expectations would
be reduced, the dollar would stabilize on the foreign exchange market,
long-term interest rates would begin to recede, and even if we did go
into a mild recession, our recovery from it would be stronger and more
103
lasting, because it would not be accompanied by another round of
runaway inflation.
I am delighted that we have two panels of such distinguished experts
in monetary economics before us today. The conclusions I have drawn
from our previous testimony are strong and powerful, though con
troversial. I am eager to hear an assessment of them by today’s
witnesses.
Thank you, Mr. Chairman.
Chairman M i t c h e l l . Thank you. I have checked with our other
two subcommittee members who are present, and they do not have
opening statements. Therefore, I will now introduce the first panel.
We will hear from Dr. Peter Berman, of the Bank of America,
Prof. Karl Brunner, of the University of Rochester and University
of Bern, Switzerland, and Dr. Michael Hamburger of New York
University.
Gentlemen, I welcome you on behalf of the subcommittee, and
thank you for appearing before us today, and we will proceed with
your testimony. You have two options; I think we have copies of all
of your testimony before us, and if you so desire, you can request that
the entire testimony be submitted for the record, and speak to the
salient points in your testimony, or you may decide to present your
testimony in its entirety, that is up to you.
You may elect your own option. In fact, I will exercise only one
prerogative of the Chair, and that is to call on the first witness— and
that settles that one— Professor Brunner, would you lead off for us,
please?
STATEMENT 0E PROF. KARL BRUNNER, UNIVERSITY OF
ROCHESTER
Professor B r u n n e r . Thank you very much, Mr. Chairman, gentle
men of the subcommittees. I am delighted to have an opportunity to
speak to the issues which you have formulated just before.
I will summarize my statement to hit the major points.
M y statement first covers the inheritance from the past and the
sad heritage which has accumulated through our policy failures over
15 years.
The next section of my statement examines essentially the two
alternative procedures considering policy, as laid out in the letter
signed by the two chairmen of the subcommittees involved on Octo
ber 12, and subsequently, in the last section, I discuss some problems
of implementing proper control of monetary growth, a problem which,
in my judgment, the Federal Reserve has not faced up to so far, even
after 6 years of its operations.
Now, with respect to the first section of my statement, I simply
want to emphasize that we have now, since 1965, a policy of increasing
inflation. Until 1965, monetary policy had been proceeding on a re
markable course of comparative stability. There were three or four
inflationary surges during this period from 1945 to 1965, and they
were effectively contained by low growth of the money stocks.
Now, there was a shift in monetary policy very clearly occurring
around the middle of the sixties. Since then we have stayed on this
inflationary course; there were several attempts at reversal, but they
were quickly abandoned, usually within less than 1 year. In 1976 and
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1970, and 1970-71, and 1972 again, a rather famous case, and then
again in 1975-76.
Now, as a result of all of that, we have reached the situation of
October 6, further pressure on the dollar after the debacle of 1977-78,
and even further acceleration in the inflation rates, to double-digit
figures again.
So Chairman Volcker pronounced what the issue was on October 6,
and three items in his program are presented. First, reserve require
ments on a specific array of nondeposit liabilities. Second, the discount
rate was raised by one percentage point. Third, we were promised that
the Fed, which had looked more substantially at interest rates in the
past, would look less at interest rates in the future and be more con
cerned about the evolution of monetary aggregates.
Well, in terms of an anti-inflationary policy, if I wished to evaluate
what is going on, the following has to be said. With respect to the raise
in reserve requirements on this array of nondeposit liabilities, this
raises essentially the cost of operation to the banks, it imposes a tax
on the banks with revenues going to the Federal Reserve.
It puts an additional wedge between the interest rates charged to
the customers of the banks on their loans, on the one side, and against
interest rates paid to customers of various deposit or liability types on
the other side.
We have had a small “ once and for all” effect on the money stock,
with very little persistent effect on monetary growth at all. From the
point of view of a persistent anti-inflationary policy, it contributed
very little if anything at all to cope with our problem.
The raising of the discount rate again, by itself alone is marginally
significant. The discount window contributes only about 1){ percent
of the total amount of base money issued by the Federal Reserve, and
any time— as it happened in October, 1965, when President Johnson
was inviting the Chairman of the Board to Texas, in order to talk to
him about the highs in the discount rate— the Federal Reserve can
overcome that any time through massive open market operations.
And so the discount rate— the rise in the discount rate plays a role
in the specific circumstance; namely, when the Fed decides to lower its
open market purchases, to lower the growth rate in the monetary base,
then a rise in the discount rate is appropriate in order to prevent that;
the discount window becomes an escape hatch through which the
lowering of the monetary base is sort of offset to some extent.
So it depends crucially on what the Fed is really doing in terms of
its total operations bearmg on the monetary base and upon monetary
growth.
Now, the third point by itself alone, again is rather weak, and
deserves some clarification, particularly as it stands. It indicates to
me that the Federal Reserve itself is not quite clear how to go about,
in terms of controlling monetary growth.
Now, the letter of October 12, which was sent out, gives two alterna
tive procedures with respect to monetary growth, and I will quickly
attend to that.
One is essentially a continuation of past policy centered on interest
targeting. The other involves a shift to really a deliberate monetary
targeting, a targeting of monetary growth.
M y point in this respect is simply this: that interest-targeting
policy is a device which creates substantial problems for an effective
105
monetary control, that interest targeting in the past contributed to
opposing the movement of monetary growth, contributed to amplified
economic fluctuations, and particularly, also, that it is a device which
makes it very difficult to assess what really has to be done.
I mean by that the following: The question is sometimes raised,
“ Well, how much does the Federal funds rate have to be raised in
order to really get things under control?” I submit that nobody really
knows the answer to that one; we don’t have the detailed knowledge
to answer that question, particularly as the relationship between the
Federal funds rate and monetary growth is exceedingly loose and very
unreliable. Exactly this looseness and unreliability has created the
problem in the past. It created to a large extent the unreliable mone
tary growth patterns and deviations from targeted policies which we
have experienced in the past 5 years since House Concurrent Resolu
tion 133 was passed in March 1975.
Now, there is a better alternative than to proceed this way, as in
the past, but we never quite know what will really emerge until the
circumstances, and this is to make a deliberate attempt to control
monetary growth.
Now, the letter raises several questions. What about the inter
national aspects of the Humphrey-Hawkins bill, the goals of the
Humphrey-Hawkins bill? What about the interest effects, and what
about finding and committing decisions in this respect?
Well, on the international aspects, I wish to mention the following:
That the problem which we are confronting is a problem of domestic
inflation and international disarray expressed by confusion and un
certainty on the exchange markets, now particularly expressed by the
debacle of the dollar over the last 2 years, or even longer, in the last
5 years.
Now, the solution to this—both problems—is essentially the same.
What we have to do is get hold of our monetary growth. B y appro
priate monetary growth control, we can both cope with domestic
inflation problems and we can also cope with international problems.
The dollar still remains a currency, for a variety of reasons I do not
wish to elaborate at this point, but it still remains, and it is a respon
sibility which the United States has, to make sure that these functions
are proper.
The functioning really means that we do control our monetary
growth, that we cope with domestic inflation, and there will be a lot
of countries in Europe which will be very happy to follow suit—
actually just waiting that the U.S. policymakers really make decisive
gestures and decisive and committing moves in this direction. This
will be the most important gesture which we can make in order to
contribute to a stable international monetary order.
Now, with respect to the Humphrey-Hawkins bill, we have a choice
between two alternatives. One, we continue with the past policies of
the last 15 years, or we proceed with a definite, deliberate, and de
termined anti-inflationary policy.
On the first tack, we certainly will not cope with inflation; the in
flation will get worse and more erractic. Also, unemployment will not
be lowered; actually, the average inflation— the probability is that it
will drift slightly higher, on the average.
On the other side is a determined anti-inflationary policy that will
certainly cope with inflation. On this tack, we should get out of infla
106
tion and have a stable price level in 4 or 5 years at the latest. Unem
ployment is certainly not decreasing over this period. The average—
the normal rate of unemployment will probably go down slightly. We
will be nearer to the goals of the Humphrey-Hawkins bill with that
policy than with the alternative of contmuing as we have been doing
over the past 15 years.
Lastly, with interest rates, with a binding commitment, interest
rates— there is one way only to lower interest rates. Chairman Volker
has repeatedly stated that, in repeated interviews on television— “ Face
the Nation,” “ Meet The Press,” and so on— we have to get out of
inflation.
If the prime rate is more than 15 percent now, and was 4% percent
between 1961 and 1965, with a stable price level between 1961 and
1965, then it is essentially the result of the current inflation rate re
flected in the prime rate. If we lower inflation, we lower interest rates.
Now, with respect to binding decisions and committing decisions,
the problem which the Fed faces is credibility. We had four attempts
at an anti-inflationary policy which were promptly abandoned. The
record is perfect: 100 percent.
Now, the problem at this stage is: How do we create credibility? If
we create the situation where we move to an anti-inflationary policy
with strong expectations that this policy will be abandoned again at
the first whiff of problems of pressure, we will never get out. Then we
will stay on inflation and we will drift higher and into more erratic
inflation.
In order to make it credible— and this is necessary in order to
minimize the social cost of an anti-inflationary policy— we will have to
make clear that it is binding and committing in the strongest terms
possible.
Now, the last point in the last section, which I wish to emphasize
just shortly; the problem is not just to say that is what we do. One also
has to execute it in a reliable fashion, and this is a problem, somehow,
I wish the Fed would really face up to in one fashion or the other.
There are technical procedures to control monetary growth. Now,
the Shadow Policy Committee— the Shadow Open Market Committee
has repeatedly laid out the details. I summarize these details again in
my paper here, in my opening statement, but I don’t want to do this
immediately now; I just simply indicate this.
I simply indicated also that this procedure is exactly the one which
was executed by the Swiss National Bank from 1973 and 1974 on.
That certainly worked quite effectively, and if it abandoned it in the
last year— the middle of last year— it was not because of any technical
problems, but simply, essentially, the political pressure from the
export industry which arose as a result of the drifting of the Swiss
franc relative to the dollar.
Now, the problem is here that somehow, in the strongest terms,
I wish to draw the Federal Reserve staff’s attention to the problem
which one faces here, and what should be done in these terms, and
having heard some proposals coming out from the Federal Reserve
staff to control the reserve base, and what this involves, I make some
computations. I present some computations— pardon me—from one
of my friends of the Shadow Open Market Committee, to indicate
107
that very probably, this procedure which they are considering will be
less satisfactory than the procedure which we have proposed over the
past 4 years, time and again.
But this is very temporary. The real issue is that the Federal
Reserve staff should really look into the procedure, so that we really
get ultimately over the next 4 years, a handle on this problem and get
out from inflation.
I submit to you that we can do that if we really want to.
[Professor Brunner’s prepared statement follows:]
108
Statement Prepared for the Hearings on Monetary
Policy — Goals and Conduct for the 1980fs
Subcommittee on Domestic Monetary Policy
and
Subcommittee on International Trade, Investment and
Monetary Policy
U.S. House of Representatives
Washington, D.C.
December 4, 1979
Karl Brunner
University of Rochester
109
The Choice and Implementation of Monetary Policy
Opening Statement
I.
The Inheritance from the Past
This country’s monetary policy adopted around the middle of the 1960’s a
radically different course. The early postwar inflation, the Korean inflation and
the inflationary surge of the middle 19 50*s were all rapidly contained by a low rate
of monetary growth.
This policy produced a period of remarkable stability of
interest rates, price-levels and of the maintained rate of economic expansion
during the years from 1961 to 1965.
Beyond this period, monetary policy moved
along a track of accelerating inflation. All attempts to reestablish a stable pricelevel were usually abandoned within less than one year.
Three years ago the rate of inflation had dropped to 4.5% p.a. and US policy
makers had another opportunity to lower the rate of inflation even further over the
subsequent years. A well designed monetary policy could have assured us a stable
price-level beyond 1979.
This opportunity was forfeited with another burst of
inflationary policies pursued by the Board of Governors and supported by the White
House.
Within less than one year domestic inflation accelerated again and the
price of the dollar fell on exchange markets. Our financial policies thus produced
severe international repercussions and imposed burdensome adjustments on many
other countries.
The international reaction eventually caught the Carter Administration's
attention and an "anti-inflationary and dollar support program” was launched on
November 24 and October 1, 1978.
55-123
0
-
8 0 - 8
This package still added no substance to the
110
accustomed rigmarole generously labelled as an anti-inflationary policy. President
Carter offered no comment or commitment involving a determined reversal o f our
monetary course with the definite promise to maintain a stable price level. The
major thrust of the program was concerned with a vast network of intervention
operations on exchange markets in order to support the dollar. As it happened, the
growth rate of the montary base was substantially lowered until March/April 1979.
This pattern contributed to the moderate rebound of the dollar relative to the low
level observed in the fall of 1978. But the tradition of the Fed prevailed once
more. The monetary base accelerated rapidly beyond March 1979 and moved to
levels exceeding those experienced in 1978. The newest failure of Federal Reserve
Policymaking became quickly recognized on exchange markets and reenforced the
inflationary momentum inherited from previous failures. The basic inflation rate
produced by this trend moved to 9% - 10% p.a. The promise of a determined antiinflationary policy has, once more, been revealed as a political gesture without
effective translation into relevant and reliable actions.
The outcome observed
during this summer and fall was quite unavoidable under the circumstances.
Almost one year after the debacle of the dollar unfolding in 1977 and 1978
wakened the attention of the Carter Administration, Chairman Volcker was forced
to address on October 6 the same circumstances. The latest program covered three
different aspects: Reserve requirements on an array of non-deposit liabilities of
commercial banks were raised, the Fed!s discount rate was increased and lastly, a
promise given (once more) that the Fed would in the future be less concerned with
interest rate targeting and more attentive to monetary targeting than in the past.
The first item in the package essentially imposes a tax on the banks with the
revenues accruing to the Fed. This tax raises the cost of issuing specific liabilities
and expands the wedge between the average interest paid by banks on the one side
and charged on the other side to customers. It lowered slightly the money stock
2
I ll
with no persistent effect on monetary growth. In view of the futility of the gesture
as an anti-inflationary gesture one may wonder whether the action was prompted
by the Fed’s old confusion between credit and money.
The second action, the increase of the discount rate, is by itself alone some
what irrelevant. Only about 11/2% of the total monetary base was issued via the
discount window.
This window played for many decades a marginal role in our
domestic money supply process. Any increase in the discount rate can always be
overcompensated by suitable open market purchases.
Such overcompensation
occurred subsequent to President Johnson's objections in October 1965. A decision
to lower the growth rate of the monetary base does require however an adjustment
of the discount rate in order to prevent the discount window from offseting the
lowered rate of supplying base money via open market operations. The significance
of the first two actions mentioned depended to a large measure on the
interpretation of these announcements. They were understood to signal a new turn
in Federal Reserve policy. The behavior of the markets revealed however that this
interpretation was burdened with a massive uncertainty bearing on the precise
meaning of the announcement. This uncertainty was particularly fostered by the
last item in the package and the varying interpretations subsequently supplied by
other officials.
Chairman Volcker promised that monetary policy would proceed
differently in the future, with more attention to monetary control. But the nature
and detail of the new course and procedure remained obscure. One suspects that
the Fed's bureaucracy has still not grappled, after more than 60 years, with the
technical and institutional requirements of monetary control. It appears at this
stage that House Concurrent Resolution 133 adopted in March 1975 involved, in the
view of the Fed's bureaucracy, no obligation on the Fed beyond some rhetorical
adjustments.
3
112
n.
A Reexamination of Policy Procedures
Chairman Volcker's announcement on October 6, followed by his forthright
and admirable discussions in the repeated public interviews, focuses our attention
on the fundamental issues confronting our policymakers. We face two major and
closely related problems:
domestic inflation and the confusion and uncertainty
prevailing on the international exchange markets.
Both problems fortunately
require the same solution. A reduction of monetary growth to a non-inflationary
level distributed over several years with a reliable anticipation by the majority of
market participants would produce, after at most five years, a stable price-level at
a comparatively small social cost.
The social cost associated with this policy is
actually much smaller than the social cost of permanent and erratic inflation. The
reduction of monetary growth also forms the crucial condition for a stable
international system.
The dollar functioned for many decades as a "hegemonial
currency". We need not explore the reasons for this evolution but we can compare
it to the emergence of a "lingua franca” necessary for worldwide communication.
The very persistence of the dollars hegemonial role, inspite of the accumulated
history of policy failures, reveals the social advantages of such a "vehicle
currency”.
An acceptance by US policymakers of the condition required for a
stable domestic price level also involves ultimately an acceptance of the
responsibility confronting a hegemonial currency area.
The break-down of an
international monetary order was foremost the result of the hegemonial currency
area's refusal to recognize the international responsibility associated with this
position.
This international responsibility is however quite consistent with the
long-run domestic responsibility of monetary policy. Once this is acknowledged and
well understood we need to clarify the appropriate strategy assuring the most
reliable achievement of our goal. The letter of October 12, mailed by Congressmen
Neal and Mitchell specifies two alternative strategies.
4
My subsequent comments
113
examine the comparative advantages and problems associated With these
alternatives.
1.
An Hiterest-Target Approach
One ^>proach would continue the procedures established over the lost dveade
for the execution of monetary policy. The staff assesses first projections of gross
national product over the next four quarters and feeds these projections into a
money demand function in order to determine a relation between the Federal furxfe
rate and the money stock. Given the projected output growth, inflation rate and
the projected monetary target path, the money demand function determines a
sequence of Federal fund rates consistent with the projections prepared.
The
FOMC chooses on this basis a Federal funds target rate best geared to assure the
desired monetary growth. The account manager is then instructed to adjust open
market operations according to the location of the actual market rate relative to
the target rate selected for operational purposes.
A market rate exceeding the
target rate induces open market purchases whereas a comparatively fow market
rate rfiay induce open market sales.
The accumulated record of performance offers substantial information about
this procedure.
We note first that it produced a pro-cyclic movement of the
growth rate of monetary base and money stock. The adjustment of the selected
target rate typically lags behind the prevailing market conditions. We observe thus
under the circumstances a rising monetary expansion whenever market forces raise
interest rates and a receding monetary growth whenever interest rates are sub
stantially lowered by market conditions. The mode of executing monetary policy
contributed in the manner described on many occasions to the cyclic component in
the evolution of our economy.
This aspect of the Fed’s traditional policy procedure bears importantly on our
current prospects. Implementation of lowered monetary growth with the aid of an
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114
interest targeting procedure involves a serious risk that the resulting monetary
deceleration will be too large and rapid relative to the inflationary expectations
built into price setting behavior as a result of our past failures.
This pattern
occurred during the winter of 1974/75 and reenforced the sudden fall in activity
initiated in September 1974.
An interest targeting approach to the required
monetary deceleration risks under the circumstances a larger recession and a larger
social cost than the alternative procedure discussed below.
A more general point need be made concerning the realization of monetary
growth via interest control. The record of the 1970’s exhibits a remarkable pattern
of deviations from the desired monetary growth target. The performance measured
in terms of deviations from the announced monetary growth path is quite poor.
This pattern results moreover only to a small extent from errors of projecting
national income.
The observed failure is dominantly produced by a highly
unreliable and very loose relation between money stock (or monetary growth) and
the Federal funds rate.
This unreliability of the central relation anchoring the
Fed’s implementation of monetary policy determines the basic flaw o f the interest
targeting procedure. This flaw is clearly revealed with the question how much the
Fed needs to raise the Federal funds rate in order to lower monetary growth (or the
growth rate of the monetary base). The crucial fact is simply that nobody knows
the answer. This is an immediate consequence of the fundamental unreliability of
the central relation governing policy procedures in the context of an interest
targeting.
This uncertainty implies that policy produces with large probabilities
target changes which are either too small or too large.
Lastly, an interest target policy tends to misdirect public attention. Shortrun changes in interest rates tend to be attributed to the policymakers even when
they dominantly reflect current market forces. Of course, the current conditions
on credit markets reflect the accumulated inflationary thrust embedded in nominal
6
115
interest rates produced by a history of excessive monetary growth. We should also
note in conclusion that an interest target approach poses substantial uncertainties
to foreign monetary authorities.
produced by the
The erratic behavior of monetary growth
traditional technique obscures
the signals conveyed
to
international markets and impairs whatever coordination may be feasible.
2.
A Monetary Targeting Approach
Under
this
approach
the
FOMC
essentially
accepts
the unanimous
recommendation advanced by the Committee on Banking, Finance and. Urban
Affairs last March.
The Federal Reserve Authorities should publicly announce a
time path of declining monetary growth. This path should eventually lead to 2% or
3% p.a.
by 1983/84.
The announcement need be made with all the "pomp and
circumstance” required to assure a skeptical public that the old game has vanished.
The announcement might usefully be coupled with a full explanation to the public
by the Chairman of the Board without reinterpreting comments from other
officials.
A number of questions were raised in the letter of October 12 pertaining to
the monetary target approach. The first refers to some international aspects and
asks in particular whether the Fed could proceed with such a policy independently
of other Central Banks.
The answer for the USA is most affirmatively yes.
I
indicated above, that the policy of explicit monetary control expresses the
responsibility of a hegemonial currency area. European Central Banks would surely
welcome a determined acknowledgement of American monetary responsibility and
probably follow the financial lead provided.
There
emerges
under
the
circumstances a much more stable‘international monetary order. The new policy
would prevent in particular a further fall in the price of the dollar on international
exchanges. With an increase in confidence that the Fed really has mended its ways,
the dollar may even improve somewhat on the exchange market.
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116
The response to the question concerning the achievement of the goals stated
for 1983/84 by the Humphrey-Hawkins Act needs to compare two alternative
policies. We can either continue the past course of inflationary policies or accept
the House Committee's recommendation. In the first case we will experience rising
and even more erratic inflation rates in the future. But a permanent and erratic
inflation will not lower unemployment.
There is even a danger of a further
increase in the average rate of unemployment. A policy of gradual deceleration of
monetary growth will certainly lower inflation over the next four years. It may
also slightly lower the average rate of unemployment. The proposed course moves
the economy, in balance, nearer to the goals emphasized by the Humphrey-Hawkins
Act.
It will not be able, by itself, to achieve the unemployment goal of 4% p.a.
without supplementary institutional reforms which have been discussed in the
professional literature.
The essential point to be emphasized however is that a
continued policy of excessive monetary expansion neither copes with inflation nor
does it lower the average rate of unemployment.
The monetary policy
recommended last March by the House Committee is much better attuned to the
requirements of the Humphrey-Hawkins Act. It does involve of course some risks
of a temporary increase in unemployment and a corresponding loss in output. But
this social cost can be lowered by the gradual decline in monetary growth and a
major attempt to raise public credibility in the Fedfs policy.
But even with a
positive social cost of an anti-inflationary policy we need to reiterate that the
social cost of the alternative (inflationary) policy is substantially larger.
One of the questions reflects the widespread concern about interest rates.
Chairman Volcker repeatedly emphasized over recent months that the rise in
interest rates is dominantly attributable to inflation. The difference in the prime
rate between 1961/64 and this fall measures about eleven percentage points. This
difference corresponds closely with recent inflationary experience. Any instruction
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117
to the Fed to lower interest rates by means of further monetary expansion would
only produce more inflation and still higher rates of interest in the future.
Excessive monetary expansion is the surest way to raise interest rates. There is
only one procedure to Iowa* interest rates permanently to the levels experienced in
the early 1960's: a policy of monetary control which assures a stable price-level.
The initial impact of such a policy, or of incipient expectations about such a policy,
will raise the level of interest rates. But this impact effect lasts at most for a few
months and will be followed by a persistent decline.
The credibility of the Fed's policy was emphasized on several occasions in
previous paragraphs. This credibility was particularly linked with the magnitude of
the social costs produced by an anti-inflationary policy. This policy needs at this
stage to be binding and committing in the strongest possible way. The longer the
period of erratic inflation and the larger the accumulated number of aborted "antiinflationary" policies, the greater is the social cost of both anti-inflationary and
continued inflationary policies.
The temporary accommodations to this or that
pressure emerging on the political horizon erode the confidence in the Fed's antiinflationary policy and lengthens the period required to establish credibility.
A
policy of temporary accommodations quite likely steers the economy back to the
course of permanent inflation.
HI.
The Implementation of Monetary Control
A decision to abandon an interest targeting approach and institute a control
over monetary growth does not assure by itself a more reliable execution of
monetary policy. The Fed's bureaucracy faces at this stage a crucial responsibility.
It should publicly accept the responsibility to develop a reliable technique for
controlling monetary growth.
Congress may well instruct the Federal Reserve
Authorities to examine such techniques and present a case on behalf of its
preferred procedure.
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118
The Shadow Open Market Committee submitted on repeated occasions a
detailed proposal for monetary control to the public's attention*
The procedure
involves four steps.
a)
The first step concerns the determination of the required noninflationary rate of monetary growth. It includes at this stage also a
determination of the path guiding monetary growth to a noninflationary level by 1983/84.
b)
A second step requires a statistical evaluation of the relation between
the money stock and the monetary base.
This requires a careful
projection over the next four quarters of the profile expected for the
monetary (base) multiplier.
The first two steps determine the required growth rate of the monetary
base.
c)
The Fed then evaluates in a third step the movement of all the source
components of the monetary base for the immediate week and month.
This yields a computation of the required net volume of open market
transactions for the ensuing week and month. This required net volume
will be formulated as an instruction to the account manager.
The
FOMC may allow him some discretion in the distribution of the sum
over the week and the month.
d)
Lastly, in a fourth step, the Fed reexamines with the aid of new
information the expected profile of the monetary multiplier, compares
the actual and computed movement o f the monetary base with its
components over the past weeks or months and determines in the light
of this new information the required net volume o f open market
transaction for the following month.
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119
No step in this procedure Is beyond the technical capacity of the Fed. What
ever the statistical preparations and groundwork may involve, it is hardly more
demanding than the econometric modelling and money demand estimations already
proceeding in the context of traditional policymaking.
The first step requires
information about the normal rate o f real growth and the trend in velocity. The
second step confronts the Fed's staff with an unfamiliar procedure. The feasibility
of the technique involved is however not untested. The Swiss National Bank used
that technique under much more difficult conditions. A member of the Shadow
Open Market Committee (Robert Rasche, Michigan State University) developed this
procedure in some detail for the conditions of the USA. The results were published
in the reports of the Shadow Open Market Committee and most particularly in the
report issued in September 1979.1
The analytic procedure has been described
moreover in a paper, "Predicting the Money Multiplier”, jointly authored by James
M. Johannes and Robert H. Rasche, and published in the July 1979 issue of the
Journal of Monetary Economics. Both the experience of the Swiss National Bank
and the experimental results produced thus far by Johannes-Rasche suggest the
technical feasibility of step two. The third step poses no problem for the Fed. It
has already all the information required for this purpose, and the fourth step
repeats the procedures in order to absorb systematically the new information.
A successful application of monetary control still requires some additional
attention to the following aspects.
The Shadow Open Market Committee
emphasized over a number of years the importance of a reliable data base and the
role of institutional adjustments. The Fed should be instructed to direct more and
continuous attention to the economically relevant measures of the money stock and
1.
These reports are available upon request from the Center for Research in
Government Policy and Business at the University of Rochester.
11
120
the monetary base.
The conceptual and measurement problems were, with the
exception of the occasion of the Bach report, somewhat neglected in the past.
Some of the data problem emerged moreover as a result of the innovations
encouraged by regulations and inflation.
The inherited regulations and arrangements were so far never examined in the
light of the basic responsibility of the Fed. They involve essentially an implicit
system of taxes and subsidies with little relation to the central purpose of
monetary policy. A preliminary assessment suggests that our prevailing arrange
ments probably raise the shorter-run variability of the monetary multiplier and thus
aggrevate the monetary control problem.
The Fed might usefully explore the
feasible changes of institutional arrangements and regulatory devices which
effectively simplify monetary control.
The Fed exhibited so far no interest in the proposal advanced for some time
by the Shadow Open Market Committee. The announcement of October 6, induced
apparently a search for another mode of implementing policy. This search seems
however confined by the inherited views and bureaucratic constraints.
Most
disturbing in this context are the signs suggesting a revival o f ancient notions. The
"reluctance theory” of bank borrowing, which dominated the Fed’s conception
during the 1920’s into the 1930’s and affected policy deep into the Great Depression
(note the large increase o f reserve requirements in 1936/37) surfaces again - and so
does attention to free reserves. The "reluctance theory" is thoroughly discredited
by the most basic economic analysis and is on a par with the propaganda of the Flat
Earth Society.
Attention to free reserves emerged beyond the 1930fs in order to
generalize the "reluctance theory" and accommodate for the persistent occurrence
of excess reserves.
But the free reserves doctrine of the 1950's and early 1960’s
suffered, as a simple generalization o f the original "reluctance theory", from the
same glaring laws.
It is useful to remember that reliance on such conceptions
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121
explains the dismal and tragic record of the Fed's policymaking during the Great
Depression. It seems time that we move on beyond such dangerous misconceptions.
The most promising suggestion signalled by the Fed's officials centers on a
reserve targeting procedure. The Fed should certainly be encouraged to examine
the performance quality of such a technique of monetary control. But this is hardly
sufficient.
The Fed should really feel obliged, in the best interest of a reliable
execution of monetary policy, to compare systematically the suggested procedure
with the proposal made by the Shadow Open Market Committee. This comparison
centers on the two distinct multipliers linking monetary base or total reserves with
the money stock.
A tentative analysis indicates that both the monetary base
multiplier and the reserve base multiplier depend on exactly the same set of
proximate determinants. But the nature of the dependence differs substantially.
The monetary multiplier responds more sensitively to variations in the currency
ratio, whereas the reserve multiplier responds much more sensitively to variations
in the adjusted reserve ratio (i.e. the banks observed reserve ratio adjusted for
changes in reserve requirements) and the time deposit ratio (i.e. ratio of time to
demand deposits). One would suspect at this stage that in the context of similar
orders of variability exhibited by the proximate determinants the derived
variability of the reserve multiplier exceeds the corresponding variability of the
monetary multiplier.
This proposition should not be accepted however without
substantial further investigation.
Robert Rasche already initiated a systematic
comparison of the forecast errors associated with the projections based on the two
multipliers.
The detailed results will be developed in a paper presented at the
forthcoming American Economic Association meetings in Atlanta. The paper will
be published with other contributions to "The Public Accountability of the Federal
Reserve System" in the form of a Symposium published by the Center for Research
in Government Policy and Business at the University of Rochester.
13
122
The table attached to my statement shows a definite advantage for the
monetary multiplier. The forecast error associated with the monetary multiplier
appears to be substantially smaller than the forecast error resulting from the
reserve multiplier.
This result, however provisional and uncertain, should be
sufficient to motivate some probing research guiding eventually the Federal
Reserved rational choice of policymaking procedures.
14
123
Summary of Forecast Errors for Three Distinct Periods
(in percentages)
Errors for the period
Errors for the period
1/1979-8/1979
5/1979-8/1979
7/1979-8/1979
based on 1978
based on 3/1979
based on 6/1979
mean absolute
error
RMSE
Errors for the period
mean absolute
mean absolute
error
RMSE
error
RMSE
m-m
.56
.70
.92
.95
.47
.47
r-m
1.45
1.60
.89
.96
1.36
1.37
.52
.59
1.21
1.28
.04
.04
1.11
1.27
1.19
1.21
.96
.98
Mi
m-m
M2
r-m
Notation:
RMSE:
root mean square error
m-m:
monetary multiplier
r-m:
reserve multiplier
124
Chairman M i t c h e l l . Thank you very much, Professor Brunner.
Dr. Berman?
STATEMENT OF DR. PETER I. BERMAN, BANK OF AMERICA
Dr. B e r m a n . The theme of my prepared statement is that the proper
focus of monetary policy in the early 1980’s should singlemindedly be
restoring the integrity of our currency. As a practical matter we first
need a national commitment to reasonable price stability as our No. 1
economic priority. Once the Federal Reserve is provided with a shield
against short-term pressures, we need required that it steadfastly
follow over a 2}i- to 3-year period a well advertised and carefully
monitored program of a phased reduction of monetary stimulus from
the 6- to 7-percent rate of recent years to about 3 percent annually,
in line with our potential real growth rate.
Over the last 15 years the goals of maximizing employment and
output through stimulative aggregate demand policies have clearly
taken precedence over the goal of maintaining the purchasing power
of our currency. Unfortunately the rate of monetary stimulus used to
stimulate aggregate demand has been well in excess of our potential
growth. As a consequence the general price level has doubled in the
1970’s and inflation is well recognized by the American people as a
serious problem.
If we are to restore price stability— prices increased an average
about 2 percent yearly in the halcyon 1950’s— we need a reordering
of our priorities with a firm national commitment to that goal. Then
we need consider specific policies once our national commitment to
rice stability is made. While we are long on explanations about ination, few enjoy solid empirical support. M y research suggests that
a phased reduction in Mi money growth is essential for any successful
anti-inflation program. I find that for the 1970’s less than 1 year’s
increase in prices came from factors other than excessive monetary
stimulus. I recommend careful consideration of a phased reduction in
Mi money growth over a 2}i- to 3-year period. While that suggestion
does not preclude adopting other sensible anti-inflation policies, such
as fiscal restraint, productivity enhancement and accelerated capital
goods depreciation, ending our policy of excessive monetary stimulus
is an essential requisite to achieving price stability.
I wish to emphasize that is especially important that the phased
money growth reduction program proceed in a well advertised and
consistent fashion in which the quarterly targets are well specified.
The financial community, both here and abroad, and the general
public need real confidence that the program will indeed be followed
through. Without such confidence, expectations cannot be readily
changed and at least a 5- to 6-year program would be required.
Unfortunately our experience with target achievement by the Fed
eral Reserve has not been successful. One way of illustrating this
point is comparing the growth of the M x money supply in the 4 years
since House Concurrent Resolution 133 with the 4 previous years.
In the 4 years since the resolution was passed,
has grown at a 6.6
percent rate on average, about the same as the 6.1 percent average
figure in the 4 years prior to the resolution. Moreover those rates
exceed Federal Reserve’s long run targets for M x money growth.
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125
While the refocus announced in the October 6 initiative is a useful
step, the proof of policymaking is in the pudding, not intentions or
statements of purpose. To affect inflation expectations and ultimately
inflation itself we need a phased reduction in the rate of M x money
growth. That requires successful pursuit of several years duration.
October 6, then, is but a small step.
It is worth emphasizing that it is unreasonable to place the entire
burden on the Federal Reserve unless we do in fact erect a firm
umbrella with a strong national commitment to restoring the integrity
of our currency as our No. 1 priority. With that umbrella in place we
have good reason to believe, that by the end of 3 years, a phased Mi
growth reduction on the order of about 1 percent per annum would,
in fact, bring inflation down to 3 to 5 percent per year.
If done in a carefully monitored and well publicized fashion this
program need not incur any downside risks on output and employ
ment. Indeed we would know, 2 to 3 years in advance, what rates of
monetary stimulus would be injected into the economy by the Federal
Reserve. That knowledge alone would greatly reduce uncertainty
about national economic policy. We could expect new vitality in our
economy with that uncertainty removed.
Summing up, we have two urgent tasks ahead of us in the 1980’s
as regards monetary policy. First, we need a national commitment
placing price stability as our No. 1 economic priority. Second, with
that umbrella in place, we need require that the Federal Reserve
temporarily abandon for 2% to 3 years its discretionary mode and
steadfastly undertake a phased reduction in Mi money during that
period. That program is in our national interest and I recommend
its adoption.
[Dr. Berman’s prepared statement follows:]
55-123
0
8 0 - 9
126
Testimony Prepared For
Joint Hearings on
"Monetary Policy - - Goals and Conduct for the 1980s"
Subcommittee on Domestic Monetary Policy and
Subcommittee on International Trade, Investment and Monetary Policy
of the
Committee on Banking, Finance and Urban Affairs
Ninety-Sixth Congress
December 14, 1979
Peter I. Berman
Bank of America
127
Introduction
I appreciate the opportunity to present my views on the important topic
of ’’Monetary Policy —
record
Goals and Conduct for the 1980s
As I read the
over the last 15 years, the priorities of encouraging output and em
ployment have taken clear precedence over the priority of maintaining the
purchasing power of our currency.
inflation of the 19709
During the unprecedented peacetime
prices have* nearly doubled and at current rates of
increase they will again double within eight years.
For both domestic and
international considerations there is strong need to make the integrity of
our currency our number one economic priority, and once that umbrella is
raised, steadfastly implement purposeful policies to serve that end.
Unless
that umbrella is firmly in place, short run pressures will negate the best
designed and intended policies.
That has been the lesson of the l!970s;
nation can no longer afford that luxury.
in the 1980s
the
The proper focus for monetary policy
should be restoring the integrity of our currency.
The consequences of failing to pay careful attention to the integrity
of our currency in the 1970s
national arenas.
are highly visible in both domestic and inter
Although the dollar for some decades has remained the world’s
principle trading and reserve currency by the sheer size of the United States
economy, it understandably comes under severe pressure when it depreciates
faster than currencies of our major trading partners.
The doubling of the
dollar price of gold this past year is a forceful reminder that the continued
integrity of the dollar is questioned.
Since crude oil is dollar denominated,
128
the O.P.E.C. countries have a strong self interest to raise the dollar price
of crude oil to at least keep pace with the declining purchasing power of the
dollar.
Unfortunately, there is little prospect that these price hikes and
the great uncertainty surrounding them, with their disruptive effects on the
economies of the industrialized and developing economies alike, will moderate
unless more attention is paid to restoring the integrity of the dollar.
On the domestic scene, public monies set aside to aid the disadvantaged
in our society are seriously eroded by continuing inflation, thereby denying
the achievement of important social goals.
Funds invested in private pension
plans by millions of Americans under the presumption that their Government
would maintain the integrity of their currency have lost purchasing power,
seriously impairing retirement prospects.
(But Federal workers do have cost
of living protection for their pensions). The inflation tax on money imposes
special hardships on those whose incomes just cover the bare necessities.
In
an unplannned fashion the decade long inflation tax has transferred income
and wealth from the saver to the borrower.
Given the progressive nature of
our tax system, inflation takes an increasingly larger bite of adjustments
to income made simply to retain purchasing power.
The incentive to save has
diminished to where in recent years personal savings has declined to but five
percent of disposable income.
While there is no shortage of causal explanations of our unprecedented
peacetime inflation, few have been subjected to careful econometric testing.
129
Explanations that receive strong empirical support after careful scrutiny
deserve our attention even if they do not follow traditional views about the
economy.
Eventually there may indeed be several mutually compatible key
explanations that are supported by strong quantitative evidence.
At the
present time, however, hard empirical evidence about the central causes
of inflation remains in short supply.
Based on my econometric study entitled Inflation and the Money Supply in
the U.S., 1954-77 published last year by Lexington Press, I find that over
the past 25 years changes in the rate of growth in monetary stimulus injected
into the economy are, in a causal sense, a strong candidate as a core ex
planation of the growth of the general price level, i.e. inflation.
The
evidence from that study suggests inflation is a primarily a home grown
product with all but about five percent of the increase in the general price
level in the 1970s
in the 1970s.
causally explained
by the rate of monetary stimulus
In other words, for the past decade as a whole, less than
one year's increase in prices originated from sources other than the rate
of growth of monetary stimulus.
To be sure a carefully designed model of
this type does not always give accurate forecasts.
use the 1950s; and the 1960s
For example, when we
experience and project out into the 1970s,
the forecasts for 1974 and 1975 are not completely satisfactory.
However,
even in those two years the monetary factor clearly dominates over all other
factors combined.
In recent years the projections based on the pre-1970
experience have been satisfactory.
Since this carefully tested powerful re
lationship has remained stable over more than two and a half decades and
ordinarily does provide good forecasts, it merits serious consideration in
any program designed to restore price stability.
130
The principle Government policy used to promote output and employment
in the 1970s
has been stimulating aggregate demand through applying monetary
stimulus at rates well in excess, on average, of our potential growth.
Over
the decade the Ml money supply has increased some 160 billion dollars, a gain
of almost 100 percent.
In contrast, the Ml money supply on average grew only
2*s percent yearly during the 1950s*
with average increases also of
a decade of reasonable price stability
2H percent
a
year.
However, while excessive
monetary stimulus has yielded unprecedented peacetime inflation, it has not
proved successful in maximizing economic growth and employment.
the 1960s,
the 1970s
Compared to
have had lower rates of real output, higher unemploy
ment and a sharply lowered rate of investment in plant and equipment.
investment proceeded at only one half the pace of the 1960s,
Business
boding ill for
the productivity enhancement so essential for our future economic well being.
At the very least a casual inspection of the 1970s
suggests that excessive
monetary stimulus has not brought outstanding results in achieving other na
tional economic goals. But it has brought an unprecedented and an unacceptable
rate of inflation.
Since we have not received any extraordinary benefits
from a decade long program of excessive monetary stimulus, there is a good
reason to reduce it to a rate commensurate with reasonable price stability.
That objective is in our national welfare.
A
Program
To restore the integrity of our currency I suggest.we give thoughtful
consideration to a straight forward two phased program lasting between two and a
half and three years.
131
First, we need to declare a national commitment that for the next two
and a half to three years restoring reasonable price stability will be our
number one economic priority (short of an unambiguous national emergency).
Second, once that priority is established, I recommend the following
policy to realize the goal of price stability.
The Federal Reserve, charged
with regulating our money supply, should maintain an orderly, well advertised
and monitored plan to reduce Ml money growth over a
year period
two and a half to three
to the three percent rate of monetary stim
ulus consistent with reasonable price stability.
For the Federal Reserve,
stabilizing the rate of monetary stimulus injected into the economy under a phased
reduction program would replace stabilizing interest rates.
The first part of the program simply acknowledges that any anti-inflation
program has the best chances for success under the umbrella of a national
commitment to price stability. A temporary reordering of our priorities is
a sensible prerequisite to enhance the prospects of any frontal assault on
inflation.
The second part of the program is a specific policy proposal that in
my judgment deserves consideration once the umbrella of the national com
mitment to price stability is firmly established.
That need not preclude
adoption of other policies towards achieving price stability.
132
Under the best of circumstances with strong public support, credibility for
the money growth reduction program and absence of sharp external shocks,
then by late 1982, the Ml money supply would increase by only 40 billion
dollars or about one half of what could be expected if the 6 - 7 percent
rate of monetary stimulus in recent years continued.
The expected inflation
path would be as follows:
Late 1980
Planned Ml Money Growth
5%
Expected Inflation(GNP Deflator)
7-8%
Late 1981
4
5-6
Late 1982
3
3-5
In considering any proposed program designed to restore reasonable
price stability, it is also important to specify short term downside risks
in terms of foregone employment and output.
Unfortunately, I doubt that we
have sufficient knowledge to quantify those risks with precision.
It would
be sensible to have standby programs so that any unexpected burden of ad
justment does not fall unfairly on the disadvantaged.
To minimize downside
risks it is crucially important those we do in fact create a national
commitment to price stability and then carry out an orderly, consistent and
well advertised phased money growth program with careful attention to hitting
the preannounced money growth targets.
In that manner inflation expectations
could be revised downward before the program is completed.
If there are strong
doubts about whether the program will be followed through, expectations will
adjust slowly and the downside risks on employment and output will become
pronounced.
To an important degree the downside risks are a function of the
preceived degree of our commitment to rearranging our priorities and following
through with specific programs.
133
In a real sense our choice is to incur the short term downside risks
or be forced eventually by circumstances to mount an all out frontal assault on
inflation.
There is ample historical precedent that well functioning
economies cannot successfully contain double digit inflation over the long
term.
With our present priorities and monetary policy, we can expect in
flation to be ratcheted upwards ever higher with each successive economic
expansion and continued disruption in foreign exchange markets.
Calls for
moderating excessive monetary stimulus give way to short term pressures
for yet additional stimulus.
At the present time we do have the luxury of
trying out alternative proposals.
such program.
A phased money growth reduction is one
If we delay we will not have that luxury.
It is clearly in
our national interest to take the bull by the horns, temporarily change our
national priorities, mount a sensible program towards reducing excessive
monetary stimulus and recognize that to encourage maximum employment of our
people and resources we need specifically tailored programs rather than the
blockbuster approach of stimulating aggregate demand directly and hoping
that all goes well.
The damage
from pursuing- that policy of the 197Ce
is our challenge in the 1980s*
The Challenge
Excluding unexpected external events the challenges
to the successful
implementation of the phased money growth reduction program, are first, our
resolve to follow through and maintain the national commitment to price
stability, and second, sharply contraining Federal Reserve policy making
in a non-discretionary mode for two and a half to three years.
Owing to the
134
delayed impact between changes in money growth and inflation, about two and
a half years, little success would be visible in the first year of the pro
gram.
Inflation expectations carefully nutured for over a decade cannot be
quickly reversed in a matter of several months short of a sharp down turn
in aggregate demand.
The litmus test of a phased money growth reduction program is surely
our willingness to resist short term pressures to stimulate aggregate demand
calling fdr higher rates of monetary stimulus. The past decad* vividly Illustrates
what happens when we succumb to the temptation of answering short term needs
and accommodating Federal budget deficits but ignoring longer run requirements.
With a weakening economy facing record high interest rates and prospects for
continued O.F.E.C. oil price hikes, those pressures are clearly visible.
A recession would certainly encourgage demands for yet additional monetary
stimulus.
There is a clear danger that if we embark on any serious frontal assault
on inflation and loose heart, it would prove far more difficult in the fu
ture to reverse inflation expecations.
The alternative then would be a long
drawn out money growth reduction program over 5 - 6 years in which expecta
tions are finally changed only after the fact of several year's slower money
growth.
The odds are clearly against holding price stability as our number
one priority for that long a period.
135
The second challenge is that the program requires a forceful change in
the conduct of Federal Reserve policy making for a period of several years.
Traditionally, Federal Reserve policy has been discretionary with simultaneous
attention to varied economic objectives.
In practice, financial market
participants and others traditionally face considerable uncertainty about the
future course of interest rates and the rate of monetary simulus. The contrast
would indeed be marked under a non-discretionary Federal Reserve policy.
The
rate of monetary stimulus would be known well in. advance for
several years in the future.
Financial market detective work would largely
focus on interest rates forecasts determined by market forces rather than
Federal Reserve policy.
Maintaining a single focus monetary policy specifically geared to meet
Ml money growth targets for several years, while within the professional
capabilities of the Federal Reserve, would be the most dramatic reorientation
of the Federal Reserve since the 1930s.
growth targets has not been successful.
Our recent experience with money
Target bands are uncomfortably wide,
various aggregates are concurrently targeted and reference dates are shifted
forward.
Targeting dates back to House Concurrent Resolution #133 in the
spring of 1975.
However, the rate of Ml money growth in the four years since
the Resolution has been 6.6 percent, just about equal to the 6.1 percent growth
rate in the four years prior to that Resolution.
Moreover, these rates are
above long term target figures set by the Federal Reserve itself.
136
While the refocus announced in the October 6th initiative is a useful
step, it is just a beginning.
Presently there is considerable uncertainty
about the course of Ml money growth in 1980 and 1981.
For example, it is not
known how much additional- money growth will be created between October 6th
and one year later.
gram
needs
To gain credibility a phased money growth reduction pro
narrow target ranges, e.g. +
h
percent, a single fixed re
ference date, e'..g. October 6th, 1979, and sole reference to a specific aggre
gate, e.g. Ml.
With these technical features in place, careful adherence to
the pre-announced targets at quarterly intervals would create
the credibility
necessary to reverse inflation expectations.
Restoring the integrity of our currency would yield attractive benefits
both at home and abroad.
ment.
Americans would have new confidence in their govern
A credible program for maintaining reasonable price stability would
greatly reduce pressures on the dollar in the foreign exchange markets.
And
with a stable currency the incentive for purchasing power maintenance O.P.E.C.
oil price hikes would be reduced.
With a more predictable environment
business planners would encourage productivity enhancing investment in the
plant and equipment vital to our nation's economic well being and competitive
ness abroad.
Funds allocated to fulfill important social needs would not have
their purchasing power seriously eroded.
would be protected.
Similarly, private pension values
Embarking upon the program that I have outlined is well
within our grasp; it would clearly demonstrate the vitality of the world's
leading economy.
137
To be sure there are risks in any frontal assault on inflation; our know
ledge is. not as broad as would be desired.
But there are very substantial
risks of sitting still as inflation winds ever higher to utterly unacceptable
rates.
in the
There is never a good or convenient time to mount a phased reduction
rate of monetary stimulus.
stances to restore price stability.
Ultimately we will be forced by circum
But the sooner we embark on this program
the sooner the integrity of our currency will be restored, our economic well
being will be enhanced and the sooner we will be able to devote important new
energies to other national goals.
138
Chairman M i t c h e l l . Thank y o u , Dr. Berman.
Dr. Hamburger.
STATEMENT OF BE. MICHAEL J. HAMBURGER, VISITING PROFES
SOR OF ECONOMICS, NEW YORK UNIVERSITY
Dr. H a m b u r g e r . Thank y o u , Mr. Chairman.
It is a pleasure to be here today and to contribute to your com
mittee's important discussions regarding the goals and conduct of
monetary policy.
My statement is very short; and if you will bear with me, I will
read most of it.
I want to begin by indicating my very strong support for the deci
sion taken by the Federal Reserve on October 6 to slow the growth
of the money stock and the complimentary decision to adopt a new
means of controlling money.
The latter action represents a fundamental change in the Federal
Reserve’s day-to-day operating techniques. It involves a shift in em
phasis from containing short-term fluctuations in the Federal funds
rate to controlling the supply of bank reserves.
There is every reason to believe that the new procedures should
substantially improve the Federal Reserve’s ability to achieve its own
targets for money and credit.
Indeed, as Chairman Volcker has testified, the earlier procedures
may have actually contributed to the recent excessive growth in the
monetary and credit aggregates, and the inflationary and speculative
psychology that it helped to generate.
I share this view and will have more to say about the new tactics
later on. Before doing so, though, let me address some of the issues
of monetary strategy raised in Chairmen Mitchell and Neal’s letter
of invitation.
Like Mr. Volcker, I also believe that it is essential for the United
States to embark on a credible, long-lasting program that gradually,
but steadily, reduces monetary growth to a noninflationary level.
Efforts to slow monetary growth in the face of strong credit demands
and inflationary pressures are likely to result in a temporary rise in
interest rates, as occurred in the days and weeks immediately following
the Federal Reserve’s actions on October 6.
But as more recent developments indicate, such increases need not
persist. Moreover, practically all observers are agreed that the only
means of attaining permanently lower interest rates is by lowering
nflation.
i Controlling or reducing the rate of inflation at home is also the only
method we know of maintaining the value of a currency in the foreign
exchange markets.
Time and again history has shown that those countries with the
lowest inflation rates are also the ones with the strongest currencies.
Thus, there is no basic inconsistency between a monetary policy
strategy that concentrates on announcing and remaining on or very
near a longrun disinflationary money growth path and a strategy that
focuses on maintaining the international value of the dollar.
The relevant question is: Are there times or circumstances when it
would be useful to deviate temporarily from such a path in order to
139
improve the chances of achieving either domestic or international
objectives?
I wish very much that I could respond affirmatively to this question.
Clearly, there should be circumstances when informed judgment
can improve upon a predetermined money growth path. The problem
is that almost all past efforts to “fine tune” monetary policy have
had undesirable longer term consequences.
In early 1971 money growth was accelerated sharply to help lift
the economy out of the 1969-70 recession. This action did stimulate
real output. However, it also contributed to the rapid deterioration
of the U.S. balance of payments position and was soon followed by a
breakdown of the Bretton Woods agreements and the first of a long
and costly series of dollar crises.
More recently, the rate of monetary growth was boosted in late
1976 in an attempt to deal with an apparent pause in the ongoing
economic expansion. This acceleration turned out not to be temporary
at all and, in retrospect, set the stage for our present dilemma.
Other examples could be cited where departures from a monetary
growth target to temporarily stimulate or restrict real economic
activity had detrimental long-term consequences. Instead, let us
consider another possible rationale for such departures; that is to
alleviate financial market disturbances. Here the recent historical
record is clear. The actual deviations that have been needed to solve
such problems have been relatively minor.
The failure of the Penn Central Transportation Co. in June 1970 is
a useful case in point. Initially, widespread fears of a general liquidity
crisis were generated as major business corporations were unable to
roll over their maturing commercial paper and scrambled for scarce
funds in other markets.
The Federal Reserve System acted quickly and efficiently to dispel
the fears and restore stability by early July. During the period, addi
tional reserves were provided to the banking system through both
open market operations and the discount window.
However, in the end, the growth of the narrow money stock re
mained essentially unchanged from what it had been in the months
immediately preceding the disturbance.
The Federal Reserve’s handling of the insolvency of the Franklin
National Bank in 1974 provides another example of the authorities’
ability to discharge their lender of last resort responsibilities without
seriously interfering with monetary control.
Between May 9 and October 8, 1974, the day that Franklin National
was declared insolvent by the Comptroller of the Currency, its
indebtedness to the Federal Reserve Bank of New York, rose from
$125 million to more than $1.7 billion, a large amount by any standard.
Despite this increase in borrowed reserves, the Federal Reserve
was able to pursue its objective of slowing the growth in the monetary
and credit aggregates during 1974.
Currently, there are some who suggest still a different reason for
deviating from a gradual but steady decline in the growth of money.
Their proposed strategy places top priority on haltmg the decline in
the value of the dollar on the foreign exchange markets, and would do
so by keeping money “ tight” at home and resisting speculative attacks
against the dollar abroad.
140
Specifically, the Federal funds rate would be increased substantially
above its present level, and the Federal Reserve and the Treasury
would stand ready to intervene in the exchange markets to combat any
excessive speculation against the dollar even in the face of high interest
rates.
In my judgment, such a policy would be misguided. As with past
efforts to fine-tune money growth, it is likely to prove disruptive for
both the domestic economy and international financial markets.
To the extent it involved a sharp deceleration in monetary growth,
it could contribute to aggravating a recession. Not only would a more
serious recession be undesirable in its own right, but the anticipated
policy response could have destabilizing effects on the foreign exchange
markets and interfere with the effort to reduce the long-term rate of
inflation.
An attempt to vigorously fight the recession through increases in
monetary growth, or merely the expectation of such increases, could
quickly rekindle speculative pressures against the dollar.
Perhaps even more damaging are the effects such a policy could
have at home. It would make it difficult for economic participants to
determine the authorities, longrun policy intentions.
Hence, it would contribute little to moderating inflationary expec
tations or reducing the very high level of uncertainty and instability
that pervades the economy. Thus, inflation could reaccelerate quickly.
Moreover, in such an atmosphere, economic participants would be
reluctant to make long-term commitments. In particular, businesses
are likely to continue to hold off making the long-term investments in
plant and equipment that seem necessary to reverse the recent de
clining trend in U.S. productivity.
Lest this scenario be viewed as unduly pessimistic, let me call
attention to the similarity between it and the disappointing behavior
of the U.S. economy since the end of the last recession.
I return, therefore, to my previously stated view, namely that the
Federal Reserve should use its new control procedures to achieve
sustained, preannounced targets for money growth that can gradually
bring the average rate of inflation to zero in the next 4 to 5 years.
At the outset, any anti-inflationary effort will have a temporary
negative impact on output and employment. But these effects can be
minimized if the public’s inflationary expectations can be reduced
decisively.
For this reason, I believe that it would be an important step forward
for the monetary authorities to publicly commit themselves to a credi
ble set of monetary growth targets for the next several years.
Such a bold departure from past behavior would undoubtedly incur
some risks. One can list a host of possible developments that might
alter the appropriate monetary growth path.
However, it seems to me that the U.S. economy is at or very close
to the point where we can no longer avoid taking some risks to end the
steady upward climb in inflation.
Alternative monetary policy strategies have been given a fair trial
and have not proven particularly successful. In contrast, those foreign
countries that have set and generally achieved monetary growth tar
gets over a number of years have been able to stabilize, and in some
mstances reduce, their long-term rate of inflation.
141
Thus, I find myself in considerable sympathy with many of the
provisions of the bill recently introduced by Chairman Neal, H.R. 5476.
Let us now turn briefly from questions of monetary strategy to
those relating to the Federal Reserve’s new operating tactics.
As indicated earlier, I believe that the shift in emphasis from shortrun interest rate stabilization to reserve control is a major advance.
It is not a panacea, but it should substantially increase the Federal
Reserve’s ability to achieve monetary growth targets.
To further this end and, perhaps more importantly, to ease the
financial markets’ adjustment to the new era, I strongly recommend a
number of additional changes in procedures.
First, the Federal Reserve needs to use all of its available resources
to fully understand the intricacies and details of the changes that have
already been implemented.
Once this is done, the authorities should make an effort to provide
the markets with short- and immediate-term projections of the re
serves they intend to supply.
Initially such projections will be quite rough. Nevertheless, they
should help market participants plan their activities. And this, in
turn, should help to moderate shortrun interest rate fluctuations.
A second change that would contribute to the success of the new
procedures and also help to eliminate unnecessary interest rate fluctua
tions is a shift from lagged to contemporaneous reserve accounting.
Under the present lagged reserve accounting system, a bank’s
required reserves depend on its deposits 2 weeks earlier. A shift to
contemporaneous reserve accounting would make the bank’s require
ments depend on the current level of deposits.
Such a change could make a slight improvement in the precision of
shortrun monetary control. More importantly though, it should reduce
the effects of unexpected changes in banKs’ reserve positions and
thereby help to moderate shortrun interest rate movements.
Finally, let me say that I agree wholeheartedly with Professor
Brunner’s comments that the Federal Reserve’s focus—or its an
nounced focus on nonborrowed reserves—is a less efficient way of
gaining control of the money stock.
A more efficient procedure would be to focus on the monetary base.
Thank you very much.
[Dr. Hamburger’s prepared statement follows:]
5 5 - 1 2 3 0 - 80 - 10
142
Testimony Prepared for
Joint Hearings on
"Monetary Policy— Goals and Conduct for the 1980's"
Subcommittee on Domestic Monetary Policy and
Subcommittee on International Trade, Investment and Monetary Policy
of the
Committee on Banking, Finance and Urban Affairs
United States House of Representatives
Ninety-Sixth Congress
December 4, 1979
Michael J. Hamburger
Visiting Professor of Economics
New York University
*0n leave as Advisor from the Federal Reserve Bank of New York.
The views expressed here are mine alone, and are not necessarily
those of the Federal Reserve Bank of New York nor the Federal Re
serve System.
143
It is my pleasure to be here and to contribute to your
Committees' important discussions regarding the goals and conduct
of monetary policy.
Let me begin by indicating my strong support
for the decision taken by the Pederal Reserve on October 6 to slow
the growth of the money stock and the complimentary decision to adopt
a new means of controlling money.
The latter action represents a
fundamental change in the Federal Reserve's day-to-day operating
techniques.
It involves a shift in emphasis from containing short
term fluctuations in the Federal funds rate to controlling the sup
ply of bank reserves.
There is every reason to believe that the new procedures
should substantially improve the Federal Reserve's ability to
achieve its own targets for money and credit.
Indeed, as Chairman
Volcker has testified the earlier procedures may have actually con
tributed to the recent excessive growth in the monetary and credit
aggregates and the inflationary and speculative psychology that they
helped to generate.
I share this view and will have more to say
about the new tactics later on.
Before doing so, though, let me
address some of the issues of monetary strategy raised in Chairmen
Mitchell and Neal's letter of invitation.
I also agree with Mr. Volcker that it is esential for
the United States to embark on a credible long-lasting program
that gradually, but steadily reduces monetary growth to a noninflationary level.
Efforts to slow monetary growth in the face of
strong credit demands and inflationary pressures are likely to
result in a temporary rise in interest rates, as occurred in the
days and weeks immediately following the Federal Reserve's actions
144
on October 6.
But as more recent developments indicate such
increases need not persist.
Moreover, practically all observers
are agreed that the only means of attaining permanently lower
interest rates is by lowering inflation.
Controlling or reducing the rate of inflation at home
is also the only reliable long-term method we know of maintaining
the value of a currency in the foreign exchange markets.
Time and
again history has shown that those countries with the lowest in
flation rates are also the ones with the strongest currencies.
Thus, there is no basic inconsistency between a monetary policy
strategy that consentrates on announcing and remaining on or very
near a long-run disinflationary money growth path and a strategy
that focuses on maintaining the international value of the dollar.
The relevant question is, are there times or circumstances
when it would be useful to deviate temporarily from such a path
in order to improve the chances of achieving either domestic or
international objectives?
to this question.
I wish that I could respond affirmatively
Clearly there should be circumstances when in
formed judgment can improve upon a predetermined monetary growth
path.
The problem is, that almost all past efforts to "fine tune"
monetary policy have had undesirable longer-term consequences.
In early 1971 money growth was accelerated sharply to
help lift the economy out of the 1969-70 recession.
did stimulate real output.
This action
However, it also contributed to the
rapid deterioration of the U.S. balance of payments position and
was soon followed by a breakdown of the Bretton Woods agreements
and the first of a long and costly series of dollar crises.
More
145
recently, the rate of monetary growth was boosted in late 1976
in an attempt to deal with an apparent pause in the ongoing econo
mic expansion.
This acceleration turned out not to be temporary
at all, and in retrospect set the stage for our present dilemma.
Other examples could be cited where departures from a
monetary growth target to temporarily stimulate or restrict real
economic activity had detrimental long-term consequences.
In
stead, let us consider another possible rationale for such de
partures, that is, to alleviate financial market disturbances.
Here the recent historical record is clear; the actual deviations
that have been needed to solve such problems have been relatively
minor.
The failure of the Penn Central transportation Company in
June 1970 is a useful case in point.
Initially, widespread fears
of a general liquidity crisis were generated as major business
corporations were unable to roll over their maturing commercial
paper and scrambled for scarce funds in other markets.
The Federal
Reserve System acted quickly and efficiently to dispel the fears
and restore stability by early July.
During the period additional
reserves were provided to the banking system through open market
operations and the discount window.
However, in the end the growth
of the narrow money stock remained essentially unchanged from what
it had been in the months immediately preceding the disturbance.
The Federal Reserve’s handling of the insolvency of the
Franklin National Bank in 1974 provides another example of the
authorities ability to discharge their lender of last resort re
sponsibilities without seriously interfering with monetary con
trol.
Between May 9 and October 8, 1974, the day that Franklin
National was declared insolvent by the Comptroller of the Cur
rency, its indebtedness to the Federal Reserve Bank of New York
146
rose from $125 million to more than $1.7 billion, a large
amount by any standard.
Despite this increase in borrowed re
serves the Federal Reserve was able to pursue its objective of
slowing the growth in the monetary and credit aggregates during
1974.
Currently, there are some who suggest still a different
reason for deviating from a gradual but steady decline in the
growth of money.
Their proposed strategy places top priority on
halting the decline in the value of the dollar on the foreign
exchange markets and would do so by keeping money "tight" at home
and resisting speculative attacks against the dollar abroad.
Specifically, the Federal funds rate would be increased sub
stantially above its present level and the Federal Reserve and the
Treasury would stand ready to intervene in the exchange markets
to combat any excessive speculation against the dollar even in
the face of high interest rates.
In my judgement such a policy would be misguided.
As
with past efforts to fine tune money growth it is likely to prove
disruptive for both the domestic economy and international finan
cial markets.
To the extent it involved a sharp deceleration in
monetary growth it could contribute to aggravating a recession.
Not only would a more serious recession be undesirable in its
own right, but the anticipated policy response could have de
stabilizing effects on the foreign exchange markets and interfere
with the effort to reduce the long-term rate of inflation.
An
attempt to vigorously fight the recession through increases in
monetary growth, or merely the expectation of such increases,
could quickly rekindle speculative pressures against the dollar.
147
Perhaps even more damaging are the effects such a policy
could have at home.
It would make it difficult for economic par
ticipants to determine the authorities' long-run policy intentions.
Hence, it would contribute little to moderating inflationary ex
pectations or reducing the present level of uncertainty and in
stability that pervades the economy.
accelerate quickly.
Thus, inflation could re-
Moreover, in such an atmosphere economic
participants would be reluctant to make long-term commitments.
In particular, businesses are likely to continue to hold off mak
ing the long-term investments in plant and equipment that seem
necessary to reverse the recent declining trend in U.S. producti
vity.
Lest this scenario be viewed as unduly pessimistic let me
call attention to the similarity between it and the disappoint
ing behavior of the U.S. economy since the end of the last reces
sion.
I return therefore, to my previously stated view, namely,
that the Federal Reserve should use its new control procedures
to achieve sustained pre-announced targets for money growth that
can gradually bring the average rate of inflation to zero in the
next four to five years.
At the outset any anti-inflationary
effort will have a temporary negative impact on output and em
ployment.
But these effects can be minimized if the public's
inflationary expectations can be reduced decisively.
For this
reason, I believe that it would be an important step forward for
the monetary authorities to publicly commit themselves to a
credible set of monetary growth targets for the next several years.
148
Such a bold departure from past behavior would undoubtedly
incur some risks.
One can list a host of possible developments
that might alter the appropriate monetary growth path.
However,
it seems to me that the U.S. economy is at or very close to the
point where we can no longer avoid taking some risks to end the
steady upward climb in inflation.
Alternative monetary policy
strategies have been given a fair trial and have not proven par
ticularly successful.
In* contrast, those foreign countries that
have set and generally achieved monetary growth targets over a
number of years have been able to stabilize and in some instances
reduce their long-term rate of inflation.
Thus, I find myself
in considerable sympathy with many of the provisions of the bill
recently introduced by Chairman Neal, H.R. 5476.
Let us now turn briefly from questions of monetary
strategy to those relating to the Federal Reserve*s new operat
ing tactics.
As indicated earlier, I believe that the shift in
emphasis from short-run interest rate stabilization to reserve
control is a major advance.
It is not a panacea, but it provides
the technical basis for increasing the Federal Reserve's ability
to achieve monetary growth targets.
To further this end and, per
haps more importantly, to ease the financial markets' adjustment
to the new era, I strongly recommend a number of additional changes
in procedures.
First, the Federal Reserve needs to use all of its
available resources to fully understand the intricacies and details
of the changes that have been implemented.
Once this is done,
the authorities should make an effort to provide the markets with
short- and intermediate-term projections of the reserves they in
tend to supply.
Initially such projections will be quite rough.
149
Nevertheless, they should help market anticipants plan their ac
tivities and this, in turn, should moderate short-run interest
rate movements.
A second change that would contribute to the success
of the new procedures and also help to eliminate unnecessary in
terest rate fluctuations is a shift from lagged to contemporaneous
reserve accounting.
Under the present lagged reserve accounting
system a bank's required reserves depend on its deposits two weeks
earlier.
A shift to contemporaneous reserve accounting would
make the bank's requirements depend on the current level of de
posits.
Such a change could make a slight improvement in the
precision of short-run monetary control.
More importantly, though,
it would also reduce the effects of unexpected changes in banks'
reserve positions and thereby help to narrow short-run varia
tions in interest rates.
150
Chairman M i t c h e l l . Thank you, Dr. Hamburger, and all three of
you gentlemen.
I must confess it is rare that this committee has heard such a high
degree of consensus in testimony. It is a very rare occasion for us.
I will reserve my questions until the other members have had an
opportunity to put their questions to you.
Chairman Neal.
Chairman N e a l . Professor Brunner, you said, during the course of
your remarks, that a decisive gesture is needed to insure that the
public financial institutions in the international community under
stand that we are serious about bringing down the rate of inflation in
this country.
What would you see as that decisive gesture?
Professor B r u n n e r . Mr. Chairman, I was delighted to hear Dr. Ber
man essentially emphasizing the same aspects, and also Dr. Hamburger.
If I would be permitted for a moment to offer a comment in some
what a sardonic mood: I have been playing with the idea that one
should impose a special tax on all of the Governors of the Board, and
all of the presidents of the Federal Reserve banks, and the top officials.
This tax provides for every percentage point of inflation in a particular
year a 10-percent reduction in the previously mentioned officials’ net
income.
Chairman N e a l . I would have to say I don’t find that as amusing
as some, because that same idea has been suggested for Members of
Congress.
Professor B r u n n e r . Well, I am in good company then. The problem
is, however, quite serious. The event of October 6 reminds us unavoid
ably of October 24 and November 1, last year. And we are also
reminded of the subsequent events. The Federal Reserve authorities
acted for 5 months.
The growth rate of the monetary base declined substantially and
followed the requirements of an anti-inflationary policy. But then we
experienced once more the old story—we observed a reversal to even
more inflationary levels of monetary expansion than ever before. The
result appeared during the summer on the international exchange
markets.
So, in one way or the other, we should create a pattern, with all of
the pomp and circumstance required, assuring us that the Fed really
means business. This may involve pressures from Congress, pressures
from the public, and public and specific commitments on the part of
the Fed. I am not sure about the best procedure to create credibility
and reliability. But certainly one way which would substantially help
in my judgment, would be the congressional committees’ determina
tion to supervise the Federal Reserve’s policies, assess the account
ability of the Fed, take a hard line to force the Fed to acknowledge a
public accountability, and to really deliver.
Chairman N e a l . Let me interrupt for a moment, if I can.
I have spent more time on this subject than any other single subject
since I came to Congress. I think I was elected to try to do something
about the problem of inflation.
I was the chairman of this Domestic Monetary Policy Subcommittee
several years ago. I am now chairman of the Subcommittee on Inter
national Trade. I understand the impact that it has on the value of the
dollar and our trade situation.
151
And there is no subject that interests me more that I want to do
something about. I have become convinced that the only way that
we’re going to get inflation under control in this country is to gradually
bring down the rate of growth in the money supply until it reaches
something that approximates the rate of growth of the gross national
product, and keep it there.
I have introduced a bill that would bring that precise result about.
And in that bill—and I believe we sent copies of the draft bill to all of
you—we provide an escape hatch for exceptional circumstances.
I am inclined to agree with Dr. Hamburger that, if used at all, that
should only be used in the most severe circumstances.
And, in fact, we suggest that before that could be used that there be
a vote of a—majority of the Board of Governors of the Federal Open
Market Committee.
My specific question—I am convinced that the action taken by the
Fed on October 6 will begin to move us to the point where, if taken
seriously, we will see reductions in interest rates relatively soon and
that we will see a steady decline in those interest rates; but I am con
vinced, as the three of you appear to be, that no one really takes that
decision very seriously.
We have seen decisions taken like that in the past and not followed
through on, and so on. So even though it is with a great deal of trepida
tion that I would want the Congress to impose on the Federal Reserve
System, I do make this one proposal very, very seriously: That we, in
fact, in the Congress mandate that the Fed bring down the rate of
growth in the Mi we use by about a percent a year until it reaches
about 3 percent and then leave it there.
We see that gradual approach as the sensible approach to the radical
ups and downs we have seen in recent years. And I personally have
come to conclude that nothing else will get the job done.
Even the strongest statement by the Chairman of the Federal Re
serve System—and we have urged him to make that statement—will
still not be taken seriously.
As I remember, under legislation passed by this Congress, a new
President will have the option, after his first year in office, of naming a
new Chairman. If this country should elect a President that does not
appreciate the role of monetary—excuse me, the House has passed a
bill that would give the newly elected President the opportunity to
name a new Chairman of the Federal Reserve Board of Governors.
And if we should elect a President in this country who does not
understand the importance of the role of monetary policy, and should
choose to flood the economy again with money and devalue our cur
rency again, that would be entirely possible unless there is some strong
mandate, it seems to me, from the Congress.
I would like to have all of your comments on that specific proposal,
if I could.
Professor B r u n n e r . May I make a suggestion?
Chairman N e a l . Yes.
Professor B r u n n e r . Last March, I think it was, when the House
Committee on Banking, Finance and Urban Affairs—I seem to re
member it was a unanimous recommendation-----Chairman N e a l . And we used the exact formula in that unanimous
recommendation in drafting our bill.
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Professor B r u n n e r . N o w , what I would like to suggest is that
Chairman Volcker go to the public and say, “We, at the Fed, accept
that recommendation,” that he publicly announce that, and that this
will be the policy of the Fed over the next 5 years, and that he an
nounces now what the path of monetary growth should be over the
next 4 or 5 years, and that it will be adhered to in the strongest terms.
Chairman N e a l . I would agree with you that that is important.
But is that enough?
Professor B r u n n e r . Well, what we need to find is a procedure
which will assure us a better performance.
Chairman N e a l . Well, how do we make sure that it will be done?
Professor B r u n n e r . What are the instruments available to us
in this respect?
Chairman N e a l . In my opinion, should it be done? If the Congress
would pass the bill that I recommended, it would say that it would
be the policy of the Federal Reserve to bring down the rate of growth
by 1 percent a year for the next—whatever it takes—3, or 4, or 5
years, until it reaches 3 percent, and then leave it there.
Would you support that?
Professor B r u n n e r . That is exactly the point. I fully agree with
you. I would support this policy and this proposal which you have
mentioned.
Chairman N e a l . Y o u know what I see happening over and over
again is that we go through these cycles. And who is hurt? The young
people trying to buy a home, the savings and loan industry, which
suffers first; the homebuilding industry; the furniture business, of
which I have a lot in my district; and then the industries which depend
upon that, the homebuilding industry, furniture, carpets, textiles,
and so on.
It is absurd. In my own opinion, we know the answer—we know
how to solve the problem. And I simply don’t think it’s going to be
solved unless we mandate that it be solved by the Congress.
Dr. B e r m a n . I would like to note that we in the financial markets
are perenially cast in the role of playing monetary policy detective.
In the last year alone we were surprised, to put it mildly, by two major
policy initiatives, first on November 1, 1978, and then on last October
6. Moreover, the growth of the money supply was most unusual, with
the economy being whipsawed by 6 months of no growth followed by
an unprecedented 6 months of 10 percent growth.
On the basis of the past year’s unsettling experiences, no public
statement, no matter how well crafted, by the Federal Reserve or the
Federal Reserve Chairman, would likely convince financial market
participants and others that they have any degree of assurance about
the rate of money growth over the foreseeable future. To make that
point clear, we simply do not know at this time how much the Mi
money supply will increase 1 year from October 6, 1979. We do know
that the stated longrun targets are between 1^-4% percent, well below
actual growth over the past decade. Yet several weeks ago Chairman
Volcker made a statement to the effect that because of expected OPEC
price hikes, additional monetary stimulus will be required. Thus the
announced 4J4 percent upper target range is not terribly informative.
As long as we remain in constant uncertainty about the rate of
monetary stimulus, financial markets will exhibit similar uncertainty.
153
For 50 years, uncertainty has been an important facet of discretionary
Federal Reserve decisionmaking. What is required to control the mone
tary aggregates is nothing less than a dramatic change in the way that
our central bank functions. To successfully implement a phased reduc
tion in Mi money growth requires a single focused Federal Reserve
able to resist the inevitable shortrun pressures for additional stimulus.
We should appreciate the difficulty of the task faced by the Federal
Reserve if required to implement a phased Mi growth reduction pro
gram over 2% to 3 years. A 50-year tradition of discretionary policy
making would need be set aside for several years to allow pursuit of
a well defined, narrow policy focusing on money growth rates. It would
be an extraordinary change for the Federal Reserve to announce
clearly, in detail, what the targeted rates of money growth will be
over the next several years.
Now there are some important shopkeeping details that will help
instill confidence and credibility in a phased money growth reduction
program.
First, we need a specific reference date rather than the confusing
practice of shifting reference dates forward. October 6 would be a
suitable date.
Second, one reference monetary aggregate should be targeted rather
than four of five. Multitargeting sows confusion. Now, I am well
aware that there are differing opinions about what is or should be the
proper aggregate for targeting. I suggest we stick with Mx. My studies
of the monetarist inflation thesis find that Mx clear and away has the
most powerful causal relationship with prices among the various pub
lished aggregates. Since the purpose of this proposed program is restore
reasonable price stability, it makes good sense to target that monetary
aggregate that has the most powerful causal relationship with the
price level. Empirically and theoretically that argues for Mx. To be
sure it is not perfect but it is the best we have.
Third, it would be helpful to maintain a stabilized rate of money
growth while the phased reduction program is carried out. To gain
confidence the program requires that quarterly rates of money growth
should be constrained within a narrow range, say plus or minus onehalf percent or a range of about 1 percent. Otherwise, if the de facto
quarterly money growth rates bob up and down, true believers will
be long in the making. This is particularly important in view of last
year’s money growth whipsaw of 6 months flat growth followed by
6 months of unprecedented 10 percent growth. Additionally de facto
growth has long been above posted targets. There is a credibility
problem. Hewing the line is a necessary clemand of the phased reduc
tion program—a program designed to reduce both inflation and
inflation expectations.
These suggestions would greatly restrict the discretionary freedom
that has characterized central banking in the United States. To require
any institution to adhere for several years to a straight and narrow path
is indeed a challenge. But the facts are not in dispute. Prices have
doubled in the last decade and the money supply nearly so. Over the
last decade the money supply has grown at 6 to 7 percent annually,
far in excess of the economy’s potential real rate of growth. Over the
last 3 years money growth has averaged roughly 7 percent. If we can
put together a forceful national commitment to restoring the integrity
154
of our currency then it is certainly appropriate to require that the
Federal Reserve change its ways and follow a straight and narrow
policy for several years in fulfillment of that commitment. Once
shielded from shortrun pressures there is no technical reason why a
phased money growth reduction program cannot be successfully
implanted.
Finally, there is never a good time and I suggest that there will
never be a convenient time to begin a phased money growth reduction
program. But the past decade argues forcefully that such a program
be begun. We need resolve to do something other than stop-start. If
done openly and purposefully such a program would not have down
side risks on income and employment. It is in our national interest to
begin such a program in earnest and as soon as possible in order that we
may rightfully restore the integrity of our currency.
Dr. H a m b u r g e r . As I indicated in my opening statement, I fully
agree with the spirit of your proposed legislation, Chairman Neal.
I also indicated that in the past the reasons given for deviating from
the monetary growth path turned out not to carry much weight.
Nevertheless, we probably want to leave some possibility for some
escape, as I think you do. So I fully agree with the general spirit of
that bill.
I also would find it hard to improve on Dr. Berman’s elaboration
and indication of why it is so important to be very specific and have
everything set out very well in advance.
I just wanted to add that I think that the costs of a high and
varying rate of inflation are much wider than Dr. Berman suggested.
They are not restricted to the financial industry. Rather, they affect
us all. It is well known or it seems to be reasonably well documented
that productivity in the United States began to slow down sharply
in the late 1960’s, just the time when we entered this new era of a
high and varying rate of inflation. And I think the connection is not
surprising.
I am not aware of any detailed empirical evidence to show that the
cause is one to one. But I think the relationship seems quite reasonable.
In a situation of great instability, as we have been experiencing, I
think businessmen would find it very hard to make the long-term com
mitments in plants and equipment to provide for increased
productivity.
Chairman N e a l . Thank you. I have exceeded the time allotted me.
But the chairman has agreed to let me ask one further question and
just get a simple yes or no answer from each of the panelists.
In my opinion, the single most important thing that we can do in
this country to solve the problem of inflation, stabilize the value of the
dollar, increase employment, bring down interest rates, is to adopt a
monetary policy as I described earlier, that is, to bring the rate of
growth down about 1 percent a year until it reaches the rate of
growth in our GNP and leave it there. I would just like a yes or no
answer from each of you whether you agree or disagree with that
statement.
Professor B r u n n e r . Yes, indeed.
Dr. B e r m a n . I agree.
Dr. H a m b u r g e r . Yes.
Chairman N e a l . Thank you very much.
155
Chairman M i t c h e l l . I think it might be prudent if from this point
on we operated under the 5-minute rule in order to enable all the
members of the subcommittees to raise questions.
Chairman N e a l . I apologize, Mr. Chairman.
Chairman M i t c h e l l . Well, it was clear that y ou had asked special
concern be given, and I have no problem with that.
Mr. Campbell?
Mr. C a m p b e ll. Thank y o u , Mr. Chairman.
I was very interested in the last statement Dr. Hamburger made
and he had referenced earlier, and that was the decline in the growth
rate of our productivity in this Nation and how it impacts; and also,
the correlation that you seem to draw between that decline and the
growth in the monetary growth in this Nation.
Let me ask you this, because you have raised the question and
because we are strictly speaking of the role of the Fed and controlling
the growth of Mxor actually having a decline in the growth of Mx; and
because economies go through periods of expansion and contraction,
and because we constantly seek this balance between growth and in
come redistribution, which all impact on what we do.
Is it possible—and I would like your comment on it—that we have
reached a point in our programs in income redistribution where it is
exceedingly difficult, if not impossible, to really control the growth of
money in this Nation? Is it possible that we have automatically
triggered in so many things into our legislative programs that the
Fed would be completely—it would be impossible for them to set an
absolute target and hold to it, because of the short-term pressures
that you have mentioned earlier? Are those short-term pressures built
into legislation now? Would the countercyclical forces come into being
and completely undermine everything that we have done?
And I think, in asking this broad-based question, let me ask you
this: Is it not probable that in order to get a handle on inflation, that
we not only have to follow the program set down by the Fed for some
sort of goal, applaud the decision of October 6, and at the same time
recognize that our Federal spending programs and our tax policies in
this Nation have also been the other two things that have to be
addressed at the same time in order to truly get a handle on this?
I know that is very broad based. But in a 5-minute period, Mr.
Chairman, that is the only way I could get them all wrapped up into
one. I would just throw them out there for comment as a whole. I
would start with Professor Brunner.
Professor B r u n n e r . We face at this stage several problems. The
inflation problem, initiated by the Federal Reserve authorities in
1965, stayed with us over 14 years. The 1980,s threaten us moreover
with economic stagnation.
Our slide into economic stagnation results mostly from the cumu
lative effect of the many disincentives introduced into our system by
past economic policies. Such negative incentives do affect, indeed, our
welfare in terms of lower real growth, lower real income per capita,
and so on. These aspects are very important in terms of our welfare,
and I would certainly hope that they would be removed in the future
by suitable changes in prevailing policies.
We need to understand however that their contribution, that is,
the direct contribution of these welfare-obstructing policies, to the
156
inflation problem is comparatively small. The basic inflation rate
which we experience currently, which is determined by the tack on
which our monetary policy has been moving over the recent past,
measures 9 or 10 percent per annum. The decline in real growth
contributed at the very most 1% percentage points to the basic infla
tion rate. The low significance with respect to the rate of inflation is
quite consistent with the substantial cumulative effect on our welfare.
The central point and the major aspect of our inflation problem is due
to our monetary policy. So we have to bring this policy or—nonpolicy—
under control. I am happy to note that I can fully agree in these mat
ters with Dr. Berman and Dr. Hamburger.
We should also note in this context that a stable and predictable
framework of monetary policy lowers the range of uncertainty con
fronting the private sector. It may thus encourage somewhat the
development of our productive resources. But the crucial measures
addressing this purpose are beyond monetary policy.
Dr. B e r m a n . I would certainly like to agree with Professor Brunner
that to restore price stability it is essential that the Federal Reserve
change its policy of injecting excessive monetary stimulus economy.
That doesn’t mean that we can’t move any other contributory policies
but they will not ultimately prove effective is restoring price stability
unless the Federal Reserve changes its policy of injecting execessive
monetary stimulus into the economy.
Our prospects for resuming vigorous economic expansion in the
1980’s at the 5-percent real growth rate characteristic of expansions
since the 1950’s are not encouraging. The legacy from the 1970’s is
high and continuing inflation, record mterest rates, and a rate of capital
investment in plant and equipment only one-half of what it was in
the 1960’s. With this discouraging background and considerable un
certainty about whether our Government will ever mount and follow
through with an effective program to restore reasonable price stability,
it is understandable why capital spending plans are restrained.
We will often be unable to simultaneously achieve our goals of
maximizing growth and employment, maintaining the purchasing
power of our currency and a healthy dollar abroad. But we have seen
the consequences of not paying careful attention to the integrity of
our currency. I therefore recommend that we give that goal No. 1
priority for several years and once that umbrella is free to stand against
the downpour of short-term pressures, forcefully implement a phased
reduction of money growth. Otherwise our economy will needlessly
incur substantial costs throughout the 1980’s, grappling with inflation
in a stop-start, hit-and-miss fashion.
Mr. C a m p b e ll. I totally concur.
My time is limited. I am sorry I can’t follow that up. But if the
chairman will indulge me for a moment, I totally concur with your
erecting an umbrella.
But I think the thing I was trying to drive toward was, if we set
this policy with the Fed, if we do it, will the political pressures as a
whole be so great because of the system we have set up that we cannot
hold to it?
Dr. B e r m a n . Everyone in this great Nation is aware that inflation
is our No. 1 economic problem. There is a broad consensus that we
need to have a fixed focus on restoring price stability. I suggest that,
yes; we can do it; we can resist those shortrun pressures.
157
Mr. C a m p b e ll. That fixed focus would also probably have to take
into consideration the spending policy of the Federal Government
itself; is that correct or not?
Dr. B e r m a n . I am sorry, I didn't quite follow you.
Mr. C a m p b e ll. If we had a focus on the Fed, to not ruin the ef
fectiveness of it as a whole, would it not also have to take into con
sideration the spending policy of the Federal Government during
that particular period of time, as a part of that whole umbrella?
Dr. B e r m a n . Yes.
Dr. H a m b u r g e r . Let me address myself specifically to your followup
question, Mr. Campbell. Political pressure clearly makes it more
difficult for the Fed to stick to some noninflationary growth path. But
recent past history says that that pressure does not have to be com
pletely overpowering. We had a recession in 1973-74. The recession
ended. The trough date for the economy is the first quarter of 1975,
the end of the last recession.
The economy then began to pick up. Monetary growth stayed very
much on target. The Federal Reserve's behavior was very responsible
throughout 1975, throughout early 1976, when the economy was at
its depths, when the Federal deficit was largest.
When did monetary growth pick up? In the middle or the latter
part of the present expansion. It was only in the last quarter of 1976.
That is when monetary growth which previously had been about
5% percent, went up to 8 percent, and it has remained 8 percent.
Talk about political pressure. What political pressure was there
after the Presidential election when Congress was out of session?
Mr. C a m p b e ll. Then why did they do it?
Dr. H a m b u r g e r . The reason that they did it was because of the
deep concern—I argued at the time and still believe—the misguided
concern that the economy needed extra stimulus.
Mr. C a m p b e ll. They; overstimulated from a political standpoint,
then, is what you're telling me?
Dr. H a m b u r g e r . From a political standpoint? I don't understand.
They overstimulated because everyone was concerned that the recov
ery that had been going on for 18 months or so looked like it was begin
ning to fizzle out. Had we stayed with the monetary growth target,
the expansion would have been slower, the unemployment rate might
have come down somewhat less, at a lesser speed. I think it would have
stayed to about where we are now or maybe a little higher. But I
believe that the inflation rate would have been a lot lower, and we
would not be beginning on a policy to produce a new recession.
Chairman M i t c h e l l . It is difficult for the Chair not to raise his
questions at this time. But let me just comment that, from your re
sponse to Mr. Campbell's inquiry, I infer that you believe that it was
monetary policy which was more inflationary than the fiscal spending
and tax cuts that we did in the Congress when we hit the trough of the
1974-75 recession. Is that a correct inference?
Dr. H a m b u r g e r . The monetary policy was not inflationary through
out the latter part of 1975 and the early part of 1976. Monetary
growth—Mi growth—during that period was 5% percent, and that
was reasonably appropriate.
For the best of intentions, the growth of the money stock was pushed
up to 8 percent at the end of 1976. But I think—and most people,
I think, agree now—that looking back, that that was wrong.
55-123
0
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8 0 - 1 1
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Chairman M i t c h e l l . I am in agreement with that, too. But the
point I was trying to make was simply that there is a great deal of
discussion about fiscal spending to stimulate, and in my opinion, that
is of importance, but generally of lesser importance than the gyrations
and fluctuations in monetary policy.
Dr. H a m b u r g e r . 1 agree with y ou .
Chairman M i t c h e l l . Thank y o u .
Congressman Lowry?
Mr. L o w r y . Mr. Chairman, that was my question also. I just want
to clarify. I believe that in answer to Chairman NeaPs question, we
received an affirmative from all three of you that you would support
congressional action directing the Fed to accomplish a reduction in the
money supply gradually over the next 3 or 4 years to somewhere near
the growth in the GNP; and that this should be congressional action,
as opposed to the normal send-them-letters procedure.
I think that is the important question and I agree. In fact, I have
asked Chairman Neal if he would consider me as a cosponsor on this
biH.
As a little insurance against the shortrun displacement of people
that may occur as a result of that policy, would a fiscal policy of this
Government being prepared with rather extensive increases—let’s say
$7 billion—in transfer payments expenditures, of unemployment or
job replacement-type provisions for individuals displaced during this
period of restraining or reduction in the monetary supply, be counter
to this program? Is there a way that we can be prepared for an increase
in fiscal support through, say, maybe an additional $7 billion in
increased unemployment or other type of individual aid to people
who may find themselves displaced temporarily as we go through this
tightening period? Would that be contrary to this goal of reducing the
money supply and getting a handle on inflation?
Professor B r u n n e r . The traditional procedure of the Fed has
established some connections between monetary and fiscal policy.
Large and persistent deficits foster monetary growth, and large surplusses, as in the early postwar period, encourage monetary
retardation.
It was exactly the interest targeting policy of the Fed which assured
this connection.
The proposal of m onetary control advanced last March by the House
Committee on Banking, Finance and Urban Affairs would break this
connection. An effective anti-inflationary policy cannot persist with a
monetary growth conditioned by budget deficits.
It should also be noted that the requirement of a predictable frame
work for monetary policy also extends to fiscal policy.
It would be very useful if a stable framework of fiscal policy per
taining to taxes and spending programs were instituted. The economy
could look forward over several years under the circumstances and
know where it stands. It would not have to reassess every year the tax
situation, the shifts and modifications in spending programs, the
newest interpretations of the tax laws, another round of pending legis
lation, and continuously search and invest in necessary readjustments.
We encounter here aspects of the problem which contribute to
stagnating productivity and investment.
So a similar pattern applies to fiscal policy in this respect for our
prospects over the 1980’s.
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Dr. B e r m a n . I would like to concur and add that some additional
fiscal stimulus would also be appropriate.
Again, I would emphasize, as I have, perhaps too many times, that
the most helpful thing could be done to minimize downside employ
ment risks in pursuit of a phased money growth reduction program is
to have a clear mandate from Congress, as specific as we can make it,
so that as many people as possible could be convinced that after 15
years, we are really serious and have a strong national commitment
and that we’re going to get on with the job and we’re going to do it.
Dr. H a m b u r g e r . I would like to support that proposal. However,
I do have some reservations and they stem from the fact that I am
very much concerned about the relative size of the U.S. Government
in the U.S. economy.
And while it might be nice to provide that kind of aid for people who
got displaced, or additional aid for people who got displaced during a
period of recession, I think it might be appropriate to go back and look
more fully at the total balance of transfer payments and various kinds
of compensation for the unemployed and the needy, and decide do we
realty have to add to that or perhaps we should just reallocate what
we are already doing?
Mr. L o w r y . A s you well know, we are projecting a deficit of $30
billion now and it was $65 billion 3 years ago.
Given the importance of this reduction in the monetary supply
versus having a $37 billion deficit, it seems to me that it would cause a
relatively small difference in the deficit for insurance on this program.
Woula this spending increase throw away our move toward fiscal
restraint which we have had and are continuing to have and have a
commitment in this Congress to have?
Is the difference of $7 billion that important as relative to the
monetary policy gains toward inflation?
Dr. B e r m a n . Over the next 3 years, if we maintain the same 7 percent rate of monetary stimulus that we have had over recent years,
the Mj money supply will increase perhaps another $80 billion.
If we have a phased reduction, then the money supply need only
increase $40 billion. And I would suggest that that $7 billion when
compared to $40 billion would not seriously jeopardize the objectives
of an anti-inflation program.
Mr. L o w r y . Thank y o u , Mr. Chairman.
Chairman M i t c h e l l . M s . Oakar?
Ms. O a k a r . Thank y o u , Mr. Chairman.
I want to follow up on that question. My problem sometimes with
economists, to be honest, is that they look at the Nation’s economy
and the value of the dollar and so on, but they don’t always deal with
the realities of monetary policy in terms of unemployment, what it
does to the housing industry, and the real worlds that people live in
day to day.
Now some of you have talked about 5-year plans and so on. But
specifically—and I am sorry. I will read your testimony, but I have
not heard all of it or had a chance to read it all, but specifically, since
all three of you really support a policy that places a primary focus
on inflation, what specific effects would this have on unemployment?
Professor B r u n n e r . Let us see what happened under the inflationary
policy pursued over the last 14 years.
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Our average unemployment rate has persistently risen, and ratcheted
up in repeated steps.
This inflationary policy hardly contributed to keep unemployment
down. We abandoned a stable price-level without any reduction in
unemployment. We have consequently raised interest rates by a very
large margin beyond the levels existing in the early 1960’s. This change
has injured low-income groups more severely than higher income
groups.
Should we really proceed with an anti-inflationary policy, we know
on the basis of substantial and strong evidence what will happen:
inflation will go down and we could lower it down to zero.
But what about unemployment? We do indeed face a risk of tem
porarily increased unemployment produced by an anti-inflationary
policy. This problem largely results however from the pervasive lack
of credibility encountered by the Fed’s policymaking. A credible and
convincing shift to an anti-inflationary policy would substantially lower
the magnitude and length of excessive unemployment. I wish we could
avoid this risk but nothing is quite without risk in life and we have
to acknowledge this. But anti-inflationary policy would involve a sub
stantially smaller risk for the next years than a policy which continues
what we have done over the past 14 years.
Dr. B e r m a n . I would again like to emphasize that the past histoiy
of the 1970’s versus the 1960’s was that a decade of extraordinary
monetary stimulus was accompanied by 3-percent real growth instead
of 4 percent, an average unemployment rate of 6.2 percent versus
4.8 percent, and a rate of investment in plant and equipment only
one-half the rate of 1960‘s.
Ms. O a k a r . What about the 1970’s? You said the 1960’s.
Dr. B e r m a n . I am comparing the 1970’s with the 1960’s and trying
to make the point that in the 1970’s, we have had less real growth,
higher unemployment and only half as much investment.
Now if one takes those figures and fully appreciates what has
happened as a consequence of a decade long program of excessive
monetary stimulus, then I think that we have fairly good reason to
expect that if we initiate a serious anti-inflation program, we will have
strong gains in output and in employment and every American will
benefit.
Ms. O a k a r . Did you want to comment?
Dr. H a m b u r g e r . I fully agree with that. But let me go on and say,
I don’t want to engage in any kind of active exchange, but to the
extent that economists are accused of thinking about things in
generalities and not worrying about-----Ms. O a k a r . I was being the devil’s advocate. Don’t take it personally.
Dr. H a m b u r g e r . I am not. But you mentioned housing. What is
the appropriate level of housing construction and should we be
concerned if the rate of housing construction were to fall off? How bad
would that be?
Well, one of the questions in my mind is who has been doing all the
house building or who has been doing all the house buying in the
recent inflationary period.
I wonder to what extent that inflation causes people to invest in
housing? And presumably, these are people with considerable means
and not those at the lower ends of the income structure.
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So I just wonder whether, to the extent we are afraid to pull back
and we continue on this upward inflationary cycle, people with means
are going to continue to believe that housing is the only way to protect
themselves. I don’t think that that is going to do very much for the
lower end of the income structure.
Also, when we say that investment has been held down by the un
certainty created by the policy of the 1970’s, it should be kept in
mind that when investment increases and productivity rises the whole
economy benefits from that.
Ms. O a k a r . I think I will let it go at that. Thank y o u Mr.
Chairman.
Chairman M i t c h e l l . I am mindful of the fact that we have other
panelists, and therefore, I will limit myself to just one observation
and perhaps two questions.
While I am in agreement that we ought to set some specific goals for
monetary policy, I must say to you gentlemen that I have a real
concern about any policy that is established based upon total rigidity
and total inflexibility.
I just don’t believe that we know the science of economics or the
way the market operates sufficiently well that we can set a policy
that is absolutely inflexible and absolutely rigid.
Now I understand under Chairman Neal’s bill that there are some
outs. But I was a bit disturbed by testimony from two of the witnesses
that suggested very strongly, no matter what happened, we hold on to
that policy.
I just don’t think we know the functioning of the economy that well.
I don’t think that we know it well enough to advocate that kind of
position.
Now I want to follow up on the question by Congresswoman Oakar
and Congressman Lowry.
There is an agreement that there will be a rise in unemployment
in 1980. To what percent? How much will it rise? If it rises to 7 percent
or 8 percent, what do we do? Just tolerate that level of unemployment
until such time as there are adjustments in the business world so that
employment opportunities are advanced, and in that way reduce
unemployment?
The point I am trying to make is, in a followup to Congresswoman
Oakar and Congressman Lowry, unfortunately, there are some human
beings out there. And if unemployment goes up 1 percent, those who
lose their jobs or can’t get jobs have got to eat, they have got to pay
rent, they have got to feed and clothe their children.
And it sounds kind of callous to me to suggest that this temporary
increase in unemployment ought to be just borne by those people,
with the optimistic assumption that if all things go well, the market
will be stimulated sufficiently and they will become employed at
some point in the future.
That is my area of concern. What do you think if we were able to
set the targets that you suggest, how much do you think unemploy
ment would rise immediately?
Do you have any idea?
Professor B r u n n e r . Your questions address the central reason for
our insistence on a public and committing announcement by the Fed
on a stable and predictable course with a gradual decline of monetary
growth distributed over several years. I am very much opposed to a
hard, sudden and rapid decline in monetary growth.
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If the Fed would accept this proposal, Mr. Chairman, then I would
be very much astonished to observe an unemployment rate piercing
8 percent for any length of time. This would be quite improbable under
the circumstances.
Chairman M i t c h e l l . Beyond what percent?
Professor B r u n n e r . Beyond 8 percent for any length of time. If it
rises beyond 8 percent for half a year, say.
Chairman M i t c h e l l . For how long do you think that 8 -percent rate
of unemployment, that rise, would be sustained?
Professor B r u n n e r . If the Fed would start executing now this
policy, then the unemployment rate would start drifting down at the
lastest, by the spring of 1981. This is my best judgment in view of the
uncertainties still remaining about the Fed’s execution and
performance.
Chairman M i t c h e l l . Then roughly a year, or a little better, that
we would have to tolerate an 8 -percent rate of unemployment?
Professor B r u n n e r . Well, Mr. Chairman, the alternative is that
we continue the polic}^ which we have been pursuing the last 15 years.
Chairman M i t c h e l l . Please don’t misunderstand me, Professor
Brunner. I think the goals that you have stated are laudible and I
share them. But I also have to share some concern with flesh and
blood.
Therefore, for a year, according to your speculation, they are going
to be out of work.
Dr. Berman?
Dr. B e r m a n . Chairman Mitchell, I very strongly share your con
cern that you quite justifiably have about any narrow focus policy.
I wish I could sit here and advise that there is a magic way of re
storing reasonable price stability without incurring any downside risks
whatsoever on unemployment while that policy was being pursued. I
believe those risks to be quite small, and certainly acceptable. And just
to be prepared, standby programs would make good sense.
It is precisely because of what has happened in the last decade and
what promises to most certainly happen throught the 1980’s that we
need begin frontal assault on inflation. If we do not rise to the chal
lenge, those on fixed incomes, the disadvantaged and the elderly will
continue to take the full brunt of the soaring rise in the costs of
basic necessities. Those who have moneys set aside in private pension
plans will continue to see their prospects of enjoying respectable re
tirement decline. Failing to mount an effective anti-inflation program
unquestionably has longrun costs that for overshadow the potential,
small as it is, shortrun costs involved in getting that program
underway.
Chairman M i t c h e l l . I agree. I agree. But I am dealing with the
segment of the population that is going to become unemployed as a
result of the policy.
My question, I guess, is: Would you support some kind of fiscal
policies to help those people who are enjoying unemployment as a
result of the laudable goal that you have set forth?
Dr. B e r m a n . I certainly would and I would add that if there was
a powerful commitment that was understood throughout the private
enterprise sector that something in fact was going to be done about
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inflation, then I think that we would see a strong increase in invest
ment. It is enhancing productivity investment that creates jobs. Those
jobs make our country a better place in which to live.
Chairman M i t c h e l l . There is no question in my mind but that
you are right on target. I am talking about human suffering in the
interim.
Dr. Hamburger?
Dr. H a m b u r g e r . First of all, I would not support providing benefits
to any people who enjoy unemployment.
Chairman M i t c h e l l . Y o u notice the way I phrased the word
“ enjoy unemployment.’’ The meaning of that word is to endure as
well as to have pleasure from enduring.
Dr. H a m b u r g e r . A s I indicated before, I would be in favor of such
a policy, subject to two qualifications: First, Congress ought to try
to hold the line on total Federal spending. Second, it would help
immensely if a bill like Chairman Neal’s was also passed. Then the
economy would get the message that it is not business as usual, that
Congress is not going to provide benefits, increase the deficit, and then
complain to the extent that the deficit means rising interest rates and
finally beat on the Fed to lower the interest rates and increase the
money supply.
So if one had a package of those three things, I think it would be
beneficial.
Also, as I indicated in my statement, I too,, initially, found fixed
rules difficult to accept.
But my experience, and I have worked for a number of central
banks, is that they don’t use the discretion that they have to the
country’s best advantage. Their intentions are good, but it doesn’t
work out very well.
Finally, the clear and present benefit of adopting a firm monetary
policy guide is that it would limit the increase in the unemployment
rate.
I would be willing to bet that this reduction could be half a per
centage point if the public was persuaded that the anti-inflation pro
gram was a permanent one, because then some businesses might
decide to lower their prices.
On the other hand, if the public believes that nothing has changed,
the Fed is tightening now, but it will expand later, businesses would
be much less likely to cut their prices.
Businesses, large businesses, are not supposed to cut their prices,
but some do. The large automobile companies cut their prices when
things don’t go well.
If the Fed made it clear that it was gradually going to lower the
rate of inflation, the rate at which firms increased their prices would
slow. A few might actually reduce their prices. And this would mean
that some of the decline in nominal income would come in prices.
Less would come in real activity. And hence, there would be less of
an upward push on unemployment.
So that is a clear and present benefit of adopting a tight monetary
policy rule.
Chairman M i t c h e l l . Clear, present, but delayed because you agreed
earlier that there would be an immediate rise.
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Dr. H a m b u r g e r . Yes; but less of a rise.
Chairman M i t c h e l l . Let me just make one point here.
Gentlemen, I will tell you, I am not a very good politician, but I
think I have studied this Congress. And you let unemployment hit
8 percent. And 50 percent of those who define themselves as fiscal
conservatives, when they find 8-percent unemployment in their dis
tricts, even on a temporary basis there is going to be an enormous
pressure, an enormous pressure to ask the Fed to violate that policy.
My point is that we, in our thinking as we move toward a fixed
monetary policy, and I use “fixed” in quotes, have got to find some
very, very significant means of addressing the problem of immediate
increases in unemployment as may result from that monetary policy.
Ms. O a k a r . Would the chairman yield on that?
Chairman M i t c h e l l . I would be delighted to yield.
Ms. O a k a r . Mr. Chairman, thank you, because I think that you
are reiterating my thoughts far more eloquently.
I serve on the National Commission on Unemployment
Compensation.
One of the crucial issues that we are talking about is whether or
not to dismiss extended benefits or to expand them. It is a very, very
important question.
Or do we do it only in areas of the country that are most affected
by unemployment, areas such as the urban areas, such as States like
Michigan, that every time you have a rise in oil prices, and so forth,
their trust funds for unemployment compensation are just about bank
rupt, if they are not already.
So you see, we have this problem. Also, the question of investment.
It would be great to think that with expanded investment, women
and minorities are going to get those new jobs. But we all understand
that at least in 1979 or 1980, that they are not going to be the ones
who get the jobs. They are going to be the ones who have the hardest
time getting the job to begin with and are the first to go off the payroll
when unemployment takes place.
I think that is what I was talking about when I said that the com
prehensive view of economists should be to take all that into considera
tion and then come up with advice.
But if you just take it in a provincial manner, just as I suppose I
take it in a provincial manner from the other side of the coin, then
I think we are going to have—we are never going to resolve the
problem.
Chairman M i t c h e l l . Let me just kind of try to get ourselves along
some kind of path again. I would like to yield to Chairman Neal to
make a point. I feel very guilty. We have two other panelists waiting.
Perhaps I shouldn’t have opened up this area of inquiry, but I would
like to cut it off after Chairman Neal makes his comment. We have
held the other panelists waiting for almost an hour and a half. Maybe
if you are around a little while, maybe we can come back to you. I am
sorry. I don’t want to sound arbitrary, but I think it is only fair to
other panelists.
Chairman Neal.
Chairman N e a l . Well, I will be very brief.
I share the concerns expressed by the chairman and Ms. Oakar.
I think in my own mind the significant question is: Are we going to
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have, on this specific question, are we going to have higher unemploy
ment by bringing down the rate of growth of inflation, or are we going
to have higher unemployment by continuing on the course that we
are on?
I would argue very strongly that we are going to have much higher
unemployment, much more suffering, by continuing on the course that
we are on than we will if we would pursue the policy we have been
talking about and all agreed upon this morning.
I would be most grateful if you all could find the time to submit
some analysis of this question: Will we have more unemployment by
following the path that we are on, or are we going to bring down the
rate of unemployment by bringing inflation under control?
And I thank the panelists very much.
Chairman M i t c h e l l . Gentlemen, thank you very much.
If you can stay, fine. I merely want to reiterate what my immediate
concern is. Anybody who knows anything about the way the economy
functions knows that if we have growth in the private sector, that ulti
mately is going to do more to reduce unemployment than most of the
Government efforts on hand right now.
My hard-focused area of concern is: You add another million people
to the unemployment rolls—and I am only using 1 million as a
figure—we add them to the rolls when we adopt this policy; how do
you deal with that add-on? Not necessarily even those who are
presently unemployed? That is my area of concern.
Gentlemen, thank you very much. I appreciate it.
Next, we will hear from Prof. David I. Fand, of Wayne State
University, and Prof. Jacob A. Frenkel of the University of Chicago.
Gentlemen, thank you very much for taking time from your busy
schedules to be here. You have the same option as our other panelists:
If you have prepared statements, which I believe that we have, you
may submit that in its entirety for the record and merely talk from
the salient points in your testimony, or proceed with your testimony
in its entirety. It is entirely up to you.
Professor Fand, why don’t you lead off with the testimony.
STATEMENT OF DAVID I. FAND, PROFESSOR OF ECONOMICS, WAYNE
STATE UNIVERSITY
Professor F a n d . Mr. Chairman, I am grateful for the opportunity
to testify here at the meeting of the two subcommittees on the oc
casion of their oversight hearings. The subject of these hearings is,
in my opinion, of crucial importance to the American economy.
I have several sections that I will summarize very briefly. I first
would like to deal with the specific questions that you raised in your
letter about the two strategies, make a few comments about the
Federal Reserve action of October 6 , make a comment about monetary
credibility, and then I would like to talk about the short-run and the
long-run effects if we follow this policy. So, I will just summarize very
briefly what I have.
Under strategy 1 , we would be operating on short-term rates in
order to halt the decline in the value of the dollar. There are some
important risks which I think we should summarize briefly. Strat
egy 1 is, in some ways, very similar to a gold standard, in that the
166
domestic economy is being asked to adjust to the exchange rate. But
it differs from a gold standard in that in a gold standard this is auto
matically accomplished through gold flows. Under strategy 1 it would
be accomplished through central bank action.
While I present some criticism of strategy 1 , I also would like to
point out that this is not really being proposed as a serious and com
prehensive approach to monetary policy. Fundamentally, strategy 1
deals with the symptoms of the problem rather than with the funda
mentals. And because it deals with the symptoms, it is the kind of
policy that is often resorted to when the symptoms are bad; that is,
when the dollar takes a sharp decline. But while it is not advocated
as a comprehensive approach to monetary policy, in practice it is used
quite often; and because it is used quite often, I think it is worthwhile
discussing what may be some of its shortcomings.
To begin with, we in general do not know what kind of change in
interest rates will do the 30 b properly. In other words, we do not know
how much you have to change rates to get the desired capital move
ment or the reduction in aggregate demand. Also, when the exchange
rate is under pressure, we don’t know whether we should try to correct
it by reducing aggregate demand or by attracting capital. Also,
modern portfolio theory, and here I will defer to Professor Frenkel,
argues that a given differential will only have a one-short effect, so
that if you raise U.S. rates, you will force portfolios all over the world
to make adjustments, and you get a stock effect which is substantial
in the first period, but you do not get a continuing effect. If you want
to get a continuing effect on the balance of payments, you’ve got to
keep raising the differential. To this extent, it is a weak policy.
Finally, even if we succeed in accomplishing the desired exchange
rate by means of this policy, one has to ask the more fundamental
question, because if we are relying on an inflow of capital to stabilize
the exchange rate, we may be in effect operating with an overvalued
currency and one can raise a question as to whether this is desirable.
There is also the opposite problem. You can raise the rate high enough
to attract enough capital to live with an overvalued currency; the
opposite danger is that you may raise the rate so high as to cause
serious damage to the domestic economy.
rork unless there is tremendous
ve for not following strategy 1 .
Now I would like to make some comments about strategy 2 . I am
very much in favor of strategy 2 , and I would like to point out that
while strategy 1 has never been articulated as a comprehensive mone
tary policy, in practice it is used quite often. Strategy 2 , which has
been advocated by some articulators and formulators of monetary
policy has thus far, never been adopted by any central bank. In other
words, there is sort of a paradox that one policy has never been form
ulated but it is often used, the other policy has been formulated quite
a bit but it has never been instituted.
In my comments here—and I want to emphasize I have great sym
pathy for this doctrine—I am very much in sympathy with Chairman
Neal’s bill. I thought it would make sense for me to focus on what
may be some of the problems if we follow this policy. And in doing that,
I thought of what actions could happen which would make you want to
reconsider the policy.
167
The first action that could happen would be: What if interest rates
go through the roof? In other words, suppose we institute this kind of
policy where we have a program for the path of the monetary aggre
gates and then, for some reason, interest rates go through the roof?
Now, here, I think, one has to go a little further and ask why interest
rates are rising so abruptly. They could be rising because there has
been an outbreak of inflationary expectations. They could be rising
because the real economy is being stimulated more than we expected
it. They also could be rismg because there is a sudden autonomous in
crease in the demand for money.
In some cases, the smart thing, the correct thing, to do is to do
nothing. In other cases, there may be a case for violating the guide
lines. The point that I would make is that you may want to violate the
guidelines if you had very strong evidence that it was due to an auton
omous shift in the demand for money. If that was the problem, if you
could find that there has not been an increase in inflationary expecta
tions, if you could find that the economy is not heating up, that there
is increasing slack and in spite of that interest rates are rising very
sharply—then I think that would lead you to believe that you are
dealing here with the problem that demand for money is increasing,
and thus there may be some reason there to interfere with the
guidelines.
Another problem could arise: Suppose you institute Chairman
Neal’s guidelines and the inflation rate goes through the roof un
expectedly. Here, too, we have to go through and analyze the various
possibilities: Is it due to inflationary expectations; is it due to the fact
that the economy has less slack than we thought, that the economy is
heating up; is it due to something that has happened to the world out
side of us that is causing this? Here, also, it could be due to the fact
that there has been an autonomous abrupt decline in the demand for
money.
In some cases, you stick with the guidelines; in other cases, you may
want to violate them. Again, you have to go through the various cases
to see if you can build an impressive case for deviating from the
guideline.
Another case you might want to consider is: We institute Chairman
Neal’s guidelines, and, say, the exchange rate drops through the floor.
Again, you would have to consider a number of factors: Whether this
is due to a very strong economy; to inflationary expectations; or to
something happening abroad. In some cases, we would decide to stick
with the guidelines because we get a self-correcting policy; in other
cases, we may have to modify the targets.
Then I come to the most difficult question—which I have had the
benefit of hearing your comments—which is: What if unemployment
rises and goes way beyond where we expect it? This is the most serious
question. And here my view would be that we would have to use fiscal
policy to alleviate some of the problems. And as was brought out in
the prior session, I think Chairman Neal’s proposal would pass easier
if it was coupled with another proposal to deal with the unemployment
hardships that could be generated in instituting what I consider to be
the correct monetary policy.
My views, of course, are going to be influenced by the fact that I
live m Michigan, and I know that some sectors get hit very hard—
for example, automobiles. Also, you are likely to get a sharp rise in
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unemployment in the inner cities. So, in order to get greater acceptance
of what I consider to be your correct monetary proposal, I think it
should be coupled with a comprehensive plan to ease the unemploy
ment burden, and when to bring in certain programs on the fiscal side
to offset some of the damage done in this desirable disinflation effort.
My proposal would be on the fiscal side and would not alter the
monetary guidelines. Also, I would not go in for general stimulus. I
think these problems are apt to be specific; they are apt to be, as I
said, in the automobile industry, or they are apt to be in housing, or
they may be in the inner city and places like that. Since the problems
are apt to be specific, I think the fiscal policies should be geared in
that direction.
Finally, I come to what I consider also a very difficult question in
following out Chairman Neal’s guidelines: What happens if there is
a supply shock—say, the price of oil is doubled or tripled—in other
words, there is a significant enough shock that if we follow through
the guidelines we are going to generate a lot more unemployment and
a lot more difficulty than we would ordinarily expect?
This is difficult to deal with, and it requires judgment. But I think
that if we had a very serious shock, this would be a case for modifica
tion of the monetary guidelines. However, I would like to make this
point: The link between monetary policy and oil prices points up a
paradox: If we follow very expansionary policies, we will generate
high rates of inflation and we will end up with sharp oil price increases.
It would be ironic if the consequences of a monetary policy that per
mitted high inflation and the resulting high oil prices were used to
stop us from adopting a policy which could thwart inflation and, in
this way, slow down the escalation of oil prices.
I would like to make a few brief comments about the Federal
Reserve action of October 6. Basically, they took three actions. I
think one was more symbolic than real—namely, the discount rate.
There was an action about the managed reserves. But the third, the
announcement that they would abandon interest rate targeting and
that they would try to control money through reserves rather than
through interest rates, is, everybody now agrees, the most significant
action.
In my opinion, a very important point of support for the Fed’s
new policy to highlight the monetary aggregates is that if we stick
with this policy, we may achieve for the first time monetary credibility
with the public. Should we achieve this kind of credibility, monetary
policy may once again become the beneficiary of stabilizing expecta
tions; thus, whereas, up to now, the public has been expecting in
flation to become worse and has been making successful bets on this
basis, if we stick with the new policy, those that bet on stability will
be rewarded and not those that bet against it.
So, in my opinion, that is the most important thing—namely,
monetary credibility.
Now, just a brief comment about monetary credibility and the
aggregates. A lot of people go through debates as to whether the
Federal Reserve can control the monetary aggregates within a month
or within a week or within a quarter. I think basically this is a very
interesting technical question, but it does not get at the issue of
credibility, which I think is the important question.
169
The crucial issue, in my opinion, is: Is monetary credibility whether
the Fed is committed to pursuing a policy of achieving a given path
for the aggregates and whether the Fed will stick to this policy, or,
conversely, whether the Fed will follow a permissive and passive policy
that accommodates interest rate movements and imparts an in
flationary bias into the economy?
Now, in my testimony I have comments about the substitutes, the
monetary substitutes. I think there is a little problem there. I think
you do have to think a little bit about the ATS, the HP’s, and offshore
deposits, but I think this can be worked out and we can arrive at a
monetary aggregate that would do the job.
Now I would like to conclude with making a few comments about
the shortrun and longrun effects of this policy. First, let us consider
the shortrun effects of following a policy like Chairman Neal’s bill.
We are now in a quite difficult economic situation with double-digit
inflation, historically high interest rates, and an economy which is
teetering toward recession. No policy, no matter how good it may be
intrinsically, can look good when it is introduced in these conditions.
Any policy introduced in these circumstances—even one crafted by
the wisest of minds and the noblest of hearts—could not give us
results that could be called satisfactory.
Consequently, one should bear in mind, when assessing the effective
ness of this new approach to monetary policy, that it is being in
troduced at a time when the very survival of the American economy
is at stake. A good captain with a good ship and a good approach to
navigation may safely pilot a ship through a stormy, turbulent
sea, but even the best captain with the best navigational skills could
hardly make this trip smooth.
We should therefore keep in mind that the consequences of disinflating the economy in the next few months are going to be painful and
that those pains cannot be cited as a fair criticism of the policy. So
much for the short run.
What about the long run? For the long run, the new monetary
policy is apt to bear abundant fruit. In sharp contrast to the short
run, where even the best policy will generate short-term transition
and disinflation effects that will not look good, the longrun results
are likely to be extremely good and beneficial—if we have the patience,
the fortitude, and the maturity to stick with this policy. It is a policy
that offers the promise of giving us a noninflationary economy while
still maintaining free markets without credit rationing, without
commodity rationing, and without controls.
It also offers the hope that, if we get through the disinflation
transition period, we may once again see the American economy
develop along the path it was going before we ran into the devastating
and destructive turbulence of the post-Vietnam inflation and its
threat to our free institutions. I hope we follow and stay with this
policy, and I think this is the only policy that will enable us to get
the goals of the Humphrey-Hawkins bill.
[Professor Fand’s prepared statement follows:
170
TESTIMONY BEFORE THE UNITED STATES HOUSE OF REPRESENTATIVES
COMMITTEE ON BANKING, FINANCE AND URBAN AFFAIRS
December 4, 1979
David I. Fand
Professor of Economics
Wayne State University
Mr. Chairman:
I am grateful for the opportunity to testify here at this meeting of
the two subcommittees on the occasion of their joint oversight hearings on
"Monetary Policy - Goals and Conduct for the 1980*s."
The subject of these
hearings is of crucial importance to the future of the American economy.
You asked us to comment on two alternative monetary strategies for
1
the 1980 s.
Strategy I places top priority on halting the decline in the value of
the dollar; it proposes to do so by keeping money "tight" and by resisting
speculative attacks against the dollar.
The Federal Reserve, under this
strategy, would raise the federal funds rate, keep U.S. short term interest
rates high, slow U.S. money growth and provide incentives for money managers
throughout the world to buy and hold dollars and dollar denominated securities.
The Federal Reserve and the Treasury would, in cooperation with other banks,
intervene to combat excessive fluctuations in exchange rates that might
arise in speculation against the dollar.
Once the dollar is stabilized,
monetary policy could gradually be reoriented toward domestic goals.
171
Strategy II, in sharp contrast, does not focus on movements in interest
rates and in the exchange rate and concentrates instead on establishing a
long run non-inflationary money growth path.
Specific recommendations to
fix monetary policy in terms of .money growth rates may be found in H.R. 5476,
recently introduced by Mr. Neal, and in the Housing Banking Committee's
recommendations in its “Second Report on Monthly Policy for 1979” which
suggests that a stable monetary policy should take precedence over efforts
to prop up the international dollar.
I would like to comment on these two alternative monetary strategies
and to focus on some of the problems that may emerge if we follow either of
these two policies.
I will also discuss briefly the actions taken by the
Federal Reserve on October 6 > the feasibility and desirability of
controlling monetary aggregates, and some of the short run and long run
effects jthat might emerge from this new policy,
I.
SOME PROBLEMS WITH STRATEGY I
Under Strategy I, we would be operating on short term rates in order to
halt the decline in the exchange value of the dollar.
There are, however,
several important risks which this kind of monetary policy entails, and I
shall discuss these in some detail.
Strictly speaking, Strategy I, which seeks to maintain the exchange
value of the dollar, is in some ways similar to a gold standard, and
suffers from its main defect.
But whereas under the gold standard, the
exchange value of the currency tends to be automatically adjusted by means
of gold flows, under Strategy I it takes central bank action to bring about
172
this stability in the exchange value.
In presenting detailed criticism of
Strategy I, I do not want to leave the impression that it is being seriously
advocated as a comprehensive approach to monetary policy.
Fundamentally,
Strategy I deals only with the symptoms of the problem rather than the
fundamentals.
And because it deals with symptoms, it is the kind of policy
that is often resorted to when the symptoms are bad; that is, when the
dollar is suffering a persistent decline.
While it is> strictly speaking,
not being advocated as a comprehensive monetary policy, it is in practice
quite often used, and it may not be amiss to discuss it in some detail.
(1)
We do not know in general the kind of short term rates that will
give us the desired capital movements or the necessary reduction in aggregate
demand to ease the pressure on the exchange rate.
It is a quite difficult
question in practice to determine, in a particular circumstance, how much
of a change in the federal funds rate and in other short term rates is
necessary in order to bring about a desired movement in the exchange value
of the dollar.
The relations between the federal funds rate and other short
term rates, between short term rates and capital flows, and between short
term rates and aggregate demand are not all that precise.
The implementation
of this approach to monetary policy poses a difficult task in practice, and
especially when the exchange rate is under pressure.
(2)
When the exchange rate is under pressure, how do we decide whether
we want to raise interest rates in order to obtain an inflow of capital so
as to finance our deficit or whether we want to raise interest rates in order
to reduce aggregate demand and eliminate the imbalance.
This fundamental
question whether we want to finance the imbalance or, conversely, change the
173
underlying circumstances and eliminate the imbalance is a fairly basic
question; and it is unclear how we go about selecting instruments to
implement either of these two alternatives.
(3)
We also have to confront the problem whether a given interest rate
differential will do the job.
Recent portfolio theory would seem to suggest
that if we raise U.S. rates and introduce a differential, it will have a
one-shot effect on attracting capital, and it will take an increase in the
differential, or an increasing differential, in order to bring about a
continuing inflow of capital.
(4)
This portfolio theory suggests that it will be necessary to keep
ratcheting interest rates upward in order to get a continuing effect on the
exchange rate.
Accordingly, this is a weak policy since it requires a
continuous rise in U.S. interest rates in order for the policy to achieve
and maintain a given exchange rate.
(5)
Even if our exchange rate policy should succeed in maintaining
some desired value for the exchange rate, we still must go on to ask the
next question.
To what extent are we relying on an inflow of capital to
maintain an exchange rate which is perhaps overvalued?
We are, in effect,
following a policy which is generating an excess supply of dollars on the
one hand, and then we raise the interest rates so that these dollars will be
taken up in foreign loans which will enable us to maintain an overvalued
currency.
But is it desirable for the U.S. to maintain an overvalued
currency, and is it desirable to raise interest rates in order to generate
capital inflows to enable us to maintain an overvalued currency?
The
interest rates which maintain equilibrium in the exchange market also
maintain a level of aggregate demand that generates an excess supply of dollars.
55-123
0
-
8 0 - 1 2
174
(6)
There is also the opposite problem in which the interest rates
that maintain equilibrium in the exchange market may be too high for the
domestic needs of the economy.
Thus, the interest rates which equate the
demand and supply of dollars in the exchange market may also cause a slow
down in U.S. monetary growth and a recession.
There is no assurance that
the interest rates which produce equilibrium in the exchange market also
produce equilibrium in the other domestic markets.
(7)
There is also the problem that such an interest rate policy cannot
be successful without the cooperation of other central banks, for if other
central banks raise their interest rates as we raise ours, this policy
will not have the desired effect on the exchange value of the dollar.
But even if all the central banks do cooperate with us, there is still the
problem, which we just noted, that the interest rates that are appropriate
for the ^exchange rate may be too high for domestic purposes and would cause
a sharp deceleration in monetary growth and recession or, alternatively,
they could also be too low relatively and enable us to maintain a level of
aggregate demand that is responsible for the excess supply of dollars.
II.
SOME PROBLEMS WITH STRATEGY II
While Strategy I has not been formally advocated as a guide for monetary
policy, it tends to be used by governments and central banks when their
currency is under pressure.
In contrast, Strategy II has had some advocates,
but it has never been officially adopted, up to now, by any central bank.
Strategy I is, in a de-facto sense, popular with the practitioners in
175
central banks but has not really been advocated explicitly by the formulators and articulators of monetary policy.
Strategy II does have some
support among the articulators of monetary policy, but has very few adherents
among the practitioners in central banks.
I would like to focus on some of the problems that may emerge as we
follow Strategy II and fix on some path for the monetary aggregates over
time.
We will be focusing on the problems that may emerge, and we will not
consider the case where everything goes along smoothly,
(1)
One problem that may emerge is that interest rates may rise much
more than we expect, and we have to consider what we would do if that
should happen.
Suppose there is a sharp escalation of interest rates while
we have been following a policy of relatively stable growth in the monetary
aggregates.
We have to consider why interest rates are rising.
conside^ a few prototype cases.
Let us
It could be due to the fact that inflation
is accelerating, or it could be due to the fact that real economic growth
is exceeding potential growth, and that there is very little slack in the
economy.
Alternatively, it could be due to a sudden sharp, autonomous
increase in the demand for money.
In the first two cases, if we stick with
the same path for the aggregates, we have essentially a self-correcting
situation, and that will help us avoid an escalation in inflation.
The
third case is more difficult, and perhaps unlikely, but if we had some
basis for ascertaining that there was an autonomous shift in the demand for
money that was causing the rise in interest rates, and that it was not due
to an increase in inflationary expectations or to an above potential increase
in real economic activity, then there is a basis for seeking to modify
the monetary growth targets.
176
(2)
The inflation rate may be rising beyond our expectations.
again, one would have to consider a number of different prototypes:
Here
It
could be that the real supply of output— potential output— is smaller than
we thought; it could be due to an increase in inflationary expectations;
it could be due to a rise in world prices; or it could be due to a reduction
in the demand for money.
If the increase in inflationary expectations is a
temporary one, sticking with a given path for the monetary targets will give
us a self-correcting policy, but if the problem persists, they may be a
basis for adjusting the money growth path.
In the other case, and especially
when there is an autonomous reduction in the demand for money that it is
not associated with inflationary expectations, there is a more direct basis
for reducing the monetary targets.
(3)
Suppose the exchange rate starts falling beyond the range we
thought reasonable or possible.
number of different factors.
Here again one would have to consider a
Such a sharp decline could be due to the
fact that the real economy is growing at a very rapid rate.
due to the fact that inflation is accelerating.
It could be
It could reflect a portfolio
switch from U.S. dollars to foreign currency, or it could be due to
conditions abroad and have very little to do with what is going on in the
United States.
In some of these cases, sticking with the targets would
give us essentially a self-correcting policy.
In others, there may be a case
for some modifications of the targets.
(4)
Unemployment may be rising substantially and beyond the range that
we expected.
Should there be a larger, than expected rise in unemployment— one
that is deemed to be excessive but still also believed to be somewhat
177
temporary— I would not opt for changing the monetary growth path.
If
necessary, I would propose using fiscal policy measures in order to
alleviate some of the problems when it is determined that we have excessive
unemployment.
Considering all the relevant factors, I would not want to
change the monetary targets unless we had convincing evidence that the
unemployment rate was due to a low rate of monetary growth, and the dis
inflationary effect was too severe.
(5)
The most difficult question is the case of a supply shock and,
specifically, a very rapid increase in the price of oil.
This brings up
a question which is not only analytically difficult but also involves
questions of judgment.
has been doubled.
To take a dramatic case, assume the price of oil
If we continue with the same path for the monetary
targets that were appropriate before the shock, they will generate more
unemployment in the short run.
One could make a case that some modifications
of the targets may be appropriate in the event of such a supply shock vrhere
oil prices are raised beyond a certain point.
But while some modification
of the targets may be necessary if there is a very sharp escalation in
oil prices, I would also like to suggest that we are less likely to run into
such inordinate increases in oil prices if we improve our disinflationary
performance.
The possible link between monetary policy and oil prices points up
a paradox.
If we follow very expansionary policies, we will generate high
rates of inflation and end up with sharp oil price increases.
It would be
ironic if the consequences of a monetary policy that permitted high inflation
and the resulting high oil prices were used to stop us from adopting a
policy which could thwart inflation and, in this way, slow down the escalation.
178
III.
THE FEDERAL RESERVE ACTIONS ON OCTOBER 6
The Federal Reserve on October 6 announced three policy moves.
First, there was an increase in the discount rate to a record 12 percent— an
action that may be more symbolic than real.
Second, there was the
imposition of an additional 8 percent reserve requirement on larger
quantities of purchased money; the reserve requirement applies only to
those funds in excess of those held in the base period.
Third was the
announcement that the Fed would abandon its efforts to control money and
credit supplies by regulating short term rates and, instead, permit short
term rates to fluctuate in line with market conditions.
The Fed would
concentrate on the availability of reserves to the banking system.
The third action is the most significant of all.
Attempts to manage
the monetary system by jiggling short term interest rates were self-defeating.
Each tiiie the Fed wanted a signal that it was tightening policy, it increased
the federal funds trading rate.
Under this system, the prime rate advanced
from 7 percent to 13 percent in 18 months.
But even at these high rates,
there is very little evidence that money and credit were in tight supply.
Banks had abundant funds to lend and competed aggressively to increase new
loans.
The change in the procedures for open market operations which the Fed
has announced is significant.
The new procedures in which the Fed focuses
on the quantity of reserves rather than on the funds rate should lead to better
control of the money stock.
But the immediate consequences of this procedure *
were uncertainty, an unsettled state of affairs in the securities market,
and these were aggravated by errors in the money supply figures.
One wonders
whether the turbulence that was generated in October was necessary.
179
It would appear that the Fed may have to float the discount rate.
Otherwise, there would be a need for frequent and large changes in the
discount rate which could be confusing.
The funds rate has been averaging
about 15 percent in October, while the discount rate was 12 percent.
There is great temptation for member banks to borrow from the discount
window rate than from the federal funds market.
problems for the Fed's new objectives.
Such borrowing could cause
The Fed may plan on moral suasion
to persuade banks from borrowing, but this may prove to be very difficult.
In my opinion, a very important point in support of the Fed's new
policy to highlight the monetary aggregates is that if we stick with this
policy, we may achieve monetary and inflation credibility with the public.
Should we achieve this kind of credibility, monetary policy may, once again,
become the beneficiary of stabilizing expectations.
Thus, whereas up to
now the ^public has been expecting inflation to become worse and has been
making successful bets on this basis, if we stick with this new policy,
those that bet on stability will be rewarded and not those that bet against
it.
IV.
MONETARY CREDIBILITY AND CONTROL OF THE MONETARY AGGREGATES
There are two other related questions which we have to consider.
(1) Whether it is possible for the Fed to control the monetary aggregates
and (2) whether it is desirable for the Fed to conduct monetary policy by
controlling the path of the monetary aggregate.
Let us consider these two
questions in turn.
Can the Fed control the growth of the monetary aggregate within
reasonable limits?
The Fed, in my opinion, can, although it does require
180
some changes in the operating procedures.
I believe that the Fed can
achieve a desired monetary growth rate within a quarter and perhaps even
on a monthly basis; but a quarterly growth rate would be sufficient.
Many discussions about whether or not the Fed can control the
monetary aggregates raise interesting technical questions but do not key inon the issue of monetary credibility.
Whether the Fed can hit the monetary
target fairly closely within a quarter or within a month is, of course,
an interesting and important question.
I am inclined to believe that they
probably could do so even on a monthly basis if they set up their operating
procedures to achieve this goal.
Nevertheless, it is possible that a quarter
might be a more reasonable period that would enable the Fed to comfortably
hit the monetary targets.
The crucial issue, in my opinion, is monetary
credibility— whether the Fed is committed to pursuing a policy of achieving
a given path for the monetary aggregates, and whether the Fed will stick
to that policy or, conversely, whether the Fed will follow a permissive and
passive policy that accommodates interest rate movements and tends to impart
inflationary bias into the economy.
Also, the proliferation of monetary substitutes for money would
complicate the problem.
A reasonable operational definition of money
would have to take account of ATS accounts, RPs and perhaps other
developments including, perhaps, some offshore deposits and money market
funds.
This is a problem that requires some research at this point.
I
would also add that much of what is viewed as financial innovation is, in
my opinion, much closer to financial evasion resulting from a host of interest
rate controls and other regulation.
181
The second question is whether it is desirable.
I would answer yes.
As noted, once we focus on the monetary aggregates, and especially if we
persist and succeed in controlling the growth of the money stock, there is
the hope that the Fed will, once again, achieve monetary credibility with
the public.
It would be possible then for monetary policy to benefit from
stabilizing expectations.
A very important part of the struggle against
inflation hinges on the expectation held by the public.
If the public is
really convinced that the Fed will take the necessary steps to win the
war against inflation, that in itself constitutes a very major victory in
the battle.
I therefore hope that the Fed will follow through with this
approach to monetary policy and that the American public will bear with the
Fed as it is learning and mastering these new techniques of monetary policy.
V.
SOME SHORT RUN AND LONG RUN EFFECTS OF THE NEW APPROACH TO MONETARY POLICY
I would like to conclude my testimony with some comments on the short
run and long run aspects of this new approach to monetary policy.
First, let us consider the short run.
We are now in a quite difficult
economic situation with double digit inflation, historically high interest
rates and an economy that is teetering toward recession.
No policy, no
matter how good it may be intrinsically, can look good when it is introduced
in these conditions.
Any policy introduced in these circumstances, even
one crafted by the wisest of minds and the noblest of hearts, could not
give us results that could be called satisfactory.
Consequently, one should
bear in mind, when assessing the effectiveness of this new approach to
182
monetary policy, that it is being introduced at a time when the very
survival of the American economy is at stake.
A good captain with a good
ship and a good approach to navigation may safely pilot a ship through a
stormy, turbulent sea, but even the best captain with the best navigational
skills could hardly make such a trip smooth.
We should, therefore, keep in
mind that the consequences of disinflating the economy in the next few
months are somewhat painful and that those pains cannot be cited in a fair
criticism of the policy.
So much for the short run.
What about the long run?
apt to bear abundant fruit.
For the long run, the new monetary policy is
Thus, in sharp contrast to the short run,
where even the best policy will generate short term transition and dis
inflation effects that will not look good, the long run results are likely
to be extremely good and beneficial if we have the patience, the fortitude
and the maturity to stick with this policy.
It is a policy that offers the
promise of giving us a noninflationary economy while still maintaining free
markets without credit rationing, without commodity rationing, and without
controls.
It also offers the hope that if we can get through tlie disinflation
transition period, we may once again see the American economy develop along
the path it was going before we ran into the devastating and destructive
turbulence of the post-Vietnam inflation and its threat to our free
institutions.
I hope that we follow and stay with this policy.
183
Chairman M i t c h e l l . Thank you very much. Professor Frenkel.
STATEMENT OF JACOB A. FRENKEL, PROFESSOR OF ECONOMICS,
UNIVERSITY OF CHICAGO
Professor F r e n k e l . I am pleased to have the opportunity to present
my views during these joint hearings. My remarks will deal mainly
with the implications of the alternative strategies outlined in Chair
men Mitchell and Neal’s letter of invitation on the value of the dollar
in foreign exchange markets. I will deal basically with three issues:
First, the relationship between exchange rates and interest rates;
Second, I will examine whether there is a conflict between policies
aimed at reducing inflation and policies aimed at strengthenmg the
external value of the dollar;
And, third, I will examine the notion of “ excessive fluctuations of
exchange rates,” a term that was used in the letter of invitation, and
the implied policy implications.
To set the stage for the analysis, it is useful to pose the following
question: Is a high interest rate likely to strengthen or weaken the
dollar? The intuitive and the standard textbook answer is that a high
rate of interest is likely to strengthen the dollar. The explanations are
numerous. For example, a high interest rate will attract foreign capital,
will induce a surplus in the capital account, and will therefore appre
ciate the dollar.
Likewise, high interest rates will lower spending and improve the
balance of trade, which in turn will appreciate the dollar.
And there are various other explanations, the bottom line of which
is the conclusion that a high interest rate is good for the dollar. In
ractice, however, these predictions have not been in accord with the
road effects. Over the recent period, the rise in the rate of interest
in the United States—relative to the foreign rate of interest—has been
associated with a rise in the exchange rate; namely, with the deprecia
tion of the U.S. dollar.
This fact is illustrated in figure 1 of my prepared statement. The
same broad facts emerge when one examines the circumstances in a
cross-section of countries. Countries with relatively low rates of inter
est—Germany and Switzerland—are also countries with relatively
strong currencies. Countries with relatively high rates of interest—
Canada and Italy—are also those countries which are typically asso
ciated with weak currencies.
The explanation is straightforward: During an inflationary environ
ment, the primary causes for variations in interest rates are variations
in inflationary expectations, and a relatively rapid rise in prices is
associated with a high nominal rate of interest, as well as with a
depreciating currency. In an inflationary environment, a rise in nominal
rate of interest may just compensate for the erosion of the purchasing
power, without providing for any higher real return.
Under these circumstances, a rise in the U.S. rate of interest need
not attract foreign investment in dollar-denominated securities. The
vast amount of empirical evidence about the so-called covered interest
arbitrage indicates that international capital markets are rather
sophisticated. Consequently, higher nominal rates of interest are
associated with forward discounts on the currency in foreign exchange
markets, without necessarily raising real yields, and therefore without
necessarily attracting foreign capital.
E
184
All of this illustrates again the danger which arises from viewing
rates of interest as the relevant indicator for determining whether
money is easy or tight during inflationary periods. It is vital to draw
the distinction between nominal and real rates of interest, and it is
essential to recognize how unreliable interest rates are as an indicator.
Table 1 in my prepared statement demonstrates with the aid of
econometric analysis, that during the recent period of floating rates,
the association between the relevant interest rate differential and the
exchange rates have been along the lines that I have indicated;
namely, higher interest rates have been associated with weak rather
than strong currencies.
In the foregoing discussion, I spoke about the link between inflation,
nominal interest rates, and the value of the dollar. Thus, I linked the
internal value of the dollar with the external one. The recognition of
this link is pertinent for the design of policy. An excessive growth of
the supply of dollars relative to the demand for dollars for a given
behavior of foreign monetary aggregates reduces the value of the dollar
in terms of domestic goods, as reflected by the inflation rate, as well
as in terms of foreign goods and money, as reflected by the deteriora
tion of the dollar in foreign exchange markets.
The policy implication is obvious. If it all started from excessive
monetary growth, we know what to do about it. Moreover, since the
high inflation rate and the high rate of depreciation of the dollar are
both symptoms of the same fundamental cause, there should be no
conflict between policies aimed at lowering domestic inflation and
policies which are aimed at halting the external depreciation of the
dollar.
Very few economists recommend fighting inflation by pegging the
price level through direct intervention in commodity markets. Quite
similar arguments, even though not identical, could be made against
fighting the external depreciation of the dollar by pegging the ex
change rates. Both dimensions of the deteriorating dollar are reflec
tions of macroeconomic policies, and both can and should be handled
writh the aid of macroeconomic policies.
It is imperative to recognize that prices and exchange rates are
manifestations of policies, rather than tools that should be manipu
lated as instruments of policies. For this reason, as well as for the un
reliability of interest rates as monetary indicators, I come strongly in
favor of strategy 2 (as outlined by the letter of invitation) which shifts
the weight away from interest rates and toward establishment of
a longrun disinflationary monetary growth path, which is at the heart
of H.R. 5476 as introduced by Chairman Neal.
I should also note that a key difference between strategy 1 and
strategy 2 is not that the first is attempting to halt the deterioration of
the dollar while the second is attempting to fight inflation. That is not
the difference. The key difference is that the first goes back to manip
ulating interest rates, while the second goes toward establishing a
stable path of monetary growth.
I have indicated already before that once you fight the deteriora
tion of the dollar in the right way, you have fought inflation and con
versely. This perspective also indicates that there must be a close co
ordination between the domestic desk of the Federal Reserve Board
and the external desk. The reason is that open market operations are
associated with purchase and sales of dollars for securities, while
185
foreign exchange interventions are associated with the purchase and
sales of dollars, this time for foreign exchange. But fundamentally,
both interventions mean a change in the supply of dollars relative to
the demand for dollars, and consequently it is imperative that both
policies be coordinated.
I would like to turn now to another part of strategy 1, according to
which—and I quote:
Simultaneously, the Federal Reserve and the Treasury would intervene vigor
ously in foreign exchange markets, in cooperation with other central banks, so to
combat excessive fluctuations in exchange rates that might arise from speculation
against the dollar, even in the face of high interest rates.
In the first place as I have indicated above, the concept and def
inition of intervention is extremely vague, because, in a fundamental
sense, monetary policy, which alters the supply of dollars, and foreign
exchange intervention, which alters the supply of dollars, have a lot in
common.
Second and more fundamentally, the notion of excessive fluctuations
needs to be clarified. Perhaps the simplest measure of fluctuations of
exchange rates is the average percentage change over an interval of
time. I would like to turn you attention to table 2 in my prepared state
ment, which reports the average monthly percentage change for the
exchange rate between the U.S. dollar and the U.K. pound, the French
franc, and the DM over the period June 1973 through February 1979.
In all cases, the average absolute change exceeded 2 percent per
month.
In comparison, the average absolute monthly percentage change of
wholesale and consumer price indexes and of the ratios of national
price levels were only about half that of exchange rates. These facts
are also illustrated in figures 2-4 of my prepared statement.
In assessing whether these exchange rate fluctuations have been
excessive, it is important to note that the period since 1973 witnessed
great turbulence m the world economy and great uncertainty about
the future course of economic events. In this environment all prices,
not only exchange rates, have shown large fluctuations. Indeed, while
exchange rate changes have been large in comparison with price levels,
they have been considerably smaller than changes in the price of other
assets, like gold and many other commodities and common stocks, as
indicated in table 2.
Not all fluctuations have to be stopped. A relevant question, there
fore, is: How can Government policy be managed to reduce costly
and undesirable turbulence in exchange rate markets? It is clear that
as a technical matter there is no problem of eliminating all turbulence
in foreign exchange markets. You can always fix the rate.
But obviously, when you fix the rates you shift the burden toward
another direction. Basically, when you fix an exchange rate, you sac
rifice control over the money supply since the latter is becoming an
endogenous variable that is used in order to fix the rate. Therefore,
the alternatives are not whether one does or does not like turbulence
in exchange rates, but rather, whether one likes turbulence in exchange
rates or turbulence in the money supply. Those are the real alterna
tives. And I would claim that to a large extent foreign exchange market
turbulence is likely to be much cheaper from the economic viewpoint
than turbulence in any other part of the system.
186
The reason is that foreign exchange markets are designed to accom
modate risks. These markets are capable of handling risk by providing
the facilities for selling and buying in forward markets. If you interfere
in foreign exchange markets and shift this risk to another segment of
the economy, like, for example, the labor market, it is clear that in
such markets you cannot deal with this risk in an efficient a manner
as in the foreign exchange market.
So therefore, I would like to emphasize again that the alternative
is not turbulence or not, but rather, turbulence in what.
The way in which Government policy can make a positive contri
bution to reducing costly and unnecessary turbulence of foreign ex
change rates is by reducing high and variable rates of monetary
expansion, which, for example, result from misguided attempts to
stabilize nominal interest rates. This is especially important because
exchange rates are affected not only by current policies, but also by
current expectations about future policies. If expectations about
future policies are highly sensitive to current policy, then the in
stability of policy can have a magnified effect on the exchange rates,
as it had in the past.
And in this case, that is where the cost starts to come up. If, as I
believe the case to be, the instability and unpredictability of policy,
particularly monetary policy, has contributed significantly to the
turbulence of exchange rates since 1973, then the turbulence and its
associated cost can be reduced by adopting more stable and predict
able patterns of Government policy. This is particularly relevant in
the context of the United States. The reason is that the United States
is unique in its size and the United States is unique in terms of its
capital market, and the role of the dollar is unique in the international
financial system.
The U.S. dollar has performed the role of world money in serving
the functions of invoice currency, intervention currency, storer of
value, international reserve asset, and the like. The principal contribu
tion that the U.S. economic policy can make in reducing exchange rate
turbulence and achieving greater economic stability is by reducing
the level and variability of U.S. inflation, and simultaneously reducing
uncertainty about U.S. economic policies.
This would increase the efficiency and enhance the role of the dollar
as world money.
Let me close with one final remark concerning Chairman Neal’s
bill. And I want to approach it from a statement that Chairman
Mitchell made in the meeting of November 13. In that meeting Chair
man Mitchell asked Mr. Volcker, the Chairman of the Federal Reserve,
can we pull it off. My own answer is: Yes, we can, provided we stick
to the necessary stable, predictable and disinflationary course of policy.
The danger lies in the fact that adjustments of the economic system
require more time than the political system is typically willing to
provide.
In the past this conflict resulted in stop-go policies with the sub
sequent accelerated inflation. It is imperative that the Fed continues
to follow its new course of policy with vigor and determination. The
current turnaround of interest rates merely signals the first signs of
success. But the process is long.
Thank you.
[Professor Frenkel’s prepared statement follows:]
187
MONETARY POLICY — GOALS AND CONDUCT
FOR THE 1980'S: AN ASSESSMENT OF ALTERNATIVE STRATEGIES
Statement by
Jacob A. Frenkel*
before the
Subcommittee on Domestic Monetary Policy and
the Subcommittee on International Trade, Investment
and Monetary Policy of
the Committee on Banking, Finance and Urban Affairs
U.S. House of Representatives
December 4, 1979
*Professor of Economics, University of Chicago and Research Associate
National Bureau of Economic Research.
188
I
am pleased to have the opportunity to present my views during these
joint oversight hearings of the subcommittee on Domestic Monetary Policy and
the Subcommittee on International Trade, Investment and Monetary Policy of
the Committee on Banking, Finance and Urban Affairs, United State House of
Representatives on: Monetary Policy — Goals and Conduct for the 1980's.
My remarks will deal mainly with the implications of the two
alternative strategies outlined in Chairmen Mitchell and Neal's letter of
invitation on the value of the dollar in foreign exchange markets.
The key features of the two alternative strategies on which I was
asked to comment are:
Strategy 1 places top priority on halting the decline in
the dollar on the foreign exchange markets, and proposes
to do so by keeping money "tight" at home and resisting
speculative attacks against the dollar abroad until the decline
is halted. Under this strategy, in the months immediately
ahead, the Federal Reserve would raise the Federal funds rate
substantially above the current level. The purpose would be to
raise U.S. short term interest rates and slow U.S. money growth
so as to provide incentives for money managers around the world
to buy dollard and hold dollar denominated securities.
Simultaneously, the Federal Reserve and the Treasury would
intervene vigorously on the foreign exchange markets, in
cooperation with other central banks, to combat any excessive
fluctuations in exchange rates that might arise from speculation
again3t the dollar even in the face of high interest rates.
After the dollar had been stabilized, primarily against the
German mark, sufficiently long to convince foreign exchange
traders that further precipitous declines would not be tolerated,
monetary policy could be gradually re-oriented toward the domestic
goals of full employment and price level stability.
Strategy 2 would ignore movements in interest rates and
concentrate instead on establishing and remaining on or near
a long run disinflationary monetary growth target path. (See,
for example, the Banking Committee's recommendations of July
27, 1979 (Report No. 96-396) and H.R. 5476, recently introduced
by Mr. Neal...).
I
will discuss three issues.
First, the relationship between
interest rates and exchange rates; second, the implications of the fundamental
changes (announced on October 6, 1979) in the operating procedures of the
189
Fed and the question of whether there is a conflict between fighting inflation
and strengthening the external value of the dollar; and third, I will deal
with the notion of "excessive fluctuations" of exchange rates as well as
with the implied policy implications.
I.
Interest Rates and Exchange Rates
To set the stage for the analysis it is useful to pose the following
question: "Is a high interest rate likely to strengthen or weaken the dollar
in the market for foreign exchange?" The popular (and the standard textbook)
analysis usually implies that a high rate of interest is likely to strengthen
the value of the currency in international markets.
numerous.
The explanations are
For example, one line of reasoning claims that a higher rate of
interest attracts foreign capital which induces a surplus in the capital
account of the balance of payments and thereby induces an appreciation of
the domestic currency.
Another variant of the popular approach states
that the higher rate of interest lowers spending and thus induces a surplus
in the current account of the balance of payments which results in an
appreciation of the currency.
A third variant of this approach claims that
the higher rate of interest implies (via the interest parity theory) a
higher forward premium on foreign exchange and to the extent that at a
given point in time the forward exchange rate is predetermined by past
history, (an assumption that is clearly rejected by the evidence on the
comovements of spot and forward rates), the required rise in the forward
premium will be brought about by a lower spot rate (i.e., by an appreciation
of the domestic currency).
Whatever the route, this approach predicts a
negative relationship between the rate of interest and the spot exchange
rate (or alternatively, a positive relationship between the rate of interest
and the foreign exchange value of the domestic currency).
55-123
0 - 8 0
13
190
These predictions, however, do not seem to be in accord with the
broad facts.
Over the recent period the rise in the rate of interest in
the U.S. (relative to the foreign rate of interest) has been associated
with a rise in the spot exchange rate (i.e., with a depreciation of the
dollar). Figure 1 illustrates the point by plotting the foreign exchange
value of the U.S. dollar against the interest rate differential.
As is
evident, in contrast with the popular prediction, the higher (relative)
rate of interest in the U.S. has been associated with a higher exchange
rate (i.e., with a lower foreign exchange value of the dollar).^ The
sane broad facts emerge from an examination of the circumstances prevailing
in a cross-section of countries.
Generally, countries with relatively low
rates of interest (Germany, Switzerland) are having relatively strong
currencies while countries with relatively high rates of interest (Canada,
Italy) are having relatively weak currencies.
The explanation is straightforward.
During an inflationary
environment the primary cause for variations in rates of interest are
variations in inflationary expectations.
In such an environment a relatively
rapid rise in prices is associated with high nominal rates of interest as well
as with a depreciation of the currency.
In an inflationary environment a
rise in the nominal rate of interest may just compensate for the erosion
of purchasing power without providing for a higher real return.
Under these
circumstances, a rise in the U.S. rate of interest is not likely to attract
investment in dollar denominated securities.
Capital markets are much more
^This Figure is taken from Mudd, Douglas R., "Do U.S. Interest Rates
Imply a Stronger Dollar?" Federal Reserve Bank of St. Louis Review, 61, no.
6 (June, 1979): 9-13.
191
Figure 1
Foreign Exchange V alue of the
U.S. Dollar and Interest Rate Differentials
S o u rces: F e d e ra l R eserve S tatistical R ele ase H. 13; Fe d e ra l Reserve B u lle tin ; In tern atio n al M onetary
Fund, In te rn atio n al Fin a n c ia l Statistics.
L i S e c o n d a ry m arket rates for 9 0 -d a y la rg e c ertificates of d e p o sit in the United S tates less the
w eighted a v e ra g e of foreign three-month money m arket rates.
12 U.S. long-term govornm ent bond yields less the w eighted a ve ra g e of foreign long-ferm
g o vernm ent bond yie ld s.
Latest d ata plotted: M ay
Source:
D. R. Mudd (197 9 ).
192
sophisticated than what is presumed by some of the simplistic theories.
The evidence indicates that higher nominal rates of interest are associated
with a forward discount on the currency in foreign exchange markets without
2
necessarily raising real yields and without attracting foreign capital.
The above discussion provides another illustration of the potential
danger which arises from the choice of a wrong monetary indicator.
Traditionally,
the criterion for assessing whether monetary policy is easy or tight has been
the height of the rate of interest: a high interest rate was interpreted
as indicating a tight monetary policy while a low interest rate was
interpreted as indicating an easy monetary policy.
By now it is recognized
that during in inflationary period it is vital to draw a distinction between
nominal and real rates of interest and, as a result, during inflationary
periods the rate of interest may provide a very misleading interpretation
of the stance of monetary policy.
The same logic also applies with respect
to the analysis of the relationship between exchange rates and interest
rates.
Recent theoretical developments in the theory of exchange rate
determination indicate that exchange rates, like the prices of other assets
which are traded in organized markets, are strongly influenced by expectations
concerning future course of events.
This analytical framework Implies that
one of the important factors which determine changes of exchange rates are
"news" which provide market participants with new information which in turn
causes a revision of expectations concerning the future, and alters the
current value of the currency.
From this perspective it follows that changes
in the rate of interest have a relatively strong effect on the exchange
2
For further details and analysis see Frenkel, Jacob A., and Levich,
Richard M,, "Transactions Costs and Interest Arbitrage: Tranquil Versus
Turbulent Periods," Journal of Political Economy, 85, no. 6 (December, 1977):
1209-26.
193
rate if these changes are not anticipated.
Table 1 illustrates this fact.
3
It demonstrates that during the recent period the various exchange rates have
been influenced by the unexpected interest differential and that the
association confirmed the prediction: for a given value of the lagged
forward rate, an unanticipated rise in interest rate differential was
associated with a weaker dollar (i.e., with a higher spot exchange rate,
defined as the price of foreign exchange in terms of the U.S. dollar).
II. Is There a Conflict Between Fighting Inflation and Halting the Depreciation
of the Dollar?
In the foregoing analysis I discussed the link between inflation,
nominal interest rates and the value of the dollar in foreign exchange markets.
Thus, I linked the internal value of the dollar with its external value.
The recognition of this link is pertinant for the design of policy.
An
excessive growth of the supply of dollars relative to the demand for
dollars (for given behavior of foreign monetary aggregates) reduces the
value of the dollar in terms of domestic goods and services (as reflected by
the domestic inflation rate) as well as in terms of foreign exchange (as
reflected by the decline in the external value of the currency). Since the
source of this phenomena is well identified, the policy implications are
obvious.
Moreover, since the higher inflation rate and the higher rate of
depreciation of the dollar are both simptoms of the same fundamental cause,
there should be no conflict whatsoever between policies that are aimed at
lowering domestic inflation and policies that are aimed at halting the
external depreciation of the dollar.
Very few economists recommend fighting inflation by pegging the
price level through direct intervention in commodity markets.
3
Similar
For further details and analysis see Frenkel, Jacob A., "Flexible
Exchange Rates in the 1970’s" in Stabilization Policies: Lessons from the
1970*8 and Implications for the 1980*s. Center for the Study of American
Business at Washington University, St. Louis, Missouri, 1980, forthcoming.
Table 1
Interest Rate Differentials and Exchange Rates
Monthly Data: June 1973 - July 1979
(standard errors In parentheses)
Dependent Variable
in St
Constant
Ft-1
(1-1*)t
s.e.
R2
D.W.
.027
.95
1.73
.388
(.165)
.026
.96
1.77
.546
(.199)
.026
.96
1.80
.029
.79
2.11
.377
(.132)
.028
.81
2.22
.540
(.206)
.028
.81
2.32
.032
.93
2.02
.601
(.271)
.031
.94
2.08
.583
(.349)
.031
.94
2.08
[(i-i^ -E ^ U -i* )^ ]
Dollar/Pound
.032
(.019)
.959
(.025)
.030
(.017)
.961
(.024)
.019
(.019)
.968
(.024)
-.155
(.111)
-.335
(.100)
.776
(.067)
.184
(.125)
-.301
(.079)
.801
(.051)
-.231
(.104)
.851
(.070)
.195
(.188)
-.070
(. 43)
.926
(.045)
.237
(.229)
-.037
(.027)
.955
(.032)
-.040
(.046)
.952
(.047)
.017
(.096)
Dollar/Franc
Dollar/DM
NOTE:
.024
(.290)
Interest rates are the one-month (annualized) Euromarket rates. The expected interest rate differential Et l (i - i* ) t
was computed from a regression of the Interest differential on a constant and on lagged values of the
differential* ( i - i * ) t denotes actual in terest rate d iffe r e n t ia l where i denotes the rate o f in terest
on se cu ritie s denominated in U.S. d o lla rs and i* denotes the rate o f in terest on s e c u r itie s denominated
in foreign currency, [ ( i - i * ) t-Et_ ^ ( i - i * ) d e n o t e s the unexpected in terest rate d iffe r e n t ia l.
195
(though not identical) arguments could be made against fighting the external
depreciation of the dollar by pegging the exchange rate.
Both dimensions
of the deteriorating dollar are reflections of macroeconomic policies and
both can (and should) be handled with the aid of macroeconomic policies.
It
is imperative to recognize that prices and exchange rates are the manifestation
of policies rather than tools that should be manipulated as instruments of
policy.
For this reason as well as for the unreliability of interest rates
as monetary indicators I come strongly in favor of Strategy 2 which shifts
the weight away from interest rates and towards the establishment of a long
run disinflationary monetary growth path which is at the heart of H.R. 5476
as introduced by Congressman Neal.
I should also note that the key difference between Strategy 1 and
Strategy 2 as outlined in Chairmen Mitchell and Neal's letter of invitation
is not that the one attempts to strengthen the dollar while the other
attempts to lower inflation.
I have already argued that those policies
which lower inflation would also strengthen the external value of the dollar
and, parenthetically, these policies will also lower nominal rate of
interest by reducing inflationary expectations.
The key difference between
the two strategies is the choice of instrument: Strategy 1 manipulates the
federal fund rate while Strategy 2 concentrates on the long term monetary
growth path.
I believe that the difference between the two is much more
fundamental than just being a technical change of the Federal Reserve
Operating Procedures.
The perspective' that policies which strengthen the domestic value of
the dollar are consistent with policies which strengthen the external value
of the dollar imply the need for a close coordination between the domestic
desk and the external desk at the Fed.
Domestic monetary policies like
open market operations involve sales (or purchases) of dollars against
196
securities.
External intervention policies like interventions in foreign
exchange markets ultimately involve sales (or purchases) of dollars against
foreign exchange.
Both policies result in changes in the relative supplies
of U.S. dollars and both therefore are expected to alter the domestic as well
as the external value of the dollar.
Under these circumstances it 'Is essential
that such policies be closely coordinated.
An additional reason for my preference for Strategy 2 is its concentration
on long-term trends rather than placing excessive weight on short-term
fluctuations.
History has shown time and again that the Fed can exert a
much better control of monetary growth over the medium run or over the long
term than over a very short period of time.
Furthermore, the record indicates
that the effects of secular trends are much more predictable and more
lasting than those of short term fluctuations.
It is reasonable therefore
that policies should be guided by these long term considerations as characterized
by Strategy 2.
III.
Excessive Fluctuations of Exchange Rates and the Policy Implications
I turn now to another part of Strategy 1 according to which
"Similtaneously, the Federal Reserve and the Treasury would intervene vigorously
on foreign exchange markets, in cooperation with other central banks, to
combat excessive fluctuations in exchange rates that might arise from
speculation against the dollar even in the face of high interest rates.”
In the first place, as I have indicated above, the concept and
definition of intervention is somewhat vague since there is a fundamental
sense according to which monetary policy may be viewed as an intervention
in the determination of exchange rates.
Second, and more fundamentally, the notion of "excessive fluctuations"
needs to be clarified.
197
Perhaps the sim plest measure o f flu ctu a tio n s o f exchange rates Is the
average percentage change over some In terva l o f time.
Table 2 reports the
average monthly percentage change fo r the exchange rate between the U.S.
d o lla r and the U.K. Pound, the French Franc and the D.M. fo r the period June
1973-February 1979.
percent per month.
In a l l ca ses, the average absolute change exceeded two
In comparison, the average absolute monthly percentage
change o f w holesale and consumer p ric e in d ice s and o f the r a tio s o f nation al
p ric e le v e ls were only about h a lf o f that o f the exchange r a te .
This phenomenon i s a lso illu s t r a t e d in Figures 2-4 where i t i s seen
that the extent o f flu ctu a tio n o f the dollar/Pound, d ollar/F ran c and the
dollar/D .M . exchange rates fa r exceeded the corresponding d iffe r e n t ia l
in fla t io n r a te s.
Likewise, the extent o f the flu ctu a tion s o f the various
exchange rates fa r exceeded those changes which were p red icted by the forward
premium on fo re ig n exchange.
This la s t observation in d icates that most o f
the flu ctu a tio n s were unpredicted.
The risk that is associa ted with the
unpredictable flu ctu a tio n s i s presumably a source o f s o c ia l c o s t .
a d d ition , the recent evolu tion
In
o f exchange rates have not conformed with
the p red iction s o f the simple v ersion o f the purchasing power p a rity theory.
illu s t r a t e d in Figures 5*7, spot and forward exchange rates have moved
together (co n siste n t with the hypothesis that both respond to new inform ation
in a sim ilar way) but the ra tio s o f n ation al p ric e le v e ls have not moved in
conform ity with the exchange ra te s.
These devia tion s from purchasing power
p a r itie s have resu lted in changes in " r e a l" exchange rates which many viewed
as being another source o f s o c ia l c o s t.
In assessing whether these exchange rate flu ctu a tion s have been
excessiv e i t i s important to note that the period sin ce 1973 witnessed great
turbulence in the world economy, and great uncertainty about the future
As
198
Table 2
Mean Absolute Percentage Changes in P rices and Exchange Rates
Monthly Data: June 1973 - February 1979
x^Variable;
Country^v
Exchange Rate
COL/COLyg
Against the D ollar
WPI
COL
U.S.
.009
.007
.038
-
-
U.K.
.014
.012
.066
.020
.007
France
.011
.008
.054
.020
.003
Germany
.004
.004
.031
.024
.004
Note:
Stock
Market
A ll v a ria b le s represent the absolute values o f monthly percentage changes in
the data.
WPI denotes the wholesale p ric e index and COL denotes the c o s t o f
liv in g index.
1979 v e r s io n ).
Data on p ric e s and exchange rates are from the IMF tape (May
The stock market in d ice s are from C apital In tern ation a l
P e rs p e ctiv e , monthly issu e s.
PERCENT
CHANGE
199
Figure 2:
Monthly percentage changes o f the U.S./U.K. consumer p ric e
in d ice s [A(£n COL™/COL__.) ] , o f the $ /£ exchange ra te ,
(A £n S ) , and the monthly forward premium; [£n(F
..) ]
July 1973 - July 1979.
PERCENT
CHANGE
200
Figure 3:
Monthly percentage changes o f the U.S./France consumer p ric e
in d ic e s , [A(An COL -/C O L -], o f the $ /F .F r. exchange r a te ,
(A An S ) , and the monthly forward premium; [&n(F . /S - ) ]
July 1973 - July 1979.
PERCENT
CHANGE
201
Figure 4:
Monthly percentage changes o f the U.S./German consumer p ric e
in d ic e s , [A(£n C0L-.-/C0L.,) ], o f the $/DM exchange ra te ,
(A Jin S ) , and the monthly forward premium; [&n(F ,/S . ) ]
July 1973 - July 1979.
C~A
EXCHANGE
RATES AND PRICE RATIOS
202
Figure 5:
/%
Monthly observations o f the D o lla r
spot (Jin S ) and Forward
(An Ft ) Exchange Rates and the Ratio o f the U.S?/U.K. Cost
o f L ivin g Indices [An (COL-.g/COL.-.) (sca led to equal the spot
exchange rate at the i n i t i a l month)]•June 1973 - July 1979.
EXCHANGE RATES AND PRICE RATIOS
203
Figure 6:
Monthly observations o f the D o lla r/F .F r. spot (An S ) and Forward
(An Ft > Exchange Rates and the R atio o f the U.S./French Cost
o f Living Indices [£n(C0L_.g/C0L_) (sca led to equal the spot
exchange rate at the i n i t i a l month)] :June 1973 - July 1979.
EXCHANGE
RATES AND PRICE RATIOS
204
Figure 7:
Monthly observations o f the D ollar /DM spot (An S ) and Forward
(An Ft > Exchange Rates and the Ratio o f the U.S./German Cost
o f Living Indices [£n(COL-,s /COL-) (sca led to equal the spot
exchange rate at the i n i t i a l month)]:June 1973 - July 1979.
205
course o f economic e v e n ts.4
In th±s environment a l l asset p r ic e s , not only
exchange ra te s, have shown large flu ctu a tio n s.
Indeed, while exchange rate
changes have been larg e in comparison with changes in na tion al p ric e l e v e ls ,
they have been considerably sm aller than changes in the p ric e s o f other
assets lik e g o ld , many other commodities and common stocks (see Table 1 ).
Not a l l flu ctu a tio n s serve a useless r o le and not a l l flu ctu a tion s have to
be stopped.
A relevant question i s how can government p o lic y be managed to
reduce c o s tly and undesirable turbulence o f exchange rates?
I t i s c le a r that,
as a tech n ical matter p o lic y can reduce exchange rate flu ctu a tion s even to
the extent o f a complete pegging o f the ra te .
I t may n o t, however, be assumed
that such p o lic ie s w i l l autom atically elim inate the ultim ate cause underlying
the flu ctu a tio n s.
Such p o lic ie s may only tra n sfer the e ff e c t s o f disturbances
from the fo re ig n exchange market to somewhere e ls e in the economic system.
For example, i t i s c le a r that a commitment to peg the rate o f exchange
im plies a lo s s o f c o n tro l over the supply o f money which would have to
vary so as to ensure the f i x i t y o f the ra te .
In that case the attempt to
reduce v a r ia b ilit y o f exchange rates re su lts in an increased v a r ia b ilit y
o f the money supply.
There i s no presumption that tra n sferin g disturbances
w i l l reduce t h e ir o v e r a ll impact and lower th e ir s o c ia l c o s t .
Indeed, sin ce
the fo re ig n exchange market i s a market in which r is k can e a s ily be bought
and s o ld , i t may be se n sib le to concentrate disturbances in th is market,
rather than tra n sfer them to other markets, such as labor markets, where they
cannot be d ealt with in as e f f i c i e n t a manner.
Thus, the issu e is not
turbulence or not but turbulence in what.
A
This and the fo llow in g three paragraphs draw on Frenkel, Jacob A.
and Mussa, Michael L. "E ffic ie n c y o f Foreign Exchange Markets and Measures
o f Turbulence" American Economic Review 70, no. 2 (May, 1980) forthcom ing.
206
One exception to th is general p r in cip le i s that government p o lic y
can o f f s e t disturbances a risin g from s h ift s in demands to hold d iffe r e n t
n ation al monies.
The co rre ct p o lic y i s to accommodate such demand s h ift s
by o ff s e t t in g supply s h i f t s , thereby elim inating the need fo r c o s tly
adjustments o f exchange rates and n ation al p ric e le v e ls .
The d i f f i c u l t y
with implementing th is p o lic y i s in id e n tify in g when a s h ift in money demand
has occurred and in adju sting the asset sid e o f the balance sheets o f
n ation al banking systems.
The way in which government p o lic y can make a p o s itiv e con trib u tion
to reducing c o s tly and unnecessary turbulence o f fore ig n exchange rates i s
by reducing high and v ariable rates o f monetary expansion which, fo r example,
r e su lt from misguided attempts to s t a b iliz e nominal in te r e s t ra te s.
This is
e s p e c ia lly important because exchange rates are a ffe c te d not only by current
p o lic y a c tio n s, but a lso by current expectations o f fu tu re p o lic y .
If
expectations o f future p o lic y are high ly s e n s itiv e to current p o lic y , then
in s t a b ilit y o f p o lic y can have a m agnified e f f e c t on exchange rates and on
the r e la t iv e p rice s o f d iffe r e n t na tion al outputs, thereby generating
s ig n ific a n t s o c ia l c o s ts .
I f as I b e lie v e , the in s t a b ilit y and u n p red icta b ility
o f p o lic y , p a r tic u la rly monetary p o lic y , has contributed s ig n ific a n t ly to
the turbulence o f exchange rates sin ce 1973, then the turbulence and i t s
associa ted c o s t, can be reduced by adopting more sta b le and p red icta b le
patterns o f government p o lic y .
The re sto ra tio n o f p red icta b le and sta b le patterns o f p o lic y is at the
heart o f Congressman N eal's b i l l .
C r itic s o f the b i l l might argue that i t
deprives the Fed from an e sse n tia l degree o f freedom and th at, as a lo g ic a l
m atter, a lo s s o f degrees o f freedom w i l l worsen rather than improve the
s itu a tio n .
I do not b e lie v e that the promoters o f the b i l l would dispute th is
l o g i c a l deduction per s e , they would argue, however, that what matters i s not
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the lumber o f degrees o f freedom a v a ila b le fo r p o lic y makers but
rather
the way by which these degrees o f freedom are used (o r m isused).
The stron gest
case fo r the b i l l i s not i t s a ttra ctiv en ess as a matter o f p rin cip le but
rather i t s attra ctiv e n e ss in comparison with the past record .
The past record
in d ica tes that ex cessiv e f l e x i b i l i t y might induce a p o lic y o f fin e-tu n in g
and might re su lt in unpredictable and unstable patterns o f p o lic y which is
p re c is e ly what the b i l l i s attempting to c o r r e c t.
I am, th e r e fo r e , supporting
the concept o f p o lic y which i s recommended by H.R. 5476.
I am, however,
somewhat le s s convinced that the optimal way to achieve th is pattern o f
p o lic y i s through congressional le g is la t io n .
There are numerous a ltern a tiv e
ways (t o be su re, each with i t s own d e fe c ts) and I b e lie v e that these options
should be thoroughly discussed and evaluated.
Further i t seems that the
ultim ate d e cisio n would depend on bureaucratic consid eration s concerning the
most e ff e c t iv e le g a l framework fo r the conduct o f p o lic y .
These consideration s
do not depend e x clu siv e ly on the p rin cip le s o f economic theory and an economist
may not possess the comparative advantage fo r determining whether or not
the be st procedure i s that o f a congressional le g is la t io n .
I f i t turns out
that le g is la t io n is required, I would suggest to incorporate in the b i l l two
ad d itio n a l fea tu res.
F ir s t, a p rov iso which allows the Fed to accommodate
autonomous large changes in the demand fo r d o lla rs, which would most probably
be a very rare phenomenon but the recent Iranian c r i s is brings up th is
p o s s ib ility .
Second, and more im portantly, i t would be u sefu l to s p e c ify the
proposed short term f i s c a l remedies to a tra n sitory r is e in unemployment which
might occur during the i n i t i a l phases follow in g the implementation o f the new
monetary ru le .
The lik e lih o o d and the magnitude o f such a r is e in the
unemployment rate (and th erefore the lik e lih o o d that there w i l l be a need
to r e so rt to such a f i s c a l supplement) w i l l be lower the more c re d ib le and
the more understood the new p o lic y i s .
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The general p r in cip le o f having a sta b le and p red icta b le pattern o f
p o lic ie s i s o f a s p e c ia l importance in the context o f the United S ta tes, in
view o f i t s s i z e , and in view o f the sp e c ia l r o le o f the d o lla r in the
in te rn a tio n a l monetary system.
The U.S. d o lla r has performed the r o le o f
"world money" in serving the fu nction s o f in v o ice currency, unit o f account,
in terven tion currency, sto re o f v alu e, in te rn a tio n a l reserve a s s e t, and the
li k e .
The p rin cip a l con trib u tion that U.S. economic p o lic y can make in
reducing exchange rate turbulence and achieving greater economic s t a b i l i t y ,
i s by reducing the le v e l and v a r ia b ilit y o f U.S. in fla t io n and sim ultaneously
reducing uncertainty about U.S. economic p o lic y .
This should increase the
e ff ic ie n c y and enhance the r o le o f the d o lla r as "world money."
In h is opening statement on November 13, 1979 Chairman M itch ell
asked Mr. Paul V olker, the Chairman o f the Federal Reserve Board, "Can we
p u ll i t o f f ? "
My own answer i s yes we can, provided we s t ic k to the necessary
course o f p o lic y .
The d i f f i c u l t i e s l i e in the fa c t that adjustments o f the
economic system require more time than i s ty p ic a lly provided fo r by the
p o l i t i c a l system.
In the past th is c o n f l i c t resu lted in stop-and-go p o lic ie s
with the subsequent accelera ted in fla t io n r a te .: I t i s imperative that the
Federal Reserve continues to fo llo w i t s new course o f p o lic ie s with v ig o r and
determ ination.
The current turn-around o f in te r e s t rates may already sig n a l
the f i r s t signs o f success b u t, one should be ready fo r temporary setbacks
and one should r e a liz e that the process i s long.
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Chairman M it c h e l l . Thank you very much, Professor Frenkel
and Professor Fand. I must say that we very often have hearings and
in each of the hearings I, as one member, always learn a lot. But your
testimony, both of you, has been most instructive to me, it really
has. And I think I have learned some things, or at least looked at
some areas that I had not looked at before, nor learned about before.
That is one of the blessings of being a Member of Congress. W e
actually gain some very significant insights from witnesses who appear
before us.
Thank you, gentlemen.
Chairman Neal, do you want to lead off?
Chairman N e a l . M r. Chairman, you have been overly generous
with the time.
Chairman M i t c h e l l . Let me just advise what this little colloquy
is about. I told Chairman Neal, I remember the years that I sat down
there on that lower bench, never getting a chance to raise a question.
And I said, once I became chairman, I would always maKe every
attempt to make sure that every member of the committee had a
chance to raise questions before the Chair raised questions.
Chairman N e a l . Well, I thank the chairman.
I believe you were both in the audience earlier when I raised— I
made the comment that I think there was no single thing that would
be more effective in bringing down the rate of inflation and bringing
down interest rates, stabilizing the value of the dollar and increasing
productivity, increasing employment, than the adoption by the Fed
eral Reserve of a policy of slowly bringing down the rate of growth in
the money supply until it reached the rate of growth in the economy,
and leaving it there.
And I would just like, for the record, for you all to give me a yes
or no answer as to whether you find yourselves in agreement or not
with that statement.
Professor F a n d . Yes; and I would add that I think the monetary
credibility, once established, would then benefit from stabilizing ex
pectations. Thus, there is an additional benefit there.
Chairman N e a l . Yes, sir, I agree with that also. In other words,
the point you are making is that if we could get a firm announcement
of that policy, not only the implementation of that policy, but an
announcement now or as soon as possible, then you would see the bene
fits of that policy begin to take effect much sooner than they would
otherwise. Is that what you were saying, essentially?
Professor F a n d . Once the public really believes it.
Chairman N e a l . Of course, then the question is how we are going to
get the public or anyone else to believe it. In my own view, the only
way we are going to do that is pass legislation, because— and frankly,
I come to that conclusion very reluctantly. But frankly, I think, be
cause we have had inconsistent policies in the past, that no matter
what is said------Professor F a n d . I think a point Chairman Mitchell raised, would
help it. If you can couple your bill with a program that at some point
would help out certain areas of unemployment, I think that may give
your bill a little bit more credibility.
Chairman N e a l . Well, I think it would, too. And I want to pursue
that with both of you.
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Chairman M it c h e l l . Would the gentleman yield just a moment?
Chairman N e a l . Y es.
Chairman M it c h e l l . I want to take this opportunity to say that
this is why I am having difficulty with the way the legislation that we
passed, the Humphrey-Hawkins full employment bill, is being im
plemented. I think there is a great deal of movement to meet the re
quirements of that legislation on the one side with reference to in
flation; but there is an absence of any kind of movement to meet the
employment goals. And I too wrould urge that my colleague take
another look at his bill, because I think if you don’t put in that kind of
proviso, we are merely extending the wrongdoings that we are pre
sently engaged in vis a vis the Humphrey-Hawkins full employment
legislation.
Thank you for yielding to me.
Chairman N e a l . For the record, I would just like to get a response
from Professor Frenkel.
Professor F r e n k e l . Well, my answer about the inflation rate is yes.
About the interest rate, yes. Unemployment rate, yes. Namely, fol
lowing the course of policies that you have suggested would indeed
lower all of them.
As far as the exchange rate, I believe that the outcome is somewhat
less clear, because it takes two to tango. If the United States carries a
disinflationary policy without a change in foreign policies, the answer
is yes, namely, the dollar will be strengthened in foreign exchange
markets. However, to the extent that foreign policies become even
more disinflationary the U.S. dollar may depreciate.
However, it is important to place it in the right perspective of orders
of importance: I would argue that if we pursue the policy that is cap
able of lowering the inflation rate, lowering the interest rate, lowering
the unemployment rate, then I wouldn’t care much about a situation
in which the external value of the U.S. dollar fluctuates due to foreign
olicies which are unstable, because that is the nice trick about having
exible exchange rates: It provides a partial insulation from foreign
misguided monetary policies.
So the policy guidelines should insure that we do not conduct the
monetary policy that punishes us, but we want to have the exchange
rate system that protects us from foreign misguided policy.
Chairman N e a l . I would like to just for a moment pursue what I
imagine would be the worst case kind of situation that this economy
might find itself in, I am not suggesting that we will, and I am certainly
hoping we won’t. But let’s take what I imagine would be the worst
case, which would be a wartime economy. If we found ourselves in a
situation as we were in 1941, for example, when we had to make an
all-out effort, an all-out military effort, wrould that, in either of your
opinions, be reason to essentially change this prescription for monetary
policy?
Professor F a n d . Offhand, I don’t see why. In other words, you still
have a lot of power in the budget. You are trying to mobilize the
economy in a war effort. Congress can do quite a bit there. I don’t see
why a higher rate of monetary growth would aid the war effort.
Chairman N e a l . That would be my own view, also. And the reason
I raise the worst case is because, in studying it and looking at the
various alternatives, I can’t find anywhere, even in the worst case,
any reason for deviating very much from this policy, and that is really
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the kind of question— and I am not trying to get into the question of
war or peace, but I am really trying to use that as an example of the
worst case.
Professor F r e n k e l . I basically agree with this line. Let me translate,
however, the question from the situation of war and peace to a some
what different situation, namely, should we allow for political crises
of one form or another— a war is one of them— to guide the course of
our macroeconomic policies? Now, once you put it in that way, the
answer becomes so much clearer, and we don’ t have to speak about
being a patriot or not. As a general rule, economic policy should be
designed so as to maximize the size of the pie, and the political system
may influence the distribution of the pie.
Let me, if I may, refer to your previous question about legislation.
I am much more comfortable with the answer to two of the following
three questions, and I have some doubts about the answer to the third.
The first question is where do we want to go? And here I think it is
clear that we want to have low unemployment, low inflation, lower
interest rate, stability, and all of that.
The second question is what is the implications of following the
line of policies that you suggest?
And here, again, my answer is very positive. They are consistent
with where we want to go.
The third question is, how do we want to go there? And I will be
honest with you by saying that I am not sure that the advice that an
economist can give on that question is the advice that you necessarily
need to seek because we are really asking now a bureaucratic admin
istrative question about how to insure that some guidelines are being
followed.
And the question is whether it has to be legislation or not.
I am not sure that I, as an economist, have a comparative advantage
in this matter. I can say, however, that the mere fact that we dis
cussed it here, the mere fact that the proposed bill comes to the public
domain, the mere fact that this bill is discussed, I am sure that
whether it passes or not, will have had its positive results.
And for this, I fully applaud your proposals.
Professor F a n d . Can I add one comment? I have no doubt that if
your bill passed and if the Fed followed that policy, after about a year
or so, everything would work out very well on all the crucial variables.
But I think the first year could be difficult. That is the problem. If we
could somehow do things or put things in to take the fears away from
other people about that first year— and I think that the area that
would give people the greatest fear is unemployment.
Chairman N e a l . I quite agree. And this is the most legitimate con
cern of Chairman Mitchell, and one that I share. And then, and that
is the question I wanted to pursue, what would be your advice?
M y own preference would be for specifically targeted programs for
those that suffer because of this policy and there will certainly be
some. And we are talking about unemployment and probably mostly
among minorities and women, as M s. Oakar said, who always seem to
suffer the worst.
Professor F a n d . I would like to make a comment. I am no expert
on suffering, but I do notice certain things. In Michigan, I notice,
for example, that some people suffer in style. When they are unem
ployed, they get 95 percent, or even more of their pay. Some may go
212
to Florida, even though they are unemployed. There are other people
that suffer in misery.
In other words, I think if you are talking about minorities and so
on, they may not get a job and they will not receive unemployment
compensation. I thmk it would be very good if we could figure out a
way to alleviate the real suffering.
Chairman N e a l . I quite agree with that. Thank you, Mr. Chairman.
Professor F r e n k e l . M ay I refer to a related issue?
I think that there is an important point to notice, that monetary
policy matters, usually when money is out of order, because when
money is in order, we know that money just serves as a veil.
Chairman N e a l . I didn’ t understand that.
Professor F r e n k e l . Y ou see, it is a rather subtle point. W e know
that, basically, money is just a veil covering the real transactions.
. When does monetary policy matter? When can you, by changing
the money supply, affect unemployment rather than just raising prices
or lowering prices?
It is only when monetary policy is unexpected or when it is not fully
understood. Whenever it is very variable and unstable— in short,
when money is out of order.
So I think it is extremely important to notice, and this is in reference
to Chairman Mitchell’s question of the morning— what is the likely
effect of an announcement, a clear announcement of a given monetary
policy on unemployment?
The answer to it depends on whether people perceive what is going
on or not.
The more they perceive, the more money will just serve as a veil
and contractory monetary policy will have less real effect on unem
ployment, and the less will t>e the real suffering.
So the clarity and the predictability of policy are extremely impor
tant. This implies that the bill which attempts to restore control over
the money supply is not motivated by a desire to manipulate money,
but rather, a desire to control it so as to insure that it is not manipu
lated and that thereby it becomes completely unimportant, so it
doesn’t interfere with the real stuff and it just serves as a veil.
Chairman N e a l . To add stability?
Professor F r e n k e l . Yes, indeed.
Chairman N e a l . Confidence and stability. They are the goals.
Thank you, M r. Chairman.
Chairman M it c h e l l . M s . Oakar?
M s. O a k e r . Thank y o u , M r. Chairman.
Mr. Chairman, let me just say about Michigan, I am not from
Michigan. I happen to be from Ohio. But I will say that having
served on the Unemployment Compensation Commission, that the
majority of people who are unemployed do not go off to Florida
and so forth.
And so in terms of Michigan’s unemployment, among the highest
who are hit who are autoworkers happen to be minorities. And I
think that that is important to say for the record. And they don’t
take off to Florida. They would just as soon have their jobs back.
But I do have one quick question for Professor Frenkel or the
other gentleman, if he cares to comment.
W hat would happen if— you know, there is some comment about
the possibility-—I suppose we are more aware of it because of the
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Iranian crisis, but that OPEC and other oil-producing countries may
not use the dollar in terms of pricing their assets, which are now mostly
priced in terms of dollars.
But what would happen if they do change the type of currency that
they use? W hat would happen to the exchange rates and possibly the
value of the dollar?
Have you projected anything?
Professor F r e n k e l . Yes. I think the answer to this question is
quite clear and the policy implications, I believe, are also relatively
clear.
Basically, what you are describing now is a situation where the world
demand for dollars declines.
M s. O a k a r . Right.
Professor F r e n k e l . Whether it is a change in O PEC’s taste or in
my own taste. Whenever there is a fall in the demand for dollars, the
value of the dollar will decline. In terms of what? In terms of every
thing.
So we should expect under these circumstances that the value of
the dollar will decline in terms of foreign currencies and that the price
level at home will be higher.
There are just more dollars now than there were before because
previously, they were in hoards and now they are being dumped on
the market.
W hat is the proper policy?
Now here I am coming back to— the exception mentioned by Pro
fessor Fand.
An exception to the rigid guidelines of Chairman Neal’s bill should
precisely be such circumstances in which there is a drastic autonomous
shift in the demand for dollars.
How can we make sure that this shift in demand for dollars does
not alter exchange rates or prices? And I ’m less worried about exchange
rates, than prices.
Well, we can reduce the effect of such a shift in demand by adjusting
the supply.
Now if there was, indeed, a once and for all shift in the demand for
dollars and you had a vacuum cleaner which would just take it all in
without letting it go through the economic system, then the Fed
should accommodate and absorb it immediately and very little
would happen.
If you looked at the statistics the day after, you would find a tre
mendous decline in the growth rate of money which would probably
be in violation with respect to the guidelines prescribed by the bill.
Now that is a unique case for exception to that current version of
the bill. However, what we know is that we have to put it into perspec
tive. This bill gains its force from one important point; namely, the
demand for money is basically stable— or at least, it is more stable
than the supply of money. And therefore, the major fluctuations in
the excess demand or supply is due to the supply side.
If the demand for money was unstable, then we should not tie our
supply side to a rigid rule; we should accommodate it.
Now I described it as an extreme exception, and I think that those
are the extreme exceptions that should and could be dealt with in the
context of the bill.
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So if I can summarize the two points that were specified in our
discussion as useful points to be added to the bill are the specification
of the actions to be taken if there was a large rise in the unemployment
rate as a result of the transition toward the adaptation of the new
monetary rule, and the specification of the monetary response to a
clearly announced or clearly shown autonomous changes in demand.
Those are the cases where we may want to deviate from the rigid
predetermined monetary growth path.
M s. O a k a r . But you are in favor of setting the policy first and not
relying on projections of what happens in the foreign market. And
two, after we have set the policy, then accommodate any extreme
changes— I mean, you would be in favor of some de facto policy a la
the Neal bill, for example, right?
Professor F r e n k e l . Y es; because I agree with empirical force
underlying the bill. The demand for money is the much more stable
blade of the factors that bring together the demand and the supply.
M s. O a k a r . Thank you, and thank you, M r. Chairman.
Chairman M i t c h e l l . Earlier today Professor Brunner voiced a
statement, an opinion, that said if we develop this new macroeconomic
policy geared toward slowly slowing money supply growth, that
foreign nations and foreign markets would be delighted and would
follow suit.
Well, I assume that Germany would with its relatively stable
economy, and Switzerland would.
In your opinion, was the statement fairly accurate? Do you think
that France— let’s deal just with the nations of Western Europe, do
you think that they would be happy that we have embarked on a
fixed-money-growth policy and woula attempt to follow suit in terms
of their own monetary policies?
Let’s take Italy as a case.
Professor F a n d . I don’t see why not. I would be inclined to agree,
but I really have not thought about it?
Chairman M i t c h e l l . Professor Frenkel?
Professor F r e n k e l . The experience of the 1960’s up to the rapid
acceleration of the rate of inflation associated with the Vietnam war
suggested that when the United States had a stable monetary policy,
and when the price level in the United States was not rising as fast,
indeed, the Europeans adhered to the rules of the game of the fixed
exchange rates and were delighted to use the services of the great
banker of the world, that is, the United States.
When did the system break? When the banker did not provide the
financial services that it was supposed to.
And at that point the U.S. currency started to deteriorate, the
Canadians decided to go to a floating rate, and the Europeans had the
stimulus to have the European monetary system; the deteriorating
dollar provided stimulus for the search for substitutes.
So I believe that if stability is restored, the dollar will regain its
traditional and natural role in the world financial system. I would
rather not predict the course of monetary policy in Italy, since we
need a bill to insure a stable monetary policy in the United States.
I would not guess what would be required m the context of the political
framework of Italy.
215
Chairman M it c h e l l . Gentlemen, we face a dilemma here. There
are a series of votes that are now coming up based upon the legislation
that was discussed yesterday in the House of Representatives.
I am going to reluctantly have to leave you.
Chairman N e a l . Would the chairman yield?
Chairman M it c h e l l . I was just about to say others who want to
stay can.
Chairman N e a l . I just want to get back to this very basic question
of the policy implications regarding unemployment implied by the
bill, and this policy of gradually reducing the money supply.
It is a very important point that the chairman has raised and others
have raised that this should be accompanied by some fiscal policy to
help those that are distressed by the policy.
But my own opinion is that we ought to be very careful about that
and trigger it to unemployment caused by the policy because, in fact,
my opinion is that you would not see very much unemployment pro
duced as a result of this policy because once it were known, and I wish
I might have the attention of the chairman just for a moment, because
it is my opinion, m y strongly held opinion, that if those who make
investment decisions knew that we were serious about fighting infla
tion, that they would be inclined to make those investment decisions
and thus, employ more people.
Chairman M it c h e l l . Will the gentleman yield for just a moment?
Chairman N e a l . Yes, Mr. Chairman.
Chairman M i t c h e l l . I love, admire, and respect my colleague, but
this is a brandnew policy on which we are embarking, if we, indeed,
embark on it.
And I do not think that any of us can predict what unemployment
might be as a result of embarking on this policy.
M y only caveat is: Let us be prepared to deal with any increase,
whether it be small or large, so that we don’t get these enormous
pressures, political pressures exerted which would undo that which you
seek to do.
Chairman N e a l . Well, I agree with the chairman.
Professor F a n d . Can I make a comment on that?
You say we have to distinguish the unemployment that would be
enerated by any disinflation policy from the unemployment that will
e generated by the specific policy in your bill. M ost people will not
know that difference. In actual fact, you could be right. If your bill
is passed, we may, in fact, get less unemployment than we would have
received if we didn’t pass your bill. But there may still be a rise in
unemployment and people are going to blame your bill for that. It
was toward that manifestation that I was directing m y comments, not
with the implication that you are causing more unemployment than
there would have been otherwise.
Chairman N e a l . Well, there was that impression left by an earlier
witness also. And I just think that this is something that we ought to
examine very carefully because I think it would be very hard to pro
duce any hard evidence that this policy, in fact, would increase the
unemployment rate.
Professor F r e n k e l . It seems that we are facing here a very happy
course of affairs as far as political relations within the committee is
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216
concerned. If you, Mr. Neal, are convinced that your bill will not
raise unemployment, then you should have no problem of attaching
appendixes to the bill specifying how to deal with the unemployment
smce, presumably, these special provisions would never be used.
Chairman N e a l . I quite agree.
Professor F a n d . But you meant that there won’t be any additional
unemployment that is attributable to your bill. In other words, any
disinflation effort will raise unemployment. So we are talking about any
additional unemployment due to the implementation of your bill.
Chairman N e a l . Well, the inflation policy that we are following
raises unemployment.
W ell, 1 would also like to thank the witnesses very much. Let me
say that we welcome your advice at any time and this also goes for the
other witnesses— I don’t Imow if we have any left in the hall. But we
will continue to pursue this subject for some time to come.
And I want to thank you again, and please feel free to advise us
whenever it is convenient for you. W e welcome your advice. The
hearings now stand adjourned, subject to the call of the Chair.
[Whereupon, at 12:40 p.m., the hearing adjourned.]
[The following letters and statements were received by the subcom
mittees for inclusion in the record:]
C h a s e E c o n o m e t r ic A s s o c ia t e s , I n c .,
Bala Cynwyd, Pa., November 6, 1979 .
Hon.
Hon.
P a r r e n J. M it c h e l l ,
S t e p h e n L. N e a l ,
House Committee on Banking, Finance and Urban Affairs, Subcommittee on, Domestic
Monetary Policy, Washington, D.C.
G e n t l e m e n : This letter is in response to your request that I review, with
respect to the Fed’s October 6, 1979 policy pronouncements, the findings of the
study which I directed for the Subcommittee on Domestic Monetary Policy in
August 1976 and which was reprinted in the record as part of the Hearings held
on January 30, 1978, “ Review of Monetary Policy in 1977.”
One portion of my study compared the efficiency of using a “ reserves” target
relative to a federal funds rate target. The results were interesting in that they
supported a long held tenet of most “ monetarists” — that a reserves target is
superior to a federal funds rate target—even though the analysis was based upon
a so-called “ Keynesian” model. Tnus, the conclusion of this study supports the
change in targets announced by the Fed in October 6.
Some important caveats to this conclusion should, however, be stressed. First,
any attempt to slavishly adhere to a monetary growth or reserves target on a
short-term basis, particularly in a quarter dominated by some special circum
stance such as unwanted inventory accumulation, was likely to lead to serious
economic disruptions. Thus a “ modified reserves target” approach such as the
one the Fed appears to be following was strongly recommended rather than a
single invariant “ rule of thumb” . Second, exogenous forces such as a massive oil
or farm price increase requires a rethinking of the desirable targets on either
basis. If the Fed refuses to accommodate, at least partially, inflation caused by
shocks of these types, the impacts upon real growth and unemployment would
be intolerable.
Third, changes in monetary policy should be made gradually over a period of
several years. Any attempt to reduce inflation by sharply reducing monetary
growth in a single year would burden the economy by sharply reducing invest
ment and hence productivity. While continuous fluctuations in short-term interest
rates such as those caused by the adoption of a reserve target do not slow invest
ment, large fluctuations such as those caused by policy reversals do have a
significant impact on long term rates and do adversely affect the nation’s inflation/
unemployment tradeoff point. In this regard I should note that the timing of the
policy change, while perhaps unavoidable, was unfortunate in view of the unsettled
nature of the economy and the financial markets last month.
217
Another major conclusion of my study was that the choice of a level and
starting point for any monetary target is at least as important as a decision to
move to that target. Thus, substantial amounts of human judgment are required
in terms of an analysis of current conditions and forecasts of the economic outlook,
just as were required under a funds rate target. The major advantage of a reserves
target is that hopefully it will allow additional concentration upon long run goals
and the position of the economy in the business cycle and will require less con
centration upon short-run fluctuations in interest rates.
Sincerely yours,
L e o n W. T atjb,
Vice President.
218
Statement by Ralph C. Bryant-^
Senior Fellcw
The Brookings Institution
prepared for the
Subcommittee on Domestic Monetary Policy
and the
Subcommittee an International Trade, Investment, and Monetary Policy
of the
Committee on Banking, Finance, and Urban Affairs
U. S. House of Representatives
December If, I979
It is a privilege to testify before these subcommittees on the goals
and operating procedures of American monetary policy.
Ify statement will
touch on several issues of current interest, summarizing in each case
some broad conclusions that I believe should guide policy decisions and
Congressional oversight of them.
Constraints on U. S. Economic Policy from Interdependence
The letter from the subcommittees inviting me to testify indicates
concern about the exchange-market value of the dollar and international
influences on Federal Reserve decisions.
Before I address that concern
directly, I want to emphasize that the openness of the U. S. economy inevitably
imposes constraints on all aspects of U. S. economic policy.
* / The views expressed here are my own and not necessarily those of the
officers, trustees, or other staff members of The Brookings Institution.
219
In an interdependent world economy, each nation's government can act
independently to adjust its cwn policy instruments hut cannot be assured of
effective control over its own economy.
Indeed, the contrast between de jure
sovereignty over national policy instruments and de facto control of national
ultimate targets is the central problem confronting policymakers in a single
open economy.
As the openness of a nation's economy increases, policy actions of its
government have a greater tendency to spill over into the rest of the world,
thereby affecting the ability of other nations to achieve their economic
objectives.
Similarly, policy actions taken by foreign governments and
nonpolicy disturbances originating abroad can increasingly influence the ulti
mate objectives of the home nation's economic policy.
Increasing interdepen
dence thus makes national policy decisions more difficult to implement and
more uncertain in their consequences; the ability of a nation's policymakers
to achieve national objectives is undermined.
The financial aspects of interdependence have especially important conse
quences for a nation's monetary policy.
If financial interdependence is
extensive and increasing, a nation's central bank will have increasing diffi
culties in bringing about conditions in domestic financial markets that
diverge greatly frcan financial conditions in the rest of the world.
Other things being equal, the diminished ability of a nation1s policymakers
to influence national macroeconomic conditions is unfortunate.
Policy autonomy
and ability to control the economy, however, are not ends in themselves.
substantial benefits accrue to a nation from economic interdependence —
And
for
example, because of the more efficient allocation of resources brought about
by international trade and capital movements and the resulting ability of the
220
nation’s residents to enjoy a higher standard of living.
at most times probably do —
Those benefits may —
more than offset the disadvantages associated with
*/
diminished controllability.-'
The United States may have seemed an exception to these generalizations
in earlier decades.
For a majority of Americans, the constraints resulting
from interdependence were hidden from view and seemed of little direct conse
quence. to them.
In fact, even in the 1950s the U. S. econonor was significantly
dependent an the world economy, and vice versa.
degree of openness increased substantially.
In the 1960s and 1970s the
Most Americans, having had to
live through the dramatic consequences of events such as the Arab oil embargo
and OPEC price increases in 1973-7^ and the Iranian revolution in 1978-79 ,
have probably by new abandoned the illusion of economic insulation from the
rest of the world.
In any case, the reality is not in doubt; the constraints
resulting from interdependence will be a major factor determining the evolu
tion of the American econonor in the 1980s.
To conduct a sensible monetary policy for the the United States, the
Federal Reserve must form judgments about the autonomy of its policies and
about the impacts of international influences on the U. S. economy and must
then use those judgments in shaping policy decisions.
If policy is formulated
on the basis of exaggerated perceptions of the ability to control American
target variables, decisions may have consequences quite different from those
intended and serious policy mistakes may result.
The international constraints on Federal Reserve policies, while important,
•are not so dominant as to render monetary policy a hostage to world financial
* / The conclusions in this and the preceding paragraphs are discussed in
detail in part 3 of ny forthcoming book, Money and Monetary Policy in Inter
dependent Nations (Brookings Institution, 1980).
221
conditions.
Interdependence is not so extensive that there is no scope
for divergences between economic conditions here and abroad.
Nonetheless,
the scope for such divergences has been perceptibly narrowing.
Increasing
financial interdependence has been a main driving force underlying this
trend.
Inescapably, therefore, the Federal Reserve in the 1980s will have
to be more and more concerned with the international aspects of its policy
decisions.
Exchange-Rate Variability as an Antidote for Interdependence?
Until recently, the conventional wisdom amcmg economists asserted that
the United States and other nations could pursue independent monetary policies
if exchange rates were permitted to be perfectly flexible.
That proposition
is now understood to be analytically incorrect and a misleading guideline for
policy decisions.
economy.
Flexibility of exchange rates cannot insulate the American
It is true that the effects of policy actions and nonpolicy distur
bances originating abroad tend to spill over less into the United States when
dollar exchange rates are flexible than when exchange rates are kept from
adjusting.
If American policymakers wish to buffer the U. S. economy against
most types of foreign policy actions and against many types of disturbances
originating in the real sector of foreign economies, they should let the dollar
appreciate in response to external stimuli that are expansionary and depreciate
in response to those that are contractionary.
a s s o c ia t e d
with
exchange
But the buffering tendencies
rate variability do not apply to every type of
disturbance originating abroad; for example, they do not apply to autonomous
portfolio shifts into or out of dollar assets (by foreigners or Americans).
Nor is it always desirable to have the U. S. economy buffered against the rest
222
of the world.
In periods dominated by real-sector disturbances originating
in the United States, for example, it is in the selfish interest of the
United States to share, to the greatest extent possible, the adverse conse
quences of those disturbances with the rest of the world.
The idea that exchange rate variability insulates nations' economies is
frequently associated with another incorrect idea, that flexible exchange
rates unshackle monetary policy from international constraints, freeing the
central bank to forget about the balance of payments and to worry merely
about domestic economic goals.
The injunction to focus attention on the
domestic economy can easily be interpreted to mean that economic developments
abroad can be ignored; by implication, flexible exchange rates provide
complete insulation.
But there is no meaningful sense, no matter hem monetary policy may be
conducted, in which the Federal Reserve can safely ignore the interdependence
of the
u. S. economy and the rest of the world. Since the balance of payments
is nothing more than an accounting record of the consequences of that inter
dependence, moreover, there is no meaningful sense in which the Federal Reserve
can safely "forget" about the balance of payments.
affect the U. S. economy —
impacts on the
Events abroad always
sometimes favorably, sometimes unfavorably.
The
u. S. eccnony of Federal Reserve actions and of events occurring here
at home are always conditioned by interdependencies with the rest of the world —
s canetimes favorably, sometimes unfavorably.
Those international influences can
be ignored in the same sense that an airplane pilot flying under conditions of
low visibility can look merely at his plane's compass and speedometer and
choose to ignore the altimeter.
makers behave in that manner.
If prudent, however, neither pilots nor policy
223
Guidelines for External Monetary Policy
For many years, two views about variability in exchange rates —
hence about the external aspects of national monetary policy —
dominated academic and policymaking discussions.
and
have
The first view, the
untrammeled-market position, holds that each nation should pursue appropriate
domestic macroeconomic policies and permit currency values to be freely
determined in the exchange markets without any intervention by central
banks.
A pragmatic variant of this view allows for "smoothing" intervention
when exchange-market conditions become "disorderly."
The other view may be
labeled the minimum-variance position. Those holding this view emphasize
the uncertainty and disruptions that may be associated with fluctuations in
exchange rates and argue that central banks should act to maintain as much
exchange-rate stability as possible.
Pragmatic variants of this view recognize
that "stability" cannot feasibly be taken as synonymous with fixity.
Careful analysis of the policy options open to the United States and to
any other individual nation shews that neither of these traditional positions
is sensible as a guideline for external monetary policy.
The key point is
that variability in the dollar's external value facilitates adjustment to
some types of economic disturbances and mistaken policy actions but aggravates
the adverse consequences of others.
It is thus simplistic and wrong to label
exchange-rate variability for the dollar as either good or bad.
Not even a
pragmatic variant of either the minimum-variance position or the
untramme led-marke t position can possibly be the appropriate policy far coping
with all types of economic situations.
American policymakers are better off
224
with an eclectic approach.-'
It also follows from the same analysis that it is inappropriate to
regard either the absence or the presence of variability in the dollar's
external value as a goal of Federal Reserve and Treasury policy.
Neither
the United States nor other nations have to make the artificial choice
between fixed and flexible exchange rates, and should not make it.
The
sensible strategy for the United States, acting cooperatively with other
nations, requires avoidance of a pegging of dollar exchange rates against
other major currencies and avoidance of a pegging of the
reserve position.
u. S. external
Both exchange rates and the U. S. external reserve posi
tion should be capable of substantial variability over time, depending on
discretionary policy responses to economic developments within the United
States and in the rest of the world.
I stress this case in favor of "managed floating" (or, equivalently,
"managed fixing") because policy debate about the pros and cons of exchange-market
intervention commonly fails to acknowledge the potential superiority (sometimes
even the existence) of an eclectic approach.
As an example of the tendency
to polarize the choices, consider the letter inviting us to testify in these
hearings.
It identifies two alternative strategies: strategy 1 would place
"top priority an halting the decline in the value of the dollar," while
strategy 2 would "concentrate on establishing and remaining on or near a
long run disinflationary monetary growth target path."
By implication, so
as to be sure of achieving the target path for the money stock, the Federal
Reserve under strategy 2 would not engage in exchange-market intervention
(except perhaps transitorily in cases of disorderly market conditions).
*/ The conclusions in this and the preceding section are drawn from the
analysis in part 5 of my forthcoming book Money and Monetary Policy in
Interdependent Nations.
225
The choice between those two strategies is portrayed as an either-or matter.
But far the reasons I have summarized, neither strategy is attractive as
a guideline far the international aspects of Federal Reserve policy. American
economic objectives have a better chance of being achieved if the Federal
Reserve follows a discretionary differentiated approach, trying to tailor
exchange-market intervention to current and prospective circumstances affect
ing the domestic economy and the global economy.
Guidelines far Domestic Monetary Policy
Appropriate guidelines far the domestic aspects of monetary policy are
similar to those I have just summarized for the external aspects.
In
particular, any simplified strategy that requires the Federal Reserve to
focus exclusively on a "price" variable (an interest rate) or exclusively
on a "quantity" variable (a financial aggregate) cannot be appropriate in
all circumstances.
Consider the issue of which variable the Federal Reserve should use
as the main instrument in its operating procedures.
For example, does it
make a great deal of difference whether the Federal Reserve selects the
interest rate on Federal Funds or the quantity of unborrcwed bank reserves
as its day-to-day operating instrument?
The choice of the main instrument can be an important matter if the
instrument, once chosen, is "pegged" at a particular setting far a lengthy
period.
Especially troublesome problems can arise when an interest-rate
instrument is pegged or changed excessively sluggishly (as monetarist
economists, correctly, have long pointed out); when nonpolicy disturbances
occur in the real sectors of the economy, monetary policy can then have
226
procyclical rather than anticyclical influences on the economy.
But
there are also circumstances (for example, autonomous shifts in the demand
for financial assets) when it is definitely incorrect to peg a quantity
instrument.
Just as with variability in exchange rates, there are some
occasions when variability in interest rates is appropriate and other occasions
when it is not.
However, the choice of the main instrument of monetary policy need not
be an important issue.
If the Federal Reserve discretionarily adjusts the
setting on its instrument fairly promptly to developments in the economy,
either an interest rate or a financial aggregate can be used with roughly
similar results.
Nothing in economic analysis argues persuasively that a
quantity instrument is inherently superior to an interest-rate instrument,
or vice versa.
An exclusive concentration on a quantity or an interest rate becomes
still more problematic if the Federal Reserve tries to conduct monetary policy
with an intermediate-target strategy.
The term "intermediate variable"
refers to all variables in the economy that are not policy instruments or
ultimate targets.
The money stock is an example of an intermediate variable
and the one most commonly selected as the pivot in an intermediate-target
strategy.
Intermediate variables are not pursued in their own right as
final goals of policy; and although they can, like ultimate targets, be
influenced by the instruments of the Federal Reserve, they cannot be controlled
precisely.
An intermediate-target strategy focused on the money stock decomposes
the complete decision problem facing the Federal Reserve into two subordinate
227
problems, with decisions at the two levels made separately and sequentially.
The upper-level decision in such a strategy involves reasoning backward from
desired time paths for the ultimate targets to a target path far the money
stock.
The lower-level decision takes Ifae upper-level target path for
money as given and determines time paths for the instrument settings designed
to keep the actual money stock tracking as closely as possible along its
target path.
An intermediate-target strategy presupposes different periodicities
of decisionmaking for the two levels.
Upper-level specifications of the
target path for money are revised only periodically (far example, once
a quarter or once every six months); but lower-level decisions are revised
more or less continuously —
every day dr every week —
in response to observed
discrepancies between the actual money stock and its target path.
A given
upper-level specification of the target path for the money stock thus becomes
a surrogate for the ultimate objectives and is the day-by-day operating
objective of lower-level policy actions.
But why, it should be asked, is there a need to decompose the overall
decision problem into two stages?
What justifies the differences between
the upper-level and lower-level periodicities of decisionmaking?
An obvious
alternative is to derive preferred time paths for policy instruments from
the best feasible paths of ultimate target variables in a single-stage inte
grated decision (for short, "discretionary instrument adaptation") rather
than interposing a two-stage process that pivots on an intermediate surrogate
target.
Four -types of justification far the two-stage characteristics of a money
strategy are conceivable.
They assert that a money strategy (1) makes mare
228
efficient use of the flew of new information about the economy, (2) copes
more successfully with policymakers' uncertainty about how the economy func
tions, (3) takes better advantage of game-tieoretic, expectaticnal interactions
between policymakers and* the private sector, and (It) provides better insula
tion far monetary policy from the political process and from human error.
It is not feasible to include an assessment of these rationales here,
even in summary form.
But it can be shown that each of the justifications
is analytically inadequate.
Indeed, the first two are flatly wrong; a
money strategy is demonstrably less efficient in processing new data about
the economy and less successful in coping with uncertainty than a singlestage strategy of discretionary instrument adaptation
Conducting monetary policy with a two-stage money strategy is an
inferior approach even when the behavioral relationships underlying the demand
for and supply of money are reasonably well behaved.
But in periods when
innovations in the financial sector are numerous and quantitatively impor
tant, that approach is especially problematic.
The last few years, of course,
have been a period of rapid innovation; a partial list of major developments
includes NOW accounts, money-market mutual funds, ATS accounts at commercial
banks, six-month money-market CDs at thrift institutions, security repurchase
agreements, and more extensive use of Eurodollar borrowings.
*/ All of the possible justifications far a two-stage money strategy
are analyzed and rejected in Money and Monetary Policy in Interdependent
Nations, part 4.
229
I have identified two issues in these observations about the domestic
operating procedures of the Federal Reserve.
of the issues —
procedure —
To sum up my conclusions, cue
the question of a two-stage versus a single-stage decision
really ought to be a non-issue; when examined closely, the
case for a two-stage money strategy does not stand up to careful analysis.
The other issue —
instrument choice —
can only be a major issue if the
Federal Reserve is prone to pegging its instrument settings or to adjusting
them excessively slowly.
Many economists seem to believe that the Federal Reserve’s operating
procedures are fundamentally important.
They pose the issues in terms of
money versus interest rates, and monetarism versus Keynesianism.
But in
my view, that way of characterizing the issues is overblown and unhelpful.
Monetarists who argue against stabilizing interest rates are right —
some of the time.
ties are right —
Keynesians who argue against stabilizing financial quanti
some of the time.
Again, however, the key point is that
neither a price-stabilization nor a quantity-stabilization presumption is
the appropriate guideline for domestic monetary policy in all circumstances.
Awkward though the truth may be, no good reason exists far the Federal
Reserve to emphasize quantities instead of prices (interest rates), or prices
instead of quantities.
As operas require a libretto and a scare, a sensible
approach to national monetary policy requires an integrated perception of
both prices and quantities, combined with a discretionary differentiation of
decisions in accordance with the current and prospective circumstances of
the national ecanony.
55-1 23
0
-
8 0 - 1 5
230
Ultimate Goals:
I
The Real Business of Congressional Oversight
have thus far commented mainly on the operating procedures with which
the Federal Reserve conducts monetary policy.
Although important for
Federal Reserve decisions from day to day, those procedures are
not the aspects of monetary policy that merit the greatest attention of the
Congress.
Indeed, in my view, Congressional oversight of monetary policy —
of the October 6th decisions of this year, and also more generally since
the passage of House Concurrent Resolution 133 —
has devoted excessive
emphasis to the Federal Reserve's operating procedures.
Congressional oversight of prospective decisions should normally avoid
anticipating or second guessing the Federal Reserve’s judgments about which
settings on monetary-policy instruments are most likely to attain the path
for the economy that is the objective of policy.
For retrospective evalua
tion of policy, some amount of Monday morning quarterbacking is inevitable
and desirable.
Even for retrospective evaluation, however, the Congress
should avoid entrapment in the technical details of operating procedures.
What the Congress is preeminently qualified to do, and where it should
concentrate its attention, is to help determine the target path for the
economy at which the Federal Reserve should be aiming.
In effect, Congress
should participate actively in identifying the set of trade-offs among the
ultimate target variables of policy that seems feasible and, within the set of
outcomes regarded as feasible, the choice of that outcome judged to be
desirable.
The Federal Reserve tends to be reluctant, except in vague terms, to
discuss its ultimate objectives with the Congress and with the public.
231
The reluctance is partly due to lack of clarity in the Federal Reserve's cwn
internal deliberations about hem to trade the ultimate target variables off
against one another.
Part is also due to an instinct to avoid controversy;
if the Federal Reserve has noticeably different views about the goals of
policy from those of the Congress and the Administration, there is a better
chance of the Fed being able to pursue its different goals if it can avoid
discussing them openly.
To an extent that continually surprises me, the Congress has been willing
to let the Federal Reserve get away with vague statements of ultimate goals
and the trade-offs among them.
Almost as if by common consent, the most
difficult and most important issues are avoided by both sides.
House Concurrent Resolution 133 was an important step forward in Con
gressional oversight because it requires the Federal Reserve to testify
regularly in defense of its policies.
But insofar as the resolution has
diverted Congressional and public attention away from the ultimate goals of
Federal Reserve policy to intermediate targets for the monetary aggregates,
Congressional oversight has been weakened rather than strengthened.
A Crucial Issue;
What Target Path for Nominal GNP?
Defining appropriate objectives for U. S. economic policies is in
principle a complex exercise, not least because we are committed to a democratic
political process.
But some of the most important aspects can be simplified
by focusing attention on alternative paths for nominal GNP.
Nominal GNP is
the value of the goods and servioes, measured at current prices, produced by
the (physical and human) resources owned by the nation's residents.
If a
path for nominal GNP is chosen as a target path for macroeconomic policy, that
232
choice therefore embodies a combination of preferences about inflation
and real growth of the economy.
The actual experience of the U. S. econony in the last several
years has been an average annual increase of sane 2-1/2 to 3-1/2 percent
in real output and an average annual inflation rate of some 8 percent
(GNP deflator), and hence an average annual rate of increase of sane 12 percent
for nominal GNP.
If it were feasible to specify target paths for real growth and
inflation independently, virtually everyone in the Federal Reserve, the
Administration, and the Congress could probably agree that we should aim
for an inflation rate of at most 1 or 2 percent and for an increase in real
output at a rate permitted by increases in population and productivity —
in the range 2 to 4 percent.
say,
Those goals would together imply an annual
rate of increase in nominal GNP of no more than 5 to 6 percent.
But
it is not feasible to specify inflation and growth targets independently.
Given the present momentum of inflation in the U. S. economy, it is impossible
to attain a path along which nominal GNP grows at a 5 to 6 percent rate with
two-thirds or more of the increase representing growth in real output.
Such a path is impossible because of the nature of inflation in our
economy.
The wage-price process is characterized by a basic inertia.
Most
wages are set in accordance with complex contracts, sometimes explicit but
often only implicit; these contracts respond to economic conditions only
with a lag.
Many prices are set in accordance with complex customer relation
ships; they, too, respond sluggishly to changes in economic conditions.
Only
some prices and only a very few wages are determined in "auction" markets
where prices adjust promptly to remove excess demand or excess supply.
233
The inertia in the price-wage process means that any sudden change
in total spending in the economy has a small initial impact an inflation
and a correspondingly large initial impact on real output.
With the passage
of more time, the relative impact on inflation becomes larger.
But the
important fact is that inflation is a «law-starting phenomenon, and slow in
stopping once it gets started .i/
Because of the inertia in the inflationary process, the choice of a
path for nominal GNP to be aimed at by the Federal Reserve and the Administra
tion —
so to speak, the choice of a "demand-management" objective —
is
probably the most important aspect of choosing goals for macroeconomic policy.
In times of lew inflation, aiming at too high a path will yield short-run
gains in increased output and employment but only at the expense of triggering
a stubborn inflationary process that will feed on itself.
In times of already
rapid inflation, aiming at too precipitous a reduction in the rate of expan
sion of nominal GNP will have only a small initial payoff in dampening
inflation but a large initial impact in forcing the economy into a recession.
The most difficult and controversial choices facing policymakers about
inflation and unemployment are thus embedded in the demand-management choice
of a target path for nominal GNP.
Debate about the best feasible path
should be a central feature of the dialogue between Congress and the Federal
Reserve about the conduct of monetary policy.
* / These aspects of the nature of inflation have been carefully analyzed
by Arthur Okun; see, for example, his "The Invisible Handshake and the
Inflationary Process," Acceptance Paper for the Seidman Distinguished Award
in Political Economy (September 27, 1979).
234
The Need fo r a D iversified Macroeconomic Policy
The analysis of inflation as a slow-starting, slew-stopping process
leads to the conclusion that it is even more important than traditionally
supposed to avoid overly stimulative monetary and fiscal policies when
inflation is quiescent.
And that analysis reinforces the traditional
conclusion that inflation, once under way, cannot be stopped without a
determined policy of slewing the growth of aggregate nominal spending.
But the analysis of the inertia in the inflationary process also
highlights the high costs of aggressively trying to slew down an inflation
once it has acquired momentum.
For today’s circumstances, therefore, the
most timely inference to be drawn from the analysis is a warning about the
inefficiency and riskiness of a policy for fighting inflation that relies
solely on demand management.
The macroecanonic policy we need in the United States today is a
diversified policy that supplements prudent demand management with
"supply-management” measures that reduce costs.
The characteristics of
such a policy have been presented and widely discussed by, among others,
Arthur Qkun. * /
The main ingredients an the supply side could include: (1)
better management of the government’s own cost-raising activities (such as
acreage restrictions on agricultural output, changes in import restrictions,
and increases in the minimum wage); (2) reductions in those taxes that affect
* / In addition to Okun's Seidman lecture referenced above, see his April
30, 1979 testimony before the Special Study on Economic Change of the Joint
Economic Committee.
235
private-sector costs directly (for example, payroll taxes and sales taxes);
and (3 ) creation of tax incentives geared to wage and price guidelines for
the economy as a whole (so-called tax-based incomes policies).
Supply-management measures of this sort pose many problems, both
*/
economic and political.-'
As evidenced by the lackluster support so far
received, they are exemplars of the complex collective action that demo
cratic polities find it difficult to implement.
Yet compared with the
inefficiencies and riskiness of relying solely cm demand management for
influencing the economy, supply-management measures are less problematic
and the wisest course of action.
The Near-Term Economic Outlook
As best one can new discern the outlook for the U. S. economy, a
significant recession is in the offing during
1980.
At one end of the range
of forecasters' views, the weakening in output and employment is projected
as shallow and short.
At the other extreme, some forecasters project a
deep recession lasting well into the second half of I9 8 O; the unemployment
rate in some of these more pessimistic projections rises well above
8
percent.
The inflation rate is projected to remain high in virtually all fore
casts.
Even in the forecasts with the deepest recession, the inflation rate
falls only modestly during
the second half of
1980
from the high rates we have experienced in
1979.
*/ See the wide range of views summarized in Arthur M. Okun and George
L. Perry (eds.), Curing Chronic Inflation (Brookings Institution, 1978).
236
Unfortunately, therefore, the near-term outlook is for a sharp decline
in the rate of growth of nominal GNP.
As suggested by what I have said
about the inertia of the inflationary process, I believe it is quite
wrong to welcome such a rapid reduction in the pace of nominal demand.
Its
short-run costs in terms of foregone production and employment much more
than outweigh the short-run benefits in reducing inflation with which it
is associated.
Unless new information drastically alters the outlook,
however, a recession of some magnitude is already in the pipeline.
The
best that can be done at this point is to choose as sensible a policy as
possible taking this outlook into account as the starting point.
The unfavorable outlook for the American economy needs to be seen
in the light of likely developments in the rest of the world.
Economic
activity during 1979 had substantial momentum in most of the main European
economies and Japan.
Current forecasts for the industrial countries,
however, envisage more sluggish growth in output during 1980 —
at half the pace of 1979 —
perhaps
combined with a somewhat faster rate of inflation.
Output growth for the developing nations' economies might better maintain
its momentum early in 1980 than in the industrial countries, but their
growth could falter later in the year in response to the slowdown in the
United States, Europe, and Japan.
The reduction in Iranian oil output and the large increases in oil
prices already experienced in 1979 are an important factor contributing to
this worldwide outlook for weak growth in output and high rates of inflation.
The increases in oil prices raise the general price level and reduce output in
the oil-consuming countries (in an analogous way to increases in excise taxes).
The current-accaunt payments surpluses of the Middle Eastern OIEC countries
237
w ill become even larger in 1 9 8 0 than in 1 9 7 9 . For a sig n ific a n t number of
oil-im porting countries whose current-account d e fic its w ill correspondingly
tend to worsen, the resulting financing problems could be severe.
Because the o i l price increases and production cutbacks are a common
disturbance buffeting a l l the oil-im porting countries, they have heightened
the risks that economic a c tiv ity in national economies w ill again become
synchronized (as in the 19 72-7 3 world boom and the 197U-7 5 world recessio n ).
Further large o i l price increases resulting from the next OEEC meeting on
December 17 or any additional p o litic a l turbulence in the Middle East would
heighten these risk s of synchronization further.
At the moment, the best
guess of forecasters in the OECD and the IMF i s that the world outside the
United States w ill not experience a recession in 1980-8 1 . But the p o ssib il
it y of such an outcome is markedly greater now than i t was s ix months ago.
Alternative Policies for the American Economy
Given th is rather grim outlook, at what medium-run path for the American
economy should the Federal Reserve and Administration aim?
should be used to try to attain that path?
And what p olicie s
To oversimplify but without
d istorting the main elements of the choice, four broad alternatives may be
distinguished.
F ir st, policy could re ly so lely on hawkish demand management.
Such a
policy would accept the sharp reduction in the grcwth rate of nominal spending
brought about the recession (a f a l l from a rate of 10-12 percent per year
to a rate o f, say, 5 -7 percent) and would not take stimulative monetary or
f i s c a l action to promote a return to higher r a te s.
The aim would be to
wring in fla tio n out of the economy, paying whatever cost of lo s t output was
necessary and hoping fo r a le ss sluggish adjustment of wage-price behavior
238
and inflationary expectations than predicted "by the inertia model of
inflation.
Consistent advocates of this policy would he prepared to persist
in the hawkish demand management until inflation slewed dewn to an
acceptable rate.
The second broad alternative, like the first, would rely solely on the
traditional instruments of monetary policy and fiscal policy.
Unlike the
first, however, the stance of policy would be dovish demand management.
As soon as incontrovertible evidence of a recession becomes available,
advocates of this view would propose expansionary policies that would
promise a prompt recovery of output and employment. An effort would be
made to avoid excessively expansionary policies, but decisions would none
theless err on the side of preventing the lost output resulting from a
slack economy.
A third alternative would combine wage and price controls with some
sort of demand-management stimulus to promote economic recovery.
An argu
ment that will often be heard in favor of this alternative during 1980 is
the point.that controls have a chance of working in times of slack demand
whereas there is no hope of their being successful in a buoyant economy.
Such a policy may attract increasing support in the short run as the economic
situation worsens.
But the allocative inefficiencies of direct controls
are a decisive disadvantage.
In any case, direct controls in the past have
been politically unsustainable over a longer run.
The fourth alternative —
the one I believe is least problematic —
may be characterized as cwlish demand management combined with determined
efforts to implement cost-reducing policies on the supply side.
This policy
239
would aim for a nominal GNP path somewhere in between the hawkish and
dovish alternatives, characterized by a rate of growth that would at
first rise from the low rate of the recession quarters to, say, 8-11 percent
but would then gradually decline thereafter.
If the current projections
for 1980 begin to materialize, a tax reduction of moderate size is likely
to seem appropriate as part of the supporting policies for this path.
Such a tax reduction should be framed not only with its demand-management
impacts in mind but should also be viewed as an opportunity to institute
supply-management policies.
Tax reductions far consumers could take the
form of cuts in the payroll tax.
Busins ss tax cuts, following Okun’s sug
gestion, could link accelerated depreciation allowances to -compliance with
the wage and price guidelines of the Council an Wage and Price Stability . t /
It is not feasible here to argue the case against the first three
alternatives nor to develop the brief for the fourth.
But I do at least want
to stress that the difficult choice among the four is the key macroeconomic
decision facing American policymakers, and hence Congressional oversight
of Federal Reserve policy, in the coming year.
The Desirability of a Greater Consensus on Goals
In a federal political system with a quasi-independent central bank, a
failure to focus debate an the ultimate objectives of policy can permit a
significant but largely unacknowledged discrepancy to evolve between the
goals of the different parts of the government.
of this sort may now exist in the United States.
To some degree, a discrepancy
Implicitly if not explicitly,
* / Arthur M. Okun, "The Invisible Handshake and the Inflationary process,"
p. 17.
240
the Federal Reserve may be aiming at a low expansion path for nominal GNP
that the Congress will find politically unacceptable if it actually
materializes. To put the same point another way,.the Federal Reserve may be
willing to accept greater risks of a sharp recession ‘and a prolonged period
of severe slack than the Congress would be willing to accept if the Congress
were to focus an the risks and weigh them carefully.
If this surmise has some validity, the coming year could bring a deteriora
tion in relations between the Congress and the Federal Reserve.
If bad
progressed to worse, such a deterioration could even lead to a stop-go
outcome for macroeconomic policy, including a further twist in the fiscal-monetary
mix undermining the incentives for capital formation.
Surely the worst of
all outcomes for the medium run would be a sizable recession brought about
partly by excessively contractionary monetary policy followed "by panicky
restimulation of the ecanon$r through fiscal actions after the recession has
already hit bottom (a vigorous reflation under the leadership of the Congress
and, possibly, the Administration).
In that roller-coaster scenario, the
American econony would be subjected to all the high costs of lost output and
jobs during the recession; yet little if any longer-run improvement in the
inflation outlook might be purchased as a result.
If such a sequence of events occurred, Congress in the shorter run might
be able to indulge in the luxury of making the Federal Reserve the scapegoat
for the recession.
In the medium run, critics of fiscal policy could indulge
in the luxury of making the Congress the scapegoat for renewed inflation.
But little would be gained by such efforts to lay the blame for poor
macroeconomic policy at someone else's door.
It would be far jxreferable to try
241
new to narrcw any discrepancy in ultim ate goals between the Federal Reserve,
the Administration, and the Congress.
I f the governmental actors in the
economic p o licy process could present a reasonably united fro n t to the
private sector and the r e s t of the w orld, a much b e tte r chance would e x is t
o f staying an a steady course — and educating public opinion so that the
steady course i s a p o l i t i c a l l y sustainable one.
242
Southern Illinois
University at Carbondale
Carbondale, Illinois 62901
Department of Economics
December 5, 1978
To the participants in the Federal Open-Market Committee:
There cannot be much dispute over the fact that, in the past twenty
years, the rate of inflation in this country has shown close conformity
to the rate of monetary growth. This conformity is illustrated by the
attached diagram, which compares overlapping decade rates of change in
prices and in the adjusted monetary base (denoted high-powered money).
To reduce the inflation rate, a slowdown in monetary growth is required.
The question is, how to do it? Even a mild slowdown in the monetary
growth rate appears likely to cause further increase in interest rates and
to increase the danger of a recession. Without any political support from
the administration or Congress, the Federal Reserve will be in a very
vulnerable position to take the blame for these unpopular results. Yet
at the same time the Federal Reserve bears moral responsibility for pro
tecting the value of the dollar both domestically and on international
exchanges.
I
would like to propose a strategy which I believe can extricate the
Federal Reserve from its dilemma. Crucial to it is winning the confidence
of the financial community by establishing the credibility of the Federal
Reserve. This is possible, in large part, because if the Federal Reserve
succeeds in slowing the inflation rate, long-term interest rates will tend
to decline, and prices of marketable bonds (and probably prices of common
stocks also) will tend to rise. If the financial markets become convinced
that rising bond prices are in prospect, investors will have an incentive
to begin bidding up bond prices immediately. I believe that with proper
management, the Federal Reserve can minimize the transitional rise in
interest rates which may attend the initial phase of a monetary slowdown.
The strategy that is proposed is predicated on the assumption that the
financial markets already know that the inflation rate and the international
decline of the dollar are both responses to an excessive rate of monetary
growth, and that excessive monetary growth is the chief reason why nominal
interest rates are now at record levels. One need not believe that "rational
expectations" permeate the entire world to believe that financial practi
tioners, whose personal livelihoods are closely connected with understanding
these relationships, have been led by experience to such understanding. The
editorial position of the Wall Street Journal can be taken as representive.
However, the strategy is also predicated on the distressing fact that
the monetary interpretation of inflation and interest rates is probably not
accepted by the majority of professional exonomists in academic positions
Figure 1
Tfen-Tear Rates of Change In Adjusted High-Powered Money and in Consumer Prices in
the U.S., 19lfc-197&v
Average Annual
Percent Change
over Decade
Ik
1920
1930
I 9k0
1950
i 960
1970
244
Federal Open-Market Committee
December 1, 1978
Page 2
and is universally rejected by leaders in the administration, in Congress,
and in major private interest groups such as the housing lobby and organ
ized labor. The Federal Reserve must take more responsibility toward
promoting a better understanding of the inflation process among such
groups, and as much as feasible, among the public in general.
In terms of the actual conduct of monetary policy, the strategy is
brief and simple. The first step is to stop increasing the growth rate
of the adjusted monetary base. The next step is to announce in advance
a time table for a very gradual decrease in that growth rate. On this
matter, I have nothing to add to Arthur Bum£s remarks which appeared in
the Federal Reserve Bulletin, April, 1977, p. 362. The time table can
be a gradual one, say at the rate of one point reduction per year over
a four-year period. An escape clause could be added, such that scheduled
reductions would be suspended if the measured unemployment rate should
rise beyond a certain threshold. But it is crucial that a credible time
table be articulated in advance and adhered to.
The trick is to carry this off without a disastrous political back
lash. The Federal Reserve is not politically strong enough to achieve
this without careful preparation. The following strategy is designed
chiefly to build Federal Reserve credibility. Without same such strategy,
the Federal Reserve*s proposed monetary slowdown will not be believed by
the people who understand it (the financial community and the international
observers) and it will not be understood by political leaders o '? the general
public. The Federal Reserve must undertake to educate public opinion and
political leadership. Fortunately, the recent elections provide a handle.
In reaction to the inflation, public opinion is now pressing for drastic
cuts in public expenditures, and public officials can perhaps avert these
if the true cause of the inflation is publicized and addressed.
To prepare the way for gaining credibility, the Federal Reserve
should adopt the following measures:
1.
Federal Reserve policy should be geared entirely to management of
the growth rate of the adjusted monetary base. Current policy
procedures are distintegrated by the plethora of monetary aggregates,
none of which is truly under direct Federal Reserve control.
2.
Since the adjusted monetary base is directly controllable, the
Federal Reserve should discontinue using the federal funds interest
rate as an intermediate target for policy. Present practice has
the undesirable effect of leading people to believe the funds
rate is subject to detennination by the Federal Reserve.
3.
The Federal Reserve system should set its formidable staff of
professional economists to work preparing educational materials
which set forth in simple, readable style the impressive evidence
on the relationship between money and prices. In doing so, the
Federal Reserve has t<Kwil1ingjjaccept the responsibility for the
fact that its policies have been the cause of the inflation.
These educational materials need to be addressed to all levels
of readership. Academic economists are particularly in need of
enlightment on this count; few of them have ever been willing
to look at the historical evidence.
245
Federal Open-Market Committee
December 1, 1978
Page 3
4.
To reassure organized labor and the liberal supporters of full
employment, the Federal Reserve should develop for the future
a rule for the guidance of monetary policy. This rule should
avoid responses to recent price level movements. In the long
run the rate of increase of prices will tend to be approximately
equal to the chosen growth rate of the adjusted monetary base
(see diagram). For the short run, variations in the monetary
growth rate should be directed toward counteracting variations
in the unemployment rate. By making the target monetary growth
rate equal to, or proportional to, the measured unemployment
rate, the Federal Reserve will achieve a workable degree of
economic stabilization and will placate the anti-monetarists
(such as Franco Modigliani) who dislike the idea of a rigidly
fixed monetary growth rate.
5.
In public pronouncements and publications, the Federal Reserve
needs to stress the fact that expansionary monetary measures
tend to raise, rather than to lower, nominal interest rates.
This may be the most crucial element in a prospective educational
campaign.
It is crucial that the educational campaign begin immediately,
because without it the actual slowdown in the monetary growth rate
cannot be safely undertaken. If the country needs to go for a year
with a constant rate of growth of the adjusted monetary base, during
which time the Federal REserve formulates and articulates a simple and
plausible position (including frank acknowledgement of past mistakes),
it will not be too high a price to pay for the prospect of long run
inflation control.
If this strategy is successful, the financial comnunity will
respond in a few months. The Federal Reserve can take advantage
of the fact that corporate stocks at home and the dollar internationally
are both undervalued. The mere prospect that further monetary de
terioration will be averted will produce a recovery in those markets.
Similarly, long-term interest rates could begin to fall and bond prices
rise even before the actual slowdown in the monetary growth rate
begins.
These altered financial terms will in turn help to protect the
economy against recession. The prospect of a diminished inflation
rate will make long-term bonds and mortgages extremely attractive
to investors; the resulting fall in borrowing costs should cushion
the real sectors of the economy against decrease in aggregate demand.
If such a strategy is promptly undertaken, the actual pace of
the deceleration can be quite gradual. What is crucial is that some
deceleration, however gradual, be undertaken and on the basis of a
firm long-term commitment. Equally crucial, however, is the educational
task confronting the Federal Reserve. If that task is effectively
carried through, informed political leadership and public opinion
will become an effective protection against a recurrence of this
inflationary experience.
Sincerely,
Paul B. Trescott
Visiting Professor of Economics
55-1 23
0
80
-
16
246
MONETARY POLICY AND INFLATION
IN THE UNITED STATES, 1912-1977
by
Ronald L. Tracy *
and
Paul B. Trescott *
Department of Economics
Southern Illinois University
Carbondale, Illinois 62901
*The authors are respectively Assistant Professor and Professor in the
Department of Kconomics, Southern Illinois University - Carbondale.
247
I. Introduction.
In recent years a number of studies have supported the contention
that the current inflation can be interpreted as a response to rapid
monetary growth (e.g., Selden [1975], Mehra [1978], Barth and Bennett
[1975]). This paper compares recent price experience with the patterns
observed over the entire period since the formation of the Federal Re
serve system. Particular attention is directed to lagged monetary’
effects and their stability over time. Significant influence from mone
tary policy to the price level can be observed during most of the period
1912-1977. But there have been significant variations in the magnitude
of the monetary impact and in the time-lag patterns. As this study
utilizes only annual data, conclusions with respect to time lags are
necessarily tentative. Further inquiry using monthly data over the same
period is now under way.
II. The Model.
The simple demand for money function,
In ^
In Q - 32 In R + u
(1)
is used as the basis for our study, where Q represents real output, R
interest rates, P the price level and u the unobserved disturbance term.
The price level is assumed to change in response to a discrepancy between
the desired and actual stock of money. Rearranging equation (1) to solve
for In P and assuming that money demanded is equal to the existing supply,
we obtain,
In P ■ 6Q - 6j In Q + 62 In R + 63 In M + v
(2)
Because of the strong time component in real output, the price level and
nominal money balances (Laidler, [1971]), it is more appropriate to specify
248
model (2) in terms of first differences, resulting in the model,
ln Pt " ln Pt-1 = 64 ~ V ln Qt " ln Qt-1} + 62(ln Rt ‘ ln Rt-1}
♦ «3(ln Mt - ln Mt_1) + W.
(3)
(It should be noted that this is equivalent to adding a time trend to
model 2 where 6^ is the coefficient of the time trend). However,
estimates using the levels of the data are reported in the appendix.
To minimize the problem of monetary endogeneity, high powered money
(currency plus bank reserve deposits) adjusted for the dollar equivalent
of changes in legal reserve requirements is used instead of
or M2,
since HPMA is viewed as a relatively unbiased measure of monetary policy
(Brunner and Meltzer, [1964]).
In addition, since many authors have shown
that money balances have an impact on prices for many years, the monetary
variable will be represented by a distributed lag structure.
In place of
real output, a measure of working-age population (POP) and worker pro
ductivity (PROD) are used while the interest rates are measured with the
Aaa corporate bond rate since a long term interest rate seems more
appropriate using yearly data.
Finally, the consumer price index is used
as a measure for price. Model 3 as a result can be rewritten as,
Ain CPIt = Yq " Yi Ain POP^ - Y£ Ain PROD^. + Y3 Ain Aaa
+
Ain HPMAt + Yg Ain HPMA^^ + • • • +
Y4+£ Ain HPMAt Jl + wt , t = 1, . . . , n
(4)
'Hie disturbance terms w^ will be assumed to satisfy the classical assump
tions, although some of these assumptions will be tested.
III. Tlie Statistical Analysis.
111.1 1912-1977 period
Since many recent studies have shown that the current response of
249
price to money growth takes around four years (DeLeeuw and Gramlich [1969],
Andersen and Carlson [1970], Selden [1975], Mehra [1978]), the first task
is to examine if this response framework has existed since the inception
of the Federal Reserve System.
In order to test this initial hypothesis,
a number of tests for stability of the regression coefficients over time
are used. The first and most straight-forward test uses the "homogeneity
statistic,” which is a generalization of the well known Chow test (Chow
[I960]). The remaining two tests were developed by Brown, Durbin and
Evans [1975] and use recursive residuals. These residuals are obtained by
estimating the model with the first K (number of exogenous variables in
the model) observations and then reestimating the model after adding one
additional observation. The string of residuals associated with each
additional observation are the recursive residuals. The first statistic
involves the cumulative sum of the recursive residuals (hereafter CUSUM)
while the second statistic involves the cumulative sum of the squared
recursive residuals (hereafter CUSUM SQ). Because there are only N - K
recursive residuals, it is imperative that both tests be undertaken using
a forward and backward ordering of the observations. Since under the null
hypothesis of a stable relationship over the entire time period a backward
ordering is as appropriate, although not as intuitively appealing, as a
forward ordering, this presents no problem.
In analyzing the period 1912-1977 with model (4) using four lags of
high powered money one obtains (t-ratios are in parenthesis),
250
Eq. 1
Ain Pt * -.0089 + .0568 AlnPOPt - .096 AlnPR0Dt + .3066 AlnAaa*.*
(-.4480) (.0504)
(-.5079)
(3.8813)
.2993 AlnHPMA^ - .0727 AlnHFMA^^ + .3428 AlnHPMAt_2 +
(2.5255)
(-4.678)
(2.0744)
.1290 AlnHPMAt 3 - .0512 AlnHFMA^^, t = 1912...... 1977
(.8466)
(.4434)
R2 - .4640, R2 * .3888, a « .0426,
DW - .9462, F = 6.1681
In addition to the above summary statistics, the homogeneity statistic
for three subsamples of equal size that are mutually exclusive and
exhaustive of the entire sample is 2.704. Under the null hypothesis of
a homogeneous sample period, this statistic is distributed as F with 18
and 39 degrees of freedom. The sample statistic rejects the null
hypothesis at the 1 percent level. This finding of instability is further
supported by Brown and Durbin*s tests.
In using the forward ordering, the
CUSUM statistic is .9505 (rejecting homogeneity at the 5% level) and the
CUSUM SQ statistic is .2814 (rejecting homogeneity at the 1% level) while
the backward ordering yields a CUSUM statistic of .7595 (does not reject
homogeneity at the 10% level) and a CUSUM SQ statistic of .3976 (rejects
homogeneity at the 1% level).
III.2 Subperiods of Stability.
In trying to identify the periods of stability within the 66 year
period under examination, a three stage strategy was employed. First
Quandt*s Likelihood Ratio Statistic (Quandt [1958, I960]) was examined
251
for large negative values (although the distribution of the statistic is
unknown, some indication of the changing point between different popula
tions is given by large values of the likelihood ratio). Second, an
examination of the plot of the CUSUM SQ residuals normalized at successive
time periods is made.
In analyzing this plot, periods where a slope change
occurs should be noted. After tentatively identifying subperiods of
stability with these two stages, the third stage involves an analysis of
the end point residuals derived from regression estimates for each subperiod.
Using this strategy, subperiods of relative stability are identified
as 1912-1930, 1930-1935, 1936-1958, 1957-1977. Because of the constraint
of using yearly data, the short 5 year period 1931-1935 is omitted from
the analysis. Since HPMA was rising in 1930-33 while prices were falling,
the model is clearly inappropriate for that period.
To analyze each of these subperiods (containing 19, 23 and 21 observa
tions respectively) with models involving a variety of different length lags
would severly curtail degrees of freedom. To solve this dilemma, a second
degree polynomial (Almon) distributed lag in high powered money is used to
represent the HPMA term in model 4). In addition, since no end point
restrictions are inposed, the resulting shape is not affected by this
often made criticism (Dhrymes [1971], Schmidt and Waud [1973]).
In order
to determine the proper length of the lag, each period is analyzed using
a second degree polynomial with lags ranging between 3 and 9 periods. The
minimum squared error criteria was then used to choose the statistically
appropriate model (Maddala [1077], p. 359). With relatively weak assumptions
this procedure is equivalent to maximum likelihood estimation (see appendix
1). Table L compares the error sum of squares of each model and period.
252
From these results it is apparent that in every case the "likelihood
contours'1 are relatively flat in the area under examination. Asterisks
indicate the number of lagged HPMA terms which minimized the error sum
of squares in each subperiod:
five, for 1912-1930, and eight for both
1936-58 and 1957-77. Estimates on these bases (and closely related ones
for comparison) are reported in the following.
III.3 1912-1930.
Estimates of model 4) for 1912-1930 are presented in Table II.
Equation 2 contains five lagged HPMA terms, the number which minimized
the error sum of squares. Since Equation 2 implies significant HPMA
impact back only to t - 2, an estimate containing only three lagged HPMA
terms is also shown (Equation 3).
(A strong case could be made for
estimating the model using a geometrical declining weight structure; how
ever, for fear of introducing autocorrelation into our model a Koyck
transformation was not performed.) Although the total inpact of the
monetary variable is similar (1.243 as compared with 1.276), Equation 3
implies significant HPMA impact for only periods t and t - 1. However,
the stability test applied to both models rejects Equation 3 at the 10
per cent level (ClISUM SQ., forward), so the longer lag seems more appropriate.
Both equations fit extremely well for first difference estimates, with
2
adjusted R values around 0.87. This is a period which includes the sub
stantial wartime inflation, a drastic price decline in 1921-22, and
comparative price stability in the remainder of the 1920s. Virtually all
the explanatory power derives from the monetary variable, as the parameter
estimates for population, productivity, and the interest rate are all
statistically insignificant. The Durbin-Watson statistic falls in the
upper region of the inconclusive range and thus the assumption of firstorder auto-regressivity cannot be rejected.
253
Table I: ERROR SUM OF SQUARES USING A SECOND DEGREE POLYNOMIAL
DISTRIBUTED LAG.
Period
Lagged HPMA
Terms
(years)
1912-30
1936-58
1957-77
3
.0092
4
.0095
.0105
.0013
5
.0091*
.0104
.0012
6
.0092
.0107
.0012
7
.0114
.0103
.0012
8
.0125
.0089*
.0011 *
.0095
.0012
9
*Minimizes ESS.
.0014
254
Table II:RESULTS OF ESTIMATING MODEL 4, 1912-1930
Eq. 2
5 year lag
Eq. 3
3 year lag
Const
-.0285
(-1.1609)
-.0281
(-1.1497)
PBODt
-.2795
(-1.6424)
-.2447
(-1.4358)
Aaat
.1780
(1.1376)
.1663
(1.0629)
P0Pt
.6580
(.5602)
.7179
(.6105)
HPMAt
.7136
(6.0487)
.7553
(5.2422)
HPMAt-l
.3689
(6.4799)
.3201
(3.4788)
”^ - 2
.1325
(2.5766)
-0931
(1,0973)
HPMAt_3
.0042
(.0847)
HPMAt_4
-.0158
(-.3664)
H P M ^ .g
.0 72 4
( .7 7 9 8 )
.0744
(.6281)
Sum of IIPMA Coef
ZYt-i
1.2758
(5.5135)
1.2429
(6.2580)
R2,!*2
.9104
.8656
.9102
.8653
^,F
.0276
20.327
1.0277
20.2683
19
1.6310
f
DW,N,K
1.7064
7
CUSUM Backwards
.5321
.5733
CUSUM SQ. Backwards
.2014
.3186
CUSUM Forward
CUSUM SQ. Forward
.4579
.2084
.5562
.3773
19
7
255
Additional equations for 1912-1930 are shown in the appendix tables.
Equation 18 estimates the level of ln CPI using all the explanatory
variables. Equations 22 and 25 explain prices by only the HPMA variable
for first differences (22) and levels (25). The sums of the HPMA
coefficients for these three equations are .970, 1.270, and .827.
III.4 1936-58.
Table III presents estimates for the period 1936-58 using eight
lagged HPMA terms, (Equation 4) the number which minimized the error sum
of squares. One bothersome feature of these results is that the highpowered money coefficients increase as they recede in time and show no
indication of turning down as would be expected. For comparison, Equation
5 shows the results when nine lagged HPMA terms are used. Equation 5 does
display the expected decrease in the most remote HPMA coefficients.
Goodness of fit for 1936-58 is fair, with E2 values around 0.6, but
distinctly inferior to those for the other two subperiods. The impact of
the monetary variable is substantially less than unity, being on the order
of 0.5. And the impact of monetary policy is subject to a very long lag.
In both equations 4 and 5, the HPMA values for periods t and t - 1 are
insignificant, while significant monetary influence extends all the way
back to period t - 7 in both cases.
In contrast with the estimates for 1912-1930, Equations 4 and 5 show
a significant positive influence for the interest rate. This supports the
belief that two very different mechanisms were at work in these two periods.
The productivity variable is also highly significant with the expected
negative sign.
Hie Durbin-Watson statistic does not reject the hypothesis
of no.autocorrelation and the stability tests cannot reject a homogeneous
time period.
256
Table III:RESULTS OF ESTIMATING MODEL 4, 1936-58
Eq. 4
8 year lag
C0NSTt
.0077 (.2226)
Eq. 5
9 year lag
.0199 (.5617)
PRODt
-.7979 (-3.7779)
-.8392 (-3.8206)
Aaat
.2519 (2.8581)
.2661 (2.9448)
POPt
.6013
(.1933)
HPMAt
.0297
(.6090)
HPMAt.1
.0319 (1.1728)
.0323 (1.1350)
HPMAt_2
.0358 (1.7419)
.0462 (2.4474)
HB1At_3
.0413 (1.7272)
.0560 (2.7228)
HPMAt_4
.0483 (1.8468)
.0617 (2.5411)
HPMAt_5
.0570 (2.3082)
.0633 (2.5069)
HPMAt_6
.0673 (2.9028)
.0608 (2.5915)
HPMAt_7
.0793 (2.4990)
.0542 (2.3916)
HPWVt_8
.0928 (1.7236)
.0435 (1.4385)
HPMAt_9
-.4599 (-.1464)
.0143
.0287
(.2916)
(.5929)
Sum of HPMA CoefJ
Zyt _±
-4835 (3.7869)
}
.4608 (3.2629)
R2, R2
.7405
.6432
.7213
.6168
S, F
.0236
7.6105
.0244
6.9008
EW,N,K
1 8965 23 7
1.9543
23 7
CUSUM Backwards
.5584
.6841
CUSUM SQ. Backwards
.1654
.3218
(USIJM Forwards
.3797
.5594
CUSUM SQ. Forwards
.0877
.07447
257
Additional equations for 1935*58 are shown in the appendix tables.
(Equations 19, 23, 26).
The sums of the HFMA coefficients for these
three equations are .601, .476, and .408.
III.5 1957-77.
For 1957-77, estimates are again presented using eight lagged HPMA
terms (Equation 6), the number which minimized the error sum of squares.
Since the last three HPMA terms are not significant, Equation 7, using
only six lagged values, is shown for comparison. Both imply very similar
lag patterns, with significant HPMA impact beginning after one year and
extending back through t - 5. The average lag is thus greater than for
1912-30 but less than for 1936-58.
2
Goodness of fit for 1957-77 is again very good; the R values are
very similar to those of 1912-30, being in the neighborhood of 0.89.
The
total monetary impact is slightly less than unity, with equation 7 coming
much closer (0.88) than equation 6 (0.82).
Productivity is highly sig
nificant and negative, but the interest rate and population are not sig
nificant.
The Durbin-Watson statistic cannot reject the null hypothesis
of no first-order autocorrelation.
Additional equations for 1957-77 are given in the appendix (Equations
20, 24, 27).
The sums of the HPMA coefficients yielded by these equations
are 1.233, 1.139, and 1.153.
In contrast with our two earlier subperiods, the estimates for 1957-77
cannot pass all the homogeneity tests.
Thus we are left with the possibility
tluit liquat ions <> and 7 do not represent stable relationships equally valid
for the entire period 1957-77.
A number of exploratory estimations prompted by the lack of stability
produced rather inconclusive results. A few interesting findings can be
258
Table IY. RESULTS OF ESTIMATING MODEL 4, 1957-77
Eq. 6
8 year lag
Const
.0438
(2.4320)
PRODt
Eq. 7
6 year lag
.0402
(2.2454)
-0.7736
(-4.4958)
Aaat
.0053
(-.1508)
B0Pt
-1.3122
(-1.3469)
.0474
(.4876)
.0400
(.2438)
.1189
(2.4053)
.1081
(2.2170)
IIPMAt_2
.1645
(5.3775)
.1526
(2.1644)
HPM/Vt _3
.1842
(4.5970)
.1736
(1.7997)
HFMAt , 4
.1779
(3.6418)
.1709
(2.1540)
HPMAt_5
.1457
(2.9290)
.1446
(2.5555)
.0876
(1.8160)
.0947
(.6165)
.0036
(.0590)
-.1064
(-1.0943)
.8845
(6.2300)
HPM&t
UPM^t.g
Sum of HPMA Coef.V
.8236
(5.4578)
R2,E2
.9215
(.8879)
o,F
.0088
27.393
T.y t r i
}
DW,N,K
1.5218
21
7
-0.7252 (-4.3103)
.0080
-1.2572 (-1.2829)
.9152
(.8789)
.0092
1.5265
OJSUM Backwards
.67725
.3663
QJSUMSQ. Backwards
.3011
.1046
CUStM Forwards
.5429
.3185
QJSUM2 Forwards
.4607
.4155
(.2338)
25.1971
21
7
259
briefly summarized as follows:
a. The model was estimated for the entire period 1936-77. As one would
suspect, this period is unstable', failing the backwards ordering of
the CUSUMand CUSUM sq. test.
In addition, a Chow test (simple foim
of the homogeneity statistic) applied to the 1936-56 versus 1957-77
subperiods also rejects (at the one per cent level)
the homogeneity
of the entire period (lending some credence to our original division).
b. A series of 21-year overlapping regressions were estimated for 1936-56,
1937-57, . . . , 1957-77. Scanning these revealed a tendency for the
interest-rate coefficient to decline and, after 1950-70, the sum of
the HPMA coefficients to rise (Table V). The average lag fell
substantially after 1950-70 also.
c.
Another series of regressions were estimated for 1936-63, 1936-64, . . . ,
1936-70. The estimate for 1936-63 passed the homogeneity test, but
those for longer periods showed progressively poorer homogeneity
qualities.
Many of these issues can better be investigated with monthly data.
But it may be that it is unrealistic to assume there is a model with an
invariant lag structure under the conditions of the 1960s and 1970s.
Perhaps
the period calls for a model in which variation in monetary impact and
length of lag can themselves be explained.
IV. Some Interpretations.
Kach of the three subperiods emphasized here contains a major in
flationary episode as well as a number of years of relative price stability.
For each subperiod, the data are consistent with a monetary interpretation
of the inflation and of the noninflationary episodes as well.
But it is
Table V:
ESTIMATE OF NDDEL 4, FOR DIFFERENT PERIODS BETWEEN 1936-1977.
Years
Sq. 8
1956-19S6
CONST
PROD
.0049
-.7899
POP
.2705
Aaa
HPMA
HFMA_^
HPMA.2
HFWA.j
HPMA.4
HPMA.5
hpma_6
hpma_7
.2744
.0425
.0418
.0432
.0468
.0526
.0605
.0705
.0826
.0969
.0843
.1275
.1743
.2269
.2874
.3579
.4405
.5374
Curailative e f fe c t
sq. 9
1940-1960
-.0058
-.7386
1.526
.2133
.0382
Cun.
Sq. 9
1945-1965
-.0253
-.5870
2.973
.1706
.0929
Cun.
Eq. 10 1948-1968
-.0143
-.2154
1.2961
.1338
.1301
Cun.
Bq. 11 1950-1970
.0013
-.6424
1.595
.0732
Cun.
Eq. 12 1952-1972
.0150
-.0053
-.2393
.9364
.0319
Cun.
Bq. 13 1953-1973
-.0052
-.0058
-.2543
.8489
.0296
.0138
-.6138
-.0785
.0114
.0438
-.7737
-1.312
.0053
Cun.
-.0180
-.7211
3.095
.1272
.0392
.0470
.0585
.0738
.0929
.1157
.1473
.1942
.2528
.3266
.4194
.5351
.0616
.0413
.0318
.0332
.0455
.0685
.1025
.1474
.1545
.1958
.2276
.2608
.3063
.3748
.4773
.6247
.0877
.0567
.0368
.02S1
.0308
.0446
.0697
.1061
.2179
.2746
.3113
.3395
.3703
.4149
.4846
.5908
.0202
.0415
.0586
.0717
.0806
.0853
.0859
.0825
.3527
.4386
.5211
.0565
.1151
.1868
.2674
.1570
.1053
.0269
.5250
.6820
.7874
.8143
-.0820
.0134
.0474
Cun.
Bq. 16 1936-1977
.0351
.1081
.1818
Cun.
Eq. 15 1957-1977
.0348
.0730
.0130
.0955
.1511
.1798
-.0962
-.0332
.01233
.1634
.3432
Cun.
Bq. 14 1955-1975
HPMA.f
.0197
+.0254
.1064
.1610
.1890
.1906
.1658
.1145
.0368
-.0566
.0499
.2108
.3998
.5905
.7563
.8708
.9075
.0885
.1428
.1759
.1880
.1791
.1492
.1020
.2447
.4206
.6086
.7876
.9369
.0982
1.035
.0264
1.061
.1189
.1645
.1842
.1779
.1457
.0876
.0036
-0.1064
.1663
.3308
.5150
.6929
.8386
.9262
.9298
.8234
.0219
.0273
.0359
.0476
.0626
.0807
.1021
.1266
.0416
.0690
.1049
.1525
.2151
.2959
.3980
.5246
261
important to try to account for some of the differences between periods.
The role of interest rates provides one important basis of compar
ison.
Equation 1 indicated that for the entire period 1912-1977, the
interest rate exerted a substantial positive influence on the price
level.
There are several bases for this influence. Higher interest
rates tend to raise the velocity of money, and may also raise the money
multiplier linking the public's money holdings to high-powered money.
To the extent that high interest rates reflect inflationary expectations,
such expectations could be the basis for wage and price increases by
sellers.
(Anderson and Carlson [1970])
In 1912-30 and 1957-77, the interest rate responded positively to
monetary growth and price increases in a manner consistent with the
Fisher effect.
Our regression estimates for those periods indicate that
the separate influence of the interest rate was not significant.
In
effect, the interest rate in periods 1 and 3 was an endogenous variable
responding to change in HPMA through monetary effects on prices and price
expectations in the maiuier analyzed by Rutledge (
).
The interest-rate
data contain very little information not already contained in the HPMA
data.
The picture for 1936-58 is quite different.
In this period the
interest rate moved negatively with respect to the rate o f monetary
growth, in the manner depicted in Keynesian analysis.
The interest-rate
movements were not well explained by changes in HPMA; thus the interestrate series contains significant information not contained in the HPMA
data, and is statistically significant for the subperiod.
The relatively large role inplied for interest rates in Equation 1
for 1912-77 can thus be interpreted as reflecting the differences between
5 5 -1 2 3 0 - 8 0
1 7
262
periods, particular with regard to the different extent o f inflationary
expectations and other aspects of capital-market equilibrium.
The following are some factors which help explain the variations in
timing and magnitude of monetary response in the three subperiods:
1912-1930. Domestic monetary and financial conditions were significantly
influenced by international forces, especially during World War I.
In
1914-18, European demand for U.S. goods was financed in part by gold flows
and in part by liquidating investments and borrowing. These influences
tended simultaneously to raise HPMA, prices, and interest rates.
However,
Federal Reserve policy was clearly responsible for the sharp expansion and
contraction of HPMA in 1918-21, and for its very slow growth in the 1920s.
The timing of the interest-rate decline after 1920 suggests that the
Fisher effect was operating. A slight downtrend in the currency and
excess-reserve ratios between 1912 and 1930 helps explain why the response
of prices to HPMA would be slightly greater than unity.
1936-58. This period was marked by conditions of disequilibrium in the
monetary system, in the labor market, and in the capital market,
a.
Disequilibrium in the monetary system was marked by the abnormal
build-up and subsequent decline in currency and excess reserves, which
served as a reservoir for much of the increase in HPMA after 1930. The
ratio of currency to M2, which had reached a historic low of 8.2 per cent
in 1930, rose to a peak of 19.9 per cent in 1945, and has been declining
since then, though the rate of decline has been slight since 1963. Excess
reserves, which were negligible in 1929, rose to a peak in 1940 relative
to demand deposits, then were largely eliminated by 1946 and have been in
consequential since. The monetary system after 1933 was also plagued by
the existence of thousands of banks undergoing liquidation, with disturb
ing influence on credit markets in general.
263
b.
Labor-market disequilibrium was the most conspicuous malaise of the
1930s. Excess labor supply was reflected in high unemployment rates and
also in a condition in which many employed workers would have worked
longer hours at prevailing wage rates i f permitted to do so.
Labor-market
disequilibrium made the supply schedule of output highly elastic.
Hie
rise of aggregate demand after 1933 operated largely to increase output
and enployment rather than prices.
The excess supply of labor was elimin
ated by the end of 1942.
c.
Capital-market disequilibrium to an extreme degree prevailed in the
1930s and 1940s.
It helps explain the economy’ s response to expansion of
HPMA in the 1930s and 1940s, and particularly helps us to understand why
interest rates fell so markedly in the depression with so little apparent
stimulation to investment.
The fall of output from 1929 to 1933 created a large volume of excess
capacity.
Deterioration of asset values raised debt burdens and caused
balance sheets to deteriorate. Willingness and ability to borrow were
thereby impaired for business firms, home owners, and fanners. Persistent
risk aversion by lenders resulted in severe credit rationing, so that the
low interest rates which prevailed on low-risk assets were not reflected
in ready availability of loan funds to prospective borrowers.
The catastrophic experiences of the 1930s created expectations con
cerning demand, prices, and profits which were over-pessimistic. This
helps explain why the substantial inflation of the 1940s did not generate
the kind of behavior we associate with inflationary expectations.
The
velocity of money declined, and the public willingly accumulated vast
sums of interest-bearing deposits and bonds despite negative real rates
of interest.
Prices of corporate stocks rose only grudgingly.
264
Capital market disequilibrium was reflected in the decline in the
corporate Aaa bond interest rate from 5.01 per cent in 1932 to 2.53 per
cent in 1946. The low rates reached in the 1940s were not consistent
with the true value of the potential productivity and profitability of
capital goods, particularly after wartime conditions had eliminated the
excess capacity.
In the 1950s, the economy moved to eliminate capital-
market disequilibrium through a process which involved simultaneous in
crease in interest rates, stock prices, and the ratio of capital goods
to output.
This process created a bouyant economy in which prices
crept upward in spite of an extremely low rate of increase in HPMA. It
is noteworthy that the same regressions which account for the "demandpull" inflation of the 1940s also account for the "cost-push*’ upcreep of
prices after 1953, The end of the period of capital-market disequilibrium
can be identified with the tendency for the interest rate to stabilize
around 4.5 per cent in 1959-65.
1957-77. This period is relatively unique in that its substantial rate of
inflation apparently came to be fully anticipated, as reflected in behav
ior in capital and labor markets. A gradual increase in the monetary
growth rate in the 1960s initially raised output and employment, but also
generated accelerating inflation and inflationary expectations.
The rise
in interest rates was sufficiently large as to suggest that the existing
rate of inflation was full incorporated into people's expectations. Hie
learning process by which these expectations were formed probably accounts
for the gradual shortening of the lag and increase in the total impact of
monetary policy on prices.
In conclusion, the total monetary impact on prices is similar in
1912-30 and in 1957-77, the elasticity in each case approximating unity.
265
The period 1935-57 is the anomaly historically; yet it has played a
disproportionately influential role in shaping our image of the inflation
process and methods for dealing with it.
Keynesian analysis took lold.
It is the period in which the
Evidence of this period appeared to show
that monetary expansion could lower equilibrium interest rates and raise
equilibriun output and employment. The link between money and prices
appeared to be very loose, so the feasibility of government price controls
was not seriouly questioned. Actual inflation did not generate inflation
ary expectations operating on capital markets and interest rates.
Thus
the bond-price support program of the Federal Reserve did not lead to
explosive results.
Monetary policy has been the direct cause of each sustained infla
tionary experience during the lifetime of the Federal Reserve system.
However, recognition of this causation has been obscured by the rela
tively long lags between monetary stimulus and price response which have
prevailed during much of this time. Because of the lagged effects,
prices will tend to rise in the near future in response to monetary ex
pansion which has already occurred. The Federal Reserve has apparently
undertaken a systematic monetary slowdown since last October. Only i f
this is sustained are we likely to see the inflation rate diminish
appreciably.
266
Appendix I
Theorem: Assume the model,
(1)
t - 1, . . . , n
where yt is the observed dependent variable, xl t , . . . , x^t are k
independent variables, 3q, 8^, • . • >
zt_i> . . . ,
are
I
corresponding parameters
are k + 1 unobserved parameters,
successive lagged values of the variable
with
which follow a polynomial of degree m and ut
are the unobserved disturbance terms which are assumed to be independently
and identically distributed normal variates with mean of zero and constant
variance.
the lag
I
If the degree of the polynomial m is known but the length of
is not then the length of the lag that maximizes the likelihood
function is the same length which minimizes the error sum of squares using
least squares estimators of the unknown parameters.
Proof
Rewriting model (1) to constrain the parameters
to follow a
polynomial of degree m one obtains,
(2)
where A(), . . . ,
are the parameters of the m'th degree polynomial.
For
notational simplicity however model (2) will be rewritten as,
Y_ *
X3 + V\ + u
where £, X, £,
(3)
u are the straight forward model (2) while the matrix
P is an n x (m+1) matrix of variables where the (t,s)*th element equals
^ s-1
£ i
z. . . Using this simplified notation the logarithmic likelihoc
1-0
z ' x
267
function can be written as L * - y log (2tt) - y log
a2
—
Qr-XfJ-PV)’ (y-Xp-l'A).
2a
2
Maximizing this function with respect to a and using this estimator to
replace
2
a
one obtains the concentrated likelihood function,
L' = - j log (2ir) - 1
| log [(£ - Xg - PX)'(J1 - X6 - PX)].
this expression is maximized by those values of £,
(y - XB - PX)'
\9
and
Quite clearly
I
which minimize
- X3 - PX). However, this is exactly equivalent to
estimating model (3) using least squares with successive values of
choosing the result that minimizes the error sum of squares.
I
and
268
Appendix of Tables
Table A-1
Regressions in levels o f the Variables, Alnion lag
Kq. 18
liq. 19
liq. 20
1957-77
1936-58
1912-30
liq
. 21
191 2-77
HPMA
.517
(7.78)
.065
(2.53)
.247
(3.02)
(1. 59)
HPMAt-1
,
.290
(7.72)
.057
(4.12)
.161
(5.01)
(4*22)
HPMAt-2
.
.126
(2.74)
.053
(5.83)
(6.27)
096
(5.‘ 63)
IIPM/V.
t-3
•023
(.57)
.052
(5.13)
.065
( 1. 86)
12. 89)
HPMAt_4
-.01
(.62)
.055
(5.02)
.054
(1.23)
(2! 19)
HPMAt.5
.006
(.08)
.061
(6.74)
.068
( 1 . 68)
(2*. 12)
hpm^ .6
.071
(13.11)
.107
(3.93)
(2*.80)
HPMA.t-7
.084
(9.08)
.171
(6.15)
.101
(4.68)
.260
(3.87)
(1*. 14)
002
(.’ 04)
.101
097
098
089
079
065
045
027
Prod.
.084
(.35)
-.826
(4.99)
-.344
(3.11)
(2.’ 28)
Pop.
-.659
(1.89)
.236
(.35)
-.232
(.58)
C32)
(1.22)
.221
.426
(6.47)
.039
(1.43)
dll 64)
4.688
4.379
2.605
4. 652
A aa
constant
R2
l)W
.9923
1.93
.9977
2.39
.9994
2.82
s.e.
.027
.016
.007
eiipma
.945
.601
1.233
CUSIJM backward
.5743
(IJSIM Sq. backward.4468
.2020
.5149
.3292
ClJSliM forward
.6095
CUSUM Sq. forward .2881
.2434
.3606
.6538
.6063
.3987
559
107
561
967
34
601
269
Table A-2
First Difference Regressions, HPMA only, Almon lag
Eq. 22
Eq. 23
Eq. 24
1912-30
1936-58
1957-77
HPMAj.
.803
(6.32)
.009
(.14)
-.059
(.42)
HPMAt_1
.330
(3.57)
.014
(.42)
.075
(1.07)
HPMAt_2
.097
(1.33)
.022
(.87)
.172
(3.75)
^ - 3
.021
(.29)
.032
(.99)
.231
(3.66)
HPMAt.4
.017
(.18)
.045
(1.21)
.252
(3.34)
HPMAt_s
.002
(.01)
.060
(1.75)
.236
(3.20)
HPMAt_6
.077
(2.79)
.182
(2.79)
HPMAt.7
.097
(2.90)
.090
(1.13)
.120
(1.92)
-.039
(.29)
-.022
-.005
-.005
.877
.373
.746
constant
R2
DW
s.e.
ZHPMA
2.07
1.34
1.33
.030
.034
.014
1.270
.476
1.139
270
Table A-3
Regression in Levels. HPMA only. Almon Lag
Eq. 25
Eq. 26
Eq. 27
1912-30
1936-S8
1957-77
HPMA.
.501
(7.13)
-.020
(.54)
-.295
(3.49)
HPMA. ,
w
.338
(16.07)
.012
(.83)
-.037
(1.06)
HPWL ,
w
.188
(4.04)
.037
(3.98)
.156
(5.74)
HPMA.. t'-i
.052
(1.10)
.056
(3.08)
.284
(6.28)
HPMA„ .
-.071
(3.62)
.068
(3.10)
.346
(6.46)
HPMA. c
t_:>
-.181
(2.75)
.073
(3.80)
.343
(6.95)
HPMA.
t_(>
.071
(6.67)
.274
(7.28)
HPMA. -
.063
(6.04)
.141
(3.16)
HPMA. ft
tr#
.048
(1.50)
-.058
(.66)
3.226
.393
.987
.9962
1.04
0.93
1
■ '
constant
R2
DW
2.686
.983
1.09
s.e.
.035
.034
.016
EHPMA
.827
.408
1.153
271
Data Sources:
POP: Population aged 14-64, U.S. Dept, of Gomnerce, Long Term Economic
Growth, 1860-1970 (1973), pp. 200-3; 1973-75 data from current issues of
Statistical Abstract of the U.S.; 1970-72 estimated by interpolation;
1976-77 estimated by extrapolation.
PROD:
Index of labor productivity, Long Term Economic Growth, pp. 208-9;
Economic Report of the President, 1978, p. 300.
HPMA: High-powered money adjusted for changes in legal reserve requirements,
Milton Friedman and Anna J. Schwartz, A Monetary History of the U.S. 1867-1960,
(NBER, 1963), pp. 799-808; worksheets and current publications of the Federal
Reserve Bank of St. Louis. Dollar equivalents of reserve requirement changes
prior to 1950 were estimated by Professor TresCott from data in Banking and
Monetary Statistics, Federal Reserve Board, 1943, pp. 396; 340, and current
issues of Federal Reserve Bulletin.
Aaa:
Interest rate on corporate Aaa bonds, Banking and Monetary Statistics,
p. 368, Economic Report, 1978, p. 332. Values for 1912-19 were estimated
by multiplying 1.16 times the railroad bond .yields in Banking and Monetary
Statistics, p. 478.
CPI: Consumer price index, 1947-49*100, U.S. Department of Commerce, Historical
Statistics of the U.S., Colonial Times to 1960, 196 , pp. 125-6, Economic
Report 1978, p. 314; spliced backwards into data of Ethel Hoover in U.S.
Congress, Joint Economic Committee, Hearings on Employment, Growth, and Price
Levels, 1959, Part 2, pp. 397-8.
Year-to-year Changes in Cm.vnsx
Jjadex in JU.S.* 19^1977^-
Aetual changes
and .•• ehanger eistinate* % subperio* regressions for 1912-30, 1936-58> 1957-77*
rcent
fcange
272
273
References
Andersen Leonall C., and Carlson, Keith M., [1970] "A Monetarist Model
for Economic Stabilization", Federal Reserve Bank of St. Louis,
Review, April, 1970, pp.7-25.
Barth, Janes R., and Bennett, James T., [1975], "Cost-push versus
Demand-pull Inflation: Some Empirical Evidence", Journal of Money,
Credit, and Banking, August, 1975, pp.391-7.
Brown, R.L., Durbin,J., and Evans, J.M., [1975], Techniques for Testing
the Constancy of Regression Relationships over Time, Royal Statistical
Society.
Brunner, Karl, and Meltzer, Allan A., [1964], "Some Further Investigations
of Demand and Supply Functions for Money," Journal of Finance, May,
1964.
Chow, G.C., [1960], 'Tests for Equality between TVio Sets of Coefficients
in Ttoo Linear Regressions," Econometrica, 28:591-605.
DeLeeuw, Frank, and Gramlich, Edward, [1969], "The Channels of Monetary
Policy," Federal Reserve Bulletin, June, 1969.
Dhrymes, P., [1971], Distributed Lags: Problems of Estimation and
Formation, Holden-Day.
Kmenta, Jan, [1971], Elements of Econometrics, Macmillan.
Laidler, David, [1971], "A Survey of Some Current Problems," in Monetary
Theory and Monetary Policy in the 1970s, ed. G. Clayton, J.C. Gilbert,
and Sedgewik, Oxford University £ress.
Maddala,
G.S., [1977], Econometrics, McGraw-Hill.
Mehra, Yash P., [1978], "An Empirical Note on Some Monetarist Propositions,"
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Quandt, Richard, [1958], "The Estimation of the Parameters of a Linear
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American Statistical Society, 53:873:9.
Quandt, Richard, [1960], 'Tests of the Hypothesis that a Linear Regression
System Obeys Two Separate Regimes," Journal of the American
Statistical Society, 55: 324-330.
Rutledge, John, 1197 ], A Monetarist Model of Inflationary Expectations,
Schmidt, P., and Waud, R., [1973], "The Almon Lag Technique and the Monetary
versus Fiscal Debate," Journal of the American Statistical Society,
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Selden, Richard, [1975], "Monetary Growth and the Long Run Rate of Infla
tion," American Economic Review, May, 1975.
274
Table A-4
Listing of Data and Sources
YR
HPMA
Aaa
04
fc # 4 1
4 . 0 7
POP
PROD
-CPI
2 3 e 2
JO e 1
0 5
2 •4 7
4 . 0 1
r >4 e 1
2 5 . 4
3b
06
2
#63
4 . 1 3
3 -> e 4
2 7 e 1
3 8 e b
0 7
2 s 82
4 . 3 u
5 6 e6
2 6 e 9
4 0 e 0
OB
3 • 0 v
4 • 3 b
7 eo
2 b e0
3
0 9
3 • 12
4 . 2 b
y •
c 7 e J
3 o •
10
11
3 • 1 6
4 # 4 2
6 0 e6
2 6 e b
4 0 * o
3 . 2 o
4 # 4 7
6 1 e7
2 7 e 3
4 Q e-D
4 1 #-,
■ -)
e 1
e 3
12
3 . 3 b
4 e b 1
6 2 eO
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13
J . 4 £
4 • 7 1
6 3 e -»
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14
.1 • to 3
4 * 7 0
b~? e 1
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4 2 e V
1:^
3 .dti
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bo
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i6
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b o e >
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4 u e 6
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4 £ e 3
1U
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6 .6 2
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20
7 . 1 *
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6 ^eU
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21
22
6 • *'./4
3 e 9 7
71
3 4 e3
7 6 e 4
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b e 1 0
7c- e 1
3 3 eb
7 1 e 6
23
24
b . o b
.■> e 1 2
7 3 ew
b 4 e
72 e v
6 . L>7
3 e 0 0
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36 e
73 e 1
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7 • 0 3
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26
7 • 12
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29
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61
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21
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32
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3 :*e 4
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33
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4 e 0 0
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41
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2 ? . 2
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4 b e6
6 V . 7
4 3
2
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V 5 e 4
4 o e 7
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s»6«
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46
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4 7
4 £. • 6
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51
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101
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275
Table A-4 (continued)
Listing of Data and Sources
YR
52
S3
*34
5S
56
f>7
58
HPM£
45
4o • j
4 7• 1
4 7 •o
4 o sb
:j 9
). y
60
6
*
Orf • 3
o1
4 3sO
4 v •7
6?
S^eh
o3
* »0 e 0
t ?S s7
64
c>5
06
67
o8
69
70
71
id
(3
Z4
75
76
77
O i ft)
64 • t>
6 o# 1
7Hs4
7‘3 s v.
7 V ,3
tiOs 6
vl to
Aaa
C S '*6
POP
PROD
CPI
c\ e
.^#*20
^0
1 02 e £ 6 J e 0
1 vx? s '.i 6 3 e 3
1 03s u 6 6 s ->
3 s Ob
3 s 36
3•cV
1^4*-, O S w.
i 0 vj's o 70 • <1
1 u ^s 0 7 c. s^>
1 lu«u
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1 1 Qe 7 7<l5# i
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i :•£ e ti o s
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1 14 s3
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1 4 b #7
10 3 s V I u 6 s 7
4 0 4 s —* 1 OO e y
10 7 s w> i 7 3 e I
100s V
1 03 s u
1 J-v s 1 1 1 1 s V I 7 os d
137 #4
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1 1 1 S O 2 3 0 eO
143# .> 1 1 o s J ^ 43 # . >
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