View original document

The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.

FEDERAL RESERVE'S FIRST MONETARY
POLICY REPORT FOR 1979

HEARINGS
BEFORE THE

COMMITTEE ON
BANKING, HOUSING, AND URBAN AFFAIRS
UNITED STATES SENATE
NINETY-SIXTH CONGRESS
FIRST SESSION

ON
OVERSIGHT ON MONETARY POLICY REPORT TO CONGRESS
PURSUANT TO THE FULL EMPLOYMENT AND BALANCED
GROWTH ACT OF 1978

FEBRUARY 20 AND 23, 1 7
99
Printed for the use of the Committee on Banking, Housing, and Urban Affairs

U.S. GOVERNMENT PRINTING OFFICE
42-3580




WASHINGTON : 1979

COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
WILLIAM PROXMIRE, Wisconsin, Chairman
HARRISON A. WILLIAMS, JR., New Jersey
JAKE GARN, Utah
ALAN CRANSTON, California
JOHN TOWER, Texas
ADLAIE. STEVENSON, Illinois
JOHN HEINZ, Pennsylvania
ROBERT MORGAN, North Carolina
WILLIAM L. ARMSTRONG, Colorado
DONALD W. RIEGLE, JR., Michigan
NANCY LANDON KASSEBAUM, Kansas
PAUL S. SARBANES, Maryland
RICHARD G. LUGAR, Indiana
DONALD W. STEWART, Alabama
PAUL E. TSONGAS, Massachusetts
KENNETH A. McLEAN, Staff Director
M. DANNY WALL, Minority Staff Director
' STEVEN M. ROBERTS, Chief Economist
ANTHONY T. CLUPF, Minority Professional Staff Member




01)

CONTENTS
LIST OF WITNESSES
TUESDAY, FEBRUARY 20
G. William Miller, Chairman, Board of Governors, Federal Reserve System

Page

3

FRIDAY, FEBRUARY 23
Allen Sinai, vice president and senior economist, Data Resources, Inc
Edward J. Kane, professor of banking and monetary economics, Ohio State
University
H. Erich Heinemann, vice president, Morgan Stanley & Co., Inc

117
154
160

THURSDAY, MARCH 29
ADDITIONAL STATEMENTS AND DATA SUPPLIED FOR THE RECORD
Carnegie-Mellon University, letter to Senator Proxmire with statements of the
Shadow Open Market Committee from Allan H. Meltzer
248
Federal Reserve System:
Letter to Senator Stewart from G. William Miller, Chairman
109
Questions submitted by Senator Stewart with responses by G. William
Miller, Chairman
110
Monetary policy report to Congress pursuant to the Full Employment and
Balanced Growth Act of 1978:
Chapter 1. Recent Economic and Financial Developments
35
Section 1. Overview
36
Section 2. Aggregate Economic Activity
38
Section 3. Labor Markets
49
Section 4. Productivity
55
Section 5. Investment
59
Section 6. International Trade and Payments
62
Section 7. Prices
70
Section 8. Financial Markets
75
Chapter 2. Objectives and Plans of the Federal Reserve
88
Section 1. The Objective of Monetary Policy in 1979
89
Section 2. Growth of Money and Credit in 1979
90
Section 3. The Economic Outlook
98
Chapter 3. The Relationship of the Federal Reserve's Plans to the
Administration's Goals
104
Section 1. The Short-Term Goals in the Economic Report of the
President
105
Section 2. The Relationship of the Federal Reserve's Monetary Growth
Ranges to the Short-Term Goals in the Economic Report
106
National Retired Teachers Association and the American Association of
Retired Persons:
The Associations and the Elderly
215
The 1970's: Economics in Disarray
217
Restoring Economic Order
223
A Phased Reduction in the Growth of Money Stock
225
A Stable Economy versus Stable Money Markets
228
Reducing the Money Stock Growth Rate: Will It Bring on a Recession?
230
Monetary Policy for 1979
231
Employment and Inflation
235
Money: The Quantity Matters
238
Monetary Growth and Prices
239
World Inflation and Monetary Accommodation
242
Appendix
245




(Hi)

IV

TABLES, CHARTS, AND EXHIBITS SUPPLIED FOR THE RECORD
Page

Activity ratio
63
Average annual growth of capital stock
58
Consumer credit outstanding
42
Estimated impact of ATS and NOW accounts in New York State
14
Funds raised by domestic nonfinancial sectors
83
Growth of Federal Government, State and local government purchases of goods
and services
48
Growth of Federal outlays, receipts and deficit
101
Household debt repayments relative to disposable personal income and
nonfinancial corporations
85
Interest rates; short, long term
76
International comparison of investment shares, 1966-76
61
Labor costs and prices
73
Labor market
'.
50
Mi
:
94
M2
95
Ma
.'
•
96
Bank credit
97
Monetary growth as an indicator of inflation
246
Money supply growth, Mi, M2, Ms
79
Non-agriculture exports
65
Oil imports
65
Output per hour
56
Outstanding balances of money market certificates and deposit growth at thrift
institutions
81
Post-World War II trends in nominal and real gross national product and in
money stock (Mi aggregate) 1947/1977
245
Private housing starts
45
Ratio of capital stock to labor force
58
Real GNP and major sectors
40
Real GNP 1972 dollars
40
Real new orders, construction contracts, plant and equipment expenditure
99
Real personal consumption expenditure, and real disposal personal income
42
Savings rate
42
Trends and fluctuations of money, prices, output, and unemployment
247
Unemployment rates
53
Unit cost indicators
72
U.S. current account and trade balances
63
U.S. international price competitiveness
67




FEDERAL RESERVE'S FIRST MONETARY
POLICY REPORT FOR 1979
TUESDAY, FEBRUARY 20, 1979

U.S. SENATE,
COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS,
Washington, D.C.
The committee met at 10:05 a.m. in room 5302, Dirksen Senate
Office Building, Senator William Proxmire (chairman of the committee) presiding.
OPENING STATEMENT OF CHAIRMAN PROXMIRE

The CHAIRMAN. The committee will come to order.
Chairman Miller, I want to tell you how much I admire the fact
that you showed up this morning. There's every reason to expect in
this weather that it would be very hard to get through and I think
it's to your great credit that you do appear. Most hearings have
been canceled around the Hill and both Members of Congress and
witnesses just haven't been able to make it, so I am delighted that
you are here today and I'm looking forward to your testimony and
I think it is historic.
Today we begin consideration of the monetary policy plans, and
objectives of the Federal Reserve Board for the calendar year 1979.
The Federal Reserve Board has sent the Congress its report on
monetary policy as required by the Humphrey-Hawkins Act. This
is the very first time that's been done, of course, because the
Humphrey-Hawkins Act has just gone into effect in the last few
months. We are pleased to have Federal Reserve Chairman G.
William Miller with us today to explain those intended policies and
how they relate to the economic goals that President Carter has set
forth in his economic report.
These hearings and the committee's consideration of the Federal
Reserve monetary policies for 1979 mark a historic occasion.
For the first time, the Banking Committees of both the Senate
and the House of Representatives are required by law to report
their views and recommendations with regard to the Federal Reserve's intended policies to their respective Houses of the Congress.
The committee will want to analyze whether and to what extent
those policies will foster the achievement of the short-term economic goals—the goals for employment, unemployment, production,
productivity, real income, and prices—that have been established
for calendar years 1979 and 1980. The Humphrey-Hawkins Act also
requires that monetary and fiscal policy be coordinated and that
they work in tandem, rather than separately and at odds, to foster
the desired economic conditions.
(l)




you expected interest rates to remain at high levels for an extended period of time and also that the United States would continue to fight inflation by practicing tight monetary policy. I support
the conclusion that monetary policy should be restrictive until
significant progress is made in reversing the rate of inflation. That
was the major conclusion of this committee, as you know, in its last
report on the conduct of monetary policy following the hearings
which were held last November. The report also indicated that the
monetary aggregate growth rate targets should be gradually lowered and that actual growth should be kept within the bounds that
are specified.
I think that's critically important and I personally would also
like to see those money growth rate ranges narrowed. The Federal
Reserve's job is to bring the growth of money and credit down
gradually. If monetary growth is too restrictive so that the aggregates are growing at rates below the bounds you have specified the
potential economic consequences could be serious and the economic
dislocations dramatic.
Chairman Miller, I look forward to your report and your explanation as to where monetary policy is going to take the economy
this year.
I apologize for the lengthy opening statement in view of the fact
that you have been standing and not comfortably seated. I hope
that indicates you don't have a bad back.
Mr. MILLER. No, Mr. Chairman. I just thought I would experiment with standing. I think there's a certain amount of advantage
to me in being able to respond to members of the committee from
this position. At least, I'd like to experiment, if it's all right with
you, to see if this would be more comfortable.
The CHAIRMAN. That raises you to a level so our eye levels are
about the same.
Mr. MILLER. That's true to a degree. But I'm sure I'll never get
raised to the level of the committee members.
STATEMENT OF G. WILLIAM MILLER, CHAIRMAN, BOARD OF
GOVERNORS, FEDERAL RESERVE SYSTEM

Mr. MILLER. Mr. Chairman, I appreciate your holding this hearing today because I was fearful that it might be postponed. As you
know, all great events must be marked by natural phenomenon.
Nature has a way, I believe—if something is important enough—of
calling it to our attention, and certainly all of us can write in our
diaries that the first hearings on monetary policy under the Humphrey-Hawkins Act took place at the time of the great snowstorm
of 1979.
The CHAIRMAN. And in spite of it.
Mr. MILLER. And in spite of it. When I was a youngster in Texas,
we thought the great snowstorms were wonderful. We always hiked
to school and, because fewer students were there, we always had a
lot more fun; I hope we will enjoy today. Snowstorms don't try
men's souls, but they try our perseverance and our patience, and I
hope that our perseverance in the face of this weather is typical of
the perseverance we will have with the economic policies we face.
Mr. Chairman, this is our first experiment in responding to the
mandate of the Humphrey-Hawkins Act to make semiannual re-




ports to the Congress. We apologize for the fact that our report,
which was finished in draft on Friday and was to be reproduced
over the weekend, was not delivered to you earlier because of the
snowstorm. We certainly hope that such delays don't occur in the
future.
We have organized our report into three chapters that correspond to the three particular mandates to us that are contained in
Humphrey-Hawkins. We hope that this method of presentation is
beneficial and illuminating, and that we will have your comments
and suggestions on how we can improve future reports.
We have not prepared any testimony separate from the report
because it seems that the real purpose today is to review this
report, which considers, first, recent economic and financial developments; second, objectives and plans of the Federal Reserve for
the current calendar year; and, third, the relationship of those
objectives and plans to the administration's short-term goals.
It would be our hope that this report normally could be filed
enough in advance to be studied by members of the committee so
that less time need be spent in reviewing it here and more time
could be spent responding to questions. Because it has just been
delivered I thought I might hit the high spots and then file it with
the committee for the record. I would particularly like to spend a
little time on the last two chapters, where we discuss the future
rather than the past.
You have given, in your opening statement, Mr. Chairman, a
partial overview of past and more recent developments in the
economy that are important. The overview given on the first page
of our report is also worth noting.
The main thing to point out is that we are about to enter the
fifth year of economic expansion, and that, in terms of longevity, it
is a very durable expansion. We started that expansion from a very
low trough, because of the great recession of 1974-75, so that the
gains from that trough have been rather substantial.
Rather than try to cover the text, perhaps it would be helpful to
go through some of the charts and then come back to any part of
the report that is of interest.
The CHAIRMAN. Yes. It might be helpful if you would refer to the
page.1
Mr. MILLER. Certainly. The upper panel of the chart on page 5
shows the performance of the current economic cycle compared to
prior cycles. This cycle looks very much like the others except that
toward the end of the fourth year it seems to be on an upswing and
has momentum, rather than the tendency to tail off as was typical
of prior economic cycles.
The bottom panel shows over the same 4 years—actually over
one quarter short of 4 years, because our figures only go through
the fourth quarter of 1978—that real GNP has grown at an average annual rate of 5.1 percent. Housing expenditures have the
greatest expansion in terms of relative change; but since these
began from depressionary levels, a 14-plus percent average annual
increase in housing expenditures is a bit misleading. Business fixed
investment has grown at an average annual rate of 5.4 percent;
1

References are to the prepared statement of Mr. Miller which begins at page 33.




personal consumption at 5 percent; and Government purchases at
just over 2 percent.
On page 7, looking at the white bar in the upper panel, we see
that real personal consumption expenditures have generally continued very strong, running, for much of the period, ahead of real
disposable income. As a result, savings rates—shown in the center
panel—have gone down; consumers have maintained their level of
purchases by lowering their savings rates and increasing their
credit, which is shown in the bottom panel.
As a result, we have had a stronger than average contribution to
the economic upswing from consumer spending .
The chart on page 10 shows why housing has been a particularly
strong component. From the end of 1972, through the 2 years 197374, housing virtually collapsed. It was only to be expected that it
would recover from that very low level at a relatively higher rate
than other components of the economy.
It is worth noting, however, that over 1978 housing leveled off; it
did not continue to expand beyond capacity. As we know, part of
that leveling off, at a high rate, is related to demographics—the
relationship of the age of the population to needs for shelter. It is
also related to the buying of housing as a hedge against inflation,
as well as the decision of the regulatory agencies to authorize
money market certificates that allow thrifts, and thus the housing
industry, to compete with other sectors for funds. So the housing
sector has been maintained.
On page 13, we can see, in the upper panel, the growth of
Federal Government expenditures in nominal terms and in real
terms. You can see the erratic pattern; but, nonetheless, Federal
spending was a sustaining element during this cycle. In the lower
panel, we see the trend in State and local government purchases of
goods and services in 1972 dollars.
Labor market developments have been rather critical during this
time.
On the chart on page 15, we see that the growth of the labor
force has been quite rapid; greater than in any prior cycles, for
several reasons: demographics again; plus social change that has
brought more women into the labor force; plus the fact that families have, in the face of inflation, tended to add more household
members to the labor force.
Employment, which dipped rather dramatically in the 1974-75
recession, has gained just as dramatically in this expansion. A very
high rate of job creation—a record rate—has existed during this
period, so that we have seen the unemployment rate drop down its
the present 5.8 percent. It is particularly worth noting—in the
bottom panel—that the civilian employment population ratio has
risen to record levels; 60 percent of the adult population is now
actually employed. This is rather encouraging.
Page 18 breaks the unemployment rates down, showing that for
adults, the unemployment rate is now 4.1 percent; and for skilled
blue-collar workers, 4.6 percent. These are very near to where they
were at prior peaks of activity. But we haven't made that kind of
improvement in the unemployment rate for teenagers; it is still
high.




6

However, if we recomputed unemployment today using the agesex composition of the labor force of the midfifties—that is, without
the enlarged proportion of teenagers who have a higher rate of
unemployment until they gain experience—we would find that the
unemployment rate would actually be about 1 percentage point
below its present level. So the employment outlook has at least
been encouraging.
If we look at the chart on productivity, on page 21, we see a
different story: a very disturbing trend of lower output per manhour in the nonfarm business sector. From 1947 through 1967, the
annual rate of increase was 2% percent; since 1973, it's only been
1.2 percent—recently, as you know, even worse. This is quite disturbing. High compensation gains have been Made as employees
seek higher income to make up for inflation, and the combination
of high compensation gains with low productivity gains has increased unit costs and contributed to inflation.
The chart on page 23 shows part of the reason for this drop in
productivity, and that is that the ratio of capital stock to labor
force has just not kept up. Capital stock has fallen below the trend
line. The bottom panel shows that the average annual growth of
capital stock has been declining, from 5.1 percent in 1962-67, to
only 2.9 percent in the last 5 years. That is one of our difficulties.
On page 26, comparing our investment to the rest of the world,
we can see that on a real basis—I sometimes use nominal figures,
so I hope you will excuse me if in this case I use real figures—the
United States is obviously spending less on investment than other
major industrial countries: 13.5 percent in the 1966-76 period compared to 26.4 percent for Japan, for example, and to higher rates in
all the other countries shown.
I would hasten to point out that a direct comparison must be
made cautiously, but there is a significant lag in U.S. investment
that is not accounted by differences in the structure of our economy as compared to other industrial nations.
Looking at the chart on the international sector briefly—page
28—we are all aware of the ups and downs of our trade balances
over this decade: First going into a deficit, then recovering to a
surplus, and more recently going into a larger deficit. As shown in
the upper panel, both the trade and the current account balances
have shown significant deficits. But, of course, during the year 1978
there was a narrowing of the trade deficit and a narrowing of the
current account deficit, so that the outlook now is for significant
improvement in these components.
If you look on page 30, you can see a few of the reasons for this.
Nonagricultural exports have been growing in value, partially because of relatively higher growth rates abroad and also because of
the improved competitiveness of American products. The value of
these exports has gone up even more than the volume. On the
other hand, one of our major imports is oil; there, volume has been
trending down and value has stabilized for a while, although we
know with the situation in Iran that is vulnerable and could be a
difficulty for us.
The chart on page 32 tracks the exchange value of the dollar
over the last few years, and the relative consumer prices, foreign to
United States as the dollar has declined.




Mr. Chairman, before coming to prices, let me repeat something
I mentioned earlier that's shown on page 37. With compensation
per hour—the upper panel—rising rapidly in recent years (almost
10 percent if we include fringe benefits), and output per hour—the
center panel—dropping, unit labor costs have skyrocketed. Hence,
one of the difficulties we have with inflation.
Page 38 looks at labor costs and various components of prices.
Food price rises, of course, have been rapid in the last couple of
years for many reasons, including a beef cycle which has caused
substantial increases in beef prices. Energy has continued to be a
substantial component of inflation and will be so again in 1979
with OPEC price increases and the uncertainty in Iran. The bottom
panel shows the total price situation. As we know, on a GNP
deflator basis, the inflation rate last year was 8% percent, far
higher than I would have predicted when I first appeared before
this committee.
On financial markets, page 41, just a word. We know that with
the acceleration of inflation and the trend of monetary restraint
begun in 1977, we have seen short-term interest rates go up 3 to 4
percent in the last year. Long-term rates, generally have gone up
about 1 percentage point reflecting the pattern that this kind of
restraint produces.
With restraint applied, the monetary aggregates, as you pointed
out, have begun to moderate. For 1978, M! grew at a 7.3-percent
annual rate as compared with about an 8-percent rate in 1977. A
great deal of that decline in growth came in the fourth quarter; in
the fourth quarter, the rate of growth of M] was 4.4 percent. But
we must take account of the impact of the new automatic transfer
service. We believe, from our data, that to allow for that development about 1 percent would be added to MI. So one would say that
the fourth quarter showed about a 5.4-percent growth rate for MI
which does reflect the moderation that we have been endeavoring
to accomplish.
Greater of M2 slowed in 1978 to an annual growth rate of 8.5percent. No allowance need be made for ATS because any shift
from demand into savings accounts would show up in M2. The
slowing is therefore from about 9.8-percent in 1977 to 8.5 percent in
1978.
M3 growth slowed from a rate of 11.7 percent in 1977 to 9.8percent in 1978.
I mentioned the money market certificates. The chart on page 46
shows how we have avoided disintermediation in this cycle by the
authorization of the new money market certificates. As of the end
of January, there was a total of about $105 billion in money
market certificates. While not all of this represents new funds, it
does represent the holding of funds that otherwise in all likelihood
would flow out. So deposit growth of thrift institutions has been
maintained in better condition, and this has helped maintain the
housing industry.
A word about overall financial demands. If you just look at the
total funds raised by domestic nonfinancial sectors you will see
there has actually been a leveling off in overall demand for credit
in 1978, more or less at the level of 1977. You will notice there was
an expansion in demand from the private sector, which is a trend




8

that we have been encouraging so that we can shift to more activity in the private sector, less in the Federal, and attenuate the
overall demand for finance and credit.
In the credit area—page 50—we do know that one phenomenon
has been the rapid growth in consumer credit such that the
amount of disposable personal income required to meet repayments
of household debt has gone up to a high level. Part of this may be
from a demographic shift, with more younger families who are at a
stage when they need more credit. But certainly it's a worrisome
development and one that we need to watch carefully. So far,
repayment schedules have been met, and delinquency rates have
not risen, but we would be concerned if there were a slow-down in
the economy, that there might be somewhat more difficulty in
handling these repayments.
Corporations, in the face of inflation and higher interest rates
have generally preferred to finance their needs with short-term
liabilities. Hence the ratios of liquid assets short-term liabilities
have dropped off somewhat, similar to prior patterns where corporations postpone longer term borrowing because of current rates of
interest.
That, more or less, in a summary way meets the first mandate of
the Humphrey-Hawkins Act, which is to review and analyze recent
economic developments in the Nation.
I would like to turn to chapter 2. The Full Employment and
Balanced Growth Act of 1978 requires next that we report to you
the objectives and plans of the Board of Governors and the Federal
Open Market Committee with respect to the ranges of growth or
diminution of the monetary and credit aggregates for the calendar
year during which the report is transmitted, taking account of past
and prospective developments in employment, unemployment, production, investment, real income, productivity, international trade
and payments, and prices. This is what we have endeavored to do.
The objective of the Federal Reserve is to foster financial conditions conducive to a continued, but more moderate, economic expansion during 1979 that would permit a gradual winding down of
inflation and the maintenance of the stronger position of the dollar
in international Exchange markets.
Given the limited margin of unutilized labor and industrial resources remaining in the economy, it is critically important to
avoid strong aggregate demand pressures that would aggravate our
already serious inflation problem. At the same time, the current
condition of general balance in the economy suggests that it should
be possible to continue restraint to relieve inflationary pressures
without triggering a recession.
Mr. Chairman, the specific targets that the FOMC has set are
reflected in the text of chapter 2 and, perhaps, can be most easily
seen if we look at the charts beginning on page 59.
For this calendar year, the growth range for Mi adopted at the
recent FOMC meeting is between 1.5 and 4.5 percent. You have
pointed out from time to time that you would like to see us narrow
these ranges. I call to your attention that this range involves a 3percent spread. We are conscious of your counsel in this regard,
but we felt that with uncertain conditions—and particularly with
the unknown effects of automatic transfer and other changes in




the way deposits are held and used—it was only prudent to have
an adequate range, yet one we believe to be consistent with our
overall objective of moderation.
It is our estimate that the effect of automatic transfers could
reduce the growth of Mi by as much as 3 percent from what it
otherwise would have been. However, that's a very uncertain
figure, and so we have set ranges that would create tolerance for a
greater shift to ATS or a lesser one. We realize that this is imperfect, but we believe it's a range that is consistent with our objectives and one that can be met.
As to M2, you will recall that for some time the range of growth
for M2 has been established at a rate of 6l/2 to 9 percent. The range
that has now been adopted for 1979 is lower—5 to 8 percent. Once
again, with the many uncertainties in the way that money is
behaving, we have widened the range to 3 percent, but we have
reduced the level so that we would expect even further moderation
in the growth of M2.
Mr. Chairman, I should point out that, while it is not an objective of the FOMC, it is my intention to keep track of the midpoints
of these ranges which I think will give us a better gage of how well
we're doing.
For M3, the growth range previously established was 7.5 to 10
percent; this has been lowered to 6 to 9 percent consistent with our
objectives.
As for bank credit, the range established for this year is 7.5 to
10.5 percent.
These ranges have been set in view of the past performance of
the economy, which we have discussed, and, in view of the projected outlook for the economy in the current year.
One of the elements that would appear to indicate a sustaining
of economic activity in a moderate way is shown in the upper left
panel of the chart on p. 64. There is a significant base of orders for
maintaining business fixed investment spending. Surveys indicate
there will be a continued increase in business investment but at a
more moderate pace, so this component of the GNP should be
expected to continue to grow.
The upper right panel relates to construction contracts that are
involved in business investment; they have been rather strong in
relation to overall investment. The bottom panel shows nominal
and real rates of increase in plant and equipment expenditures.
The chart on the top of page 66 shows, the growth of Federal
outlays. In 1979, the expectation is for a 9.4-percent growth in
Federal outlays; as you know, the budget report contemplates a 7.7percent growth in 1980.
The middle panel indicates a growth in Federal receipts from
about 12.3 percent in 1978, in nominal terms, to 13.4 percent in
1979, and down to 10.2 percent in 1980. This affects the Federal
deficit shown in the bottom panel: A change from about $49 billion
in 1978, to $37 billion plus in 1979, to a proposed $29 billion deficit
in 1980.
I would be pleased to go into further detail, but in order to
complete my oral presentation I might just move on to the last
chapter, the report to this committee on the relationship of the




10

Federal Reserve's objectives and plans to the short-term goals set
forth in the most recent economic report of the President.
I'd like to call your attention to a few figures on the table on
page 69 on the goals set forth in the President's economic report.
One is the level of unemployment; for the fourth quarter of 1979,
the goal is 6.2 percent; for fourth quarter 1980, also 6.2 percent. On
consumer prices, the goal for fourth quarter 1978 to fourth quarter
1979 is 7.5 percent; and for 1980, it's 6.4 percent. Real GNP is to
increase by 2.2 percent in 1979, much more moderate than the 4
percent in 1978, and by 3.2 percent in 1980.
These figures would indicate nominal GNP growth in 1979 and
1980 of about 9% percent. The ranges for the monetary aggregates
that have been adopted by the Federal Reserve will be consistent
with achieving that level of nominal GNP.
It would perhaps be worth noting that the recent reports on
early activities this year—the slowdown in personal income, housing, and retail sales in January, which, Mr. Chairman, you noted,
but which may be seasonally affected; coupled with the very disappointing performance of the Consumer Price Index in Januarywould indicate that it's going to be difficult to achieve the price
objectives of the administration program. After all, this data is
new; at the time the President's goals were established the data
was not as up to date.
We believe that the rates we have established for the growth of
the monetary aggregates are consistent with accomplishing the
President's goals. This is because of the trend toward higher velocity of Mi in the face of monetary restraint, higher interest rates,
and the tendency of indivduals and businesses to go to great extents to minimize their non-interest-bearing deposits. As a result
some additional velocity increase can be expected.
Recognizing that there is some risk and uncertainty in this situation, we do believe the administration's 1980 forecast can serve as
an appropriate goal for Congress as it considers its budgetary plan
for fiscal 1980. If inflationary pressures subsequently prove stronger than the administration has projected, then the prudent course
for Government policy would be to exercise a substantial degree of
restraint even if it risks less real growth in 1980 than the 3.2percent goal. Such a policy would lay the foundation for balanced
economic growth over the years ahead and help us to maintain the
integrity of the dollar.
Mr. Chairman, I appreciate your attention. I hope that my statement has not been too lengthy, but it is our first experiment with
this particular format.
The CHAIRMAN. Well, Mr. Chairman, I want to thank you for—if
you'd feel more comfortable sitting down, please do that.
Mr. MILLER. I may do that.
The CHAIRMAN. Whenever you feel like it, go right ahead and do
that.
I think that your review of recent economic developments has
been outstandingly good, an excellent objective report on the developments we have had in these areas, and it was not easy because
this was the first time the Board has had to do this and I think
that you and the Federal Reserve Board staff deserve a lot of credit
for a splendid review.




11
Mr. MILLER. The staff deserves the credit, Mr. Chairman.
The CHAIRMAN. Well, after all, you edit it. You could throw it
out or include it or whatever. You have to take the blame for it
too, so you deserve a great deal of credit.
Now let me just start off by saying that when we come to the
prognosis for the future, the difficulty is that it's hard to know
whether or not the Federal Reserve Board is going to be able to do
the things it indicates it intends to do. I realize that many things
are outside of your grasp. Certainly the level of inflation and
employment is something you can influence, but you could hardly
be held completely accountable for it. On the other hand, as we get
down to the monetary aggregates, the feeling is that the Federal
Reserve Board does have a great deal more responsibility.
In 1978, the old targets were for M3, which is a broader measure
of money than Mi or M2, 7.5 to 10 percent. You have just said that
we might take a midpoint as a way of finding where you really are
aiming. On that basis, the midpoint was 8.25 roughly, and actually
in 1978 M3 increased 9.4. When you come to M2, a little narrower
definition of money, the midpoint was 7.4 for your targets, and you
hit 8.5. That was well above the midpoint. And then for Mi, it was
really a disaster. You had a broad range of 2 to 6 percent and the
actual increase in Mi was 7.3. Now this, at a time when the No. 1
problem facing the country was inflation, and when monetary
policy does play an important part in inflation, it seems that the
Fed was just unable to do the job that it intended to do and unable
by a very large margin—the difference between the midpoint of 2
to 6, which is 4 percent, and the 7.3 percent you realized is about
85 percent. It's a miss which is about as wide as I can imagine.
What's your reaction to that?
Mr. MILLER. Mr. Chairman, I would like to react to all those
things, but I would just make one slight correction first. For the
year 1978 as a whole, the goal for Mi was 4 to 6.5 percent; 2 to 6
percent was set only for the third quarter of 1978 to the third
quarter of 1979 after the ATS went into effect.
My comment is that the degree of monetary restraint necessary
to bring the aggregates down to the midpoint of their ranges
proved to be more difficult and more tasking than had been expected. For much of the year 1978, Mi was above the ranges and it
ended up the year slightly above the upper range of 6.5 percent. M2
and M3 were within the established range.
I can only suggest that, given the lag effects of monetary restraint, we were able to make up for some of the earlier overshoot
by reducing the rates of growth of Mi in the fourth quarter when,
as I pointed out, Mi was, even adjusted for ATS effects, back at the
midpoint of our ranges.
The CHAIRMAN. I appreciate that, but nevertheless, the fact is
that it was an inability of the Federal Reserve Board to achieve
anything like the targets you set. You're right, of course, in correcting me, in pointing out that your range was 4 to 6.5 percent for
most of 1978, except for the last quarter, and you missed the top
part of that broad range by a considerable amount.
Mr. MILLER. That's correct.
The CHAIRMAN. In view of the fact that the overall increase was
7.3 percent. Unfortunately, I presume that this may be one of the




12

reasons why we have a more serious inflation problem than we
might otherwise have, because it affects people's expectations. Of
course, there would have been other consequences. You would have
slowed the economy a little more. We would have had higher
interest rates than we had, but the prime objective of reducing
inflationary pressures would have been better achieved if you had
been successful in achieving your goals; is that correct in your
view?
Mr. MILLER. There's no question that we should endeavor to stay
within the ranges we set. We did not accomplish that in 1978 as to
Mi. What we must be careful about now is not to drift off from our
objectives in 1979; now that we have got ourselves onto moderating
growth we must make sure that we do achieve our targets.
Mr. Chairman, you are correct, we had an overriding consideration in how we achieved the monetary aggregates. For example,
while we were staying within the ranges on M2 and M3, and we
were not in Mi, it was our judgment that the best way to get
within the range on Mi was through a progressive application of
restraint on a smooth basis rather than by creating a sudden
dramatic change that would create a shock in the economy and
have other destabilizing influences.
So we chose between getting within the range earlier and getting
there later through a smoother process that avoided dislocations.
The CHAIRMAN. Now your new targets are decisively lower. 1.5
percent to 4.5 percent at the midpoint is around 3 percent for Mi.
That would be a sharp reduction from the change of 7.3 in 1978, a
very sharp reduction, and I wonder if that's consistent with your
last remark that what you want to do is do this gradually. Is it
realistic to expect that you could have a reduction in your Mi in
the coming year to 3 percent?
Mr. MILLER. Chairman Proxmire, we have to take account of the
effect in Mi of the new automatic transfer service. Our estimate is
that that could effect as much as a 3-percent reduction in growth.
The midpoint of our present range is 3 percent; if you had a 3percent reduction from ATS
The CHAIRMAN. May I just interrupt. Can you give us the basis
for that 3-percent projection?
Mr. MILLER. It's based upon an analysis of what shifts occurred,
first, with NOW accounts in areas where they were in effect, and
the tracking of what has happened to date with ATS, which seems
to be consistent. Our midpoint of 3 percent would actually be 6
percent under a system without ATS; and 6 percent is an appropriate adjustment downward from the 7.3 percent in 1978.
The CHAIRMAN. So what you're saying is you would presume you
would have an increase in MI adjusted for the changes?
Mr. MILLER. Of 6 percent midpoint.
The CHAIRMAN. Of an increase of 6 percent?
Mr. MILLER. If the 3 percent is correct.
The CHAIRMAN. Can you give us for the record the detailed
analysis behind that figure of 3 percent?
Mr. MILLER. We will submit that.
[Chairman Miller subsequently submitted the following information for inclusion in the record of the hearing:]




13
Based on reported data, it is estimated that automatic transfer service accounts
(ATS) and (NOW accounts in New York State, introduced in November 1978, reduced MI growth, on average, over the November 1978-January 1979 roriod by
about 3 percentage points. Beginning in early November the Federal Reserve
System and the Federal Deposit Insurance Corporation collected weekly ATS and
NOW accounts data from a stratified random sample of about 350 commercial
banks. Early in the period data were also collected from a sample of mutual savings
banks but these institutions contributed less than $50 million to total ATS and
NOW accounts outstanding, and this survey was discontinued at the end of the
year.
Table 1 shows weekly universe estimates of ATS and NOW accounts deposits at
all commercial banks, as derived from the weekly sample, through the end of
January 1979. The table also shows monthly average levels and the estimated
impact of these accounts on monthly MI growth rates. Employing information from
sample bank respondents, the Board staff estimated that roughly 60 percent of total
ATS and NOW accounts reflected shifts from demand deposits included in MI.
In early February, the Board staff estimated that ATS and NOW accounts would
reduce MI growth between QIV 1978 and QIV 1979 by about 3 percentage points.
This estimate reflected not only the experience of the preceding 3 months, but also
an analysis of the experience in the New England states when NOW accounts were
authorized. The staff estimated that, in the first year that NOW accounts were
offered in Connecticut, Maine, Rhode Island, and Vermont, about 20 percent of
eligible household demand deposits shifted to NOW accounts. In that NOW account
episode, both commercial banks and thrift institutions were permitted to offer the
new service; because only commercial banks are able to offer ATS, it has been
assumed that shifts out of demand accounts into ATS and NOW accounts during the
year ending next November will only amount to between 10 and 15 percent of
outstanding eligible deposits. Employing data from the Federal Reserve's survey of
demand deposit ownership to identify the amount of deposits eligible for shifting to
ATS accounts—roughly one-fourth of all MI balances—this 10 to 15 percent shift
translates into about a 3 percent reduction in Mj over the year.1

1
It has been assumed that payment order accounts, if authorized by the Federal Home Loan
Bank Board, will have only a minor impact on MI.




14
Table 1
Estimated Impact of ATS nnd NOU' Accounts in New York State
(Millions of dollars, not seasonally adjusted)

Date

ATS
accounts

NOW
accounts

Total

Monthly
average-'

Estimated
impact
on M-l —'

Impact on
M-l monthly
per cent
annual rate
of growth

1978
November

December

8
15
22
29

770
1360
1720
2005

5
10
50

770
1365
1730
2055

6
13
20
27

2475
2835
3125
3245

125
190
270
295

2600
3025
3395
3540

3760
4025
4310
4215
4305

470
630
695
790
830

4230
4655
4940
5005
5135

1480

890

-2.8

3140

1885

-3.1

4795

2875

-3.1

1979
January

3
10
17
24
31

\J Average of weeks in the month.
2/ 60 per cent of total ATS and NOW accounts.

The CHAIRMAN. We would like to have that.
As you indicate, and you indicate properly, one difficulty here is
that when you get 1.5 to 4.5 percent or whatever, it makes it
appear that we are likely to be more precise in these areas than we
are likely to be and that we are really guessing. This is a very,
very broad measure and as you indicate it's undergoing a very big
change and we don't know how to interpret it. So I take it that
there's somewhat more reliance than maybe in the past on interest
rates and the level of interest rates and what interest rates tell us
about monetary policy and how successful you have been there.
When you appeared before the Joint Economic Committee, I
asked you, as I have often in the past, about the level of interest
rates and you argued that we have to recognize that interest rates
accommodate to inflation and that there's an inflation premium in
the rates of interest.
A recent comment by Mr. Robert Bowling of Business Week I'd
like to call to your attention because I think it's a remarkably
acute analysis of the problem here. I'd like your reaction because
he puts it in very simple, understandable terms. He says,




15
The Miller and Carter administration officials, along with Charles Schultze,
Chairman of the Council of Economic Advisers, have become so deeply committed to
preaching the virtues of measuring real rather than nominal interest rates in
recent weeks that they could qualify for the 1979 "Cheap Money Oscar." To hear
Miller and Carter's gurus is to believe banks are having fire sales on money and the
Citibank chairman, Walter Riston, has become Robin Hood. Miller proudly tells
Congress that real interest rates on mortgages now are the lowest they have been in
5 years and that current interest rates leveling are not extraordinary after allowance is made for prevailing levels of inflationary expectations. Borrowers are willing
to pay those rates because they expect inflation to continue escalating. Indeed, with
the administration likely to be announcing soon that inflation zipped up to a 12percent annual rate in January, borrowers would be crazy, by Miller's standards,
not to be taking down all the credit they could get their hands on, for by that logic
the Fed has given the country absolutely free money. No one, of course, believes
bankers are giving away money, but the argument Miller is using is to buy time for
the Fed while it waits for its high interest rates to have an impact * * * if Miller is
even half right in diverting attention to inflation adjusted interest rates and pocketbook rates, the best that could be said for Fed policy is that its huge 3- to 4-percent
increase in market rates so far has been real spending that has barely kept money
costs even with inflation * * * investors expect worse, not better conditions of
inflation in coming months and this has to be measured by what investors expectations will be in months ahead.

What's your response to that criticism?
Mr. MILLER. I'm not sure I got the drift, except that it sounded to
be rather of a journalistic style in its overuse of adjectives. It
seemed to be fairly correct, if what it said is that interest rates are
made up of two components; and that while we have been trying to
exercise restraint, a lot of people have been willing to take on more
debt because they expect inflation to continue.
The CHAIRMAN. You see, what this also indicates is that if that's
the situation, you don't really have a restraining monetary policy
at all. Interest rates at this level are encouraging people to go out
and borrow and with inflation as high as it is the mortgage rates
are the lowest they have been in 5 years—if that's the case, there's
no bite here. There's no restraint on the part of the Federal Reserve Board. Is that right?
Mr. MILLER. Mortgage rates are now affected more by usury
limits, I would think, than by monetary restraints. You could do as
we did in 1973-74, and that is deny credit to the housing industry
by not allowing rates adequate to attract deposits, in which case
there would be no money available for housing. Instead, we have
allowed market rates to be paid on 6-month certificates. But the
fact is that households begin to get to a point where their disposable income can't service the debt; and in some States you have a
usury ceiling. So there is some restraint in housing already showing up, as we expected, in the attitudes of thrift institutions about
making mortgage commitments, the attitudes of individuals about
taking on this debt. The fact is that housing starts are beginning to
slow down, so I think we see the effect of restraint.
The argument we get, of course, is that we are somehow crunching the economy by allowing rates to come up to this level. Our
claim is that we are not crunching the economy. On the other
hand, we agree that we are retarding aggregate demand, which is
showing up, in our opinion, in the current figures; and that reduction in aggregate demand will contribute to allowing the economy
to begin to wind down from inflation.
The CHAIRMAN. Mr. Chairman, you can't have it both ways. You
can't have a situation in which you argue that interest rates can be




16

fully explained and then some by inflation, and that they are
really low, and then say you're also restraining the economy and
restraining inflation. It's one way or the other. Either these interest rates now are high enough so it's some restraint or they are not
really having any effect in retarding the economy. Which is it?
Mr. MILLER. It's both, if I may say so. I think that the real
interest rate is not as high as we have seen it in the past. On the
other hand, you can look at the nominal situation; households do
pay their bills out of nominal income. As I pointed out, households
are nearing 23 percent of disposable income in debt repayment;
that is causing restraint. A shift of liquidity at banks, the fact that
in order to maintain loanable funds banks have reduced their
investment portfolios—all of these things have begun to have an
impact on demand. At the same time, we have not had to crunch
the economy up to real interest rates that might do far more
damage and might push us into a recession.
Now the balance we are seeking is moderation, a slow growth
philosophy for a period of time to get inflation down; we are not
seeking a recession.
The CHAIRMAN. You see my problem with your response, Mr.
Chairman, is that, again, you just seem to be having it both ways.
As this article says, the biggest problem in the Miller real rate
focus, of course, is that he's asking everybody to believe that monetary policy is restrictive at the same time he's telling Congress it
really is not. It seems to me we have got to make up our minds. Is
this a restrictive policy or isn't it? You're saying it is and it isn't.
It's both things at once. I don't see how it can be.
Mr. MILLER. It's restrictive enough to bring down the growth rate
of the economy, but not restrictive enough toThe CHAIRMAN. You're guessing. You don't know that.
Mr. MILLER. I would say we must rely upon our best judgment,
and it seems to coincide with the outlook in the President's economic report for a growth rate in 1979 below the trend. Now if
there are those who prefer a more restrictive policy and produce a
recession, I would argue with them that they are wrong. A recession is not going to cure inflation. The restraints that are put on
demand during periods like this, Mr. Chairman, come not only
from nominal interest rates, but from the fact that much of the
buying and incurring of debt, at least for households, relates to
durables or to housing. Inflation drives up the price of these particular goods for a double impact: higher cost housing, plus a higher
interest rate to carry it and therefore a higher percentage of disposable income to repay it. And, therefore, there is restraint.
There's no question in my mind or that of any forecaster I know
that housing is going to come down 15 percent to something like
1.6 to 1.7 million starts in 1979.
The CHAIRMAN. That's the expectation. We don't know. As to the
start figures in January, and what they are likely to be in February in view of what's happening here in the East, it will be probably 3 or 4 months before we can tell.
Mr. MILLER. Mr. Chairman, we are always in a dilemma. We
have to make our best estimate, and our best estimate is for a 15percent decline in housing. If we're wrong, and housing continues




17

strong, then we should have been more restrictive. If we're wrong
and housing goes deeper, we have been too restrictive. So we have
to pay our money and take our chances.
The CHAIRMAN. If we compare current interest rates to a weighted average of inflation over the last 3 years, we get a little different picture because I think we are comparing it with an immediate
inflation which is one thing. It depends on what inflation level we
take. If we do that, then inflation adjusted bond rates now are
closer to 3 percent against 2.5 percent in the 1974 credit crunch
and real mortgage interest rates are 2.68 percent against a negative rate in 1974. In other words, in 1974, you had a situation
where inflation was so high that your nominal—your actual rate of
interest, allowing fully for inflation, was less than zero. So I think
it's very hard to take an adjustment for inflation on interest rates
into full consideration because it's a very slippery kind of a concept
and it's a conclusion that doesn't really lend itself very well because, of course, I suppose what you are really trying to get at is
the expectation of what interest rates are likely to be during the
life of the loan. Obviously, if people have confidence that the
Government is going to get a grip on inflation and if inflation is
going to come down, then they won't be willing to pay these high
rates of interest.
On the other hand, if they assume inflation is going to remain at
a high level, then it is like free money.
Mr. MILLER. I think you're right, Mr. Chairman, that you can't
take just one point in time—1 month, one quarter—and make
absolute comparisons about interest rates. One of the reasons, in
my view, that long-term interest rates have only increased about a
percentage point over the past year is that looking at it from a
longer term point of view—I'm talking about long-term rates other
than mortgages—there is not an expectation of inflation rates like
that in 1978 for the term of the outstanding debt. I think this is
true. But in terms of current purchases, where there will be quick
repayment, it's true that many consumers have not been inhibited
by the rates of interest, but rather have been influenced by both
nominal interest rates plus their expectations that prices will be
higher; we have had anticipatory buying.
The CHAIRMAN. Mr. Chairman, the 1980 budget presented by
President Carter has interest rate projections for 1979 and 1980.
According to the budget figures, the 1980 Treasury bill rate is
expected to average 8.8 percent in 1979 and 7.6 percent in 1980.
Two questions.
First, do you view these forecasts as accurate; and second, how do
they square with your inflation outlook?
Mr. MILLER. As I understand, those figures are not intended as
forecasts, but as calculations based upon the interrelation between
inflation and interest rates in Government securities. As I understand it, the administration feels that if inflation is expected to
come down and, therefore, Government revenues to be less than
they would be at a higher inflation rate, then it's reasonable to
make a parallel adjustment in interest rates on Government
security.
The CHAIRMAN. Now you're dead right in that these are not
forecasts in the sense they predicted them so people would have




18

something to look at. They did it because they have to do it as part
of the budget projections. They have to determine what the service
costs and the debt will be and so forth. Nevertheless, they are
assumptions as to what's going to happen. You can call them
forecasts or not. I just wonder whether or not the Federal Reserve
Board should be making these estimates rather than the Treasury,
rather than the administration. This is your field. You have the
competence.
Mr. MILLER. We do not make such projections, but you asked me
how I would feel about it, and I can give you my own personal
reaction. My own personal reaction is that, based on what we have
seen happen so far this year and therefore what is more likely to
happen than was known at the time the economic report was put
together, the inflation outlook is slightly optimistic; and if it's
optimistic, then the assumed interest rate would be slightly optimistic.
The CHAIRMAN. That means the deficit would be somewhat
deeper?
Mr. MILLER. If there's higher inflation, there could be higher
revenues because you get corresponding
The CHAIRMAN. As far as the interest costs that would add to the
deficit, but you say the revenue would be higher?
Mr. MILLER. The revenue might be higher.
The CHAIRMAN. Now there's a study for the National Bureau for
Economic Research by two Princeton economists, Blinder and
Newton, that shows that the 1971-74 Nixon control program had a
temporary beneficial effect on inflation—very temporary—1.7 percent for a couple years, but that was lost quickly once the program
was over and that there was a permanent increase in inflation of 1
percent above what it would have been.
Now what their conclusion of this is, is that the administration
ought to promptly get rid of its guideline policy. We should keep in
place the fiscal and monetary policy, of course. They argue that the
guideline policy is likely to be harmful and for these two reasons:
first, they argue that controls discourage business from adding to
plant and equipment for fear of not recouping its investment and
results in inadequate productive capacity reducing the potential
output of the economy and reducing productivity. Second, inflation
does not hit all goods equally. Some prices move up sharply while
others move up moderately or not at all and thus create an imbalance in relative prices of different goods. Once controls are lifted,
prices usually skyrocket and tend to overshoot in an attempt to
restore the equilibrium in relative prices and their conclusion
therefore is that part of the inflation program is counterproductive
in the long run and we should end it.
Now I notice in one of the last pages of your presentation here
you attribute some utility to that part of the anti-inflation program. You have a paragraph on it in which you say it's helpful and
in your judgment it makes monetary and fiscal policy somewhat
easier.
Mr. MILLER. Chairman Proxmire, I would riot agree with that
analysis for a couple reasons. If mandatory controls were in force,
you might get different behavioral patterns on the past business




19

than you would from voluntary restraints; that's the first point.
But even with mandatory controls, in my own business experience,
we accelerated our capital spending in order to cut our costs to
maintain our profits within the
The CHAIRMAN. Do you think your experience was typical?
Mr. MILLER. Perhaps not, but I'm saying there are different
reactions.
Second, I would say that it depends upon the parallel fiscal and
monetary policy. In hindsight, one might say that during the
period of controls, fiscal and monetary policies were too stimulative
so that the economy, perhaps, was supporting too heavy a demand;
that may have been the problem, rather than the philosophy of
controls.
The very purpose of this oversight hearing is to judge our policies and to make sure that they do not become overaccommodative
in the case that we have massive compliance with the voluntary
standards. We don't have massive compliance holding down our
figures yet. I hope we will have. When we do, I hope we will have
the discipline not to take that as an excuse for a monetary or fiscal
policy that would be unduly stimulative at a time when we need,
above all, to moderate demand, to maintain a more or less low
growth philosophy, until we work out these inflationary pressures.
So I wouldn't discard the incomes policy and the fact that it can
contribute and buy time and help us in this very difficult task of
trying to get our economy to grow at a far more moderate rate
than we have been used to in the past or liked in the past. Over
time, this will achieve the greatest good for the most number of
people.
The CHAIRMAN. Now there's one other development that gives
me great pause as to the guideline policy. That s the experience
that Canada is having. As you know, they had a wage-price control
program and they rolled back the wage limit 6 percent annually.
They kept it in effect for a while. Unfortunately, inflation increased by 8.5 percent and now the unions are steaming mad. They
are insisting on much higher settlements than before and it appears that while there was a temporary holdback, that 8.5-percent
inflation might have been worse if they hadn't been able to hold
down wages, that now they are really in great difficulty, and I'm
concerned that that same kind of situation could confront us if we
have a wage holddown, continued inflation, and especially if we
don't get the wage—I should say the tax rebate proposal that the
administration is making. Absent that—and, of course, that's only
a 50-50 shot, unfortunately, right now, maybe less than 50-50—if
we don't get that rebate, unions are going to be very hesitant and
you wouldn't expect them to hold the line on 7 percent if they can
anticipate an 8.5-percent or 9-, or 10-percent inflation, and no basis
for expecting that they can be made whole.
So doesn't that Canadian experience suggest that in the event we
do not get the rebate through the Congress that in that event we
might drop the guideline policy and rely on monetary and fiscal
policy?
Mr. MILLER. The Canadian program, as I recall—I had a little
experience with it personally—was a mandatory program.
The CHAIRMAN. That's right.




20

Mr. MILLER. I would think, again, that the voluntary program
has a great deal of merit in that if there is
The CHAIRMAN. Of course, the labor people say there's no difference as far as they're concerned because you've got 5 million
enforcers. Every employer is going to enforce that guideline.
Mr. MILLER. I would say this, Mr. Chairman: That implementation of an idea is as important as the idea. If we were to try to put
on a wage-price standard that was unduly low, and we did enforce
it by whatever means—voluntary or otherwise—and in doing so we
aggravated a situation of undercompensation for a period of time,
we, too, would have pressures as you see in Canada and England. I
don't think the 7-percent standard, coupled with real wage insurance, represents the kind of buildup or differential of wage demands that would create that pressure. I think this is a moderate
program. If we had a wage standard this year of 4 percent, what
you're talking about could well happen. If we got people to accept
it for 1 year, they would want to make the difference up later. But
with 7 percent, particularly with real wage insurance—which as
you know I don't think is critical, but I think it is desirable to try
to see if it will contribute
The CHAIRMAN. You don't think it's critical?
Mr. MILLER. Pardon me?
The CHAIRMAN. You don't think it's critical?
Mr. MILLER. I do think it's worth
The CHAIRMAN. Worth trying?
Mr. MILLER. Worth trying for 1 year.
The CHAIRMAN. But you don't think it's critical to the program?
Mr. MILLER. I think that if we didn't have it we could still make
progress. I think with it there's a chance, as you point out, that
with real wage insurance more bargaining units may be willing to
accept a standard.
The CHAIRMAN. You already have now the UAW Union that
supported the rebate saying that they can't go along with it due to
the price increases in January. They may very well have to come
in and ask for a 9- or 10-percent wage increase. So if that wage
rebate doesn't make it—I have been talking to union people around
my State in the last couple weeks, as other Members of Congress
have during the recess, and it seems to me we need everything we
can get if we can get their cooperation, including that rebate. If we
can't get it, I think it's going to be extremely hard for this program
to have more than a very temporary beneficial effect.
Mr: MILLER. You may well be right.
The CHAIRMAN. Now the Humphrey-Hawkins Act requires the
Federal Reserve discuss the relationship of its policies from shortterm goals of employment, unemployment, production, real goals,
and productivity.
How will the policies you announced this morning lead to the
achievement of 4-percent unemployment by 1983 which, of course,
is in the minds of most Americans, most Members of Congress, the
principal goal of Humphrey-Hawkins? You do indicate in your
presentation that you expect unemployment to be about the same
in the coming years as it is now, around 6 percent, as I understand
it.




21

Mr. MILLER. Yes; that's correct. By the end of the year, as distinguished from the average unemployment rate over the year, I
would expect unemployment to be slightly higher. I could see
it
The CHAIRMAN. Higher?
Mr. MILLER. Higher than it is now; certainly a little over 6
percent. For the whole year, I have said that the unemployment
rate average for 1979 might be not significantly different from
1978; 1978 started a little higher and came down. We may see it
start lower and go up a little in 1979. It may average out the same.
I think it's going to be extremely difficult to achieve a 4-percent
unemployment rate by 1983, unless we make tremendous progress
in curing inflation. Without that, I think the prospect for absorbing
additions to the labor force is going to be extremely difficult.
The CHAIRMAN. Aren't these two things contradictory? Can you
achieve 4 percent unemployment in 1983 and make progress
against inflation at the same time?
Mr. MILLER. In that short timetable, I think it's unlikely.
The CHAIRMAN. The answer is something you stressed often, over
and over again, perhaps more than anybody in Government or
private business, in arguing for efforts to do something about structural unemployment and provide training for unskilled people and
provide opportunities for those who have little opportunity now
and motivation to those who
Mr. MILLER. We mentioned that in this report; it seems the way
to go is not to depend upon macropolicies but to make a far more
targeted effort in those areas you just noted than we have done so
far.
I hope the private sector initiative that is awaiting funding will
be funded by Congress. There is a supplemental appropriation for
$400 million, and that is something, despite our need for austerity,
that should be stressed. It is the best way to break the unemployment cycle for those coming to the labor force who don't have
appropriate skills, who haven't had the opportunity to gain work
experience, and who are therefore sort of in limbo for far too long a
period.
The CHAIRMAN. The fact private forecasters think we will have
more inflation in 1979 than the administration is really disconcerting.
Humphrey-Hawkins, as we just said, established a 3-percent inflation goal and a 4-percent unemployment goal for 1983.
If we are going to reach those goals, we have to get inflation
under control as quickly as possible.
We are going to have to see evidence that fiscal and monetary
policy are all working to reduce inflation. Fiscal policy has been
fixed for fiscal year 1979. The budget for fiscal year 1980 has a $29
billion deficit, with spending at $532 billion.
It seems that the only way spending is likely to go is up. That
may happen to the supplemental appropriations. Receipts may also
fall short of the targeted level if the economy slows.
In brief, it looks to me that fiscal policy will not be restrictive
enough—will not be restrictive enough this year, and for fiscal
1980, we have a $29 billion deficit recommended.




22

That's far too large at this stage in the business cycle. Your
chart shows big deficits during this whole period of recovery. The
burden of restraint will probably fall upon monetary policy.
How restrictive will your policies be? For example, in the area of
homebuilding and construction, will there be housing starts in the
area of 1.6 or 1.7 or less?
Mr. MILLER. I think 1.6 or 1.7 million would be correct.
The CHAIRMAN. What about business investment? Do you see any
improvement there?
Mr. MILLER. Yes; a slight improvement in real terms. It appears
that it will be quite moderate, unless businesses are encouraged, by
better prospects for curbing inflation, to step up their investment.
The CHAIRMAN. The President's budget in fiscal year 1980 projects a 7.7-percent increase in outlays over 1979 and a $29 billion
deficit. Some have questioned whether this budget is tight enough
to convince the private sector that the Government is sufficiently
determined to arrest inflation.
What would be the offset, or I should say, what would be the
effect on inflation and employment if Congress were to cut spending by, say, an additional $10 billion?
Mr. MILLER. Mr. Chairman, I have been looking very carefully at
the Congressional Budget Office report on various alternate strategies. Certainly, one strategy that is possible is to cut more deeply
than is proposed, which would indicate another dilemma; that is,
that inflation under that scenario would be much lower in the next
few years than otherwise, but the Congressional Budget Office at
least feels that unemployment would also be much higher.
So, the dilemma we face is the rate at which Federal spending
can be cut as we accomplish our twin goals of balancing our actions
so as not to increase the unemployment rate as we reduce the
inflation rate.
I have felt that the $29 billion deficit is not ideal, but certainly is
in the right range.
My present personal estimate—and it is probably too early to
have a good estimate on this—but I suspect the deficit in fiscal
year 1979 will be slightly lower than the $38 billion that was in the
budget resolution. If it does come in at, let's say, $35 billion, which
is a likely figure, it would seem to me then that we could get that
$29 billion deficit proposed for 1980 down even further. I don't
know that we can reduce it by $10 billion, but I think even half of
$10 billion would be helpful in this balance between how fast we
can come down so as not to increase unemployment, yet keep on
our path of fiscal discipline so as to reduce inflation.
The CHAIRMAN. You are in a very difficult position. Of course, I
don't mean to make it tougher than it is, but Dr. Bosworth, when
he appeared before this committee 10 days ago or so, said that,
frankly, what you have to face is if you are going to get on top of
inflation, you have to recognize you have to have higher levels of
unemployment. People have to be thrown out of work.
That is just it. That's the sad, unfortunate fact that we have to
face. Nobody wants to admit it, because whether you are a Member
of Congress or a member of the administration or Federal Reserve
Board member, you just don't like to spell out the pains that have
to be achieved.




The most vexing economic problem facing our economy today is
inflation. The primary stabilization tools that must be counted on
to reduce and eventually eliminate our inflation are fiscal and
monetary policy. Without moderation in both Federal spending and
the growth of money credit, inflation will not be reduced. Since
1974 the cumulative deficits in the Federal budget have totaled
over $218 billion. If you add to that the very large amount of
Federal off-budget financing and loan guarantees, the demand that
the Federal Government sector has placed on the money credit
markets is simply incredible. There is little wonder that the monetary aggregates have grown so rapidly over the past 3 years. If the
Federal Reserve had clamped down to fully offset the Government's demand for credit, other sectors of the economy would not
have gotten as much credit as they desire and interest rates would
be much higher than they are now. A major question that we face
is just how restrictive monetary policy should be, given current
fiscal policy, to slow the economy enough to have a significant
impact on inflation, but not so much as to put us into a recession.
To date, there have been only a few signs that the restrictive
monetary policies pursued by the Federal Reserve last year were
enough to slow the economy down. Real GNP increased at a 6.4
percent annual rate during the fourth quarter of 1978, which is
much too fast if inflation is going to be reduced. During that
quarter growth in the monetary aggregates, as they are currently
measured, moderated substantially. But it is not all clear how
much of that deceleration in money growth was due to Federal
Reserve policy and how much resulted from shifts of funds in
response to the newly created automatic transfer accounts and the
new 6-month money market certificates. Our main indicators of
monetary policy—growth in the monetary aggregates—are much
more difficult to understand at this point than I think they have
been at any time in my memory. I would hope that the Federal
Reserve has begun to develop better indicators and that they will
begin to use them as soon as they possibly can.
The latest economic data are just beginning to show signs of
somewhat more sluggish economic performance. Industrial output
rose by only one-tenth of 1 percent in January, which is the smallest amount in over a year. Retail spending increased by only fourtenths of 1 percent in January, the smallest gain since last
summer. Personal income rose by only four-tenths of 1 percent last
month, and housing starts, which is one of our key indicators,
dropped to 1.6 million in January, a decline of 19.7 percent, and
also the lowest level for housing starts in 2 years. All these variables indicate that the economy may have slowed. However, in view
of the severe weather, which we are just getting in the East now,
and which the Midwest suffered in January in extremis, these may
not be indicative of the course of the economy. Not only are they
monthly observations, but also, as I say, we did have extremely bad
weather in the Midwest. So we should not rush to any conclusions
that economic conditions have changed dramatically. I hope that
Chairman Miller will help us understand the meaning of these
events and what they portend for the future.
Chairman Miller, last week you made a comment in a speech
before the Conference Board about interest rates. You said that




23

But inflation is so menacing and in the long run likely to be so
destructive of employment opportunities, that it would seem we are
just going to have to grit our teeth and pay a higher price in
unemployment.
Would you agree with that?
Mr. MILLER. No, sir. I really don't think so. I think that it's
possible to continue on a course that moderates the social damage
of unemployment. The other side is that if we achieve reductions in
inflation that are more dramatic than otherwise possible at the
expense of high unemployment, we may have other outcomes to
our societyj;hat would be just as damaging as inflation. I think we
have to keep a better perspective; a better balance.
I have claimed only that we should be reducing inflation initially, about three-quarters of 1 percent a year. As we get down that
slope on reducing it, we can accelerate.
I have pointed out that it's going to take 5 to 7 years to wash
inflation out. If you try to wash it out faster, you accelerate unemployment, and other consequences will flow that will be just as
damaging to the country as inflation.
If we get inflation going in the right direction, I think our own
confidence will build, and our progress will be quite adequate
toward the overall goals that we want. We may reach them later
than 1983, but we can reach them if we are persisent and stick
with it; we can do it.
The CHAIRMAN. One of the things that has kept the housing
industry going is the 6-month money market certificate authorized
last June. Thus far, through December about $75 billion of these
have been issued.
What percentage of that money has actually gone into mortgages? The reason I ask is, we hear persistent rumors a significant
share is not going into housing but has been invested by savings
banks in bank investments.
Do you have any information on that?
Mr. MILLER. Mr. Chairman, you asked me that question, as I
recall, in November. At that time I said our evidence was that
most of it was going into mortgages or being held for mortgage
commitments.
Since November, I would say an increasing amount of it is being
invested and is not being targeted into mortgages, but merely held
in liquid investments, as you indicate.
I don't know if I can give you a precise number now. Perhaps I
can send up a number.
The CHAIRMAN. Fine.
[Chairman Miller subsequently submitted the following information for the record:]
It is impossible to determine precisely how money market certificates (MMC)
proceeds have been invested by thrift institutions; balance sheet data do not allow
the specific source of asset flows to be traced. However, such data do suggest that
savings and loans and mutual savings banks initially increased their holdings of
liquid assets following the introduction of the MMC, in part to repair the damage
done earlier in the year to their liquidity positions, but also as a temporary measure
reflecting the normal lagged response between changes in deposit flows and mortgage lending. In November and December, both S. & L.'s and MSB's actually drew
down their cash and investment security holdings. Moreover, over the same period,




24
mortgage lending accounted for about 91 percent of the change in assets at S. & L.'s
and 97 percent of the change at MSB's. As of year-end 1978, 60.2 percent of MSB
assets was invested in mortgages, a slightly larger proportion than recorded 1 year
earlier. At S. & L.'s, mortgage holdings represented 82.7 percent of assets as of the
end of December, about in line with the proportion in the previous year. In consequence, it appears that thrift institutions have not significantly altered their typical
investment practices because of the MMC; S. & L/s and MSB's apparently continue
to invest the bulk of deposit flows—from all sources—in mortgages.

Mr. MILLER. It has gone that way. The reason is
The CHAIRMAN. I would like to know.
Mr. MILLER [continuing]. That more and more these institutions
are fearful of the rollover rates they would be paying and are not
showing themselves as willing to put these funds into mortgage
commitments, as they were earlier.
The CHAIRMAN. We want to see the pattern.
Mr. MILLER. We do want to see the pattern. As you know, the
percent of deposits, particularly at S. & L/s, held in these certificates has gone up quite a bit; not as much at banks. That's been
noted in this report. So that percentage of deposits not going to
mortgages becomes more and more of a concern to us, too.
It is a pattern we want to watch carefully.
The CHAIRMAN. When you appeared before the Joint Economic
Committee, I asked you about the ceiling that we have on regulation Q and the gross unfairness that represents now with the high
interest rates. You agreed, as I understand it, with the proposal I
introduced to gradually increase regulation Q over a period of time
at a rate of, I think, one-quarter of 1 percent every 6 months.
So that the small saver wouldn't be discriminated against as
grossly as he is at the present time.
As I recall, you supported that. Do you support that position?
Mr. MILLER. Yes, I do, Mr. Chairman.
The CHAIRMAN. Your support is very important. I think it will be
extremely hard to get that done. The resistance in the institutions
is great. They are maintaining a beautiful profit margin. At the
same time I think the public interest is certainly in favor of modifying that.
I think your support would be very helpful.
Mr. MILLER. There's no question that equity would require adjustment. I said that a sudden removal of that ceiling would be
disruptive. The added costs of the deposit would be destabilizing. If
you do something, like what you suggest, phase an increase in, so
that on another cycle you won't repeat the mistakes of this cycle,
that would be healthy.
My feeling is that if there had been no ceiling at all, the adjustment would have been much easier over this cycle. There would
have been competition for small savings earlier by the offering of
higher rates. It probably would have meant that mortgage rates
might have gone up a little earlier, and that the general process of
spreading demand out over a more appropriate period might have
worked even better.
I think it's a proper direction to go.
The CHAIRMAN. How about the CD's from $10,000 to $1,000?
Mr. MILLER. Again, philosophically, that's a correct way to go. In
terms of present disruptions of markets, I think it would really




25

squeeze the profits of mutual savings banks and S. & L.'s. It would
be a difficult thing for them to absorb right now. For banks, it's not
so much of a problem.
The CHAIRMAN. Do you favor it on balance or oppose it?
Mr. MILLER. I favor the concept. I think the timing is not too
propitious.
The CHAIRMAN. What timing do you suggest?
Mr. MILLER. I would hope that that might be something that
could come later this year or perhaps a year from now. It should be
considered only when we are over this cycle of interest rates, when
we are seeing less pressure on the earnings of thrift institutions.
Banks could probably absorb it better; mutual savings banks,
particularly, I think, would be heavily hit, as would some S. & L.'s
whose profitability is not as great
The CHAIRMAN. How about gradually reducing it from—instead
of making it -overnight from $10,000 to $1,000, reducing it over a
period of months?
Mr. MILLER. That's a possibility.
The CHAIRMAN. Now in your speech to the Conference Board last
week you said you expected interest rates to remain at high levels
for an extended period of time.
How does that statement reflect your perception about the future
cost of inflation? If inflation were to be brought under control,
going down, there would be no need for high interest rates, would
there?
Mr. MILLER. Mr. Chairman, I am not sure that I remember what
I said at the Board in that context.
I thought I indicated that there should be no immediate expectation of any letup in monetary restraint; or it was premature to
judge some of the lower interest rates recently as a signal for
generally lower rates.
I don't recall that I indicated an "extended period of time." The
Federal Reserve posture, now, is that of trying to maintain a
balance. Many people are arguing that it's time for less restraint;
others continue to indicate that we need to show more restraint.
We have felt, just as we felt all during 1978, that the bias is in
favor of maintaining adequate restraint, and that there should be
no expectation of any early relenting in that regard.
I hope I didn't speak out of turn or improperly in indicating an
extended period of time.
This could all change in months, if we find economic indicators
confirming January's figures, although I tend to believe the economy is somewhat stronger than the January figures indicate.
The CHAIRMAN. At any rate, then you would reaffirm your
notion that interests rates pretty much rise with inflation? That in
the event we get a reduction in the rate of inflation, then we will
get a corresponding reduction in the level of interest rates?
Mr. MILLER. I would think that, with a constant degree of restraint, interest rates would go up or down with inflation. The
degree of restraint that might
The CHAIRMAN. Is that the degree of inflation or the degree of
inflation expectation?




26

Mr. MILLER. It's an interaction of both, I think. Rates are influenced not only by the current day's inflation, but by the expectation of what's going to happen in the next quarter. We see that
when we get spurts, like in the second quarter of last year. I don't
think interest rates behaved based just on the numbers for the
second quarter. They were looking
The CHAIRMAN. It's very interesting. I think few people have
really tried to key that in with the behavior of the stock market. I
suppose one of the reasons the stock market which presumably
should rise with inflationary expectations, inasmuch as it's presumed to be a hedge, falls and one of the reasons, I suppose, is
because interest rates rise. Of course, that's bad news, because of
alternative investment opportunities. Instead of putting it in the
stock market, where you get a lower yield, you can put it into fixed
investment with interest rates rising.
You do much better. If inflation goes up, interest rates go up;
therefore, the stock market will go down.
Mr. MILLER. It's interesting. Last week I somewhat jokingly
pointed out that some of my acquaintances in heavy capital industries told me they thought interest rates were too high while those
in corporations with excess cash told me they thought interest
rates were too low.
\
I guess it depends on where you are, whether you are a borrower
or a lender; Polonius said you should be neither.
The CHAIRMAN. Polonius was living in a much simpler time. He
wasn't living at all. It was a much simpler time in Shakespeare's
imagination.
Mr. MILLER. The Muslim religion has a simpler answer. You
don't have interest rates; you have fees. Then you can talk about
whether fees are related to inflation.
The CHAIRMAN. Well, that's one solution. [Laughter.]
Mr. MILLER. At least we can change the words.
The CHAIRMAN. Let me ask. Interest rates rose dramatically from
March to December last year. Was that the result of monetary
policy action taken by the Federal Reserve or because of inflation
accelerating?
Mr. MILLER. I think both. The monetary action of the Federal
Reserve was to restrain credit, and this was having its impact, but
I think there was also heavy demand for some types of credit
because of anticipatory buying from those trying to beat inflation.
There was an interaction of the two.
The CHAIRMAN. Many private sector economic forecasters expect
a recession to occur this year. The administration doesn't think so.
I believe you have said you don't think we will have a recession. Is
that correct?
Mr. MILLER. That's correct. I have felt, and continue to feel to
this day, that there are no economic indicators that signal a recession in 1979. I have pointed out that, in case there is not a return
to significant production in Iran, there could be an increase in the
price of oil and that could increase the risk of a recession. But even
that situation doesn't shape up to predict a recession at the
moment.




27

My analysis is very simple: while consumer debt is high, the
number of employees coming into the labor force and the general
growth of compensation will keep consumer spending, even with
higher savings, as a positive force. Business fixed investment is
going to go up slightly in real terms; that is a positive force.
Government spending will not, in the aggregate, be a negative
force. The only negative factor, probably, is that housing will be
down somewhat. I also point out that inventories are in very good
balance.
The CHAIRMAN. How about consumer psychology? The Michigan
survey, which was supposed to be the best, indicates that people
are extremely pessimistic. As you point out in your charts, there
was a sharp drop in savings which could easily be reversed. People
could save more and spend less. Wouldn't that have a depressing
effect?
Mr. MILLER. Yes. Things would shift if consumers did change
their actual spending patterns, but I say, so far we don't see that.
We expect moderation, but we don't see the sharp dropoff that
would be necessary to trigger a recession. It could happen, but it
certainly is not evident at the moment and has not been evident
even with the various dislocations and shocks we have seen in
recent months.
The CHAIRMAN. Now, let's assume just for a minute we do have a
recession. Certainly there's—in spite of the optimism on your part
and the administration's part, there is a strong chance there will
be this year. The normal tendency would be for Congress to fight it
through a combination of more spending and tax reduction. If that
could be avoided, it might be far better to have a fiscal policy that
remained firm, but to Have some relief come through a more accommodating monetary policy. Do you agree with that view?
Mr. MILLER. I do agree with that. If there is a recession—even
though we don't now expect one—the Federal deficit will widen in
any case. It is a self-adjusting process: revenues will drop as less
people are employed and incomes go down; and there is automatic
spending and transfer payments that will go up with higher unemployment. So there's an automatic increase in the Federal fiscal
stimulus. I think Congress would be wise not to contribute more to
that.
You might say, Mr. Chairman, there's also an automatic adjustment as to monetary policy. If we have a recession, the demand for
credit will drop. As a result, interest rates will tend to drop in a
cyclical fashion, so there will be some easing. I think we ought to
accommodate more through monetary policy and not have the
tendency to become too stimulative in fiscal policy. I am just supporting your analysis, and filling in a few of the gaps.
The CHAIRMAN. Now, you as the Chairman of the Federal Reserve Board, and this committee as the Banking Committee, both
have a very serious responsibility with respect to the Nation's
banks.
The Council on Wage and Price Stability has been struggling for
weeks to come up with a profit standard for commercial banks and
other financial intermediaries. They seem to be left out of the
guidelines almost entirely except for the wage part.




28

According to The New York Times this past Sunday, administration officials put it this way. How does the Government control the
price of the banks making commodity money without affecting
interest charged by banks and incurring market dislocations? Profits at banks were tremendous during the fourth quarter of last
year, very sharp increases. I noticed virtually all the big bank
holding companies had increases from 25, 35, 45 percent. A spread
between the prime rate and the rate paid on commercial paper is
wide, especially if you look back before 1974.
Why shouldn't banks be asked to narrow their spread to help
fight inflation? If they did, wouldn't that negate monetary restraint?
The problem is that if we are successful in jawboning banks, and
the Chairmen of the Federal Reserve Board, Presidents, others
have been successful in the past in doing so, so that they slowed
down their rates on business loans, what happens to your monetary
policy?
Mr. MILLER. It goes out the window; you just don't have the
restraint on demand that you need to fight inflation, so that works
against you.
The CHAIRMAN. I don't know what we can go about that. Of
course, they could ration their credit or impose nonprice terms.
Nobody proposes that. It seems to me we are in a dilemma here.
Mr. MILLER. We are in a dilemma, but let's hope that we will get
out of it in due course by fighting inflation and bringing things
back to normal.
The CHAIRMAN. Of course, if we do something about regulation Q
and so forth, that will help some?
Mr. MILLER. Yes.
The CHAIRMAN. In 1974, when the price of oil quadrupled, the
Federal Reserve response was to restrict money and credit and
drive inflation to an all time high.
Interest rates to an all time high to offset those increases. Monetary policy usually is not effective in controlling inflation from the
supply side. It's not at all clear tight monetary policy in 1974
helped. However, it did contribute to the recession that ensued.
What would be your response now to a situation where oil prices
rise, perhaps dramatically, because of the political unrest and the
new government in Iran?
Mr. MILLER. Mr. Chairman, I don't see, even through withdrawal
of the Iranian oil supply, the magnitude of change that took place
after the 1973 boycott. I would think that our problem will be less
severe now than it was seen to be by the Federal Reserve in 1974. I
dp think that one has to adapt monetary policy to exogenous
circumstances and not wreck the economy by following some
mechanistic formula. I am not sure how we will respond. We are
talking about a hypothetical situation in which the choice will
relate to the condition of the economy when the event occurs, to
what other challenges are there.
In general, I think we have to be adaptive and not just doctrinaire.
The CHAIRMAN. Let's assume we do have a sharp increase in
prices. It's certainly possible now with the situation—the supply




29

situation in the world seems to be moving in that direction in the
short term anyway.
Mr. MILLER. I don't think we should rely on monetary policy to
handle that. I think we should be pursuing a more forceful conservation policy; that would be the only way to solve the problem.
The CHAIRMAN. If necessary, rationing?
Mr. MILLER. If necessary, there are a number of things that
could be done. It's still rather disappointing to me, frankly, that
with the Iranian situation we have not seen a burst of enthusiasm
by businesses—although businesses have been doing fairly well in
adapting their industrial plants—by individuals and by the population generally to conserve their use of energy. I maintain that we
all, everyone in this room, everyone in the United States, could use
15 percent less gasoline this year. Yet we don't get very enthusiastic about that.
The CHAIRMAN. One way is to run to work.
Mr. MILLER. Exactly. I m not sure, though; that may burn up
more energy.
The CHAIRMAN. Well, not gas, anyway. There's been growing
concern about resolutions approved by 24 States calling for a constitutional convention in order to get an amendment to the Constitution requiring a balanced budget. Many economists have opposed
this approach. You said when you appeared before the Joint Economic Committee that you did oppose this. The point that cannot
be passed off is that people want Government spending held down.
They want the deficits reduced. They want tax burdens lightened.
These things are difficult to do in normal times and doubly difficult when the economy is weak and inflation is high.
The Government has to have the same discipline we have asked
from the private sector.
I think we have been helped in a technical sense but spending
has continued to grow and deficits have continued to mount.
Would you support stronger constraints on Government deficit
spending such as the establishment of a goal to reduce federal
outlays as a proportion of GNP to 20 percent or less by 1983?
Mr. MILLER. Mr. Chairman, I would, if they were statutory. I
really think it would be inappropriate to put these restraints into
the Constitution.
The CHAIRMAN. You would support them if they are statutory?
Mr. MILLER. Yes, statutory.
I would point out, on the constitutional issue, that I think this
country would make a terrible mistake by trying to put into the
Constitution what is really a legislative matter.
The CHAIRMAN. Now, I have another statute. That's one statutory proposal I am making before the committee. I am hopeful we
can incorporate it into the Council on Wage and Price Stabilization. In addition to that, I proposed a bill that has a wide sponsorship in the Senate that would require that the President submit a
budget that would be in balance whenever the real growth of the
economy is 3 percent or better. If we had that, we would have had
instead of 16 deficits and one small surplus in the last 17 years, we
would have had 12 surpluses and only 5 deficits. It would have
meant that we would have had a far smaller national debt; spending there alone would have been billions of dollars less.




30

We certainly would have had less inflation from Government
activity. What would be your reaction to that as a statutory proposal, and with an escape clause, of course, if Congress by a two-thirds
vote could set it aside?
Mr. MILLER. Philosophically, Mr. Chairman, I'm for it, but I
guess I have a little trouble with how it would work. Right now,
Congress is addressing the deficit issue for fiscal year 1980, which
begins next October 1 and ends, you know, a long time from now. It
seems to me that your spending and your deficit decisions ought to
be made concurrently.
The CHAIRMAN. That's the beauty of this proposal. What it would
do is put into effect a budget which would be in balance and in the
event you have growth of 3 percent or more, surplus. But if you
don't have that—you can't predict what you are going to have—
you would have the deficit you should have.
Mr. MILLER. So you have flexibility? I see; that could have merit.
But let me point out that even your propostion to reduce spending
to a certain percentage of GNP becomes permanent. I would have
hated to have Congress lock in, for all times, spending as a percentage of GNP in 1900 when the country was entirely different.
The CHAIRMAN. It would be statutory. The Congress by a majority vote could change it.
Mr. MILLER. The proposal probably should have limited horizons,
so it could be looked at over a few years.
The CHAIRMAN. Run a sunset on it.
Mr. MILLER. Yes, I think so.
The CHAIRMAN. During 1978 consumer credit expanded at a
rapid rate. Questions have been raised about whether consumers
can expand their holdings in 1979. Some observers are convinced
some form of credit controls have to be used. Your table would
show that very dramatically. How significant a problem is the
large volume of consumer debt in terms of stability of the economy?
Mr. MILLER. At the moment, as I pointed out, part of that picture
may be demographic; it may just reflect a period of family formation or young families who have higher demands for credit than
normal.
Part of the expansion may be due to the increasing use of credit
cards to handle transactions; credit card debt gets counted in here,
and there may be some technical changes to consider. I would
think that the amount of debt burden will be a restraining force on
continued growth of demand in the economy. However, because of
the new factors, I am not yet prepared to say, that we have a
serious problem. Delinquencies, as I mentioned, have been, if anything, going down. Households have had the capacity to service
debt so far.
If there is an economic slowdown, however, and if there were a
recession, I would think repayments would be somewhat more
difficult.
The CHAIRMAN. Do you contemplate the use of any type of credit
control?
Mr. MILLER. No, sir. It seems to me we are better off to get
ourselves back into a mode where the highest and best use of
purchasing power is determined by those who make the decisions




31

to spend their money. But we should keep an overall restraint, so
that the deferrable, less necessary, less meritorious decisions and
purchases are put off by consumers or businesses themselves,
rather than determined by a Federal regulator. The greater degree
to which we can operate with more market freedom, let prices be
the mechanism for determining purchases rather than allocation,
is, I think, a healthy sign.
The CHAIRMAN. Well, Mr. Chairman, I want to thank you very
much. As usual, you did a splendid job. You are extremely articulate and persuasive.
I do feel, however, that we are now confronted with a situation
in which the Federal Reserve and the Congress, too, in contemplating monetary policy has the very difficult problem of trying to cope
with monetary aggregates which are in a period of transition
which are anything but explicit. Having missed our targets by a
wide margin last year, and then we we turn to interest rates as a
guide, we find again it's based on a relationsip between interest
rates and inflation which is a very slippery concept, very hard to
pin down; and for a while, it was a situation in which you could
kind of look to the Federal Reserve Board because most of us know
so little about monetary policy. It was kind of in the land of the
blind the one-eyed man is king; but now I am not sure that any of
us have eyes to see.
The situation is about as difficult to establish any real confidence, it seems to me, on the part of Congress as any I have seen. I
don't mean that to be any derogation of your fine ability or the
people who serve with you, the capability on the Board and your
outstanding staff which is as fine an economic staff as I think there
is in the Government.
Thank you very much for your appearance.
Mr. MILLER. Thank you, Mr. Chairman. If we have only one eye,
we will try to make it all-seeing and try to do better.
[Whereupon, at 11:48 a.m., the hearing was adjourned, to reconvene at 10:00, Friday, February 23, 1979.]
[Complete statement received from Mr. Miller and an additional
letter received for the record follows:]




33

Board of Governors of the Federal Reserve System

Monetary Policy Report to Congress
Pursuant to the
Full Employment and Balanced Growth Act of 1978

February 20, 1979

Letter of Transmittal

BOARD OF GOVERNORS OF THE
FEDERAL RESERVE SYSTEM
Washington, D.C., February 20, 1979
THE PRESIDENT OF THE SENATE
THE SPEAKER OF THE HOUSE OF REPRESENTATIVES.
The Board of Governors is pleased to submit its first Monetary Policy Report to the Congress pursuant to the
Full Employment and Balanced Growth Act of 1978.
Sincerely,
G. William Miller, Chairman




34
TABLE OF CONTENTS

Letter of Transmittal
Chapter 1.

Recent Economic and Financial Developments
Section
Section
Section
Section
Section
Section
Section
Section

Chapter 2.

1.
2.
3.
4.
5.
6.
7.
8.

Overview
Aggregate Economic Activity
Labor Markets
Productivity
Investment
International Trade and Payments
Prices
Financial Markets

Objectives and Plans of the Federal Reserve
Section 1. The Objective of Monetary
Policy in 1979
Section 2. Growth of Money and Credit in 1979
Section 3. The Economic Outlook

Chapter 3.




1
3
14
20
24
27
35
40

54
55
63

Hie Relationship of the Federal Reserve's
Plans to the Administration's Goals
Section 1. The Short-Term Goals in the
Economic Report of the President
Section 2. The Relationship of the Federal
Reserve's Monetary Growth Ranges
to the Short-Term Goals in the
Economic Report

69

70

35
CHAPTER 1

"a review and analysis of recent developments
affecting economic trends in the nation"




Section 108(a) Full Employment and
Balanced Growth Act of 1978

36
Section 1. Overview
The current economic expansion is about to enter its fifth
year.

It thus outranks in longevity every prior cyclical upswing

of the postwar era with the exception of that in the 1960s. Yet it
has maintained considerable vigor, with real gross national product
rising more than 4 percent during the past year. The attendant increases
in employment and industrial capacity utilization have reduced considerably the margin of unutilized productive resources in the economy.
The narrowing of the gap between actual and potential output
implies that a tighter hold on the Nation's aggregate demand for goods
and services is necessary if inflationary forces are to be contained.
The urgency of such restraint is reinforced by the fact that there
has already been an acceleration in the rise of wages and prices.
Aggregate measures .of unit labor costs and prices advanced around
9 percent in 1978, appreciably more than in the preceding years of this
economic expansion.
Apart from the hardship that this large and generally unanticipated surge in inflation created for many families and business
enterprises, the behavior of prices deepened concerns around the world
regarding the stability of the U.S. economy and the soundness of the
dollar. The value of the dollar on foreign exchange markets declined
through most of 1978, exacerbating domestic inflationary pressures in
the process.

To prevent a serious disruption of the international

financial system, abroad program of corrective actions was initiated
last November. The dollar has since strengthened, but remains vulnerable
to shifts in sentiment among exchange market participants.




37
The longer-range strength of the U.S. economy and of the dollar depends greatly on our success in retarding inflation. This was
recognized during the past year in actions taken to reduce the size
of the Federal budget deficit, in the establishment of voluntary wageprice standards, and in efforts to curtail the inflationary impact of
Federal regulation.

In the monetary sphere, too, there was movement

toward moderation of aggregate demand growth and restraint of inflation
as the Federal Reserve acted to prevent excessive growth of money
and credit.




-2-

38
Section 2. Aggregate Economic Activity
The current economic upswing, which began in the spring of
1975, ranks among the most durable in this Nation's history.

In the

period since World War II, only the expansion of the 1960s was longer,
and it was marked by massive increases in military outlays associated
with the Vietnam War.
The past four years have seen sizable gains in production and
employment. Between the first quarter of 1975 and the fourth quarter
of 1978, real gross national product rose more than 20 percent. By
last month, industrial production had increased about 35 percent and
nonfarm payroll employment more than 14 percent from their levels
at the cyclical trough in March 1975.
The momentum of expansion, furthermore, has been well maintained.

Real GNP increased 4.3 percent from the fourth quarter of

1977 to the fourth quarter of 1978—a bit slower than the average
pace over the earlier part of the expansion, but still well above
the trend growth of potential output in the economy. The persistent
strength of aggregate demand was demonstrated by the surge in activity
during the final quarter of last year, when GNP grew at an annual
rate in excess of 6 percent.

Available indicators suggest that the

economy has remained generally strong in the opening months of 1979.
Residential construction, which provided a good deal of
impetus to the early recovery, stayed on a high plateau last year
in the face of rising interest rates and a continued rapid escalation in building costs.

Household demands for shelter have been

bolstered by demographic trends as well as by an inflation-hedging




-3-

39
motive.

The sustained advance in economic activity also has been

fostered in good part by strength in consumer spending.

A marked

turnaround in the willingness of consumers to spend—reflected in
a sharp drop in the personal savings rate—provided much of the
impetus to over-all expansion in the early stages of the economic
recovery, and consumption expenditures have remained unusually
robust throughout the upswing.
In the business sector, spending on new plant and equipment
has continued to rise, but there have not as yet been the large
increases seen in some earlier cycles.

Business fixed investment

actually declined during the initial quarters of the economic expansion, as firms concentrated on the repair of strained financial
positions in an environment of low capacity utilization.

Capital

spending policies have continued to be characterized by considerable
caution, and it was not until mid-1978 that the previous peak level
of real outlays was reattained. Firms also have exercised caution
in managing their inventory positions, and stocks generally have
remained lean relative to sales.
Government purchases of goods and services rose briskly at
both the Federal and State and local levels during the second half of
1978, but have been a moderating influence on over-all activity during
most of the cyclical upswing. The over-all budgetary position of the
Government sector, including transfer payments and revenues, has
remained stimulative throughout the expansion, albeit in diminishing
degree. An improving net export position contributed to the expansion
of GNP during the early recovery phase, but deterioration in the




-4-

40

REAL GNP
1972 Dollars

Index, trough quarter=100

120

Average of the
Five Previous Cycles
110

100

1975

1976

1977

1978

REAL GNP AND MAJOR SECTORS
1975Q1 -1978Q4

Percentage change, annual rate

Housing
Expenditures

GNP




15

Business
Fixed
Investment

Personal
Consumption
Expenditures
Government
Purchases

-5—

41
trade balance was a decidedly negative, factor from 1976 to early
1978.

The U.S. trade deficit did narrow over the course of 1978,

however, owing in part to the strengthening of economic expansion
in other major industrial countries.
Personal Consumption Expenditures
Consumer outlays grew 3.8 percent over 1978 after averaging
5-1/2 percent, at an annual rate, earlier in the economic recovery
and expansion.

The slower growth of spending reflected relatively

smaller recent gains in real disposable income; increases in real
personal income were eroded by larger tax burdens related to higher
contributions for social security and the interaction of inflation
and a progressive tax system.
The proportion of consumption in gross national product
has held at a high level over the course of this upswing.

In prior

cycles this share typically fell as the expansion matured.

In par-

ticular, household spending for durable goods has hovered at around
10 percent of GNP throughout the past three years, while during other
economic expansions it accounted, on average, for about 7-1/2 percent.
This exceptional strength in consumption and the associated rapid
increase in instalment credit and low savings rates can be attributed,
in part, to the higher relative number of younger households.

But

it also appears to be in some degree a reaction of households to
persistently high inflation rates.

For example, opinion surveys

suggest that many consumers have been buying durable goods in anticipation, of price increases.




-6-

42
REAL PERSONAL
CONSUMPTION EXPENDITURES
REAL DISPOSABLE
PERSONAL INCOME

change from previous period,
annual rate, percent

I

1975

I

1976

1977

1978

SAVINGS RATE

Percent

10

8

6
4

I

I
1975

1976

1977

CONSUMER CREDIT OUTSTANDING

1978

Billions of dollars
350

— 300

— 250

1975




43
Business Fixed Investment
Real business fixed investment rose 8-1/4

percent over

1978. This was nearly the same pace of advance as in the two previous
years and almost twice the rate of expansion in aggregate activity.
Recently, nonresidential construction activity has become an important
source of business investment growth.

In 1978, real spending for

such structures increased 12-3/4 percent as outlays for commercial
and industrial buildings showed particularly impressive gains.

On

the other hand, investment in producers1 durable equipment grew about
6-1/2 percent in real terms during 1978 compared with increases of more
than 10 percent in each of the previous two years. Demands for motor
vehicles, which were exceptionally strong earlier in the expansion,
began to tail of f in 1978, while machinery outlays continued to advance
at about the same moderate pace experienced since early 1976.
Inventory Investment
Investment in business inventories was characterized by caution in 1978, as it generally was in the three previous years.

As

a result, aggregate inventory-sales ratios remained at or below historical averages.

This caution, which can be traced back to the severe

inventory cycle of 1974-75, appears to have been responsible for the
avoidance of the types of overhangs that preceded several prior cyclical
downturns.

Incipient build-ups of stocks have been met with prompt

increases in sales promotion or curtailments of orders and production.
Most recently, overhangs that developed at general merchandise retail
outlets in the fall apparently were corrected by the sharp rise in




-8-

44
sales during the holiday season and a. slowing of production of durable home goods.
Residential Construction
The rate of private housing starts advanced briskly during
the 1975-77 period and in 1978 they were sustained at the high annual
rate of 2 million units.

Spending for residential construction

in real terms increased at an average annual rate of 21 percent
from the 1975 trough before leveling off in 1978.

In addition

to production capacity constraints, the recent developments in housing activity reflect the tightening in financial markets.

Interest

rates on both construction loans and long-term mortgages rose appreciably in 1978 and by year-end they had reached usury ceilings in
a number of states and record postwar highs in many other areas.
Even so, the variable-ceiling six-month time accounts introduced
in June of last year buoyed deposit growth at key mortgage lenders
and helped maintain the high rate of housing construction.
Within

the housing sector, the rise in single-family

starts led activity early in the recovery. More recently, multifamily starts—supported by an increase in Federally subsidized
rental units—have increased while single-family starts have remained
above their 1972-73 peak levels.

Indeed, in the fourth quarter

of 1978, total housing starts averaged an annual rate of 2.1 million
units, the same as a year earlier.




-9-

45
PRIVATE HOUSING STARTS

1970




Annual rate, millions of units

1978

46
International Trade
After providing some initial stimulus to economic growth
during the early recovery period in 1975, the U.S. balance of trade
began deteriorating.

In large part this reflected the relatively

stronger rate of economic expansion in the United States compared
with our major trading partners. The deficit in net exports narrowed
during 1978, however, as activity abroad picked up in contrast to
the moderation in the U.S. expansion.

In addition, the more favor-

able trade balance reflected a 20 percent rise in agricultural exports
last year, associated with unusually poor harvests of wheat and
soybeans in the Southern Hemisphere.
Government
Growth of purchases by the Federal Government has been
uneven in this expansion.

In real terms, such purchases increased

little during 1975 and 1976, rose substantially in 1977, and then—
despite a surge in the second half of the year—declined slightly
in 1978.

Total expenditures, however, have risen consistently,

reflecting increased grants to State and local governments and transfers to individuals for Social Security, food stamps, and retirement
benefits.

Revenues have increased even more than outlays over the

past several years, so that the Federal budget deficit has declined
from $66.4 billion in fiscal year 1976 to a projected $37 billion
for the current fiscal that ends next September.




-11-

47
State and local government purchases also have grown irregularly over the past four years.

In real terms, outlays by this

sector for goods and services expanded at a 2-1/4 percent annual
rate during the second half of 1978, matching the average pace
over the expansion as a whole.

This is well below the trend rate

of increase experienced during the 1960s and early 1970s. The slowing
of growth reflects changing requirements for services, associated
with demographic developments, and a degree of fiscal conservatism
prompted partly by the financial difficulties encountered by some
communities- in recent years.

In 1978, however, a tendency toward

tax relief—occasioned in part by voter preferences expressed in
California1 s Proposition 13 and like measures elsewhere—outweighed
the impact of spending economies on budgets. As a result, although
the aggregate operating surplus of State and local governments totaled
$6 billion for the year, this was only half the size of the 1977
surplus.




-12-

48
GROWTH OF FEDERAL GOVERNMENT
PURCHASES OF
Change from previous period,
annual rate, percent
GOODS AND SERVICES
H Nominal

• Real
12

+
0

1975

1976

1977

STATE AND LOCAL GOVERNMENT
PURCHASES OF
GOODS AND SERVICES

1978

Billions of 1972 dollars

— 180

170

160

1975




1976

1977
-13-

1978

49
Section 3. Labor Markets
Labor demand has been strong throughout the current economic expansion. During the three years following the cyclical trough
in early 1975, nonfarm payroll employment advanced at an average
annual rate of 3.7 percent—compared with a 2.8 percent median
rate of gain during the five previous postwar expansions.

During

the past year—at a stage when in earlier cycles employment levels
had begun to level off or even fall—payroll employment has continued
to advance at a 4.2 percent annual rate. Over the almost four years
of expansion, employment has increased by 12 million, and today
the ratio of employment to total civilian population aged 16 and
over stands at the highest level on record.
Employment in the goods-producing sector of the economy
rose rather slowly early in this recovery, reflecting in part the
sluggish behavior of business fixed investment.

It was not until

late 1978—as a result of large hiring increases in the hard goods
industries—that factory employment reached its pre-recession peak.
Similarly, construction hiring showed only small increases for nearly
three years after the trough.

During 1978, however, employment

in contract construction surged ahead to record levels.
In the private service-producing sector, employment dipped
only briefly in early 1975 and has been on a steady uptrend since
then—far exceeding the gains of previous expansions. The trade and
service industries have continued to grow faster than other sectors,
and by the end of 1978 they accounted for more than 4 of every 10




-14-

50

LABOR MARKET

Change from previous period,
annual rate, millions

• Civilian Labor Force
— HD Employment

— 4

«

Percent

Unemployment Rate

Percent

Civilian Employment Population Ratio
60

58

56

1975




1976

1977

— 15—

1978

51
jobs in nonfarm establishments.

In contrast to the private sector,

Government hiring has been modest. Federal Government civilian employment has been fairly stable at around 2-3/4 million over the past
4 years, about
1960s.

the same level that has prevailed since the late

State and local government employment has risen, but growth

has slowed substantially in recent years as a consequence of reduced
needs for education personnel and fiscal retrenchment by many units.
The reduction in educational labor demand reflects the
shift in the age structure of the population that has been affecting not only school enrollments, but also the size of the work force.
Growth of the teenage population (ages 16 to 19) in the late 1960s
and early 1970s was exceedingly large, reflecting the attainment of
working age

by

the postwar baby boom cohort.

At the same time,

labor force participation rates for teens rose sharply. In the mid1970s, growth of the 16 to 19 age group slowed, and in 1978 the
teenage population actually began to contract. Nonetheless, with
participation rates still rising rapidly, the teenage labor force
continued to grow at a rapid pace (up 3.2 percent in 1978 compared
to 1.6 percent on average in the preceding four years).
An even more significant factor in the expansion of the
work force has been the continued rise in the participation rates of
adult women.
as well

The longer-run trend, which reflected low birth rates

as changing attitudes and social

trends, apparently was

augmented in the 1970s by a desire of families to maintain their
material living standards in the face of rapid inflation.




-16-

As a

52
result of these participation rate patterns, the total civilian labor
force grew 3 percent during 1978—about the same as in 1977, but
up considerably from the 2-1/4 percent annual rate during preceding
years of the decade.
With the growth of employment outstripping even the large
increase in the size of the labor force, the unemployment rate fell
one-half percentage point over the course of 1978 to just under 6
percent.

Labor market conditions improved significantly for most

groups of skilled and experienced workers.

For example, unemploy-

ment rates for workers 25 to 54 years old, skilled blue collar workers,
and workers seeking full-time employment all were at or near the
levels reached in 1972 when labor and product markets were beginning
to tighten noticeably.

While there was as yet no general shortage

of skilled workers during 1978, many firms reportedly were finding
it increasingly difficult to fill certain job vacancies at prevailing
wage rates.
The improvement in employment conditions during the current
expansion has not been uniform.

Despite the gains made by many

groups, unemployment rates for younger workers, minorities, and the
unskilled were still very high at the end of 1978.

For example,

the unemployment rate for teenagers at the end of 1978 was 16-1/4
percent, more than four times the rate for workers 25 to 54 years
old; for minority youth the rate was over 35 percent. Younger workers
between 16 and 24 years of age accounted for about one-half of all
joblessness in the fourth quarter of 1978.




-17-

53
UNEMPLOYMENT RATES
Total

Adults

16 Years and Over

25—54 Years

20

1972

1975

1972

1978Q4

1975 1978Q4

Percent

Skilled Blue-collar Workers

Percent

Teenagers
16—19 Years

20

15

1972

1975 1978Q4

1972

1975 1978Q4

Percent

Percent

Unskilled Blue-collar Workers
20
15.6

1972




1975 1978Q4

1972
-18—

1975 1978Q4

54
The enlarged proportion of the labor force accounted for by
teenagers and women means that the over-all unemployment rate does not
imply the same degree of labor force pressure that it would have
in past years.

These groups tend to have relatively high rates of

joblessness for a number of reasons, including generally more limited
training and work experience. Asa rough adjustment for such structural
influences, the average, unemployment

rate can be recomputed using

the age-sex composition of the labor force in the mid-1950s.

The

result of such a calculation is an unemployment rate about one percentage
point below its current level, which vividly illustrates that the
level of labor utilization consistent with price stability may change
considerably over time.

To enhance the possibility of simultaneously

achieving low unemployment and price stability, it may be necessary
to augment monetary and fiscal policies with carefully focused programs
to facilitate job placement and to provide skill-training.




-19-

55
Section 4.

Productivity

The 3.5 million increase in payroll employment during 1978
was much larger than would have been expected on the basis of the
historical relationships between output changes and labor demand.
Although real GNP growth decelerated from 5-1/2 percent in 1977 to
4-1/4 percent in 1978, businesses added to their payrolls at almost
the same rate.

Output per hour of work rose only slightly over

the four quarters of 1978.
Much of the slowdown in productivity growth last year occurred
outside the manufacturing sector; output per hour in manufacturing
increased 3-1/2 percent during 1978.

Normally productivity growth

slows as labor markets tighten and capacity constraints are approached,
but the fall-off in productivity gains in the past two years has
been particularly sharp.
This poor performance of labor productivity continues a trend
toward slower growth evident since the late 1960s. During the period
from 1947 to 1967, productivity in the nonfarm business sector rose
on average by 2-2/3 percent per annum, and accounted for almost 70 percent of the gain in output for this sector.

Since 1967, the rise

in output per hour has slowed, with average annual gains of only
1.2 percent recorded since 1973.

As a result, less than 50 percent

of output growth over the last five years can be attributed to gains
in efficiency.
The deterioration of productivity performance in recent
years is a complex phenomenon that is not completely understood. It




-20-

56
OUTPUT PER HOUR
Nonfarm Business Sector

Ratio scale, index 1967=100
—1140
130

120

1947-1967 Trend

100

80

60

'48




'53

'58

'63

—21—

'68

'73

'78

57
appears, however, that a crucial factor has been the failure to maintain an adequate rate of capital formation. Indeed, the Nation's stock
of capital has shown little growth relative to the size of the labor
force over the past decade; in contrast, the capital-labor ratio trended
upward rapidly in the preceding 20 years.

Other factors that may

have contributed to reduced productivity growth in recent years are
the influence of environmental

and safety regulations that divert

resources to uses not measured in the National Income and Product
Accounts, and the increase in the proportion of young and inexperienced
workers in the labor force.




-22-

58
RATIO OF CAPITAL STOCK
TO LABOR FORCE

Ratio scale, thousands of 1972 dollars par person

12

1947-1967 Trend

10

'48

'53

'58

'63

'68

'73

AVERAGE ANNUAL GROWTH OF CAPITAL STOCK*

1962-1967

1967-1972

* Private nonresidential net capital stock measured in constant dollars




ii

-23-

'78

Percent

1972-1977

59
Section 5. Investment
Since the early 1960s, there has been a marked trend toward
slower growth of the stock of business capital in the United States.
Although real gross business fixed investment last year surpassed
the 1973 record, still stronger investment activity will be needed
if there is to be a sustained reversal of this trend.

In part this

merely reflects the arithmetic truth that unchanged absolute amounts
of investment translate into declining percentage increases in a
growing stock of plant and equipment.

Also important, however,

is the fact that it is net investment—that is, gross investment
less the depreciation of existing capital goods—that adds to the
capital stock, and real net investment has yet to reach its previous
peak level.

Because the fraction of the capital stock in the form

of relatively short-lived equipment has been increasing in recent
years, a higher level of gross investment is now needed simply
to maintain the existing capital stock.
It also must be noted that even the figures for net investment probably overstate the contribution that capital outlays have
been making recently to the expansion of productive capacity.

A

significant share of plant and equipment spending has been undertaken
to meet Government pollution, health, and safety regulations. During
the past several years roughly 5 percent of total capital spending
has been for the purpose of pollution abatement, and some estimates
suggest that perhaps an additional 2 percent of investment has
been for improvements in health and safety conditions.




-24-

Although

60
these outlays may well yield important; benefits to society, they do
not directly enhance productive capacity.
When an economy is near full employment, the commitment
of additional resources to capital formation will require some nearterm sacrifice of consumption by individuals or Government. However,
there is ample evidence that higher levels of investment effort can
enhance long-range economic growth and raise living standards. The
increase in U.S. capital spending last year raised the ratio of real
gross business fixed investment to GNP to 10.2 percent—the first
time since 1974 that it reached the 10 percent level, but still somewhat
below the average of the late 1960s and early 1970s. Although international comparisons must be made with caution, owing to differences
in accounting and other technical problems, it is clear that other
major industrial nations have allocated greater shares of GNP to investment and, as a result, have enjoyed substantially faster increases
in productivity and output. While this does not lead to the conclusion
that the United States should attempt to achieve the same investment-toGNP ratios as prevail elsewhere, it tends to confirm the proposition
that this Nation would benefit from higher proportions of capital
spending to GNP than have been experienced in recent years.




-25-

61
INTERNATIONAL COMPARISON OF INVESTMENT SHARES*
1966-1976

Percent

—

*Real nonresidential fixed investment as percent of real gross domestic product; OECD data.
Includes Government purchases of capital goods.
Data for France cover the period 1970-75.




—26—

5

62
Section 6. International Trade and Payments
From the mid-1960s through the early 1970s, the U.S. merchandise trade balance moved

gradually from surplus to deficit.

Then, during the 1974-75 worldwide economic slowdown the United
States a suffered disproportionately sharp contraction, so that—
despite an enormous increase in our outlays for imported oil—the
U.S. trade balance swung into surplus in 1975. The surplus proved
temporary, however; the subsequent economic recovery was stronger
here than abroad, and this played a major role in the steep increase
of our trade deficit from 1976 through early 1978.
The trade deficit in 1978 was $34 billion, slightly larger
than in 1977. But the deficit peaked at an annual rate of $45 billion
in the first quarter of 1978, and developments in both exports and
imports contributed to a narrowing of the imbalance to a rate of
about $30 billion in each of the subsequent quarters.
The growth of exports accelerated in the second quarter.
The step-up was partly attributable to temporary causes—for example,
demand for U.S. agricultural commodities was stimulated by poor
Southern Hemisphere harvests.

More important, however, was a

strengthening of economic activity abroad and the improved competitiveness of U.S. goods resulting from the substantial depreciation
qf theU,S. dollar that began in the fall of 1977.

The real volume

of non-agricultural exports increased 6 percent in 1978, and growth
picked up strongly in the second half of the year. Prices of exports
increased in line with the general pace of domestic inflation,




-27-

63

U.S. CURRENT ACCOUNT AND
TRADE BALANCES

Billions of dollars

Current Account Balance

Trade Balance
International Accounts Basis

— 18

— 30

'65

'70

'75

'78

ACTIVITY RATIO

1975=100

102

Ratio of Foreign Real GNP*
To U.S. Real GNP
100

I
1974

1976

"^Weighted average of G-10 countries plus Switzerland
using total 1972—1976 average trade of these countries




-28-

1978

64
and the total value of merchandise ea^ports rose 17 percent from

1977.
The relatively moderate rise in the volume of imports
in 1978, following two years of very large increases, resulted primarily from a slower increase in nonoil imports, but it was reinforced
by some decline in petroleum imports. Although total U.S. petroleum
consumption is estimated to have increased 3 percent, the higher
demand was more than met by increased Alaskan production and by
a drawing down of inventories from unusually high levels.

The

total value of imports increased 16 percent in 1978 with the gain
spread over most major commodity categories.

Almost half of this

increase was in volume terms as imports responded to the continuing
strength in U.S. economic activity. Prices of nonoil imports were
boosted by the decline in the international value of the dollar.
The current account deficit in 1978, estimated at $17
billion, was slightly larger than in 1977. As in other recent years,
net receipts from service transactions provided a substantial offset
to the merchandise trade deficit.

Earnings, fees, and royalties

from foreign direct investments have shown a strong uptrend during
the 1970s.
In the period between the onset of generalized floating of
currencies in March 1973 and September 1977, the exchange value of
the dollar went through several phases of appreciation and depreciation.

The average value of the dollar increased sharply (nearly

15 percent) from October 1973 to January 1974, despite large sales
of dollars by foreign central banks. Continued large sales of dollars




-29-

65
NON-AGRICULTURAL EXPORTS
Ratio scale, annual rate
Billions of 1972 dollars

Ratio scale, annual rate,
billions of dollars

160

160

120

120

100

100

80

80

60

60

I

I

1974

1976

J_

1978

OIL IMPORTS
Millions of barrels per day

Annual rate, billions of dollars

60

40
10
9




20

1974

1976
—30—

1978

66
by foreign central banks in 1974, later reinforced by the easing
of domestic interest rates associated with the U.S. recession, contributed to a decline in the dollar that began in the first quarter
of 1974 and did not end until the spring of 1975.

Thereafter, the

emergence of a large current-account surplus and a relative firming
of U.S. interest rates led to a substantial appreciation of the
dollar until the spring of 1976. The dollar subsequently held relatively steady until the fall of 1977.
The dollar began to depreciate markedly against most major
foreign currencies in late September 1977 as forecasts for 1978 suggested that the U.S. trade deficit would be no smaller than in 1977.
The decline continued through the end of 1977, despite large intervention purchases of dollars by foreign central banks. An announcement in January 1978 that the U.S. Treasury would join the Federal
Reserve in exchange market intervention in German marks, followed
by an increase in the discount rate, improved market sentiment only
temporarily, and by early April the dollar had declined about 10
percent on a weighted-average basis. Between early April and mid-May,
a relative firming of U.S, interest rates contributed to a recovery,
but ttie dollar declined fairly steadily thereafter in response to
continuing concerns about the size of the U.S. trade deficit and
increasing fears that U.S. price performance was deteriorating.
Although some depreciation of the dollar was justified
by the need to restore external balance in the face of differential
growth rates in the United States and major foreign economies and




-31-

67

U.S. INTERNATIONAL PRICE COMPETITIVENESS
March 1973 = 100

Relative Consumer Prices
Foreignyu.S.
— 108

— 104

Foreign Exchange Value
Of the U.S. Dollar*
— 88

1974

1976

1978

^Weighted average against other G-10 countries plus Switzerland using total 1972—1976
average trade of these countries




—32—

68
a relative worsening of U.S. inflation,, by mid simmer it was clear
that the dollar's decline was becoming excessive in trading that
was increasingly disorderly.

Consequently, in August the Federal

Reserve announced a 1/2 percentage point increase in the discount
rate and reduced to zero reserve requirements on borrowings by member
banks from the Eurodollar market. The Treasury subsequently announced
that it would increase the size of its regular monthly gold auctions.
These measures produced a brief rally and then a few weeks of stability
for the dollar.

However, the dollar's slide soon resumed. After

the President announced his wage-price program on October 24, the
decline steepened alarmingly, threatening to undercut

the anti-

inflation effort at home and to lead to further erosion of confidence
abroad.

By late October, the dollar had fallen 21 percent from

its September 1977 level.
Under

these circumstances, more

forceful

action was

required. On November 1, the Federal Reserve increased the discount
rate by 1 percentage point and imposed a 2 percentage point supplementary reserve requirement on large time deposits. To increase
the availability of foreign currencies for exchange market intervention, enlarged swap lines were arranged with the central banks
of Germany, Japan, and Switzerland. The U.S. Treasury simultaneously
announced

its

intention

to draw on its reserve position in the

IMF, to sell SDRs, and to issue foreign currency denominated securities. In addition, the Treasury announced a doubling in its rate
of gold sales.




-33-

69
The aim of these measures was to correct the excessive
depreciation of the dollar and thereby to counter upward pressures on
the domestic price level. When viewed in its entirety, the policy
initiative of the Administration and the Federal Reserve System
indicated that the United States recognized the need for an integrated
approach in addressing domestic and international economic concerns.
The announcement of these measures on November 1 produced a dramatic
jump in the dollar's exchange value. On that day alone the dollar
advanced by 5 percent on a weighted-average basis. Heavy cooperative
central bank intervention over the following few weeks provided
support for the dollar as market participants tested the authorities'
resolve, but the need for such intervention abated in January. As
of mid-February of this year, the dollar was more than 7 percent
above its October low on a weighted-average basis.




-34-

70
Section 7.

Prices

Inflation typically has accelerated over the course of cyclical expansions

in economic activity, and this upswing has proven no

exception. However, the marked increase in the pace of price advance
during the past year was in large measure a consequence of forces
not directly related to an intensification of general demand pressures
on available productive resources. Government-mandated increases in
costs and special developments in the agricultural and international
sectors contributed substantially to the pick-up in inflation during

1978.
Inflation moderated during the first stages of the cyclical
recovery in 1975 and 1976. The earlier extraordinary pressures associated with the rise in oil prices, the sharp escalation in food
prices, a worldwide boom in other commodities, and domestic price
decontrol subsided, and the considerable slack in labor and product
markets restrained wages and prices. Inflation began to speed up
again in 1977, however, and prices then surged in 1978. The Consumer
Price Index, the Producer Price Index, and the fixed-weight price
index for gross business product all registered increases of around
9 percent during 1978, about 2 percentage points more than in the
preceding year.
The acceleration of inflation

last year reflected impor-

tantly the pressure of rising labor costs. Wage rates in the private
nonfarm sector increased

8-1/4 percent, compared with about 7-1/2

percent in each of the preceding two years.




-35-

A boost in the Federal

71
minimum wage contributed

appreciably to

the accelerated rise

of wages; the impact was especially noticeable in the trade sector,
which has the largest concentration of lower-wage workers and saw
average wage increases of more than 9 percent last year.
Hourly compensation, which includes, in addition to wages,
the costs to employers of social insurance contributions and of
privately negotiated fringe benefits, rose 9-3/4 percent—about 2
percentage points faster than in 1977.
acceleration resulted

from increased

About one-quarter of the
Social Security taxes and

unemployment insurance contributions. In addition, private fringe
benefits continued to rise faster than wages.
Given

the weak performance of labor productivity, the

larger compensation gains were translated into rapid increases in
unit labor costs. Unit labor costs in the nonfarm business sector
rose 9 percent during 1978 versus 6-1/3 percent in 1977.

As 1979

began, labor costs again were given an upward jolt by further increases
in the minimum wage and Social Security taxes.
Apart from the broad pressures exerted by rising unit
labor costs, the general level of prices was affected considerably
in 1978 by developments in the farm and food sector.

Retail food

prices rose 12 percent over the year—the largest increase since
1974. The increases at the retail level reflected a rise of almost
20 percent in farm prices during 1978 following little change in
the preceding year. Meat price increases were particularly rapid,
as beef production continued to decline.




-36-

72
UNIT COST INDICATORS

Change from year earlier,
annual rate, percent

Nonfarm Business Sector

Compensation per Hour

10

— 4

—

2

—

2

12

I

I
1975




1976

1977

—37—

1978

73
LABOR COSTS AND
PRICES

Change from year earlier,
annual rate, percent
—115

Nonfarm Unit Labor Costs
10

GNP Prices

Excluding Food and Energy

10

Energy

12

Total Prices

I

I

1975




1976

I
1977
-38-

1978

74
The decline in the foreign exchange value of the dollar
also aggravated inflation. Aside from the direct impact of higher
prices for imported merchandise, the price-restraining pressure of
foreign competition was weakened for many domestic products. Large
price increases for domestically produced automobiles and other durable goods reflected both of these effects. The inflationary pressures associated with the steep depreciation of the dollar that
began in September 1977 appear to have accounted for about 1 percentage point of last year's rise in the Consumer Price Index.
At the producer level, the inflation of prices of capital
equipment accelerated considerably less than that for consumer finished goods. But crude materials prices, for both food and nonfood
items, increased sharply, and prices for construction materials also
rose rapidly. In the first month of this year the continuing strength
of inflationary

forces was demonstrated by a 1.3 percent jump in

the Producer Price Index; although consumer foods posted an especially
large increase, all of the major groupings of finished goods and
materials showed accelerated advances.




-39-

75
Section 8. Financial Markets
Interest Rates
Interest rates generally declined during the early part
of the current economic expansion. This departure from usual cyclical patterns probably was attributable in part to a diminution of
inflation expectations associated with the observed slowing in the
advance of prices and to the limited credit needs of businesses which
were pursuing cautious capital spending policies.

Interest rates

began to move upward in the Spring of 1977, however, as the Federal
Reserve acted to restrain accelerating growth in money and credit.
Over the course of 1977, yields on short-term market instruments
generally rose about 2 percentage points, while corporate and Treasury
bond yields increased around 3/4 percentage point.
With inflation picking

up, the margin

of unutilized

resources narrowing, and the dollar under downward pressure in foreign
exchange markets, the Federal Reserve applied increasing restraint
to the expansion of money and credit in 1978.

This was reflected

in further increases of 3 to 4 percentage points in most shortterm rates over the course of the year.
short rates and heightened inflation

The combination of rising
expectations resulted in

increases of roughly 1 percentage point in bond yields. By year-end,
a number of interest rates were near or above the peak levels of 1974.
Monetary Aggregates
The monetary aggregates have exhibited some unusual patterns of behavior during the past several years.

This has been

especially true with respect to the narrow money stock, M-l. During




-40-

76
INTEREST RATES
SHORT-TERM




4-6 Month Prime
Commerical Paper

Home Mortgage
Interest Rate

77
1975 and 1976, growth in M-l averaged juat over 5 percent per annum.
Given the concurrent decline in interest rates, the sizable increases
in M-l velocity—that is, the ratio of GNP to M-l—were much larger
than would have been predicted on the basis of previous historical
relationships among money, income, and interest rates.
The moderation of the public's demand for M-l may have
reflected to a degree an unusually strong cyclical swing in confidence
and increased willingness to spend out of existing cash balances
as the economy recovered from a severe recession.

However, there

is also considerable evidence that other factors played an important
role.

The unprecedentedly high level reached by interest rates

in 1974 stimulated the creation and adoption of new cash management
techniques that permitted individuals and businesses to economize
on nonearning demand deposits. This development apparently continued
to exert a significant influence even after interest rates turned
downward, and it was reinforced by several important legislative and
regulatory developments and innovations affecting the payments system.

These included the authorization of NOW accounts in all of

New England, of savings accounts for businesses and governmental
units, and of preauthor!zed third party and telephone transfer privileges for personal savings accounts.
By the beginning of 1977, the level of M-l was well below
that predicted by most standard econometric models of the demand for
money.

This downward shift in money demand abated in early 1977,

however, and growth of M-l generally conformed to historical patterns
until the final months of 1978.




-42-

M-l expanded 8 percent during

78
1977 and at about the same pace over the first three quarters of
1978; rising interest rates and slowing economic expansion worked
to moderate M-l growth over this span, but these influences were
offset by the effect of accelerating inflation on transactions requirements.
On a quarterly

average

basis M-l growth in the fourth

quarter of 1978 was at a 4.4 percent annual rate, but the average
level of the money stock in January was slightly below that for
October.

A portion of this weakness is the direct consequence of

the introduction of automatic transfer services (ATS) last November
1; many individuals have shifted their transactions balances from
checking accounts to savings accounts from which funds are automatically transferred to cover checks. These shifts appear to have reduced
M-l growth rates by roughly 3 percentage points per month, on average.
Even after allowance for this, however, growth in M-l has been weaker
than might have been expected in light of the recent expansion of
income

and

spending.

It

may

be

that, as in

1974, interest

rates have reached a high threshold level at which households and
businesses are induced to seek out and adopt cash management techniques
that permit major economies in demand deposit holdings. The advent
of ATS—which occasioned basic changes in the checking account pricing
policies of many

banks—undoubtedly

has caused many individuals

to assess more carefully the opportunity costs of holding noninterestearning demand deposit balances as compared not only with ATS accounts
but also with other highly liquid interest-earning assets.




-43-

79
MONEY SUPPLY GROWTH
M-1

Change from previous period, annual rate, percent

12

I

1975

illl
llil

I

1976

1977

1978

M-2

12

I

1975

I I

I

1976

1977

1978

M-3




12

I
1975

1976

1977

—44—

1978

80
The behavior of the interest-bearing

components of the

broader monetary aggregates—M-2 and M-3—was generally in line
with historical patterns during the first three years of the economic
upswing, but there has been a marked deviation since last June.
Commercial banks and thrift institutions experienced rapid growth
of savings and small denomination time deposits until the latter
part of 1977. At that point a gap began to develop between interest
rates on short- and intermediate-term market securities and the
rates permitted on insured deposits by Federal regulations. As the
gap grew, inflows to savings and small time accounts gradually diminished through the spring of 1978. Commercial banks found it necessary
to rely more heavily during this period on large time deposits
and other managed liabilities to fund their lending activities, and
savings and loan associations borrowed heavily from Federal Home
Loan Banks.
To prevent a repetition of past episodes when markedly
reduced deposit inflows led to an abrupt curtailment of credit
to home buyers and others reliant on the depositary institutions
for credit, the Federal regulatory agencies authorized two new time
deposit categories effective June 1.

One was an 8-year account

paying up to 7-3/4 percent at commercial banks and 8 percent at
thrift institutions.

The other was a 6-month "money market certi-

ficate" (MMC) whose maximum rate varies weekly with the average
yield on newly issued 6-mpnth Treasury bills. Given rate relationships, the 8-year certificate has not added significantly to over-all




-45-

81
OUTSTANDING BALANCES OF
MONEY MARKET CERTIFICATES

Billions of dollars

Commercial
Banks

—

90

50

30

10
July

August

September

October

November

December




1976

1977
—46—

February

Change from previous period,
annual rate, percent

DEPOSIT GROWTH AT THRIFT INSTITUTIONS

1975

January

J_

1978

82
deposit flows, but quite the contrary is true of the MMCs. During
the first 5 months of 1978, time and savings deposits subject to
rate ceilings at commercial banks, savings and loan associations,
and mutual banks grew at a 7.9 percent annual rate; since the beginning
of June, these deposits have grown at a 10.3 percent rate despite
substantial further increases in market interest rates. MHC balances
at the end of January totaled about $105 billion and accounted
for 7-3/4 percent of savings and small time deposits at banks and
almost 13 percent at thrift institutions.
The MMCs have greatly reduced the sensitivity of time
and savings deposit growth to changes in market interest rates,
but they have not eliminated it.

Indeed, inflows have moderated

during the past few months, at least partly in response to the
substantial further rise in interest rates. Increased noncompetitive
tenders in auctions of Treasury securities and record growth of
money market mutual funds are indications that recent interest rate
levels have been inducing some diversion of funds from savings
and small time accounts subject to fixed rate ceilings.
Credit Flows
Although accelerating inflation has tended to dampen the
impact of rising nominal interest rates on credit demands, there has
been a perceptible flattening of the over-all pace of borrowing in the
economy over the past year. Total funds raised in credit markets by the
private domestic nonfinancial sectors have expanded only moderately




-47-

83

FUNDS RAISED BY DOMESTIC
NONFINANCIAL SECTORS

Billions of dollars

400

Total

300

Private

200
Federal
Government

100

1975




1976

1977
—48-

1978

84
since the second half of 1977

after having

the earlier part of the economic expansion.

risen rapidly during

Although the liquidity

of depositary institutions has declined over the past two years, the
introduction of the MMC has prevented the disintermediation that
accompanied previous interest rate cycles and permitted banks and
thrift institutions to continue to account for a very large share
of the funds advanced to ultimate borrowers.
Households, in particular, are heavily reliant on depositary institutions for credit, and their demands for funds have remained
strong.

Home mortgage borrowing in 1978 was slightly larger than

in 1977, and consumer instalment borrowing rose to a new record as
households financed purchases of autos and other large ticket items.
The aggregate flow of credit to households in 1978, at more than
$160 billion, was 15 percent greater than in 1977 and three times
the volume recorded in 1975.
The build-up of indebtedness by households over the last
three years has outstripped both the growth of this sector's financial
asset holdings and of disposable income. Repayment burdens have reached
record proportions.

Although loan delinquency data indicate that

families have not as yet encountered significant difficulty in meeting
their obligations for debt service, the diminished liquidity of household financial positions suggests a greater fragility and vulnerability to any deterioration of income flows.
The nonfinancial

business sector also experienced

decline in liquidity in the past year.
capital

spending and internal cash




-49-

some

The gap between corporate

flow widened, and

firms met

85
HOUSEHOLD DEBT REPAYMENTS RELATIVE
TO DISPOSABLE PERSONAL INCOME

Percent

23

22

21

20

1975

1976

1977

1978

NONFINANCIAL CORPORATIONS
Balance Sheet Ratio

Percent

Liquid Assets to
Short-Term Liabilities

34

30

26

1975




1976

1977
—50—

1978

86
a substantial portion of their external financing needs through shortterm borrowings—particularly from commercial banks. While commercial
mortgage borrowing increased and private bond placements remained
large, many of the big, highly rated industrial firms that have ready
access to the public bond markets evidently preferred to defer long-term
financings in the expectation that long-term rates would eventually
decline.

As a consequence, the aggregate ratio of liquid assets to

short-term liabilities in the nonfinancial corporate sector declined
over the course of 1978, to a level only slightly above the 1974
low.
State and local borrowing was about the same in 1978 as in
1977.

Advance re funding s again accounted for a sizable share of tax-

exempt bond issuance, but such operations virtually ceased after August
owing to the combination of restrictive IRS regulations and rising
interest rates. Despite some rise in the past few months, the ratio
of yields on municipal bonds to those on taxable obligations has
remained relatively low by historical standards, reflecting in part
the continued demand for tax-exempt securities by casualty insurance
companies, commercial banks, and individuals.
Borrowing by the U.S. Treasury has declined over the past
year, reflecting the diminution of the Federal budget deficit. Government borrowing

from the public totaled $59 billion in FY 1978, but

is projected by the Administration at about $40 billion in the current
fiscal year. The preponderance of the increase in outstanding Treasury
debt during 1978 was absorbed by State and local governments, which
purchased a large volume of nonmarketable Treasury securities with




-51-

87
proceeds of advance re fund ings, and by foreign official institutions,
which invested dollars obtained in exchange market intervention.
Commercial banks satisfied a substantial proportion of the
credit demands of households, businesses, and State and local governments during 1978.

Total bank credit expanded 10.9 percent over the

course of the year, with loan portfolios increasing by 14.6 percent.
To meet loan demands many banks had to liquidate holdings of Treasury
securities and to borrow either from correspondents or in the open
market through the issuance of large CDs or nondeposit liabilities
such as Federal funds and repurchase agreements. Aggregate bank liquidity ratios declined appreciably, especially among the smaller and
regional institutions that have experienced the strongest business
loan growth during this expansion.
Thrift

institutions experienced considerable cash

pressure during the

first

flow

half of 1978r but they have been able

to rebuild their liquid asset positions since the MMCs began to
bolster deposit growth.

Thrift institution mortgage lending declined

moderately during 1978, although there was some upturn in the final
quarter in lagged reaction to the midyear pick-up in deposit inflows.
Outstanding loan commitments also rose during the second half, but
in December were slightly below the year-earlier level.
Life insurance companies and pension funds have continued
to experience large inflows of investable funds.

In 1978, as in

previous years of the economic expansion, these institutions absorbed
the bulk of the net issuance of corporate bonds.

The insurance

companies also have supplied a large share of commercial mortgage
credit.




-52-

88
CHAPTER 2

"the objectives and plans of the Board of Governors and the
Federal Open Market Committee with respect to the ranges of
growth or diminution of the monetary and credit aggregates
for the calendar year during which the report is transmitted^
taking account of past and prospective developments ia employment, unemployment, production, investment, real income, productivity, international trade and payments, and prices"




Section 108(a) Full Employment and
Balanced Growth Act of 1978

89
Section 1. The Objective of Monetary Policy in 1979
The objective of the Federal Reserve is to foster financial
conditions conducive to a continued, but more moderate, economic
expansion

during

1979 that should permit a gradual winding down

of inflation and the maintenance of the stronger position of the
dollar in international exchange markets.

Given the limited margin

of unutilized labor and industrial resources remaining in the economy,
it is critically important to avoid strong aggregate demand pressures
that would aggravate our already serious inflation problem.

At the

same time, the current condition of general balance in the economy
suggests that it should be possible to continue restraint to relieve
inflationary pressures without triggering a recession.




-54-

90
Section 2. Growth of Money and Credit in 1979
The Federal Open Market Committee has selected growth ranges
for the monetary aggregates that it believes will bring to bear an
appropriate degree of restraint in light of current outlook for fiscal
policy and the underlying strength of private demand in the economy.
Over the year ending with the fourth quarter of 1979, M-l is expected
to grow between 1-1/2 and 4-1/2 percent; M-2, 5 to 8 percent; and
M-3, 6 to 9 percent.

Commercial bank credit has been projected to

increase between 7-1/2 and 10-1/2 percent during the year.
The growth range for M-l calls for a marked deceleration
from the pace of recent years.

This reflects in part an expectation

that the shifting of funds to savings accounts with automatic transfer
facilities and to the NOW accounts recently authorized in New York
State will continue to depress the growth of demand deposits throughout
1979.

The Board's staff has projected that such shifting will damp

growth in M-l this year by around 1 percentage points. Because there
has been only a brief period of experience upon which to base an
analysis of the attractiveness of the ATS accounts, this projection
carries a broad range of uncertainty.
The unexplained flatness of M-l in recent months introduced another uncertainty in the FOMC's deliberations regarding the
monetary growth ranges.

At this stage it is impossible to tell

whether the weakness of M-l relative to what would have been expected
on the basis of historical relationships among money, income, and
interest rates is a transitory phenonenon or one that is likely
to persist for some time. The range for M-l assumes that the recent




-55-

91
weakness does in some degree reflect a change in the public's desired
allocation of funds among various financial assets that may persist
for some time ahead, though not so strongly as in recent months.
The breadth of the specified growth range for M-l recognizes
the considerable uncertainties that currently exist. As subsequent
information begins to resolve those uncertainties, the range may be
adjusted. In the meantime, M-l may continue to be a somewhat ambiguous
indicator of monetary policy, and it will be especially important
to monitor carefully the behavior of other financial variables.
It may be noted that the Federal Reserve is studying possible redefinitions of the monetary aggregates. Among the proposals
made in a staff paper published for public comment in the January
Federal Reserve Bulletin is that M-l be redefined to encompass ATS,
NOW, and other similar transactional accounts. While such a redefinition would not eliminate the need to understand the behavior of
the various financial assets, it might produce an aggregate that is
more reflective of the public's need for transactions balances in
light of ongoing institutional changes.
The behavior of M-l was not the only puzzling development
confronting the FOMC early this month as it considered the appropriate ranges for monetary growth during 1979. There were questions
as well regarding the movements of the interest-bearing components
of the broader aggregates—especially the time and savings deposits
at commercial banks that, along with M-l, constitute M-2. Bank savings




-56-

92
deposits have declined appreciably in the past few months, despite
the influx of funds to ATS savings accounts. While savings deposit
inflows might be expected to exhibit weakness when market interest
rates are so far above regulatory ceilings, a large gap had existed
for a considerable time and it might have been expected that most
of the interest-sensitive funds had already moved into other instruments.

It is possible,

deposits—the recent

however, that—as perhaps with

demand

further sharp increase in interest rates to

historically high levels has prompted many people to seek out more
aggressively

alternative assets carrying market

yields.

The M-2

range adopted by the FOMC reflects an expectation that growth of
the interest-bearing component

will be somewhat stronger in the

months ahead, buttressed by further sizable increases in the large
denomination

time deposits included in the total and abatement of

the recent unusually large withdrawals of funds from savings deposits.
The range for M-3 implies a continued substantial growth
of deposits at nonbank thrift institutions. The money market certificates have proven a reliable source of funds. While some institutions
have reduced their promotion of MMCs, the certificates have continued
to be widely offered at ceiling rates—although there has been some
erosion of thrift institution earnings since mid-1978 as these relatively high

cost deposits have taken a growing share of thrift

institution liabilities.
The projected range for bank credit expansion reflects an
expectation that loan demands will be less intense in 1979 than in
1978, in line with the prospective more moderate growth of economic




-57-

93
activity.

Banks likely will have to continue relying heavily on

large time deposits and other money market liabilities to fund asset
growth, and this implies some further decline in traditional measures
of institutional liquidity.




-58-

94
M-1

Billions of dollars

360

-Actual
-Adopted Range

340

1978Q4-1979Q4

320

300

1975




1976

1977
—59—

1978

95
M-2

Billions of dollars
950
8% .

900

• Actual
•Adopted Range
1978Q4-1979Q4

800

700

1975




1976

1977
-60-

1978

1979

96
M-3

Billions of dollars
—11700

• Actual
-Adopted Range

1400

1978Q4-1979Q4

J_

1975




1976

1977
—61—

1978

1979

97
BANK CREDIT

Billions of dollars

ioy a %

1100

1000

Actual
Adopted Range
1978Q4-1979Q4

700

1975




1976

1977

—62—

1978

1979

98
Section 3.

The Economic Outlook

Despite the surge in real GNP during the fourth quarter,
it appears that underlying economic and financial conditions will
lead to a moderation of economic

growth

in the year ahead.

The

absence of the sorts of distortions and imbalances that have often
precipitated economic downturns in the past indicates that it should
be possible to slow the pace of expansion—and thereby relieve inflationary pressures—without prompting a recession. However, any further acceleration of inflation or the occurrence of severe shortages
of critical commodities, such as oil, would imperil this outcome.
The monetary restraint applied over the past year by the
Federal Reserve is expected increasingly to affect the residential
construction sector. Higher costs of credit will cause land developers
and builders to put aside marginally profitable projects, and the
combination of

higher house prices and mortgage rates will lead

some families to defer home purchase.

Nonetheless, owing to the MMCs

and various institutional developments that have broadened the sources
of mortgage funds, as well as to the strong underlying demand for
shelter, the decline in housing activity should be moderate by
comparison with past cycles.
Business

fixed investment

likely will continue to grow

during 1979, but at a slower rate than in 1978. There has been some
indication in the past few months of a slowing in the steep upward
trend of contracts and orders

for plant and equipment, and this

is generally consistent with surveys of capital spending plans which




-63-

99
REAL NEW ORDERS

REAL CONSTRUCTION
Billions of dollars

CONTRACTS

I

1976

1977

Billions of dollar-.

3-Month Moving Average

Nondefense Capital Goods

1976

1978

PLANT AND EQUIPMENT
EXPENDITURES

_L

1977

_L

1978

Change from previous period, annual rate, per cer

[Projected *]
-110

Nominal

1976

1977

1978

* Department of Commerce Survey of Anticipated Plant and Equipment Expenditures, December, 1978.




—64—

1979

100
point to smaller gains in outlays this year than last.

On the other

hand, the climate for investment can be expected to improve as business managers begin to perceive some progress in retarding inflation
and become more confident about the sustainability of expansion.
Government spending probably will post only a small increase
in real terms this year. Indeed, real Federal purchases could decline
during the first half due partly to expected repayments of Commodity
Credit Corporation loans (which are, in effect, sales of agricultural
stocks).

At the State and local level, slower growth of Federal

financial aid and the pressure for tax relief will tend to hold
spending increases to small proportions.
Foreign demand for U.S. exports should tend to strengthen
during 1979.

Economic expansion abroad is generally expected to

continue at its recent more rapid pace, and the effects of the substantial depreciation of the dollar on the U.S. trade position
should become more evident as the year progresses.
On balance, the aforementioned sectors are likely to provide a reduced impetus to income growth .during the year ahead.

As

a consequence, consumer spending is likely to grow less vigorously.
Moreover, the substantial debt repayment burdens faced by many households and generally reduced liquidity of the household sector could
prompt households to increase their recent relatively low savings
rate.

The demand for imports also should moderate this year, not

only because of the slower expansion of domestic income and production, but also because of the lagged effects of the 1977-1978 decline




-65-

101
GROWTH OF FEDERAL OUTLAYS

Percent

Fiscal Years
20

15

10

I

I

GROWTH OF FEDERAL RECEIPTS

Percent

Fiscal Years
20

15

10

FEDERAL DEFICIT

Billions of dollars
10

30

50

1975

1976

1977

1978

1979

1980

Fiscal Years
Note: Projections for 1979 and 1980 are from The Budget of the U.S. Government.




—66-

102
in the international exchange value of the dollar. Inventory investment is likely to be relatively flat in the projected economic environment .
With a slower growth of activity, pressures on productive
capacity should ease a bit. Industrial capacity utilization rates,
which in the manufacturing sector are not now far below past cyclical
peaks, should decline slightly.

In labor markets, the growth of

employment should moderate from its recent rapid pace.

Labor force

increases likely also will diminish, as the growth of the working
age population slows slightly and as labor force participation rates—
especially for youth—respond to the slackening in economic expansion. Together, the prospective changes in employment and the labor
force point to a small increase in the aver-all unemployment rate
during 1979.
The moderation of demand pressures in labor and product
markets will tend to slow the advance of wages and prices and thus
to reduce

the present, unacceptable rate of inflation.

However,

uncertainties will remain as a result of highly volatile and largely
exogenous influences such as farm prices and oil prices.

It now

appears that food prices will increase somewhat less this year than
last. Unfortunately, the price of imported oil will be boosted substantially this year as a result of the decisions taken by OPEC in
December, and the unsettled situation in Iran raises the possibility
of even larger price increases.
Setting aside these special factors, a key determinant of
the rate of inflation this year will be the performance of unit labor




-67-

103
costs.

Although there may well be some improvement in productivity

in the next few years as the work force tends to become, on average,
somewhat older and more experienced, there is little reason to expect
any marked acceleration of productivity growth during 1979.

Conse-

quently, if there is to be a noticeable slowing in the rise of
unit labor costs, compensation gains will have to moderate significantly.
Toward this end, the Administration's wage-price program
can play an important role. By providing a standard for constructive
behavior on the parts of both business and labor, the program can
be a vehicle

for helping to brake the wage-price spiral.

Broad

compliance with the Administration's standards would make a significant contribution to the slowing of inflation.

Of course, the

wage-price program can be successful only if there is complementary
restraint in monetary and fiscal policy—to contain aggregate demand
pressures and to assure the public of the Government's commitment
to the restoration of price stability.




-68-

104
CHAPTER 3

"the relationship of the [Federal Reserve's] objectives
and plans to the short-term goals set forth in the most
recent Economic Report of the President"




Section 10S(a)

Full Employment and

Balanced Growth Act of 1978

105
Section 1. The Short-Term Goals in the
Economic Report of the President
As specified by the Full Employment and Balanced Growth Act,
the President's Economic Report, transmitted to the Congress last month,
lays out a detailed set of economic goals for 1979 and 1980.

The

discussion of the Act's requirements points out that the Administration's "short-term goals for [1979] and 1980 represent a forecast
of how the economy will respond over the next 2 years not only to
the budgetary policies proposed by the President for fiscal 1979 and
JL/
1980 but to the anti-inflation program announced on October 24."
The Administration's goals, along with the comparable figures
for 1978, are summarized in the following table:

The President's Economic Goals
Item

1978
1979
1980
Level, fourth quarter

Employment (millions)

95.6

97.5

99.5

5.8

6.2

6.2

Unemployment rate (percent)

Percentage change, fourth quartet
to fourth quarter
Consumer prices

8.9

7.5

6.4

Real GNP

4.3

2.2

3.2

Real disposable income

3.3

2.8

2.3

Productivity

0.2

0.4

1.1

I/ Economic Report of the President, p. 108.




-69-

106
Section 2. The Relationship of the Federal Reserve* s
Monetary Growth Ranges to the Short-Term Goals in
The Economic Report
The Full Employment and Balanced Growth Act directs the
Federal Reserve to assess the relationship of its plans for monetary
growth to the short-term goals in the Economic Report. This task is
complicated by the fact that goals are specified for a variety of
economic variables, and monetary policy does not affect each of them
separately.

Monetary policy has its most direct short-term impact

on aggregate nominal GNP. Within the context of a particular nominal
GNP outcome, the mix of real output gains and inflation, the growth
of employment, and the movements in other variables are influenced
importantly by conditions at the beginning of the period, by other
governmental policies, by the structural and behavioral relationships
in the economy, and by developments outside the domestic economy.
As required by the Full Employment and Balanced Growth Act,
the Federal Reserve at this time has established ranges for monetary
growth through the end of 1979.

It will reassess these and report

preliminary ranges for 1980 in July, unless developments in the months
ahead necessitate earlier reconsideration.

At this juncture, the

monetary growth ranges and the Administration's 1979 economic goals
appear reasonably consistent. The Administration's forecast implies
an expansion in nominal GNP of around 9-3/4 percent from the fourth
quarter of 1978 to the fourth quarter of 1979.

The midpoint of the

FOMC's growth range for M-l is about 6 percent after adjustment
for the expected impact of shifts of funds to ATS and NOW accounts.




-70-

107
This suggests an increase of M-l velocity on the order of 3-1/2 percent,
a figure somewhat above the longer-teriii trend, but reasonable in light
of the lagged effects of the recent substantial increases in interest
rates and the downward shift in money demand that has been occurring.
The upper and lower boundaries of the M-l range, of course, allow
for the possibility of smaller or faster increases in velocity over
the year.
The output-price mix in the Administration's 1979 forecast
appears attainable if there is reasonable compliance with the wage-price
standards and as long as there are no untoward
unanticipated

surge in food or energy prices.

shocks such as an
The employment and

productivity forecasts appear consistent with the output goal, and
the unemployment rate forecast seems consistent with reasonable assumptions about labor force growth in the projected economic environment.
Considerably greater uncertainties naturally are encountered
with respect to the Administration's goals for 1980, a period that is
still rather distant. Nothing in the monetary or economic projections
for 1979

suggests to us that conditions prevailing at yearend will

bar the achievement of the Administration's forecasted 9-1/2 percent
growth

in

nominal GNP during

1980.

At this time, however, the

achievement of the output-price mix projected for 1980

appears to

be more difficult.
The Administration

has forecast a marked acceleration of

real GNP growth in 1980 and a marked deceleration of inflation.
an outcome




Such

is certainly attainable, but given the projected levels
-71-

108
of resource utilization—with the unemployment rate remaining around
6-1/4 percent—this result will require considerable progress in the
lowering of inflation expectations.

There will have to be broad

conformance to the Administration's wage-price standards, and Government will have to give careful attention to the potential cost-raising
impacts of its regulatory and legislative actions. Continued budgetary
restraint also will be necessary, both to build confidence in the
Government's commitment to avoid fiscal excesses and to minimize pressures on the capital markets.
Recognizing the risks and uncertainties that currently exist,
the Administration's 1980 forecast can serve as an appropriate goal
for Congress as it considers its budgetary plan for fiscal 1980.
If inflationary pressures subsequently should prove stronger than the
Administration has projected, then the prudent course for Government
policy would be to exercise a substantial degree of restraint even if
it risks less real growth in 1980 than the 3.2 percent goal.

Such

a policy would lay the foundation for balanced economic growth over
the years to come and help to maintain the integrity of the dollar.




-72-

109
.-;is^gi^;..

B O A R D DF G O V E R N O R S
OFTHE
FEDERAL RESERVE S Y S T E M
WASHINGTON, D. C. SO55I

G. Wl LLIAM

MILLER

C H A I R MAN

March 7, 1979

The Honorable Donald Stewart
United States Senate
Washington, D.C.
20510
Dear Senator Stewart:
Chairman Proxmire recently relayed to me a
number of questions you raised in connection with the
February 20 hearings on monetary policy. Enclosed are
the answers to those questions, and, as noted below, I
have forwarded a copy to Chairman Proxmire for inclusion
in the hearing record.
If I have failed to respond fully .to your
inquiry or if you would like to pursue these matters
further, please let me know. If it would be useful, a
member of the Board's senior staff could be made available to discuss some of the technical issues.

Sincerely,
(Signed) G, Will/am

Enclosure

cc:




Chairman Proxmire

110
MAR

7 1979

Questions submitted by Senator Stewart and Chairman Miller's response
for inclusion in the record of the hearing before the Senate Banking Committee
on February 20, 1979.

1.

How will the Federal Reserve's plans and objectives:
-- help slow down the rate of inflation?
-- help maintain a growing economy without a recession?
-- help increase productivity by encouraging capital investment?

Federal Reserve policy is directed at fostering financial conditions
that favor sustained, but more moderate, economic expansion.

An

easing of demand pressures in labor and product markets would contribute
to the restraint of inflation.

The prospect of a more stable, non-

inflationary environment should encourage businesses to make investments
that will enhance the longer-range growth of productivity.

2.

How should monetary and fiscal policy be coordinated?
—
—

Should both be tight?
Should one be tight and the other relaxed?

It is essential that the overall thrust of monetary and fiscal policy
be in the direction of restraint of aggregate demand if domestic
inflationary pressures are to be reduced and international confidence
in the dollar bolstered.

The question of policy mix is a very difficult

one, with no clearcut answer.

Emphasis on fiscal restraint would be

relatively conducive to business investment, while emphasis on monetary
restraint might offer some advantage in attracting private capital
from abroad.




At this time it would appear desirable to chart a budgetary

Ill
course that will eliminate the Federal deficit within a reasonably
short period; the Administration's FY 1980 budget proposal is
generally consistent with that goal.

By limiting Federal demands

on credit markets, this will help to create an environment in which
interest rates could decline as inflation expectations abate.

3.

Can monetary policy offset expansive fiscal policy?

It is possible for tight monetary policies to offset an expansive
fiscal policy.

It would not appear that there is currently any

reason for substantial concern about monetary and fiscal policies
working a cross-purposes; there is good communication among the
policymakers involved and a broad recognition of the problems confronting the nation.

4.

What is the likelihood of a recession in 1979 given current conditions?

The economic outlook is discussed at some length in Chapter 2 of the
Board's Monetary Pol icy Report.

As is noted there, it does not

appear that a recession this year is the most likely outcome.

However,

the state of the economy is such that unforeseen inflationary pressures
or supply constraints could make it more difficult to avoid a downturn.

5.

What would be the best public policy response if the economy goes into
a recession?

Much would depend on the nature and causes of the recession and the
prospects for an early self-correction.




However, several considerations

112
suggest that if stimulative action is required, monetary policy might
possess some advantage.

One is the greater ease with which monetary

policy can be adjusted in the short-run; discretionary fiscal policy
involves a relatively time-consuming legislative process.

Another

is that, as a practical matter, stimulative fiscal actions generally
prove d i f f i c u l t to reverse once they are no longer needed; it would
be most unfortunate if any action were taken that represented an
impediment to longer-range progress toward budgetary balance.
Finally, a policy mix that relied relatively less on fiscal stimulus
would be most favorable to business capital formation.

6.

How does the monetary policy restrain inflation?

Monetary policy restrains inflation by raising the cost and reducing
the availability of credit.

The tightening of credit conditions

damps aggregate demand and thereby eases pressures in labor and
product markets.

7.

Can monetary policy restrain inflation without causing a recession?

Yes, so long as monetary restraint is not applied with excessive
severity.

In the present instance, the Federal Reserve has set

a realistic goal of gradually reducing the pace of inflation over
an extended period.

Nonmonetary developments could precipitate a

downturn, but it is the objective of the Federal Reserve to promote
financial conditions that are conducive to continued economic
expansion and an easing of inflationary pressures.




113
8.

Why has money growth been so weak in recent months?
—

What should the Federal Reserve's response be to this slow
noney growth?
-- Should monetary policy be relaxed temporarily?

As was discussed in the Monetary Pol icy Report, the causes of the
recent weakness of monetary expansion are not at all clear.

In

deciding its response to the behavior of the monetary aggregates,
the Federal Reserve has considered—as it always does—the broader
financial picture and developments in the economy.

With economic

growth recently quite robust and credit demands evidently still
strong, it has not appeared appropriate to ease policy.

9.

How should the Fed react to downward pressure on the value of the
dollar?

There is in place a broad program of dollar support operations by
the Treasury and the Federal Reserve.

This program has proven very

successful to date, and there is no reason to doubt that it will
continue so.

The United States and other governments have shown their

willingness to intervene in foreign exchange markets to support the
dollar; there are adequate resources available under present arrangements to finance further sizable intervention if the necessity

arises.

Most important for the strength of the dollar is the commitment of
this nation to domestic policies that will restore price stability and
bolster U.S. productivity and international competitiveness.




114
10.

How would you evaluate the impact of the 6-month money market
cert i ficates?

The money market certificates have given commercial banks and thrift
institutions an effective means of competing for the savings of
smaller investors in a period of high market rates of interest.
While the higher cost of the certificates has put some

pressure

on thrift institution profit margins, the certificates have
prevented disintermediation, which in past periods disrupted
credit flows and economic activity.

The certificates have not

eliminated the impact of monetary policy, but they have altered it
by placing greater emphasis on interest-rate rather than creditavailability effects.

Financial markets thus should allocate

credit more e f f i c i e n t l y , and the impact of monetary restraint should
not fall with such severity oq certain sectors, most notably housing.




FEDERAL RESERVE'S FIRST MONETARY
POLICY REPORT FOR 1979
FRIDAY, FEBRUARY 23, 1979

U.S. SENATE,
COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS,
Washington, D.C.
The committee met at 10 a.m. in room 5302, Dirksen Senate
Office Building, Senator William Proxmire (chairman of the committee) presiding.
Present: Senators Proxmire, Tsongas, Garn, and Kassebaum.
STATEMENT OF CHAIRMAN PROXMIRE

The Chairman. The committee will come to order.
Gentlemen, I want to thank you for appearing in spite of the
weather we've had. A number of Senators have indicated they're
coming, but they will be a little late.
This is our second and final day of hearings to consider the
Federal Reserve's monetary policy report to the Congress pursuant
to the Humphrey-Hawkins Act.
Chairman Miller testified before the committee on Tuesday at
which time he indicated that the Federal Reserve's intended policies for 1979 will be directed at dramatically decelerating the rate
of growth of the monetary aggregates from the pace of recent
years.
The objective of this policy, according to Federal Reserve, is to
foster financial conditions conducive to a continued, but more moderate economic expansion during 1979 that should permit a gradual
unwinding of inflation.
According to Chairman Miller, it would be possible to lessen
inflation without triggering a recession given the current condition
of general balance in the economy today.
The Federal Reserve's report described the relationship between
the intended monetary growth ranges and the administration's
1979 economic goals as appearing to be "reasonably consistent."
What we want to know is how are they consistent? I'm not sure
that the Fed has answered that question sufficiently.
Chairman Miller indicated that the Federal Open Market Committee's growth rate range for Mi has been reduced to 4V2 to IVfe
percent for 1979, which seems like a dramatic reduction, the midpoint being 3 percent.
He also indicated that this marked deceleration reflects, in part,
the Federal Reserve's expectation that funds will be shifted out of
demand deposits and into automatic transfer savings accounts and
NOW accounts.




(115)

116

The Board's staff has estimated that this shifting will dampen
growth in Mi this year by about 3 percent. I have asked Chairman
Miller to send us the background analysis which leads to that
conclusion.
Quite frankly, no one can be sure that the Board's staff estimate
of 3 percent is even close to what will actually occur.
Allowing the Fed the 3 percent adjustment to its Mi growth rate
range would call for Mi growth between ll/z and 41/2 in 1979. The
midpoint of that range—6 percent— was emphasized by Chairman
Miller. He said that it would be sufficient to lead to economic
expansion in nominal GNP of around 9% percent.
I think, therefore, at this point we have to assume that the Fed
will be aiming at the midpoint of the adjusted Mi range.
The administration's nominal GNP growth of 9% percent is composed of an output-price mix of 2.2 percent real GNP and 7.5
percent increase in consumer prices. Chairman Miller told the
House Banking Committee on Wednesday that he is a little less
optimistic about real GNP growth, 1.75 to 2.25 percent, and a little
more pessimistic on inflation, 7.5 to 8.25 percent, than the administration.
The principal objective of monetary policy during 1979 should be
the slowing down of inflation. If fiscal policy, and Federal spending,
in particular, can be constrained and the wage-price guidelines are
successful, we will have a coordinated fiscal-monetary approach
toward restraining inflation, and fiscal restraint should allow the
Federal Reserve to gradually lower the growth of the monetary
aggregates without causing a recession.
However, if a recession is not avoided, the correct policy mix
would call for fiscal policy to remain restrictive and for monetary
policy to become more accommodative to help stimulate private
investment and the economy.
I think it is important for the committee to quantify these general observations about the relationship between monetary policy
and the administration's economic goals. The Federal Reserve was
somewhat less responsive to that requirement in the new reporting
requirements than they could have been, so I hope that our witnesses today will be able to help us fill in some of the gaps and give
us suggestions as to how the monetary policy reports of the Federal
Reserve can be improved.
We are fortunate to have with us today a panel of economists:
Dr. Allen Sinai, vice president and senior economist, Data Resources, Inc.; Prof. Edward Kane of the Ohio State University; and
Mr. Enrich Heinemann, vice president of Morgan Stanley & Co.,
Inc.
I think, Mr. Heinemann, you are also a former New York Times
commentator on economics.
Franco Modigliani, who is the past president of the American
Economic Association, was supposed to be here today, but had to
change his plans at the last moment because of an unfortunate
accident that he suffered.
So, gentlemen, we are happy to have you.
And, Dr. Sinai, if you would go ahead first, and we will follow
with Professor Kane and Mr. Heinemann.




117
STATEMENT OF ALLEN SINAI, VICE PRESIDENT AND SENIOR
ECONOMIST, DATA RESOURCES, INC.

Dr. SINAI. My statement is divided into two sections, one having
to do with some general comments on the conduct of monetary
policy and a number of new realities that have arisen to complicate
the decisionmaking at the Federal Reserve, and a second part that
is more concerned with the monetary policy target set by the
Federal Reserve and their consistency with the administration's
goals and outlook for the economy in 1979.
Although the material on the conduct of monetary policy intrigues me greatly, I think I will skip over that.
The CHAIRMAN. Yes; let me say to you, Dr. Sinai, that your
entire statement will be printed in full in the record, and we would
appreciate any abbreviation so we can have as much time for
questions as possible.
Dr. SINAI. Well, that material really raises other issues that we
could turn to, but in view of your introductory remarks, I would
like to turn directly to the material in the statement that begins
about page 24; and it probably would be helpful if you have copies
to use them, because I will refer to some numbers, charts, and
tables in the testimony.
If we look at the economic goals of the Carter administration as
embodied in the 1979 Economic Report of the President—I have
reprinted them in table 10, on page 25, along with the corresponding DRI projections for the economy.
Now, in table 10, the items, the variables—the projections of
which are reprinted there—they were not all provided in the Economic Report of the President, but what we did was to take the
DRI model of the economy and to use the key parameters of the
administration policy, as was stated in the Economic Report, and
then to simulate them.
And so, you see, for the range of variables listed, the sometimes
explicitly stated figures of the administration and the derived numbers, out of the derived model simulation for 1979 and 1980, fourth
quarter to fourth quarter.
The administration goals and outlook can be summarized in the
phrase "soft landing on orderly deceleration of the economy" that
produces real economic growth of 2.2 percent between now and the
end of next year—between the fourth quarter of 1978 and the
fourth quarter of 1979.
The inflation outlook by the administration is for about 7*/2
percent in consumer prices, and the unemployment rate projection
is 6.2 percent in the fourth quarter.
The DRI view of the economy is more pessimistic; from fourth
quarter of 1978 to fourth quarter of 1979, we think there will be
almost no growth in the real economy—two-tenths of 1 percent—
and considerably higher inflation, at 9 percent.
The differences in the components of the various expenditures
are shown in table 10, and we see a weaker housing result, much
slower consumption expenditures and, later on this year, weaker
investment; and that accounts for the differences between the two
projections, the implied monetary growth rates from the two projections—the one embodying the Carter goals and outlook and the
one that represents our current forecast are shown in table 11.




118

There I have reprinted the new Fed target ranges for Mi, M2, and
M3.
And if we look at the Mi, implied as a result of our model
simulation—the Mi growth implied by the administration forecast,
it is 4.4 percent. The Mi growth that comes out of the current DRI
forecast, over the time period, is 2.7 percent.
For M2, it is TVa percent for the administration scenario and 7.1
percent for the DRI forecast.
And for M3, it is 7.9 percent for the administration projections
and 7.1 percent for the DRI forecast.
Let me again say that those monetary growth rates are not
explicitly stated by the administration as a consequence of what
they think will happen in the economy or what they think will
happen to inflation. They are the results of putting the key administration parameters into the DRI model and then floating them
through two previous sets of monetary growth rates.
It is interesting to note that taking the Carter Administration
assumptions on monetary growth and flowing them through our
model produces monetary growth rates that are very near the
upper end of the new target ranges announced by the Fed. And so,
if you ask, are the monetary growth rate targets new ones, consistent with the Carter objectives and goal, the answer is "barely,"
because if we have the Carter administration-type world in 1979,
we would have monetary growth just about at the upper ends of
the new ranges.
The DRI forecast that produces these monetaiy growth rates
that are much closer to the midpoints—are conditioned on a mild
recession in the second half, higher inflation and, really, a worse
picture of the economy.
We have run a couple of other exercises to assess the consistency
for the prospects for monetary growth under a Carter administration view, and under what we would think would be a more realistic view, based on our forecast, through the simulation of the DRI
model.
In table 13, we see the results in terms of the probabilities of the
likelihood of monetary growth occurring within the Fed target
ranges, contingent on the DRI forecast for the next year.
It is virtually certain, given the parameters of our forecast, that
the new target ranges of the Federal Reserve will enclose the
forecasted monetary growth for both M2 and M3—less likely for Mi.
The table that underlies table 13 is on page 28, table 12, which
shows the results of a simulation of the DRI model and the resulting probability distribution for the potential range of outcomes.
We see there that the basic key parameters of the forecast, the
DRI forecast, is two-tenths of 1 percent real growth within the next
year, 9 percent—8.3 percent growth in the GNP deflator, 9 percent
in consumer prices, the rest of
The CHAIRMAN. Could I just interrupt for a minute? I take it that
what you're saying is that when you say that the Fed range—that
the Fed monetary policy would barely permit the Carter scenario
to develop, because it would work out, provided the monetary
increase was at the top of the range—the range is so broad as to
be, in my view, almost meaningless. And the Chairman has countered that by saying: "All right, let's talk about the midpoint of the




119

range;" and we have agreed that, to the extent it varies from that,
that it is higher than it was intended to be.
So, in that sense, I would presume that you would argue that
their policy may be too restrictive—the Federal Reserve Board may
be so restrictive that you will not be able to have the kind of very
moderate growth that the administration wants.
Dr. SINAI. That's correct. If you take the midpoint as the key
parameters for policy, then the implied monetary growth of the
administration goals and the administration outlook will be substantially above the midpoint, and that would require—if the Federal Reserve took such a result seriously and acted upon it, it
would require considerably higher interest rates.
The CHAIRMAN. Let me just ask one more question—I hesitate to
interrupt while you're making a presentation, but right at this
point it just seems so appropriate—do you accept the argument
that because of the change in Mi, because of transactional accounts
availability, that there will be the kind of shift out of demand
deposits into savings deposits inasmuch as they can be almost used
as demand deposits and could be as much as 3 percent shift here,
and that would be about $20 billion?
Dr. SINAI. My assumption in this work was 2.7 percent, so it is
very close to the Fed's assumption. Our assumption is based only
on the fragmentary data that has been produced so far and an
extrapolation of that, so I think their 3 percent guess or our 2.7
percent guess in the reduction of Mi growth due to ATS is about in
the right ballpark.
Let me turn to another part of the statement that may not be in
your copies. I have added two tables, 14 and 15, on yesterday. We
took the Carter administration scenario and ran simulations on it
to obtain the probabilities that, given the Carter assumptions that
monetary growth would be—where monetary growth would lie,
relative to the Federal Reserve target ranges—and the results are
interesting.
Whereas, in table 13 we see that the odds are almost certain that
the monetary growth in the DRI forecast will be within the Fed
target, the odds are much, much less that the monetary aggregrate
growth implied by the Carter economic scenario will fall within the
Fed target ranges. This is the result—this is a little stronger result
than the forecast implied by the two scenarios; because this is run
on the basis of 100 stochastic simulations, and we find that the
odds are 38 percent—or they are actually 51 percent that M3
growth under a Carter scenario will be greater than the upper
limits of the Mi target range—38 percent of Mi growth will be
greater than the upper limit, than the M2 target range; and 53
percent—that the M3 growth will be greater than the upper limit
for that target range.
So, I would say, again, it looks to me that either the administration goals are unrealistic and very unlikely to happen or the Federal Reserve target ranges are tougher than the administration goals
will be able to meet.
The CHAIRMAN. Are you suggesting then the committee ought to
recommend to the Federal Reserve Board that they raise the lower
limit?




120

Dr. SINAI. In order to achieve the orderly deceleration and the
kind of real growth that the administration wants, the target
ranges should be higher.
The CHAIRMAN. Thank you.
Dr. SINAI. The reason I gave the—didn't answer your question
directly, yes or no, is I am not sure that it is a weaker result in the
economy than the administration is talking about.
The CHAIRMAN. What we're trying to deal with in the Humphrey-Hawkins Act is to get coordinated economic policy and not
have the Fed going one way and the President going the other way.
As I understand it, what we would like to do is to bring the
programs together and have them work in tandem.
Dr. SINAI. It is interesting that the parameters of Chairman
Miller's testimony before the House—where the breakdown was
between the projections of the Federal Reserve—were about the
same, but they were more pessimistic.
Chairman Miller reported a lower growth rate for real GNP than
has come out of the economic report of the President, and he
talked about a higher inflation rate.
Given the data that came in for January, I think this more
recent view by Chairman Miller of the outlook is probably better—
closer to what will actually happen than the view that is embodied
in the economic report of the President.
Well again, still on this subject, let me just provide for you the
results of some further simulations with the model, having to do
with what would happen under different interest rate patterns.
The CHAIRMAN. Let me just interrupt once more. What you are
saying is that if you follow the Fed's approach, that you're going to
have a more likely prospect of a recession, or a slower rate of
growth, with a higher level of unemployment—that is the price you
pay for more effectively combating inflation; is that right?
Dr. SINAI. Yes. I'm not totally unsympathetic to that view. The
slower real economic growth, implied by their targets, that would
be necessary to produce the midpoints of the target ranges announced, so long as we don't get into an area which goes into a
deep recession, might not be such a bad thing at this time.
Well, with regard to a little further sensitivity analysis, the
remaining few pages of this section of the statement reported on
what happens—what would happen under different assumptions
about interest rate patterns in the economy.
There are those who argue that interest rates should be raised
very sharply now and whatever happens ought to happen, because
there would be significant long-run benefits. The Federal Reserve
is following a course of moderation on interest rate rises. And
there are those who feel that the interest rates ought to go lower.
By varying the assumptions on monetary policy so that high and
low interest rate patterns could be produced, we get some idea of
what would happen to the economy on unemployment and the
inflation rate. And these results are summarized in charts 12a
through 12e—charts 12e and 12d are reversed. Actually, I'm not
sure what 12e—there is something wrong with chart 12e, but if you
look at chart 12a, on page 30, you get an idea of the range of
variation in the Federal funds rate.




121

Just to assume different policy questions by the Fed— and this is
now assuming a kind of interest rate target of growth rather than
an ordinary growth approach, but in a high rate situation where
Fed funds could go over 12 percent, we would get a prime of near
14 in the summer, which is one view of what will happen in the
next 5 or 6 months.
We don't get that much. We get worse real economic growth in
1979, but—and a deeper recession and a higher unemployment
rate, and rather substantial further impacts on housing starts, in
12c, but we don't get much benefit on inflation.
I think inflation is shown in what is now called chart 12e—that
is, the implicit GNP deflators. The downward variation of inflation
over the next 3 years in that kind of interest rate pattern is not
anything to get too excited about. What it does say is that so much
of the inflation now is due to other causes besides demand-pull
causes and so much of it structural and cost-push and oil-price
oriented that interest rates of 12 and 13 percent in the summer
will not provide us with that much benefit; and at the same time,
the major shock of such interest rate would be on housing and
would be on unemployment.
If one varies the monetary growth rates—we performed simulations that produced high, relatively high growth rates for Mi, M2,
and M3 growth, near the upper bands, the upper limits of the Fed
targets, and then another simulation with monetary growth rates
at the lower ends. One produces wide variations in interest rates.
Once again, it does not do much to jog the economy.
What I conclude from all of this is the following: It isn't going to
make much difference to the economy and to inflation this year
whether the Fed chooses policies to keep interest rates—the rate of
interest rates at another 100 or 150 basis points. The recession this
year is pretty well in place, and there isn't really much that
anyone can do about it. And so when you bring in other considerations—such as sustaining the dollar and the strength of the
dollar—into the picture, I would conclude that it pays to keep the
interest rates about where they are, and to keep them up, and not
to turn interest rates down sharply when the economy does begin
to unwind. It isn't going to do much good now, one way or the
other, to vary interest rates 100 basis points up or down; and so the
appropriate policy would be to keep them high and to demonstrate
for the rest of the world our resolve to fight inflation in order to
sustain dollar stability.
[Complete statement of Dr. Sinai follows:]




122
NEW REALITIES FOR MONETARY POLICY

by
Allen Sinai
Vice President and Senior Economist
Data Resources, Inc.
Lexington, Massachusetts

Corrected version of statement prepared for the Senate Committee on Banking,
Housing and Urban Affairs, Hearings on the Conduct of Monetary Policy Pursuant
to the Full Employment and Balanced Growth Act of 1978, Washington, D.C.
presented originally on February 23, 1979.




123
NEW REALITIES FOR .MONETARY POLICY
by Allen Sinai

A set of new economic realities is complicating
the formulation
and implementation
of
monetary policy. These "new realities" include:
(1)

> a sluggish response of aggregate
demand and inflation to rising nominal
interest rates, with considerable
uncertainty over when, how, and where
tighter monetary policy will bite to
slow the economy;

(2)

changes in the structure of the
financial system that have altered the
response of the economy to monetary
impulses and the meaning of the
monetary aggregates for the conduct
of monetary policy;

(3)

the discipline imposed on the U.S.
economy by a chronic balance of
payments disequilibrium and a weak
dollar;

(4)

a pervasive high and accelerating
inflation, brought about by a complex
set of forces not easily amenable to
standard short-run stabilization policy
prescriptions;

(5)

the necessity for greater coordination
of monetary, fiscal, and incomes
policies to avoid self-defeating policy
actions;

(6)

growing prospects for a "mild
austerity" in the U.S. economy, with a
recession in 1979 to be characterized
by still high inflation and rising
unemployment.

What difficulties do each of these "new
realities" bring to the conduct of monetary
policy? Are nominal interest rates now high
enough for an orderly deceleration of the




economy?
Are the monetary aggregates no
longer relevant to Fed policy-making?' Of what
significance is the recent sluggish growth in the
monetary aggregates? How critical is dollar
defense for monetary policy? Are the new
monetary growth targets of the Federal
Reserve consistent with Carter Administration
goals? What is the likelihood that the monetary
aggregate targets selected by the Federal
Reserve will produce these goals? What is the
appropriate posture for monetary policy in the
months ahead?
In this statement, the new realities for
monetary policy are analyzed in terms of their
consequences for the conduct of monetary
policy. A brief analysis of the recent behavior
for nominal, "real", and real after-tax interest
rates is presented. The new Fed targets for
monetary aggregate growth are examined for
consistency
with
respect
to
Carter
Administration goals and in light of the DR1
outlook for the U.S. economy. Alternative
patterns for interest rates and monetary growth
are simulated with the DRJ Model to examine
their likdy impacts in 1979 and 1980. Finally,
some sugges ions for the conduct of monetary
policy are offered, based on current prospects,
the model simulations, and analyses reported
here.
In summary:
monetary policy has only been
unambiguously tightened in the past
three months, so that the slow
response of the economy should not be
a surprise.
At current levels of
nominal interest rates, the bite of
tighter monetary policy is impacting
significantly on the mortgage flows to
housing and will continue to do so
throughout most of 1979. There will
be lesser effects on consumption and
business spending, given the relatively

124
New Realities
low real after-tax costs of borrowing
that exist. However, by mid-year, the
tighter monetary policy and other
factors such as reduced purchasing
power, the oil price shocks, worsened
confidence, and a tight fiscal policy
will combine to push the economy into
a mild recession.
nominal interest rates do not have to
be raised further to produce the
desired slowdown in the economy.
"Real" interest rates are on the rise
and, although lower than in most
postwar tight money episodes, remain
above the levels of 1975-74. DRI
model simulations indicate that the
1979 recession is well-in-place, and
would occur even if interest rates
remained at current levels for the rest
of the year. And, the pattern for
nominal interest rates necessary to
prevent a recession later this year
would involve declines that would be
unwise, given the current near full
employment condition of the economy
and weak position of the dollar.
Sharply higher rates of interest would
only serve to intensify the coming
recession without much benefit to
inflation, real economic growth, or
unemployment in 1980.
changes in the structure of the
financial system have made • the
monetary aggregates less meaningful
for the conduct of monetary policy, at
least until better concepts are
developed.
However, the recent
sluggish monetary growth is too
pervasive and entrenched to be a
transitory phenomenon.
All of the
major
monetary
aggregates are
showing growth rates characteristic of
late in the business expansion,
reflecting the systematic impact of
tighter money on the economy. The
fundamental behavior that is in
process will not be reversed for many
months, and the slow monetary growth
signals the long-awaited deceleration
in the economy.
the discipline of dollar defense is a
critical reality for monetary policy,
given the dangers a weak dollar poses




for domestic inflation and economic
stability.
The implication for
monetary policy is that sustained, high
interest rates are necessary for longer
than otherwise would have been the
case. At the same time, too high a
profile of interest rates could deepen
the coming recession sufficiently to
hurt the dollar through repercussions
on the economies of our trading
partners.
the new monetary growth targets of
the Federal Reserve will permit the
achievement of Carter Administration
economic goals, although barely. DRI
simulations of the Carter economic
assumptions for 1979 imply Ml growth
from 1978:4 to 1979:4 of 4.4%, M2
growth of 8.0% and M3 growth of
9.1%; about at the upper Fed targets
of 4-1/2%, 8%, and 9%, respectively.
Thus, higher interest rates may be
necessary if the "soft landing" scenario
of the Administration actually unfolds.
stochastic simulations with the DRI
model indicate the mild recession and
high inflation forecasts of DRI are
more
consistent
with
achieving
monetary growth near the midpoints of
the new Fed target ranges than the
Administration or Federal Reserve
views of the economy. Given the DRI
forecasts and model structure, the
probabilities of above-targeted growth
for Ml, M2, and M3 during the next
year are 10% or less.
Given the
Administration outlook, the odds on
above-targeted monetary growth rise
to over 50% in the case of Ml or M3,
and 38% for M2.
the current U.S. inflation is primarily
from cost-push and structural factors,
and less from excess demands. Too
great a reliance on monetary policy to
limit such an inflation would be
counter-productive, as was the case in
1973-74.
A better solution is to
combine a tight fiscal-tight monetary
policy over the near-term with TIPlike incentives to reduce wage costs,
while simultaneously providing tax
incentives
for
business
capital
spending and R&D outlays.
As

125
New Realities

inflation unwinds and the dollar is
permanent!/ stabilized, a "tight fiscalecsier money" policy mix would be
more appropriate.
3ut any turn
toward easier money must only be
modest, so long as inflation remains
between 7 and 10% and the dollar is
fragile.
the "new realities" will make the
conduct of monetary policy difficult
and suggest a "mild austerity" in the
U.S. economy to sustain an unwinding
of inflation. Although the near-term
implications of the new realities
require high and perhaps even further
rises for interest rates, the longer-run
prospects are for enhanced economic
performance. The key is whether the
resolve to maintain tougher policies
will last until there is a fundamental
reversal in the rate of inflation to near
5 or 6%. Current actions and evidence
suggest optimism for the longer-run,
with potential implications that should
not be lost on decision-makers.
The New Realities
and the Fed Policy Dilemmas
The post-World War II era has been
characterized by three phases of Federal
Reserve policy-making:




1) 1946-1951: constant interest
support Treasury financing:

5/1/75
7/24/75
11/4/75
2/3/76
5/3/76
7/27/76
11/11/76
2/15/77
5/3/77
7/77
11/77
2/78
5/78
7/78
11/78
2/20/79

Target Period
March 1975-Morch 1976
75:2 - 76:2
75:3 - 76:3
75:4 - 76:4
76:1 - 77:1
76:2 - 77:2
76:3 - 77:3
76:4 - 77:4
77:1-78:1
77:2 - 78:2
77:3 - 78:3
77:4 - 73:4
78:1 - 79:1
78:2 - 79:2
78:3 - 79:3
78:4 - 79:4

3) 1971-1978: a "monetarist" approach with
monetary aggregate growth the target of
Fed policy and the Federal funds rate the
operating lever used to achieve the desired
monetary aggregates.
Relatively narrow
target ranges have been set for the
monetary
aggregates,
following
the
monetarist prescription that stability in
monetary growth should bring less volatility
to the economy and prices.
Did a switch to a monetary aggregate approach
make a significant
difference
in the
performance of monetary policy and its relation
to real economic growth, inflation, and
unemployment? A casual look at the record of
the U.S. economy over the past eight years does
not suggest success. The economy has shown
considerable instability during the period since
1970, despite greater stability in monetary
growth. Real economic growth has fluctuated
between -10 and over 11%; inflation rates have
varied from 3 to 13%; and the unemployment
rate has been 4.8% but also as high as 8.7%.
The four-quarter rate of increase for Ml has
ranged between 4.6 and 8.2%, exhibiting a more
stable pattern of behavior than in previous

Ml (%)

M2 (%)

5-7fc
5-7h

3*t-IO*i
8*1-10*1
7*1-10*1
7*i-IO*i
7*i-IO
7*i-9*i
7*i-IO
7-10
7-9*i
7-9*,
6*i-9
6h-9
6**-9
6*i-9
6*i-9
5-8

4h-7*i
4h-7
4*i-7
4*1-6*1
4fa-6fe
4!ii-6*i
4-6fe
4-6*i

ts

4-6*1
2-6

ML
SJ
5.3
4.6
5.8
6.5
6.8
3.0
7.9
7.7
8.2
3.1

Hi

4.0
2.7
2.7 '

M2
9.6
9.6
9.3
10.9
11.0
10.8
II. 1
9.8
8.8
3.0
3.6
8.5.
7.5
7.0
6.5
7.1 '

•Based on published statements by the Federal Reserve Board, beginning 5/1/75.
The long-run monetary growth targets were not made public prior to that time.
'from 2/19/79 ORI forecast.

to

2) 1952-1970: a credit conditions approach,
with interest rates the focus of Fed policy:

Table I
Federal Reserve Performance
In Meeting Long-Run Objectives: 1975 to 1979*
Dote Announc ed

rates

126
New Realities
periods, although the long-run year-over-year
Ml growth targets have been achieved in only 5
of 12 instances since May 1975. The r-ed has
done better with respect to the M2 targets,
succeeding in obtaining growth within the
designated ranges in 8 of 12 cases.
During 1978, a series of events caused
significant changes in the conduct of monetary
policy, after many years of the "monetarist"
experiments.
First, dollar performance
considerations emerged as a major constraint.
Some 225 to 280 basis points of the rises in
short-term interest rates since last January can
be at least partially attributed to dollar
support, capped by the near 100 basis point rises
on November 1 of most short-term rates in a
coordinated defense by the Administration, U.S.
Treasury, and Federal Reserve to prevent
further dollar deterioration.
The tightening of monetary policy in support of
the dollar was unprecedented for the postwar
period, coming after many years of dollar
weakness and accelerating U.S. inflation. The
dilemma for monetary policy in 1979 is how
much of a loss in real economic growth and
employment to accept for dollar stability and
some lessening of inflation. The rate rises of
1978 probably will cost I to 1-1/2% of real
economic growth in 1979.
Second, although short-term nominal interest
rates rose 250 to 350 basis points between
1977:4 and 1978:4 and bond yields were higher
by 100 basis points, the real economy remained
resilient and inflation rates accelerated. Real
economic growth moved strongly ahead at 4.3%,
with the more typically interest-rate sensitive
spending categories, such as automobiles and
housing, proving to be exceptionally strong.
The major price indices rose between 8 and 10%
for the worst performance on inflation since
1974.
The puzzle for monetary policy, as yet
unresolved, but with important implications, is
whether aggregate spending and inflation can be
slowed by the current, high nominal interest
rates.
Or, whether further sharp rises are
required for interest rates to offset the higher
rates of inflation that have been occurring.
Third, the cumulative impact of at least a
decade of financial innovations and new moneysaving technological advances surfaced most




decidedly in 1978, with major impacts on
housing activity and the monetary aggregates
used to guide Federal Reserve policy. The
effects of the financial innovations have been
to delay or mitigate the impacts of tight
monetary policy and to distort the monetary
aggregates enough to make their use as a guide
to policy uncertain. Some of the innovations
have arisen within financial institutions in order
to circumvent restrictive monetary policy, such
as the implementation of large CD's in 1961,
use of the Eurodollar market in 1969, the
variable rate mortgages of the past few years,
pass-through mortgage-backed certificates, and
recently new issues of commercial paper for
thrifts. However, the monetary and regulatory
authorities also have instituted changes which
made the implementation of monetary policy
more difficult, e.g., the six-month money
market certificates (MMC's). The financial
innovations are eliminating barriers to flexible
interest rates and the flows of funds through
financial institutions. The recent thrust of
monetary policy, too, has been toward a
reliance on interest rates to slow real economic
growth and inflation, rather than to squeeze
liquidity as in 1966, 1969-70, and 1973-74.
The dilemma for the Federal Reserve is
whether these innovations are making monetary
policy less potent and itself inflationary, as
higher nominal interest rates become integrated
into the structure of prices. Also, with moneysaving technology and new portfolio practices
making uncertain the meaning of the monetary
aggregates, deviations of actual monetary
aggregate growth from targets could provide
false signals for policy. The sluggish monetary
growth of late 1978 and early 1979 is a case in
point. If truly signaling a sluggish economy,
then moderation in monetary policy would be
appropriate. On the other hand, if the slowed
growth of the monetary aggregates is the result
of money-saving technology, then moderating
monetary policy could prove to be a mistake,
permitting too much stimulus at a time when
the economy is close to full employment. The
task is to devise appropriate measures for the
monetary aggregates and systematic procedures
for choosing the growth targets.
Fourth, a pervasive high and accelerating
inflation for over a decade has led to a growing
realization that inflation is a multi-dimensional
problem, requiring a coordinated attack from
monetary, fiscal, and incomes measures.

127
New Realities

Tougher demand management policies to slow
real economic growth, wage-price restraints
short of controls, and removal of government
props to costs and prices are being instituted.

growth, growth in the monetary base, real
money balances, and "real" interest rates might
not have unambiguously indicated tightness.
Second, even if monetary policy was tight,
financial innovations, especially in housing, may
have acted to insulate the economy. Third, a
stress on interest rates rather than credit
availability to slow aggregate spending could
have
been misdirected,
since previous
slowdowns
have so often
required
a
corresponding squeeze on liquidity. Finally,
even the rapid nominal interest rate rises are
perhaps insufficient if it is "real" interest rates
that impact most significantly on spending and
borrowing.

The dilemma, however, is the degree to which
tight monetary policy should be applied to fight
an inflation that has much of its origin in costpush factors,
structural elements from
government
regulations,
and significant
exogenous influences such as severe weather
effects on crops and livestock, and the vagaries
of the Mideast or OPEC oil pricing.
Fifth, the necessary coordination with other
arms of policy to successfully achieve the goals
of the Full Employment and Balanced Growth
Act of 1978 is a new feature of contemporary
macroeconomics. The dilemma is to determine
an optimal policy mix, given stated objectives
on economic goals but differing views on the
means to achieve them and the outlook for the
economy.

Has monetary policy been tight? Table 2 shows
the behavior for a broad range of monetary
policy indicators between 1977:1 and February
1979. The Federal funds rate rose a large 550
basis points.
Net free reserves, a good
indicator of banking system tightness, was quite
negative over the same period, also suggesting
restraint. Both of these measures, however,
could have been responding to demand-side
pressures rather than Fed restriction.

Finally, a new "mild austerity" may be emerging
as an effect of high inflation, low productivity,
and a weakened dollar. The straight]acket of
U.S. economic problems is likely to remain for
some time, until a better performance can be
achieved on inflation. The dilemma is to figure
out an escape from stagflation, the policies
necessary to stimulate capital formation and
productivity, and the required duration for
relatively tough demand management policies.

Another dimension of monetary policy is related
to growth in the monetary base, defined as total
bank reserves plus currency and adjusted for
changes in reserve requirements. The Federal
Reserve has strong control over bank reserves
but little impact on currency held by the public.
Given that total reserves have averaged 39% of
the monetary base, its growth is an important
indicator of supply-side tightness. For much of
the past two years, monetary base growth has
been quite high, portending further rises in the
growth rates for the other monetary aggregates
and suggesting that rising nominal rates were
not indicative of a tighter monetary policy.
Recently, however, growth in the monetary
base has slackened considerably, rising by only
6.9% during the last three months.

Is Monetary Policy Working?
There are several questions that relate to the
apparent failure of monetary policy to bite on
the economy during 1978. First, has monetary
policy really been tight? Even though nominal
interest rates have risen sharply in the past
two years, other indicators of monetary policy
such as free reserves, the pace of monetary




Table 2
Dollar Weakness and Money Market Rate Increases
latest
Federal Funds
Rate (%)
Free Reserves
(Blls. of $'s)
Monetary Base

Jan.
1979

78:4

78:3

78:2

78:1

10.15

10.07

9.58

8.10

7.28

-0.73

-0.59

-0.73

-0.99

-0.77

-0.17

-23.3

-3.7

-O.I

-1.2

77:4

77:3

77:2

77:1

6.51

5.82

5.16

4.66

.0.70

-0.44

0.00

0.15

3.7

-I.I

-0.7

-I.I

6.76

Ml Growth
M2 Growth
Real Ml Growth
-23.0
(Annual %)
Real M2 Growth
-16.2
(Annual %)

•Nominal and Real Ml and M2 Growth as of February 21, 1979.

2.9

128
New Realities

Indeed, the other measures in Table 2
unambiguously indicate a very tight monetary
policy, although only for the past few months.
Free reserves are still quite negative; the
monetary base is on a much slower growth path;
both the growth rates for the nominal and real
money supply are declining sharply; and interest
rates are at or near record highs.
Have financial innovations insulated the
economy from the impacts of a restrictive
monetary policy? Most certainly, the financial
innovations that are maintaining the mortgage
flows to housing are a mitigating factor. In
almost all the housing downturns of the postwar
period, interference with interest rates and a
crunch on the supply of funds caused rationing
in the mortgage markets. But, with the new
MMCs circumventing existing deposit rate
ceilings, bank and nonbank thrift institutions
have been able to prevent a severe
disintermediation despite record short-term
interest rates. DRI estimates place the "saved"
housing starts from the MMCs at 253,000 units,
seasonally adjusted at annual rates, during
1978:4. Other factors that have held housing up
include I) higher deposit rate ceilings and fewer
usury limits; 2) support by mortage and housingrelated agencies; and 3) investment in housing
as a hedge against inflation.
Chart I
Housing Starts With and Without
Special Factors: 1977:4-1978:4
(mils, of units)*

1

Actual Homing Starts

The brunt of the tighter monetary policy has
been falling on the buyer with borrowing costs,
rather than funds availability, the major
mechanism for reducing housing demands. It is
only within the last two months that mortgage
availability, along with costs, has been limiting
the pace of housing activity. Without the
MMC's and other financial innovations to
support the mortgage markets and housing, the
pattern of housing starts in 1978 would have
closely resembled previous tight money
episodes.1
Chart 2
Auto Loan Rate: Nominal vs.
Expected After-Tax Real (Percent)

10-

/r ;•••-••..-.,./••
'n *

0-

-101933

1960

1963

1970

1973

Chart 3
Mortgage Loan Rate: Nominal
vs. Expected After-Tax Real (Percent)
20

o-\ I Housing St«t$N
''without Flnawial aid .

•101933
IV
1977

I

II

*Source: Footnote I




1978

II

1960 1963

1970 1973

Allen Sinai, Roberta Gerson, and Terry
Glomski, "Mortgage Finance and Housing," Data
Resources Review/February 1979, p. 18.

129
New Realities

At the same time, a greater proportion of
families in higher tax brackets end embedded
high expected rates of inflation have made the
real expected after-tax costs of borrowing
much lower than indicated by nominal interest
rates.
The bottom line is that higher nominal interest
rates are now required to produce a given
amount of economy slack, so long as the
Federal Reserve does not want to interrupt the
liquidity flows of the financial system.
Should monetary policy continue to stress
"costs" or strive to restrict "availability"? The
reliance on flexible market interest rates rather
than interruptions in the flow-of-funds is a
preferred means for slowing the economy. The
postwar history of the economy is filled with
instances of perverse reactions to interference
with the interest rate mechanism.
Severe
credit crunches and deep recessions have been
the typical response to sharp reductions in
liquidity. A quick slowdown in the economy
could be achieved, especially in housing,
through measures that sharply reduce liquidity
and limit lending. However, unless an abrupt
braking is required, it is better to rely on higher
interest rates as the cutting edge of monetary
policy.

Chart 4a
Savings Rate: Nominal vs. Expected
After-Tax Real (Percent)

Are nominal interest rates high enough to do
the job? Much has been made of the oossibiiiry
that spending is less sensitive to tighter money
in this business expansion because high rates of
inflation have reduced real borrowing costs and
real returns on financial assets. If real aftertax returns on savings and borrowing are low,
high nominal interest rates might fail to weaken
spending. Embedded inflation expectations and
the increasingly progressive U.S. tax system
might well have rendered ineffective the
current Fed policy of slowing demand through
interest rates, requiring much sharper rises in
nominal interest rates than have yet occurred.
Charts 4 through 9 show nominal and expected
real after-tax rates for six important financial
instruments, along with two measures of "real"
interest rates.
The period shown extends
through 1979:4 and reflects the current DR1
forecasts. The "ex-post" real interest rate is
defined as the nominal interest rate less thecurrent percent change in the relevant inflation
rate. The inflation rate utilized for a given
interest rate is based on the relevant price
index for the spending category of a sector.
The "ex-ante" real rate is defined as the
nominal rate of interest minus a weighted
average of the relevant inflation rate over a
horizon approximating the holding period for

Chart 4b
Savings Rate: Ex-Post Real
vs. Expected Real (Percent)

10-

-5. £xp«etei Afrar-Tax Seal

-101953




1960

1963

1970

1973

1953

1960 1963 1970 1973

130
New Realities
Chart 5a
Wjnicipal Bond Rate: Nominal
vs. Expected After-Tax Real
(Percent)

Chart Sb
unicipal Bond Rate: Ex-Post
Real vs. Expected Real
(Percent)

10-

a--'
-h
1935

I960

-t1963

-t1970

-t1975

the instrument. The weights either form a
rectangular distribution with lengths up to 20
quarters or a second order Pascal distribution
on consumer goods paces as in the case of the
long-term bond yield.

1353

I960

1963

1370

1973

Charts 6 and 7 show that the expected real
. costs of auto and mortgage loans are now on the
upswing after a series of declines into early
1978. The ex-post real rates show a more
decided upturn than the ex-ante values.
Furthermore, the rises are quite recent,
following on the heels of the decidedly tighter
monetary policy that was instituted during the
fourth quarter. But the after-tax costs for
borrowing by households are quite low, relative
to history.

The shorter the holding period for a given
instrument, the closer the ex-ante and ex-post
real interest rates. The return on savings
deposits has been on a steady decline since
1974, with no upturn forecasted yet (Chart 4b).
The expected real return on muncipal bonds, on
the other hand, has been on the upswing since
1977 (Chart 5b). Both returns, however, are
negative and regardless of how measured,
remain below the levels for most of the period
since 1955. After correction for taxes, almost
all of the real rates of return and real interest
rates are negative (Charts 4a, 5a, 6a, 7a, 8a,
and 9a).

In Charts 8 and 9 , the interest rates on prime
business loans and new issues of high-grade
corporate bonds are seen to be rising. The
expected real rates are near those in many
other periods since 1955. After taxes, however,
. the average costs of business loans and topquality bond issues are among the lower of the
tight money periods since 1955.

See the Appendix for details of the
calculations. Expected real interest rates are
the most relevant concept for spending, since it
is expectations of rates upon which behavior is
based. An expected real rate is a nominal rate
less the expected rate of inflation. The
problem is estimating the expected rate of
inflation.
Different schemes for forming

expected inflation rates will produce different
real rates. Extrapolative methods were used
here, except for the long-term bond yield which
embodies a theory of "permanent expectations
formation." For another approach, see W.
Eiiott, "Measuring the Expected Real Rate of
Interest: An Exploration of Macroeconomic
Alternatives," American Economic Review,
June 1977, pp. 429-Wt.




131
New Realities
Chart 6b
Auto Loan Rate: Ex-Post Real
vs. Expected Real (Percent)

Chart 6a
Auto Loan Rate: Nominal vs.
Expected After-Tax Real
(Percent)
20Exbecred Afrir-Tax r.ec!

-101955

1355

1363 1370 1373
Chart 7b
Mortgage Loan Rate:
Ex-Post Real vs. Expected Real

1360

1363 1370 1973
Chart 7a
Mortgage Loan Rate:
Nominal vs. Expected AfterTax Real (Percent)

1360

(Percent)

20-

a--

-101955

1360

1363

1370

1973

1953

Chart 8a
Prime Commercial Loan Rate:
Nominal vs. Expected After-Tax
Real (Percent)

1950

1365

1970

1373

Chart 8b
Prime Commercial Loan Rate:
Ex-Post Real vs. Expected Real
(Percent)

20. sxp«cfed Aftsr-Tox

10-.
0-',

-10-'

-t- -h

-t-

-201935




• 1960

1963

17
30

1973

-20

1955

1960

1963

1970

1373

132
New Realities
Chart 9b
Rate on Top-Quality Corporate
Bond Issues: Ex-Post Real vs.
Expected Real (Percent)

Chart 9a
Rate on Top-Quality Corporate
Bond Issues: Nominal vs. Expected

After-Tax Real (P-rcant)

10-

Expected After-Tax ftco!

1935

1333

1360 1363 1970 1973
Chart lOa

1360 1365

1 7 1973
90

Chart I Ob
Ex-Post Real Average Yield
on New Issues of High-Grade
Corporate Bonds (Percent)

Average Yield on New Issues
of High-Grade Corporate Bonds

(Percent)
10-

-10-

-20'
1930

1960

1970

1980

1930

Chart lOc
Expected Rate of InflationPersonal Consumption Expenditures
Deflator (Percent)

I960

1970

1930

Chart lOd
Expected Real Average Yield
on New Issues of High-Grade
Corporate Bonds (Percent)

2-

o-2'

1950




13SO

1970

1980

1930

1960

1970

1980

133
New Realities
Chart 11 a
Average Market Yield on
U.S. Government 3-Month Bills
(percent)

46

48

30

52

54

36

38

60

62

64

68

68

70

77

74

76

78

80

Chart lib
Compound Annual Percent Change
in the Wholesale Price IndexAll Commodities (Percent)
50

-soH—I—I—I—I—I—I—I—I—I—I—I—I—I—I—I—I—h46

48

50

52

54

36

38

60

62

64

66

68

70

72

74

76

78

80

Chart Me
Expected Real Average Market
Yield on U.S. Government 3-Month
Bills (Percent)

wj—

/Y~ ' ~ ^
~

o—

-utf**~--

46 48 30 32 54 36 38 60 62 64 66 68 70 72 74 7S 78 80

Charts 10 and 11 show the nominal and real
rates for 90-day Treasury bills and the longterm corporate bond yield during the full
postwar period. The weighting on the expected
rate of inflation for long-term bonds is obtained
as a second order Pascal lag on the implicit
deflator for consumer goods and simultaneously
estimated in the DRI model with other
parameters for the AAA-equivalent corporate
bond yield. On the other hand, the ex-post real
new issue rate is fairly stable over the postwar
period. In both cases, however, the real rate is




either rising or forecasted to move higher in the
next year.
Several general conclusions can be drawn from
these various calculations of nominal and real
interest rates.
First, real interest rates,
although low by historical comparisons, are now
on the rise. The modest increases for interest
rates forecasted by DRI in 1979 will maintain
the higher real rates that began in 1978.
Second, the rising real rates are of recent

134
New Realities

vintage, mostly beginning in the second half of
1978. Third, real returns on financial assets are
much lower relative to historical values than
are the real costs of borrowing. Fourth, the
real costs of consumer borrowing are lower
relative to history than the costs of prime
business loans and issues of long-term corporate
debt. Fifth, after taxes, all interest rates and
returns are among the lowest of the postwar
period, reflecting the growing impacts of

accelerated inflation and the progressive U.S.
tax system on net interest rate returns and
costs. Sixth, the modest rises of interest rates
in the DRI forecast are sufficient to bring real
rates higher, although not up to the levels
typical of most other tight money periods,
However, the real rates in this episode are
generally higher than in the 1973-7^ credit
crunch episode and lower than in other
situations where deep recessions have occurred.

Table 3
'Ex-Ante1 After-Tax Real Rates During 'Tight Money1 Periods*
Savings
Rate

Mortgage
8111 Rate

PHine
Business
Loans

Commercial
Paper

Top-quality
Bond Issues

Corporate Sector

Househo d Sector

55:4
56:1
56:2
56:3
56:4
57:1
57:2
57:3
57:4

,MA
0.66
0.29
-0.69
-1.25
-1.28
-1.20
-1.12
-0.26

-0.30
-0.69
-4.11
0.20
-2.63
0.56
1.53
-0.84
2.46

0.05
0.70
0.76
0.78
1.19
1.14
1.12
1.37
1.37

4.42
5.08
4.69
4.25
4.74
4.80
4.35
4.20
4. 68

NA
NA
NA
NA
NA
3.74
3.70
4.21
4.92

MA
NA
NA
NA
NA
NA
NA
NA
NA

-0.96
-2.56
-2.63
-4.43
-5.23
-5.34
-4.63
-3.12
-2.77

-5.02
-6.81
-5.27
-4.72
-6.67
-5.56
-2.72
-0.15
-0.11

0.25
0.34
0.56
0.68
0.76
0.60
0.58
0.51
0.21

59:2
59:3
59:4
60:1
60: Z

0.57
-0.16
0.30
0.55
1.02

1.01
4.31
5.12
2.46
1.41

1.30
1.25
1.16
1.16
1.02

4.02
3.08
2.89
3.78
3.46

2.14
2.72
3.67
6.19
6.34

NA
NA
NA
NA
NA

1.48
0.53
1.27
1.02
1.53

-0.31
1.43
3.12
1.62
0.48

0.39
0.56
0.61
0.41
0.43

66:1
66:2
66:3
66:4

1.02
0.75
0.30
0.70

-0.82
1.86
0.08
6.30

1.74
1.66
1.92
1.72

4.96
4.96
5.04
4.88

6.29
5.69
6.39
6.22

-0.86
-2.06
-0.86
-0.43

1.35
0.68
0.91
0.19

0.46
-1.43
-0.37
0.07

1.32
1.33
1.51
1.36

69:1
69:2
69:3
69:4
70:1

-0.19
-0.73
-0.99
-1.36
-0.85

1.70
-0.56
3.13
0.23
2.26

1.82
2.04
2.29
2.42
2.36

3.37
2.97
3.09
2.70
2. 58

2.99
3.94
3.98
4.62
5.60

-0.59
1.17
0.56
1.32
4.40

-0.66
-0.52
-0.40
-0.55
-0.64

-0.36
-0.85
-1.03
-1.18
-0.36

0.69
0.71
0.72
0.82
0.72

73:1
73:2
73:3
73:4
74:1
74:2
74:3

0.26
-1.27
-2.11
-3.67
-5.15
-6.99
-7.44

-13.58
-13.98

-24.19

0.59
0.37
0.39
-0.13
-0.33
-0.06
0.23

2.34
2.33
2.34
2.45
2.18
2.23
2.68

3.70
3. 85
2.98
3.08
5.99
4.91
2.22

-2.06
-4.02
•6.61
-7.35
-5.70
-3.95
-5.18

0.37
0.47
1.53
1.55
0.11
-1.32
-3.41

1.41
-0.11
-0.49
-0.67
-2.72
-6.60
-10.73 •

0.32
0.39
0.55
0.22
0.11
-0.09
-0.17

78:1
73:2
78:3
78:4
79: IF

-1.08
-2.35
-2.89
-2.09
-2.06
-2.60
-3.01
-2.65

-4.29
-6.06
0.35
-3.46
-5.59
-3.01
-1.34
-0.74

-2.40
-2.07
-1.99
-1.77
-1.40
-1.08
-1.06
-0.94

2.21
2.29
2.05
2.47
2.87
3.05
2.99
2.72

-1.93
0.59
0.23
0.83
1.38
1.40
0.56
1.07

-3.66
-4.10
-4.73
-3.60
-2.68
-2.34
-2.12
-2.65

-2.21
-2.69
-3.00
-2.16
-1.33
-0.91
-1.42
-1.93

-3.83
-3.19
-4.63
-3.39
-1.83
-1.35
-2.24
-2.59

-1.00
-0.90
-1.12
-0.94
-0.63
-0.63
-0.82
-1.22

79:2F
79:3F
79:4F

-9.97
0.26

-20.63

-7.09

Expected after-tax real rales are after-tax nominal interest rates If
average of the compound annual percent change in the inflation rat-. See the '
Appendix for further clorificotion.
*Pre-Cnjnch Periods: 1955:4 to 1957:4, 1959:2 to 1960:2,
1966:1 to 1966:4, 1969:1 to 1970:1,
1973:1 to 1974:3, 1978:1 to 1979:2 («t.)
F = DRI Interim Control Forecost of 2/19/79




135
New Realities

Whether thasa rates, sx-sr.te or ex-post,
before- or after-tax, bear a systematic
relationship to spending and borrowing by
households and corporations remains a topic for
further investigation. The simple association
between low after-tax returns on savings
instruments and the currently low personal
savings rate, the relatively low after-tax costs
of borrowing for households and rapid pace of
spending, and the somewhat higher costs for
corporate borrowing and cautious pace of
business spending do not necessarily mean these
relations would hold in econometric analyses.

next year to 0.8% from the 0.2% of the
forecast, but only cause inflation rates to rise
0.1% higher.
The most sensitive responses
would occur in housing, with strong reactions to
swings of interest rates from current levels.
The low interest rate pattern would bring the
unemployment rate down to 6.5% by 1980:4.

Chart I2a
The Effective Rate on Federal
Funds (Percent)
13

According to the DR1 forecast, interest rates
somewhat higher than currently, nominal or
1
real, are sufficient to produce a mild recession
in the U.S. economy during the second half of
1979. The effects of alternative interest rate
patterns on real economic growth, housing
starts, inflation, and unemployment appear in
Charts I2a to I2e. Three alternative interest
rate scenarios are simulated (Constant Rates,
High Rates, Low Rates) with the DRI
projections for moderate rises of interest rates
also represented (Base). The results show that
even a low interest rate scenario does not fully
eliminate negative real economic growth from
the 1979 economy, although preventing a
recession by the standard National Bureau of
Economic Research definition. The forecasted
recession is consistent with the interest rate
patterns that appear in the charts. In other
episodes, nominal and real interest rates have
risen considerably higher, but at the same time
the recessions have been deeper. Therefore, if
the goal of policy is to avoid a deep recession,
the nominal interest rate pattern of the DRI
forecast probably should not be exceeded and
the lower real interest rates of this episode are
to be desired.
Indeed, the DRI model simulations, summarized
in more detail in Appendix Tables A3 to AS,
indicate that the Federal Reserve can do little
on interest rates to change the outlook for
1979. Raising interest rates 100 to ISO basis
points would deepen the recession to -0.9% real
economic growth between 1978:4 and 1979:4,
limit the change in real GNP to 4.3% from
1979:4 to 1980:4 compared with the 4.8% in the
Base, but at the expense of a 0.3% higher
unemployment rate and with little effect on
inflation. The low interest rate scenario, with
the Federal funds rate dropping to 9.0% by
1979:4, would raise real economic growth for




Constant Rat«
High Rat«»
. . - . . - . . Low Rot«s
1378

1979

1980

1981

Chart I2b
Real Economic Growth
(Compound annual percent)

1978

1979

1980

1981

136
New Realities
Chart I2e
Umemployment Rate - All
Civilian Workers (Percent)

Chart !2c
Housing Starts, Private
Including Farm-Total
(Mils, of units)
,.

A

*>,

\

''^

ill! •"*

I i;ii

\

Wll

Wl

1

\

1

1

1978

Chart I2d
The Rate of Inflation as Measured
by the Compound Annual Growth
Rate of the All Urban Consumer
Price Index-All Items (Percent)

1379




1979

1980

1381

7
1979

Constant Rate*
High Rates
.. Low Rqt«s

191

Is monetary policy working? The answer is yes,
for now. The monetary policy indicators in
Table 2 all signal tightness and real interest
rates, as well as nominal, are on the rise.
Recent evidence also suggests a slowing in the
pace of the economy, although it is difficult to
attribute the patterns solely to restrictions in
monetary policy. Exogenous inflation shocks
and tighter fiscal policy, the reduced purchasing
power of consumers and business, and a
worsening of confidence all are contributing to
the slowdown. Nevertheless, the weakness in
mortgage finance and housing that has arisen
recentJy is suggestive that monetary policy has
begun to bite. So is the 0.4% rise in retail sales
during January, the sluggish pace of business
loans that has been occurring, and the weakness
of industrial production.
How will monetary policy work further to
produce the forecasted recession? In the DR1
model, monetary policy impacts on housing,
consumption, and business fixed investment
through rental prices, debt burdens, the stock
market, and financial risk. The consumer
spending boom and record pace of borrowing
have established the base for a future slowdown
in household expenditures, with a record high

137
New Realities

debt burden relative to disposable income that
eventually will have to be reduced. A similar
effect appears in the corporate sector, through
the burden of debt and debt service relative to
cash flow. The long-time weakness of the stock
market is now affecting consumer spending,
after long lags. Finally, the rental prices of
housing, autos, and business fixed investment
have risen quite high. The bite of monetary
policy will not require higher nominal interest
rates unless there is another shock, dollar or
otherwise,
that threatens
to raise the
"permanent" rate of inflation. However, it is
also true that a mildly higher pattern for
interest rates will do little further damange to
the economy, except for housing, now that rates
have reached the current plateau.

Financial Innovations and the Conduct
of Monetary Policy
The major
impacts from the financial
innovations of the past decade have been to
insulate housing longer and to change payments
mechanisms in the economy. The innovations
include:
1)

the ending or relaxation of regulation
Q deposit rate ceilings;

2)

improved
secondary
markets
in
mortgages,
with
the advent of
mortgage-backed security issues by
thrifts and mortgage market support
from agencies such as the Federal
Home Loan Mortgage Corporation
(FHLMC), Federal Home Loan Bank
Board (FHLBB), the Federal National
Mortgage
Association
(FNMA),
Government
National
Mortgage
Association (GNMA), and HUD;

3)

six-month money market certificates
(MMCs) tied in yield to the six-month
Treasury bill rate, as a new time
deposit account for households;

4)

the gradual elimination or relaxation
of mortgage rate usury ceilings with
only 18 states now having ceilings of
10% or below, 9 with ceilings at 12%,
and the rest with ceilings above 12%;




5)

new lending instruments such as
variable rate mortgages (VRM's),
graduated payment mortgages (GPM's),
and terms for consumer installment
borrowing up to five years;

6)

in effect, an end to the ban on interest
payments for checking accounts, with
the institution of automatic deposit
transfer
systems
(ATS),
NOW
accounts, and special savings accounts
for corporations;

7)

new portfolio practices of households
and
corporations,
stressing
conservation of cash and high returns
on near-money liquid assets, and
favoring direct purchases of money
market
instruments,
repurchase
agreements and new outlets such as
money market funds.

x

Perhaps most importantly of late, NOW
accounts; ATS accounts; and instruments such
as security repurchase agreements, money
market funds, and direct holdings of short-term
securities
have
altered
the
monetary
aggregates. With so many leakages now from
the various M's, it is difficult to determine
whether the monetary aggregate approach to
monetary policy is being successful and what
the appropriate interpretation of the monetary
aggregates is for policy implementation.
Monetary growth has been exceptionally weak
in recent months. Based on revised data, the
two-month growth rate for Ml was -3.9%, well
below the latest short-run Fed targets, M2 rose
0.2% over the same period, far below the lower
limit of the December-January target range of
5 to 9%. At 4.9%, long-run MI growth was only
slightly above the new 4-1/2% upper target
limit set for 1978:4 to 1979:4. M2 growth, at a
year-over-year 7.1%, was easily within the
newly announced 5 to 8% target range for the
coming year. And, growth in M3 is projected at
6.7% by DRI for 1979:1, also well within the
designated target range for 1978:4 to 1979:4.
The weak monetary growth has lasted too long
to be only temporary, or a result of the new
ATS or NOW accounts. It is more likely the
result of a systematic process in response to
high interest rates, one that has occurred in the
late stages of every business expansion since
1955. The negative two-month growth rates for

138
New Realities
Table 4
Monetary and Reserve Aggr^ites:
Recent Growth Rates (%)*
Last
13 Weeks

Last
Month

Last
8 Weeks

Money! **
(SAAR, as of 2/14/79)

-8.5

-19

-2.3

-1.7

4.9

Money 1 Plus ***
(SAAR, as of 2/14/79)

-11.9

-7.1

-5.5

-OJ

2.7

Money2 ****
(SAAR, as of 2/1 4/79
Nonborrowed Reserves »**•»
(SAAR, as of 2/2 1/79)
Monetary Bcse
(SAAR, as of 2/2 1/79)
Adjusted Federal
Reserve Credit
(SAAR, as of 2/2 1/79)

Lost
26 Weeks

Last
52 Weeks

-0.7

0.2

I.S

5.3

7.1

-14.1

-17

20.6

19.1

9.9

4.5

8.9

6.5

8.9

8,6

2.1

10.7

9.9

11.3

9.8

Percent change, simple annual rates: 4 week average
ending on date indicated from 4 week average ending
at the earlier period.
Latest announced growth targets:
1978;* to 1979:4, UI/2 to 4-1/2%
December-January, 2 to 6%
Latest announced growth targets:
1978:3 to 1979:3, 5 to 7-112%
Latest announced growth targets:
1978:4 to 1979:4, 5 to 8%
December-January, 5 to 9%
Unadjusted for changes in reserve requirements.

Ml that have appeared in nine of the last 12
weeks represents the weakest performance
since the credit crunch of 1966. In the case of
M2, the low growth rates of the past three
months are approaching the 1969 experience
and are weaker than in 1966 and 1973-74. The
corresponding weakness of MU indicates that
the automatic funds transfers instituted on
November lore not the explanation for the slow
growth of Ml, since MU includes these
accounts.
The most likely reason is the economizing on
transactions balances occasioned by the near
record level of interest rates. A shift of funds
out of regular passbook accounts at commercial
banks to six-month money market certificates
has accelerated. Another factor impacting to
slow monetary aggregate growth is the
increased use of money market funds and
security repurchase agreements by both
households and corporations. With daily yields
at 10 to 11%, no penalty for withdrawal, checkwriting privileges, and required deposits as low




as $1,000, the money market funds have become
increasingly attractive to households. The most
recent Federal Reserve flow-of-funds data show
a rise from $6.4 billion in 1978:1 to $9.6 billion
for this instrument in 1978:4. Further sharp
increases are likely in 1979:1. The security
repurchase agreements held by nonfinancial
corporations have been near $10 to $12 billion
for several quarters now, indicating a major use
of this instrument as a repository for corporate
liquid funds. These effects are responses to
high interest rates and differ in kind from past
episodes, but not in substance.
How meaningful are the monetary aggregates
now? Clearly, Ml has lost its significance as a
measure of the transactions accounts in the
economy and is too ambiguous for appropriate
Federal Reserve reaction. Even allowing for
the ATS, there will still be considerable
difficulty in using monetary aggregate growth
as a guide to policy until further study has been
completed. Thus, the implication for monetary
policy of this new reality is more reliance on

139
New Realities
direct indicators of economy performance such
as inflation, real economic growth, and dollar
stability.

of payments. The U.S. policymakers, especially
the monetary authority, must therefore remain
vigilant until the dollar and balance of trade are
on a solid footing.
Table 5
Dollar vs. Major Foreign Currencies
(Bid, % change as of today)

DOLLAR DEFENSE AND MONETARY POLICY
Perhaps the most significant event for
monetary policy in 1978 was the collapse of the
dollar and the emergence of international
financial considerations as a major constraint
on the central bank. With imports over 10% of
GNP and the price structure such that rises in
import prices impact greatly on U.S. domestic
inflation, the Federal Reserve had no choice but
to move toward substantial restriction in order
to prevent further declines in the dollar.
Without some interruption, the cycle of higher
inflation, a weaker dollar, and even higher
inflation might have continued until both the
political and economic fabric of the U.S. was
undermined. In addition, the threat to the role
of the U.S. currency as a key international
reserve was severe, with a potential run on the
dollar that would have created chaos in
international trade and finance.
Given all of these considerations, the worsening
balance of payments disequilibrium that arose
in 1978 could not be ignored by the central bank.
To aggravate the situation further, holders of
dollars, whether foreign central banks or U.S.
institutions, had begun to rebalance portfolios,
adding to the extended weakness in the dollar.
Even with an improvement in the so-called
"fundamentals", lack of confidence in the
determination of the U.S. to move the economy
to a sustainable growth path with moderating
inflation was sure to bring continued erosion of
the dollar, further U.S. inflation, and the need
for even more severe restriction later. The
classic policy mix for a country facing inflation
and weakness in the balance of payments is
austerity, implemented primarily by tight
monetary policy.
The dollar has performed well since the
unprecedented November I tightening. But the
November 1 measures can only provide a stopgap until the comparative economic growth
rates of the U.S. and its trading partners,
relative rates of inflation, and trade positions
permit a sustained improvement in the balance




3 Months One Year

1 Week
restertay
2/19/79

2/13/79

10/30/73

11/21/78

2/21/73

fen

0.2

-0.1

13.1

3.3

-15.3

Fr. Franc

0.1

-0.1

7.2

-3.0

-11.2

SM. Franc

0.0

-.
07

12.3

-3.1

-9.1

German Mark

0.0

-0.5

7.3

-3.S

-9.3

-0.1

-0.7

4.4

-3.3

-3.1

Pound

Source: 3/VMCS (Sank of -America. Money and Credit Statistics)

Current DRI projections indicate that this will
not be possible before year end, when a
recession is in place and inflation rates have
turned downward. Monetary policy must remain
relatively tight until then, regardless of the
growth in the monetary aggregates, unless the
recession is much deeper than expected.

MONETARY POLICY AND INFLATION
Restrictive monetary policy has been a key to
slowing the economy in every cyclical episode
since 1955. But in each case, a tight Fed policy
was overstayed to the point of driving the
economy into a deeper recession than was
necessary.
Why did the Federal Reserve remain restrictive
for so long? The most likely answer is that the
monetary authority probably did not appreciate
the potency of monetary policy or have
adequate knowledge of the lags between policy
implementation and its effects. The central
bank reacted strongly to contemporaneous
signals, especially inflation, at the same time a
weakening was in process. It was difficult to
ease up on policy prior to signs of a significant
economy slowdown and reduced inflation,
despite the lagging nature of the inflation and
unemployment indicators. Yet, in order to

140
New Realities

avoid overkill, monetary policy, because of the
lags, must t-jrn before full proof of tha success
from earlier restrictive policy appears.
In addition, the current
experience is
complicated by the fact that much of the
inflation has not been caused by excess demand.
Restrictive monetary policy is most effective
against the excess demand variety of inflation
rather than cost-push or other factors. The
complex set of forces that has brought about
the continuing high and accelerating inflation in
the U.S. economy is not easily amenable to the
standard monetary policy prescription. In order
to effectively combat inflation, the sources
must be known and policies appropriate to a
specific attack applied.
According to DRI studies, the escalation of
inflation in 1978 was only due in small part to
excess demand, which accounted for 0.3% of
the rise from the "trend" or "hard-core"
inflation rate of 5.3% to the actual change in
consumer prices of 7.7%. Much of the 2.4%
acceleration was due to higher food prices and
the surge in home ownership. Cost-push factors
from the dollar depreciation, minimum wage,
and social security increases, and other policies
brought about 0.8% of the acceleration.
Table 6
What Made Inflation Worse?
(Consumer prices, percent change)
1978

5.3

The Trend Inflation Rate
Food Prices
- Policy
• Livestock
The Dollar
Minimum Wage
Social Security 4 Other Poficy
Actual change in consumer prices

0.7
0.3
0.4
0.4
O.I
0.3
0.6
0.3
7.7

Sourcei R. Cough and R. Siege), "Why Inflation Became Worse",
in Data Resources Review, January 1979, p. 16.

See A. Sinai, "Credit Crunches—An Analysis of
the Postwar Experience," in 0. Eckstein, ed.,
Parameters and Policies in the U.S. Economy
(Amsterdam: North-Holland, 1976), pp. 273-74.




The base inflation rate, estimated at 5.3%, is
Tiuch the effect of wage end price increases in
excess of productivity and lingering as well as
current effects from higher energy prices,
especially on oil. With so much of the current
inflation the result of high wage costs relative
to low productivity, policies designed to impact
on these factors are necessary. Inflation is no
longer a one-dimensional phenomenon, to be
treated solely with aggregate demand measures.
Like the cancer of physical illness, a battery of
medicines needs to be applied for optimal
results.
Given these realities of inflation in the U.S.
economy, the role for monetary policy is
circumscribed. Even if the recent January
acceleration
of inflation was primarily
intensified by excess demand, the prospects for
a deep reduction in the current inflation
through tighter monetary policy are not good.
A sharp restriction in response to Iranian oil
shortages, the winter weather effects on food
prices, or any other exogenous shocks, would
prove counter-productive, just as in 1973-74.
If not through monetary policy, how then to
impact inflation? The answer lies in attacking
the core rate of inflation at the same time
demand-management policies remain tough.
TIP-like policies to induce reductions in wages
would be most beneficial, accompanied by tax
incentives for business fixed investment and
R&D to raise productivity. A sustained hardline on fiscal and monetary policies but without
an abrupt move toward the restriction that
would cause a deep recession, combined with
inducements to wage-earners to accept lower
wages, holds the most hope for improvement.
Regardless of the policies attempted, the
process of unwinding the current high inflation
promises to be long, extending well into the
1980's.
Tax subsidies to wage earners who accept
significantly lower wage increases might well
produce sufficient
economy stimulus to
generate offsetting tax revenues.
Just as
"exogenous inflation shocks" have been
associated with worsened price inflation and
higher unemployment, so would "exogenous
deflation shocks" work to benefit the economy.
See A. Sinai, "Inflation and Business Capital
Spending," in Special Studies on Economic
Change. Hearings Before the Joint Economic
C-ommittee
(Washington,
D.C.:
U.S.
Government Printing Office, 1978), pp. 883-901.

141
New Realities
POLICY COORDINATION
Monetary and fiscal policy should be
coordinated more closely to seek a higher level
of economy performance without raising the
prospects for accelerated inflation. Neither
monetary nor fiscal policy alone can do much
about the current inflation. Until recently, the
two policies had never been closely related, and
were often at odds with one another. One
possibility is a "tight fiscal-easier money"
approach. By tight fiscal policy is not meant
decreased
expenditures
by the Federal
government. More realistically, it refers to
slower growth in Federal government spending
than has been the case in previous years. The
"easier money" component of a tight fiscaleasier money policy also does not refer to a
radically extreme measure. By easier money is
meant a Federal Reserve policy that permits
money growth between 7-1/2 and 8% per annum,
in recognition of the difficulty in reducing the
core 5 to 6% inflation rates of the U.S.
economy. The tight fiscal component simply
would make monetary relaxation 5 a more
agreeable choice for the central bank.
Unfortunately, the easier money component of
the "tight fiscal-easier money" policy mix must
be delayed because of dollar considerations.
The policy now is "tight fiscal-tight money" and
should continue until the U.S. economy slows
and the excess demand component of inflation
is diminished. At that time, however, the
appropriate coordination of policy will be to
move the mix toward a "tight fiscal-easier
money" mode, with particular restraint on the
spending of the Federal government. Should the
Administration and Federal Reserve manage
such a policy posture once the dollar is
stabilized, the prospects for a better economic
performance in the I980's will be enhanced.
In the past year, important strides have been
made toward closer cooperation in stabilization
policy. The Federal budget deficit was moved
significantly toward restraint, in part due to the
urging of the Federal Reserve. Tax reduction
scheduled for 1978:4 was postponed to ease the
For a simulation analysis of such a policy, see
A. Sinai, "The Conduct of Monetary Policy:
Performance and Prescriptions," in Hearings
before the Senate Committee on Banking,
Housing, and Urban Affairs (Washington, D.C.:
U.S. Government Printing Office, 1977), pp.
266-269.




demand-side pressures on the economy. The
Federal Reserve, Treasury, and Administration
moved together on November I to prevent
further deterioration of the dollar.
In
retrospect, all of these policy moves were
correct,
given
the
worse-than-expected
inflation that has materialized.
Such
complementarity in the actions of the major
arms of macroeconomic policy is not typical of
the postwar period and illustrates the benefits
from a close, but independent collaboration.
In particular, further attacks on inflation must
involve attempts to strengthen productivity.
General
macroeconomic
policies
which
stimulate business fixed investment can be of
little benefit in this area, now that full resource
utilization is close-at-hand. As the economy
nears full employment, tax incentive measures
for
business capital
formation
become
particularly important because the mix of
spending would be shifted away from
consumption and toward business fixed
investment.
Tax policy to remove the inflation drag on
business spending should be implemented.
Households should not be the only group to be
granted tax relief to ease the "bracket effect"
that arises from accelerated inflation. Business
firms face the same problem given original cost
depreciation and present inventory valuation
methods. More rapid depreciation is needed and
investment tax credits for capital formation
and R&D spending should be examined closely.
MONETARY POLICY TARGETS FOR 1979
The
economic
goals
of
the
Carter
Administration, embodied in the January 1979
Economic Report of the President, are
provided in Table 7,
along with the
corresponding DRI projections for 1979 and
1980?
The details of the Administration forecast
have been worked out in the DRI model
simulation "Carter Country-January 26, 1979,"
which reflects the key economic assumptions
of the Administration, but also provides the
. complete macroeconomic detail from the DRI
model. The entries in Table 7 for many of the
variables are implied by the DRI model, based
on key Administration projections that appear
in Tables 21 and 22 and pages 97-123 of the 1979
Economic Report of the President.




142
New Realities
Table 7
Economic Goals of the Carter Administration and the OR! Forecast*
1973
Actual

Item

1979

1930

Annual Average
1979
1930

Percent change, fourth quarter to fourth quarter
Consumer Prices
Administration
ORI

9.0
9.0

74
9.0

7.2

3.2
9.1

6.7
7.7

Nominal GNP
Administration
ORI

12.9
12.9

9.7
34

9.9
12.4

114
11.0

94
9.9

Real GNP
Administration
ORI

4J
4J

2.2
0.2

3.2
4.3

3.6
24

24

Real Consumption Expenditures
Administration
ORI

3.3
3.3

3.3
1.2

1.6
4.0

4.4
3.2

2.0

Real Business Fixed Investment
Administration
ORI

3J
3.3

1.8
0.0

11

4J
3.3

2.3
IJ

Real State and Local Purchases
Administration
ORI

34
34

2.0
1.7

2.7
2.0

24
2J

2.4
1.3

Productivity
?
AdministrationORI

OJ
OJ

0.4
1.4

1.1

NA
1.2

NA
2.6

Level, fourth quarter'
Employment (millions)
Administration
ORI
Unemployment Rate (%)
Administration
OR.

95.6
95.6
5.3
5.8

974
96.3

994
98.3

96.9
964

93.8
97.3

6.2
6.3

6.2
6.3

6.0
6J

6.2
7.0

1.332
1494

2.163
2.044

1.967
1.715

2.006
1.373

Housing Starts
(mils, of units)
Administration
ORI

2.009
2.009

Auto Sales
(mils, of units)
Administration
DRI

11.1
11.1

11.9
9.7

10.9
II. 1

11.2
104

II. 1
10.8

Treasury Bill Rate (%)
Administration
ORI

7.19
7.19

3J3
344

7.19
3.63

3.31
9.27

740
3.10

'Sources: 1979 Economic Report of the President, p. 109; Data Resources, Inc.
Interim Control of February 19, 1979; "Carter Country" ORI Simulation,
January 26, 1979
seasonally adjusted
real GNP per hours worked

143
New Realities
The Carter
Administration
envisions a
moderation of real economic growth during
1979, but no recession. From 1978:4 to 1979:4,
the goal for real economic growth is 2.2%, a
pace below potential, but that would permit
moderation in the inflation pressures on the
economy. The goal for consumer prices is near
7.5%, a slight deceleration from the 7.7% of
1977:4 to 1978:4. But greater optimism on the
efficacy of the voluntary program on wages and
prices is exhibited than appears in the ORI
forecast. The unemployment rate would rise
somewhat, to 6.2% by the end of 1979, as a
result of the slowed pace in real economic
growth.
The DR1 forecast takes a more cyclical view. A
mild recession is forecasted during the second
half of 1979, holding real economic growth to
0.2% for 1978:4 to 1979:4. Higher interest rates
than are assumed by the Administration, a
greater decline in housing, weaker real
consumption, and a worse result for auto sales
are the primary differences between the DRI
view and the Carter goals. A 45-day auto strike
in 1979:4 and even higher inflation due to a
partial cutback in Iranian oil also are assumed.
On balance, the DRI forecast is more
pessimistic than the Carter Administration




outlook. Higher unemployment and inflation
rates characterize 1979 and 1980 than under the
Administration view. This weaker performance
is mostly due to the near-term outlook and, in
particular, the higher profile of interest rates
that results from Federal Reserve "sustained
restraint" to maintain dollar defense and the
fight against inflation. The effects of the
higher interest rates and extended financial
position of consumers impact most greatly on
housing activity and consumer spending during
1979. But real economic growth is projected at
4.8% by DRI for 1980, considerably above the
Administration goal of 3.2%.
The monetary growth rates in the DRI interim
forecast of February 19, 1979 and those implied
by the Carter Administration goals are
presented in Table 8. The new Federal Reserve
target ranges for Ml, M2, and M3 announced on
February 20 also are given.
The various
monetary aggregates, Ml, MI+, M2, and M3 all
grow more slowly from 1978:4 to 1979:4 under
the DRI forecast than in the Administration
scenario. Ml growth is projected at 2.7%, near
the mid-point of the 1-1/2 to 4-1/2% Fed target
The assumption in the DRI forecast is that
ATS reduces monetary growth by 2.7% in 1979.
The Federal Reserve estimate is 3%.

Table 8
Fed Targets and Monetary Growth Under the Carter Administration
and DRI Scenarios (Fourth quarter to fourth quarter)
1978
Actuol
Fed Target Ranges
Ml
Ml*
M2
M3

lt-6h
«5a
7*-IO

1979

1980

Ih-Ah
2*8
6-9

NA
NA
NA
NA

Monetary Growth

Ml
Administration
DRI

7.3
7J

k.k
2J

4.5
5'.9

Administration
DRI

5.3
5J

3.6

9.3
10.4

Administration
DRI

8.5
3J

8.0
7.1

8.9
9.9

Administration
DRI

9.0
9.0

9.1
7.9

10 J
10.8

MU

M2

M3

a

lotest available

144
New Realities
from 100 stochastic simulations of the DRI
model over the period 1978:4 to !?79:4. These
simulations trace a probability distribution for
the potential results on real GNP, wages and
prices, incomes, the monetary aggregates, the
unemployment rate, and several key interest
rates. With the odds on positive real growth
during 1979 only a little more than 50%, the
likelihood that Ml will fall within the 1-1/2 to 41/2% target range is 95%. The probabilities
that M2 and M3 will fall within the bands set by
the Fed are even higher according to the
stochastic simulations, at near 100%.

range. M2 growth is 6.6%, easily within the
desired 5 to 8% range. ,V.3 is projected to grow
at 7.7%, somewhat above the mid-point of the 6
to 9% range announced in Chairman Miller's
testimony. Thus, the monetary growth targets
for 1979 are consistent with the DR1 forecasts
of a mild recession, 9% inflation of All-Urban
consumer
prices,
and a rise in the
unemployment rate to 6.8%.
Indeed, given the assumptions on the principal
exogenous variables in the DRI forecast and the
structure of the DRI model, the probabilities
are extremely high that the Federal Reserve
target ranges for monetary growth will be
achieved in 1979. Table 9 presents the results




°Appendix Tables AI and A2 present the details
for 1979 and 1980.

Table 9
Risk Ranges From Stochastic Simulations with the DRI Model
Growth Rates 1978:4 to 1979:4

ReaT~GNP
Cons mint 1 an
Fixed Investment
Residential
Imports
Gov? -v«nt Spending
State & Local
Federal
Wages and Prices
Avg. Hourly Earnings
G.N.P. Deflator
Wholesale Prices
Consumer Prices
Incomes
Personal Income
Real 01sp. Income...
Corporate Profits
Before Taxes
After Taxes
Other
Money Supply
Money2
Money3
Indust. Production..
Housing Starts
Car Shipments

Unemployment Sate
Fed. Surplus (811. J).
Interest Rates
Federal Funds
Prime Bus. Loans....
New Corporate Sonds.

•NonStochastic
OR I
Forecast
0.2
1.2
0.0
-12.4
3.3
-0.5
1.7
-2.5

Stochastic Simulation
Hi

3.5
3.4
5.7
-2.0
9.2
5.5
4.3
3.6

95*
1.5
2.5
26
-6'.9
7.0
4.4

75X

Pe •cent1l< s
SOS
25X

0.5
1.4

0.1
1.0

I 3
01
-llll -13*.6
4.8
3.4
2.2
0.1

-0.8
0.1

5X

-2.1
-0.3

Low

-2.7
-1.3

-4 5
-1.3 -2.3
-21*. 4 -25 is
1. 3 -0.7
-2.3
-3.8
-4.9
-2.2

3.4
1.7

2.3
-1.3

1.6
-2.7

1.0
-4.1

-0.8
-5.8

-l.l
-8.2

8.7
8.3
10.6
9.0

9.9
9.5
13.4
10.7

9.3
9.1
12.0
10.3

3.9
8.6
11.3
9.4

8.7
3.3
10.5
8.9

3.4
7.9
10.0
3.4

3.0
7.4
9.0
7.8

7.7
7.0
3.4
6.3

11.1
3.0
-10.2
-7.1

13.0
4.9
3.9
9.6

12.5
3.7

11.3
3.2

10.6
2.6

9.3
1.9

8.7
0.3

7.8
-0.1

-1.0
4.2

-4.5
-0.9

-6.5
-3.5

2.
7.
7.
-4.
-25.
-12.

4.3
7.8
8.8
7.0
-11.1
-0.3

6.2
-28.4

10.4
11.7
9.5

-8.9
-6.6

-12.0
-11.5

4.0
3.1
2.7
2.2
1.5
0.6
7.6
7.0
7.3
6.3
6.0
73
8.5
8.0
6.6
2.1
-0.4
-1.2
-. I
6'
-16.9 -23.3 -26.1
-33.9 -42 '1
.
-3.3
-9.6 -12.7 -16.8 -21.1 -25.4

j'.s
-29ia

Stat lonary Series
Av« rage for 1978:4 to 1 }79:4
(Percentage Except For Federal Surplus)
7.1 6.7 6.4 6.3 6.0
5.7
-18.5 -22.0 -26.1 -29.0 -32.0 -35.6

11.8
12.7
9.9

-16.6
-14.5

11. 1
12.3
9.7

10.8
12.0
9.6

10.5
11.8
9.4

10.2
11.6
9.3

9.8
11.3
9.1

5.7
-35.3
9.7
11.2
9.0

145
New Realities
Table 10
Probabilities for Growth of the Monetary Aggregates:
I978:4to 1979:4, Classified According to the Target Range*
Ml

M2

M3

Greater Than Target
Within ftange
Below Target

lfc-4*

5-3

6-9

0
.95
.05

New Target Range (73: it to 79:4)

0
1.00
0

0
1.00
0

* DRI Interim Forecast if February 19, 1979

Thus, according to the DRI model, the interest
rate patterns consistent with monetary
aggregate growth near the midpoints of the
new Fed targets will be sufficient to produce a
mild recession during 1979. These rates include
a peak of 11-1/4% for Federal funds at mid-year,
12-1/2% in the prime, and 9-3/4% for tooquality bond yields. Subsequently, the declines
in rates would be very modest. These results
suggest that the target ranges necessary to
avoid a recession would have to be considerably
higher than the ones set by the Federal
Reserve.
The Carter Administration scenario, on the
other hand, produces Ml, M2, and M3 growth
rates near the upper bounds of the Federal
Reserve target ranges.
The growth rates
exceed the target for M3 slightly and deviate
significantly upward from the mid-points of the
announced target ranges of Ml and M2. As
Table II shows, the probabilities that the
monetary growth rates implied by the Carter
Administration goals will be within Fed target
ranges are much less than for the DRI forecast.
The implication is that interest rates must be
raised significantly from current levels to
achieve the midpoints of the targets, given the
Administration goals on real economic growth
and inflation.
Table II
Probabilities for Monetary Aggregate
Growth: 1978:4 to 1979:4, Classified
According to the Target Range*
Ml
New Target Range (7&<t to 79:1)
Greater Than Target
Within flange
Below Target
* "Carter Country 0126" simulation.




IVAh

-SI
.49
0

M2
5-3

M3
6-9

J8
.£2

.53
.47
0

a

The Federal Reserve has yet a different outlook
for 1979, as revealed in Chairman Miller's
testimony.
Table
13 compares
the
Administration, DRI, and Federal Reserve
projections for 1979. The central bank view also
is more pessimistic than the Carter goals, but
consistent with the monetary growth rates that
have been chosen. It would take much higher
inflation, a surprising continuation of economywide strength, or a turnabout in the
conservative stance of fiscal policy to cause the
upper bounds to be violated. Too low monetary
growth is the most probable error, especially if
the economy weakens more because of
unexpected shocks.
Charts 13a to I3i show the results of high and
low monetary growth scenarios compared with
the baseline. Appendix Tables A2, A6 and A7
provide the details. The interest rate swings
are magnified in order to quickly achieve the
lower or upper ranges of the new Federal
targets. To obtain the lower bounds for Ml, M2,
and M3 in 1979, interest rates would have to be
raised to all-time peaks, with the Federal funds
rate reaching 14.1% during 1979:3 and AAAequivalent bond yields at 9.8%. Achieving
growth rates for the monetary aggregates near
the lower bounds would be associated with a
deep recession, with real economic growth
dropping 0.9% over the next year and not even a
full recovery in 1980.
There would be
significant reductions of inflation, especially in
1980, but at considerable expense to
employment.
On the other hand, the high monetary growth
scenario, associated with a much lower pattern
of interest rates, would generate additional
inflation and lower unemployment.
The
deterioration of inflation would not be so great
relative to the reduced unemployment.




146
New Realities
Table 12
Risk Ranges From Stochastic Simulations with the OR! Model
Srcwth Rates 1973:4 TO 1979:4

NonStochastic
"Carter Country*
Forecast
H1
Seal GNP
Consume t1 on
Fixed investment
3us1ness
Residential
Exports
I/sports
Government Spending

95X

Stochastic Simulation
PercentHes

7SX

50X

25X
5
.0

SX

Low

0.4
2.1

-0.1
1.2

3. a
5.0

2.9
4.4

2.2
3.3

S.O
3.0
9.5
6.5

.1.0
3.4
5.4

3.0
-0.1
6.7
3.5

2.0
-3.0
5.4
2.2
0.0

-1.7

-4.1

-l.l
-5.3

7.3
6.5
7.0
6.1

7.2
6.1
6.3
5.3

2.2
3.7

4.9
5.1

1.7
-2.S
5.3
1.9

.2 -1.0 -4.2
- .2 -10.0 -13.3
0.7
1.7
.3
0.1 -3.3 -5.1

-0.3

4.3

3.5

l.S

Wages and Prices
Avg. Hourly earnings
G..1.P. Deflator
Wholesale Prices....
Consumer Prices

3.3
7.4
8.7
7.4

9.1
3.7
11.7
9.2

3.9

3.6

3.3

3 1

10.6
3.3

9.4
7.3

3.7
7.2

3.1
6.9

Incomes
Personal Income
Real 01sp. Income...
Corporate Profits
Sefore T«es

10.2
3.3

13.1

11.3

10.3

10.4

9.5

3.4

7.5

1.4

11.2

6.4

4.0

1.4

-0.7

-4.3

-5.9

4.4
7.9
9.1
1.2
-13.9
7.4

5.2
3.9
10.2
9.2
-4.0
19.0

5.7
3.6
9.9
4.4

4.9
4.5
3.1
7.9
9.4 9.1
3.0
1.3
-0.1 -10.7 -U.3
15.5 10.3
7.0

-0.4

Federal

Other
«ON£Y3
Indust. Production..
Housing Starts
Car Shipments

3.0
2.5
7.1
5.7
7.9
-2.4 -3.3
-23.5 -27.3
-4.4
3.6
0.3

1.3
7.8

fl. 3 3.4

Stationary Series
Av raqe for 1973:4 TO 1979:4
(Percentage Except ?or Federal Surplus)
Unemployment Rate
Fed. Surplus (311. 5).
Interest Rates
Federal Funds
New Corporate Bonds.

6.0
-30.7
10. 0
11.5
9.4

6.7
6.4
5.2
3.3
5.9
5.5
5.3
-20.0 -25.0 -27.7 -31.3 -34.0 -37.3 -40.7

11.4 10.9
12. S 12.1

10.4
11.3

10.0
11.5

9.7
11.3

9.2
11.0

3.9
10.3
9.0

Table 13
The 1979 Outlook*
1979 (Otfi Quarter to Oth Quarter,
percent change)
Administration Federal Reserve
DPJ
Nominal GNP
Real CNP
Consumption
Nonresidential Fixed
Investment
Residential Investment
Federal Purchases
State and Local Purchases

2 to 2.S
l-3/o to 25i
0 to OJi
-Sft to-9ft
-0.3

3.5

CNP Implicit Price Deflator
Real Disposable income

7V. to 7ft
2.S

Unemployment Rate (%)
Housing Starts (mils, of units)

6 to 6*
Mi in 1-3/0

1-3/0 to 251
NA

NA
NA

to
C.I to

-O.S

-1.3
-II. 1

NA
NA
7Ji to S'A
NA

1.7 to -O.I
t to 3K
7.9 to
1.9 to

Level, Oth Quarts r
NA
NA

•Source: 1979 Economic Report of the President; Miller Testimony; Table 12

0.5
1.0

to
1.3
to -15.9

,&

3. ft
3.2

147
New Realities
Chart I 3a
M1 Growth (4 Qtr. % chg.):
Interim Control and High and
Low Money Growth Simulations*

Chart I3b
M2 Growth (4 Qtr. % chg.):
Interim Control and High and
Low Money Growth Simulations*
_Interim Control
.High Money Growth
. . Low Money Growth

8--\

\

\
Ss

Vy

J

w
Chart I3c
Federal Funds Rate (Percent):
Interim Control and High and
Low Money Growth Simulations*

Chart 13d
New Issue Rate for AAA-Equivalent
Corporate Bonds (Percent):
Interim Control and High and
Low Money Growth Simulations*

/

Low Money Growth

• r**^. '•
Interim Control

i
1

\

^

/i

1

High Money Growth
Low Money Growth

High Money Growth—N. ^ ""
I




I

I

I

I

I

I

I

I

•High Money Growth Simulation: Long-run money growth at upper limit of recently
announced Fed target range for 1978:4 to 1979:4.
OR! Interim Control long-run money growth midway between lower and upper
limits of recently announced Fed target range for 1970:4 to 1979:4.
Low Money Growth Simulation! long-run money growth at tower limit of recently
announced Fed target range for 1978:4 to 1979:4.

w

148
New Realities
Chart I3e
Real Growth in GNP (% chg.):
Interim Control and High and
Low Money Growth Simulations*

Chart 1 3f
Unemployment Rate (Percent):
Interim Control and High and
Low Money Growth Simulations*
— Interim Control
-High Money Growth
. Low Money Growth ,-

_ Interim Control
.High Money Growth
,. Low Money Growth

ZT

\

i i i i i i i i i
W

Chart I 3h
Housing Starts, Private Including
Farm - Total (Mils, of units):
Interim Control and High and
Low Money Growth Simulations*

Chart I3g
Inflation-Implicit GNP Deflator
(% chg.): Interim Control and
High and Low Money Growth
Simulations*
_
____
......

.
/K

6-0|

|
W




|
l

|

|

Interim Control
High Money Growth
Low Money Growth

|

W

'

|
l

|

1

W

I

— Interim Control
-High Money Growth
. Low Money Growth

L-2\

I

I

I

I

<

•High Money Growth Simulation: Long-run money growth at upper limit ol recently
announced Fed target range for I978rt to 1979:4.
ORI Interim Control: long-run money growth midway between lower and upper
limits ol recently announced Fed target range for I97&4 to 1979:4.
Low Money Growth Simulation: long-run money growth at lower limit of recently
announced Fed target range for 1978:4 to 1979:4.

I

I

I

I

I

149
New Realities

Chart I 31
Growth in Real Fixed Nonresidential
Investment (% chg.): Interim
Control and High and Low Money
Growth Simulations*
_ .High Money Growth
. . . Low Money Growth

Concluding Comments
"Mew realities" in the economy will make the
conduct of monetary policy considerably more
difficult in the months ahead. In particular, the
dollar defense constraint and an inflation that is
not amenable to tight Fed policy suggest a long
period of high interest rates and "austerity"
before any significant headway can be achieved.
A mild recession in 1979 and slow growth for
1980 appears to be the minimal costs necessary
for significant reductions in the inflation that
has been occurring.
Over the longer-run, however, the new realities,
improved policy coordination, tough demand
management and a turn to conservatism in
politics holds considerable hope for a
decelerating inflation and the benefits to U.S.
economic performance that would arise.

-io|

I
1978

I

[
l

I

2

i9733

I

I

4

l

I

I

I

2

13«03

announced Fed target range for I978t4 to 1979:4.
ORI Interim Control: long-run money growth midway between lower and upper
limits of recently announced Fed target range for 1973:4 to 1979:4.
Low Money Growth Simulations long-run money growth at lower limit of recently
announced Fed target range for I97&4 to 1979:4.




The United States is now biting the bullet on
inflation. Although painful over the short-run,
if the various arms of policy and the public have
the staying power, the decade of the 80's should
more closely resemble the 50's and early 60's
than the 70's.

150
New Realities
APPENDIX
Nominal Interest Rates:
The savings rate is the weignted overage effective rate on
savings aeposjts at commercial banks, mutual savings banks,
and savings and loan associations, weighted by the ratio of
each institution's deposits to fatal deposits.
The bill rate is the average market yield on 3-month Treasury
bills, quoteapcn a bank discount basis.
The municipal bond rate is the yield on Moody's AAA State
and local government oond issues.
The return on stocks is the expected cost of equity financing.
As derinea'ByTJRrrthis return equals the yield on Standard
and Poor's daily stock price index - SCO composite - plus a
weighted moving average on the growth of earnings per share
- 500 composite.
The auto loan rate is the interest rate on direct consumer
loans of new automobiles (36 months) at
reporting
commercial banks.
e loon rate is the average effective interest rate
SeTlor purchasing newly built, single-family
homes for all major types of lenders, led one quarter.
The rote on prime business loons is the most common large
business prime loan rate.
The rate on commercial paper is the rate on prime, four-tosix month commercial paper, the designation for jhort-ferrn,
negotiable, unsecured promissory notes sold by reporting
companies to investors, usually other companies.
The rate on
new issues *
OR1.

bond

__ is the average yield on
re bonds, as calculated by

Ex-Post Real Interest Rotes;

annual growth rate for the median sales price of new onefamily nouses sold. The rate of inflation for consumer loans
is the compound annual rate of growth in the average orice of
a new car. For the prime and the commercial paper rates,
the rate of inflation is determined by the compound annual
growth rate in the implicit price deflator for gross fixed
private nonresidential investment.
Expected Real Interest Rates;
The expected real interest rate is the nominal interest rate
less a moving average of me compound annual percent change
in the rate of inflation. The number of quarters over which
the moving average rate of inflation for each interest rate is
calculated is 3 (savings rate), I (bill rate), 20 (municipals and
stock), 12 (auto and mortgage loons), 6 (prime business loans)
and 2 (commercial paper). For the average yield on topquality bond issues, the expected rate of inflation rate is
defined as a second-order Pascal lag distribution on past
actual percent changes in the consumption goods deflator.
This form of the weights results from joint estimation of the
expected rate of inflation and parameters of the ORI Model
equation for the AAA-equivalent corporate bond rate.
After-Tax Nominal Interest Rates;
The after-fax nominal interest rate is the nominal interest
rate less deductions for rederai ana State and local personal
or corporate faxes. Specifically, the after-tax interest rate
for savings is the nominal savings rate less deductions for
Federal and State and local personal taxes. The after-tax bill
rate is net of Federal personal taxes.
The after-tax
municipal bond rote is net of State and local personal taxes.
The after-tax return an stocks is the nominal rate less
personal capital gains on rhe Federal and State and local
government level. The offer-tax consumer Joan end mortgage
rates are net of Federal personal taxes. Kinaily, me rates on
prime business loans, commercial ogper, end toc-auoirfy"bong
\m, otter faxes, are after aeauctions for reaeral ano state
il corporate faxes.
Ex-Post After-Tax Real Interest Rates;

The ex-oost real interest rote is the nominal interest rate less
the compound annual percentage change in the inflation rate
in the same period. The rate of inflation For the savings,
municipal bond, stock, and top-quality bond issue rates is
defined as the compound annual rate of growth in the implicit
price deflator for personal consumption expenditures. For
the 3-month Treasury bill rate, the rate of inflation is defined
as the compound annual percentage change in the Wholesale
Price Index - All Commodities. The measure for the inflation
rate connected with the mortgage rate is the compound




The ex-post after-tax real interest rote is the after-tax
nominal interest rate less the compouncTannual percentage
change in the rate of inflation.
Expected After-Tax Real Interest Rates;
The expected after-tax real interest rote is the after-fax
nominal interest rate less a moving average of the compound
annual percentage change in the rate of inflation.




151
New Realities

1379:4/1373:* 1330:4/1373:4

(i Chg.)

d Chg.)

9.53

10.43

10.53

10.12

9.34

-2.5

-20.2

9.19

9. SI

9.53

9.51

9.23

0.4

1.2

Ml d Chg.)
Ml* ('. Chg.)
« (". Chg.)
M3 (5 Chg.)

4.4
2.5
3.0
9.7

3.0
S.4
6.4
' 8.J

4.4
. 3.2
7.5
3.7

4.9
10.5
3.7
9.5

5.3
10.S
9.1
10.1

4.4
3.6
3.0
9.1

4.5
9.3
3.9
10.3

Inflation (X Chg. - C?I)
Unemployment Rate (X)

3.6
5.3

3.5
S.3

7.2
6.0

7.4
5.0

6.4
6,2

7.4
6.1

6!3
-0.1

Velocity (X Chg.)

9.9

3.3

4.4

3.6

j.6

5.1

5.1

2.129

2.071

2. 045

1.919

1.332

-13.9

13.3

U.I

11.0

10.9

11.1

11.9

7.4

-3.7

1978 :4A
Federal Funds Rate (S)
AM-£quiva1ent Corporate
Sand Held (3)

Housing Starts
(Mils, of Units)
Auto Sales
(M1!s. of Units)

1379:1 1979:2

1979:3 1979:4

U.S. Economic Performance: 1978:4 to 1930:4
(ORI Interim Control - Feoruary 19, 1979)

1978 :4A 1379:1 1979:2 1979:3 1979:4

1979:4/1973:4 1980:4/1979:4
(S Chg.)
(S Chg.)

Ml (X Chg.)
Ml* (t Chg.)

9.53

10.26

11.07

10.91

10.12

5.6

9.19

9.48

9.73

9.56

9.24

0.5

3.9

4.4
2.5

Federal Funds Rate (X)
AAA-€qu1valent Corporate
Bond Yield (X)

1.4

2.2

3.0

4.4

2.7
6.9
7i
7.9

5.9
10.4

ft

M3 (X Chg.)

-7.6

10.3

Inflation (X Chg. - CPI)
Unemployment Rate (I)

3.4
5.3

9.9
S.9

9.1
6.1

3.7
6.4

8.1
S.3

9.0
16.0

7.2
1.1

Velocity (% Chg.)

9.9

9.6

7.3

4.4

1.2

5.6

6.0

2.129

1.323

1.753

-25.1

28.2

11.1

11.2

10.7

-12.4

13.8

Housing Starts
(Mils, of Units)
Auto Sales
(Nils, of Units)

1.636 1.594
10.2

9.7

Total. A3

U.S. Economic Performance: 1973:4 to 1980:4
(ORI Constant Rate Simulation - February 19. 1979)

1978 :4A 1979:1 1979:2 1979:3 1979:4
Federal Funds Rate (X)
AAA-cQuivalent Corporate
Bond Yield (X)

9.53

10.15

10.17

10.11

3.*

-5.4

7'S'
3.4

10.5

Ml* (X Chg.)

.5

43

7.3

9.3

10.1

ffl (X Chg!)

.7

63

7.3

9.0

10. 0

Real GNP (X Chg.)
Inflation (S Chg. - CPI)
Unemployment Sate (X)

.1
.4
.3

22
99
59

1.5
9.1
5.1

0.0
3.7
6.4

-1.6
3.2
6.7

Velocity (X Chg.)
Housing Starts
(Mils, of Units)
Auto Sales
(Mils, of Units)

1979:4/1978:4 1980:4/1979:4
(XChg.)
(X Che.)

9.90

0.5
9.0
14.7

11.0
4.9
7.2
0.1

9.9

9.5

7.2

4.3

1.3

5.6

5.0

2.129

1.332

1.781

1.741

1.667

-21.7

24.3

11.1

11.2

10.7

10.3

9.3

-11.3

13.6




152
New Realities

U.S. economic Performance: 1978:4 to 1380:4
(ORI High Rates Simulation - raoruary 19, 1979)
1979:4/1978:4 1980:4/1979:4

1978: 4A 1979:1 1979:2 1979:3 1979:4

(X Chg.)

d Chg.)
-13.3

9.53

10.35

11.75

12.26

11.53

20.3

9.19

9.49

9.32

10.12

9.33

2.0

0.7

Ml (X Chg.)

4.4

1.4

1.9

2.3

3.4

2.2

5.1

M2 (X Chg.)
M3 (X Chg.)

3.0

5.2

6.3

7.3

7.5

6.6

9.1

,6.1

2.1

1.0

-1.0

-2.9

-0.2

5.3

5.9

5.1

6.5

6.9

17.6

4.3
70
4.4

Federal Funds Rate (X)
AAA-equivalent Corporate
3ond Yield (X)

Real GNP (X Chg.}
Unemployment Rate (X)

9.9

7.4

4.5

1.3

5.6

6.2

1.324

1.728

1.629

1.483

-30.1

29.9

11.1

Housing Starts
(Mils, of Units)
Auto Sales
(Mils, of Units)

9.6

2.129

Velocity (X Chg.)

11.2

10.7

10.2

9.6

-13.3

12.7

U.S. economic Performance: 1978:4 to 1980:4
(OSI Low Rates Simulation - February 19, 1979)
1978.-4A 1979:1 1979:2

1979:4/1973:4 1980:4/1979:4
(XChg.)
(X Chg.)

1979:3

1979:4

9. S3

10.15

9.55

9.30

9.04

5.7

9.19

9.39

9.35

9.30

9.05

-l.S

7.9

Ml (X Chg.)
Ml* (X Chg.)
M2 (X Chg.)
M3 (X Chg. )

4.4
2.5
3.0
9.7

l.S
4.3
5.2

3.0
8.2
7.4

4.2
10.7
9.3

5.5
11.5
10.0
10.3

a:a
a.o

3.5

6.4
10.7
10.4
11.2

Real GNP (X Chg.}
Inflation (X Chg. - CPI)
Unemployment Rate (X)

6.1
8.4
S.3

2.2
9.9
5.9

1.7
9,1
6.1

0.4
3.7
6.4

-i.l
3.2
6.6

0.3
9.0
13.5

5.0
7.3
-1.2

Federal Funds Rate (X)
AAA-Cqufvalent Corporate
3ond Yield (X)

5.3

9.9

9.5

7.0

4.2

1.3

5.5

5.9

2.129

1.332

1.313

1.791

1.734

-18.5

21.4

11.1

Velocity (X Chg.)
Housing Starts
(Mils, of Units)
Auto Sales
(Mils, of Units)

11.2

10.3

10.4

9.9

-10.4

13.6

U.S. economic Performance: 1978:4 to 1980:4
(ORI High Money Growth Simulation - February 19, 1979)

1978: 4A 1979:1 1979:2 1979:3 1979:4
Federal Funds Rate (X)
AAA-£qulvalent Corporate
Bond Yield (X)

Ml (X Chg.)
Ml* (X Chg.)
M2 (X Chg.)
M3 (X Chg. )
Real GNP (X Chg.)
Inflation (X Chg. - CPI)
Unemployment Rate (X)
Velocity (X Chg.)
Housing Starts
(Mils, of Units)
Auto Sales
(Mils, of Units)

1979:4/1978:4 1980:4/1979:4
(X Chg.)
(X Chg.)

9.58

9.35

10.04

9.25

7. 95

-17.0

9.19

9.45

9.67

9.53

9.17

-0.2

3.2

4.4
2.5
.
0

1.6
5.1
5.4

2.3
7.8
7.3

4.1
10.2
9.1

6.1
12.2
10.4

3.6
3.3
3.0

7.5
12.5
11.4
12.4

.1
.4
.8

2.3
9.9
5.9

1.6
9.1
6.1

0.3
8.7
6.4

-0.9
3.2
6.6

0.8
9.0
13.5

5.7
7.4
-4.3

15.3

9.9

9.5

7.1

4.2

1.0

5.4

5.7

2.129

1.344

1.303

1.739

1.776

-16.6

27.4

11.1

11.2

10.3

10.3

9.9

-10.4

16.3




153
New Realitie
Table A 7
U.S. Economic ?«rfomanca: 1973:4 to 1980:4
! Low Money Srcwth Slnulitisn - r*:«Jiry 19, 1979)

1973 :4A 1979:1 1979:2 1979:3 1979:4
Federal Funds Rate (S)
AAA-cquivalent Corporate
Sond Yield (X)

1979:4/1973:4 1330:4/1979:4
(XChg.)
(S Chg.)

9.53

11.10

12.96

14.13

13.99

46.0

-32.6

9.19

9.S4

9.34

9.31

9.34

1.7

-3.3
3.6
72
75
33

34
63
10 0

Ml (X Chg.)
Ml* (X Chg.)
M2 (X Chg.)
M3 (X Chg.)

4.4

1.0

1.1

1.0

1.6

9.7

6.2

6.1

5.3

5.7

1.2
J.
5.
6.

Real GXP (X Chg.)
Inflation (X Chg. - C?I)
Unemployment Bate (X)

6.1
3.4
5.3

1.9
9.9
5.9

0.5
9.1
6.2

-1.9
3.6
6.6

-4.2
3.0
7.0

-0.
3.
20.

1.5

5.3

6.4

2.129

1.797

1.669

1.513

1.312

-33.4

23.5

11.1

11.2

10.6

10.0

9.3

-15.9

10.0

Velocity (X Chg.)
Housing Starts
(Mils.' of Units)
Auto Sales
(Mils, of Units)

154

The CHAIRMAN. Thank you very much, Dr. Sinai.
Dr. Kane is our next witness. Dr. Kane, go right ahead, please.
STATEMENTS OF PROF. EDWARD J. KANE AND EVERETT D.
REESE, PROFESSOR OF BANKING AND MONETARY ECONOMICS, THE OHIO STATE UNIVERSITY

Dr. KANE. Mr. Chairman, I want to thank you and the committee for inviting me here to share my analysis of what the Fed's
current policy statements mean.
The CHAIRMAN. May I say the same: If you could abbreviate your
statement, we would appreciate it, and your statement will be
printed in full in the record.
Dr. KANE. My statement is fairly abbreviated as it stands.
Official Federal Reserve pronouncements are as intricately crafted as medieval scrolls. Like illuminations in the Irish Book of
Kells, Fed statements have an iconography all their own and filigree embellishments that alternately cover and uncover a long and
complicated line of reasoning. Fed argumentation is so artful that
almost no one can follow every twist and turn.
Fed officials speak in arabesques for sound bureaucratic reasons:
To foster and exploit public confusion about the political appearances and political realities of U.S. monetary policy decisions. Popular views of how the Federal Reserve works are confused in three
ways:
First: They're confused about how to tell whether monetary
policy is tight or easy in an inflationary environment;
Second: They are confused in thinking Federal Reserve officials
are effectively insulated from political pressures by long terms of
appointment and budgetary autonomy;
Third: They are confused by disingenuous Federal Reserve statements as to what its policies are intended to accomplish.
THEORY OF MONETARY POLICY

I want to talk first about the theory of monetary policy. Basically, this theory is a theory of policy dilemmas. Every action the
Federal Reserve may take to improve one of the several economic
performance rates.that concern people tends to worsen at least one
of the other rates. Experience teaches that while rapid growth of
the money stock reduces unemployment, it simultaneously tends to
aggravate inflation and to lower the foreign-exchange value of the
dollar. Slow money growth tends to raise unemployment, but to
improve the other two performance rates.
Experience—and economic theory—also teaches that when the
inflation rate varies over time, the policy effects of changes in the
level of nominal interest rates become hard to interpret. Nominal
interest rates treat loan repayments of future dollars as the equivalent in value of current dollars. But with inflation, future dollars
have increasingly less purchasing power. To account for this, it is
better to focus on real interest rates. These are nominal interest
rates minus the anticipated rate of price inflation. For example,
with 9-percent anticipated inflation, a 10-percent government bond
rate would pay only 1-percent real.




155

Now, although real and inflation-adjusted interest rates would
measure the thrust of monetary policy more accurately, in the
popular mind and in the popular press the Fed's chief task is to act
as the arbiter of nominal interest rates. During times of monetary
restraint, this adversary perception subjects the Fed to political
pressures from sectors that are hurt by rising interest rates. These
sectors' political action leads elected officials to resist increases in
nominal interest rates.
This political response then focuses attention on the change in
market interest rates and reinforces the mistaken popular notion
that changes in the level of nominal interest rates are reliable
indicators of the microeconomic thrust of monetary policy.
POLITICS OF FED DECISIONMAKING

Next, I want to discuss the political dependence of the Federal
Reserve System. Fed officials have a narrow political base. What
political strength they have is drawn from an incohesive constituency against inflation. Responding to this constituency, Fed spokespersons are fond of drawing parallels between their situation and
that of the Supreme Court. They argue that long terms of apointment and budgetary autonomy insulate them from shortsighted
election-year pressures to expand the money supply, to promote
employment today, at the expense of inflation later.
But since the Fed's special privileges are revocable by a simple
act of Congress, their insulation is paperthin. To protect its bureaucratic privileges, the Fed must respond to short-run political pressures. Hence, even in such strongly inflationary environments as
those of 1972 and 1978, the Fed finds itself compelled to downgrade
its efforts to fight inflation during an election year.
It is wrong to suppose that the timing of Federal Reserve policy
actions can be explained as passive, statesmanlike reactions to
independent economic cycles of inflation and unemployment.
First: One must allow for the lags in the effects that the Fed
policy instruments have on the macroeconomic goal variables.
Second: To understand the abrupt shifts in the tradeoffs that the
Fed actually makes in executing its conflicting assignments of
fighting inflation and fighting unemployment, one must look simultaneously at the electoral cycle and factor in the distance until the
next Federal election. The role that this distance plays in the Fed
decisionmaking has increased noticeably in the last 14 years.
Among electoral strategists, it is an article of faith that a strong
economy benefits incumbents. A second article of faith is that a
rising trend in unemployment costs incumbents many more votes
than a similarly rising trend in inflation. Finally: It is widely
supposed that the inflationary consequences of less than fully anticipated monetary expansion take longer to develop fully than
effects on unemployment.
Cyclically shifting electoral payoffs to incumbents combine with
lags in the effect of monetary policy to produce an overlay to the
ordinary business cycle. This process goes a long way toward explaining the cyclical worsening in U.S. levels of unemployment and
inflation. Throughout the first 9 or 10 months of an election year,
the Fed is pressed to err on the side of monetary ease. However, as




156

the election draws closer, lags in the effect of monetary policy
make further attempts to reduce unemployment less useful to incumbent politicians, and the buildup of inflationary pressure more
worrisome.
Before money-market certificates were instituted, the effect of
disintermediation on housing and savings and loan associations,
and the complaining voices of other sectors vulnerable to rising
market rates of interest, tended to cloud incumbents' immediate
interest in seeing the election-induced acceleration in inflation stabilized as soon as possible before the next election. But in November 1978, the choice was clear. Approximately 1 week before the
polls opened, the President virtually commanded the Fed to shift
its operating priorities back to fighting inflation again.
These hypotheses not only explain zigs and zags in 1978 monetary policy. They also let us predict the pattern the Fed will follow
in 1979. Post-election monetary restraint will be held overlong in
the largely futile effort to overcome the lagged effects of electionyear monetary expansion. This policy will be held until unemployment establishes a clear upward trend.
By this time inflation, though still high, will begin to decelerate,
making it reasonable for the Fed to undertake its politically necessary election-year task of making the fight against unemployment
its No. 1 priority again.
THE FED AS A SCAPEGOAT

Last: I would like to discuss my view that Fed officials are
political scapegoats, whose job requires them to engage in doubletalk. Especially in election years, one of the least reliable indicators of the state of U.S. monetary policy is what the Federal
Reserve tells us about FOMC intentions. Particularly in the late
stages of any business-cycle expansion, the occupant of this political hot seat is virtually forced to talk out of both sides of his
mouth.
To placate the Fed's natural constituency in the business and
financial community, the Chairman must emphasize how vigorously Fed officials are fighting inflation with high and rising nominal
rates of interest. However, to keep Congress and the administration off their backs, the Fed officials must simultaneously fight
unemployment by expanding the money stock.
In the first 10 months of 1978, Fed officials claimed repeatedly
that monetary policy was highly restrictive, even though the
money supply was growing rapidly and estimates of future inflation, along with observed inflation, were rising faster than nominal
interest rates.
To put monetary policy effects in proper perspective, the Fed
should focus on the level of real interest rates, that is, on the
difference between nominal interest rates and anticipated rates of
inflation. Focusing on the level of nominal interest rates badly
serves the Fed's anti-inflation constituency. It takes pressure off
elected officials by deceiving the public into believing that, even
when the Fed has temporarily abandoned the battlefield, it is
somehow waging a continual war against inflation.




157

In the face of the three-point acceleration in the inflation rate
observed in 1979, it was unconscionable for Fed officials to cite
smaller changes in nominal interest rates as evidence that their
policies were anti-inflationary. Their doing so fostered confusion
and indicates that they value the political options that public confusion currently confers on them.
The Fed's political tasks are almost always contradictory in election years. This sharpens the horns of the Fed's policy dilemma.
Fed officials are expected simultaneously to lead the verbal and
educational onslaught against inflation and to deliver approximately the degree of monetary expansion that employment-oriented
elected officials decide the public interest requires.
Although the Fed is formally an off-budget agency, Congress and
the President know how to threaten it into line. The Fed as scapegoat hypothesis is confirmed by events in 1978. By Presidential
order, the monetary stimulus shifted dramatically just before the
November elections. The approximate growth rate for the first 10
months of 1978: M i grew at about 8.4 percent, M 2 at about 8.6
percent. In the next 3 months, M i declined by about 1 percent and
M 2 grew only about 1% percent—I have not seen the latest figures
that came out yesterday.
Because monetary policy affects the performance rate only after
a few months' lag, this change in policy was conveniently timed to
allow incumbent Congresspersons and a frustrated President to
take credit for both an improving employment picture and a promising anti-inflation program.
The dramatic turnaround in the M i growth rate may or may not
be overstated because of the legalization of the ATS accounts in
November. But the measured decline in M 2 growth is free of this
bias, and is itself sharp enough, if it continues into the summer, to
bring on a recession.
While elected officials talk reassuringly about the possibility of
"soft landings," most of them are fairly fatalistic about the eventual need for a recession to decelerate inflation. With the current
boom a record 4 years old, officeholders who are cognizant of
business-cycle mortality statistics feel that a recession is inevitable
by 1980. Incumbents would rather feed the economy its recession
medicine now, so as to be able to run against the backdrop of an
improving economy in 1980.
To hold up its end, the Fed is prepared both to deny now that it
is manufacturing a recession and to confess in 1980 that its 1979
policies may perhaps have been a shade too restrictive. This is
merely an exquisitely open variation of the cynical policy gambit
that over the last 20 years the Fed and elected officials have
adopted more and more plainly.
Sooner or later, the public and the press are going to learn that
stop-and-go monetary policy is a game played at the electorate's
expense.
The CHAIRMAN. Thank you, Dr. Kane.
[The complete statement of Mr. Kane follows:]




158
PREPARED STATEMENT OF EDWARD J. KANE AND, EVERETT D. REESE, PROFESSOR OF
BANKING AND MONETARY ECONOMICS, THE OHIO STATE UNIVERSITY
Mr. Chairman, I want to thank you and your Committee for inviting me to share
with you my analysis of what current Fed policy statements mean. Official Federal
Reserve pronouncements are as intricately crafted as medieval scrolls. Like illuminations in the Irish Book of Kells, Fed statements have an iconograph all their own
and filigree embellishments that alternately cover and uncover a complicated line of
reasoning. Fed argumentation is so artful that almost no one can follow every twist
and turn.
Fed officials speak in arabesques for bureaucratically useful reasons: to foster and
exploit public confusion about the political appearances and political realities of
U.S. monetary-policy decisions. Popular views of how the Federal Reserve operates
are confused in three fundamental ways. First, they are confused about how to tell
in an inflationary environment whether monetary policy is tight or easy. Second,
they are confused in presuming that Federal Reserve officials are effectively insulated from myopic political pressures by long terms of appointment and budgetary
autonomy. Third, they are confused by disingenuous Federal Reserve explanations
of what its policies are intended to accomplish.
This confusion allows the Fed institutionally to shield incumbent politicians from
being blamed for politically induced short-sighted mistakes in monetary policy while
simultaneously allowing Fed officials to pose as disinterested and far-sighted
macroeconomic troubleshooters.
A. THEORY OF MONETARY-POLICY EFFECTS

The theory of monetary policy is a theory of policy dilemmas. Every action that
FR authorities may take to improve one economic-performance rate tends to worsen
at least one of the other rates. Experience teaches that, while rapid growth in the
money stock reduces unemployment, it simultaneously tends to aggravate inflation
and to lower the foreign-exchange value of the dollar. Slow money growth tends to
raise unemployment, but to improve the other performance rates.
Experience (and economic theory) also teaches that, when the inflation rate varies
over time, the policy effects of changes in the level of nominal interest rates become
hard to interpret. Nominal interest rates treat loan repayments of future dollars as
the equivalent in value of current dollars. But with inflation, future dollars have
increasingly less purchasing power. To account for this, it is better to focus on real
interest rates: nominal interest rates minus the anticipated rate of price inflation.
For example, with 9-percent anticipated inflation, a ten-percent government-bond
rate would pay only one-percent "real."
When the inflation rate varies only slightly from year to year, nominal and real
interest rates move fairly sympathetically. However, when (as in recent years) the
inflation rate fluctuates sharply, nominal interest rates do not accurately track
changes in household and business incentives to save and invest.
At times when the "moneyness" of various assets is not changing rapidly, various
monetary and bank-reserve aggregates provide good alternative measures of the
current thrust of monetary policy. However, when accelerating inflation is causing
Federal Reserve membership to decline and with deposit-rate ceilings making deposit substitutes proliferate, changes in "real" or inflation-adjusted interest rates
become more reliable indicators of the impact of current monetary policy on financial incentives.
Despite the obvious need to factor in the distorting effects of changes in anticipated inflation, in the popular mind and in the financial press, the Fed is perceived as
the beleaguered arbiter of nominal interest rates. During times of money restraint,
this perception implies that the Fed is subject to short-run political pressures from
sectors hurt by rising interest rates. These sectors' political action leads elected
officials openly to resist increases in the level of nominal interest rates. This
political response system focuses attention on changes in market interest rates and
reinforces the mistaken popular notion that changes in the level of nominal interest
rates are reliable indicators of the macroeconomic thrust of current monetary
policy.
B. POLITICAL DEPENDENCE OF THE FED

Fed officials have a narrow political base. What political strength they have is
drawn from an incohesive constituency against inflation. Acutely conscious of this
constituency, Fed spokespersons are fond of drawing parallels between their situation and that of the Supreme Court. They argue that long terms of appointment and
budgetary autonomy insulate them from short-sighted election-year pressures to
expand the money supply to promote employment today at the expense of inflation




159
later. But since the Fed's special privileges are revocable by a simple act of Congress, their insulation is paper-thin. To protect its bureaucratic privileges, the Fed
must respond to short-run sectoral and electoral pressures. Hence, even in such
strongly inflationary environments as those of 1972 and 1978, the Fed finds itself
compelled to downgrade its efforts to fight inflation during an election year.
It is wrong to suppose that the timing of Federal Reserve policy actions can be
explained as passive statesmanlike reactions to independent economic cycles of
inflation and unemployment. First, one must allow for the inevitable lags in the
effect that Fed policy instruments have on macroeconomic variables. Second, to
understand the abrupt shifts in the tradeoffs that the Fed actually makes in
executing its conflicting assignments of fighting inflation and fighting unemployment, one must look simultaneously at the electoral cycle and factor in the distance
until the next federal election. The role that this distance plays in Fed decisionmaking has increased noticeably since the early 1960's.
Among electoral strategists, it is an article of faith that a strong economy benefits
incumbents. A second article of faith is that a rising trend in unemployment costs
incumbents many more votes than a similarly rising trend in inflation. Finally, it is
widely supposed that the inflationary consequences of less than fully anticipated
monetary expansion take longer to be fully felt than effects on employment.
Cyclically shifting electoral payoffs to incumbents combine with lags in the effects
of monetary policy to produce a politically induced overlay to the ordinary business
cycle. This process goes a long way toward explaining the secular worsening in U.S.
levels of unemployment and inflation.
Through the first nine or ten months of an election year, the Fed is pressed to
"err on the side of monetary ease." However, as the ballotting draws very close, lags
in the effects that monetary policy has on macroeconomic goal variables make
further attempts to reduce unemployment less useful to incumbent politicians and
the build-up of inflationary pressure more worrisome. Before money-market certificates were instituted, the effects of disintermediation on housing and S&Ls and the
complaining voices of other sectors vulnerable to rising market rates of interest
tended to counterbalance incumbents' immediate interest in seeing the electioninduced acceleration in inflation stabilized as soon as possible before the next
election. But in November 1978, the choice was clear. Approximately one week
before the polls opened, the President virtually commanded the Fed to shift its
operative priorities back to fighting inflation again.
Besides explaining zigs and zags in 1978 monetary policy, assuming that Fed
policy serves the perceived interest of incumbent politicians allows us to predict the
pattern that the Fed will follow in 1979. Post-election monetary restraint will be
held overlong in a largely futile effort to overcome the lagged effects of 1978's
election-year monetary expansion. Monetary restraint will be maintained until unemployment establishes a clear upward trend. By this time, inflation (though still
high) will begin to decelerate, making it reasonable for the Fed to undertake its
politically necessary 1980 election-year task of making the fight against unemployment its number-one priority again.
C. FED OFFICIALS ARE POLITICAL SCAPEGOATS WHOSE JOBS REQUIRE THEM TO ENGAGE
REGULARLY IN DOUBLETALK

Especially in election years, one of the least-reliable indicators of the state of U.S.
monetary policy is what Federal Reserve Chairmen tell us about FOMC intentions.
Particularly in the late stages of any business-cycle expansion, the occupant of this
political hotseat is virtually forced to talk out of both sides of his mouth. To placate
the Fed's natural constituency in the business and financial community, the Chairman must emphasize how vigorously Fed officials are fighting inflation with high
and rising nominal rates of interest. However, to keep Congress and the Administration off their backs, Fed officials must simultaneously fight unemployment by
expanding the money stock.
In the first ten months of 1978, Fed officials claimed repeatedly that monetary
policy was highly restrictive, even though the money supply was permitted to grow
overly rapidly and observed inflation along with estimates of future inflation rates
to rise faster than nominal interest rates. To put monetary-policy effects in proper
perspective, the Fed could have focused on changes in the level of real interest
rates: nominal interest rates corrected for the anticipated rate of inflation. To do
this most effectively, the Fed would have to survey regularly a stratified sample of
financial and business decisionmakers for their expected inflation rates over different horizons. Such information would usefully supplement distributed-lag functions
of past inflation rates currently used as proxies for these forecasts.




160
Focusing on the level of nominal interest rates badly serves the Fed's antiinflation constituency. It takes pressure off elected officials, by deceiving the public
into believing that, even when the Fed has temporarily abandoned the battlefield, it
is somehow waging a continual war against inflation. In the face of the 3-point
acceleration in the inflation rate observed in 1979, it was unconscionable for Fed
officials to cite smaller changes in nominal interest rates as evidence that their
policies were anti-inflationary. Their doing so fostered confusion and indicates that
they value the political options that public confusion currently confers on them.
The Fed's political tasks are almost always contradictory in election years. An
approaching election sharpens the horns of the Fed's policy dilemma. Fed officials
are expected simultaneously to lead the verbal and educational onslaught against
inflation and to deliver approximately the degree of monetary expansion that employment-oriented elected officials decide the public interest requires.
Although the Fed is formally an off-budget agency, Congress and the President
know how to threaten it into line. The Fed-as-scapegoat hypothesis is confirmed by
events in 1978. By Presidential order, the direction and magnitude of monetary
stimulus shifted dramatically just before the November elections. Whereas Mi and
M 2 each grew at roughly 8.5 percent per annum during the first ten months of 1978,
monetary growth has dramatically decelerated since. During the next three months,
Mi declined at approximately one percent per annum, while M 2 grew at a rate of
only 1.5 percent. Because monetary policy does not affect macroeconomic performance rates until after at least a few months lag, this change in policy was perfectly
timed to allow incumbent Congresspersons and a frustrated Democratic Party to
take credit for both an improving employment picture and a promising anti-inflation program.
The dramatic turnaround in the Mi growth rate may or may not be overstated
because of the legalization of ATS accounts in November. But the measured decline
in M 2 growth is free from this bias and is itself sharp enough—if it continues into
the summer—to bring on a recession.
While various officials talk reassuringly about the possibility of "soft landings,"
most incumbent politicians are fairly fatalistic about the eventual need for a recession to decelerate inflation. With the current boom a record four years old, officeholders who are cognizant of business-cycle mortality statistics feel that a recession
is inevitable by 1980. Incumbents would rather feed the economy its recession
medicine now, so as to be able to run in 1980 against the background of an
improving economy. '
To hold up its end, the Fed is prepared both to deny now that it is manufacturing
a recession and to confess in 1980 that its 1979 policies may perhaps have been a
shade too restrictive. This is merely an exquisitely open variation on the cynical
policy gambit that over the last 20 years the Fed and elected officials have adopted
more and more plainly. The problem is not that the Fed is accountable to elected
officials. In a representative democracy, policymakers must be accountable at least
indirectly to the electorate. The problem is both that re-election pressures lead
politicians to press for short-sighted monetary policies and that the Fed protects the
true authors of its policies from punishment at the polls by pretending that monetary-policy mistakes are entirely its own doing.
Sooner or later, the public and the press are going to recognize that stop-and-go
monetary policy is a political shell game being played at the expense of long-term
economic stability. I sincerely hope that these and subsequent hearings held under
the Humphrey-Hawkins Act contribute to the learning process.

Mr. CHAIRMAN. Mr. Heinemann, go right ahead, sir.
STATEMENT OF H. ERICH HEINEMANN, VICE PI ESIDENT,
MORGAN STANLEY & CO., INC.

Mr. HEINEMANN. I appreciate the opportunity to present my
personal views on the conduct of monetary policy to 'hi. committee. In my remarks today, I plan to sketch a few detaiL eorcerning
the current economic setting that appear pertinent, I will try to
suggest an alternative approach to the problem of monetary policy
measurement and targeting that in my opinion is both simple and
meaningful.
I will argue that so long as the Federal Open Market Committee
insists on trying to manage the Nation's money stock by pegging




161

short-term interest rates, the actual record of policy implementation will most likely be procyclical—too easy during economic expansions and too tight during economic contractions—and indeed,
will bear very little relationship to targets announced at these
oversight hearings.
Finally, I will make some comments about desirable strategic
goals of monetary policy, based in part on the most recent policy
statement of the Shadow Open Market Committee, of which I'm a
member.
I believe that a number of significant policy errors in macroeconomic policy were committed prior to Mr. Miller's taking office
a year ago. I think these errors make the likelihood that the
Nation will in fact be able to avoid at least a moderate contraction
in real business activity very, very small.
In the circumstances, I think that more expansive policies aimed
at postponing a moderate downturn would, in all probability, eventually result in a more serious recession than would otherwise
occur, thus placing some very heavy burdens on sectors of the
economy least able to bear the cost.
I do not concur with Mr. Miller's frequently announced judgment
that the economy, quote, "is in reasonably good balance" at the
present time. We can identify perhaps six major areas of distortion
in the economy at the present time. We see a clear pattern of
excess demand, with nominal spending rising about four times
more rapidly than can be sustained in a noninflationary manner
over the long term. We see a sharp buildup of household sector
leverage, with a debt service burden in the household sector which
promises to be very troublesome at some future time.
We see a lagging investment sector, with productivity suffering
accordingly. We see tight labor markets, with skilled labor essentially at full employment now for quite a long period of time.
In financial markets and foreign exchange markets, we see patterns which characteristically are associated with the peak of a
business cycle rather than the stages of the cycle where continued
expansion is implied.
And finally, we see Federal financing demands which by any
standard I believe are excessive for this stage of the business cycle.
Overall, we would conclude that a number of important cyclical
imbalances are already in place, which in a sense preclude the
policy option of avoiding recession. As far as I am concerned, for
the past year fiscal and monetary policymakers have not been
debating whether or not the Nation will have a recession, but
rather, when one will occur and what its magnitude will be.
I don't think there is any real debate from the administration
these days concerning the need to restrain the growth of aggregate
demand. The Secretary of the Treasury, Mr. Blumenthal, has been
making that point repeatedly in recent weeks in his congressional
testimony.
We strongly endorse Mr. Blumenthal's conclusion that there are
indeed warning signals of excess demand in the economy at the
present time and, secondly, that without fiscal and monetary discipline, no combination of policies to control inflation will be successful. But while we endorse these conclusions, we think the timing of
the administration's actions is tragic.




162

By waiting until evidence of excess demand pressures in the
economy is clearly visible, by waiting until after prices were rising
at a clearly unacceptable rate, the administration has, as far as Fm
concerned, condemned the economy to yet another dismal round of
stop-and-go policies, the very result that they say they want to
avoid.
I think what we have here is a classic example of the whites-ofthe-eyes approach to inflation—waiting until the clear evidence is
at hand, at which point inflation cannot be halted short of at least
a moderate business downturn.
I think that monetary policy has to bear a significant portion of
the burden for the growth of excess demand in the economy. There
is, of course, on a long-term basis, a close association between
sustained changes in the rate of change of money and a lagged
response of a similar nature in the price level.
Nevertheless, I would not single out the Federal Reserve as an
institution for blame. It seems to us that monetary policy has been
correctly reflecting the general political consensus within both the
administration and the Congress, despite warnings from the private sector about the danger of inflation. I think that the Washington view of the economy during 1977 and the first part of 1978 was
one that tended primarily to focus on symptoms of underperformance in economic activity rather than the potential for excess
demand.
In terms of the general thrust of its policy, I think the Federal
Reserve—and indeed, I would say as it must—has followed the lead
of the administration. I have developed the view over many years
of reporting on the Fed that the impact of monetary policy is
indeed so intensely political that to speak about a nonpolitical
central bank really is a contradiction in terms. As a country, we
believe in civilian control of the military. I think the same general
political principle is involved as far as the monetary authority is
concerned.
If we do not have the political discipline to control policy at the
political level, I think it is highly unrealistic to expect a group of
individuals who are essentially technicians at the central bank to
do the job for us.
The Federal Reserve, within the statute, the Federal Reserve
Reform Act of 1977, has a mandate, quote:
To maintain long-run growth of the monetary and credit aggregates commensurate with the economy's long-run potential to increase production, so as to promote
effectively the goals of maximum employment, stable prices and moderate long-term
interest rates.

Close quote.
I think this is a fine target. I do not think, without solid support
from political leadership both in the administration and in Congress, that the Fed will succeed in accomplishing this task.
In the short run, as has already been pointed out here this
morning, I think the Fed has lost its freedom of maneuver. I think
the foreign exchange markets have demonstrated repeatedly that
they have no tolerance at all for administration policies or American economic policies that suggest a lack of resolution in dealing
with the problem of inflation. I think that we have in fact, in the
way we have conducted our international financial affairs, gener-




163

ated some significant international political costs which are beginning to undermine our leadership position in the industrial world.
I think that the administration and the Federal Reserve must
take action in a sustained and credible manner to reduce inflationary pressures in the United States relative to those in other industrial nations, if in fact the dollar is to be stabilized over some
period of time in the exchange markets.
Now, an important goal of the Humphrey-Hawkins legislation
was to set up a structured procedure for reviewing monetary policy
for given periods ahead. I think this is all to the good. It tends to
perhaps further formalize the existing practice, and it clearly confirms the congressional determination that the measure of monetary policy that is relevant for purposes of these oversight hearings
is the long-run rate of change in the monetary aggregates. I think
this emphasis is all to the good. I think it should help in the
process of weaning the Federal Open Market Committee from its
fixation with trying to manage short-term interest rates instead of
long-run rates of monetary expansion.
But having established that the proper business of the central
bank is the management of the money stock over time, we are still
left with the messy but vital task of establishing a meaningful
analytical framework within which to judge the performance of
monetary policy. I'm not suggesting that Congress write legislation
on this subject. But I do think that this committee could make a
substantial contribution through these oversight hearings in focusing the attention of the money managers on relevant targets.
I think that the moving target approach, which was developed by
the Federal Reserve in 1975, changing not only the growth rates,
but also the base for the growth calculation every three months,
has not been useful. At best it has been meaningless; at worst it
has been misleading.
The Fed has been telling the country for the last 4 years that its
monetary policy was gradually tightening, when in fact monetary
expansion has been accelerating almost continuously over that
period up until about 6 months ago.
I think that the procedures established under Humphrey-Hawkins for targeting monetary policies is all to the good. The use of a
fixed base in the fourth quarter of each year for the calculation of
projected monetary growth is helpful, but I would suggest it doesn't
go far enough. We have had some success in our own work in my
firm in looking at a continuous measure of the rate of monetary
change which is stable, free of seasonal factor distortions, and
tends to reflect the underlying numbers accurately, which I have
spelled out in my prepared statement.
You can see a chart of this measure on page 173 at the bottom of
the page, figure 4. It shows the highly procyclical record of monetary policy over the period since 1960.
At the beginning of this testimony I suggested that so long as the
Federal Open Market Committee continues to be preoccupied with
pegging short term interest rates, the record of monetary policy
will most likely continue to be procyclical.
I think that in trying to fix short term interest rates, the Fed
has created a procedure which is inherently self defeating and will
inherently lead it into the kind of policy pattern which we in fact




164

have seen during periods of economic expansion. The Federal Reserve has been characteristically reluctant to see short term interest rates rise. Their reluctance has been expressed in terms of
more rapid rates of expansion in their holdings of Government
securities, which feeds directly into the monetary base and eventually into more rapid rates of expansion in the monetary aggregates.
On the down side of the cycle there is a consistent record that
the Fed is reluctant to see short term interest rates come down,
which gives us sharper contractions, temporary cyclical contractions in monetary expansion than is desirable. I think the solution
is for the Fed to abandon its preoccupation with short term interest rates and begin to manage the one aggregate over which it has
direct control, namely, the monetary base.
This of course is not a new idea. There is a rich literature
available on this subject. I think that this committee could make a
major contribution to the quality and efficiency of the administration of economic stabilization policy by focusing attention on the
costs and benefits in social and economic terms of trying to stabilize short term interest rates instead of trying to stabilize the long
term rate of monetary expansion.
I have no illusion that technical reforms of this sort will solve
the basic problem of monetary strategy; for example, whether the
fundamental trend of growth in the money stock over the next
decade will accelerate or decelerate or stay about the same.
I think that the answer to this question obviously will have an
important influence on the quality of life in the country and indeed
as far as I'm concerned on the stability of its political institutions.
This is a political question which should be properly answered by
the political process.
Meanwhile, the tactical problems of monetary policy implementation are pressing and should be dealt with quickly. Until that
occurs, I think that the relationship between the Fed's announced
policy intentions at these oversight hearings and the actual course
of monetary policy will be a very uncertain one indeed.
Looking further ahead at the general strategy of monetary
policy, I strongly support the bipartisan objective of gradually reducing the rate of monetary expansion over the next 5 to 10 years
or even longer that has been advocated both by Mr. Miller and his
predecessor, Dr. Burns.
But as the experience of the last 4 years demonstrates so convincingly, mere advocacy of monetary virtue has precious little
impact on the rate of increase in aggregate spending or the rate of
change in prices.
In specific terms, the underlying rate of monetary expansion, as
far as I'm concerned, should be reduced gradually, perhaps by
about 1 percentage point a year, to take a useful rule of thumb,
until a noninflationary rate of growth in the money stock is
achieved. I think that American voters have demonstrated that
they want the more stable economy that would result from a
sustained and credible long run reduction in monetary growth. A
major contribution to effective implementation of such a policy, as
far as I'm concerned, would be achieved if the Federal Reserve
could be induced to let short term interest rates respond to current




165

market forces and instead concentrate on the management of the
monetary base.
At the same time, I think Congress needs to proceed with its
work of implementing the administration's pledge to reduce the
rate of growth in Government spending below the growth of private spending. Steady reductions in the absolute size of the Treasury deficit must be a major goal of public policy if the fundamental
task of monetary stabilization is to be achieved.
And finally, the real burden of taxation at all levels of Government must be reduced in order to energize" the creativity and
dynamism of the private sector.
[Complete statement of Mr. Heinemann follows:]




166
MORGAN STANLEY

Investment Research I

Weekly Federal Reserve Report

February 23, 1979

The following is the text of testimony presented by H. Erich Heinemann to the Senate
Committee on Banking, Housing, and Urban Affairs on February 23, 1979. The hearing
was held pursuant to the Committee's statutory responsibility to oversee 1 the Federal
Reserve System's conduct of monetary policy. The title of Mr. Heinemann s remarks
was "Avoiding Recessions. "
I appreciate the opportunity to present my personal views on the conduct of monetary
policy to this distinguished committee. In my remarks today I plan to sketch a few
details concerning the current economic setting that appear pertinent to me. I will
suggest an alternative approach to the problem of monetary policy measurement and
targeting that in my opinion is both simple and meaningful. I will argue that so
long as the Federal Open Market Committee insists on trying to manage the nation's
money stock by pegging short-term interest rates, the actual record of policy implementation will most likely continue to be procyclical -- too easy during economic
expansions and too tight during economic contractions. Finally, I will make some
comments about desirable strategic goals of monetary policy, based in part on the
most recent policy statement of the Shadow Open Market Committee, of which I am a
member.
CONTENTS

A BALANCED ECONOMY?
In testimony before the House Budget Committee on January 25, Mr. G. William
Miller, chairman of the Board of Governors,
maintained that "an examination of available indicators suggests that the economy
currently is in reasonably good balance."
He stated that "the Federal Reserve does
not consider a recession desirable," and
that "'stop-go' patterns of economic growth
have discouraged productivity-enhancing
investment and brought no lasting relief
from inflation."

A Balanced Economy?
The Change in Strategy
The Federal Reserve's Contribution
to Inflation
The International Constraint
How to Monitor Monetary Performance
Proper Use of the Monetary Base

The Strategy of Monetary Control
As a general matter, we agree with the
Chairman's desire to avoid recession —
now and in the future. But we believe that Figures of the Week
significant policy errors were committed
prior to Mr. Miller's taking office. These Statistical Appendix
errors make the likelihood that the nation
will in fact be able to avoid at least a

This memorandum is (or general information II
accurate or complete Morgan Stanley & Co Incorf
long or short positions in and may Irom time to time purchase or
perform investment banking services for or solicit investmei




9
12
14
15
16

relied upon in connection with the purchase or sale of any securities No representation is made that the information contained herein is
ffiliales. Iherr directors, advisory directors, officers, and accounts with respect to which the forgoing have investment discretion may have
iell securities ol companies referred to in this memorandum Morgan Stanley & Co Incorporated or one of ils affiliates may Irom lime to time
I banking business from, companies referred lo in this memorandum

7257 Avenue of the Americas, New York, N. Y. 10020 (212) 974-4000

167
moderate contraction in real business activity very small. In the circumstances, we
believe that policies aimed at postponing a moderate downturn would in all probability eventually result in a more serious recession than would otherwise occur. Heavy
burdens would be placed on those in the economy least able to bear the cost. Furthermore, we do not concur in the judgment that the economy "is in reasonably good balance"
at the present time.
Federal Reserve Data
(Weekly Averages of Daily Figures; in Millions of Dollars)
Latest Week

Change From
Prev. Week

Rates of Change Over
3 Months 6 Months 1 Year

$360,000

$-

100

- 2.3%

+ 1.6%

+ 4.9%

M-l-Plus* (1)

580,800

-

300

- 5.4

- 0.5

+ 2.7

Money Supply Plus Comm'l
Bank Time Deposits Other
Than Large CDs (M-2)* (1)

878,500

+ 1,600

+ 1.5

+ 5.3

+ 7.1

Monetary Base* (2)

144,000

+

700

+ 7.0

+ 8.9

+ 8.4

Adjusted Federal Reserve
Credit* (2)

125,300

+

700

+10.2

+ 11.5

+ 9.9

300

--

+ 4.4

+ 5.7

117

NA

NA

NA

Money Supply (M-l)* (1)

Total Effective Bank
Reserves* (1)
Member Bank Borrowing (2)

44,600
937

-

Wedne sday Figures
Short-Term Business
Credit (1) R
Total Commercial Paper
Outstanding* (1)

N/AV

N/AV

N/AV

N/AV

N/AV

87,165

+ 1,490

+44.6

+26.9

+30.0

Business Loans:
All Large Banks (1) R

N/AV

N/AV

N/AV

New York City Banks* (2)

38,507

+

274

- 3.0

+12.0

+ 11.8

Chicago Banks (1) R

13,421

+

129

N/AV

N/AV

N/AV

N/AV

N/AV

R = Series Revised; Figures are not comparable with those published during 1978.
*Seasonally Adjusted

NA = Not Applicable

N/AV = Not Available

Rates of change are compound annual rates. Short-term business credit includes
commercial and industrial loans at large banks plus loans sold to affiliates less
bankers' acceptances and commercial paper held in portfolio plus loans at large banks
to finance companies and nonbank financial institutions plus nonbank commercial
paper.
(1) February 14




(2) February 21

168
There are a number of reasons for this conclusion:
• During this business cycle expansion, from the beginning of
1975 to the end of 1978, total spending in the economy
measured in current dollars has grown at a rate of almost 12%.
This rate of growth in total spending was, and is, clearly
unsustainable. According to the most recent estimates of the
President's Council of Economic Advisers, the real growth
potential of the economy from 1973 through 1978 was only 3%.
This means that aggregate demand for goods and services expressed in current dollars has been rising at a rate roughly
four times the long-run ability of the economy to grow in a
noninflationary manner. This disparity is so great that it
has long been a foregone conclusion that a serious inflation
would develop sooner or later. On the assumption that a
reported unemployment rate of 5.1% represents "full employment" in today's economy (an assumption that we would not
necessarily accept), the Council estimates that the actual
level of real GNP in 1978 was only 2.66% below its "potential." Even if this calculation is only partially correct,
the rate of increase in total spending must be slowed in a
gradual and sustained manner to avoid a rampant, demand-pull
inflation.
• As Mr. Miller has frequently -- and very usefully -- pointed
out in his testimony over the past year, there has been an
explosion of debt in the household sector in the past few
years. Total household sector debt now exceeds $l.l-trillion,
up about 50% since 1975. More important the debt-service
burden of households has risen very rapidly to levels that
are extraordinary by postwar standards. Repayments of
interest and principal on mortgages and consumer credit are
estimated by the Federal Reserve Board to have been at a
seasonally-adjusted annual rate of $344-billion in the fourth
quarter of last year, or 22.8% of disposable personal income.
Since income and debt are not evenly distributed through the
age structure (debt is concentrated in younger groups and income in older groups), this means that actual debt service
ratios are probably much higher than these aggregate numbers
would suggest. In our view, this constitutes a serious economic imbalance which will have to be corrected. Many analysts in the financial community believe that a sudden retrenchment by overextended consumers could trigger a much more serious business downturn than is now contemplated by the consensus economic forecast. We do not share this view, but neither do we dismiss this concern as frivolous.
t This committee is, of course, well aware that new investment
activity over the past four years has lagged well behind the
norm of the postwar period. The value of the real capital
stock per member of the labor force -- if you will, the tools
the economy provides to its workers -- has been falling in




169
the last few years, after having risen at a trend rate of
2.6% from 1948 through 1973. The secular slowdown in productivity growth, which underlies the reduction last month in
the Administration's estimate of the economy's real growth
potential, has coincided with this secular slowdown in investment. In a number of key areas -- for instance, cement,
aluminum, and paper -- low levels of investment in new facilities are now contributing to product shortages. This, too,
is an important economic imbalance.
• An unprecedented surge in the demand for labor has pushed the
employment rate (total civilian employment as a percent of the
population 16 years of age or older) to a high of 59.3%, which
is not only far above any previous cyclical peak, but is also
sharply above the trend value for this key measurement (see
Figure 1). We have observed that there has been a close and
systematic association between periods when the employment
rate has been substantially over its long-term trend value and
periods of cyclical weakness in productivity and cyclical strength
in unit labor costs (see Figure 2). This association suggests
to us that when employment is high relative to its own long-term
trend, skilled, trained, and motivated workers tend to be in
short supply, and productivity and unit labor costs tend to
suffer accordingly. In our view, these relationships provided
fair warning during 1977 that the economy was much closer to
its effective limits than did more conventional measures such
as the Federal Reserve Board's index of manufacturing capacity
utilization.
•

Financial markets, both at home and abroad, would also seem to
point toward imbalance and instability in the economy at the
present time. Short-term interest rates have spiked upward to
near-record levels in nominal terms, and some measures of longterm credit costs are now above the points posted in 1974. Overseas, of course, the dollar has been under intermittent attack
for more than two years, as participants in world financial markets have reacted to the inflationary implications of excessive
monetary and fiscal stimulus in the United States. In the past,
disturbances of this sort in financial markets have typically
not been associated with stable and well-balanced economic expansions.

•

Finally, the Federal Government is continuing to impose a
massive financing requirement on the nation's money and capital markets four years into the nation's longest peacetime
economic expansion. New estimates just published by the
Federal Reserve Board show that the nonfinancial demand for
funds from the Federal Government (net of the change in the
Treasury's cash balance) came to $47.1-billion last year,
only moderately lower than the $55.7-billion demand
in 1977. Including borrowing by Federal agencies, the total







170

_
_—-.

1960

Civilian Employment as a Percent of the Working Age Populatio
Long Term Trent! (1960 1978)

1962

1964

1966

1968

1970

1972

1974

1976

1978

Shaded areas represent periods of recession as designated by the National Bureau of Economic Research
except for the mini recession of 1966 1967.
Sources. Chase Econometric Associates Data Base; Morgan Stanley Research

Figure 2
. Has Been Associated with Falling Productivity and Rising Unit Labor Costs

1960

1962

1964

1966

1968

1970

1972

1974

1976

197

Shaded areas represent periods of recession as designated by the National Bureau of Economic Research
except for the mini recession of 1966 1967
Sources : Chase Econometric Associates Data Base, Morgan Stanley Research

171
U.S. Government demand for funds last year came to $92.8billion, up from $84.3-billion in 1977, and only 5.5% below
the recession peak posted in 1975. Put another way, the
Federal Government's financing demands came to 19.2% of
total funds raised by all sectors in the money and capital
markets last year (both financial and nonfinancial). This
is well below the record peak of 44.7% reached in 1975, but
it is almost double the Federal Government's proportionate
demand for funds at the cyclical peak in 1973. Preemptive
demands for funds from the Treasury of this size -- at
this point in the business cycle -- can only serve to distort the market's allocation of the available stream of
savings in the economy.
Overall, we conclude that a number of important cyclical imbalances have already
developed in the economy which preclude the policy option of avoiding recession. In
our view, for the past year, fiscal and monetary policymakers have not been debating
whether or not the nation will have a recession, but rather when one will occur and
what its magnitude will be.

THE CHANGE IN STRATEGY

To be sure, there is now no debate from the Administration concerning the need to restrain the growth of aggregate demand. As the Secretary of the Treasury, Mr. W.
Michael Blumenthal, has observed repeatedly over the past few weeks in his testimony
to various Congressional committees on the Administration's economic policy for 1979,
"The centerpiece of the President's anti-inflation strategy is sustained and concerted restraint on aggregate demand, effected through both fiscal and monetary
policies." There are two reasons for this approach, according to Mr. Blumenthal:
First, "in recent months," there have been "warning signals" of excess demand, and
second, without fiscal and monetary discipline, no combination of policies to control
inflation will be successful. We strongly endorse these conclusions, but the timing
of the Administration's change in policy is tragic.
By waiting until evidence of excess demand pressures in the economy was clearly visible — by waiting until after prices were rising at a clearly unacceptable rate -the Administration has condemned the American economy to yet another dismal round of
stop and go policies. The very result that the President, Mr. Blumenthal, and Mr.
Miller say that they most want to avoid has, in our opinion, already been locked in
place. This amounts to a classic example of the "whites-of-the-eyes" approach to
stabilization policies.
In a system as large and viscous as the American economy, there are substantial and
uncertain lags between policy actions undertaken by Government and their impact on
spending and investment decisions by millions of economic units. Yet it was not
until the summer of 1978 -- following the vote on,Proposition 13 in California -that the basic tone of economic policy began to change. History's message in circumstances of this sort is very clear -- once a major cyclical inflation has been allowed to take hold, it cannot be controlled short of at least a moderate economic
downturn.




172
THE FEDERAL RESERVE'S CONTRIBUTION TO INFLATION

We believe that the sustained and powerful stimulus provided to the economy by monetary policy over the past few years has played a major role in maintaining the growth
of aggregate spending at an excessive level and thus contributing to our present
inflation. The "underlying rate of expansion" in M-l -- see Figure 4 for a definition of this measure -- was about 5% at the end of 1975 and about 8% at the end of
1977. Even on the assumption of only a loose association between sustained changes
in the rate of change of monetary expansion and the behavior of aggregate spending, a
cyclical acceleration in the growth of the money stock of this size necessarily will
have a major influence on the trend of outlays and prices. In fact, the association
between monetary policy, aggregate spending, and the long-run behavior of the price
level is anything but loose (see Figure 3). Therefore, monetary policy must carry a
large portion of the burden for the critical state of the economy at the present
time.
Nevertheless, we would not single out the Federal Reserve as an institution for
"blame." It seems to us that monetary policy has been reflecting the general political consensus within both the Administration and the Congress. Despite warnings
from the private sector about the danger of inflation, the "Washington view" of the
economy during 1977 and the first part of 1978 was one that tended primarily to focus
on symptoms of underperformance rather than the potential for excess demand. In
terms of the general strategic thrust of its policy, the Federal Reserve -- as indeed
it must -- has followed the lead of the Administration.
The central issue of monetary policy is not a failure of the central bank to coordinate with the political authorities. Rather, it is the failure of the political
process to perceive the problem of economic stabilization as other than a series of
ad_ hoc accommodations to pressures of the moment. The Federal Reserve has a legal
mandate to "maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote
effectively the goals of maximum employment, stable prices, and moderate long-term
interest rates." It will not succeed in this task without the full support of the
nation's political leadership.

THE INTERNATIONAL CONSTRAINT

In the short run, the Administration and the Federal Reserve have already lost any
meaningful freedom of maneuver. Participants in the foreign exchange markets have
demonstrated repeatedly that they have no tolerance for American policies that imply
a lack of resolution in dealing with inflation. But, in our view, the turmoil in
the foreign exchange markets is only symptomatic of a much more fundamental difficulty.
The expansionist bias in United States economic policy for much of the past two years
has, naturally enough, generated expectations of accelerating inflation, which, in
turn, has led to severe downward pressures on the dollar in the foreign exchange
markets. In the face of what has appeared to be at best a passive attitude on the
part of the Administration toward the international value of the dollar (at least
until mid-summer 1978), foreign governments have felt compelled to intervene heavily
to stabilize the key currency. To have failed to do so would have risked serious







173
Figure 3
Money and Prices

_
_—._

1960

The Long-Run Associatio

Lonq-term rate of increase in M-1
Long-term rate of increase in cons

1962

1!

Data for money and prices are 60-month trailing moving averages of the year-over-year percentage
change in M-1 and the consumer price index. Price data have been plotted 36 months earlier than
their actual occurrance.
Shaded areas represent periods of recession as designated by the National Bureau of Economic Research
except for the mini-recession of 1966-1967.
Sources. Chase Econometric Associates Data Base; Morgan Stanley Research

Figure 4
Underlying Rate of Monetary Expansion - Ml

1960

1962

1964

1966

1968

1970

1972

1974

1976

1978

Shaded areas represen* periods of recession as designated by the National Bureau of Economic Research
except for the mini recession of 1966 1967.
Sources: Chase Econometric Associates Data Base: Morgan Stanley Research

174
disruption in the conduct of world trade.
consequences:

Their actions have produced a number of

• One, domestic financial markets have benefited in the short
run as foreign central banks have purchased roughly one-third
of total new Treasury and agency issues sold over the past
two years. The massive foreign buying of Treasury and agency
securities during this business cycle expansion has helped
to delay somewhat the normal cyclical rise in interest rates.
Thus, a frothy, speculative boom in residential real estate
markets has been able to coexist -- up until now -- with a
record peacetime Treasury deficit.
• Two, the central banks of some of our closest allies — West
Germany, Japan, and the United Kingdom, in particular -- have
acquired substantial open, unhedged positions in dollars. On
the basis of data published by the International Monetary
Fund, we estimate the increase in the dollar holdings
of the main industrial countries to have been about $45-billion just over the past two years. Given the sharp drop in
the value of-the dollar in this time period, it is safe to assume
that these portfolios are now showing substantial losses.
• Three, these dollar-support operations have contributed to rates
of monetary expansion in the countries that have provided the
bulk of such assistance -- rates that are substantially in excess of the targets established by their governments. As one
example, the German monetary base rose at an average rate of
about 11.4% last year, far above the official target of 8%.
Thus, it would appear that the Administration's policy toward the dollar, while in
the short run generating some "beneficial" domestic effects, has created some far
more serious long-run international costs. We do not pretend any expertise in
foreign affairs, but it seems to us that financial policies which impose major costs
on America's strongest allies are not consistent with continued United States leadership of the main industrial nations in political and military affairs. To our way of
thinking, one of the principal lessons of the crisis in the exchange markets last
October is that this approach is no longer viable. The Administration and Federal
Reserve must take action in a sustained and credible manner to reduce inflationary
expectations in the United States relative to those in other industrial nations.
Only in this manner will the performance of the dollar in the exchange markets be
stabilized.

HOW TO MONITOR MONETARY PERFORMANCE

One important thrust of the Full Employment and Balanced Growth Act pjf 1978 was to
require structured and systematic consultation between the Federal Reserve System and
the banking committees of Congress on the targets for monetary policy and their
relationship with the economic goals of the national administration. While for the




175
most part this requirement simply formalizes existing practice, it provides an opportunity to improve substantially the management of monetary policy. In particular,
the statute reconfirms the Congressional determination -- which was also clearly
stated in the Federal Reserve Reform Act of 1977 -- that the measure of monetary
policy that is relevant for purposes of these oversight hearings is the long-run rate
of change in the monetary aggregates. This emphasis is all to the good. It should
help in the process of weaning the Federal Open Market Committee from its fixation
with trying to manage short-term interest rates instead of long-run rates of monetary
expansion.
But having established that the proper business of the central bank is the management
of the money stock over time, we are still left with the messy, but vital, task of
establishing a meaningful analytical framework within which to judge the performance
of monetary policy. We are not suggesting that Congress attempt to write legislation
on this technical subject, but we do believe that this distinguished Committee can
make a substantial contribution through the medium of these oversight hearings in
focusing the attention of the money managers on relevant targets.
Under the prod of House Concurrent Resolution No. 133, 94th Congress, the Federal
Open Market Committee on April 15, 1975 established for the first time formal targets
for growth in the money supply. Since that time, including the new targets that Mr.
Miller announced on Tuesday of this week, the FOMC has established a total of 16
monetary growth targets. Just by way of illustration, the target growth for M-l was
originally set at a lower limit of 5% and an upper limit of 7 1/2%. Over the ensuing
four years, these stated growth targets have been gradually lowered to the present
level of 1.5% to 4.5%. Leaving aside for the moment the Federal Reserve's success
(or lack of it) in achieving its announced targets (a subject to which we will return
shortly), the message that the Federal Open Market Committee has conveyed to the
nation through these actions has been faulty. At best, the FOMC's targets for
monetary expansion have been meaningless; at worst, they have been misleading. The
Federal Reserve System has been telling the country that its monetary policy has
become increasingly more restrictive over the past four years, when in fact up until
about six months ago it was increasingly more expansionary". It has not been clear to
us why the Congress has not objected to this deception more vigorously than it has.
The problem with the FOMC's procedures is well known. Every three months, the
authorities not only review their growth targets, but also they change the basis for
their growth calculation. Each quarter's target is based on the average level of the
aggregates for the quarter just ended. The result of this "moving target" approach
to monetary management has been to compound the errors of policy implementation. For
example, during 1977 and 1978 the actual levels of the monetary aggregates were frequently above those specified by the FOMC. Therefore, as new monetary targets were
established every three months, the bases for these calculations were ratcheted
toward steadily higher levels. Thus, while the Federal Reserve's targets were held
steady or lowered, the actual rate of monetary expansion showed a sustained and
powerful acceleration.
The Federal Reserve's errors over the past four years have been -- as is characteristic during the expansion phase of the business cycle -- predominantly on the
upside. Actual monetary expansion has been more rapid than desired. The great
danger now is that the monetary authorities will make a similar error on the down-




176
side, which could easily lead to a more serious economic contraction than otherwiseneed occur. The FOMC's procedures for establishing its monetary targets enhance
rather than diminish this danger.
In our view, the Federal Open Market Committee should state its intentions about
monetary policy for the year ahead in much more specific terms than those that are
now in use. The fundamental determination should be whether or not monetary growth
during the target period is to speed up, slow down, or stay roughly the same. In our
own analytical work, we have had substantial success in making calculations of this
sort with a measure that we call the "underlying rate of monetary expansion." The
technical definition of this measure is very simple: We calculate a 12-month moving
average of, say, M-l; we center the moving average on the sixth month of each 12month period; then we calculate the year-over-year percentage change in the moving
average. You can see the results of this calculation in Figure 4 on page 8 and in
Table 1 on page 16.
There are four important advantages to this approach:
• By using 12-month moving averages, we eliminate any possible
distortion in the data from faulty seasonal adjustment
procedures. The rates of change are the same whether seasonally adjusted or seasonally unadjusted data are used.
t Since these data are annual averages of monthly averages of
daily figures, there are in fact 365 discrete observations
of the monetary aggregate as defined in each data point.
With a sample of this size, we think it is very unlikely
that there are significant errors in the data. (This does
not consider the issue of the proper definition of the monetary aggregates, which is beyond the scope of this presentation. We would observe in passing, however, that the recent proposal of the Federal Reserve Board staff to redefine
the aggregates appears to be deficient. It does not include transactions balances held by the business sector
in the form of so-called zero-balance accounts and overnight repurchase agreements.)
0 Since we are comparing points along a moving average line,
the resulting rate of change calculation is smoothed sufficiently so that even a casual observer can quickly and easily
form an accurate impression of the general thrust of monetary
policy. Figure 4 shows clearly that there has been a stable
association between sustained changes in the underlying rate
of monetary expansion as we have defined it here and movements
in overall business activity. (Figure 5 on page 12 and Table
2 on page 17 show the same calculation for M-2.)
•

If the underlying rate of monetary expansion were to be used
as the criterion for monetary policy, target levels for the
monetary aggregates could be specified very precisely. For
example, M-l for the 12 months ended January 1979 averaged
$354.5-billion, which was 7.57% higher than the average of




177

The Underlying Rate of Monetary Expansion

M2

Sources: Chase Econometric Associates Data Base, Morgan Stanley Research

$329.5-billion in the 12 months ended January 1978. (The
percentage change was calculated from unrounded numbers.)
The underlying rate of monetary expansion for the 12 months
ended February will depend on whether the relative change in
M-l this month from the same month last year is greater than,
the same as, or smaller than the similar change from 1977 to
1978. Since the 1977-1978 change is already known, the
desired 1978-1979 change can be easily specified. In actual
fact, current data suggest that the underlying rate of monetary expansion will drop to under 7.4% in the 12 months ended
February, down sharply from the 7.99% rate of expansion in M-l
for the 12 months ended September 1978. This confirms the
rapid shift in monetary policy toward restraint that Mr. Miller
described to this Committee on Tuesday.

PROPER USE OF THE MONETARY BASE

At the outset of this testimony we stated that so long as the Federal Open Market
Committee continues to be preoccupied with pegging short-term interest rates, the record of monetary policy will most likely continue to be procyclical. The reason is




178
simple. In its day-to-day operations, the FOMC is in fact attempting to peg a price
(namely, the Federal funds rate) in a market where demand is inherently and characteristically unstable. The historical record suggests that the managers of the Federal Open Market Account at the Federal Reserve Bank of New York are normally slow to
recognize changes in the aggregate demand for funds. During cyclical expansions in
the economy, this means that the authorities typically feed money into the marketplace at progressively more rapid rates in order to slow the rise in the cost of
short-term money. During the declining phase of the cycle, they have been equally
reluctant to see short-term interest rates fall, with the result that there has been
a progressive deceleration in the provision of new funds to the market. These changes
in the Federal Reserve System's posture have tended to be sustained over fairly long
periods of time. They directly affect the rate of change in "high-powered" money in
the economy -- that is, the monetary base -- and hence also the general trend of
expansion in the monetary aggregates. Figures 4 and 5 on pages 8 and 12, respectively,
make plain just how cyclical the record of monetary policy has been since 1960.
The Federal Reserve's problems with trying to manage short-term interest rates are
not due, in our opinion, to any technical shortcomings. Rather, the basic approach
is wrong. Indeed, we would argue that the market for liquid dollar balances -- for
which the Federal funds rate is one of the most sensitive indicators -- is now so
huge and complex that no individual, no institution, can understand all of the forces
bearing upon it on a real time basis. Among other things, the overnight money market
in New York is now tightly linked to the overnight Eurodollar market in London. This
means that the supply and demand factors that come to bear on the Federal funds rate
are global rather than simply domestic in character.
The solution, of course, is for the Federal Reserve to abandon its preoccupation with
short-term interest rates. It should begin instead to manage the one aggregate over
which it has direct control, and which generally determines the trend of monetary
expansion -- namely, the monetary base. This is not a novel idea. There is a rich
literature available on the tactics of monetary control. This Committee could make a
major contribution to the quality and efficiency of the administration of economic
stabilization policy by bringing its resources to bear on this issue. Given the
unstable record of monetary policy over the past 20 years, the Federal Reserve should
be asked to justify its preference for managing short-term interest rates. We need
to examine the tradeoffs in social and economic benefits and costs that might occur
if short-term interest rates were allowed to fluctuate freely in relationship to market
forces, but greater stability were achieved in the rate of monetary expansion.
As a practical matter, we would endorse the three-point program advocated the other
day by Mr. Lawrence K. Roos, president of the Federal Reserve Bank of St. Louis, in
an important policy address to the New York Society of Security Analysts:
• "One, we should totally abandon the stabilization of interest
rates as the primary goal of monetary policy and move gradually toward a freely-fluctuating Federal funds market.
t "Two, we should concentrate instead on establishing and adhering to long-term money supply growth rates that are consistent with national economic policy.




179
•

"Three, as the most effective available means of controlling
monetary growth, monetary policymakers should target on the
monetary base, which is the source of money creation."

We should have no illusions that technical reforms of this sort will solve the basic
problem of monetary strategy -- for example, whether the fundamental trend of growth
in the money stock over the next decade will accelerate, decelerate, or stay about
the same. The answer to this question will have an important influence on the
quality of life in the United States, and indeed, on the stability of its political
institutions. This is a political question, which should properly be answered by the
political process. Meanwhile, the tactical problems of monetary policy implementation are pressing and should be dealt with quickly. Until that occurs, we would
venture that the relationship between the Federal Reserve's announced policy intentions at these oversight hearings and the actual course of monetary policy will be an
uncertain one indeed.

THE STRATEGY OF MONETARY CONTROL
For the future, we strongly support the bipartisan policy objective of gradually reducing the rate of monetary expansion over the next five to 10 years, or even longer,
that has been advocated by Mr. Miller and by his predecessor, Dr. Arthur F. Burns.
But as the experience of the last four years demonstrates so convincingly, mere
advocacy of monetary virtue has precious little impact on the rate of increase in
aggregate spending, or on the rate of change in prices. In specific terms, the
underlying rate of monetary expansion should be reduced by one percentage point
annually until a noninflationary rate of growth in the money stock is achieved. The
decision to adopt such a course is, of course, political -- our view is that American
voters have demonstrated that they want the more stable economy that would result
from a sustained and credible long-run reduction in monetary growth.
A major contribution to effective implementation of such a policy would be achieved
if the Federal Reserve could be induced to let short-term interest rates respond
freely to current market forces and instead concentrate on the management of the
monetary base. At the same time, the Congress should implement the Administration's
pledge to reduce the rate of growth in government spending below the growth of private spending. Steady reductions in the absolute size of the Treasury deficit must
be a major goal of public policy if the fundamental task of monetary stabilization is
to be achieved. Finally, the real burden of taxation at all levels of government
must be reduced in order to energize the creativity and dynamism of the private
sector.
Not long ago, our good friend, Jerry L. Jordan, senior vice president and chief
economist of the Pittsburgh National Bank, enunciated a new and fundamental law of
human behavior and economics. The only sure way to avoid a hangover, Mr. Jordan
said, was not to get drunk. We might add a corollary to Mr. Jordan's proposition (as
well as mix a metaphor): If one is overweight, one must be prepared to be hungry for
a while in order to reduce. Eventually, one will be healthier and probably live
longer, but there is no easy, painless way to correct the problems of prolonged overindulgence.




180
In economic terms, we have to admit that the party is coming to an end, and that a
hangover is on the way. We have to admit that we are overweight and will have to
reduce. Having come to this recognition, we will have the opportunity -- but only
the opportunity -- to avoid hangovers, crash diets, and, yes, even recessions, in the
future.

The interest rates regularly monitored by the Federal Reserve were as follows:
Rate
Federal Funds

Daily Average Week Ended
February 14 February 21
10.15%

Change in
Basis Points

9.97%

- 18

90-Day Treasury Bills

9.28

9.34

+ 6

90- to 119-Day Commercial Paper

9.96

9.96

-

90-Day CDs (Secondary Market)

10.17

10.16

- 1

90-Day Eurodollars

10.90

10.80

- 10

20-Year Governments

9.05

9.05

.._




H. Erich Heinemann
(212) 974-4410
February 23, 1979

181
STATISTICAL APPENDIX
Table 1
The Underlying Rate of Monetary Change - M-1

Oct

Aug

Year

Jan

Feb

.Mar

Apr

1960
1961
1962
1963
1964
1965
1966
1967
1968
1969
1970
1971
1972
1973

$143.3
144.4
148.9
151.5
156.9
164.2
172.6
175.6
188.3
203.4
210.6
220.8
235.7
257.7

$ 142.9
44.9

$142.8
145.2

$143.0
145.6

151.8
157.3
164.4
173.3
177.3
189.2
204.4
209.8
222.7
237.7
258.2

152.2
157.8
164.9
174.1
178.6
190.0
205.0
211.2
224.4
240.0
258.2

152.
158.
165.
175.
177.
190.
205.
212.
225.
241.
259.0

153.3
159.0
165.4
175.3
179.8
192.9
206.0
213.3
228.3
242.2
261.9

154.0
159.5
166.5
175.6
181.2
194.2
206.5
213.3
229.4
242.9
264.0

1975
1976
1977
1978
1979

282.7
296.6
316.1
341.9
360.0

282.8
298.9
317.9
342.4

285.0
300.0
319.7
343.2

284.8
301.7
322.5
347.9

287.6
304.0
323.6
350.7

291.5
304.1
325.3
352.5

$142.7
146.4

$142.6
146.1

$144.0
146.8

$144.3
147.3

$144.3
147.8

154.6
160.6
166.9
174.9
182.8
195.5
207.0
213.9
230.7
245.1
264.7

154.7
161.4
167.4
174.9
183.8
196.6
207.1
215.8
231.9
247.3
265.2

291.5
304.9
328.7
354.5

293.0
306.6
330.6
357.0

155.1
162.3
168.6
175.9
185.0
197.8
207.5
217.3
232.3
249.2
265.1
279.6
294.1
307.8
333.1
361.1

155.8
162.9
169.8
175.3
186.1
199.1
208.3
218.0
232.7
251.0
266.2
280.7
293.6
310.7
335.4
361.6

$143.5
146.5

12-Month Mov imj Aver age

Aug

$144.2
148.4
150.5
156.9
163.6
170.4
175.4
186.6
200.8
208.9
218.6
233.1
252.2
268.6
282.4
296.1
311.9
336.5
361.0

$144.2
148.7
150.9
156.5
163.7
171.4
175.8
187.4
202.5
209.0
219.7
234.0
255.3
270.5
282.9
295.2
313.8
338.7
361.5

Sep

Oct

Nov

Dec

1960
1961
1962
1963
1964
1965

$143.4
145.0
148.8
151.7
157.3
164.3

$143.3
45.2
149.0
152.1
157.9
64.8

$143.3
145.5
149.2
152.6
158.5
165.3

$143.4
145.8
149.4
153.1
159.1
165.9

$143.4
146.1
49.6
53.6
59.6
66.5

$143.5
146.5
149.7
154.1
160.3
167.1

$143.6
146.9
150.0
154.5
160.9
167.8

$143.
147.
150.
155.
161.
168.

$143.9
147.6
150.4
155.5
162.0
169.3

$144.2
147.9
150.6
155.9
162.6
170.1

$144.5
148.3
150.9
156.4
163.2
171.0

$144.8
148.5
151.3
156.8
163.8
171.7

1968
1969
1970
1971

189.2
202.9
210.4
222.6

190.2
203.8
211.2
224.0

191.3
204.6
212.0
225.2

192.4
205.3
212.8
226.4

93.6
206.0
213.6
227.7

194.8
206.6
214.5
228.8

196.1
207.2
215.4
230.1

183.
197.
207.
216.
231.

184.8
198.6
208.1
217.5
232.6

185.9
199.8
208.7
218.6
233.9

187.0
200.9
209.3
219.9
235.1

1973
1974
1975
1976
1977
1978

256.6
271.9
284.2
298.5
317.1
342.3

258.1
273.1
285.4
299.7
319.1
344.5

259.4
274.3
286.6
300.8
321.2
346.8

260.6
275.5
287.7
302.2
323.2
349.0

262.0
276.6
288.8
303.5
325.3
351.0

263.3
277.7
289.8
305.1
327.3
352.9

264.5
278.6
291.0
306.7
329.5
354.5

265.
279.4
292.3
308.3
331.5

267.1
280.2
293.6
309.9
333.5

268.4
281.0
295.0
311.7
335.6

269.6
282.0
296.4
313.3
337.9

188.1
201.9
209.9
221.2
236.2
254.9
270.8
283.1
297.4
315.1
340.1

Year

Jan

Mar

Apr

Sep

Oct

Nov

Dec

1960
1961
1962
1963
1964
1965
1966
1967
1968
1969
1970
1971
1972
1973
1974

0.92%
1.15
2.62
1.94
3.72
4.42
4.94
2.98
6.54
7.26
3.73
5.79
6.64
8.06
5.99

.57%
.34
.61
.07

0.30%
1.51
2.55
2.27

0.11%
1.68
2.47
2.48

-0.02%
1.89
2.34
2.72

-0.11%
2.11
2.21
2.91

-0.11%
2.30
2.09
3.06

-0.02%
2.43
2.00
.21

0.14%
2.54
1.91
3.36

0.31%
2.62
1.83
3.49

0.59%
2.63
1.82
3.61

0.89%
2.61
1.85
3.67

.36

4.30

4.27

4.26

4.27

4.32

.39

.04
.70
.11
.64
.06
.58
.11
.82

3.11
6.84
6.94
3.63
6.24
6.61
8.02
5.74

3.36
6.91
6.74
3.64
6.41
6.71
7.87
5.69

3.65
7.01
6.43
3.69
6.57
6.84
7.72
5.58

3.98
7.14
6.02
3.85
6.69
7.06
7.46
5.47

4.44
7.20
5.65
3.96
6.84
7.28
7.14
5.34

.81
.31
.20
.25
.89
.44
6.90
5.15

4.48
3.85
5.12
7.44
4.80
4.52
6.95
7.49
6.81
4.93

4.61
3. 6
5. 1
7. 7
4. 5
4. 6
.00
.52
.73
.68

1976
1977
1978
1979

5.03
6.21
7.96

5.00
6.47
7.97

4.96
6.77
7.99

5.06
6.95
7.98

5.10
7.16
7.92

5.26
7.30
7.82

5.40
7.43
7.57

5.46
7.54

5.57
7.60

.66
.68

4.77
3.18
6.01
7.42
4.19
5.05
6.92
7.69
6.50
4.57
5.10
5.72
7.84

.86
.00
.34
.35
.94
.41
.78
.92
.22
.55
.05
.94
.96

May

_ Feb

Year-Ove r-Year Percentage Change
May
Jul
Jun
_Ayg_

Sources: Chase Econometric Associates Data Base; Morgan Stanley Research




182

The Underlying Rate of Monetery Change -- M-2

1960
1961
1962
1963
1964
1965
1966
1967
1968
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979

$210.7

$209.9

218.0

219.5
231.7
245 8
261.1
281.1

230.2

244 7
259.9

279.1
303.9

319.7
351.7
384.8
393.2
428.4

477.1
530.3
576.0

305.4
323.0
354.3
386.6
392.2
435.0
482.2
533.0

$209.7
220.0
233.5

247 1
262.0
282.7
307.0
325.9
356.4
388.0
394.7

441.2
487.1
535.5

581.0
619.1

585.1
624.1

747.5

680.0
753.3

816.0

819.4

684.3
759.2
822.6

614.8
671.6

$214.7
226.1
238.3
255.0
272.1
293.8

$215.6
239.9
256.7
273.6
296.7

241.5

316.0

316.8

346.5
375.8

348.3
379.7
392.2
420.0
467.9

250 0

251 4

263.0

264.8

284.1

285.1
311.1
331.4
361.2
390.1
400.1

266.4
287.4

312.1

312.7

313.9

315.7

335.0
363.7

391.6
402.1

341.3
369.3
390.0

343.8
372.5
390.6

410.4

414.4

450.7
493.9
544.0
590.5
634.0
696.5
769.9
836.7

454.2
497.4
547.9
594.5
642.9
699.4
775.5
842.6

338.4
366.0
390.7
405.7
456.9
502.3
550.6
597.4
646.8
704.3
783.9
848.7

459.2
507.4
554.2
600.2
650.4

461.6
511.9
556.6
602.3
653.3

710.8

717.5

789.6
856.9

795.5
866.2

221.2
235.1
248 6
309.8
327.3
358.3
389.3
398.0
445.6
490.4
538.4

588.1
626.5
690.7
765.6
830.3

$210.1
222.5
235.6

$210.6
223.4
236.6

$216.5
228.3

$213.5
225.2
237.5
253.8
270.0
291.2

$212.1
224.3
237.2
252.7
268.2
289.3

$210.3

227.1

391.2
417.3
464.5

259.0
275.5
299.0

$217.1
228.6
242.9
258.9

277.1
301.4
318.2
350.0
383.3
392.5
423.7

471.9

516.2
561.0

519.7

525.3

566.4

606.7
656.0
726.3

610.4

571.4
612.2

662.6
732.9
805.2
874.3

664.7
740.6
809.4
876.3

801.2
870.9

875.5
12-Month Moving Ave rase

Year

Jan

Feb

1960
1961
1962
1963
1964
1965

$210.8

$211.0

218.9
231.3

219.8

245.0
260.7
279.8

262.1
281.5

1967
1968
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979

323.4
353.5
383.5
395.2
433.2
479.6
530.0
576.8
620.0
676.2
748.6

818.1

232.3
246.4

325.7
355.8
385.2
396.9
437.2
483.6
533.9
580.7
624.2

681.2
755.2
823.7

Mar

Apr

Ha*

Jun

$211.2
220.8
233.3
247.8
263.5
283.3

$211.6

$212.1
222.7
235.5
250.6
266.3
287.2

$212.6
223.7
236.7
252.0
267.8
289.2

$213.2
224.7
237.9
253.2
269.4

328.1

330.6
360.6
388.0

333.2
363.2
389.0
403.4

335.9
366.0
389.8
406.0

449.1

453.1

338.5
368.8
390.5
408.9
457.2
505.3
552.9
598.6
646.0

358.2
386.7
398.9

441.2
487.8
537.6
584.5
628.4
686.5

761.7
829.6

221.7
234.4
249.2
264.9
285.3

401.1
445.1
492.1
541.4
588.3
632.5
692.4
767.9
835.4

496.5
545.3
592.0
636.9
698.3
773.9

500.9

549.1
595.4

641.3
704.6
779.7
846.7

841.2

Ju1

291.3

Aug

Sep

Oct

Nov

Dec

$214.0

$214.8
226.8
240.2
255.8
272.8
295.4

$215.7
228.0

$216.8

241.3

242.5
258.2
276.3
299.7

$217.8
230.2
243.7
259.4
278.0

34 .7
37 .1
39 .5
41 .4
46 .9
513.6
561.1

346.3
376.7
392.3
420.3
468.6

225.
239.
254.
271.
293.

710.9

341.
371.
391.
412.
461.
509.
556.
601.
651.
717.

785.4

790.9

851.7

257.0
274.6
297.5

517.6

229.1

348.8

379.1
393.1
424.5
472.2

521.8
569.1
611.8

605.0

565.2
608.2

656.1

661.4

723.3
796.2

729.5

666.7
735.6

801.5

807.1

1.90%
5.59
5.88
6.48
6.66
8.27
7.07
8.68
8.84
4.66
6.34
11.66
10.48
9.24
7.84
8.44
10.24
10.08

2.32%
5.68
5.84
6.49
6.85
8.36
6.79
9.00
8.78
4.13
7.16
11.50
10.45
9.19
7.61
8.75
10.29
9.88

2.83%
5.68
5.86
6.47
6.99
8.48
6.58
9.20
8.69
3.69
8.00
11.24
10.49
9.06
7.52
8.96
10.34
9.72

301.7
35L2

381.4
394.0
428.9
475.8
526.0
572.9

615.9
671.4
742.0

812.7

Year-Over-Year Percentage Change

1960
1961
1962
1963
1964
1965
1966
1967
1968
1969
1 70
1 71
1 72
1 73
1 74
1 75

1.36%
3.83
5.67
5.95
6.41
7.30
8.55
6.51
9.28
8.49
3.06
9.60
10.73
10.51
8.84
7.48
9.06
10.71
9.29

.It %
.2
.6
.0
.3
.4
.5
.'2
.0
1 .1
1 .6
1 .4
.7
.4
.l
1 ).8

j.o 5

0.97%
4.53
5.67
6.20
6.35
7.52
8.49
6.73
9.18
7.96
3.15
10.59
10.58
10.21
8.71
7.52
9.25
10.94
8.92

0.91%
4.79
5.70
6.32
6.31
7.68
8.32
6.99
9.08
7.59
3.37
10.97
10.57
10.00
8.67
7.52
9.46
10.90
8.79

0.92%
5.03
5.72
6.44
6.24
7.86
3.10
7.33
9.01
7.10
3.69
11.33
10.55
9.83
8.56
7.59
9.63
10.84
8.69

0.99%
5.23
5.80
6.47
6.28
8.00
7.83
7.70
8.97
6.50
4.15
11.60
10.55
9.62
8.42
7.71
9.87
10.66
8.61

Sources: Chase Econometric Associates Data Base; Morgan Stanley Research




1.19%
5.41
5.86
6.46
6.38
8.13
7.51
8.09
8.93
5.89
4.72
11.80
10.54
9.41
8.26
7.92
10.05
10.47
8.45

1.51%
5.49
5.9
6.4
6.5
8.2
7.2
8.4
8.88
5.25
5.50
11.78
10.52
9.29
8:05
8.19
10.13
10.30

3.3
5.6
5.8
6.4
7.1
8.5
6.4
9.2
8.6
3.2
8.8
10.9
10.5
8.9
7.4
9.0
10.5
9.5

183

The CHAIRMAN. Well, gentlemen, thank you very much for the
most provocative and fascinating presentations.
Mr. Heinemann and Dr. Kane, you both take the same position
that many people have taken for years. Well, I was going to say it
sounds like echoes of Wright Patman in a way and the criticism of
the Federal Reserve coming from an entirely different angle, but at
any rate, you argue on the basis of your fascinating analysis in
your statement, Mr. Heinemann, that it is procyclical, that the
money supply decreased just before or during the recessions as it
did in 1967, 1970 and 1974. And then with an exuberant growth in
the money supply, it seems to aggravate the cycle.
And Mr. Kane, I understand you to say it is pretty much the
same kind of thing.
Dr. KANE. Yes, the major difference betwe'en us is that I believe
the Federal Reserve isn't fooled into thinking that focusing on
short-term interest rates is sound policy. Rather I believe that the
political response system, driven by sectors that are ill-served by
rising interest rates, makes it necessary for the Fed to follow
nominal interest rates closely and to increase them less rapidly
than the fight against inflation would require. It is merely convenient internally and externally for Fed officials to rationalize their
interest-rate focus as they do.
The CHAIRMAN. You see my problem with this is I just wonder if
the Federal Reserve does have control of monetary policy, if they
can do what they really want to do. I have a feeling here that one
of the reasons for this chart is because, as Chairman Martin said,
in the old days, you can't push a string.
You come to a period in which business activity goes down as it
did in the depression, and Milton Friedman used to fault—does
fault the Fed of course for their performance in the depression
when we reduced the supply of money on the grounds that it's very
hard in those circumstances to persuade people to use credit.
As you know, interest rates were extraordinarily low during that
period. I don't know what they could have done to persuade people
to come in and borrow money when business prospects were so
bleak. The situation is nothing like that in recent years, but at the
same time I just wonder if they had followed, Mr. Heinemann, your
prescription, if they would have had success in the 1970 and 1974
period, at least, of actually being able to smooth out that recession
or even avoid it.
Do you think so?
Mr. HEINEMANN. My impression would be that because of the
Fed's reluctance to see short-term interest rates decline—and there
is a lot of very specific tactical evidence of that reluctance which
developed in 1974 and 1975—that indeed money growth was driven
lower than it should have gone. I do not subscribe to the "pushing
on the string" hypothesis, the notion that you can't push on a
string. I would restate it to say that if you tie some money on the
end of a piece of string, somebody will pull it.
The Fed has the power to inject reserves into the banking
system, and the banks will use those reserves to create new money
so long as interest rates are sufficiently high to cover the cost of
the transaction. That certainly was the case during 1974 and 1975.




184

In historical terms, short term interest rates were quite high in
that period, even though they were coming down.
If the Fed had provided reserves to the banking system, monetary expansion would not have contracted to the extent that it in
fact did. I think the procyclical record does in fact grow out of what
I regard to be a completely mistaken fixation of the Federal Open
Market Committee and the Federal Reserve Bank of New York in
managing the Federal funds rate rather than trying to manage the
monetary base or some other reserve aggregate.
The CHAIRMAN. Mr. Sinai, one problem with this whole exercise
we have here and what the Fed is doing is that we are in a period
when we aren't very sure of the kind of standards we have in
measuring what the monetary policy is doing. The money supply
figures, Mi and M2, are in a period of transition because of the
transactional balances and so forth.
As we indicated earlier, when you first opened your remarks, it
is hard to know whether or not in fact the flat performance of Mi
in the last 3 months was actually a situation in which the money
supply was stationary or was really a trend of money out of Mi.
At the same time, interest rates, it is hard to focus on those
because they are distorted to grossly by inflation. We are told by
Mr. Miller, as you know, that the very high interest rates really
aren't very high now, that they are quite low. As a matter of fact,
if you correct them for inflation, the mortgage rate is lower than it
has been in many years, so that it is hard there to get a notion of
what monetary policy is really doing and how effective it is.
Can you help us on that? Incidentally, I read that fascinating
commentary by Bob Bowling in Business Week in which he uses
you at some length in pointing out how Miller's arguments about
interest rates and the nominal rate corrected for inflation, and so
forth, is wrong. That is one of the reasons I wanted to ask you
about that.
Dr. SINAI. There are several strands of questions in what you've
said. One is: How do we know what monetary policy is doing. And
that other part of that is: What are the monetary aggregates
telling us now? What informational content is there in their performance about how the monetary policy affects the economy.
And the third part of what I think you said is: What about this
distinction between nominal and real interest rates and how meaningful is that and what have they been doing? In looking at what
monetary policy is doing, I would suggest that perhaps the worst
indicators of the current state of monetary policy are the actual
growth rates in the Mi and M2 and M3. Those growth rates are
very much the result—and if I don't say it, I'm sure Professor
Modigliani would if he were here— but the demand side forces of
the economy, the transactions and the demand for money and the
portfolio choice—but they're overwhelmingly the result of inflation
and real economic growth.
And I think they account for the procyclical findings of Mr.
Heinemann and our own findings that Mi has been—is extemporaneous of how the economy is performing; the information content
in Mi, M2 and M3 is more about what's going on in the economy
than what the state of monetary policy is at this time.




185

Now, with regard to what we are learning about this weak
growth in the monetary aggregates over the last 3 or 4 months, I
think it is not temporary. It is not transitional. It is not a function
of only the new definition or the ATS or NOW accounts and their
effects on Mi. Since the slow monetary growth is so pervasive and
appears in all the aggregates, it just can't be the new money saving
technology which is in Mi. It really is showing that the economy
isn't one that there is a portfolio adjustment process, a choice of
higher interest yielding financial assets by households and corporation.
That is slowing the growth of the monetary aggregates.
The CHAIRMAN. Well, that's fascinating. You explained that not
in terms of Federal Reserve policy, but in terms of what the
economy is doing when the Federal Reserve policy is more passive.
Dr. SINAI. Well, I'm not alone in that. The alternative view on
what controls the monetary growth to what has been presented
here would be that it is very much the demand side of the economy, what portfolio choices of the various households, corporations,
financial institutions are bringing and they are telling me that, at
least as I look at it, that all of those numbers—that flights of Mi
and M2 and M3 and to high yielding alternatives that I think is
going on now is very much part and parcel of a systematic process
that we've seen in every late stage of every business expansion
since 1955.
So it is meaningful in the sense that it is across all of the
monetary aggregates. When you get to the question of which of the
aggregates do you attach any meaning to and how do you read the
effects of monetary policy, I suggest that if slow money growth
were only showing up at Mi then you could conclude that it was
the money saving technology that was doing it.
You can't look only at one of those aggregates now to discern
what is happening. You have to look at all of them and probably
some other measures, too. And so I've come to look at seven or
eight measures of monetary policy: real money growth; nominal
money growth. I think both of those are not very good, by the way,
for what monetary policy is doing now.
They tell you what monetary policy did 6 or 7 months ago. They
tell you more about what is happening in the economy now, so you
have to look at a wide range of numbers. As for real and nominal
interest rates, that is a tough one, too. I can't really conceive of the
Federal Reserve trying to control real interest rates, nor can I
conceive of them trying to control real money balances because the
inflation component is something that in the short term is beyond
anything they can do.
The record on real interest rates does tell us a different story
from what the nominal rates show. They do show—and there are a
number of charts in my statement—that real rates almost no
matter how you measure them are lower relative to what they
have been in the historical postwar period. And indeed, when you
correct them for taxes, you get an even lower figure.
The CHAIRMAN. They're always low, however, when you have a
big inflationary situation; are they not?
Dr. SINAI. Yes.




186

The CHAIRMAN. They are not as low as they were in the 1974
period.
Dr. SINAI. That's correct.
I want to make really two points: They are relatively low compared to most of the postwar period. They are higher compared to
1973, 1974 and lately they have been rising, and so you have to say
all of those things to look out for the—quote, unquote—what has
been referred to as the double talk about nominal and real interest
rates. I think they are high enough now.
They are at least in our world. To produce a mild recession—I
don't think anybody wants anything more than a mild recession.
And so I would not be for sharp rises in nominal interest rates that
would produce real interest rates like some of the previous episodes
we have had in the postwar period. I think then we might get a
deeper recession than anyone is looking for.
The CHAIRMAN. Senator Kassebaum.
Senator KASSEBAUM. I would just like to ask Dr. Kane what
suggestions you might see in disentangling, so to speak, the Federal
Reserve System from its political influence.
Dr. KANE. Well, I think the need is not so much to disentangle
the Federal Reserve System from political influence as to help the
American public to understand who is responsible for bad policy
performance. Accountability for our economic policies, and for
monetary policy in particular, should flow through to elected officials; that what I find stunning about the current U.S. situation is
that the Federal Reserve tries to convince people that it is truly
independent. Every Senator and Congressperson knows that the
Fed responds to political pressures, as indeed it ought to do under
our system of government. Why should it take the blame institutionally for mistakes of policy that are forced on it? The problem is
not so much the Federal Reserve cannot flatten out business cycles,
although I don't think that it can, but that it acts in ways that
aggravate the cycle. It serves as a mechanism for injecting politically induced, procyclical influences that make these cycle swings
wider.
Senator KASSEBAUM. I almost think that's a fact of life, though.
Dr. KANE. That, trying to do well, we dp worse? That's just what
I'm saying. In their efforts to do well, given the constraints they
feel, Fed officials end up doing worse. An important part of the
difficulty is the emphasis they place on nourishing the false image
of independence. If they could accept clearly either in their charter
or in their hearts that they are fundamentally servants of Congress
and the President no different from any other bureaucrats, things
would be better. It would clear up some of the confusion.
The CHAIRMAN. Senator Tsongas.
Senator TSONGAS. Could I get a sense from the three of you as to
how you view the impact of monetary policy in this day and age
compared to what it has historically been? I get the distinct impression that you are saying that given various forces, structural,
inflation, et cetera, we really have far less capacity to deal with
our economic problems than we have in the past.
Is that a fair restatement in lay terms?
Dr. SINAI. I have an opinion on that, and that is that monetary
policy cannot bear the brunt of response to inflation that it did in




187

the past because the nature of inflation is such that the standard
monetary policy—medicine can't work well. It's like a patient with
a multiple series of disorders. You can throw a general antibiotic at
that patient and it will fix some of the disorders and not others.
And it could also kill the patient because of allergies or something
like that.
And so what has been happening in American policy making is
that there has been a move toward a multiple kind of attack on
inflation in recognition of the different sources of inflation that
have been occurring and less of a reliance solely on monetary
policy and my own reading of the administration and the Fed's
attempt at doing something about structural causes of inflation is
that this has finally been recognized in the policymaking scene. We
are not all the way there yet, but it is a good start.
It is a somewhat unfortunate analogy. But it is like the treatment of cancer. These days it's very multiple medicine oriented
because there are so many kinds of cancer and the same approach
has to be used on inflation. And in the past the policy has been to
attack inflation just by going hell bent on dealing with it and to
drive us into a recession.
Dr. KANE. I would say that much of the inflationary thrust we
observe at any time is the effect of past monetary policy. Some of
what Dr. Sinai calls structural adjustments I would portray as
defensive or catchup reactions to price changes that have already
occurred in sectors that react more quickly to monetary policy.
Uneven price and wage changes occur as lagging sectors attempt to
realine prices and wages with prior changes in other sectors.
This adjustment process forces the Fed into a policy dilemma.
Does it support today the additional adjustments which have their
roots in the expansive monetary policy of the past? Can it dare to
fight the momentum of change emanating from the weight of the
past?
In practice, it tends to follow both courses in sequence. When it
finally decides to resist, it tends to overdo and to create new
problems for the future. It is not so much that monetary policy
can't do an awful lot. It is that it can't do an awful lot very
quickly. One has to conduct monetary policy over a long horizon.
Again, this is where the electoral cycle and the way it conditions
policy formation prevents monetary policy from responding to the
economy's true long-run needs.
Mr. HEINEMANN. I think that if one looks at monetary policy
solely in terms of the level of short-term interest rates, if one
equates tight money with high nominal rates, then one indeed is
left with a puzzling situation at the present time. It seems as
though monetary policy has no bite, and we have lost one of our
primary tools. I think that is an incorrect perception. I think that
the level, the rate of change, the direction of change in short-term
interest rates are not reliable guides to monetary policy which
should in fact be measured by sustained changes in the rate of
change of the monetary aggregates.
In fact, we have not had monetary restraint until 4 or 5 or 6
months ago. There is no credible or sustained evidence of a slowing
of the rate of monetary expansion until very recently. The economy has appeared not to respond because there hasn't been any




188

restraint. I would concur with some of the comments that Dr. Sinai
made just a minute ago about the problems in trying to interpret
the monetary aggregates at the present time. The published aggregates are indeed severely deficient. And I think one needs to raise
the public policy question why the ATS, the introduction of the
ATS system was not in fact synchronized with reforms in the
reporting mechanism. There is no reason why the economic intelligence system has to lag 6 months or a year or 2 years behind the
structural changes.
The regulatory people at the Fed and the economic people at the
Fed ought to be able to talk to each other to coordinate their
actions. We have had the same kind of thing happen at a very
technical level with the weekly data on the condition of large
banks. The data have been totally changed in the last month and a
half and no provision was made for any continuity between the old
reporting system and the new reporting system.
Senator TSONGAS. Would you concur with the analogy, with the
medical analogy that was used, that the problem of inflation in our
economy is just so multifaceted that to be a monetarist and purist
in this day and age is a lot more difficult and requires a little
intellectual movement?
Mr. HEINEMANN. For support, I guess I would turn to Secretary
Blumenthars statement that no combination of policies will work
in dealing with the inflation we have today that does not include
effective long-run restraint on aggregate demand.
Senator TSONGAS. That, I think there is no question on, that
particular issue. But you have to agree, I would think, that in
totality monetary policy is of diminishing significance, not that it is
not significant, but relative to other causes.
Mr. HEINEMANN. I would say that the danger in using incomes
policies, in using—in putting an ice cube on the thermometer temporarily, is that we may be tempted to avoid the fundamental
correction: We may appear to be getting results through a series of
controls and jawboning or whatever, and this tends to take some of
the heat off of macro economic policy.
We saw a very explicit example of this, of course, in 1971 and
1972, when we had direct controls and very stimulative policy. The
tactic did not work, and the lid blew off and we had very serious
inflation.
Senator TSONGAS. Let me pursue this, if I might.
What I am trying to get to is the argument that one hears all the
time about what kind of impact on the economy does the Federal
deficit have; is the Federal deficit at these projected levels all that
serious? Other questions such as given our increasing interdependent world order—oil being the best and most noted example—
whether you can in any way isolate the United States from outside
economic shocks that have as much, if not more, impact than what
the Fed may be doing. It is the context I am trying to raise.
Mr. HEINEMANN. There is no question that—and I tried to indicate this clearly in my statement—that the size of the federal
financing in the economy is a major distorting factor at the present
time.
I would suggest, however, that the size of the deficit, per se, is
less important than how the deficit is financed. If the deficit is




189

heavily financed through the mechanism of the central bank, it
has highly inflationary implications. If the central bank does not
finance the deficit, the implications are much less inflationary.
We saw, so far as the oil price increase is concerned, a quadrupling of oil prices in 1973. However, because of a stabilizing monetary policy, perhaps through most of 1975 and in 1976 we saw the
rate of inflation come down very rapidly toward levels that might
be implied by the long-run demand factors in the economy.
I think monetary policy can play a stabilizing role. It is not
impotent, and if we ignore it, we will fail in fact to deal with the
fundamentals of the problem.
Senator TSONGAS. I don't think anyone is suggesting that we
ignore it. It is sort of like a political district: If part of your
constituency is growing, you take note of that; if part of it is
diminishing, you take note of that as well. It doesn't mean that
they don't exist anymore.
Mr. HEINEMANN. I do not agree that the monetary policy district
is shrinking.
I would just like to add one little footnote to Dr. Sinai's comment
before about the current reading of monetary policy. I find x it
extremely interesting and highly significant that in the last 4 /2
months or so we have had a major change in the behavior of
monetary base and bank reserves. The aggregates that the Fed
does control that are not distorted or impacted by those regulatory
and structural changes have in fact slowed down in a major way.
The total effective reserve base of the American banking system,
for example, grew at a rate of 10.3 percent from December of 1977
to October of 1978. From October of 1978 through the second week
of February this year, the rate of growth in the effective reserve
base in the American banking system was minus two-tenths of 1
percent. There has been a major downshifting in the rate of growth
of bank reserves. Unless one is prepared to argue that the Fed
simply sits there and responds passively to random changes in the
level of demand deposits in the banking system—which I think
some people would argue; I don't agree with that—this suggests a
major change in the way the Fed is behaving if they keep this up.
We are beginning to put in place a very restrictive monetary
policy.
Dr. KANE. I would like to add a footnote with respect to how to
tell what Fed policy is right now. Throughout the business cycle,
institutional change affects the moneyness of various assets. Interest ceilings on time and savings accounts and the total prohibition
of interest on demand deposits promote, in an inflationary climate,
the development and substitution of new assets for regulated deposits. In the past many substitute assets developed that are broadly
similar to the automatic transfer services that have just been legalized for households. For some years now, corporations have had
automatic repurchase agreements that insure that corporate
demand funds do not have to sit at zero interest. Funds in the
automatic purchase agreements do not count in Mi, but they are
every bit as spendable as ordinary checking accounts.
I think that, as a matter of public relations, the Fed finds it
convenient at this time to fuss a lot about possible special effects
from newly authorized ATS accounts. Households accounts are far




190

from predominant in Mi, and banks and other intermediaries have
offered similar services for a long time. As market interest rates
have risen, new services have been provided as ways of paying
implicit interest. Bill-paying services, sometimes available via telephone, have been set up to improve the substitutability of savings
accounts for checking accounts. In more and more parts of the
country, electronic machines are open 24 hours a day and can be
used for instant access to passbook funds. The spendability of time
and savings accounts has increased more or less continually with
inflation throughout the last 10 years.
ATS is merely a change that can be dated more easily than these
other changes. Given that households respond to new opportunities
slowly as they learn about them and decide how they can best take
advantage of them, I think that growth rates in monetary aggregates are not severely distorted by ATS. The cutback in monetaryaggregate growth rates evidences a definite change in policy thrust.
The Chairman. Mr. Heinemann, you claim in your testimony
that the Federal Reserve should abandon its preoccupation with
short-term interest rates and instead look at one aggregate over
which it has control; namely, the monetary base.
Dr. Sinai's statement indicates that the monetary base is defined
as: total bank reserves plus currency and adjustments for changes
in reserve requirements. He adds that the Fed has strong control
over bank reserves, but little impact on currency held by the
public.
If the Fed has little control over currency, which makes up about
two-thirds of the monetary base, can and should it be counted on as
a direct control instrument by the Fed? And if anything close to
the base should be controlled, shouldn't it control bank reserves?
Why not focus on that?
Mr. HEINEMANN. I think that the reserve component of the base
is a useful target. However, I would take some fairly strong exception to the way in which the monetary base was described. The
monetary base is a concept which is very much like a corporate
balance sheet: It has sources analogous to assets; it has uses which
are analogous to liabilities.
The uses—the liability side, if you will, of the monetary base
balance sheet—are bank reserves and currency. The sources are
the Fed's portfolio of securities, the monetary gold stock, discount
window credit, and a miscellaneous collection of other smaller
items.
What the Fed does is to operate on the source side of the monetary base. That is where open market operations have their impact.
The public decides how the monetary base which the Fed makes
available is to be used: how much is in the form of currency, and
how much is in the form of bank reserves.
The Fed has direct and complete control over the size of its own
securities portfolio, and that is in fact the only significant dynamic
component on the source side of the monetary base over time.
I think that the monetary base is a highly relevant monetary
policy target. I would not quibble, however, with the notion of
using the reserve component of the base as an additional complementary target for policy.




191

The Chairman. Would you say that this indicates the need for
universal reserve requirements? Monday we are starting hearings
on that proposal by the Federal Reserve Board, that they have a
system of universal reserve requirements with exemptions for
small institutions, applying it across the board not only for commercial banks, but for all institutions.
Mr. HEINEMANN. My own very, very personal view is that the
same kind of deposits ought to have the same reserve requirements, no matter where they are located, and I would not include
an exemption for small institutions. I am aware of the earnings
impact, but I think that the benefit to monetary control with truly
universal reserve requirements would in fact provide substantial
long-run social benefits.
The Chairman. Well, frankly, the reason why we have decided on
the exemption is political and practical: You're not going to get
support if you're going to bring in a lot of small institutions into
reserve requirements that they don't have to meet now.
Mr. HEINEMANN. I am aware of that.
The Chairman. And the Federal Reserve feels it is not necessary
anyway, that they can handle it with a reduction in reserve requirements so that all of the banks would be better off but with no
reserve requirements for the smaller banks.
I would like both Dr. Sinai and Dr. Kane to comment.
Dr. SINAI. With regard to universal reserve requirements?
The CHAIRMAN. No; on the monetary base question.
Dr. KANE. I would be happy to comment on the universal reserve
requirements. I have done a great deal of research on the so-called
Federal Reserve membership problem.
To understand reserve requirements, one must first recognize
that they are a tax: a differential tax on different types of deposits
and on deposits at different types of banks. They are a tax in the
sense that they influence the net proceeds from various resources.
Banks and their customers earn less money by holding deposits
subject to reserve requirements than they would otherwise. In fact,
in our system much of the revenue from required reserves even
passes through to the Treasury. The Federal Reserve earns interest
income that might have been earned by banks or paid out to their
customers, income which is largely passed on to the Treasury. So,
changing the structure of reserve requirements changes the structure of our tax system.
This matter is on the legislative agenda primarily because the
Federal Reserve is embarrassed by its continuing loss of members,
and it argues that these losses are somehow harmful to its policy
performance. But it is very hard to make the argument that it
makes a lot of difference to the effectiveness of monetary policy
that banks are leaving the Federal Reserve System. A considerable
body of analysis suggests that nonmember banks do not seriously
inhibit monetary control. In this respect, the membership problem
really is not a problem at all. Of course, in some different type of
economy or in some distant future it might become a problem. But
operationally the important issues are tax issues.
Bank liabilities that are not to be taxed will be induced to grow
more rapidly than those that are. Hence, requirements would by
their selectivity among bank liabilities change the shape of bank




192

balance sheets. I am also concerned about distinguishing the initial
structure of these requirements from their long-run equilibrium
structure. I am skeptical of the permanence of a tax system that
promises to exempt the vast majority of banks from its provisions.
The current proposal reminds me very much of the initial shape of
the income tax. The income tax was originally going to apply only
to the rich, and to be imposed at very low rates. Through time, the
Government's need for revenue led to restructuring of the tax.
Now it falls on everybody and rates become higher and higher.
The CHAIRMAN. It didn't fall on everybody. We exempt about
half the population with the proposal we have now.
Dr. KANE. Well, we don't so much exempt them
The CHAIRMAN. From the income tax. People with low incomes
are exempt.
Dr. KANE. We have personal exemptions, a standard deduction,
and a low-income tax credit. It's certainly true that a lot of people
don't literally pay taxes, but as an incentive system the tax is
there, and it affects at the margin what everyone does. Implicitly,
the highest rate of tax may be paid by someone who is currently on
welfare and is discouraged from taking a good job. In that it affects
incentives, everyone is taxed.
The CHAIRMAN. Well, I agree everyone is taxed, but the income
tax, there is a substantial exemption there.
Dr. KANE. I grant that many individuals may not be paying any
positive federal income tax in hard cash, but they are taxed implicitly because they know that if they rearrange their activities to get
more income
The CHAIRMAN. Well, I didn't mean to get off on that.
Dr. KANE. Reforming Reserve requirements is a very serious tax
issue, and it should properly be combined with various privileges
that commercial banks now enjoy under the income tax code.
What I find most odd in the tax code's treatment of banks is that
it permits them to engage in interest arbitrage by borrowing in
taxable markets to finance holdings of tax-exempt securities issued
by State and local governments. Banks are able to borrow at largely regulated interest rates and to treat that money as a deductible
expense. Interest paid on the funds banks borrow is deductible
against their taxable incomes, although the income that they earn
on tax-exempt securities remains fully tax exempt. I believe that
the conventional justification for this has been that banks face
burdensome reserve requirements anyway, so that they may deserve a break or two.
Because this philosophy imbues that tax code, easing reserve
requirements should lead us to reconsider other substantial elements of banks' Federal treatment. The change should be linked
conceptually to their overall treatment under the tax code.
The CHAIRMAN. Dr. Sinai, did you want to make a comment on
the monetary base as the aggregate we should focus on?
Dr. SINAI. Yes. I think at the moment we are suffering because
we don't have a target.
The CHAIRMAN. That's right. That's one of the reasons this committee is in a dilemma.




Dr. SINAI. The monetary base problem there, I think, is the
currency component. I think currency up until recently has grown
at about 9 or 10 percent.
The CHAIRMAN. What would be wrong, then—I think Mr, Heinemann would agree—-that the bank reserves are under the control
of the Federal Reserve, and currency isn't, But how about the
reserves then?
Dr. SINAI. On the reserves, you can go one step further,, and if
you get away from the borrowed reserve component, which is behavior that is determined by the commercial banking system, we
then get to reserves, which are even better, and. indeed, the best
one would be the one that Mr. Heinemaun, ! think, would be the
one that the Federal Reserve portfolio that we all agree, I know,
that that really is what they control
But the problem with all of those '& that of the linkage between
what is done to the base or to the Federal Reserve portfolio. The
linkages from those concepts to the money stock to the economy to
inflation, are really not well understood. The kind of correlation
that you get or used to get between Mi and the nominal GNP
doesn't appear to work with the monetary base that the Federal
Reserve holdings of Government securities. So, if you look at that
as something to operate on, you don't know quite what you are
heading for.
One advantage of the monetary aggregates has been, I think, in
the procyclicality argument that Mr. Heinemann made, and I
think I support that. That is that it is a problem for the economy,
and when you operate on ends that deviate from the target, then
you knew you were operating on something that was approximately going on in the economy at that time and have always presumed
that was the rationale for the Fed's action on Mi, and in that sense
supported it.
What we need is a good monetary aggregate concept that represents reality and tells what is available for transactions. Transactions are driven by the real economic behavior, by inflation. And if
we have a concept and a process for that, that is available every
week; then when the Fed operates on that concept it is actually
operating on the key parameters of the economy.
The CHAIRMAN. This is exactly what the Fed is working on now.
Dr. SINAI. I think all I have to offer there is that they would only
consider adding to the various components.
The CHAIRMAN. Well, I like what both of you gentlemen have
suggested, because you have said that we ought to look at a
number of aggregates, not just one.
And Mr. Heinemannn, I think, has very, very properly focused
on the slipperiness of these other factors and the fact that the
monetary base could be a very helpful indicator and it is much
more stable and one that doesn't have some of the problems these
others have.
Let me ask you, Dr. Kane: The Fed says very little about the
relation between monetary policy and the administration's targets
for 1980. You get the feeling that the Fed thinks they are a little
optimistic. You say—and say very emphatically—that the Federal
Reserve Board and Reserve banks are too politically sensitive.
Since they are an independent agency, independent of the execu-




194

tive branch—constitutionally, they are a creature of this branch, of
the Congress—shouldn't they be more forthright and give us their
unbiased forecast of economic conditions and policies?
Dr. KANE. I think they should. But the reward system works
against such behavior. If you see Fed officials (as I do) as scapegoats, the perennial issue they face is how to absorb and distribute
blame within the Federal Reserve System.
The concept of the Fed as a scapegoat that must absorb guilt
efficiently explains very well the complicated, arbitrary-looking
structure of the Federal Reserve System. If the Federal Reserve
Chairman is asked here whether he changed policy at such and
such date, he will reply that he is "only one among equals/' He
will emphasize that the Board and Federal Open Market Committee make these decisions. He will tell you that the FOMC consists
of 19 people some of which don't even vote. By the time he finishes,
it won't be possible to pin down any blame at all.
The CHAIRMAN. They haven't done that. They have been very
direct in taking full responsibility for what the Fed does, and all
three—Martin, Miller, and Burns—in my experience, they have all
come before us, and they all say they don't speak for themselves,
they speak for the Board. They have made that very clear. That's
why all of them have refused to permit other Governors to come
and testify on monetary policy, something I would like to see done.
But I can understand their viewpoint. They feel it is a corporate
position they're taking, and they speak for the whole Board.
Dr. KANE. This is what I am saying, that because they say they
speak for a group they are better able to shoulder the blame that is
heaped upon their institution.
The CHAIRMAN. Senator Garn?
Senator GARN. Mr. Chairman, I am sorry. I was in the Intelligence Committee all morning, and I don't want to come in and
interject myself in the middle, so you proceed.
The CHAIRMAN. Senator Kassebaum?
Senator KASSEBAUM. I think the other question I had has been
answered.
The CHAIRMAN. Senator Tsongas.
Senator TSONGAS. I hate to raise this issue again. Mr. Heinemann raises the issue of how you finance a deficit. But if the
Federal deficit were reduced to zero in this budget that we are now
considering, what impact would that have to our inflation rate?
And I know this is a very simplistic question.
Mr. HEINEMANN. Other things being equal?
Senator TSONGAS. What will Milton Freidman have to write
about if we balance the budget?
Mr. HEINEMANN. One result of significantly reducing the Federal
borrowing requirement is to reduce the pressure on the Fed to
monetize the debt and to make it easier for the Fed to carry out its
announced policy objectives of gradually reducing monetary growth
over time.
Senator TSONGAS. I understand that. But if the budget were
balanced tomorrow, would things be significantly different, realistically?
Mr. HEINEMANN. If we shifted from a $40 billion to $50 billion
deficit to a balanced budget tomorrow, I am sure there would be




195

short-run shock effects of substantial magnitude, and that Dr. Sinai
could describe in great detail, as a result of the DRI model.
As a general matter, over time, a lower Federal borrowing requirement makes it more feasible for the monetary authority to
maintain a stable policy.
Senator TSONGAS. Let me pursue that, if I might.
You consider yourself a monetarist, I take it?
Mr. HEINEMANN. That's correct.
Senator TSONGAS. There is much discussion of the balanced
budget amendment that has now passed, I think, 29 State legislatures. If you perceive fiscal policy as perhaps not as important as
monetary policy but a useful vehicle, are you concerned about what
impact the straitjacket on the budget would have on having that
weaponry to deal with economic dislocations?
Mr. HEINEMANN. Fiscal policy is not my primary area of expertise, but I would say that I have not been terribly excited about the
budget deficit as the principal target that one ought to be concerned about when dealing with these policy questions.
It seems to me that the deficit is a residual; it reflects both
spending and revenue decisions. It reflects a broad range of macroeconomic factors that are beyond the reach of the legislative
process, certainly in the short-run.
My own preference would be to deal with the problem much
more through restraint on spending.
I think that a legislative or, indeed, a constitutional requirement
for budget balance could, in fact, prove to be, in my personal
judgment, a very difficult requirement to live with.
I think that the element of restraint in fiscal policy needs to be—
is more properly -implemented through the medium of spending
restraint rather than a mechanical requirement to balance the
budget.
Dr. KANE. Could I comment on that?
Senator TSONGAS. Yes.
Dr. KANE. One can always say that flexibility is potentially
better than having an inflexible rule.
The issue has to be whether if, in practice, a zero-deficit rule
would lead on average to better policy, even if policy might be
worse at some stages in the business cycle.
But I would turn back to the point that if this zero budget
became uncomfortable, bureaucrats and legislators would find ways
to avoid it. For example, they could agree to move some expenditures off budget. Such maneuvers could provide substantial practical flexibility.
So, I think, the controversy is just a tempest in a teapot.
Senator TSONGAS. That's the same argument you're using against
people in the Fed now, though. They give you the impression of
certain behavior, yet, they don't always have recourse to these
techniques which you are suggesting.
So where do you come out?
Dr. KANE. On this issue, I'm saying that I don't think it makes a
lot of difference whether anyone legislates a zero-budget restriction. If it is enacted, it will have mainly cosmetic benefits. Initially,
some people may feel better about the Nation's economic future. It




196

may lead some people to see greater hope that our secular inflation
will settle clown.
It is not going to make a lot of difference by itself, without
specific further restrictions on expenditures, per se.
Senator TSONGAS. So you might be tilted in the direction of
voting no on the Constitutional Convention by the introduction of
legislative economic language?
Dr. KANE. Yes.
Dr. SINAI. Reducing the deficit would be pretty costly in unemployment and might be worth about 1 percent or 1 1 /2 percent down
in inflation in 1980.
The CHAIRMAN. Can't hear you. Will have what effect on inflation?
Dr. SINAI. My guess would be that we've run enough simulations
in the model and checked out questions like that, that if you took
$80 billion of spending out and removed that projected $29 billion
deficit, that it would have substantial effects in the second half of
this year. And you talked about a 1-percent, or IMz-percent reduction in inflation in 1980. And probably about the same rise, maybe
somewhat more of a rise in the unemployment rate.
Now that is one extreme.
Dr. KANE, I wouldn't challenge this analysis of what such large
changes in Government activity would do. If you could work such a
change de facto, it would have a significant impact on the economy.
I just don't feel that the institutions of this country would allow
such a quick change. First, we almost always grandfather in significant changes in the rules of the game. Second, the more grandfathering occurs, the more opportunities exist to avoid the stated
intent of any piece of legislation.
The CHAIRMAN. Would the Senator yield on that?
Senator TSONGAS. Yes.
The CHAIRMAN. You say it's social because you don't know what
the psychological effect might be and that might overwhelm any
mechanical, economic effect. After all, if you have a balanced
budget, the effect that this could have on the business community
in holding down their prices might be substantial.
If you have a substantial increase in unemployment, the effect
that this might have on wage demands, and therefore, wage costs,
and therefore, prices, might be very significant.
But you just don't know because, of course, so much of this
depends upon bargaining and depends upon the psychological reaction to balanced budget, which has become such an article of faith
with a very large proportion of the American people.
Dr. SINAI. Let me respond. I presume that gets a little deeper,
which is expenditure restraint.
Now on expenditure restraint, I think it's interesting that with
all economists, and I certainly would argue for legislatures to come
down higher on expenditure restraint because at this time when
we're pretty close to full employment, if you get tough on spending
and have less of a demand on the capital markets from the central
government financing, the mix of what happens favors lower interest rates and naturally favors capital formation, productivity, and
that is a major problem.




197

So going to a zero deficit is probably a little extreme and very
costly. But being tough on spending is really a good idea.
Now whether you should be so tough as to have a constitutional
amendment on balancing the budget, that I am very much opposed
to. And I would rather rely on the potential for errors in the
policymakers than put them in this straitjacket.
Senator TSONGAS. The point I'm trying to make is I don't think
that the Constitution is something you tamper with for what may
be marginal advantages.
I'm in favor of balancing the budget. I think you can do it
legislatively but you don't amend the Constitution of the United
States for this kind of interesting intellectual exercise.
This really takes time away from other concerns that I think are
equally valid and it's unfortunate.
I have a final question which I don't think I have time for.
The CHAIRMAN. Go ahead.
Senator TSONGAS. On the question of productivity, I have in my
State, basically, a thrust toward high technology as our economic
future, which I support and have been working on.
What concerns me is that if, indeed, we are going to be productive, and now I'm taking the country as a whole, that if we just
continue the policy of noninvestment in capital equipment, et
cetera, and achieve a zero productivity that we saw recently, what
does that portend over the long run and how can we change that?
Dr. SINAI. Some work we were involved in recently suggests that
retractions, or tax incentives for R. & D. spending, which is a
question that concerned you some months ago, could be of significant benefit, some other work on tax incentives and effects on
business capital spending, which we have done a lot of work on
that topic, has always indicated that tax credits and accelerated
depreciation would give very good results on business capital formation.
And, indeed, as we get close to, so close to full employment, these
are measures that are worthwhile considering, especially in view of
the fact that productivity results have been so miserable over the
past few years.
Senator TSONGAS. Mr. Chairman, are these issues outside the
domain of this committee—productivity and capital investments?
The CHAIRMAN. No, indeed. Well, of course, the immediate jurisdiction would be the Ways and Means and Finance Committees on
any kind of tax legislation. But we would have an input on it and
we would have an interest in it. And I think it is perfectly proper
for us to consider it.
Furthermore, many times the committee has considered various
means of improving productivity but not by the tax routes.
Senator TSONGAS. I would be curious. I have a capital formation
committee back in Massachusetts that tries to deal with this issue,
and it seems to me it is so complex. Maybe at some point we might
consider holding a hearing just on that issue.
The CHAIRMAN. Let me get into this. This also is not precisely a
monetary question, but I would like to ask each of you gentlemen
about this because the point has been raised so well by Senator
Tsongas.




199

In 1953, of course, we had the Korean war going on. Because
such a large component of transfer payments are appropriated
through an automatic appropriation process, I would suggest that
there are some major structural problems involved in trying to
legislate expenditure control from the top down rather than the
bottom up.
I think we have to go into the individual programs and begin to
try to get some control over the spending in the items that have
actually been increasing over time.
The CHAIRMAN. Let me interrupt to say I couldn't agree with you
more. You're absolutely correct and your analysis undoubtedly is
right.
But it seems to me that, nevertheless, it would still be desirable
to achieve what the economists tell us they would like to achieve,
which is a balance over the cycle and not have it based upon,
really, what has been, which is a full-employment surplus.
We never get to the full employment, which is 4 percent, which
is probably right now an extraordinarily inflationary kind of situation.
The result is we pile up these enormous deficits. The country is
rightly exorcised about them. We're not going to do anything about
it, really, unless we take some kind of action.
What I propose may not be the right kind of thing but something
of that kind that provides an extraordinary restraint on the Congress and, theoretically, we should not have that.
But the experience year after year after year and deficit after
deficit in periods of growth and to have the country talking about
an austere budget with a $30 billion deficit in the fifth year of
recovery really is pretty ridiculous.
Mr. HEINEMANN. I completely agree. I think to implement this,
the process has got to involve going back into the uncontrollable
expenditures and making them controllable.
I am with you at your goal. I don't know whether a requirement
expressed in percentage terms of nominal GNP, in fact, would
achieve the practical result if that were all that were done.
Dr. SINAI. The advantage of the constitutional amendment which
I would definitely oppose is it is almost like an order from the top:
We don't care how you do it, but to make sure it happens.
The CHAIRMAN. I'm not proposing that.
Dr. SINAI. I'm just saying that's one extreme. I think your proposal is much mc^re practical and much more in tune with what
the public would want and be much more acceptable.
So I think it is a sound one to make.
The implementation, though, at least as a principle, the problem
is so many stress factors arise during the course of a 3- to 7-year
business cycle, that there are all kinds of special contingencies,
whether it's a war or a war on poverty or whatever it is, that can
happen to change that.
The CHAIRMAN. Well, a war we can set aside. We always come
out of our recessions like gangbusters. The feeling is that we just
have to reduce taxes and increase spending and put people to work.
And we just overdo it every time.
Dr. SINAI. But you have to watch, I think, in your proposal,
because in a recession, we would have low growth and you would




198

I've got two proposals: One would meet what, Mr. Heinemann,
you refer to as the importance and all of you gentlemen referred to
as the importance of holding down spending.
This is an amendment that I'm going to offer on Tuesday when
we mark up the Council on Wage and Price Stability. That would
provide for a reduction in the proportion of Federal spending in
relationship to the gross national product of approximately 22 percent down to 20 percent over a 5-year period.
The President has announced he's for it, but there's nothing in
the legislation that would require that he be responsible.
And I'm hopeful we can get favorable consideration of that.
Now the other proposal would be to try to do something about
balancing the budget over a cycle.
I have agreed that to rigidly require a balanced budget every
year would be counterproductive and wrong. And there are all
kinds of problems involved in that.
But what I propose instead of that is this: That the President
should propose a budget and Congress should pass a budget which
would provide that in the event we have real growth of 3 percent,
that the budget would be in balance. If we had that in effect over
the last 17 years instead of 16 deficits and 1 small surplus, an
explosion of the national debt, we would have had 12 surpluses and
5 deficits.
It is a proposal that is flexible because in the event of slow
growth, where you have a deficit, which you should have, and in
the event of recession, you have a deeper deficit, which you ought
to have also.
But in the event of exuberant growth, you have a surplus which
you ought to have, which tends to hold down the prices and tends
to counteract inflationary forces.
Now why wouldn't a combination of these two be desirable in
providing for a greater degree of economic stability?
Now this would be a bill, not a constitutional amendment. Congress can change it if they wish. It would be subject, of course, to a
two-thirds vote if the Congress wanted to overrule it and provide
for a bigger budget or a bigger deficit.
Why wouldn't that be sensible? Mr. Heinemann?
Mr. HEINEMANN. I think that the general principles that you
have enunciated, Senator, are completely sound. I would observe,
however, that as we look at the composition of the growth in
Federal spending over the last 30 years or so, that there are some
extraordinary problems of implementation which I think need to
be addressed.
Looking at the Federal budget in real terms and breaking it
down by its main components in the national income accounts—the
purchase of goods and services, transfer payments, grants-in-aid to
State and local government—all of the growth of Federal Government spending, virtually all since the 1950's has come from the
transfer of payment side. I have adjusted transfer payments by the
personal consumption deflator in the national income accounts.
Real Federal purchases of goods and services, in fact, were lower
in absolute 1972 dollars in the first year of Mr. Carter's administration than they were in the first year of Mr. Eisenhower's administration.




200

accept some sort of deficit as part of the balanced budget over the
cycle, and it still would permit the speed or the pace that the
policy stimulates.
That is very important.
The CHAIRMAN. That's right. It would retard the pace of the
stimulus. That would be a price you pay. But it seems to me on the
basis of our experience, that is a pretty good price to pay.
Dr. SINAI. If you're going to balance it over the cycle, why
couldn't somebody come out of a recession spending $20 billion
instead of $5 billion?
The CHAIRMAN. Well, that is what we've done. That is what we
do all the time. We come out of a recession—we came out of the
1975 recession with a colossal deficit and the deficits continue.
Dr. SINAI. But it could happen under your proposal just as well
because there is that leeway over the whole cycle in terms of a zero
deficit.
The CHAIRMAN. No. My proposal would automatically, regardless—this is something that the economy would do for you—the
President would submit a budget which would be in balance in the
event real growth, or 3 percent. If the growth were 4 percent, you
would have a bigger surplus, 5 percent, a still bigger surplus.
If he was wrong and you had a recession, you would have a
substantial deficit which would stimulate the economy.
In other words, the economy
Dr. SINAI. I see, the Government takes no action and lets the
economy do it.
The CHAIRMAN. That's right.
Dr. SINAI. I'm not sure.
The CHAIRMAN. Well, I would like to get your reaction because it
would be very helpful.
Dr. Kane?
Dr. KANE. I think your proposal would be very useful in terms of
educating voters and other Members of Congress to the trade-offs
involved in detailed expenditure decisions. That is the great value
of it. It should make people think about placing another road in
the middle of Kentucky, if it is going to force a reduction in
expenditure something else.
The CHAIRMAN. It's a good thing you did not say Wisconsin,
Utah, or Kansas.
Dr. KANE. You'll notice that I didn't say Ohio either. In any case,
speaking about roads raises the issue of how to regulate capital
formation by the Government. When we talk about balancing the
budget over the business cycle, we must recognize the possibility
that the Government should undertake some important capital
expenditures that ought not to be financed on a pay-as-you-go basis
because the benefits of the project spread out into the distant
future. A so-called good war provides an extreme example of such
an expenditure.
The CHAIRMAN. Senator Garn?
Senator GARN. Thank you, Mr. Chairman.
Along this same line, I agree with most of what I have heard in
the last few minutes.
I favor a constitutional amendment because in the 5 years I've
been in the Senate, we had a national debt limit, and I think we




201

should do away with it because it not only is meaningless because
we simply increase it every year so that the Government can
continue to function. Then it becomes a Christmas tree.
And we had all kinds of ornaments on it and add all kinds of
amendments that would otherwise never pass.
So we get bad legislation. So I'm opposed to the debt limit on the
statutory basis because it has a negative impact, in my opinion.
I see no reason that Congress, being what it is, and its ability to
spend—and I certainly agree that we need spending limitations—
would have justification in a year for going beyond any statutory
limitation, just like it does with the debt limit.
I see no restraint.
I understand the problems of a constitutional amendment and,
from a principle standpoint, I say we shouldn't be putting into the
constitution those kinds of details.
But when you have served in this body for 5 years and you see
the lack of restraint that any statutes place upon us, that is why I
go the constitutional amendment route.
However, I would oppose any constitutional amendment that just
requires a balanced budget. We could have a $2 trillion balanced
budget with nothing but spending.
So I think we have to have a combination and I would like your
comments on this, just to throw something out, a constitutional
amendment requiring a balanced budget, but with a limitation of
whatever, 18, 19, 20 percent of gross national product to provide
the flexibility that you need. Put in maybe a requirement that a
two-thirds or three-fourths majority of the Congress is needed to
have a deficit in order to meet such things as a war or war on
poverty, or whatever, recessions.
It would be much more difficult to get two-thirds or threefourths, as you well know.
What do you think about that kind of a three-pronged proposal
to try and attack all of the things that I've talked about?
Dr. KANE. Well, I think that the action that the Congress takes
on the national debt limit illustrates my thesis that almost every
legal restriction that is put on a group of people who really don't
fully accept the purpose of the law leads to avoidance rather than
compliance.
I think the newscasters have increasingly ridiculed Congress
whenever they announce that the national debt ceiling has been
raised again. It is a charade.
But I want to discuss what worries me about putting your ratio
into the Constitution. It is fairly clear that it would be an improvement to restrict Federal Government expenditures to 20 percent of
GNP today.
That ratio seems prudent relative to today's circumstances, but it
seems very likely that this won't always be the size of government
we're going to want. I don't think we should adopt a constitutional
amendment with the intention of reopening it again and again.
Prohibition has a lesson to teach us here.
It would set very dangerous precedents vis-a-vis fundamental
amendments, such as the Bill of Rights, that I hope are truly
inviolable. Constitutional solutions should have a permanence to




202

them that limiting the Federal Government to 20 percent of GNP
could not.
Senator GARN. That is why I added the third thing, and that is
the supermajority in order to go beyond that 20 percent if necessary.
Dr. KANE. Again, it is a question of what we mean by a constitutional amendment. I think that, once we recognize that a rule we
have in mind is going to need future adaptation, it should be
incorporated into an ordinary public law rather than made part of
the Constitution. If we have a rule that reasonable persons could
agree with year in and year out, century in and century out, then
and only then should it be lodged in the Constitution.
Senator GARN. I agree with you in principle. But look what we've
turned into. We've turned into a circus, a zoo. This is the best show
in town, actually, next to the National Zoo downtown. We give
conservative speeches, everybody around here. Everybody ran as a
conservative last fall. And we've reached the point where, as the
chairman pointed out, we talk about a $29 billion or a $30 billion
budget as being austere.
Where is the control? I really don't think it should be in the
Constitution, except I'm going to support some kind of constitutional amendment, because we have not restrained ourselves. There is
a need for some dramatic bolt of lightning out of heaven that
suddenly takes some of the rhetoric and doubletalk out of some of
pur colleagues that speak one way and vote another—I am searching for an answer to control this monster.
And, I'm tired of those who continually attack the military
budget when it has continued to go down as a percentage of GNP
and a percentage of the total budget. And you're right, most of the
increases come in the transfer payment area, taking from one and
giving to another.
And I am frankly tired of being told those are uncontrollable.
They are not uncontrollable. If Congress has the courage to tighten
the eligibility requirements and take out some of the golden California children who come to my ski resorts in Utah and buy food
with food stamps and collect unemployment while they ski all
winter—sure, they are unemployed. But we need to get the money
to the really needy. And you could eliminate thousands of most of
these transfer payments, and the most that would happen is they
couldn't ski as much or surf in California. I guess they go back to
California in the summer and work long enough to get back on the
benefits, and then they snow ski in the winter and water ski and
surf in the summer.
But I don't know how to control it, other than a constitutional
requirement. It works in Utah. Obviously, we have a State that has
an entirely different economic requirement than the country. We
don't have wars. We don't have all of the factors involved. But I
will guarantee you, had we not had a constitution that requires
balanced budgets, the budgets would not have been balanced in the
State and local and city governments in my State.
So I look at it as something that is not preferable to get that
specific in the Constitution, but I don't have any other answer. And
my hindsight tells me that my colleagues will not control themselves with statute. They will do what is politically expedient for




203

the next election, and they will buy votes with expenditures of
Government funds and programs in their States.
So you're looking at it from an economic standpoint, that I agree
with you. I'm looking at it from a political standpoint and political
realities and what has happened in this country over the last 25 or
30 or 40 years.
I have nothing else, Mr. Chairman.
The CHAIRMAN. Did you want to respond, Dr. Sinai?
Dr. SINAI. Well, rules arise from problems that exist at the
moment. But unfortunately, rules you make today, 5 or 10 years
down the road don't look like such good rules.
I think ultimately here the answer is in the election process. We
have seen a major shift in political opinion in this country, and
the, quote, unquote, "message" sent to the legislature. I see it every
time I come down here to testify. Because the kinds of views
legislators had 4 or 5 years ago are not the views they hold today.
And I think that is really the answer, is not a constitutional
amendment. It is that all too slowly the American electorate will
come to really, I think, the right conclusion. Maybe it is too slow
for some of us.
Senator GARN. Well, I'm not convinced you're right.
Dr. SINAI. But I would suggest that something that is more in
between is the kind of a proposal that Senator Proxmire is making,
which also has a problem, in that it is rules now which 5 or 6 years
down the road might not look so good. But at least it would get the
message through and provide something to shoot at.
The CHAIRMAN. You mean change by law.
Dr. SINAI. Yes.
Senator GARN. Well, it isn't a momentary thing, as you say. It is
40 years.
Dr. SINAI. But I can see a situation under the balanced budget,
under the constitutional amendment, that would lead to, 5 or 6
years from now, a very large number of people unemployed, maybe
an inflation rate down to 2 or 3 percent, which we could applaud,
but then you might have 10 or 12 percent unemployment. And all
those people and their sympathizers running around and voting
out the people who put those policies in.
Senator GARN. Well, let's go back and look at hindsight again.
Historically, you have not had that much of a range in Federal
expenditures. If you pick Senator Proxmire's figure of 20 percent,
and if you go back over 40 years, it hasn't varied that much. You
have not had those big swings. It has been a gradual increase.
I don't see a momentary crisis from setting that kind of a limit
or percentage if the economy is growing.
Dr. SINAI. I think the percent is a good idea, but not by constitutional amendment.
Senator GARN. Without these kind of restraints, we have had the
kind of unemployment you talked about. We have had everything
you have described, without a constitutional amendment. I don't
see that we have a great deal to lose.
Dr. KANE. Well, it sounds to me a little like looking for courage
in a bottle. You said that courage will come when Congress is
ready—and the President, too—to take a tough stand on these
matters: to recognize that trade-offs exist and that actions should




204

be avoided whose short-run benefits are not worth the obvious longrun harm worked on the economy. Only then will we get different
policies.
Putting in a constitutional amendment would, of course, come
across as a much more dramatic action than passing an act of
Congress. Passing an act of Congress leaves open the possibility
that you're going to have to show resolve again every day to make
it stick.
But that's the only way that individuals do reform, is by continually reresolving that they're going to behave differently.
Senator GARN. Well, there's another point you miss in talking
about the public and their attitudes for a long time, proposition 13
is going around this country. No matter where you went, the
conservative mood was there. The attitudes against the big budget
deficits and big government have been there. They have not been
organizing an opportunity to vote. But what you're seeing happening right now happens every day in my office. Constituents will
come in and say: Senator Garn, we love the way you vote. You just
keep voting against those big deficits. But now we want to talk to
you about the supplemental appropriation for veterans. And everybody wants everybody else's budget cut but their own. And that is
something that is being missed in this conservative trend across
the country.
I had a meeting in my office this morning. Boy, we think this is
great. We wish we had a proposition 13 in our State. Now we want
to talk to you about community mental health.
Well, there is somebody that is for every program in my State,
somebody in Senator Proxmire's that thinks their portion of the
Federal budget is good but everybody else's should be cut because it
is wasteful.
So it isn't quite as easy as you say. The constituencies are rather
demanding for their particular tiny piece of the budget.
So I'm not convinced that we are out of the area yet. I've got a
proposal here: Don't cut our military base in Utah. We've got a
whole bunch of very high-up people. One of the things it says in
here: They hate to lose the officers club because of the tax on
booze. Isn't this great. It's a whole big memorandum. I'm getting a
lot of pressure to fight the closing of this one base in my State, and
I'm going to take the attitude that you're going to have to prove it
to me economically. If it isn't justified, then it's going to go, whether it's in my State or not.
But you cannot believe the political pressures on this budget to
maintain an officers club so they can have untaxed booze. It is
incredible, despite what you hear about proposition 13.
So again, we've got to have something dramatic. We've got to
have something so a Senator can say: Well, I'm sorry, I would love
to keep that base, I would love to fund this and I would love to
fund that, but we're at the limit, we can't go any further.
I'm just maybe a little bit too politically realistic right now. But
you have more trust in my colleagues than I do.
Dr. SINAI. It is difficult without some kind of rule like that
backing you up, it is difficult to say that there are problems here.
But I think it's easy for me to say this, because I am not now




205

running for election or anything like that. I think you just have to
stand up and tell them exactly what you told us.
Senator GARN. Maybe if we could limit a President to one 6-year
term and Senators to two 6-year terms and Congressmen to three
4-year terms and send us all home, so that we don't have to keep
getting reelected. Maybe that is the ultimate budget restraint, is to
turn us over.
Dr. KANE. That is one of the things we could do. Having elections
every 2 years encourages stop-and-go monetary policy. To the
extent that the problem is that election-year pressures force policymakers to adopt an inappropriately short-run horizon, somewhat
longer terms in office would be helpful.
However, no matter what you choose to do with the Constitution,
you are still going to face pressures from your constituents to take
care of their needs. People want their tax rates lower and their
benefits increased. Everyone wants his or her life to become better
and better. Voters know that it costs somebody for the Government
to make them happier. Their goal is to get the fruit and ship the
rind to someone else.
Right now the argument tends to be: Why can't we have goodies
from the Government when everyone else is getting goodies, too.
The question is whether we can change with an act of Congress (or
even with a Constitutional amendment) the general environment
in which public choices are made. Voters must learn that relying
habitually on the Government for help produces not more for some
people, but less for everybody.
The CHAIRMAN. Gentlemen, the hour is late, and I apologize for
continuing, but there are a few more questions I would like to ask.
Two weeks ago I introduced legislation known as the Small
Saver Equity Resolution of 1979. It would have the effect of directing the financial regulatory agencies to lower the minimum denomination on deposits such as the 6-month money market certificates
to $1,000 from the current $10,000. The reason why this is so
important is that savers with less than $10,000 are being discriminated against in a very inflationary environment.
The real rate of interest on savings deposits is close to —4
percent. So the old and very young, who don't have sufficient funds
to purchase floating rate instruments are stuck.
I also intend to introduce legislation to gradually phase out
Regulation Q ceilings by raising them a quarter of a percentage
point every 6 months for the next 10 years.
I would like to ask each of you to comment on that. Dr. Kane?
Dr. KANE. Let me begin by taking these proposals apart. First, to
relax regulation Q in stages as you describe is an excellent idea.
The costs to small savers of regulation Q have been obvious and
unfair. The only way we will ever get rid of these ceilings is to plan
a staged withdrawal, setting immutable dates for moving from one
stage to the next. To provide room for affected institutions to
protect themselves, it is useful to proceed in stages. In any case,
regulation Q has already been extended through the end of 1980.
So, you are talking about relaxation beginning in 1981?
The CHAIRMAN. That's correct.




206

Dr. KANE. Managers of institutions currently benefitting from
reg Q would have some time before they lost the "Q crutch," time
to plan how best to operate in the new environment.
Any harm a change in law might work on someone is less when
they have advance notice. This occurs partly because future harm
must be discounted back to present value and partly because interim adaptation can lessen the ultimate harm.
Consumers would benefit from anything that creates more effective competition for their savings. The problem of reducing the
money-market certificate denomination to $1,000 is that it would
reduce discrimination only against "large" small savers. Anyone
who can put aside $1,000 for 6 months in one of these certificates
has far more money than the average U.S. resident. We are still
going to have our ordinary citizens—those who can put aside only
a little bit of money perhaps in hopes of buying a house—having
an unfairly hard time accumulating any kind of nest egg.
In short, this part of the proposal certainly moves us in the right
direction, but it is a very small movement.
The CHAIRMAN. Well, would you do it or not? It seems to me that
it does increase the equity.
Dr. KANE. Sure, but I would say why not take away the minimum denomination altogether?
The CHAIRMAN. Yes. But if I could I would. The question is, Will
you go from $10,000 to $1,000? What about the people with $10,000?
Dr. KANE. Well, I realize that this is not necessarily my function
to advise you on this. But if you start with zero and make the
industry try to compromise at $1,000, you've got a lot better chance
to force movement. They're going to fight $1,000. They couldn't
fight zero any harder.
I would suggest an additional provision that you might consider
putting in your bill. This would be to remove as soon as possible all
ceilings and minimum denominations on relatively long-savings
instruments, those of 3 or more years in maturity.
The Chairman. At the same time I proposed reviewing the
$10,000 to $1,000, I also propose that regulation Q be lifted. So the
really small saver would be unlikely to buy certificates of less than
$1,000. If he puts his money in a savings deposit, then he would be
able to get a better rate of interest.
Dr. KANE. I understand that. But I'm saying that even the savings and loan industry can offer very little justification for ceilings
on long instruments. They should be able to pay the market rate
on such funds, whose maturities are only a little shorter than the
effective maturity on their mortgage assets. I think such a provision would be a wise addition to your bill.
Dr. SINAI. Those, I think, are most superb ideas on a large
number of grounds. The only problem is the usury ceilings in some
18 States, which would hurt the thrift institutions. At the same
time, those usury ceilings could be lifted.
The CHAIRMAN. This would be one of the elements that would
help lift the usury ceilings.
Dr. SINAI. Well, I think both of those ideas are excellent on
economic grounds and any way you look at it.
Dr. KANE. The industry does tend to talk a great deal about
these usury ceilings, but I don't think Federal policy for the entire




207

Nation should be made contingent upon the action or inaction of a
minority of State legislatures.
The CHAIRMAN. Well, just this week, I think, Maryland repealed
their mortgage usury.
Dr. KANE. That's right. Moving toward market competition in
savings deposits is forcing other State legislatures to reconsider
what low ceilings on nominal interest rates mean when inflation is
high.
Mr. HEINEMANN. Price controls on deposit interest rates, from
my point of view—and I totally agree with my colleagues—have
been counterproductive and harmful to the country. From my
point of view, any way station, any progress that can be made at
all along the road toward complete elimination of interest rate—of
price controls on deposit interest rates is positive and beneficial.
And I would really not pretend any expertise on the best legislative
tactics required to accomplish that.
I think we ought to move with all deliberate speed to get rid of
all controls on deposit interest rates, because I think they have not
done the job. As a matter of fact, they have produced counterproductive results.
The CHAIRMAN. How about on the 6-month certificates?
Mr. HEINEMANN. I would leave the establishment of interest
rates on deposits to the open market, and I would move in a phased
manner, as Dr. Kane said, I would move in a phased manner
toward the elimination of all Federal controls on deposit interest
rates.
The CHAIRMAN. Now, Dr. Sinai in his statement said that a
sustained hard line on fiscal and monetary policies without an
abrupt move toward the causes, would cause deep recession. I am
in general agreement with Dr. Sinai. I think the administration is
prepared to follow this type of approach.
Also, Dr. Sinai, the inducements to wage earners that you referred to, are you talking about the real wage insurance?
Dr. SINAI. No, I was talking about another type of plan. But it
boils down to the same thing. Real wage concerns, the type of plan
that I referred to, which is, simply stated, to make payments to
people to induce them to behave the way you want them to. And
because the wage cost and the labor cost, et cetera, is such a large
part of our inflation on the cost-push side of our inflation, that it
could have dramatic effects. The real wage insurance plan itself, I
would say, would not have a dramatic effect on inflation, on minimizing inflation.
The CHAIRMAN. Well, I feel very, very ambivalent about that
program. I'm against mandatory controls. They worked so dismally
in the Nixon period. They have not worked before in wartime. This
is kind of a halfway house weVe got. It would seem to me if we
can't get the wage insurance, you could make a very strong case
against the rest of the program.
Look what's happened to Canada. As we know, in Canada they
held wages down to about GVa percent and they had inflation of 8J/2
percent over the last 2 or 3 years, and now they are paying the
price of that. Now they are in a position where they're going to
have to settle, make their wage settlements 9 or 10 percent. It's
highly inflationary.




208

We have the Blinder and Newton study, a Princeton study
which, as you know, they made a study of the Nixon controls and
found in the long run they were counterproductive, that we have a
higher rate of inflation because of those controls than we would
have had had we never had them.
Dr. SINAI. Well, in anything like that, in fact, in financial markets and otherwise, we get reverse effects. In retrospect, I think
we'll find that some of the terrible inflation of the last 2 or 3
months is just because of the wage-price voluntary program, because it has affected the natural pattern of pricing that would have
occurred.
The only way you can deal with that is to change the relative
prices through taxes, as we have done in some other cases.
The CHAIRMAN. The argument that Dr. Bosworth and Dr. Kahn
made to us was that what you buy when you get the controls
program is a lower level of unemployment for a given rate of
inflation. They feel that this—it may be marginal, but they think
that it is significant, and that it'll work this time, provided you
have restraining monetary and fiscal policy, and that it is going to
result in a lower level of unemployment and a lower level of
inflation than you would have had absent that.
Do you buy that or not?
Dr. SINAI. Well, it is so marginal that I'm not really sure. I think
what it comes down to is, it will turn out to be inflationary and the
wage-price program will have very little to do with it.
The CHAIRMAN. As far as you're concerned, we're just as well off
with monetary and fiscal restraint, and let the rest of it go?
Dr. SINAI. Except for the carrot kind of—-TIP program is different. Unfortunately, there's very little support for that, which is
really what I'm alluding to, to simply pay people through the tax
system so that they don't, in a sense, lose anything in their real
income, to lower their wage demands, and when they do that the
wage costs of business are less, the business markup of prices is
less. And that kind of policy would be like an exogenous deflationary shock, instead of the inflationary shocks that have caused us so
much problem.
The CHAIRMAN. That is what the wage insurance program tries
to do.
Dr. SINAI. It is only very minor.
Dr. KANE. I just wanted to say that the one predictable effect
that even a voluntary controls program has is to increase uncertainty in the economy. People begin to worry whether what they
could do now, can still be done later.
The CHAIRMAN. So you think on the whole it is negative?
Dr. KANE. I think it is very negative. There have been cases
where individuals have believed that they had better get that wage
increase or price increase in now, because 1 year from now, as we
get closer to the 1980 election, the Government may have a mandatory program.
The CHAIRMAN. You think the January disaster was part of that?
Dr. KANE. I would say that it is part of the explanation. I haven't
any hard economic evidence by which to sort the situation out, but
it is obvious that many people think this way.
The CHAIRMAN. Mr. Heinemann?




209

Mr. HEINEMANN. Senator, actually I would like to pass on that
one. But I wondered if I might have your permission to change the
subject and to insert a comment that I had wanted to make earlier
in regard to the analysis I tried to present on the monetary base.
And this is simply to make a very simple international analogy.
There are many reasons why price performance in Germany and
Switzerland has been relatively favorable in the last few years. The
performance of their currencies, the relative size of foreign trade, a
lot of things have influenced it. Clearly, there is a political determination in both countries to keep prices relatively stable.
I would observe, however, that both the German and the Swiss
central banks use the monetary base as their formal operating
target. The complaints of the Federal Reserve that this is not a
practical technique, I think, have little standing in the face of the
developing evidence in some of the countries that are doing the
best in terms of controlling prices.
The CHAIRMAN. Has the Bundesbank done that consistently?
Mr. HEINEMANN. Oh, yes.
The CHAIRMAN. The monetary base, not Mi?
Mr. HEINEMANN. Yes. Their target is expressed in terms of the
monetary base. They call it the central bank money stock, and they
define it exactly the way we define ours.
The CHAIRMAN. And you say they have been quite successful, of
course, in both countries?
Mr. HEINEMANN. Yes. Their record in hitting their monetary
base targets has been uneven. The Germans substantially exceeded
their monetary base target in 1978. I alluded to that in my formal
statement.
Their price level has not responded to money growth above their
target levels, in part because their currencies have been so strong.
But they are beginning now to change monetary policy because
they feel that further appreciation of the deutschmark, for example, is unlikely. They are beginning to tighten up.
I am merely speaking about the technical feasibility of using a
target of this sort. That does not, dealing with the tactical issue,
does not solve the long-term structural problem. It does not solve
the political issue. But it does get over an important technical
hurdle that I think we need to cross.
The CHAIRMAN. Well, this is very helpful. What I'm going to do
is to send this, your testimony, on to the Federal Reserve and Mr.
Miller and ask for their response on this, because I think it is a
very helpful suggestion, so that we can get some standards we can
rely on better. And it seems to have good support among your
colleagues here this morning.
Dr. KANE. I think that the Fed could make an important contribution to economic stability if it were to survey regularly and
carefully the inflation expectations of business and financial decisionmakers.
If they were to conduct a stratified sample survey of capital
market participants as to what rates of inflation respondents
expect over several different horizons, it would make it possible to
employ the real interest rate as an additional index of the effect of
monetary policy on economic incentives. The real interest rate




210

would track more closely effects on the spending and lending decisions that are featured.
The CHAIRMAN. Real interest rate? The difficulty, you see—the
real interest rate, it would seem to me, would depend upon the
estimate of the investor as to what inflation is going to be during
the life of the security that he is buying. So there's a short-term
rate—that he might estimate what the inflation is going to be
during that period. If it's a long-term rate, it's going to make a
different estimate. And those estimates are so subjective, so varying. And, as Dr. Sinai pointed out—in the article referred to, in
Business Week—-so erratic, and when you have a sudden inflation,
it is sometimes negative.
And I think you pointed out that they were negative for mortgages in the 1974 period, that it is a little hard to rely on that as a
useful index.
Dr. KANE. One of the problems we have is, as you say, to discover
what these decisionmakers are thinking. There is some variation in
that thinking, but through survey techniques we could obtain an
additional supplementary measure of what expected inflation rates
actually apply. My analysis is that right now there is a tendency
for policymakers to focus on nominal interest rates and not always
to factor in how anticipated inflation may be eroding the apparent
impact of monetary policy. But we need better measurements, and
I think this would be one way to get it.
The CHAIRMAN. I have one final question, and each of you gentlemen might take a crack at it.
The report we received from the Federal Reserve, is the first
under the new requirements imposed by the Humphrey-Hawkins
Act. In many ways we've had improvements, which we will know
more about the new process in July when the second report, for the
year 1979, is presented.
I am disappointed that the Fed did not lay out the assumptions
underlying the monetary and credit aggregate targets; and also to
discuss in more detail the relationship between the intended monetary policies and the administration's goals, the Fed did not give its
view of the output price mix or indicate how its policies relate to
the 1980 goals, as the act requires.
I would like to get your reaction—and we will start with Mr.
Kane—to the Federal Reserve's report and any suggestions you
would have for improvement in that report for the future.
Dr. KANE. Well, I did not get the report until very late last
night. I have been traveling this week and, as you know, heavy
snows slowed the mails throughout the East.
If one looks through the report as if one were a book reviewer,
one's first reaction is that editorial space and emphasis are badly
misallocated. The bulk of the report is designed to provide a summary discussion of economic events in the recent past.
The CHAIRMAN. If you go to page 53, I think that's—you have to
go until there, till you get to talk of the future.
Dr. KANE. Right. At that point, they cite a quote from your act,
and turn to discuss, very quickly, what they have decided to do.
From the point of view of congressional oversight, some passages
struck me as particularly distressing. At one point they proceeded
from the standpoint—on page 57, line 7—that it is possible that




211

various things would happen. Such reasoning makes it very hard
for a reader to evaluate their thinking. I don't think they should
focus on mere "possibilities." They should talk about "probabilities" and give us some notions of how they assess the probabilities.
All in all, it is a fairly impenetrable presentation. It is written in
code. One has to have an awful lot of outside knowledge to translate the presentation into meaningful statements.
Despite all they tell us about the economy, they don't tell us
enough about how their policies are made, how they change their
policies to deal with shortfalls in macroeconomic goals or what
trade-off they are prepared to strike between shortfalls on individual goals. That is surely the sort of information Congress envisioned
when it drafted this legislation.
The CHAIRMAN. Dr. Sinai.
Dr. SINAI. I'm sorry, I haven't got a copy. I would be happy to
respond later in writing.
The CHAIRMAN. Fine. If you would do that when you correct your
remarks, if you would give us in writing your reaction, that would
be very helpful; and we will look forward to that.
Dr. KANE. Could I do that, too? That would be my corrected
version.
• The CHAIRMAN. Yes, indeed.
[Dr. Kane submitted the following information for the record:]
I have already commented on Chapter 1. Probably the most remarkable change in
the document is the sharply lower range of growth rates targeted for Mi in Chapter
2. This is, I believe, the first time that the FOMC has changed the upper and lower
endpoints of one of its target ranges by more than half a point. On page 58, this
change is presented as merely incorporating an uncertain staff projection of shifts
in Mi growth due to ATS and NOW accounts. We are warned (on page 56) that the
Fed may adjust the range as information on the growth of these new accounts
develops.
This exegesis gives the Fed complete flexibility on the Mi front.
The chapter goes on to suggest that the other conventional aggregates may give
misleading signals as to the thrust of Fed policy, too. These explanations serve to
fuzz up any policy commitment that the selected range of growth rates might
otherwise have conveyed to your Committee.
Chapter 3 (the shortest of the lot) is potentially the most interesting section, but
the analysis the Fed provides does not truly reconcile its policy plans with the
President's short-term economic goals. The text does tell us that the Fed considers
the Administration's inflation and unemployment forecasts to be excessively optimistic. Keeping this in mind, the report's last paragraph tells us that the Fed is
prepared to accept additional unemployment in fiscal 1980 to restrain inflation. It
would, of course, be helpful to know just how much unemployment the Fed expects
to trade for what degree of improvement in the inflation rate.

Mr. HEINEMANN. I, too, received it late yesterday afternoon, and
I've only general comments. And the comments I would make
would be those that would apply in general, and not simply to this
specific document.
The recent performance of monetary policy, in my judgment, is
not set forth in relevant terms. I think that monetary policy needs
to be described by the Central Bank in terms of what technically
would be the second derivative, the change in the rate of change of
monetary growth. I think it needs to be stated in that way, in a
consistent manner through time.
We need to have an explicit recognition by the Central Bank
that, in fact, there has been a major acceleration in monetary
growth during this business cycle which they are now finally start-




212

ing to do something about. I think we need to look at measures of
monetary change within a relevant framework.
I think that the way in which the Fed has chosen to do this—to
develop Professor Kane's theme—is really written in code. It is
designed to present a moving target that is very hard to hit. That
really was the strategy, I think, in the rolling target, reset every 3
months, that we got beginning in April of 1975.
I think, in ,terms of policy implementation, we ought to see some
explicit language describing just exactly how fast bank reserves are
expected to grow, consistent with the monetary growth which the
Fed wants to achieve.
The Fed does not control, directly, the monetary aggregates. It
does control, directly, the reserve base, the monetary base of the
banking system.
I think we need to see some explicit forecasts of the behavior of
the money multiplier. There is a great deal of quite sophisticated
work being done, for example, at Michigan State University on the
whole issue of forecasting the relationship between monetary base
and the money supply—the way changing public portfolio preferences about the form in which money is held interact with what
the Fed does to the monetary base to produce the ultimate monetary aggregate growth rate.
I think there could be a great deal more specificity in this
document in terms of where the Fed is going, how they're going to
get there. I think the issue of how they get there, how they progress along the road they propose to take, is a highly relevant issue.
If the signposts—if the description of the scenery is no good, we
really don't know what they're doing.
The CHAIRMAN. This is a most helpful answer, but I'm not sure I
understand when you say they should describe how they're going to
get there.
Now, they've indicated that a considerable change in their Mi
rate of increase
Mr. HEINEMANN. By how they want to get there.
The Federal Open Market Committee today gives an operating
instruction to the Federal Reserve Bank of New York that has
meaning, in day-to-day terms, only in one respect.
Mr. Alan Holmes, who is Executive Vice President of the Federal
Reserve Bank, is told to maintain the Federal funds rate at a
particular level. That's the only thing that he's told to do that he
can do on a day-to-day basis.
The Fed, for I think good and sufficient reasons, doesn't want to
forecast what that interest rate target is going to be; and I perhaps
might differ with some of my monetarist colleagues about the
desirability of disclosing that rate target. I think that rate target
ought not to be disclosed. We shouldn't have any rate target at all.
When I talk about the road going forward, I am speaking in
terms of the path expected for the monetary base, the path expected for bank reserves, and the anticipated relationship between
those aggregates which the Fed can control directly in its day-today operations and the desired rate of change in the money supply,
defined in a variety of different ways.
There is no reason for the Congress or the country to pick Mi, or
M2, or M3—we can all have all of the flavors. It is the way they




213

behave in concert, over time, that's going to give us a consistent
pattern which will suggest whether we have increased monetary
stimulus, or a stable policy, or increased restraint.
The CHAIRMAN. Well, would this give us a picture of how they
would expect monetary policy to achieve the unemployment target
and the inflation target?
Mr. HEINEMANN. This is one step beyond. I'm talking only about
the relationship—in the narrow, technical, operating sense—between what they do from day to day in the open market and how
that is going to be translated into a particular kind of monetary
control.
The CHAIRMAN. To apply to the Humphrey-Hawkins Act and
make it meaningful to the Congress and the public.
Mr. HEINEMANN. The next set of assumptions has to be an analysis, really, of the velocity of income, if you will, of the kind of
spending that's going to result. There's a mix between consumption
and investment goods, the working out of their forecast. Certainly,
that would fully specify the report in terms of what I would read,
as a casual observer, to be the intent of the Humphrey-Hawkins
legislation.
The CHAIRMAN. That's a very fine answer. I appreciate it.
And I want to thank you gentlemen so very much for your fine
testimony. This is one of the best panels we've had in a long, long
time. It's most constructive and thoughtful, and we're in your debt.
You have made a fine record.
[Whereupon, at 12:35 p.m., the hearing was adjourned.]
[Additional material received for the record follows:]




214
STATEMENT
OF THE

NATIONAL RETIRED TEACHERS ASSOCIATION
AND THE

AMERICAN ASSOCIATION OF RETIRED PERSONS

TABLE OF CONTENTS

Page
The Associations and the Elderly

1

The 1970's: Economics in Disarray

3

Restoring Economic Order

9

A Phased Reduction in the Growth of
Money Stock

11

A Stable Economy vs. Stable Money Markets . . . . .

14

Reducing the Money Stock Growth Rate: Will
It Bring on a Recession?

16

Monetary Policy for 1979

17

Employment and Inflation

21

Money:

24

The Quantity Matters

Monetary Growth and Prices

25

World Inflation and Monetary Accommodation

28

Appendix

31

TABLE I -Post-World War II Trends In Nominal and
Real Gross National Product and in Money Stock
(Ml Aggregate) 1947/1977
TABLE II - Monetary Growth As An Indicator of
Inflation
CHART - Trends and Fluctuations of Money, Prices,
Output, and Unemployment




215
The Associations and the Elderly
The National Retired Teachers Association and the
American Association of Retired Persons have a membership
in excess of 12 million persons.

This is a significant por-

tion of an elderly population that is increasing very rapidly.
In 1950 there were 18.5 million persons age 60 and over.

By

the year 2000, there will be 40.6 million.
The 75 and over segment of the elderly population is
increasing even faster.

In 1950, there were only 3.9 million

persons in that age category.

But by the year 2000, there

will be about 13.5 million - 3 1/2 times more than there
were in 1950.
The Associations have been leading proponents of the
idea that the elderly should, to the extent possible, be
encouraged to remain productive and useful members of our
society.

We feel that the proportion of the elderly who are

working is much too small; only 1 out of 5 men and only 1
out of 12 women 65 years of age and older are now working.
But even if this proportion is significantly increased (as
it must be if the elderly are to enjoy a reasonably adequate




216
standard of living in the future), the majority of the
elderly will be either fully retired or working only parttime.

Thus savings and private and public pensions will

continue to be the primary sources of income for most persons in their later years of life.
Yet these primary income sources are seriously
threatened.

The rapid decline in the value of the dollar

during the past decade has drained away a significant portion of the income of many of the elderly in real terms.
Our Associations are convinced that the monetary policy
pursued during this period was a major contributor to the
weakening of the dollar and the price inflation that account
for that loss.
Congress has the power to promote long range monetary
policies that would gradually reduce the currently high
(and rising) level of inflation. N- Regretably, much time
has already been lost.

There has been a refusal over the

past decade to face the fact that the money supply has been
excessively expanded year-after-year.

The lack of disci-

pline in controlling the expansion of money has been obscured
by much discussion of the details of money markets and




2

217
general macroeconomic objectives, and by an increasing acceptance of the idea that "money does not matter".
The levels of persistent ("hard core") inflation have
been rising over the past decade.

For this phenomena there

is no single or simple explanation; yet too often academic
and government economists have attributed it to "exogenous"
shocks of various kinds, which the economy cannot shake off
or to a number of microeconomic factors (the majority of
which have long been in existence but failed to raise the
rates of inflation significantly before the 1970's).
The 1970fs: Economics in Disarray
The 1950's and the 1960's were years of rapid and
sustained real wage and economic growth in this country.
In contrast, the years of the 1970's afford little comfort
to any sector of the economy.

The decade began with prices

tending to rise so fast that mandatory controls on wages
and prices'became a component of the economic stabilization
policy of the U.S. Government (August 1971 to April 1974) .
This experiment was followed by accelerated inflation:

in

1974 prices increased at an 11 percent rate in the United
States and at even higher rates abroad.

In late 1974 and

early 1975 the deepest recession of the post-war period set
in.

While the rate of inflation moderated, it still remain-




218
ed high but was now accompanied by high rates of unemployment.

The conjunction of these two factors, formerly thought

to be largely mutually exclusive, led to the popularization
of the word "stagflation".
The economic recovery, which began in 1975, has been
long and is continuing.

However it has been marked by de-

clining productivity, declining rates of investment and
stabilized

unemployment levels that are relatively high

(between 6 and 7 percent).

In addition, the annual infla-

tion rates have been high and persistent.

Because of the

sustained inflation levels more and more families have
found it necessary to have both husband and wife working to
attain any significant increase in living standard or just
to maintain what they already had.
little if any during the 1970's.

Real wages have risen

For the elderly living on

relatively fixed income - and especially for the elderly
middle class - these years have been a disaster.
Economic disarray has not been confined to this country.
Stagflation has become endemic in many of the older, industrial
countries.

However, although prices have been rising abroad,

the United States has found that it has been losing its
ability to compete with many of the products of foreign
industry like steel, electronic equipment and textiles.




4

219
It can be argued, with some force, that much of the
economic disarray on the international scene dates from
the August 15, 1971 suspension of the convertibility of the
dollar into gold for international settlements.

This, in

effect, ended the Bretton Woods agreement under which exchange parities between currencies had been fixed and during
the life of which post-war trade had flourished.
The second devaluation of the dollar (February 12, 1973)
suspended the Smithsonian Agreement.

This was the death

knell of any serious attempt, on a world-wide basis, to
reestablish fixed parities among the major currencies.

Since

the collapse of this agreement, international conferences
have brought little order to the international monetary
scene.

As the currency of the dominant free-world power,

however, the U.S. dollar continues to be the reserve currency
of most countries and provides much of the liquidity needed
for international transactions.
Unfortunately, the dollar has continued to decline in
value against such major currencies as the German mark, the
Japenese yen and the Swiss franc.

Unless the U.S. begins

to pursue tough anti-inflation policies, this decline is
likely to continue, contributing further to instability
abroad and exacerbating inflation at home.




5

220
There have been many who have felt that the U.S.
dollar has been undervalued and that the falling value
of the dollar in the foreign exchange markets should be
treated with "benign neglect".

However, as long as

foreigners see U.S. productivity declining, inflation
running apparently out of control and the U.S. money supply
expanding too briskly, they are likely to continue to discount the dollar.
The dollar's abrupt decline in the foreign exchange
markets during 1977 and 1978 prompted the government's
rescue attempt last November.

But while the government's

intervention in the exchange markets has halted the slide
in the dollar's value, this type of intervention - as the
British found in their many post-war attempts to support
the pound sterling - is only a palliative.

The attack on

the dollar will cease when we merid our economic ways and
that entails a "disciplining" of money supply expansion.
Also in the 1970's an important change has occurred
with respect to;this country's balance of payments.

Not

only have trade deficits appeared, but they are persistent and increasing in size.
$26.7 billion.

During 1977 the deficit was

This was four times larger than the previous

1972 record and demonstrates how far we have drifted from




221
the trade surplus situation which prevailed prior to 1971.
The problem is not just due to the cost of energy imports (now
running in excess of $40 billion) but also to an increasing
trade deficit in manufactured goods.

The international com-

petitive environment has changed; several countries (notably
Japan) have become more productive and innovative in manufacturing than we have and the governments of those countries
support their exports trade more aggressively than we do.
If it seems that we are unfairly painting the decade
of the 1970's as chaotic in the United States (and abroad),
we would point out that the 1978 "Economic Report of the
President" carried a detailed discussion of the "Origins of
the Current World Economic Disorder."

Cited as the principal

sources of disorder were prolonged inflation, rising unemployment and large current account imbalances.

While the report

cites the strong expansionary policies existing everywhere in
1972, the rising rates of inflation were attributed to nonmonetary factors:

the demand for raw materials and grains

during the early years of the decade, OPEC's quadrupling of
crude oil prices in 1973, and the wage/price momenetum which
had become institutionalized in the economies of many industrialized states.

The Council of Economic Advisors, which

prepared the report, has, in our view, however under-estimated the contribution that overly expansive monetary policy
has made to the economic ^instability of the 1970's.




222
In an October, 1978 Boston interview the well-known
Cambridge economist, Joan Robinson, spoke of the capitalist
world's arriving at a deep crisis, with the foundations of
its economies shaking loose.

She thought that the capitalist

world was up against the limits of its resources, with no
easy way out of the mess. Americans, she said, were "bastard
Keynesians" in that they believe that the capitalist economies
were essentially stable and that government spending could
bring unending growth and prosperity.
During the 1950's and early 1960's, this country experienced unparalled prosperity.

If the foundations are now

coming apart, perhaps it is because we have tried to follow
Keynesian economic prescriptions too closely since the mid19 60' s.

According to this school of economics, it is not

enough to give counter-cyclical fiscal help; the economy must
be perpetually fine-tuned.

An emphasizing of income stream

manipulation has lead to a deemphasizing of money value
stabilization.

Increasingly, the value of money has ceased

to matter.
In fact, however, money matters a great deal in a
capitalist society (and to the elderly in such a society).
If money is not reasonably stable, savings, investment, and
enterprise are at a disadvantage..

If money becomes highly

unstable, substitutes must be found, or industry will grind
to a walk.




8

223
Restoring Economic Order
The Associations believe that a fundamental (but by no
means the only) cause of -the economic disorder of the 1970's
had been the lack of stability of the dollar.

If economic

order is to be restored in the 1980's the dollar must be
stabilized in a dynamic sense by assuring that over the long
run the rate of growth in the money supply is tied to the rate
of growth in real (non-*inflationary) Gross National Product
(GNP).

The Council of Economic Advisors should set real GNP

growth rate targets for five year periods.

These targets and

the statistics that accumulate during the period should be
forwarded to the appropriate Congressional Committees so that
long term plans for the money supply as proposed by the
Federal Reserve/ can be closely coordinated.
Because present law requires the Federal Reserve Board
to submit a statement of its policy only for the one year
period for which the report is written, the scope of the policy
in terms of the time period covered is much too short.

What

are we proposing is a five year plan, which will, of course,
be subject to annual review and adjustments.

We think a plan

of this length is needed so that the rate of expansion of the
money supply, to the extent it exceeds the rate of real GNP
growth, can be brought down gradually and systematically,




9

224
without generating a serious recession.
The rationale for our proposal is this.

The country's

economic machine will apparently be capable of only an
annual real growth rate of between 2 and 3 1/2 per cent during the coming years.

Therefore the money supply growth rate

ought to be brought down gradually to this same range.
Obviously, the monetary expansion policy we call for is quite
the opposite of what has been pursued in the recent past.
A simple comparison between the growth of Ml money stock
and the growth of real GNP reveals that in the first two decades after World War II Ml grew at a slower rate than real GNP.
However, for the 9 years from 1967 through 1976, real GNP grew
at an annual rate of only 2.6, while the money stock grew at
a 5.8 per cent annual rate.

In the following pages we cite

much refined analysis of post-war money supply growth to
support what appears from a superficial examination of the
data - money stock growth rates have become so high that they
are supporting elevated rates of inflation.
We recognize that enabling legislation would be needed
to carry out our proposal for gradually reducing the money
supply growth rate and ultimately coordinating that growth
rate with the real GNP growth rate planned over a five year
period.

Immediately, however, the Federal Reserve Board can

See Table I in Appendix, p.




10

225
commence a phased reduction in the money supply growth rate,
without any new legislation.

The Banking Committees ought

to use the consultation process with respect to the monetary
policy proposals(that the Federal Reserve Board must present
each year under last year's Humphrey-Hawkins legislation) to
make sure such a gradual reduction is undertaken.
A Phased Reduction in the Growth of Money Stock
If any significant progress toward price stability is
to be made, the uncharacteristically high Ml growth rates of
the 1970's must be substantially lowered.

To avoid a serious

recession, the reduction should be at a steady rate, phased in
over a period of years.
A careful econometric examination of the possibilities of
this approach was made by Peter I. Herman, recently a senior
economist with The Conference Board.

Dr. Berman investigated

the usefulness of a number of measurements but determined upon
the Ml money stock for his final, econometric model, about

P. Berman, Inflation and the Money Supply in the United
States, 1956-1977 (1978).




11

226
which he had this to say:
"The correct specification for the Ml model
is a stable 10 quarter distributed lag with uniformly
sized weights. Since 1956, this model explains about
70 per cent of the variability in inflation. For the
1963-1971 period R2 increases -to 80 per cent and the
normally distributed residuals imply that, stochastically,
money growth completely explains inflation, i.e. the
real sector price effects are adequately captured in
the trend term."3
Mr. Herman assessed the effects of increases in the Ml money
stock as follows:" ....a permanently maintained 1 per cent increase in Ml growth will eventually increase inflation by 1.4
percentage points provided there is no change in the net influence of the real sector on the price level.

By inference,
4
the quantity theory may not hold in the near term."
The value of the model of course must be based on its
ability to forecast.

On this subject Dr. Herman had the

following to say:
"An out-of-sample forward simulation beginning
in mid-1971 gives impressive forecasts. For 1976
and 1977, the average forecast error is only 0.5 percentage point, and the forecast errors do not show
any sign of progressive deterioration
Only one
quarter 1977/2 has a forecast error exceeding two
standard errors, 1.6 percentage points. At the very
least, the Ml model is a useful forecasting tool."5

3

Id. at 6.

4

Id.

5

Id.




12

227
According to Herman, a phased reduction of 1 per cent
a year in the Ml growth rate would reduce inflation by about
4.5 per cent over a five year period.

A 1-1/2 per cent a

year reduction would reduce inflation by 4 per cent over a 4
year period.

A 2 per cent a year reduction - a "crash" pro-

gram - would reduce inflation by 4-1/2 per cent in 3 years.
The Associations would be satisfied with any phase-down
program(like the ones cited in the above paragraph)that could
be adopted without generating a major recession.

Because of

changes in banking practices, Ml may have to be redefined; M2
might be a better aggregate to serve as a standard for the
phase-down.

The main thing, as we see it, is to slow down

the growth of the money stock in a gradual and systematic
fashion. This recommendation calls for a gradual slowing of
the money supply growth rate until it is brought into line
with the rate of growth in real GNP.

This recommendation

also requires that GNP be targeted for monetary policy purposes.

In other words, the target GNP real rate of growth

figures must not be made so large that more inflation is
promoted.

Id. at 120.




13

228
Recommendations that monetary policy focus on planned
money stock growth over a five-year period and that the size
of the money stock be disciplined in accordance with the needs
of an expanding (or contracting) real GNP are recommendations
which represent substantial change from monetary policy as
practiced in the past.

The proposed policy would be focused

on changes in monetary aggregates rather than on changes in
interest rates.

We think such a shift in focus is called for. The

fact is that the dollar is now an inconvertible paper currency.
we cannot afford to continue to give in to popular demands for
cheap money and abundant supplies of money because this makes
the growth of the money supply/and the inflation such growth
facilitates,a secondary consideration for the central bank.
A Stable Economy vs. Stable Money Markets
With the adoption of House Concurrent Resolution 133
on March 24, 1975, the Congress began to emphasize the importance of money stock aggregates, requiring the Federal Reserve
Board to propose ranges of growth of monetary aggregates for
a twelve month forward period.

Historically, however, the

primary objective of central bankers including our own Federal
Reserve has been to keep "the financial structure on an even
keel" and the ideal situation for them has been financial




!

14 ,

Thus,

229
stability, with interest rates stabilized.
Our objection to having interest rate stability as the
primary focus of monetary policy is that supplies of bank
credit and money become determined by the demand for them.
Because changes in money supply are induced by changes in
private demands for money and credit, a rate stabilizing
policy results in money supply changes which tend to amplify
business fluctuations, rather than countering them.

Expand-

ing the money supply in order to moderate increases in interest rates is effected at the cost of increasing price inflation.

The correct approach it seems to us, is to keep

the money supply growing at a relatively steady rate in accordance with the needs of an expanding or declining real GNP.
Interest rate fluctuations should then be no cause of great
concern, since they would not be indicators of either an excessively deflationary or an excessively inflationary policy.
The history of the monetary policy of the 1970's - a disaster
in terms of its inflationary consequences - has led us to
conclude that pre-occupation with interest rates as the primary
guide for monetary policy is just not the correct course to
follow.
Because this country has had a history of low inflation
rates, we are only now beginning to appreciate the significance




15

230
of the inflation premium that is being added to real interest
costs.

Expanding the money supply to keep down interest rates

only yields temporary success; lenders soon perceive that they
will be paid back in a devalued dollar and thus must include an
inflation premium in their rate of interest.
sult is a rise in interest rates.

The long-term re-

An expansionary monetary

policy to keep interest rates down will, if it contributes to
more inflation, lead to even higher interest rates in the
future.
Reducing the Money Stock Growth Rate:

Will It Bring on

a Recession?
We have proposed a phased reduction in the rate of
growth of the money stock over a period of years to bring
it into line with real GNP growth rates. One questions that
will be raised is whether or not this course of action will
eventually produce a recession. ";We think it will not.

A

gradual slowing of the money stock growth rate has not produced recessions in the past.

As the chart in the appendix

on page 34 indicates, the gradual money stock growth rate reductions that occurred in 1955, 1962, 1965, 1971 and 1976
did not spawn recessions.

Only when the reductions were very

sharp, as they were in 1959, 1969 and 1973, did they tend to




16

231
bring on recessions.
A sharp reduction in ^growth rates will not be needed
and a serious recession can be avoided if a phased and systematic reduction is purused in the years immediately ahead.
The sharp reduction in money stock growth rates in the 4th
quarter of 1978 and the 1st quarter of 1979 is likely to
provoke a recession, if continued into the 2nd quarter of
1979.

This abrupt restraining of money supply growth might

not have been needed if monetary policy had been oriented
since 1976 to steady growth, rather than to interest rate
stability.
Since the last quarter of 1976, when Ml grew at a rate
of 7.7 per cent on an annual basis, and up until the last
quarter of 1978 when the present restraint began, the Ml
growth rate has dipped below 7 per cent only once - during
the 1st quarter of 1978.

These ftigh and sustained growth

rates have virtually institutionalized inflation in the 6 to
8 per cent a year range.
Monetary Policy for 1979
This Committee has responsibility for reconciling




17

232
the short term goals of the President's Economic Report with
the short term goals and targets of the Federal Reserve Board
and its Open Market Committee.

The Committee will be receiv-

ing proposals for various ranges for the monetary aggregates
from the Board for the coming quarters and proposals for interest rates to be established for Federal Funds.

We hope the

Committee agrees with one of the main points of this statement:
the Federal Reserve system cannot, at this juncture, adequately
control both monetary aggregates and interest rates; if the
focus is on interest rate stabilization, control of money stock
growth will be sacrificed; if the focus is on the monetary
aggregates, interest rates will fluctuate.

Our recommendation

is to abandon the past emphasis on interest rate stabilization
and concentrate instead on control of money stock growth in
the context of a long range - preferably 5 year - plan.
It follows from our recommendation that we believe the
Committee should relate the proposals of the Federal Reserve
Board for the control of monetary aggregates to the expected
growth of real GNP for the coming years.

The President's

January 25, Economic Report has estimated the real GNP will
grow

at a rate of only 2 1/4 per cent during calendar year

1979.

This is optimistic when compared to the - 0.1 to 1.9

per cent real GNP growth rate which the Congressional Budget
Office projects for the period 1978:4 to 1979:4.




18

The CBO

233
estimates real GNP growth for 1979:4 to 1980:4 in the range
of 2.7 to 4.7 per cent.

While the Economic Report speaks of

monetary restraint, there are no specifications whatsoever
for restraint under the discussion of "Policies to Control
Inflation."-

This failure to be specific about monetary

restraint by relating money stock to the needs of the economy
as measured by real GNP is puzzling.

Could it be the Administra-

tion has failed to recognize the connection between the economic disorder of the 1970's and the undisciplined expansion of the
U.S. money supply?
It appears that an annual four percent real economic
growth rate is not attainable in the immediate future.

De-

clining investment, declining productivity, rising energy
costs and other factors appear to preclude that.

Politicized

goals for real GNP growth cannot be trusted as a guage for
the expansion of the money supply.

The Wharton School's

econometric projection of real growth in GNP for the 5 years
ending with 1985 is an annual average rate of 3.2 per cent.
As a long range goal, we think an average annual rate of
growth in the money stock of 3 per cent would be appropriate
and non-inflationary.

However, we ought to move toward this

optimum growth rate over a period of years to avoid bringing




19

234
on a severe recession by decelerating to quickly from the
very rapid growth rates of the recent past.
For simplicity we are specifying our plan for reducing
money stock growth in terms of Ml.

Nevertheless we recognize

that changes in the ways banks and thrift institutions handle
accounts may make it necessary to restate the resulting Ml
stock aggregates in nominal currency.

If so, the Federal

Reserve Board is fully capable of making such a re-statement.
Alternatively, the Federal Reserve might wish to use another
aggregate such as M2.

But the objective is to arrive, in a

systematic manner at the end of a period of years at a money
supply rate of expansion that is no greater than the rate of
growth of real GNP.
The phased reduction that we propose would proceed in
accordance with the following schedule.
Ave. Ml Money
Stock Growth
4 Quarters

Year

1979
1980
1981
1982

6%
5%
4%
3%

If this schedule does not reduce the inflation rate to 2 per
cent a year, a further reduction in the growth of money stock




20

235
could be made in 1983, so that annual inflation is reduced
to this rate.
The adoption by Congress and the Federal Reserve system
of a disciplined method for controlling the expansion of the
money stock should begin to dampen inflationary expectations
immediately.

The world will be put on notice that this

country intends to defend the value of the dollar on a long
range basis.

Persistent, elevated rates of inflation should

gradually fall.

Vigor should be restored to our capital mar-

kets, both in equity offerings and in fixed securities, since
lenders will be able to calculate real long range returns with
reasonable accuracy.

New enterprise should be promoted with

the elimination of the uncertainties affecting the return on
investment created by fluctuating, elevated rates of inflation.
The return of relative stability to the dollar should eliminate
the enormous inflationary burdens that the social security system would otherwise have to bear.

Finally, the growing elderly

population'should be better able to sustain themselves through
savings.
Employment and Inflation
We know the Committee will be reviewing short term
monetary policy against the economic goals set forth in

7

P. Berman, supra note 1, at 14, 20




21

236
The Full Employment and Balanced Growth Act of 1978.

The

Associations have expressed on many occasions our support
for counter-cyclical action by the Federal Government to
promote employment and business activity during the declining phase of the business cycle.

However, we are much

opposed to the Federal Government's pursuit of stimulative
monetary and fiscal policies as full employment is approached.

We believe that the pursuit of stimulative policies

in both good economic times and bad has been another major
factor contributing to the lifting of the inflation rate
levels.

The Federal Reserve system has found itself obliged

during recent quarters to try and brake the inflation rate
which has once again risen to double digit levels by freezing the expansion of the money stock and by raising the
Federal Funds rate to very high levels.

This action is cer-

tain to promote uncertainties of all kinds in the business
>
community and to induce a severe recession if continued.
We hope the Committee will agree with the point of
view of our testimony that monetary policy ought not to be
used to expedite short term economic goals but instead
should focus on the long term goal of expanding the money
supply in accordance with the rate of expansion of real GNP.




22

237
Because many researchers have found that the money supply
tends to act slowly on prices and business activity, monetary
policies should not be changed on an ad hoc basis from quarterto-quarter or even from year-to-year; underlying all changes
in policy should be sound long range planning.

The failure

to follow a long range policy of expansion has made for stopand-go policies (even during the present economic recovery)
that have had damaging effects on employment and on the rate
of persistent inflation.
The Humphrey-Hawkins bill was intended, in the eyes of
some of its sponsors, to be a blueprint for economic action
by the Federal Government.

However, not only do we consider

its goals to be rather "dated", but we have also found that
the methods of control implied by the bill - fine-tuning of
the economy - work poorly as evidenced by the results of the
past decade.

Full employment godls in the 3 to 4 per cent

range fail to take account of important changes in the working population.

Phillip Cagan of the American Enterprise

Institute has estimated that full

employment at which infla-

tion neither increases nor decreases is somewhere between
5.9 and 6.3 per cent.

We believe that the goals of full em-

ployment and low inflation for the United States can best




23

238
be promoted by stabilizing the value of the dollar by methods
we have outlined in the previous paragraphs.
Money;

The Quantity Matters

The thesis of our statement is that the quantity of money
issued by government is an important determinant of the exchange
value of that money and to stabilize its value, long range monetary policy should center on a planned expansion of the money
stock in accordance with the expansion (or contraction) of GNP
in real terms.
While we have referred to certain studies in previous
paragraphs, we would like to conclude our statement with
descriptions of two more, one by the Federal Reserve Bank of
St. Louis, and one by the Brookings Institute.

Both find a

close association between money supply expansion rates and
rising price levels.

However, before proceeding to these,

we would like to refer to an older study of great depth, which
was done by Milton Friedman and Anna Jacobson Schwartz, The
Monetary History of the United States 1867-1960.

One of

their most important findings is summarized in the following
quotation from that study:




24

239
"Throughout the near-century examined in detail
we have found that:
1. Changes in the behavior of money stock have
been closely associated with changes in economic
activity, money income and prices.
2. The interrelation between monetary and economic changes has been highly stable.
3. Monetary changes have often had an independent origin; they have not been simply a reflection
of changes in economic activity."
Although it is nearly twenty years since these conclusions
were formulated, we have no reason to believe that they are
other than fundamentally sound.

In saying this we are not try-

ing to make money stability the touch-stone of economic prosperity.

We are simply affirming again that money changes -

which are long range in their effect on economic activity and
on prices - are important - so important that they must be made
according to a long range plan.

We simply can no longer afford

"stop-and-go" monetary policies or policies that shift with the
political winds.
Monetary Growth and Prices
A December 1978 study by the Federal Reserve Bank of
St. Louis demonstrated that there is a simple monetary guide
to the rate of inflation: the rate of change in prices over
the next year will be about equal to the average rate of
growth of the money stock over the previous five years.7
7

Albert E. Burger "Is Inflation All Due to Money?",
Bulletin of the Federal Reserve Bank of St. Louis
(December 1978).




25

240
As shown in Table II of the appendix (page 33)-, over the
nineteen year period 1953-71 the average difference between
the actual rate of inflation and the rate indicated by the
past rate of monetary expansion was only 0.2 of a percentage
point.

In two-thirds of the years the error in the predicted

rate was 0.5 of a percentage point or less.

It was found that

although prices oscillated around the trend rate on a quarterto-quarter basis, the rate of change of prices returned consistently to that dictated by the rate of monetary expansion.
Also during this period it was found that the five-year
trend in the growth of money accurately indicated changes in
the year-to-year rate of inflation, up or down.

For example,

as the trend in the growth of the money slowed in the period
1958-63 the rate of inflation slowed down.

Over the next eight

years the trend in the growth of money accelerated steadily
from around 2 per cent a year to 5 per cent and this corre-i
y

sponded with a rise in the annual inflation rate from, 2 to 5
per cent. •

Over the short run the level of prices may be strongly
influenced by factors other than the trend in the growth of
the money supply.

However, after the effects of the non-

monetary factors (frequently described as shocks) have been
absorbed into the economy the level of prices tends to revert




26

241
to the trends indicated by the past growth in the money
supply.

Table II shows that prices in 1974 and 1975 rose far

higher than what would be indicated by the past five-year
growth in the money supply.

The shocks that raised prices

over the trend lines were the two separate dollar devaluations
of 1973, which raised the costs of imports in the following
years, the worldwide food shortages of 1973 and 1974, the fourfold increase in world crude oil prices dating back to mid-1973,
and raw material shortages.

Price levels in those two years

were probably also boosted by widespread expectations of inflation.

But in 1976 and 1977 the inflation rates reverted to

those indicated by past growth in the money supply; the 1977
inflation rate of 5.9 per cent was only 0.1 percentage points
off target.
We do not cite this study as proof that there is a
mathematically verifiable relationship between the level of
prices and the growth of the money supply; it remains possible
that other factors could account for the apparent relationship
between price levels and past money supply growth rates.
However, elaborate econometric models of the economy have been
failing to forecast the rate of inflation with reasonable
accuracy since the rates began to accelerate in the late




27

242
sixties.

The money stock method for predicting inflation

rates ought at least to be deemed a useful tool.

In addition,

it raises the possibility that more elaborate demonstrations
may prove a casual relationship between money supply changes
and changes in the rates of inflation.
World Inflation and Monetary Accommodation
An important econometric study of the sources of inflation in this country and several other industrial countries
was described in the "Brookings Papers on Economic Activity,
8
2: 1977."
The Report was supervised by Robert J. Gordon of
Northwestern University.

The research was supported by the

National Science Foundation.

The period analyzed covered the

years 1958 to 1976.
The major alternative explanations for the acceleration
in the rate of inflation since 1965 and the advent of world
V

wide inflation have been monetary expansion, (an increase
attributable primarily to the excessively expansionary monetary policy of the United States) and wage-push inflation,
promoted by the strength of labor unions.

The paper assumes

that in the long run inflation is a monetary phenomenon, confirmed by many studies on the connection between the growth
o

R. Gordon, "World Inflation and Monetary Accomodation in
Eight Countries", Brookings Papers on Economic Activity
(1977).
"




28

243
of world money and prices.

However, this is to be regarded

as an initial step in the understanding of the inflation process, because the sources of change in the money supply remain
to be explained.

In other words, we may correlate world prices

and money but we do not rule out wage-push as a source of
world monetary growth.

We ought not to regard the behavior of

the monetary authorities and wage-push factors as competitive
explanations for inflation, because the monetary authorities
may be expanding the money supply to accommodate wage-push and
other causal factors like fiscal deficits, supply shocks and
the counter-cyclical monetary reaction function.

Thus, if we

are analyzing why the monetary authorities are expanding the
money supply at certain rates, we must investigate the various
factors that may be affecting their judgement.

The reason

that wage-push factor assumes so much importance is that central bank must - for political reasons - expand the money
supply so that it is adequate to'ratify any given level of
money wages, regardless of how the wage levels are determined.
If they fail to do so, excessive unemployment may be the consequence.
Econometric analysis of the relative importance of the
various sources of inflation is a difficult task.




29

The results

244
- 30 of the study can only be accepted with reservations.
theless, the study is solid in one respect:

Never-

the growth of

the money supply was found to be a critical factor in determining the inflation rate and control of money supply growth
was found to be essential to control of inflation.

The im-

portance of this conclusion is such that we quote this
particular summation as set forth in the study.
"Is the control of the money supply sufficient to control inflation?!1 Money growth has a significantly positive impact on wage growth in four major countries making up 72 per cent of the 1976 GNP of the eight countries considered here. Not only does this tend to deny
the contention of some wage-push proponents that wage
claims are numbers "picked out of thin air," but it
also supports the international-monetarist position
that control of world monetary growth is a crucial
requirement in the determination of the world inflation rate. A qualification is that in the remaining
four countries the effect of money on wages is weak or
nonexistent. A further qualification is that the estimated elasticity of wages with respect to money is
small, and that of prices with respect to money is
smaller still. Finally, this effect of money on
prices apparently operates in conjunction with the
effect of money on output. " v;




30

245
APPENDIX

TABLE I
POST-WORLD (AJAR II TRENDS livl NOMINAL AND REAL GROSS N A T IONAL PRODUCT AND IN MONEY S T D C K ( ffll AGGREGATE)1947/1977
(All figures in Billions)
Year

Nominal
GNP

Money
Stock
ifil Aggregate

Real GNP in
1972 Dollars

1947
1948
1949
1950
1951
1952
1953
1954
1955
1956
1957

$232.8
259.1
258.0
286.2
330.2
347.2
366.1
366.3
399.3
420.7
442.8

$113.1
111.5
111.2
116.2
122.7
127.4
128.8
132.3
135.2
136.9
135.9

$468.3
487.7
490.7
533.5
576.5
598.5
621.8
613.7
654.8
668.8
680.9

1958
1959
1960
1961
1962
1963
1964
1965
1966
1967

448.9
486.5
506.0
523.3
563.8
594.7
635.7
688.1
753.0
796.3

141.1
143.4
144.2
148.7
150.9
156.5
163.7
171.3
175.7
187.3

679.5
720.4
736.8
755.3
799.1
830.7
874.4
925.9
981.0
1007.7

1968
1969
1970
1971
1972
1973
1974
1975
1976

868.5
935.5
982.4
1063.4
1171.1
1306.6
1413.2
• 1516.3
1692.4

202.2
208.8
219.6
233.8
255.3
270.5
283.1
294.8
311.9

1051.8
1078.8
1075.3
1107.5
1171.1
1235.0
1214.0
1191 .7
1265.0

30 yr.
awe. an.
growth
rate

7 . A/O
I"/
i

3 . 6%

3 . 5c/o

IY11 G r o w t h rates: 1947/1957 -1.9/o; 1957/1967 -3.3%;
1967/1976 -5.8>u.
Real GNP growth
rates: 1947/1957 -3.8/i; 1957/1967 -4.0^;
1967/1976 -2.6/0.
Date from various government sources as given in the
1977 Economic Report of the President.
- 31 -




246
TABLE II
M O N E T A R Y GHLUTH A5

\N INDICATOR UP 1 N F L A T I U N

(1)

Period

Growth Rate
of Money

Period

(2)
Growth Rate
of Prices

(0- (2)

1947-52

2 . 3°/o

1953

1948-53

2.7

1954

1.4

1.3

1949-54

3.2

2.2

1.0

1950-55

3.3

1951-56

2.7

1955
1956
1957

1952-57

1.8

1953-58

1.5

1954-59

2.0

1955-60

'1,3

1956-61

1.5

1957-62

1.8

1958-63

2.2

1959-64

2.2

1960-65

3.1

1961-66

3.6

1962-67

4.0

1963-68

4.8

1964-69

5.2

1965-70

5.1

1966-71

5.5

1967-72

6.1

1968-73

6.2

1969-74

6.1

1970-75

6.2

1971-76

6.0

1.5/0

0.8

3.1

•0.2

3.4

-0.7

1958
1959

1.6

0.2

2.2

-0.7

1960
1961

1.7

0.3

0.9

0.4

1962
1963
1964

1.8

-0.3

1.5

0.3

1.6

0.6

1965
1966'
1967

2.2

0.0

3.3

-0.2

2.9

0.7

1968
1969
1970
1971

4.5

-0.5

1972
1973
1974
1975
1976
1977

5.0

-0.2

5.4

-0.2

5.1

0.0

4.1

1.4

5.8

0.3

9.7

-3.5

9.6

-3.5

5.2

1.0

5.9

0.1

Table reproduced from Page 9, December 1978 Review of
the Federal Reserve Bank of St. Louis, "Is Inflation
all Due to Money?"




247
Trends and Fluctuations of Money, Prices, Output, and Unemployment
'95' 19-5 I9S6 1957 1958 19S9 1960 1961 1962 1963 1964 1965 1VJ(- 1967 1968 1969 1970 1971 19?2 1973 1974 1975 1976 1977 1978 1979




248
Carnegie -Mellon University

Graduate School of Industrial Administration
William Larimer Mellon. Founder

Schenley Park
Pittsburgh, Pennsylvania 15213
[412] 578-2283
Allan H. Meltzer
Maurice Falk Professor of
Economics and Social Science

March 14, 1979

Senator William Proxmire
United States Senate
5241 Dirksen Building
Washington, D. C. 20510
Dear Senator Proxmire:
Enclosed are the most recent statements of the Shadow Open
Market Committee. You will note that we have issued two statements this time. One discusses the redefinition of monetary
aggregates.
The Committee believes that there is a serious risk of an
error in monetary policy arising because of current uncertainties
about the definitions of the monetary aggregates. The committee
believes that Congress should act promptly to reduce the risk of
serious error.
May I again ask you to circulate our recommendations to the
members of the Senate Banking Committee?
Cordially,

Allan H. Meltzer
AHM/jep
encl.




249
SHADOW OPEN MARKET COMMITTEE

The Committee met from 1:30 p.m. to 8:00 p.m. on Sunday, March

11, 1979.
Members:
Professor Karl Brunner, Director of the Center for Research in Government Policy
and Business, Graduate School of Management, University of Rochester,
Rochester, New York
Professor Allan H. Meltzer, Graduate School of Industrial Administration, CarnegieMellon University, Pittsburgh, Pennsylvania
Mr. H. Erich Heinemann, Vice President, Morgan Stanley & Company, inc. New York,
New York
Dr. Homer Jones, Retired Senior Vice President and Director of Research, Federal
Reserve Bank of St. Louis, St. Louis, Missouri
Dr. Jerry Jordan, Senior Vice President and Chief Economist, Pittsburgh National
Bank, Pittsburgh, Pennsylvania
Dr. Rudolph Penner, American Enterprise Institute, Washington, DC
Professor Robert Rasche, Department of Economics, Michigan State University, East
Lansing, Michigan
Professor Wilson Schmidt, Department of Economics, Virginia Polytechnic Institute,
Blacksburg, Virginia
Dr. Beryl Sprinkel, Executive Vice President and Economist, Harris Trust and Savings
Bank, Chicago, Illinois
Dr. Anna Schwartz, National Bureau of Economic Research, New York, New York




250
POLICY STATEMENT
Shadow Open Market Committee
March 12, 1979
A surge of inflation in 1978 and 1979 has made the effects of excessive
monetary and fiscal stimulus visible to all. Inflation reached an average of 9%
in 1978 and is likely to be even higher in 1979.

In the past two years, the

dollar has depreciated substantially against the currencies of our trading partners. Oil price increases have added to the costs borne by consumers and producers. Although political events in Iran contributed to the most recent rise
in oil prices, most of the current inflation is the result of misdirected economic policies of the Federal Reserve and the Federal Government in recent
years.
Many forecasters predict that recession and rising unemployment will add to
the nation's economic problems in 1979.

Recessions have occurred at irregular

intervals during most of our history, and no fundamental change has occurred to
break the pattern.

The occurrence of a recession possibly could be postponed by

increasing monetary and fiscal stimulus; however, additional stimulus at this
time would further raise the ultimate cost of reducing inflation. The Shadow
Open Market Committee is strongly opposed to the adoption of stimulative fiscal
and monetary policy to postpone a recession.
The desire to "do something" about rising inflation appears to have produced a shift towards antiinflation policy in recent months. It should be
recognized that inflation this year has largely been predetermined by past
policies. Increasingly restrictive steps over the coming months should be
avoided, but also the temptation to reverse policies once again when the economy
slows must be resisted.




251
The principal aim of economic policy, now and in the future, should be to
establish conditions under which the U.S. and other market economies can achieve
stable, noninflationary growth and rising standards of living in the 1980's.
Another round of "stop and go" culminating in higher inflation and slow growth
of productivity in the early 1980's is a highly probable outcome if a break with
past approaches to stabilization is not made at this time.
What Has Been Done
For the fifth time in two decades, lower inflation and a smaller budget
deficit are given high priority in the rhetoric about economic policy. But the
words will not necessarily be matched by deeds. Announced policies are likely
to increase instability in the near term, while not offering any assurance of
increased stability in the early eighties.
Current economic policy has three main features:
(1) A pitiably small reduction in the proposed budget deficit for
the fiscal year starting next October, to be achieved principally
by allowing inflation to increase taxes. Estimates by the Congressional Budget Office show no reduction in the budget deficits
for fiscal 1980.
(2) An unprincipled system of coercion masquerading as voluntary price and wage restraint.

Programs of this kind confuse the

symptoms of inflation with the causes of inflation, encourage strikes,
involve the President and his staff in collective bargaining to
the detriment of that process, impose large costs of compliance,
arbitrarily restrict the incomes earned by particular groups of




252
workers and firms, but do nothing to slow inflation. The many attempts at formal or informal wage and price controls, here and
abroad, during the past fifteen years have not produced success for any policy of this kind.
(3) Continued emphasis on the level of short-term interest
rates as a measure of the degree of monetary restraint. In the
past, emphasis on interest rates has caused excessive monetary
growth and rising inflation during years of economic expansion, and
insufficient monetary growth and recession at other times.
In 1976, 1977 and 1978, the Federal Reserve refused to permit modest,
prompt increases in interest rates in response to the borrowing demands of
the public and private sector. Instead, money growth and inflation rose, and
the dollar fell on foreign exchange markets.

Eventually, market interest rates

and inflation rose to much higher levels than would have been required if a
policy of gradually reducing money growth had been followed in these years.
Now the risks are in the opposite direction. If private demand for credit
were to slow, a policy of controlling short-term interest rates would cause
money growth to fall. The economy would be pulled into a deeper recession than
is required to slow inflation.
The risks of serious recession are increased by the absence of reliable
information about the nation's money supply. The interaction of inflation with
interest rate ceilings, complex reserve requirements, and new regulations prevent
the public and the government from knowing what is happening to actual money
growth. Congress should promptly eliminate restrictions on the payment of
interest on demand, time, and savings deposits as part of a program to restore
the reliability of data on the monetary aggregates.




253
What Should Be Done?
The high priority now given to controlling inflation will have no lasting
effect on inflation unless it is a part of a sustained program. Anything less
than a sustained program, lasting three to five years, would be a costly, wasted
effort. After fifteen years of rising inflation and many commitments by past
administrations and Federal Reserve officials, skepticism is large and government credibility is small.
At our meeting last September, we urged that monetary growth be reduced as
one part of a program to end inflation and restore stability within the next
five years. Although excessive monetary growth continued in the fall, there is
growing evidence that the annual growth rate of money has now been reduced even
after adjustment for change in definitions. We believe that further reductions
in the annual growth rate of the money aggregates at this time would be a mis.take. Instead we urge:
One - the importance of growth in monetary aggregates is now widely recognized. Uncertainty about these growth rates can lead to major errors in the
interpretation of monetary policy and to severe recession or increased inflation. Uncertainty can be minimized only if Congress removes controls on the
payment of interest on demand and time deposits. Continued failure to act
imposes large risks and small benefits.
Two - the growth of the monetary base should be 8% for the year ending in
August 1979.

This is consistent with the recommendation of this Committee at

our meeting in September 1978, when we selected the monetary base, as published
by the Federal Reserve Bank of St. Louis, as the most reliable measure of monetary growth currently available in this period of uncertainty about the interpretation of growth rates of monetary aggregates. The monetary base is entirely




254
controllable by the Federal Reserve since changes in the base are the direct
result of changes in the Federal Reserve portfolio. To control the size of its
securities portfolio — which is the principal source of the monetary base
— the Federal Reserve must allow short-term interest rates to respond freely
to forces in the open market.
Three - we have urged repeatedly that the Federal Reserve adopt a fiveyear program to end inflation by reducing the growth rate of the monetary base
by 1% a year for the next five years. The need for a program of this kind has
now been recognized by Chairman Miller. During the past four months, the Federal Reserve has not made any effort to announce and implement the program. The
Federal Reserve can reduce the cost of ending inflation by publicly accepting a
commitment to sustained, gradual, but persistent reductions in money growth.
Four - productivity has grown at an average rate of 1% for the past two
years. Capital investment has lagged behind the growth.of the labor force. To
encourage investment and output, Congress should further reduce the growth of
government spending (including off-budget items) below the recommendations of
the President, and reduce real tax rates. A tax reduction bill, to reduce the
real burden of taxation on households and firms should be passed early in the
session to encourage investment.
Five - to reduce uncertainty in financial markets, Congress should move at
once to repeal the Credit Control Act of 1969 and the International Emergency
Economic Powers Act of 1977. These laws -- which, respectively, create standby
authority for (1) direct government control of domestic financial markets and
(2) the imposition of foreign exchange controls in peacetime — are unnecessary.
Should the Administration ever implement these authorities, the result would be
counterproductive and very costly to American society.




255
REDEFINING THE MONETARY AGGREGATES
Statement on Monetary Aggregates
Prepared by the Shadow Open Market Committee
March 12, 1979
Monetary aggregates are now widely recognized as important indicators of
exchange rates, interest rates, inflation, and economic activity. Central banks
in several countries now seek to control some monetary aggregates, and even the
Federal Reserve states target rates of growth for various monetary aggregates.
Governments, central bankers, investors, and savers throughout the world draw
inferences about the future by observing trends in monetary aggregates. While
foreign central banks have employed some variant of the monetary base concept,
the Federal Reserve has stated its targets exclusively in terms of the money
stock concept.
The monetary base statistics have proven to be accurate and reliable over
extended periods of time. However, money stock statistics periodically have
been subject to major revisions after the identification of measurement errors.
As long as errors in the reported statistics remained small or could be regarded
as constant, no major problems of interpretation arose. Currently, errors appear to be large and variable. The possibility of a major error in monetary
policy or in private decisions based on a misinterpretation of monetary aggregates as currently recorded has increased.
The Federal Reserve Bulletin for January, 1979, invited interested parties
to comment on the staff's proposals to redefine the monetary aggregates so as to
reduce potential errors of interpretation. Our Committee believes that the
proposed changes in definition are in the right direction. However, the published
proposal neither addresses the central problem nor fully adjusts the definitions
for past changes in financial arrangements. Measures of the monetary aggregates
can never be entirely accurate, but current errors can be reduced to more
acceptable levels.




256
The staff of the Board of Governors proposes two principal types of change
to M-l and M-2. One removes deposits of foreign banks and official institutions
from these aggregates.

The other adds consumer-type transaction deposits at

thrift institutions to the aggregates.
The proposal does not incorporate into the monetary aggregates the effects
of substantial changes in businesses1 asset management practices such as the use
of overnight repurchase aggreements, overnight Euro-dollar deposits and other
relatively close substitutes for bank deposits. These practices appear to have
as much importance for the levels and rates of change of monetary aggregates as
the items in the staff proposal. Currently, there are no comprehensive measures
of these items. The Federal Reserve should promptly institute sampling procedures to .assure adequate measurement.
It is regrettable that the Federal Reserve did not foresee the need to
change its data collection procedures in advance of the regulatory changes it
recently instituted. Future changes in regulatory practice should be coordinated
with monetary policy and data collection.
The Central Problem
The central problem cannot be solved permanently by changing definitions.
There is now a large and rapidly growing volume of financial assets not subject
to ceiling rates on deposits, not covered by Federal Deposit Insurance programs,
and in some cases not subject to reserve requirements. The private benefits
from these arrangements are entirely the result of archaic regulations and controls on interest rates.
Interest rate controls on savings, time, and demand deposits encourage
innovation to circumvent regulations. Differential reserve requirements for the
types of liabilities issued by banks and non-bank institutions provide additional




257
incentives to innovate. The relatively high market rates of interest, resulting
from past and currently anticipated inflation, increase the incentives for
owners and issuers of financial liabilities to circumvent regulations and controls on the payment of interest. The net social cost resulting from misinformation about the growth of the aggregates is high and probably is rising.
The proper remedy is to remove these restrictions and controls. The Congress, the Federal Reserve, the Federal Home Loan Bank Board, and other regulatory
agencies should act promptly to remove controls on interest rates and other
incentives to socially wasteful innovation.





Federal Reserve Bank of St. Louis, One Federal Reserve Bank Plaza, St. Louis, MO 63102