Full text of Monetary Policy Oversight : Senate Hearings : Federal Reserve's First Monetary Policy Report for 1981 : Hearings Before the Committee on Banking, Housing, and Urban Affairs, United States Senate, Ninety-Seventh Congress, First Session

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FEDERAL RESERVE'S FIRST MONETARY
POLICY REPORT FOR 1981

HEARINGS
BEFORE THE

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

OVERSIGHT ON MONETARY POLICY REPORT TO CONGRESS
PURSUANT TO PUBLIC LAW 95-823
FEBRUARY 25 AND MARCH 4, 1981
Printed for the use of the Committee on Banking, Housing, and Urban Affairs




[97-8]

U.S. GOVERNMENT FEINTING OFFICE
WASHINGTON ; 1981

COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
JAKE GARN, Utah, Chairman
JOHN TOWER, Texas
HARRISON A. WILLIAMS, JR.. New Jersey
JOHN HEINZ, Pennsylvania
WILLIAM PROXMIRE, Wisconsin
WILLIAM L. ARMSTRONG, Colorado
ALAN CRANSTON, California
RICHARD Q LUGAR, Indiana
DONALD W. RIEGLE, JR., Michigan
ALFONSE M. D'AMATO, N«w York
PAUL S. SARBANES. Maryland
JOHN H. CHAFRE, Rhode Island
CHRISTOPHER J. DODD, Connecticut
HARRISON SCHMITT, New Mexico
ALAN J. DIXON, Illinois
M- DANNV WALL., Staff Director
HOWARD A. MENELL, Minority Staff Director and Counsel
JOHN T. COLLINS, Counsel
CHARLES L. MAHINACCIO, Minority Counsel




CONTENTS
WEDNESDAY, FEBRUARY 25, 1981
Page

Opening statement of Chairman Garn

1
WITNESS

Paul A. Volcker, Chairman, Board of Governors, Federal Reserve System
Technical operating techniques
Targets for 1981
Panel discussion:
Potential confusion of monetary policy
Tax cuts
Bringing interest rates down
Limited anti-inflation fight
Balanced budget by 1984
Defense spending and inflation
President s tax cut program
Encourage a higher savings rate
Confidence in economic program
Monetary target range
Credit market activity
Credit controls released
Employment and monetary policy
Dangers to the thrift industry
Transaction accounts
Competitive equity
Inflation predictions
Maintain tight monetary policy
Tax policy
Noncommittal policy
Prepared statement
Table 1—Planned and actual growth of monetary and credit aggregates
Table 2—Growth of money and bank credit
Appendix S—Treatment of reserve items for institutions granted the
banker's bank exemption
Monetary policy report to Congress:
Chapter 1. A Review of Developments in 1980
Section 1.1 Monetary Policy and the Performance of the
Economy in 1980
Section 1.2 The Growth of Money and Credit in 1980
Section 1.3 Issues in Monetary Control
Chapter 2. Monetary Policy and the Prospects for the Economy
in 1980
Section 2.1 The Federal Reserve's Objectives for the Growth
of Money and Credit
Addendum: The Impact of Nationwide NOW Accounts on
Monetary Growth in 1981
Section 2.2 The Outlook for the Economy
Appendix. Staff Study of the New Monetary Control Procedure:
Overview of Findings and Evaluation
Answers to subsequent questions of Senator Garn
Letter to Senator Garn concerning weekly money supply data
(HI)




2
2
4
7
9
10
11
13
14
15
17
19
21
24
26
27
29
31
32
34
37
39
41
42
52
52
53
55
55
67
76
88

88
92
94
98
134
145

IV

WEDNESDAY, MARCH 4, 1981
Page

Opening statement of Chairman Garn

159

WITNESSES
Murray L. Weidenbaum, Chairman, Council of Economic Advisers
Prospective impact of the program
Regulatory policy
Prepared statement
;
Monetary policy
Regulatory policy
Tax policy
Budget restraints
Overriding theme
Controlling money and credit
Panel discussion:
Types of coordination
Budget cuts accompanied by tax cuts
Stop and go policy
Pragmatists versus theorists
Committee recommendations
Measuring the money supply
CPI inadequate measure
Reviewing operational policies
No increase in the debt limit
Tax package timing
Saving accounts losing money
Are tax cuts inflationary?
Garn-Proxmire resolution
Operating loans difficult to obtain
Jerry L. Jordan, dean, Robert O. Anderson Schools of Management, University of New Mexico
Fed's reputation damaged
Erratic monetary growth
Recommendation
Prepared statement
Monetary policy actions in 1980
Money growth in 1981
Prospects for reducing inflation
David M. Jones, vice president-economist, Aubrey Lanston Co
Flaw in administration's budget program
Problems with reducing the money supply growth
Prepared statement
Federal Reserve policy
The Reagan budget program
Financial and economic conditions
Table I—Selected monetary aggregates, actual growth versus Fed
targets
Table II—Federal receipts, spending and deficits
Table III—Consumer spending, prices and savings
Chart I—Yields on selected securities
Bond market best sounding board
Panel discussion:
Reprint of article from Morgan Guaranty Survey
Delay of tax cuts
Corporate tax cuts
Double taxation
Federal Reserve activities criticized
Monitoring the Federal Reserve Board
No guarantee of hitting targets
Economic future depends on fiscal prudence

159
160
162
163
164
167
168
168
169
170
171
173
175
176
178
181
181
183
185
188
189
192
193
196
197
197
198
200
201
206
208
210
212
212
213
221
222
225
226
229
230
232
231
220
214
232
234
237
238
240
242
244

ADDITIONAL DATA
Briefing materials from the Congressional Research Service, Library of Congress




148

FEDERAL RESERVE'S FIRST MONETARY
POLICY REPORT FOR 1981
WEDNESDAY, FEBRUARY 25, 1981

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 Jake Garn (chairman of the committee)
presiding.
Present: Senators Garn, Tower, Heinz, Lugar, Williams, Proxmire, and Riegle.
OPENING STATEMENT OF CHAIRMAN GARN

The CHAIRMAN. The committee will come to order.
We are happy to have you with us today to receive your testimony.
During the past year the Federal Reserve has been pursuing a
generally restrictive monetary policy. Unfortunately, with the
downturn—even with the downturn last year, inflation continued
to build up. Although the Fed attempted to implement a consistent
policy, the monetary aggregates fluctuated rapidly. Economic activity rose and fell quickly, partly due to the unfortunate use of credit
controls last spring.
I have been one who has generally supported the Fed's efforts to
maintain control of growth in the money supply. As you and I have
discussed many times, Mr. Chairman, I have always said that it
had to be a team effort, and although I've expressed my disagreement regarding the technical management of the money aggregates, the monetary supply, nevertheless, I have also made the
point many, many times, it would make no difference who the
Federal Reserve Board Chairman was, whether it was you, or if we
brought back Arthur Burns or anyone else, as long as this Congress
in the management of fiscal policy spends $50 to $60 billion a year
more than we take in. The Fed has to monetize that debt. You
have no choice, but to monetize it, when we spend that much more.
So I just want to express to you how strongly I feel that if the
budget and the deficits are not reduced, the Fed's policies will
cause more problems than they solve.
So it has to be a coordinated effort. I for one will do everything I
can to support President Reagan's plans, not only his budget cuts,
but his tax cuts. I feel very strongly that budget cuts alone are not
sufficient, that we will never, and I repeat never be able to balance
the budget with expenditure cuts alone, unless we relieve the tax
burden on the American people and provide more money for investment capital, for increased jobs in the private section.
ID




Again, I just want to stress how strongly I feel the necessity for
not only restrictive monetary policy, but that we have a restrictive
fiscal policy as well. I think the Congress will make a very_, very
grave mistake, if they do not generally support the President's
program, if we do not get control of the budget and reduce Federal
spending as a percentage of gross national product. And I think
those in both parties, Republicans and Democrats alike, will pay
the price at the polls, unless the economy is brought under control.
You have also heard me express many, many times, my feelings
about the importance of the independence of the Federal Reserve.
And I still feel that way very strongly; however, it must be a
coordinated effort on both fiscal and monetary policy, if we ever
hope to be sitting here across these tables talking about reasonable
interest rates, reasonable inflation rates.
So I pledge my support on the fiscal side to do everything that I
can to bring the budget under control. Senator Tower, do you have
any comments before we hear Chairman Volcker?
Senator TOWER. I would rather hear from the oracle first and
then probably comment during the questioning period.
The Chairman. Go right ahead, Mr. Chairman.
STATEMENT OF PAUL A. VOLCKER, CHAIRMAN, BOARD OF
GOVERNORS, FEDERAL RESERVE SYSTEM

Mr. VOLCKER. I don't consider myself an oracle, Senator Tower.
Thank you, Mr. Chairman, you will find a good deal of common
ground in the statement I am about to read.
I am pleased to be here this morning to discuss with you the
Monetary Policy Report of the Board of Governors which review
economic and financial developments over the past year and sets
forth appropriate ranges for growth of money and credit for 1981.
Because I have already reviewed recent developments with the
committee, my emphasis this morning will be on the present and
future concerns of monetary policy. In that connection, I would like
to touch first on some more technical considerations of Federal
Reserve operating techniques.
TECHNICAL OPERATING TECHNIQUES

As you well know, 1980 was a tumultous year for the economy
and financial markets. While most measures of the monetary and
credit aggregates grew at or very close to our target ranges for the
year as a whole, there was considerable volatility from month to
month or quarter to quarter. Moreover, interest rates moved
through a sharp cycle, and had considerable instability over
shorter timespans.
In the light of these developments, I initiated in September a
detailed study by Federal Reserve staff of the operating techniques
adopted by the Federal Open Market Committee in October 1979,
looking among other things, to the question of whether the particular techniques we employed contributed importantly to the observed votality. Those techniques, as described in our report, place
emphasis in the short run on following a path of nonborrowed
reserves.
The study drew upon the substantial body of staff expertise both
at the Board of Governors and at the regional Federal Reserve




banks, thus bringing to bear a variety of viewpoints and analytic
approaches. The Open Market Committee has had some discussion
of the findings, and we are now at a point where the work can be
made available to interested outside experts. To assure full review,
Board staff will be arranging "seminars," as appropriate, with
economists having a close interest in these matters, and I would
hope that your staff and the staff elsewhere on the Hill could
participate in some of those seminars, Mr. Chairman.
Among the important questions at issue is whether alternative
techniques would promise significantly better shortrun control over
the monetary and credit aggregates, and whether such techniques
would imply more interest rate instability.
We also examined again the significance for the economy and for
basic policy objectives of monthly, quarterly, or longer deviations of
monetary growth from established target ranges.
For the convenience of the committee and others, I have listed in
this text some of the technical findings that may be of more general interest. I won't read all of this material, Mr. Chairman, now,
but I would note point one confirms what you already know, and I
think you and Senator Proxmire have written to us about the
amount of volatility and noise in weekly figures and, indeed, in the
monthly figures. The weekly data may fluctuate as much as $3
billion without really having any significance other than randomness. More importantly, perhaps, we did not find in this study that
alternative approaches to Reserve targeting would increase the
preciseness of monetary control. Indeed, we believe the present
technique really offers more potential in that connection. And
whatever technique is used, you will have to expect in the current
institutional setting, very substantial deviations in the monthly
money supply measures, say, one-third of the time, the econometric
evidence is the change from the target will be as much as 8 to 10
percent. It would exceed 8 to 10 percent deviation from the target
one-third of the time, even if we pursue the target perfectly, in
terms of reserves.
The third point simply makes a point that we have made before,
that there is a tradeoff between following a stable money supply
and interest rate stability. The more stable one makes the money
supply in many conditions, the more short-term volatility you will
have in interest rates. The major fluctuations in interest rates last
year were reflected—were a result of changes in the economy and
the credit control program, we believe, rather than a technique per
se.
And finally, we do not believe that money supply fluctuations of
the sort we had last year of a quarter or even longer, according to
the study, have any profound effect on the general costs of economic activity or on inflation.
In analyzing the results of the study, and given the basic intent
to control monetary and credit growth within target ranges over a
period of time, the Open Market Committee continues to believe
present operating techniques are broadly appropriate. Assuming
the present institutional structure, alternative reserve control approaches do not appear to promise more short-term precision.
We do, however, have under consideration possible modifications
and improvements. Without going into technical detail, such mat-




ters as more frequent adjustment of the discount rate, more forceful adjustments in the "path" for nonborrowed reserves when the
money supply is "off course," and a return to contemporaneous
reserve accounting are being actively reviewed.
In each case, the possible advantages in terms of closer control of
the monetary aggregates need to be weighed against other considerations, including contributing to unnecessary short-run interest
rate volatility.
As a personal observation, I would emphasize that swings in the
money and credit aggregates over a month, a quarter, or even
longer should not be disturbing and indeed may in some situations
be desirable, provided there is understanding and confidence in our
intentions over more significant periods of time.
A major part of the rationale of present, or other reserve based
techniques, is to assure better monetary control over time. I believe, but cannot "prove," that the money supply in 1980 was held
under closer control than if our operating emphasis had remained
on interest rates.
I hope 1980 was instructive in demonstrating that we do take the
targets seriously, both as a means of communicating our intentions
to the public and in disciplining ourselves.
TARGETS FOR 1981

In that light, I would like to turn to the targets for 1981. Those
targets were set with the intention of achieving further reduction
in the growth of money and credit, returning such growth over
time to amounts consistent with the capacity of the economy to
grow at stable prices.
Against the background of the strong inflationary momentum in
the economy, the targets are frankly designed to be restrictive.
They do imply restraint on the potential growth of the nominal
GNP. If inflation continues unabated or rises, real activity is likely
to be squeezed. As inflation begins noticeably to abate, the stage
will be set for stronger real growth.
Monetary policy is, or course, designed to encourage that disinflationary process. But the success of the policy, and the extent to
which it can be achieved without great pressure on interest rates
and stress on financial markets that have already been heavily
strained, will also depend upon other public policies and private
attitudes and behavior.
Abstracting from the impact of shifts into NOW accounts and
other interest-bearing transaction accounts, growth ranges for the
narrower monetary aggregates—M-1A and M-1B—have been reduced by one-half percent to 3-5V2 percent and 3%-6 percent,
respectively. Growth last year from the fourth quarter 1979 average to the fourth quarter 1980 average when adjusted for shifts
into NOW accounts approximated 6V4 percent and 6% percent, just
about at the top of the target range.
When I cite those figures, Mr. Chairman, they are adjusted. I
just want to emphasize that the shift into NOW accounts, those are
not the figures recorded in the published data. They are given in
the footnote and there is a table at the end of this statement which
reconciles the targets before and after switches into NOW
accounts.




It is potentially confusing, and I think the table might be worth
some careful study by those interested. The substance is that the
ranges have been reduced by a half and we came in at the top end
of the range, essentially, last year, so that the implication is the
reduction this year could be more than the half percent reduction
in the range, because we don't aim at the top end of the range.
The committee did not change the targets for M-2 or M-3. In the
case of M-2, the upper end of the range was exceeded by about %
percent in 1980, and there seems to have been some tendency
recently for M-2, which includes new forms of market-rate savings
instruments and the popular money market mutual funds, to grow
more rapidly relative to the narrow aggregates.
In the past few years, M-2 growth has been much closer to the
growth of nominal GNP than has M-l growth. Should those conditions prevail in 1981, actual results in that case may well lie in the
upper part of the range indicated.
M-3, which includes instruments such as certificates of deposit
used by banks to finance marginal loan growth, is influenced, as is
bank credit itself, by the amount of financing channeled through
the banking system as opposed to the open market. Changes in
those aggregates must be assessed in that light.
I must emphasize that both M-l series, as actually reported, are
currently distorted by the shift into interest-bearing transaction
accounts. Those shifts were particularly large in January, when for
the first time depositary institutions in all parts of the country
were permitted to offer such accounts. As the year progresses, we
anticipate the distortion will diminish, as has already been the case
in February. However, any estimate of the shifts into NOW-type
accounts for 1981 as a whole, and the source of those funds, must
be tentative.
Survey results and other data available to us suggest perhaps 80
percent of the initial shifts during January into NOW and related
accounts were from demand deposits included in M-1A, thus "artificially" depressing that statistic. The remaining 20 percent was
apparently shifted from savings accounts or other investment instruments "artificially" increasing M-1B.
More recent data suggest the proportion shifting from demand
deposits, while still preponderant, may be slowly falling. Making
allowance for these shifts, M-1A and M-1B through mid-February
of this year have remained near the December average level. At
intervals, we plan to publish further estimates of the shifts in
accounts and their implications for assessing actual growth relative
to the targets. But I cannot emphasize too strongly the need for
caution in interpreting published data over the next few months.
Once these shifts are largely completed, we plan publication of a
single M-l series.
In that connection, I must note that the behavior of an M-l
series containing a large element of interest-bearing deposits, with
characteristics of savings as well as transactions accounts, is likely
to alter relationships between M-l and other economic variables.
For that and other reasons, the significance of trends in any monetary aggregate even over long periods of time must be analyzed
carefully, and, if necessary, appropriate adjustment in targets
made.




6

Those technical considerations should not obscure the basic
thrust of our policy posture. Our intent is not to accommodate
inflationary forces; rather we mean to exert continuing restraint
on growth in money and credit to squeeze out inflationary pressures. That posture should be reflected in further deceleration in
the monetary aggregates in the years ahead, and is an essential
ingredient in any effective policy to restore price stability.
During 1980, despite the pressures arising from sharply higher
oil prices and the strong momentum of large wage settlements and
other factors, inflation did not increase. But the hard fact is we as
a nation have not yet decisively turned back the tide of inflation.
In my judgment, until we do so prospects for strong and sustained
economic growth will remain dim. In that connection, forecasts by
both the administration and members of the Open Market Committee anticipate continuing economic difficulties and high inflation
during 1981.
I have emphasized on a number of occasions that we now have a
rare opportunity to deal with our economic malaise in a forceful,
coordinated way. As things stand, the tax burden is rising; yet, in
principle the need for tax reduction—tax reduction aimed to the
maximum extent at incentives to invest, to save, and to work—has
come to be widely recognized.
Regulatory and other governmental policies have tended to increase costs excessively and damage the flexibility of the economy;
but realization of the need to redress the balance of costs and
benefits is now widespread.
Despite efforts to cut back from time to time, Government spending has gained a momentum of its own; now the possibility of
attacking the problem head on presents itself.
We are all conscious of the high level of interest rates and
strains in our financial system. Yet there is widespread understanding of the need for monetary restraint.
The new administration is clearly aware of these realities and
has set forth a program of action. It has seized the initiative in
moving from opportunity to practical policy.
I know that the case is sometimes made that monetary policy
can alone deal with the inflation side of the equation. But not in
the real world—not if other policies pull in other directions, feeding inflationary expectations, propelling the cost and wage structure upward, and placing enormous burdens on financial markets
with large budgetary deficits into the indefinite future.
That is why it seems to me so critical—if monetary policy is to
do its job without unduly straining the financial fabric—that the
Federal budget be brought into balance at the earliest practical
time.
That objective cannot be achieved in a sluggish economy. Moreover, tax reduction—emphasizing incentives—is important to help
lay the base for renewed growth and productivity.
For those reasons the linchpin of any effective economic program
today seems to be early, and by past standards massive, progress in
cutting back the upward surge of expenditures, on and off budget.
We know the crucial importance of restraint on money and
credit growth. When I am asked about the need for consistency
among all the elements of economic policy—a policy that can effec-




tively deal with inflation and lay the groundwork for growth—I
must emphasize the need to combine that monetary restraint with
spending control. Cutting spending may appear to be the most
painful part of the job—but I am convinced that the pain for all of
us will ultimately be much greater if it is not accomplished.
Thank you, Mr. Chairman.
[The complete statement of Chairman Volcker and a copy of the
Monetary Policy Report to the Congress begin at p. 42.]
The CHAIRMAN. Thank you very much, Chairman Volcker.
Before asking any questions, I would like to refer back to pur
hearings in January when we discussed some of the technical
aspects of handling the money supply, specifically the nonborrowed
and borrowed reserves and contemporaneous reserve accounting.
I would like to express my appreciation to you for being willing
to look at contemporaneous reserve accounting, a market rate on
the discount rate, and faster adjustments for increases of the borrowed reserves.
I hope that we will have further reports on your progress in
looking at those, but I do appreciate your willingness to at least
consider some of those recommendations from the January hearing.
Mr. VOLCKER. Sheer mass may not produce accuracy, Mr. Chairman, but the studies we have undertaken on this subject are being
placed in the public domain, and I think it would be a good idea if,
as I suggested earlier, the staff of your committee and others who
are interested take a look at this material and discuss it with us
and see what conclusions they draw from some of this technical
work.
The CHAIRMAN. We would appreciate it if we could have access
to your studies. I am not sure I wanted to precipitate, when I asked
those questions in January, that mass of paperwork.
Mr, VOLCKER. This started before January, we are not that quick.
POTENTIAL CONFUSION OF MONETARY POLICY

The CHAIRMAN. Chairman Volcker, it is interesting to not;e in
January, the first NOW account month, total traditionally defined
demand deposits by banks fell by $30 billion while NOW and ATS
accounts in banks and thrifts increased by $20 billion.
The other major financial aspect category to increase during this
period was money market mutual funds which increased over $7
billion.
During the past few months we have also noted a substantial
reduction in savings deposits of banks, S. & L.'s, and mutual savings banks, while time certificates at these institutions have increased dramatically.
This all adds up to what we all know is very rapidly rising cost
for financial institutions, and potential for confusion in the administration of monetary policy by the Fed.
We have an administration that is now advocating stimulating
economic development and at the same time advocates monetary
restraint, request rates of growth. As you can see, a possible conflict exists here. Do you feel, as a basis for this, the Fed should
continue the restraint? Or should they readily fund the hoped for
growth in the economy?




Mr. VOLCKER. I don't think we are going to get growth in the
economy for any period of time, Mr. Chairman, if we don't get a
handle on inflation. And, of course, the monetary policy objective is
important in connection with getting a handle on inflation. So I
don't see any ultimate conflict between the objective of growth,
dealing with inflation, and the kind of monetary restraint we have
set forward.
That does not mean that in the short run everything is necessarily going to go perfectly smoothly or that we can just sit back and
assume that inflation is going to disappear without doing anything
about it.
In the past year there has been considerable pressure in financial markets, as you indicated, and I don't have any instant remedy
for that. I don't think there is an instant remedy so long as the
inflation forces remain so strong. But I think we can make progress on inflation, and as we begin making progress on inflation I
think expectations can change and subsequent progress can come
more rapidly. In that way you begin laying the stage for sustained
growth; I don't know any other way to do it.
The CHAIRMAN. Monday, February 23, in the Wall Street Journal, both governors of the Fed, Schultz and Wallich and Henry
Kaufman all said they felt President Reagan's spending cuts were
too small. Demand for credit will keep interest rates high throughout the year.
Do you agree that the President's spending recommendations are
too small?
Mr. VOLCKER. The President has made recommendations for
spending cuts that are more massive than anything we have seen
before. I think that is appropriate and I support that effort with all
the ardor that I can bring to bear.
I would note in that connection that even in the President's
program as presented—$41 billion of gross spending cuts, which, of
course, are partly offset by increases in defense spending—large as
those spending cuts are, in historic context they are only a kind of
down payment on what his program calls for in subsequent years.
This is a first stage, and I think it is important, certainly against
the background of the tax program.
It is also being recommended that those spending cuts be
pressed. They are the linchpin of the program, as I see it; they are
vital to make the whole thing work.
Commenting on the program generally, I would say that the risk
is in the direction of not doing enough on spending cuts rather
than on doing too much. I see no risk of overdoing the spending
side of this equation. The more that can be done, the safer and
more effective the total program will be. What I have in mind in
saying that is essentially the point that you made initially, Mr.
Chairman; that it will then become easier for us to maintain the
restraint on money and credit growth that is necessary without
unduly straining the financial markets. You can't do too much on
the spending side. In that sense, the risk is in not doing enough.
The CHAIRMAN. I would agree with you completely. Would you
agree with me, then, that the $41 billion is a minimum? And
obviously it is up to Congress. The President will not back off. But
it is now in our court. And what I fear is that I hear some of the




9

reports from some of my colleagues, both in the Senate and in the
House, that they are going to fight this cut or that cut, and I hear
projections about well, he will probably get $30 billion of it.
I would suggest then that if the higher interest rates continue
with high inflation, the blame can be laid properly where it belongs, with the Congress of the United States which has the authority over fiscal policy and the spending policy.
Mr. VOLCKER. I believe these cuts are a minimum. When you
reduce the expenditure cuts it raises more questions about the
other parts of the program.
The CHAIRMAN. I wish Congress would go the other direction and
one up the President and go beyond the $41 billion. They might be
absolutely staggered in the future and what it did for the economy
and what it did for their reelection prospects. For the first time in
their public careers maybe cutting the budget might be the thing
that would guarantee their election, because I do think the American people are a lot smarter than some of we politicians give them
credit for,
I am hopeful that the Congress will recognize the difficulties this
country is in and not look for scapegoats, particularly blame everything on the Fed. Look at our own house and make certain that at
least those $41 billion of cuts are made, if not more, or the economy will pay the consequences.
Also at issue is the relationship between the White House and
the Fed. And the Fed, of course, is legally independent of political
influence. I have outlined how strongly I feel that there must be a
coordinated policy.
What is your opinion of what the appropriate relationship between the Fed and the administration should be?
Mr. VOLCKER. My view, of course, is that we are an independent
agency. Congress has delegated its authority in the monetary area
to the Federal Reserve, and we are responsible for reaching judgments that we think are appropriate. In that process, I am a very
strong believer in maintaining communications as open as possible
with the administration, so that we understand their thinking and
they understand our thinking. But when the day is done we have
to make our own judgments. I hope to maintain that kind of
relationship with the administration.
I might say the administration made a broad statement about its
assumption about reduction of money and credit over a 5-year
period or longer in connection with the President's program. That
statement is broadly compatible with what we have been saying
consistently ever since I have been here.
TAX CUTS
The CHAIRMAN. In previous testimony you have stated that you
felt the spending cuts must be coincident with or should precede tax
cuts. You have also expressed a preference for business rather than
personal tax cuts in the early going. How do you feel about the
present tax cut recommendations, the ratio between business tax
cuts and personal tax cuts? And if you disagree, how would you
recommend that they be restructured?




10

Mr. VOLCKER. It is true that in the past I have put somewhat
greater emphasis on tax cuts pointed more toward the problem of
business investment and savings.
The general point that should be made, first of all, is that the
emphasis should be on incentives—incentives for investment, incentives for savings, incentives for work. How you best apply that
point in practice is a matter, I suppose, of some judgment. Technical disagreement may arise.
The administration has certainly emphasized the point of concentrating on incentives. They have structured the program in a way
that puts more of the reduction on the individual side of the
equation., which perhaps relates to some statements I made some
time ago.
That is a matter of judgment. I can see a different kind of
emphasis, but that question is secondary to the importance of
shaping the package with maximum impact on incentives in all
these directions.
That leads you to the viewpoint that has been taken, properly, to
put in a second priority some tax changes that don't seem to me to
have incentive effects, but still lose revenue. They may serve other
purposes, but they don't serve incentive purposes.
The CHAIRMAN. Thank you, Mr. Chairman. My time has expired.
Senator Proxmire?
Senator PROXMIRE. Thank you, Mr. Chairman. Mr. Chairman,
first I would like to say I am sorry I was a little late. But I
certainly join you in your opening statement.
I am told you made a strong statement in favor of requesting the
Chairman of the Federal Reserve Board to continue a policy of
monetary restraint, monetary conservatism. I think that's absolutely essential. The Fed, I think, has been the only game in town
fighting inflation. Some people don't agree that you have been, but
I think you have. I hope you will continue it, Mr. Chairman.
I also want to tell the chairman how enthusiastically I share his
view that your position will be impossible unless we have a much
more restrained fiscal policy.
I would like to ask you, Mr. Chairman, Chairman Volcker, what
we can do besides what you are doing, or trying to do, in holding
down the rate of increase in the supply of money. What the President has done in recommending sharp budget cuts—is there anything else we can do to bring down this cruel high interest rate
that is the cutting edge of inflation?
BRINGING INTEREST RATES DOWN

Frankly, the big reaction I get from my constituents continuously is what they are concerned about more than anything else are
high interest rates. It's very hard for the farmer, for the small
businessman, impossible for the homebuilder, devastating the automobile industry. And I think it's a big factor in retarding economic
growth and recovery and in causing unemployment.
What, if anything, can we do in addition to the kind of conservative policy that Chairman Garn has outlined?
Mr. VOIX^KER. I know you understand, Senator Proxmire, that
our policy is not to have high interest rates per se. We are restraining money and credit in an inflationary environment with heavy




11
demands for credit. The result tends to be high interest rates,
particularly when the economy is expanding, and it has been
expanding.
I think I can just say flatly that the only way that interest rates
are going to be brought down and stay down over a period of time
is to get the inflation rate down.
In the shorter run, interest rates are affected by many other
factors, including the strength of business activity and the strength
of credit demands at the time. If the economy slows down, presumably interest rates will go down, but that's not a very happy result.
You would then have a slowdown in the economy, and that's not a
very effective policy.
The critical dimension that you can influence is the one you
have mentioned, fiscal policy. The other question that is raised
from time to time is, as you well know: Can you control the credit
expansion through some kind of direct control?
We went a little distance in that direction for a time last year. I
think that period shows some of the real problems that arise from
an attempt to intervene directly.
Senator PROXMIRE. Let me ask you another aspect of this, however. Past administrations, Republican and Democratic, have emphasized much more than this administration seems about to emphasize, other anti-inflation strategies, including vigorous antitrust enforcement, including championing free trade.
At this table at my left is the distinguished Senator from Michigan. On my right is the distinguished Senator from Pennsylvania.
Autos and steel are concerned about imports, and properly so.
On the other hand, the only kind of competition we. have with
steel, price competition, is imported steel. By far the most vigorous
kind of competition we have in the automobile industry is with
imported automobiles.
It seems to me that this, too, can be used as an effective antiinflation strategy, and then finally, it seems to me that this administration has indicated—Chairman Weidenbaum appeared before
this committee a short time ago, Chairman of the Council of Economic Advisors, and indicated complete indifference toward jawboning by the President.
Maybe that's right. Other Presidents have engaged in this with
success, have jowboned, down inflationary wage and price increases. This administration won't do that. This administration
shows no interest in tax based incomes policy which some eminent
economists, including your colleague, Dr. Wallich, have championed.
LIMITED ANTI-INFLATION

FIGHT

It seems to me it's a very narrow, limited anti-inflation fight,
confined very largely to a fiscal policy which may or may4not work
out—particularly in view of the fact that they also propose deep
tax cuts.
Mr. VOLCKER. Let me make several comments. First of all, it is
not my understanding of the administration's intent—certainly
they can speak for themselves on this point—to ignore what I
loosely think of as the regulatory side and the trading side of the
equation.




12

I think it's terribly important to maintain open markets. If we
closed our markets when we have competitive problems, we would
be sending exactly the opposite of an anti-inflation signal to the
American public: that prices will go up, rather than down, for the
very reasons that you suggest.
Many governmental policies built up through the years and reflected in the regulatory process, in labor markets, and in other
policies tend to ratchet up costs and put a floor under the price
level. I hope—and really expect—that some of those policies will be
reexamined. I think that is very important.
Wage-price guidelines or tax-based incomes policies have often
looked attractive in concept, and I understand that, because they
appear to offer some way of speeding the process or avoiding some
of the conflicts that otherwise arise.
Apart from all the other difficulties in terms of the rigidities
that those policies imply and the difficulty of keeping them in
place for any period of time, my difficulty is that I have not seen
any very successful demonstration of those policies in practice.
I don't think we have had any practical evidence that those
policies are terribly useful over any particular period of time. The
great danger is that they are looked upon as a crutch. They are not
going to work if these other basic things aren't done. And I think
there is an insidious
Senator PROXMIRE. Recognizing they won't work, if the other
things aren't being done, can't they be used for supplement? You
know, we don't have a perfect competitive system. And unless you
have some recognition that the President has that bully pulpit, he
ought to use it.
Mr. VOLCKER. So far as the jawboning side is concerned, it seems
to me the point ought to be made—and it ought to be made over
and over again—that to the extent private behavior on wages and
prices moves ahead in a way that is out of step with bringing
inflation down or out of step with the competitive position of a
particular industry, problems are going to be created, and it is
going to be harder to bring down the total inflation rate. The
responsibility ought to be put where it lies in those cases: if people
are moving way ahead of what the overall economic indications
justify in terms of wage settlements or pricing policies, then they
will get into competitive trouble. Then we've got a problem. The
country has a problem. Those industries have a problem. And I
think that that point ought to be made that there is a responsibility and a connection here.
Senator PROXMIRE. You wrote me on January 8 in response to a
letter I wrote you, and you seemed to indicate—it's hard for me to
imply anything but that you would be vigorously and forcefully
against passage of anything like the Kemp-Roth tax cut.
Now, here's why, here's what you said, and I quote:
"It is critical that tax cuts be conditioned on the maintenance of
budgetary discipline. Budget deficit now estimated for fiscal year
1981 and the trend of Government spending, taking account of our
national security and other needs, clearly places limits on the
amount of tax reduction that would be prudent at this time.







13

"Consequently tax reduction without the budgetary discipline
necessary to achieve budgetary balance at more satisfactory levels
of economic activity could be clearly productive."
A very strong, clear statement. It seems to me you would put a
much higher value on reducing the deficit and moving toward a
balanced budget than you would substantial personal tax reduction; is that right?
Mr. VOLCKER. I don't think it's inconsistent to move toward a
balanced budget and have some tax reduction. We are not going to
balance the budget in an atmosphere of high-level unemployment.
Senator PROXMIRE. You're calling for business tax reduction.
Mr. VOLCKER. The way I look at this, I would do all the spending
reduction you can do; I don't think you can do too much, as I said
earlier, from the standpoint of general economic policy.
Then I would see how much room that left for tax reduction
consistent with returning to a balanced budget, as soon as possible,
in reasonably favorable economic conditions. That's the way I
would measure the size of the tax cut.
The administration, as I understand it, has not only proposed
this immediate package of tax cuts and of spending cuts, but there
is some followon that has to come very promptly afterwards.
Senator PROXMIRE. And immediate tax cuts and the followon tax
cuts?
Mr. VOLCKER. They put both of those together, and they do come
up with a narrowly balanced budget, in reasonably favorable economic conditions. The concept follows—I think, what I was suggesting in that letter.
The question is whether that will be achieved, and whether those
proportions are right.
BALANCED BUDGET BY 1984

Senator PROXMIRE. The balanced budget, as I understand it, is
1984. Has the Fed staff examined economic model now used by the
OMB to project a balanced budget in 1984, and if so, can you give
us whether or not that indicates we'll have a balanced budget in
1984, under the most reasonable and realistic assumptions as to
growth et cetera?
Mr. VOLCKER. I'm sure we haven't examined that particular
model. The way I would go about it is, in projecting a balanced
budget—or whether or not one can reach a balanced budget in the
years ahead—I would have to make some assumptions about economic activity. When you are looking for a balanced budget—let's
look beyond a balanced budget to a surplus—I think you do have to
make some assumption about reasonably favorable economic background.
That's not saying it will be attained just because you forecast it,
but I think it is a reasonable benchmark for measuring what you
are doing on fiscal policy. You know if the economy is performing
poorly, unemployment compensation, for instance, will be exceptionally high, higher than it normally would be; revenues will be
depressed merely by the fact that the economy is running at a
lower level. So I do think you have to measure these things against
a reasonable assumption—let's call it an "assumption" rather than
a "forecast" at that stage—about economic activity.

14

Senator PROXMIRE. Mr. Chairman, my time is up. I am not going
to ask another question, but it would be very helpful for the record
if the chairman would have the Fed staff take a look at this
scenario and see what assumptions would have to be made to get a
balanced budget.
Mr. VOLCKER. We have made some preliminary calculations of
that sort, looking toward 1983, actually, and just making an "assumption" and not a forecast about the condition of the economy.
You have to come up with spending cuts in the full magnitude that
have been proposed—again, not just the $41 billion, but the
followon cuts—to have a fair chance of a balanced budget with a
tax program of the size that's being proposed. Again, this is an
assumption, not a forecast.
Senator Tower?
DEFENSE SPENDING AND INFLATION

Senator Tower. Mr. Chairman, do you have any assessment as to
whether defense spending has a greater or lesser impact on inflationary pressures than certain types of domestic spending, such as
transfer payments and categorical grants and aid?
Mr. VOLCKER. The point is often made, Senator, that defense
spending, by its nature, producing goods that are put on the shelf,
so far as the economy is concerned—and they may be terribly
important in terms of the national interest but they don't provide
satisfaction for consumer wants—can have a more inflationary
impact, I suppose, then even in transfer payments. They don t
produce anything either, when they are made, but they may at the
secondary stage give rise to production that satisfies consumption.
1 think another factor that has to be looked at in a rapid expansion of the defense program is whether you don't create bottlenecks, shortages of capacity, other factors that put pressure on
prices in particular sectors of the economy.

I do think there are problems from the inflation standpoint in
rapid increases in defense spending. That doesn't, obviously, mean
that you don't do defense spending as a matter of priority if the
country needs it.
Senator TOWER. What if most of your increase goes in contractual authority, rather than actual outlays?

Mr. VOLCKER. I would think it would depended upon the rate of
speed and the condition of the particular industries that have to
supply the defense goods. I am not particularly expert in just what
exists in that area now, but the problem could arise of so congesting a relatively depleted defense production capability that it
would do aggrevate cost pressures in that particular sector. But I
simply have not reviewed the situation closely enough to make any
good judgment as to what the dangers are in this particular
situation.
Senator TOWER. What about areas where production line may be
underutilized?
Mr. VOLCKER. Then it's much easier. That problem wouldn't
arise.
Senator TOWER. Looking at the international situation, why has
the dollar risen so well lately against other hard currencies, and
against gold?




15

Mr. VOLCKER, I would like to think there is a recognition that
ultimately the kind of policies that we and others are pursuing will
assure a better future for American policy generally, and particularly for inflation. Obviously in the short run, the dollar has been
affected by a relatively high level of interest rates. The fact is that
our current account position is in relatively good shape—compared
to other industrialized countries in quite good shape. Our exports
have been doing quite well, and I think there is increasing appreciation of that, relative to the external performance of other countries recently.
You have to look at the other side of the equation. The fact is
that some other countries have some very substantial and continuing current account deficits. In some cases they are having to cope
with increased inflationary problems, so that, apart from the more
technical considerations, attitudes have shifted considerably in
favor of the dollar.
Senator TOWER. What do you see the potential impact on the
dollar being as a result of actions being undertaken overseas—one
instance I know of, and that is the Bundesbank raising its interest
rates. What impact is that going to have?
Mr. VOLCKER. It should have the impact of strengthening the
DM. I don't consider that, in a sense, a weakening of the dollar.
But if you measure just by the DM-dollar exchange rate, if that
action strengthens the DM, the dollar exchange rate relative to the
DM goes down; it has been, historically speaking quite high in
recent weeks, as you know.
Senator TOWER. Can we expect similar actions like that to be
taken by other central banks in Europe?
Mr. VOLCKER. I would not necessarily think so. The DM has been
under particular pressure. They are dealing with a situation that,
in a sense, is peculiar to the DM.
Senator TOWER. Thank you, Mr. Chairman.
The CHAIRMAN. Senator Riegle?
Senator RIEGLE. Thank you, Mr. Chairman.
Chairman Volcker, let me just say at the outset—as a member of
the Budget Committee—that I think you are going to see us meet
the President's spending reduction goals. Whether these cuts will
be enough in combination with all the other things we're talking
about, is another question which needs further discussion.
With respect to the tax proposals, though, I think it is becoming
clear that those are going to be changed. I think there is a growing
sentiment both on the Senate and in the House, to make some
changes in the tax program. And without getting you caught in
that debate, but using your vantage point and expertise, I would
like to ask you some questions about some tax alternatives.
PRESIDENT'S TAX CUT PROGRAM
If you look at the President's program in 1982, he is talking
about the personal tax cut amounting to about a $44 billion return.
And the business side, the accelerated cost recovery system, at
about $9.7 billion, is a very dramatic stacking of the tax package in
favor of personal tax cuts. In 1983 the same pattern pretty much
prevails. You see $81 billion on the personal side and about $18.6
billion on the business side.




16

We have talked here many times before about the need to modernize the country, to improve productivity, to encourage saving,
and turn the movement of savings into capital investment. Is this a
satisfactory ratio in your mind?
If we were to change that and make it, say, closer to 50-50, do
you have any feeling as to what that might do in terms of helping
in the fight against inflation?
Mr. VOLCKER. I don't think you can answer the question purely
as a matter of ratio. Obviously the program can be restructured to
give more pinpointed incentives, so to speak. But I don't think you
can answer the question generally in terms of a particular
percentage.
If you took some of the cut away from personal and did something ineffective on the business side, you wouldn't improve
anything.
Senator RIEGLE. I don't want to make it trivial.
Mr, VOLCKER. Obviously opinions differ in this area. You are
going to have to make a judgment as to whether you are more
effective cutting the marginal tax rates on individuals or doing
something more explicitly directed toward savings and business
investment.
Senator RIEGLE. Let me try to help you. I recognize you are
trying to sort of work around the question, here. [Laughter.]
What I would like to know is this: Should we seriously consider
beefing up the investment incentives on the front end of this
program? Those of us who come from regions where we have major
reindustrialization requirements and major capital investment requirements, feel strongly that this restructuring is needed.
Mr. VOLCKER. I have expressed an opinion in the past on the
importance of looking at a variety of techniques that are directed
toward the business investment savings area. I think that is a fair
subject to review.
Senator RIEGLE. Let me ask you this: If it were 50-50, in your
opinion, would that have any impact on productivity and any
impact on inflation? Or do you think it doesn't really matter?
Mr. VOLCKER. Again, I just hate to express the view in terms of
50-50 on any ratio. It depends upon what you do. There are proposals made, for instance, to encourage personal savings through some
kind of tax deduction or exemption.
Senator RIEGLE. How do you feel about that? Would you want to
see that?
Mr. VOLCKER. It sounds like a good idea, but when you look at
the proposals in detail, it is very hard to make them effective at
the margin. Congress 2 years ago provided an exemption for some
interest payments. My own feeling was that that involved a large
revenue loss, and while it is pinpointed, probably without having
any significant effect on savings incentives, because the great bulk
of the people who saved were already beyond the limits where they
would be affected at the margin by that change. I don't know
where you list that on your priorities. It's a personal income tax
change; it is a pinpointed personal income tax change; the problem
is it is probably ineffective. Where we are having a little difficulty
is the conclusion of the administration that they will get a very
high incentive effect by changing marginal tax rates.




17

I think it is true you will get an incentive effect. I've always
thought that you will from changing individual tax rates. Now you
are asking me to balance that against a sayings exemption of that
kind of magnitude. I think the administration is right in that case.
As balanced against some other possible approach that could be
taken in the business area or elsewhere, you d have to look at each
approach individually. I think you should look at each proposal
individually.
Senator RIEGLE. What I am trying to do is give you an opportunity to express a view as to whether the capital investment side of
this program ought to be strengthened, and I would urge you to
take it that way. If you don't, I want to go to another question
before my time is up. [Laughter.]
Mr. VOLCKER. I think the whole name of the game, in a sense,
ought to be the capital investment side, or the research side and
the work side. The argument should be about how best to do that.
Senator RIEGLE. I think that's the issue here.
Mr. VOLCKER. I think it is an issue, and in that connection, I
would think that Congress would well want to look at other approaches and reach a conclusion as to how much weight ought to
be put on reduction in personal rates alone.
Senator RIEGLE. What I take that as is a suggestion that if we
found a way to beef up the $9.7 billion, or to somehow alter this
ratio so that it was more favorable toward a greater share of
capital investment in the near term, that you might see that as
helpful.
Mr. VOLCKER. I am not going to take as my criterion the ratio. If
you can come up with a package that you feel is more effective,
given the basic objective, then I agree with you wholly. That ought
to be your whole concern at this point, whether you can do it more
effectively.
Senator RIEGLE. Let me ask you one more question. In this
scaling of the tax reduction across the personal rates, the theory,
as I understand it, as I listen to Mr. Stockman and Secretary
Regan refer to it, is the general belief that folks in the high-income
brackets are more apt to save their money, and therefore they
ought to be given more to save; and the hope is that money will
make its way into not just savings, but capital investment. On the
other hand, folks at the lower-income levels on the margin are less
able to save, or less apt to save, and therefore you don't get the
same savings effect if you give the tax reduction to them.
Do you have any evidence at the Fed that would indicate that
savings—that this proposal, in terms of the high tax cut at the
higher income levels, will actually make its way into savings? In
other words, it's one thing to give somebody the money, and it's
another thing to do it with any kind of certainty that will make its
way into capital investment, hopefully even a productive capital
investment.
ENCOURAGE A HIGHER SAVINGS RATE

Mr. VOLCKER. I don't think we have special research at the
Federal Reserve that bears on that point. I think it's fair to say
that the general presumption of most economists is that you will
get more savings and more investment incentive in relation to the




high marginal rates at the top than you will at the bottom, for
obvious reasons.
Senator RIEGLE. Do you think we'll get what they're predicting?
As you probably know, they're predicting a higher savings rate
than we've ever seen before. Do you think that's realistic?
Mr. VOLCKER. I don't think it's very useful to speculate frankly,
the evidence is, at best, muddy. It depends upon what time period
you use in estimating the amount an individual will save out of his
tax saving.
If you take the first month or two, the figure probably looks
high, but then typically it diminishes rapidly, as time passes. I
think the right way to look at it—and I think the way they've
looked at it, in part at least—is that in terms of the program as a
whole, it is important to raise the overall savings rate. You can't
trace that to individual taxpayers.
Senator RIEGLE. I think you've got a hundred Senators that
would agree to that.
Mr. VOLCKER. As you make progress on inflation, as the economy
grows, you want to encourage a higher savings rate. That should be
a major objective. You have to look for that result in terms of the
package as a whole, not just in terms of this tax reduction.
Senator RIEGLE. My time is up.
Could we ask that we have something done for the record, Mr.
Chairman? Could I ask—this augments the request of Senator
Proxmire, I think.
The CHAIRMAN. Certainly.
Senator RIEGLE. I would like to ask the Federal Reserve to take
its basic economic forecasting model and plug into it the Reagan
program as it has been put forward, the spending cuts, the tax
cuts, the magnitudes, the timing, and give us, if you would, what
your model tells you in terms of what the outcomes will be, in
terms of inflation rates down the line, deficits down the line,
capital investment, whatever else that you put out—the reason I
ask for that, I think that's a neutral way to get at least one more
measurement of how this is likely to work.
As you know, one of the criticisms of the Reagan package has
been—that it really isn't based on an economic model as much as it
is on expectations. Could you do that for us?
Mr. VOLCKER. I understand your request, but I frankly am a
little bit reluctant to do that. We have some models of the sort that
you are referring to. We have never, to the best of my knowledge,
presented forecasts coming out of those models in any kind of a
public forum. And I feel a little bit strongly about it, because I
don't have much faith in the models myself, [Laughter.]
I kind of hate to, crank this through a mathematical model—
particularly for 2 or 3 years ahead. I have limited confidence in
that kind of time frame.
Senator RIEGLE. That raises another problem, because if the
Federal Reserve was to do it and your findings were at variance
with what the Administration is predicting, somebody is wrong and
either you need to change your model or they need to change
theirs.
Mr. VOLCKER. That doesn't follow.
Let me express my own feeling




19

Senator RIEGLE. I don't want to press past my time. I think we
ought to get it settled if we can.
Mr. VOLCKER. If I can just express an opinion about the matter. I
have limited confidence in any detailed economic forecasts these
days, I think a limited confidence, amply justified by recent experience. These models—or any forecast, whether done econometrically
or otherwise—have not been very accurate, even in the short run,
recently.
I don't think you can escape the proposition that you put together a program that you think as a matter of general analysis is the
best program that one can conceive of under current circumstances, and you move ahead on that program. That program
should not rest upon whether a forecast suggests that the economy
is going to take off 12 months from now, or 18 months, or just how
long it takes.
I don't think you can escape the responsibility of putting forward
the program that you think is the best, most balanced program,
aimed at the variety of problems that we have; you can t escape
that responsibility by taking assurance from an economic forecast
that in itself is inevitably shaky.
I don't think, the inevitable uncertainty of a forecast in any way
makes it difficult or impossible to come up with the best economic
program you can shape.
I am reminded of the fact that for almost the whole time I have
been sitting in my present job, the prevailing economic forecast has
been that there's a recession next quarter.
We did have a recession one quarter, but only one quarter out of
the seven that I've been here, I think you're deluded if you say,
"Well, we've got a forecast. The majority of the economists are
forecasting a downturn in the next half of the year, so we'll adopt
this kind of economic policy or that kind of economic policy."
You've got a 50-50 chance that that's going to be wrong, if that is
the sole basis of the economic policy.
We do know some things. We know savings are low. We know
inflation is high. I am convinced you're not going to deal with the
growth problem and the sayings problem and the productivity
problem until you deal with inflation. You start with an economic
program that's going to deal with inflation. You know productivity
has been low; you know capital spending needs to be increased; so
you put something in the program to deal with those.
CONFIDENCE IN ECONOMIC PROGRAM

You do that whether or not the economic forecast is correct as to
what's going to happen in the fourth quarter of 1981 or the second
quarter of 1982. I don't know precisely what's going to happen in
those time periods, but I do know we have these basic problems
and any economic program ought to be directed towards these
economic problems. I am perfectly confident that if it is successfully directed toward these problems, you will have the best program
that can be put together and you will have grounds for confidence
that the economy is going to improve.
I'm going to have that confidence, however long we argue about
a particular economic forecast, because I just don't put that much
weight on any of them in any particular time period.




20

The CHAIRMAN. Gentlemen, I do think we have to proceed.
I'm certainly glad, Senator Riegle, that you didn't ask the Chairman another question. [Laughter.]
Before I turn to Senator Heinz, I can't resist a couple of editorial
comments.
The first one is: After sitting on this committee for 6 years, may
I agree about economic models. We have had the best liberal and
conservative and Republican and Democratic economists before
this committee. And I don't remember any of them being right in
their forecasts in the last 6 years. [Laughter.]
The second comment I would make: I would tend to agree somewhat with Senator Riegle on the mix. If I were designing the tax
package, I would like to see larger business cuts. But if the President had proposed a larger proportion of business cuts, I can see
what the press would do with it—"Look at those darn Republicans,
how they favor big business. They're doing it again to the poor
people."
So I am pleased to have some of our Democratic colleagues
believe in—that some more supply-side incentives for business are
necessary.
Mr. VOLCKER. If I could just put a footnote on top of that.
[Laughter.]
My skepticism on economic forecasts does not mean that economic analysis does not have a lot to tell us about how the program
could be shaped and should be shaped.
The CHAIRMAN. Senator Heinz.
Senator HEINZ. No, no. Not yet.
A footnote to the footnote is he has to say that, otherwise all the
economists at the Fed will walk out en masse. [Laughter.]
The CHAIRMAN, Senator Heinz, now your time starts.
Senator HEINZ. Thank you, Mr. Chairman.
Chairman Volcker, as Senator Riegle said, 100 Senators agree
that the savings rate ought to be increased if you can figure out
how to do it.
You have indicated that there might be better ways of increasing
the savings rate than the tax package proposed by President
Reagan. What kinds of changes in that tax package would you
recommend to increase the savings rate?
Mr. VOLCKER. I meant to make a broader statement.
Senator HEINZ. I'd like some specific
Mr. VOLCKEK. I think the most important thing for the savings
rate is going to be more confidence in the outlook, particularly on
inflation.
Senator HEINZ. We all agree.
Mr. VOLCKER. That bears particularly on the tax package.
Senator HEINZ. Having said that
Mr. VOLCKER. I'll give you a negative answer first. I have not
seen any proposal directed toward savings per se—that is, an exemption of some sort for savings per se—that has looked terribly
effective to me, for the amount of revenue lost, for the reasons that
I suggested earlier.
If you do something like the depreciation in the program, you get
a double-barreled effect. You automatically generate the savings in
the business community from the savings in taxes, and you have







21

provided an incentive to reinvest. That should be a pretty effective
way of approaching that problem.
Other issues must be considered. It's particularly favorable for
companies making heavy capital investments, and it's less favorable for companies that may be productive and useful but don't have
the same proportion of capital spending.
Senator HEINZ. So you have no specific proposals that you believe would increase either business or personal savings in this tax
package?
Mr. VOLCKER. I didn't come up here with specific proposals.
You've got things to look at
Senator HEINZ. Let's proceed then.
Some people say that where monetary policy is concerned our
choice is between inflation or unemployment; others say it is between high and low interest rates. But, in fact, I believe—and I
think some other people would agree, that it's really between longrun economic stablility and instability. And we have had a lot of
the latter.
There has been reported—excuse me. There has been prepared
by the staff of the House Banking, Finance, and Urban Affairs
Committee, by their Domestic Monetary Policy Subcommittee, a
report. That report is really quite critical of the Fed, and it suggests that the Fed has concerned itself much too much with trying
to meet will o' the wisp, short-term targets and has abandoned its
responsibility to have a long-term, stable policy on the money
supply.
Are you familiar with the report?
Mr. VOLCKER. I recall something about it. It is not fresh in my
mind. In any event, I do not agree with the conclusion you state.
Whether or not it is the conclusion of the report, I would violently
disagree with the comment that you quoted from the report.
Senator HEINZ. The administration white book replaced the
black book. In the white book there is some prescriptions absent
from the black book for the Federal Reserve System and monetary
policies. Specifically what President Reagan calls for is a gradual
reduction in the growth of the money supply. Do you agree with
that prescription?
Mr. VOLCKER. We have been following that policy, yes.
Senator HEINZ. The administration plan also over the next 2 to 3
years sees a substantial increase in economic activity. Is a policy of
gradually ratchetting down on the money supply consistent with
gradually ratchetting up? Or in some cases some forecasts dramatically ratchetting up on economic growth?
Mr. VOLCKER. Only if the inflation rate declines.
Senator HEINZ. And do you believe it will?
Mr. VOLCKER. That is the aim of our policy.
Senator HEINZ. I know what the aim is. Do you believe it will hit
the target?
MONETARY TARGET RANGE

Mr. VOLCKER. Do I believe we will hit our monetary targets? Yes,
pur aim is to hit the monetary targets. My belief is that the
inflation rate will come down. The question is the timing of this

22

whole process. But I think certainly you will not reach these objectives unless the inflation rate comes down.
Senator HEINZ. Now in your statement, obviously the Fed didn't
hit a single one of its rather wide monetary target ranges in 1980,
not a one.
Mr. VOLCKER. That is not true.
Senator HEINZ. As I read what you handed out, according to
table one it would appear to be true, the possible exception being
bank credit.
Mr. VOLCKER. Bank credit certainly is an exception. The M-1A
and M-1B targets rest upon a particular estimate made of the
shifts into NOW accounts. We either very narrowly missed it or we
hit it, it depends upon, how these things are calculated. This looks
at the fourth quarter; we were on the edge.
If you recalculated these figures and looked at the average for
the year as a whole, and assumed that these applied to every
quarter instead of the fourth quarter, we would have hit it for M-l.
If you just look at December we would have hit it.
Senator HEINZ. I am going by what you gave the committee.
Mr. VOLCKER. I understand.
Senator HEINZ. And what you gave the committee, with the
exception of bank credit, you missed your ranges. Now the point I
would like to be very clear on is that yes, you may have missed
your ranges by a little amount, but the ranges are now narrow. For
M-1A the range is froml 3Vfe to 6. That is pretty broad. That is
nearly a 100 percent of 3 /2, the size of that range.
The range for M-1B between 4 to 6Vfe is again pretty broad. That
is again 50 percent on the base of 4, latitude 4 era.
So when you miss a range that broad it is a little bit like missing
the entire target. Even if you miss the target by a few inches you
still missed it. Now it seems to me that if the ranges mean anything they mean that you ought to be within not outside of the
range.
Which brings me to my last concern and question. I think the
Federal Reserve is a vital and important institution. We all salute
the independence of the Federal Reserve System because its responsibilities are so important and need to be shielded from transient political influence. But what is unclear to me is what—when
one organization or institution is vested with tremendous responsibility, the means of holding such an institution accountable ought
to be. And my question is what should the accountability of the
Federal Reserve—how should it be recognized when you miss?
Mr. VOLCKER. I think it is recognized by these hearings, in a
general sense.
Senator HEINZ. Suppose you miss again?
Mr. VOLCKER. You would presumably question us as to why that
took place, whether it was justified or not justified.
Senator HEINZ. And suppose you miss again? You know, each
year the Fed misses by a Vs or 2 or 3 points. At what point is there
a means of facing up to the division of accountability and responsibility?
Mr. VOLCKER. The means exist in the nature of things, I suppose.
Congress has delegated the responsibility to us. Congress always
has the option—I don't recommend it obviously—of removing the




23

delegation; they could do so. But I think, in the broadest sense, our
performance depends on whether you are satisfied with it.
Senator HEINZ. Some people have suggested that since there is
some reluctance to deliver the policies of the Fed into the hands of
the Congress, and there has been a general feeling that it is important, as stated by you and others, that the Fed should work in
concert with the executive branch, why shouldn't, when the Fed
misses it targets, the Chairman or the Board of some delegation of
the Fed step forward and say we serve at your pleasure, Mr.
President, and we have not done very well? Why shouldn't the Fed
act a little bit more like a cabinet in the parliamentary system
when a fellow comes up short on a vote of confidence?
Mr. VOLCKER. There may be good or bad reasons for missing the
target, and I think it depends on whether you are satisfied in the
last analysis that the reasons were good or bad over a period of
time.
The theory is that exposing monetary policy to direct political
control, which seems to me the implication of what you are saying,
will over time, clearly lead to a less satisfactory performance
rather than a more satisfactory performanceSenator HEINZ. Not quite, because that is not what I suggested.
What I suggested is that the Fed sets the targets.
Mr. VOLCKER. Certainly.
Senator HEINZ. And you figure out what targets you want to set?
Mr. VOLCKER. That is right.
Senator HEINZ. And the question is not what you set those targets at. The question is when you don't need the targets you set for
yourself what should be the appropriate response of the elected
branches of Government, the executive branch and the Congress?
That question is not answered by anything that I have said or that
you have said.
Mr. VOLCKER. The appropriate response is that you have hearings and satisfy yourself or remain dissatisfied as to the result.
Let's not avoid some of the issues here. First of all the money
supply series is inherently unstable. We have done an important
study of this; control is not perfect by any means.
If you look at international experience, we have come as close to
our targets, generally speaking, as have other countries that use
these techniques. We have a more stable performance in those
terms.
You have to ask whether you are asking us to do something that
is possible or impossible—that is, on the technical side.
On another side, in the short run certainly, there is some
tradeoff between the pressure on financial markets and the growth
in money. We get a lot of complaints about interest rates, and a lot
of complaints that we are much too tight. A lot of people think
that that is the crucial issue, rather than how precisely you come
out on the target. There are a variety of considerations involved.
All I can say is I don't know of any way of approaching this
other than reaching a judgment about whether, broadly, we are
following appropriate policies or not. I don't think you will get a
magic answer to the significance of whether we are or are not a
quarter of a percent above the range. That is one consideration, but
it is not the whole of the factors bearing upon monetary policy. It




24

is one important factor which we consider; it is an important
discipline on ourselves.
If we didn't have these targets last year—I can't be sure of this—
my suspicion is that the growth of money and credit would have
been much greater, because there were a lot of pressures on the
markets. Traditionally over the years, it seems to me, the Federal
Reserve had not pressed as hard as hindsight might suggest they
could have pressed toward restraint.
Now these targets help us to be more disciplined, in my opinion.
That doesn't say we are going to hit every target every year. In
fact, as things turn out, it may be impossible to meet all the
targets because they may unexpectedly turn out to be mutually
inconsistent.
Senator HEINZ. I would like to point out that my time has
expired and I thank you, Mr. Chairman.
The CHAIRMAN. I would just say you are suggesting something,
John, that may be very dangerous, if the Fed should resign because
of not meeting their monetary targets. And only using 1 year as an
example, we passed the first current budget resolution of $613
billion last June, and it is going to be around $670 or $680. So I
guess it would follow then the entire Congress should resign.
[Laughter.]
Senator HEINZ. Well, there is some merit. [Laughter.]
The CHAIRMAN. I don't disagree. I am just saying you might set a
precedent.
Senator HEINZ. I think the Chairman is on to a very appropriate
analogy.
The CHAIRMAN. Senator Lugar.
Senator LUGAR. Mr. Chairman, although there has been discussion, a great deal of it about the targets and whether you missed or
not, the most intriguing aspect of your report for me is in the
longer section on page 22, net funds raised and supplied in the
credit and equity markets and specifically the second quarter of
1980.
CREDIT MARKET ACTIVITY

Now you have mentioned the extraordinary range of activity in
credit markets. But I had not appreciated until I saw this laid out
quarter by quarter that, for example, net funds raised total all
sectors in the second quarter was $253 billion as opposed to the
previous quarter at $497 billion. And then this came all the way
back to $454 billion and finished at a strong $534 billion for the
final quarter.
Interestingly enough, foreign credit was highest in the second
quarter as opposed to any of the other three.
The Federal Government had a reasonably steady pattern,
moving upward toward the latter two quarters, whereas there was
a devastating change in business and in household net funds raised
in that period.
This indicates, it seems to me, that whatever you were doing at
that point worked, as far as the changing interest rates and changing the amount of money that was being raised.
I went on into page 26 to find the explanation of why all of this
changed, and apparently—and the explanation covers really sever-







25

al pages. But one of the factors which you cited is that the Fed
came to a conclusion—and this is actually the sentence on page 28
of the report—that the sharp plunge in interest rates, even though
it occurred against the backdrop of marked monetary weakness
and steep recession, did arouse concerns in some circles about the
system's commitment to anti-inflationary restraint.
And then later on in the next paragraph, the indicator of policy
feared that the system is being inflationary because rates were
falling sharply.
Now, as you look back on that particular quarter, is it a fact that
the fear of the Nation at that point was that the Fed's policies
were going to foster inflation? It seems to me that the criticism, if
there is one made, of all of us operating in the political system is
that following that precipitous drop of interest rates and the fears
of substantial recession in the country and in the midst of a presidential campaign there were many, many pressures on the Fed and
on lots of other people, for that matter on the Congress, for example, for spending or for hyping the economy in some way.
But clearly something occurred there in terms of combinations of
your policies that was devastatingly effective with regard to lowering interest rates. Now why in your judgment did you change?
Because that quarter alone spells the difference between missing or
hitting the targets. As a matter of fact, as you pointed out, you
missed on the low side during the period.
Mr. VOLCKER. At that point we were on the low side. I think it is
illustrative of the point that certainly in any particular quarter,
asking us to hit a target is asking us to do something we can't do.
There is just too much fluctuation in the figure. But to explain
that quarter, you have to consider that there are lags in this
process.
What went on in the second quarter was basically a combination
of two things. We had the sharpest decline in GNP in one quarter
that we had ever had in the postwar period, which affected
demand. We had credit controls in effect. Those two things were
somewhat interrelated.
Senator LUGAR. Did the controls come before the fall? Or what is
the relationship?
Mr. VOLCKER. The controls came in March. They came technically in the first quarter, but late in the first quarter, and they
exerted their effect clearly, virtually entirely, during the second
quarter. In fact, there was some anticipatory borrowing, which
helped push up these figures in the first quarter; you will see those
figures are quite high in the first quarter.
We had the artificial restraint, so to speak, on credit from the
the credit controls, plus the natural effect of a very sharp decline
in economic activity. That is why the business and the household
credit in particular declined so sharply.
The concern that you referred to about our policy, which was
quite marked, I think, in some areas of the financial markets, was
not about what was going on with credit at that moment. Their
concern was that the rapid drop in interest rates would at some
later time encourage excessive growth—excessive growth in credit
and maybe excessive growth in the economy—and that it might not
be consistent with a persistent anti-inflationary policy. Indeed, the

26

economy did recover much faster than virtually all economists had
anticipated at that point.
It is another commentary on economic forecasting, I guess. As
the economy got going again the credit demands headed up back
toward the level that they were at earlier. This was exceptionally
large, but you expect sharp fluctuations as economic conditions
change, and you have got to look at these things over a period of
time.
All of these are reflected in, and in some degree influenced by,
changes in the money supply itself, which makes it very hard to
say you must be on track in any particular quarter. I don't think
there is any way of approaching this other than looking at the
trend over a period of time.
Senator LUGAR. After the second quarter you released some of
the constraints, did you not?
CREDIT CONTROLS RELEASED

Mr. VOLCKER. We released the controls during the second quarter, or very early in the third quarter.
Senator LUGAR. Why did you do that?
Mr. VOLCKER. Because they seemed to have accomplished their
purpose. Quite simply, we were looking at the fact that the economy was in recession, the credit demands were repressed. The controls were put on, as far as I was concerned, as a purely temporary
measure. When their usefulness was over we took them off.
Senator LUGAR. At that point wasn't the fight against inflation
sort of given up? The cynicism of the public with regard to this is
that, given the pressures of the President's campaign, that the
economy really had to be revved up in the third quarter, that the
recession had come at a very unfortunate time, and so, as a result,
although maybe unwittingly, the Fed by moving into lack of restraint in allowing all forces to proceed again, contributed to an
unfortunate result.
Mr. VOLCKER. I have to reject that interpretation, certainly the
political aspects entirely. During the second quarter itself, as you
noted, the money supply was low. We had not an abnormal situation, I suppose, a feeling on the part of some people, as reported
here, that we were unduly easy in some sense, purely because
interest rates were down. People looking at the same phenomenon
through a differently set of glasses said, "My goodness, the money
supply is low. You are unduly restrictive." We had appeals from
both sets of people at the same timeSenator LUGAR. I know the sorts of appeals. What I cannot
understand is—I can understand those who want things to be
revved up. What I can't understand is the rationalization that
some way inflation would be assisted. I grant the point that if
interest rates are down people might buy more cars, for example,
might buy more houses, and apparently did so for a little while
until they came up again. But would this have been all bad? In
essence, didn't we have several of the best worlds all at the same
time there and gave it up by moving in a different direction?
Mr. VOLCKER. You know, with hindsight you always want to play
the game a little differently. And I have said before that once you
do something different you don't know what otherwise would have







27

happened. But when I look over the past year, I am a little concerned that in an effort to maintain the stability of the money
supply, we may have inadvertently encouraged some people
wrongly, to conclude that things were too easy. In everyday nomenclature, the economic forecast prevalent at the time turned out not
to be very accurate, and the economy did resume a growth trend
earlier than was thought. Maybe we would have been better off, in
a sense, not chasing the money supply quite so actively during that
period. That is not a conclusion that everybody comes to.
Without taking the time to go through it in detail, I will point
out that the chart on page 27 of the report attempts to follow our
operating intentions. Remembering that nonborrowed reserves are
our proximate policy tool in the sense of controlling the money
supply. We pulled them down when inflation was very high and
the economy was high in the first quarter. We pushed them up in
the second quarter to hold up the money supply. From then on we
held them essentially stable.
We were not trying to encourage that increase in the money
supply that took place in August, September, October. It took us
several months to get a real handle on it. But we were applying
pressure right through that period, and by December, I think it is
pretty clear, we had a handle on it. I think this chart makes it
quite clear that we were applying pressure right through that
period.
Senator LUGAR. My time has expired. But let me just get a
quickie in. Why wouldn't you have made the rate range for this
coming year lower generally? I appreciate you have made it a half
point, but why not much lower?
Mr. VOLCKER. I think the implication of a half-point change in
the range is of more than a half a point change in reality, because
we set out to be within the range. We will see what happens, but
our intent is to be within that range, which implies a larger rate of
decline, given what happened in 1980, than the half-point reduction
in the range itself suggests.
The Chairman. Senator Williams.
Senator WILLIAMS. Thank you, Mr. Chairman.
Chairman Volcker, in the report that you are submitting, in fact
your appearance here—is a result of the Full Employment and
Balance Growth Act of 1978, the Humphrey-Hawkins Act.
EMPLOYMENT AND MONETARY POLICY

I see very little in your submission—and I haven't been here
through the entire morning of your testimony, but I'm told there is
very little in your testimony about full employment. I just wonder
what will the Fed monetary policy do for employment, and also
why is there so little mention of full employment in the current
debate over fiscal and monetary policy?
Mr. VOLCKEK. I don't know how you define full employment. It's
defined in that act as 4 percent, if I recall correctly.
Senator WILLIAMS. Right.
Mr, VOLCKER. That objective of 4 percent unfortunately is not
realistic in the short run, and I think various administrations have
recognized that.

I am wholly convinced—and I think I can speak for the whole
Board and whole Open Market Committee—that recognizing that
that objective for unemployment cannot be reached in the short
run—the kinds of policies we are following offer the best prospect
of returning the economy in time to a course where we can combine as full employment as we can get with price stability.
I bring in price stability because we will not be successful, in my
opinion, in pursuing a full employment policy unless we take care
of the inflation side of the equation while we are doing it. I think
that philosophy is actually embodied in the Humphrey-Hawkins
Act itself. I don't think we have the choice in current circumstances—the old tradeoff analysis—of buying full employment with
a little more inflation.
We found out that doesn't work, and we are in an economic
situation in which we can't achieve either of those objectives immediately. We have to work toward both of them; we have to deal
with inflation. And the Federal Reserve has particular responsibilities in that connection.
Senator WILLIAMS. You have another report coming later in the
year under that law. I hate to get into any attempted precision
about timing and goals here, and I don't know what we can assume
in terms of time and passage of the President's recently announced
economic program, a program of substantial reductions of expenditure, the infusion of tax changes, both designed to bring on greater
productivity.
It just seems to me none of this can have, in the short term—by
your next report, for example—too much effect on either of the
factors here, productivity or inflation.
Mr. VOLCKER. I think that's right.
Senator WILLIAMS. The public there expects great things to
happen within a year. The polls show that. How do you look at
things?
Mr. VOLCKER. I don't want to encourage overly optimistic expectations on the part of the public in the time frame that you are
speaking of. I think we have a very difficult problem here. We
discussed earlier that there's not going to be room for growth in a
substantial way until we get the inflation rate moving down. We
haven't, in my opinion, yet turned the corner on inflation. We've
had a lot of pressure on the financial system. We have restrained
growth in money and credit in general terms—I think that's quite
clear, compared to the demands out there.
We have, I believe, prevented the inflationary situation from
exploding, as it easily could have; we've been sitting on top of a
boiling kettle. But we have not yet succeeded in turning the corner
on inflation. We must do that; that's the first step; and that is
going to be a difficult process. Nothing that's happened suggests
that's easy.
We have gone through quite a lot of agony just keeping the lid
on that kettle. We have got to get this thing turned around. That,
in a sense, is the job for 1981.
If we can succeed at all in 1981—when I say "we," I just don't
mean the Federal Reserve; I mean public policy—we will then have
begun to set the stage for the kind of growth and further progress
on inflation that we would like to see.




29

But I think there is a very substantial risk of disappointment, as
you suggest, if the hope is held out that this is going to happen
magically in the next 6 months without a lot of stress and strain in
the process.
Senator WILLIAMS. We are going to go through the agony here in
those next 6 months. That's the way it seems to me.
DANGERS TO THE THRIFT INDUSTRY

There is one specific economic problem here that hit my office
this week—and perhaps others, too. And that deals with one of the
effects of the high interest rates. We all know the toll they're
taking on homebuilders, automobile dealers, small businessmen,
and individuals, too. They are also having a very, very destructive
effect on the thrift industry, which is experiencing massive deposit
outflows and severe earnings problems.
Money market mutual funds are often blamed for exacerbating
the problem. I don't know if you call this disintermediation or not,
but a massive amount of funds are flowing into the money market
mutual funds from thrift institutions. I know that some of the
members of the Board have expressed their opinions about the
many problems that are presented by these funds.
Why don't I put three questions, and then if you could give us
your feelings:
First, I would like to know what your views are on this explosive
growth of money funds, and whether they complicate the conduct
of monetary policy?
Second, do they take investment capital out of the economy?
And, third, do they pose a real and present danger to the thrift
industry?
Mr. VOLCKER. I don't think they take money out of the economy,
in the most general sense. I think it is true that the investment
behavior of money market funds results, perhaps, in somewhat
larger flows into the Eurodollar market than might otherwise take
place. But the markets are closely interconnected anyway, and it's
hard to argue that that's a very significant influence. The funds do
buy Eurodollar, CD's, and so forth. One might assume that if the
money came out of thrift institutions or commercial banks it might
now flow a little more easily abroad. But those markets are very
closely connected anyway, and it's hard to say that that is, in
ordinary circumstances, a major influence.
Otherwise, the money comes back automatically someplace in
the American economy. It may come back to somewhat different
places than it otherwise would have, but it's not going out of the
economy entirely. There is some distributional effect, but it doesn't
take money out of the economy, per se.
As you know, we've put on some restraints on those funds when
we had credit controls, partly because we felt that they were draining money from smaller banks and thrift institutions—which were
particularly hard-pressed at that time—and in channeling the
money into the central money markets or into the Eurodollar
market, where there was already, in relative terms at least, more
ability to borrow by the big companies that used those markets.
I think there is a structural question that arises that is relevant
to the conduct of monetary policy over a period of time; that is, to




30

the extent money market funds are really running a transactions
account business—checks, third-party payments—their shares do
become a kind of money or quasi-money, but they operate without
the same constraints—without reserve requirements in particular—that thrift insitutions or commercial banks have when they
are running a transactions account business.
Using a kind of broad logic, this development does suggest the
reasonableness of equalizing the competitive conditions under
which these institutions operate, Our analysis suggests that while
that logic is correct, it's the kind of problem that would emerge
over a period of time, because it depends on how actively they are
using these transactions accounts.
You also raised the point as to the extent to which that complicates the very real problems that thrift institutions and commercial banks have at this time- That is a more immediate kind of
question.
I think I would make two general comments. The problems the
thrift institutions have is basically that they've got a lot of old
assets that were bought in a different economic climate, when
there wasn't much inflation, and they find it very difficult to make
the adjustment to a high level of inflation; this comes back to the
priority of dealing with inflation.
Second, as long as interest rates remain high, there are a
number of alternative places for money to go other than money
market funds, including into Treasury securities directly. The markets are very ingenious about developing new institutions or new
techniques for attracting money when there is an interest rate
discrepancy.
Therefore, I don't want to suggest that a change in money
market funds, per se, will make a revolutionary difference in the
condition of the thrift industry at this time, so long as the basic
conditions of high market interest rates and high inflation remain.
Senator WILLIAMS. Do you have any suggestions for action now?
If so, we'd like to hear about them.
Mr. VoLCKER.The Board of Governors, as a whole, has not considered this, but we would be glad to make such recommendations.
[Chairman Volcker subsequently furnished the following information:]
The Board will be considering this matter in the near future and will report its
views to the committee.

Senator WILLIAMS. There are some ideas on the old rates that
they're stuck with.
Mr. VOLCKER, I understand.
Senator WILLIAMS. Thank you very much.
The CHAIRMAN. Chairman Volcker, what Senator Williams just
brought up is going to be my next line of questioning, so let me
follow up in more detail.
At the time we were considering the problem of Federal Reserve
membership decline there were different solutions. Senator Tower
and I prefer to pay interest on reserves and have a voluntary
system. That was not what was passed in H.R. 4986.
We do have a mandatory reserve system, whether an institution
is a member of the Federal Reserve or not. At that time, one of the
great arguments made for that was the necessity for reserves in




31

order to manage monetary policy. And yet we now have $90 billion
of money market funds floating outside of that, so it must have a
more dramatic effect than you've indicated to Senator Williams; or
else your whole thesis of needing mandatory reserves to manage
the money supply is questionable, because $90 billion is a lot of
money to be floating outside the system.
Mr. VOLCKER. The only disagreement I would have with your
comment is on the practical matter of how much emphasis to give
at the moment to the $90 billion out there. All of that $90 billion is
not acting like a transactions balance, which is where the reserve
requirements are. In the past these funds have acted more like
savings accounts where we're phasing out reserve requirements.
In fact, they are now a mixture in type, and my concern is that
the mixture would get heavier on the transactions aspect over
time. I think that's probably happening.
I'm fully with your logic, but I don't think you can say that $90
billion is the equivalent of $90 billion in transactions accounts.
TRANSACTION ACCOUNTS

The CHAIRMAN. Let's go to the transaction' accounts. Also for 5
years we struggled and finally came up with H.R. 4986, the socalled level playing field. For the first time the small institutions
that Senator Williams is talking about—the thrifts, the S, &. L's,
the credit unions—have NOW accounts and share drafts all the
way since January 1. They are very carefully regulated.
Here the securities industry and some of the giants like Merrill,
Lynch are in the third-party checkwriting business, totally outside
of that regulation. I don't know of anything I've seen that I believe
is more patently unfair but probably legal. Merrill, Lynch is operating through Bank One in Columbus, Ohio. I happen to think
Bank One in Columbus is either operating branches in my State or
other places in violation of the McFadden Act or else Merrill
Lynch is a bank. If it looks like a duck, walks like a duck, it must
be a duck.
I'm concerned that the Fed is so interested in regulation—and
there is no industry more carefully regulated in these transaction
accounts than the financial community banks, savings and loans,
and thrift institutions, and yet here we have this giant out there
issuing checks, third-party checks. And I hear very little from the
Fed.
Now in the State of Utah, the Utah Legislature is involved in the
process right now of a 403-page bill, and what they are going to do
with it, I don't know. But it really disturbs me when we talk about
the so-called level playing field—and what one person's definition
of a level playing Field is is obviously different from someone
else's—but I don't think anyone can conclude from the transaction
accounts of money market funds—and I'm certainly bright enough
to understand the difference between 17 percent and 5.25 percent
interest and the advantages to the consumer—but the narrow
issue, not the issue of money market funds or whether consumers
should have that choice, but whether they should be allowed to
write checks.




32

It seems to me, we've either got to let banks, financial institutions, get into municipal revenue bond writing and get into money
market funds or else tighten the screws the other way.
I prefer less regulation, but still it seems the issue that Senator
Williams is talking about—it is hurting some of the small institutions, and it is unfair competition that is created by Government,
and we're going to have more hearings on this. I guarantee it.
So I would hope the Fed could get their act together and come up
with some recommendations of what is an incredibly unfair competitive situation with the giants of the securities industry and the
small little thrifts that are struggling with this high cost of money.
COMPETITIVE EQUITY

Mr. VOLCKER. I don't disagree at all that there's an equity problem. To the extent these are transactions accounts, the treatment
is different, and it's inequitable, and I don't question that this
helps bring pressure on financial institutions.
I simply did not want to suggest that bringing those funds into a
situation of competitive equity would mean that the problems of
the thrifts or the commercial banks would disappear, given the
basic situation that exists.
The CHAIRMAN. Yesterday the Supreme Court issued a decision
upholding the Fed's regulation permitting bank holding companies
to sponsor, organize, and control closed end mutual funds—closed,
end as you know, limiting the number of shares compared to open
ended funds that continuously offer their securities.
Do you believe this decision means that the bank holding companies can offer closed end money market funds?
Mr. VOLCKER. I don't now, I'm not familiar enough with it.
The CHAIRMAN. Is it practical?
Mr. VOLCKER. I'd better not comment on the issue. I'm just not
familiar enough with it at this point.
The CHAIRMAN. See, it's interesting when you start talking about
level playing fields, when you start talking about banks getting
into the securities business, then all the securities people put up
their hands and say: "Hey, that isn't fair; they are banks."
Well, the banks and the thrifts have a right to say, "The securities industry are not thrift institution." So with third-party check
writing, I'm disappointed that the Fed seems to have just overlooked what is obviously a very inequitable situation.
Mr. VOLCKER. I don't think it's quite fair to say we've overlooked
it. The Merrill, Lynch plan was before I was on the Federal Reserve Board, but it was looked at at that time. Apparently the legal
conclusion was reached that it had been arranged in such a way as
to thread its course between the banking laws and the security
laws.
The CHAIRMAN. They have about four different laws. They've
done a very good job of it.
Mr. VOLCKER. I think you'll recall that the money market fund
issue was considered at the time the Monetary Control Act was
considered, and I've had some discussion with Senator Proxmire
and others as to whether it was logical to include them under the
law on precisely the grounds that you are describing. The logic and




33

the equity was that the transactions accounts business should be
brought into the level-playing-field concept.
At that time, what emerged was that we would not deal with
that issue in the context of that particular law. But that doesn't
close the issue forever, in my judgment.
The CHAIRMAN. The reason I'm so upset about it, Mr. Chairman—if there's anything I will try to do as chairman of this
committee, it is to attempt to find equity, and there is no one that
is more in favor of free competition than I. But here you have a
situation of where Government is giving the competitive advantage
to one sector over another. When the Government is in the process
of delineating what the competition is—it isn't free competition.
That's the problem. It's not one of just taking the thrift side at all,
because you can solve it two ways. You can deregulate them and
let the securities people scream, or you can put some more control
on securities.
Mr. VOLCKER. That is why I stated precisely in my answer to
Senator Williams that as a matter of logic, if they're doing a
transactions account business, that business ought to come under
the same rules, one way or the other, as you point out.
The CHAIRMAN. We'll see what can be done about that in the
next few months so they are treated equitably.
My time is not up, but I do believe we should move along.
Senator RIEGLE. Can I just say, I agree with the concern that you
have been raising. I hope we can press ahead on that issue.
The CHAIRMAN. Senator Proxmire?
Senator PROXMIRE, Chairman Volcker, John Berry, who as you
know is the highly reliable, honest, accurate, precise reporter for
the Washington Post
[Laughter.]
Senator PROXMIRE [continuing]. Reported the following, and I
quote:
Fed Officials fear that the administration's highly optomistic economic forecast
which predicts a simultaneous increase in real output, a sharp drop in inflation, and
rapidly falling interest rates beginning late in this year is setting public expectations much too high. If the central bank is successful in slowing money growth but
at the cost of higher interest rates and lower levels of economic activity than
predicted, there could be a public and Congressional backlash with the Federal
Reserve.

That's you Paul Volcker cast as the villain—"we are being set
up, one official said flatly." And that quote comes from the reliable, honest, accurate, precise John Berry, and I want to ask you,
are you being set up?
Mr. VOLCKER. I won't characterize Mr. Berry, other than to say
that my impression is not unlike yours. But he isn't quoting me, to
the best of my knowledge, on that subject. I don't think there's
anyone being set up. I expressed my concern earlier to Senator
Williams about public expectations and the importance of dealing
with this inflation problem, and I would be concerned if people
thought that it was easy to get this situation turned around because in that
Senator PROXMIRE. The administration and their top responsible
spokesmen, like Mr. Stockman and others who have been making
these predictions—they say we're going to have a sharp drop in
inflation if we enact the President's program; we're going to have a




34

reduction in unemployment; we're going to have a very sharp drop
in interest rates.
It seems to me that that is what the public expectation is built
on more than anything else. And if we don't have that, then
obviously the fall guy is going to be you.
INFLATION PREDICTIONS

Mr. VOLCKER. I don't think their projections of inflation by themselves are unreasonable. I hope we could accomplish that. I would
hope we could accomplish more than that.
My concern is that the road from here to there may not be
totally smooth, if I may put it rather conservatively. I don't know
just what that road is going to be, but I don't think
Senator PROXMIRE. You say their inflation predictions might not
be unreasonable. How about the interest rate predictions? They
have predicted that interest rates, the prime rate would drop to 8
to 9 percent next year.
Mr. VOLCKER. The interest rate should be related to the inflation
rate in a general way over a period of time, a point that you have
made yourself. I religiously refrain from forecasting interest rates.
I, myself, just don't want to add to any impression that getting
from here to there will be smoother. I would like to see it as
smooth as possible, but whatever stress, strain, and pain there is I
think is worth it. I think we have got to get to that result.
Senator PROXMIRE. In President Reagan's program for economic
recovery, he has a chapter on controlling money and credit, calling
for a reduction in monetary growth rates for the years ahead. The
document says the administration will do nothing to undermine
the Fed's independence. Are you familiar with President Reagan's
plan?
Mr. VOLCKER. I'm familiar with the section that was written.
Senator PROXMIRE. Was the Fed consulted?
Mr. VOLCKER. I saw it before it came out.
Senator PROXMIRE. Was that the consultation—you saw it before
it came out?
Mr. VOLCKER. You mean on the program?
Senator PROXMIRE. Yes.
Mr. VOLCKER. On the program itself, I have had quite a lot of
contact with individual administration officials since Christmas
time.
Senator PROXMIRE. You discussed this program with the Secretary of the Treasury and other officials?
Mr. VOLCKER. Yes.
Senator PROXMIRE. Has the Fed adopted the Reagan statement
as its policy?
Mr. VOLCKER. We adopt our own policies as policies. But as I
indicated earlier, that particular statement seems to me broadly
consistent with what we have been saying all along.
Senator PROXMIRE. Did the Open Market Committee consider
adopting the Reagan policy?
Mr. VOLCKER. No.
Senator PROXMIRE. Now I think Senator Heinz' questioning was
very, very enlightening.




35

Mr. VOLCKER. I don't know whether there's any sort of misunderstanding. The Open Market Committee, per se, had no discussion
about adopting "the Reagan policy," in terms of that sort. The
Open Market Committee met to discuss these ranges before the
Reagan program was announced, although obviously there have
been a lot ofSenator PROXMIRE. So your posture is simply that the Reagan
program doesn't clash with or contradict your position? In fact,
that's the position the Federal Reserve has had?
Mr. VOLCKER. Those comments do not clash at all. That's precisely the distinction I want to make.
Senator PROXMIRE. When Senator Heinz was questioning you,
frankly I hadn't studied that table I, and it is startling, because
I've been complaining for years, as you know, that the ranges are
much too broad—M-1A, M-1B, and so forth. In every measurement
of the money supply, as Senator Heinz pointed out, you were above
the top part of the range, and if you take the midpoint as a
comparison, in M-1A you were 50 percent over; M-1B, 30 percent
over; M-1A about 60 percent over; M-1B again you were about 60
percent over; M-2 you were 40 percent over; M-3 you were 35
percent over.
You were above-higher
Mr. VOLCKER, If I may interject, Senator, I don't think it's meaningful to say we were 35 percent
Senator PROXMIRE. You were.
Mr. VOLCKER. If the target were 1 percent, and you missed by a
quarter of 1 percent, you'd be 25 percent over. It's not economically
meaningful. If the target was zero, we'd miss it by infinity. [Laughter.]
It is not a meaningful comparison. We are dealing with a series
that is inherently volaties. If I may refer back to the technical
material—in it, I submitted that if we hit our reserve targets
perfectly, or hit any reserve target perfectly—which we cannot
do—in 1 month one-third of a time, the money supply figure would
be off plus or minus 10 percent.
Senator PROXMIRE. I'm not talking about monthly functions are
one thing. This is for the entire year. You told us that you missed,
and missed badly, in every case as far as the midpoint is concerned.
As I say the ranges you make are so broad that it's like they say,
you couldn't hit the broad side of a barn door if you fell against it.
Mr. VOLCKEK. We have got to be realistic about what the real
world is like. I commented that our money supply figures and our
performance relative to these targets compares well internationally. We are dealing with a series that is not subject to the kind of
close shortrun control that the question implies.
Senator PROXMIRE. I understand that. You made, I thought, a
very interesting response when you told Senator Heinz that maybe
it was right that it parts from the target. After all, the conditions
change. The condition that changed was the second quarter of 1980
was the worst quarter we've had since the Great Depression. It was
a terrific, calamitous, sudden, sharp drop in economic activity.
Obviously in that time we shouldn't follow a restrictive policy. And
apparently you didn't follow a restrictive policy.
Mr. VOLCKER. At that point, in fact, the money supply was low.




36

Senator PEOXMIRE. It was, but it came back very fast because of
that situation.
Mr. VOLCKER. It came back very fast. It came back, in some
sense, too fast. It took us several months
Senator PROXMIRE. It may be one of the reasons we recovered so
rapidly from that disasterous second quarter—as a matter of fact,
the way things worked out according to the technical definition of
recession, we didn't have a recession, because we didn't have two
successive quarters of negative growth. That was the only quarter
in 1980 that we had negative growth.
Your policies probably did assist in the recovery. At the same
time, however, it seems to me that may tell us something about
how persistent you will be in following an anti-inflation policy if
we dip again.
Mr. VOLCKER. I would like to think our performance does say
something about how persistent we will be. You are looking, in
terms of this chart, at how we came out with respect to one
particular quarter during the year; that's the way we conventionally set forth these targets, fourth quarter to fourth quarter. But
there is nothing ordained in heaven that says the fourth quarter is
any more significant than any other quarter.
Senator PROXMIRE. The thing is, as Senator Heinz said, they are
your figures. This is your table. You put it together. You handed it
to us.
Mr. VOLCKER. I agree. And by convention, for simplicity of explanation, we want to capture the period during the year. We say,
let's set forth the target fourth quarter to fourth quarter. But let's
not mistake the convention, which is ours, as an explanation of all
reality.
If we look at the annual average change in the money supply—
which for some purposes is a more reasonable way of looking at it
because it encompasses the money supply during the entire year—
the growth in M-1A last year was 5.6 and the growth in M-1B was
5.9. If you interpret these targets as an average for the year, we
would have been just inside them.
I don't think we ought to get hung up on a quarter of 1 percent.
Our intent is to be restrictive, to restrain this growth, to reduce
this rate of growth over time.
If you extended last year's target into January and February of
this year, we would be comfortably inside right now. It depends
upon just when you take the snapshot. But it is important
Senator PROXMIRE. My time is up. But Mr. Chairman, the fact is
that you are the ones that gave us this picture, and I think it was
an accurate, an honest picture. And on the basis of what you gave
us, you were way, way over your midpoint and you had a much
more stimulating monetary policy than you indicated you would
have.
As you say, statistics can prove anything you want, but these are
your statistics.
Mr. VOLCKER. I think they are accurate statistics. All I am
saying is that no set of relatively few numbers can portray all of
reality, and that's as true of this table as any other series of six or
seven numbers I can give you. And they have to be interpreted in a
larger context.




37

The Chairman. Senator Riegle?
Senator RIEGLE. Mr. Chairman, on page 44 of the Fed report you
show the economic projections for 1981 by the Federal Open
Market Committee, and you show the range that the committee
foresees versus that of the administration. I don't want to get into
that right at the moment, but do you also make those projections
for 1982?
Mr. VOLCKER. No.
Senator RIEGLE. They don't exist?
Mr. VOLCKER. No.
Senator RIEGLE. Is there a reason for that?
Mr. VOLCKER. Well, we have
Senator RIEGLE. Let me not use my time that way. The point is,
they don't exist for 1982. Would it be possible to get them for 1982?
Mr, VOLCKER. I could. The way we got these figures is by polling
the committee, but we have not followed, [Laughter.]
We did not poll them for 1982.
Senator RIEGLE. I think that would be useful. I would like to just
ask, as long as you are able to do it for 1981, maybe that also be
done for 1982.
But let me go on from there, because there is a more specific
question I want to ask. What is likely to take place in 1982? And, of
course, none of us know that. We've got a plan here -_
Mr. VOLCKER. That is my concern.
Senator RIEGLE. And ours as well. Assuming we are going to go
ahead, and I think a lot of the program that is before us, the
Reagan program, will be enacted, I think the spending cuts, by and
large, will be made maybe in somewhat different areas, but I think
in the aggregate we will be very close to those numbers. I think the
tax numbers may be about the same, although it may be shifted
around as between investment type versus personal tax cuts.
MAINTAIN TIGHT MONETARY POLICY

But my question to you is this: If we get out into 1982, and even
if the program is put in place, for some reason it just doesn't work
the way people thought it would—there might be outside shocks
from OPEC and oil interruption, you know as well as I, bad harvest, other things that singularly or together could take and knock
everything askew—if we find outselves in a situation where the
deficit starts ballooning, for whatever reason, and the inflationary
expectations are still high—would it be the intention of the Fed,
then, to maintain a very tough and tight monetary policy?
Mr. VOLCKER. Our present intention—and I don't see that intention changing—is to maintain the kind of monetary policy described in this report. Now, if those kinds of contingencies that you
describe materialize, it would imply, I think, very heavy pressure
on financial markets.
Senator RIEGLE. So I gather, and this relates to Senator Proxmire's question, that the responsibility to take some additional
further action might then fall to the Fed, and you are prepared to
take that action in terms of the restrictive monetary policy, if you
feel that has to be done.




38

Mr. VOLCKER. The only way that I would restate your conclusion
is changing the words "take further action." We intend to persist
in this course, in terms of these monetary numbers. Its implications for financial markets depend upon all those other things that
you rightly emphasize.
Senator RIEGLE. I think it's helpful for the Senate to be aware of
your direction under different eventualities, because if the prospect
was to be for a period of tight monetary policy, resulting in a
continuation of relatively high interest rates, I think that presents
a whole set of problems that we ought to try to forestall. I frankly
would feel that would be a disaster, if we find ourselves in that
situation.
Mr. VOLCKER. I agree with you. The conclusion I would draw
from that is certainly not that we should ease up, because that is
not going to help the inflationary situation or help us to get out of
this problem at all. My conclusion from that is, in evaluating this
program, you get in there as big a safety margin, so to speak, as
you can, in terms of the Federal budgetary picture and spending in
particular.
You have to operate on both sides of the equation, but the
immediate instrument that you have and the key point is not to
take risks on the expenditure side.
Senator RIEGLE. Now, the Reagan deficit projection for 1982 is
$45 billion. Is that an acceptable figure? If we hit that figure, will
that be sufficient, from the Fed's point of view?
Mr. VOLCKER. I don't think I can analyze that figure in isolation.
If you had a deficit of that size as clearly a transition toward a
balanced budget, in circumstances in which the inflation rate was
clearly coming down, in which there is a considerable margin of
slack in the economy—which affects tax collections and affects
certain payments on the other side—I don't think you could say
that that deficit, under those particular set of conditions, was
unreasonable.
Senator RIEGLE. Under worse conditions it would make you nervous, I take it?
Mr. VOLCKER. Under other conditions it would make me very
nervous, yes.
Senator RIEGLE. Let me ask you this. When the President spoke
to the Senate in the joint session the other night, in the course of
his two paragraphs on the Federal Reserve and monetary policy,
he said: We will consult regularly with the Federal Reserve Board
on all aspects of our economic program, and so forth and so forth.
Is this a new practice? Have you found yourself now working in
consultation with the administration, in a different way than was
true in previous administrations?
Mr. VOLCKER. No. Of course it is very early in this administration.
Senator RIEGLE. So it's really not changed; is that what you're
telling us?
Mr. VOLCKER. At this point.
Senator RIEGLE. On the question of the degree to which you were
consulted on the economic package, was the Fed asked to give it its
blessing in private conversation, or not?
Mr. VOLCKER. No.




39

Senator RIEGLE. It was not?
Mr. VOLCKER. No.
Senator RIEGLE. And does that also mean that it did not? Or did
the Fed volunteer an opinion one way or the other?
Mr. VOLCKER. No.
Senator RIEGLE. It did not?
Mr. VOLCKEB, No.
Senator RIEGLE. So it isn't fair to say it either has the blessing or
the lack of blessing of the Fed.
Mr. VOLCKER. That is correct. That degree of formality, or whatever, was not at issue.
Senator RIEGLE. Has there been any discussion to indicate that
the process from this point forward may be different; that the
Reagan administration may have something in mind in terms of
coordination that would be different than past practice?
Mr. VOLCKER. I don't have any indication of that. They've had
some discussion with me about how these arrangements took place
in the past, and how we felt we might handle it, just on a personal
basis. Our meetings have been thus far, as a very practical matter,
not necessarily less frequent, but perhaps less regular, perhaps
because they are very occupied with getting this program together
and with their various appearances up on the Hill.
We are very busy men at this point, so we have had to get
together when we can, rather than on a very organized basis.
TAX POLICY

Senator RIEGLE. If I may, and hopefully without intruding on the
privacy of the sessions, but I think it is important for us to know, if
we can; and that is were you asked your opinion on the kind of tax
cut that might work best or not?
Mr. VOLCKER. As you would expect in this kind of informal
conversation, they informed me at times of what their planning
was as to the cuts, and with respect to the size of the tax program,
and how they were proceeding. I don't think it's fair to say that we
had any particular dialog or debate about the shape of the tax cut.
They determine that.
Senator RIEGLE, So you made no particular recommendation one
way or the other on that?
Mr. VOLCRER. We've had some discussion of the balance among
tax reduction and expenditures, as you would expect. But I don't
think I can go much beyond that. The shape of this program is
entirely theirs.
Senator RIEGLE. Might I just ask this? If by some means the
Senate or the Congress were to decide to exactly reverse the proportions of the tax package—I'm not suggesting that it will, but
just for the sake of the illustration, let's just suppose we reverse
the ratios. Would that have any effect, in your mind—good, bad or
otherwise—on the impact on inflation going out in time, or not?
Mr. VOLCKER. I really don't think I can give an intelligent
answer in terms of proportions. I am interested in very general
terms. There is a lot of debate about tax policy. It is not my direct
responsibility. But I think the more that can be done in terms of
incentives the better off you will be, and the job is to determine




40

what the best program is, putting the emphasis on that characteristic.
Senator RIEGLE. Let me ask your opinion. If you take the $44.2
billion in the personal tax reductions in 1982, what would be your
estimate as to the percent of that that would make its way into
savings? What is your judgment on that?
Mr. VOLCKER. I can't look at it that way. I don't know. I think
you can only answer the way I did before. You can only answer
what the impact is of the total program—and that is a big component in the program—on the prospect for getting the total savings
rate up; you can't try to trace through where particular dollars
went and what an individual's behavior will be.
Senator RIEGLE. It is kind of a key question, isn't it? If you have
a low margin or rate of savings on that it wouldn't help.
Mr. VOLCKER. I don't think it really is. I guess what I am saying
is what is important is what is done to effect the marginal rate of
savings or the average rate of savings for the economy as a whole.
It is not so important to try to pick out what a group of individuals
have done with their tax money. You can't really tell anyway,
because after the first quarter or two, people's motivations become
entangled with everything else.
Senator RIEGLE. You have got to remember we are borrowing to
pay out the money. It is not as if we are going to be running a
balanced budget in 1982. We are projecting a $45 billion deficit.
Mr. VOLCKER. I would like to get a maximum impact on savings.
You asked me for a technical judgment as to just how much of this
will be saved. I think what econometric or analytic work has been
done on this says it all depends on the particular setting of a tax
program. In the very first month when somebody ends up with a
bigger pay check, he may save it. He may stick it in his bank
account. That is a form of savings.
So it looks like he is saving it for the first month or two. The
question is what happens after the first month or two; all the
analysis says what appears as savings in the first month or two
rapidly diminishes as people restore a more normal position.
If you reduced taxes for 6 months and said you were going to
raise them again you would get more saved than if you said you
were going to reduce taxes permanently. That is what the analysis
suggests.
I think the real question is not just what this part of the program does but what the program as a whole does to the total
savings rate.
The CHAIRMAN. Senator Proxmire.
Senator PROXMIRE. I have some questions for the record, too. I
would just like to call your attention, finally, Chairman Volcker, to
pages 22 and 23 in the program of economic recovery, the administration's document on the economy and the economic policies.
Those pages affect you, the Federal Reserve controlling money and
credit.
And they say in the next to the last paragraph and following,
economic scenario assumes that the growth rates of money and
credit area steadily reduced into 1980 levels to one-half of those
levels by 1986.




41
NONCOMMITTAL POLICY

How they can make that assumption without any commitment,
and you have indicated to Senator Riegle that there has been no
commitment, no promise, is beyond me, particularly in view of the
fact this would go well beyond your term, of course. But it projects
a policy which you might approve now, but it projects it in the
future, and there is no commitment to abide by that policy; isn't
that right?
Mr. VOLCKER. In a technical sense I think that is right. But that
statement, again, is in general congruence with what we have been
saying.
Senator PROXMIRE. General congruence. There is a very precise
estimate by 1986 the growth rate would be one-half of what they
are today.
Mr. VOLCKER. I thought there was an about in there.
Senator PROXMIRE. There is no about at all. To one-half those
levels by 1986.
Mr. VOLCKER. The about may have been in another context. I
would not interpret it as more; maybe less, I had seen a statement
of that kind before it was issued, and my response was that I didn't
know whether they would want to say it or not, but it seems to me
if they want to make that assumption it is not out of keeping with
the sense of what we have been saying.
Senator PROXMIRE. I understand that. There is just no commitment. Mr. Chairman, I just want to express the same concern that
you did, that the thrifts are under heavy pressure from money
market funds. We must fight inflation. But also we need to address
the issue of equitable competition, which you discussed with the
Chairman, between thrifts and money market funds, and we also
need to consider the need to maintain free financial markets.
I hope, Chairman Volcker, that you will provide the committee
with your guidance for the record on that issue, because the committee must be taking the issue up.
Mr. VOLCKER. We will.
The CHAIRMAN. Mr. Chairman, we appreciate your testimony
today and your patience. I am sure as you are questioned on the
performance of the Fed you must have sometimes an incredible
desire to have us in the witness box asking us how we performed
on our targets and on the fiscal side.
I would only close by saying that the ball is in our court. I
cannot emphasize that enough, that unless we restrain the fiscal
policy, unless we have cuts in the magnitude the President has
asked for, not only in this year, that will not solve it at all unless
those cuts in the out years are made as well.
You will be back here every 6 months and we will be talking
about the same high interest rates and performance of the monetary aggregates. So I hope that from the condition of the economy
that Congress will respond and we will do our part in helping to
control inflation.
Mr. VOLCKER. I very much share those thoughts and those hopes,
Mr. Chairman.
The CHAIRMAN. Thank you very much.
The committee is adjourned.
[Whereupon, at 12:30 p.m. the hearing was adjourned.]




42

[Complete statement of Chairman Volcker, copy of the report
from the Federal Reserve Board, answers to subsequent questions
of Senator Garn, and reprint of briefing materials from the Library
of Congress Congressional Research Service follow:]
Statement by
Paul A. Volcker
Chairman, Board of Governors of the Federal Reserve System
I am pleased to be here this morning to discuss with
you the Monetary policy--Report' of the- Board1 of Governors -••--" •
reviewing economic and financial developments over the past
year, and setting forth appropriate ranges for growth of
money and credit for 1981.

Because I have already reviewed

recent developments with the Committee, my emphasis this
morning will be on the present and future concerns of monetary
policy.

In that connection, I would like to touch first on

some more technical considerations of Federal Reserve operating
techniques.
As you well know, 1980 was a tumultuous year for the
economy and financial markets.

While most measures of the

monetary and credit aggregates grew at or very close to our
target ranges for the year as a whole, there was considerable
volatility from month to month or quarter to quarter.

More-

over, interest rates moved through a sharp cycle, and had
considerable instability over shorter time spans.
In the light of these developments, I initiated in
September a detailed study by Federal Reserve staff of the
operating techniques adopted by the Federal Open Market
Committee in October 1979, Looking, among other things, to
the question of whether the particular techniques we employed
contributed importantly to the observed volatility.

Those

techniques, as described in our Report, place emphasis in the
short run on following a path of nan-borrowed reserves.







43
... The study .drew .upon, the,.substantial body, of. staff
expertise both at the Board of Governors and at the
regional Federal Reserve Banks, thus bringing to bear a
variety of viewpoints and analytic approaches.

The Open

Market Committee has had some discussion of the findings,
and we are now at a point where the work can be made available to interested outside experts.

To assure full review,

Board staff will be arranging "seminars," as appropriate,
with economists having a close interest in these matters.
Among the important questions at issue is whether alternative techniques would promise significantly better short-run
control over the monetary and credit aggregates, and whether
such techniques would imply more interest rate instability.
We also examined again the significance for the economy and
for basic policy objectives of monthly, quarterly, or longer
deviations of monetary growth from established target ranges.
' For the convenience of the Committee and others, I have
listed in this text some of the technical findings that may
be of more general interest.
1.

The work confirms that the week-to-week money
supply figures are subject to a considerable
amount of statistical "noise" — unpredictable
short-run variations related to the inherent
difficulty of computing reliable weekly seasonal
adjustment factors and other random disturbances.
One analysis suggests the random element in the
weekly M-l data, as first published, is about S3
billion, plus or minus. While those variations
average out over time, they could amount to $1%
billion on a monthly average basis, equivalent to
a change of 4% percent at an annual rate.




44
Ha- clear, evidence ..was found that,,, in the.
present institutional setting, alternative
approaches to reserve1(or monetary base)
targeting would increase the precision of
monetary control. Indeed, in current circumstances , some other approaches would appear to
result in less precision in the short run.
Perhaps more significant, the linkage between
any reserve measure and money in the short run
was loose; econometric tests seem to suggest
that, even assuming absolute precision in
meeting a reserve target (which is not in fact
possible), monthly M-l measures would be
expected to deviate from the target by more
than plus or minus 8 to 10 percent (at an
annual rate) one-third of the time. Those
deviations should tend to average out over
time, so that much closer control could be
achieved over s three-to-six month period,
assuming no constraints on operations from
interest rates or other factors. Those
econometric results are consistent with the
actual experience of 1980,
Pursuing the closest possible short-run control
of the money supply by any technique entails a
willingness to tolerate large changes over short
periods of time in short-term interest rates —
greater than were experienced in 1980. The
technique actually employed, as expected,
contributed to more day-to-day or week-to-week
volatility than earlier procedures, but presumably not so much as otiier, more rigid reserve
targeting approaches. Experience in 1980 also
strongly suggested that short-run changes in
money market rates became more highly correlated
with fluctuations in long-term interest rates,
which may be of more significance to investment
and financial planning. The degree to which that
closer association reflected uncertainty and a
learning process unique to 1980, or is inherent
in reserve-based targeting, cannot be determined
at this time.
Interest rate instability associated with the new
techniques ger se is extremely difficult to distinguish
from other sources of interest rate fluctuation.
However, the major swings in interest rates during
the year — historic peaks in early 1980, the sharp
drop in the spring, and the return to historic highs —




45
can "be traced to disturbances -in the economy
ifcaetfV'to-1- the'.1. ira^sittcm .and; removal-.of^-- • credit controls, to the budgetary situation,
and to shifting inflationary expectations.
Indeed, while much compressed in time, the
broad interest rate fluctuations were, in
relative magnitude, not out of keeping with
earlier cyclical experience.
Money supply fluctuations last year over periods
of a quarter or so were probably larger than
might have been expected on the basis of econometric analysis of reserve control techniques.
The inference from the study is that the credit
control program and other external "shocks" could
have been responsible. At the same time, the
evidence is that the quarterly deviations in money
growth from the trend for the year did not have
an important influence on economic activity. If
money growth had somehow been held constant, shortrun interest rate variability would have been still
larger.
In analyzing the results of the study, and given the basic
intent to control monetary and credit growth within target ranges
over a period of time, the Open Market Committee continues to
believe present operating techniques are broadly appropriate.
Assuming the present institutional structure, alternative
reserve control approaches do not appear to promise more shortterm precision.

We do, however, have under consideration possible

modifications and improvements.

Without going into technical

detail, such matters as more frequent adjustment of the discount
rate, more forceful adjustments in'the "path" for non-borrowed
reserves when the money supply is "off course," and a return
to contemporaneous reserve accounting are being actively
reviewed.

In each case, the possible advantages in terms of

closer control of the monetary aggregates need

to be weighed

46
against other considerations, including contributing to
unnecessary short-run interest rate volatility.
As a personal observation, I would emphasize that
swings in the money and credit aggregates over a month,
a quarter, or even longer should not be disturbing (and
indeed may in some situations be desirable), provided
there is understanding and confidence in our intentions over
more significant periods of time.

A major part of the rationale

of present, or other reserve based techniques, is to assure
better monetary control over time.

I believe, but cannot

"prove," that the money supply in 1980 was held under closer
control than if our operating emphasis had remained on interest
rates.

I hope 1980 was instructive in demonstrating that we

do take the targets seriously, both as a means of communicating
our intentions to the public and in disciplining ourselves.
In that light, I would like to turn to the targets for
1981.

Those targets were set with the intention of achieving

further reduction in the growth of money and credit, returning
such growth over time to amounts consistent with the capacity
of the economy to grow at stable prices.

Against the back-

ground of the strong inflationary momentum in the economy,
the targets are frankly designed to be restrictive.

They do

imply restraint on the potential growth of the nominal GNP.
If inflation continues unabated or rises, real activity is
likely to be squeezed.




As inflation begins noticeably to




47
the..stage, will be. sat^f or, stronger, seal, -growth..
Monetary policy is, of course, designed to encourage that
disinflationary process.

But the success of the policy,

and the extent to which it can be achieved without great
pressure on interest rates and stress on financial markets
that have already been heavily strained, will also depend
upon other public policies and private attitudes and behavior.
Abstracting from the impact of shifts into NOW accounts
and other interest-bearing transaction accounts, growth ranges
for the narrower monetary aggregates — M-1A and M-1B — have
been reduced by one-half percent to 3-5^ percent and 3V-6
percent, respectively.

Growth last year from the fourth

quarter 19.73 average to the fourth quarter 198(1 average (when
adjusted for shifts into NOW accounts) approximated 6-1/4 percent
and 6-3/4 percent, just about at the top of the target range.*
Consequently, the new target ranges imply a significant reduction
in the monetary growth rates.
The Committee did not change the targets for M-2 or M-3.
In the case of M-2, the upper end of the range was exceeded
by about 3/4 percent in 1980, and there seems to have been

*Growth, as statistically recorded, was 5% for M-1A
in 1980 and 7-1/4% for M-1B. Available evidence suggests
about 2/3 of the transfer into interest-bearing checking
accounts in 1980 reflected shifts from M-1A, "artificially"
depressing M-1A and about one-third reflected shifts from
savings or other accounts, "artificially" raising M-1B.
The data and the targets cited in the text are calculated as
if such shifts did not take place. Both adjusted and unadjusted
data are shown in the attached tables.

48
some tendency recently for M^2, whicft.-includes- new forms---1-of market-rate savings instruments and the popular money
market mutual funds, to grow more rapidly relative to the
narrow aggregates.

In the past few years, M-2 growth has

been much closer to the growth of nominal GNP than has M-l
growth.

Should those conditions prevail in 1981, actual

results may well lie in the upper part of the range indicated.
M-3, which includes instruments such as certificates of
deposit used by banks to finance marginal loan growth, is
influenced, as is bank credit itself, by the amount of
financing channeled through the banking system as opposed
to the open market.

Changes in thoae aggregates must be

assessed in that light.
I must emphasize that both M-l series, as actually
reported, are currently distorted by the shift into interestbearing transaction accounts.

Those shifts were particularly

large in January, when for the first time depositary institutions in all parts of the country were permitted to offer
such accounts.

As the year progresses, we anticipate the

distortion will diminish, as has already been the case in
February.

However, any estimate of the shifts into NOH-type

accounts for 1981 as a whole, and the source of those funds,
must he tentative.
Survey results and other data available to us suggest
perhaps 80S of the initial shifts during January into NOW and
related accounts were from demand deposits included in M-lA,
thus "artificially" depressing that statistic.




The remaining

49
20% was apparently shifted from savings' accounts for investment instruments), "artificially" increasing M-1B.
More recent data suggest the proportion shifting from demand
deposits, while still preponderant, way be slowly falling.
Making allowance for these shifts, M-1A and M-1B through midFebruary of this year have remained near the December average level,
fit intervals, we plan to publish further estimates of the shifts
in accounts and their implications for assessing actual growth
relative to the targets.

But I cannot emphasize too strongly

the need for caution in interpreting published data over the
next few months.
Once these shifts are largely completed, we plan publication of a single M-l series.

In that connection, I must

note that the behavior of an M-l series containing a large
element of interest-bearing deposits, with characteristics
of savings as well as transactions accounts, is likely to
alter relationships between M-l and other economic variables.
For that and other reasons, the significance of trends in any
monetary aggregate even over long periods of time must be analyzed
carefully, and, if necessary, appropriate adjustment in targets made,
Those technical considerations should not obscure the
basic thrust of our policy posture.

Our intent is not to

accommodate inflationary forces; rather we mean to exert
continuing restraint on growth in money and credit to squeeze
out inflationary pressures.

That posture should be reflected

in further deceleration in the monetary aggregates in the years




50
ahead,-and is an. essential, ingredient in any. effective policy.,
to restore price stability.
During 1980, despite the pressures arising from sharply
nigher oil prices and the strong momentum of large wage settlements and other factors, inflation did not increase.

But the

hard fact is we, as a nation, have not yet decisively turned
back, the tide of inflation.

In ray judgment, until we do so

prospects for strong and sustained economic growth will remain
dim.

in that connection, forecasts fay both the Administration

and members of the Open Market Committee anticipate
continuing economic difficulties and high inflation
during 1991.
I have emphasized on a number of occasions that we now
have a rare opportunity to deal with our economic malaise in
a forceful, coordinated way.

As things stand, the tax burden

is rising; yet, in principle the need for tax reduction — tax
reduction aimed to the maximum extent at incentives to invest,
to save, and to work —

has come to be widely recognized.

Regulatory and other governmental policies have tended to increase
costs excessively and damage the flexibility of the economy; but
realization of the need to redress the balance of costs and
benefits is now widespread.

Despite efforts to cut back from

time to time, government spending has gained a momentum of its
own; now, the possibility of attacking the problem head on
presents itself.




We are all conscious of the high levels of

51
interest- rates- and1 strains, in. our, financial- system; Yetf
there is widespread understanding of the need for monetary
restraint.
The new Administration is clearly aware of these
realities and has set forth a program of action.

It has

seized the initiative in moving from opportunity to practical
policy.
I know that the case is sometimes made that monetary
policy can alone deal with the inflation side of the equation.
But not in the real world —

not if other policies pull in

other directions, feeding inflationary expectations, propelling the cost and wage structure upwards, and placing
enormous burdens on financial markets with large budgetary
deficits into the indefinite future.
That is why it seems to me so critical —

if monetary

policy is to do its job without unduly straining the financial
fabric —

that the Federal budget be brought into balance at

the earliest practical time.
in a sluggish economy.
incentives —

That objective cannot be achieved

Moreover, tax reduction —

emphasizing

is important to help lay the base for renewed

growth and productivity.

For those reasons, the linchpin of

any effective economic program today seems to me early( and
by past standards massive, progress in cutting back the upward
surge of expenditures, an and off budget.
We know the crucial importance of restraint on money and
credit growth. When I am asked about the need for consistency
among,.all the elements of economic policy —

a policy that

can effectively deal with inflation and lay the groundwork
for growth —

I must emphasize the need to combine that

monetary restraint with spending control.

Cutting spending

may appear to be the most painful part of the job — but I
am convinced that the pain for all of us will ultimately be
much greater if it is not accomplished.




52

PLANNED AND ACTUAL GBOWTH OF MONETARY AND CREDIT AGGREGATES
(percent changes, fourth quarter to fourth quarter)
M-l target_s and-growth, before and_aEter_shj.ft> iRto_aJS/MgH^cco.unts
After adjustments for shifts
intoTATS/NOW accounts

M-lA
Planned for 1990

3>j to 6

M-1B

M-lA

M-1B

4 to 6%

2fe to 4-3/4 b

4S to 7 b

5

7V

6-3/4

Actual 1980
Planned for 1981

3 to 5%

Before adjustments for shifts
into &TS/NOH accounts

a

C

3<i to 6

-4% to -2

6 toS^

M-2, K-3 and Bank Credit Tarqets and Growth
Bank Credit

*tl

M-3

Planned for 1980

6-9

6*i-9»j

6-9

actual I960

9.B

9.9

7.9

Planned for 1981

6-9

6-9

(a)

Reflects current estimates of the impacts on M-lA and M-1B of
shifting from demand deposits and other assets into new ATS and
NOW accounts not taken into account in 1980 targets. Growth of
M-lA is about 1-1/4 percentage points larger than actual recorded
data after adding back in shifts out of demand deposits; growth 5f
M-1B is reduced by about 1/2 percentage point after taking out shifts
into M-1B from savings accounts and other assets.

(b)

Target adjusted to reflect NOW/ATS account shifts referred to in
note above.

(e)

Reflect tentative assumptions regarding impacts of shifts into new
ATS and NOW accounts in 1981. Growth of M-lA is assumed to be
reduced by roughly 7-1/2 percentage points by transfer from demand
balances to NQW-ATS accounts; growth of H-1B is assumed to be increased
by 2-1/2 percentage points by transfer from sources outside of M-l.
Iheae assumptions will be reviewed from time to time.

• GROWTH-OF MONEY- AND. BWSK CSEB1T, - (percent changes, fourth quarter to fourth quarter)
After adjustment
for shifting into
NOW/ATa accounts

Before adjustment
for shifting into
NOW/ ATS accounts'

M-lA

M-1B

M-LA

M-1B

M-2

M-3

Bank
Credit

1975

4.9

4,9

4..7

4.9

12.3

9..4

1976

5~ 8

58

5,.5

6.0

13.7

11..4

7.5

1977

a.o

s.o

7,.7

8.1

11.5

12..6

11,1

4.1

1978

7.9

8.0

7.,4

3.2

3.4

11..3

13.3

1979

6.7

6.8

5..0

7.7

9.0

9..8

12.3

1980

6.3

6.7

5,.0

7.3

9.8

9.,9

7.9







53
APPENDIX s
EREATMEHT _OF_ RESERVE ITEMS FOR IHSTITUTIOfJS
GRANTED THE BANKER'S BANK EXEMPTION '

For chose institutions filing a FR 2900 report that have been
granted the banker's bank exemption' and are thereby waived reserve
requirements, the treatment of items dealing with reserves, on the
EDDS/Flashwire data flows varies according to certain situations.
Those
micro data records that, in the discussion to follow, are indicated as
inappropriate for an institution, may, by virtue of the EDDS system
principle of variable item sets, be treated as zero or simply omitted
from the respondent micro data (EDDS) record. Those raacro data items
indicated as inappropriate for an institution are not aggregated in the
macro data (Flashwire) record for that entity type. It is therefore
important to understand which items are inappropriate according to the
various reporting situations of these exempt institutions. The
following discussion depicts the various situations in which certain
reserve items are inappropriate or appropriate for a reporting institution granted the banker's bank exemption:
Flashwire
jjem

EDDS
Item
0180

Treatment
Inappropriate in all cases.

EGAS I
EGOG f
EPTO J
0115

EGAL

Appropriate only if the reporting institution is
a pass-through correspondent.

0116

ERBO

Appropriate only if a clearing balance requirement has been established for the reporting
Institution, to be fulfilled in the second week
following the current week.

0095

ETTA

Appropriate only if the reporting institution
has a reserve balance with the Federal Reserve.

0110

SBRE

(1) If the reporting Institution is a passthrough correspondent, the item is appropriate
only if (1) the reporter has a reserve balance
with the Reserve Bank; and (2) that reserve
balance is unequal to the sum of the required
reserve balances of its pass-through respondents' _plus any clearing balance requirement^ of
the correspondent.

^Currently, the only institutions that have been granted the
banker's bank exemption are certain corporate central credit unions,
whose data are aggregated with credit unions on the Flashwire.
2

As established in the second week prior to Che current week.
Change No,
Rev. 2/81

54

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

February 25, 1961

Letter of Transmittal

BOARD OF GOVERNORS OF THE
FEDERAL RESERVE SYSTEM
Washington, E.G., February 25,1981
THE PRESIDENT OF THE SENATE
THE SPEAKER OF THE HOUSE OF REPRESENTATIVES.
The Board of Governors is pleased to submit its Monetary Policy Report to the Congress pursuant to the
Full Employment and Balanced Growth Act of 1978.
Sincerely,
Paul A. Volcker, Chairman







55
Chapter 1
A Review of Developments in 1980

Section 1.1

Monetary Policy and the Performance of the Economy in 1980

The past year was narked by considerable turbulence In the nation's
economy and credit markets.

Output and employment experienced extraordinarily

sharp swinge—generally confounding forecasters inside and outside government—
and ao, too, did Interest rates and financial flows.

On balance, the level of

the aggregate output of goods and services at the end of 1980 was little changed
from that at the beginning of the year, and with a growing labor force,
unemployment was appreciably higher.

At Che same time, Inflation continued at

about the game unacceptably high rate as In 1979.
Many factors—some of thea beyond the realm of the purely economic—
combined to produce this distressing performance.

At bottom, however, the

behavior of the economy demonstrated rather vividly the difficulties o£ overcoming a deeply entrenched Inflation and, particularly, the stresses that arise
when necessary monetary restraint la not adequately supported by other instruments of public policy.
As 1980 began, the underlying trend of price increase was approaching
a double-digit pace, and a recent further jump In International oil
threatened to worsen that trend.

prices

There was broad consensus that fighting

Inflation must be the top priority for national economic policy.

The Federal

Reserve shaped its policy for 1980 with the objective of reining in inflationary
forces in the economy ami establishing a framework within which decisIon-makers
In both the public and private sectors could look forward over the longer run
to a restoration of reasonable stability In the general price level.
The basic premise of the System's policy is the broadly accepted
notion that inflation can persist over appreciable spans of time only If

it

56

Is accommodated by monetary expansion.

The strategy to which the System has

committed Itself is to hold monetary growth to rates that fall short of such
accommodation and thus encourage adjustments consistent with a return to price
stability over time.

To be sure, the relationships between the growth of

money and the behavior of the economic variables of ultimate concern—such
as production, employment, and inflation—are not in practice absolutely
stable or predictable, especially In the short run.

But the crucial fact is

that rates of monetary expansion in the vicinity of those specified by the
Federal Open Market Committee last February implied a substantial degree of
restraint on the growth of nominal GNP—that la, the combined result of inflation and real growth.

Put differently, the FOMC's ranges for monetary growth

implied that, if inflation did not abate, there would In all likelihood be
strong financial restraint on economic activity, reflected in an easing of
pressures on markets for goods and services and thence on productive capacity,
factors that in turn would help to contain the momentum of inflation.

This

stabilizing Influence was especially critical in a circumstance in which the
impulse of an OPEC price hike could easily have led to a ratcheting upward of
the trend rate of inflation.
In the event, inflation did not abate in 1980; but neither did it
gain new momentum, as many feared it might.

Rather, the increases in most

aggregate price indexes were about the same aa were recorded in 1979.

The

fixed-weighted price index for gross national product rose 9-1/2 percent last
year, a little more than In 1979, while the consumer price index rose 12-1/2
percent, somewhat less than in 1979.

Such rates of inflation thenselves

result in a substantial Increase In the amount of money needed to finance
transactions.




Thus, even though the monetary aggregates generally expanded




57
-3-

at rates near or a bit above upper ends of the FOMC's announced ranges, the
steep rise in prices resulted in marked pressures in the credit markets that
exerted restraint on economic activity and kept inflationary pressures from
worsening.
These developments did not occur evenly throughout the year.

During

the opening months, the late-1979 boost in Imported oil prices combined with
other factors—including strife In Afghanistan, unsettlemettt In the Middle East
generally, and attendant fears that an escalation of defense spending might
greatly enlarge already sizable federal deficits—to aggravate inflationary
expectations.

These expectations contributed Importantly to the upward pres-

sures on Interest rates that were associated with the Federal Reserve's efforts
to contain growth in the monetary and credit aggregates.

Then, in March,

President Carter announced an anti-inflation program that Included the application by the Federal Reserve of special restraints on credit growth, utilizing
the powers of the Credit Control Act of 1969.
The tightening of credit markets and the psychological impact of the
credit restraint program on consumers contributed to the sharpness of the
economic decline that occurred in the first half of the year, although a decline
at some point had long been anticipated In the light of strong pressures on
financial positions and other factors.

The drop In real gross national product

during the second quarter far exceeded the expectations of forecasters; In
fact, it was the sharpest of the postwar period.

However, with the slump In

activity came a pronounced weakening of demands for money and credit and a
steep decline In interest rates.

The lowering of credit costs, coupled with

removal of the special credit restraints, in turn was instrumental in bringing
about an rebound in economic activity in the second half of the year which




58

GNP Prices
Change from Q4 to 04. perc ent
Rxed-We ghted Index

198QO1

99

O2

91

03
O4

82
10.1

—

12

8

-

-

-

1977

1978

1979

4

1980

Real GNP
Change from Q4 to Q4, perce nt
1972 Dollars

I960 Q1

3.1

8

Q2 -9.9
Q3 2.4
O4

—

4.0

4

0

1977

Interest Rates

19T8

1979

1980




59

turned out to be unexpectedly early and strong and restored real GHP almost to
its yearend 1979 level.

During this period of recovery, the public's demands

on financial markets grew and Interest rates rose as tbe System attempted to
hold monetary expansion within bounds.
The financial pressures on the private sector of the economy last year
were Intensified by the competition of the federal government for the limited
supply of credit.

The federal deficit (unified basis, including off-budget

agencies) grew from S^l billion In calendar year 1979 to S83 billion in calendar
year 1980.

During 1980, moreover, the massive federal deficit and repeated up-

ward revisions in spending forecasts added to the prevailing raood of uncertainty
and weakened public confidence In the government's willingness and ability to
mount a successful anti-inflation effort.
In 1980, as in most periods of financial tension, it was those types
of purchases that involve longer—term investments of large sums that were hardest h i t .

The residential construction sector, especially, was squeezed by

high interest ratea and, particularly in the first half of the year, by reduced
credit availability.

Housing starts fell from a 1.6 million unit annual rate

in the fourth quarter of 1979 to a 1.1 million unit rate in the second quarter
of 1980; they then snapped back sharply to Just over 1.5 million units by the
end of the summer, leveling off at that rate as Interest ratee moved upward
again in the final months of the year.

The mortgage markets have seen remark-

ably rapid institutional change in the past year, reflecting an adaptation to
recurrent cyclical pressures on key lenders and to the difficulties potential
honebuyers face with traditional mortgage Instruments.

Still, these changes

have not insulated the real estate market from the effects of inflated horae




60

Federal Government Deficit
Billons of dollars
Unified Budget Basis,
Including Otf-Budget Agencies

1977

1978

1979

Housing Starts
Millions of units, annual rate

1977

1979

1978

1960

Q Real Personal Consumption Expenditures
CD Real Disposable Personal Income
Change from O4 lo Q4, percent
1972 Dollars

pee
1980

n

(

1

1978

1
1979

Q!
Q2
Q3
O4

OB
-9.8

51
8.7

DPI
13
-49
41
23

i r-OIHI

~~

61

prices and high mortgage rates on the willingness and ability of people to
borrow and buy houses.
Credit conditions also played a role in damping personal consumption
expenditures in 1980—particularly outlays on blg-tlcket durable goods.

However,

several other Influences militated against a robust pattern of consumer spending.
The period leading up to 1980 had been marked by weakness In real disposable personal income and by an erosion of the financial flexibility of households.

Faced

with budgetary strains caused by relatively rapid Increases in the prices of such
basic necessities as food and energy, many American families had sought to maintain customary consumption patterns—and in some cases to finance extra purchases
in anticipation of inflation—by borrowing.

A declining trend in the personal

saving rate suggested that consumers were becoming overextended and that some
weakening in spending relative to income was quite likely; indeed, the saving
rate rose from 4,7 percent In the fourth quarter of 1979 (a 28 year low) to
6.2 percent In the second quarter of 1980.

Automobile purchases, which tend to

be deferable In the short run, bore the brunt of the consumer retrenchment.
Although credit conditions discouraged dealers from financing large Inventories
and to some extent were a depressant on demand for autos more generally, the steep
Increases in the prices of cars and gasoline appear Co have been more decisive
elements In the picture.
Business firms, like households, entered 1980 in a weakened financial
condition.

The preceding years of expansion had seen a substantial deterioration

in aggregate measures of corporate liquidity; many enterprises were heavily
burdened with short-term debt, and they thus were exposed to severe cash flow
pressures when interest rates rose.

The combination of deteriorating balance

sheets, a high cost of capital, and slackening demands for final products resulted







62

Real Business Fixed Investment
Change from 04 to 04, percent

1978

1979

1980

Business Inventories Relative to Sales
1972 Dollars

International Trade
Seasonally adjusted, annual rale, billions of dollars

20

Current Account Balance t

o

20

1979




63
-9-

In a 5 percent drop in real business fixed investment during 1980.

Some Indus-

tries—particularly in the defense, energy, and high-technology sectors—did
register gains in capital outlays, but those elements of strength were more than
o f f s e t by declines In most cyclical manufacturing industries.
tion spending was especially weak.

Plant construc-

Meanwhile, businesses kept a tight rein on

inventories, encouraged by the high costs of carrying stocks; a moderate accumulation during the first-half recession—concentrated in the automotive and
related industries—was largely eliminated in the subsequent rebound.
In the government sector, purchases of goods and services by the
federal government rose moderately In real terras during 1980, reflecting in part
a pick-up in defense outlays.

At the state and local level, real purchases were

about unchanged, owing to fiscal strains associated with a slowing of growth
in tax revenues and cutbacks in federal grants as well as to political pressures
for spending restraint.
The slackening of domestic aggregate demand worked to hold down Imports; In the case of petroleum imports, the impact of decreased economic
activity was reinforced by the incentive for conservation provided by a sharply
increased relative price of oil and other energy products.

At the same time,

U.S. exports—including both agricultural commodities and other products—rose
appreciably in real terms.

Net exports thus registered a noticeable increase

during 1980, and the U.S. current account moved into sizable surplus in the
second half of the year.

The trade and current account developments contrasted

sharply with those of some other major industrial countries and contributed
to a Substantial appreciation of the dollar relative to continental European
currencies over the course of the year.




Employment
Millions ot persons
Nonfarm Payroll

1977

1978

1979

Unemployment Rate

Productivity
Charge from Q4 to Q4, percent
Output oer Houi. Nonfami Business Sector

1977

1978

1979

1980

65

-uErnployment traced a path similar to that of output In 1980—that Is,
down substantially in the first half and up substantially in the second, with
little net change.

There was some alteration in the composition of employment

over the course of the year, however, with jobs in manufacturing and construction decreasing and those in service industries Increasing.

The combination

of this change In employment mix and a tendency for enployers to lag in adjusting their work forces co lower levels of production contributed to a continued
disappointing performance of labor productivity—output per hour worked—which
showed no gain for the year.
With no moderating influence from the productivity aide, the rise in
unit labor costs reflected directly the behavior of wages and other labor expenses during 1980.

In the nonfarm business sector, average hourly compensa-

tion—which includes employer contributions for social Insurance and the cost
of fringe benefits—rose 10 percent, a bit more than In 1979.

However, this

measure, because It does not account for changes in the mix of employment or In
overtime, probably understates the acceleration in wage rates.

For example,

the Index of average hourly earnings for production and nonsupervlsory personnel,
which does include adjustments for such factors, Increased 9-1/2 percent In 1980
compared with 8 percent In 1979.
Wages typically are slow in responding to economic slack, and, given
the large increases in consumer prices in 1979 and 1980, there were strong
tendencies toward sizable catch-up wage hikes even in the face of an unemployment that reached 7-1/2 percent last spring.

This tendency manifests

in a direct way when formal cost-of-living escalator clauses exist.

itself
Such

clauses are most common In the manufacturing sector, especially where there is
collective bargaining by large industrial unions, and the acceleration of wage
rates was In fact relatively pronounced In that sector.







66

Wage Rates
Change from year earlier, percent
Nonfarm Business Sector

Hourly Compensation

Average Hourly
Earnings Index

1977

197B

Labor Costs and Prices
Change from year earlier, percent

Unit Labor Costs
Nonfaim Business Sector

1977

67
-13Section JL. 2^ ^Th^Growth <>f Jioney-and Credit in 1980
In Its report to the Congress lagt February, the Board of Governors
Indicated the plans of the Federal Open Market Committee regarding the growth
of money and credit In 1980.

As in previous yeara, the FOMC set desired ranges

for the growth of several monetary aggregates and of commercial bank credit.
Measured from the fourth quarter of 1979 to the fourth quarter of 1980, the
growth ranges were as follows: M-IA, 3-1/2 to 6 percent; M-1B, 4 to 6-1/2 percent; M-2, 6 to 9 percent; M-3, 6-1/2 to 9-1/2 percent; and bank credit, 6 to
9 percent.!.'

It waa recognized that legislative Initiatives—then pending—in

the area of financial regulation could alter the desired rates of increase, as
could any other unanticipated developments that indicated that the prescribed
growth rates were inconsistent with the basic objectives of policy.

As stated,

however, the ranges suggested a clear deceleration of money and credit growth
from the pace of 1979—a specification that appeared appropriate in terms of
both the near-terra and long-term requirements of antI-Inflation policy.
As noted in the preceding section, the monetary and credit aggregates
grew quite rapidly in the opening part of Che year.

Then, as economic activity

began to fall rapidly, the growth of money and credit slowed markedly.

Indeed,

the narrow monetary aggregates, M-IA and M-lB, whtch are measures of the public's
transactions balances, actually contracted significantly in the second quarter.
T 7 M - I A is currency plus private demand deposits at commercial banks net of
deposits due to foreign commercial banks and official institutions. M-lB is
M-IA plus other checkable deposits (i.e., negotiable-order-of-withdrawal accounts, accounts subject to automatic transfer service, credit union share
draft balances, and demand deposits at mutual savings banks). M-2 is M-lB
plus savings and small denomination time deposits at all depository institutions, shares in money market mutual funds, overnight repurchase agreements
(RPs) Issued by commercial banks, and overnight Eurodollar deposits held by
U.S. residents at Caribbean branches of U.S. banks. M-3 is tf-2 plus large
time deposits at all depository institutions and term RPs issued by commercial banks and savings and loan associations. Bank credit is total loans and
investments of commercial banks.




-14This decline, occurring as It did at the same time that interest rates were
falling sharply, was considerably greater than would have been expected on the
basis of historical relationships among money, Income, and Interest rates.
The weakness in the M-l measures tended to restrain the growth of the broader
monetary aggregates.

Bank credit meanwhile contracted slightly.

At midyear, when the FOMC reassessed the monetary growth ranges for
1980,

there were few, If any, signs of the then Incipient economic recovery.

The monetary aggregates, though again on the rise, were either below or In the
lower portion of the previously announced ranges.

The Depository Institutions

Deregulation and Monetary Control Act of 1980 had been signed into law at the
end of March, but there was no clear evidence yet of significant impact on the
behavior of the monetary aggregates.

In these circumstances, the Committee

reaffirmed the ranges for money and bank credit that it had adopted in February,
but It did indicate that, if the public continued to economize on the use of
cash as strongly as in the second quarter, M-1A and M-1B Might well finish the
year near the lower end of their respective ranges .i'

Such a proviso was

called for because a sustained downward shift la the demand for money Implies
that a given rate of monetary growth Is more expansionary in its impact on
the economy than would otherwise be the case.
Over the second half of the year, however, the monetary aggregates
and bank credit grew very rapidly.
turnaround In econotalc activity.

There was a surprisingly swift and strong
And simultaneously the public's demand for

money retraced most of the evident downward shift of the firat half.

Both of

1? There ~ha<T been previous episodes, particularly In the mid-1970s, of lastIng downward shifts in the demand for M-l balances following rises in interest
rates to nev record high levels. Such interest rate movements evidently encouraged greater efforts to economize on holdings of nonearning assets.




69
-15these developments may have been associated with the phasing out of the extraordinary credit restraint program at the end of the second quarter.

In retro-

spect, this program seems to have played a greater role than waa apparent at
midyear tn Influencing the particular patterns of spending and financial flows
that developed In the spring and summer.
Although the Federal Reserve resisted the accelerating growth in money
and credit—and did succeed in bringing about a clear deceleration In the latter
months of the year—the growth of the monetary aggregates on a fourth quarter to
fourth quarter basis In 1980 waa generally near or a bit above the upper ends of
the ranges announced by the System.
specified by the FOMC.

Bank credit growth was within the range

The movements of the various financial aggregates are

charted on the next two pages.
Considerable care must be exercised ia assessing the behavior of M-1A
and M-18.

Last February, when the ranges for the aggregates were set, it was

assumed that the growth rates of the two aggregates would differ only by 1/2
percentage point, based on an expectation that, under prevailing statute,
growth in automatic transfer service (ATS) and negotiable order of withdrawal
(NOW) accounts would draw few funds from demand deposits (depressing M-1A) and
savings deposits (boosting H-1B).

With the passage of the Monetary Control

Act, however, which authorized NOW accounts on a nationwide basis as of December
31, 1980, commercial banks began to promote ATS accounts more vigorously.
a result, actual growth of ATS and NOW accounts substantially exceeded

As

the

amount allowed for In the FOMC ranges for M-1A and M-1B.
As may be seen In the charts, M-1A Increased 5 percent over the year
ended in the fourth quarter of 1980, close to the midpoint of the FOMC's range
for that aggregate; meanwhile, growth In M-1B was 7-1/4 percent, 3/4 percentage




70
-16-

Growth Ranges and Actual Monetary Growth
M-1A
Billions of dollars
400
Range adopted by FOMC tot
1979 Q4 101980 Q4
Range adjusted for unexpected shifts
into ATS and related accounts

390

Rale ot Growth
1979 O4 M1980 O4
5OP6TC8TI1

O | N

| D |

J | F

Billions of dollars
420

Rale of Groivlh

1979 O4 101980
T.3 Pmcanl

O l N l D




J l F | M | A | M | J | J

I A

I S

I O

t

N

I D

71

Growth Ranges and Actual Monetary and Bank Credit Growth
M-2
Billions of dollars
1700

Range adopted by FOMC lot
197904 to1980Q4

Rale ot Growth _
1979 O4 101980 Q4
9 9 Percent

1650

l

N

l

D

|

J

l

F

l

M

l

4

|

M

l

J

|

J

]

A

I

S

l

O

l

N

l

D

M-3
Billions ol dollars
—I 2000
Rate ol Growl h
(879Q4 to I860 04
9 9 Percent

1900

18OO

Ol

N_ I

O I J

| F | M | A ) M | _ J [ j _ | A I S L O | N ) O

1979

1980

Commercial Bank Credit




Billions ol dollars
1280
Ram ol Growth
1979 O4 to 1980
7 9 Parcanl

O

) N ) O I J | F ) M^ i, i M | J | J | A | S | O | N_| 0

1979

1980

Q4




72
-18polnt above the upper end of Its longer-run range.

But If the FOMC's ranges

are adjusted for current estimates of the actual impact of shifting into ATS
and NOW accounts, as shown in the chart by Che shaded lines, the increases In
both the narrow aggregates are close to the upper bounds of the FOHC's ranges
for 1960.

It may be noted that, although conventionally f o u r t h quarter averages
have been adopted aa the basis for measuring annual growth in the noney and
credit aggregates, the choice is somewhat arbitrary and is only one of many
possible approaches. Moreover, citing figures for any particular calendar
period doea not necessarily give a clear sense of the longer-term trends,
which are more relevant in assessing policy.

For that reason, the table on

page 19 offers measurements of annual growth on several bases.

Owing to the

particular monthly patterns over th« past tvo years, the fourth quarter to
fourth quarter calculations show a lesser tendency toward deceleration in the
growth of M-1A and M-lB than do other measurements of the 1980 experience.
The effects on M-2 of shifting into ATS and NOW accounts likely are
minor, since nearly all the inflows to those instruments appear to be from assets
within this broad aggregate.

For the year as a whole, M-2 grew about 9-3/4 per-

cent, 3/4 percentage point above the upper end of the FOMC's range.

All of the

growth in the nontransactional component of M-2 occurred in those assets offering market-Ielated yields—primarily 6-month "money market certificates,"
2-1/2-year "small saver certificates," and shares of money market mutual funds.
4s of December, these assets accounted for 45 percent of the nonttransactionsi
component of M-2, compared with 28 percent a year earlier.

In earlier periods

of high interest rates, when such instruments did not exist, M-2 tended to
decelerate markedly as diaintemediation occurred, with savers shifting funds

73
-19-

Growth of Honey and Bank Credit
(percentage changes)

M-1A

tt-lB

M-2

M~3

Bank Credit

1978

7.4 (7.9)

8.2 (8 .0)

8.4

11. 3

13. 3

1979

5.0 (6.7)

7.7 (6 .8)

9 .0

9. 8

12. 3

1980

5.0 (6.3)

7.3 (6 .7)

9 .8

9. 9

7. 9

7.1 (7.8)

6.2 (7 .9)

8 .3

11. 2

13. 6
11. 5

Fourth quarter to
fourth quarter

December to
Dec ember

1978
1979

5.2 (6.6)

7.5 (6 .8)

8 .9

9. 4

1980

4.1 (5.2)

6.5 (5 .8)

9 .7

10. 3

8. 9

1978

7.7 (8.0)

8.2 (8 .0)

8 .9

11. 7

12. 3

1979

5.2 (6.8)

7.8 (7 .0)

8.9

10. 3

13. 4

1980

4.6 (5.6)

6.4 (5 .9)

9 .1

8. 6

8. 3

Annual average to
annual average

Note;




Nuabers In parentheses are adjusted for the estimated Impact of shifting
to ATS and NOW accounts from other assets, and should give a better Indication of the underlying trend of monetary expansion.

74
-20Into market instruments.

In 1980, the growing popularity of these relatively

new assets may well have drawn some funds into M-2 from market securities such
as Treasury btllfl, causing M-2 to grow somewhat more rapidly than in the preceding two years and also faster relative to H-1B.
M-3 grew almost 10 percent over the four quarters of 1980, 1/2 percentage point above the upper end of Its longer-tun range.

Large time deposits

expanded moderately at commercial banks and thrift Institutions during the year;
in the case of banks, which Issue the bulk of these instruments, the borrowing
was offset by a reduction of net liabilities to foreign branches.
Bank credit grev about 8 percent in 1980.

Fluctuations in this mea-

sure followed the general pattern of aggregate credit flows in. the economy, but
they were exaggerated by changes In the composition of business borrowing.
During the f i r s t quarter, nonfinancial firms avoided long-term borrowing at
record high Interest rates and turned instead to the commercial banks for funds.
In fact, they appear to have borrowed beyond their Immediate needs in anticipation of greater credit stringency.

During the second quarter, as bond rates

dropped sharply and as banks tightened their lending policies in response to
the special credit restraint program, corporations Issued an unprecedented
volume of long-term securities and repaid outstanding bank loans.

During the

summer months, as interest rates began to rise, the pattern of financing began
to reverse again and In the fourth quarter businesses again deferred long-term
borrowing and tapped their tanks for credit.
Broader measures of credit flows in the economy also exhibited a
considerable cyclical fluctuation in 1980.

Total funds raised by all sectors

of the economy In credit and equity markets fell by almost one-half In the second
quarter and then retraced most of that decline in the third quarter.

For the

y«ar as a whole, aggregate funds raised were substantially less than in 1978
and 1979.

Comtpercial banks provided about the same share of total credit

flowing to all sectors as In 1979, while the share of t h r i f t institutions rose
somewhat.




75
-22NET FUNDS RAISED AND SUPPLIED IN CREDIT AND EQUITY MARKETS
(Btlliona of dollars)

1980

Sector

1978

1979

1980p

Ql

Q2

1

p3

Q4p

NET FUNDS RAISED

Total, all sectors
U.S. government
State and local government
Foreign
Private domestic non financial
Business
Household
Domestic financial
Private intermediaries
Sponsored credit agencies
Mortgage pool securities

482

483

434

497

253

454

534

54

37
16
21

79
21
30

62
21
24

67
12

99
24
27

89
27
33

291
128
163

321

234

133

303
163
140

119

156
165

79
40

231
133
98

281
155
126

81
40
23
18

88
36
24
28

70

87
32
34
21

20
-16
16
20

73
33
12
28

104
44

24

32

101

23
24
23

35

36
24

NET PONDS SUPPLIED

" 482

484

435

498

253

456

534

U.S. government
State and local government
Foreign

20
15
40

23
13
-6

26

29
18
-8

30
2
47

24

36

21
23

22

27

Private domestic nonflnancial
Business
Household

51
-1
52

81
10
71

29
10

74
8
66

-51
-10
-41

55
22
33

39
22
17

356
305
129

373

338

319
293
129
74

424

285
104
57

385
315
117
35
103
60

225

308
121
56
90

40
21

6
20

9

20

Total, all sectors

Domestic financial
Private intermediaries

Commercial banking
Thrift institutions
Insurance and pension funds
Other2
Sponsored credit agencies
Mortgage pool securities
Federal Reserve System

76
84
16
26
18
7

20
22

19

41

98
26

29
28
8

25
23
5

179
-2

27
108
46

353

93
-3

171
94
86
2

24
28
-26

24
15

32

1. Seasonally adjusted annual rates.
2. Includes finance companies, money market funds, real estate investment trusts,
open-end investment companies, and security brokers and dealers.
p—Data for the fourth quarter of 1980 are preliminary.




76
-23-

Section 1.3 Issues in Monetary Control
Monetary growth in 1980 was, on balance, fairly close to the ranges
specified by the FOMC.

And, more Important, the Federal Reserve's actions

clearly Imposed a significant—and essential—degree of restraint on the aggregate demand for goods and services In the economy.

Nonetheless, particularly

In view of the magnitude of the short-run swings in interest rates and financial flows in the past year, questions have been raised—inside as well as
outside the Federal Reserve—about the techniques of implementing monetary
policy and, especially, about the efficacy of the new operating procedures
adopted in October 1979. These questions have been addressed in an Intensive
study of the recent period. & staff memorandum presenting an overview o£ the
findings of that study and an evaluation of the new operating procedures is
appended to this report.
As a prelude to discussing the key points raised by the staff work,
it Is useful to describe in broad outline the general approach of the Federal
Reserve to monetary policy. For a number of years, monetary aggregates have
played a key role as Intermediate targets for policy, that is, as variables
standing midway In an economic chain linking the proximate Instruments of the
Federal Reserve—open market operations, the discount window, and reserve
requirements—to the variables of ultimate concern, such as production, employment, and prices. Economists have debated extensively the question of the
optimal intermediate target variable, with the controversy centering on the
virtues of monetary aggregates versus interest rates.

The System historically

has, in effect, taken an eclectic viev, believing that it would be remiss in
ignoring the information provided by the movements of any financial or economic







77
-24variable.

However, It has perceived a clear value in Focusing special attention

on the behavior of the money stock, especially in an environment in which
Inflation is such a prominent concern,

A special role for the monetary aggre-

gates is, furthermore, dictated by the requirement of the Humphrey-Hawkins Act
that the Federal Reserve report to the Congress on its objectives for monetary
expansion.
Analysts of all

schools agree that, over the long run, inflation can-

not persist without monetary accommodation.

Thus, careful attention to the trend

of monetary expansion is an absolutely essential feature of responsible monetary
policy.

In addition, however, In a shorter-run context, monetary aggregates

are attractive aa intermediate targets because they provide a mechanism of
"automatic stabilization."

When the economy begins to expand too rapidly, the

associated increase in the quantity of money demanded for transactions purposes
comes Into conflict with the monetary target, and this results In a rise in market rates of interest; the rise In Interest races, In turn, damps the aggregate
demand for goods and services.

Similarly, If there Is a recessionary Impulse Co

the economy, the associated reduction in the demand for cash balances leads to an
easing of credit conditions that moderates the Impact of that impulse.

Pursuit

of an Interest rate target carries with it a greater danger that an unanticipated
impulse to the economy will tend to be fully accommodated, with greater inflationary or recessionary consequence.
Open market operations are the major tool of monetary control.

Prior

to October 1979, the basic approach employed by the System was to supply or
absorb reserves through open market operations wtch an eye to holding short-term
interest rates—most immediately, the federal funds rate—within a relatively
narrow but changing band thought consistent with the desired growth of the

78
-25raoney stock.

This method placed considerable Importance on the System's

ability to predict the quantity of money the public would wish to hold at
given Interest rates.

This never was an easy matter, bvit In 1979, particularly

as the advance of prices accelerated and Inflationary expectations became a
more significant and volatile factor a f f e c t i n g economic and financial behavior,
predicting the public's desired money holdings at given levels of nominal
interest rates became exceedingly difficult.

As & consequence, in October

the Federal Open Market Committee altered Its technique of monetary control,
substituting the volume of bank reserves for interest rates as the day-to-day
guide In conducting open market operations.
Under the approach adopted In October 1979, the FOMC sets short-run
targets for monetary expansion, as it did previously, to guide operations
between meetings.
reserve aggregates.

The staff then calculates corresponding paths for various
A path for total reserves Is calculated based on the

expected relationship between reserves and the money stock—the so-called
reserves-money multiplier-

This relationship Is variable and not known with

certainty because of the differences in reserve requirements on various components of the monetary aggregates, which shift in relative importance from week
to week; moreover, in addition to required reserves, depository institutions
aleo hold a varying amount of excess reserves.

A path for nonborroved reserves

then is calculated by making an allowance for the portion of total reserves
expected to be provided through borrowings at the Federal Reserve Bank discount windows.
Between meetings of the FOMC, the Open Market Desk focuses on achieving a given level of nonborrowed reserves, the reserve measure that is controllable through open market operations on a day-to-day basis.

If the monetary

aggregates deviate from their prescribed growth rates, the resultant movement







79
-26iii required reserves Is reflected In an increase or decrease In borrowing at the
discount window.

Owing to administrative limitations Imposed by the Federal

Reserve on the frequency, amount, and purposes of borrowing, an Increase in
borrowing puts upward pressure on the federal funds rate as individual depository Institutions bid more aggressively in the market for the available supply
of nonborrowed reserves in an e f f o r t to shift the need to borrow to other
Institutions.

A decline In borrowing has the opposite effect.

The resultant

movements In short-term Interest rates induce portfolio adjustments by depository
institutions and the public that tend to move the money stock back toward the
targeted level.

If It appears that these automatic effects are not going to

be prompt enough or strong enough—as evidenced in part by sustained deviations
In total reserves from their path—the System can reinforce them by making
adjustments In the path for nonborrowed reserves that Increase the upward or
downward pressures on money market interest rates.

Similar e f f e c t s can be

achieved through changes in the discount rate, given the nonborrowed reserves
path.
The workings of this mechanism of monetary control are Illustrated
clearly by the movements In reserves and interest rates during 1980, which are
shown In the chart on the next page.

During the early part of the year, when

the money stock was running above the FOHC'a short-run target, the volume of
adjustment credit provided by the discount window (the vertical dimension of
the shaded area) Increased substantially while the amount of nonborrowed reserves
provided through open market operations declined, partly as a consequence of
reductions in the nonborrowed reserves path to ho!4 down total reserves and restrain the growth of money over tine.
federal funds rate rose sharply.

As can be seen, during this period the

Restraint was Intensified by increases in




80

Reserve Aggregates
Billions of dollars

Shaded Area is Adjustment Borrowing

Total Reserves
37

Required Reserves
Nonborrowed Reserves
Includes Special Boirawings*

J

F

M

A

M

J

J

1980

Interest Rates

f

c

S

O

N

D

81
-28the basic discount rate and the introduction In mid-March of a surcharge on
frequent borrowing by large banks.
As the monetary aggregates weakened In the apring, the pattern of the
first quarter was reversed.

The System countered the weakness of the aggregates

by maintaining the supply of total reserves; this required substantial Injections
of nonborrowed reserves to o f f s e t the inpact of the repayment of discount window
borrowings.

The federal funds rate fell very sharply.

The sharp plunge in interest rates, even though it occurred against a
backdrop of marked monetary weakness and steep recession, did arouse concerns
In some circles about the System's commitment to anti-Inflationary restraint.
This nervousness was evident not only In domestic financial markets but in the
Foreign exchange markets too.

By and large, the foreign exchange value of the

dollar had fluctuated in a way that represented a fairly direct response to
the pronounced relative movement of Interest rates on dollar and foreign-currency
denominated assets.

But aa U.S. interest rates reached comparatively low levels,

there was a sense of a growing risk that downward pressures on the dollar might
cumulate•
In a sense, the Federal Reserve was caught in an expectational crossfire.

On the one side, those who concentrate on the money stock in assessing

policy feared that the System was being coo restrictive because the various
measures of money were slowing sharply or contracting; on the other, some of
those in the financial markets and elsewhere who view interest rates as the
indicator of policy feared that the System was being Inflationary because rates
were falling sharply.

The FOMC, In weighing the risks, decided to exercise

some caution in the latter part of the spring by setting Its short-run monetary
growth targets With a view to a gradual ratlier than Immediate return to the
longer-range path for the year.




82

Weighted Average Exchange Value of U.S. Dollar*
March 1973 = 1

1976

19fl1

1979

3-Month Interest Rates

Weighted Average of
Foreign Interbank Rates*

1978

1979

1980

19B1

* Weighted average agairtsl or or G - f O countries olus Switzerland using total 1972-76 average trade o< llieee countries




83
-30-

The picture soon changed dramatically, however, for by mid-summer the
monetary aggregates—buoyed by the surprising atrong turnaround In economic
activity—were rising rapidly.

And as required reserves began to exceed nonbor-

rowed reserves, borrowing and interest rates climbed.

As In the first quarter,

pressures on money market Interest rates were reinforced by reductions In the
path for nonborrowed reserves and by increases In the discount rate and Imposition
of surcharges on frequent borrowing.

Borrowing and the federal funds rate

continued to rise until mid-December when a drop in the money stock relieved
some of the pressure on reserve positions.
The staff study has examined the experience of 1980 In considerable
detail In an effort to assess the causes of the extreme variability of money
and Interest rates In 1980 and the efficacy of the new reserves-oriented operating procedure In achieving the objectives of policy.

Certain key conclusions

of the study may be highlighted:




(1)

Nineteen^eJghty wag a year of extraordinary variability in
money and nominal Interest rates.

In the case of money,

however, It Is important to note that comparisons with past
years are complicated by the fact that monetary data for those
periods have been considerably smoothed as additional information has been obtained on changes in seasonal patterns.

If the

1980 figures are compared with the initial figures for earlier
years, the difference In monetary variability is substantially
reduced.

Still, a f t e r making such allowances, it appears that

money has been somewhat more variable over the past year, especially on a monthly or quarterly basis—though, as far as can
be judged from available data, remaining within the range of
foreign experience with money stock variability.




84
-31(2)

Much of the variability—certainly the broad swings—In money
and interest races since October 1979 was attributable to an
unuaual combination of economic circumstances and not to the
new operating procedures jjer £e.

The "real" and financial

sectors of the economy were subjected to unusual disturbances
in 1980. The imposition and subsequent removal of credit controls, especially, appears to have had A major impact on the
demands for money and credit and to have strongly affected the
behavior of money and Interest rates in the second and third
quar ters.
(3)

Simulation exercises utilizing several models of the money market provided no clear evidence that, under present Institutional
arrangements, alternative operating techniques—using, say,
total reserves or the monetary base instead of nonborrowed
reserves as an operating target—would improve short-run monetary
control.

(4)

It appeared clear that efforts to severely limit deviations in
money from its

longer-run growth path would requite acceptance

of much more variable short-tern interest rates.
(5)

Short-run variability in the monetary aggregates does not appear
to involve significant impacts on the behavior of the economy.
Weekly and monthly changes in the monetary aggregates are
Inherently quite "noisy."

Moreover, available models suggest

that, because of the relatively long response lags involved,
sizable quarterly (or even semi-annual) fluctuations la monetary growth—if offsetting—do not leave an appreciable imprint
on movements in output and prices.

85
-32(6)

The federal funds rate haa been more variable since October
1979, as would be expected with use of a reserves operating
target, but In addition very short-run fluctuations In other
market rates both—short- and long-term—also have been
larger In magnitude than formerly.

These rates of Interest

have exhibited higher correlations than previously with
movements In the federal funda rate. The reasons for this
closer correlation between the federal funds and other rates
in the very short run are not entirely clear, and it la not
certain that such a pattern will prevail In the future*

But,

in any event, there are few signs that the resulting variability haa imposed appreciable costs In terms of reduced
efficiency of financial markets or of Increased costs of capital
In the period analyzed by Che study.

There are considerable

difficulties In separating the effects of the new operating technique from those of other factors.

However, It does appear that

much of the strain on financial Institutions and. many of the
changes In financial practices observed in the past year were
related to the broad cyclical pressures on interest rates during
the year, caused by accelerated inflation and heightened Inflationary expectations, and to tbe changes in credit demands
associated with the behavior of economic activity.
The Federal Open Market Committee has reviewed the s t a f f ' s work.
Fundamentally, the research suggests chat the basic Operating procedure represents a sound approach to attaining the longer-run objectives set for the
monetary aggregates.




However, the Committee and the Board of Governors will

86
-33-

toe considering the practicability of modifications that might reduce alippagea
between reserves and noaey, without unduly Increasing the risk of an unnecessarily heightened variability of interest rates. These Include the possibility
of prompter adjustment of nonborrowed reserve paths or of the discount rate
at times when, In association with undestred aovements in money, the levels of
borrowing and consequently total reserves are running persistently stronger or
weaker than projected.

In addition, the Board has already indicated Ita incli-

nation to switch from the present system of lagged reaerve accounting to a
system in which required reserves ate posted essentially contemporaneously
with deposits; It is continuing to study the practical merits of such a system,
to ensure that the operating problems created for depository institutions and
the Federal Reserve and the potentially Increased volatility of the federal
funds rate would not outweigh the possible benefits in terms of tighter shortrun monetary control.
The Committee has continued to get broad ranges of tolerance for
money market interest rates—generally specified in terms of the federal funds
rate. These ranges, however, should not be viewed as rigid constraints on the
Open Market Desk In Its pursuit of reserve paths set to achieve targeted rates
of monetary growth. They have not, in practice, served as true constraints in
the period since October L979, as the Committee typically has altered the
ranges when they have become binding.

But, in a world of uncertainty about

economic and financial relationships, the interest rate rangea have served
as a useful triggering mechanism for discussion of the implications of current
developments for policy.
The reserves operating procedure—or any modification of it—needs
to he viewed in the context of a number of practical considerations that affect







87
-34-

the basic targets for the monetary aggregates and the process of attaining them.
First, targets need to recognize the lags in the adjustment of wages and prices
whtch may limit the speed with which noninflationary rates of monetary expansion
can be attained without unduly restraining economic activity.

Second, the

potential for costly disturbances In domestic financial or foreign exchange
markets may occasionally require short-run departures from longer-run monetary
targets.

Third, precise montn-by-month control of money is not possible, nor

is it necessary in terms of achieving desirable economic performance.

Finally,

uncertainties about the relationship between money and economic performance
suggest the desirability of a degree of flexibility in the targets—including
the use of ranges for more than one measure of money—and the potential need
to alter previously established targets.

88
Chapter 2
Monetary Policy and the Prospects for the Economy tn 1981

Section^ 2.1

The Federal Reserve'9 Objectives for the Growth o^ Money and Credit

In Its midyear report last July, Che Federal Reserve Indicated to the
Congress that its policy In 1981 would be designed Co maintain restraint on the
expansion of money and credit.

Nothing Chat has occurred In the Intervening

months haa suggested the desirability of a change In that basic direction.
Events have only served to underscore the Importance of such a policy—and of
complementary restraint In the fiscal dimension of federal policy as well.
Few would question today the virulence of the inflation that Is
afflicting this economy or the urgency of mounting an e f f e c t i v e attack on the
forces that are sustaining it.

The rapid rise of prices is the single greatest

barrier to the achleveoent of balanced economic growth, high employment, domestic
and international financial stability, and sustained prosperity.

The experience

of the past year—the stresses and dislocations that have occurred—attests to
the d i f f i c u l t y of dealing with inflationary trends that have been many years
In the making, b\it it does not indicate that there is any less need to do so.
Indeed, the need has become more urgent, for as price Increases continue, the
public's expectations of inflation becomes more and more firmly embedded, and
those expectations in turn contribute co the stubborn upward momentum of wages
and prices.
Persistent monetary discipline ia a necessary ingredient in any e f f o r t
to restore stability in the general price level.

To be sure, other areas of

policy are also important, but It ia essential that monetary policy exert continuing resistance to inflationary forces.

The growth of money and credit will

have to be slowed to a rate consistent with the long-range growth of n a t i o n ' s
capacity to produce at reasonably stable prices.

Realistically, given the struc-

ture of the economy, with the rigidities of contractual relationships and the




89
-36-

natural lags in the adjustment process, that rate will have to be approached
over a period of years if severe contractionary pressures on output and
employment are to be avoided.
The ranges of monetary expansion specified this month by the Federal
Open Market Committee for the year ending tn the fourth quarter of 1981 reflect
these considerations.

They imply a significant deceleration of growth in the

monetary aggregates from the ratea observed in 1980 and other recent years.
The ranges are: for M-1A, 3 to 5-1/2 percent; for M-lB, 3-1/2 to 6 percent;
for M-2, 6 to 9 percent; and for M-3, 6-1/2 to 9-1/2 percent.

It should be

emphasized that, owing to the introduction of NOW accounts on a nationwide
baata at the end of 1980, the monetary ranges have been specified on a basia
that abstracts from the impact of the shifting of funds into Interest-bearing
checkable deposits; only by adjusting for the distorting effects of such shifts
can one obtain a meaningful measure of Monetary growth.

The FGMC also adopted

a corresponding range of 6 to 9 percent for commercial bank credit.
The ranges for M-lA and M-lB are 1/2 percentage point leas than those
the federal Reserve sought in 1980. Since realised growth lost year, after adjustment for the lapact of shifting Into interest-bearing checkable deposits,
was close to the upper ends of the stated ranges for the period, the new ranges
are consistent with a deceleration of considerably more than 1/2 percentage
point.
The actual observed changes in M-lA and H-1B will d i f f e r by a wide
margin; in fact, it Is quite possible that, because of the movement of funds
from demand deposits to NOW accounts, H-1A could contract this year, while M-lB
could grow more rapidly in reflection of funds moving into NOW accounts from
savings deposits and other assets.

It must be stressed that valid comparison

of actual year-to-year growth has to allow for this institutional change.




90
-37The behavior of M-1A and M-1B thus far this year has reflected this
pattern, but In an exaggerated degree because of the large initial transfer of
funds to NOW accounts.

An addendum to this section discusses In some detail

the distortions caused by shifting to SOW accounts and the expected behavior
of M-1A and M-1B.

As the discussion there indicated, any estimates of the

extent and character of the prospective shift into NOW accounts must be tentative.

The Federal Reserve will be monitoring the shifting Into Interest-

bearing checkable deposits as the year progresses and will be assessing its
impact on the expansion of the monetary aggregates.

From time to time, the

System will report Its eatlnates of the adjusted growth of M-1A and M-1B so
that the public and the Congress can better assess the consistency of monetary
expansion with the FOMC's stated objectives.
The 1981 range for M-2 is the same as that in 1980; however, the
upper end of the range Is roughly 3/4 percentage point less than the actual
growth recorded in 1980.

A reduction in the range does not appear appropriate

at this time lei light of what Is known about the relationships among the various
monetary measures, as affected by public preferences for various types of
assets and by expected economic and Institutional circumstances.

In f a c t ,

there la a distinct likelihood that, consistent with the planned decline
In the growth of the narrower aggregates, M-2 growth In 1981 will be in the
upper half of its 6 to 9 percent range.

With the changes in regulatory ceilings

that have made small time deposits more attractive In comparison to market
Instruments and with the growing popularity of money market mutual funds, the
nontransacttonal component of M-2 la likely to continue growing quite briskly.
Moreover, if the tax cuts proposed by the President result in a marked increase
In the proportion of income saved, this may contribute to relatively robust




91
-38-

M-2 growth, which has in any event tended In recent years to approximate the




increase in nominal GMP.
The range for M-3 In 1981 is the sane as that for 1980, but again ia
below the actual growth experienced last year.

The deceleration would reflect

the slower expansion specified for M-2, which accounts for more than threequarters of the broader aggregate.

Large time deposits at commercial banks—the

other major component of M-3—likely will expand moderately again this year,
hut much will depend on the patterns of credit flows that emerge.
of bank credit is now expected to be about the same as in 1980.

The growth

Household

borrowing at banks could Increase, especially in the consumer installment
area, where credit use was severely damped for a time last year by credit
controls.

However, nonfinanclal firms likely will wish to rely less heavily

on bank borrowing than they did in 1980, in light of the deterioration of
balance sheet liquidity that they have already experienced.

Indeed, should

credit market conditions be such as to encourage a substantial funding of
short-term debt by corporations, commercial banks might play a lesser role in
the overall supply of credit and M-3 could be damped by reduced bank reliance
on large time deposits.

On the other hand, if conditions in the bond markets

are not conducive to long-term financing then bank credit and M-3 could be
relatively strong.

92
-39Addenduni;

The__IatBjjtgt__of_S.atigj»gijjg: jjOti Account^ onJtoqetary^Growthin 196^
As noted In the preceding section, 'the behavior of M-1A and M-1B will

be greatly affected this year by the advent, under the Monetary Control Act of
1980, of nationwide availability of HOW accounts and other Interest-bearlog
checkable deposits.

The phenomenon la qualitatively similar to what occurred

In 1980 when growth In M-1A waft depressed and growth In M-1B enhanced by the
shifting of funds into ATS (automatic--tranafer-from-saving) accounts—but the
distortions In 1981 will be quantitatively much greater.
With the introduction of a new financial instrument like the NOW
account, there may be a broad adjustment of the public's asset portfoliosUnder the present circumstances, however, It seems reasonable as a practical
matter to expect that the major impact will be a shifting of funds into the
new accounts from existing nonearnlng demand deposits and from the interestearning assets included in M-2 (especially highly liquid, relatively low yielding
savings deposits).

The analysis of experience In paat years with NOW accounts

la the northeastern part of the country and with ATS accounts throughout the
nation indicates that flows from demand and savings deposits have accounted
for the great bulk of the growth of Interest-bearing accounts.

Furthermore,

various surveys and other analyses have indicated that in the past roughly
two-thirds of the funda flowing into ATS/NOW accounts have come from demand
deposits and roughly one-third from savings deposits.
During January, a somewhat larger share of the funds flovring into
interest-bearing checking deposits appears to have come from demand deposits—
perhaps about 75 to 80 percent, with only about 20 to 25 percent coming from
savings deposits (or, to a very limited extent, other sources).

This change

from past patterns appears to reflect a relatively fast adjustment on the pare




93
-40-

of holders of large demand deposit balances at commercial banks.

It Is expected

that the sources of subsequent growth In interest-bearing checkable deposits
will be more along the lines of the past two-thirds/one-third break.
Depository Institutions have marketed the new accounts very aggressively, many of them lining up a sizable number of customers before the end of
1980.

Since December 30, the net growth of Interest-bearing checkable deposits

already has totaled more than $22 billion.

It obviously is extremely difficult

to forecast the further growth oE interest-bearing checkable deposits over the
remainder of the year.

A working assumption would be that the net increase in

such deposits this year will amount to somewhere between $35 and $43 billion,
which would mean that half, or a little more than half, of the funds already
have been shifted.

If the shares of funds coming from demand and savings

deposits move promptly to a two-thirds/one-third proportion, the result will
be a 7 to 8 percentage point depressing effect on M-1A growth and a 2 to 3
percentage point Increase In M-lB growth. Taking the midpoints of these estimates and applying them to the basic ranges specified by the FOMC for monetary
growth this year, the observed Change in M-1A from the fourth quarter of 1980
to the fourth quarter of 1981 would be -4-1/2 to -2 percent and that in M-lB
would be 6 to 8-1/2 percent.
As indicated above, the growth of interest-bearing checkable deposits
In January was extraordinarily rapid.

This resulted In an extreme divergence

of H-1A and M-lB movements. Observed M-1A contracted at a 37-1/2 percent
annual rate in January, while M-lB increased at 12-1/4 percent annual rate.
On the assumption that three-quarters to four-fifths of the funds flowing into
interest-bearing checkable deposits came from demand deposits, both M-1A and
M-lB, on an adjusted baais, showed only small growth In the early weeks of this
year.




94
-41SectiOTi 2.2

The Outlook for the Economy

The economy entered 1981 on an upward trajectory, extending the
recovery in activity from last year's brief but sharp recession.

January saw

further large gains in retail sales, employment, and industrial production.
On the whole, the demand for goods and services has continued to prove oore
buoyant than most analysts had expected.

Unfortunately, at the same time there

has been no abatement of inflation.
The persistence of intense inflationary pressures jeopardizes the
continuity of economic expansion over the remainder of the year.

Moreover,

unless the rise of prices slows, there can be little hope of an appreciable,
sustained easing of interest rates or of A substantial Improvement in the
balance sheets of the many units of the economy that already have experienced
a deterioration in their financial condition.
The near-tern prospects for prices are not favorable.

In the months

immediately ahead, the major price Indexes will reflect the effect of poor
agricultural supply conditions on food prices and the impact of higher OPEC
charges and doraeatic decontrol on energy prices.

Increases in the Consumer

Price Index, furthermore, will reflect—in a way thst exaggerates the true
change in the average cost of living—the rise In mortgage Interest rates that
occurred in the latter part of 1980.
Aside from these special factors, the basic trend of prices is linked
closely to the behavior of unit labor costs, which constitute the largest
element in costs of production. As noted earlier, poor productivity performance
has contributed to rising costs.
been sizable.




It Is also quite clear that wage demands have

Despite the acceleration In wage increases that has occurred,

95
-42che wages of many workers have failed to keep pace with the upward movement of
prices in the past few years.

This development was virtually inevitable in

light of the decline In productivity and the adverse terms-of-trade effects of
the tremendous Increase in foreign oil prices.

So long as those conditions

continue, the average worker cannot anticipate a rising living standard, and
attempts to "make up" losses In real income will be reflected in strong cost
and price pressures.
The condition of labor markets Is, of course, a factor affecting wage
decisions.

Despite the fact that the overall unemployment rate stands at 7-1/2

percent, there are scarcities of skilled workers In some sectors of the economy.
But, even where there Is slack in labor demand, its Impact on wages is rather
slow in emerging; wages appear to have a strong momentum rooted in inflationary
expectations, which are baaed to a great extent on past experience, as well as
in attempts Co maintain teal Income.

Workers' wage demands are influenced by

expectations about prices, as well as by patterns established in previous wage
bargaining.

Meanwhile, employers' wage offers are conditioned In good measure

by their own sense of the prospects for inflation and of whether they will be
able to pass along higher compensation costs by increasing prices.
It Is essential that this momentum be turned in a favorable direction.
To do so will require a commitment to monetary and fiscal restraint that Is firm
and credible, and a direction of other governmental policies toward fighting
inflation.

Labor and management must be persuaded that the Inflationary process

will not he accommodated—that wage and price decisions based on an anticipation
of rapid inflation will prove inimical to their ability to maintain employment
and sales volume.

Put more positively, they have to be convinced that modera-

tion in their Individual wage and price actions will not put them at a relative
disadvantage and will in fact produce a better economic environment for everyone.




-43-

Such an alteration of the expectaeional climate will not be easy to
achieve.

Rut it is Important to do so.

For, to the extent that those attitudes

can be changed, the short-run coats of restraint on aggregate demand, in the
form of economic slack, will be ameliorated.

Conversely, prolongation of

high wage and price demands would come into conflict with needed monetary and
flacal restraint, aggravating economic dlfficultiea.

la any event, once expec-

tations are turned, further progress toward price stability should come Increasingly easily so long aa excessive pressures on productive capacity are avoided.
The policy of monetary restraint adopted by the Federal Reserve is
intended to contribute to the process of breaking the momentum of Inflation.
Fiscal policy also has a crucial role to play.

Cuts in federal taxes potentially

can help to Invigorate private capital formation and thereby enhance productivity,
reduce costs, and pave the way for faster economic growth.

But it ia Important

that government spending be held firmly in check at the same time so that aggregate demand does not become excessive and so that the pressures of governaent
demands on the credit markets do not impede the financing of private Investment.
The members of the Federal Open Market Committee, in assessing the
economic outlook, have recognized the possibility of aone reduction this year
in business and personal Income taxes and some Initial steps In the longer-range
effort toward the slowing of federal expenditure growth.

Given these working

assumptions, the Individual members of the Committee have formulated projections
for economic performance in the current year that generally fall within the
ranges indicated in the table on page 44.

As may be seen in that table, the

FONC members' projections for output and inflation encompass those that underlie
the Administration's recent budget proposal.




97
-44-

Economic Projections for 1981
Actual 1980

Projected 1981
FOHC members
Administration

Changes, fourth quarter
to fourth quarter, percent
Nominal GNP
Real GNP
GNP deflator

9.5
-0.3
9.8

9 to 12
-1-1/2 to 1-1/2
9 to 10-1/2

11.0
1.4
9.5

Average level In the fourth
quartet, percent
Unemployment rate

7.5

8 to 8-1/2

7.7

The members of the POMC see Inflation aa remaining rapid In 1981,
although not as rapid throughout the year as seems likely to be the case
early in the period.

The failure of Inflation to slow more quickly, and

Che large budgetary deficits in prospect for the year, are seen aa resulting
In continued strong demands for money and credit and in the maintenance of
relatively high interest rates. Against this backdrop, economic activity is
likely to show only intermittent strength, and unemployment probably will rise
between now and the end of the year.




98
-Al-

February 1981

APPENDIX
Staff Study of the Mew Monetary Control^ Procedure!
Oyarvigy o^ Flndlnga and Evaluation
This paper reviewa experience with the new monetary control
procedure established in October 1979 and evaluates Implications for
current and alternative control techniques.

The new procedure involved

employing reserve aggregates—on a day-to-day basis, nonborrowed reserves—
as operating tools for achieving control of the money supply.

Less

emphasis was thereby placed on confining short-term fluctuations in the
federal funds rate—the overnight market rate reflecting the demand for
and supply of bank reserves.

The change in procedure, it

should be

pointed out, represented a technical innovation rattier than a change In
the broader objectives of monetary policy or in the monetary targets
themselves.

Target ranges for various measures of the money supply,

together with the actual behavior of money in the course of 1980, are
shown in the charts on the next three pages*
The paper is divided into three sections.

Section I presents

an overview of findings about e f f e c t s of the new monetary control
procedure on economic and financial behavior baaed on evidence gathered
In staff papera.i/

Because the new control procedure was designed to

strengthen the System's ability to control the money supply, section II
(page A15) ptovides certain additional background analysis relevant to
assessment of the role of money as an intermediate target for monetary
policy.

Section III (page A.21) then contains an evaluation of the current

operating procedure, and alternatives.
\JA list of staff papers prepared Is contained on page A33.







99
Growth Ranges and Actual Monetary Growth
M-1A
Billions of dollars
400

Range adopted by FOMC tor
1979O4 101980 04
Range adjusted lot unexpected shifts
into ATS and related accounts*

Q

| N

|

D

J | f

A

|

M

J

|

J

[

A

|

S

|

O

|

N

D

* The shaded lines reflect adjustments that should be made for technical
reasons to the original range for M-1A to allow for unanticipated shifts of existing
deposits from demand deposits to interest-bearing transactions accounts, such
as ATS [automatic transfer savings) and related accounts. At the beginning of
1980 it appeared that such shirts would have just a limited effect on growth of
M-1 A, and the tongef-run growth range for M-1 A was set only % percentage
point below the growth range for M-1B. Passage of the Monetary Control Act
subsequently altered the financial environment by making permanent the
authority of banks to offer ATS accounts and by permitting all institutions to offer
MOW and similar accounts beginning in 1981. As the year progressed, banks
offered ATS accounts more actively and more funds than expected were being
diverted to these accounts from demand deposits. Such shifts are estimated to
Have depressed M-1 A growth over the year 1980 by % to 1 percentage point
more than had been originally anticipated. The shaded range allows tor these
unanticipated shifts, and therefore in an economic sense more accurately
represents the intentions underlying the original target.




100
Growth Ranges and Actual Monetary Growth
M-1B
Range adopted by FOMC lor
1979 Q4 I01980Q4

Billions of dollars
420

Range adjusted for unexpected shifts
into ATS and related accounts*

~- 390

* The shaded lines reflect adjustments that should be made tor technical
reasons to the original range (or M-16 to allow foi unanticipated shifts into
interest-bearing transactions accounts from savings deposits and other
instruments not included in M-1B. At the beginning o( 1980 it aopeared that
such shifts woJd have just a limited effect on growth ol M-1B, and the longer-run
growth range for M-1B was set only Vi percentage point above the growth
range for M-1A. Passage crt the Monetary Control Act subsequently altered
the financial environment by making permanent the authority of banks to ottet
ATS accounts and by permitting all institutions to offer NOW and similar
accounts beginning in 1961. As the year progressed, banks offered ATS
accounts more actively and more funds than expected were being diverted to
the accounts. Such shifts are estimated to have increased M-1B growth over the
year 1980 by 'A to % of a percentage point more Wsn had been anficipated.
The shaded range allows tor these unanticipated shifts, and therefore in an
economic sense more accurately represents the intentions underlying
the original target.




101
Growth Ranges and Actual Monetary and Bank Credit Growth
M-2
Billions ot dollars
—11700
Range aOoptetj by FQMC lor
19T9Q4 to 1980 Q4

Rule o^Growlh

1650

1600

1550

1973

M-3
Billions of dollars
2000

Rale ot Growtti
197fl Q4TOI960 O4

9 9 pfrcanl

— 1900

1800

0

| N

[

O | J

|

F l M i A l M I

J

J

J

J

A

j

S

j

O

l

N

l

D

Commercial Bank Credit
Bitliona of dollars
1280

Rite at Qnswitt

1230

A

_L "_|

—| J_L. *J 3 | o | N i D
1980

J

102
-A2I.

Overview of Findings with Regard to Experience
since Adoption of Sew Procedure

Questions investigated in reviewing experience with the new
control procedure Included, among others, its Impact on precision of
money control, volatility of interest rates, the course of economic
activity, and exchange market conditions-

There were, of course, other

influences on financial markets and the broader economy that were surely
of far more importance than the particular technical innovations under
consideration here.

Indeed, a major problem has been to distinguish the

impacts of the new procedure per se from larger influences operating on
the economy.

This difficulty is particularly acute given the relatively

short period of time since the new procedure was implemented—a period
of time that may have been too short for market participants to have
fully adjusted to the new environment and a period of time In which
markets were buffeted by changing inflationary expectations, fiscal
uncertainties, credit controls, and oil price shocksA.

Relation^ietweer^jreserves and money
1.

Over the operating periods between FOMC meetings, actual nonbor-

rowed reserves fell below the Trading Desk's operating target by about
.3 of one percent on average; the average absolute miss was about .4 of
one percent.

These deviations reflected In part errors In projection of

uncontrollable factors affecting reserves (such as float).

In addition,

the Desk at times accommodated to variations relative to expectations In
banks' demand for borrowing in the course of a bank statement week (for
example, an unexpected willingness by banks to obtain reserves by borrowing heavily over a weekend).




Total reserves came out somewhat above

103
-A3interraeeting period paths, by about .2 of a percent on average; the
absolute miss averaged about .8 of a percent.

The individual intermeet-

Ing period misses reflected deviation of money stock from short-run
targets, variations In excess reserves, and multiplier adjustments to
the original path (to take account of changes in required reserves for a
given level of deposits) that turned out to be Incomplete.
2.

Econometric evidence from simulations of monthly money market

models carried out with various reserve measures as operating targets
(nonborrowed and total reserves and the monetary base), given the
existing Institutional framework, buttresses indications from actual
experience last year that the relationship between reserves and money
Is relatively loose in the short run.

Over the one year period since

October 1979, the mean absolute error of mfgse* in the level of M-1B
relative to target path during the 4- to 7-week operating periods between
FOHC meetings was a little over .6 of one percent.

This degree of

variability was in line with—in some cases less than and In some cases
more than—model simulation results (holding various reserve measures at
pre-determined target levels for the simulations)-I/

In comparing the

models and the reserve technique actually used, it should also be
observed that model simulations generally implied more interest rate
variability last year than proved to be the product of the technique
actually in use.
If




The root mean square errors of actual misses and simulated model
misses ranged around -7 to .8 of a percent over short-run operating
periods of a month or so. This would mean that, With disturbances
similar to last year's, two-thirda of the time M-1B would generally
come within plus or minus .7 to .8 of one percent of the interneeting
target path over approximately a one-month period (or, expressed in
annual rate terms, within a range of plus or ninuB 8 to 10 percentage
points over such a period).

104
-A4-

3.

In the model simulations of the past year, control of money supply

through strict adherence to a total reserves or the total monetary base
target produced more slippage than control through their nonborrowed
counterparts.

This phenomenon largely reflects the presence of multiplier

disturbances on the supply side that would be generated, for example, in
the current institutional environment by changes in deposit mix and hence
in required reserves for any given level of money supply.

In the model

simulations, uee of total reserves or the total base as an invariant target
over the control period does not permit these disturbances to be cushioned
by changes in borrowings.
4.

Judgmental predictions of the multiplier relationship between

reserves or base measures and money made since the shift in operating
procedure were generally superior to, though on a few tests not
significantly different from, forecasts derived from econometric models.
5.

Over a longer period than a month (or than an Intermeeting period)

errors in the predicted relationship between money and reserves may be
expected to average out—that Is, over time, errors in one direction tend
to be offset by errors In the other.

Simulations of the Board's monthly

model suggest that such a process Is at work-

In actual operations over

a one-year period since October 1979, the absolute miss In the level of
M-1B when individual misses relative to the short-run target paths are
averaged over three or four Intermeetlng periods was reduced from a
little over .6 of a percent (reported In paragraph 2) to over .4 of a
percent.

This represents a somewhat smaller reduction than would have

been expected from certain results, and may have reflected the nature of
unusually large, unanticipated successive month-to-month changes in ooney




105
-A5demand last year, f i r s t In one direction and then In the other.
changes were related In part to Identifiable

These

special factors such

as the Imposition and subsequent removal of the credit control program.
Accommodation to such special and temporary factors, as they emerged,
might tend to lengthen the period over which deviations from monetary
targets could be expected to average out, but would, by the same token,
tend to dampen fluctuations In interest rates that would not have
contributed to better control of money over time.
B.

Variability In money growth
1.

Evaluation of the variability of money supply series is

Importantly a f f e c t e d by the seasonal adjustment process.

Seasonal factors

applied during a current year are unable adequately to reflect changing
seasonal patterns In the course of that year; a f t e r a year Is over,
therefore, reestimation of seasonal factors often tends to smooth
variability.

Based on current seasonal adjustment factors for the year

just past (that Is, factors before seasonal revisions that taken account
of the influence of actual experience this year), variability in weekly,
monthly, and quarterly growth of M-l (and also W-2) was substantially
greater than In any year during the past decade.

However, when the

variability in money growth during the year from October 1979 to October
1980 Is compared with variability In earlier years, with earlier years
adjusted using seasonal factors that were current in those years, nearly
all of the heightened variability tn weekly growth of M-l, and a sizable
portion of the monthly and quarterly variability, is removed.

While

this comparison makes it seem probable that seasonal factor distortions
are overstating variability In the year Just past, the extent cannot be




106
-A6assessed wtth confidence until a number of years have passed.

In

general, It would appear that money has been more variable over the past
year, especially on a monthly and quarterly basis—though so far as can
be judged from the available data, still generally well within the range
of foreign experience with money supply volatility.
2,

The variability In money growth of the past year appears to be

related to an unusual combination of circumstances:
a.

There were large swings within the year in the demand for

money resulting from sharp short-run variations in economic activity
caused in large part by factors independent of the new monetary control
procedure, such as the imposition and subsequent removal of the credit
control program.

The imposition and subsequent removal of the credit

control program may have also increased the variability of money growth
through a more direct channel, as the associated large variation in
bank, loans was accompanied by temporary changes in demand deposits—
for example, as large loan repayments were initially made from existing
demand balances.
b.

In addition, econometric evidence from a variety of models

suggests that there were "unexplained" factors other than economic
activity and interest rates causing substantial fluctuations in money
demand.

In particular, money levels fell considerably short of model

simulations (given GUP and interest rates) in the second quarter,
when money growth was negative.

Relatively rapid growth in subsequent

quarters reflected in patt a tendency for money levels to move back
toward more normal relationships with GUP and interest rates.
3.

The money targets on which reserve paths were based reflected the

intention to return money over time to the long-ruti objective following







107
-A7divergenees.

In 1980 the target for narrow money in the month following

the FOMC meeting typically implied making up about 30 percent of the
difference between the projected level of the money stock In the month of
the meeting and the long-run target path.

If disturbances In 1980 had been

more representative of those prevailing in the 1970s, simulations using
Che Board's monthly model suggest that the reserve operating technique
would have kept money closer on a tnonth-by-raonth basis last year to longrun objectives than actually was the case.

These simulations also indicate

a distinct trade-off between variability of the federal funds rate—and
money market rates generally—and the speed with which attempts are made
to return the money stock to Its longer-term path once it moves off path.
The more rapid the attempted return to path, the larger are the Implied
fluctuations in money market rates.
4.

Interpretation of money supply volatility is complicated by the

large amount of noise in weekly and monthly changes In flrat published
figures for the narrow monetary aggregates (and for monthly changes in M-2)
resulting from transitory variation and seasonal factor uncertainty.

Saaed

on data for the 1973-79 period, the estimated standard deviation of the
noise factor for monthly changes in M-1A and M-1B Is about $1.5 billion
(4-1/2 percent at an annual rate), and about $3.3 billion for weekly
changes.

For M-2, the estimated standard deviation of noise in monthly

growth rates is 3-1/2 percent at an annual rate.

The noise factor declines

for growth rates over longer periods of time.
C.

Variability of interest rates
1,

As had been expected, the federal funds rate has been more variable

on an intra-day, infra-weekly, and inter-weekly basis since the new procedure was implemented.

Intra-day and day-to-day variability Has tended

108
-A8to be at least twice aa large as before, as have weekly changes after
adjusting for trend.

This greater variability of the federal funds rate

reflects the role of nonborrowed reserves as an operating guide for the
Desk.
2.

There has also been heightened variability of Interest rates on

Treasury securities of all maturities following adoption of the new
operating procedure.

Based on data from which cyclical movements were

removed, the variability in Treasury yields measured on a weekly average
basis has been at least twice as large as before October 1979.
3.

The relationship over interest rate cycles between the federal

funds race and yields on Treasury securities of all maturities has been
essentially the same before «nd after October 1979, suggesting that the
underlying linkage between the federal funds rate and other market rates
has remained about unchanged. "At the same tine, however, correlations
between very short-run nonsystematic movements in the funds rate and
other market rates have increased substantially since the new procedure
was Implemented.

This higher correlation possibly reflects the sensi-

tivity of market participants to day-to-day changes In the funds rate in
the uncertain environment that prevailed last year but possibly also
reflects concurrent adjustments la market interest rates generally,
particularly short rates, that tend to occur as closer control is sought
over the money supply, given variations in money demand.
D.

Effects on doaestic financial markets

The swings in Interest rates last year, and the high levels reached,
clearly affected behavior in financial markets. It la difficult, to
isolate the role of the new operating procedure, as such, in contributing




109
-A9-

to Interest rate swings or changes in market behavior.

It Is likely that

large cyclical variations in Interest rates would have developed last
year In any event If the basic monetary aggregate targets were pursued by
other operating techniques In the face of cyclical variations In money and
credit demands that were exceptionally large and coapressed In tine. And
adjustments Chat took place in financial market behavior laat year largely
represented adaptations that would have been expected on the basis of
past cyclical experience—for example, constraints on housing finance—
or were related to the special credit control program.

Market adjustments

that might have primarily reflected adaptations to the new procedure as
such art likely to be those more associated with a perceived greater
continuing rlak of short-Cerm Interest rate volatility—adjustments
that would be difficult to detect in an environment like that of last
last year, which was dominated by cyclical changes in credit flows, a
credit control program, and inflationary expectations.
1.

jtortgage^markets.

Greater Interest rate volatility since October

1979 may have hastened the trend In process for a number of years toward
more flexible mortgage instruments, such as variable rate, renegotlable,
and equity participation mortgages.

In addition, mortgage bankers and

other originators in their commitment policies appear to have attempted
to avoid some of the rlak of interest rate changes occurring between the
time a commitment Is made and funds are extended.

They have done ao by

setting rates or points at the time of closing, shortening the period
for guaranteed fixed-rate mortgage commitments, and by Imposing large
noorefundable commitment fees to discourage cancellation if rates should
decline.




no
-A10-

2.

Dealer market for Treasury a.nj j^gncy^Securities.

Wider bid-ask

spreads on Treasury bills appear to have emerged last year. Evidence on
such spreads for coupon Issues la difficult to Interpret; spreads rose
considerably a few Booths prior to Introduction of the new procedure, and
thereafter remained wider than in earlier years.

Greater uncertainty

about Interest rates may have Influenced dealers to maintain leaner inventory positions relative to transactions; turnover of dealer inventories
rose last year as a very large expansion in gross transactions outpaced
the rise in the level of inventories.
3.

Underwriting^ spreads oa corporate! bonds.

Underwriting spreads on

corporate bonds issued on a negotiated basis did not widen, on balance,
over the year since October 1979. However, data on competitively bid
Issues suggest that spreads on such issues have widened. This sight tend
co raise bond costs, but any such effect last year would appear to have
been very ana.ll relative to the more basic supply and demand conditions
affecting aarketB.
4.

Coanerctal bank behavior.

Bank behavior last year was strongly

influenced by a number of factors other than the new procedure, such a«
th* Imposition and removal of the special voluntary credit restraint
program, marginal reserve requirements on managed liabilities, and
Increasing reliance, especially by small banks, on money market certificates s» « source of funds.

It Is difficult to detect changes la behavior

associated with the new procedure per •«. There appears to have been
some Increased reliance on floating rate lo»n», especially for term
loans, but this trend was evident prior to October 1979.







Ill
-All-

5. Futures markets.

Futures market activity expanded rapidly in the

period following October 1979, raising the possibility that the new
procedure led to an increased desire to hedge against expected greater
interest rate fluctuations.

However, the expansion in activity represented

a continuation of the trend of recent years, as has been the case with
other market adaptations noted above. It Is virtually tnposalble to
separate growth in future* activity arising fron attempts to reduce exposure
to interest rate risk in the new environment from underlying trend growth
connected with increasing familiarization by the public with the variety
of financial futures instruments that are becoming available.
6.

Liquidity premiums.

An attempt was made to determine whether

there was an increase last year In liquidity premiums, manifested by a
rise in long-term rates relative to short-term rates.

Such a result

might be expected if risk-averse financial market participants attempted
to protect themselves from a perceived risk that the new procedure would
make for greater interest rate variability and hence greater risk of capital loss on holdings of longer-term issues.

There appears to be little,

If any, evidence that liquidity premiums became greater laat year--although
as noted in paragraphs 2 and 3 above there may have been some Increase of
transactions coata in financial markets.
E. Exchange market and other external impacts
1.

The spot value of the dollar appreciated by acre than 5 percent

in the 14-month period subsequent to late September 1979, though there
were pronounced cycles that coincided with intermediate-term movements of
interest rates In the United States.
2.

Day-to-day atovetaent in money market rates related to the new

procedure could have had some Influence on very short-term exchange rate

112
-A12volatillty.

Spot rates have displayed more variability on a daily baaia

since the new procedure was adopted, reflecting greater daily variability
of interest rate differentials between U.S. dollar and foreign currency
assets.

The evidence on weekly and monthly exchange rate movements also

suggests mare variability, but the evidence is not so conclusive as that
foe daily variability.
3.

There is little evidence of a significant increase in the

variability of foreign interest rates, apart from in Canada, on & monthly
basis related to the new procedure as such.

Some countries, especially

developing countries with currencies tied to the dollar and with inflexible Interest-rate structures, appear to have experienced some technical
difficulties over this period connected, for example, with the impact of
interest-race variability on financial flows.
4.

The evidence does not suggest that the new operating procedure

has contributed to the variable nature of gross U.S. International capital
flows since the fall of 1979.

Significantly greater contributing factors

were the credit control program and marginal reserve requirements on
managed liabilities.
5.

The proposition that mote short-term variability of exchange

rates could have adverse e f f e c t s on the domestic price level, because
price increases caused by currency depreciation would not be fully offset
by the reverse effect of currency appreciation, Is not supported by
econometric evidence.

Therefore, the short-term variability of exchange

rates since October W9 would not Itself appear to have raleed the
domestic price level*

Meanwhile, the underlying trend toward appreciation

since that time would have had a favorable effect on the price level.




113
-A13-

F.

EC o nom i e_a. etiv:Icy
1.

Assessing the contribution of the new procedure as such Co Che

pattern of economic activity and Inflationary expectations IB complicated—
aa noted at other points In this paper—by the force of other factors
that were Importantly influencing the markets for goods and services over
the recent period, including the effect of the basic money supply targets
themselves.

Certain "fundamentals"—such as the previous sharp increase

in oil pricea, the relatively low saving rat*, and the Illiquid balance
sheet of the household sector—suggest that economic activity would have
contracted in any event in 1980.

In addition, prices and real economic

activity were strongly Influenced by the highly sensitive state of
inflationary psychology, the Imposition and removal of the credit control
program that lasted from mid-March to early July 1980, and erosion of
fiscal restraint.
2.

Nevertheless, Co Che extent that the new control procedure

encouraged more prompt interest rate adjustmenta in response to cyclical
fluctuations In money and credit demands. It probably exerted some
influence on the pattern of economic activity.

It may have hastened the

slowdown in economic activity—especially in housing and possibly consumer
durables—in early 1980 and also hastened th« recovery in the summer, as
interest races advanced rapidly to peak levels and then contracted sharply.
Psychological reactions to the credit control program, however, may have
been an Important Influence on the depth of the recession and the promptness
and strength of the subsequent rebound. There was a sharp contraction In
spending following Introduction of the program, and relief on the part of
both financial Institutions and borrowers aa the program was phased out
probably encouraged a sizable resurgence of spending.




114
-A143.

In vlev of the lags In the response of capital spending plans to

changes In credit conditions, the new procedure does not appear to have
exerted much influence on plant and equipment spending during the past
year.

The timing of Inventory movewents, by contrast, may have been

altered to the extent that the new procedure had effects on the pattern
of final sales and on movements in short-term financing costs.
4.

The new control procedure was adopted in part to provide more

assurance that inflation would come under control (as money growth was
restrained), and thereby to reduce inflationary expectations.

It Is

difficult to measure inflationary expectations, let alone to attribute
changes to a technical change In monetary control procedures In so highly
unsettled a period as last year.

Indirect evidence about inflation

expectations based on changes in Interest rates is obviously difficult to
Interpret, since interest rates are also influenced by other factors.
Some direct evidence about consumer expectations of Inflation can be
gleaned from the Michigan survey.

No clear Improvement In inflationary

attitudes Is evident until into the spring, probably related to large
part to the sharp contraction of economic activity In the second quarter.
There did noc appear to be any significant worsening of expectations, as
Judged by the Michigan survey, In the latter part of the year as the
economy strengthened.
5.

The Board's large-scale quarterly econometric model, as well as

two other much more simplified models used for comparative purposea, were
employed to help evaluate the extent Co wtiich the actual fluctuations in
money and interest rates affected economic activity in the course of the
year.

These models, of course, all suffer from an Inability to take

account adequately of attltudlnal changes and other behavioral factors







115
-A15-

related to the special conditions of a aacticulai year, including any
attltudlnal changes that might be occasioned by the shift In operating
procedure.

Simulation results suggest that, because of long response

lags, the pattern of economic activity last year would not have been
particularly sensitive to e f f o r t s at smoothing the quarter-to-quarter
pattern of either money growth or of interest rate variations, though
saoothlng money growth had slightly more Impact.

The smoothing of

money growth would have been at the cost of even greater interest rate
variability than was actually observed over the last five quarters.
II.

Genera^ Considerations

Evaluation of the current and alternative operating techniques
to be discussed in section III depends very much on the role accorded
intermediate targets, particularly the monetary aggregates, In the
formulation of monetary policy.

This section examines advantages and

disadvantages involved in employing aonetary aggregates, or for that
matter Interest rates, as intermediate targets, and also examines certain
limitations on the feasible range of target settings.
A.

Advantages and disadvantages of Monetary aggregates as intermediate
target^
1.

Advantages
a.

Money stock control tends to work toward stabilising GNP when

the economy Is buffeted by disturbances to spending on goods and
services and shifts In Inflation expectations; such factors appeared
to be an important influence on economic and financial behavior last
year.

If spending surges unexpectedly, for example, as it did in the

116
-A16second half of 1980i adherence to a money gtock target would automatically lead to tighter financial markets, tending to o f f s e t some
of the surge in spending.

Similarly, If spending were to weaken

unexpectedly, and very substantial weakness developed In the second
quarter of last year, efforts to hold to a money stock target would
lead automatically to lower market rates oE Interest, which would
tend to partially restore spending to desired levels.
b.

Current approaches emphasizing control of monetary aggregates

rest on the proposition that planned deceleration In monetary grovth
vlll lowet inflation over time by limiting funds available to
finance price Increases and encouraging expectations and behavioral
patterns consistent with reduced Inflation.
c.

By clearly communicating to the public the Federal Reserve's

objectives for monetary policy, a monetary aggregates targeting
procedure enables private decision-makers to better plan their
activities and to make wage and price decisions that are more
harmonious with non-inflationary growth in money and credit.
d.

Targeting on monetary aggregates involves adjustments of

market Interest rates, in response to underlying changes In demands
for credit, that might otherwise be unduly delayed, either on the
down- or up-aIda,
2.

Disadvantages
a.

Looseness la the relationship between money demand and

noninal GNP reduces the significance of monetary aggregates aa a
target, particularly in the short run.

unexpected shifts in this

relationship lead to undesirable interest rate aovenenta vith strict




117
-A17adherence to money supply targets.

Last year, there was evidence

of looseness in thla relationship.

For example, aa noted earlier,

econometric models suggest a sizable downward shift in the demand
for money in the second quarter, given actual GNP and Interest
rates.
b.

Attempts to achieve steady growth in monetary aggregates

on a raonth-by-month or even quarter-by-quarter basis can lead to
large interest rate fluctuations, given the high degree of
variability in short-run money flows and the relatively interestinelastic demand for money over the near term.

Large fluctuations

in interest rates have certain risks; for instance, they might endanger financial instltutiona that are unable to make timely compensating adjustments in their balance sheets, adversely affect the
functions of securities and exchange markets, and lead to confusion
about the basic thrust of policy.
c.

Money supply targeting procedures might themselves Introduce

recurrent cyclical responses of economic activity following an
economic disturbance.

Whether this is a realistic risk depends on

the nature of response functions in the economy.

It would be a high

risk in the degree that; (i) money demand was very Insensitive to
interest rate changes (and thus interest ratea would need to change
sharply to maintain steady money growth In response to an exogenous
disturbance from the goods market), and (H) there vaa no significant
current Impact on spending from such changes in ratea but impacts
were felt over later periods.

It would be difficult to attribute

the cyclical behavior of economic activity over the past year to




118
-A18-

auch a process, though, given model estimates of the interestelastlclt)' of money demand and of relatively long lags between
interest rates and spending (with such lags Implying a longer cycle
than observed last year).
d.

The concept of money is elusive, and Is becoming more so

as new substitutes evolve for traditional transactions media, and as
improvements In financial technology facilitate the ability o£
the public to shift funds about for payments purposes,
B.

Interest rates aa targets
1.

Advantages
a.

Control over total spending can be strengthened by greater

emphasis on stabilizing interest rates when disturbances stem
mainly from the monetary sector rather than from markets for goods
and services.
b.

Control over rates might make for greater short-run stability

in financial markets, since market institutions might be relatively
certain about the terms and conditlone under which they can "safely"
neet near—term credit demands.
2.

piaadvaqtages^
a.

It is very Difficult to determine the appropriate Interest

rate level, particularly in an inflationary environment in which
shifting expectations of Inflation are continuously altering the
relationship between real and nominal market rates of Interest.
b.

Efforts to stabilize Interest rates tend to amplify economic

cycles Btending from cyclical variations in the demand for goods







119
-A19and services, aince by stabilizing rates, pro-cyclical growth In
money and credit would be heightened.

An upswing in the demand for

goods and services, for example, would be accompanied by an expansion
in the volume of money and credit.

By contrast, with a taoney stock

targeting procedure resistance would be Introduced automatically
through increases In interest rates.i/
c.

While interest rate targets could in concept be adjusted

promptly so aa to minimize the likelihood of a pro-cyclical monetary
policy, in practice the institutional decision-making procedure often
limits the ability to make sizable adjustments In the target.

This

could constrain interest rate variations when rates are taken as the
intermediate target of monetary policy.
C,

Limitations in __thg targeting process
Regardless of whether monetary aggregates or interest rates are

selected aa Intermediate targets, there appear to be a number of limitations
on the monetary authority's range of choice of the particular target
setting and the precision with which the target Is pursued.
1.

The particular target setting must take into account the capacity

of the economy and financial markets to adjust to the targets, and the
degree to which the Implications of those targets can be understood by and
are acceptable to the larger public whose behavior patterns are Involved.
Inflexibilities in wage and price determination, for example, have implications for the degree to which monetary targets can be reduced, without
risking unduly adverse Implications for economic activity in the short
T/

Even with a money stock procedure such resistance may not be sufficient
to hold nominal GNP down to a previously desired level If the upward
shock In demand for goods and services Involves a rise in velocity—aa
it well night If it resulted from, say, expansion in Federal spending.

120
-A20-

run.

This would be less of a limitation to the extent that attitudinal

shifts—either in response to announced monetary targets or other factors—
brought upward wage and price pressures down In line with monetary targets.
Experience of the past year has not yet provided a haala for believing
that the lengthy lags between money growth and price changes have been
shortened significantly or that Inflation expectations have begun to
respond more rapidly to the money control procedure per se.
2.

The question may arise as to whether disturbances in domestic, or

foreign exchange, markets nay on occasion require short-run departures
from intermediate-term targets o£ monetary policy.

However, these markets

appear to have adjusted to a substantial degree of interest rate or
exchange rate fluctuation during the past year.
3.

Precise nonth-by-month control of money does not seem possible,

given existing behavior patterns la the economy and financial markets and
institutional factors.

Nor is there evidence that such close control is

needed to attain the underlying economic objective of encouraging noninflationary economic growth.

Statistical investigation suggests that

"noise" alone accounts for substantial variation In monthly money growth
rates.

Moreover, model simulations indicate that variations in money

growth above or below targets lasting a quarter or so are not likely to
have substantial economic effects.
4.

Uncertainties Involving the relationship between money demand and

GNP—as evidenced by unexpected variations in such demand last year—
suggest the need for a degree of flexibility la target setting (ranges
nay be preferable to point estimates), and also suggest the possibility







121
-A21that, at times, there nay be a need for large deviations from predetermined targets or for changes in the targets.

On the other hand,

deviations from target ranges involve the risk of changes in ioarket
expectations that are counter-productive ( f o r example, when money supply
runs strong relative to target, inflationary expectations may be heightened, compounding the difficulties of controlling inflation).

In general,

though, in the degree that there la success In achieving targets over
time, expectations are less likely to be adversely affected by short-run
deviations in money growth.
III.

Evaluation of Operating Procedures

Because the past year was in many ways exceptional—and because
a year, or 15 months. In any event is too short a time frame within which
to judge whether observed relationships are accidental to the period or
are lasting—evaluation of the new control procedure, and possible alternatives, most at beat be quite tentative.

The choice of operating proce-

dure would be Influenced by the predictability of certain financial and
economic relationships and by the capacity of markets to adjust to operating techniques without severe distortions—evidence about which was
presented In section I.

In addition, the desirability of retaining the

present reserve procedure (with or without possible modifications), of
shifting to an alternative reserve procedure, or indeed of shifting back
entirely to a federal funds rate operating guide depends in part on the
value to be placed on relatively tight short-run control of money, given
uncertainties about the likely sources of potential disturbances In
economic and financial conditions.

122
-ft.22If there were complete certainty about economic relationships,
the choice of operating procedure would not be particularly critical, for
a given money stock target would be associated with unique, known values
for the federal funds rate, nonborrowed reserves, and the monetary base.
And the monetary authority could achieve Its objectives no matter which of
these Instruments was selected for operating purposes.
In practice, however, markets are continually subject to disturbances that are not known in advance.

The principal kinds of disturbances

are those occurring in overall spending (the market for goods and services),
those occurlng In the demand for money (IndependenPly of GNP and Interest
rates), and Chose affecting the supply schedule for money {such aa deposit
mix or banks' demand for excess reserves).

Moreover, such disturbances—

all of which were evident last year—can be of a temporary, or self-reversing
variety, or they can be permanent.
Alternative operating procedures tend to produce different

out-

comes for the pattern of interest rates and money growth in the face of
these disturbances.

With some procedures, and depending on the source of

the disturbance, interest rates would be changed more, while with others
the money stock and other financial quantities would absorb more of the
impact.

The choice of operating procedure therefore involves, anong

other, things, judgments about whether there Is more risk to monetary
policy's ultimate objective of non-inflationary growth from procedures
that tend to emphasize Interest rates as operating targets with some
implication of a relatively gradual change in rates, or from those that
tend to wort more directly against money supply variations.







123
-A23A.

A^ae^sment oj: present Operating ji rgc.edu r^
The present reserve operating procedure proved flexible enough

to permit some accommodation in the short run to unexpected shifts in
money demand, given GNP and Interest rates, that occurred last year.

At

the sane time, the procedure worked to limit the extent to which changes
in demands for goods and services (and thus In transactions demands for
money) were reflected in actual money growth.

Actual money growth devi-

ated from short-run targets last year, but there were large accompanying
changes in interest rates that tended, over time, to set up forces bringing money back toward path.

Nonetheless, money growth over time deviated

more from path than might have been expected relative to the average
degree of looseness that aeens to exist In reserve-to-money relationships.
While the experience of last year may have been atypical because
of the nature of disturbances during the year, still a number of modifications to the operating procedure used since October 1979 might be
considered for their potential value In reducing slippage In money relative
to reserve paths.

These modifications all have certain disadvantages,

however, that need to be weighed aginst their varying advantages for more
precise monetary controli to the degree that closer control in the shortrun is considered desirable.
1.

Evidence of the past year suggests that during an internetting

period relatively prompt downward (or upward) adjustments In the original
nonborrowed reserve path may be needed in an e f f o r t to o f f s e t , over time,
Increased (or decreased) demand for borrowing when money Is strengthening
(or weakening) relative to target,

As an alternative, more prompt upward

(or downward) adjustments in the discount rate would tend to discourage

124
-A24(or encourage) borrowing over time (In practice the actual level of
borrowing will not change u n t i l money demand changes sufficiently to
alter reserves demanded to meet reserve requirements).±J

These adjust-

ments rim the risk of increasing the volatility of short-run Interest
rate movements in view of the transitory fluctuations often experienced
In short-run money demand.

However, they could also dampen the amplitude

of longer-term swings of interest rates by more promptly leading to adjustments by banks that bring money growth back toward path.
2.

More fundamental changes in the administration of the discount

window and in tbe way discount rates are structured and varied could be
considered for strengthening the relationship between reserves and money.
a.

At an extreme, discount window borrowing might be limited

to emergency needs.

This Is tantamount to adhering to a total reserves

or monetary base path.

However, this would eliminate the valuable

buffering function of the discount window.

The window buffers the

money stock (and the markets) from disturbances affecting the supply
of money (such as changing demands for excess reserves and changes
1?Experience has demonstrated that It Is d i f f i c u l t to determine in advance
the appropriate level of borrowing to be employed In constructing the
nonborrowed reserve path consistent with Che short-run money supply
target. This level of borrowing vould depend on a projection of market
Interest rates consistent with the money supply target path and knowledge
of depository institutions* willingness to borrow, given the spread
between market rates and the discount rate, and could d i f f e r significantly
from borrowing levels based on or ranging around recent experience. In
attempting to forecast borrowings, evidence from models may be usefully
weighed along with judgmental assessment of particular conditions at
the time. However, In viev of considerable uncertainties about interest
rate projections, the high degree of year-to-year variability In the
success with which models project economic and financial relationships,
and in light of the heightened variability In demands for discount window
credit evident last year, projections of borrowing demand from interest
rate forecasts and past bank behavior are subject to a considerable
degree of error.







125
-A25in the deposit mix affecting required reserves).

Its role In that

respect was evident from the results of model simulations showing a
weak relationship between total reserves or the monetary base and
money (when reserves or the base are treated as exogenously determined).

In addition, ehe discount window cushions markets from the

full Impact of variations in money demand that raay be transitory or
which the FOHC may wish at least partially to accommodate.

Finally,

lagged reserve accounting requires access to the discount window In
the short run on occasions when required reserves run above the nonborrowed reserve path (if that path is to be maintained),J7
b.

Another approach to consider would be to ellairtate administrative

guidelines at the discount window and to substitute a graduated discount
rate schedule for adjustment credit—in contrast to emergency and other
longer-term types of discount window credit—baaed on, say, size of
borrowing.

This approach would tend to make the relationship between

borrowing and short-term market rates more certain by eliminating from
the decision to borrow the uncertainties connected with administrative
guidelines.

It also thereby tranaforma the highest discount rate on

the schedule into an upper limit for the federal funds rate.

There

are, however, legal questions about the System's ability to use size
of borrowing aa a criterion, administrative problems in overseeing
the adequacy of collateral and the financial condition of a vast
number of potential regular borrowers, and d i f f i c u l t questions with
regard to the appropriate gradient for the discount rate schedule.
If

Even with contemporaneous instead of lagged reserve accounting. It is
by no means clear that banks would be able to make needed adjustments
reducing their required reserves within a statement week—except at the
expense of relatively extreme Interest rate movements.

126
-A26Too steep a gradient risks undue market Interest rate fluctuations,
particularly at tlraea when borrowing demands may tie changing for
transitory reasons, while too flat a gradient—and at the Unit a
perfectly flat one—would tend to ellainate the incentive of banks
to make portfolio adjustments that would bring money supply
back to target.
c-

The recent policy of applying a surcharge above the basic

discount rate for frequent borrowing (by larger banks) represents
a step toward a graduated discount rate structure within the present
administrative guidelines and tends, when applied, to speed up the
response of market rates to overshoots or undershoota of Money
relative to path.

This approach has the attraction of flexibility,

but In practice It has proved difficult to assess, because of the
limited experience with it thus far.
d.

Another approach to speeding up the response of banks within

present administrative guidelines would be to tie the discount rate
to market rates, either as a penalty rate or not.

However, this

approach tends to limit flexibility and raises the danger of upvard
or downward ratcheting of market rates In the short run that may be
excessive for monetary control needs and unduly disturbing to the







127
-A27-

functloning of markets..!/

While a tied rate accelerates the response

of market rates, the change may be counter-productive—particularly
t£ money behavior was going to reverse Itself naturally or if the
rise tn borrowing was needed to moderate shocks from the supply side—
and could intensify short-run money supply and Interest rate cycles.
3.

A closer short-run relationship between reserves and money could

be attained by measures that strengthen the link between required reserves
and deposits In the particular money stock that Is being controlled. One
such measure would be a shift from lagged reserve accounting (LRA) to
contemporaneous reserve accounting (CRA), which the Board has already
announced that It Is contemplating.

Such a shift would make the link

between current reserves and current deposits stronger, though there
still would be relatively sizable slippage between reserves and money
from other sources.

The monetary control advantages of CRA apply

particularly to the short run.

They have to be weighed against (1) the

benefits of LRA for reducing the cost of reserve management by the
banks, (ii) the contribution of LRA to the Trading Desk's ability to assess
reserve supply conditions, and (ill) judgments about the adequacy of
monetary control under LRA over a longer-term period.
This danger Is greatest in the degree that the discount rate Is tied
to a current or very recent market rate. If required reserves expand
rapidly in the current week, banks will have to borrow the added required
reserves that are not being accommodated by the nonborrowed reserve
target. As a result market rates must rise to the point where banks
are willing to borrow from the discount window. With an attempt to
maintain a "penalty" discount rate, the new market rate would therefore
have to move temporarily above the discount rate which could not be
maintained, In those circumstances, above current market rates. Market
rates would go up by the amount needed to re-establish the normal
spread of market rates over the discount rate (that emerges from
pressures generated by discount wiodov administration and hanks'
reluctance to borrow). But this rise In rates may well bring about a
further rise in the discount rate if an attempt is made to re-establish
a "penalty" rate, entailing yet a further rise In market rates, so long
as required reserves remain at an advanced level.

128
-A284.

The present relatively complicated reserve requirement structure,

even apart from LRA, makes for considerable slippage In the relation
between reserves and money.

While the Monetary Control Act has tended to

siaplify the required reserve structure, it will be a number of years
before the new structure Is fully phased in.

Because of the unpredic-

tability of s h i f t s in deposit mix, in the ratio of currency to deposits,
as well as in banks* demand for excess reserves, Judgmental multiplier
adjustments to original paths were made week-byveefc. last year as new
information was obtained.

Model simulations suggest money-reserve rela-

tionships would have otherwise been more variable on average.

Thus,

there is no reason not to continue making such adjustments, though it
remains unclear, because multiplier changes are so erratic, whether full
adjustment should be made to each week's added information.
5.

It appears from tentative results based on the Board's monthly

money market model that the faster the FOMC attempts to move back toward
the longer-run target for money, once off target, the more likely Is the
long-run target to be h i t , assuming no federal funds rate constraintHowever, these results also suggest that the more quickly a return to path
la sought, the more substantial fluctuations in money market rates are
likely to be.

And experience of the past year suggests these more

substantial fluctuations would be transmitted broadly through ehe rate
structure.

Moreover, for a more rapid return beyond a certain speed—pec-

haps around 3 months—it seems as If the gain in reducing the chance of
departures froa longer-term money targets is small compared with the
increasing chance of a wider range of variability In money market rates.







129
-A29B,

Assessment of other targeting procedures
I.

Monetarybase or total reserves
A.

The principal reason for adopting these measures as day-to-

day operating guides would be to ensure more precise control of money.
However, there is no clear evidence that money can be controlled more
closely through use of a strict total reserves or monetary base
operating procedure under the present institutional framework than
through current procedures.

Indeed, most of the evidence suggested

that these measures could produce more slippage because of supplyside shocks to the money multiplier.

These shocks tend to be

partially offset by changes in borrowing with a nonborrowed reserves
day-to-day operating target.

Under a total reserves or base target,

there would not automatically be an offsetting tendency.

In practice,

though, the precision of a total reserve or base target would be
improved through judgmental adjustments to the reserve path that
offset multiplier shifts.

Improvements could also be effected, and

the need for judgment reduced, by further simplification of the
reserve requirement structure (such aa removal of the reserve requirement on nonpersonal £lae deposits If the FOMC wishes to control mainly
narrow money) and by a return to CRA.

tthile

such changes would

tighten the linkage between reserves and money, shifts between currency
and deposits would still tend to be a factor causing slippage—with
model simulations Indicating greater slippage with the monetary base
as the operating target (which is essentially currency plus total
reserves) than with total reserves.

Hlth a monetary base target,

short-run volatility In currency would Lead to large variations in




130
-A30money supply because changes In the public's holdinga of currency
would need to be offset by equal changes in baok reserves; and these
changes in reserves would, given the fractional reserve system,
force a multiple change of deposits In the money supply.

With a

reserves target, the changes In aoney supply would be no larger than
the currency variation; consequently, money supply would be less volatile with a reserves c«rg«t.
b.

In any event, strict adherence to total reserve or baae targets

appears to be impractical over short-run operating periods in the
current institutional setting.
clearly not feasible.

With the present LRA ayatem. it

is

If CRA were adopted, such targets might become

somewhat more practical, though efforts to attain them would accentuate
short-run interest rate fluctuations.

Such fluctuations, given the

inelasticity of money demand relative to interest rates over the short
run, would stem from the inability of the reserve supply to provide
at least partial accommodation to transitory money demand variations,
and would also result from remaining multiplier slippage.

In the process,

borrowing at the discount window vould fluctuate widely, as banks reacted
to e f f o r t s by the Open Market Desk to reach the total reserve target.
c.

While there are practical questions about the feasibility of

targeting on total reserves (or the base) on a day-to-day of week-toweek basis, in a longer-run context a path for such reserve aggregates,
properly adjusted for multiplier shifts, could serve as a general guide
in helping to make adjustments in the nonborrowed reserve path or in
indicating the need for a change In the basic discount rate—as is,

in fact, present practice. For example, when total reserves are




131
-A31runnlng strong relative to its adjusted path, thta can be taken SB
an Indication to hold back on the supply of nonborrowed reserves
relative to its path (in order over time to offset the rise in borrowing)
or to raise the discount rate (in order over time to discourage a rise
in borrowing).
2. Federal funds rate target
a.

Model simulations, given existing institutional arrangements,

indicated that In concept slippage in short-run money stock targets could
be little different on the whole under a funds rate targeting regime
than under a nonborrowed reserves regime.

However, in practice—to be

reasonably certain of attaining Its long-run target—the POMC would n«ed
to be willing to move the funds rate quite actively when It waa the
operating instrument and be able to predict fairly fell the appropriate
extent, and indeed the direction, of Che required change. Uncertainties
In those respects of course were among the factors leading to a shift
toward reserve targeting.
b. A federal funds rate operating target would have advantages
if the FOMC wished to provide more scope for being accommodative to
variations in money demand, either because of uncertainties about the
proper path of money growth within ita longer-run target band or
because of a belief that money demand disturbances are more likely
to occur than disturbances in the market for goods 0nd services.
c. Th« federal funds rate range under the current reserve
operating procedure has been much wider than under the earlier funds
rate targeting regime.

Moreover, the range under the new procedure

ha» generally been changed as the limits were approached—a practice

132
-A32-

that has been consistent with evidence suggesting that a wide range of
variation in the funds rate is a by-product of efforts to attain tight
control of the money supply.

In that context, a relatively narrow

acceptable funds rate range would only have advantages in the degree that
the FOMC (i) felt more scope could be given in a particular period, for
one reason or another, to variations of money from a pre-aet target,
or (ii) felt that narrow funds rate limits provided a device that,
given the need to make judgmenta about sourcea of economic and monetary
disturbances, would prompt further assessment of underlying monetary
and other conditions by the Committee In the interval between meetings.







133
-A.33-

Monetary Cgntn^PrgJect^Staff Papery
Davis, Richard. Monetary Aggregates and the Use of "Intermediate Targets"
in Monetary Policy.
Enzler, Jared.

Economic Disturbances and Monetary Policy Responses.
and Lewis Johnson.

Cycles Reulting from Money Stock

Targeting.
Greene, Margaret. The Hew Approach to Monetary Policy—A View From the
Foreign Exchange Trading Desk.
Johnson, Dana and Others. Interest Rate Variability Under the Hew
Operating Procedures and the Initial Response in Ftnancial Markets.
Keir, Peter. Impact of Discount Policy Procedures on the Effecttvness of
Reserve Targeting.
Levin, Fred and Paul Meek.
the Trading Desk.

Implementing the New Procedures: The View Proa

Llndsey, David and Others.
Operating Procedures.

Monetary Control Experience Under the Hew

Pierce, David.

Trend and Noise In the Monetary Aggregates.

Slifman, Lawrence and Edward McKelvey. The New Operating Procedures and
Economic Activity since October 1979,
Tinsley, Peter and Others.
Procedures.

Money Market Impacts of Alternative Operating

Truman, Edwin M. and Others. The New Federal Reserve Operating Procedure:
An External Perspective.

134

UIXCLI. UIMMITT iTvr omen* AW contn.

UHB*N AFFAIRS
WASHttTOTOn, D.C. J0510

March 16, 1981
The Ifonorable Paul A. Volcker, Chairman
Board of Governors of the Federal
Reserve System
Federal Reserve Building
Washington, D. C. 20551
Dear Mr. Chairman:
The Banking Committee appreciated your appearing before it on February
2S to present the Federal Reserve's monetary policy report. In order to
complete the Committee's hearing record, your responses to the following
questions would be appreciated:




1. Much of economic policy to this day is based upon an idea of
Irving Fischer known as the equation of exchange. This simply
suggests that if one multiplies the quantity of money by the
velocity of that money, the product will be equal to the
product of the number of transactions in the economy multiplied
by the average price of each transaction. This equation has
been used to "show" that if velocity is stable (and it was suggested that it was), and if we are near full employment so that
the number of transactions does not increase greatly, then an
increase in the quantity of money will lc;id to higher prices
and vice versa. This was used to prescribe monetary policy for
some time.
is there any validity to this equation in today's worlJ? Is
velocity stable, or at least predictable? If the concept here
is no longer valid, is there any way to justify activist monetary policy, especially in a world in which we have trouble
even deciding how much money there is?
2. The Reagan tax program purports to have as its purpose increasing savings.
Wouldn't it serve that purpose better to have less income tax
cuts and more exclusion of taxable interest on savings? It
would seem that such a policy would better increase capital
formation.
3. Mr. Greenspan was quoted by Mr. liobart Rowcn recently ns saying
that if thrift institutions were given massive loan aid the
resultant inflation rate would double from 10 to 201 with interest rates going sky high.

135
The ftenorablc Paul A- Volcker
March If), 1981




Page Two

Mr. Greenspan raised a basic question therefore about the economy
in relation to the stability of the financial system.
May we have your comments?
4.

We heard Mr. Stockman say recently that if the Reagan program is
adopted intact there would be a dramatic change in interest rates
to the 8 or 9",, range within a very short period of time.
Do you agree or disagree with Mr. Stockman?

5.

During your confirmation hearing, you expressed some concern
over the threat to the Fed's ability to actually control the
growth of the money supply posed by the innovativeness of
financial markets which has resulted in the creation of forms of
money or near money springing up which are outside of your
direct control. These innovations, combined with the uncertainty
over NOW accounts, make me wonder if your concern is greater or
less than it was IS months ago?

6.

IXiring the last several weeks Ml-A has shown a marked decline,
while Ml-B has grown at a moderate rate. Presumably this
behavior is due to NOW accounts that were authorized nationwide
as of January J ,
Has the growth of NOW accounts been consistent with the Board's
expectations, and has the shift of funds been from demand
deposits and savings in the proportions expected?
Would you say that the week-to-week changes on Ml-A and Ml-B
remain useful indicators of Federal Reserve policy or would you
caution the public against watching them?
And, would there be any benefit in changing the way the Ml-A and
Ml-B data are published--perhaps publishing them as monthly
averages as is done with M2 and M3, or only on a non-seasonally
adjusted basis, or only in component deposits not aggregated?

7.

The discount rate has been at 13% since December 1980. hjring
that time the prime lending rate has been as high as 20 3/8°i
and is now 19. Borrowing has been averaging $1.7 billion per day.
This implies a high subsidy being given to borrowing banks—perhaps
$200-$300 million at an annual rate.

Can this subsidy be justified?
Given the recent strong desire by the electorate to let the
free marXct work in this economy, why not have the discount rate

136
The Honorable Paul A. Volckcr
March 16, 1981

Page Three

be at or above the rate paid for similar funds in the market
place rather than at the ad hoc discretion of the Federal
Reserve?
8.

An interesting column by James Lebhenz in the WASHINGTON
POST on Sunday, February 22, 1981, indicates that short-terra
interest rates have declined by 500 basis points, but longterm Treasury rates have increased by 125 basis points. Last
April, a 500 basis poin£ decline on short-rates produced a
174 basis point decline in long rates.
Why the difference? Why have long-term rates increased
rather than declined?
What does this indicate about inflationary expectations and
the possibility of future economic growth?

9.

Some are very concerned over the apparent tremendous growth
in banks' loan conrnitments over the past few months.
How much impact would such an increase in commitments have?

10.

In the past, you have recognized "the challenge of restoring
employment, growth and productivity while at the same time
visibly reducing inflation." An important goal of the
Humphrey-Hawkins Act -- The Full Bnployment and Balanced
Growth Act of 1978 -- is to reduce unemployment. Unemployment
in Michigan is currently at 13.75. Employment has not been
restored or unemployment reduced in the seventh largest State
in the country.
In your opinion, what specific steps should be taken -- which are
not currently being taken - - t o reduce unemployment?

11.

lias the Federal Reserve done any studies on the effect of high
interest rates on different regions of the country? For
example, is there any difference between the effect of high interest rates in the State of Michigan -- which is a large industrial State -- and say a predominantly rural, agricultural
State? What is the difference?

Your cooperation in providing the Committee with your additional views
is appreciated.
Sincerelw^urs,

JG*JCrra







137

B O A R D DF [ I - D V E R N O R S
FEDERAL RESERVE SYSTEM
W A S H I N G T O N , D. C. 30551

March 25, 1981

= * U L A. V U L C
CHAIBMA

The Honorable Jake Garn

Chairman
Committee on Banking, Housing
and Urban Affairs
United States Senate
Washington, D. C. 20510
Dear Chairman Garn:
Thanh you for your letter of March 16
forwarding additional questions in connection with
your Committee's hearing on February 25.

I am

pleased to enclose my responses to the questions.
Please let me know if I can be of further
assistance.
Sincerely,

Enclosure

138
CHAIRMAN V O L C K E P ' S RESPONSES TO WRITTEN QUESTIONS SUBMITTED BY
CHAIRMAN GAM AS A FOLLOW-UP TO THE HEARING HELD BF-r'OHE THE
SENATE B A N K I N G COMMITTEE ON FEBRUARY 25,
1981

(1)

The e q u a t i o n n f exchange ts r»erhnns h e S t viewed ,ts a mathematical
i d e n t i t y d e f i n i n g the concept of v e l o c i t y ,
as correct t o d a y as I t ever w a n ,

In that sense I t c e r t a i n l y la

However, I t can serve aa a framework for

policy only In the broadest t e r m s .
As T have stressed on many occasions, the relationship of money to
spPTidinr,— t h a t is,
short rim.

v e l o c i t y — I B a rather loose one, e s p e c i a l l y in the

The problem of d e f i n i n g money is a facet nf t h i s looseness.

In the short r u n , v e l o c i t y is miite variable and n n t f u l l y predictable.
And the same is true of the d i v i s i o n of changes in nominal spending between
pains in real output an^ Inflntion.

This variability and unpredictability

does argue for a cautious approach to monetary a c t i v i s m or f i n e - t u n i n g .
Tn n longer run c o n t e x t , however, t h e r e are discernible trends ro
v e l o c i t y that enahle one to relate in .1 roufih wav the g r o w t h of money to
the prowrh of n o n l n s l GUP. Moreover, over such lonf, p e r i o d s — several years
In l e n g t h — t t is possible to d e f i n e the trend of real CMP, p a r t i c u l a r l y of
p o t e n t i a l o u t p u t ; Riven t h a t r e f e r e n c e p o i n t , one c.-\n r e l a t e the trend
g r o w t h rai.e of motley to the trend of i n f l a t i o n , at least to a useful
apiiroxinatlon.

1C Is this long-ranfie c o n n e c t i o n hetup^n noney and I n f l a t i o n

t h a t underlies the Federal Reserve's view that a m o d e r a t i o n over time in
M o n e t a r y e x p a n s i o n Is an essential part of the flp,ht a R a i n s t




inflation.




139

<"?.)

I h e l i e v p that It I s a p p r o p r i a t e to focus malor a t t e n t i o n in the design
of a Can cut packnfie on the implications for c a p i t a l formation.

Higher levels

of saving and investment *re needed to improve p r o d u c t i v i t y performance and
thus pave the way for the reduction of p r o d u c t i o n costs find for rising llvinp, s t a n d a r d s .

ITou to provide the m a x i m u m incentives for capital f o r m a t i o n

at the m i n i m u m cost In terms of lost federal revenues Is a complex technical
m a t t e r on which I c a n n o t o p f e r d e f i n i t i v e answers.

I am inclined to think,

t h a t i n c e n t i v e s for I n v e s t m e n t are likely to be the most c o s t - e f f e c t i v e
approach, w i t h the investment essentially hrfnging forth the corresponding
saving; however, there undoubtedly Is some role for direct Incentives to
saving as well.

U n f o r t u n a t e l y , raany of the proposals I ' v e seen in this area

appear l i k e l y to be rather I n e f f i c i e n t .

For example, the Interest exemption

legislated last year probably will provide l i t t l e Impetus for a d d i t i o n a l
saving since many people already have Interest Income in excess of the exemption l e v e l .

It is i m p o r t a n t tbat savings I n c e n t i v e s he focused on en-

covirafcinp, ajdltiona^ saving—and p a r t i c u l a r l y additional t_iita_l saving, not
.lust saving in one form that represents a s u b s t i t u t i o n for o t h e r f o r m s .

140

(1)

Thrift

I n s t i t u t i o n s a r e f a c l n s some slftM flcaot d l f f l e n i t i e s

today;

"massive loan aid" would n o t , h o w e v e r , appear an I m m i n e n t r e q u l r e m e n t .
Even I f c r p c H t n s s l s t a n c e In some form were p r o v i d e d at some p o i n t , I t Is
not a t . a l l c l e a r t h a t i t would have a n I n f l a t i o n a r y Impact.

I f such assis-

tance were provided t h r o u g h the Federal R e s e r v e d i s c o u n t w i n d o w , the impact
on o v e r a l l r e s e r v e a v a i l a b i l i t y could be o f f s e t through open m a r k e t operations t o Veep m o n e t a r y e x p a n s i o n w l t h ' n h o u n d s .
be provided through other channels,

of c o u r s e ,

C r e d i t a s s i s t a n c e might
but 1 see no n e c e s s a r y

reason for such an I m p a c t on I n f l a t i o n or I n t e r e s t r a t e s .
The dangers In a m a j o r f i n a n c i a l c r i s i s tend generally to run in the
d i r e c t i o n of recession and d e f l a t i o n .

The Federal Reserve, In Its

role

aa lender of last resort:, would make evevy e f f o r t to p r e v e n t a l i q u i d i t y
crisis from a r i s i n g as a r e s u l t of a n t i c i p a t e d or a c t u a l i n s t i t u t i o n a l
failures.

It

is i m p o r t a n t , however, t h a t we not e x a g g e r a t e the dangers of

surh ( J e v e l o p n e n t s and u n d e r t a k e r a s h " h a i l o u t " actions on a broad scale.
It mtfiht Indeed he said t h a t an excessive r e a d i n e s s t h r o u g h the years to
brine f o r t h a federal

s a f e t y npt when f i n a n c i a l I n s t i t u t i o n s o r b u s i n e s s e s

have e n c o u n t e r e d d i f f i c u l t i e s has f o s t e r e d a d i s d a i n for t r a d i t i o n a l rules
of

sound

f i n a n c e and has c o n t r i b u t e d i n d i r e c t l y to the i n f l a t i o n a r y process.

Thus, w h i l e we c a n n o t a f f o r d a cumulative f i n a n c i a l d l s t g r b a n c e , we roust
he w11\!rt£ to a l l o w the m a r k e t to exert a m e a s u r e of d i s c i p l i n e if

we are

to e n c o u r a g e t h e s o r t of f i n a n c i a l and business p r a c t i c e s t h a t f o r m the
f o u n d a t i o n of a s t a b l e economy.




141

(4)

Mr. Stocknan hai, I b e l i e v e , revised Ms s t a t e m e n t a b i t .

It is my

u n d e r s t a n d i n g t h a t he is not p r e d i c t i n g a quick r e t u r n to such low rates.
In any e v e n t , t h e r e is an i m p o r t a n t and accurate e l e m e n t in Mr. Stockman's
Reneral v i e w — n a m e l y , t h a t a reduction in i n f l a t i o n a r y expectations is the
Vey to a s i g n i f i c a n t , sustained decline fn Interest rates.

(5)




The r a p i d i t y of f i n a n c i a l Innovation (foes remain a concern as we a t t e m p t
to set a p p r o p r i a t e t a r g e t s f o r m o n e t a r y expansion and t h e n to achieve chose
targets.

The impact of NOW accounts is a d r a m a t i c example, b u t , as you sug-

gest. I t is j u s t one of many changes a f f e c t i n g the behavior of money.

I

d o n ' t t h i n k we can as a practical m a t t e r put an end to such innovation—nor
would it

be d e s i r a b l e .

But I would wish t h a t there vas a more general appre-

c i a t i o n of the n e e d , in such an e n v i r o n m e n t , for some f l e x i b i l i t y In poUcy.
1 f i n d i t d i f f i c u l t to square the obvious fact of d r a m a t i c change In instit u t i o n s a n d n a r k o t s w i t h t h e calls f r o m m a n y o f o u r c r i t i c s f o r more r i g i d
a p p r o a c h e s to tionetary p o l i c y .

142

(fi)

The m o v e m e n t s of the narrow m o n e t a r y aggregates have, as you say,
been d i s t o r t e d r e c e n t l y by the Introduction of NOW a c c o u n t s on a nationwide
basis.

The growth of NOW balances has been somewhat f a s t e r t h a n we expected

before the vear began, and the degree to which s h i f t i n g

from demand deposits

has accounted for Che I n f l o w to NHWs has hi>en a bit g r e a t e r than expected.
The weekly lf-1 numbers are extremely "noisy."

Given the large random

fInclinations they e x h i b i t , I Jiave alwavs c a u t i o n e d a g a i n s t p l a c i n g g r e a t
i m p o r t a n c e on any w e e k l y change.

We have e x a m i n e d the q u e s t i o n of whether

our p u b l i c a t i o n p o l i c y should he c h a n g e d , and are s o l i c i t i n g public comment
on t h i s issue at ttita time.

Our thinking on t h i s score uas o u t l i n e d In a

recent letter to you, which I am s u b m l t t t n f > here for t h e record.

(7)

The issue of the discount rate Is a complex one.

It was examined in

some d e t a i l in the recent s t a f f s t u d y of the Federal R e s e r v e ' s m o n e t a r y
policy operating procedures.

I am u n c o m f o r t a b l e about the "subsidy" problem;

the use of s u r c h a r g e on f r e q u e n t borrowing hy larj>e banks has reduced the
extent of the phenomenon, but it does not e l i m i n a t e I t .

As I have I n d i c a t e d

i n Congressional testimony ( a n d Is discusser! a t l e n g t h in t h e s t a f f s t u d y ) ,
the concepts of a tied or p e n a l t y d i s c o u n t r a t e are not without their shortcomings.

The Hoard is c o n t i n u i n g to wrestle w i t h tMs question I n the hope

of finding a solution that avoids u n r e a s o n a b l e subsidies hut does not at
the same t i m e I n t r o d u c e n e w d i f f i c u l t i e s I n m o n e t a r y c o n t r o l o r u n d u l y exacerbate short-run interest v o l a t i l i t y .







143

(R)

n h < j r t - and l o n e - t e r m I n t e r e s t r a t e s tend t o f l u c t u a t e together ( a l -

though the a m p l i t u d e of f l u c t u a t i o n in long rates generally is smaller),
but Lliia

need not he so over everv p a r t i c u l a r time span.

The broad nove-

n e n t s in r a t e s over the past year or so c e r t a i n l y have conformed to this
p a t t e r n , an>) in r e c e n t weeks both short- and Ion?,-term s e c u r i t y yields
have d r o p p e d .

Temporary departures from t h i s p a t t e r n may r e f l e c t unusual

supnly c o n d i t i o n s nr other special f a c t o r s .
It is true t h a t Ions-term interest r a t e s are s t i l l very h i g h by hist o r i c a l s t a n d a r d s , and t h i s Is an indication of p r e v a i l i n g concerns about
the p e r s i s t e n c e of bifch rates of I n f l a t i o n .

Lowering those e x p e c t a t i o n s

is c e r r a f n l y i m p o r t a n t to provide an e n v i r o n m e n t n o r e conducive to improved
economic p e r f o r m a n c e .

Loan c o m m i t m e n t s do c o n s t i t u t e a p o t e n t i a l call on t h e resources of a
hank.

R i s i n g levels o f unused c o m m i t m e n t s In e f f e c t

in the l i q u i d i t y of the b.iiikinfi system, all

represent a reduction

other t h i n g s e q u a l .

By the same

token, t h e y r e p r e s e n t a source of l i q u i d i t y for the business firms h o l d i n g
the c o m m i t m e n t s .

Ue at the Federal R e s e r v e w a t c h the loan commitment

to p.auee both the l i q u i d i t y of the banks and the p o t e n t i a l b o r r o w i n g
nesses .

figures
by busi-

144

(10)

Unemployment is high by h i s t o r i c a l s t a n d a r d s on average across the
c o u n t r y , and e s p e c i a l l y high In aome areas where there are concentrations
of i n d u s t r i e s — s u c h as a u t o m o b i l e m a n u f a c t u r e — t h a t are experiencing
p a r t i c u l a r d i f f i c u l t y . It i s vorth n o t i n g , h o w e v e r , t h a t t h e proportion
of the t v j p u l a t i o n employed is also at a h t ^ h level.

S t r u c t u r a l changes

1n the work force have tended to push average unemployment rates above
the norms of the past.
T h e r e c l e a r l y Is a role in employment policy for veil-designed programs to I n c r e a s e t>>e n o b i l i t y of lahor and for a c t i o n to remove the res t r a i n t s on wage f l e x i b i l i t y that Inhibit h i r i n g , p a r t i c u l a r l y of lower
s k i l l e d workers,

"hat Is most c r i t i c a l over the long rwi, however, is the

adherence to a n t i - i n f l a t i o n a r y monetary and f i s c a l p o l i c y t h a t will fostec
a s t r o n g e r economy t h a t Is move competitive tn world m a r k e t s .

(11)

The Board has not undertaken any d e t a i l e d s t u d i e s of the regional
imnaet of hi^h I n t e r e s t

rates.

C e r t a i n l y , t h e r e Is the possibility of

a d i f f e r e n t i a l Impact, owirif* to relative c o n c e n t r a t i o n s of capital Intensive i n d u s t r y or c y c l i c a l l y sensitive d u r a b l e Roods p r o d u c t i o n .
present instance,

In the

the c y c l i c a l problems experienced In the state of

M i c h i g a n h a v e been r e i n f o r c e d b y d i f f i c u l t i e s f l s s o c l a t e d w i t h t h e f a i l u r e
of the U . S . m a n u f a c t u r e r s to gear t h e i r p r o d u c t i o n of automobiles to models
t h a t are c o m i w t i t i v e in terms of p r i c e , q u a l i t y , and f u e l economy with
foreign-made cars.

It would be f a i r to say, however, t h a t all

areas of

the c o u n t r v are s h a r i n j j in the d i f f i c u l t i e s caused by the high interest
r a t e s t h a t have hcen t h e r e s u l t o f I n f l a t i o n a n d t h e e f f o r t t o c o n t a i n




it.

145

B O A R D OF G O V E R N O R S

FEDERAL RESERVE SYSTEM
WASHINGTON, D. C. 2OS5I

March 24, 1981

The Honorable Jake Garn
Chairman
Committee on Banking, Housing
and Urban Affairs
United States Senate
Washington, D. C. 20510
Dear Chairman Garn:
The concerns and questions raised in the recent letter from
you and Senator Proxmire about weekly money supply data have been discussed and debated by the Federal Reserve Board, the Federal Open Market
Committee, and the staff for some time. The issues are extremely
important and strong arguments—other than Freedom of Information Act
implications—can be made for and against publication of weekly data.
There is nearly unanimous agreement by all observers that
weekly money statistics are extremely erratic and therefore poor indicators of underlying trends. While monthly data cart often deviate
considerably from such trends, the weekly observations are particularly
"noisy". Week-to-week changes are quite large and recent estimates
indicate that the "noise" element—attributable to the random nature
of money flows and difficulties in seasonal adjustment—accounts for plus
or minus $3.3 billion in weekly change two-thirds of the time. Such a
large erratic element appears Intrinsic to money behavior, rather than
implying poor underlying statistics. In 1980, weekly M-lA and M-1B
statistics revised on average only about $300 million between the first
published and "final" data several weeks later, though in twelve weeks,
revisions were larger than $500 million, and the largest single revision
was $1.6 billion.
The great preponderance of active market participants are by
now aware of the highly volatile nature of the weekly series. Publication has had that educational advantage, and the data to be used with
a certain caution. However, from time to time overreactions have
occurred.




146
The Honorable Jake
Page 2

Gam

As a result of concerns about the reaction to and significance
of weekly figures, the Federal Reserve has considered possible revisions
to its current publication schedule or to its method of presentation.
One option night be to delay weekly publication an additional seven days
to incorporate more data—an important issue with additional reporters
under the Monetary Control Act, This could reduce revisions to the
weekly statistics. On the other hand, this option would increase the
risk of inadvertent leaks and would increase the interval over which
market participants night react to guesses and rumors of money stock
changes, based in part on fragmentary data such as may be available in
the weekly figures from large banks on deposits and loans. Even if no
greater volatility in interest rates occurred over the unpublished
interval, lagged publication of a more accurate, but still different
than expected, change in weekly money might simply postpone the market
reaction. In any event, weekly revisions are usually small, as noted
above, relative to the underlying volatility of the series.
Another option might be to publish seasonally unadjusted money
data in order to reduce the "importance" of the statistics. Our concern
here is that market participants would then create their own seasonally
adjusted series. The availability of a large number of conflicting
series would only heighten market confusion, and might inevitably lead
to questions to the Federal Reserve about what it considers to be the
"normal seasonal" change in a particular week if what might seem to be
an unusual change occurs in a seasonally unadjusted figure.
Another approach might be to publish data only monthly—as is
now done, because of data reporting problems, with M-2 and M-3—and/or to
publish weekly, but only a moving average series of weeks. Under the
monthly approach, market participants would still try to estimate weekly
series from bank balance sheets and clearing house data, and the market
could be swept by rumors and guesses on movements in the money supply.
And they would also probably attempt to glean the weekly number from a
moving average series. In any event when a monthly figure was finally
published, deviations from market expectations could.cause yet further
changes in interest rates as the new information was Incorporated into
market expectations. I might note that this has not been a significant
problem with monthly publication of M-2 and M-3. A relatively small
portion of these aggregates are supported by reserves, and they have
played a less important role in the day-to-day targeting process than
M-l.
In general, there is considerable merit to the view that
weekly data as such convey little information and that weekly seasonal
adjustments are subject to substantial uncertainty. However, the Board
is not certain at present that the public interest would necessarily
be better served if any of the alternatives noted above were adopted.
While no one can be sure of their judgment in this respect, it does




147
The Honorable Jake Garn
Page 3

seem possible that volatility of money market conditions could be encouraged
by misinterpretation of fragmentary data as well as by the continued availability of the present weekly data.
We will, of course, continue to review the money supply publication
schedule, taking account of the constraints Imposed by the Freedom of Information Act, To aid in our assessment of the value of weekly money supply
data, we plan to ask for public comment on the desirability of continuing
the weekly series, or of shifting to the options noted above. Our decision
will be taken in the light of those comments. Should Freedom of- Information
Act requirements present difficulties in the light of the appropriate course,
we will consult with you further.
I appreciate your interest in these questions.
to all of us.




Sincerely,

Identical letter also sent to Senator Proxmire.

They are of concern

148

Congressional Research Service
The Library of Congress
Washmgton, DC 20540

BRIEFING MATERIALS FOB. FEBRUAR? 1981 MONETARY POLICY OVERSIGHT
Congressional review of economic policies, Including monetary policy, Is
conducted on A coordinated basis pursuant to the Full Employment and Balanced
Growth Act of 1978 (P.L- 95-523).

The Act requires the Federal Reserve to

submit a monetary policy report to the Congress twice annually.

The reports

are to present a review of recent economic trends, a statement of objectives
for growth of money and credit, and an assessment of the relationship of the
growth objectives to economic goals set forth in the Economic Report of the
President.
This document contains presentations of monetary and financial measures
which are constructed to assist in reviewing the Federal Reserve's monetary
policy report to the Congress for February 1981.

Included are charts portray-

ing money and credit growth, in raLatton to Federal Reserve one-year targets,
the velocity of money and selected interest rates as well as tables showing
data for selected monetary and financial measures.







149
CRS-l

MONEY SUPPLY (M-1A)
Actual Levels and Growth Rates, 1977-1960 and
Federal Reserve Projected Growth Ranges for 1980 and 1981

MONEY SUPPLY (M-1B)
Actual Levels and Growth Rates. 1377-1930 and
Federal Reserve Projected Growth Ranges for 1980 and 1981

1980-




150
CRS-2

MONEY SUPPLY IM-2)
Actual Levels and Growth Rates, 1977-198D and
Federal Reserve Projected Growth Ranges (or 19BO and 1981

MONEY SUPPLY IM-3)
Actual Levels and Gtovrth Rates, 1977-1990 and
Federal Reserve Projected Growth Ranges for 193d and 1381




151
CRS-3

BANK CREDIT
Actual Levels and Growth Rates, 1977-1980 and
Federal Reserve Projected Growth Ranges for 1980 and 1981

1977

-1978-

-1973

1380-

-1981-




GROWTH RATES FOR SELECTED MONETARY AND CREDIT AGGREGATES, 1975-1980
AND FEDERAL RESERVE ONE-YEAR TARGETS, 1980-1961
(Seasonally adjusted compound annual growth rates, percent)
I/

Monetary aggregat ea
M-2

t i m e period

H-1A

M-1B

1975
1936

1977

4 .7
5 .5
7 .7

4. 9
6. 0
8. 1

1978
1979
1980

7 .4
5 .0
5 -0 2/

8. 2
7.7
7 - 4 Z/

1980: first quarter
second quarter
third quarter
fourth quarter

4 .6
-k .3
12 .0
8 .4

11. 4
12. 6

4.1
7-5
11.1

8. 4
9. 0
9. 9

11. 3
9. 8
10. 0

13.5
12.3
7.9

6. 0
-2. 4
15. 4
11, 3

7. 6
5. 7
17- 0
9. 6

8. 3
6. 0
13. 6
12. 4

9.3
-0.5
7.2
15.7

4.0 to 6.5

6.0 to 9.0

6.5 to 9.5

6.0 to 9.0

targets 3/

1981:

t a r g e t s , subject to revision in February 1981
0.0 to 2.5

Bank
credit

12. 3
13. 7
11. 4

1960:

3.5 to 6.0

M-3

5-0 to 7 . 5

9. 4

Federal Reserve Report 47
5.5 to 8.5

6-5 to 9.5

6.0 to 9.0

\J

Annual data are for periods frora the fourth quarter of the previous year to the fourth quarter
of the year indicated. Quarterly data, entered for 1980j are for periods from the previous
quarter and are stated at annual rates.

21

The Federal Reserve stated on 1/7/61 that deposit shifts resulting from passage of the Monetary
Control Act m o d i f i e d growth of M-1A and M-1B for 1980 in r e l a t i o n to growth i n i t i a l l y a n t i c i p a t e d ,
decreasing M-1A growth by 3/4 to 1 percentage points and increasing M-1U growth by 1/2 to 3/4
of a percentage p o i n t .

3_l

Announced by the Federal Reserve in its Monetary Report to the Congress, February 19, 1980.

k ) Targets for 1981 appearing above, announced by the Federal Reserve in July 1980. These targets
take into account s h i f t s of deposits arising from passage of the. Monetary Control A c t .
Sources:

Calculated from d a t a series of the Board of Governors of the Federal Reserve System,
accessed J a n u a r y 1981 from data files of Data Resources, Inc.

to




GROWTH RATES FOR SELECTED RESERVE AGGREGATES AND THE MONETARY BASE, 1975-1980
(seasonally adjusted compound annual growth rates, adjusted for
changes in reserve r e q u i r e m e n t s , percent)

11

total
reserves

required
reserves

1975
1976
1977

0 .5
1.2
4 .7

0 .3
1 .2
4..8

4.3
1.4
2.1

5 .4
7 .1
a .3

1978
1979
i960

6 .2
2 ,7
7 .0

6 .3
2 .4
6..8

6.3
0.4
7.7

9 .1
7 .8
a .7

4 .0
0 .4
6 .9
17 .5

5,.2
0 .6
5 .9
16,.0

2.9
7.6
13.0
7.4

7 .7
5 .4
10 .2
11 .6

time period

1980:first quarter
second quarter
third q u a r t e r

fourth quarter
_!/

nonborrowed
reserves

monetary
base

Annual data are for periods from the fourth quarter of the previous year to the fourth quarter
of the year indicated. Quarterly d a t a , shown for 1980, are for periods from the previous
quarter sad are stated at annual rates.

Sources:

Calculated from data series of the Board of Governors of the Federal Reserve Syatem,
accessed January 1961 Crotu data files of Data Resources, Inc.




154
CRS-6

INCOME VELOCITY OF MONEY (M-1A)
7. CHANGE: FROM SAME QUARTER, PREVIOUS YEAR
ANNUAL RATE OF CHANCE

1976

1977
1978
1979
1980
CALCULATED FROM SEASONALLY ADJUSTED DATA
DATA SOURCES: FEDERAL RESERVE BOARD; DEPARTMENT OF COMMERCE

INCOME VELOCITY OF MONEY (M-1B)
% CHANGE FROM SAME QUARTER, PREVIOUS YEAR
ANNUAL RATE OF CHANGE

1976

1977
!97fl
1979
1980
CALCULATED FROM SEASONALLY ADJUSTED DATA
DATA SOURCES; FEDERAL RESERVE BOARD; DEPARTMENT OF COMMERCE

155
CRS-7

SELECTED INTEREST RATES
October 1977 through January 1981
Percent
22.0

20.0

Federal Funds Rats

mo
16.0
14.0

Rate for
Conventional First Mortgages
on New Homes

12.0
10.0

Federal Reserve
Discount Rate

8.0
6.0

4.0 iO N D J F H A H J




77-/N
1

j—'_' '-.'

I A S O N D I F M A M I J A S O N D / F M A M / J 4 $ O N D . T J

1978

A

1979

A

!980

A

:

M A M J

I A S O N D

1981

Th* Fidvnl Rt4i» impo»d th« following d(«ount nt* lurclivQX 4|Wllabl* 10 borrowjngi Inr moft tan on* WHfc in • rovr or
man Dun *iM*luiic>l>nilHi|UH»rbvi«i<utniiIHi(lld<pD«liDl 1600 million « man: Much 1*. 1980 *rao(h Miy *. 1MO3 (WDWUgl pointi; NoonibK 17. 19BO through DtanbH 7.1S80-1 pveHiugt poina; ml Dumbv t, IBWtmf In ttttamat

/•




SELECTED INTEREST HATES, 1975-1980
(average, percent pec annum)

Year or
Month

Treasury
bills,
3 month,
new
issues

Treasury
bonds ,
over
10 years,
composite

Corporate Aaa
bonds ,
Moody ' a

Prime
commercial
paper,
3
months

Prime rate
charged by
banks

New home
mortgage
yields
FHA/HUD
series

Federal
Reserve
Discount
rate I/

Federal
funds
rate

1975
1976
1977

5 .84
4 ..99
5 ,.26

j .00
6 ,79
7 .06

8 .83
8..43
8..02

6 ,.25

7 .86
6 ,.84
6 ..82

9 .10
9 .00
9 .00

6 ,.25
5,.50
5..46

5..82

5,.24
5,,55

1978
1979
1980

7 ,.22
10 .04
11 .61

7 .89
8 .74
10 .81

8 .73
9 ,,63
11,.94

7..94
10,.97
12..66

9..06
12 .67
15..27

9 .70
11 .14
13 .95

7..46
10,,28
11,. 7 7

7 .94
11 .20
13,,36

1980;
Oct.
Nov.
Dec.

11..58
13,.89
15,.66

11 .20
11 .83
11 .69

12 .31
12 .97
13 .21

12..52
15,.18
18.,07

13,.79
16..06
20..35

14 .10
14..70
15 .05

11..00
11 .47
12..87

12..81
15 .85
18..90

1981;
Jan.

14..72

I t .65

12..81

16,.58

20 .16

13..00

19,,08

»<it

5 ,.05
5..54

I/ The Federal Reserve imposed the following discount rate surcharges applicable to borrowing
for more than one week in a row or more than. 4 weeks in a calendar q u a r t e r by i n s t i t u t i o n s w i t h d e p o s i t s
of $500 m i l l i o n or more: March 14, 1980 through May 6, 1980 — 3 percentage points; November 17, 1980
thcough December 7, 1980 — 2 percentage p o i n t s ; and December 8, 1980 and in e f f e c t as of January 30,
1981 — 3 percentage points.
Sources:

Board of Governors of the Federal Reserve System, D e p a r t m e n t of Housing and Urban D e v e l o p m e n t , and
M o o d y ' s Investors Service.




FUNDS RAISED IN U.S. CREDIT MARKETS
[In billions of dollars; quarterly data are seasonally adjusted at annual races)

1975

Total funds r a i s e d ,
by i n s t r u m e n t :
Investment company shares

1976

1977

1978

1979

223.5

296 ,0

392 .5

481.7

482.3

-.1

-1 .0

- .9

-1.0

-2.1

1979
(IV)

(I)

1980
(II)

(HI)

448 .3

502.4

266.0

446. 4

-5 .1

-2.5

13.8

-4, 2

10.8

12 .9

4 .9

4.7

7-6

10 .6

13.7

9.1

11 . 2

212.8

284 .1

388 .5

478.0

476.8

442 .8

491.2

243.2

439. 5

U . S . Government securities

98.2

88 .1

84 .3

95.2

89.9

116 .5

117.0

100.5

134. 0

State and local obligations

16.1

15 .7

23..7

28.3

18.9

22,.2

20. 8

14.8

23.

Corporate and foreign bonds

36.4

37 .2

36 .1

31.6

32.9

26 .9

28.5

63.4

38. 3

Mortgages

57.2

87 .1

134 .0

149.0

158.6

152 .3

149.2

71.2

126. 5

9.7

25 .6

40 .6

50.6

42.2

31 .1

25.9

-44.2

6. 1

Other corporate e q u i t i e s
Debt instruments ;

Consumer c r e d i t
Bank loans, n . e . c .
Open market paper
Other loans

Source;

« ii

-12.2

7 .0

29 .8

58.4

52.5

24 .8

52.5

-10.7

74. 3

-1.2

8,.1

15,.0

26.4

40.5

28,.6

50.8

33.0

7. 3

15,.3

25..2

38.6

39.5

40 .3

46.6

15.1

29. 6

8.7

Board of Governors of the Federal Reserve System.

1980(111) based on incomplete data.




FEDERAL RESERVE'S FIRST MONETARY
POLICY REPORT FOR 1981
WEDNESDAY, MARCH 4, 1981

U.S. SENATE,
COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS,
Washington, D.C.
The committee met at 9:30 a.m., in room 5302, Dirksen
Senate Office Building, Senator Jake Garn (chairman of the committee) presiding,
Present: Senators Garn, Heinz, Schmitt, and Proxmire.
OPENING STATEMENT OF CHAIRMAN GARN

The CHAIRMAN. The committee will come to order.
One week ago, the committee discussed the Federal Reserve
Monetary Policy Report with Chairman Volcker. The Fed has indicated its resolve to maintain slow, but steady, growth of the money
supply. Chairman Volcker announced reduced targets for growth of
the monetary aggregates during 1981.
While I generally support the Fed's initiatives, I share the concerns of other committee members that the Fed's specific monetary
goals and techniques be effective. Although I may differ with the
Fed on certain matters, I wholeheartedly agree with Chairman
Volcker's often repeated statement, that the budget and the deficit
must be reduced before long-term economic progress can be made.
On this second day of hearings, the committee will explore the
relationship between the Fed's monetary policy objectives and the
administration's economic plan with testimony from Dr. Murray
Weidenbaum, the Chairman of the Council of Economic Advisers.
The hearing will conclude with testimony from two distinguished
economists, Dr. Jerry Jordan of the University of New Mexico, and
Dr. David Jones of Aubrey Lanston Co. in New York.
Before I turn to you, Dr. Weidenbaum, I would like to ask
Senator Proxmire, if he has any opening remarks, he would like to
make.
Senator PROXMIRE. No, thank you, Mr. Chairman.
The CHAIRMAN. Dr. Weidenbaum, we would be happy to have
you proceed with your testimony.
STATEMENT OF MURRAY L. WEIDENBAUM, CHAIRMAN, THE
PRESIDENT'S COUNCIL OF ECONOMIC ADVISERS

Dr. WEIDENBAUM. Thank you, Mr. Chairman, Senator Proxmire.
It's a real pleasure to be back before the Banking Committee. I
particularly welcome this opportunity to discuss some important
economic aspects of current policy developments.




(159)

160

This surely is a time that merits careful analysis of impending
policy changes, and that covers a wide range of monetary, fiscal,
and regulatory decisions.
As you are well aware by now, the President's program involves
a four-pronged approach to our Nation's economic problems. Each
of these four elements should be considered a necessary complement to the other three. Each is worthy of extended discussion and
analysis by itself.
The CHAIRMAN. Excuse me, Doctor. We can hear you fine, but if
you would pull the mike closer to you for those in the back.
Dr. WEIDENBAUM. Thank you, Senator, this morning I would like
to share with you a few thoughts on particular aspects of the four
elements which have not, in my opinion, received the attention
they deserve.
PROSPECTIVE IMPACT OF THE PROGRAM

However, before I turn to each element individually, let me
briefly summarize the overall prospective impact of the program.
Over the near-term, at least through midyear, we expect real
growth will continue to be very sluggish and that inflation will
continue at or near double-digit rates. Thus, the year-to-year real
growth in 1981 is estimated at a modest 1.1 percent and the inflation rate, as measured by the Consumer Price Index, at 11.1 percent.
Assuming prompt implementation of the administration's program, we then anticipate more rapid growth—over 4 percent in
1982 through 1986—and steady reduction in the rate of inflation.
While the unemployment rate is anticipated gradually to decline
on a yearly average basis during this period, progress will be
steady but undramatic, and month-to-month fluctuations in this
volatile series should be anticipated.
Let me begin with monetary policy, a topic for which this committee has oversight responsibility. Some historical perspective
may be useful. In 1951, the administration of President Harry
Truman reached an understanding with the Federal Reserve Board
which was popularly known as the "Accord." The Accord relieved
the Fed of its prior commitment to hold interest rates down, in
order to help the Treasury finance the budget deficit at relatively
low costs.
The 1951 Accord and the congressional hearings dealing with it
at that time stressed that the coordinated use of fiscal and monetary policy is necessary for effective Government action against
economic instability. Direct controls over wages and prices were
eschewed and the Federal Reserve was given more flexibility to
control the growth of money and credit. Also stressed was the need
for consultation between the administration and the independent
Federal Reserve System. These steps marked the beginning of a
successful postwar stabilization effort that eventually brought price
stability to the United States and world economies.
I don't want to draw historical parallels too tightly, but I think
there is considerable similarity between President Reagan's first
major address to the Congress on economic policy. That address
emphasized the need for coordinated fiscal and monetary policy.




161

He stressed—as Congress recommended 30 years ago—the close
consultation between the independent Federal Reserve and the
administration on all aspects of our economic program. We have
certainly done that, and we are delighted to see the strong support
from Chairman Volcker.
In an attempt to be as informative as possible about the linkages
between monetary policy and the rest of the program, we have
included in the white paper describing the President's program, an
explicit statement of the rate of monetary growth which would be
consistent with the administration's targets:
The policies that are proposed in the program will help to advance the efforts of
the independent Federal Reserve System. In particular, the substantial reductions
of the Federal Government's deficit financing and the achievement of a balanced
budget in 1984 and the years that follow should enable the Federal Reserve System
to reduce dramatically the growth in the money supply.
To that end, the economic scenario assumes that the growth rates of money and
credit are steadily reduced from the 1980 levels to one-half those levels by 1986.

The white paper goes on to point out that, with the Federal
Reserve gradually but persistently reducing the growth of money
and credit, inflation should decline at least as rapidly as anticipated. Since interest rate movements are largely a mirror of price
expectations, reduction in one will produce reduction in the other.
Although the entire white paper is a statement of the administration's economic program, it should be noted that the section on
monetary policy benefited from close consultation with Federal
Reserve officials. Subsequent events will enable us to judge the
significance and usefulness of this development, especially in terms
of the actual ability of the Federal Reserve System to achieve a
steady and substantial reduction in the growth of the money
supply.
I note that the Chairman of the Federal Reserve Board has
announced a one-half percentage point reduction in the target
ranges for M-1A and M-1B for 1981. Last year, the Federal Reserve operated at the high end of the target ranges, or slightly
above. If the growth of the monetary aggregates were to end the
current year at or around the midpoint of the target ranges, that
would represent a reduction in monetary growth consistent with
the administration's program. Monetary growth rates fluctuated
sharply during the past year—due in part, no doubt, to independent factors which were difficult to control.
Nevertheless, there are improvements in the implementation of
monetary policy that can be made, such as those suggested in
recently completed studies by the Federal Reserve staff. And we
assume the system will continue to seek other ways to improve
control procedures.
Further, I want to emphasize the need at this time to keep close
to the long-run growth targets during the year—and to try to avoid
the kinds of month-to-month fluctuations we saw last year—even if
that means increased interest rate volatility. I would suspect that
stability in monetary growth would reduce interest rate volatility.
The objectives of increased confidence and heightened expectations
for the future could be served if both fiscal and monetary policies
were to be perceived by savers and investors, and financial markets
in general, as being significantly more stable and predictable than
in the past.




162
REGULATORY POLICY

I would like to turn to an important related subject, regulatory
policy. In the various areas of economic policymaking, it is important to learn from the policy experiences of the past. For example,
while we concentrate on reforming and improving the existing
regulatory apparatus of the Federal Government, we should be
alert to the possible imposition of new Government burdens on the
economic process.
In this connection, we should be mindful of the pressures for
restricting the flow of trade and investment, both between regions
of this Nation and among the nations of the globe. Acquiescence to
such pressures would represent a backward step at a time when
economic policy is being geared to reducing the degree of Government intervention in the marketplace.
Although we all are aware of the conditions that give rise to
these portectionist or interventionist sentiments, surely the worst
answer is for governments to erect barriers to commerce. Such a
response would not serve the interest of consumers nor would it
help to expand productive employment. For too long, we have
acquiesced in Government policies—like trade restrictions—that
individually add "only" two-, or three-, or five-tenths of 1 percent
to the Consumer Price Index. We have to stop feeding the fires of
inflation with a steady stream of concessions to special-interest
groups who are oblivious to the harm done to the American consumer.
Rather, we need to create the type of healthy economic environment in which regions and industries can enhance their competitive positions in a positive way. That, of course, is the major thrust
of the Reagan administration's economic program—to provide
greater incentive to the private sector to increase saving, investment, production, and employment. The effort underway to reduce
the burdens of existing regulation and to carefully screen new
regulation, surely is a concrete example of positive incentives.
In terms of tax policy, very briefly, our tax program is another
key part of the economic policy package. The desire to reduce the
scope of governmental intervention by business decisionmaking can
be seen in the tax proposals that President Reagan has urged the
Congress to enact. Note the clear underlying direction of the administration's tax program—to reduce the role of the tax collector
in business decisionmaking. This basic approach can be seen in the
recommendation for a far simpler system of depreciation
allowances than the status quo, as well as in the proposed acrossthe-board reduction in personal income tax rates.
If there is any consistent, overriding theme that is common to all
of these proposals for dealing with the Nation's serious economic
problems, it is the compelling need to reduce the intrusion and
power of Government in the private sector of the economy. That
reduction of the size of Government must involve all of the many
dimensions of Government intervention—expenditures, taxes,
credit, and regulation. That, in turn, will enable this Nation once
again to rely on the private enterprise system as the primary
engine of economic growth and progress.
Thank you very much.




163

The CHAIRMAN. Thank you, Dr. Weidenbaum. And I assume from
your statement you do have some additions, and we will include
your entire statement, as well as the additions in the record.
[Complete statement follows:]




"ADVANCING ECONOMIC ANALYSIS AND ECONOMIC POLICY"
Statement
of
The Honorable Murray L. Weidenbaum, Chairman
The President's Council of Economic Advisers
I welcome this opportunity to discuss some important
economic aspects of current policy developments.

This surely

is a time that merits careful analysis of impending policy
changes, which cover a wide range of monetary, fiscal, and
regulatory decisions.
As you are well aware by now, the President's program
involves a four-pronged approach to our nation's economic
problems.

Each of these four elements should be considered

a necessary complement to the other three.

And each is

worthy of extended decision and analysis by itself.
This morning I would like to share with you a few
thoughts on particular aspects of the four elements which
have not, in my opinion, received the attention they deserve.
However, before I turn to each element individually, let me
briefly summarize the overall prospective impact of the program.
Over the near-term, at least through mid-year, we expect real
growth will continue to be very sluggish and that inflation
will continue at or near double-digit rates.

Thus, the year-to-

year real growth in 1981 is estimated at a modest 1.1 percent and
the inflation rate (as measured by the CPU at 11.1 percent.
Assuming prompt implementation of the Administration's
program, we then anticipate more rapid growth - over 4% in 1982
through 1986 - and steady reduction in the rate of inflation.
While the unemployment rate is anticiapted gradually to decline
on a yearly average basis during this period, progress will be
steady but undramatic, and month-to-month fluctuations in this
volatile series should be anticipated.

164
Monetary Policy
Let me begin with monetary policy, a topic for which this
Committee has oversight responsibility.

In 1951, the Administration

of President Harry Truman reached an understanding with the
Federal Reserve Board which was popularly known as the "Accord".
The Accord relieved the Fed of its prior commitment to hold
interest rates down in order to help the Treasury finance the
budget deficit at relatively low costs.
The 1951 Accord and the Congressional hearings dealing with
it at that time stressed that the coordinated use of fiscal and
monetary policy is necessary for effective government action
against economic instability.

Direct controls over wages

and prices were eschewed and the Federal Reserve was given more
flexibility to control the growth of money and credit.

Also

stressed was the need for consultation between the Administration
and the independent Federal Reserve System. These steps marked the
beginning of a successful postwar stabilization effort that
eventually brought price stability to the U. S. and world economies.
Similarly, President Reagan's first major address to the
Congress on economic policy emphasized the need for coordinated
fiscal and monetary policy.
recommended 30 years ago —

He stressed —

as Congress

the close consultation bet-ween

the independent Federal Reserve and the Administration on all
aspects of our economic program.







165
In an attempt to be as informative as possible about the
linkages between monetary policy and the rest of the program,
we have included in the White Paper describing the President's
program an explicit statement of the rate of monetary growth which
would be consistent with the Administration's targets:
"The policies that are proposed in the program
will help to advance the efforts of the independent
Federal Reserve System. In particular, the substantial
reductions of the Federal Government's deficit financing
and the achievement of a balanced budget in 1984 and the
years that follow should enable the Federal Reserve System
to reduce dramatically the growth in the money supply.
To that end, the economic scenario assumes that the
growth rates of money and credit are steadily reduced
from the 1980 levels to one-half those levels by 1986."
The White Paper goes on to point out that, with the Federal
Reserve gradually but persistently reducing the growth of money
and credit, inflation should decline at least as rapidly as
anticipated (see attached excerpt).

Since interest rate

movements are largely a mirror of price expectations, reduction
in one will produce reduction in the other.
Although the entire White Paper is a statement of the
Administration's economic program, it should be noted that
the section on monetary policy benefitted from close consultation with Federal Reserve officials.

Subsequent events will

enable us to judge the significance and usefulness of this
development, especially in terms of the actual ability
of the Federal Reserve System to achieve a steady and substantial
reduction in the growth of the money supply.

166
I note that the Chairman of the Federal Reserve Board
has announced a 1/2 percentage point reduction in the target
ranges for MIA and M1B for 1981.

Last year, the Federal

Reserve operated at the high end of the target ranges, or
slightly above.

If the growth of the monetary aggregates

were to end the current year at or around the mid-point of
the target ranges, that would represent a reduction in monetary
growth consistent with the Administration's program.

Monetary

growth rates fluctuated sharply during the past year —

due in

part, no doubt, to independent factors which were difficult to
control.

Nevertheless, there are improvements in the implementation

of monetary policy that can be made, such as those suggested
in recently completed studies by the Federal Reserve staff.
And we assume the System will continue to seeK other ways to improve
control procedures. Further, I want to emphasize the need at this
time to keep close to the long-run growth targets during the year
—

and to try to avoid the kinds of month-to-month fluctuations

we saw last year -- even if that means increased interest rate
volatility.

The objectives of increased confidence and heightened

expectations for the future could be served if both fiscal and
monetary policies were to be perceived by savers and investors,
and financial markets in general, as being significantly more stable
and predictable than in the past.







167
Regulatg ry_ Policy
In the various areas of economic policymaking, it is
important to learn from the policy experiences of the past.
For example, while we concentrate on reforming and improving
the existing regulatory apparatus of the Federal Government,
we should be alert to the possible imposition of new government
burdens on the economic process.

In this connection, we should

be mindful of the pressures for restricting the flow of trade
and investment, both between regions of this Nation and among
the nations of the globe.

Acquiescence to such pressures would

represent a backward step at a time when economic policy is
being geared to reducing the degree of government intervention
in the market place.
Although we all are aware of the conditions that give rise
to these protectionist or interventionist sentiments, surely
the worst answer is for governments to erect barriers
to commerce.

Such a response would not serve the interest of

consumers nor would it help to expand productive employment.
For too long we have acquiesed in government policies —
trade restrictions —

like

that individually add "only" two, or three,

or five-tenths of one percent to the consumer price index.
We have to stop feeding the fires of inflation with a steady
stream of concessions to special-interest groups who are
oblivious to the harm done to the American consumer.

168
Rather, we need to create the type of healthy economic
environment in which regions and industries can enhance their
competitive positions in a positive way.

That, of course, is

the major thrust of the Reagan Administration's economic
program —

to provide greater incentive to the private sector

to increase saving, investment, production, and employment.
The effort underway to reduce the burdens of existing regulation
and to carefully screen new regulation surely is a concrete example
of positive incentives.
Tax Policy
Dur tax program is another key part of the economic
policy package. The desire to reduce the scope of governmental
intervention by business decisionmaking can be seen in the
tax proposals that President Reagan has urged the Congress
to enact.

Note the clear underlying direction of the Administra-

tion's tax program —

to reduce the role of the tax collector

in business decisionmaking.

This basic approach can be seen

in the recommendation for a far simpler system of depreciation
allowances than the status quo, as well as in the proposed
across-the-board reduction in personal income tax rates.
Budget Restraints
Monetary, tax, and regulatory reforms are vital parts of
our economic program.

The leading edge, of course, is the

program of budget restraint.

It is important to understand

that the effort to control the growth of government spending
cannot be a one-shot affair.




We must expect pressures for




169
greater government spending to arise continually.

Thus the

advocates of economy in government must constantly be on their
guard.

What is so heartening in this Administration is the

President's consistent response to those pressures for more
spending —

to redouble our efforts to achieve our targets

for limiting Federal spending and reducing the budget deficit.
Let me try to strike a note of realism on the basis of
many years' involvement in budget matters. The estimates of
future expenditures are always subject to periodic revision.
Many factors affect the rate at which appropriated funds are
expended: administrative procedures, availability of resources
in the private sector, price changes, demands by those
"entitled" to certain government benefits, etc.

Interestingly,

not all changes in expenditure estimates are necessarily in
one direction.

Over the years we have seen downward revisions

as well as upward changes.
Overriding Theme
If there is any consistent, overriding theme that is
common to all of these proposals for dealing with the Nation's
serious economic problems it is the compelling need to reduce
the intrusion and power of government in the private sector
of the economy.

That reduction of the size of government must

involve all of the many dimensions of government intervention
—

expenditures, taxes, credit, and regulation.

That, in turn,

will enable this Nation once again to rely on the private
enterprise system as the primary engine of economic growth
and progress.

170
Attachment —

excerpt from The White House, America'j; Hew Beginning;

A Program for Economic Recovery, Washington, D. C. U. S. Government
Printing Office, February 18, 1981.

VL Controlling Money and Credit
Monetary policy is the responsibility of the Federal Reserve System, an independent agency
wUhin. fce structure of the government. The Administration win do nothing to undermine chat
independence. At the same time, the success in reducing inflation, increasing real income, and
reducing unemployment will depend on effective interaction of monetary policy with other aspects of
economic policy.
To achieve the goals of the Administration's economic program, consistent "monetary policy
must be applied. Thus, « is expected thai the rate of money and credit growth will be brought down
to levels consistent with noninflaoonary expansion of die economy.
If monetary policy is too expansive, then inflation during the years ahead win continue to
accelerate and de Administration's economic program will be undermined. Inflationary psychology
will intensify. Wages, prices, and interest rates win reflect the belief that inflation — and Che
destructive effects of inflation — wfll continue.
By contrast, if monetary policy is unduly restrictive, a different set of problems arises,
unnecessarily aggravating recession and unemployment. At times in the pasi, abruptly restrictive
policies have prompted excessive reactions toward short-term monetary ease. As a result, frequent
policy changes can send confusing signals, and the additional uncertainty undermines long-arm
investment decisions and economic growth.
Wiflj money and credit growth undergoing steady, gradual reduction over a period of years, it
will be possible to reduce inflation substantially and permanently. In this regard, the Administration
supports the announced objective of the Federal Reserve to continue to seek gradual reduction in the
growth of money and credit aggregates during the years ahead. Looking back, it seems clear taw if a
policy of this kind had been successfully followed in the past, inflation today would be substantially
lower and would not appear to be so intractable.
Until recently, the Federal Reserve had attempted to control money growth by setting tars«s
for interest rates, particularly the rate on Federal funds. Experience here and abroad has shown
repeatedly that this interest rate management approach is not sufficient to achieve reliable control
Mistakes in predicting movements in economic actix-iry or tendencies on die pan of policymakers to
avoid large interest rale fluctuations can lead to undesirable gyrations ia &e rate of mosey growth.
Under new procedures me Federal Reserve adopted in October 1979, the Federal Reserve sets
targets for growth of reserves considered to be consistent with the desired expansion in the monetary
aggregates. Interest rates are allowed to vary over a. much wider range in response ID changes in ttoe
demand for money and credit. A number of factors — such as the introduction of credit controls and
their subsequent removal and frequent shifts in announced fiscal policies — have contributed to
pronounced fluctuations in interest rates and monetary growth over the past year. At the same time,
we need to leam tram the experience with the new techniques and seek further improvements. The
Federal Reserve has undertaken a study of last year's experience. We look forward to the results and
encourage diem 10 make tat changes that appear warranted.




171
In thai connection, success in meeting the targets ihat the Federal Reserve has set win itself
increase confidence in the results of policy. O&erwise, observers are likely to pay excessive attention
to ihon-run changes in money, growth and revise anticipations upward or downward unnecessarily.
Without confidence in the long-term direction of policy, such short-run changes may lead to
unwarranted but disturbing gyrations ia credit, interest races, commodity prices, and oiher sensitive
indicators of inflation and economic growth.
Better monetary control is not consistent with the management of interest rates in die short run,
But, with monetary policy focusing on long-term objectives, the resultant restraint on money and
credit growth would interact with the tax and expenditure proposals to lower inflation as wen as
interest rates.
The Administration will confer regularly with die Federal Reserve Board on aH aspects of our
economic program. The policies that are proposed in the program wiB help to advance the efforts of
the independent Federal Reserve System. In particular, the substantial reductions of the Federal
Governments deficit financing and the achievement of a balanced budget in 1984 and the yean that
follow should enable the Federal Reserve System to reduce dramatically the growth in the money
supply.
To that end, the economic scenario assumes that the growth rates of money and credit are
steadily reduced from the 1980 levels to one-naif those levels by 1986.
With the Federal Reserve gradually but persistently reducing the growth of money, inflation
should decline at least as fast as anticipated. Moreover, if monetary growth rates are restrained, tben
inflationary expectations win decline. And since interest rate movements are largely a mirror of price
expectations, reduction in one will produce reduction in the other.

The CHAIRMAN. As you have described it, the administration's
economic program consists of four integrated parts— a reduction in
the growth of Federal expenditures, a reduction in Federal tax
rates, relief from Federal regulatory burdens, and a monetary
policy on the part of the Federal Reserve System which is consistent with those policies.
TYPES OF COORDINATION

Can you describe for the committee, what type of coordination
has been accomplished between the administration and the Fed to
insure that we do have consistent fiscal and monetary polices, yet
preserving the independence of the Fed?
Dr. WEIDENBAUM. Yes. Mr. Chairman, first of all, at the procedural or institutional level, the President in his very first week in
office held a lunch meeting with the Chairman of the Federal
Reserve Board and the troika, the three key economic policy advisers, the Secretary of the Treasury, the Director of the Budget, and
Chairman of the CEA. It was, as I described it subsequently, a "getto-know-you" session.
What I think was very significant was the President opened that
lunch meeting, restating his commitment to the independence of
the Federal Reserve. We then went on to point out the two-way
street, and we have done this subsequently in a variety of public
forums, as well as private meetings, that there is a two-way street.
There is an important responsibility on the part of the executive
branch and the legislative branch, for that matter, to conduct the
kind of fiscal policy which enables the Federal Reserve to maintain
a monetary policy to fight inflation. It is extremely difficult for




172

example, for the Federal Reserve to conduct a coherent, consistent
monetary policy, at a time when, as in the previous administration
the President urges the imposition of credit controls, and shortly
thereafter, eliminates the credit controls.
Those arbitrary actions make it extremely difficult to conduct
Federal Reserve policy. However, we think the fiscal policy that we
have designed—steady, predictable reduction in the growth of Government spending, steady, predictable reduction in the use of the
off-budget credit mechanisms, our plan to reduce and eliminate
deficit by fiscal year 1984, and to keep the budget in balance in the
years thereafter—is our fundamental contribution to this two-way
street.
Periodically, the Chairman of the Council of Economic Advisers
meets with the Chairman of the Federal Reserve Board. The members of the Council of Economic Advisers meet with the members
of the Federal Reserve Board. The Secretary of the Treasury and
his colleagues have similar relationships with the Chairman and
members of the Federal Reserve Board.
Communications are frequent. They are close. But, of course, we
are mindful of the different responsibilities that we have. So we
feel free to communicate our views and certainly we welcome the
advice that the Federal Reserve Board has given over the years on
fiscal policy. I think sometimes that has been very useful advice.
And we think the flow of advice also should be a two-way street.
So as I point out in my statement, we have some ideas on targets
for monetary growth which we have stated both in the white paper
and in my statement this morning.
The CHAIRMAN. Are the Federal Reserve's monetary aggregate
targets for 1981 consistent for the administration's program.
Dr. WEIDENBAUM. Yes, they are.
The CHAIRMAN. And even in light of the administration's assumption that the money growth rates in 1986 will be reduced to
one-half of what they are in 1980?
Dr. WEIDENBAUM. Yes, Mr. Chairman, I would expect that most
of that growth, that most of the reduction in the growth rate in the
money supply would occur between now and 1984. That is the year
of our target to balance the budget. I do think that monetary policy
and fiscal policy are now on the same path.
The CHAIRMAN. Well, the Fed didn't meet its targets for 1980,
even though they were rather broad ranges. Their ranges for M-1B
in 1981 are one-half percent below the actual M-1B growth rate for
1980. This apparently takes into account projected shifts caused by
NOW accounts. Does the administration's plan to reduce M-1B by
one-half by 1986 take into account NOW shifts?
Dr. WEIDENBAUM. The plan to reduce M-1B by one-half is, of
course, the Federal Reserve's plan, their determination.
In my statement I refer to operating closer to the middle of the
range rather than the high end of the range, as was the case last
year. And should that be the case, I think that there is adequate
allowance there for the institutional shifts, that is, the NOW accounts.
The CHAIRMAN. When Chairman Volcker testified last week, he
was generally supportive of the administration's program; however,
the Fed's economic projections for 1981 are not entirely consistent




173

with the administration's. For example, the
Fed predicts the unemployment rate will be between 8 and Sl/z percent, whereas, the
administration projects 7.7 percent rate. The Fed estimates that
real GNP will increase or decrease in the minus IVa to plus IVa
percent, while the administration projects a real GNP growth of 1.4
percent. In other words, the administration paints a rosier picture
than the Fed.
How do you respond to these differences in projections?
Dr. WEIDENBAUM. I must say, I find the two sets of numbers
quite close.
The CHAIRMAN. Close enough for Government work? [Laughter.]
Dr. WEIDENBAUM. I would say, were I still a private macroeconomic forecaster, which I have been for many years, that both of
these were within the forecasting range variable, frankly.
BUDGET CUTS ACCOMPANIED BY TAX CUTS

The CHAIRMAN. Chairman Volcker also indicated last week that
he wants to see budget cuts accompanied, but not preceded, by tax
cuts. Do you agree that they should proceed in tandem?
Dr. WEIDENBAUM. I think there is a compelling case for the two
to proceed in tandem. I should note that when a few years ago the
Senate Finance Committee asked me that question, I had a different relationship between the cart and the horse. I urged the Senate
Finance Committee to enact multiyear tax rate cuts first, so that
the long-term budget planning on the expenditure side could be
made in the context of a lower set of tax rates, and therefore,
thereby avoiding the kind of budget deficits that arise when the
process is reversed, when appropriations are made in the context of
a higher expected set of tax rates. Then the Congress cuts taxes,
and then we wind up with a larger budget deficit.
I think that at this point, wisdom is on the side of the two going
in tandem, but I certainly wouldn't delay the tax cuts. I think the
state of the economy makes prompt action highly advisable.
The CHAIRMAN. What if the tax cuts were passed and the budget
cuts were not, what would you advise the President to do? Go
ahead and accept the tax cuts, without the expenditure cuts to go
with them?
Dr. WEIDENBAUM. Well, the President, as you know, has the very
wise attitude of not making a decision on a bill until it reaches his
desk. I obviously think that is the proper position to take. I think
frankly, Mr. Chairman, the onus is on us to convince the Congress
of the strong desirability of accelerating action on both the tax and
expenditure sides of the budget, so that the two truly do go in
tandem.
The CHAIRMAN. Chairman Volcker did not appear fully supportive of the administration's tax cut proposals. He supports tax cuts
in general, but he kept stressing in his testimony that business
incentives were the critical ingredients for economic growth. Would
it be better to target more of the tax cuts toward the business side
rather than the personal tax cuts?
Dr. WEIDENBAUM. I very frankly strongly favor the distribution
between personal tax cuts and business tax cuts that we have
arrived at. The reason I say that is my major concern about the
flow of savings to finance badly needed expansion in business in-




174

vestment. I would like to see the saving pool in this country come
in much larger proportion from families and individuals, rather
than relying too heavily on business.
I think it is a question of balance, to be sure. We have certainly
the largest business tax cut, I believe, ever proposed, in the form of
our liberalized depreciation allowance proposal. But I think it is
vitally important to raise the now depressed—and 5 percent is a
depressed rate—of consumer savings. I think it is vitally important
to raise that, hopefully, to the traditional 7 percent, which has
been the historic norm. I think we have, in many regards, a far
healthier economy from our package than one that relied exclusively on the business sector to generate savings for the private
enterprise system.
The CHAIRMAN. Well, my time is up, but I would just like to have
one follow-on, with Senator Proxmire's permission. I would agree
with you that individual savings are highly important, and although I favor the President's tax package, I am not able to determine how much, or if there will be significant savings as a result of
the individual tax cuts. My question is why did we not consider
some specific individual tax cuts that would directly generate savings, such as an exemption on the first $1,000 on individual returns
and $2,000 on a joint return on savings accounts. And then in order
to get the tax cut and the tax benefit, people would save to do that.
Dr. WEIDENBAUM. Well, I can give you my response. And it really
gets down to my philosophy of government. As an economist, I very
much want to see a larger level of saving, but I don't really want
the Federal Government to tell people directly or indirectly that
they have to save more.
I would like to see the creation of an economic environment
which gets people voluntarily to save more, and I think the real
answer there is to reduce the inflation, and even more important,
inflationary expectations, which I think are at the heart of the
depression in the savings rate.
The CHAIRMAN. Well, I would agree with you, but in the short
run, it would seem to me some more specific incentives for savings
might be helpful.
My time is up, and I don't want to intrude more on Senator
Proxmire's time.
Senator PROXMIRE. I believe you and the Reagan administration
are calling for both more conservative fiscal and monetary policy. I
applaud that. I think you are absolutely right.
I think it will slow inflation if you persist in it. But you contend
this conservative policy will also stimulate the economy and will
provide for a big increase in growth, to go from 1 to 4 percent next
year and even higher levels of growth in succeeding years.
What is there in our historic experience to persuade us that if we
only jam on the monetary and fiscal brakes that the economy will
grow more rapidly? That contradicts the usual assumptions.
Dr. WEIDENBAUM. I would use somewhat different language in a
term describing the impact.
Senator PROXMIRE. All right. Ease down on the brakes then.
Dr. WEIDENBAUM. I would use the term incentives to describe the
impact of our program on the capacity of the economy. I think it is




175
vitally important to increase the supply side of the economy to
provide the necessary incentives to increase saving and investment.
Senator PROXMIRE. Well, I understand the theory. What I am
asking for is historic experience that would indicate that this kind
of policy will work either here or in any other country.
STOP AND GO POLICY

Dr. WEIDENBAUM. First of all, I think what is quite clear is the
traditional stop-and-go policy has not worked. If anything the risks
are in maintaining the status quo. And I urge you to compare our
tax proposals, for example, with early tax proposals which were
much more consumption oriented.
Senator PROXMIRE. Let me just interrupt again. I am not challenging that this is the right policy. I think this is a policy that is
necessary and in the long run will result in growth. I am just
concerned that you are giving us such an optimistic scenario that
there is going to be bitter disappointment next year when we don't
get 4 percent growth. We may not get it, and then the feeling will
be that the program is a failure.
I would hope that you would look at it on a long-term basis and
recognize that it may take 2 or 3 or 4 years before you can bring
prices down and get the economy on a sounder, more stable basis
and then get the growth.
You are talking about growth of 4 percent next year.
Dr. WEIDENBAUM. Yes, I am, and I think that is badly needed.
And very frankly, no disrespect to the distinguished Senator, but
what you describe sounds like these stop-and-go policies which have
been tried so frequently in the past, and that is, concentrate only
on one of those objectives. Either concentrate on fighting inflation
or concentrate on expanding growth rate and reducing unemployment.
I think if there is any lesson from the American economic history in recent decades it is the stop-and-go policy doesn't work and
we need a comprehensive sustainable policy that simultaneously
fights the interrelated twin evils of high inflation
Senator PROXMIRE. I will ask my question again. Can you give
me any historic experience which would show that this kind of
policy has worked in the past anywhere, here or in any other
country?
Dr. WEIDENBAUM. Well, first of all, there are periods both in the
United States and in Western Europe where we have seen substantial reduction,
I will be glad to provide historical detail for the record.
[The following information was received for the record:]
EXAMPLES OF LOWER INFLATION AND HIGHER GROWTH IN SELECTED COUNTRIES

Germany:
1975..
1976.




176

EXAMPLES OF LOWER INFLATION AND HIGHER GROWTH IN SELECTED COUNTRIES-Continued

Italy.
17.0
16.8

1975
1976

Canada:
1975
1976
Japan:

-3.6

5.9

10.8

1.1
5.8

7.5
6.1
4.5

1971
1972
1975
1976
1977
1978

5.1
9.3
1.4
6,5
5.4

11.8

9.3
8.1
3.8

5.9

United Kingdom:
15.8

1977
197B

United States:
1971

1.0
3.6

8.3

,

1972
1975
1976

4.3
3.3
9.1
5.8

'3.4
5.7

!

'-1.1
'5.4

Dr. WEIDENBAUM. We have had periods where we have seen
strong growth rates accompanying reductions in the inflation rate.
There surely is evidence of that.
Senator PROXMIRE. I hope you can supply that for me, because
again I think there seems to be a contradiction that you can have
both a growth rate accompanied by a fall in the rate of inflation,
particulary the kind of fall that you have predicted.
Dr. WEIDENBAUM. Very frankly, Senator, there used to be a
concept called the Phillips Curve, that there was a trade-off between inflation and unemployment, I think that idea has been
thoroughly discredited, because we have seen the obverse of that.
We have seen rising inflation and rising unemployment.
Senator PROXMIRE. We have seen that, but we haven't seen the
reverse.
Dr. WEIDENBAUM. This is precisely why I am here to urge the
Congress to adopt a true innovation in economic policy, a break
with the past.
Senator PROXMIRE. Now this morning's New York Times has an
interesting article which you may or may not have read, talking
about the Reagan administration having a split economic team, a
sharp division. It is an article by Steve Ratner. He is an outstanding reporter.
Dr. WEIDENBAUM. I share that view.
PRAGMATISTS VERSUS THEORISTS

Senator PROXMIRE. He reports that there is a rather disturbing
division here, that you and Mr. Stockman are lined up on one side
as the pragmatists versus the so-called supply side theorists in the




177

Treasury Department and elsewhere. And he gives a couple of
examples of how you have had clashes and you prevailed, but
indicating that there is this division, No. 1, on forecasts; that you
and Stockman were persuasive in denying the so-called supply
siders, Norm Ture and some of the others, their desire to come
forward with a much more optimistic forecast. In the second place,
that they had a much more vigorous attack on the Fed, the Federal
Reserve Board and its policies, and you softened that. And my
question is, What substance is there in this kind of speculation?
Dr. WEIDENBAUM. Very frankly, it has not been my policy to
comment on such speculation, but let me describe the situation as
clearly as I can.
First of all, a good deal of staff work inevitably is done prior to
the development of the final forecasts that are used and in the
final language that appears in such official documents as the white
paper. And surely some of those staff interpretations were more
optimistic or some less optimistic than the ones finally determined.
That is par for the course.
I can say this, that the economic projections used in the President's February 18 message to the Congress represent the position
of the administration. I believe they are a reasonable, doable, realistic scenario of the economy.
They are based on a major supply side oriented tax cut. In fact,
as you recall my answer to one of your own questions, I couched
my response in what I truly believed to be the proper relevant
supply side orientation, which is the essence of the tax program.
Senator PROXMIRE. Well, let me just say I am not trying to get
into this because of the gossip about personalities. What I am
concerned about is particularly the latter part. But I understand
there were three positions with respect to what the administration
might do as far as monetary policy is concerned.
One was quite a stringent position taken by people in the Treasury Department that the administration's position should be quite
critical of the Fed. And second is that that should be toned down,
that you should have what you finally ended up with, a chapter on
the Federal Reserve Board and the policies that should be followed.
And a third policy that Chairman Volcker urged, that you not have
a chapter on the Fed policy, and that he urged you to take it out,
but that he failed and you put it in anyway.
Dr. WEIDENBAUM. Let me assure you that the Secretary of the
Treasury, the Director of the Office of the Management and
Budget, and the Chairman of the Council of Economic Advisers
have a very strong concurrence on that white paper, on the material in that; that the various staffs available to us provide us advice,
guidance, and suggestions.
We have a responsibility. We feel free, of course, to accept and
project or to modify or ignore the various staff inputs available to
us. But the President has given us the responsibility to be his
principal economic advisers and we do not shy from that responsibility. And I will take personal responsibility for the preparation of
that white paper.
Senator PROXMIRE. Yes. But my question related also to the
position taken by the Chairman of the Federal Reserve Board, Mr.




178

Volcker. He was reported to have requested that you not have that
chapter in your paper.
Dr. WEIDENBAUM. I obviously was anxious to get the informal
views of the Chairman of the Federal Reserve Board, and obviously
we gave them very considerable weight. But this is not a joint
statement. The white paper is the statement of the Reagan administration's economic program, and I urge you to take it on that
basis.
Senator PROXMIRE. Well, I understand. At any rate you did not
accept the request of the Chairman of the Federal Reserve Board.
You included
Dr. WEIDENBAUM. There was no official request, you appreciate.
Senator PROXMIRE. No official request, but there was a desire
expressed by the Chairman according to this reliable report.
Dr. WEIDENBAUM. Well, as I say, I would not comment on this
informal discussion, because very frankly if I did that might reduce
the promptness, the usefulness of such discussions in the future.
And I am delighted that we have a continuous interchange of ideas
and comments. I think the acid test of our relationship is the
strong support that the Federal Reserve Chairman has given to the
Reagan administration's economic program, which I find very
heartening.
Senator PROXMIRE. Now, as you may know, last summer Dr.
Burns announced the formation of a committee to fight inflation,
consisting of seven eminent Democrats and six eminent Republicans, including Dr. Burns, former Treasury Secretary Blumenthal,
Frederick Demming, Douglas Dillon, Paul McCracken, George
Mahon, William McChesney Martin, Wilbur Mills, George Schultz,
William Simon, and John Williams.
COMMITTEE RECOMMENDATIONS

They proposed a series of steps to fight inflation, some of the
which the administration is following in your policies but three
others which you are not, and one is a balanced budget, which they
gave very high, the top priority, No. 1.
You are not going to balance the budget this year, next year or
1983, or maybe in 1984.
Another was, they recommended we schedule reductions in business taxes in each of the next 5 to 7 years and reduce the capital
gains tax. They said nothing about the personal income tax cuts,
and since then the committee has indicated, the Burns committee,
that they feel that they should take a back seat to balancing the
budget, very much of a back seat.
And finally, they recommended a series of measures to increase
productivity, including increased research and development, improved manpower training, productivity councils, due to individual
plants, none of which the administration seems to be interested in
pushing.
Why is the administration not supporting what seems to be a
logical and very broadly supported anti-inflation effort?
Dr. WEIDENBAUM. First of all, Senator, my understanding is that
much of our program moves in the very same direction as that
recommended by that distinguished group; in fact, many members
of that group have warmly endorsed our program.




179

To be specific, we share their concern about balancing the
budget. We inherited a budget deficit for the current year in an
order of magnitude of $60 billion. It is our determination not just
to seek a one-shot balanced budget, but to reduce and ultimately by
1984 eliminate deficit spending as a way of life in this Nation.
So I concur with their view on balanced budgets in the strongest
way.
Now, on the reduction of business taxes. Again, we have recommended the most ambitious program of business tax reduction ever
submitted to the Congress, and the enactment of our proposals on
individual tax rates will effectively reduce the capital gains tax,
And finally, we strongly share their concern with productivity.
And that is a central feature of our very ambitious regulatory
relief effort, as well as the expectation behind so much of the
justification for the individual tax relief to encourage a higher
level of saving, a higher level of investment and hence a restoration of our traditional strong growth and productivity.
So I find, by and large, the statements of that distinguished
committee very supportive of our approach to economic policy.
The CHAIRMAN. Senator Schmitt?
Senator SCHMITT, Thank you, Mr. Chairman. And welcome, Dr.
Weidenbaum. I am very happy to see you in the position you are
holding and look forward to working with you in the future.
One of the puzzles, of course, of this whole business is; How do
you monitor and in fact anticipate changes in money supply under
current policies so that you can modify that policy and improve the
monetary situation in the country?
For example, I think we know historically that there is a direct
correlation in retrospect between the rate of growth of the money
supply, and the excess of that growth in relation to the value of
goods and services. Furthermore that difference is a close measure
of the inflation rate some 12 to 18 months prior to the measurement of that difference, if I have made myself clear.
Senator PROXMJRE. Yes, sir.
Senator SCHMITT. I think historical analysis is quite persuasive,
but our problem, of course, is how to deal with that fact in the
present and in the near future. Do you have any suggestions on
how can we make better use of the knowledge that there is a direct
correlation—despite the fact that at any instant of time we have
trouble seeing just what is happening within the money supply and
its affects upon the value of goods and services?
Dr. WEIDENBAUM. Senator, let me make an attempt to be helpful,
and you may want to follow up your original question.
I am still mindful of the concern about high interest rates these
days. And so many people, when they think of monetary policy,
they think of high interest rates. I think modern economic analysis
is quite clear, that the genesis of high interest rates is high inflation and expectations of high inflation. And that is the vital link.
It is the excessive growth in the money supply that is at the
heart of the inflation problem facing our Nation. Therefore, to deal
with high interest rates, to deal with high inflation and the expectations thereof, it is vital to embark on a policy to maintain a
policy of predictable, steady and moderate growth in the money
supply.




180

However, it is not a matter of looking at the money supply
hourly or daily or taking the temperature even weekly. I think we
need
Senator SCHMITT. That can be counterproductive, can't it?
Dr. WEIDENBAUM. Yes, it can, to the extent people do that. I
think we need to look at money supply trends over a broader
period of time by quarters, by half-years, and also annually. I think
the approach to monetary policy is truly vital, that is concern over
the growth of the money supply. There are various measures. I
think given the institutional shifts in the NOW accounts, and the
money market mutual funds, for example, a battery of indicators,
including the monetary base, is needed to really keep abreast of
developments in that aspect of the economy.
I think, however, what we need to do, if I understand the thrust
of your question, Senator Schmitt, is to monitor the changes in
these key monetary aggregates, including monetary base, to see the
underlying direction of movement.
This is why I find Chairman Volcker's statement so heartening
that the Federal Reserve is moving down their target range for the
growth in money supply. That is a very clear signal of a directional
change, so that, given steady decline in the growth rate of the
money supply, we now will have the basis, coupled with the steady
reduction in deficit spending and deficit financing, we now will
have the basis for a less inflationary economy.
Senator SCHMITT. Dr. Weidenbaum, I appreciate what you have
said and agree with it. But the difficulty that we have, is it not,
that if we achieve say, today, within the quarter, a measurable
decrease in the rate of growth of the money supply it would take
something like 12 to 18 months to, on an historical basis, see a
measurable decrease in the inflation rate? This would be a consequence of that decrease in the rate of growth in the supply, assuming a constant production of a constant rate of growth of the value
of goods and services. I believe the historical evidence is, that there
is about that kind of lag time.
The Congress has a terrible time dealing with the kinds of situations in which there is that much inertia built into the economy.
Dr. WEIDENBAUM. It has been a while since I studied the question
of lags in monetary and fiscal policy, but I have studied it on
earlier occasions. Very frankly, I didn't see in my studies any clear
consensus as to the length of those lags. I would expect, very
frankly
Senator SCHMITT. But there is a lag.
Dr. WEIDENBAUM. Yes, but it may be shorter in the coming year
because so much of the impact is on expectations.
Senator SCHMITT. The psychology thing?
Dr. WEIDENBAUM. Yes, that can turn around quite quickly. Very
frankly, I think financial markets at home and abroad are waiting
for a signal, not a signal involving talk by the administration but,
frankly, action by the Congress. When the Congress enacts that
major package of tax reduction along with expenditure reduction,
the largest program of expenditure reduction ever, that will be a
powerful signal to financial markets, to investors, and to savers,
that there is a seed change in the inflationary environment in this




181

Nation. And I think that seed change can occur far more quickly
than the traditional lags would indicate.
MEASURING THE MONEY SUPPLY

Senator SCHMITT. A final question. Do you think that the normal
means of measuring the money supply, whatever M you take, takes
into account the actual availability of money? I mean to include
the availability of credit that will affect the effective money supply,
if I may use that term, versus the actual number of dollars that
are out there in the market.
Dr. WEIDENBAUM. This is a subject, Senator, that I have written
on as a private scholar, pointing out the need to constantly update
our measures of the money supply as the institutional changes
shift. Specifically the growth of money market mutual funds. The
movement of NOW accounts. This is why I refer to a battery of
aggregates rather than concentrating on any single one.
I have been urged by specialists in this area to give special
attention to the monetary base as the measure which is least
subject to influence by these changing institutional structures of
our financial markets.
Senator SCHMITT. Changes, say, that result in money moving
more rapidly from transaction to transaction which can have the
effect of increasing the effective money supply at least temporarily?
Dr. WEIDENBAUM. Yes, sir, which, of course, also points out why
we need to look at velocity as well as
Senator SCHMITT. Well, that is basically the term I was using,
but it is not used very commonly. And you think, though, that
velocity is important particularly for shorter term examination of
what is happening with the economy?
Dr. WEIDENBAUM. Yes, sir.
Senator SCHMITT. I don't think there is any historical evidence
that velocity has any long-term effect, and maybe that is understandable.
Dr. WEIDENBAUM. It is certainly very difficult to predict velocity
and changes in velocity. I think people who have tried to do that
are very well aware of it.
Senator SCHMITT. Thank you, Mr. Chairman.
The CHAIRMAN. Dr. Weidenbaum, how good is the CPI as an
indicator of real inflation?
CPI INADEQUATE MEASURE

Dr. WEIDENBAUM. It is truly an inadequate measure. There are
many shortcomings to the CPI. And the housing component certainly is the most serious one.
No doubt, the chairman is aware of the experiments, on the part
of the Bureau of Labor Statistics, with alternative concepts of the
CPI. We have very limited data for these experimental indexes.
I think it would be very worthwhile to study in depth some of
these alternative indexes, to see whether the CPI should be revised.
But, given the extensive use of the CPI in collective bargaining
agreements and business agreements and government activities, I




182

think the change should be made very carefully, on a totally nonpartisan basis.
I do point out that the relationship between the CPI and what
we call the GNP deflator, the more comprehensive measure of
price changes in the economy, is a changing one.
That is, in recent years, given high interest rates or rising interest rates, the CPI has gone up much faster than the GNP deflator.
If you notice, in our economic projections accompanying the
White Paper—or as part of the White Paper—we show, in the
1980's, as we approach 1986, that the CPI would be, under our
scenario, rising less rapidly than the GNP deflator, precisely because we would anticipate interest rates to be coming down very
substantially.
So, in recent years, the CPI has overstated the rate of inflation.
I could see a period in 1984, 1985, 1986 where the CPI would
understate the degree of inflation. I think we need to be mindful of
that, in making any shifts.
The CHAIRMAN. Well, everybody seems to agree that it is inaccurate, and that it has such a dramatic effect, either way. As you say,
in. the future, it may go the other way. But, certainly it has in it a
lot of automatic escalators—COLA's and things of that nature.
It is contributing to the inflationary problem, certainly, to the
Government spending in the period you have just talked about.
It would seem to me that the administration ought to look very
carefully at making some changes—and I certainly have none to
recommend. I am not an economist. I don't know what you would
do with it.
But I certainly think that, again, where everybody thinks it is so
inaccurate, why are we basing such a tremendous amount of
shift—in not only the private sector, but in Federal spending—on
what everybody agrees is an inaccurate measure?
Dr. WEIDENBAUM. Mr. Chairman, if we really had—and when I
say "we," I mean Government extending over several administrations—had adequate foresight, the Consumer Price Index should
have been modified very fundamentally, many years ago.
One of the problems, as I see it now, is a question of equity.
Programs have been indexed to the CPI—have been overindexed,
so to speak. Should the program of the administration succeed—
which I expect to be the case—that will be compensated in the
future.
Now, if we suddenly shift the price indices, that compensation—
that offset—won't occur. So, I think we need to exercise great care
in the timing of the change, particularly from the viewpoint of
minimizing the drain on the Treasury from these indexed programs.
The CHAIRMAN. The leading indicators are down. Certain officials
at OMB have anticipated a recession in the middle quarters of
1981,
What is your opinion?
Dr. WEIDENBAUM. We are in a soft economy. That is very clear.
There is no single quarterly pattern that emerges from our year-toyear forecasts. There are a variety of quarterly patterns which are
consistent with our very modest 1-percent growth in real GNP in
1981.




183

I am not prepared, at this point, to provide a quarterly forecast.
I would say that the softness in the economy is a compelling
reason for rapid action by the Congress on the tax and expenditure
parts of the program. Because the upturn that we are forecasting
in the economy is based on the enactment of our program.
I would expect that the economy, in the absence of the enactment of the Reagan administration program—that the economy
would stay soft and, perhaps, worsen.
The CHAIRMAN, And your forecast would be out the window?
Dr. WEIDENBAUM. Our forecast assumes, very clearly—and we
state that—the enactment of President Reagan's program.
The CHAIRMAN. In October of 1979, the Fed announced a change
in its monetary policy implementation, away from fine tuning interest rates, to maintaining a closer watch over the money supply.
This past year has seen both interest rates and monetary aggregates go up.
What is your opinion of the effectiveness of the Fed's change in
techniques?
Dr. WEIDENBAUM. Hope springs eternal.
I hope that, in the year ahead, the Federal Reserve System has
better results. I think it was a fine statement of policy.
I think it is a question of implementation.
But, Mr. Chairman, I think we have to be mindful of the difficulties put in the way of the Fed in carrying out those policies. The
difficulties that I referred to earlier, were essentially not of their
doing. That is, looking back at 1980, the large budget deficit that
had to be financed, the growing off-budget agencies of the Federal
Government that had to be financed, plus the stop-and-go effect of
the imposition and the elimination of the credit controls.
All that invariably, inevitably, made the Federal Reserve's role
in carrying out its policies far more difficult. And I think, needlessly so.
The CHAIRMAN. Much discussion has taken place over the economic condition of the United States, compared with other Western industrialized countries.
I would appreciate any comments that you would like to make,
on the techniques of central banks, in West Germany and some of
the other countries that have been discussed so much in this committee; compared to the monetary policy technique of our own Fed.
Dr. WEIDENBAUM. Very frankly, Mr. Chairman, I'm not expert in
those matters.
But, from my very modest observations, it is quite clear that
monetary policy—West Germany, I think, is a cogent example—
monetary policy quite clearly is central to keeping down the inflation rate. That is the lesson that I get from looking at the German
economy.
Of course, they, in turn, received a very powerful and difficult
lesson in inflation. And I hope that we can learn from their experience, in avoiding undergoing their sad experiences.
REVIEWING OPERATIONAL POLICIES

The CHAIRMAN. Another issue that has come up in this committee's hearings—both in January, with Chairman Volcker, and
again a couple of weeks ago—has been the Fed's apparent reluc-




184

tance to change some of its operating techniques. And I'm specifically talking about lagged reserve accounting and the belowmarket discount rate.
Chairman Volcker did announce in the committee hearings last
week that the Fed is reviewing the need to change those operational policies.
In your opinion, would a contemporaneous reserve accounting
market-related discount rate be beneficial?
Dr. WEIDENBAUM. Mr. Chairman, mindful of the independence of
the Federal Reserve System, I would not, in my present position,
make such specific recommendations.
I do state, in my
The CHAIRMAN. I would. And I have.
Dr. WEIDENBAUM. I should hope you do, sir.
But, in my position, I merely acknowledge the staff studies, and
point out our expectation that the Federal Reserve Board—the
Federal Reserve System—will give serious consideration to those
policies, for changing its procedures.
But that, of course, is a judgment on the part of the independent
Federal Reserve System. We wish them well in their deliberations.
The CHAIRMAN. Senator Proxmire?
Senator PROXMIRE. Dr. Weidenbaum, the President is asking for
budget cuts of $41 billion. Is that right?
Dr. WEIDENBAUM. That is the present number.
He has given us a very specific set of marching orders, you
understand, Senator. And that is to keep the lid on spending, to
attain our deficit reduction objectives. So that the efforts to find
additional economies in Government can surely continue unabated.
Senator PROXMIRE. The arithmetic of this adds up something like
this: $41 billion in budget cuts for fiscal year 1982; a tax cut of $52
billion; defense outlays will increase by $7 billion, maybe more.
So, we start with a deficit this year of $50 billion; and we add the
arithmetic here—$65 billion to $70 billion. Even with the most
optimistic assumptions for stimlus, growth, et cetera, it seems
we're looking at a deficit in 1982 of $40 billion or $50 billion.
Do you think that deficit will help us to flight inflation?
Dr. WEIDENBAUM. Senator, I would have liked to have seen a
smaller deficit.
I think, however, given the needs of this Nation for a stronger
national defense; given the needs of this Nation to maintain what
we call the "safety net" of essential programs for the needy; given
the many responsibilities that the Congress has given the executive
branch—that the budget estimates that we have presented—and
which, on March 10 we will present in far more detail—represent
the most responsible program of budget restraint that we could
develop.
Senator PROXMIRE. Now, supposing things don't work out as you
would like them to work out. Supposing, instead of inflation moderating next year, it stays at the present level and maybe increases
some—it is at 11 percent or 12 percent as your expectation for this
year. Say it goes to 11 percent or 12 percent next year.
Will you persist, under those circumstances, in asking for the big
personal tax cut that you are requesting?




185
Dr. WEIDENBAUM. Well, first of all, it is our expectation that the
Congress this year will approve the 3 year personal tax cut; and
that that trend will set in motion the expansion of the supply
capacity of this Nation, which is the basic way of dealing with the
inflation.
That is, increasing the production of goods and services.
Senator PROXMIRE. I stand corrected. That is right. I understand
that. And, of course, we have to act this year.
Doesn't it seem wise, however, in view of what many would view
as the fragility—or the insubstantial nature—of forecasts generally—even your forecasts—the great possibility that we might continue to have inflation at double-digit levels?
Wouldn't it seem wise, under those circumstances, to enact a 1
year tax cut and see how it works? And then see if we could afford
to go ahead with the second installment?
Dr. WEIDENBAUM. Senator, if this was the traditional Keynesian
demand-side type tax cut, I would say it shouldn't be a 3 year tax
cut. In fact, it shouldn't be a 1 year tax cut.
But the substantial reduction in marginal rates, which is the
essence of the supply-side-oriented tax cut, I think is essential to
expand employment, savings, and investment. And I urge you to
look at the major extent to which the budget deficit rises, from the
expansion of those entitlement programs, which are paced by the
state of the economy.
So, to the extent that the business and personal tax cuts together
can succeed in providing incentives for a larger, a faster rate of
economic growth, not only will that expand the tax base, bringing
in more revenues; but it simultaneously will reduce the need for
these spending programs. And, hence, the will reduce the inflationary pressures, on both the expenditures side and the revenues side.
Therefore, I urge you, as part of our anti-inflationary strategy, to
promptly act on the tax cuts for all 3 years, at the outset.
And, as I stated earlier, I think it is vital that Government
spending be planned in the context of a lower set of tax rates.
Senator PROXMIRE. Well, now, all of this is based on a new
theology that may or may not turn out to be
Dr. WEIDENBAUM. Senator, this is economic analysis I am expending, to the best of my ability. I give my sermons on Sunday, as
I told the mayors.
Senator PROXMIRE. Well, I think you are still giving us a sermon.
It may be a very wise and correct sermon. You may be confirmed
by historical experience; but you may not.
Dr. WEIDENBAUM. I was confirmed by the Senate.
NO INCREASE IN THE DEBT LIMIT

Senator PROXMIRE. Well, I was one of a small minority in the
Senate that voted against increasing the debt limit. And I think I
was right in doing that. And I think here is a real instrument—if
you want to balance the budget for sure, just say "no increase in
the debt limit; no trillion-dollar debt."
Now, the President will have an opportunity. I understand why
he did it this time. The Carter spending put him into a position
where he felt that he couldn't responsibly take that action.




186

But, supposing he digs his heels in, here, at $985 billion, and
says: "No more increase in the national debt; that's it. Unless, of
course, we have a deep recession or have a military emergency. But
otherwise, no increase."
We would simply have to come forward with cuts, whether we
like it or not. We would have to do it.
You would create a situation, a crisis situation, in which Congress would have no choice. The President could say: "All right, if
you don't do this, that means we're not able to pay 36 million
people who vote and who get social security benefits. If you don't
make the cuts elsewhere, it means we can't pay the Army, Navy,
and Air Force."
The pressure on us in Congress would be irresistable. Then, we
would have to balance the budget.
Dr. WEIDENBAUM. Senator, that reminds rne of the Herblock
cartoon, a few years ago, showing a great big fat dog labeled
"government spending deficit," and a small doghouse labeled "debt
limit"; and Congress telling the big dog: "You get in there."
Senator PROXMIRE. Maybe we ought to tell him to get in there.
Dr. WEIDENBAUM. There's no way that big dog, which represents
the expenditures under the appropriations that the Congress enacted, is going to get into that smaller doghouse.
Senator PROXMIRE. Well, you put that dog on a fast diet. I will
tell you. [Laughter.]
Dr. WEIDENBAUM. The responsibility is on the Congress to reduce
the size of that dog.
There is no substitute for appropriating less, in the first place.
Senator PROXMIRE. Well, I'm not talking about creating a situation, however. The President has the power; he can veto any increase in the debt limit. And I'm sure, if he did so, and if he lent
the force of his office, there's no way Congress would override that
veto.
If he does that, then we do conform with what you're asking for.
We make the cuts.
We are told by the Chairman of the Federal Reserve Board that
cuts are the key. And I think you take the same position, too. We
have to make those cuts. They are absolutely essential. We must
make them.
We may not make them. We may not make them as deep as we
should.
But one way the President can absolutely assure that we make
them, without any question, without a doubt, is to say: "We're not
going to increase that debt limit unless you have a catastrophic
situation."
It doesn't take a constitutional amendment to do all that that
embodies. It's not that rigid. The President can change his mind
and approve an increase in the debt limit.
But, if he would say under these circumstances: "We think that
fighting inflation is the most important thing in the world," what a
marvelous psychological message that would give to the public.
We would know, then, that we would cut the spending and
balance the budget.




187

Dr. WEIDENBAUM. That's like telling your wife, who has incurred
all of those charge bills, "I won't pay the bill when it comes at the
end of the month."
The thing is to control the use of the charge plate at the beginning. That's the only way to soundly manage either family finances
or Government finances.
Senator PKOXMIRE. No. It's not. It's like taking the charge card
away from your wife.
Dr. WEIDENBAUM. That's the idea precisely.
Senator PROXMIRE. That's what you do with the debt limit.
Dr. WEIDENBAUM. No, sir. That's what you do when you appropriate too much, and I'm urging you to appropriate less.
Senator PROXMIRE. Dr. Weidenbaum, we've been through this for
years. We've been trying to persuade Congress
Dr. WEIDENBAUM. Precisely. The debt limit hasn't worked as, in
fact, a control over Government spending.
Senator PROXMIRE. No President has ever said it. It's like President Reagan did this time; he said: "Increase it."
Dr. WEIDENBAUM. There's no substitute for appropriating less.
And that is what—precisely what President Reagan has urged. If
anything, we are urging a reduction in the appropriations that are
outstanding.
I hope you join us promptly in that high priority.
Senator PROXMIRE. Oh yes. I'm with you all the way, as you may
know.
Dr. WEIDENBAUM, We welcome your support.
Senator PROXMIRE. Except in the dairy price support area.
[Laughter.]
Nobody's perfect.
My time is up.
The CHAIRMAN. Senator Heinz?
Senator HEINZ. Just one comment, Mr. Chairman.
I was listening to the charge card analogy, and I assume it had
nothing to do with the legislation we reported earlier this week.
I would only say to my good friend, Senator Proxmire, that the
analogy, it seems to me, with respect to the charge card and the
debt ceiling, is not taking away the charge card.
The analogy is really when you get all of the bills from your
friendly American Express or Visa company, saying that you have
purchased a car, a home, an around-the-world trip. And you, at
that point, say: "No. I'm not going to pay my bills."
That is the same effect as the vetoing of a debt ceiling bill. By
the time you get to the debt ceiling bill, all of the commitments
have been made; all of the appropriations have been released; all of
the money that has been committed through entitlements has been
committed. All of the budget authority, in other words, has been
obligated. All of the bills are coming due.
One of the big bills that comes due is the refinancing of the debt.
And to not, at some point, face up to that is to be unrealistic. And
that is where the President's economic program is very realistic.
It says what we have to do is stop all of this obligational authority. And the President has been extremely bold.
The CHAIRMAN. Like price supports. Right?




188

Senator HEINZ. Mr. Chairman, I don't want to get into any
unnecessary discussion with somebody from the Minnesota-Wisconsin area on the subject of price supports.
The CHAIRMAN. We have dairy farmers in Utah. It just takes
political courage.
Senator HEINZ. Mr. Chairman, we are well aware of your political courage. And I knew this discussion would get us into that.
Anyway, .just to wrap it up, Mr. Chairman, I think that what the
administration indeed deserves to be commended on is the fact that
they recognize the charge card problem. And what they're trying to
do is to put this country on more of a pay-as-you-go basis.
Thank you, Mr, Chairman.
Dr. WEIDENBAUM. Thank you, Senator, for those kind remarks.
The CHAIRMAN. Senator Schmitt?
TAX PACKAGE TIMING

Senator SCHMITT. Mr. Weidenbaum, it has been suggested in
hearings that the Appropriations Committee held some weeks
ago—which, unfortunately, you were not yet able to participate
in—that the tax package might be more properly constructed in
terms of its timing. The package would be constructed to give us a
bigger window in which to work the spending reductions without
as much of an immediate short-term impact on deficits.
The package would clearly allow for directly investment-related
cuts—that is, job creation, business creation cuts—be retroactive to
January 1 of this year. Also the more personal cuts would be
postponed to January 1 of next year, to give us a full 12-month
window in which to work.
If I understand the President's proposals, that window is really
about 6 months long; and since July 1 comes very quickly, it is
probably not, in truth, a window at all.
Do you have any further comments on that?
Should we consider expanding that window?
Dr. WEIDENBAUM. Senator Schmitt, I hope you don't. The economic problem facing this Nation is a problem for today. Those
high interest rates are a very serious problem to many institutions
today. That soft economy and the high unemployment again is
economic distrust right now; and I think investors, financial markets, business decisionmakers, as well as many consumers, are
looking toward the Congress for action, for decision, not for delay.
Senator SCHMITT. I am not proposing that. I am proposing the
package be enacted. I am just talking about the schedule and
timing, and with direct reference to the interest rates,
I don't know whether you would agree or not, but the principal
pressure on those interest rates has been the borrowing by the
Federal Government. Any time the Federal Government wants to
borrow money it goes to the head of the line and pays what the
market demands, in order to get that money. It's been doing it at a
$60 billion rate for several years.
Dr. WEIDENBAUM. I share your concern. I do think, however, that
making those personal tax rate reductions effective July 1 is really
an essential part of the program, because we need to expand the
pool of private saving as rapidly as possible, and July 1, is not too
soon at all.




189

Senator SCHMITT. Well, let me suggest some other means to
expand that pool. As you know, our savings rate is the lowest in
the industrialized world- The Japanese are saving from 20 to 25
percent of their disposable income. Many Europeans are saving 15
to 18 percent, I believe are the recent numbers. We are at 3 to 3Va
percent.
I detected, unfortunately, surprisingly little interest in removing
the tax on interest and dividend income in this country,
Dr. WEIDENBAUM. Very frankly, it is my personal view, having
studied the tax code over a long period of time, that specially
targeted provisions are not the most productive course of action.
General purpose tax reductions, where the decisions really are
made by families, by individuals, as to how much they want to
spend, how much they want to save, is the much more desirable
way.
In other words, I strongly share your concern that we have more
saving in this economy. But I think the healthier way to do it, the
more economically efficient way to do it, is to create an environment in which voluntarily, without looking at the tax collector
over your shoulder, citizens voluntarily increase their saving. And
in my diagnosis, the major barrier to saving today is the inflation
and the inflationary expectations. And, therefore, I think the
prompt enactment of our package in the form that we have prepared it, will do more to reduce those inflationary expectations,
and hence restore the a higher savings rate, that any specifically
targeted thing.
Senator SCHMITT. Mr. Weidenbaum, the problem is—and I am
fully sympathetic to the President's package; we can debate the
timing at another time—the biases against sayings, even under
your program. Anybody who puts money in a savings account today
is doing it because of patriotism, not because they are going to earn
any money.
SAVINGS ACCOUNTS LOSING MONEY

I happen to have some savings and I keep them there because I
think I should have a savings account. I think it is important, and
I hope more and more people do. However I am losing money on
that savings account; and there is nothing in the President's program in the short term, and when I say that I mean 2 or 3 years,
that is going to significantly change that loss to a gain looking at
inflation and other factors.
What I am saying is that you need, I think, to build into that
package some real incentives to put money into savings and into
investment. At this point you don't have them there.
Dr. WEIDENBAUM. I would like to offer just two quick points.
First of all, the Treasury is considering items for inclusion in a
second round of tax proposals. And you might wish to call it to
their attention, although I am sure they are already aware of the
specifically targeted approach to savings.
I anticipate from the prompt enactment of our program, a significant increase in savings in the course of the coming year. First
of all, we are talking about a declining Federal deficit and we are
taking action not only to achieve a reduction in the deficit per se,




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but in total Government financing, in the total Government competition with private borrowers.
Senator SCHMITT. Off-budget as well?
Dr. WEIDENBAUM. Precisely. One of the things we are urging is
that the Government credit programs, wherever possible, charge
market rates of interest. And I think that will do more—that one
change will do more to reduce the off-budget drain on capital
markets, and hence, increase the effective pool of saving available
for the private sector.
Senator SCHMITT. Well, when I speak of the savings rate, I am
talking about either a full exemption or a percent of savings—not
the specific dollar amount. I don't think that solves the problem at
all. It is helpful to those who are already saving. It is not helpful to
increase the amount of savings. I hope that you will continue to
look at that issue, and there are other ways to encourage people to
create a situation where they can earn money on savings. They
can't do that today, and I think you are going to be disappointed. I
am afraid you are going to be disappointed in how much money
actually goes into savings, and the relatively low rate of return
investments, because there is no monetary incentive to do that.
You aren't going to earn anything today.
Dr. WEIDENBAUM. I think it is a question of comparison, Senator.
Senator SCHMITT. You are too far away right now, with the 12
percent inflation rate. You are just too far away from earning
anything on a savings account.
Dr, WEIDENBAUM. Those of us, for example, who are saving to
put our children through college, really don't have an alternative.
It is a question of what savings instrument do you use? But quite
clearly, if anything, the inflation increases your need to save because of the higher cost of schooling. So to that extent, quite
clearly, I think there is a continuing need for savings on the part
of the average consumer.
Senator SCHMITT. Well, my time is up. I don't understand that.
Any money you put into a savings account is losing value. The
interest you gain on it
Dr. WEIDENBAUM. But if you spend all of that on current consumption, none of it will be available.
Senator SCHMITT. I agree. But all of the incentives are to spend,
or to invest in real estate or something like that; rather than to
put it in where it is directly usable by the economy.
Dr. WEIDENBAUM. Again, I think this is why we need to deal with
the fundamental problems facing the economy.
Senator SCHMITT. I have no argument with you. I am just afraid
that the short-term effect of the policy without some incentives to
save, is not going to be what you anticipate.
The CHAIRMAN. Dr. Weidenbaum, as you know from several
meetings you and I have had, you have, or the administration has
no more ardent supporter of cutting the budget than this Senator.
Dr. WEIDENBAUM. Yes, sir.
The CHAIRMAN. And as I have said, I am willing to accept the
cuts in dairy price supports, even though there are dairy farmers
in my State. Even more politically sensitive, I am willing to accept
cuts in the central Utah project, the secondmost arid State in the
country. Water is absolutely vital to not just growth, but sustaining




191

the present population of that State. No public official in 20 years,
in either the Republican or Democratic Party, or at the State or
National level, has been willing to accept cuts; but I feel the budget
situation is so critical that even there, whatever the political heat
is, I will accept the President's recommendations.
But the thing that I am absolutely incapable of understanding is
when you recommend cutting the vital water project, dairy price
supports, why tobacco subsidies are not on the hit list? A product
that is a known killer, certified by the Surgeon General. It causes
heart disease, lung cancer, emphysema, and associated other problems.
We ban cyclamates because if your rat drinks half a million
gallons, it may get cancer. [Laughter.]
The CHAIRMAN. We talk about banning saccharin. But the one
thing that we absolutely know causes cancer, the Federal Government is subsidizing it in our austerity plan. There is no recommendation to cut.
Dr. WEIDENBAUM. First of all, Mr. Chairman, I personally and
most sincerely want to thank you for your strong support of budget
restraint where it hurts, as well as where it just affects the other
fellow. In the case of the farm price supports, as in many other
areas, we went after the biggest opportunities first. And we emphasized the reduction in the dairy price supports, because that represents such a very large drain on the Treasury, and hence reducing
The CHAIRMAN. I understand the economics. But milk is helpful,
Dr. WEIDENBAUM. Not in excess, of course. [Laughter.]
I am a nonsmoker.
The CHAIRMAN. My baby drinks milk. He does not smoke.
[Laughter.]
Dr. WEIDENBAUM. I neither smoke nor drink milk, so I am really
neutral on this.
Let me point out, in all seriousness, we have embarked on a longterm program of expenditure restraint. The initial results, and
only the initial results, have been presented to the Congress. We
continue to look for future opportunities for saving, and personally
I welcome the chairman's suggestion and I will pass that on to my
colleagues in the administration to seriously consider your recommendation, Mr. Chairman.
The CHAIRMAN. I would appreciate that, because all of us across
the country have particular programs that affect our States more
dramatically than some others. And I would suggest tobacco State
Senators might be willing to bear their share even if it is symbolic,
even if it is not a large amount of money. Because if I had my way,
there would be no subsidies for any product that causes the kind of
problems that tobacco does. And I am not moralizing, I am talking
about the proven antihealth problem. The No. 1 cause of preventive disease.
Dr. WEIDENBAUM. As the chairman knows, as a private citizen I
have written extensively, or frequently rather, in support of the
chairman's position.




192
ARE TAX CUTS INFLATIONARY?

The CHAIRMAN. Let me ask you one other question about the tax
cuts. Is it not true that in actual fact, in reducing Federal revenues
there is no tax cut? Even the President's $51 billion, there will still
be in the neighborhood of $40 billion of tax increase collectively on
the American people?
Dr. WEIDENBAUM. Yes, indeed. In fact, were it not for—if Congress were not to enact the tax rate reductions proposed by the
President, there would be an increase in the average tax burden on
the average family because of the rachet effect of inflation pushing
people into higher brackets, plus the increases in payroll taxes. So
that in order to avoid an increase in the burden of taxation on the
average family, it is necessary to enact the tax cut.
The CHAIRMAN. So the argument, really, about tax cuts is not
valid. It is whether we slow the increase of taxation on the American people?
Dr. WEIDENBAUM. Yes, sir.
The CHAIRMAN. Is there any reason to believe that if Government takes that $100 billion away from us and spends it, that that
is less inflationary than if they leave part of it with us to decide
how we spend?
Why is it the attitude of some in Government, as it was during
the campaign, we constantly heard that tax cuts were inflationary?
Why is it more inflationary to leave money with you and I to
spend, then to have this Congress take it away from us and decide
the priorities of how it should be spent?
Dr. WEIDENBAUM. It isn't. First of all, we can debate what the
savings ratio is going to be in the private sector. Will it stay down
at 5 percent? Will it rise back to 7 percent, or go higher than that?
But the savings rate is not only zero, it is negative in the public
sector.
So surely, if we are concerned about savings and investment,
restoring the position of the private sector is paramount. Savings
come from the private sector.
The CHAIRMAN. Isn't it also true that when we are looking at the
future, as far as balancing budgets, as much as I favor a balanced
budget and always have, is it not a higher priority to reduce
Federal spending as a percentage of the gross national product
than to achieve a balanced budget?
My point is this; That you could have a $3 trillion balanced
budget. We can have a balanced budget. We can increase taxes.
Dr. WEIDENBAUM. Precisely.
The CHAIRMAN. But if you drain all of that money out of the
private sector, and we are already at 40 percent of GNP as being
taxed away by State and local government, we could balance the
budget. We could tax at a 50-percent rate and balance the budget.
So I want to establish that the importance of tax cuts is to reduce the
involvement and the percentage of the public sector in the private
capital markets.
Dr. WEIDENBAUM. Yes, indeed. If there is any common theme to
all of our proposals, it is to reduce the size, the power, the intrusion of Government in the American economy; Government in all
its dimensions; expenditures, taxes, credit programs, and regulation.




193

The CHAIRMAN. I would ask my other two colleagues, if they are
here, if they would have any other questions?
Senator PROXMIRE. I would just like to ask two very quick questions. One is, I wonder if you have any idea how we, as the agency,
the arm of Government that created the Federal Reserve Board
and with jurisdiction over the Federal Reserve Board, this committee particularly can persuade the Fed to stay within its targets.
As Senator Heinz brought out with very skillful questioning
when Chairman Volcker was here, they miss their target on every
single measurement of the money supply. They were over it on all
seven measurements over their range, and the range was a very
broad range. Talk about the midpoint; they missed the midpoint by
anywhere from 30 percent to 50 percent above it.
Now, one way we might be able to do this is to try to persuade
them to narrow their range, or do what they do in Germany and
have a single target. In other words, say the increase in the money
supply for next year is going to be 4 percent for certain measure.ment, or 6 percent, or whatever. And then we could hold them to
perhaps a closer level.
But on the basis of their past performance, even if they stay
within the range, it can be a rather high increase. And I notice
that you emphasize that they should hit at the midpoint of the
range.
So do you feel it would be good policy for us to do what we can to
try to persuade the Chairman of the Federal Reserve Board to
narrow that range just as much as possible, and maybe to reduce it
to a single figure?
Dr. WEJDENBAUM. I think it is very useful for this committee, as
you do regularly, to call in the Chairman of the Federal Reserve
Board so he can report to the Congress, and get whatever guidance
the Members of the Congress want to give the Federal Reserve
System. Because after all, the Federal Reserve is a creature of the
Congress. The Federal Reserve is independent of the executive
branch of Government. Nevertheless, I think we need to be mindful of the actions that are taken both in the legislative as well as
the executive branch, which make it difficult for the Federal Reserve to carry out that policy.
Eliminating the power to regulate credit, the credit controls, I
think would be very useful, so last year's sad experience of onagain, off-again credit controls does not reoccur. I think that would
certainly be useful. And second, that the reduction in the deficit
again
Senator PROXMIRE. This committee recommended that. And we
did, as the chairman just pointed out to me, sunsetted that as of
1982, the credit controls.
Dr. WEIDENBAUM. The sooner the better, I would say.
And surely steady progress in eliminating the budget deficit is
another vital contribution that enables the Federal Reserve to
follow their stated policy more closely.
GARN-PROXMIRE RESOLUTION

Senator PROXMIRE. Now, the final question I have is I hope you
will find it in your heart to support the Garn-Proxmire resolution
on monetary policy. This says monetary policy would express the




194

views of the Burns committee on how they should follow a conservative anti-inflation monetary policy.
Dr. WEIDENBAUM. A resolution bearing the names of Senator
Garn and Senator Proxmire is one that I would give the greatest
consideration to. However, not having read the resolution, I am not
prepared to comment on it at this point.
Senator PROXMIRE. Well, some things you won't accept on faith,
although that doesn't include the administration's views.
Dr. WEIDENBAUM. I would expect that to be an important contribution to economic policy.
Senator PROXMIRE. Well, we will send this to you.
Thank you, Mr. Chairman.
The CHAIRMAN. Senator Heinz?
Senator HEINZ. I have just a brief question or two. In the administration's economic recovery plan, as set forth in the white paper,
there is a very laudable statement about how you want a consistent, strong monetary policy through the Federal Reserve. And if
this question has already been asked earlier, please say so, and you
make it even shorter. But the Fed has suggested a set of targets for
1981, and I assume you have seen them.
Dr. WEIDENBAUM. Yes.
Senator HEINZ. Does that meet your prescription? Does that fit
with your objectives, the set that has been suggested?
Dr. WEIDENBAUM, Yes. And, Senator Heinz, I say in my statement that achievement of those targets, especially toward the midpoint of the range, clearly would be consistent.
Senator HEINZ. You would rather have it closer to the midpoint
than at the upper range?
Dr. WEIDENBAUM. I think closer to the midpoint would represent
greater progress in achieving the inflationary objectives, or the
anti-inflationary objectives.
Senator HEINZ. Suppose the Fed does this year what it did last
year, which is it misses the range in every single instance. What
policy should there be for dealing with somebody who has accepted
responsiblity by setting a target, and says that target is over there
on the wall and I can hit it, if not in the middle, 1 can always hit
at least the entire target, even if it is in the white ring as opposed
to the red or yellow in the middle. And the person keeps throwing
the darts into the wall. What do you do about that?
Dr. WEIDENBAUM. As an analyst, the first thing I would ask is,
why did they miss it? If it was due to factors effectively beyond
their control, I would understand. If not, I would encourage them
to give even greater consideration to changes in operating procedures, which is again a point I covered in my statement.
Senator HEINZ. One last question. When you and Senator Garn
were discussing the tax cut, you were quite properly pointing out
that the increase in taxes that is built into our tax system is so
severe that really what the administration is proposing in terms of
a so-called tax cut is little more—may not be even any more—than
keeping people from having—the average person, from having a
higher average tax burden.
Does the Administration's plan in fact reduce the average tax
burden, or does it hold it pretty much the same?




195

Dr. WEIDENBAUM. The enactment of our program would reduce
the tax burden on the average family.
Senator HEINZ. So it goes a little bit beyond?
Dr. WEIDENBAUM. Yes, sir. However, that still would be above
the average tax burden of, say, 5 or 10 years ago.
Senator HEINZ. Very well. Thank you very much.
Dr. WEIDENBAUM. Thank you, Senator.
Senator SCHMITT. Mr. Weidenbaum, that's the direct tax burden?
I mean, there is nothing yet to really envision to reduce the indirect tax burden that comes with things like windfall profits taxes
and other things that are passed on to the taxpayer as a consumer?
Dr. WEIDENBAUM. That is right, Senator.
Senator SCHMITT. So the net tax burden is still increasing quite
rapidly over the foreseeable future?
Dr. WEIDENBAUM. I'm afraid you are right, which indicates the
need for future attention to the tax system, which is why the
administration and the President specifically, has talked about
developing a second round of tax proposals.
Senator SCHMITT. Does the rapid increase in the popularity of the
money market mutual funds, which I think in a year or two has
jumped from about $11 billion to $95 billion, represent purely a
transfer of existing investments? Or is this a net increase in savings?
Dr. WEIDENBAUM. I frankly have not done a study of that. To my
knowledge, the typical investment, the typical saver, the typical
investment in money market mutual funds is similar to competitive thrift institutions, as far as I understand the arrangement.
I would suggest, however, that the inflation and the high interest
rates that we are now experiencing are a major factor in the shift
toward money market mutual funds, and I wouldn't be surprised in
a regime of lower interest rates to see another rearrangement of
savings patterns.
Senator SCHMITT. Well, I think you are right, but in the meantime the normal or traditional thrift institutions are having some
difficulty, are they not, dealing with this shift from their resources
from their deposits to these funds?
Dr. WEIDENBAUM. Yes, we are aware of and are very closely
monitoring developments in the thrift institutions.
Senator SCHMITT. There is also a tendency for those money
market funds to move out of the more rural States, from the thrift
institutions in the smaller population States into centralized banking areas, such as New York, Chicago, et cetera.
Dr. WEIDENBAUM. I really have not made such a study, Senator.
Senator SCHMITT. I hope you will look at that. Although it may
seem like a detail, it is not a detail to thrift institutions in Albuquerque, N. Mex., or elsewhere that see their deposits moving into
these other areas.
Dr. WEIDENBAUM. Having moved here from the Midwest, I am
mindful that not all of the wisdom of this Nation is in the Northeast nor necessarily should all of the financial resources be there.
Senator SCHMITT. Some of the big institutions are on the West
Coast, too, so we won't discriminate.




196
OPERATING LOANS DIFFICULT TO OBTAIN

And finally with respect to interest rates, we really are seeing,
not only in construction where most of the publicity has been, but
in agriculture and other businesses that require operating loans in
order to conduct their year's business. We are seeing the extraordinary difficulty these small and medium size businessmen and farmers are having to obtain operating capital for this year.
Has the administration begun to focus on this? This is something
that is going to happen this year, and I don't think even your
economic plan or anybody's economic plan can prevent extraordinary difficulty in certain parts of the country?
Dr. WEIDENBAUM. The Federal Government continues to maintain a variety of financial institutions in the farm sector under the
auspices of both the Department of Agriculture and, of course, the
whole galaxy of credit agencies under the Farm Credit Administration, off budget as well as on budget.
Senator SCHMITT. I will tell you those loan mechanisms are not
working nearly as well or, in some places apparently, adequately
for this year's crop. They are not working as well as business
attempting to provide operating capital for agriculture. And other
businesses are having trouble getting to it because of those interest
rates or just because the money is not there.
Dr. WEIDENBAUM. Very frankly, in my analysis of various Government credit programs and their effects, I have described them,
maybe too tersely, as robbing Peter to pay Paul and that the real
answer is to increase the pool of savings available to the private
sector. And there is no substitute for that. And here Government
directly can't do much to help. It can do a great deal and does a
great deal to hinder.
Senator SCHMITT. It can help by getting out of the marketplace
as fast as possible. Senator Proximire I think, though, brought us
down to Earth when he, as I agree, said that even with all your
Herculean efforts and maybe more that will be required it is going
to be tough to get that Federal deficit much lower than it is this
year and the same pressures are going to exist. Maybe we can
reduce off-budget borrowing. We always should talk about deficit
and off-budget borrowing. That is the competition that the private
sector has from the Federal Government and it has been over $100
billion for several years.
Dr. WEIDENBAUM. I should urge the Congress to consider very
carefully the proliferation and overly rapid expansion of off-budget
borrowing which has occurred much faster than on-budget credit
programs. These have literally, through the Federal Financing
Bank, become a form of back-door financing. However, I think we
certainly are moving in right direction in our own recommendations to reduce the use of the Federal Financing Bank.
Senator SCHMITT. Thank you, Mr. Chairman,
The CHAIRMAN. Dr. Weidenbaum, we appreciate your testimony
today. Thank you very much.
Dr. WEIDENBAUM. Thank you, Mr. Chairman and Senator
Schmitt.
The CHAIRMAN. Now I would like to call to the table Dr. Jerry
Jordan and Dr. David Jones.
We appreciate your patience, gentlemen.




197

Senator SCHMITT. Mr. Chairman, would you yield just for a
moment? I would like to welcome Dr. Jordan from my almost
hometown of Albuquerque. He is relatively new in the Albuquerque area. We are certainly excited about having him at the Anderson Schools of Management, one of the fastest growing, at least in
terms of reputation, economic and research institutions in the
country. We are excited about its future and we are particulary
excited about having Dr. Jordan there to help lead us on.
Welcome to the committee, Doctor, and that is not to any way
say that Dr. Jones isn't appreciated also.
The CHAIRMAN. We are happy to have both of you with us. And
we took longer with Dr. Weidenbaum than I anticipated, and we
would appreciate it if you could summarize your statements, and
your entire written statements will be included in the record. Then
we would be able to get to questions more rapidly.
Dr. Jordan, would you like to begin?
STATEMENT OF JERRY L. JORDAN, DEAN, ROBERT O. ANDERSON SCHOOLS OF MANAGEMENT, UNIVERSITY OF NEW
MEXICO

Dr. JORDAN. Thank you very much, Mr, Chairman and Senator
Schmitt. I appreciate this opportunity and I will summarize the
main points of my statement.
Chairman Volcker's statement in October 1979 that there would
be significant changes in the Federal Reserve's approach to monetary policy gave us a lot of reason to believe that the results would
have been better than they actually have been. The difficulties of
implementing gradual reduction in monetary growth down to a
noninflationary rate are not quite as great as the experience of last
year might suggest.
I think that a slow, noninflationary monetary growth is a necessary underlying condition to achieve the other objectives of our
economic policies. It is not going to be sufficient to solve all of our
problems, but it can be done. It not as technically difficult as some
have suggested.
Recent news reports have emphasized the disparity between the
economic forecasts of the economy for the next 4 years. I think this
attention to rival forecasts is all out of proportion to the importance of such exercises. Whether the administration, or the Federal
Reserve Board, or Congress forecasts are more accurate for this
year and for next year and beyond is of much less importance than
the public's confidence that any of the economic policymakers have
the knowledge to deal with the problems.
FED'S REPUTATION DAMAGED

The Fed's reputation as an effective inflation fighting institution
has been so adversely damaged by events of the last decade or so
that I doubt that their views on the economy and the appropriate
policies to deal with the present circumstances carry very much
weight with the public. But restoring the public's confidence in our
central bank is essential if the other policies proposed by the
administration and those eventually enacted by Congress are to be
successful.




198

Last year the growth of the money supply fluctuated over such
an extremely wide range that it is hard to have confidence that the
net outcome for the year was more than merely accidentally close
to the Fed's intentions. Reactions to the new target growth ranges
for 1981 are bound to be met by considerable skepticism. That is
not a very healthy situation.
The variance of the growth rate of the money supply around its
underlying trend becomes important when the deviations exceed
periods of three or four months or longer. The recent past pattern
consistently has been one in which sharp accelerations in monetary
growth, or decelerations, for a few months have been followed by
sharp reversals. There is a risk that a sharp deceleration in monetary growth early in 1981 will foster expectations of an offsetting
sharp reacceleration later this year. That development would be
very damaging to any potential for an anti-inflationary program to
be successful.
It would be wrong to say that restrictive monetary policies this
year must cause a recession in order to effectively reduce inflation.
But we should expect that a contraction in economic activity is
likely to occur. The depth and the duration of any recession that
does occur will be more a function of the credibility of the Government's commitment to reduce inflation and the expeditious implementation of whatever fiscal policies Congress agrees to than it
will be other forces.
If it were universally believed that the Fed would have the
support of the legislative and the executive branches of Government for as long as necessary to achieve price stability, then I
think that the real economic cost of eliminating inflation would be
minimal. Other countries have done so. But if individuals in their
roles as consumers, workers, labor leaders, business leaders and
Government officials do not believe that we have the national will
to persevere until inflation is eliminated, and if they continue to
base their economic decisions on the assumption that inflation in
the early 1980's will come close to matching, if not exceeding, the
inflation in the late 1970's, then the real economic costs and the
dislocations associated with strongly anti-inflationary policies will
be considerable,
The highly expansionary growth rates of money during the
spring and summer of 1979 gave way to a marked reduction in
monetary growth in the winter and spring of 1980. Then the sharp
decline of M-1B, a narrow measure of the money supply, occurred
in the second quarter of last year when credit controls were put in
effect.
Monetary growth in the second half of 1980 was excessively
expansionary. No matter how you look at it, there is simply no
excuse for the Federal Reserve having permitted such an explosion
in growth of bank reserves and the money supply in such a highly
inflationary environment.
ERRATIC MONETARY GROWTH

It is important to analyze why monetary growth was so erratic
last year in order to guard against a repeat occurrence this year or
later.




199

After Chairman Volcker's very dramatic Saturday evening announcements in October 1979, monetary growth decelerated to a
significantly less inflationary pattern. For a while it appeared that
the Fed's deemphasis of control over daily interest rate fluctuations, and the increased emphasis on growth of bank reserves,
would produce a steadier and less inflationary growth of money.
But the imposition of credit controls in March of last year severed
access to the credit markets for many individuals and businesses
and caused the sharpest decline in real final sales and real output
in recent decades.
Interest rates declined mainly because the demand for real goods
and services was declining. Interest rates were being pulled down
by a contracting economy in an environment of credit controls. But
the Fed was reluctant to let interest rates decline as rapidly as
market forces would indicate. So open market operations provided
for only a very small growth of bank reserves and the money
supply contracted sharply. It is important to understand the policy
actions actually became more restrictive while interest rates were
declining.
The credit controls were removed in early summer and the economy began to bounce back from the artificially depressed level of
the spring quarter. The increase in real economic activity implied
an increase in credit demands to finance this greater activity.
Naturally, short-term interest rates began to rise from the sharply
lower levels that they had fallen to during the period of controls.
But since it was at that time generally accepted that the economy
was in a recession, and most forecasts suggested that the recession
would continue through most of the second half of the year, the
Fed was reluctant to allow interest rates to rise for fear that it
would prolong or possibly deepen the recession.
The initial rebound of economic activity was accompanied by a
large injection of reserves into the banking system in an attempt to
moderate the tendency for interest rates to be pulled up by the
strengthening credit demands. The extremely rapid acceleration in
monetary growth that ensued caused many observers to believe
that the Fed had prematurely abandoned its anti-inflationary policies and that renewed expansion was being stimulated before any
lasting progress had been made.
The rapid increases in bank reserve and money growth raised
concerns about continued high inflation, and that put further
upward pressure on market interest rates, and that caused the Fed
to inject more reserves. Ultimately the monetary actions became
highly expansionary for a full half-year, even though interest rates
were rising and there were complaints about the price of credit.
The rising interest rates were an indication of a strengthening
economy and rising credit demands and should not be interpreted
as the result of a restrictive or tight money policy.
The second half acceleration of monetary growth did stimulate
economic activity that is lasting into early 1981. However, it also
has resulted in intensified inflationary pressures and in higher
interest rates.
Chairman Volcker reemphasized the importance of a sustained
deceleration of monetary growth to a noninflationary level and the
target ranges for 1981 represent a slight further reduction com-




200

pared to the ranges for last year. But it should be recognized that
the mistake that the Fed made in the second half of last year by
permitting extremely high growth rates to occur will create problems now in 1981. During the second half of the year M-1B grew at
a 12.8 percent annual rate, over double the upper limit of the Fed's
range for 1981.
The achievement of a 6 percent or lower growth of M-1B this
year will represent a significant deceleration of monetary growth
compared to the second half of last year. After somewhat of a lag
that deceleration in monetary growth can be expected to have a
retarding effect on total spending in GNP this year. The growth of
M-1B at the upper limit of the Fed's 3.5 to 6 percent range for the
four quarters of 1981 would be consistent with total spending
(GNP) growth of about 9 or 10 percent. That would compare with
last year's 9.8 percent.
If inflation in 1981 is about the same as it was in 1980 that will
mean we will have another year of no growth of real output. But I
am more optimistic about inflation this year than most people are,
and I believe that the deflator will rise by 1 or 2 percentage points
less this year than it did last year.
RECOMMENDATION

My recommendation for 1981 is that the monetary base grow no
more than 7 percent at an absolute maximum. I would prefer
around 6 percent as a centerpoint target for the monetary base.
That would be consistent with the growth of M-1B below the upper
limit of the Fed's target, and it would take us more rapidly toward
a noninflationary growth path.
If I am correct that inflation and interest rates do decline this
year, it is important that declining interest rates not be misinterpreted. If it is taken as a sign that the Federal Reserve is shifting
to a less restrictive stance or that the anti-inflationary policies are
once again being abandoned in favor of antirecessionary policies
because unemployment is going to be rising, the dollar would
weaken on foreign exchange markets and domestic credit demands
would start to increase rapidly again.
Also, following the economic contraction that we are likely to
experience this year, there would be an interim short-run tendency
for market interest rates to be pulled up by strengthening credit
demands in a recovering economy. At that time it will be a mistake
to once again misinterpret rising interest rates as being an indication of a more restrictive policy. The point is that market interest
rates have to be allowed to be pulled down and then be pulled back
up again by real economic forces and not be resisted by the Federal
Reserve or misinterpreted by the rest of us.
I am optimistic that the rates of inflation and levels of interest
rates we experienced in 1980 are going to turn out to be a secular
peak as well as a cyclical peak.
Congress should make it clear to the Fed that they expect monetary growth to remain within the announced target ranges. If
present implementation procedures are not adequate, the Fed
should make those changes that are necessary to insure that the
announced target ranges are reliable guides to the actual growth
that can be expected by the private sector.




201
The performance of the economy in 1981 is now going to be
adversely affected by what the Fed did last year. In turn, the
performance of the economy in 1982 will be strongly influenced by
the implementation of monetary policy this year.
Thank you.
The CHAIRMAN. Thank you very much.
[The complete statement follows:]

BEFORE THE
COMMITTEE ON" BANKING, HOUSING AND URBAN AFFAIRS
UNITED STATES SENATE
March 4, 1981

Mr. Chairman and Members of the Committee.
1 am pleased to have this opportunity to present my views on the economic
outlook and monetary policy.

In the six years of Congressional oversight hearings

since Concurrent Resolution 133 was first passed, the quality of discussion concerning the issues involved in the Conduct of monetary policy has been improved
considerably.

Understanding of the problems of formulation and implementation

of monetary policy has been improved, and I am hopeful that in the future ths;
execution also will improve.
The announcement by Chairman Volckcr in October 1979 of significant changes
in the Federal Reserve's approach to monetary policy gave us reason to expect
thai- subsequent results would have been better than has been the cast? since then.
The difficulties of irplement ins a gradual reduction of the trend rate of monetary
growth, as announced by Chair-pan Volcker almost 18 months ago, are not as great
as the experience of 19BO night suggest.

I do not believe a slow and relatively

steady growth of the aoney supply would be technically difficult to achieve.

I

also do not believe tluit sach a monetary policy is sufficient to solve all of our
national economic problems.

But I do believe that it is a necessary underlying

condition that must be net in order for other economic policies to have a chance
of working in the way they arc- intended.




202
Decent news reports have emphasized the disparity among various forecasts
o~ the economy for Che next few years.

This attention to rival forecasts seems

to Toe to be out of proportion to the importance of such exercises.

Whether the

Administration, the federal Reserve or the Congress has the most accurate forecast for this year and beyond is of much less importance than the public's confidence level that any or all of out nation.il economic policymakers have the knowledge and the will to deal with our problems.
The Federal Reserve's reputation as an effective inflation fighting institution
has been so severely dajtaged by events of the past decade that I doubt that their
views on the economy and the appropriate policies for che circumstances carry ouch
•-•eight with the. public.

Yet restoring the public's confidence in our central

b~-,k is essential if the other policies proposed by the Administration and those
ulti.-ate.ly enacted by Congress are to be successful.
The federal Reserve is a creation of Congress, and it is appropriate that
the legislative branch of government monitor the policy actions of the central
b=nk.

These hearings provide a useful forum for debating, and attempting to recon-

cile, the longer-run impact of monetary and fiscal policies on inflation, employment
and real growth.

Clearly stated anil consistent objectives for the price level,

capital formation, productivity improvement, and real tax burdens would be a
-ajor contribution to the functioning of the nation's financial markets and to
the performance of the dollar in foreign exchange markets.
The requirement that the Federal Reserve announce monetary growth targets is
potentially an important contribution to the objective of promoting economic stability, but only if the targets can be relied upon.

Decisicnmakers in ttie private

sector, both management and labor leaders, would find it valuable to know in
advance the rate of inflation that will be tolerated by the monetary authorities.
ihe credibility of the central bank's stated intentions is the key to the success
of monetary policies in Germany, Switzerland, and other countries that also announce
—or-e.ta.rv growth targets.




203
_=.st year the growth of the money supply fluctuated over such an extremely
uiic- raagy that it is hard to have confidence that the imi. outcome for the year
**£s ncra tnaii merely accidently close to Che Fe.d's intentions.

Reactions to new

target growth ranges for 1931 are bound to be met hy considerable skepticism.
That is act a healthy situation.

At this time it is less important which measure

of cor.etary growth the Fed choses to emphasize than it is that they demonstrate a
nucri greater degree of success of staying within an announced

target range.

The

variar.ee of the growth rate around an underlying trend becomes important for
periods of three to four months or longer, and at the present time I would be
willing to accept a somewhat higher average growth of a given measure of monetary
growth if a steadier growth path could be assured.
trade-offs are necessary.

But, I do not believe such

The question of the appropriate rate of growth of

-cney =r any time is a question of what rate the public is willing to believe
will as sustained.

The recent past pattern consistently has been one in which

sharp Accelerations and decelerations of monetary .growth for a few oonths have
baeri zallo'ved by sharp reversals, there is a risk that a sharp deceleration of
Mnetsry growth in early 198L would foster expectations of an offsetting sharp
reacceleration later.

That development would be very damaging to the poteiitial.

fer the Administration1s prograa to be successful.
As understanding of thy role of expectations about the future and thfe highly
variable lags between policy actions and results is necessary to interpret econcziic developments this year.

It would be wrong to say that restrictive monetary

pcli~i=s LOIS year oust cause? a recession in order to effectively reduce inflation.
Huvfever, ve should expect that a contraction of economic activity is likely to
u;c--:r so-atico this year.

The depth and duration of any recession that does

occ-ir vill be a function of both the credibility of the government's commitment
to TiL-d'Jce inflation and the expeditious implementation of whatever fiscal actions
Con"r;-s5 agrees to.




204
The central issue is no longer the relative importance of monetary versus
fiscal policies nor noney supply versus interest rates as it was in the past.
Sow Che central issue is consistency and credibility.

Declarations of a renewed

commitment to coabat inflation were made with such increasing frequency during
the past fifteen years, only to be abandoned before lasting progress waa made,
it should be expected that for some time the public will remain skeptical about
the durability of policies implemented this year.

The ultimate total cost to

the economy in terms of lost output and reduced erapj-uyroient of an effective antiinflationary set of policies will depend on ho« rapidly the public begins to
believe that this time the policymakers will persevere.
If it were universally believed that the Federal Reserve would have the
total support of the legislative and the executive branches of government for
as long as necessary to achieve price stability, then the cost of a successful
policy to eliminate inflation would be minimal.

However, if individuals in their

roles as consumers, workers, labor leaders, business leaders, and government
officials do not believe that we have the national will to persevere until inflation is eliminated, and if they base their economic decisions on the assumption
that: inflation iri the early 1980's will be at least as high as in the late 1970's,
then the real economic costs and the dislocations associated with strongly antiinflationary policies could be considerable.
Restoring credibility about, the commitment to persevere against inflation will
not be easy.

Participants in financial markets suffered large losses in recent

years when they prematurely anticipated a downturn of inflation and interest
rates;.

Consumers and honebuyers have been conditioned to believe that there is no

benefit to delaying purchases based on the expectation of relative price stability.
The psychology of "buy now before prices rise further" IK deeply entrenched.

Workers

have watched averse consumer goods prices rise more rapidly than wages on average




205
in recent y e a r s and v i l l n o t be easily convinced that t h e i r compensation for
accepting smaller wage Increases now vill come in the. fora of smaller price
increases in the f u t u r e .

M a j o r c o r p o r a t i o n s have been willing to borrow long-

ter:r. even at the highest interest rates in history In the belief t h a t high
i n f l a t i o n will c o n t i n u e a-a t h e y will repay their debts with, greatly Jepteciated dollars.
s u c c e s s f u l , all

If a policy of permanently reducing inflation is going to be
those a t t i t u d e s must be changed.

The skeptics a r g u e t h a t monetary policies will become highly stimulative
once again as soon as re.a.1 output declines and th'e unemployment rate begins to
ride r a p i d l y .

These pessimists about Li. S. i n f l a t i o n f i n a l l y must be- proven

w r o n g , or our standsrcs-of-liviilg will continue to stagnate i n d e f i n i t e l y .

I

v i l l not repeat all of the arguments as to why r e d u c t i o n of the trend rate of
inflation is e s s e n t i a l .

However, I am convinced it

is necessary b e f o r e ue can:

r e s t o r e tin1- soundness of lae financial system; achieve once again higher rates
of saving, invo&tr-ent ar.d p r o d u c t i v i t y ; stabilize our currency in foreign
exchange m a r k e t s ; and c r e a t e an environment where high rates of employment can
be sustained.
Ttiere snould be -3 c o n t r o v e r s y over wtiether reducing i n f l a t i o n
cost.

The n o t i o n of £ st = '_>le i n f l a t i o n rate is an illusion-

is worth the

Either monetary

and f i s c a l policies are Beared towards reducing the long-run trend rate of
i n f l a t i o n , or the avore=;e r a r e of i n f l a t i o n can be expected to c o n t i n u e r a t c h e t i n g
upwards.

1 d o n ' t see how t h e r e can be any question about the h a r m f u l e f f e c t s of

the s e c u l a r rise o f i:iLLc,cion since tVie early W o O ' s , and I d o n ' t sec how there
c _ n be any doubt about t h e b e n e f i t s t h a t would come f r o m eliminating I n f l a t i o n
in t h e 19SO's.




206
Monetary ?i_licy Actions in 193Q
Monetary growth in 1930 was highly erratic and expansionary on balance.
Growth rates foe the monetary base and MTU on a quarter-to-quarter basis for
the past two years were as follows:

Monetary
Base

1979/Q1
Q2
Q3
Qi

1980/Q1
Q2

03
Q4

6-85;
7.3
9.8
9.3
6.0
5.6
11.1
10.5

MIB

4.92
10.8

9.9
5.0
6.1

-2.3
14.2
11.3

The highly expansionary growth rates of the spring and summer of

1979

gave way to a narked reduction in monetary growth in the winter and spring of
1980.

The sharp decline in .MIB in the second quarter of last year occurred at

the time the credit controls were in effect.

At that time, concern was expressed

by some observers that isonetairy policy was becoming excessively restrictive, even
though interest rates were also declining rapidly.
Monetary growth in the second half of 1980 was excessively
matter how you look at it.

expansionary no

There is simply no excuse for the Federal Reserve

having permitted such an explosion of growth of bank reserves and money in this
highly inflationary environment.

I believe it is important to analyze why monetary

growth «s so erratic in 1980 in order to guard against a repeat occurrence in the
future.
Follswinr. the dramatic Saturday evening announcements by Chairman Volcker on
October 6, 1979, monetary growth decelerated to a significantly less inflationary
growtli pEt'i.

For a whili? it appeared that the Fed's de-emphasis of control over

daily interest rate- fluctuations and increased emphasis on growth of bank reserves
would produce a scriadier and less inflationary growth of money.




207
I n t e r e s t rates rose to unprecedented levels in the F i r s t fetf months of
last year as a result of sever.-il f o r c e s — h e i g h t e n e d u n c e r t a i n t y following the
I r a n i a n seizure of our Embassy and the Soviet invasion of A f g a n i s t a n ; concern
in t h e credit and c a p i t a l m a r k e t s over the implications of the continuing large
f e d e r a l borrowing requirements, especially in view of the necessity for increased
~ilitary spending; a n d , the s h a r p , short-run, upward p r e s s u r e on the race of
i n f l a t i o n f o l l o w i n g the latest round of large world oil price increases.
The i m p o s i t i o n of c r e d i t controls Last March was too strong of an action
taken r.uch too Late.

The. controls severed access to the credit markets for many

individuals and businesses and caused the sharpest single q u a r t e r decline in real
f i n a l sales in r e c e n t d e c a d e s .

I n t e r e s t rates declined because, the demand for

real goc>c!s. and service? was declining.

The interest rates were being pulled

C_O-T\ t>y a contracting economy in iin environment of credit controls.

However,

the

F e d e r a l Reserve vas r e l u c t a n t to allow interest rates to decline as rapidly as
-.srket f o r c e s were i n d i c a t i n g .

Consequently, open n\aTket i-jperations provided

for only a very saaLl growth of bank reserves and the money supply declined sharply.
It

is i n p o r t a n t to u n d e r s t a n d t h a t policy actions actually become more restrictive

as i n t e r e s t r a t e s d e c l i n e d .
The c r e d i t c o n t r o l s were removed in e a f l y sunwier and the economy began to
louace. back ftc"a the artificially depressed level of the spring quarter. The
i-creast in re^l economic a c t i v i t y — a s i n d i c a t e d by the rise in retail sales,
housing s t a r t s , i n d u s t r i a l p r o d u c t i o n , and other measures.— ijnplied an increase in
c r e d i t d e m a n d s to finance; f.ceatev activity.

N a t u r a l l y , short-terra market i n t e r e s t

r ^ l t s also began to rise f r u n the s h a r p l y lower levels they had f a l l e n to w h i l e
th;- cfiiLrols verc i :i e f f e c t .

However, since it was generally accepted t h a t t-he

e c o n o m y i.-as i:i a r e c e s s i o n , arid raost f o r e c a s t s suggested the recession would contiiiue; t h r o u g h ~ y s t of the second half o£ the ycsr, the F e d e r a l Reserve was reluct a n t to allo-- iiiLfc-rest r a t e s to rise for f e a r t h a t it would p r o l o n g or possibly




208
deepen the recession.

As a result, the initial rebound of economic activity

was accompanied by a large injection of additional reserves into the banking
system as open market operations ws>re geared to moderating the tendency for
interest rates to be pulled up by strengthening credit demands.

The extremely

rapid accelerations of monetary growth that ensued caused many observers to
believe that ths Federal Reserve had jireioaturely abandoned its anti-inflationary
policies, and that renewed expansion was being stimulated before any lasting
progress ag&inst inflation had been made.
The process became one that fed on itself for several months.

Rapid in-

creases in bank reserve and money growth raised concerns about continued high
Inflation; that put further upward pressure on market interest rates which, in
turn, caused the Fed Co inject more reserves through open market operations.

In

Ey view, monetary policy actions became highly expansionary in the second half
of the year, even though Interest; races were rising arid there were coraplaints
about the price of credit.

The rising interest rates were an indication of a

strengthening economy and rising credit demands and. should not be interpreted
as the result of restrictive or "tight" monetary policies.

The latest available data indicate that the growth of a narrow measure
of the money supply (M1B) was down slightly in the four quarters ending In
Q-W1930 compared vith the prior year.

The growth of the monetary base at the

end of the year was the same as the prior year.

The growth rates at the end of

each year cc~per^d with the prior year end for the past three years was as
follovs:




8.2
7.6
7.]
3.3-6

209
As noted earlier, the growth rates (if tlierc measures were down sharply in
t h e f i r s t half of 19SO, then up sharply in the second half of the year.

The

second-half acceleration of n a n e t a r y growth stimulated a renewed expansion t>£
econonic a c t i v i t y t h a t has i.:on t i n n e d into early 1981.

However, it

also resulted

in intensified iaflationary pressures and h i g h e r i n t e r e s t rates.
Chairman Volcker has re-enphasised the importance of a sustained deceleration
of eonetary growth to a non-inflationary le^el, and the target rangey for

1981

represent a slight f u r t h e r r e d u c t i o n compared with the ranges for l a s t year.
it

should be rsco^nized

But,

t h a t the cistake tUe Federal Reserve made in the second half

of last year by p e m i t L i n g extremely high growth rates to yccur will create proble:-.3 in 5981.

D u r i n g the t h i r d and f o u r t h quarters of 19SO, M1B grew at a 12.8

p e r c e n t annual r a t e , which is over double the upper limit of the range announced
for 1981.

The a c h i e v e m e n t of a 6 percent or lower growth of money this year will

represent a s i g n i f i c a n t d e c e l e r a t i o n of monetary growth compared with the second
h a l f of last yesr.

A f t e r snne;-tiat of a lag,

that deceleration of monetary growth

can be expected to have a r e t a r d i n g e f f e c t on total spending (GNP) growth of the
economy.
Growth of Ml3 at about the upper limit of the Feii's 3.5 to & percent target
range for ti-.e tout quarters of 1981 would be consistent with t o t a l spending
growth of about 9 to 10 p e r c e n t , which would compare with the 9.8 percent increase
in 1980.

If i n f l a t i o n in 19S1 wece to continue at about the same r a t e ,-is in 1980,

•*•£ would have another year of no g r o w t h in real o u t p u t .

However, I am more opti-

m i s t i c shout i n f l a t i o n this year t h a n roost, and believe the i m p l i c i t p r i c e deltator vtll risp by I to 2 percentage poirtts le&s; in 1981 than in 1980.
My TC'co:v-'.".&nriEsi.ion for

19S1 would be for a growth of the m o n e t a r y base of no

r.ore than 1 p e i r c e ^ t a t t h e a b s o l u t e maxinun, and a c e n t e r - p o i n t tacp.et of 6 percent
v c u l d be n r e f e r r e r .




i h a t voulc be consistent with a growth of tllB below t h e u p i > e r

210
l i m i t of the Fed s announceC target range, and would cake us more rapidly
towards a n o n - i n f l a t i o n a r y Kor.etary growth,

£ro_s£ec rs foe Reducing In f l a t ion
I an not as convinced s» others apparently are about tile intractability
of recent rates of i n f l a t i o n .

There is a tendency to forget how rapidly i n f l a -

tion has declined in earlier periods in Che country and in other countries whtm
the detcmination or the government was unmistakable.

Ln 1974, the prices rose

on average by 12 p e r c e n t in t:iia c o u n t r y , but by 1976 the rate of Inflation
was under 5 p e r c e n t .

A 50 p e r c e n t r e d u c t i o n in the rate of inflation within a

two-year p e r i o d is a t t a i n a b l e , and should be t h e u n d e r l y i n g objective of monetary policy.

T a r g e t growth rstes of monty supply should not be at all

by a n y o n e ' s forecast oE real o u t p u t .

influenced

The approach to monetary policy 1 would

recommend would be to set a t a r g e t for i n f l a t i o n for the middle of the decade,
then derive a m o n e t a r y gro-.rth p a t h that would be consistent w i t h t h a t objective
and s t i c k to

it.

As p e o p l e begin to r e v i s e downwards their expectations about f u t u r e inflation, i n t e r e s t rat^.s would begin a sustained d e c l i n e .

How rapidly interest rates

decline is Lsore d e p e n d e n t on the p u b l i c ' s convictions about an anti-inflationary
policy h e t i i ^ sue ti5im j d .ben any other v a r i a b l e .

1 happen to be personally opti-

m i s t i c t h a t i n t e r e s t r a t e s -"ill tlecline significantly this year and next, but
at t h i s p o i n t I v:cj.jld not a d v i s e anyone to place a very large bet that that will
be the. case.

If investors act on the expectation tliaC interest: rates uill decline

bat t h t y go u p , Isrgc I O S S ^ T will be i n c u r r e d .

H o w e v e r , if

interest r a t e s to re^t-in h i g h , but then d e c l i n e , then it
gone o p p o r t u n i t i e s to r.&kc c a p i t a l gains.
difficult

investors expect

is only a m a t t e r of fore-

I t is this asymetry Chat makes it

t h e i r p o r t f o l i o s <-n tiii? fl-isii'-stion of a s u s t a i n e d decline of i n f l a t i o n and
interest rates.




so

LO Lor.vivK-i.- f i n a n c i a l narkejt p a r t i c i p a n t s that they should r e s t r u c t u r e

211
If I a\a correct aud inilition and interest rates do begin to decline later
this year, it is important that declining interest rates not be misinterpreted.
If it is taken as a sign chat the Federal Reserve is shifting to a Less restrictive stance, or that anti-inflationary policies are once again being abandoned
in favor of anti-recession=ry policies, the dollar would weaken on foreign exchange
markets and domestic credit denands would start to increase rapidly again.
Similarly, following the economic contraction that is likely to occur this
year, there will be an interim short-run tendency for market interest rates to be
pallet! up by strengthening credit demands in a recovering economy.

It would be

a mistake Co once again QisiTiterpret rising interest rates in that circumstance
as being an indication of E. more restrictive policy.

The point is that market

interest rates must be alloved to be pulled down and then up again by real economic
forces, and not be resisted by the policymakers nor misinterpreted by the rest of
us.

In conclusion, I an optimistic that the rates of inflation and Jevcls of
interest rates we experienced in 1980 will turn out to be secular peaks as well
as cyclical peaks.

Congress should make it clear to the Federal Reserve that

they expect monetary growth :o remain within the announced target ranges.

If

present implementation procedures are noc adequate, the Fed should moke those
changes ne.cessary to insure that announced target ranges arc reliable guides to
the actual money growth that can be expected.

The performance oE the fconomy in

1981 will be adversely affected by what happened in 1980.

In turn, the perfor-

mance of the economy in 1932 will be influenced by the implementatioLi of monetary policy actions this year.




212

The CHAIRMAN. Dr. Jones?
STATEMENT OF DAVID M. JONES, VICE PRESIDENTECONOMIST, AUBREV LANSTON CO.

Dr. JONES. Mr. Chairman, I will depart from the text and I will
summarize, if it's all right with you, my essential points.
I want to bring to this committee the view, today, that we are at
a critical and urgent juncture in Government policy. We may be
starting to turn the corner against inflation psychology; but we
desperately need the help of the Congress.
Fed policy is on the right track, and the objectives of the Federal
Reserve are laudable, in attempting to lower money supply growth,
year by year, with a view toward reducing inflation.
The administration is on the right track, in one of the most
major budget cuts we've seen in the past 50 years.
But Fed control over the money supply is limited, as I will talk
about in a moment. Accordingly, it is difficult for the Fed to assure
Congress that it will hit the stated target for the aggregates.
FLAW IN ADMINISTRATION'S BUDGET PROGRAM
Second, there is an inherent flaw in the administration's budget
program. The administration says: "We want budget-breaking tax
cuts, together with large spending cuts," at a time when inflation
is already too high, and financial strains are already too great. We
cannot have our cake and eat it too.
We must face the fact that spending cuts come first, and tax cuts
should come only later, if we want our financial markets to get out
of the mess they are in in 1981, in one piece.
Here, I think Congress can play an absolutely critical role. What
I would like to see is Congress enlarge upon the spending cuts of
the administration, not reduce them, so that the psychological
picture can be improved. I call it the "psychological threshold."
It looks as though, judging things from the bond market, that
threshold is a $50 billion spending cut in fiscal 1982. The administration is toying with that level. We don't have an exact number.
The last official one I saw was $41.4 billion. Presumably, modifications are coming.
What I would like to see Congress do—for psychological impact,
more than anything else—is to top the Reagan administration in
their determination to cut spending in a way that will result in
lower inflation levels.
Second, in terms of Congress role here, I would like to see the
tax cuts postponed. I would like to see the business tax cuts deferred to January 1982; and I would like to see the individual tax
cuts—which, contrary to supply-side thinking, I think are potentially very inflationary—delayed to July 1982.
Finally, on the tax matter, I would like to see the business sector
receive not 20 percent of the total net tax cut in 1982 fiscal year;
but 50 percent.
So, I think, at this juncture, the ball is in the court of Congress.
The administration and the Fed, for the first time in recent
memory, are moving together in a way that can change inflation
psychology.




213

But they can't make it without Congress taking the initiative,
improving upon an already good program offered by the administration; but adjusting the timing in a critical way, to reduce: No. 1,
Treasury borrowing in the markets, which is becoming critical at
this time; and No. 2, to reduce inflation psychology.
PROBLEMS WITH REDUCING THE MONEY SUPPLY GROWTH

Allow me, if I might, to enlarge a bit on the Federal Reserve's
problem.
It is well and good—and I certainly agree with Jerry and the
tone of this committee—that the Fed should be charged with reducing the money supply growth each year.
But there are three essential problems:
The state of the art of monetary control is simply not adequate
to assure that those annual targets can be met. It was a matter of
luck, more than anything else last year, that we even came close.
And, as was so well pointed out by the committee, we exceeded the
target levels.
What is the problem? In 1979, which is the most recent year for
which we have official evidence, the Fed's miss in estimating reserves for the next week, which should be a relatively easy task,
was $840 million on average, per week.
It is difficult, in view of the unpredictability of changes in float
and other factors affecting reserves, for the Fed even to get a fix on
next week's reserves, in hopes of achieving monetary control; let
alone next month's reserve changes. The actual change in total
reserves, week by week, in 1979 was only $360 million. So, the
mistake the Fed made in estimating reserves for the next week—
which is absolutely critical for any kind of tight money control
program—totally swamped the actual dollar change in total reserves.
The problem is that these factors are not under Fed control.
A second factor: There are extremely wide fluctuations in the
linkage between reserves and money; in part, because of volatility
and large CD's, which are a financial instruments—not money—
but against which banks must hold reserves.
Second—and perhaps we can find out the reasons from Utah
bankers, or others—there was a tendency earlier this year for bank
demand for excess reserves—mostly smaller banks apparently—to
surge upward; perhaps out of concern over NOW accounts or concern over new reporting under the Monetary Control Act.
In January, reserves were at three times normal levels—nearly
$700 million. That is high-powered money. When banks demand
excess reserves, those reserves don^t go into raising the money
supply.
So, the volatility is difficult to predict. It could be getting worse,
rather than better, in the linkage between reserves and money.
And, finally, the linkage between the money supply and the
economy, which we're trying to hit, is extremely volatile. Velocity,
in essence, is what we're talking about here.
And, in that respect,^ would recommend an excellent article
which appeared in the February 1981 Morgan Guaranty Monthly Survey—if I could have it put in the record—suggesting
i that velocity, even of M-2, which is a broader monetary measi ure, is sojyolatile as^to make it difficult to be sure how a given
target ofInoney growtlFwTII, in lact, relate to the economy. Particularly on a short-term quarterly basis.
[The article referred to follows:]




214
Copied from
The Morgan Guaranty Survey.
February 1981

The Pitfalls of Mechanical Monetarism

T

HE highly publicized shift by the Federal
Reserve some sixteen months ago toward
more emphasis on bank reserves and fess on
interest rates as the instrument for monetary
policy was widely viewed at the time as a major
move in a direction that monetarists had been
urging for years. Nevertheless—and despite the
fact that the Federal Reserve came close to its
monetary growth objectives for the full year
1980—criticism of the monetary authorities by
monetarist economists has not subsided.
Instead, there has been a steady drumbeat of
complaint in recent months about the Fed's performance—with the main charge being that, as
a result of the Fed's failure to be monetarist
enough, 1980 saw an unnecessary and undesirable degree of volatility in both monetary
growth and interest-rate movements. Grumblings have been heard about making (he Fed
"more accountable," and it is clear that some
of the monetarists who eilhcr have found their
way into the ranks of the new Administration or
have maintained close advisory links to it are
hopeful that the Federal Reserve can be influenced to mend its ways.
The issues involved here are obviously of
great importance. The q u a l i t y of the Fed's performance can make an enormous difference to
the health and stability of the American economy. If monetarist criticism serves to improve
that performance, so much the better. Indeed,
there can be no doubt that in important ways
such criticism already has helped. The evidence
is persuasive that the long preoccupation of
System officials with very close interest-rate
management was inimical to noninflationary
monetary growth. The shift in October 1979 to
greatly diminished emphasis on interest ratesfostered in Mgnificant part by monetarist criti-




cism—unquestionably was a constructive move.
It does not follow, however, that all the elements of monetarist complaint about Fed performance in 1980 are valid or that the nation's
interest would be well served by strict adherence
to every aspect of the monetarist prescription.

"Unnecessary" fluctuations
The key monetarist complaint about the conduct of monetary policy in 1980 is that it did
not succeed in holding monetary growth steady
thrangliout the year. Professor Milton Friedman* and others accuse the Fed of having
erred in letting the money supply (as measured,
for example, by M I B ) decline between mid
February and May, rise too rapidly from May
to October, and decline between mid November and ihe end of the year. These "unnecessary" fluctuations in monetary growth, it is asseriecl, not only greatly intensified ihe magnitude
of cyclical fluctuation of the economy within
the year (aggravating the recession and accentuating the rebound) but also caused interest
rates to be much more volatile than they otherwise would have been.
Untangling cause and effect in economic data
is rarely easy. There obviously are other explanations besides that offered by the monetarists fur the particular cyclical configuration of
19SO—including one which emphasizes the key
importance of the shock of March 14's credit
controls. But one need not get bogged down in
the details of competing explanations to evaluate the monetarist criticism of last year's Fed
policies. At (he heart of that criticism are two
propositions which transcend the specific events

The Morgan Guaranty Survey

215
of 1980. The first is that the link between money
giowth and economic activity is stable even, in
the short run. And the second is that the Fed
has the ability to maintain close control over
the growth rates of the various monetary aggregates even over short intervals. The evidence
to support ihese contentions is shaky at best.

The Velocity of M1B

Searching for stability
The concept of the velocity of money provides a. useful approach for gauging just how
stable the link is between money and economic
activity. The velocity of any of the monetary
aggregates is simply the ratio of nominal GNP
to the level of that aggregate. Thus, velocity
measures how many dollars of economic activity are being carried out with a single dollar
of money, or how many times a dollar of money
"turns over" in the course of a year.
Pragmatic monetarists have long argued that
the appropriate money supply to use as a policy
target is the one whose velocity is most stable.
Thai test has tended to point away from narrowly defined aggregates (such as M I A and
M 1 B * ) , since, wilh the uptrend of interest rates
in the postwar years, great strides have been
made in the efficiency wilh which money is used
in carrying oul transactions. The velocities of
the narrower aggregates indeed have shown .1
decided long-term upward trend. The monetary
authorities can try to allow for the trend faclor.
But any allowance is complicated by the faci
that shifh have occurred from time lo time in
the steepness of the trend.f Even were it not
for the challenge of trend estimation, it is clear

percent cfianee it compound annual ntet

-6

I
1985

I
67

I

I
69

1

I
71




I
73

I

I
7S

I

[
77

I

I
79

I
80

from the substantial quarter-to-quarter volatility
of MlB's velocity (lower panel, chart above)
counts iMlJonuide. A-. individuals shift funds fiom rcBula
checking accounts Lo NOW accounts, uhith are included
M 1 1) hut mil in M I A. the same .lollar amount. of econnm
activity "ill lend 10 he curried oul wilh .1 tm;iller ar
of MIA than before— i.e., the velocity of MIA timing th
transition period will lend to increase over and above
former trend rate of erowih. While MID »»ll not bu
fecicd by ihifis from checking to NOW accounts. iu (hi
extent ih.il fiiruk .ire also shifted from savinjs. to NOW
accounts, MIQ mil gum lister ih.m uiiul :>nd ihc growth

l lo

February 1981

I

NOTE 1MB velocity II «« ratio of 6NP lo «i( me animate.
Plotting ire quarterly.

216
that a lot of slippage occurs in the short run between what happens to a narrow aggregate such
as M1B and what happens to gross national
product.
The trend problem present in the velocities
of the narrower aggregates is absent in the velocity of M2.* As can be seen in the upper panel
of the accompanying chart, the velocity of M2
has shown no appreciable trend either up or
down in the last decade and a half. However,
while the velocity of M2 shows no secular trend,
its quarterly variations, as can be seen from the
lower panel of the chart, are of comparable
magnitude to those of M1B. This erratic behavior of money's "second dimension" (as velocity is sometimes called) inevitably means that
—however money is measured—there is simply
no way in the short run of confidently assessing
the appropriateness or in appropriateness of variations in (he money stock itself.
In the past, monetarists have typically acknowledged that changes in the rate of money
growth over short time spans, if soon reversed,
do not necessarily imply subsequent changes in
economic activity. Thus, the attention given to
short-run swings in money growth during 1980
(and the allegation of v i r t u a l l y simultaneous
impact on economic activity) is something new
for monetarists. The faci is that monetarists
have almost always argued that changes in
money growth affect economic activity only
with a considerable time lag. Not only have they
not advanced persuasive evidence of n simultaneous effect; their call for tight short-run control of money supply smacks of the kind of

aL ciimmcicl.il Kink*,, oilier checkable deposits, vivin;:'. unJ
tm;ill-i)cn»mm;mon I i.e . imik'i S HtO.iilKj) nine dtpuMlx jt
mcrd^l hanks, nHinc) m.nkcl nniKi.il fniu! -li.nc-, ;iml
I'vcrniuhl l-Timlnll.ir Jcp.>-,u^ of U.S. notilunk i,',iiL-iK. :il
C.uihK-i.n lir:intht^ nl L.1 V Li.inU.

10




The Velocity of M2

"line tuning" which monetarists have so consistently criticized for many years.

How ji-cisiblc is tit^hl control.'
Totally apart from the question of whether
it is important to prevent temporary deviations
ol the aggregates from larget. there is the issue
of w h e t h e r it is even possible for the Fed to
achieve close control over money growth in the
ihort run. In this regard, it is important to recThe Morgan Guaranty Survey




217
ognrze that !hc quantity of money at any time
is a function not just of the actions of the Fed.
What the Fed effectively controls is the amount
of reserves which it makes available to the
financial system through open market operations
and at the discount window.* But the quantity
of money that a given level of reserves will support can vary significantly depending on changing public preferences for different components
of money and, indeed, depending on the public's
choice as between money and other financial
assets. The faci that reserve requirements differ
importantly according to the kind of deposit
held and the nature of the depositary institution
accepting the deposit is, of course, very significant in explaining why no uniquely determinable volume of money results from a particular volume of reserves. (The Depositary [n-

stitutions Deregulation and Monetary Conirol
Act of 1980 complicated these requirements still
further.t)
The Fed is fully capable of guiding the
growth of any monetary aggregate back toward
a desired trajectory jf such aggregate has tended
to veer away. But it cannot hope to hold moneysupply estimates precisely on a desired trajectory at all times and must realistically expect
that deviations above and below that trajectory
will occur from time to time,** reflective of
changing privale-sector preferences thai are impossible to predict precisely. Experience has
shown that the relationship between reserves
and money—like that beiween money and CNP
—is loose, and that selecting the appropriate
growth rate of reserves to achieve desired money
growth is inevitably a mailer of Irial and error,

The money multiplier

vol.ime of reserves to supply in ioi;il. Kcnirrrrrf fescues.

serves nr a l l ™ fm.inci.il iTMiuili.w HI m.iU up -my dec i i u r u ' w i n j u u . Hiwcvcr. if the To.l at any [mini finds u10 (hi
[;ij>idly th,in i m p l i e d by ra.nn.-y i m p e l s ) , n c;m f u i c e .in
.luiusimcru in k-rulini!- .ind rtepi'MV^ncntiiii: ncliv.rn.-, c,l

l>,.irowtil rtsL-ru-s. llur Jisuplmirii! rirrfiu-riic on IUI.HH.,.,}
m s i L i u l i o n s ul lestrinm!; nonhoi r < ™ e d icscivc .n.nl.ilnliu
w o r k s in i n o w a \ v t l r r o i i f / i !ln- I") 1 '' ilJ-ainiloii Hum ii-

Ftbruarv 19S1

Just as the concept of velocity summarizes
the link of money to GNP, an analagous concept—the money miiJliplier—is useful in evaluating the relationship between reserves and
money The money multiplier, however, is not
simply the ratio of money to reserves. Currency
held by the public must also be taken into account in calculating the money multiplier, since
currency h a pan of the money supply thai is
provided by the Federal Reserve but not a p.in
linked to ihe reserves held by financial institution. Tht' nccommotiation of currency is achioMjd by calculating the money multiplier as
the ratio of money to the total of reserves aitd

218

Changes in the Multipliers
Compound annual rales

serves and currency provided by the Fed, and
the growth that stems from changes in the
amount of money supported by each dollar of
reserves and currency. The latter component
of money growth—summarized by changes in
the multiplier—reflects the multitude of decisions
the public makes about the composition of their
financial assets.
The chart on this page shows how the M1B
and M2 multipliers have fluctuated in recent
years.* Mere visual inspection of the multiplier
relationships should suffice 10 warn just how
difficult it would be for the Fed to keep money
growth lightly on target by manipulating the
monetary base. Given the magnitude of the
varin.ions in the multipliers, it is puzzling (hat
anyone should believe that a policy of steady
reserve growih should be expected to produce
steady money growth, particularly if the focus is
on relatively short time spans.

Market constraint

-s

I 1 1 I I I I I I I t I I I I

1965
67
69
71
73
75
}7
73 BO
NOTE: Mjttiplitrs are calculated as ratios of the respecliva runnels^ agpegsles to ine adjusted monetary Dase (consisting ol
currsnci and jOjuslefl tQlat rese'vesi as publiil>«fl By Hit

curreiKy-ihe so-called monetary base— rather
than to reserves alone. This puts currency in
both the numeraior and denominator of the
money multiplier and thus frees the multiplier
from a downing influence thai would arise;
if currency's presence in the money supply were
not explicitly allowed for,
The money multiplier makes it possible to
distinguish between the growth in money thai
slems from variations in [he amount of re12




The Fed itself probably would not be overly
concerned with shori-run variations in money
growth if the financial markets did not react so
much to these movements. Unfortunately, the
"Tlie le-serve* scries uscii to calcuLuc ih£ momrijry hasc,
•Kid ihc multipliers appearing in ilie thans on Tliis pjpe. is

mcnts clunce. so ,loes ihe level of tlcpo-ns u h i t h can he
HHnHnitd (*y ;* given Timoiint i>! resenes--i.e., ihc elTect is
,( ihe FcJ had cha f J [lie Ic
ill the fin.im.-i.il n-,tem. It the multirilie.. Here cakul.iled
I rum .in uoail)uil«l monwary h.i.c. moves hy [lit Feii (o
ihe multipliers. Bui Hut woulJ he ineon.i-.tcnt uiih Ihi
rejMin lor inuuuucing ihe concept of ihe multiplier in the
lirsi pl.ite: to \epar;itc ihe imp.ict on liie nionty supply v(
.ictiimi hy iiniinci.il iniinutions :tnd the puhlic from itie
iiiipjil o[ jamni h> Ihe l-td, ihe futmtr beine nic.iiurfd
In changes m [he nujIrifiLcr. jnd the Litrcr by cU^c\^c« m

The Morgan Guaranty Survey




219
Fed is caught in a bind somewhat of its own
making: One reason for the market's attention
to short-run changes in money growth is the
fact that, in the past, such movements have
been allowed lo cumulate. The Fed thus has
a credibility problem to contend with. But the
Fed's recent willingness to allow a sharp rise in
short-term interest rates at the very start of an
economic recovery in order to restrain the aggregates has helped significantly to convince
market participants that the Fed is now very
seriously committed to its money-growth targets.
In thai sense, the upside pan of last year's
interest-rate volatility yielded an important psychological dividend that will continue to grow
if the Fed maintains a policy of monetary restrain!. Curiously, however, because of the need
to reestablish credibility, the Fed has helped
impart a greater degree of importance to mone-

February 1981

tary (argetry in the short run than is justified
by the looseness of the relationships between
reserves and money and between money and
economic activity. The fact is that, given the
looseness of those relationships, no one can be
sure that any particular target is precisely the
right one or that it will not actually prove perverse to the health of the economy under changing condiiions. But to the extent that the public
now measures anti-inflationary determination,
as it apparently does in considerable measure,
by whether specified monetary targets are being
met, Ihe Fed has limited practical ability to depart from its targets even briefly. The Fed is
constrained even if it is thoroughly convinced
that departure from its rargets is desirable because of changing circumstances. This is unfortunate. The nation needs continuing monetary
discipline. It does riot need—and indeed would
be ill served by—rigid mechanical monetarism.

220

Dr. JONES. So, I would submit that Fed policy is imperfect, and
that it will be unable to do the job alone, without major financial
catastrophe in 1981.
BOND MARKET BEST SOUNDING BOARD

The bond market is perhaps the best sounding board for where
we stand now. There is a tendency to believe that the Fed, in fact,
means business, although control is understandably imperfect. And
there is a tendency to feel that, perhaps, President Reagan is going
to be tougher with the budget than we have ever seen before.
But the verdict is still open.
The bond market, in recent days, has been swamped by Treasury
borrowing at $36 billion projected in this quarter, alone, the highest quarterly level we've ever seen. That interest rate pressure
reinforced, of course, by inflationary expectations, poses major
threats for the savings and loan industry this year, for mutual
savings banks this year, for insurance companies this year.
Any institution that has invested in longer term debt—and I've
seen the market value of that debt fall dramatically—any institution that suddenly must pay prohibitive costs for funds available
for lending.
So, I would submit that the moment is critical. The time is now.
And the key factor in breaking inflation psychology this year lies
in the hands of the Congress—again, if anything, to out-Reagan
Reagan, in terms of budget cuts; and, No. 2, to be careful about the
tax cut timing. That could be the most critical element in the
entire program.
Spending cuts, first; tax cuts, later.
Thank you, very much, Mr. Chairman.
[Complete statement follows:]




221
Testimony by

Dr. David M. Jones
Vice President and Economist
Aubrey C. Lanston £ Co. Inc.

"The Impact of Federal Reserve Policy
and the Reagan Budget Measures on
Financial and Economic Activity in 1980"

There has never been a greater need or opportunity in our country for effective
Government monetary and fiscal policies.
raqing inflationary pressures.

The objective is, of course, to dampen

Ideally, the combined anti-inflation efforts by the

Federal Reserve, the Reagan Administration and the Congress should rival in intensity
of course for wholly opposite reasons,
the anti-depression actions of theRoosevelt Administration/nearly 5 decades ago. Nothing
short of an all-out, coordinated effort will work—given the deeply embedded inflation
psychology which has ravaged our economy and our currency over the past decade
and a half.

Encouragingly, the Federal Reserve, under the able leadership of

Chairman Volcker, has made considerable progress towards establishing anti-inflation
credibility
over the past year or so, though Fed efforts at short-term monetary control
understandably
/have left much to be desired. Similarly, President Reagan has launched, as the first
major act of his new Administration, an impressive array of anti-inflation spending cuts.
The anti-inflation ball is now in Congress'
waste.

court, and there is no time to

In recent weeks the Government securities market has-been choking on a

massive flood of Treasury debt arising from years of fiscal irresponsibility.

Resulting

financial market strains and record-high interest rates on both Government securities
and private debt such as corporate bonds have discouraged business investment
on productivity-enhancing plant and equipment.

In order to break the vicious

circle of fiscal irresponsibility, escalating inflation, and prohibitively high interest
rates. Congress must act promptly and boldly.

Perhaps most importantly. Congress

should consider enlarging upon, rather than diminishing. President Reagan's proposed
Federal spending cuts.

In addition. Congress should delay final action on the

President's tax cut proposals until the precise magnitude of the spendino cuts can
be determined.

Moreover, the effective dates of these somewhat controversial supply-sids

enhancing tax cut measures should be delayed until 1982.




222
Federal Reserve Policy

The Federal Reserve has recently made real progress in establishing antiinflation credibility.

In his report to this Committee last week (and elsewhere)

Fed Chairman Volcker emphasized that we currently have a "...

rare opportunity to

deal w i t h our economic malaise in a forceful, coordinated way."

Summing up the

Fed's appropriate and commendable general policy stance. Chairman Volcker has
stated "...our intent is not to accomodate inflationary forces; rather we mean to
exert continuing restraint on growth in money and credit to squeeze out inflationary
pressures.

That posture should be reflected in further deceleration in the monetary

aggregates in the years ahead, and is an essential ingredient in any effective policy
to restore price stability".
To the credit of Congress, the Fed's anti-inflation credibility has been enhanced
by its highly visible reports to Congress in February and July of each year on annual
objectives for monetary expansion under the provisions of the Humphrey-Hawkins
Act.

The monetary authorities have not only sought to lower their targets for

monetary expansion each year with a view to dampening inflationary pressures,
but they have, more importantly, acted recently with conviction when these targets were
in danger of being exceeded.

For example, in the closing months of 1980 an

un-

expectedly brisk rebound in economy activity and related increases in individuals'
and businesses' demands for money and credit threatened to push monetary growth far
above the Fed's 1980 targets.

The Fed responded by clamping

down on bank

reserve positions through its open market operations, and toleratinq a sharply higher
Federal funds rate

(and other money market rates) with a view to dampening excessive

money growth.
As matters turned out, actual 1980 growth in the Fed's various monetary and
credit aggregates exceeded target limits, though the misses were relatively small.
For the M.A and M.B aggregates, for instance, actual growth exceed Fed targets by
only .25 of a percentage point last year.




In the case of the broader M, and M

223
aggregates the misses on the high side of the targets were slightly larger at ,8
and . U of a percentage points respectively-

The point is that the Fed made a real

effort to reign in money growth to a pace close to target levels late last year,
irrespective of the fact lhat the economy was still in the early stage of reqovery-following a drastic free fall in economic activity in the second quarter of 19pO.
Moreover, there is every reason to expect a repeat of such Fed lightening moves
should similar

monetary excesses prevail towards the end of this year, or nerxt.

While the Fed's overall policy approach is praiseworthy, a word of caution is
in order.

There is a current misconception—both within some Fed policy-making

circles and,

more ominously, among the numerous "monetarist" economists at the

Treasury and elsewhere in the Reagan Administration—that monetary policy can be
reduced to a simple mechanical process.

In essence this simple-minded view is that

the money supply can be stabilized if only the Fed would give its undivided attention to
the

reserve-money relationship.

This misguided viewpoint emphasizes the need for some

added technical refinements such as a shift to contemporaneous reserve accounting from
lagged reserve accounting and a change in the discount rate to a floating or penalty
rate, solutions that would only add to already excessive interest rate volatility.
This "ivory tower" monetarist view, to put it bluntly, bears little, if any, relationship
to reality.

The "state of the art" of Fed monetary control is simply not sufficiently

advanced to guarantee short-term monetary ob]ccliv«s.Consider the following items:

(1) In 1 9 7 9 (the latest year for which official data are available) the average
weekly Fed miss in estimating bank reserves was a whopping $810 million.
This error factor

actually swamped the change in total bank reserves which

averaged $360 million per week in this period.
(2)

Wide fluctuations in the reserve-money multiplier casts doubt on the proposition




that steady reserve growth (even assuming the Fed could accurately forecast
reserves) should be expected to produce steady money growth.

224
(3) The public's (individuals' and businesses1! demand for money is inherently
unstable, rather than stable as the monetarists claim.

For example, in 1980

A

M.fl growth fluctuated violently from a decline of 20% (annual rate) in April
to a 19.33 increase in August.
In light of these glaring imperfections

in the monetary control mechanism, the

Fed must fall back largely on psychology and the powers of persuasion.

The current

reality is that Fed policy-makers must typically react to unstable monetary and economic
fluctuations rather than initiating control.

Minor reserve accounting refinements

in the money control apparatus will do little good.

In these circumstances the

monetary authorities must, above all, continue to demonstrate consistency and steadfast determination to slow money and credit growth sufficiently to wring inflationary
excesses out of the economy.

In its day-to-day operating framework.
of observatory and adjustment.

Fed policy should be a continuous process

Specifically, when, say, the recent trend in money

growth is excessive the Fed rnust convince banks and other lenders that it will
continue to tighten until a slowing in money growth occurs.

When the Fed, in such

a situation, clamps down on bank nonborrowed reserve growth, banks are forced to
scurry to the Fed discount window for additional funds.

However, the discomfort

felt by banks availing themselves of the privilege of borrowing at the Fed [including
administrative limits on the frequency,amount and purpose of such borrowings}
eventually causes banks to become more selective in their investment and loan activities
thereby slowing deposit (money) growth.

If the Fed conveys sufficient determination

in this tightening process it may speed up the 2-3 month bank asset adjustment process,
particularly as related share increases in short-term interest rates lead to unsettled
conditions in the markets for CD's and other sources of bank funds.

At the extreme

"crunch" case, banks may turn off their new lending activities out of fear that they
will be unable to roll over their maturing CD's or other term liabilities.

The restraint-

related jump in interest rates will, of course, have the additional side effect of causing




225
the public to conserve its money balances, thereby acting as a further dampening
factor on observed money growth.
Looking ahead. Fed policy in 1981 is likely to be characterized by "more of Ihe
same", including extremely volatile short-term interest rates and Fed difficulties in
dampening wide savings in the public's demand for money.
for example, it is a good bet that

Between now and mid-1981,

an increasingly hesitant economy, combined with effort:

by consumers and businesses to improve their fragile financial oositions by paying off
excessive short-term bank loans,

will result in generally sub-par money growth.

In thesecircumstances, the Fed is likely to respond by easing pressures on bank
reserve positions, with a resulting drop in short-term interest rates.
makers have resolved not to repeat their generally acknowledged

Fed policy-

mistake of easing

too fast and too far last spring, but the results remain to be seen.

Later in 1 9S1,

Fed policy makers may conceivably face the opposite conditions should confidence
in the Reagan economic program cause a late-1981 pick up in economic activity and
money growth.

The Fed would most likely tighten in these circumstances, pushing

interest rates again sharply higher,thereby threatening to choke off economic recovery
for a third time in two years.
The Reagan

Budget Program

Can the Reagan Administration and the Congress, working together

on the

fiscal front, help to smooth out the potential financial and economic instability
resulting from an imperfect and hard-pressed monetary policy?

The answer is emphat-

ically, yes! Currently,the best way to break the vicious cycle of inflation,

inflation

psychology, and high interest rates is to cut Federal spending deeply and across
the board.

For fiscal year 1982 the "psychological threshold" for an effective anti-

inflation budget cut appears to be in the vicinity of 550 billion.

The Government

bond market is a good sounding board for the perceived fiscal responsibility (or lack then
of) of the Administration and Congress.

This was vividly demonstrated last February

when a bond market collapse (a kind of vote of no-confidence) forced President Carter to
rethink his excessively unbalanced budget.




The recent collapse in prices of Government




226
bonds, pushing interest rates on 30-year issues above 13%, suggests that participants
are skeptical of the Reagan Administration's ability tr oiisri its spending cut program
through Congress promptly and laraely in tack.

The Congress could help dispell

these market fears by recommending Federal spending cuts in excess of the $41.4 billion
(plus modifications) proposed by President Reagan in order to insure that the budget
impact in fiscal 1982 is sufficiently anti-inflationary.

[In this connection it should be

noted that merely removing the borrowing of certain agencies from the Federal Financing
Bank is not sufficient to reduce the Federal government's intrusion into the private
sector.)
In order to strengthen prospects for a reduction in inflation psychology, while at thr
same time insuring sustained longer-term growth in real economic activity, the Congress
should also make three important changes in the President Reagan's proposed tax cuts.
First, the tax cuts should be shifted to more heavily favor incentives for business
spending on new plant and equipment, with a view to enhancing productivity and reducing inflationary bottle necks.
businesses
20%.

1

As the President's tax cut proposal now stands

relative share of the net $51.9 billion lax cut proposed for fiscal 1982 is only

Businesses' share of the tax cut should be closer to 50%.

Second, tax cuts for

individuals—which, contrary to supply-side thinking, are potentially inflationary—should
be considered on a year-by-year basis rather than over the 3-year period proposed by
the President.

Finally, the effective dates of the new tax cuts should be postponed

until January 1, 1982 for business and June 1, 1982 for individuals in order to cut
down en the Federl deficit and related borrowing, and to help reduce inflationary
expectationsFinancial and Economic Conditions
The urgency of lessening the inflationary strains on our financial markets can't
be emphasized enough.

Because of inflation, recurring periods of tight money, and

a prevailing inverted yield curve (higher short-term interest rates than longer-term
rates), the underpinnings of such key financial sectors as our savings and loan
industry, mutual saving

banks, and insurance companies are becoming increasingly

227
shaky.

Earnings are under pressure and longer-term asset values are deeply depressed

(particularly longer-term mortgages and bond holdings).

Also many financial institutions

find that lendable funds [deposit) footings are either eroding or prohibitively expensive.
At the same time, the unsettled

financial

to financially strained ran financial businesses.

market conditions are inhospitable
For many smaller business, in

particular, the unexpectedly onerous cost of short-term

is almost too much to bear.

borrowing

Even adjusted for the $.H% inflation

rate last month, the rea| cost of borrowing is at an all time high.

Recently, many

businesses financial positions have come under special strain as their efforts to borrow
in the longer-term bond market in order to acquire the funds to repay excessive and
burdensome short-term debt have been thwarted by unsettled bond market conditions .
Government competition for funds has contributed to these unsettled bond market
condilions with Treasury new money borrowing in the current January-March period
projected at an all time quarterly high of at least $36 billion.
The simple fact is that time is running out.

Unless Congress makes drastic moves

to reduce the strain on the markets from Government borrowing, a massive wave of
financial and corporate bankruptcies

will likely swell up before this year is out.

This threat is reinforced by the one critical flaw in the Reagan economic program.
It Is the attempt to link budget-breaking tax cuts to spending cuts in fiscal 1982,
while, at the same time, calling for increasing monetary restraint (in the form of a
halving of money growth by (966).

The problem is the next 6 to 12 months.

for financial strains to ease and interest rates to decline,something must give.

In order
Either

inflation must suddenly ease dramatically {any relief is more likely to come later than
sooner) or real economic activity (production and jobs) must collapse.
At the very least, the prevailing financial strains are likely to result in a second
recessionary phase in 1981 (following the first phase which began last February and ended
last July or A u g u s t ) .

Specifically, real economic growth is expected to fall by 2-3°

at an annual rate in the second quarter of 1 9B1 and by 1-2% in the third quarter of this
year.

Also contributing to this reemerging weakness in the U.S. economy will be wide-




228
spread recessionary conditions in Western Europe

conditions that were not

present in the first stage of U-S. recession last year.
The future course of the U.S. economy depends even more than usual on
how carefully fiscal and monetary policies are designed.

There is hope if fiscal

prudence prevails and spending cuts come first, followed by carefully designed
tax cuts—aimed not at a quick and potentially

inflationary fix through consumer

stimulus but at apotential for future sustained real growth through productivityenhancing capital investment and research.

When the anti-inflation burden is

shared by fiscal policy in this way, then monetary policy can, hopefully, be
managed in a way less unsettling to the financial markets.




229
Table 1
Selected Monetary Aggregates
Actual Growth vs. Fed Targets
(Annual percentage change)
M1-B

MI-A

Actual

Target

Actual

Target

M2
Actual

Target

Annual
Growth*
1979

5.0

1980

(61/4)

7.7
3 1 / 2 - 6

9.0

( 6 3/4)

4 - 6 1 / 2

71/4

(41/2-7)

9.8

5

(2 1/4 - 4 3/4)

3.4

4 1/2

7.5

6 1/2

2.1

4 1/2

8.5

61/2

ill

13.5

G 1/2

17.1

11.3

IV

1-5

2 1/2

3.8

7.1

Quarterly
Growths

1
||

Monthly
1980
January

2.6

4.3

6.8

Febraury

9.11

9.6

10.1

March

1,9

April

-20.0

5.4

-15.6

3.2

May

1.3

0.6

10.3

June

1 2. 1

16.2

18.3

July

8.4

12.9

18.8

19.3

21.8

14.9

September 12. 3

15.8

B.7

October

9.1

11.8

8.8

November

6.5

8.7

10.4

August

9.0
2.0
December - 1 1 . 1
( ) Figures in parenthesis adjusted for impact of ATS and NOW accounts.
- Fourth quarter average to fourth quarter average.
+ - Measured from last month of quarter.
Source: Board of Governors of the Federal Reserve




12

7 1 /U




230
Table II

Federal Receipts,Spending and Deficits
(Millions of dollars)
;cal year

Receipts

Spending

Deficit (-)
or surplus

1960

92,492

92,223

269

1961

94,389

97,795

3,106

1962

99,676

106,813

7,137

1963

106560

111,311

- 1,751

1964

112,662

118,554

- 5,922

1965

116,833

118,130

1,596

1966

130,856

131,652

3,796

1967

149,552

158,251

8,702

1968

153,671

178,833

-25,161

1969

187,781

181,518

3,236

1970

193,713

196,588

2,815

1971

188,392

211,425

-23,033

1972

208,649

232,021

-23,373

1973

232,225

217,071

-11,849

1971

261, 932

269,620

I.Gae

1975

280,997

326,151

-45,154

1976

300,005

366,418

-66,113

81,773

94,728

-12,956

1 977

357,762

102,710

-41, 948

1978

401,997

150,804

-48, 807

1979

165,940

493, &35

-27,694

1980

520,050

579,613

-59,563

1981e

605,000

670,000

-65,000

Transition quarter

Sources: Department of the Treasury and Office of Management and Budget,
e-estimated by Aubrey C. Lanston £ Co. Inc.

231
Chart I

YIELDS ON SELECTED SECURITIES
AVERAGES OF D A I L Y RATES ENDED F R I D A Y

< 15 !? I t ?8 11 25 9 ii
FEB
"AH
APR
MAY

'IS
JAM

6 20
JUN

' 19
JUL

1 15 29 II !fl 10 ft
AUG
SEP
OCT

7

?1

MOV

S

19

DEC

2

18 JO

JAN

I960

1J

FEB
1981

!'

15

27

MAR

LATEST OUT* PLOTTED ARE AVERAGES OF RATES AVAILABLE FOR THE WEEK ENDING: FEBRUARY !7. 1981

90 OAV
CD ' S

JAN.

2

FES

9
16
^3
30
fi

1J

20

27 ,
WAR.




PRIME
COlWf RCI'L

PH1WE
BANKERS'

15.80

16.28
16. QJ
17.09
7 38
6.38
5.92
E.23
5.48

CORPOHUTE

COHPPflATE

UUMICEPAL

12.83
12.59
1 2.76

I 5. 09
4.93
4.96

g.rs

12.98
13.07
13.11
13. SI
13.10

S. 15
5.3£

"

6.99
6.55

15.43
16. 33
16.67
15.94

7.42

7.R2

r 03

I5.5J

6.58
6.71
6.11
5.29

15.77
15.34
14. 53

A

85

n.9i

s.oa
5.4P

15.36
5.36

9.49
9.57
9.68
9.91
9. 9O

9.99
10.32
N. A.

6

1J
20
?^

.

.

PREPARED 8i FEDERAL RESERVE BANK OP si, LOUIS

232
Table

Consumer Spending, Prices and Savings
(Month-to-month percent change)

Personal
Consumption
Expenditures
(Current doMars)

January

Personal
Consumption
Expenditures
(Constant 1972 dollars)

Implicit
PCE
Deflator

Savings
as a % of
Disposable
Personal
[ncome

«. 8

+ 1.8
.3

+ 1.2

1.9

March

+1.0

+1.i|

5.3

April

-1.0

+ .5

5.8

-t- .5

6.2

February

May

•

.2

June

+ 1.0

+ .4

July

+ 1.9

+1.3

August

+

+ .2

September

+ .7

.1

October

+ 2.0

+ 1.3

+ .7

November

•fl . 5

+ .7

+ .7

.9

+ .6
+ .8
tl.1

6.2
6.0
6.1
5.9
5.6
5.2
it. 9

December

Source:

+ .6

U . S . Commerce Department

The CHAIRMAN. Dr. Jones, I couldn't agree with you more, on the
part of your comments about the expenditure reductions.
I would like to out-Reagan Reagan. I think $41 billion is an
absolute minimum, and would like to see larger cuts.
But I disagree with you on the tax side. I think they should go
hand in hand. I'm not in favor of tax cuts without the expenditure
cuts in the same fiscal year.
But I would like you to explain to me why you feel—or you want,
by delay, to increase the tax burden on the American people again.
More than $100 billion taken out of the economy, at a time when
we do not have the funds available for modernization of automobile
plants, steel mills, and so on; and Japanese competition.
I won't argue at great length on the individual tax cuts. But I
think the business tax cuts, the incentives for capital formation,
are far past due. We should have had them years ago, or we might
not have been in the difficulty we are in now.
So, could you expand on why you are so forceful on at least that
part of delaying those tax cuts?
I would just take the absolute opposite position: That we would
injure the economy by waiting until January of 1982.




DELAY OF TAX CUTS

Dr. JONES. Two points, in answer to your excellent question:

233

The cruelest tax of all is inflation. And I feel that the juncture is
critical, and the timing is critical. What we need is, essentially, a
big bang. Maybe as big a bang as Roosevelt gave, on the opposite
side of the fence, in his antidepression policy.
The point is that the best way to get full and maximum impact
on inflation psychology—psychology first, we will see the results
later—as was so well pointed out in the earlier questioning of Dr.
Weidenbaum—is to be sure that:
No. 1: We get maximum effect in reducing inflation of that
budget program. And the danger I see in the program is, that if
you take it in terms of what is proposed, what we gain in terms of
fighting inflation in fiscal 1982, in terms of spending cuts, we lose
potentially in terms of fighting inflation.
On the tax cut side, I agree completely with your point about
business. I wouldn't be quite as urgent about postponing business
tax cuts to January 1982 as I would the individual income tax side.
I think supply-side economics, which we were talking about earlier—it was being discussed earlier this morning—consists of two
parts: one is a tested part, I will certainly admit, and that is by
giving tax incentives to businesses, one can indeed—going all the
way back to the Kennedy administration—see new plant and
equipment spending, improved productivity, and reduced longer
term inflationary results.
The point is this, though. On the consumer side, it is the radical
part of supply-side economics. We are supposed to save more if we
get greater tax cuts. That is untested, unproven, in terms of the
evidence.
No. 2: We are supposed to work harder if we get tax cuts. I don't
know about Jerry, but I may play harder with my tax cuts. Although it is difficult to measure the productivity of some economists, including myself, I recognize that.
But the point is that I'm looking for maximum impact.
I recognize that postponing business tax cuts even for an extra
year is going to cause some problem in the sense that we don't get
the new plant and equipment improvements. But I'm willing to pay
that price to get maximum anti-inflation impact.
The CHAIRMAN. You also postpone a return in increased revenues, as a result of a tax cut. Kennedy found out that it produced
more revenue than it lost. Not immediately, obviously.
But, the point of it is you're also increasing that revenue from a
tax cut.
Dr. JONES. Slightly.
But, again, the question, in terms of the financial market impacts and in terms of the psychology, would tell me, at least, that
the benefits of a postponement outweigh the negatives which you
point out.
The CHAIRMAN. What about the experience we've had in the
past, of tax cuts, where less income is then sheltered? People in the
high marginal rates aren't trying to find places to prevent it from
being taxed, at all, with lower marginal tax rates.
Dr. JONES. That is possible.
But again, to me, that is
The CHAIRMAN. It's not only possible; it has happened in the
past.







234

Dr. JONES. It has. But it is a secondary consideration, in the
moment at hand.
In essence, what I want to see is maximum big bang effect. And I
think there is a reasonable way to come out.
The CHAIRMAN. The only problem I have with all of these fears—
as Senator Proxmire expressed, and many of our Democratic colleagues—is that the Reagan program won't work.
Well, you know, sometimes after all of these years in the minority, I stop and wonder if our philosophy does work. Because we
haven't tried it.
But if Senator Proxmire hadn't left, I would say: "Well, we are
familiar with the typical economy we've had for many, many years.
And we know that that doesn't work." And certainly not just to
blame it on Democrats; Republicans have participated, as well.
But the point of it is: If we don't have ample evidence from what
has happened the last 2 or 3 years—that these high, high levels of
taxation, increasing to 22 percent of GNP, don't work—then I'm
willing to gamble. I'm willing to try something else. Because we
have totally failed, and botched up this economy. I don't know how
we could have done it worse than we have.
Dr. JONES. I'm willing to gamble, too. I think your point is
extremely well taken.
But I feel a slight shift in timing—and maybe it's because of my
participation in the bond market—timing is everything there—a
slight shift in timing will give us, hopefully, the benefits of fresh
and new ideas, in the form of some supply-side logic; but without
major damage being done to this program, or to the economy, or to
the financial markets in 1981.
I think, in a sense, we haven't thought out, to the full, the
potential problems that could exist.
Take the savings and loan industry. As a result of more pressure,
short term, on interest rates, because of excessive Government
borrowing, due to a linkage of tax cuts to the spending cuts
We are essentially at a critical juncture. Many S. & L. s thought
they couldn't make it through last year. The ability to get through
this year—should Government borrowing continue as excessivemay be even more remote for them.
So, my feeling is a sense of urgency about the current market
conditions. And I feel, even trying new ideas, that the timing shift
on balance has more benefits than costs.
The CHAIRMAN. Dr. Jordan, how do you feel about the timing of
the tax cuts?
CORPORATE TAX CUTS

Dr. JORDAN. I would do the tax cuts—especially those that are in
the form of corporate, or accelerated depreciation—immediately.
As soon as possible.
The mix of the whole package
The CHAIRMAN. I like your answer better. [Laughter.]
Dr. JORDAN [continuing]. Will have to be geared toward encouraging accumulation of productive real assets, and productivity enhancing technology.
We have shifted, over the last 15 years, at an accelerated rate—
particularly in the last 5 years, since the first sharp oil price

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increases—the mix of our resources, going toward current consumption—both in the private sector and the Government sector.
The oil price increases amount to, in present value terms, a
transfer of wealth from this country to the exporters of oil.
As a nation, we have the choice to take that transfer either out
of current consumption or out of future consumption. By trying to
maintain current consumption levels, everything from the first $50
tax rebates and all the other policies since then, and the fact that
the Government has increased as a share of the national income,
meant that, by default, the transfer to OPEC has come out of
future consumption.
We need to tilt the mix of our resources back away from current
consumption, toward future consumption. Which means new, truly
productive, capacity, in addition to the investment—what is counted as investment spending—that goes to clean air, and clean water,
and all of the rest.
That can only be accomplished, I think, with something like
accelerated depreciation and an across-the-board corporate rate.
The people don't understand, really, I believe, that businesses
don't pay taxes. It is a matter of deciding which type of tax that
the people pay, do you want to cut. The type of tax I would
encourage to do away with is the double taxation of dividends, and
get the corporate rate down as much as possible, as quickly as
possible.
The CHAIRMAN. Well, I think you're absolutely right. People
don't understand that businesses don't pay taxes. That people pay
taxes.
And, as a result, we always get into this populist argument of:
"Well, there they go, treating the big rich boys and businesses, and
not having the individual cuts."
My time is up.
Senator Schmitt?
Senator SCHMITT. Thank you, Mr. Chairman,
Dr. Jordan, in your statement, you said M-1B grew at 12.8
percent annual rate. I think that in the last two quarters of last
year the gross national product probably was growing at something
like 3 percent in the same period of time.

Dr. JORDAN. In real terms, yes.
Senator SCHMITT. Now, would that imply, to you, that the builtin inflation rate has risen to 10 percent?
Dr. JORDAN. I believe, right now the underlying rate is probably
around the 10-percent range, measured by something like the overall deflator, or the personal consumption component of the deflator. Yes.
Senator SCHMITT. And what your recommendations would do is,
basically, set a target that would, hopefully, within 12 to 18
months, get that built-in rate down to 5 percent or 6 percent?
Dr. JORDAN. It would probably take longer than 12 to 18 months
to get it down to 5 percent or 6 percent. That depends upon the
credibility of the program.
Other experience—for instance, Germany after the hyper-inflation, after World War I—or even in this country in 1971, when the
initial impact effect of the wage-price freeze demonstrated the







236

psychological effect that can be achieved when you capture the
people's imagination.
If they really want to believe it's going to work, you can get a
very pronounced effect. That is what we are still looking for to
happen this time.
Senator SCHMITT. What do you think the so-called psychological
component of the earned interest rates is?
That is, the component that you might relate to people's expectation of money as a commodity.
What is the future value going to be and how much of it is there
going to be available?
Dr. JORDAN. I think both the long-term bond yields and shortterm market rates are considerably above what is consistent with
underlying conditions. They are certainly above what is consistent
with a program of deceleration of inflation.
The bond market demonstrates, by the yields you observe, that
they simply don't believe—or they are not really willing to bet—
that inflation is going to come down.
I think that you could have, this year even, a drop as much as
200 basis points, 2 percentage points, in long-term bond yields, if
people believed that the program would be sustained—not just this
year, but beyond.
The capital gains to individuals, too, by investing long-term financial assets, if they believe inflation interest rates are going to
come down, are considerable. They are foregoing that right now,
for the fear that it may actually go the other way. In the past,
when individuals acted prematurely in betting that inflation and
interest rates would come down, they lost. And that experience is
making people twice as cautious, now.
I think that short-term interest rates may have as much as a 5percentage point difference between what would be consistent with
underlying on-going inflation and what we are observing in the
markets right now. That much can come out very quickly.
Senator SCHMITT. So, you think that if the Congress and the
administration work together and are successful in showing a
major new thrust in Federal fiscal policy; and that if the Federal
Reserve sticks to its guns; that, within a few months, the interest
rates—that are holding up construction and some agricultural activities, and some other business activities—would drop as much as
5 percent?
Dr. JORDAN. Yes.
I believe the short-term—for instance, 90-day Treasury bill
rates—will be below 10 percent this year, if people believe that this
program is going to be enacted and maintained.
Senator SCHMITT. Do you think it's going to take actual enactment?
Do you think it's going to take the President's signing the whole
thing more or less into law, in October, for this to happen?
Dr. JORDAN. If will start happening, and the markets will start to
assimilate the information as they observe the kinds of discussion
that take place; the questions about whether it will be a 1-year tax
cut or a multiyear tax cut.
I am not convinced that the current projections for budget expenditures do represent a reduction as a share of national income.

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They do so only if you assume a high growth in annual income,
over the next 5 years.
I would like to see a lower growth path for Government expenditures over the next few years.
Senator SCHMITT. So, you would agree with Dr. Jones, that we
ought to seriously consider taking a bigger cut than what the
administration apparently is coming up with now?
Dr. JORDAN. Yes. I do, very much.
Senator SCHMITT. How much bigger. 25 percent?
Dr. JORDAN. Well, the approach I would use would be to set
targets for the growth of nominal income, over the next 4 or 5
years, would be the path of sharply decelerating the growth of
nominal GNP total spending in the economy. And then, set your
ceiling on the Government's spending, as a share of that, to bring
it down sharply from the 23-percent level to something 20 percent,
or even less.
The administration's numbers project, I think, 19.4 in 1986. But
that is based on a much higher assumption of nominal income
growth than I'm willing to accept.
I would like to see a much lower growth path than that.
In effect, what we're talking about is cutting the growth of
nominal spending in half, over the next 4 or 5 years.
Senator SCHMITT. Do you think the incentives within the savingsinvestment economy exist, so that decreases in the marginal rate
will actually result in a measurable increase in savings and investment.
Dr. JORDAN. It will go in that direction. It will be positive. I'm
not convinced that it is sufficient. After the fact, the economy only
saves, when it also invests. I would like to see more focus on the
investment side. There is a tendency at times to think first you
have to stimulate savings, and then investment will occur. I would
go the other way around. I would go directly trying to stimulate
investment, in the confidence that the savings will be forthcoming
to support it.
DOUBLE TAXATION

Senator SCHMITT. How do you feel—and then I will ask Dr. Jones
the same question. Do you think we should remove any kind of tax
disincentive for savings and investment, as generally exists in
other industrialized countries? You mentioned, I believe, double
taxation.
Dr. JORDAN. Yes. Double taxation of dividends.
Senator SCHMITT. How do you feel about the exemption of savings
income and investment income entirely?
Dr. JORDAN. Well, the exemption of savings income, in the form
of certain types of financial assets, deposits, for instance, in financial institutions, doesn't necessarily increase the total aggregate
amount of saving, unless you can be sure that it is going to go into
long-lived productive assets. It may just cause a substitution of one
form of savings instrument for another form. So you've got to be
sure that investment side is being stimulated simultaneously with
that action. Regulation Q has been the most negative antisaving
device that we have had since the 1930's. It has had a very pervasive negative effect on this economy throughout the 1970's, and the




238

action last year to phase out Regulation Q, even though very, very
slowly, is very positive.
I think it is much more important to eliminate the double taxation of dividends than it would be to have an interest tax exemption.
Senator SCHMITT. But you're saving that if you did both, they
would be synergistic? You would get more bang for the buck, so to
speak?
Dr. JORDAN. Yes, it would have a more positive effect, and it
might be a nice companion to the phasing out of Regulation Q
ceilings, because the phasing out of Reg Q ceilings is going to put
upward pressure on the liability costs of financial institutions,
while a disinflationary program is going to reduce the returns to
the financial institutions on the asset side. So you're going to have
an interest margin squeeze. You can have reluctance of the financial institution to take on new commitments. If you exempted
savings or some part from taxation, then the financial institutions
could attract savings at lower nominal interest rates than otherwise, and they would be operating in a healthier condition.
Senator SCHMITT. Dr. Jones, my time is up, but would you care to
comment briefly?
Dr. JONES. Yes. Two points. One has to do with the overall
national savings rate. I think that the key consideration there is
the Federal sector. If we run budget deficits as we have for 20 out
of the last 20 years through fiscal irresponsibility, that the chance
of generating enough economy in this economy to promote investment, which I certainly concur is critical right now, is virtually
hopeless. We have to change that policy. That is one of the reasons
why I want that budget to move as quickly as possible toward
balance. Ideally, the budget should be budgeted over the cycle, so
that in expansion periods we should see surpluses in the Federal
budget, which is perhaps the biggest source of savings of all.
The second point is that I would agree that direct savings incentives for individuals is a very appropriate idea, particularly with
the untested feature of the supply-side reasoning of the economy. I
sense that many administration economists are saying over and
over again to themselves, "Supply side economics works. Supply
side economcs works." And I wonder if they're not trying to convince themselves, as well as those of us brought up on other knowledge. Now it may work, but I would like to help guarantee it
working with direct savings incentives.
Senator SCHMITT. So would I. Thank you, Mr. Chairman.
The Chairman. Senator Heinz.
Senator HEINZ. Thank you, Mr. Chairman.
FEDERAL RESERVE ACTIVITIES CRITICISED

Mr. Jordan, in your statement, I read that as a fairly stiff indictment of the Federal Reserve's activities subsequent to the imposition of credit controls. I read your statement, both your written
and your verbal, as being extremely critical of that Board, which
was represented here by Mr. Volcker a few days ago. Am I characterizing your testimony inaccurately, when I say that you believe
that they acted irresponsibly?




239

Dr. JORDAN. I wouldn't say "irresponsibly." I would say maybe
incompetently. What Chairman Volcker did in 1979, was very bold
and very courageous. It captured the imagination of observers of
the Fed policy, that something really would be different in the
future. The actions of the subsequent spring were very disappointing. The Fed was reluctant to let interest rates drop sharply as the
economy contracted in an environment of controls, because they
were afraid that it would cause the dollar to weaken on foreign
exchange markets. It was a policy focused more on the exchange
rate than it was on the money supply, so the money supply contracted very sharply, and when the controls were lifted, interest
rates started to move up again, and the Fed was afraid that rising
interest rates abort the recovery or deepen the recession. And so
they tried to resist that.
So it means that they took their eye off the money supply. They
first let it drop too sharply, and then they let it expand too sharply. They didn't do what Chairman Volcker said he was going to do
in October of 1979, and we're now going to have to pay a price, and
I'm afraid maybe a large price, in 1981, for that mistake.
Now he says that he is going to get back to the policy that he
announced in 1979. His problem is like that all of his predecessors
in the Fed—they kept stating intentions that we could all applaud
as the right thing for the Central Bank to be doing, and they kept
missing, time and time again. And now he made that mistake in
1979, he's going to have to recover from it.
Senator HEINZ. Now when Mr. Volcker was here, he pleaded that
it was not a question of incompetency, he pleaded that this was
simply beyond the ability of mortal men. Why do you disagree?
Dr. JORDAN. Since I have read the statements of the record of
policy actions released after every meeting last year, the dissents
that did occur, the reasons for those dissents, my observations of
the Fed over the last 14 years—I was employed by the Federal
Reserve for 8 years—I think I understand their operating procedures fairly well. I have studied this large document of their explanations, and I am convinced that they simply didn't want interest
rates to go up, mainly, because it was not only perceived to be a
recession—their forecasts were that the economy would decline in
the second half, and it didn't—but also because it was an election
year.
Senator HEINZ. So your case against the Fed as being—is really
that they were woefully incompetent as judged by the minutes of
Federal Reserve meetings?
Dr. JORDAN. That they refused to let interest rates rise as rapidly
as the market would have dictated? Yes, sir.
Senator HEINZ. Now the same man is Chairman of the Federal
Reserve this year as last year: Mr. Volcker. Everybody I've talked
to holds him in very high esteem. He is obviously an intelligence
man, and I think you yourself do.
Dr. JORDAN. Very much so.
Senator HEINZ. And you yourself underline one of the major
concerns, which is, after a decade of Federal Reserve pronouncements of how they're going to whip inflation, if not now, then, and
now again, and a record of performance that somehow doesn't ever
seem to measure up to Arthur Burns' or anybody else's pronounce-




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mente, that the credibility of what Mr. Volcker is saying and doing
is necessarily cast into some doubt, and it would be extremely
valuable for the economy, for Ronald Reagan, for the economic
program, were the Fed's word to be considered in this instance, as
opposed to previous instances, good, which you are saying, as I
understand you, that the road to hell seems to have been paved
with Fed good intentions.
Now my question is, what should Ronald Reagan or the Congress
do, in order to assure that when the Fed sets some targets which it
freely selects, and which it freely supposes to meet, what should we
do, what mechanism of accountability for the performance goals
they set for themselves, should we aaopt, if any, because there is
none now, Q.E.D.?
Dr. JORDAN. First, I agree with the suggestion that Senator Proxmire made today, and has made many times, that a single-point
target would be better than a range, because of the information
conveyed by that.
Senator HEINZ. And you like the monetary base?
Dr. JORDAN. I prefer the monetary base, but I would adjust it in
conjunction with M-1B at this time, for additional information as
to what is going on in the economy. But the monetary base can be
controlled much more directly. It is their balance sheet, consolidated with the Treasury's monetary accounts. They can hit that
quite closely, certainly, on a monthly basis. It is not necessary to
hit it on a weekly basis, but they can do a good job there too. It is
the same target that the Swiss National Bank and the Federal
Bank of Germany uses. The people understand that the Central
Bank can hit it tf they want to, and so there is credibility when
they announce their targets, that there is a tendency to believe
them.
We don't have that. It would be a very healthy thing if we did.
The thing that is missing, as you suggest, is sanctions. The Fed has
announced targets so regularly in the past and proceeded to miss
them, and nothing happens, that—well, it is just not a safe bet.
Senator HEINZ. What kind of sanctions makes sense?
MONITORING THE FEDERAL RESERVE BOARD

Dr. JORDAN. It has been suggested by a group of private economists that monitors the Federal Reserve regularly, on a semiannual basis, that closely observe their actions, as well as their words,
that requesting the resignation of the Federal Reserve Board would
be appropriate.
Senator HEINZ. You mean the entire Board, or would the head of
the Chairman be sufficient?
Dr. JORDAN. No, I would recommend the entire Board.
Senator HEINZ. That seems like very severe punishment.
Dr. JORDAN. Not that the resignations would be accepted, or at
least not necessarily for all seven of them, but that it would demonstrate that it was going to get close scrutiny—the decision for
them to continue would be closely looked at, and there would be an
explicit decision. It is not that they automatically stay in office, if
they are not responding, but that they are expected to perform,
and if they don't perform, then it is going to be looked at as to
whether or not they ought to be replaced, just to assure that the




241

public knows that a very close serious evaluation is going to take
place.
These targets and the achievement of the target is such an
important variable right now, that I just don't feel that the rest of
the program is going to work, if that doesn't. And we have to have
something new to communicate very effectively to the Congress
that created the Federal Reserve and that oversees the Federal
Reserve, that it is going to do whatever it can to make sure that
they are going to be achieved.
Senator HEINZ. Would the group to which you refer—I assume it
is the so-called Shadow Open Market Committee.
Dr. JORDAN. Yes, it is.
Senator HEINZ. Has the group formally made that suggestion in
any public way?
Dr. JORDAN. It was discussed at their meeting last September,
but I do not recall whether or not it was made a part of the press
release—the "Directive," as it was called. I do know that the proposal will be made again at their meeting later this month.
Senator HEINZ. At this point, do you feel that it is a suggestion
that the Reagan adminstration or the Congress, this committee and
its counterpart committee in the House should take seriously? It
would require statutory enabling legislation, I would think.
Dr. JORDAN. I think it could be in the form of a resolution, as a
request that this be considered. I am not for a minute suggesting
that Chairman Volcker or Vice Chairman Schultz should be replaced. I strongly support them. I would not recommend that their
resignations be accepted if they were submitted. It may be voluntarily on their part to offer to resign. I think it is to make the point
that they are serious about these targets, and the Congess is serious about these targets. I can't think of anyone right now that I
would rather see as the Chairman of the Board of the Federal
Reserve. I think that Volcker is the right man. He has been the
right man since he went in August 1979, and I hope he stays there.
But I think it is to communicate how serious the Fed is about their
targets and how seriously the Congress is about their targets.
Senator HEINZ. Mr. Jordan, thank you. I want to direct one last
question with the Chairman's indulgence to Dr. Jones. Two, really.
One question with two parts.
First, would you agree with Mr. Jordan on his analysis and his
solution, and second, to the question of technically making it easier
for the Fed to do what they say they're going to do, do you endorse
the principle of getting rid of lag reserve accounting, and second,
do you believe, as I believe Mr. Jordan believes, that if you control
over an extended period of time, only the monetary aggregates, not
that you don't have to control M-1B and the other monetary
aggregates?
Dr. JONES, I totally disagree with Dr. Jordan on the question of
Federal Reserve policy. I would categorize the view he offers as
mechanical monetarism, and I see no evidence in recent Federal
Reserve experience that it is possible to achieve tight control over
any particular policy aggregate with effective economic results.
That is what we're aiming for. It is quite possible, technically, to
control some kind of reserve aggregate, but if it bears up for a
loose relationship to the economy and to inflation, I'm really not




242

sure what the exercise is all about, with the exception of the word
"credibility," which I personally feel Paul Volcker is beginning to
achieve as a very responsible and effective Fed Chairman. I think
what we do, if we lift up arbitrary growth rates in these aggregates, as almost a political football, is we make the Fed a political
animal, and I would never want to see that kind of emphasis.
Senator HEINZ. Does that mean that you feel that the targets
which they themselves set, in fact, are political footballs?
Dr. JONES. They could become one, if the Fed was subject to
dismissal on the basis of some kind of arbitrary time frame for not
meeting them.
Senator HEINZ. Well, what is the meaning given the very broad
range
that they encompass—M-1A, last year, the range was from
J
3 /2 to 6 percent. A very broad range. What is the meaning of those
targets, if you are not within the range.
NO GUARANTEE OF HITTING TARGETS

Dr. JONES. Well, the point is this, that the difficulties in hitting
those, in view of the very unstable public demand for money, are
overriding in many cases. It is impossible to perfect policy to the
point of guaranteeing that as of the fourth quarter of 1980 or 1981
or 1982, that the Fed, in fact, will be able to hit with precision
those targets. And let me add another point. Even if they do hit
those targets with some degree of precision, it is going to put an
even greater burden on other sectors of the economy.
That is one of the problems and the flaws in the program, as I
see it now. Tax cuts plus budget cuts, at a time when the Fed is
reducing money supply, means something has to give. Either interest rates continue to go up,as the government is borrowing more
and more, and the financial sector becomes subject to perhaps
major bankruptcy or insolvency problems, or the real economy has
to give, that is jobs and production are lost, or ultimately, hopefully, inflation comes down.
The problem is the arbitrary nature of these targets. I think you
have to make a very important distinction between a group of
public officials who are discharging their responsibilities, which I
firmly believe the Fed is doing, and their statements that they
mean to do as much as they can, and the idea that you can—the
contrasting idea in my view that you can mechanically tell them
that on December 31, they are going to hit their targets. The
numbers for the monthly period of last year speak for themselves.
The Federal Reserve started a money-control experiment. They
think in terms of reserves. And I would also disagree with Dr.
Jordan on his reading of the Fed policy record. Virtually the entire
reading of the Fed policy record is now in terms of reserves and
money. We had a reasonably fair test of the Fed operation to
emphasize money according to their view money supply growth
fluctuated approximately from minus 20 in April M-1A to plus 19
percent in August to minus 11 percent in December.
Now we can say credit controls were relevant, and they were.
The public pulled back. It paid off loans in April. They started to
borrow some in August. But the question is December. Nothing was
unusual at that particular point.




243

The point is, that Dr. Jordan and the mechanical monetarists
assume that the public demand for money is stable. I say it is
highly unstable, and I have a perfect case in point for 1981. Instead
of credit controls being the problem in terms of volatile public
demand for money in 1981, my bet would be, it is balance-sheet
rebuilding. What, for example, would happen if the business sector
started to borrow in the bond market and repaid bank loans. The
money supply would fall.
Dr. Jordan would conclude the Fed has gone too far the other
way. I would conclude that the public's demand for money, in this
case, corporate lending activity, is highly volatile and varies over
the cycle.
So I'm trying to say that we have to face reality in this matter of
monetary control, and I would put full confidence in Fed Chairman
Volcker. He is probably the best Fed Chairman we've had since
Marriner Eccles.
The CHAIRMAN. I would like to comment, however, on this discussion we had with Chairman Volcker the other day on whether the
Fed Chairman should resign or not. And Dr. Jones, I agree with
you; I don't believe that they can be precise enough or that that
could have any real effect.
As I made the comment in that hearing, and I will make it
again, that if the Congress was asked to resign on the basis of the
targets that we set for fiscal policy, we would be resigning every
other month. You look at just the budget estimates. Last year,
forgetting the 6 years I've been here, we started out and passed the
budget resolution, $613 billion last June 12, and promised the
American people a $200 million surplus. And then suddenly, by
September 15, the budget was so badly out of balance we just
ignored the law in the Budget Control Act and adjourned until the
lame turkey session, so we could hide from the American people
what happened in the budget.
So I really don't see in this case, Dr. Jordan, a useful tool in
asking them to resign if they don't meet their targets. But the Fed
would be able to do a much better job, and an easier job, and I am
sure then we would be able to—we would all be agreeing with Dr.
Jones, that the present Board is doing a fantastic job, if we had
stable fiscal policy and balanced budgets. And then you might
could pin that on the Fed, where they have some stable economic
conditions.
But I don't care who the Chairman of the Federal Reserve Board
is; as long as we spend $50 or $60 million a year more than we take
in, they are going to have to monetize that debt. And I can be
critical of some of the technical managements of the Fed, and I
am—the lack of a penalty on the discount window, and the borrowed versus nonborrowed reserves, and mechanical things like
that—but I would sure hate to sit and pick targets for this year
and be told I was going to go to the guillotine if they were not met.
And I know you are not advocating that they necessarily be accepted, but I just can't believe that we can be that precise in those.
And I do think that the key is here in Congress. I suppose that,
Dr. Jones, this is the important point you have made, is it is with
us, and a lot of people don't realize that a President cannot spend
one dime not appropriated by the Congress. He can recommend, he




244

can plead, yell, scream, shout, threaten, veto. But nevertheless, the
entire appropriations process is here with the Congress. And we
tend to look for scapegoats and blame the economic problems on
the Fed or a President; anybody but ourselves.
I wish there was some way we could get that over to the American people, that the solution to this problem is going to primarily
come of the fiscal side when we finally decide to forget our own
parochial interests and face up to the economic realities, rather
than the political realities. We might find a lot of those people out
there will vote for us, even after we have voted.
As a matter of fact, we might be surprised at how the votes
would go, because I think the American people are ready for fiscal
restraint in this country, even though they will yell and scream
about individual programs. Overall, I really think they will support
the program.
But let me say that the testimony from both of you has been
very, very impressive. You obviously have a very detailed knowledge of the economy. And although there are some differing opinions, we do appreciate your testimony and I was just going to close.
But if Senator Proxmire would like to ask some questions?
Senator PROXMIRE. No, no. I am not going to detain the committee any longer. I want to apologize for having had to leave. I have
great respect for both of you gentlemen.
The CHAIRMAN. You missed some very fine testimony.
ECONOMIC FUTURE DEPENDS ON FISCAL PRUDENCE

Senator PROXMIRE. Well, I know that, and I was particularly
impressed by the conclusion of Mr. Jones' statement. I would just
like to commend you on it, because I think you were right when
you said that the future course of the U.S. economy depends, even
more than usual, on how carefully fiscal and monetary policies are
designed. It is hoped that fiscal prudence prevails and spending
cuts come first, followed by carefully designed tax cuts aimed not
at a quick and potentially inflationary fix or consumer stimulus,
but the potential for future sustained real growth and productivityenhancing investment and research.
Hallelujah. I think you are absolutely on target on that. That is
absolutely correct, and I hope we can do that. I think that this is
going to determine whether or not we have more stable prices,
whether we have the kind of growth we need, and I think that is
the key to our success, and I am so happy that you have emphasized this.
The CHAIRMAN. Dr. Jones would probably support cuts in milk
price supports, too.
Senator PROXMIHE. Well, he would. Let me just say that you can
stop beating me over the head with that, Jake. The Agriculture
Subcommittee this morning, by a 14 to 2 vote, voted in favor of
supporting the President and denying the dairy farmers of Wisconsin their price supports. That will mean a cut for every Wisconsin
farmer one third of his income will be cut, by $5,850. Right now he
is making $2.87 per hour, on the average, and this is going to put
him down below $2 an hour. So it is going to be a cruel, tough,
unfortunate cut for Wisconsin dairy farmers, but a great triumph
for the President.




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The CHAIRMAN. Just beating you over the head gives you the
opportunity to make those speeches in defense of your constituents.
Senator PROXMIRE. Unfortunately, the Wisconsin press is not
here this morning. But I want to thank you very much, your
presentations were very good.
The CHAIRMAN. You all should know that if former Chairman
Proxmire and I did not have the opportunity to beat each other
over the head, this committee wouldn't be any fun at all. We have
had much mutual respect and fun with each other over the last 6
years; and if we couldn't stick the knives in each other, it would be
terrible to listen to this economic theory all day long.
But gentlemen, thank you very much. We appreciate your testimony. The committee is adjourned.
[Whereupon, at 12:15 p.m., the hearing was adjourned.]




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