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FEDERAL RESERVE'S FIRST MONETARY POLICY
REPORT FOR 1985
HEARING
BEFORE THE
COMMITTEE ON
BANKING, HOUSING, AND UKBAN AFFAIRS
UNITED STATES SENATE
NINETY-NINTH CONGRESS
FIRST SESSION
ON
OVERSIGHT ON THE MONETARY POLICY REPORT TO CONGRESS PURSUANT TO THE FULL EMPLOYMENT AND BALANCED GROWTH ACT OF
1978
FEBRUARY 20, 1985
Printed for the use of the Committee on Banking, Housing, and Urban Affairs
U.S. GOVERNMENT PRINTING OFFICE
WASHINGTON : 1985
COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
99th Congress—January 3, 1985
JAKE GARN, Utah, Chairman
JOHN HEINZ, Pennsylvania
WILLIAM PROXMIRE, Wisconsin
WILLIAM L. ARMSTRONG, Colorado
ALAN CRANSTON, California
ALFONSE M. D'AMATO, New York
DONALD W. RIEGLE, JR., Michigan
SLADE GORTON, Washington
PAUL S. SARBANES, Maryland
MACK MATT1NGLY, Georgia
CHRISTOPHER J. DODD, Connecticut
CHIC HECHT, Nevada
ALAN J. DIXON, Illinois
PAUL TRIBLE, Virginia
JIM SASSER, Tennessee
GORDON J. HUMPHREY, New Hampshire
FRANK R. LAUTENBERG, New Jersey
—
•
(Vacant)
COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
99th-Congress—February 21. 1985
JAKE GARN, Utah, Chairman
JOHN HEINZ, Pennsylvania
WILLIAM PROXMIRE, Wisconsin
WILLIAM L. ARMSTRONG, Colorado
ALAN CRANSTON, California
ALFONSE M. D'AMATO, New York
DONALD W. RIEGLE, JR., -Michigan
SLADE GORTON, Washington
PAUL S. SARBANES, Maryland
MACK MATTINGLY, Georgia
CHRISTOPHER J. DODD, Connecticut
CHIC HECHT, Nevada
ALAN J- DIXON. Illinois
PHIL GRAMM, Texas
JIM SASSER, Tennessee
M. DANNY WALL, Staff Director
KENNETH A. McLEAN, Minority Staff Director
W. LAMAR SMITH, Economist
(II)
CONTENTS
WEDNESDAY, FEBRUARY 20, 1985
Page
Opening statement of Chairman Garn
Opening statements of:
Senator Proxmire
Senator Heinz
Prepared statement
Senator Dixon
Prepared statement
Senator Cranston
1
2
4
5
7
7
127
WITNESS
Paul A. Volcker, Chairman, Board of Governors of the Federal Reserve
System
Prepared statement
The economic setting
Monetary policy in 1984
Monetary policy in 1985
The challenge ahead
Conclusion
Table on growth ranges
Charts:
Chart 1: Ml target ranges and actual
Chart 2: M2 target ranges and actual
Chart 3: M3 traget ranges and actual
Chart 4: Debt monitoring ranges and actual
Attachment I: The implications for monetary policy of the near failure of the Continental Illinois Bank
Attachment II: The international debt situation in 1984
Attachment III: Targeting real growth
Attachment IV: The base for monetary target ranges
"Monetary Policy Report to Congress Pursuant to the Full Employment
and Balanced Growth Act of 1978"
Section 1: The outlook for the economy in 1985
Section 2: The Federal Reserve's objectives for money and credit in
1985
Section 3: The performance of the economy in 1984
Chart 1: The performance of the economy in 1984
The household sector
Chart 2
The business sector
Chart3
The government sector
Chart 4
The foreign sector
Charts
Labor market developments
Chart 6
Price developments
Chart?
Section 4: Monetary policy and financial developments in 1984
Chart 1: Ranges and actual money growth
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10
10
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Page
Paul A. Volcker, Chairman, Board of Governors of the Federal Reserve
System—Continued
"Monetary Policy Report to Congress Pursuant to the Full Employment
and Balanced Growth Act of 1978"—Continued
Section 4—Continued
Chart 2: Ranges and actual money and credit growth
Table: Growth of money and credit
Chart 3: Short- and long-term interest rates
Chart 4: Reserve aggregates
Need for public announcement
Evaluation of performance
Ml rising recently
Inflation under control
Reduction of $50 billion
Significant reduction in deficit
Burden of debt as a nation
Effects from the strong dollar
Progress of Continental Bank
Squeeze on indebted farmers
Steps to help the farmers
Response to Senator Dixon from Chairman Paul Volcker concerning a
budget freeze on Federal spending
Possible solutions for the trade problem
Currency intervention
Breakthrough on deficit is getting dimmer
Flexibility needed
Question of farm bank failures
Crisis situation
Response to written questions from:
Senator Proxmire
Senator Gam
Senator Mattingly
Senator Cranston
Senator Dodd
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FEDERAL RESERVE'S FIRST MONETARY
POLICY REPORT FOR 1985
WEDNESDAY, FEBRUARY 20, 1985
U.S. SENATE,
COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS,
Washington, DC.
The committee met at 8:35 a.m., in room SD-538, Dirksen Senate
Office Building, Senator Jake Garn {chairman of the committee)
presiding.
Present: Senators Garn, Heinz, Mattingly, Hecht, Gramm, Proxmire, Cranston, Riegle, Dodd, Dixon, Sasser, and Stennis.
OPENING STATEMENT OF CHAIRMAN GARN
The CHAIRMAN. The Banking Committee will come to order.
Mr. Chairman, we appreciate you changing the schedule from
9:30 to 8:30, 8:30 hearings in the Senate are not the normal thing
that we do. But we can blame the British. I'm sure everyone knows
that Prime Minister Thatcher, whom I have great admiration for,
is speaking to a joint session in Congress at 11 o'clock, and the
Senate is to form in the Senate at 10:30. That was the reason for
the request. At the time we set the hearing, we certainly did not
know that Mrs. Thatcher would be speaking. Clearly she is a great
world leader, and it is necessary for us to be there.
I would hope that we would be able to conclude in 2 hours. If we
have not, I have reserved time at 2 o'clock to return. I would hope
that is not necessary, but if my colleagues on the committee wish
to question longer than a 2-hour period, we will return at 2 o'clock.
The Full Employment Balanced Growth Act of 1978 requires the
Federal Reserve to come before the Banking Committees of Congress twice each year to testify on monetary policy. These biannual
hearings are important because Congress must understand the central bank's monetary policy in order to fulfill Congress' constitutional responsibilities in this area.
Public hearings on monetary policy are also important because of
the Federal Reserve's intentions with regard to monetary policy
must be understood by the private sector in order to make intelligent economic decisions.
As part of the biannual hearings, the Fed is required by the 1978
act to announce specific target ranges for growth in the monetary
aggregates. While these target ranges provide important information to Congress and to the private sector, they are not sufficient to
provide an adequate understanding of the Fed's intentions regarding monetary policy.
(1)
Questions which are outstanding today include the following:
Which monetary aggregate currently is the primary focus of
monetary policy?
Is the Federal Reserve continuing to target interest rates?
To what extent does the Federal Reserve feel its freedom of
action in setting monetary policy is limited by agricultural, energy,
and international loan problems facing the banking system?
To what extent do foreign exchange considerations, like the
rising value of the dollar, affect monetary policy?
Enhancement of the public's needed understanding of these aspects of monetary policy is a primary purpose of this morning's
hearings.
I would also say, Mr. Chairman, that I have been keeping up
with what's been going on while I have been in other parts of the
country doing other things. And I have seen considerable criticism
of your speaking out against budget deficits. Well, we have had
that conversation many times over the last several years—the relationship of monetary and fiscal policy—and I see no reason why
you should not continue to speak out on the actions of Congress
and the need to reduce the deficit. There has certainly been no hesitancy on the part of my colleagues in this body and the House of
Representatives to speak out on monetary policy. There should be
no double standard here.
We make comments about how you conduct monetary policy, and
you should feel free to talk about how we conduct fiscal policy and
keep the pressure on Congress. Maybe if you and others do, we will
do something about the deficits and make your job of managing
monetary policy easier.
Senator Proxmire.
OPENING STATEMENT OF SENATOR PROXMIRE
Senator PROXMIRE. Mr. Chairman, first, it's good to welcome you
back from the brink of outer space and back here in an area which
certainly reminds us of the fact that we have problems here as well
as in space. And also the columns of Doonesbury.
The CHAIRMAN. The only thing that bothers me, Bill, is the
number of people who were happy to see me go into space, but they
don't want me to come back. [Laughter.]
Senator PROXMIRE. Chairman Volcker, when you were appointed
to a 4-year term as Chairman of the Federal Reserve Board in July
1983, you filed a statement with this committee, as we require of
all Presidential nominees. One of the questions was, and I quote:
"Do you expect to serve the full term for which you have been
appointed?"
Here is how you answered that question. You said: "I do not feel
committed to do so."
Now, your statement at the time was widely interpreted as a
signal that you would step down as Fed Chairman, shortly after
the next Presidential election, probably a year after or so.
However, a careful reading of the transcript of your nomination
hearing reveals that at no time did you say that you would step
down, or reach an understanding that you would do so. You were
simply indicating to the committee and to the Congress that you
did not feel yourself committed to serving a full 4-year term.
I recall this history because I now urge you to abandon whatever
plans you may have had for an early resignation, and that you
serve out the balance of your 4-year term. The country clearly
needs your continued leadership of the Fed. I do not know what
private understanding you may have reached with President
Reagan concerning your reappointment, but serving out the remainder of your term would be entirely consistent with your representations to this committee and the Congress. And I hope you will
stay the course, and here's why.
First, none of your potential successors enjoys anywhere near the
degree of confidence and respect that you have built up with the
business and financial community. Your policies at the Fed have
been credited, and rightfully so, with breaking the back of inflation. But, inflation is still a threat and it is not time to be changing
leadership at the Fed until we have squeezed out most of the residual inflationary expectations which are responsible for keeping
real interest rates far above their historic levels.
Second, we have a brand new economic team at the Treasury.
Secretary Baker is a brilliant and able lawyer but he has practically no experience in financial matters, especially on the international level. More than ever, we need the sure hand of the Fed under
your experienced leadership to help the new Treasury team meet
its difficult responsibilities.
Third, there still has been no satisfactory progress in closing our
enormous budget deficit. Indeed, this year, it will be bigger than
it's ever been in our history by far. It's expected to be $222 billion.
It will probably be substantially bigger than that.
President Reagan's budget proposal is clearly inadequate. The
Republican leadership in the Senate, despite high hopes, has been
unable to develop their own package. The Democrats in the House
have not presented their alternative. We need the forceful leadership of someone like yourself to keep us on target. You have managed to maintain independence from both the administration and
the Congress, and your voice is listened to with respect. I don't
know of anyone else who could carry that role as successfully as
you.
Now, finally, and most important of all, Mr. Chairman, during
the next 2 Vz years, we can expect immense pressure on the Federal
Reserve Board, probably more than ever before in its history, to
ease up on monetary restraint. That's a nice way of saying to monetize the debt.
This year, we will have a deficit of $222 billion, as I say, according to the optimistic estimate of the administration. It could be
higher, much higher. We may or may not reduce that deficit significantly next year, in 1986; even if we vote to do so, any number
of unforeseen economic developments could frustrate our intentions and skyrocket the deficit to $300 billion or more.
Also, foreign countries could cool, maybe suddenly and dramatically, their willingness to loan capital to this country. The pressure
for the Federal Reserve Board to step into the breach to ease credit
in a big way could be swift and powerful. This country urgently
needs a chairman who, under those conditions, would not only
have the will to say no but would have the support of the business
and banking community necessary to make that no stand up.
Mr. Chairman, I realize that I am asking for you to make a painful sacrifice. As you may recall, when you were before this committee in 1983 for your confirmation, I stressed the massive difficulties
you face with an, alas, poor Volcker warning.
So I hope you will consider this plea and decide to stay on for
your full 4 years. In my judgment, the country needs you more
than they need any other public official in this country today. We
need your calm, sane voice.
As the chairman of the committee has just reminded us, a remarkable British Prime Minister is going to address the Congress
in a couple of hours. And I hope that if you have a thought to
whirl around in that fine mind of yours while you're deciding
whether to stay or go that you will strike a blow for mental health
and remember the words of a previous distinguished British Prime
Minister, the Earl of Beaconsfield, Benjamin Disraeli, who observed
the only thing that has driven more men mad than love is the currency question. [Laughter.]
And with you gone, the currency question will, as Disraeli foresaw, make a bumper crop of blithering idiots on this committee, in
the Congress, in the business community, and throughout the country.
So I hope you will, as I say, strike a blow for mental health and
stay where you are.
The CHAIRMAN. I'm not sure there's any mental health in Washington. I made the comment the other day when somebody asked
me what I'd been doing lately. And I said, well, I'd been down in
Houston, where everybody knows what they're doing. And that's a
very unique experience after 10 years in the Senate. [Laughter.]
Before I turn to Senator Heinz, I would like to welcome Senator
Gramm to the committee. We have not yet officially organized because the Senate has not yet been able to come to an agreement on
the size of committees or the ratios. But it appears that the Senate
Banking Committee, and I use the term "appears," will be reduced
in number from 18 to 15, which is what I've been trying to do since
it grew from 15 to 18 a few years ago. I think that is the way it will
stay. Senator Gramm, we are pleased to have you as a member of
the committee. I know you will be a valuable addition.
Senator GRAMM. Thank you.
The CHAIRMAN. Senator Heinz.
OPENING REMARKS OF SENATOR HEINZ
Senator HEINZ. Mr. Chairman, thank you. First, I'd ask unanimous consent that my prepared remarks be placed in the record in
their entirety.
The CHAIRMAN. Without objection.
Senator HEINZ. Second, I would like to commend you, Senator
Garn, on the very special effort you made to make sure that while
you are engaged in your training, which we know is long and onerous that, nonetheless, you are here fulfilling in their entirety your
responsibilities as a U.S. Senator this week.
I think it needs to be pointed out that we all do read Doonesbury. [Laughter.]
That, in fact, this is the first official business of the committee.
This is our semiannual meeting where we hear from the Chairman
of the Federal Reserve on monetary policy. We've been tasked with
that responsibility by the Congress.
There have been no recorded votes, although one is likely today.
And we know that you plan both the Meese nomination vote and
this particular hearing, so that there would be absolutely no question that you were performing your duties in space and your duties
in Congress 100 percent.
By the way, anybody who can do two jobs at one time is probably
going to be accused of moonlighting. [Laughter.]
The CHAIRMAN. I'll think about it. [Laughter.]
Senator HEINZ. The only other comment, and this I direct to
Chairman Volcker, which I hope he will touch on in his remarks,
we are faced with a most unusual situation. We have a trade deficit that is $127 billion and going up. We have interest rates that
appear to be going down. And we have the Treasury Department,
breaking with earlier precedent, intervening in the exchange markets to hold the value of the dollar down.
In spite of these three factors which would normally, each of
them, bring the dollar down, the dollar has risen on the international exchange markets. That causes me to ask whether or not it
is now true that such things as trade flows are indeed what we
have traditionally thought to be a major significant determinant of
the strength of a nation's currencies, have not been outflanked to a
considerable degree, indeed, to the point of significance, by capital
flows.
In 1983, the Treasury Department estimated that there were $2
trillion of trade worldwide. But that there are $20-$30 trillion of
capital flows. That is, a factor 10 to 15 times larger than trade
flows.
I would be interested if we can touch on that in your commentary or in the questions because it seems to me the inevitable question that is posed to you is whether the Federal Reserve must now
consider the demand for capital. And, if you will, from your point
of view, the foreign demand for dollars, or the foreign demand to
invest in the United States as a very vital and appropriate factor
in determining the appropriate monetary growth rate.
I would only agree that having asked that question, Disraeli was
right on the mark. I hope that I have asked the right question and
I hope there is, if I have asked the right question, an answer to it
that will not drive men mad.
Thank you, Mr, Chairman.
The CHAIRMAN. Thank you, Senator Heinz.
[The complete prepared statement of Senator Heinz follows:]
OPENING STATEMENT OF SENATOR HEINZ
As we meet here this morning, many of the overall measures of
the performance of our domestic economy look relatively good. For
all of 1984, real GNP was 6.8 percent higher than in 1983. This constituted the largest 1-year expansion of output since 1951.
6
Last year nonfarm productivity grew 3.1 percent. This compares
with an 0.8 percent average annual growth rate during the previous decade.
On the inflation front, performance remains far superior to that
of a few years ago. Consumer prices rose 4 percent in 1984, about
the same rate of increase as in 1982 and 1983.
While the unemployment rate in January edged up 0.2 to 7.4 percent, this reflected a surge in the number of people seeking employment, not a decline in the number of jobs.
Finally, since our last monetary policy hearing in July 1984, the
prime rate has declined from 13 to lOVfc percent.
Of course, we all know that the budget and trade deficit numbers
are not as rosy. The President's budget foresees a deficit of $180
billion in fiscal year 1986, even if Congress were to adopt all of the
administration's proposed expenditure reductions.
Last year the United States ran a $123 billion trade deficit, and
the deficit for 1985 appears certain to be even higher.
A major contributor to that trade deficit is the soaring value of
the dollar. On an index weighted according to the amount of U.S.
trade with individual countries, since mid-1980 the dollar has risen
more than 50 percent in value.
Equally troubling is the fact that old conceptions about economic
policy are being subjected to increasing challenge. Our domestic
economy does not appear to be operating as it once did, and the
explanation appears to lie in the growing importance of international economic developments.
Until recently, macroeconomic policy here at home could be
based on the assumption that the success or failure of an industry
would be determined by its ability to meet the competition in
terms of quality of product and cost of production.
Under such a concept of how our economy operates, exchange
rates were determined by trade flows. A rise in our exchange rate
would reflect an increase in the demand for our country's exports,
and the rise in the exchange rate would tend to equalize trade
flows.
Today, exchange rates clearly are not driven by trade flows, and
the prospects for U.S. industries that depend on exports clearly do
not reflect their ability to control costs and compete in quality.
As a second example of the growing challenges to old conceptions
about economic policy, I point to the presumed inevitable tie between an acceleration in money growth and an acceleration in inflation. Statistical analysis of the past performance of our economy
had pointed to the conclusion that an acceleration in monetary expansion would lead to an inevitable upward jump in the inflation
rate after a lag of about 2 years.
Given this historical statistical relationship and given the acceleration of money growth after mid-1982, many economists predicted that inflation in the U.S. economy would accelerate during 1984.
But, as I have already noted, this did not occur. A primary reason
appears to be an international influence on our domestic economy:
the rising value of the dollar lowered the cost of imports and prevented domestic producers from raising their prices.
As yet another example of the growing challenges to old conceptions about economic policy, I point to factors presumed to deter-
mine the demand for money. Statistical analysis of historical data
had pointed to the conclusion that the demand for dollars was a
function of economic growth here in the United States and domestic interest rates.
Prof. Ronald I. McKinnon, however, has argued persuasively that
foreign demand for dollars has become a major determinant of the
overall demand. As a result, Dr. McKinnon has argued that the
Federal Reserve must now consider the foreign demand for dollars
in determining the appropriate monetary growth rate.
In conclusion, I believe that the growing importance to our economy of international economic developments is posing a serious
challenge to old conceptions about economic policy. This morning I
intend to focus on the appropriate policy responses to these new
international economic realities.
The CHAIRMAN. Senator Dixon.
OPENING STATEMENT OF SENATOR DIXON
Senator DIXON. Mr. Chairman, I'm delighted to see a person I
regard so highly in public service, Chairman Volcker, here this
morning. As I mentioned to the Chair, I have to go over to the
House side to testify at 9 o'clock on Congressman Annunzio's
Statue of Liberty's coin bill. I'll be back here, I assure you, by 9:30
for the question period.
I ask consent to put this statement in the record at this time in
the interest of our time constraints, and I'll return about 9:30.
The CHAIRMAN. Without objection. Thank you, Senator.
[The complete statement follows:]
PREPARED STATEMENT OF SENATOR DIXON
According to the President's proposed budget for fiscal 1986, I
should be very optimistic about the future prospects for the U.S.
economy. The statistics the President cites are very impressive:
Economic growth of 6.8 percent in 1984; corporate profits up 90 percent since the recession; 7.2 million new jobs created in the last 25
months; and inflation of only 4 percent.
These numbers paint a rosy picture of the prospects for a bright
economic future. Unfortunately, however, this is not the total picture. Other numbers show: A national debt that will soon exceed
$1.8 trillion; an all-time record budget deficit of $223 billion for
fiscal year 1985; interest expense that will exceed $140 billion next
year; a dollar that is 40 percent overvalued; and a trade deficit of
more than $123 billion for 1984.
The real question is how long the first set of numbers can coexist
with the second? How long can low inflation and high GNP growth
last when we are forced to borrow $100 billion a year or more overseas to meet Government borrowing requirement, when the export
sectors of our economy are literally being destroyed by the impact
of the too-strong dollar? In short, how long can we go on like this
before we have to pay the bill?
I raise these questions not because I have some simple answers
but rather because it is long past time to take a hard look at where
our failure to address the Federal budget problems is taking us.
Illinois is a major agricultural State. Right now, conditions in the
agricultural economy in my State are worse than any time since
the Great Depression. Illinois farmers depended on export markets
to sell a large part of their crop, but those export markets are
drying up because of the rise in the dollar.
Caterpillar tractor, one of Illinois' preeminant manufacturing
firms, is similarly affected. It is literally being beaten down by the
dollar. The company is being forced to move an increasing amount
of its operations offshore, and those jobs, once lost, will not likely
return to Illinois.
The Chairman of the Federal Reserve Board is with us this
morning to discuss monetary policy and the outlook for the economy. His statement and his announcement of the monetary targets
for this year are, as always, matters of great interest, if the crowd
in this hearing room is any indication.
I have an enormous amount of respect for Chairman Volcker and
I am always delighted to have the benefit of his counsel and advice.
However, I am increasingly uneasy about the burdens we are putting on the Chairman, and I wonder how long the Federal Reserve
Board will be able to successfully conduct monetary policy without
better cooperation from Federal fiscal policy.
I think that the Federal Reserve has, by and large, done a good
job of managing monetary policy. But I do not believe that monetary policy can, by itself, ensure long-term steady, noninflationary
economic growth for our economy. I do not believe that monetary
policy can by itself, correct the imbalances in our economy being
created by the continuing rise of the dollar. I am not even convinced that monetary policy can, by itself, bring down our current
too-high interest rates. I know that rates have come down somewhat in the past year, but I would note that the premium over inflation still seems to be at record levels and that the Congressional
Budget Office is forecasting higher rates by 1986.
I know that Chairman Volcker will be the first to acknowledge
that he cannot go it alone. So what's really at issue here this morning is whether we are willing to begin taking the steps to create a
more balanced approach to managing the economy, reducing the
degree of stress past actions by the President and Congress have
put on the conduct of monetary policy.
Simply put, I think our economic future depends less and less on
the monetary targets and more and more on our ability to restrain
the growth of Federal spending and our ability to reduce evergrowing Federal deficits.
I look forward to hearing from the Chairman this morning, and
having his comments about what we can do to keep the healthy
segments of our economy healthy and also about what we can do to
restore economic health to the parts of our economy that aren't in
such good shape, particularly the export sectors in both manufacturing and agriculture.
The CHAIRMAN. Senator Hecht.
Senator HECHT. No statement. Just a welcome, sir.
The CHAIRMAN. Senator Gramm.
Senator GRAMM. Mr. Chairman, please proceed.
The CHAIRMAN. Chairman Volcker, please proceed.
9
Mr. VOLCKER. Well, Mr, Chairman, let me say first of all that I
particularly appreciate your presence here this morning for these
hearings, recognizing your other preoccupations. I thought for a
moment Senator Heinz was going to suggest the dollar was in
orbit. [Laughter.]
The CHAIRMAN. I'm not sure, Mr. Chairman, that I'll be able to
see the top of the national debt when I'm up there. [Laughter.]
Mr. VOLCKER. I do appreciate, too, the comments that Senator
Proxmire made. I appreciate them very much. I haven't got any
commitments one way or the other, except to maybe my own
mental health at some point.
Also, of course, I appreciate the opportunity to be here to present
our objectives for next year. We have distributed the regular Humphrey-Hawkins report this morning, and I'll just comment more
generally on our decisions, the outlook for the economy in the context of some important, unfinished business that we all face.
Thank you, Mr. Chairman.
[The complete prepared statement and the monetary policy
report to Congress follows:]
10
STATEMENT OF PAUL A. VOLCKER, CHAIRMAN, BOARD OF
GOVERNORS OF THE FEDERAL RESERVE SYSTEM
I appreciate this opportunity to appear before you to
present the Federal Reserve's monetary policy objectives
for 1985.
In accordance with the Humphrey-Hawkins Act, the
semi-annual report of the Federal Reserve was transmitted
to you this morning.
That report reviews in detail economic
developments and monetary policy in 1984, and sets forth
for 1985 the plans for policy-'by the Federal Open Market.
Committee.
This morning I would like to discuss the Committee's
decisions and the outlook for the economy in the context of
some important unfinished business facing all of us responsible
for economic policy.
The Economic Setting
The familiar objective of monetary policy is to foster
sustained economic growth and employment in a context of
reasonable price stability.
Stated so generally, that
objective can hardly be challenged; it indeed encompasses
the broad goals of economic stabilization policy generally.
11
Measured in those terms, there is clear reason for
satisfaction in the performance of the economy last year.
In summary, with real gross national product up by 5-1/2
percent over the year, and by about 12 percent in two years,
we have enjoyed the strongest expansion since the Korean
War period.
On top of the gains in jobs in 1983, employment
increased by over 3 million last year.
The unemployment rate
fell one full percentage point to 7.2 percent at year-end.
Real incomes for the average American are up.
Prospects for sustained growth and productivity over
time rest importantly on success in achieving and maintaining
an environment of greater stability of prices and financial
markets.
In that light, it is encouraging that, contrary
to widespread earlier expectations, the strong growth of 1984
took place without inflation increasing appreciably from
the sharply reduced levels of 1982 and 1983.
Specifically,
the consumer price index increased around 4 percent last year,
little changed from the previous two years, and prices of most
12
goods (in contrast to services) at the wholesale and retail
levels rose by less than that.
While the evidence Ls less
tangible, there are also encouraging signs that chronic
expectations of future inflation have been damped.
The behavior of actual prices and nominal wages,
which by some measures rose more slowly in 1984 than in
1983 despite expanding demands for labor, may in some part
reflect those changes in attitude.
Businessmen and workers
no longer seem so preoccupied with a need to anticipate
inflation in their pricing and wage decisions.
And declines
in bond yields after midyear seemed to reflect, to some degree,
less fear of future inflation.
To be sure, a number of factors that may not be lasting
have helped to hold price increases down.
The continuing
appreciation of the dollar and strong competition from imports
have placed strong pressures on prices and wages in some
manufacturing and mining industries. Widespread declines in
commodity prices cannot persist indefinitely.
Unemployment
13
is still higher than we would like to see.
But it
is also true that progress against inflation, as it is
prolonged, can potentially feed on itself by encouraging
restrained price and wage behavior.
As we start 1985, the immediate economic outlook
reasonably favorable in these respects.
appears
Projections of Federal
Open Market Committee members that I will be reviewing later
in my testimony broadly parallel those of the Administration,
the Congressional Budget Office, and many other observers;
economic growth is expected to remain strong enough in 1985
to produce some further decline in unemployment, with little
if any pickup in inflation.
But we must not be beguiled by those tranquil forecasts
into any false sense of comfort that all is well.
If the
enormous potential of the American economy for growth and
stability —
not just for 1985 but for the years beyond
is to become reality, we need a sense of urgency, not of
relaxation.
—
14
For one thing, with the general price level still
rising in the neighborhood of 4 percent a year —
and with
prices of services that today account for so much of the
economy rising more rapidly than that —
we should not
confuse evidence of progress against inflation with ultimate
success.
Indeed, the more favorable price expectations I
noted a few moments ago could prove fragile —
highly vulnerable
to any indications that public policy is prepared to accept and
accommodate to inflationary forces.
That must be of particular
concern in the conduct of monetary policy.
Perhaps more immediately, despite the strength of the
overall expansion, some important areas of the economy are under
strain and there have been recurrent international and domestic
credit problems.
Those strains and pressures are aggravated
by underlying imbalances that, unless dealt with effectively,
will undercut the long-term outlook.
One of those imbalances was highlighted by the slowdown
in GNP growth we experienced in the third quarter.
Such a
15
"pause" is not an unusual feature of an expansion period.
Demand does not grow smoothly, and occasional inventory
imbalances will develop that require production adjustments.
What was unusual last summer was that the slowing of demand
growth was accompanied by a surge in imports, magnifying the
effects on domestic producers.
That summer import surge was
reversed by year-end, but the underlying trend toward higher
imports is clear.
Our trade deficit increased to about
$110 billion in 1984, far higher than ever before, and the
entire external current account deficit —
goods and services —
since 1982.
counting both
has deteriorated by about $100 billion
The sustainability of that trend, politically
as well as economically, is, to say the least, questionable.
The rising trade deficit helps account for the failure
of a number of important sectors to participate at all fully
in the expansion.
Agriculture, heavy capital equipment
producers,
and the metals industry, all of which face difficult structural
problems in any event, are examples.
They are further pressed
16
by interest rates that, as you know, remain historically high,
both in nominal terms and relative to recent inflation.
Looking abroad, growth in many industrial countries
remains sluggish amid continuing high levels of unemployment,
and depreciation of their currencies vis-a-vis the dollar
seems to be one factor inhibiting more expansionary policies.
Important developing countries are still struggling to restore
stability and maintain growth while laboring under heavy debt
burdens.
In this interdependent world, these difficulties
feed back on our own prospects.
It is no coincidence that the record external imbalance
and continued high interest rates have been accompanied by
large federal budget deficits —
deficits that according to
projections of both the Administration and the Congressional
Budget Office will only deepen in the years ahead in the
absence of decisive corrective action.
Government deficits can be relatively benign and
even useful in boosting incomes and purchasing power in the
17
slough of recession and when private investment and credit
demands are weak.
It is also true that our growing volume
of imports over the last two years has provided an impetus
for growth in other countries when other expansionary forces
were weak.
Moreover, the kind of obvious squeeze on, or
"crowding out" of, domestic housing and investment that
many anticipated as the expansion has developed has not
been apparent.
We have been able to reconcile high deficits, sharply
rising imports, and strong investment mainly for one reason:
we have been able to attract an enormous amount of savings
from abroad to supplement our own.
The net capital inflow
approached $100 billion last year, and it will probably need
to be still larger this year.
Domestic net savings —
by
individuals, businesses, and state and local governments —- are
running at about $325 billion, so the supplement from abroad
adds close to a third to net savings generated internally.
The
18
net capital inflow was equivalent last year to more than half
of the budget deficit.
That same inflow of funds has encouraged a very strong
dollar.
The strong dollar, in turn, contributes importantly to
the huge and growing trade deficit.
but perhaps not fully understood.
Our policy dilemma is simple
We cannot logically welcome the
capital inflow from abroad in one breath and complain about the
trade deficit in the next.
They are two sides of the same coin.
We are managing to finance the deficit and maintain
housing and investment expenditures with the help of imported
capital.
At the same time, the exporter, those competing
with imports, and the farmer are being "crowded out."
Looking ahead, the stability of our capital and money
markets is now dependent as never before on the willingness of
foreigners to continue to place growing amounts of money in
our markets.
So far, they have been not only willing but
eager to do so.
But we are in a real sense living on borrowed
money and time.
19
It is up to all of us to make constructive use of both
the money and the time.
all of us —
In essence, that is the challenge for
for monetary and fiscal policy, and for all the other
policies that can contribute to a productive, growing economy.
Monetary Policy in 19EU
As you will recall, the economy was expanding particularly
rapidly during the early part of 1984, and demands for money
and credit —
and for bank reserves to support monetary growth
were also strong.
—
By early spring, data available at the time
showed Ml increasing at rates well into the upper portion of
its range for the year, which targeted growth at 4-8 percent.*
At the same time, driven by the financing needs generated by
rising levels of private spending and by the Federal Government,
M3 and non-financial credit were expanding around or above the
upper end of their long-term ranges.
*The data in this testimony for the monetary aggregates
reflect recent seasonal and benchmark revisions. While the
changes for the year as a whole were small, the revised data
for Ml for the first half of the year are lower, and the second
half higher, than reported earlier.
20
The strong expansionary
forces in the economy were
reflected in some limited upward movements in interest
rates ir February and March, and early in the spring the
Federal Reserve began to exert some additional restraint on
reserves being supplied through open market operations.
Consequently, depository institutions were forced to rely
increasingly on borrowing at the discount window to satisfy
demands for reserves.
With credit demands and the economy
continuing to expand strongly, and with markets concerned
about the possibility that inflationary forces might reassert
themselves as the period of strong expansion lengthened,
interest rates moved noticeably higher in the spring.
In
April the Federal Reserve increased its discount rate 1/2
of a percentage point to 9 percent to bring this rate into
better alignment with market rates and to discourage reserve
adjustment at the discount window.
In May, a liguidity crisis developed in one of the
largest commercial banks in the country, growing out of
21
continuing concerns over weaknesses in its loan portfolio.
The Federal Reserve, the FDIC, and the primary supervisor
of the bank, the Comptroller of the Currency, worked closely
together to support the orderly functioning of the institution
while more permanent recapitalization and other elements of a
long-term solution could be developed.
Nonetheless, that incident,
together with continuing concerns about international debt
problems, for a time contributed to uneasiness in banking markets,
and interest rates on short-term private credit instruments
rose appreciably above those on government securities.*
Demands for money slackened after midyear as the economic
expansion slowed.
Long-term
interest rates began to drop from
the higher levels reached in the spring as inflation concerns
moderated.
With the problems of the Continental Illinois
Bank contained and progress made toward restructuring the debts
of some important developing countries, the abnormal interest
*Attachments I & II summarize these and related
developments, and the Federal Reserve response, more fully.
22
rate spreads began to narrow, but the money markets as a whole
remained under some pressure.
By late August and September,
with Ml growth moving toward the midpoint of its range and M3
expansion slowing toward the upper end of its range, and with
some evidence that economic growth had slowed, the Federal
Reserve began to ease pressures on reserve positions.
That process continued through the fall, and borrowing
at the discount window fell steadily from September through
January.
Late in the year, total and nonborrowed reserves began
to grow rapidly.
Short-term interest rates declined between 2-1/2
and 3-1/2 percentage points over the last four months of the year.
Reacting to these declines, and to an extent facilitating them,
the Federal Reserve in two half-point steps reduced the discount
rate to 8 percent, the lowest level since 1978.
Several additional factors influenced judgments about
the appropriate degree of easing of reserve positions during
the fall.
The dollar remained exceptionally strong in foreign
23
exchange marKets, potentially increasing pressures on some
sectors of the American economy and a source of growing concern
amony some of our trading partners experiencing depreciating
currencies vis-a-vis the dollar.
At the same time, relatively
favorable incoming data about prices and wages tended to
allay concerns about actual and potential inflationary
pressures.
in tact, prices of many sensitive commodities
were falling appreciably.
In these circumstances,
reserves
could be provided more liberally, and growth in the money
supply more actively supported without providing a basis
for a destructive rise in inflation
expectations.
The fall in interest rates and the more generous provision
of reserves in the context of some increases in economic activity
led to a rather strong revival of Ml and M2 growth around
year-end, bringing both aggregates relatively close to the
mid-points of their respective ranges.
As monetary and
credit growth continued at a relatively rapid pace into
January, the easing process came to an end.
24
Unlike the pattern during much of 1982 and 1983, when
Ml grew more rapidly than nominal GNP (that is "velocity"
slowed), the income velocity of Ml rose 4 percent last
year.
That is broadly in line with cyclical experience in
the past, taking into account both the pattern of interest
rate movements ai\d income growth.
M2 velocity also increased,
rising around 1-1/2 percent following two yearly declines.
These developments provide some support for the view
that velocity trends over time, as well as cyclical changes
for these aggregates, may be returning to patterns more
along the lines of earlier experience.
In contrast, in
1982 and 1983, during a period of rapid transition to deregulation of deposit interest rates and substantial economic
uncertainty, those earlier patterns had been disrupted and
velocity had declined appreciably.
The rise in M3 and credit during 1984 exceeded
expectations at the start of the year, and both measures
exceeded by a considerable margin the upper limits of their
25
ranges over the year as a whole.
In fact, credit increased
at its most rapid pace over the entire post-World War II
period, both in absolute terms and relative to nominal GNP.
Debt growth of this magnitude would appear to be much faster
than consistent with the long-run health of our economy and
financial system.
It reflects to some degree the imbalances
in our economy I emphasized earlier.
For example( the budget deficit led to expansion of
federal debt of 16 percent, an unprecedented rate of growth
in the second year of a business cycle.
The growth of the
debt of non-federal sectors, at nearly 13 percent, also was
high relative to past experience.
A portion of this growth
in private debt -- perhaps around 1-1/2 percentage points
—
can be attributed to a huge volume of mergers, leveraged
buyouts, and stock repurchases by businesses which had the
effect of substituting debt for equity.
Despite some sizable
sales of new stock, non-financial corporations on balance
retired about $70 billion of stock last year.
26
Whatever the circumstances and justification for the
particular companies involved, a financial structure that
tends toward more debt (and shorter debt) relative to equity
becomes more vulnerable over time.
More cash flow must be
dedicated to debt servicing, exposure to short-run increases
in interest rates is magnified, and cushions against adverse
economic or financial developments are reduced.
These are
factors that prudent lending institutions should take into
account in evaluating new credits, and reports suggest that
some banks did in fact review their policies toward mergers
and leveraged buyout financing as the year wore on.
While the effect cannot be isolated, the rapid growth
of debt relative to GNP may also reflect the fact that
domestic spending increased appreciably faster than domestic
production, which is what the GNP measures.
A new machine,
for instance, will require financing, whether purchased at
home or abroad, and sharply increasing amounts of capital
equipment have in fact been imported.
As I indicated earlier,
27
directly or indirectly, that financing may be supplied from
abroad, alleviating the pressures on our market.
But the
debt burden inevitably rests with the borrower.
Monetary Policy in 19.65
At its meeting last week the FOMC agreed to some small
changes in some of the ranges for the monetary and debt
aggregates tentatively set out last July.
The modifications
are in response to analysis of information now available and
do not represent any change in policy intentions.
As shown on
the attached table, for Ml, the Committee reaffirmed the lower
tentative range it adopted last July of 4 to 7 percent growth
from th« fourth quarter of 1984 to the fourth quarter of 1985.
H2 is targeted to grow between 6 and 9 percent, the same range
as used in X984.
The upper end of that range was increased by 1/2
percent from the tentative range for 1985 set in July.
adjustment reflects a technical judgment —
of recent developments —
That small
based on assessment
that M2 could expand more in line with
28
income growth this year, in keeping with the historic record
of little trend growth in its velocity.
The upper end o£ the new M3 range of 6 - 9 1/2 percent
was also set 1/2 percent higher than tentatively agreed in
July.
The associated monitoring range for credit was set
at 9 to 12 percent, a percentage point above the 1984
range.
Adjustments in both target ranges still contemplate
a considerable slowing in these two aggregates from what
actually occurred in 1984.
Even so, credit growth, fueled
in part by the budget deficit, is expected to be quite
strong, significantly exceeding the rate of expansion of
GNP for the third consecutive year.
The Committee does not anticipate that growth of debt
within the targeted range would necessarily pose significant
new risks for the economy or the financial system in the
year immediately ahead.
However, a healthy financial
structure will in time require more restraint on borrowing
29
relative to the economic growth that, in the last analysis,
provides the wherewithal to service the debt.
One continuing
problem in that respect is the extent to which the current
tax structure tends to favor debt rather than equity financing,
a point addressed in the Administration's reform proposals.
The ranges for growth in money and credit are expected
by FOMC members and non-voting Reserve Bank Presidents to
support another year of satisfactory economic expansion
without an acceleration of inflation.
Forecasts of real
GNP growth centered around rates of 3-1/2 to 4 percent from
the fourth quarter of 1984 to the fourth quarter of 1985
—
rates anticipated to be sufficient to reduce the unemployment
rate to around 6-3/4 to 7 percent by year-end.
Inflation,
as measured by the GNP deflator, was expected most frequently
30
to be in a range of 3-1/2 to 4 percent over the year, about
the same rate as prevailed in 1984.*
In view of the necessarily tenuous nature of any
judgment about the outlook for exchange rates, FOMC members
in preparing their projections assumed that the dollar would
fluctuate in a range encompassing
its level of recent months.
They also assumed that the federal budget deficit would be
reduced significantly in fiscal 1986 relative to base line
projections, a development that would help damp both interest
rate and inflationary expectations.
Obviously, those assumptions
suggest some of the important risks inherent in the outlook.
*These projections, now regularly set out in our HumphreyHawkins Reports, should not be interpreted as indicating
"targets" for real growth or inflation in the short or longer
run. As discussed in Attachment III, the Committee does not
target a specific long-range growth path for the economy.
31
As I Indicated in discussing 1984 developments, we
entered 1985 with the various monetary aggregates growing
relatively rapidly.
The targets for this year take, as
usual, the actual average for the fourth quarter of the
previous year as a starting point {or "base").
Consequently,
we are starting the year with the levels of the aggregates
above the target ranges as they have been conventionally
illustrated -- that is by so-called "cones" starting at a
point late the previous year and widening through the
current year.
(See Charts I to IV.)
That conventional and widely used "picture" is
essentially arbitrary.
Interpreted rigidly (and wrongly),
the narrowness of a cone in the early part of the year
—
literally narrower than some weekly fluctuations in the
money supply —
would attach policy importance to levels
or movements in the various aggregates that in fact have no
significance.
32
We have sometimes considered, and others have suggested,
a better "pictorial" approach would be to illustrate the
targets by a different (but also necessarily arbitrary)
convention —
parallel lines drawn back from the outer
bounds of the specified fourth quarter target ranges to the
base period, as shown in the charts attached. The target
range is then portrayed as maintaining the same width
throughout the year.
The current levels of the aggregates,
as you can see on the charts, are within such parallel lines.*
As a matter of economics and policy, rather than
graphics, the Committee is not disturbed by the present
level of Ml and M2 relative to its intentions for the year.
It contemplates that, as the year progresses, growth will slow
consistent with the target ranges.
*Attachment IV addresses the different but related questions
of the appropriate "base" used in setting and illustrating
targeted growth ranges.
33
Consistent with that approach, as I indicated earlier,
the progressive
process of easing reserve positions undertaken
in the latter part of 1984 ended.
The provision of reserves
through open market operations is currently being conducted
a bit more cautiously to guard against inadvertent "overshoots'
in supplying reserves.
Any further change in approach will,
as always, depend upon assessments of the trend of monetary
growth in the period ahead, evaluated in the context of the
flow of information on the economy, on prices, and on domestic
credit and exchange markets.
The annual target ranges for Ml and M2 assume that
trends in velocity are returning to a more normal and
predictable pattern.
However, there is some analysis that
suggests the trend of velocity over time may be a little
lower than the trend of 3 percent or so characteristic of
much of the postwar period when interest rates were trending
34
higher.
Should developments during 1985 tend to confirm
that somewhat lower velocity growth, and provided that
inflationary pressures remain subdued, the Committee anticipates
that those aggregates might end the year in the upper part oE
their ranges.
The lower part of the Ml range would be
consistent with greater cyclical growth in velocity than
now thought likely.
As usual, these ranges will be reviewed
at mid-year, in accordance with Humphrey-Hawkins Act procedures.
The Challenge Ahead
The approach toward monetary policy that I have
outlined for 1985 is designed to promote, as best we can,
our common objectives of sustained growth and stability.
can build on the strong progress of 1983 and 1984.
is forward momentum in the economy.
There
The public at large
seems to sense a greater degree of control over inflation
than for many a year —
and I sense some chance of further
We
35
progress toward price stability this year even as the
economy grows.
Happily, despite the strength of the economic advance
and the financing of a huge deficit, interest rates are today
little above those of two years ago.
The threats of financial
dislocation growing out of the debt problems of much of the
developing world, or from more purely domestic financial
pressures, have been well contained.
Points of strain will,
without doubt, require continuing attention this year.
But, in the context of a healthy economy, they are capable
of resolution.
By encouraging appropriate growth in money and credit,
in discharging our supervisory responsibilities, in performing
when necessary the essential functions of lender of last
resort, and in our general surveillance of the financial
system, the Federal Reserve can help build on that progress.
We aim to do so.
36
But it is equally important to understand clearly
what monetary policy and the Federal Reserve cannot do.
The progress against inflation, the strength of the
dollar and the competition from abroad, and some margins
(if diminishing) of capacity and manpower have provided a
certain degree of flexibility in the conduct of monetary
policy.
But that limited flexibility would be abused at
our collective peril.
Credibility in the effort to deal
with inflation is a precious thing.
The lesson here and
abroad, now and through history, is that, once a sense of
price stability is lost, it can be restored only with pain
and suffering.
The Federal Reserve can theoretically run the modern
equivalent of the printing press —
we can create more money.
But more money is not the same as correcting the gross imbalance
between our ability to generate real savings and the demands
for those savings posed by housing, by investment and by the
federal deficit.
37
To create money beyond that needed to sustain orderly
growth would be to invite renewed inflation -- damaging
incentives to save in the process.
In contrast, to encourage
savings from income would be to provide more of the real
resources we need for future growth -- and it would help
spur productivity and reduce price pressures in the process.
If that route isn't open to us -- and as a practical
matter we probably can't do much right now to change
ingrained savings behavior —
then the only constructive
alternative is to attack the problem from the other side of
the ledger by reducing the federal deficit.
For the time being, capital from abroad has been readily
available to close the growing gap between our domestic savings
and the demands upon them, moderating pressures on interest
rates.
Indeed, the money attracted partly by perceptions
of our strength has come so freely we have an exceptionally
strong dollar.
But that same strong dollar contributes to
38
a massive trade deficit that strains key sectors of industry
and our agriculture, aggravating structural problems.
No doubt bad monetary policy could drive the dollar
down —
a monetary policy that aroused inflationary
expectations, undermined confidence, and drove away foreign
capital.
But then, how would we finance our investment and
our budget deficit?
Nor is the process of money creation adapted to
relieving particular sectoral strains within our economy.
We can and will, in our administration of the discount
window and in our actions as lender of last resort, protect
the essential financial fabric by supporting credit-worthy
depository
institutions faced with extraordinary needs.
But the evident problems of particular sectors, in the
last analysis, will yield only to measures that support their
efficiency and broaden their markets.
That in itself is a large
agenda, for government and those involved alike.
And the process
will be much easier if we at the same time address the basic
39
imbalance between our capacity to save and our need to invest
and to finance the government that I have emphasized today.
Conclusion
I fully appreciate the difficulties of the decisions
before you as you collectively approach those excruciating
budgetary choices.
As you do so, I know that you are aware
of the priority that progressive reduction of the deficit
deserves.
That, indeed, would provide the most fundamental
kind of reassurance that growth can be sustained in an
environment o£ greater stability.
For our part, in the conduct of monetary policy, we in
the Federal Reserve will be sensitive to both the opportunities
and the dangers before us.
We believe the approach I have
outlined with respect to the monetary targets and our
implementation of policy sensibly reflects and balances the
concerns I am sure we share.
40
Growth Ranges for the Aggregates for 1984
in Comparison with Actual Growth
(QIV to Q IV I
Percent Increases
Actual
Growth
Rangers
Ml
4 to 8
H2
6 to 9
7.7
M3
6 to 9
10.5
Domestic Nonfinancial
Debt
8 to 11
13.4
5.2
Growth Ranges for the Aggregates Adopted Cor 1985
in Comparison with Tentative Ranges and Those Cor 1984
(QIV to QIV>
Percent Increases
Adopted Ranges
for 1985
Tentative Ranges for 1985
Set in Mid-1984
Ranges
for 1984
Ml
4 to 7
4 to 7
4 to 8
M2
6 to 9
6 to 8-1/2
6 to 9
M3
6 to 9-1/2
6 to 9
6 to 9
Domestic Nonfinancial Debt
9 to 12
8 to 11
8 to 11
M1 Target Ranges and Actual
Billions ol dollars
. 600
580
Actual M1
520
O N D
J
1983
F
M
A
M
J
J
'984
A
S
O
N
D
J
F
M
A
M
J
J
1985
A
S
O
N
O
M2 Target Ranges and Actual
Billions of dollars
2600
9%
— 2400
1
1
1
12150
tO
M3 Target Ranges and Actual
Billions of dollars
3300
3200
3100
3000
Actual M3
2900
2800
2700
O
N
D
J
1983
F
M
A
M
J
J
1984
A
S
O
N
D
J
F
M
A
M
J
J
1985
A
S
O
N
D
Debt Monitoring Ranges and Actual
Billions of dollars
6800
6600
H6400
6200
—16000
—I 5800
—\ 5600
—15400
—15200
1
O
N
D
J
1983
F
M
A
M
J
J
1984
A
S
O
N
D
J
F
M
A
M
J
J
1985
A
S
O
I
N
I 5000
D
45
Attachment 1^
The Implications for Monetary Policy of the Near Failure
of the Continental Illinois Bank
The condition of the Continental Illinois Bank -- the
seventh largest in the United States at the beginning of
1984 —
had been a matter of concern to regulatory authorities
and market participants for some time, particularly after
the failure of the Penn Square Bank in the middle of 1982
brought to light large loan losses and weaknesses
policy.
in credit
Continuing profit and loan problems culminated in
rumors of possible impending failure and a liquidity crisis
in May 1984, involving withdrawal or failure to renew billions
of dollars of deposits in the bank over a few days.
The FDIC, the Federal Reserve, and the Comptroller of
the Currency, with the cooperation of a group of major
banks, developed
arrangements to provide temporary capital
and liquidity support pending more permanent solutions and
reorganization.
The Federal Reserve —
acting as lender of
46
last resort —
provided large amounts of funds through the
discount window to maintain the bank's liquidity.
That
lending rose irregularly from around S3 billion during most
of Hay to a peak of more than $7 billion in August.
the autumn the amount of outstanding
reduced
During
loans declined to much
levels.
Provision of funds through the discount window has
the effect of expanding total bank reserves, and unless
otherwise offset, the lending to the bank would have had
the effect of expanding the money supply well beyond targeted
ranges.
To maintain consistency of reserve provision with
FOMC intentions, essentially equivalent amounts of reserves
were absorbed by open market operations.
While the large
borrowings necessarily involved some added technical
difficulties and uncertainties in the conduct of open
market operations, the Committee was able to achieve
its reserve objectives.
47
At the same time, however, the liquidity crisis of
Continental Illinois Bank, particularly in an environment
in which international debt and other credit problems were
attracting attention, generated concern about possible
threats to the stability of other financial institutions.
As a result, interest rates on banking liabilities rose
appreciably relative to interest rates on Treasury securities
during the spring.
More cautious funding and lending
policies by a number of banks appeared to have some effect
on maintaining short-term interest rates at higher levels
than might otherwise have been the case.
The extraordinary concerns in the marketplace
dissipated as the year wore on, reflecting some sense of
progress in dealing with both the international debt situation
and points of domestic financial strain.
Strong liquidity
pressures at one of the largest savings and loan organizations
48
during the late summer and fall, requiring sizable liquidity
support by the Federal Home Loan Bank System, had lesser
effects on market attitudes.
The experience of 1984, together with supervisory
efforts and the strong continuing pressures on some sectors
of the economy have underscored for depository institutions
the importance of adequate capital and prudent lending
policies, and other means of assessing and controlling risk.
Substantial efforts have been made by many of the larger
banking organizations to increase capital ratios and to
review credit standards.
In time, in the environment of a
growing economy, these efforts should be reflected in
stronger institutions and a reinforced banking system*
49
Attachment II
The International Debt Situation in 1984
At times during 1984, concerns about the external debt
problems of key borrowing countries continued to be an
important factor affecting attitudes in financial markets.
As the year began, markets had substantial doubts about the
viability of the Brazilian adjustment program, the programs
of the new Venezuelan and Argentine governments were unknown,
and there was some sense of weariness among the borrowing
countries and their creditors.
Tensions were aggravated by
increases in dollar interest rates in the spring and early
summer.
Subsequently, concerns in financial markets receded
somewhat as interest rates moved lower, clear progress was
recorded in narrowing some countries' external imbalances,
and plans for long-term debt restructuring were developed
for some of the largest borrowers.
50
The improvements in external accounts in Mexico and
Venezuela in Latin America, and in Yugoslavia and Hungary
in Eastern Europe, produced current account surpluses last
year,
Brazil's current account deficit was essentially
eliminated, and a number of other countries had reduced
deficits.
This progress was faciliated in many cases by significant
increases in exports,, particularly to the United States,
and in most cases was accompanied by a recovery —
a slower rate of decline —
of imports.
or at least
Such developments,
coupled with continued moderate capital inflows, contributed
to sizable increases in the international reserves of many
of tnese countries and to the prospects of reduced demands
for extraordinary external financing in the future.
At the
same time, most of those countries managed to achieve
domestic growth.
Against this background, several of the major borrowing
countries were able to move on to a second phase in their
51
adjustment and financing programs.
One important iniative,
when warranted by progress in adjustment, has been planning for
longer-term or multi-year restructuring of outstanding debts on
terms that reflect stronger creditworthiness and permit planning
on a more assured basis for the future.
Such arrangements
have been agreed in principle between the commercial banks
and Mexico and Venezuela; serious negotiations have begun
with Brazil and Yugoslavia; and the financing package
prepared for
Argentina contains some longer-term elements.
However, it is also evident from developments in 1984
and the first months of 1985 that the process of adjustment
which began in 1982 is far from complete, particularly on
the internal side.
Financial markets will remain sensitive
to indications of progress or the lack thereof.
Cooperation
among borrowing countries, commercial banks, multilateral
institutions, and creditor countries will continue to be
required.
The need for imaginative and constructive
solutions
to the problems faced by individual countries is not over.
52
Attachment III
Targeting Real Growth
Questions sometimes arise as to whether the
Committee's forecasts for real GNP growth or prices are in
the nature of short-run targets toward which the Federal
Reserve "fine tunes" policy, or whether the Committee has
preconceptions about just how rapidly the economy can and
should grow over the medium or longer run.
The answer to those questions is no.
Monetary policy
is, of course, broadly directed toward sustaining the growth
process in a non-inflationary environment.
But the Committee
as a group has no preconceived notion as to just how rapid
growth can or should be over a particular period of time,
without straining our resources or giving rise to price
pressures and imbalances that would make it ultimately
unsustainable.
53
Our capacity for growth over time depends on such
variables as the trends in productivity, in the labor force, in
incentives to save and invest, and in other factors over which
monetary policy has essentially no direct or long-run influence.
There are other policies, public and private, quite outside
the purview of monetary policy that will influence both our
growth potential and actual growth paths over time.
There
are debates in and outside the Federal Reserve as to some
of these factors that affect economic growth, but annual
monetary targets and operational decisions do not, and need
not, rest on such assumptions for the long run.
For instance, the Committee would presumably
welcome
faster growth than predicted for 1985 if that proved
consistent with moderating inflationary forces, and indeed,
less inflation than anticipated would tend to encourage
greater growth, consistent with our monetary targets. Indeed,
the relationship between money and economic growth at any
54
point in time is sufficiently loose that many other factors
bear upon actual performance.
In sum, policies are periodically reassessed in light
of incoming information about prices, output, exchange
rates and other variables bearing on our growth potential
and prospects
for inflation.
In practice there is sufficient
flexibility in our targeting procedures to accommodate
information that might suggest greater or lesser growth
potential over time.
55
Attachment IV
The Base for Monetary garget Ranges
Some questions have been raised concerning the "base"
used by the Open Market Committee in deciding on targets
for the monetary and credit aggregates for the calendar
year.
Consistent with the Humphrey-Hawkins Act procedures,
the Committee's target ranges are specified each February
as a range of growth from the fourth quarter of the previous
calendar year to the fourth quarter of the current calendar
year.
The convention that is usually used, is that the
beginning point —
or "base" from which growth is measured -•
is taken to be the fourth quarter average growth of a
particular monetary or credit aggregate.
could be used —
Other
"bases"
and occasionally have been used -- if the
conventional base period is seriously distorted, by
institutional change or otherwise.
56
During its recent meeting the Committee, as it has
from time to time, discussed the issue of the desirability
of choosing a base for 1985 for one or more of the aggregates
other than the conventional one.
it concluded that none of
the fourth quarter averages for the targeted aggregates
were distorted in a manner that strongly suggested the
desirability of departing from the usual convention, and
that such a departure might indeed confuse communication of
the Committee's intentions.
It also noted that the average
level of both Ml and M2 during the fourth quarter of 1984
was reasonably close to the mid-point of the previous year 1 s
range, an alternative base suggested by some.
M3 and credit
ran significantly above the 1984 ranges. Debasing those aggregates
at the mid-point of the 1984 ranges would thus have implied a
wrenching adjustment in the levels of those aggregates, a result
that would be contrary to the Committee's intentions.
Essentially!
such a change would have implied a substantial tightening to
bring the growth of those aggregates into the new ranges, or,
57
alternatively, a specification of ranges of growth for 1985
that would have been extraordinarily high and quite out of
keeping with longer range intentions.
More broadly, a decision to regularly target growth
from the mid-point of a previous year's range would seem to
imply the continuing validity of a judgment made a year
earlier that the mid-point of a previous range is in some
sense a uniquely "correct" level of a monetary aggregate.
The Committee does not share such a conviction.
Instead,
it believes that the appropriate trend of each aggregate
needs to be judged in the light of evidence as to velocity
changes and other factors as they emerge over time.
In setting targets for any year, the Committee is,
of course, aware of the base level of the aggregate.
Adjustments in the new target ranges themselves, or in the
conduct of policy within those ranges, can take account of
any modest distortions in the base.
Such considerations
are reflected in the discussion of policy in the testimony.
58
Board of Governors of the Federal Reserve System
Monetary Policy Report to Congress
Pursuant to the
Full Employment and Balanced Growth Act of 1978
February 20, 1985
Letter of Transmittal
BOARD OF GOVERNORS OF THE
FEDERAL RESERVE SYSTEM
Washington, D.C., February 20, 1985
THE PRESIDENT OF THE SENATE
THE SPEAKER OF THE HOUSE OF REPRESENTATIVES.
The Board o( 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
59
Section 1;
The Outlook for the Economy in 1985
Nineteen eighty-four was another year of substantial economic
growth in the united States.
Production and employment gains were large,
making the expansion of the past two years—with growth in real grosa national
product averaging 6 percent per annum—the strongest cyclical upswing since
the early 1950s.
Moreover, continued vigor of the economy was accompanied by
signs of some further lowering of inflationary expectations.
Aggregate price
measures rose around 4 percent last year, about the same as during the two
preceding years.
While prices of services continued to rise by 5 to 6 p e r c e n t ,
prices of many goods were relatively flat, and underlying wage trends seemed
to be moderating.
Economic growth had been extraordinarily rapid in the f i r s t half of
1984, and then slowed abruptly around midyear.
Although some slowing in growth
was widely anticipated, the abruptness of the change raised some question about
the continuing strength of expansionary forces.
However, during the last few
months of the year, output and employment were clearly rising, though at a
more moderate pace than earlier in the year.
The strong gains in overall activity during the year drew attention
away from a number of continuing problems, but those problems are nonetheless
real and serious.
The overall rate of unemployment la still uncomfortably high
and the joblessness among certain groups—for example, teenagers and blacks—
remains well above the average.
Sectora of the economy facing Intense compe-
tition froip abroad, such as agriculture and certain mining and manufacturing
industries, have not participated in the rapid economic expansion overall, and
have been under strong financial stress.
Strains also remain evident among
financial Institutions: a number of depository institutions have experienced
60
a deterioration of the quality of their loan portfolios, and the earnings of
thrift Institutions remain constrained by low-yielding assets accumulated
in earlier years.
While it has not been an impediment to economic expansion to
date, growth in credit has been exceptionally rapid and many households and
businesses have accumulated substantial Indebtedness, often in short-term
or variable-rate forms that make them especially vulnerable to unexpected
economic developments.
Also, despite the impetus from strong U.S. demand,
growth in economic activity has been limited in a number of important
industrialized countries, and many developing countries, in Latin America
and elsewhere, are still struggling to restore satisfactory growth.
While
progress was made in stabilizing the external finances of some of the largest
of those countries, that progress can only be secure In the context of greater
stability in their own economies and of sustained growth in the industrialized
world.
Many of the problems afflicting particular industries have causes
and complications that at least in part must be dealt with in direct and
specific ways.
But it Is also evident that the enormous imbalances in our
federal fiscal posture and in our trade and current account position have
aggravated the problems and made constructive solutions much raore difficult.
In an expanding economy requiring more private credit, the need to finance
the large federal deficits has contributed to the pressures that have held
real Interest rates at historically high levels.
The failure to deal with
budgetary deficits also has sustained doubts In the minds of the public
about the ability of the government to continue to curb inflation over the
long run.
61
The large federal deficits are mirrored in our external imbalance.
Many foreign investors have been attracted to the comparatively high real
rates of return offered on dollar-denominated assets, and U . S . lending abroad
has been reduced.
Other forces stimulating capital inflows have been at work
as well, including political aid economic uncertainties in other countries
and Che relative stability and vigor of our economy.
The s h i f t in capital
flows lias supplemented domestic saving and helped finance the federal government d e f i c i t and private investment.
B u t , at the same time, the strong
demand for the dollar has driven its value on foreign exchange markets to
extremely high levels.
As the dollar has appreciated, the demand for our
exports has s u f f e r e d and our purchases of imported goods have increased
dramatically, resulting in strong competitive pressures on the m a n u f a c t u r i n g ,
mining, and agriculture sectors and Leading to calls for p r o t e c t i o n i s t
measures.
Moreover, the capital inflows lead to niounting financial claims
of foreigners that the nation must he prepared to deal with in f u t u r e y e a r s ,
through reduced imports or increased exports, in either case lowering domestic
consumption.
The Economic Projections of the FOMC
Notwithstanding the risks associated with the domestic and i n t e r n a tional problems j u s t outlined, the weight of the evidence points to reasonably
favorable near-term prospects for aggregate economic performance.
In recent
nwnths, personal income growth has been strong, r e f l e c t i n g continuing substantial gains in employment and helping to support consumer spending.
Over-
building of multifamily residential units and o f f i c e s in some parts of the
country may pose questions about the outlook in these areas, but the lower
62
Interest rates that developed over recent months suggest that single-family
homebuilding may strengthen.
Surveys of businesses Indicate plans for
continued growth In plant and equipment spending tn the coming months, though,
at a slower pace than last year; meanwhile, some Imbalances in business
Inventories that developed during 1984 appear Co be well along in the process
of correction, and In some sectors inventories are quite lean relative to
sales.
Many states and localities are experiencing an improvement in their
finances, which portends f u r t h e r support to the expansion from that sector.
And, at the federal level, there continues to be a strongly stimulative thrust
from fiscal policy.
The smallest increases in nominal wages and compensation In more
than a decade have been accompanied by an Improvement in productivity and
downward pressures on energy and commodity prices.
These developments help
support the possibilities of continuing restraint in price Increases.
Also,
tn the context of an economy expanding at a sustainable rate, they are consistent with continuing growth in average real income.
Taking account of the above factors, the members of the Federal Open
Market Committee (as well as Federal Reserve Bank Presidents who are not at
present FOMC members) now foresee the probable continuation of the economic
expansion through its third year, although at a o»re moderate pace than in
the f i r s t two years.
The central tendency of the members' forecasts indicates
the probability of an increase in real GNP of between 3-1/2 and 4 percent
this year.
The unemployment rate is expected to dacline in 1985 to a level
of between 6-3/4 and 7 percent by the f o u r t h q u a r t e r .
At the same time,
most members expect general measures of price i n f l a t i o n to remain close to
recent trends.
63
Economic Projections for 1985
FOMC Members and
other FRB Presidents
Central tendency
Range
Administration
CBO
Change, fourth quarter
to fourth quarter (2)
Nominal GNP
Real GNP
GNP deflator
7 to 8-1/2
3-1/4 to 4-1/4
3 to 4-3/4
Average unemployment rate
in the fourth quarter (%) 6-1/2 to 7-1/4
7-1/2 to 8
3-1/2 to 4
3-1/2 to 4
8.5
4.0
4.3
7.7
3.4
4.2
6-3/4 to 7
6.9
7.0
When considering the general outlook for 1985, members of the FOMC
recognized that persisting problems could become aggravated for particular
sectors of the economy, and that there are risks for the economy as a whole.
Clearly, there Is growing distress in many farm communities.
Incomes from
farming have been low, land prices are falling, and many producers face
heavy debt burdens.
In the household and business sectors, higher levels of
indebtedness are unlikely to forestall f u r t h e r gains in spending, but unless
moderated, they would in time add to financial pressures.
Favorable price performance has been encouraged by the strength
of the dollar in the exchange markets.
A sharp and large reversal of that
strength could be reflected in at least temporarily stronger
pressures.
inflationary
Greater confidence in prospects for price stability is,
of course,
dependent over time on suitably restrained growth in the money s u p p l y , and
that necessary approach, and more moderate real interest r a t e s , would be
f a c i l i t a t e d by e f f e c t i v e action to reduce substantially the size of federal
budget deficits in the upcoming and subsequent fiscal years.
Action to
64
restore balance In the government's fiscal position Is important to the
achievement of an environment conducive to stable, strong economic growth.
In their forecasts, Che Committee members assumed that the exchange rate
would remain within the range of recent months and that effective fiscal
action is in prospect.
The "central tendency" forecast of the FOMC members is broadly
consistent with that of the Administration, as Indicated in the Economic
Report of the President, and that of the Congressional Budget Office.
The Administration's projections for both real GNP growth and Inflation
do fall, however, toward the upper part of the ranges of Committee members'
forecasts, while the CBO's estimate of real growth is a bit lower than the
FOMC central tendency range.
65
Section 2:
The Federal Reserve's Obectivea forMoney and Credit In 1985
At its meeting of February 12-13, the FOMC set monetary and credit
growth ranges for 1985 designed to be consistent with further sustainable
economic growth and progress toward reasonable price stability over time.
Specifically, the Committee (1) set a growth range for Ml of 4 to 7 percent
from the fourth quarter of 1984 through the fourth quarter of 1985, the same
as that tentatively selected last July; (2) established target ranges of 6
to 9 percent and 6 to 9-1/2 percent for M2 and M3, respectively, one-half
percentage point higher at the upper end of the range than tentatively set
In July; and (3) set an associated monitoring range of 9 to 12 percent for
the debt of domestic nonflnanclal sectors, one percentage point higher than
tentatively Indicated.
The upper end of the range for Ml is one percentage
point below that of 1984, and the range for M2 Is the same as last year's.
The upper end of the target range for M3 is slightly above that for last
year.
That increase, as well as the upward adjustment In the associated
monitoring range for the debt of domestic nonfinancial sectors, reflects
analysis of developments during 1984 suggesting that growth somewhat greater
than anticipated earlier may be consistent with Committee objectives for the
year.
Expansion within these ranges would represent a significant decelera-
tion in the actual growth of M3 and debt from the experience of last year
when the target ranges were exceeded.
In formulating these objectives, the Committee assumed that no new
statutory or regulatory developments would be enacted that would appreciably
influence the behavior of the monetary and credit aggregates In 1985.
Although at the beginning of the year the minimum denomination of super NOW
66
and money market deposit accounts was reduced from $2,500 to $1,000, to date
the promotional activity accompanying this change has been minor, and It
appears that Ml and M2 have not been a f f e c t e d s i g n i f i c a n t l y .
On average, the behavior of Ml velocity—nominal GNP divided by
Che money stock—during 1984 was broadly consistent with previous cyclical
patterns.
Together with other evidence, this development suggests that the
factors responsible for the highly unusual velocity behavior over 1982 and
early 1983 have receded.
Nonetheless, a range of uncertainty inevitably remains about the
trend of Ml relative to nominal GNP in light of recent deposit deregulation
and other financial innovations that have affected the funding policies of
banks and the cash management practices of the public.
On balance, it appears
likely that the process of deposit deregulation will lead to a trend rate of
increase in the velocity of Ml that may be somewhat lower than in the postWorld War II period as a whole.
However, In view of the multiplicity of
changes in financial instruments and practices that i n f l u e n c e the behavior
of all the monetary measures, interpretation of all the aggregates will
continue to be made within the context of the outlook for economic a c t i v i t y ,
Inflationary pressures, and conditions in domestic and international financial
markets, Including the strength of credit demands.
The new 4-to-7 percent target range for 11 encompasses growth in
Ml consistent with velocity expansion over the coming year approximating that
of last year, and also higher Ml growth that would be needed should velocity
grow at a rate approximating the reduced t r e n d suggested above.
The movements
in velocity d u r i n g 1984 occurred in a context of moderate Increases In interest
67
rates over much of the year; however, velocity has slowed substantially
in recent months in the context of an appreciable rtse in money growth and
following declines in interest rates.
In all the circumstances, a somewhat
higher rate of money growth than implied by straight line projections
from
the fourth quarter 1984 base to the targets for the f o u r t h quarter of 1985 may
be appropriate early in the year, but growth of Ml would be expected to
slow, and velocity growth to rise, as the current adjustments are completed.
Thus, as the year progresses, growth of Ml would be expected to move gradually
toward and into the FCMC's target range.
Depending upon developments with
respect to velocity and price behavior, growth in Ml and the other monetary
aggregates in the upper parts of their ranges may be appropriate over the year
as a whole.
Those developments will, of course, be closely monitored over
the year.
Like Ml, growth of M2 and M3 have been particularly strong in
recent months, reflecting the unusually favorable yield spreads in favor of
monetary assets that emerged temporarily toward the end of last year; open
market interest rates dropped more swiftly than rates offered by depository
institutions on retail deposits and returns on money market mutual funds.
In addition, M3 growth has reflected substantial issuance of large CDs by
t h r i f t institutions to support their lending in mortgage and consumer loan
markets.
Growth of the broader monetary aggregates is influenced, as well,
by the pattern of international capital Inflows associated with the huge
current account d e f i c i t .
Domestic banks may continue to borrow sizable
amounts of Eurodollar funds from their foreign branches and unaffiliated
foreign banks; such borrowings are not Included in the measured monetary
68
aggregates.
By reducing the need for funding through other managed liabilities
included in H2 and M3, these inflows tend to restrain measured monetary growth
in relation to growth of bank credit and credit generally.
Moreover, many
domestic borrowers, including the federal government and private corporations,
may continue to tap overseas securities markets directly, reducing the need
for credit expansion by U.S. intermediaries.
Given the federal budget deficit as projected by the Administration
for 1985—as well as a likely expansion of spending by domestic sectors in
excess of nominal GSP growth, as part of that spending flows abroad—the
Committee contemplates that domestic nonfinanclal debt may continue to
Increase more rapidly than nominal GNP.
Still, actual growth of debt in
1985 should be markedly less than in 1984, as nominal GNP growth and overall credit demands moderate.
Growth within the debt range for 1985 assumes
also a slowing in credit for mergers, leveraged buyouts, and other financial
restructuring.
Such credit led to some erosion in corporate equity cushions
last year, and a more cautious approach is anticipated this year.
The outlook for financial conditions generally is again expected
to be affected Importantly by current and prospective federal budget deficits,
which will remain enormous in comparison with experience in previous economic
expansions.
This massive federal borrowing will compete for available domes-
tic savings with the strong private credit demands accompanying further growth
of economic activity, keeping interest rates and exchange rates higher than
they otherwise would be.
Such relatively high interest rates and exchange
rates limit expansion in those sectors that are most sensitive to the cost of
credit and impair the competitive positions of domestic import-competing and
export industries.
Decisive and credible actions to reduce federal budget
deficits would have favorable effects on Investors' expectations and help to
lower interest rates, especially longer-term rates, even before these reductions become fully effective.
Such actions would work to relieve the Imbalances
and strains within the economy, contribute to further abatement of inflationary
expectations, and so reinforce the prospects for continued growth and stability.
69
Section 3:
The Performance of the Economy In 1984
The economy recorded major gains In 1984, with the real gross
national product up 5-1/2 percent and the unemployment rate down more than
1 percentage point over the year.
The growth in output and employment was
exceptionally strong in comparison with experience In other post-Korean Uar
expansions.
But even more striking, In terns of its departure from past
norms, was the extraordinary rise in domestic spending, which again appreciably outstripped growth in domestic production.
Over the course of the
year such spending rose about 6-3/4 percent in real terms.
Consumers and
businesses purchased greatly increased quantities of imported goods, whose
relative prices were lowered by the appreciation of the dollar in exchange
markets, and the U.S. trade deficit reached record proportions.
Last year's economic gains were achieved without a pickup tn
inflationary pressures, in part owing to the rise in the exchange value of
the dollar.
Aggregate indexes of prices rose about 4 percent or less, similar
to rates of inflation recorded in 1983,
Ample availability of industrial
capacity here and abroad helped to contain price increases.
Labor cost
pressures also were limited, as wage increases actually were slightly lower
than a year earlier.
Labor markets continued to reflect the still consider-
able unemployment In the economy as well as the adjustments of wages In some
sectors to the realities of forces associated with deregulation and foreign
competition.
Wage changes also reflected the favorable feedback effect of
lower inflation on anticipatory or catch-up pay demands.
Although the nation as a whole has made substantial progress in
the past two years toward the goals of sustained growth and high employment
70
Chart 1: The Peri'ormance of the Economy in 1984
Real GNP
Percent change, Q4 to Q4
mn
1980
1982
1984
Real Gross Domestic Purchases
Percent change, 04 to Q4
1980
1982
1984
Unemployment Rate
1980
1984
71
along with price stability, Important segments of Che economy have continued
to experience considerable difficulty.
One symptom of continuing imbalances
has been interest rates that, relative to the prevailing rate of i n f l a t i o n ,
have remained exceptionally high by historical standards.
However, a f t e r
moving upward during the f i r s t half of the year when economic expansion was
especially brisk, interest rates retraced their advances in the second half
of the year.
At year-end, they were, on balance, a little lower.
Federal government tax and spending policies have provided
substantial stimulus to aggregate demands for goods and services, but In
credit markets the d e f i c i t s have added strongly to the demands for funds and
have been one important force keeping interest rates high.
Moreover, there
is general agreement that, unless legislative measures are enacted, budget
d e f i c i t s are likely to Increase f u r t h e r , even in the context of a reasonably
growing economy.
This prospect, with its
implication of continuing pressures
on the supply of savings, has been a f a c t o r in the rise in the foreign exchange
value of the dollar and the attendant emergence of enormous d e f i c i t s
our trade and current accounts with other nations.
in
Although, as noted above,
the sharply higher value of the dollar has been an Important factor in the
movement toward price stability, inflationary pressures could become more
apparent if the U . S . dollar were to decline sharply—a risk that could increase as fundamentally unsustainable fiscal and external postures are
extended.
The Household Sector
The household sector continued to benefit last year from the
economic expansion.
A d j u s t i n g for I n f l a t i o n , the rise in disposable income
72
from Che fourth quarter of 1983 to the fourth quarter of 1984 was
percent, surpassing the large gain in 1983.
5-3/4
This strong increase in Income
supported a rapid rise in spending for consumer goods even as the personal
saving rate rose.
Household sector outlays in this expansion have been tilted more
toward durable goods than has been typical.
In the 1980-82 period, a time of
relatively slow income growth and high unemployment, consumers had curtailed
discretionary purchases of household goods.
Since the end of 1982, however,
strong employment and income growth and rising consumer confidence have been
translated into an appreciable restocking of household durables.
The strength of automobile purchases in 1984 was a part of this
restocking process.
As the stock of existing autos has aged, replacement
demand has grown.
Most recently, reductions in gasoline prices have lowered
operating costs.
Automobile sales in 1984 rose to 10-1/2 million units, the
highest level since 1979.
The foreign share of the market declined, owing in
large part to the impact of limitations on Japanese units during a period of
expanding sales.
Indeed, demand for domestic autos proved to be so strong
that producers had d i f f i c u l t y supplying many of the more popular models, even
though auto companies operated some factories at near f u l l capacity over most
of the year.
Total auto production was up 14 percent from the preceding
year, despite brief strikes in the autumn.
Spending for new homes slowed over the course of 1984, with rising
mortgage interest rates through midyear a factor reducing housing a c t i v i t y .
However, there were some I n i t i a l signs of Improvement in the housing sector
at year-end, associated with earlier declines In I n t e r e s t rates d u r i n g the
73
fall.
From the fourth quarter of 1983 to the fourth quarter of 1984, residen-
tial construction outlays, in real terms, were up 3-1/2 percent after an
extremely rapid advance in 1983.
units were started.
For 1984 as a whole, 1.7 million new housing
This was below the peak rates in the 1970s, but a marked
improvement over the performance of the first years of the 1980s, as housing
demand continued to be supported by favorable demographic factors and expanding incomes. Moreover, relatively stable house prices and the growing
use of adjustable-rate mortgages made home purchases more accessible for
many households.
The second year of strong growth In income and spending was
accompanied by significant changes in household balance sheets.
Late In 1983
and in the f i r s t half of 1984, financial assets declined relative to income—
owing primarily to the sluggish performance of stock prices—retracing a
portion of the strong gains made earlier in the recovery.
However, the sub-
sequent rise in equity prices helped to restore household asset positions to
their previous high levels, and since the t u r n of the year, with stock prices
up sharply, asset positions have improved further.
Meanwhile, growth of
household indebtedness picked up noticeably last year, and consumer installment debt as a share of disposable income moved to near its
previous peak in
the late 1970s.
Despite the rise in indebtedness, there were few signs of increased
financial stress in the household sector.
The incidence of payment d i f f i c u l -
ties on consumer installment debt remained historically low and home mortgage
delinquency rates were about unchanged for the year as a whole.
Nonetheless,
the proportion of problem loans In the home mortgage market has not receded
from Its recession high, and there is some special concern about f u t u r e
74
Chart 2: The Household Sector
Real Personal Income And Consumption
Percent change, Q4 to Q4
QJ] Real Disposable Personal Income
[
| Real Personal Consumption Expe iditu res
-
_
1,HL, 1
1
1980
I
1984
Total Private Housing Starts
Annual rate, millions of units
1.0
1982
1984
75
prospects in this area owing to the added risk exposure of homeowners who
took on mortgages carrying adjustable features, especially those made with
sizable initial interest rate concessions.
The sustained high level of
mortgage loan delinquencies appears to date attributable not so much to
adjustable rate loans as to a combination of still high unemployment and
more stable real estate prices than some borrowers had anticipated.
The_ Business Sector
The Increase in business spending for plant and equipment was
greater in 1984 than in 1983.
In factt the rise in gross business capital
outlays over these two years combined was much larger than in any other
post-World War II economic expansion.
Profits in the nonfinancial corporate
sector were up substantially In 1984, although by year-end the level had
fallen back a bit owing to the slowing in sales growth.
Growth In business fixed investment spending was strongest in the
first half of the year, but continued at a double-digit pace in real terms
In the second half.
For the year as a whole, large gains were registered
for both equipment and structures outlays.
The ebullience of total spending
reflected a number of factors, including the more favorable tax laws enacCed
in 1981, the desire to take advantage of technological advances, and the
further narrowing of the margin of unused factory capacity under strong
demand growth.
Continued competitive pressure from foreign producers pro-
vided additional impetus for rapid modernization.
At the same time, many
U.S. producers of capital equipment, especially outside the "high-tech" area,
did not fully benefit from this spending.
Instead, foreign manufacturers
captured an increasing share of capital goods purchased by U.S. firms; for
76
domestic equipment spending, this share—approximately 25 percent—was
nearly twice that experienced in the late 1970s.
Businesses accumulated inventories in 1984 after reducing stocks
in the preceding two years.
In real terms, business inventories rose
$24 billion, an historically large gain.
Those gains were concentrated
largely in the first half of the year, alongside the rapid pace of the
expansion of final demand.
When sates growth slackened in the summer and
autumn, businesses quickly cut back on orders and production to avoid
severe Imbalances.
In order to finance the combined increase in capital spending and
inventory investment, businesses relied heavily on external sources of credit.
Nonetheless, gross issuance of new equity weakened as stock prices declined
early in the year and then failed to surpass earlier highs when they rallied
in the summer.
After accounting for the retirement of equity associated with
merger activity and share repurchases, the net Issuance of stock was decidedly
negative.
Shorter-term borrowing was favored by business as in the first
half of 1984, as firms elected to finance mergers initially through bank
loans and commercial paper, and the high level of long-term interest rates
discouraged bond Issuance.
In the second half of the year, merger financing
slowed and the decline in interest rates contributed to some movement
toward longer-term debt issuance.
Even so, the traditional balance sheet
ratios used to assess aggregate business financial strength worsened over the
year: the ratio of loans and short-term paper to total debt of nonftnanclal
corporations rose, as did the ratio of debt to equity.
Severe financial strains. In many cases related to the high
exchange value of the dollar, persisted In some of the nation's basic
77
Chart 3: The Business Sector
Real Business Fixed Investment
Percent change, Q4 to Q4
Producers' Durable Equipment
Structures
10
1980
Change In Real Business Inventories
Annual rate, billions of 1972 dollars
1984
78
Industries.
Farmers continued to face less favorable export conditions
than in much of the previous decade, land prices fell further, on average,
and farm Income remained depressed.
As a result, farmers with large volumes
of debt remaining from the late 1970s continue to face serious debt-servicing
problems.
The metala, agricultural Implements, and some equipment industries
also continue to face significant problems.
The Government Sector
The expanding economy lifted federal government receipts in 1984.
At the same time, outlay growth was limited by further declines in recession
related expenditures and by a drop in agricultural support payments.
None-
theless, the federal budget deficit remained enormous, more than 5 percent
of GNP and larger than total domestic personal saving.
Moreover, at the end
of the year the deficit was again rising.
Federal government purchases of goods and services, the component
of the budget that directly adds to GNP and comprises about a third of total
federal outlays, rose strongly last year.
Excluding changes in Commodity
Credit Corporation farm inventories, federal purchases were up nearly
5-1/2 percent, after adjustment for inflation.
A major thrust to federal
purchases came from defense spending, which increased almost 7 percent in
real terms.
At the state and local government level, real purchases of goods
and services rose 3-1/2 percent in 1984, following two years of no change.
The renewed growth in such spending followed an appreciable improvement in
this sector's fiscal position: state and local governments experienced a
sizable operating and capital surplus in 1983 and early 1984 owing to the
effects of the economic recovery as well as increases in tax rates.
79
Chart 4: The Government Sector
Federal Government Deficit
Billions of dollars
Fiscal Years, Unified Budget Basis
200
Jl
1980
1982
State And Local Governments
Billions of dollars
Operating And Capital Budgets, NiA Basis
80
The_ Foreign Se_cto_r
The appreciation of the dollar over the past four years directly
contributed to the Imbalance between exports and imports in 1984.
On a trade-
wetghted average basis, the dollar climbed a further 12 percent during the
course of the year, bringing the cumulative appreciation since the end of
1980 to about 65 percent, and the rise has continued Into 1985.
Part of the
dollar's strength in the first half of last year may have been generated by a
widening of the differential between real interest rates in the United States
and real rates abroad; however, the influence of this factor appears to have
been reversed In the second half of the year.
The relative dynamism of the
U.S. economy and success in curbing Inflation helped attract capital from
abroad.
Conversely, relatively slow economic growth elsewhere and economic
and political uncertainties in various countries also may have contributed
to the dollar's appreciation throughout the year.
Notwithstanding a further weakening of the international competitive
position of U.S.
firms owing to the dollar's appreciation, and despite the
sluggishness of foreign economies, the volume of U.S. merchandise exports
increased by 9 percent in 1984.
Exports to Canada, some of which are reim-
ported after further fabrication, accounted For about a third of the rise,
with Western Europe and Mexico receiving most of the remainder of the Increase
in exports.
Economic growth in many developing nations, oil-producing as
well as others, was limited by their debt servicing problems, and demand by
those countries for U.S.-produced goods remained generally depressed.
The vigorous expansion of the U.S. economy and the strength of
the dollar pushed the volume of merchandise imports sharply higher.
Consumer
81
Chart 5: The Foreign Sector
Exchange Value Of The U.S. Dollar
Index, March 1973 = 100
150
125
1980
1982
1984
U.S. Merchandise Trade
— 200
1980
U.S. Current Account*
Billions of dollars
50
100
1980
*1984 is partially estimated
1982
1984
82
goods, materials, and capital equipment shared In the Increase.
dise trade deficit rose to about $110 billion.
The merchan-
In addition to the growing
trade d e f i c i t , net service receipts were reduced and the current account
deficit was about $100 billion in 1984, compared with $42 billion in 1983.
Labor Market Developments
Developments In labor markets continued to be favorable during the
second year of expansion.
Reflecting the strength of activity and Improved
employment prospects, growth of the labor force picked up last year.
But the
number of new jobs expanded even more rapidly, and the unemployment rate was
7.2 percent In the fourth quarter, more than a percentage point below the
rate at Che end of 1983.
Indeed, since the recession low In late 1982,
nonfarm payroll employment has increased by nearly 7 million, the largest
two-year gain In three decades.
In 1984, employment growth continued to be widespread across
industries.
jobs.
The trade and service sectors each added more than one million
And there was a gain in construction employment, owing in large part
to a rise In nonresldential building.
Government employment was up a
quarter of a million, reflecting the rise In spending by state and local
units.
The manufacturing sector, which has borne the brunt of Increased
foreign competition, registered a large increase of almost three-quarter
million in 1984; even so, the level of manufacturing employment remained
below its pre-recession peak.
Wage developments in 1984 were more favorable to the control of
inflation;
even though labor market slack was reduced substantially
during the year, wage rates increased less than in 1983.
further
The employment
83
Chart 6: Labor Market Developments
Employment Cost Index*
Percent change, December to December
12
1980
1982
1
1984
Union Settlements And Aggregate Wage Change
Percent change from year earlier
First-Year Adjustments
In Union Settlements
Average Hourly
Earnings Index*
1982
1984
84
cost Index, a comprehensive measure of change in wages and benefits, rose
Just 4 percent in 1984, nearly one percentage point less than the year earlier.
Moreover, major collective bargaining agreements during the year showed no
acceleration in nominal wage rates, even in those industries with improved
economic conditions.
These wage developments suggest that inflationary expectations
continued to moderate this past year; to an increasing degree, workers and
managers now appear to be focusing on improving job security and on enhancing
productivity, often In an attempt to remain competitive with foreign producers.
Productivity increases in 1984 were substantial in the first half of the
year, when output grew rapidly, and helped keep overall cost pressures down.
Over the course of the year, labor productivity increased 2-1/4 percent, partly
reflecting a cyclical adjustment to higher levels of output as well as apparently some improvement in the underlying trend rate of growth from the very
low pace of the 1970s.
The combination of moderate compensation increases
and favorable productivity developments held down cost pressures on prices;
unit labor costs rose 2 percent over 1984, less than a fifth of the rate
experienced in 1979 and
1980.
Price Developments
Over 1984, the consumer price Index rose 4 percent and the Implicit
deflator for the gross national product 3-1/2 percent.
The increases in
these broad indexes represent little change from inflation rates that have
prevailed since the beginning of the expansion.
The producer price index
for finished goods, which, excludes the prices of services, rose less than
2 percent last year; basic commodity prices, which had advanced more than
30 percent early in 1983, fell during most of
1984.
85
Chart 7: Price Developments
Nonfarm Payroll Employment
Millions of persons
90
1980
1982
1984
Compensation Per Hour
Percent change, 04 to Q4
Nonfarm Business Seclor
1980
1982
1984
Output Per Hour
Percent change, 04 to 04
Nonfarm Business Sector
1980
1984
86
Chart 7: Price Developments—Continued
GNP Prices
Percent change, Q4 to 04
1980
1982
Consumer Prices
Percent change, December to December
1980
1982
1984
Producer Prices
Percent change, December to December
1982
1984
87
The relative softness of demand In world-wide markets and the
strength of the dollar against foreign currencies played a large role last
year in holding down prices of basic commodities.
Importantly, energy prices,
which have been a major factor In inflation rate movements for more than a
decade, moved down.
The weakness of demand during the recession and early
recovery period restrained energy prices In J981 and 1982; moreover, conservation measures and additional oil production capacity In many countries
have continued to relieve energy price pressures.
Food prices at the retail level rose about in line with overall
prices in 1984.
Early in the year, food prices jumped sharply because farm
supplies were limited by the 1983 summer drought and a winter freeze.
How-
ever, supplies again became plentiful as the year progressed, reflecting more
favorable harvests and sagging export volume.
Apart from the food and energy areas, consumer price Inflation was
little changed from a year earlier.
The rise in consumer goods prices slowed
appreciably, owing In part to the relatively small increase in prices of
imported goods, as well as the accompanying competitive pressures on domestic
products.
Service prices rose more rapidly over 1984 than in 1983, although
the rate of Inflation In the sector remained well below those recorded in the
early 1980s.
88
S_e ct i_qn_4_!__ Mojnetary Policy and Financial Development B In 1984
Monetary policy In 1984 aimed basically at supporting
sustainable
economic growth within the context of long-term progress toward price
stability.
The target ranges for the monetary and credit aggregates chosen
by the Federal Open Market Committee last February, and reaffirmed in July,
called for growth rates 1/2 to 1 percentage point below those set for 1983.
Measured from the fourth quarter of 1983 Co the fourth quarter of 1984, the
target ranges for the monetary aggregates were 4 to 8 percent, for Ml, and
6 to 9 percent, for M2 and M3.
The associated monitoring range for the
debt of domestic nonfinancial sectors was fixed at 8 to 11 percent.
Underlying these objectives was the Committee's expectation that
the special factors distorting monetary growth rates in 1982 and 1983 would
be less important in 1984, and that relationships among the monetary
aggregates—particularly Ml—and economic activity and inflation would be
more consistent with historical trends and cyclical patterns.
Portfolio
adjustments associated with the previous Introduction of new deposit accounts
and with the steep drop in interest rates during the 1982 recession appeared
to have ended.
uncertainties
Furthermore, the economic expansion seemed to be reducing
about employment and income prospects that earlier had boosted
demands for liquid precautionary balances.
Over the year, increasing evidence suggested that Ml was In fact
behaving more in line with historical experience.
As a result, this aggregate
was given more weight In policy implementation than had been the case during
the latter part of the cyclical downswing and early phase of the economic
recovery.
However, all of the monetary and credit measures continued to be
89
Chart I
Ranges and Actual Money Growth
M1
Billions of dollars
Rate Of Growth
Range Adopted By FOMC
For 1983 Q4 To 1984 04
1983
1983 04 To 1984 Q4
5.2 Percent
1984
M2
Billions of dollars
Rate Of Growth
Range Adopted By FOMC
For 1983 Q4To 1984 Q4
2400
— 2350
— 2300
— 2250
— 2200
1983
1984
1983 Q4 To 1984 04
7.7 Percent
90
Chart 2
Ranges and Actual Money and Credit Growth
ons of dollars
Rate Of Growth
Range Adopted By FOMC
For 1983 04 To 1984 Q4
s~ 3000
1983 04 To 1984 Q4
10.5 Percent
— 2900
— 2800
2700
1983
1984
Total Domestic Nonfjnancial Sector Debt
Billions of dollars
Rate Of Growth
Range Adopted By FOMC
For 1983 04 To 1984 04
6000
— 5750
5500
1983
1984
1983 04 To 1984 Q4
13.4 Percent
91
evaluated in light of the outlook for the economy and domestic and international financial markets.
Money. Credit, and Monetary Policv_
The actual growth rates of Ml and M2 over 1984 were well within
the target ranges established by the Federal Reserve, with Ml expanding
5.2 percent, somewhat below the midpoint of its range, and M2 increasing
7.7 percent, a bit above its
midpoint.
As had been anticipated in the mid-
year policy report to the Congress, growth of M3 and domestic nonfinanclal
d e b t , at 10.5 percent and 13.4 percent, respectively, exceeded their ranges. 1
The relatively wide divergence between M2 and M3 growth rates reflected
mainly substantial issuance of large CDs and other managed liabilities by
t h r i f t institutions and commercial banks in the face of heavy credit demands.
Credit growth last year was the most rapid on record, and much
stronger relative to GNP expansion than historical trends would suggest. An
unusually large volume of mergers and related activity, including "leveraged
buyouts," involving nonfinancial corporations accounted for about 1 percentage
point of the growth of overall debt.
Around $75 billion of e q u i t y was liquid-
ated in this process, with much of it replaced, at least for a time, with
short-term debt.
In addition, more than $10 billion of e q u i t y was retired
through corporate share repurchases, frequently in defensive maneuvers to
ward off u n f r i e n d l y takeover attempts.
1.
The figures c i t e d herein for the monetary aggregates are based on recent
benchmark and seasonal adjustment revisions. Before those revisions, the
1984 increases were measured at 5.0 percent for Ml, 7.5 percent for M2, and
10.0 percent for M3.
92
Even after allowance is made for Che unusually large volume of
merger-related borrowing, it is clear that total credit demands were exceptionally strong last year.
Federal debt expansion, at more than 16 percent, was
unprecedented for the second year of an economic expansion, both in absolute
terms and in relation to income.
Private domestic nonfinancial debt grew
about 11-1/2 percent (abstracting from growth of merger-related debt issues),
also faster than, but much closer to, comparable stages of previous recoveries,
The behavior of Ml velocity in 1984 was broadly consistent with
past cyclical patterns.
In contrast to the unusual weakness of the previous
two years, over 1984 HI velocity increased 4 percent, only a little above the
average rate of growth during the second year of previous economic expansions.
M2 velocity Increased 1-1/2 percent, reversing two consecutive yearly declines.
The strengthening of velocity over 1984 apparently reflected, in part, some
unwinding of the precautionary and other, motives that had swelled demands for
liquid assets in 1982 and early 1983, as well as the rise of short-term
interest rates in the first part of the year, and, in the case of M2, the
abatement of dramatic Inflows to money market deposit accounts (MMDAs)
associated with the Initial authorization of these accounts.
Demands for Ml balances, and for bank, reserves to support deposit
growth, were robust early in the year as the economy expanded rapidly.
Credit
demands also were very strong, and market Interest rates began rising even
as the Federal Reserve, through open market operations, was keeping the degree
of pressure on bank reserve positions unchanged.
In early spring, with credit
and money demands continuing unabated,' and with economic growth continuing
1.
Annual seasonal and benchmark revisions to the monetary aggregates
subsequently lowered somewhat the growth of Ml in the first half of
1984 relative to what was estimated during the period.
93
GROWTH OF MONEY AND CREDIT^
Percentage changes
Period
Ml
M3
Domestic
nonf inanclal
sector debt
8.1
9.0
9.3
9.1
12.2
7.7
10.3
9.6
12.4
10.0
10.0
10.5
12.1
9.6
10.0
9.1
10.8
13.4
7.2
7.1
6.9
9.0
9.2
10.5
9.5
11.0
12.9
13.1
12.7
12.7
M2
Fourth quarter
to fourth quarter
1979
1980
1981
1982
1983
1984
Quarterly growth rates
1984-Q1
Q2
Q3
04
7.5
7.5
5.1 (2.5)2
8.8
10.4
5.2
6.2
6.5
4.5
3.4
revisions made in February 1985.
2. Ml figure in parentheses is adjusted for shifts to NOW accounts in 1981,
94
at an extraordinary pace, the POMC adopted a somewhat more restraining
posture toward supplying reserves, and both short- and long-term interest rates
rose further as banks relied more heavily on discount window credit to meet
their reserve needs.
Borrowing for adjustment and seasonal purposes increased
to around SI billion in March and April a f t e r averaging about $650 million
during the f i r s t two months of the year.
In April, the discount rate was
raised 1/2 percentage point, to 9 percent, to bring this rate into better
alignment w i t h short-term market rates.
Despite the absence of any f u r t h e r tightening of reserve availability
by the Federal Reserve, pressures on private short-term i n t e r e s t rates Intensified around early May in reaction to the well-publicized liquidity problems of
Continental Illinois Bank. *•
Uncertainties related to the international debt
situation also added to market concerns.
In this environment, quality dif-
ferentials between yields on private money market Instruments and Treasury
securities widened s u b s t a n t i a l l y .
While Ml growth early in the year remained in the upper part of the
FOMC's target range, 12 increased at a pace slightly below the midpoint of
range even as the economy expanded rapidly.
its
Growth in M2 relative to income
may have been damped by substantial inflows to IRA and Keogh accounts, which
are excluded from the monetary aggregates.
Also, as market interest rates
f i r m e d , sizable spreads developed between these rates and yields on retail
deposits and money market mutual funds, likely encouraging some investors to
place funds directly in credit market instruments.
1.
M3, meanwhile, pushed
Large discount window borrowing by Continental Illinois Bank, beginning
in May, was offset in terms of Its impact on overall reserve supplies
through open market operations.
95
Chart. 3
Short-term Interest Rates
— 6
Long-term Interest Rates
Percent
96
Chart 4
Reserve Aggregates
Billions of dollars
Shaded Area Is Adjustment
And Seasonal Borrowing'
1983
1
Excludes Dorrowing by Continental Illinois Bank beginning in May 19B4
1984
97
above its longer-rim range, as banks and thrift institutions issued large
CDs and other managed liabilities to accommodate rapidly rising credit
demands.
After midyear, economic expansion slowed markedly, particularly
during the summer, tending to reduce transactions demands for money.
Growth
in M3, though remaining somewhat above the upper limit of its range, also
moderated as demands for short-term business credit slackened and as some
banks adopted more cautious lending and funding policies in light of the
strains on financial markets.
Initially, the slowing in Ml was not resisted, as it reversed a
bulge that had brought Ml growth well above the midpoint of the FOMC's
target range.
However, by late August and early September, as evidence
appeared of much slower economic growth, with financial tensions high and
with the dollar rising rapidly on foreign exchange markets, the Federal
Reserve moved to lessen the degree of restraint on bank reserve positions.
That process continued through oiuch of the rest of the year.
Borrowing at
the discount window receded, reaching levels of around S575 million by late
in 1984 and dropping further to around $340 million, on average, during
January 1985.
Total reserves and nonborrowed reserves, which had shown
little expansion since June, increased markedly in the final two months of
the year and into early
1985.
Mirroring the easing of reserve market conditions, short-term
interest rates dropped considerably from their late-summer highs.
Moreover,
quality spreads on various money market Instruments returned to within normal
ranges as the strains related to the problems of Continental Illinois Bank
98
remained contained and progress was made in Latin American debt negotiations.
Responding to the provision of reserves and the reduced rates on alternative
outlets for liquid funds, Mi-type balances rose rather sharply In late 1984
and early 1985.
Growth of M2 also was very rapid, as open market interest
rates fell below average ytelda on HMDA3, small denomination time deposits,
and money market mutual fund shares.
The easing in financial markets during the second half of 1984
was reflected in, and to an extent encouraged by, two successive reductions
In the discount rate, f i r s t to 8-1/2 percent in November and then to 8 percent in December.
By year-end, short-term interest rates were 2-1/2 to
3-1/2 percentage points lower than they had been d u r i n g the summer, and 3/4
to 1-1/2 percentage points below their levels at the beginning of the year—
in some cases near their cyclical lows of early 1982.
Long-term interest rates also declined in the second half of the
year t In part reflecting some moderation of inflationary expectations.
But
for the year as a whole, most long-term rates declined by less than 1/2 percentage point, and remained above their earlier cyclical lows.
The still
relatively high level of long-term rates appears to be influenced by the
continuing budgetary uncertainties, current strong demands for total credit,
and lingering, though lessened, fears of inflation.
Other Developments in Financial Markets
Foreign savings financed a large share of the domestic borrowing
In 1984.
Net inflows of capital from abroad were more than double the already
advanced pace of 1983, thus supplementing domestic saving and enabling the
financing of Che massive federal deficits at the same time that private
99
investment expanded rapidly.
Banks continued to intermediate substantial
amounts of these inflows, and sales of Eurobonds by U.S. corporations
reached record levels.
Direct investment in the U . S . also was very strong,
reflecting several large takeovers of domestic firms by foreign corporations.
Much of the credit market borrowing—particularly that related to
merger activity—was at short term.
Commercial paper debt of nonfinancial
businesses surged more than 50 percent, o f f s e t t i n g two consecutive years of
runoffs.
With strong loan demands In business, real estate, and consumer
areas, total loans at commercial banks grew more than 14 percent.
Given only moderate inflows to core deposits in the face of this
brisk loan growth, commercial banks increased their outstanding CDs in 1984
by more than 14 percent, a f t e r having allowed a large volume of CDs to run off
during 1983.
Credit growth at banks was especially rapid during the f i r s t
half of last year, reflecting a wave of bank-financed mergers.
The bulk of
the CD issuance was concentrated in this period and likely would have been
even greater had not banks also borrowed heavily f r o m their foreign o f f i c e s .
In the second h a l f , loan expansion slackened appreciably, and large time
deposit growth tapered o f f , as some earlier merger-related
loans were repaid
with the proceeds f r o m issuance of commercial paper and other debt obligations
and from selective sales of assets of the merged companies.
Strains on some sectors of the economy, as well as the e f f e c t s of
overly aggressive lending policies by some institutions, continued to be
reflected in relatively high levels of non-performing and other troubled
loans in a number of depository institutions.
As the year wore on, there
were signs of more forceful e f f o r t s to deal with these problems and their
consequences.
Loan loss provisions were significantly increased and steps
100
are being taken to correct weaknesses In credit standards.
The largest bank
holding companies generally improved thetr capital positions over the year,
partly In response to supervisory guidelines to raise capital ratios.
These
approaches will take time to bear full f r u i t , and progress in strengthening
balance sheets will be dependent on reasonable profitability as well as on
developments external to the banking system.
In that connection, the strains
In agricultural areas, on heavily indebted foreign countries, and In sectors
of the energy Industry pose continuing challenges.
In long-term markets, municipal bond offerings achieved new highs
in 1984.
Tax-exempt offerings were relatively light over the f i r s t half of
the year as a u t h o r i t y to issue single-family housing revenue bonds lapsed and
as the market anticipated the imposition of retroactive ceilings on issuance
of Industrial revenue bonds (IDBs).
But volume rebounded in early summer
a f t e r passage of the Deficit Reduction Act, which reauthorized housing bonds
and stimulated a flood of Issues toward year-end to avoid stricter rules for
IDBs and student loan bonds—effective January 1, 1985.
Financial and non-
financial corporations also raised record amounts through bond offerings;
however, the maturities of new issues tended to be much shorter than In
previous years, and many offerings carried provisions that essentially
transformed these obligations into short-term or variable-rate debt.
Variable-rate instruments exhibited increasing popularity within
the home mortgage sector as well.
Adjustable-rate mortgages (ARMa) accounted
for almost two-thirds of the number of conventional f i r s t mortgages on homes
at ma.lor Institutional originators in 1984, up considerably from only onequarter of such originations the previous year.
Thrifts, in particular,
preferred to acquire ASMs rather than fixed-rate mortgages In an attempt to
101
reduce their already acute exposure to Interest rate risk.
The widespread
acceptance of ARMs by consumers was attributable partly to substantial initial
rate advantages offered on ARMs compared with fixed-rate mortgages, as well
as to other features that limited borrower exposure to higher future interest
payments, at least for several years-
Large initial rate discounts became
less prevalent after the adoption of somewhat tighter standards both for
purchases by federal credit agencies and for Che underwriting of ARMs by
private mortgage insurers.
'Set, despite the shift toward ABMs during
1984,
and increased consumer and business lending, the assets of thrifts remained
heavily concentrated in relatively low yielding
instruments.
The CHAIRMAN. Thank you, Mr. Chairman.
In your statement you note several instances last year when the
Fed adjusted policy.
On page 11 of your statement, you say the Fed—and I quote—
"began to exert some additional restraint on reserves in the early
spring."
On page 14, you say that "Given economic developments, reserves could be provided more liberally" in the fall.
And finally you say that, "As monetary and credit growth continued at a relatively rapid pace into January, the easing process
came to an end."
NEED FOR PUBLIC ANNOUNCEMENT
What harm would have resulted from a public announcement by
the Fed policy at the time of each of these policy adjustments?
This is part of an old discussion you and I have had about whether we should have weekly reports, but in this case when you are
making these policy adjustments, there's uncertainty in the
market, what harm would come from letting everybody know?
Mr. VOLCKEE. I think we did let everybody know. All of those
policy adjustments were accompanied by discount rate changes, up
and then, the last one, down. There hasn't been any further—no
further easing. There has not been a discount rate change.
All those changes were also apparent in the marketplace, I
think, as the decision was made, certainly within a few days, or a
week, or two.
So these were not done in the dark of the night. We can't operate
without it becoming known in the market.
The CHAIRMAN. Well, I understand that, but all I am saying, if
that is the case and you are only talking about a week or so, what
is wrong with just coming out and saying we have made a policy
change rather than waiting for the signals; that would make it apparent to everybody who watches the market?
Mr. VOLCKER. Let me take the example of late last August and
early September. The Open Market Committee meeting had taken
102
place in about the middle of August, as I recall, and at that time
there was not any very clear news that the economy had slowed
down. The money supply had leveled off for a month or two, but
was still, as I recall it—according to the figures we then had—
above the middle of the range.
The Committee essentially decided no change in policy at the
meeting, but that if certain things happened—if the economy appeared to be slowing in its rate of growth or the money supply remained sluggish—then we might consider easing.
But we had nothing to announce at that point. A few weeks
later, the first very tentative steps were taken toward easing; that
is, they were taken progressively over a period of time. It was
hardly a situation, in my judgment, that justified any dramatic
policy announcement at the end of August, when we began easing.
It was, at that stage, a very limited, delicate, and reversible step.
Now, suppose we had announced, for example, we are easing.
Then the market would have anticipated our easing much more
than we were prepared to ease at that particular point in time.
There was a progressive process of easing, and it seems to me we
are better off in doing our thing, so to speak, in whatever limited
way seemed appropriate at that point, without dramatizing it by
making an announcement.
If we feel it is important, that there is an important change in
policy that should be announced, we announce it; and we should
announce it under those circumstances.
I don't remember when we first reduced the discount rate during
the fall, but that was a policy announcement. It was clear before
that the policy had eased.
The CHAIRMAN. Well, I understand there are no black and white
answers and there are some gray areas of minor policy changes
and
Mr. VOLCKER. Minor policy changes sometimes become big ones,
and sometimes they are reversed. That is our
The CHAIRMAN. Well, I understand that, but what I am getting
at is it seems to me, as I have watched the Fed for the last 10
years—and there are a lot of Fed watchers in this country—how
much instability do we cause by the guesses that are going on out
there about what you are doing?
I understand you can cause people to overreact by announcing
policy and overly dramatize it, but on the other hand, it is a big
game in this country of trying to guess what is going on, and I am
wondering if more forthcoming information from the Fed might
contribute to more stability and less guessing out there.
Mr. VOLCKER. It is a reasonable question. I think in this case I
feel somewhat as you feel about the publication of the weekly
money supply figures; they are more confusing than useful, and I
think at some point we face that question in other areas.
We provide a lot of information. Our weekly operations are published within a day or two of when they are done. I presume what
you are referring to is published directives of the Open Market
Committee to the desk as to how they are to conduct operations in
very vague terms, very general terms—as those directives I think
must be; the issue is whether publishing them would add to stability and the performance of the markets or not.
103
All I can say is I have been observing this process for 30 years,
and my own conviction is that in the end they will probably be the
source of more confusion rather than less. I would rather let our
actions speak for themselves than try to verbalize them all the
time in necessarily imperfect words, words that are always subject
to different interpretations anyway. We can't do anything without
acting in the market. That is a very concrete action. Let that
action speak for itself.
There is no doubt in my mind that if we are introducing a policy
change—with a capital P—it ought to be announced, and I think
we have done that.
EVALUATION OF PERFORMANCE
The CHAIRMAN. Let me take it one step further. How do we, Congress, evaluate your performance when some of the aggregates are
within the targets, some of them are outside the targets, get the
M's going different directions? How do we try and evaluate the
sum of those different targets?
Mr. VOLCKER. I don't think it is easy because we are in a complicated business, and I don't think, frankly, myself, that you can
evaluate our performance simply by looking at those targets.
We wouldn't have much of a performance if we hit all the targets but the targets were wrong, and the economy greatly inflated
or greatly deflated. In the end you have to look at the final results,
and I think what really makes it difficult is that we are one influence on those final results for the economy. How is the economy
doing? How is inflation doing? There are many other things that
affect those results at the same time, but how can you separate out
our influence?
I don't have any easy answer to that, other than obviously, the
kind of hard slogging process of continuing analysis. I just don't
think there is any number that is going to give you that result.
Congress, I might say, has given us in that respect, a fairly vague
mandate. I think we understand it, but if you wanted to be more
precise in holding us to particular results, you would probably have
to be more precise in the directive you give us, such as has often
been suggested—that the central bank ought to have responsibility
for price stability, period.
That is not the way our charter reads, for perhaps good reason,
but if it did, then you would have a very much more precise measure of results or lack thereof.
The CHAIRMAN. Well, as you know, I don't want Congress attempting to dictate targets.
Mr. VOLCKER. No.
The CHAIRMAN. And we certainly do not have the ability to do
so, to make those kinds of judgments. I think they would too often
be made on a political basis, and we would have had swings up and
down in the
Mr. VOLCKER. No, I agree with that. I just meant being more precise about an economic target—price stability or whatever.
I am not sure you want to do that, but if you want to have a very
precise measure of whether we have performed, I think that would
be the precise, simple measure. You would have to give us a pre-
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else, simple order; I am not thinking of the monetary targets, but
something beyond that.
The CHAIRMAN. With our inability to give ourselves precise,
simple orders on handling fiscal policy I don't think we're in a position to
Mr. VOLCKER. What we are both saying is the economy and circumstances may be too complex for those precise, simple orders
and therefore a precise, simple measure of performance; that's the
world. But I do think our performance can be evaluated. It just
can't be evaluated by meeting any particular target.
If we kept setting out targets and they appeared inappropriate
and we kept missing them you'd obviously have a legitimate reason
for complaint, but we haven't consistently missed them and I think
the targets have been reasonable. So you don't have that gross kind
of measure.
The CHAIRMAN. Senator Proxmire.
Senator PROXMIRE. Thank you very much, Mr. Chairman.
Chairman Volcker, I want to tell you that I'm reassured by your
statement that you've made no commitment to step down and I'm
hopeful that you will, as I suggested, serve out your term. Although, as you indicated when you were confirmed you have made
no commitment to do so, I earnestly hope that you would do that
and I'm delighted to see that you haven't made a commitment otherwise.
Now, you say on the top of page 24, "Consistent with that approach I indicated earlier the progressive process of easing reserve
positions undertaken in the latter part of 1984 has ended." Now,
that sounds like no more Mr. Nice Guy and I welcome that but I
want to make sure I interpret that properly.
Mr. VOLCKER. That's not the equivalent of tightening, you understand.
Senator PROXMIRE. I understand.
Mr. VOLCKER. We were reducing
Senator PROXMIRE. But it's the end of easing
Ml RISING RECENTLY
Mr. VOLCKER. It's the end of a process where the pressure was
reserve positions. Remember bank borrowings were falling. We
brought that process to an end, and that is the definition I am
using of tightening or easing here, pressures on reserve positions.
We have been a bit more cautious in providing reserves because
the money supply has been rising fairly rapidly recently. I would
not call that a tightening at this point but a little more caution.
Senator PROXMIRE. Now, I have also the "Monetary Policy
Report to Congress Pursuant to the Full Employment Balance
Growth Act of 1978" that accompanied your statement today and
it's released as of today. Nowhere does there seem to be an acknowledgement of the fact that remarkable growth of the economy
in 1984 was preceded by three of the biggest deficits in the history
of this country, $109 billion in 1982, $195 billion in 1983, $175 billion in 1984. It seems obvious to me that these kind of back-to-backto-back deficits are bound to stimulate the economy. And I don't
see how that figures in your analysis. Certainly the fact that we
105
project this year, 1985, a deficit of $222 billion, the biggest ever, it
seems to me is another stimulative force which I don't see given
substantial weight in the analysis. Maybe I missed it.
Mr. VOLCKER. I think it's certainly discussed under the government sector. It may not be discussed quite in the terms that you
put it. I don't have any problem with what you're saying. I make
some allusion to it in my own statement. Let's stipulate that this is
a strong expansionary thrust in the economy.
Senator PROXMIRE. Well, I'm happy to get that. Yesterday I
asked Mr. Nisken and he said that deficits have no expansionary
effect whatsoever. He said they had nothing to do with effective
demand. I don't want to argue that point with you because you've
given your answer.
Mr. VOLCKER. Let me, if I may, just
Senator PROXMIRE. Yes, sir.
Mr. VOLCKER [continuing]. Say that this foreign deficit at the
same time is a strong force moving in the other direction, and
those phenomena are not entirely unrelated.
Senator PROXMIRE. Now, there's a very, very powerful case that
can be made that inflation seems to be well under control. I don't
agree with it. You obviously don't agree with it and I'd like your
answer to the fact that in the first place we have very high unemployment on any kind of an historical basis, 8.5 million people out
of work, 7.4 percent of the civilian work force. So the wage pressures on prices should be low particularly with productivity, as you
say, increasing too.
We have an energy glut. Plenty of oil, plenty of other energy resources. We have a food glut. The prospects for food prices seem to
be good. Nominal interest rates are down.
We have persisting the anti-inflation effect of the trade deficit.
The fact that when we buy from abroad it's cheap and when they
sell here they hold down prices in this country.
It seems to me that that is a very, very powerful argument. The
Federal Reserve doesn't have to be quite as concerned about inflation as they've been in the past.
What is your response to the argument that we have inflation
whipped now and that monetary policy doesn't have to worry about
inflation anymore, at least for the next couple of years?
INFLATION UNDER CONTROL
Mr. VOLCKER. I think the simple answer to the question of
whether we have inflation whipped is to look at the numbers; inflation is continuing at a rate of speed that a decade ago provoked
price and wage controls.
Now, I do think that improvements have been made, that we're
considerably better off than we were some time ago and as you
mentioned, I think, that has given us a little greater flexibility in
the implementation of policy recently.
But some of those factors are, as your question implied, temporary so that we have to be very careful that some of the continuing
elements in disinflation, some of the continuing forces working
toward more stability, are nourished and can persist.
106
Over time, of course, that takes restraint on the money supply.
But I'm thinking in a more immediate sense of the price/wage/productivity situation where nominal wages are going up considerably
slower than they were some time ago; that has been consistent, of
course, with increases in average income because
Senator PROXMIRE. Of course, any kind of caution here, it seems
to me, is likely to reduce the prospects for diminishing inflation.
Your projection indicates that you feel inflation will stay fairly
close to what it is now, drop maybe a little, marginally. The Fortune magazine predicts an increase in inflation to about 8 percent
in the coming year. lAt any rate, if we have real growth which you
projected around 3 /z to 4 percent, unemployment won't change
very much and that's very discouraging for millions of Americans
who don't have jobs now.
What's the answer to their argument that we ought to ease monetary policy even more?
Mr. VOLCKER. We do have a decline in unemployment indicated
from 7%, down to 6V& or
Senator PROXMIRE. You know it hasn't dropped since May.
Mr. VOLCKER. It's a drop of one-quarter to one-half a percent.
Senator PROXMIRE. It's the same level it was last May.
Mr. VOLCKER. We're a little lower on the average.
Nonetheless, I think the answer to your question is we're not interested in getting some brief spurt in activity which may, indeed,
reduce the unemployment rate a little faster in the short run at
the expense of generating forces that are going to bring that to an
end in a short period of time.
What we want to do is sustain growth, and if we're going to sustain growth, I think it is terribly important that we not let those
inflationary forces get the upper hand once again; that involves a
balancing judgment, I suppose, as to the economy moving ahead in
a context of, hopefully, further progress against inflation. That
may not produce as much unemployment reduction in the next 6
months as you would otherwise get, but it offers a lot more promise
that those reductions in unemployment can continue and that we
won't fall back in recession, and I think that's far more important.
REDUCTION OF $50 BILLION
Senator PROXMIRE. Now, you've been quoted as saying we need to
cut the budget deficit by at least $50 billion in fiscal 1986 to maintain credibility with the business and financial community.
President Reagan submitted a budget which proports to do that.
However, according to the CBO it is only a $37 billion cut. They
say the President's budget includes about $13 billion in paper cuts
in the defense budget, that is, money the Pentagon never had. It is
something like the head of a company who is thinking about giving
himself a 20-percent pay increase, then cuts the increase in half,
and then brags that he took a 10-percent pay cut. In reality he
gave himself a 10-percent pay increase.
If CBO is right, would you not agree that the President's budget
proposal may be deficient not only in the out years but in the next
budget year as well?
107
Mr. VOLCKER. No; I'm not familiar with the CBO analysis but let
me say that $50 billion figure that gets a lot of attention is in response to a question I answered: That if you're going to make an
impact on market psychology, if you're going to give the impression
of credibility and force in dealing with the budget problem you've
got to come up with a figure in that neighborhood. In fact, they
said upward of $50 billion.
Part of that credibility is measuring from an honest base, so to
speak. I'm not an expert on just what that base should be in defense spending. But to the extent an impression is conveyed that
the numbers are not real, obviously you lose the psychological force
of the cuts.
This always has come up in these terms because the cuts aren't
being made for many months or even a year or more. The question
is: What kind of impact will you get on the market today? To
which my response is, you've got to have a pretty forceful program
to expect expectational effects on the market today.
Senator PROXMIRE. Now, how do you account for the extraordinary strength of the American dollar. Despite reductions in U.S.
interest rates, the dollar continues to reach new highs. What's
keeping the dollar up?
Mr. VOLCKER. I can't explain it. I can't provide any fresh, new
insights into this question. We've had a period when the dollar's
been going up, when some of the basic indicators have been going
in directions that you would think would not produce a stronger
dollar, namely, interest rates have been going down, and the trade
account and current account deficit are getting larger. Nonetheless,
the dollar goes up.
I don't think there is any doubt that interest rates are still relatively high compared to many foreign countries, that's one factor.
There is a good feeling about this country as a place to put your
money, both for economic and political reasons.
I think there is a certain sourness—if that's the word to use—a
certain pessimism in Europe and elsewhere about their own economic prospects or political stability relative to the United States.
That's tended to put money here.
One factor of considerable importance which isn't often mentioned—not often mentioned in my statements either—is we're
talking about a net capital flow. Part of that increased net inflow
is a reduction in outflow. Part of that reduction in outflow has
been related to much less active lending policies by our banks in
developing countries and elsewhere for which the reasons are obvious.
So even if there was no increased inflow, of which there has been
some, you would have had a sizable net increase in capital inflows
simply because our banks are lending less abroad in Latin America
and elsewhere. That's simply a reflection of the problems in Latin
America; nothing more or less than that.
The CHAIRMAN. Senator Heinz.
SIGNIFICANT REDUCTION IN DEFICIT
Senator HEINZ. Mr. Chairman, thank you very much.
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Chairman Volcker, on page 21, you indicate that your projections
of inflation in the range of 3 Vz to 4 percent, the real growth of the
economy, the anticipated progress in lowering unemployment—all
of these are spelled out on the previous page, page 20—are all premised on your assumption that the Federal budget deficit would be
significantly reduced in fiscal year 1986 relative to baseline projections.
Therefore, you were assuming a deficit reduction in the neighborhood of the $50 billion in 1986 and subsequent years that the
President has called for; is that correct?
Mr. VOLCKER. Yes; now, these are projections for 1985. That is
the order of magnitude of the budget cuts we were assuming for
1986 and the effect you would get in 1985 would have to be very
largely expectational. There's some overlap, but I
Senator HEINZ. Right.
Were the Congress not to take those steps, to what extent would
you revise your projections for 1985?
Mr. VOLCKER. I can't give you a numerical answer to that. This is
a collection of numbers for members of the committee, but I think
the risk that is aggravated in that case is what happens in financial markets, what happens in interest rates and what pressures
come on the Federal Reserve, to monetize debt under those conditions. I think people would feel there would be lower growth and
higher inflation, but I can't quantify that. I don't want to suggest it
would be necessarily large during 1985 when we're talking about a
different period.
Senator HEINZ. But were action not taken would you be willing
to endorse the following statement which, I think, you've made.
You would see it first in interest rates. There would be some pressure to monetize the debt. If that did happen it would tend to stimulate inflationary expectations and perhaps some inflation. Those
two factors combined would have a negative effect on growth and
presumably unemployment. All of this in 1985. But the real effect
and the major effect by implication would be in 1986.
Are you saying that we would have quite high interest rates
through the possibility of substantial inflation and an economic
downturn in 1986 if Congress doesn't address the budget deficit?
Mr. VOLCKER. All I'm giving you is a sense of direction, certainly,
for 1985. You tell me whether—we assume something in the neighborhood of $50 billion.
Senator HEINZ. Let's assume it's in the neighborhood of zero.
Mr. VOLCKER. All right. I mean I was going to say if it's in the
neighborhood of $40 billion I may not find those differences
marked except psychologically.
If it's in the neighborhood of zero I do think you will get higher
interest rates next year. That increases the risks in terms of economic activity and at the same time it leads to pressures, which we
will resist, to have a more expansionary policy than we should
have in terms of the long-term inflationary problem.
I don't want to suggest we will not resist those pressures, but
that's the direction in which they come.
Senator HEINZ. I think that it's good to—and I know you've
made that point before—but I think it's good to make it continually. We have not solved the budget problem as yet.
109
Mr. VOLCKER. I think the risk that you're running on the budget,
if I may say so, Senator—to dramatize it a bit but not unrealistically—is what happens if that capital inflow stops? Apparently, we
can go along pretty nicely on the surface as long as we're getting a
lot of loans from abroad. But those are not entirely within our control and if they stop, even with changes made in the budget, and
all the more if no changes are made in the budget, we have some
very real problems.
You've got to begin to get that budget deficit out of the way,
against that contingency, which could happen any time.
Senator HEINZ. Well, you anticipate my next question because
the only way we apparently, as I understand your testimony, are
making all ends meet and having such economic success is by
virtue of the fact that we are substituting foreign capital in this
country where it is needed and a lot of it, apparently as I understand your comments, is being used for consumption. Is that an
adequate understanding?
Mr. VOLCKER. We've had a pretty good investment growth so I
can't say
Senator HEINZ. But let me—I, I
Mr. VOLCKER. I can't say we've wasted all that.
Senator HEINZ. I'm at fault in phrasing my question. That the
importation of foreign capital, although it may be used for investment purposes, facilitates borrowing by others for consumption—
for the purposes of consumption.
Mr. VOLCKER. It facilitates borrowing for any purpose. Now,
we
BURDEN OF DEBT AS A NATION
Senator HEINZ. You, yourself, made a strong point as I recollect
that our burden of debt as a nation—not just Government debt but
consumer debt and business debt and debt for leverage buyout
Mr. VOLCKER. Increasing, yes.
Senator HEINZ [continuing]. Is growing not only substantially
faster than the GNP but it is reaching a level in certain sectors
where you worry about it and you mentioned the corporate financial sector in particular.
Mr. VOLCKER. Yes.
Senator HEINZ. Let me ask you this: Do you think we should do
anything about restraining the growing overburden of debt which
either corporations have engaged in or banks have facilitated by
either restricting corporations or banks in some way?
Mr. VOLCKER. I'm not an expert in this area, but I don't myself
see any way you can importantly regulate mergers, leveraged
buyouts. I don't see how you can get the Government in all these
particular decisions. I think you can do two things, broadly. You
can obviously reduce the Government deficit directly; that's what
we're talking about, that big element in debt.
I do think our tax system has a bias against equity and in favor
of debt, and as part of the tax reform effort I would hope that that
would be addressed. It's been a chronic thing; it's still there, and it
does influence all these decisions, and I would hope that that would
be addressed.
110
Finally, I think that we, as banking supervisors and regulators
have a responsibility. This is not all bank-financed, but banks
themselves have a responsibility for encouraging prudence when
evaluating a merger, or a leveraged buyout, or whatever. It doesn't
mean they're all wrong, but they should certainly be looked at
pretty carefully to see that in those particular cases people aren't
getting overextended.
Senator HEINZ. Maybe we could discuss what the Fed should be
doing to encourage that prudence, along with other bank regulators, on another day, but it seems to me an important and critical
question.
Going back to your concern that the flow of foreign capital might
be cut off, last June, the International Finance Subcommittee of
Banking held a hearing, and I engaged in some purple prose with
Martin Feldstein, as I recollect, asking him the somewhat rhetorical question of whether the United States had become a foreign
capital junkie.
What I hear you saying is that we have become a foreign capital
junkie, and we're facing severe withdrawal pains.
Mr. VOLCKER. We haven't faced any severe withdrawal pains, because it hasn't been withdrawn.
Senator HEINZ. We haven't experienced them. We've faced them.
Mr. VOLCKER. We face them the day that it stops, yes; unless
we're prepared for it. I can draw you a pretty picture, where you
are reducing the Federal budget deficit at the same rate of speed
that foreign capital is receding and everything balances out quite
nicely and the economy gets the benefits of a better trade position.
In that picture, pressures on the market are relieved by the fact
that you're reducing the budget deficit; that is what I am pleading
for. let's get in that position where we're prepared for that.
EFFECTS FROM THE STRONG DOLLAR
Senator HEINZ. You have discussed with great erudition all the
factors that have been affecting capital flows, exchange rates and
the like, but nonetheless, there seems to be a problem that we have
to contend with some way or another. It is stated that our farmers
are the most efficient agricultural producers in the world. It is
stated by people such as the chairman of Motorola, which is a very
competitive high-tech company, that there are many industries in
the United States, like farmers, that are the most competitive in
the world. And indeed, we have been through a very painful
period, 4 years, almost, where we have done a tremendous amount
of reorienting of our economy, so that it is substantially more competitive. And if you look at the Europeans, we are way ahead of
them in so many ways, shapes or form. We are an extremely competitive economy. And yet the exchange rate system, in spite of our
underlying competitiveness, has failed to bring the dollar in line
with that underlying competitiveness.
It's not that there aren't reasons. We've been over the reasons,
but the question is, should we just stand back and say, and allow
the exchange markets, which apparently are not sensitive to this
factor that they're supposed to be sensitive, to wipe out our farm-
Ill
ers and our competitive industries and our exporters and those industries that are competitive, but import sensitive.
It is fine to say, "Senators, reduce the deficit." And let's say we
do that. Do you think that's really going to make the dollar
weaker? No; it's going to make the dollar stronger. And therefore,
after we do what you've suggested is our main policy imperative,
and we should do it, I fail to see how that is going to have helped
the exchange rate system realign with the underlying competitiveness of the U.S. economy.
Mr. VOLCKER. Let me give you two responses. Let me approach it
from the viewpoint of doing nothing, and then I think you're in a
position of driving the dollar down or hoping the dollar gets down;
I don't know what the technique is.
Senator HEINZ. No; you misunderstand my question. My question
is not that we shouldn't do anything in terms of the budget deficit.
My question is, We've got a problem. If we do what you say we
should do, we still have a different kind of problem. We may avoid
other kinds of problems, but we still have a serious problem.
Mr. VOLCKER. Let me approach it from that end.
Senator HEINZ. What do we do about it?
Mr. VOLCKER. I guess I would dispute the premise in the second
part of your comment. I don't know what would happen. If tomorrow, you said the budget deficit was going to be appreciably reduced, it wouldn't surprise me at all if the dollar suddenly went
up, because people would say, "My goodness. You can bet our policymakers in the United States are finally taking care of something we are concerned about." And the dollar goes up.
In terms of a little longer term equilibrium, I think you have
then created the opportunity, and we would create the fact, that
the dollar will be in a better competitive alignment. We will not be
so dependent upon those capital inflows; our interest rates will be
lower in this country, and that will be a factor pushing out or attracting less of this foreign capital under those circumstances.
Senator HEINZ. Mr. Chairman, our interest rates are already
lower.
Mr. VOLCKER. They're lower than they were, but not lower than
they are abroad. I'm not ready to say all the laws of economics
have been repealed and lower interest rates don't have some
impact on the dollar over a period of time, all things equal; you
would have changed the shape of policy, so that we have lower interest rates, we have less dependence upon foreign capital inflows,
and in time you would find a better competitive equilibrium in the
dollar.
I think the danger that you're running now is that you may get
that better competitive equilibrium anyway, because this confidence in the dollar may be diminished, but right now it's a question of picking your poison. We have the trade deficit. If we didn't
have the trade deficit, all those pressures would come back on domestic investment, so we've got a no-win situation.
Senator HEINZ. Yes. We may be in a no-win situation. It seems to
me that if we are unable to get, for reasons that are somewhat only
guessed at, the exchange market to align properly with our competitors, we're driven toward several alternatives, none of which
are particularly welcome. We are driven toward taking action
112
under the GATT for balance-of-payment purposes, holders of tariffs
across the board without preference to any sector. That's one fairly
unpleasant alternative.
Mr. VOLCKER. I'm not so sure that our condition is permitted by
GATT either, but go ahead.
Senator HEINZ. Another unpleasant alternative is massive intervention in the foreign exchange markets, the creation, as one of
your, I guess, New York Fed governors suggested on February 14, a
strategic currency reserve that intervenes to the tune of $100 million a day one way or the other.
A third unpleasant alternative is some kind of investment
equalization tax, which we tried once before.
None of these are very pleasant things to contemplate, because
they all have some rough bite on the other side, even though they
undoubtedly would, in one way or another, bring about the redressing of the underlying of the failure of exchange rates to align with
our competitiveness.
I don't ask you to comment on all those. My time has expired.
Mr. VOLCKER. I would make one general comment. I think in the
way things are set up now, none of those things , would work.
They're not only unpleasant, they wouldn't accomplish the purpose. They either would not reduce the exchange rate—they might
increase it, if the capital flow continued—or if that was successful
in shutting off the capital flow, then you'd just transfer the problem back to internal markets and you'd be wondering what happened to your housing industry.
Senator HEINZ. Thank you, Mr. Chairman.
The CHAIRMAN. Before I call on the next Senator, I'd like to recognize the presence of Senator John Stennis.
Senator, we're honored to have you with us. You're one of the
giants of the Senate, and I value the opportunity I had to serve on
Armed Services with you, when you were chairman of that committee.
So we appreciate you being part of the Banking Committee
today.
Senator STENNIS. Thank you, Senator, very much, for such a
warm welcome.
The CHAIRMAN. Senator Proxmire is not here, and my practice
has been in the past to welcome Senators on the basis of their appearance, but I also throw it out to your side. Senator Dixon was
the first one here and made his statement. He would be next and
then Senator Riegle, but I would leave it up to you gentlemen,
what
Senator RIEGLE. You were here before me.
The CHAIRMAN. Senator Dixon.
Senator DIXON. Mr. Chairman, I apologize for not being able to
hear your testimony. As you know, I went on the House side to a
subcommittee of the Banking Committee to testify on Congressman
Annunzio's legislation, but I did read your testimony and appreciate your comments contained in it.
113
PROGRESS OP CONTINTENTAL BANK
I see that the Continental Bank's need for borrowing from the
Fed has declined, and that the bank generally seems to be doing
better than many expected.
May I ask you first, Mr. Chairman, are you satisfied with the
Continental's progress and second, how would you assess the efforts
of the new management team there?
Mr. VOLCKER. I think I'm generally satisfied that given the conditions the bank inherited, real progress has been made over these
past 6 months or so. I think that reflects well on the management
team.
Senator DIXON. Well, I want you to know that I thoroughly supported what you did there, and I am sure that I speak for the Illinois financial community, when I say that we're well pleased. I
think John Swearingen is an exceptional man. Governor Ogilvie,
who's not of my political persuasion, but a warm friend, has just
recently been placed on the Board of Directors, and I want you to
know that all of us applaud the choice by Bill Isaacs and others,
such as yourself, of that fine gentleman to serve on the Board.
Now Senator Heinz alluded a little bit to the farm problem. I'd
like to develop that a little bit with you, because there's a real
crisis, as I think you know, going on out in the farm belt, and as
you point out in your statement farmers are being crowded out of
credit markets, and land values are falling right to the floor.
There's a real danger that a significant number of farmers won't
even be able to plant a crop this year. Agricultural banks are also
suffering. The number of banks on the problem list keeps climbing
and bank failures are rising, even though we're in the third year of
a recovery.
I'd like to ask you what kinds of solutions you'd recommend to
deal with the problems of agricultural banks and farmers who desperately need debt restructuring.
Mr. VOLCKER. When I look at the banking side, certainly there
are pressures, and there are going to be stronger pressures due to
the general situation that you describe. We are fortunate that, as a
group, those banks are probably the strongest banks that we have
had, historically. Their earnings have been good, their capital is
good, their liquidity, by and large, is good now. And they're going
to need every bit of that strength, in terms of dealing with this
problem. We're going to get some failures there. We had some failures. They tend to be of pretty small banks, and they tend to be
fully insured, so it doesn't have the same systemic implications as
some other situations might have. But there's going to be very
heavy pressures there.
I think we can—from the viewpoint of our responsibilities—
maintain the continuity of banking services. I think we can deal
with this without disrupting the financial system, but there are
going to be some particular communities that are going to be very
hard hit, and their local bank may go. That is a hardship for those
communities. There's no two ways around it.
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SQUEEZE ON INDEBTED FARMERS
The basic problem, of course, is this grows out of the pressures
on indebted farmers. I think the farmer who didn't have so much
debt may not be getting rich these days, but he can maintain himself. When you've got debts of 40, 50, 60, 70 percent of your property values, and those property values are diminishing, you've got a
squeeze. Frankly, I don't see any outcome to this problem that does
not involve losses of some fringe of farmers who are, indeed, very
heavily indebted. If you've got a typical farm with a mortgage at 60
or 70 percent of your property value, you cannot, at any where
near present prices, earn enough money to pay the interest on that
debt. The situation just gets aggravated every year.
Senator DIXON. Well, could I interrupt you to ask you this question, Mr. Chairman.
You know some of us—well, most of us in this committee, I
think, supported your point of view and the administration's on
passing legislation in the last Congress for additional money for
the IMF, and now we go home in some of our States, and the
people there say, aren't American farmers just as deserving of
help?
And I wonder what your response to that would be. I remember
your very strong position before this committee in support of additional funding from the IMF. That wasn't all too popular where I
come from. I followed your lead, as did the chairman and others,
with some reluctance, I think I might add.
What do you say to that?
Mr, VOLCKER. I want to be very careful. I would say, in broad
terms, sure, they're deserving of the same kind of help, but what
kind of help is it legitimate to give? What kind of help certainly is
legitimate for the monetary authorities to provide? We can provide
liquidity help, on the one side. Liquidity is not the problem here.
By and large, there's plenty of money out there in those rural
banks, if they had creditworthy borrowers. They will be able to
lend to their creditworthy borrowers. I have no doubt that the
farmer who isn't deeply indebted is not going to have any trouble
getting money. The problem is one of creditworthiness, and that is
something that money in itself isn't going to solve.
Senator DIXON. Some would argue out there that when we appropriated that—what was it, $8.5 billion for the IMF? There was
some creditworthiness questions pertaining to a good many countries—Argentina, Brazil, Mexico, to mention a few, and they're in
worse shape than some of the farmers I know back in Illinois.
Mr. VOLCKER. I think it's perfectly right to say there was a creditworthiness question. That question was raised, but with a little
more experience, we have been able to say that most of those big
countries have, in fact, been able to get their accounts in order, externally, at least for the time being, as we expected. Many countries that were running big deficits are now running a surplus or
have cut that deficit way down.
Mexico, for instance, is now running a surplus. Looked at from
the standpoint of a farmer, can he do that?
115
Senator DIXON. I don't want to be argumentative with you, but I
would argue that the American farmer is a fairly good investment
risk in the long term. These terms are cyclical.
Mr. VOLCKER. I think they are, too.
Senator DIXON. Mr. Chairman, you'd be the first—you're here
always talking about the cyclical experience.
STEPS TO HELP THE FARMERS
Mr. VOLCKER. I don't disagree with that at all, except that some
fringe group may just be in too deep. Something we're trying to do,
certainly in the Federal Reserve, is quite parallel to an attitude
that was taken toward some of these big foreign loans. We have
not only asked, we have directed, at meetings where this point is
made, that our examiners, in dealing with their rural banks—we
don't have so many rural banks, but we have some—should not in
any way discourage forbearance by the bank, when its in the
bank's own interest and in the farmer's interest and in the interests of working out, over a period of time, the best arrangement in
a particular circumstance.
If a farm loan of that sort is to be classified, it has to be reviewed
by the examiner's superiors to make sure that the examiner is not
overreacting in classifying more than is justified, in terms of the
actual prospects for that loan.
We put in place a number of procedures that, in essence, are
quite comparable to the attitude we took toward the bank loans, on
a much more massive scale, some of the heavily indebted developing countries. In the end, a bad loan is a bad loan. If the loan is
really bad, we classify it in either case.
Senator DIXON. Just in conclusion, Mr. Chairman, I don't know if
this question has been asked prior to my returning from the House
side, but do you have a dollar figure on the budgetary savings, at
least contemplated by the administration's budget, the domestic
cuts and then of course the increases on the military side?
What is your
Mr. VOLCKER. For the overall budget?
Senator DIXON. Yes.
Mr, VOLCKER. I think the actual figure they had for cuts in 1986
was $50 billion even, as they measured them.
Senator DIXON. Do you have any dollar figure on what a freeze
across the board would entail—domestic spending programs, entitlements, military spending—an absolute freeze?
Mr. VOLCKER. No, I think the administration, as I understand it,
has argued its program is the functional equivalent of a freeze, but
I haven't got that calculation.
I think there are many different ways of measuring a freeze and
what you mean by a freeze.
Senator DIXON. Well, I wonder whether it would be possible for
you to make available to some of us on the committee your analysis of that comparative—those relative figures—a comparative
analysis between the administration's budget, which contemplates
massive domestic cuts and substantial spending increases on the
military side and no freezing of entitlements, compared with a
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direct freeze across the board in all categories—entitlements, military spending, domestic programs?
Mr. VOLCKER. No; I would be glad to. I think you have to make a
number of assumptions here as to what you mean by a freeze, but I
could supply some
Senator DIXON. At last year's level.
Mr. VOLCKER [continuing]. Some calculation, yes.
Senator DIXON. Or this year's, I should say.
Mr. VOLCKER. I would be glad to do that.
[The following information was subsequently supplied for the
record:]
117
Chairman Volcker subsequently furnished the following
information in response to a request from Senator Dixon:
Alternative concepts of a "budget freeze" could be used
to characterize different approaches to containing federal
spending.
At an aggregate level, one approach would be to
maintain total outlays in FY 1986 at the FY 1985 level.
By
Administration estimates, this would amount to $960 billion and
would require reducing outlays in FY 1986 by $64 billion from
current services levels.
This overall approach could be imple-
mented in a variety of ways, since all budget categories need
not be affected similarly.
In fact, interest outlays, for
example, cannot be frozen.
Removing net interest on the public
debt, but freezing the total of remaining outlays, yields the
Administration's target for FY 1986:
total outlays of $974
billion, $50 billion less than current services outlays.
Freezing the current-doliar value of all appropriations, including defense, and omitting cost-of-living adjustments for
entitlements would apply the freeze concept at a disaggregate
level to those budget categories amenable to Congressional
control.
This approach, however, would reduce outlays by an
estimated $38 billion from current services levels — the actual
level of outlays would rise $26 billion between FY 1985 and FY 1986.
118
Senator DIXON. I thank the Chair.
The CHAIRMAN. Senator Mattingly.
Senator MATTINGLY. Thank you, Mr. Chairman.
Mr. Volcker, I just want to get back to the trade issue.
If interest rates go down 1 or 2 percentage points, do you think
the dollar will still remain strong as it is today?
Mr. VOLCKER. I think I would have to believe that if it went
down 1 or 2 points it would be less high than it would otherwise be.
But the dollar has been very strong. I am not going to predict that
it would go down.
Senator MATTINGLY. But don't you believe the United States
would be just as safe a haven for foreign investment, probably even
greater?
Mr. VOLCKER. It would be as safe a haven.
But, I suppose it depends upon why interest rates went down. If
the budget was reduced and that produced the 1-percent decline in
interest rates or a 2-percent decline in interest rates, there is nothing in that procedure that would at all weaken confidence in the
United States.
Senator MATTINGLY. You agree however, irrespective of what
caused them to go down. I don't mean the budget deficit going
down by tax increases or reductions in spending, but declines in interest rates.
All I am saying is if interest rates dropped, say, 1 point, the
United States will be as safe a haven and foreign investments are
not going to dry up, right?
Mr. VOLCKER. I suppose in the terms you ask the question I
would answer yes.
Senator MATTINGLY. Yes.
Mr. VOLCKER. But let me just make a point, that if we, the Federal Reserve, attempted to drive interest rates down by greatly expanding the money supply—and suppose we were successful for the
short run—I assure you the United States would then not appear
to be as safe a haven from the standpoint of many foreign holders
of money.
POSSIBLE SOLUTIONS FOR THE TRADE PROBLEM
Senator MATTINGLY. Right. But, you know, what I am getting to.
There has to be eventually, hopefully sometime soon, some answers
to the trade problems that we have. Everybody talks about the
overvalued dollar, but I don't see the dollar dropping that much,
and I don't think anybody else does either because the U.S. economy is strong.
You know, it is how do you go about coming up with a trade solution. Eventually, I assume that you would have to believe, like I
would believe and as do many others, that somebody is going to
have to talk to some of these countries about reduction of some of
their barriers.
Mr. VOLCKER. Obviously, that is one. There are two very constructive things that could happen in that connection: getting their
barriers lowered and simply getting the economy moving a little
faster abroad would help our exports.
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Senator MATTINGLY. There has been a lot of talk about moving to
some type of price rule; in other words, targeting money supply
growth to some basket of commodities to try to help stabilize the
dollar, maybe give it a more clear and precise value.
Will you comment on that idea, and do you think it would be
helpful or harmful?
Mr. VOLCKER. I don't know of any basket that is adequate for the
job. In general intellectual terms
Senator MATTINGLY. How about gold?
Mr. VOLCKER. That is one I thought of that I am not sure is adequate for the job at the moment. We went off the gold standard not
so long ago because it was thought to be deficient. I know that is
one that is proposed.
Senator MATTINGLY. Before you answer that, put aside gold, and
think in terms of creating some new basket to use as a barometer.
Mr. VOLCKER. Let me try to approach your question this way.
That would be one way, that would be a very precise way—let's
say you passed a law to that effect—of telling us to stabilize the
price level. I assume that would be the purpose of it.
Now, you could express that thought much more broadly and
simply say, "Look, your No. 1 job is stabilizing the general price
level." This apparently would go one step beyond that and say we
want you to stabilize the general price level, but we want to give
you a very precise rule about how to go about that, that is, with
some basket of commodities.
I think at that point a lot of technical problems arise. Can you
define a basket of commodities that has a high probability of being
consistent with the kind of economic performance you want in the
economy generally when its price is held stable?
That is a pretty big assumption to make about the relative price
of whatever commodities are in the basket and whatever else is
going on in the economy.
We could conceptually stabilize such a basket of commodity
prices. The question is whether and over what period of time that
would give you the results that you want in the economy as a
whole. We could have a big technical discussion as well as a general discussion about the merits of trying to stabilize a particular
basket of commodities of that sort.
It is a very old idea that has certain attractions intellectually,
conceptually. I have some doubts about its workability in practice.
Senator MATTINGLY. Are you saying such an approach would not
exacerbate the problem?
Mr. VOLCKER. I don't think it would cure this trade problem. I
think that idea would fall or rise on whether in fact it was effective
in producing more price stability and whether that price stability
would be consistent with the kind of performance in the economy
we want.
Senator MATTINGLY. Well, I guess that is what I am trying to
achieve. I mean, we are trying to create stability.
Do you think this approach would have more or less stability? I
think it is a critical point.
Mr. VOLCKER. Well, I think it is, and I would like to get to price
stability. You offer me a mechanism through a commodity basket
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or something else that has more promise of getting to stability. I
am not going to say only bad things about it.
I am not sure it is better than simply telling us more clearly, if
that is what you want, to aim at stability as best we can, that you
want us to report to you and tell you how we are doing, you, the
Congress, are interested in a broader measure of stability than
some limited basket. I think we would probably be better off.
Senator MATTINGLY. Good. I think Congress thinks anybody that
tries to trade would probably think it is better off.
Mr. VOLCKER. I don't see why that stabilizing a basket of commodities is going to help the trade problem that you started with.
Again, you get back to this kind of problem that Senator Heinz
raised in the short run. If people really thought that was going to
be of great help in stabilizing our prices, more money would likely
run into the United States, not less, and we would have the dollar
go up some more.
I think that process is self-limiting. I think we should not be
misled by that initial reaction. This money can't come in forever.
But I don't know how much short of forever is the answer.
Senator MATTINGLY. Well, I guess that is almost like the dog
chasing its tail, If the dollar stays strong, as the United States becomes stronger economically, and you know the dollar is going to
keep on getting stronger, our competitive position weakens unless
we can somehow stabilize the price of the dollar.
Mr. VOLCKER. My problem, I guess, is so long as we have this big
deficit
Senator MATTINGLY. That is not the only answer.
Mr. VOLCKER. So long as we have this deficit that has to be financed, we ought to be down on our knees every night, in some
sense, thanking our lucky stars that we got a strong dollar and got
a big capital inflow because that is the way we are getting the
budget financed; if we didn't have it, I don't know how we would
get the budget financed.
Senator MATTINGLY. Well, I think the strong and healthy economy in the United States is sort of like a welcome mat for the dollars coming in, and I don't think it is going to change.
Mr. VOLCKER. Fine, but if nothing else changes, what will eventually change is that the more and more money you borrow, that in
itself will begin to undermine the confidence that people now have.
That is true of any borrower. If he gets enough loans, at some
point the guy says enough. It may be too late at that point, but
that eventually happens.
CURRENCY INTERVENTION
Senator MATTINGLY. I sort of hate to get off the trade issue, but
Secretary Baker spoke last week about intervention in the foreign
markets, currency intervention.
Are we going to continue doing that?
Mr. VOLCKER. What we have been doing has been quite limited.
My own view is that there are times when intervention can be
useful, that by and large it is a tool of limited influence but there
may be particular times when it is useful, and I think we ought to
121
stand ready to do it when we conclude that there is a combination
of circumstances that makes it useful.
That could be this year, next year, any time.
Senator MATTINGLY. What role do you all play in that, the Fed?
Mr. VOLCKER. We do it.
Senator MATTINGLY. Good. [Laughter.]
That is a good simple answer. Good.
Mr. VOLCKER. I think we do it vis-a-vis the Treasury. I think this
is a process where we do it when essentially both are agreed and
we don't do it when both are not agreed.
Senator MATTINGLY. Good. The only thing in your testimony and
speeches I would like to change is bringing up the subject of raising
taxes. For us folks that are looking at the spending side of this
budget, it sort of weakens some of the resolve on the other side for
people who like to raise taxes.
You know, there are those of us who don't want to raise taxes.
Mr. VOLCKER. I would hope it would strengthen your resolve if
you don't want to raise taxes. I don't think I mentioned it, but I
hope that little threat
Senator MATTINGLY. No, you didn't today. I think, however, you
did the other day.
Mr. VOLCKER [continuing]. Lying in the background, that just encourages you to reduce expenditures.
Senator MATTINGLY. I forget where I was traveling in Georgia,
but I picked up the paper and saw where Volcker alludes to the
need for a tax increase.
Mr. VOLCKER. All I have said is if you can't do it on the spending
side, then you have to look at the other side.
Senator MATTINGLY. But you don't really want to do it on the
taxing side?
Mr. VOLCKER. On economic grounds, I would rather do it on the
spending side, but you have to decide all those other things.
Senator MATTINGLY. Good.
Thank you very much.
The CHAIRMAN. Senator Riegle.
Senator RIEGLE. Thank you, Mr. Chairman.
In your remarks today, on page 4, you say that there is a need
for a sense of urgency, and then on page 9 you say in a real sense
we are living on borrowed time—we are living on borrowed money
and time.
And I agree with you, and I generally agree with the ideas you
have presented in your statement designed to straighten the situation out. And just as you are expressing in your comment about
living on borrowed money and time, it looks to me as if time is running out here.
BREAKTHROUGH ON DEFICIT IS GETTING DIMMER
As I look at what is happening both on the Budget Committee,
on which I sit, and watching the whole budget process, both at the
White House end of Pennsylvania Avenue as well as here, it looks
to me as if the chances of a significant breakthrough on the deficit
are getting dimmer, as that is the general reading of the situation.
All the deadlines have slipped, all of the things that you might
122
measure indicate that despite a lot of high hopes early in January
there isn't much measurable progress going on, and certainly there
has been almost no participation by the President himself.
But to give you a further example of that, today and yesterday
on the Senate floor, where the Meese nomination is being held up
by those who represent farm States and who are greatly concerned
about the farm credit crisis, consideration of deficit reductions
measures are not being undertaken although I sympathize and understand the plight of the farmers. But I would just cite that as another example of the fact that is something that is going to cost
money. I think we need to come up with some kind of an answer,
but that, in a sense, presumably moves us again away from the
notion of some kind of a nice, neat package solution to the deficit
problem.
But what I am getting to is the point that Senator Proxmire
raised with you earlier today, and that is that I think that unless
we break the back of this problem, of this fiscal dilemma—and I
don't see us making much progress toward doing that—I think at
some point we are likely to face a crisis of confidence. I don't know
exactly when that comes, but I think the thing that would probably
bring it to a head as fast as anything would be a failure to act on
the deficit and the fact that you might decide somewhere down the
line in the absence of solving that, that for reasons of your own
that you are going to have to leave the job you are in.
And I would be very concerned about that, not that anybody in
Government is ever totally indispensable. But I think your role in
instilling a sense of confidence here and abroad is of a size and dimension now that, in the absence of resolving this financial deadlock problem, you were to leave your present position it would be a
very serious blow to the confidence many have in our monetary
policy and our ability to correct the deficit crisis we now face.
I say that based on conversations that I have had with people,
not just in the financial markets, but people in major business and
industrial sectors across the country.
So I would just urge you to consider that. Whether we are successful in coming up with a breakthrough on the budget or not, I
would hope that we would not see a disruption of the leadership at
the top of the Fed sometime later on this year because I think that
could be just one more factor that could cause people to really get a
much more serious case of the jitters about the future.
I just wanted to share that thought with you, and to have it put
on the record because I think it is a very important reality and not
necessarily a pleasant one for you or anybody else, but I think it is
part of the quandary that we are in here.
Let me just ask you this question on the issue of the foreign
loans that are pouring in here. Obviously, I am very concerned
about this, representing a State that is being damaged badly by the
import invasion and the drying up of export markets.
I am wondering how long this reliance on foreign credit can go
on. Can it go on indefinitely? Is it reasonable to imagine that for 2,
3, 4, 5 years all this foreign capital is going to continue to pour in
here and that we can continue to buy foreign durables, which is
where the bulk of the spending is going in the trade deficit?
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So we are spending, in a sense, our own capital. Our own equity
money leaves the country in exchange for these consumer durables,
which, you know, are not investments, as we would normally think
of them. They are not capital investments.
Can this just go on indefinitely? Can we just count on the world
to continue to make up for our insufficient savings rate and overspending?
Mr. VOLCKER. The whole thrust of my analysis would be that it
cannot go on indefinitely, but I can't predict for you how long it
can go on. We are a big and strong country—Senator Mattingly
and others have made the point—and it could go on for a while. It's
already gone on for a while.
But it also is true that this flow has to get bigger each year as
things now stand, because we now have to pay interest on what we
borrowed last year. And the dollar's gotten stronger and our trade
position is not going to improve.
I think the answer is it can't go on indefinitely, but I can't give
you any good feeling of what time horizon is relevant here. All I
know is I would like to do what is necessary, internally, to get prepared for that day as soon as possible, particularly since it's very
uncomfortable while it's going on. It's very nice to have the deficit
financed and this investment financed but it's not very nice to be
the farmer or whoever else is fighting the imports or not exporting.
Senator RIEGLE. Well, the thing that concerns me is that as the
economy remains strong and as the news generally is upbeat, housing starts, other things—at the present time inflation remaining
low
Mr. VOLCKER. People say why do anything?
Senator RIEGLE. Pardon?
Mr. VOLCKER. And people say why do anything?
Senator RIEGLE. Exactly. And if you've been watching closely
what's happening here in the Senate, you can detect this type of
attitude. Senator Dole announced early-on that he was going to
produce a major deficit reduction package even before the President's budget got here and that effort has just been stopped cold
insofar as one can tell.
And on the Budget Committee the chairman there who's determined to try to do something about the problem has now said that
he's had to revise all of his deadlines and push them back so it
seems that we're really grinding to a halt here on the question of a
major reduction of the deficit. I'm talking on the order of the $50
billion that has been put forward as the target.
I'm very worried about it because it seems to me that time is
running out and that even now the intervention in the currency
markets, even a slight intervention, forces you into a sort of match
against the speculators, at least, that's what I've witnessed in the
past. Then it becomes like a card game with everybody attempting
to show down the other guy. If you intervene a little bit then the
other guy is sort of forced to up the ante and then if you want to
really beat the speculators in international currency, you really
have to come down hard, and I get the sense that if for other reasons you're not too anxious to do that at this point or think that
that's wise. So it's not surprising to me to see the value of the
dollar kick up again yesterday.
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FLEXIBILITY NEEDED
Mr. VOLCKER. I think you need a little flexibility if you're going
to do this effectively.
Senator RIEGLE. Well, it sounds to me like at some point if you
really want to turn that thing around, you're going to have to intervene in a pretty substantial and sustained way and I don't get
the sense that you're close to doing that.
Mr. VOLCKER. Well, I think the effectiveness of intervention depends upon whether it is moving with or against other, more fundamental, forces. And that's, of course, a matter of judgment at
any particular time. But there's no point in intervening if, in fact,
basic forces are going in whichever direction they're going.
But I also think sometimes the market can move in ways that
aren't necessarily consistent with continuing forces for a time and
intervention may be useful in demonstrating, particularly on a coordinated basis, mutual concern or, in other circumstances, lack of
concern about this.
Senator RIEGLE. If foreigners decided to start to withdraw some
of this capital, how fast could it be withdrawn?
Mr. VOLCKER. They can't. You can't withdraw the capital unless
you find somebody else to sell it to. And if nobody wants to buy it,
what happens is not the capital goes out, but the exchange rate
goes down, our interest rates go up. And the price will change.
Senator RIEGLE. Well, don't you continue
Mr. VOLCKER. You can't withdraw capital when you're running a
current account deficit. You've got to borrow. The only thing you
argue about is the terms and conditions upon which you borrow.
Individuals can take it out but it can't go out as the whole.
Senator RIEGLE. So if people want to unload financial assets in
the United States, they just have to sell them and they can sell
them for whatever the market price is.
Mr. VOLCKER. That's right. They have effects on the interest rate
and on the exchange rate.
And you might say, fine, so the exchange rate goes down, then
we won't have the trade deficit. Then I have to ask you, How are
you going to finance yourself?
Senator RIEGLE. Well, that's my question. If foreign lenders
decide that they're not going to continue to cough up these additional increments of capital, it seems to me that we could find ourselves with a shortfall in quite a hurry.
Mr. VOLCKER. No question.
Senator RIEGLE. Could it be within a matter of days or weeks? I
mean if the psychology changed, how fast would we see the impact
in terms of a shrinkage in new foreign capital being available?
Mr. VOLCKER. I think you'd see the impact in the markets very
fast, because once it happens the markets begin anticipating it and
you could see the reaction
Senator RIEGLE. So it can happen almost overnight?
Mr. VOLCKER. In terms of market impacts, yes.
Senator RIEGLE. One final thing here and I want to be quick on
the time, although, I notice the chairman's been generous as is normally his custom.
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QUESTION OF FARM BANK FAILURES
I want to go to the farm loan problem and I'll be very quick
about it. In 1983, of the bank failures in the country—the insured
commercial banks—11 percent of those were what would be called
farm banks, principally, farm economy centered banks. In 1984 the
total failures had jumped from 11 percent representing the farm
sector banks up to 32 percent and so far in 1985 it's up to 50 percent, and the numbers are really stark in terms of what we're looking at and this is the reason that the farm State Senators are on
the floor right now blocking the Meese nomination because of the
profound sense of urgency.
My question is this: What is the best estimate you can give us as
to the dimension of this farm credit problem through these farm
banks? I won't cite the rest of the figures unless you want me to in
terms of the number of banks that are involved here. But there are
a large number of them.
What I'm concerned about is if we see a toppling or a beginning
of a toppling of a larger number of these banks, particularly in
those sections of the country, how are we going to go about maintaining credit—normal bank credit—in those areas so that we don't
have a situation where suddenly the whole commercial fabric and
network in those areas is damaged or can't function and, how serious is this problem? What are its potential dimensions if it were to
continue and grow at these rates out over the next 6 or 9 months
here?
Mr. VOLCKER. The pressures in some areas of the farming community are very intense. Let me stipulate that.
So far as the banking problem is concerned, there are about $200
billion, as I recall it, of agricultural loans outstanding of which
something on the order of $80 billion is the Farm Credit Administration and $40-$45 billion is the Farmers Home Administration, a
Government agency.
Commercial banks have something like $45 billion and then miscellaneous lenders have the rest. The $45 billion that the commercial banks have is probably among the best of this credit; those are
the farmers that went to normal, commercial sources. And, as I
said earlier, they are among the best of our banks.
So you get a combination of the best of the farm credits and
some of the best of our banks, none of which says many of those
banks are not going to be strained, that we're not going to have
more failures this year than we had last year. That's the way the
year is starting out and since the pressures are there and growing
greater that is going to happen. These tend to be quite small banks.
It's a very serious problem in some cases partly because they are
small and in very small communities. They may be the only bank
in the community. Nobody may want to buy them, even for nothing if it's an FDIC sale, because they don't see the profitable opportunities in that small community. It is a very serious problem for
that communityIs it a manageable problem in terms of its more general implications for the financial system, for the banking system in general?
Yes, I think it is a manageable problem but that doesn t mean
there is not the hardship in the local community.
126
Senator RIEGLE. SO you don't foresee a possibility that the farm
sector of the country could get caught in a credit crisis and a collapse in land values.
Mr. VOLCKER. That's a somewhat different question.
CRISIS SITUATION
I think large sectors of the farm community are in crisis and
many farmers are caught in a squeeze between heavy debts and
falling land prices. No doubt about it.
That's what we were discussing earlier. A good many of those
farmers, I'm afraid, are going to fail; that doesn't mean they can't
go back into farming and those farms can't be operated but they're
not going to be operated at the level of what they are at present.
Senator RIEGLE. I'm more concerned about the effect of a credit
collapse on the change in the underlying value of the assets that is
widespread enough so that you not only have this pattern of certain communities getting hit very hard, but in the aggregate you
have a kind of gathering storm that could spread out
Mr. VOLCKER. YOU have the potential problem that these failures
of individual farms, and pressures on many more farms lead to
pressures on land prices that go beyond, let's say, some economic
equilibrium; those pressures on land prices then set off another
round of bankruptcies and failures.
I think that kind of potential pressure exists. I find experts in
this area have a hard time telling me now that they think land
prices have been driven below some long-term economic point of viability. But I think that risk is urged by many people out there on
the firing line and I think it is a potential danger, whether or not
it's happening right now.
Senator RIEGLE. My time is up. I hope to come back on that question.
The CHAIRMAN. I might say we've got the Thatcher speech at 11
o'clock.
Senator RIEGLE. Incidentally, if I may, I've got a box of cigars
here. My wife and I hsTd a baby daughter 2 weeks ago and I
thought I would bring you what I hope is an adequate cigar, so,
help yourself to at least one when you finish.
Mr. VOLCKER. That's too fancy. I've been making my resolution
to cut down on smoking and you're not helping. [Laughter.]
The CHAIRMAN. Senator Riegle, I might ask this question
Senator RIEGLE. Senator Garn can't have one; he's in training, so
you can have his.
The CHAIRMAN. Well, I've got other problems besides being in
training. If you're a Senator from Utah you don't smoke anything.
Senator RIEGLE. I see. [Laughter.]
The CHAIRMAN. The question I was going to ask, we do have to
leave within a couple of minutes to get over to the Thatcher
speech. I potentially scheduled to come back this afternoon. Senator Proxmire and I discussed that we have no requests from other
Senators to reopen this afternoon. All of them want to submit their
questions for the record.
Senator RIEGLE. Senator Dodd has some, by the way.
127
The CHAIRMAN. So I would just ask you if that would satisfy your
situation to put the rest of your questions in for the record or if
you don't want to go to Thatcher's speech
Senator RIEGLE, Well, actually, no disrespect to her, I'd rather
hear Volcker.
The CHAIRMAN. Well, would that be satisfactory to submit the
rest of your questions for the record?
Senator RIEGLE. I think so. Will Senator Stennis have the opportunity to—I see.
The CHAIRMAN. He certainly would have that same opportunity
and the thing I wanted to use the last minute for is to see if he had
any statement he wished to make before we left.
Senator STENNIS. Well, I want to thank you again for inviting me
to come. I was very much impressed with some of this testimony
but I was expecting to be a bit impressed. I've been reading much
of what Chairman Volcker has been saying and also talking some
to Mr. Volcker. I don't mean to overcoznpliment him but he's a
great asset to the Government at this time in his field. If you have
another hearing I'll be around somewhere.
The CHAIRMAN. He manages to show up here several times a
year whether he wants to or not.
But may I apologize to my colleagues on the committee and to
Chairman Volcker for, first of all, the early start and the truncation of the hearing. As I say, we had no anticipation that Mrs.
Thatcher would be speaking, that we would have a joint session
while the hearing was scheduled.
Senator Cranston has a statement he wishes to submit to the
record. By unanimous consent we would do that.
[Statement of Senator Cranston follows:]
STATEMENT OF SENATOR CRANSTON
Mr. Chairman, I will make just one brief remark because I am
most interested in hearing what Chairman Volcker has to say to us
today. I am most concerned about the structural problem in our
economy, particularly on the fiscal side. The Congress is in the
process of enacting a so-called down payment against future deficits which is so critically important to the Federal Reserve operation and the economy as a whole. Lower inflation and interest
rates certainly have inspired confidence and a period of calm in
which Congress can proceed with this very important task. I know
that monetary policy has made its greatest contribution simply by
reducing inflation and holding it down. This in turn directly reduces the cost of carrying the public debt and helps the Congress
predict cost and revenues. It is a two-way street however; both
fiscal and monetary policy would be more effective if instability in
both is reduced.
That is why the budget is the No. 1 priority with me in this Congress and I hope to all of us in Congress.
The CHAIRMAN. We would also leave the record open for questions from any of the members on both sides of the aisle for your
response as rapidly as you can for the record.
And I thank everyone concerned. The committee is adjourned.
[Whereupon, at 10:30 a.m., the hearing was adjourned.]
[Response to written questions of committee members follow:]
128
BOARD OF GOVERNORS
FEDERAL RESERVE SYSTEM
WASHINGTON, D. C. 20551
March 12, 1985
The Honorable William Proxmire
United States Senate
Washington, D.C. 20510
Dear Senator Proxmire:
I am pleased to respond to your written questions
submitted in connection with the Senate Banking Committee's
February 20 hearing on monetary policy. Your questions concern
the amount of debt resulting from leveraged buyouts and our
views on leveraged buyouts and other merger-related activity.
Qiu's'ion 1.
You and SEC Chairman John Shad have said in the past that
there is too much debt resulting from leveraged buyouts and
takeover activity.
*
*
Answer:
What is the basis for your concern?
How much debt is resulting from this activity?
In 1984, nonfinancial corporations liquidated an
estimated $85 billion in equity through mergers, leveraged buyouts, and share-repurchase programs. Only a small portion of
these retirements--probably less than one-quarter--were financed
by new equity or noncredit sources. The remainder were financed
with debt, including a large amount of short-term bank borrowing. .Based on flow of funds estimates, borrowing for all
merger-related retirements contributed perhaps 1 percentage
point to the 13-1/2 percent growth in domestic nonfinancial debt
in 1984.
Equity retired through leveraged buyouts, per se,
totaled about $12 billion last year, based on available estimates. As implied by their name, these transactions entail high
levels of debt, a large share of which has been extended by
.banks. The high volume of debt relative to equity involved in
these transactions raises concerns from a supervisory perspective over the potential risk for firms involved in the activity
and for the lenders providing the credit.
Typically in a leveraged buyout, the debt is collateralized in part by the assets of the acquired entity--often
inventories or accounts receivable. The success of the buyout
and the ability to service the debt hinge significantly upon the
future earnings stream and cash flow prospects of the new company. In many cases the debt may carry a variable interest
rate. Thus, a heavily leveraged firm will be vulnerable to
adverse economic events that might alter the projected stream of
cash flow or to unexpected pressures in financial markets that
raise interest rates and the cost of servicing the debt. The
value of collateral also would be affected by changes in the
economic environment. To the extent that leveraged buyouts
129
The Honorable William Proxmire
Page Two
weaken balance sheets and increase the exposure of firms to
market risks, they raise concerns as well about the risks for
institutions providing the credit.
For these reasons, the Federal Reserve has actively
urged banks to be fully mindful of the potential risk in
evaluating loans for leveraged buyouts and to ensure that prudent lending standards are applied. Specific guidelines have
been issued for bank examiners to follow in reviewing a bank's
involvement in leveraged buyout financing. A copy of Federal
Reserve guidelines is enclosed. The Board will, of course,
continue to monitor these and other types of merger activities
and associated lending practices. I would hope also that the
investment community will apply caution in appraising various
types of financial arrangements, such as junk bonds, that are
being used by companies involved in takeovers and other merger
transactions.
Question 2.
The March 4, 1985 edition of Business Week featured a
cover story on mergers and acquisitions in which the point was
made that the huge debt being incurred for some of this hostile
takeover activity was being incurred during a period of strong
economic growth and generally declining interest rates but "Come
the next recession ... there will be hell to pay."
*
Is this a legitimate concern?
Answer:
As noted in the Business Week article that you cited,
the recent merger activity and heavy borrowing has been incurred
during a period of strong economic growth and lower interest
rates. To my knowledge, there have been no failures of note or
defaults on debt by firms involved in recent large transactions.
Some of these companies have begun to restructure their balance
sheets, in some cases by selling off assets and repaying debt or
funding short-term debt with other sources of financing. Nonetheless, in the event of a recession or sharply higher interest
rates, some acquiring firms, or firms taken privately through
leveraged buyouts, no doubt would find their heavy debt to be
quite burdensome. But prudent lending practices, as outlined in
our guideline and established by lenders, take these eventualities into consideration, and if sound practices are followed,
failures associated with heavy leveraging will occur only in
exceptional cases.
Sincerely,
Enclosure
130
GUARD DF G O V E R N O R S
FEDERAL R E S E R V E SYSTEM
TO THE OFFICER IN CHARGE OF EXAMINATIONS
AT EACH FEDERAL RESERVE BANK
SUBJECT:
Leveraged Buyouts
Leveraged
buyouts
have
becoms
an increasingly
important
and
prevalent acquisition financing technique which, by definition, entail high levels of
debt.
Bank involvement
in leveraged buyouts and the manner in which some
leveraged buyouts have been structured have, potential implications for the quality
of bank loan portfolios. Examiners should be aware of the characteristics of this
financing technique and its potential effect on a bank's loan portfolio and overall
financial condition.
General Background
Although leveraged buyout arrangements may vary from case to case,
they typically have a number of characteristics in common.
Generally, each
involves the financing of an acquisition of a company, or a subsidiary or division of
a company, by a group ot private investors and/or company managers. Normally,
the investors or managers put up a relatively small amount of equity, borrow
heavily against the company's assets and future cash flow and buy out existing
owners or shareholders.
Often at least a portion of the deb; is secured by the
assets of the acquired entity, generally accounts receivable or inventory.
In
particular, the linancing arrangements usually include (a) senior debt, secured or
unsecured, often provided by banks and other institutional lenders and representing
131
the largest share of the buyout financing; (b) subordinated debt and/or preferred
stock in the f o r m of paper taken back by the seller; and (c) common equity supplied
by the new owners. Debt levels amounting to seven to ten times equity and more
are not unusual in leveraged buyout situations. The viability of leveraged buyouts
is predicated upon the strength, stability and f u t u r e prospects of the earnings and
cash flow of the acquired entity.
Once a company has been acquired in a leveraged buyout its assets and
liabilities are revalued at market value. This usually results in a write-up of asset
values, and, consequently, a higher amount of depreciation expense than before the
buyout. These higher depreciation charges, coupled with the large interest expense
deductions on the acquisition debt, reduce the taxable income associated with the
purchased company and, therefore, reduce the income taxes that the company must
pay. Most leveraged buyout companies pay little or no income taxes during the
first few years after the transaction.
Banks participating in financing these arrangements often earn an up
front fee of 1/10 percent to !/<( percent while the agent bank may take an
additional l/<* percent annually for monitoring the collateral and handling the
paperwork. Banks have extended both secured and unsecured loans for leveraged
buyouts in the form of revolving credits and term loans. These loans may carry a
fixed or variable interest rate ranging from prime plus 1-1/i percent to prime plus
2-1/2 percent for senior debt and prime plus 3 percent at a minimum for
subordinated loans. Some loans have been structured in such a way as to require
the payment of interest only for the first two or three years following the buyout.
In addition to these primary loan lacilities, banks may extend ancillary lines of
credit which may be drawn upon only for the payment of interest, usually when
interest rates on variable rate primary loans exceed a certain pre-determined "cap"
132
-3-
rate.
While intended to provide the borrower some initial temporary protection
from unfavorable interest rate movements and heavy debt service obligations,
these arrangements could mask emerging debt service problems and postpone the
timely recognition of potential credit weaknesses in a bank's loan portfolio.
Supervisory Considerations
The nature of leveraged buyouts and, in particular, the level of debt
typically involved in such arrangements give rise to supervisory concerns over the
potential risk implications for bank loan portfolios.
The high volume of debt
relative to equity that is characteristic of leveraged buyouts leaves little margin
for error or cushion to enable the purchased company to withstand unanticipated
financial pressures or economic adversity. Two principal financial risks associated
v/ith leveraged buyout financing are: (1) the possibility that interest rates may rise
higher than anticipated and thereby significantly increase the purchased company's
debt service burden; and/or (2) the possibility that the company's earnings and cash
flow will decline or fail to meet projections, either because of a general economic
recession or because of a downturn in a particular industry or sector of the
economy.
While
either one of these developments can undermine the
;
creditworthiness of any loan, the high degree of leverage and the small equity
cushion typical of most leveraged buyouts suggest that economic or financial
adversity will have a particularly, large and negative impact on such companies.
Thus, a leveraged buyout arrangement that appears reasonable at a given rate of
interest or expected cash flow can suddenly appear to be questionable if interest
rates rise significantly or if earnings should fail to provide an adequate margin of
coverage to service the acquisition debt.
In addition to unfavorable interest rate movements and earnings
developments, adverse economic conditions may also have a negative impact on the
133
value of a company's collateral.
For example, if a general economic slowdown
reduces a company's sales and earnings, the marketability and value of its
collateral may also suffer.
In any event, given the amount of debt involved in
leveraged buyouts, the value of collateral is extremely important, and the risk that
collateral coverage may be insufficient to protect the bank is a significant
in evaluating the creditworthiness of these loans.
factor
In light of all of these
considerations, the quality of a purchased company's management is also extremely
important and represents another critical element in the bank's evaluation of
leveraged buyouts. This is because such management must oversee both the special
financial risks associated with the leveraged buyout "form of acquisition financing
as well as the normal day-to-day affairs and operations of the purchased company's
business.
In the course of on-site examinations, examiners should review a bank's
involvement in leveraged buyout financing as well as the loans associated with
individual leveraged buyouts.
The following general guidelines are provided to
underscore and supplement existing loan review procedures.
1.
In evaluating individual loans and credit files, particular attention
should be addressed to i) the reasonableness of interest rate
assumptions and earnings projections relied upon by the bank in
extending the loan; ii) the trend of the borrowing company's and
the industry's performance overtime and the history and stability
of the company's earnings and cash flow, particularly over the
most recent business cycle; iii) the relationship between the
company's cash flow and debt service requirements and the
resulting margin of debt service coverage; and iv) the reliability
and stability of collateral values and the adequacy of collateral
coverage.
2.
In reviewing the performance of individual credits, examiners
should attempt to determine if debt service requirements are
being covered by cash flow generated by the company's operations
or whether the debt service requirements are being met out of the
proceeds of additional or ancillary loans from the bank designed
to cover interest changes.
134
3.
Policies and procedures pertaining to leveraged buyout financing
should be reviewed to ensure that they incorporate prudent and
reasonable limits on the total amount and type (by industry) of
exposure that the bank can assume through these financing
arrangements,
it.
The bank's pricing, credit policies and approval procedures should
be reviewed to ensure 0 that rates are reasonable in light of the
risks involved and ii) that credit standards are not compromised in
order to increase market share. Credit standards and internal
review and approval standards should reflect the degree of risk
and leverage inherent in these transactions.
5.
Total loans to finance leveraged buyouts should be treated as a
potential concentration of credit and if, in the aggregate, they
are sufficiently large in relation to capital, the loans should be
listed on the concentrations page in the examination report.
6.
Significant deficiencies or risks regarding a bank's leveraged
buyout financing should be discussed on page I of the examination
report and brought to the attention of the board of directors.
This interim letter sets forth some general considerations and draft
guidelines for use in reviewing leveraged buyouts. Reserve Banks are instructed to
carefully review a bank's leveraged buyout financing activities and to forward
comments and suggestions for modifying, expanding or strengthening these
procedures as additional experience is gained in appraising these credits. Enhanced
guidelines will be provided in the future. Comments or questions may be addressed
to Richard SpUlenkothen or 3erry Edwards.
3OHN E. RJYAN
DIRECTOR
135
BOARD OF GOVERNORS
FEDERAL RESERVE SYSTEM
WASHINGTON, D. C. 20551
April 11, 1985
The Honorable Jake G a m
Chairman
Committee on Banking, Housing
and Urban Affairs
United States Senate
Washington, D.C.
20510
Dear Chairman Garn:
Thank you for your letter of February 26 enclosing
written questions in connection with the hearing held on
February 20. I am pleased to enclose my responses to the
questions for inclusion in the recgrd of the hearing.
Question: The soaring value of the dollar is causing
very serious problems for U.S. manufacturers that must compete
with foreign producers. The high level of U.S. interest rates
has been blamed for the rise in the dollar's value, and the U.S.
budget deficit has been blamed for the high interest rates.
Recently Great Britain raised interest rates sharply in
an effort to support the value of the pound sterling, but the
dollar continued to rise against the pound. Does this cause you
to question whether lower U.S. interest rates would stabilize
the dollar on foreign exchange markets?
Answer;
I do believe interest rates are a factor in
the strength of the dollar.
Partly for that reason, exchange
market developments have increasingly in recent months been a
factor in FOMC deliberations.
Our ability to influence
international interest rate differentials consistent with other
objectives is, however, limited.
As I have often emphasized,
inflationary increases in the money supply in our attempt to
keep interest rates lower would soon be counterproductive.
Lower interest rates as a result of lower budget deficits would,
in contrast, be healthy.
I do not believe the recent sharp increase in U.K.
interest rates, and subsequent exchange market developments,
suggest differential interest rate movements are not
significant.
136
- 2-3-
The increase in U.K. interest rates did, in fact,
suffice to stabilize sterling's average exchange value though
not its value against the U.S. dollar alone.
Because the dollar
was strengthening against foreign currencies generally, it also
rose somewhat further for a time against sterling.
Subse-
quently, sterling strengthened and U.K. interest rates have
retraced part of their increase.
Question: The argument has been made that reducing
prospective federal budget deficits would "remove the last
remaining economic cloud on the horizon for the U.S. economy,"
and that the result could be an even more rapid capital inflow
into the U.S.
Do you agree? Could action to reduce the budget
deficit lead to an even stronger dollar as more capital flowed
into the U.S.?
Answer:
Other things equal, meaningful action to
reduce the deficit should ultimately be reflected in a lower
level of real interest rates in the United States, which in turn
would be reflected in the value of the dollar,
I cannot
discount entirely the possibility that, in the short-run,
effects on confidence might lead to a higher dollar, but I
believe the basic economics in tine point the other way.
The dollar exchange rate has obviously been highly
volatile and subject to expectational and psychological
influences.
At some point rising trade deficits and increased
dependence on capital inflows could provoke an over-reaction,
with the dollar under sharp downward pressure.
That risk of
over-reaction would, in my opinion, be reduced by action to
close the budget deficit.
In other words, prospects for an
orderly external adjustment, with minimal interest rate and
economic dislocation, would be enhanced.
137
Question: What is your evaluation of the seriousness
of the credit problems facing our agricultural banks? How
should the bank regulators respond? Should rules for classifying loans be eased?
Answer;
Recently, many fanners and farm sector
borrowers have been subject to financial pressures brought on by
depressed commodity prices, heavy debt burdens along with
interest rates that remain high both historically and relative
to current inflation, declining land values, and natural
disasters.
These financial pressures have in turn been
reflected in loan delinquencies experienced by the nation's
financial institutions.
Some borrowers who are experiencing
financial difficulties face the prospect of foreclosure on their
farm properties, or the failure of their small businesses.
Some
of these problems are transitory, however, and some borrowers
may well be able to resume payments when general economic
conditions improve.
Under these circumstances, we recognize
that financial institutions may find that the most prudent
banking policy is to stretch out payments and adopt, selectively, a policy of forbearance rather than to take the more
drastic actions of foreclosure or forcing a borrower into
bankruptcy.
138
Clearly, the problems are serious, but we are fortunate
that the great majority of farm banks have entered this period
with substantial capital and earnings.
cushion for absorbing larger losses.
They, in effect, bave a
While failures may well
increase, I do not anticipate they will be in a different order
of magnitude than last year.
I do not believe the basic rules
for classifying loans should be changed, but I do believe those
rules should be applied with the kind of understanding about
forbearance described above.
Most of the agricultural loans in State member banks
are reviewed by System examiners located in Federal Reserve
Districts in the Southern, Midwestern, and Western sections of
the United States.
The Reserve Banks located in these areas
have an intimate understanding of the unique economic and
financial conditions facing farmers and farm-related businesses.
Federal Reserve farm sector examiners receive training in
evaluating agricultural loans and have considerable expertise
and experience in dealing with the special economic and financial problems confronting fanners and small businesses.
In
short, Federal Reserve examiners are aware of, and sensitive to,
problems in the farm economy and their effects on the quality of
agricultural loans.
139
I would also like to note that, as part of our effort
to stay abreast of conditions in the farm economy, members of
the supervisory staffs of the Reserve Banks frequently meet with
representatives from banking organizations in agricultural
states to discuss the financial condition, problems and prospects of farmers and farm-sector banks.
The specific policy of the Federal Reserve, which has
been in effect for some time, is to refrain from taking any
supervisory action that may discourage banks from forbearing on
loans or otherwise working with farmers and small business borrowers who are experiencing temporary difficulties in meeting
their debt service obligations.
This policy has been the
subject of official directives, in both 1983 and 1984, to the 12
regional Federal Reserve Bank examination departments from the
Director of the Board's Division of Banking Supervision and
Regulation.
The Federal Reserve issued these directives because
it recognizes that the economic environment has resulted in
unusual financial pressures for a rising number of bank customers, particularly fanners and certain small businesses.
We believe that selective forbearance is in the public
interest and should be encouraged when it is consistent with
safety and soundness considerations.
The Board's policy
directives, therefore, call for particular sensitivity on the
no
part of examiners to the current special problems of agriculture
and small business and for examiners to avoid criticizing bank
management that adopts a prudent forbearance policy in the
circumstances described.
In order to ensure that our policy is fully and consistently carried out, we have also modified and strengthened our
review procedures for examination reports of farm sector banks.
Pursuant to this effort, each Reserve Bank has designated a
special senior review examiner with a high level of expertise
and experience in examining and supervising farm banks.
This
specially designated senior review examiner is responsible for
reviewing the examination report of each farm sector batik for
compliance with the Federal Reserve's policy before it is
forwarded to the bank.
The special senior review examiner has
been instructed to determine whether farm loan classifications
are based on established criteria and are well-supported by the
loan write-ups.
Furthermore, the special senior review examiner
is under instructions to ensure that examiners' comments, conclusions or recommendations do not imply criticism of bank
management for exercising an appropriate and prudent degree of
forbearance.
Examination reports not consistent with these
policies must be appropriately revised before they are forwarded
to the bank's management and board of directors.
141
Question; What is your evaluation of the current
international debt situation and its current effect on the
health of the U.S. banking system?
Answer:
The improvements in external accounts in
Mexico and Venezuela in Latin America, and in Yugoslavia and
Hungary in Eastern Europe, produced current account surpluses
last year.
Brazil's current account deficit was essentially
eliminated, and a number of other countries had reduced
deficits.
This progress was facilitated in many cases by significant increases in exports, particularly to the United States,
and in most cases was accompanied by a recovery—or at least a
slower rate of decline—of imports.
Such developments, coupled
with continued moderate capital inflows, contributed to sizable
increases in the international reserves of many of these
countries and to the prospects of reduced demands for extraordinary external financing in the future.
At the same time,
most of those countries managed to achieve domestic growth.
Against this background, several of the major borrowing
countries were able to move on to a second phase in their
adjustment and financing programs.
One important initiative,
when warranted by progress in adjustment, has been planning for
142
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longer-term or multi-year restructuring of outstanding debts on
terms that reflect stronger creditworthiness and permit planning
on a more assured basis for the future.
Such arrangements have
been agreed to in principle between the commercial banks and
Mexico and Venezuela; serious negotiations have begun with
Brazil and Yugoslavia.
However, it is also evident from developments in 1984
and the first months of 1985 that the process of adjustment
which began in 1982 is far from complete, particularly on the
internal side.
Progress in coping with both internal and
external problems in a few countries has been limited.
In these
circumstances a higher level of risk remains, and cooperation
among borrowing countries, commercial banks, multilateral
institutions, and creditor countries will continue to be
required.
The need for imaginative and constructive solutions
to the problems faced by individual countries is not over.
The improvements in the external situation in the major
developing countries have of course removed some doubt about
these countries' capacity to service their debts.
This develop-
ment, in turn, has taken some financial pressure off of the
developing countries' creditors, including, importantly, U.S.
banks.
However, for the foreseeable future U.S. banks will need
to continue to work closely with the debtor countries, multilateral institutions, and creditor countries in order to solve
the financial problems of the developing countries.
An abandon-
ment by the banks of their responsibility in this endeavor would
jeopardize the gains made so far and run the risk of undermining
the health of the international financial system.
143
Question: Over the last year, the Federal bank
agencies have been working to establish uniform positions on
capital.
On Feb 11 - the FDIC approved its new capital rule-6% total capital, 5.5% primary capital.
The Comptroller voted for the FDIC rule and indicated OCC would be approving a similar regulation in
the near future.
The Fed too has proposed similar capital requirements but plans to revise its existing guidelines
rather than adopting a regulation.
Why do you believe guidelines are superior to a regulation? In the final analysis, will uniformity be achieved? Even
with regard to intangibles?
Answer:
Guidelines are preferred because of the
greater flexibility they permit in dealing with complex capital
adequacy matters.
Guidelines provide the Board, when assessing
the capital adequacy of an institution, greater latitude to take
into account its individual financial characteristics as well as
the general state of financial market conditions.
The Board
believes, moreover, that failure to meet minimum capital levels
should not automatically be construed to be a violation of a
regulation and hence a violation of law, particularly when the
Board would have to consider capital adequacy in the context of
a broad range of factors in acting upon applications.
In this
same vein, when a institution's capital position is judged to be
144
- 12 -
deficient, the Board will be in better position to tailor the
nature and timing of actions that it orders be taken to correct
this situation to the special circumstances facing the
institution than would be possible under the more rigid
structure of formal regulations.
On the question of uniformity, the Board believes that
the capital requirements of Che three federal banking agencies,
though not identical, are largely uniform.
Each agency has
agreed to a minimum primary capital ratio for banks of 5.5 percent and a minimum total capital ratio of 6.0 percent.
The
agencies have also agreed on the definition of the primary and
secondary components of capital.
The only significant area of difference is the treatment of intangible assets for purposes of computing the capital
ratios of commercial banks.
The three agencies made a strong
effort to achieve uniformity in the treatment of intangible
assets but, unfortunately, were unable to reach full agreement.
The FDIC and the Comptroller of the Currency adopted regulations
that would require the deduction of all intangibles except for
mortgage servicing rights in computing capital ratios.
The
Federal Reserve's guidelines, on the other hand, require the
deduction of goodwill but not other types of intangibles.
145
- 13 -
Intangibles are assets whose values and income flows
are, at least in some important cases, more uncertain and unpredictable than other kinds of assets.
Accordingly, the Board
agrees that these assets should be treated with special care in
assessing the capital adequacy of a banking institution.
question is bow should this be done?
The
Apparently, the FDIC and
OCC have concluded that mortgage servicing rights have sufficient predictability of value to warrant recognition in
assessing capital adequacy while all other intangibles do not.
The Board, on the other hand, believes it preferable to evaluate
the nature and character of all intangible assets on a caseby-case basis.
This preference is reflected in the Board's
capital adequacy guidelines for bank holding companies which do
not require the automatic deduction of any intangible asset for
purposes of calculating capital ratios.
At the same time, the
guidelines indicate that companies should avoid excessive
balance sheet concentrations in any category or related categories of intangible assets and that all such assets will be
given particularly close scrutiny in assessing the capital
adequacy of an institution.
In the interest of making its capital requirements for
banks more uniform with those of the FDIC and Comptroller, the
Board decided to require the deduction of goodwill from capital
146
- 14 -
before calculating capital ratios, because the value of goodwill
appears to be less certain—particularly if an institution were
to come under financial strain--than other types of intangibles.
Thus, the Board's approach differs from that of the FDIC and OCC
only in that it makes no automatic deduction for "other" intangible assets (other than goodwill).
This reflects the Board's
judgment that these "other" intangibles may have a certainty of
value and income flow more in line with mortgage servicing
rights than goodwill.
The Board would stress, however, that it
intends to give close scrutiny to all intangible assets in
appraising a bank's capital position.
147
- 15 -
Question!
The FDIC proposes to:
Release the names of banks and bank
officers who are the subject of formal
enforcement actions.
Some believe this kind of market discipline might cause
more instability than it would prevent--while others believe it
would cause bank management to take regulatory criticisms and
memorandum of understandings more seriously so as to avoid a
formal action.
What is your view? At what point does disclosure
present more of a concern for bank regulators than an enhancement of the supervisory process?
Answer;
In considering the question of the public
disclosure of enforcement actions, it should be noted that a
good deal of disclosure already takes place.
For example,
companies that are required to file public financial statements
must also disclose any enforcement actions.
In addition, the
banking agencies make public on an annual basis case-by-case
summaries of supervisory enforcement actions.
These summaries
do not identify specific companies or individuals, but they do
provide detail on the enforcement provisions of individual
supervisory actions and the specific types of problems the
actions are intended to correct.
In certain egregious cases,
the Federal Reserve has disclosed the names of individuals or
companies subjected to civil money penalties for engaging in
148
- 16 -
improper conduct or violations of substantive banking
regulations.
Finally, information is made available to the
public quarterly on a bank's aggregate loans to its executive
officers, principal shareholders and their related interests.
The question accurately sets forth the basic arguments
for and against disclosure of formal enforcement actions.
It
would seem a reasonable presumption that the threat of public
disclosure might have some deterrent effect on insiders inclined
to abuse their positions or otherwise engage in improper or
self-serving activities.
Partly for that reason, we maintain
the right to disclose such action j.n some instances.
The
further argument is made that disclosure will tend to cause
management of a bank to be more responsive to orders from its
supervisor to take actions to correct problems and/or cease
improper activities.
That possibility must be balanced against
the fact that public disclosure in some instances might have
important counterproductive effects, since it could disrupt a
bank's funding ability and weaken its financial condition,
thereby aggravating a delicate situation which the supervisory
action was intended to correct and making an orderly solution
more difficult or impossible.
In addition, our experience
suggests that if it were understood that supervisory agencies
would, as a matter of routine, disclose all enforcement actions,
149
17 -
financial institutions or individuals subject to such
proceedings would be less inclined to cooperate in the
examination process. As a consequence, discovery and correction
of problems and improper practices would be made more difficult.
In balancing these considerations we believe routine or
across-the-board public disclosure of all regulatory enforcement
actions is not desirable and intend to maintain supervisory discretion on this matter.
In support of this position, we would
note that the enforcement statutes specifically give the banking
agencies discretion to maintain confidentiality of enforcement
proceedings.
In so doing, the statute recognizes that public
disclosure, under certain circumstances, could do irreparable
and unwarranted harm to the bank, frustrate regulatory action
designed to rehabilitate the institution and, therefore, may not
be in the public interest.
I hope this information is useful.
if I can be of further assistance.
Sincerely,
Please let me know
150
B O A R D OF G O V E R N O R S
FEDERAL R E S E R V E SYSTEM
WASHINGTON, O. C. E055I
April 11, 1985
The Honorable Mack Mattingly
United States Senate
Washington, D.C.
20510
Dear Senator Mattingly:
In response to a request from Chairman Garn, I am
pleased to enclose my responses to the written questions you
submitted in connection with the hearing held on February 20.
Question; Last Friday, a Florida District Court
ordered the Comptroller of the Currency not to issue any final
approvals for limited-service banks, i.e., nonbank banks,
pending a final decision by the Court. Since most of the applications for nonbank banks have been filed by bank holding
companies, thereby requiring approval also by the Federal
Reserve, what effect will the Florida District Court decision
influence your action when considering applications?
Answer:
On March 15, the Board announced that it had
suspended further processing of the pending applications from
bank holding companies to acquire nonbank banks as a result of
the Florida District Court order.
The Board took this action
because the court's order, unless reversed or limited, eliminates the ability of the holding companies to open nationallychartered nonbank banks.
Since the applications can no longer
be consummated, the Board has decided to suspend action on the
applications during the time that the court's injunction is in
effect.
If the issues raised by the District Court are resolved
in a manner allowing the Comptroller to grant final charters for
nonbank banks, the Board would act on these applications
promptly.
Upon refiling, applications that had been pending at
the Board for 60 days or more before being returned would be
processed within 30 days of refiling if no substantive changes
had occurred, or within 60 days if the initial 60-day processing
period had not expired before the application was returned.
- 18 -
151
Question! Last March, when the Federal Reserve Board
approved the nonbank bank application for U.S. Trust Corporation, 3 strict conditions were placed on transactions between
the trust company and other affiliates and subsidiaries of the
parent holding company. The Board recently accepted "comments"
about whether such restrictions should be lifted. I hope the
Board will maintain these restrictions, especially in light of
the Florida District Court decision, to prevent interstate
banking without the approval of Congress.
Can you shed some light on where the Board is headed on
this issue?
Answer:
Transactions between nonbank banks and their
affiliates raise difficult issues, and the Board determined to
proceed cautiously with respect to a possible relaxation of
existing limitations on such transactions by soliciting public
comment on these issues.
As a result of its decision to suspend
processing of the nonbank bank applications as described above,
however, the Board does not anticipate taking any action on the
general issue of transactions with affiliates unless the
District Court injunction is reversed or limited.
The Board
nevertheless may be required to consider some limited questions
in this area since the injunction does not encompass state
chartered nonbank banks, and one such application continues to
be pending before the Board.
I hope this information is useful.
if I can be of further assistance.
Sincerely,
Please let me know
152
BOARD OF G O V E R N O R S
F E D E R A L R E S E R V E SYSTEM
WASHINGTON, D. C. 20551
April 11, 1985
The Honorable Alan Cranston
United States Senate
Washington, D.C. 20510
Dear Senator Cranston:
In response to a request from Chairman Gam, I am
pleased to enclose my responses to the written questions you
submitted in connection with the hearing held on February 20.
Question: Assuming Congress does what it can to reduce
the deficits through spending cuts, let's assume equal the
target set by the Administration and clearly a large deficit
remains; for monetary policy purposes would it be more beneficial to enact a revenue neutral tax reform package or should we
just tighten up present law and raise revenue by enhancement as
in the past?
Answer:
As 1 have said on a number of occasions, I
believe that, from a purely economic perspective, it is desirable to lower deficits as much as possible by reductions in
spending.
There are, of course, important considerations of
national security, and domestic noneconomic goals, that may
limit the size of achievable spending cuts.
In my view, if the
structural deficit cannot be closed over some reasonable period
of time by spending cuts alone, then revenue measures should be
taken.
If revenue increases are necessary to achieve these
objectives, the Congress must again balance various economic and
noneconomic considerations.
In this context it would seem
desirable to take the opportunity to strengthen the tax system
through base-broadening, simplification of the tax code, and
reduction of inefficiencies associated with the current tax
system.
- 20 -
153
- 21 - 22 -
Question: The "lead characters" in last year's
economic arid~"finaneial drama were unquestionably the budget,
deficit and the dollar.
These three factors that so dominated the landscape
last year are little diminished in importance this year. Each
is still pushing the economy, inflation and interest rates in
opposite directions.
Of these three factors, the deficit and the budget more
easily lend themselves to analysis. The dollar however, is much
more of a puzzle. With the Fed having added a considerably more
stimulative monetary policy to an already stimulative fiscal
policy, one ordinarily would have expected the dollar to have
weakened substantially. But instead it has reached a historic
high, could you give us an explanation for this?
Answer:
I would not characterize Federal Reserve
policy as considerably more stimulative in a longer-run sense.
While Ml growth has been fairly rapid for a few months recently,
this comes after several months of relatively slow growth, and
we expect it to slow in coming months.
The Federal Reserve
achieved Ml growth at slightly below the midpoint of its 1984
target ranges, and expects to achieve growth within those ranges
in 1985.
Financial markets appear to have reasonable confidence
that this will be the case, otherwise inflation expectations
would have been increased and bond prices and the dollar would
have dropped substantially.
I have no ready explanation for the
dollar's overall strength aside from the continuing relative
attractiveness of dollar-denominated investments produced by
high real interest rates (associated with our budget deficits)
and the strength and stability of the U.S. economy.
154
- 23 - 24 - 25 Question; I am concerned about the strong dollar and
what it is doing to our trade deficit, and in particular the
already hard hit domestic farm industry. There are rumors in
the foreign exchange markets that foreign central bankers are
deliberately looking the other way while the dollar soars sky
high, so that when it becomes over bought they can profit on the
downturn.
Do you think there is any merit to these rumors?
Answer:
No,
Foreign central banks have sold, net,
substantial amounts in exchange market intervention since the
G-5 announcement on January 17.
They would probably have been
willing to sell more if such sales were thought to be needed and
if the United States had been willing to intervene on a larger
scale.
Question! What option does the foreign market have in
dealing with the dollar's vigor?
Answer:
Foreign authorities could tighten monetary
policy very markedly, but this would have a deleterious effect
on economic activity, which is none too brisk in Europe.
Prob-
ably the best policies would involve structural changes,
possibly including tax cuts in some cases, which would increase
incentives and the flexibility of foreign economies, thereby
improving the overall performance of those economies.
Question: Will there be any emergency effort on our
part to force the dollar down?
Answer:
Speaking for the Federal Reserve only, I would
not foresee any emergency response of Federal Reserve policy to
the dollar's strength.
A substantially more expansive monetary
policy would certainly cause the dollar to drop, but such a
course would be self-defeating in that it would worsen future
inflation in our economy.
The soundest policy change the United
States could make to reduce various distortions in our economy,
including those arising through the channel of the high dollar,
would be to reduce substantially our structural budget deficit.
155
- 26 -
Question: Are any U.S. protectionist measures warranted by this situation such as the surcharge?
Answer:
The short answer to your question about pro-
tectionist measures is no.
In general, protectionist measures
would tend to raise, not lower, the value of the dollar.
So
long as demand for the dollar remains as strong as it evidently
is, protectionist measures that tend to restrict the supply of
dollars to the rest of the world would tend to bid up the price.
Those whose products compete with imports might be protected,
but only at the expense of consumers and exporters (including
fanners).
If other countries retaliated -- as well they might
-- exporters would be even more adversely affected.
Proponents of one widely discussed proposal for an
import surcharge claim that their proposed measures would act to
lower interest rates and the dollar.
However, in my view such
an impact would derive not from the surcharge, but rather from
the associated measures to reduce the budget deficit.
One of my
serious concerns is that imposition of a surcharge would make it
more difficult to enact more fundamental deficit-reduction
measures.
156
- 27 -
Question? Recently, Treasury investigation of banks
non-reporting of currency transactions in money laundering
operations point to a serious weakness at the Treasury and
Comptroller of the Currency examination and supervision procedure s.
Would you comment on what kind of steps should be taken
to precipitate earlier detection of this kind of behavior in the
banking system?
Answer:
Upon our request, the Reserve Banks suggested
several measures which would, in their view, result in better
compliance with the Bank Secrecy Act. Their suggestions were as
follows:
1.
Instructions regarding the examination of thirdparty transactions at nonbranch facilities of
banks, such as cash control centers and special
foreign exchange units should be expanded and
clarified.
I.
Uniform audit standards, similar to the minimum
standards established by the FFIEC for banks'
foreign exchange departments, should be established
for on-site examinations.
3.
The Treasury regulations should be clarified and
strengthened in the following important respects:
157
- 28 -
(a) require that any exemption from reporting be
approved by a bank's board of directors or a
committee thereof;
(b) provide clear, narrowly-defined criteria for
approving exemptions;
(c) require documentary evidence to support
approved exemptions;
(d)
require financial institutions who file forms
with the Internal Revenue Service and/or the
U.S. Customs Service to obtain a receipt from
those agencies as proof of filing (this could
be accomplished by revising the forms to
include a perforated receipt which would be
returned to the bank and retained in the
institution's records); and
(e) make clear that forms must be sent to both the
Internal Revenue Service and the U.S. Custoras
Service when a transaction takes place and
when currency is transported into or outside
the United States in connection with that
transaction. The Reserve Banks have observed
that in such cases many banks believe that if
a form is filed with the Internal Revenue
158
- 29 -
Service, no form need be filed with the U.S.
Customs Service, or vice versa.
The existing
regulations require both forms to be filed.
4.
Implement automated, surveillance systems at the
Reserve Banks to permit more timely detection of a
bank's unusual cash activity.
Manually prepared
records presently maintained by some Reserve Banks
are not conducive to this type of monitoring.
Board staff and officials from the U.S. Department
of the Treasury are now studying automated surveillance systems.
I hope this information is useful.
if I can be of further assistance.
Sincerely,
Please let me know
159
BOARD OF G O V E R N O R S
F E D E R A L R E S E R V E SYSTEM
WASHINGTON, D. C. 2D5SI
April 11, 1985
The Honorable Christopher J. Dodd
United States Senate
Washington, D.C.
20510
Dear Senator Dodd:
In response to a request from Chairman Garn, I am
pleased to enclose my responses to the written questions you
submitted in connection with the hearing held on February 20.
Question; You have suggested that a substantial reduction in the federal budget deficit will lower interest rates.
Would you please explain, then, why interest rates have dropped
substantially over the last few months when the Budget Director
was revising his deficit projections upwards by some $50
billion?
Answer;
I have suggested that a substantial reduction
in the federal budget would result in interest rates being lower
than they otherwise would be.
During the period to which you
refer last fall, there was very sluggish growth in Ml, signs of
much slower growth in economic activity, and a very strong
dollar internationally.
In these circumstances, the Federal
Reserve reduced the degree of restraint on banks' reserve
positions.
In all these circumstances, interest rates declined
over the summer and fall, as you noted, despite the continuing
deficit.
Subsequently, interest rates have risen moderately
during a period of relatively little change in economic or
reserve conditions.
cally.
Interest rates are at high levels histori-
Actual and potential market pressures from continued
large budget deficits are only one factor in market developments, but they have been, in my judgement, a persistent and
important factor.
- 30 -
160
- 31 -
Question: You have indicated that the Open Market
Committee s projections for a healthy economy over the next year
are premised on significant action against the budget deficit.
What would happen to the economy if the deficit is reduced by
only $25 billion, or by nothing at all?
Answer:
I expect that market participants have now
built into their expectations, and their actions that affect
interest rates, some amount of deficit reduction.
If no action
were to be forthcoming to lower the deficit, interest rates
might, therefore, rise} they would, at least, be higher than
otherwise.
Although these financial market pressures would not,
necessarily, precipitate an economic downturn, an opportunity to
begin reducing imbalances in our capital markets would be foregone, with an implication of continuing stresses and strains in
certain key areas.
For example, problems in the agricultural
sector, earnings difficulties of thrift institutions making the
adjustment to financial deregulation, and relative sluggishness
in areas of the economy exposed to international competition
could persist and even be aggravated.
The ultimate adjustments
would be made more difficult, and risks of more adverse developments increased.
161
Quejstion; The President's budget deficit estimates are
premised upon continued strong growth of the economy. Assume
that the Congress were to enact budget cuts of the magnitude
recommended by the President, but we still had a recession next
year. Assuming a recession of modest proportions, what would
the deficit be in fiscal 1987?
Answer;
Using Administration or CBO estimates of the
sensitivity of the budget deficit to economic developments, zero
real growth of the economy over the four quarters of 1986-consistent with a mild recession and certainly a rise in
unemployment--could add between $70 billion and $100 billion to
the FY1987 budget deficit.
This deficit increase, although
alarming to contemplate, is less worrisome than the structural
deficit that would persist in the absence of congressional
action.
During recessions, while the reduction in taxable
incomes and increases in income-support spending add to federal
credit demands, private credit demands usually fall off along
with private spending, taking pressures off of credit markets
and allowing interest rates to fall, damping in turn the decline
in private spending.
Deficits arising from this source would
diminish as the economy recovered.
By contrast, the structural
deficit that would persist even in times of healthy economic
activity represents federal credit demands that would compete
•with private demands during periods of economic recovery and
expansion.
162
- 33 -
Question: One thing I've learned from you over the
years is that just about everything in our economy and in the
world economy is interconnected.
If we were to reduce the
budget deficit too rapidly, it could easily tilt the economy
into a recession, which of course would increase the deficit.
Therefore, how long do you think we should take to get the
deficit down to manageable proportions in order to avoid such a
result?
Answer:
Clearly, attempting to eliminate a very large
structural deficit--estiraated by CBO to be more than $170
billion in FY1986 and rising thereafter--all in one step would
be destabilizing for the economy.
is likely to happen.
But I do not think that that
In an economy that is likely to produce
GNP at more than a $4,000 billion rate in 1986, deficit reduction of the magnitude proposed by the President should be accommodated easily.
Furthermore, actions to put the deficit on a
predictable steady downtrend over a period of years would be
helpful in allowing households and firms to adjust to the steps
being taken and, in particular, in allowing interest rates to
come down from the levels that would otherwise prevail.
By reducing the imbalances in the economy, deficit
reduction progressively over the next few years will, in my
judgement, improve prospects for sustaining orderly growth.
Deficit reductions so large and abrupt as to be potentially
destabilizing appear well beyond anything being considered in
the Congress.
163
Question: In your testimony, you suggest that both
employers and employees are beginning to behave as if inflation
was reasonably well under control. Under these circumstances,
what do you think accounts for the fact that real interest rates
remain at close to historical highs?
Answer;
The lowering of inflation expectations that
appears to be building into wage and price setting also appears
to be affecting financial market participants.
This improvement
is, undoubtedly, a factor in the decline in long-term nominal
interest rates by more than two percentage points from their
1984 peaks.
Surveys of the long-term inflation expectations of
financial analysts, for example, also show a gradual decline.
But the average rate of inflation expected by financial
investors over the next several years remains above very recent
inflation experience, as those who have seen how fast inflation
can reignite remain very cautious.
This caution is one factor
keeping long-term interest rates up, and real rates high relative to actual inflation.
Fear that continued large budget
deficits will be monetized at some time in the future likely
contributes to these cautious attitudes.
In addition, Federal budget deficits are a factor
keeping interest rates high relative to expected as well as
actual inflation.
Not only the large current deficit but also
164
- 35 -
the prospect for structural deficits and government credit
demands to remain large for the indefinite future is keeping
real interest rates fairly high, especially rates on longer-term
securities and mortgages.
Foreign capital inflows can partly
mitigate interest rate pressures from the deficit for a while,
but these flows are probably not offsetting all the current
effects of deficits on credit markets, and this ready availability of foreign capital is not infinitely sustainable.
Thus,
investors are concerned that at some uncertain time in the
future, in the absence of significant Federal government deficit
reduction, rates will have to rise to help sustain the flow of
foreign capital and to reduce the credit demands of businesses
and households.
165
- 36 - 37 -
Que stipn; As you point out, the high
dollar and the^huge trade deficits are hurting
domestic industries, including exporters. You
that a reduction in the federal budget deficit
some of these problems. What else could we do
trade deficit?
value of the
a number of
have suggested
would alleviate
to lower the
Answer •. The causes of the strong appreciation of the
dollar are not fully understood, but one can point to three
broad factors:
(1) interest rates partly related to the federal
budget deficit; (2) in general, the vigor and dynamism of the
U.S. economy relative to others' (especially in Europe); and (3)
the belief that the United States is a secure, stable country in
which to invest.
As I have said on many occasions, I believe forceful
action to reduce the budget deficit would help to achieve lower
interest rates than would otherwise be possible.
So far as the
other two factors are concerned, we do not want to inhibit the
vigor of our economy or to act in a way that would call into
question its fundamental soundness or security.
Indeed, we
should, to the extent possible, act to ensure that the dynamism
and fundamental competitiveness
increased.
of the U.S. economy are
Over time, more price stability and productivity
will help the trade balance.
I have suggested that other industrial countries should
act, where feasible in light of their inflationary situation, to
reinvigorate their own economies.
would then improve.
Markets for our products
Combined with efforts on the part of
several key developing countries to make appropriate adjustments
in their economies, other industrial and developing countries
would also be viewed as more attractive alternatives to the
United States as a place to invest.
Upward pressure on the
dollar would subside and the world economy would be better
balanced.
166
- 38 -
Question; If the value of the dollar should come down,
either as a "result of actions we take or as a result of other
forces, that will raise the costs of imports which, in turn,
will increase inflation in the United States, What would you
estimate the increase in inflation to be, assuming first a
modest drop in the dollar and, then, a more significant drop?
Answer-.
Econometric work suggests, other things equal,
a moderate depreciation of the dollar of, say, 10 percent,
against the currencies of major industrial countries, on
average, would raise the rate of consumer price inflation by
roughly 1/2 percentage point per year for a period of about
three years following the depreciation.
The impact on the price
level eventually would reach about 1-1/2 percent.
This estimate
assumes that foreign exporters would absorb some of the effects
of the decline in the dollar into lower profit margins and that
import prices would rise by less than the full amount of the
depreciation.
It also assumes that higher import prices would
lead to higher prices of domestically produced goods that
compete with imports, and would result in some increase in wage
demands (with a lag).
Moreover, the depreciation would exert
additional upward pressure on domestic prices by raising net
exports and aggregate demand.
167
- 39 -
Everything else equal, a larger decline in the dollar
would have a proportionately larger impact on domestic inflation.
In present circumstances, I believe a relatively moderate
depreciation of the dollar might have little or no visible
inflationary effect because it would merely be reversing recent
appreciation and profit margins of many foreign exporters are
unusually high.
risk of
A large fall, on the other hand, could pose the
reversing some of our hard-won gains in reducing expec-
tations of inflation, so the effects could be increased.
would depend on the setting of any decline.
Much
If the dollar
depreciated because of a decline in interest rates resulting
from a significant cut in the budget deficit, for example, its
effects on inflation would be mitigated by the reduced fiscal
stimulus to the economy.
If the dollar dropped sharply when
domestic demands are particularly strong, the inflationary
effects would be magnified.
I hope this information is useful.
if I can be of further assistance.
Sincerely,
Please let me know
@FedFRASER