Full text of Monetary Policy Oversight : Senate Hearings : Federal Reserve's First Monetary Policy Report for 1986 : Hearing Before the Committee on Banking, Housing, and Urban Affairs, United States Senate, Ninety-Ninth Congress, Second Session

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FEDERAL RESERVE'S FIRST MONETARY POLICY
REPORT FOR 1986

HEARING
BEFORE THE

COMMITTEE ON
BANKING, HOUSING, AND URBAN AFFAIRS
UNITED STATES SENATE
NINETY-NINTH CONGRESS
SECOND SESSION
ON

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

FEBRUARY 20, 1986

Printed for the use of the Committee on Banking, Housing, and Urban Affairs

U.S. GOVERNMENT PRINTING OFFICE
WASHINGTON : 1986

COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
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

For sale by the Superintendent of Documents, Congressional Sales Office

U.S. Government Printing Office, Washington, DC 20402

CONTENTS
THURSDAY, FEBRUARY 20, 1986
Page

Opening statement of Chairman Garn
Opening statements of:
Senator Proxmire
Senator Heinz
Senator Dixon
Senator D'Ainato
Prepared statement
Senator Gramm
Senator Mattingly

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WITNESS
Paul A. Volcker, Chairman, Board of Governors, Federal Reserve System
Lower rate of growth in 1986
Welcome Gramm-Rudman-Hollings Act
Mixed signals
Depressing productivity figures
Prepared statement
Monetary policy
Related approaches
Conclusion
Chart I: Ml target ranges and actual
Chart II: M2 target ranges and actual
Chart III: M3 target ranges and actual
Chart IV: Ratio of domestic nonfinancial sector debt to GNP
Table I: Ranges of growth for monetary and credit aggregate
Witness discussion:
Need for lower interest rates
Press stability
Impact of lower oil prices
CBO's revised forecast
Monetary targets
Value of the dollar
Possible drop in the discount rate
Approaching danger zone
Mexico's Financial situation
Banks are struggling
Predictions coming up roses
Rapid deflation could be a threat
Comments on H.R. 3838
Will the drop in oil prices be prolonged?
Meetings with the President
Monetary goals for 1986
Corporate debt explosion
Reform in the banking industry
Logjam on banking bill
Tax on oil imports
Bad debt reserve deduction
Response to written questions of:
Chairman Garn
Senator Heinz
Senator Gorton

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Page
Witness discussion—Continued
Response to written questions of—Continued
Senator Mattingly
Senator Proxmire
Senator Riegle

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ADDITIONAL MATERIAL SUPPLIED FOR THE RECORD
Beryl W. Sprinkel, Chairman, Council of Economic Advisers
American Enterprise Institute, article submitted by John Makin
First Interstate Bancorp, statement submitted by A. James Meigs and Jerry
L. Jordan

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116

THE FEDERAL RESERVE'S FIRST MONETARY
POLICY REPORT FOR 1986
THURSDAY, FEBRUARY 20, 1986

U.S. SENATE,
COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS,
Washington, DC.
The committee met at 1:30 p.m., in room SD-538, Dirksen Senate
Office Building, Senator Jake Garn (chairman of the committee)
presiding.
Present: Senators Garn, Heinz, D'Amato, Mattingly, Hecht,
Gramm, Proxmire, Cranston, Riegle, Dodd, and Sasser.
OPENING STATEMENT OF CHAIRMAN GARN

The CHAIRMAN. The Banking Committee will come to order.
Today's hearing on the Federal Reserve's First Monetary Policy
Report for 1986 comes at a critical time for our Nation's economy.
Economic expansion, which began in November 1982, has now
entered its fourth year. This makes it a relatively long expansion
in historical terms.
News this morning that real growth in the economy slowed to an
annual rate of only 1.2 percent in the fourth quarter of last year
raises concerns that the strength of the expansion may be ebbing.
At the same time, the economic indicators that normally presage
an end to an expansion are not apparent in the economy today. Inventories are not excessive and capacity limits are not being
pushed.
Monetary policy faces particularly perplexing choices. Last year
the narrowly defined money supply grew almost 12 percent. Historical experience would suggest that such rapid money growth would
need to be slowed to avoid a reacceleration of inflation.
Historical experience, however, also would suggest that efforts to
slow such rapid money growth can first lead to a slowing of real
economic growth, certainly not desirable in light of the relatively
weak growth of the economy in 1985.
Oil price declines as well are complicating monetary policy. Do
the oil price declines reduce the threat of a resurgence of inflation
and give the Fed more leeway to stimulate the economy or, alternatively, do the oil price declines have the same impact as a tax
cut and lessen the need for monetary stimulus?
Gramm-Rudman-Hollings raises yet more questions for monetary
policy. Is there a need for monetary stimulus to offset the reduction in fiscal stimulus implicit in reduced Federal deficits and, if
so, do the relatively long lags in impact of monetary policy mean

(1)

that the Fed must undertake stimulation before the deficit cutting
measures are agreed upon?
Finally, the decline in the value of the dollar on foreign exchange markets raises additional questions for monetary policy.
When will this decline stimulate domestic production for both
export and domestic consumption? Will the channeling of more domestic demand into domestic consumption lead to a resumption in
the growth of monetary velocity?
All of these questions are obviously difficult to answer.
Chairman Volcker, we are happy to have you with us once again.
Before I turn to you, I would like to turn to my colleagues.
Senator Proximire.
OPENING STATEMENT OF SENATOR PROXMIRE

Senator PROXMIRE. Thank you, Mr. Chairman.
Chairman Volcker, I am delighted to see that you are getting
back on the right track on the problem of inflation.
I have been very concerned about what I think was the explosive
growth of the money supply last year. Everybody in Government
wants at almost all times to have easy money in Government and
out of Government, the business community, the farm community
and so forth.
Over the last 4 or 5 or 6 years you have been the one sober and
effective voice in holding down inflation and I think you deserve a
world of credit for it.
I thought that somehow you had drifted off the reservation in
the last year, and I am glad to see on the basis of your testimony
today and yesterday that you are back on track where I have
always felt your heart really belongs.
As the chairman has so well said, there is no question that it is a
tough, tough problem to fight inflation at any time. The latest concern of course is the dollar. There are many reasons why all of us
would like to see the dollar continue to decline. It would certainly
benefit many industries in our States and would provide, at least
in the short run, more jobs. But I think the inflation problem is so
serious that we have to be concerned about it.
The CHAIRMAN. Senator Heinz.
OPENING STATEMENT OF SENATOR HEINZ

Senator HEINZ. Mr. Chairman, I join with you and Senator Proxmire in welcoming the Chairman of the Fed to these hearings.
I have found that they provide a very important forum for discussing issues that are often overlooked, and that have an enormous impact on the health and well-being, not only of our economy, but the world economy and our children's future as well.
In reviewing, Chairman Volcker, the Fed report and the chairman's prepared remarks, I was struck by the positive overall outlook for the U.S. economy. The Federal Reserve projects continued
steady growth with low inflation in a stable world economy, all in
the context of reduced Ml growth. It is comforting to have the independent voice of the Federal Reserve echoing the confidence of
the administration, for once, with regard to economic prospects for
the coming year, that is 1986.

However, as you note, balancing this basic optimism is a list of
areas of concern which, if you take them together, represent some
very significant obstacles to the happy outcome we all seek. I am
referring to continuing difficulties for the agriculture, energy, and
manufacturing sectors of our economy, slow recovery in the trade
account with initial recovery presumably on the import side due to
lower oil prices and, third, significant international debt problems.
I know of nobody who has worked longer and harder on those
problems than you; but even you must and do recognize the considerably worsened problems in certain key debtor nations like
Mexico, Nigeria, and Venezuela because of falling oil prices.
There are, as you point out, continuing strains on thrifts and
banks due to sectoral and international creditworthiness concerns,
and there are uncertain prospects that Japan and Germany will
assume a leadership role in the world growth necessary to draw
world trade into better balance and to help troubled debtors earn
essential foreign exchange.
While note is made of those problems, and I commend you for
that, I have to tell you that I worry that perhaps too little attention is nonetheless being paid to those problems, given that they
have dominated national and international policy debate for the
last several years, and have been the subject of major legislative
initiatives pending before the Congress. A scenario in which those
issues I mentioned remain unresolved, no matter how solid the
front of economists attesting to its validity, I think gives us some
reason for caution.
I made more or less the same point with regard to the dollar exchange rate at the hearings we had on the confirmation of Governors Angell and Johnson. I have been and continue to be concerned
about the exchange rate. I think it needs to be a very important
focus of U.S. monetary policy.
I would like to be reassured by projections of healthy growth and
improving trade balances. However, I think you perhaps may recall
along with me that back in 1977, 1978 and 1979 when Tony Solomon was then Under Secretary of the Treasury he reported to us
again and again that the weight of economic analysis and projections indicated that whatever problems there might be with the
fall of the dollar, they were going to be infinitesimal, virtually immeasurable.
Those projections were wrong. There were heavy costs to the
economy, as there have been costs to key sectors due to the record
high of the dollar more recently.
So we must focus on these kinds of problems. I believe they can
only be successfully addressed in a growing U.S. economy hopefully
assisted by other countries who also would decide to grow steadily.
And that most importantly, Chairman Volcker, where you come
in, is that our monetary policy must be fully consistent with and
therefore supportive of such growth.
I would only add that Chairman Volcker describes the conduct of
monetary policy as a day-to-day, week-to-week job. That is reassuring because it tells me that the Federal Reserve stands ready to
make the necessary adjustments in policy and practice to deal with
adverse developments.

Certainly the horizon, while it seems to be pretty clear, has some
clouds. We want to keep them at bay, and maybe we can if the Fed
is continually vigilant.
The CHAIRMAN. Thank you, Senator Heinz.
I would ask unanimous consent that a statement by Senator
Dixon be included in the record.
STATEMENT OF SENATOR ALAN DIXON

Senator DIXON. Mr. Chairman, we are here today to receive testimony from the distinguished Chairman of the Federal Reserve
Board, Paul Volcker, on the Federal Reserve's plans for monetary
policy. Monetary targets, however, as the Chairman knows only too
well, cannot be set in a vacuum. There are a number of important
factors that greatly influence the Fed's conduct of monetary policy.
For example, monetary policy will be influenced by Federal budget
deficits, by our terrible trade deficit, by changes in exchange rates,
and by the foreign debt crisis.
There is great uncertainty in all of these areas. The Federal Reserve attempts to conduct monetary policy in a manner that will
promote stable, long-term, noninflationary economic growth. However, there are real questions whether monetary policy tools alone
can offset the influence of a failure to reduce budget deficits, our
growing and much too high trade deficit, a too-rapid decline in the
value of the dollar, and a new round of failures of Third World
countries to be able to pay their foreign debts.
This is, it seems to me, a time of considerable challenge for the
Federal Reserve. Our trade deficit was $125 billion last year and is
going higher. The dollar has declined about 30 percent in recent
months, which will be good for American exports, but which also
carries a danger of adding to inflationary pressures and the cost of
servicing our trade deficit and huge national debt. American productivity has not been growing as we would like, and our Nation's
farmers face the worst crisis of this century. Oil prices are declining, which should benefit most American industry, but this too is a
two-edged sword because it adds to the difficulty some Third World
nations have in servicing their foreign debts.
In addition, this is a time of rapid and fundamental change in
our Nation's banking system. The marketplace is changing, and
the Federal statutory framework governing the industry has not
kept pace.
I look forward, Mr. Chairman, to hearing from Chairman
Volcker on the Federal Reserve's plans for the conduct of monetary
policy, and on all the other issues I have mentioned. I am always
glad to have the opportunity to have the benefit of his expert counsel and advice.
The CHAIRMAN. Senator Hecht, do you have a statement you
wish to make?
Senator HECHT. Thank you, Mr. Chairman.
I don't have a statement, but I do have an observation.
Mr. Chairman, you have had such nice things said about you
from all of the distinguished Senators. I never heard that so much.
And then when my distinguished colleague from New York walks

in with this big cigar, I think that means that perhaps you are on
the right track. [Laughter.]
Senator D'AMATO. I was going to give him one. [Laughter.]
Ther CHAIRMAN. We only allow one to be lit at the same time.
[Laughter.]
Senator D'AMATO. Mr. Chairman, I have had this wonderful occurrence in my life. I have become a grandfather for the first time.
My daughter married a wonderful young man. I told him the story
of how I was named after my grandfather. She rejected the idea.
That would have resulted, if she were to name the baby after its
grandfather, in a name of Alfonso Murphy. [Laughter.]
I would like to ask one of the photographers right beneath me if
you wouldn't pass this over to Mr. Volcker in the spirit of a grandfather.
Senator PROXMIRE. From one to another.
Mr. VOLCKER. I welcome you to the ranks. [Laughter.]
Senator D'AMATO. Mr. Chairman, I would ask that my remarks
be entered into the record as if read in their entirety.
OPENING RKMARKS OF SENATOR D'AMATO

Senator D'AMATO. I would like to make an observation that in
addition to the prepared text that I have submitted, I believe that
prudence would dictate, it would seem to me, and would lend to the
monetary stability and the economic growth that the Federal Reserve do all that it possibly can because the Congress is on the way
to doing that which it can to encourage lower interest rates.
I think with the decline in oil prices will have a positive impact
on productivity and inflation as a result of that is going to be a
good one. The inflation rate will go down and productivity and economic growth will go up just in the areas that we would like to see
it, and I would hope that the Reserve would see this as a unique
opportunity, because you don't get this kind of dramatic drop in
energy prices and this drop means too much to the GNP and so
much to inflation rates.
We have felt the ravages of inflation when we had just the reverse take place in the seventies. And I would suggest that this
would be an opportunity for there to be a concerted policy.
The discount rate, in my opinion, Mr. Chairman, should come
down, and I reject the idea that that is going to be inflationary. It
is going to put more Americans back to work and there is going to
be more expansion in a positive direction of the economy and this
is the opportune time for that to take place. So I add that as a part
of my prepared text.
Thank you, Mr. Chairman.
[The complete prepared statement of Senator D'Amato follows:]
PRKPARED STATEMENT OF SENATOR ALFONSE M. D'AMATO
I want to welcome Chairman Volcker to this hearing to discuss the Federal Reserve's monetary policies and their impact upon the American economy. Chairman
Volcker's testimony and the Fed's monetary policy report that was issued yesterday
are of great importance to me and my colleagues since the Fed's control over the
money supply has such a profound effect on economic growth.
At present, the economy is entering a critical phase. It has experienced a record
growth period since 1982. More Americans are working than ever before. However,
the economic expansion we have enjoyed since 198^ has not grown as rapidly in

6
recent months. It is important that monetary and fiscal policies are formulated and
implemented in a manner that sustains economic growth without stimulating unacceptable high rates of inflation.
The ability to sustain economic growth and curtail inflationary trends will be
complicated by certain external forces that will affect the American economy. For
example the recent drop in the value of the dollar and the precipitous drop in the
price of oil can have both potentially beneficial and harmful effects on the economy.
While the drop in the value of the dollar will hopefully result in the reduction of our
trade deficit, it may create inflationary pressures since domestic producers will not
be subject to stiff price competition from foreign producers. With regard to the drop
in oil prices, consumer spending will be stimulated but many banks that have
made oil related loans will be placed in more precarious financial positions. The ultimate issues therefore are whether beneficial impact oi these changes outweigh their
potential harmful effects and whether economic policies can be formulated to lessen
the destabilizing effects of these changes. I hope that we will be able to address
these issues this morning to determine what the domestic economic outlook is for
the remainder of this year.
Finally, I would urge that the Fed pursue a monetary policy that promotes a
stable dollar and economy. Investor confidence in the dollar, the economy and our
financial system is paramount to sustained economic growth. Policies that result in
destabilization and inflation must be avoided.
I look forward to the testimony of Chairman Volcker and hope he will address some
of the issues that I have raised.

The CHAIRMAN. Senator Gramm.
OPENING STATEMENT OF SENATOR GRAMM

Senator GRAMM. Thank you, Mr. Chairman.
Chairman Volcker, let me say that I welcome you before the
committee. We have begun a process here in the Congress aimed at
transferring $200 billion of resources from the Government to the
private sector, and in order to facilitate that transfer obviously we
need an expansive monetary policy with declining interest rates,
first nominal and then real.
As I look at the monetary policy of the Federal Reserve Bank in
the last 9 months I think it is the right policy. I would like to congratulate you on that policy and urge you to stay with that course
so long as we in in Congress stay on bringing deficit under control
and balancing the budget by the end of the decade.
I have no doubt about the ability of the private sector to absorb
200 billion dollars' worth of growth potential as over the next 5
years we lower the deficit from $200 billion hopefully to zero. And I
am convinced that in that process we can see a decline in real interest rates, an expansion of economic growth in employment, a decline in the value of the dollar relative to foreign currencies, and I
think your monetary policy given that objective at the current time
is right on track and I commend you for that and urge you to stay
with that policy.
The CHAIRMAN. Senator Mattingly.
Senator MATTINGLY. Thank you, Mr. Chairman.
I just want to also welcome Chairman Volcker once again to the
committee.
I guess for 5 years since I have been here you have been coming
before the committee and maybe this time you won't say anything
about raising taxes, and in fact hopefully we have in place something now that will address the spending side which I think is the
true answer to addressing the deficit problem.
Of course, I also welcome you. I think you are now considered
the second most powerful man in America and very few times do

we have those people before our committee. So we do welcome you.
[Laughter.]
I don't have a cigar to give to you, but
Senator D'AMATO. You are not a grandpa yet.
Senator MATTINGLY. No. I hope not. [Laughter.]
But, I wish you would comment of course on the falling oil prices
and the positive impact that it will have on the economy. Also I
hope you will comment on the Baker plan, in reference to the
international debt crisis which I think is very important.
Thank you, Mr. Chairman.
[The complete prepared statement of Senator Mattingly follows:]
STATEMENT OF SENATOR MATTINGLY

Senator MATTINGLY. Mr. Chairman, I, too, welcome Chairman
Volcker. It is not often that we have before the committee the
second most important man in America. I look forward to your
comments today on many important issues, including the monetary
targets of the Fed, the effect of falling oil prices and the so-called
Baker plan to ease the international debt crisis.
The CHAIRMAN. How much do you want to bet that he says that
spending cuts are a first priority, but if we can get enough out of
spending he favors a tax increase. [Laughter.]
Senator MATTINGLY. Wait a minute. You were here the last time.
[Laughter.]
The CHAIRMAN. I have heard that many times over the last
years. I know the answer to that question very, very well. I have
three grandchildren, but when you are from Utah you don't pass
out cigars when you have grandchildren. [Laughter.]
Candy or other things, but not tobacco products.
Chairman Volcker, please proceed.
STATEMENT OF PAUL A. VOLCKER, CHAIRMAN, HOARD OF
GOVERNORS OF THE FEDERAL RESERVE SYSTEM

Mr. VOLCKER. Thank you, Mr. Chairman and Senators.
I might say, first of all, I am particularly impressed by the quality of this cigar. It is quite out of my ordinary range.
Senator D'AMATO. I want the record to show that it is not Cuban.
[Laughter.]
Mr. VOLCKER. I won't read my statement, Mr. Chairman; you
have already touched upon many of the points I would have made
and so have the other Senators.
I might just take a couple of minutes to summarize some of the
points.
In setting out the monetary targets, which we do at this time of
year, we have not substantially changed those targets from what
we tentatively set out when we were before you last July. We do
have a somewhat broader range for Ml, 3 to 8 percent instead of
the 4 to 7 percent. The center is at the same point.
LOWER RATE OF GROWTH IN 1986

There is considerable discussion in my prepared statement about
Ml and its deviations from our intentions last year and the related

decline of velocity and so forth. I will not repeat that here, but we
are obviously looking forward to a lower rate of Ml growth in 1986.
As you indicated, after some slowing in GNP growth last year
and a slower fourth quarter with a revised figure announced this
morning, the more recent data does suggest some improvement in
the economy, and I think the year is off to a good start without any
reason to look toward a recession or downturn for some of the reasons you suggested.
We are fortunate on the price front in having the oil price decline which, among other things, tends to offset the adverse effects
on inflation for the moment of the exchange rate changes.
But I would emphasize that we do face a number of, I think
really unique problems and strains individually, and put together,
and I would join Senator Heinz in saying I give some emphasis to
these in my statement because I don't think they should be ignored; the bright prospects for this year and beyond really depend
upon diffusing, managing, and coping with those problems.
WELCOME GRAMM-RUDMAN-HOLLINGS ACT

We still have the very large budget and trade deficits, and I certainly want to welcome the efforts that Congress has made and the
spirit of the Gramm-Rudman-Hollings legislation to deal with that
problem over a period of time.
I know there are constitutional and other uncertainties, but that
basic effort has already had some favorable effect on the market,
and I think it is crucially important that that effort be carried on,
but in the best of circumstances you are left with a big deficit for
the time being and you don't magically get rid of that deficit overnight.
I could make the same comment about the trade deficit. We have
ourselves in a big hole here, and I think the conditions are now
better partly because the dollar has declined, pointing toward some
improvement, but you are not going to eliminate that trade deficit
in a hurry.
To the extent that the dollar depreciation is pan of the solution
to that problem, I also have to emphasize, as some of you already
have, that it is a two-edged proposition.
The dollar was too high, but we have had a lot of experience here
in the past and other countries have had even more experience
with the adverse effects of a cumulative decline in their own currency that has inflationary repercussions; a kind of self-reinforcing
decline can potentially, if we are not alert to it, produce very real
problems for the economy in another direction.
In that connection, I would just emphasize to you once again
that, given the fact that the trade deficit and the budget deficit are
not going to disappear very quickly, those deficits have to be financed, and they are going to have to be financed by a continuing
inflow of capital from abroad.
How readily that capital is available is a very important factor
in the outlook for our own capital and money markets and for interest rates, and that capital isn't going to be freely available
unless there is continuing confidence in the currency, and I think
we have to keep that very much in mind.

When one looks at the outlook for trade and when one looks at
the outlook for the world economy, of which we are part, and given
the exchange rate change that there has been, our prospects for
1986 are at least as dependent, probably more dependent, on
growth abroad.
We are not going to have very good markets for our exports and
we are going to have very heavy competition on the import side
unless there are profitable markets in other countries for our products and for their own products.
MIXED SIGNALS

There have definitely been question marks in that outlook. The
signals are mixed. Some of them have improved somewhat, particularly on the continent of Europe, but they have very high levels of
unemployment. The outlook in Japan tends to be toward slower
growth rather than more rapid growth. As their exchange rates appreciate, that is a restraining factor on their growth. On the other
hand, their outlook for price stability is very good.
They have made a lot of progress in that direction and they now
have the favorable effects on prices of their currency appreciation,
and they also have the favorable effects of oil, prices as we do, on
their price levels. It remains to be seen whether those economies
can grow, not by relying on increased exports to us and a bigger
trade deficit by the United States, but by homegrown expansion
and stimulation.
I think it is also obvious that while the oil price decline has potentially very favorable effects on the inflation outlook, offsetting
the exchange rate problem, in the short run it releases purchasing
power and it also has adverse effects.
It has distinctly adverse effects in important regions in the
United States and it adds to strains on some financial institutions,
some parts of the financial markets, and it particularly adds to the
already heavy pressures on some developing countries, notably that
one just to the south of us, the very important country of Mexico.
Senator Mattingly I believe referred to the Baker initiative. I
would simply say here that I think the basic premises of that initiative are still very valid. It was a very desirable initiative.
The challenge that it faces is increased by the impact of the oil
market on some of the heavily indebted developing countries. That
makes it only more urgent to proceed in the directions that that
plan contemplates, not only in terms of the changes that have to be
made within those countries to make their economies more efficient, more effective, more competitive, more open and more creditworthy, but also—the other side of the equation—what is absolutely essential seems as a complement is what the creditor countries
can do to make sure that they do have markets for their products
and that when they are doing the right thing they have adequate
financing for their external deficits. It simply puts even more emphasis on that initiative to make it all work.
DEPRESSING PRODUCTIVITY FIGURES

One point that I don't think any of you touched upon I will just
mention. I think it is a longer run factor, but the productivity fig-

ures last year were rather depressing reading. There was no increase in productivity, which is surprising particularly in a period
when the overall economy was growing. It was growing at a slower
rate of speed, but nonetheless growing; outside the manufacturing
sector, it was growing quite rapidly.
I don't know if that has enormous implications for our policy approach in 1986, but you look at it over a longer period of time, in
relation to the inflation problem, for instance, if productivity does
not in fact grow more rapidly than it has been growing recently, it
puts a very definite limit on the growth potential of the economy,
how much excess capacity and how much excess labor force we
really have, and the figure was depressing enough last year to call
it to your attention.
I hope and suspect that part of the difficulty may simply be the
difficulty of measuring output in the service side of the economy.
Nonetheless, it is disquieting.
I would simply conclude by noting a matter which I know has
been a frustration to you, Mr. Chairman, and other members of the
committee—that we do really face a very confusing almost chaotic
kind of situation in the banking world, the thrift world, and the
financial world when we are trying to apply law that is really now
outmoded because of a changing financial environment, changing
for market reasons and changing for technological reasons.
So that it is difficult for us and it is difficult for other banking
agencies to interpret existing law in the light of present needs. I
think the courts find it equally difficult. We get conflicting decisions and we get confusion. There is a lack of coherence, and that
is bad enough, but I think it reaches the point where that lack of
coherence does bear upon the safety and soundness of the system.
I appreciate your efforts to try to deal with that and hope that
we can get some breadth of congressional guidance on these very
difficult issues during the course of this year because I think time
is growing short.
[The prepared statement of Chairman Paul Volcker follows:]

Committee to discuss tho approach of Federal Reserve policy
w i t h i n the larger economic setting at home and abroad.
As you know, i9a& Ha^ begun with the economy continuing

S t a t erne n t by
Paul A. Volcker

to move forward after nore than three years oE expansion.

Today,

more people are employed relative to the working age Copulation
than ever before recorded.

Unemployment has continued to tall.

Elappily, the? continuing expansion has so far heen achieved tfhile
inflation remained at the lowest rate in more than a decade.
Looking ahead, there are some highly encouraging signs.
as well.

The larger employment increases in recent months are

reflected in relatively confident attitudes by consumers.
Manufacturing output as a whole, which had heen sluggish

rates and higher stock prices —

buoyed in part by the action of

Congress in improving prospects Cor declining federal deficits in

my judgment, the present expansion -- a 1ready longer than the
postwar average for peacetime years -- is not about to die Erom
old age or sheer exhaustion,

We don't have the pressures on

appear absent.
prices, or the rising interest r cites that have typically
restraint in much of industry and lower commodity prices hav
under control.

presaged cyclical downturns in the past.

The sharp breaX in oil prices should be an i

force cutting costs and prices in the period immediately ahe

every prospect pleases would be idle pretense.

There are evident

the process releasing real purchasing power to U.S. consumer
Moreover, changes in exchange rates and the welcome initiati

aggravated by the sharp decline in oil prices itself.

W h i l e the

taken by the Congress and the Administration toward budgetar
restraint offer the potential for dealing with two of Che
passed the t ime when we could, with any validity, insulate ourselv
from the d i f f i c u l t i e s of neighbors and trading partners to which *
are bound by strong ties of finance and trade.
Altogether, the opportunity clearly remains for combining

ahead, building on the progress of the past three years.

Most of these threats, in magnitude and in combination,

that changes

in actual trade flows ne-cessac' ly lag changes in

exchange rates hy a period! efcrend1 j ng intG y< 3rSj that currency
adjustments can assume a momentum of their c v-n, and that sharp

inflationary threats,
Wo doubt, some depreciation in the dollar, after the r a p i d
run up, could be absorbed uithout a sharp or immediate impact on
domestic prices.

But we cannot afford to be complacent.

Inevitably,

prospects for balance in our internal capital markets -- and therefore
prospects f^r interest rates -- remain tor the time being neavily
in exchange rates has been a necessary

part oE achieving a bette

competitive e q u i l i b r i u m and of responding to (instructive protectionist pressures.

That was explicitly recognized in the

meeting of the Finance M i n i s t e r s and Central Rankers oE the five
leading industrialized countries in September.

Fly now, a sub-

stantial adjustment in exchange rates has been made, plac ing our
producers LCI a stronger competitive position.

dependent on the willingness of foreigners to place huge amounts of
funds in dollars antf on the incentives for Americans Lo employ t h e i r

that growth w i l l in tact hi' strong ennnqn. to reduce appreciably

ment is historically at mud 1 lower levels, growth by those same

yen itself a restraining factor.
An appropriately emphasized aL tne SnptembKc G-5 mj?etin.gf
The net result should he both to reduce risks of inflation and tc

a better wurld e q u i l i b r i u m - including more rapid improvement in

Hudman-llollings legislation represents one important approach to
that end.

Stroag.se growth patterns in other leading covirilcies ar

also directly relevant.

The opportunities for policies to work

toward that result this year appear to be greatly enhanced by the
abroad do not themselves have expanding, profitable markets at home.
Prospects in that respect remain quite mixed.

There have

been signs of somewhat stronger growth in Germany and elsewhere
in continental Europe.

However, it remains questionable whether

strongly Beneficial effects of the declines in oil prices anci the

the
already strong prospects lor price stability in those countries.

Should oil prices remain close to present levels, that
development will also be a powerful force offsetting, and in the

heavily indebted developing countries are even i
Moreover^ the pervasive pressures on nuch of the agricultural

the Congress addressed and should help stero further deterioration.
overall price pertormance.

At the same time, the effect is to

and oil-consuming businesses.

These ssctoral strains and imbalances point up the crucial

The potential addition to real
For a long time, that was something we in this country thought

effects on purchasing power that some have foreseen in the full

Gramm-Rudman-Hollings legislation over the course of this year.

years —

countries, that is part of the basis for a sense ot growing
optimism about world economic prospects.

But, of course, thr

effects ace sharply adverse for energy producers, affecting

contributed to much more aggressive lending behavior over the
lending that has led to unanticipated problems in a

period of disinflation and greater competitive pressures.

Today,

with respect :-u product i vity over r.-<-.ent yeari vi^c.d qcn^rsll'y

In the end. It is l a r g e l y p r o d u c t i v i t y Lhat govern':
nontarm businesses as 3 whole sbowefi n^ yrowth, are har^J tr>
explain.

In manufacturing- where recorded perf otmance is

substantially better than in other sectors, the slower prn-

the number >jf worker';, it r,rt^ a l i m i t on our tnr.il ecO!ie;rjt; growth.
Forroruilely, in developing mnnotary policies now, we do not

potential; today, c a p a c i t y m ii i?.at ion is s t i l l aomewiiat hflow,

in productivity improveroen'' perhaps part of the seeming prohlem lies in the inherentaifficulty in measuring the volume and quality of output in ttitdominant service sector of the economy.

But the results tin

Monetary Pn] .

nt economic sitLiation points up the tact that the formiil
mplementation ot monetary

policy need to take account o£

tv of sometimes conflicting objectives and critei

a c e o b v i o u s l y c r i t i c a l r o t h e success nt ttie common e f f o r t ,
j u s t , as t h e p e r v a s i v e anri i n d i r e c t e f f e c t s o f m o n o i - T r y p o l i c y
ran tiear upon t h e success of

o t h e r p o l i c i e s boyom tin- s t n . ; : l y

Ml, r;re^ p e r i i i i t e n t i y iibfivf

( h e r a n g e set b o t h a t t h e s t s r t

iil t h e y e a r a n d dcjai.i n f l - e r t h e range was r e s e t i n J u l y (see
s t r o n g l y a f f e c t e d t h e b e h a v i o r cL c e r t a i n p o l i c y g u i r i e p o s t a -

Chart I I .

n o t a b l y M l a n d d e b t -- r e l a t i v e , t o o t h e r e c o n o m i c m o g i i r u t l e s .

above t h e y e a r e a r l i e r l e v e l , dn h i s t o r i t - a l l y h i g n r n t e of

C o n s e q u e n t l y , I d o not b e l i e v e t h a t i n c u r r e n t c i r c u m s t a n c e s

•jrnwtli.

T h a t aggreQ.VC- or 1( ,1 the

y e a r 3! miss t. 52 pt>r;:en!

In technical r r r m s , t h a t J a r g e "overshi?ot." was p e r m i t t e d
j u d g m e n t i n t h e conciurt of F e d e r a l R e s e r v e p o l i c i e s .

in the

l i g h t o£ a p e r s i s t e n t a n d s i z a b l e d e c l i n e i n M l " v e l o c i t y "

u r w i t h a one or two q u a r t e r l a g between money ar.o G N P .
both l i m i t e d a n d l i t t l e c h a n g e d .

The r i i s c u ^ a t r a ' e w a s reduced

In o t h e r

w o r d s , t h e except l o n a l g r o w t h i n Ml seeded to ht: ratclied by a n

once i n t h e s p r i n g , from 8 to 7-1/2 p e r c e n t , ar,d nost m a r k e t

equally exceptional decline

i n t e r e s t r a t e s d e c l i n e d by I t n 3 prt-cen.'.ige - ' ; i n t s , g e n e r a l l y

g r n r f t . i i n l ^ ^ f ; (!^-es n e t i m p l y t h e same i n f l a t i o n a r y p o t e n t i a l , a t

As i l l u s t r a t e ' ] i n ( - h a r t s I T a n ' i I I I a l t a c h e j , t h e

i n v e l o c i t y , s u g g e s t m y t h e hic,h Ml

i b s t r a c t J y , t h e j u d g m e n t o f t h e F e d e r a l Open. M a r k e t

9-12 percent "monitor \ Tig range" set out at the start of the yec
The aggregate debt statistic?, portrayed in relation to GNP
on Chart IV, eiaggera'o the profilem to some degree.

pending subsequent re f und i rigs • and for

There has

a vai'ii'i 1 ' "I pi : .<'>'!'•

dollar remained high, and that fact was another strong signal
that monetary policy was not unduly liberal.

counting" in the aggregate statistics because both the new

We were aware, of course, of some conflicting evidence.

municipal debt and the debt acquired in employing, 'he funds

During much of 1984 and 1985, domestic demand -- tfle spending

at a rate well beyond thp rate of domestic output, measures by

with about $100 b i l l i o n of equity retired by a combination of
stock repurchase programs, sr>-called leveraged buyouts, and as

would probably oe beyond nur long-term growth potential.

that sense we continued to live beyond our means, at the expense

part of mergers and acquisiT. tons.
The strongly rising stock market and lower interest
rates had the effect of greatly increasing consumer wealth,

Moreover, private as well as public debt continued to
accumulate at an historically rapid rate, running above thp

measured by current market values, and lowering the cost of
capital to business.

Nonetheless, the trend of debt creation,

That question is yreatly complicated both Qy the changed

composition of Ml, which now includes accounts that recei

Eragility,

The d i s i n f l a t i o n a r y process and the associated decline in

market interest rates also hove implicit nns for the '.ill

on were absent, 11 3usl.rat.ed

3n extreme form the consequences of essentially speculative
11}

lending and lax market practices.

That

the long upward

trend

i n v e l o c i t y oE

FOMC has been the lasting i i g n i f ic.ince of the snaale incrnas

in Ml.

ntf

We are well aware, as I have often reporter] no t h i s

Committee,

w i l l p r o b a h l y not be t y p i c a l of a J o r l d in wtn

ot the long history and of the economic analysis

The

is in tact excessive in the

l i g h t of recant velocity bell

s h a r p drop in v e l o c i t y last y e a r , g r o w t h t o w a r d the upper end
response to the sharp reduction in interest fates late In 1BB4,
continuing at a lesser pace over much of last year.

if thp r a n g e c o u l d w e l l be a p p r o p r i a t e - .

More b r o a d l y ,

the

In a

context of contained i n f l a t i o n , a generally strong dol)ar, and
more muted economic growth, the decline in i n t e r e s t ratss did
not appear in itself to risk excessive economic -stimulation,

broader monetary aggregates, w h i c h remained within their target

As set out in Table II attached, in establishing these
target ranges, members of the federal Reserve Be ird arid Reserve

Looking a;iead to 1986, the FOMC decided to take account

Bank Presidents a n t i c i p a t e d the economy would grow somewhat mor

to decline gradually.

Views on the outlook

for prices were

decline, while others expected that the consequences of the
lower exchange rate may, for a time, put stronger upward
pressure on prices.

while the "central tendency" of the

participants in the FOMC.

The differences are not so large as

to suggest, in themselves, inconsistency with the monetary growth

At present, with the various monetary aggregates at

targets; indeed, several Board Members and Presidents anticipated

reasonable levels relative to their new target ranges, and taki

real growth in the 4 percent area.

account of Che cross-currents in other factors bearing on polic

I might also note the somewhat

lower unemployment rate generally anticipated by the Committee

implementation, there has been no occasion for significant char

by the Administration projections.

both intermediate and long-term interest rates have been declir

Monetary policy is implemented day-by-day and week-byweek by determining the appropriate degree of pressL

bank

reserve positions in the light of monetary growth, judged in
the context of the flow of information about the economy, the

to the lowest levels seen in years and the stock market has bee

monetary policy, insofar as it can contribute, is to help assure
that those favorable prospect3 for maintaining progress toward

has underway a number of initiatives to help deal with the

stability can be a reality in the content of a growing economy.
The implementation of policy will be conducted in the light of

of examiners and supervisory personnel so that they are equipped

that objective.

to meet higher standards in the frequency and intensity of

Related ftpproaches

examination of member banks and holding companies.

I referred earlier to the pressures in some areas of the
credit markets growing in large part out of the backwash of overly

regulatory steps have been undertaken as well.

Certain

Specifically,

we have issued for public comment a proposal £or a framework cf

1C
inflation.

Irideed, those concerns have been aggravated in more

recent years Dy a continued highly aggressive approach by some

capital standards.

The proposed standards are designed to take

account of the different characteristics of bank assets and to
incorporate allowance for off-balance sheet risks that have been

and appropriate responses to them, are too large a subject for
me to deal with in the time available today; we have discussed
them before on a number of occasions.

system.

A f t e r decades of l i t t l e change in the legal s t r u c t u r e ,

by the federal "safety net." The result is a clear threat not

t e c h n o l o g i c a l and m a r k e t developments haue together created a

only tr. the coherence but also to tf!e safety and soundness of thf

proper and l e g i t i m a t e role of b a n k s , bank h o l d i n g c o m p a n i e s ,

presented an enormous new challenge to a few countries that have

thr

been heavily dependent on oil resources for the development of

CO
Regulatory decisions attempting to apply current lavs, sometimes
respect to Mexico, with which we have close trade and financial
The results are capricious as both regulatory bodies and the court?
inevitably reach different conclusions in ambiguous circumstances.
The courts themselves in recent decisions have emphasised
the need for fresh Congressional guidance.

I can only reiterate

my own view that, without such a review, tha banking and thrift

national debt crisis provide a constructive and needed overall
framework for dealing with problems.

He emphasized tha importance

-26-

-21-

economic p o l i c i e s conducive t o s u s t a i n e d growth.

That, in t u r n ,

largef loan programs in support of fundamental economic adjustments, and with the international Monetary Fund,

On that basis,

creditors, a n d by m u l t i l a t e r a l development i n s t i t u t i o n s a l i k e .
In essence, the borrowing c o u n t r i e s themselves -- "Baker
external needs.

Indeed, without complementary policies by inter-

to take those a c t i o n s necessary to improve the e f f i c i e n c y and
c o m p e t i t i v e n e s s of t h e i r own economies, i n c l u d i n g the development

outward-looking solutions to the problems by the borrowers theoselve
will inevitably be undeimined, and the adverse implications would
extend far beyond the economic arena.

sizable portion of their energy requirements or are essentially
neutral in that respect, recent developments should ease the
context o£ aci eKpending world economy, thp ptospeeY.s, for "rfViic

tasX.

s h o u l d he e n h a n c e d by the same d e c l i n e i n oil

for others —

p r i c e s t h a t make

But I oo noT: in any way jant to minimise the challenge
for Mexico, Ecuador, Nigeria, and Venezuela.

The r e s t r g c t u r I n g process can be g r e a t l y a s s i s t e d by

in valid.

1 believe that, with will and wisdom, the ba

What

defeating cycle of external depreciation ano internal
inflation, at the expense of an eroding loss of confidence,
I conclude as I started.

higher interest rates, and impaired growth.
It would be foolish to presume that the United States

With constructive policy responses, recent developments
ry the potential for enhancing prospects here and elsewhere fe

is somehow

immune from that threat -- we had too much

adverse experience in the 1970s to indulge in wishful

10
and fiscal policies, we need to be realistic about the
danger and be fully sensitive to the need to maintain

with, points of strain and danger, some of them stemming from
the very successes of the past.
Economic history is replete with examples of

Fortunately, the sharp decline in energy prices now

underway should, for months ahead, help assure satisfactory price performance overall, making the job of

countries that, in attempting to correct over-

But those lower prices are no unmitigated blessing.

-30ng lhe^r_ gt

They create new uncertainties and stresses for some

opening markets to others, and in helping to dsal with

and trading partners.

Those stresses need to be contained

and dealt with in a constructiva way, and we need to guard

strides have been made toward those goals.

However,

their growth, at least until now, has been heavily

Today, there appears to be a prime opportunity for

the problem, the direction and broad spirit of the effort
—

7or tne longer run, 1 welcome the call by the President

that, sooner or

to consider what steps might tie dssirable to achieve and

prospects.

maintain greater exchange rate stability internationally.

The success

The budgetary effort mjst be sustained.
If we expect to benefit from the break in energy prices.

We need to be patient when patience is required.

The trade

and budgetary and financial problems w i l l be with us for some timer
at the same time, we need to be insistent in carrying through the
measures to deal with them constructively.
effects of extreme exchange-race volatility to make

In much of this, I recognize the Federal Reserve and

to
that effort to reexamine the international system

posts to policy in today's setting, there w i l l be a high premium
of all countries —

including the United States — are

on careful judgment.

But through it all the basic objective does

inextricably interlocked.
We have come too far, and the stakes are too high, to fail

States —• and much more —

13 dependent upon maintaining progress

of a prosperous, integrated global economy.

M1 Target Ranges and Actual

M2 Target Ranges and Actual

L
1985

1—J

I- i
1B8G

I MM

M3 Target Ranges and Actual

Ratio of Domestic Nonfjnancial Sector Debt to GNP

Noofedeial Debt

Federal Debt

19S6

l»»i

3 to 8

3 to 8*

6 to

6 to 9

f, to 9 - L / 2

Debt

8 to 11

9 to

"Applied to p

Nominal GNP
Seal GKP
Implicit
deflstoc

toe GNP

5 to 8-1/2
2-3/4 to 4-1/4

6-1/2 to 7-1/4
3 to 3-1/2

^-\|^ to 4-1/1

verage level
in the fourth
quarter, purge
Unemployment rate

6-1/4 to 6-3/4

*CTvilian unemployment rate.

About

6-1/2

The CHAIRMAN. Thank you, Mr. Chairman.
Senator Heinz has another meeting that he must chair at 2
o'clock, so I am going to yield to him first out of part of my initial
questioning time.
Senator Heinz.
Senator HEINZ. Thank you, Mr. Chairman.
I just want to emphasize something that Chairman Volcker said
with respect to you, Mr. Chairman, on the work you are doing on
safety and soundness, trying to make sure that our principal financial market and supervisory agencies are doing everything they
can, and determining whether they need any legislation to help
them do it.
You are doing a superb job on that, and I just want to echo
Chairman Volcker. That is not my question, however. [Laughter.]
My question, Chairman Volcker, is basically this. You are saying
that Japan isn't going to grow much. The Germans still worry
more about inflation than they do about growth. The rest of
Europe seems pretty much economically confused, with the possible
exception of one or two places like Italy.
We all know that the decline of the dollar, which is uneven in
any event with respect to specific currencies, while it makes us
more competitive internationally, it is going to take a long time to
do that. It works through very slowly.
We have depressed regions and industries which you and I have
both touched on. Somebody actually estimated that in spite of the
economic growth and job creation which we have had, there are
some 30 to 35 States that actually are in depression. Now the obvious ones are the ones like Iowa, the Farm States, and some of the
less known ones are areas like western Pennsylvania, which is in
the midst of a 1930's type depression.
NEED FOR LOWER INTEREST RATES

You have mentioned that productivity growth has been zero.
That carries with it the suggestion perhaps that the very high real
interest rates that we have made make it too costly or unprofitable
to get any increases in productivity.
And if you add all of that up, doesn't that suggest that we should
pursue a monetary policy that is more expansive and aimed at lowering interest rates, both real and nominal, by whatever extent we
possibly can relative to where we are today?
Particularly, as there is anti-inflationary assistance from lowered
oil prices which is very, very helpful indeed. Given those drops in
oil prices and all those other economic growth problems that I have
alluded to shouldn't the Fed pursue a more growth oriented monetary policy?
Mr. VOLCKER. I think the aim of our policy is to achieve sustainable growth, and that has to be in the context of progress toward
price stability; and within that framework we have to make our
judgments.
I think the key to your question was with respect to interest
rates. We would all like to see lower interest rates to the extent we
possibly can. Well, I interpret that in the light of what is consistent

with sustained growth over a period of time and what is consistent
with progress toward stability.
The oil price in and of itself is certainly a factor moving in that
direction so far as the market is concerned and, looking at it all by
itself, in terms of the inflationary impacts so far as monetary
policy is concerned. But I would also point out that the oil price
decline itself releases purchasing power and is an expansionary
factor for the economy without us—the Federal Reserve—doing
anything.
I also have to point out there is another potentially strong force
at work which offsets the favorable price effects—in a way we are
fortunate they come together—and that is the exchange rate movement, and we have to look at monetary policy in the light of that
factor.
Right now, we have some indicators that tend to be on the
stronger side relative to the performance of last year. We obviously
have to look at the rate of growth in the money supply, which has
not been exactly niggardly over the past year. So a lot of factors
have to go into that judgment.
PRICE STABILITY

Senator HEINZ. With the Chairman's permission, may I ask a followup question, which is this. The term "price stability" fascinates
me because were we to have a policy that promoted price stability
at current price levels, there are a number of things we could guarantee; cutting the number of farmers in half, cutting our manufacturing sector also in half, reducing the opportunity of many new
small businesses to be created all because many price levels are too
low for U.S. producers to compete—largely due to international
monetary conditions, the relative strength of the dollar, people
hanging on to their profit margins, and so forth.
Today's price levels are unaffordable for too many sectors. That
is why we just passed a 852 billion bailout for the farmers. And all
you are saying is keep prices stable and let Government make up
the difference.
Mr. VOLCKER. I simply disagree with that analysis, I am afraid,
and I had better be pretty clear about it, Senator. I do not agree
that half of the manufacturing sector is going to disappear
Senator HEINZ. At these prices?
Mr, VOLCKER [continuing]. At the present price level. Quite the
contrary. I had a group of businessmen in my office the other day
commenting about their results for the year, and I heard a little
different tone from some of them that: it was yearend and they
were looking at their statements.
Several of them commented, "You know, for the first time in
many years we look at our yearend statements and what do we
find? We haven't had any increase in costs this year. Some prices
have declined. Our inventory adjustments are not necessary at the
end of this year because basically our own prices haven't changed.
And low and behold, we find that we can live without increasing
our prices when our costs aren't up." And of course that is the
truth.

Corporate profits in parts of the manufacturing sector without
any question have been heavily oppressed by the foreign competition. We have had almost a 30 percent change in the relative value
of the dollar in the past 12 months. They are now in a more competitive position.
Price stability does not mean that the price of every product remains the same. Farm prices have been depressed. But I certainly
think we can find a solution—I not only think we can find a solution to our problems within the context of greater price stability,
but I think the failure to achieve greater price stability will be destructive.
So if you were saying the opposite, I think we have a disagreement.
Senator HEINZ. Well, we may, but I don't wish to pursue it on
the Chairman's time any more.
Thank you.
The CHAIRMAN. Well, you left me 2 minutes.
Senator HEINZ. I yield you my 10 minutes. [Laughter.]
The CHAIRMAN. No problem.
Senator HEINZ. Thank you, Mr. Chairman.
The CHAIRMAN. We have plenty of time. You are welcome.
Chairman Volcker, let me just pursue into a different area, the
impact of oil price declines that have been so dramatic over the
last few weeks.
IMPACT OF LOWER OIL PRICES

In addition to monetary responsibilities at the Fed, you also have
regulatory responsibilities, and we are all very well aware of the
very large loans that many of our banks have with foreign countries primarily based on much higher levels of energy prices.
Can you give us some idea of the impact of these lower prices
from a regulatory standpoint, not monetary policy at the moment
on some of our banks and how we are going to attempt to manage
that international debt problem with the much lower oil prices.
Mr. VOLCKER. I can't give you a careful quantitative answer, and
I don't think it is possible in this area. But let me make a couple of
preliminary comments and then look toward the future.
First of all, as far as the foreign debt problem is concerned, there
is one sense in which from the standpoint you raised the question
we are better off, I think, significantly, than we were 3 or 4 years
ago. Right through this period the exposure of banks to heavily indebted countries has been declining in relative terms, relative to
their own capital, and this amounted to about one-third now in
terms of the ratio of debt to their own capital.
It is still very large, and it is still a very important and crucial
problem, but it has been somewhat diffused over these years,
I have comment somewhat in the same vein as far as domestic
lending is concerned. If a price decline of this magnitude had come
3 or 4 years ago it would have had a sharper and even more disturbing impact at that time, in my judgment, because banks were
in a more vulnerable position in terms of the kinds of loans they
had on the books and the volume of them in the energy area.

Put another way, a lot of their weaker loans, loans on rigs, for
instance, instead of production loans, have in some cases been written off or losses taken or, in some cases, loans repaid. So their vulnerability, given a particular price decline, I think is somewhat
less now than it was then. That has been reflected, of course, in
some continuing problems during this period, but on the other side
they have had a period of profitability, by and large, so that some
of those potential losses have been absorbed.
Nonetheless, it is obvious that when you have a decline, and
should the oil price stay around the present level, you have got another level of strains put on the system. Do I believe that is manageable? Yes; I do. In the international area I think it adds more
than an edge of urgency.
It makes even more urgent the directions that seemed appropriate before in terms of those countries restructuring their own
economies so they are not so dependent upon oil and, indeed, increasing the efficiency of their oil sector. On that basis I think they
can get the external financing that is necessary. I don't see anything inherently in this situation that says that it is not possible.
But I also point out that it depends upon their judgment and their
will in terms of the internal measures, and that is a decision that
they are going to have to make.
I think the two sides are connected, because if they feel that they
cannot count on some continuing access to credit in appropriate
amounts from abroad, it will undercut their will to do what is necessary at home. It is a situation where they tend to give up. So I
think it is very important to keep both sides of the equation together.
Now this problem, in that respect, has forced itself upon them in
the space of, what, 4 weeks or something that we have had now,
and I hope there can be enough patience all around to take the
time to look at this situation and find a constructive solution to
what is a very difficult matter.
I might also say that for some of those countries this is a net
benefit and makes the job easier. You get a country like Brazil,
which is a very sizable net importer. There is a relative handful,
but nonetheless very important countries, that are net exporters,
and it is important to them, not only because they export, but also
because those countries rely upon oil revenues for a significant
fraction of their internal budgetary financing. In many cases the
crucial problem is their internal budgeting and not the external financing.
On the internal side, obviously, we and the other supervisors and
regulators will be looking and following the situation with more
than ordinary interest, but I do think this is a situation that can be
dealt with for these banks through the tools that we have in the
Federal Reserve and elsewhere for handling those points of strain.
The CHAIRMAN. Thank you, Mr. Chairman.
Senator Proxmire.
Senator PROXMIRE. Thank you, Mr. Chairman.
Chairman Volcker, this morning the New York Times had a
front page story indicating that economists, particularly the Congressional Budget Office economists had revised their forecast of
the deficit.

35
CBO'S REVISED FORECAST

They indicated that whereas last year it projected that the baseline deficit, if we didn't do anything about it and didn't make cuts,
would be perhaps $260 billion in 1990. Now they say it will be
around $100 billion, a remarkable change, and the Office of Management and Budget has made a similar modification.
Now the heart of this is they assumed that the baseline will
mean expenditures pretty much stable for defense and they estimate that costs will not rise very much.
How about that notion? Is the budget deficit, last year's problem,
can we solve this thing if we go along with a baseline?
Mr. VOLCKER. I don't think it is last year's problem. It is very
much with us. One lesson I think could be drawn from those
changes in estimates is how fragile 5-year estimates of a budgetary
situation can be. But I think those more optimistic estimates basically reflect a projection of very constrained expenditure growth
relative to what they were assuming last year, and that in turn, of
course, reflects the congressional actions.
But there is a difference between assuming that, even in the
light of congressional actions, and seeing it develop over the next 5
years or whatever the forecast horizon is.
And I am very conscious of the fact that turning that kind of assumption into a reality is going to continue to involve very hard
choices on the part of the Congress and the administration, because
relative to past trends, those are very confined expenditure figures.
I hope they come about. And if they come about, I think the general tendency will be more favorable, but it takes time and it takes
action.
Senator PROXMIRE. You feel it does take action and it won't
happen on the basis of a baseline status quo
Mr. VOLCKER. There is no question. It is not going to happen because OMB or the Congressional Budget Office projects it. It is
going to happen because you people do it.
Senator PROXMIRE. I would like to assume the posture of a
Gallup pollster asking you a question, and you are somebody that
has been called on the phone. You know these fellows often read a
series of statements to a person and ask which statement most
nearly describes his or her views. Sometimes it is useful in eliciting
opinions that might otherwise be obscure.
With that in mind, I am going to read you three statements and
ask you which one most nearly describes current Fed monetary
policy. [Laughter.]
Mr. VOLCKER. I think I just want to describe it and not most
nearly describe it. [Laughter.]
Senator PROXMIRE. All right, let me give you the three alternatives.
No. 1, in setting its monetary targets for 1986, the Federal Reserve anticipates that Congress and the President will achieve the
deficit reduction goals specified in Gramm-Rudman. Any slippage
will necessarily require a tighter monetary policy. That is No. 1.
No. 2, the Federal Reserve wants to wait and see what the Congress and the President will actually do under Gramm-Rudman. If

the deficits are actually reduced on schedule, monetary policy can
then be loosened.
Then, No. 3, the Federal Reserve's monetary targets were determined more or less independent of Gramm-Rudman and will not be
directly affected by what Congress or the President does.
Now which is it, No. 1, 2, or 3?
Mr. VOLCKER. I am not sure I want to
Senator PROXMIRE. It is a computer and you have to, to answer
No. 1, 2, or 3.
Mr. VOLCKER. I can plead the fifth amendment to something I
guess.
Senator PROXMIRE. The fifth wasn't here. I just had three questions. [Laughter.]
MONETARY TARGETS

Mr. VOLCKER. Let me answer your question, but without making
a firm choice, No. 1, 2, or 3. I think there is a sense in which the
monetary targets are broadly appropriate within at least a variety
of budgetary outcomes. Looking at those targets already allows
some margin, as you know.
There is nothing inherent that says that you get a different rate
of growth of the money supply with a change in the budget, within
some limits anyway.
So I would say there is some validity to that view and that those
targets allow for different tactics and different judgment as the
year progresses against the light of the budget and other factors.
I think it is fair to say that members of the Open Market Committee, in making their economic forecasts and therefore in arriving at the judgment of the monetary targets, did assume that the
budget deficit will reflect, if not all, a significant part of the scheduled reductions that we would expect to see, with the budget deficit
on a declining trend as the year wears on, not necessarily immediately. It is still running very high, but as the calendar year wears
on, yes, a decline. So that was certainly in the background of thinking.
Senator PROXMIRE. Well, that seemed to imply No. 1. That is interesting to hear.
On page 20 of your statement you say that several Board members and Reserve Bank presidents anticipated real growth in the 4
percent area as projected by the administration rather than the
Fed forecast between 3 and SVz percent. Of course that makes a big
difference on the level of the deficit, unemployment, and so forth.
Did these 4 percenters also press for more expansive monetary
policy to accommodate what they regard as a higher growth potential?
Mr. VOLCKER. I would have to look at precisely who projected
those higher numbers, but I would not think so. I would think it is
at least equally likely that they would have been on the more restrained side expecting a stronger economy, but I don't know, and I
can't answer the question specifically, because I don't remember
which ones.
Senator PROXMIRE. Could you do that for the record?

Mr. VOLCKER. In general terms. You know, it also involves some
judgment about what they were in your terms pressing for at the
committee. I will look at it and see whether I can give you an intelligent reply.
[Chairman Volcker subsequently submitted the following for the
record of the hearing:]
In general, those projecting more rapid growth did not find that inconsistent with
the longer run ranges adopted.

Senator PROXMIRE. Were any votes taken on the Fed's targets
and, if so, what were the results?
Mr. VOLCKER. On the annual targets it was unanimous.
Senator PROXMIRE. Can you identify the 4 percenters by name?
Mr. VOLCKER. No; I can't at this point.
Senator PROXMIRE. I didn't think you would.
Mr. VOLCKER. And I don't think I should adopt that precedent in
any event.
Senator PROXMIRE. You have been able to read the assumptions
behind the administration's 4 percent economic forecast as outlined
in the President's Economic Report. What are the areas of the
economy where you anticipate less growth compared to the administration?
Mr. VOLCKER. I haven't looked at it in detail in terms of sectors
of the economy, and I am not sure they put forward that projection
in those terms.
I did note in my statement one logical conclusion of the differing
estimates, that to get the unemployment rate that they are projecting, which is higher than our central tendency, with a higher rate
of growth they must be assuming a higher rate of productivity. In
fact, that is explicit, I know, in the CBO's forecast. I am not sure
about the administration's, but I think it is explicit there, too. They
are assuming more optimism on the productivity side, but I can't
speak to the particular sectors of the economy.
VALUE OF THE DOLLAR

Senator PROXMIRE. Now the sensational nature of your testimony
yesterday was with respect to the value of the dollar. On page 4 of
your testimony you say that the decline in the value of the dollar
since September places our industries in a stronger competitive position. But on page 5 you express concern that the dollar's decline
could have an inflationary impact and also make foreigners less
willing to provide the capital needed to finance our budget deficit.
I notice that Secretary Baker said Tuesday he would not be displeased if the dollar declined further. Mr. Yuetter, the President's
special trade representative, last week called for an additional 15to 20-percent drop in the dollar exchange rate.
Are you in agreement with Baker and Yuetter, or do you see
more dangers than blessing in the continued decline.
Mr. VOLCKER. I suppose I am not in agreement with Mr. Yuetter
because I don't know how he knows, but I know I don't know just
what the appropriate level for the dollar is.
Senator PROXMIRE. You say you don't know what the appropriate
level of the dollar is?
Mr. VOLCKER. I don't know with that level of precision certainly.

Senator PROXMIRE. Well I thought you indicated that you felt the
dollar had declined enough.
Mr. VOLCKER. That is a different question. [Laughter.]
Senator PROXMIRE. Why is it different?
Mr. VOLCKER. I am expressing concern over a cumulative, continuing decline in the dollar that might be inconsistent with maintenance of an attitude toward the dollar that is consistent with
that capital inflow that you spoke about. I don't think I have to
reach a judgment as to what the appropriate level of the dollar is 2
years from now to express some concern about the possibility of a
kind of cumulative overshoot.
Senator PROXMIRE. All right. Then you are saying that the
present momentum and the rate of decline of the dollar concerns
you rather than necessarily the level that the dollar might have 6
months from now or 1 year from now?
Mr. VOLCKER. That is right. 1 am not smart enough to know precisely what the level of the dollar will be or should be 1 year from
now. I do know we have had a lot of experience in the world, and
the world is littered with the debris of countries that have tried to
escape their problems by devaluation and found out it only added
to their problems by forming a kind of cumulative inflation and
more devaluation.
Senator PROXMIRE. So your position relates to the short term of
3, or 4, or 5 months that the situation may change or the situation
may continue. Whatever it is, you might feel that a decline of the
dollar later on would
Mr. VOLCKER. I am not ruling or pronouncing on precisely what
the appropriate level of the dollar is over time.
Senator PROXMIRE. You are described in the current issue of
Newsweek as, you know, you have been described— —
Mr. VOLCKER. If I may just add to the question.
Senator PROXMIRE. Yes, sir; I am sorry.
Mr. VOLCKER. If I may just add to that. I would be concerned
about too much emphasis on the value of the dollar in curing our
trade problems. It is going to take more than that to cure our trade
problem.
Senator PROXMIRE. It will take more than that, but it would be
very helpful if the dollar declined somewhat more, right?
Mr. VOLCKER. It may or may not be. I would say right how, as I
said before, an important element in the equation is the rate of
growth in other countries. A net result of a decline in the dollar is
to impair that growth prospect, and it may not, on balance in the
near term, whatever the long-range competitive position, be desirable.
Senator PROXMIRE. Well, I can understand that, but I think it is
a novel theory that the decline of the dollar would be somewhat
helpful certainly in some areas, all other things being reasonably
equal.
Mr. VOLCKER. OK. All other things being equal is not a world in
which I live. [Laughter.]
Senator PROXMIRE. Well, we know the decline of the dollar, like
every other economic development, has more than one effect.
Mr. VOLCKER. That is right.

Senator PROXMIRE. It is good to have you point that out to us
but, nevertheless, we have certainly been terribly, terribly handicapped and hurt over the last few years and still are.
Mr. VOLCKER. That is when the dollar got very, very high and
impaired our competitive position.
Senator PROXMIRE. My time is up, Mr. Chairman.
The CHAIRMAN. Senator D'Amato.
Senator D'AMATO. Thank you, Mr. Chairman.
Chairman Volcker, referring back to Senator Heinz' original
question, the discount rate has remained the same since last spring
when it was reduced from 8 to 7 Vz percent.
In light of the recent fall in the prices of oil and other commodities, what is the justification for maintaining the discount rate at
its present level, and aren't we really saying—or are you really
saying that the Board has already factored in current and projected price drops in oil and the decline in the dollar's value and determined not to lower that rate?
POSSIBLE DROP IN THE DISCOUNT EATE

Mr. VOLCKER. We have determined not to lower it to date. I
think that is obvious or we would have lowered it if we had determined to lower it. In reaching that judgment, we took into account
all of those factors.
Senator D'AMATO. Am I mistaken in indicating that it was last
spring when the rate was last reduced?
Mr. VOLCKER. It was reduced last spring.
Senator D'AMATO. It was reduced last spring from 8 to 7 ¥2. Are
you saying now that you determined at that time or that the
Mr. VOLCKER. Of course not.
Senator D'AMATO. OK. If you didn't determine it at that time,
did you factor in the kind of drop that has taken place just in the
energy area, the stability that has taken place since, the decline in
the dollar and why wouldn't you at this time consider dropping
that discount rate?
Mr. VOLCKER. We did not factor in either of those considerations,
certainly very actively last spring.
Senator D'AMATO. Well, what about now? Haven't the changes in
the economic environment last spring been significant enough to
precipitate a drop in the discount rate?
Mr. VOLCKER. Right now we certainly do. You have an oil price
change which is certainly in the direction, assuming it stays of reducing prices. You have an exchange rate decline of 30 percent,
which is certainly in the direction of increasing prices and increasing economic activity, and the oil price change also goes in the direction of increasing economic activity.
You have also had a congressional action on the budget during
this period, which is not reducing the overall budget deficit appreciably at the moment, but has the prospect of doing that some
quarters down the road. That is some time off yet. Yes; all these
factors are taken into account.
Senator D'AMATO. So you will be taking those factors into account.

Mr. VOLCKEE. We will continue to take those factors into account.
Senator D'AMATO. Thank you, Mr. Chairman.
The CHAIRMAN. Senator Riegle.
Senator RIEGLE. Thank you, Mr, Chairman.
Do you think there is any possibility that we could get a free fall
in the dollar here, that it could go down, not in a managed way,
but in a nonmanaged way? Is that possible?
Mr. VOLCKER. I suppose anything is possible, but what I am
saying is that that is not what the doctor ordered in terms of our
situation.
Senator RIEGLE. In other words, you would be very concerned
about that happening.
Mr. VOLCKER. I would be concerned, yes.
Senator RIEGLE. I am just wondering if as you watch what is
taking place here, you feel some apprehension about the possibility
of that happening?
Mr. VOLCKER. I am simply saying we have had a lot of experience
collectively with a cumulative decline in the currency passing a
point of being constructive and becoming destructive.
APPROACHING DANGER ZONE

Senator RIEGLE. Are we at that point now, do you think?
Mr. VOLCKER. I think we could possibly be kind of approaching a
danger zone
Senator RIEGLE. Approaching, I am sorry? I couldn't hear your
word. You said approaching a——
Mr. VOLCKER. A danger zone.
Senator RIEGLE. What would be the kinds of things that might
cause the dollar to continue to drop? In other words, when you
think about it as an economist, what are the factors, at this point,
that might cause it to continue to go down?
Mr. VOLCKER. I won't think of it as an economist. I will think of
it as a trader. If they expect it to go down, it goes down. In terms of
more persisting factors, the most fundamental thing is, I think,
maintaining confidence in our overall economic policy and approach and not accepting, for instance, the premise that you can
escape economic problems through inflation. You only build up
more. I think that is the most fundamental factor over a period of
time to maintain the kind of confidence in the currency that I am
talking about.
That is somewhat independent of the particular level of the
dollar, if I can make that distinction again. It is a question of the
degree of confidence the people have with an effective management
of the economy over a period of time, and certainly we have some
things going on that assist that.
The Congress' action on the budget moves in the right direction,
in my opinion, in terms of maintaining that very basic sense of
confidence, but you are starting from a level in which the deficit is
very high. Other factors that contribute to further improvement in
the price outlook are obviously crucially important.
Senator RIEGLE. If to go back to what you said a minute ago is
right, if we are approaching a danger zone in terms of maybe too

great a fall in the dollar if it were to continue for it to create other
problems, I guess I should infer from that that these policy issues
that you now raise become all the more important for us to handle
properly.
Mr. VOLCKER. Yes, that is my message.
Senator RIEGLE. I would like to just stay with that 1 more
minute, and that is we are going to do everything we can to make
the right policy decision so that we don't end up with these consequences that we don't want.
If the dollar were to continue to drop or, if because of trading
pressures or whatever, we went more in that direction and went
into that danger zone and even deeply into it, what are the serious
implications that we would have to then anticipate or worry about
and what are the consequences if we were to see that happen and
not get our job done?
Mr. VOLCKER. There are two related dangers, I think. There is
the directly inflationary impact and there is the possibility that in
those circumstances—I don't think this has happened and it is
what I want to avoid happening, and I think happily it has not
happened—that people may want to, in effect, get out of the dollar.
They don't want to invest in the dollar, at least they don't want
to invest at current or lower interest rates in the dollar, and that
would be damaging, obviously, to the economy when we are relying
on the fact that we have to borrow. We are going to have to
borrow; that is not a question. What the question is, is the terms
and conditions under which you borrow.
Senator RIEGLE. You know, I have been wondering about that because as rates have come down and as we continue to rely on foreign credit to buy a lot of the debt instruments that we are issuing
as a government, as the yields fall, as they have, and as interest
rates have come down and the yields have come down, if you have
in addition a currency value risk that a lender has to take into account the possibility that the dollar might fall further, if they don't
have much of an interest rate premium on the front end and if
they end up losing more value in terms of a further fall in the
value of the dollar over the term of the time that they hold the
debt instrument, I would think that you could really run the risk
that the psychology could swing the other way and people would
not want to lend this money.
Mr. VOLCKER. My point very simply is we don't want to run that
risk.
Senator RIEGLE. But is that the key risk that you see here?
Mr. VOLCKER. That is one part of the risk, yes.
Senator RIEGLE. Now last week——
Mr. VOLCKER. I might say, I think we have had a continuing,
ample availability of money from abroad, and I think that is a very
good sign.
MEXICO'S FINANCIAL SITUATION

Senator RIEGLE. Last week Mexican financial officials told the
creditor banks in New York, as you know, that they are going to
need to borrow about $9 billion this year to keep the economy
there afloat, because of the sharp decline in oil prices. And as I un

derstand it, that is about twice what the Mexican officials told the
bankers that they would need last December. So this is quite a
swing in circumstance as might be expected because of the oil.
I am wondering if the Federal Reserve Board and/or the administration is thinking, or talking, or in the process of mounting any
kind of a rescue package for Mexico similar to the one that we did
in 1982 when they came close to defaulting, or at least there was
concern that they might?
Also, am I right in believing that the cash balances Mexico has
are so low that this is a problem of some immediacy?
Mr. VOLCKER. They have more cash balances now than they had
in 1982, but certainly it is a large problem and it is somewhat fluid
in terms of judging what their needs might be. I would not take as
written in stone the particular figure that you mentioned. This is
indeed a changing situation.
Senator RIEGLE. In other words, the $9 billion.
Mr. VOLCKER. The $9 billion.
Senator RIEGLE. It could be higher or lower I take it?
Mr. VOLCKER. I would hope that it isn't that high, but that depends upon the oil market and the oil price and how much oil they
can sell.
But in any event, whatever that need is, it will need to be covered or we will have a real problem. This is a judgment for Mexico
and not for us. What will their internal response be to this very
severe challenge? If they take actions that promise to deal with the
problem effectively over a period of time, then I think you have
one kind of setting, and it is a very constructive setting and a setting that I think is in their own interests and in which those external needs can be met.
Senator RIEGLE. I am wondering, where is this money likely to
come from? Are the U.S. banks going to have to provide most of it?
Mr. VOLCKER. I think the world banking community that is exposed in Mexico already, as in the past, would have to provide a
very significant part of it. But entirely consistent with the Baker
initiative, you would certainly look to the multilateral development
institutions to provide a significant fraction, as well to support programs that they undertake to improve their own economy.
Senator RIEGLE. Is the burden on the United States likely to be
in the order of coming up with half of the money or 60 percent of
the money? What kind of proportional share are we looking at, because I have a related question in terms of our capacity?
Mr. VOLCKER. I don't remember the exact share of American
bank lending in the total. My memory is it is something like 40
percent in the case of Mexico, less than half.
To the extent it is done through multilateral institutions, it depends in a sense upon our share of the multilateral institutions.
Senator RIEGLE. That is exactly right.
Mr. VOLCKER. It will not require, in my judgment, increased capital for those institutions in the short run. They have enough
money with what has already been pledged to them or guaranteed
to them by governments.
Senator RIEGLE. You mean the multinational organizations, some
of which comes from us.

Mr. VOLCKER. Some of which comes from us, but the World Bank
in particular has ample commitment authority and ample cash to
meet these needs for a year or two.
Senator RIEGLE. I have a hard time understanding the Baker initiative on the one hand of asking U.S. banks to come up with some
additional money, and it is going to be a lot of money that is required here not just to Mexico.
Mr. VOLCKER. For some countries it will be less as a result of the
oil situation.
Senator RIEGLE. Well, it will, but in terms if you start with
Mexico and the ones that have the larger needs, we are talking
about a lot of money. We are talking about several billions of dollars and probably something more than $10 billion, and I don't
know how much higher it is if you take the lending requirements
that are going to have to be met around the world.
On the one hand, you have that pressing need that is mounting
and, yes, you get some offsets in places where oil is helping, but
they don't seem to me to be in equal amounts. I mean the lending
problem is getting bigger.
Mr. VOLCKER. Before oil, or without assuming the impact of this
oil situation, if I remember correctly, the Baker initiative contemplated something like $40 billion of flows to the collectivity of countries over a 3-year period from commercial banks and from the
international development institutions, and more than that on a
gross basis.
So even before this the amounts involved are quite substantial
relative to the needs, and then you have these offsets. Brazil should
benefit from two directions, and maybe three. They benefit from
the oil price. If the net result is faster growth in the developed
world, they will have better markets. And, they may benefit some
from the depreciation of the dollar given the nature of their
markets.
BANKS ARE STRUGGLING

Senator RIEGLE. Well, you know, we have got a lot of problems
and time is short here, but with the FSLIC and the FDIC, we have
some regional credit problems in terms of agricultural loans, oil
and gas loans, and commercial real estate loans impacting now in
certain areas of the country that are quite hard hit. You have a lot
of financial institutions and banks that are really struggling.
The Bank of America is in the news in that capacity and stories
about the progress is slow with Continental Illinois. Up and down
the banking scale from large to small you have real problems here,
and now it seems to me we have some new credit requirements,
and I gather some considerable reluctance on the part of bankers
to want to necessarily extend this. There is talk about having to
improve the balance sheet standing and credit reserves by banks
just to put them in more of a safety and soundness position.
I guess what I am wondering here is if we are going to be able to
produce all this additional lending strength to go to these Third
World countries with Mexico sort of at the top of the list, in a
sense, because of its peculiar and immediate problems. It looks to
me as if this is a surge of additional pressure.

Do you have any apprehension about this?
Mr. VOLCKER. Nobody ever said it was going to be easy, and there
are problems in accomplishing the result. But if you asked me for
an overall judgment, I think it can be done in a context of effective
action by the borrowing countries themselves. If you don't have
that, then it can't be done.
Senator RIEGLE. Well in the case of Mexico I get the feeling, and
I will just finish here, that they have tightened things down to
quite a degree within their domestic economy. I have heard others
say that if they try to go much further in that direction they are
going to have problems and we are going to get a lot of new people
sort of walking across the border coming up here.
Mr. VOLCKER. A couple of points. It is not just the question of
tightening down, to use your phrase, the domestic economy, although oil is an important industry in Mexico. And if the price is
$10 lower than it was last year, that is a real loss of income to
Mexico that they are going to have to adjust to somehow. That is
just the fact of the matter if the price stays down.
But it is not just a question of screwing down on the valves. It is
a question of restructuring the economy so they can grow better. I
don't want to pose as a great expert on Mexico or any of these
countries, but I think there is a sense which is reflected in those
countries that there is a lot that can be done to make their economies more efficient,
Now that in itself runs into a different set of political and other
problems. Restructuring is always a difficult problem, and you
have a lot of existing interests that resist change. But I think the
potential for change is also enormous and it is in a very positive
direction in terms of the long-term growth of those economies
whether or not you had this crisis, but this makes it all the more
pressing.
Senator RIEGLE. My time is up. I appreciate your responses.
The CHAIRMAN. Senator Sasser.
Senator SASSER. Thank you very much, Mr. Chairman.
PREDICTIONS COMING UP ROSES

Chairman Volcker, it is not even springtime yet and everything
seems to be coming up roses as far as economic predictions are concerned, and I am delighted to see that at least you have sounded a
note of caution here.
The other day the Congressional Budget Office released their economic projections and they were very good, almost as good as the
administration's.
But when you peeled it back, you found that they were basing
these projections on assumptions of no real growth in defense expenditures in the short term, on taking the budget deficit reduction
targets in Gramm-Rudman-Hollings as a fact, on the fact that the
stock and bond markets were healthy and going up; and finally
came to what appeared to be a solid basing for making an economic
projection, and that is that oil prices are low. I presume they will
continue to be low as long as the Saudis continue to dump about
2Va million barrels of excess oil a day on the market.

My question to you is this: How solid, in your judgment, are
these predictions for satisfactory and even excellent economic
growth in the coming year, and what happens to these predictions
if Gramm-Rudman-Hollings and its deficit reduction targets are
not met, if Gramm-Rudman-Hollings is indeed thrown into the
trash can, which I suspect it could be if the Supreme Court sustains the lower court holding, and what happens if we get back in
the old gridlock of the President demanding his defense increases
and the Congress refusing to make the spending cuts that are necessary? What happens to the economic projections in that scenario?
Mr. VOLCKER. All economic projections are contingent. You can
give me a variety of hypotheses that would make the outlook much
less favorable, and I agree with that. That is why I called attention
to the thorns among the roses. I think the basic outlook has some
quite favorable indications in it and some very important things
are happening that could be enormously favorable to our prospects.
If we deal with these contingencies, of which you have emphasized one, I share that optimistic outlook, but I think we have to
deal with the contingencies.
Senator SASSER. But at least on the question of Gramm-RudmanHollings, Mr. Chairman, as I read the Wall Street Journal report
of your testimony yesterday, you are not optimistic enough about
that yet to start taking the Gramm-Rudman-Hollings deficit reduction numbers into account in making your economic projections.
Mr. VOLCKER. We certainly take some account of the fact that
the basic budgetary outlook looks better, but the major impact of
that is still quite a few months off, and we are aware of other important changes going on in the economy at the same time.
Senator SASSER. What, in your judgment, is the most serious
threat to our economic health at the present time? Would it be a
rapid deflation in the value of the dollar?
RAPID DEFLATION COULD BE A THREAT

Mr. VOLCKER. An overly rapid deflation in any event would, in
my judgment, be a threat. But I might point out that—and all
these things are interrelated—that particular outlook for an improved budgetary position helps to reduce that threat, and it is a
very important factor in helping to reduce that threat.
So I come back to the fact that the budgetary outlook is still an
uncertainty. In its most general terms of course I would take the
position that a resurgence of inflation is in a kind of underlying
way the biggest threat that we have. We have financial pressures,
we have these LDC problems that I think have to be dealt with in
a constructive way.
Senator SASSER. But in the main, Mr. Chairman, judging by the
projections that are made by the Fed, I gather that you yourself
are optimistic about the economy and optimistic about economic
growth in the coming year.
Mr. VOLCKER. I am optimistic, but I want to call your attention
to these threats.
Senator SASSER. You are optimistic but realistic.
Mr. VOLCKER. Yes.

Senator SASSER. All right. On one recent report, I want to ask
you a question sort of like Senator Proxmire's a moment ago, although I won't try to do it by way of a Galley Poll on the telephone. As I read the Newsweek article about your apartment, it
may be so austere there is no telephone there or maybe even a pay
phone. [Laughter.]
And I did enjoy the article. It was very good.
One recent report estimated that the average taxpayer works !J/2
weeks to pay the interest on the national debt. Now that is $699.23
of the average $3,537 in Federal income taxes that the average taxpayer pays.
It is well established that your first choice, and always has been
as I understand it, in dealing with the problem of the deficit is to
cut spending. And your second choice, as I have listened to you
over the years, a reluctant second choice, is to raise taxes to try to
reduce the deficit.
OMB estimates that every 1 point drop in interest rates would
reduce the deficit by $5.1 billion. Now you can't cut spending from
where you sit and you can't raise taxes from where you sit. But do
you see yourself having a role in deficit reduction through the
third option, and that might be cutting interest rates?
Mr. VOLCKER. To the extent that is consistent with balanced economic growth and keeping control over inflation, I would love to
see that happen, but it has got to be consistent with those factors.
Senator SASSER. I am not sure that is a world in which we politicians live, Mr. Chairman.
Mr. VOLCKER. Well I agree, we sometimes have different perspectives on that. But obviously the danger always is that in an attempt to reduce interest rates artificially, if I may use that word,
you end up with higher interest rates rather than lower.
Senator SASSER. Thank you, Mr. Chairman.
The CHAIRMAN. Senator Dodd.
Senator DODD. Thank you, Mr. Chairman.
Chairman Volcker, it is always a pleasure to be with you and to
listen to you. Your testimony always is lucid and worthwhile for all
of us.
Just a couple of points. You have really covered a lot of the bases
here. Obviously we take advantage of your presence here to extend
the parameters of what you are here for, monetary policy for 1986,
to get into some other areas as well. So I hope you are not in any
way offended by all of that.
Just to follow up a little bit on what Jim Sasser was raising, I
am sure the Fed has done some analysis to the House-passed tax
bill. Would you care to comment at all on that? I realize we ask
you all the time to comment on things that we are involved in up
here, but we value your opinion tremendously.
COMMENTS ON H.R. 3838

Mr. VOLCKER. Well, I really can't comment on that in general. I
know there are some controversial sections, and this is a narrow
section of the bill, but from my perspective not unimportant, that
affects the bad debt reserves of banks in particular. From my perspective we, of course, want to encourage the active buildup of the

bad debt reserves, and I detect some obvious incentives arising out
of that bill which concern me in my banking regulatory supervisory capacity.
Senator DODD. How about investment tax credits? I am trying to
get at the economic growth questions which we are dealing with
here. Do you see anything in that bill which is counterproductive?
Mr. VOLCKER. I just can't get into the details, but a lot of investment incentives have been removed and the level of corporate taxation is certainly increased and the effect of that kind of thing can
only be judged in an overall balance of the bill.
Certainly I can recognize, without trying to get into it, that
maybe we have gone a little incentive happy in tax provisions as a
whole, and I know just from the financial implications in the real
estate area, for instance, it seems to me we derive a lot of economically bad decisions because of particular tax incentives when they
get too big, or too liberal, or are not well designed.
So I don't think dealing with all those tax incentives is necessarily bad, but you have to look at the balance as a whole and what
weight you are putting on investment. I think, in a fundamental
sense, and particularly the way we treat interest or equity, whichever way you want to look at it in the Tax Code, it creates a kind
of balance against investment and against savings, and I am not
sure that that bill goes any distance toward correcting that and it
may be the reverse.
Senator DODD. I appreciate your comment on that. You note in
your testimony, at page 10 of your testimony, you talked about how
hard it is to explain the fact that in 1985 there was virtually no
growth in the nonfarm business sector. You have suggested today,
and it is hard to explain, and I am going to ask you in a second to
try to give us some idea of where you think the center of the problem is.
Obviously the strength of the dollar, and obviously the trade deficit have had a profound influence on that. I would ask you, and I
will put it in the form of a statement that maybe if some of the
uncertainties about the tax bill itself with some of the retroactive
dates may have had some chilling effect on business activity. And
then, last, obviously the Federal deficit, the problem we face that
you have alluded to in terms of how we cope with Gramm-RudmanHollings and the like.
Of all of those factors, do some bear more weight than others in
that?
Mr. VOLCKER.You know, it is an illusive problem, and I think all
the factors that you have mentioned could bear particularly upon
the level of investment, which in turn is related to productivity.
But what you find in these figures is that manufacturing productivity—I am tempted to say isn't doing too badly—is not doing as well
as you would conclude from listening to a lot of businessmen and
what they are doing in terms of increasing productivity. So there is
a bit of a mystery there.
The hopeful thing is that for a lot of those efforts that have been
made within industry, and particularly the manufacturing industry, the payoff still lies ahead rather than in the last year, particularly given that manufacturing was not growing much last year.

I think the real mystery is in the other part of the economy, and
it is just very obscure. The whole service end of the economy is getting larger and larger and it has been growing quite rapidly, but
you don't see much in the productivity figures.
One of the recent mysteries is why employment in retail trade, a
type of service I suppose, is increasing more rapidly than you
would think the retail trade figures themselves justify, more than
in proportion to the increase in retail trade. Are we suddenly getting so inefficient in selling goods that we now need more employees per real dollar of sales? I don't know. Maybe we are, but it
seems strange.
So you begin wondering whether there are very difficult problems in measuring output, and they are extremely difficult if you
get into the medical service area. Just to take an extreme example,
how do you measure the output of medical services? You know a
lot more people are employed there and you hope a lot more people
are getting well, but how do you measure just what service they
are getting in quantity or in quality? It is almost an impossible
task for the poor statisticians that have to make up these figures,
sometimes they assume no increase in productivity. So naturally
the figures don't show it.
WILL THE DROP IN OIL PRICES BE PROLONGED?

Senator DODD. Let me ask you about the oil question. You accurately point out that this is—and I don't know whether you mention it in your testimony, but it is almost tantamount to a tax cut I
suppose and maybe more so, the drop. In fact, it may provide some
justification for looking at some revenues.
How certain are you that this is going to be prolonged, whether
or not it continues to drop or stabilize at a vastly reduced price
than what people anticipated a few years ago?
My understanding is that the Saudis are doing this because they
are producing a barrel of oil at about $2 a barrel whereas for the
British and others it is $10 or $12 a barrel to produce that same
barrel, and that they are putting the squeeze on these other OPEC
partners because of what they consider, the Saudis consider to be a
violation of agreements. But as soon as the other partners begin to
squeal then we will see those prices start to go back up again and
that this thing will not be as long lived as some are anticipating. Is
that an accurate-—Mr. VOLCKER I will be as enlightening to you as the experts are
to me when I consult them. The answer is they don't know. [Laughter.]
I would make the judgment that given the market situation at
the moment and given the worldwide potential supply situation
and demand situation, I would not assume that the prices are going
to go up in the next year or two to where they were.
Senator DODD. That is not in the $30 range.
Mr. VOLCKER. Even something substantially less than that. Now
I think one of the longer range dangers, if you look into the 1990's,
let's say, is that you set up a force here that reduces conservation
on one side and reduces exploration on the other side; you set up a

dynamic that produces a snap back, but in a longer time perspective.
I think markets tend to run to extremes when you have lags. It
is somewhat analogous to the exchange rate situation where you
don't get instantaneous responses in consumption or production,
just as you don't on the trade side, and your market keeps pressing
and pressing to one extreme or another and then it snaps back the
other way. But I suspect that phenomenon would take years to
work out.
Senator DODD. One of the things that is being discussed is a revenue source, not just in terms of deficit reduction, but even the
President indicated every so slightly the other day that an oil
import fee is something that he has not rejected out of hand as a
way of paying for some of the provisions in the House-passed tax
bill to reopen some of those. At least that is some of the chatter
that you hear around here.
Would you care to comment on the wisdom of an oil import fee
or a gasoline tax in light of the present drop in oil prices and what
is it apt to do in terms of the economic growth and so forth in the
area of manufacturing and the like?
Mr. VOLCKER. I got that question yesterday and I will make the
same preface that I don't want to pose as any special expert in this
area. But as I look at an oil import fee in the present situation, it
seems to me we could only reasonably think of that in terms of,
frankly, exempting some of our closest trading partners in oil; and
once you look at it that way, Mexico, Canada, and so forth, it is not
much of a revenue producer because you are excluding so much of
the supply.
Senator DODD. And that is not to mention the exemptions, and
you would probably have to do rebates on home heating oil and
Mr. VOLCKER. You get into all those administrative complications, which are enormous. So it reduces itself to a question as to
whether you forego some of the gains from the price decrease.
Basically, on the analysis that you were just giving about the
long-term conservation and exploration results, one could imagine I
suppose a price that seemed so low and so damaging in its longer
term consequences that you could justify it as a kind of conservation supplement and exploration incentive. But I don't think that
says you look at it very quickly.
Senator DODD. It is not a great revenue gainer.
Mr. VOLCKER. Right, it is not a revenue gainer. Now if you look
at an energy tax across the board
Senator DODD. A gasoline tax.
Mr. VOLCKER [continuing]. Or a gasoline tax, that can be a big
revenue gainer. It also tends to hit consumption, and you can begin
to make an argument that if you had to turn to the revenue side,
that is something to look at.
Senator DODD. That makes more sense. Thank you very much.
Thank you, Mr. Chairman.
The CHAIRMAN. Senator Proxmire.
Senator PROXMIRE. Mr. Chairman, U.S. News & World Report
polled a number of prominent Americans for several years and
they consistently say that you are the second most powerful man

in Government. And, as you know, Newsweek put you on the cover
and said the same thing.
Mr. VOLCKER. I think they basically poll businessmen and get a
rather biased result.
Senator PROXMIRE. I think most thoughtful and informed people
would agree that you are a powerhouse. [Laughter-]
At any rate, when I saw the cover on Newsweek I felt that Don
Regan must be gnashing his teeth because [laughter] because that
means that President Reagan is only the third most important
man. [Laughter.]
Senator DODD. I expect to see fruit boxes in Regan's office, too.
MEETINGS WITH THE PRESIDENT

Senator PROXMIRE. Well one fascinating tidbit from the article is
that you meet secretly with the President five or six times a year.
You told us in the past that you meet with the President occasionally, but this is the first time I have seen that five or six times secretly.
Do you meet with the President from time to time and, if so, why
is the existence of the meeting secret?
Mr. VOLCKER. I meet with him from time to time. Five to six
times a year at an annual rate as economists talk would be somewhat of an exaggeration recently. I don't think of it particularly as
being secret. It often is not publicized. [Laughter.]
Senator PROXMIRE. You mean nobody asks? The second and third
most powerful men in Government meet and the press hasn't
enough initiative to find out whether you fellows met and what
you talked about?
Mr. VOLCKER. It is not very frequent, but I sometimes think it is
more convenient and I think he thinks it is more—Senator PROXMIRE. More what?
Mr. VOLCKER. It is more convenient sometimes to not make a
bigger deal out of it than it is.
Senator PROXMIRE. But you do meet with him. When was the last
time you met with him?
Mr. VOLCKER. I don't honestly remember. It hasn't been for some
time.
Senator PROXMIRE. You can't remember?
Mr. VOLCKER. No; which tells you it hasn't been at an annual
rate of five or six times a year. [Laughter.]
Senator PROXMIRE. Did you meet with him in 1985?
Mr. VOLCKER. In 1985, yes, I am sure I met with him in 1985, but
I can't tell you offhand how many times.
Senator PROXMIRE. But you can't remember when?
Mr. VOLCKER. I honestly don't remember. I should have looked
that up knowing that you would ask [laughter] but I am unprepared.
Senator PROXMIRE. I would think that would be a memorable occasion. [Laughter.]
Mr. VOLCKER. They are memorable occasions, but I don't remember the date.
Senator PROXMIRE. Mr. Chairman, given the wide range, and it is
a wide range in your monetary target of a 3- to 8-percent increase

in the Ml, it is difficult for the Congress and the public to know
what the Federal Reserve policy really is.
I remember when we first adopted the requirement that you
report your monetary target in 1975, Chairman Burns pleaded that
he be allowed to report a range and not a specific single number.
But 3 to 8 percent means they could either be quite tight or rather
permissive. And, moreover, even the outer limits of your monetary
targets don't mean very much as we saw in 1985.
In describing monetary policy for last year, you say on page 24 of
your report, and I quote, "Throughout the year the monetary
policy remained generally accommodative to emerging demands for
money."
MONETARY GOALS FOR 1986

If the phrase "generally accommodative" is an accurate description of monetary policy in 1985, how would you characterize monetary goals in 1986? Would you say that about the same degree of
accommodations as in 1985, somewhat more accommodation or
somewhat less accommodation?
Mr. VOLCKER. Obviously that is kind of a jargon word, but I can't
think of a more descriptive one. It depends on what the demand for
money is, how fast the economy is growing and all the rest, rather
than a particular number for the increase in the money supply.
We were "accommodative" in the sense, and I think I tried to describe it a bit in the statement, that rather large demands for Ml
were being met consistent with staying within the targets on
M2 and M3 and consistent with declining interest rates during the
year.
Now you put all those things together and I think that can be
fairly described as an accommodative policy. You might have a different economic environment with the same economic growth rate,
but because the economy is demanding so much money, you would
describe the policy as restrictive in some cases. What would be the
symptoms? Interest rates would be rising, there would tend to be
pressures on the credit markets and those other pieces of evidence
of how comfortable people feel about the amount of money that is
around.
Senator PROXMIRE. Well I just asked you to compare it with 1985.
Will it be more or less accommodative in 1986?
Mr. VOLCKER. I can't project it through 1986 because it depends
upon those other factors.
Senator PROXMIRE. Well what is your present disposition?
Mr. VOLCKER. I think we are essentially in the same posture now
that we were in throughout 1985.
I might say in terms of those target ranges and the width of
them in trying to describe monetary policy, it means something
that the range is as wide as it is. It means that in fact we have
some uncertainty as to what developments in velocity will be and
that we would want to take that into account in the most technical
terms in an appropriate growth in Ml in 1986.
I would hope that is more useful, that explanation, than sticking
down a single figure when we don't know whether it would be ap

propriate or not in the light of changes in velocity, just to be technical about it.
Senator PROXMIRE. Well let me ask you about some of the constraints that limit the Fed's flexibility. For example, the Fed might
wish to do a more restrictive policy, but be hampered by the fragility of the banking or financial system. As you look down the road is
the job of the Fed becoming harder and harder because of these
practical constraints and, if so, what we can do to strengthen the
ability of the Fed to keep inflation under check?
Mr. VOLCKER. I hope it doesn't become harder and harder. The
first line of defense on that kind of problem is not monetary policy,
but supervisory policy, regulatory policy, extensions of credit
through the discount window where they are necessary, which can
be offset through open market operations in terms of their aggregate effect on the market supply and on the economy.
One looks at financial strains or the lack thereof in the economy
as a factor that might have to be taken into account at times in the
design of general monetary policy, but it is not the first thing you
think ofSenator PROXMIRE. Now there are some monetarist economists
who believe that a 13-percent money growth in 1985 has laid the
groundwork for a resurgence of inflation in 1986. They say the
principal danger facing the economy is not a slowing of the economic expansion, but rather a resumption of inflation.
Do you share to any degree that moderist view of the economic
outlook?
Mr. VOLCKER. I don't share it on balance, or presumably at least
my personal voice would have been on the side of a tighter policy.
Senator PROXMIRE. Why do you think they are wrong?
Mr. VOLCKER. Because they think we are seeing unusual developments in velocity. Now if you say that it doesn't give me pause to
see the money supply rise that rapidly, obviously it does, but on
balance I gave you my judgment. I think they are wrong because
we have seen unusual developments in velocity and, based upon
what other portents we have of prices and economic activity, I
don't share that alarm.
CORPORATE DEBT EXPLOSION

Senator PROXMIRE. You have had what I think is a very good and
rather rare concern with the debt, the debt creation in this country
and the implications of greater leveraging and the potential of the
financial fragility of our institutions and so forth. But there are
some theoreticians in the Reagan administration who are essentially saying not to worry.
They point out that corporate debt equity ratios are still below
their peak reached in the early seventies. They even see a silver
lining in all that corporate debt and they argue that corporate
managers must work a lot harder to pay off all that extra debt. As
a result, companies are becoming more efficient they say.
What is your response to that benign view of the corporate debt
explosion?
Mr. VOLCKER. I would readily admit that it is hard to draw certain conclusions from the overall statistics, but I do know that this

rapidity of increasing debt relative to the economy is quite an unusual phenomenon and I do think that it does add up to more leveraging whether you think of it in business terms or more leveraging of the consumer for that matter.
Some of that has been offset. Indeed, for the consumers it has
been largely offset for the past year, if you look at the overall balance sheet, by the rise in stock prices. And of course interest rates
are down in terms of their cash flow and financial wealth, but I
don't think you can count on stock prices going up every year the
way they have been going up. Sometimes they go down as well as
up. That is a more lasting phenomenon. So I think there is cause
for concern here overall.
I get concerned when I see businesses retiring $100 billion of
equity in a year by borrowing, because I don't think the economy is
suffering from any excess of equity relative to debt.
In fact, there are particular instances where some of these corporate reorganizations, some leveraged buyout or some case where
the management of a division of a company will take that division
private, so to speak, where I suspect in some it does add up to
better management and more flexibility for that particular division. So it is hard to generalize across the board.
But when you look at the overall trends, I think it is somewhat
disquieting in terms of a persistence of those trends. And you give
me a chance to make a favorite point.
I think a lot of this must ultimately reflect, as I was saying to
Senator Dodd, the way we tax equity relative to debt. A corporate
manager when he looks at that choice, which he has to look at all
the time, has an enormous financial incentive to leverage simply
because of the difference in tax treatment involved, and I would
hope that some day the Congress will look at that seriously. It is
only touched on in a kind of glancing way in the current tax
reform bill.
REFORM IN THE BANKING INDUSTRY

Senator PROXMIRE. As you know, Mr. Chairman, there are a
number of important banking issues that are before the committee,
closing the nonbank bank loophole, closing the nonthrift thrift
loophole, providing new powers for bank holding companies, relaxing restrictions on interstate banking, strengthening our deposit insurance systems and so forth.
As you see it, what are the most important issues that the Congress should deal with this year, and what advice can you give us
as a committee?

Mr. VOLCKER. I have the same list that you do, and my advice
would be to proceed with all the energy that you can on the list
that you have in front of you.
Now you get into questions of legislative tactics where you are
the experts and not I. But let me say that
Senator PROXMIRE. Would you give us your priorities in this list?
Mr. VOLCKER. The priority in one sense is dealing with what I
see as the philosophical underpinnings of the whole thing. What is
the role of banks, and as a complement, what is the role of nonbanks in the financial system and in the economy. Unless you re

solve that kind of underlying issue, it is hard to know where else to
proceed. And in very specific terms that comes down to this socalled nonbank bank issue and the nonthrift thrift issue.
But that in itself is not resolving this whole set of problems. I
think it is at the background of a lot of these problems, but I would
urge you to clear that up—and my views on it are well known—
and on that base then deal with the problems of what are the appropriate powers for a bank holding company and what are the
limits. I think this is particularly important and relevant currently: What are the limits on the authorities provided by State banking law or thrift law where it is more pressing that may be inconsistent with the Federal safety net and the safety and soundness of
the whole system?
So if you deal with those three areas, you would have gone a
long ways toward dealing with this situation. You have this whole
series of insurance questions that you touched upon, and I think
there are very real serious questions in my mind partly because
they are so difficult. They are pressing, but maybe they do not
have the same degree of legislative priority, in my opinion, simply
because it is not quite so clear what directions to go in.
I would also say, and maybe less sweepingly, but quite important
and a matter of priority in the current environment—and a matter
you are going to have to deal with anyway because the present law
expires—are the provisions in the Garn-St Germain Act for failed
institutions to be taken over by an out-of-State institution. This has
been very useful in some instances and still, I think, is too narrowly written to deal with all the problems that we have today.
One aspect of that is the problem of agricultural banks that are
individually very small but are very important in terms of the
local community. You may not have a market for that bank, and
you have a question of the banking services for that community.
So I think some liberalization in that area in terms of dealing
with very current problems is very important.
LOGJAM ON BANKING BILL

Senator PROXMIRE. Now as you know, in 1984 under the leadership of Senator Garn, the chairman of the committee, the Senate
did pass by an overwhelming margin a bill 89 to 5, and the problem here is a very practical problem. We can't seem to get action
by the two Houses together and you can't even work out some kind
of a compromise.
Suppose we can't get agreement on moving forward with a comprehensive banking bill providing banks with new powers, should
we move forward on a bill just to close the nonbank and nonthrift
thrift loopholes, or should we defer action on these issues unless
and until Congress is prepared to grant new powers to banks and
bank holding companies?
Mr. VOLCKER. I think the only way I can answer that question at
present is that I retain that hope, which I confess is under some
strain, that you can move forward by some device or another with
a more comprehensive result than just the nonbank bank issue.
The nonbank bank alone is clearly too narrow even on its own
terms. You cannot sensibly I think deal with that problem without

dealing with the nonthrift thrift problem, because there is too
much substitution between them. But I would certainly be hopeful.
I don't know how you get the legislative process started.
The CHAIRMAN. We could have a unicameral legislative body and
that would solve the problem.
Mr. VOLCKER. Given the two houses and the different views on
how to proceed and all the rest. But I would be hopeful that somehow that gets unlocked and that the net result is a broader package than H.R. 20 in the House. But maybe that is a good starting
point, looking at it from the House's perspective. I think it may be
an essential starting point from that perspective.
Senator PROXMIRE. Attorney General Meese in a speech before
the American Bar Association argued that the so-called independent regulatory agencies, including the Federal Reserve Board are
really unconstitutional and that the President has the power under
the Constitution to hire and fire the members of the independent
commissions, the same way he can hire and fire members of his
Cabinet.
That issue was raised again in the recent decision of the court on
the Gramm-Rudman law, and the court came down on the side of
Meese. It is also before the court in a matter involving the Federal
Trade Commission.
If the Attorney General is right, what are the implications for
the ability of the Federal Reserve to conduct an independent monetary policy, and does the Federal Reserve have any plans to intervene in the FTC case?
Mr. VOLCKER. We haven't got any plans to intervene in that case,
but obviously if you are talking about by one device or another,
ending the independence of the Federal Reserve and the current
status of the Federal Reserve, I think that would have very serious
repercussions
Senator PROXMIRE. Why would you not intervene in that case? It
seems to me you would have a great deal at stake?
Mr. VOLCKER. It hadn't even occurred to me. So maybe we ought
to consider that and we will consider that. It hadn't occurred to me
until you raised the issue.
Let me say that
Senator PROXMIRE. Is it your understanding that you have the
legal authority to intervene?
Mr. VOLCKER. I don't know. We just have not considered the
issue at all, and I don't know whether that would be appropriate.
So I pronounce no judgment on that. I am aware that the Federal
Reserve itself has been in existence for 70 years without anybody
challenging its constitutionality, and some other independent agencies have been in existence longer than we have. It seems to me it
has in some large sense, without trying to play lawyer, become
part of the American system of government. I am talking about the
role of independent agencies in general and not just talking about
the Federal Reserve. But it would be a very large change in the
way things have been looked at for a very long period of time.
Senator PROXMIRE. Should the Fed be given the authority to file
its own brief with the courts without getting permission from Justice?

Mr. VOLCKER. I rather like that idea, yes. [Laughter.] I would not
oppose it.
The CHAIRMAN. Senator Cranston.
TAX ON OIL IMPORTS

Senator CRANSTON. I wanted to ask you your view on one matter
at this point. With the decline of oil and energy prices as reflected
in the cost of living and other indexes, what is your view of a tax
on imported oil and/or a tax on domestic energy as a way to cope
with the deficit?
Mr. VOLCKER. Those were two different questions that arose, I
think, with Senator Dodd shortly before you came in, Senator, and
to try to summarize my answer, I think I would look at an oil
import fee in the light of whether that is necessary and desirable
as a conservation measure or as an exploration support measure
rather than as a tax generating measure. I don't think it is a very
efficient way to raise revenues, and simply as a tax measure there
are an awful lot of complications when you begin singling out one
source product for taxation with all the exemptions and allocations
and everything else that that might involve.
So if you are looking at it as a revenue raising measure—and
against the background of any revenue raising measure being a
second choice, economically, to spending reduction measures—I
would look more toward a direct tax on gasoline or energy more
widely.
Senator CRANSTON. On another topic, and I was just talking with
one of the representatives of one of the largest banks in our country who is no longer concerned about inflation, but deflation with
oil prices going down and with the farm economy and the difficulty
it is in which he suspects may trend on into real estate values
plummeting.
Do you see anything that would cause concern on the front of deflation in contrast to inflation?
Mr. VOLCKER. Given my understanding of the word "deflation,"
there are pockets of deflation and there are sectoral deflations in
the economy. Overall, there is still obviously inflation at a much
lower rate but nonetheless still there. I suppose this might be typical of a period more broadly described as disinflation.
We were on a bit of a binge and prices were accelerating, and
now we are adjusting to a much more stable situation and I think
that is favorable. Particularly the areas that were over-extended in
the past have elements of deflation in them now, and you see that
in some commodity prices, and you certainly see it in the agricultural area, and you see it in some other areas.
The challenge during this period is to contain those problems in
a way that isn't inconsistent with working toward stability overall,
and there are risks involved in that process. There is no doubt
about it.
Senator CRANSTON. I know that inflation has been one of your
major concerns and you have been a staunch advocate of a greater
responsibility by Congress on the budget deficits and so forth.
How do you feel about the timetable in Gramm-Rudman-Hollings
getting down to $144 billion by October in the deficit and down to

zero by 1991? Do you have any concerns about that being such a
drag on the economy under any perspective circumstances that it
would cause any serious recession?
Mr. VOLCKER. When you add "under any prospective circumstances," that is a big statement.
Senator CRANSTON. Yes; I meant it to be that way.
Mr. VOLCKER. I am not concerned about the broad direction and
the pace of that effort. I think it is quite a challenge to achieve it.
Nor do I think success rests upon any precise numerical target that
we set 5 years in advance of the event. But the overall thrust of
the effort, I think, is constructive.
Senator CRANSTON. One final question. Would you support any
special assistance to farm banks that are suffering from what you
call disinflation?
Mr. VOLCKER. That is an issue which we will shortly be writing
the chairman about. He has asked us about it in particular, and
you will have your reply, Mr. Chairman, very shortly. There are
certainly elements of what I would call special attention at least, if
not special assistance. We have tried to be very careful in our examination processes, and I think the other supervisors look at it
similarly, so that we don't aggravate their problems through overly
heavy-handed reactions or overreactions in the supervisory process.
We have been very fortunate in this situation. There are very
grave problems out there, but we have been very fortunate that the
mass of agricultural banks, and there are a great many of them,
have been among our most strongly capitalized institutions and
historically among the most profitable. So they have had some considerable financial strength to withstand some of these strains.
And in that process, certainly speaking for the Federal Reserve,
if their capital is depleted temporarily below our guidelines, the
capital is there to be depleted or used at least in part in times of
strain. We would have to approach that, obviously, on a case-bycase basis, but with some recognition that temporarily capital
ratios might fall below standards we otherwise think are appropriate.
There are questions that arise that we will address in terms of
changing accounting practices and net worth certificates. We resist
those approaches because we don't think they are good in the long
run and any application of them ought to be quite limited, but our
view will not be strongly supportive of those particular approaches.
I mentioned earlier the structural factor, which is at least as
much a matter for State legislatures as the Congress, but there are
elements that affect the Congress. And when you have States that
permit no branching or, in some cases, no affiliations among
banks—although that is diminishing—it is more difficult to deal
with some of these failing situations, because there is no other
bank that can step into the shoes of the failing institution.
Now that is a matter of changing some of those laws if, indeed, it
is important to preserve banking services as it sometimes is in
those local communities.
The CHAIRMAN. Senator Proxmire.

58
BAD DEBT RESERVE DEDUCTION

Senator PROXMIRE. Mr. Chairman, when this committee held
oversight hearings on the House tax reform bill, it was argued that
the elimination of the bad debt reserve deduction will have an adverse effect on the safety and soundness of the banking system.
That is, without the bad debt reserve deduction banks will have
less incentive to establish their bad debt reserves. And since these
bad debt reserves are counted as capital for regulatory purposes,
the overall capital position of the banking system will decline.
I don't want to get into the issue of whether the bad debt reserve
deduction should or should not be repealed because that question is
outside of this committee's jurisdiction. But in looking at the issue
just from a bank regulatory point of view here, just from that point
of view, what authority do the bank regulators have to offset any
adverse effects of the tax bill?
If regulators thought that banks were inadequately capitalized,
why couldn't they have simply raised capital requirements? Why
should banks need to have tax incentives to comply with bank
safety regulations?
Mr. VOLCKER. We could raise capital requirements, but I think
the issue that is raised is how expensive that becomes. If we raise
capital requirements and the taxes on that additional capital are,
in effect, increased because of the elimination of the bad debt reserves, it comes more costly and more difficult.
Senator PROXMIRE. Have you had anybody in the Fed take a look
at the taxes paid by the banks, how much do they pay?
Mr. VOLCKER. I know that
Senator PROXMIRE. The big banks pay practically nothing.
Mr. VOLCKER. I am aware of that. Now that doesn't end the story
entirely because of two reasons. Some of the things they do to
avoid the taxes don't necessarily fall into their pockets. Their customers, in effect, are taking advantage of some tax incentives.
They finance it and it shows up on their books, but the customer is
getting credit, which was the purpose of tax incentive in the first
place.
So you have that kind of situation where the tax savings do not
translate into net profits for the financial institution, and you do
have this contrasting need, in the current circumstances, certainly
more than earlier when the bad debt reserve
Senator PROXMIRE. Well, why can't you as a regulator just say
you ought to have 10 percent capital?
Mr. VOLCKER. Pardon me?
Senator PROXMIRE. Why can't you as a regulator simply say you
ought to increase the capital ratio from 8 to 10 percent?
Mr. VOLCKER. Where are they going to get it from?
Senator PROXMIRE. I know you are doing that, but why wouldn't
that be adequate?
Mr. VOLCKER. That would be increasing the capital ratio, but the
question that always arises is where are you going to get the capital from. All we can issue is a UKASE to raise the capital ratio.
They have to raise the capital, and how difficult or feasible that is
is what we are talking about.
Senator PROXMIRE. Thank you.

Thank you, Mr. Chairman.
The CHAIRMAN. Mr. Chairman, thank you very much. I have no
more additional questions for you.
I do expect you will have the usual number for your response in
writing.
Thank you very much.
The committee is adjourned.
[Whereupon, at 3:28 p.m., the committee adjourned, subject to
the call of the Chair.]
[Response to written questions of Senators Garn, Heinz, Gorton,
Mattingly, Proxmire, and Riegle with additional material supplied
for the record follow:]

60
Chairman Volcker subsequently submitted the following
in response to written questions from Chairman Gam in connection with the hearing held before the Senate Banking Committee
on February 20, 1986:
Question: In his State of the Union address, the
President directed the Secretary of the Treasury to study possible modifications in our international monetary system.
One alternative, of course, would be increased official
intervention to bring more stability to rates.
Do you believe that foreign exchange market intervention can be effective if it is "sterilized" and not allowed to
affect domestic money supplies?
If intervention cannot be sterilized and remain effective, do you believe that exchange rate stability should be an
explicit objective of monetary policy along with the domestic
objective of low-inflation and high real growth?
Answer:

I believe that sterilized intervention can at

times play a useful role in helping to stabilize exchange rates
and, perhaps, even to correct serious exchange rate misalignments.

For example, intervention following the G-5 announcement

last September may have reinforced and made more credible the
statement that policymakers thought non-dollar currencies should
move somewhat higher, and thus may have accelerated the decline
in the dollar that had begun earlier in the year.

However,

experience over the years shows that unless intervention is
complemented by appropriate policies, its effect is likely to be
fairly small and transitory.
Changes in the exchange rate have an important impact
on our economy, and on the world economy.
ignored in the formulation of policy.

They cannot be

Indeed, as we have noted

on many occasions, the Federal Reserve in recent years has been
giving explicit consideration to exchange rates, among other
factors, in its policy decisions.

61
Question: How and to what extent should monetary
policy be adjusted to compensate for recent declines in the
price of oil?
The Federal Reserve has argued that it needs to have a
role in bank regulation to be adequately sensitive to the impact
of monetary policy on financial institutions. Does monetary
policy need to be adjusted in light of the impact of oil-price
declines on banks with large loans to the energy industry or
oil-exporting countries?
How and to what extent should monetary policy be
adjusted to compensate for Gramm-Rudman-Hollings?
How and to what extent should monetary policy be
adjusted to compensate for the decline in the value of the
dollar during 1985?
Answer:

Your question enumerates a number of key

elements in the economic outlook, illustrating the variety of
considerations that must be taken into account in conducting
monetary policy.

The effects of any of these developments are

very difficult to predict in advance, and they may interact in
complex ways.

Some have quite different and potentially off-

setting impacts.

Oil price declines and dollar depreciation

have offsetting effects on inflation rates.

While budgetary

restraint reduces demands for goods and services, the behavior
of the dollar and oil prices increases them.

But the magnitude

of the oil price decline, the extent of dollar depreciation, and
the exact amount of budgetary restraint are all subject to some
uncertainty, as is the timing of their various effects on
economic activity and prices.

Conditions to date, with this

lagged potential for the year ahead, were considered by the FOMC
in establishing its objectives for money and credit growth for
the coming year.

However, actual developments will need to be

mon,tored carefully as the year progresses in assessing the
implementation of policy and whether the monetary ranges continue to be appropriate relative to our overall goals of
fostering sustained economic expansion consistent with progress
over time toward price stability.

62
Question: The Federal Reserve's guidelines on daylight
overdrafts become effective in March. Apparently some banks are
planning to charge their corporate customers for creating daylight overdrafts.
Do you expect this to cause corporations to significantly increase their working demand deposit balances, and if
so, do you expect this to be an important downward pressure on
monetary velocity?
Answer:

It is not anticipated that the implementation

of the initial Federal Reserve policy to limit daylight overdrafts will raise corporate demand deposit balances to the
extent that Ml or its velocity would be significantly affected.
Corporate payments and funds transfers are not the only source
of daylight overdrafts of reserve balances.

A very substantial

portion reflects the morning return of overnight Federal Funds
borrowings before the receipt of newly-negotiated borrowings in
the after.noon.

Depository institutions have alternative means

of reducing daylight overdrafts — such as entering into longer
term federal funds transactions or returning borrowed federal
funds later in the day—which are the approaches likely to prove
more significant.

It is true that some depository

institutions

have reviewed their corporate payments policies in light of the
Board's efforts to focus banks' attention on the risk exposures
associated with daylight overdrafts.

But, our information sug-

gests that relatively few of the many thousands of depository
institutions are likely to need to make substantive changes to
their payments patterns in order to meet the initial limits on
daylight overdrafts to be implemented in March.

Thus corporate

demand deposit balances are not expected to be greatly affected
by the Federal Reserve's guidelines on daylight overdrafts, as
presently set out.

As overdraft limits are adjusted further,

some limited and gradual effects on the aggregates may occur.
While, as noted, no measurable impact on the aggregates is
likely to occur in 1986, the Federal Reserve will continue to
monitor depository institutions and corporate cash management in
order to detect any reaction that could alter the interpretation
of the monetary aggregates.

63
Question: The 1986 Economic Report of the President
examines monetary policy over the 1 as^ three years and Tinds
that "each of the major shifts in monetary policy appears to
(have been) a reaction to contemporaneous economic activity."
The Report concludes that, "real growth has been the primary
target of monetary policy."
Has the Federal Reserve, in fact, been trying to target
a desired level of real growth over the last three years?
Answer: The Federal Reserve does not "target" a
particular rate of real economic growth.

Clearly, sustained

expansion of the economy over time at a rate close to its
potential is a basic goal of monetary policy, and along with
continuing progress toward price stability, are fundamental
objectives.

Ranges for growth in money and credit are chosen by

the FOMC consistent with these objectives, and other policy
adjustments are undertaken in that basic framework.

However,

looking at a longer time frame, the Federal Reserve does not
control growth in the labor force and productivity, which are
the key determinants of the nation's growth potential.

The

higher productivity, the more rapid will be the long-run growth
potential and Federal Reserve policy would accommodate policy to
that as it emerges over time.
In periods of economic slack, the Federal Reserve does
seek to encourage a revival of economic activity consistent with
the economy's capacity and containment of inflationary pressures.

In the second half of 1982 and again in 1985--two of the

"major shifts in monetary policy" identified by the Report-incoming information about economic activity and prices
suggested that, in light of strong demands for liquidity and
associated declines in velocity, rapid growth of Ml above its
ranges would not have inflationary consequences, and indeed was
needed to foster satisfactory performance of the economy—in the
first case, recovery from a deep recession, and in the second,
continued expansion.

However, we do not aim at precise growth

targets from quarter to quarter or even year to year, partly
because that is not reasonably feasible with the tools at our
command and the lags involved, and also because other considerations (including prices) bear upon the gusta inability of growth.

64
Question: The House-passed tax bill, H.R. 3838, would
no longer'allow banks or bank holding companies with more than
$500 million in assets to take a tex deduction for contributions
to loan loss reserves. In addition, the bill would require
these larger banks to pay taxes on theiT previous years' deduction, as existing reserves would have to be "recaptured" into
income over a five-year period.
Do you believe it would have an impact on the safety
and soundness of the banking industry to deny deductions for
contributions to loan loss reserves?
Do safety and soundness considerations justify discriminatory treatment of banks with over $500 million in assets in
their ability to take deductions for contributions to loan loss
reserves?
Answer:

Bank regulators have generally required banks

to maintain adequate loan loss reserves to promote accuracy in
their financial statements.

In particular the objective has

been to encourage banks to recognize potential future losses
inherent in their loan portfolios and thus avoid overstating
earnings and their true equity positions in their current financial reports.
I would note that, in addition to bank regulators, the
reserve method of accounting

for loan losses has long been

recognized as appropriate by the accounting profession and is
currently prescribed by generally accepted accounting principles.

I would further note that the great majority of banks,

in complying with these principles, have made contributions to
their loan loss reserves that have substantially exceeded what
they have been able to deduct for tax purposes.
The proposed repeal of the reserve method for tax
purposes would make it more costly for banks with over $500
million in assets to maintain loan loss reserves for financial

65
reporting purposes.

These costs would be particularly high

during the proposed five-year recapture period for 1985 tax
reserves.

In short, these provisions of the bill obviously

would tend to discourage banks from maintaining as large loan
loss reserves as otherwise, at some risk in terms of safety and
soundness criteria.
I also note that the Report of the House Ways and Means
Committee on H.R. 3838 states that the bill retained the reserve
method for smaller banks because "the committee is concerned
that the repeal of the reserve method for smaller banks may have
some potential adverse impact."

I believe that larger banks

would be affected in much the same way as smaller institutions
if the proposed loan loss reserve approach were adopted.
As a regulator, I am strongly inclined toward measures
that will encourage banks to build up and maintain adequate loan
loss reserves because I thir.k this will help to promote their
safety and soundness.

Thus, viewed from this perspective alone,

I would not favor adoption of the proposed tax treatment.

Question: In your statement, you say that improvement
in the United States' trade balance will require faster economic
growth by our trading partners. You also note that the decline
in oil prices will stimulate the econonies of many of our
trading partners in Europe and Japan.
Your statement is unclear, however, on whether the
United States should encourage our trading partners in Europe
and Japan to undertake even more fiscal and/or monetary policy
stimulation of their economies.
Should we press them to stimulate more at this time?
Answer.

My public statements for more than a year

have, in fact, consistently suggested the need for more "home
grown" expansion in key foreign countries and raised the
question of whether that did not justify some changes in policy
and policy emphasis.

66
Question: Given the good outlook on the Inflation
front and given the prospect of reduced fiscal stimulus to the
economy in the years ahead, some analysts apparently expected
the Federal Open Market Committee to vote last week to ease
monetary policy.
This apparently did not occur.
Answer:

Why not?

Consideration of the appropriate stance of the

Federal Reserve in supplying reserves is nade against the
backdrop of a number of factors affecting the economy and financial markets, not all of which pointed in the direction of the
need for further ease through open market operations when the
FONC met in early February.

The growth of money and credit

generally was rapid in the latter part of 1985, and the economy
showed some signs of strengthening around year end.

Fiscal

policy, though moving toward budget balance over time, remains
relatively expansionary for the near-term and is subject to
uncertainties as Graram-Rudman-Hollings is challenged in the
courts; the decline in oil prices, while bringing down inflation
for a time, also will serve to stimulate real spending and
economic activity.

Moreover the dollar had been declining

fairly rapidly on foreign exchange markets, and it was likely
under the circumstances that a significant easing through open
market operations would risk a cumulative decline.

In the weeks

following the meeting, however, the central banks of Germany and
Japan, and a few other key countries, lowered their official
rates.

In that environment — and given declines in U.S. market

rates, relatively constrained growth of the aggregates early in
the year, and further declines in oil prices that enhanced
prospects for improved price performance—the Federal Reserve
Board on March 7 approved a cut in the discount rate from 7-1/2
to 7 percent.

67
Question: In your statement, you Indicate that one of
the reasons for recent declines in measured velocity has been
that domestic demand has been growing faster than domestic output. The declining exchange rate of the dollar should reduce
the drain from domestic demand into imports.
Has monetary velocity become highly dependent on
changes in the value of the dollar on foreign exchange markets?
Are we likely to see upward pressure on velocity this
year coning from the declines that already have occurred in the
value of the dollar?
Answer:

In my view, the more rapid growth in domestic

demands than in output—the counterpart to our burgeoning trade
deficit last year--probably contributed to the measured decline
in GNP velocity in 1985.

Such a divergence in growth rates

would contribute to a decline in measured velocity to the extent
that demands for money and credit are related to domestic
spending as well as to domestic output and income, which is
conventionally used to calculate velocity.

However, the bulk of

the substantial decrease in Ml velocity last year appeared to be
related to Che combined effects of the downward movement of
interest and inflation rates and deposit rate deregulation on
the public's desires to hold money balances, rather than to the
more rapid expansion of spending than income.

Only rarely would

I expect domestic demand and domestic output to diverge so
widely as to have any measurable effect on velocity.

For

instance, even with the recent sharp decline in the dollar, the
trade balance is likely to improve only moderately this year.

68
Question: In a paper submitted to this Committee, John
Makin emphasized the importance to monetary policy of being
alert to a resumption of velocity growth.
Mr. Makin suggested that a likely sign would be s
decline in nominal interest rates associated with a weakening oi
the dollar on foreign exchange markets.
His argument is that the weakening dollar would signal
rising inflationary expectations, and this would mean that the
nominal interest rate decline reflected a decline in the real
interest rate.
Do you agree that this would be a good way to anticipate resumed growth in velocity?
Answer:

Declines in both the dollar and nominal

interest rates could indicate that velocity was increasing, but
only under certain specific circumstances.

Usually when

interest rates decline, velocity grows less than trend or
decline.

It might rise, however, if, as Mr. Maktn suggests, the

exchange value of the dollar were confirming a drop in real
interest rates and if the lower real market rates were consistent with a decision by the public to increase its spending out
of existing money holdings because, for instance, inflationary
expectations were rising.

But it is not clear that a decline in

dollar exchange rates can always be interpreted as signalling a
rise of Inflationary expectations.

The exchange rate can be

influenced by a number of factors in addition to short-run
movements in U.S. real interest rates, including interest rates
and growth prospects abroad, the international competitive
position of U.S. producers, and concerns about the safety of
investments abroad.

69
The difficulty in Interpreting the inplications of
movements in interest and exchange rates for velocity surely
could not be better illustrated than in 1985.
rates declined considerably

Dollar exchange

from early March on, while nominal

short-term interest rates edged off and long-term rates fell
more substantially.

However, the falling exchange rate appeared

to reflect a growing realization that a realignment in the
foreign exchange value of the dollar would be necessary at some
time to restore long-term balance in our nation's external
accounts as much as it did a reduction in real interest rates.
Moreover, it was accompanied by a steep decline in velocity,
rather than an increase.

It seems evident that the Federal

Reserve will have to continue to look at movements in interest
or exchange rates in the context of information about the
economy and financial markets in judging the likely course of
velocity and the appropriate stance of monetary policy.

70
Question: In a paper submitted to this Committee, John
Makin of the American Enterprise Institute concluded that the
United States should not seek international agreement to pursue
more exchange rate stability while Gramm-Rudman-Hollings is
being implemented.
Mr. Makin 1 s argument is that more exchange rate
stability would reduce the flexibility of monetary policy and
that more flexibility, not less, will be needed as GramnRudman-Hollings is implemented.
Do you agree?
Answer:

I have supported the President's call for an

exploration of steps to achieve and maintain greater exchange
rate stability.

Maintenance of reasonable exchange rate

stability docs imply a greater need for disciplined and complementary policies among nations.

In my view, Gramm-Rudman-

Hollings is sn important step in that direction.

By helping to

close the gap between domestic investment and saving, it will
foster better balance in our international transactions — a
necessary precondition for greater stability of exchange rates.
At the same time, major shifts in fiscal policy-particular]y if they entailed a divergence between policies
pursued in the U.S. and our major trading partners — might imply
the need for changes in exchange rates to maintain satisfactory
performance of the economy and inflation.

If monetary policy

had to defend the existing exchange rate level in such circumstances, its use to achieve domestic objectives would be
constrained.

I would think that any system for achieving

greater stability in exchange rates would have to retain
elements of flexibility to allow adjustment to fundamental
changes in underlying economic conditions or policy mix.
However, the extreme volatility of recent years often has seened
unrelated to economic fundamentals, and it Is the means to
reduce this sort of exchange rate volatility that appear to me
worth looking at.

71
Chairman Volcker subsequently submitted the following
in response to written questions from Senator Heinz in connection with the hearing held before the Senate Banking Comoittee
on February 20, 1986:

Quest.ton: With regard to debt, you give credit to the
Baker Plan"1 s"feVognition of the need to deal directly with the
policy and financing problems of countries suffering from continuing debt problems, especially those such as Mexico,
Venezuela and Nigeria that are affected by falling oil prices.
These countries are claiming that nothing short of Interest rate
concessions will resolve their problems, calling into question
the value of current bank loans and making prospects for further
loans problematic. Do you believe the Baker Plan is workable
under these conditions? Should the commercial banks increase
their lending to fill a widening capital gap in these countries
when they are seeking loan concessions?
Answej-:

The Baker Plan is workable today, and the

basic approach Secretary Baker outlined in Seoul is still valid:
Che adoption of stabilization and structural policies by the
borrowing countries to promote sustained growth; support of
those policies by the IMF, the World Bank, and the other multilateral development banks; and additional lending in this
context by commercial banks to provide the necessary margins of
external financing.

This cooperative effort will be more

difficult to the extent that the borrowing countries insist upon
"loan concessions" as a substitute for the adoption of more
fundamental economic reforms.

72
Que_s.t_lp_n: A number of legislative provisions related
to U.S. monetary policy are pending in Congress. Many are
premised on the view that the level of the dollar exchange rate
has not been an explicit goal of U.S. econonic or monetary
policy, with damaging effect on the U.S. economy. Is this
criticism of U.S. monetary policy valid? You have noted concern
with and monitoring of the exchange rate in your recent reports;
how has the exchange rate factored into your 1986 monetary
targets?
Answer:

The exchange rate as it affects the outlook

for economic activity and prices inevitably enters into our
deliberations, along with other economic and financial
circumstances--such as fiscal policy, the wage-price nexus, and
conditions in domestic and international credit markets.

Thus,

implications of the sharp drop in the dollar that had already
occurred were assessed.

It was a factor exerting upward pres-

sure on prices but at the same time stimulating growth.

Over

the year ahead, though, it was generally considered that the
drop in oil prices would offset the price effects, and the
monetary targets set would be consistent with continued
constraint on inflationary pressure while encouraging real
growth.

73
Que s tjon: The Administration seems increasingly taken
with the idea~~of reform of the world monetary system, as most
recently indicated in the President's State of the Union
address. Various proposals in the Congress call for similar
discussions. Do you see a need for fundamental reform of the
system? What changes, if any t are needed?
An s wer:

As I have noted in the statement that I sub-

mitted to the Committee, I welcome the call by President Reagan
to consider what steps night be desirable to achieve and
maintain greater exchange-rate stability.

We have had enough

experience with the distorting effects of extreme

exchange-rate

volatility to justify a reexanination of the functioning of the
international monetary system.

One should not, however, under-

estimate the complexity of the task of achieving intellectual
and operational consensus about modifying the currency international monetary arrangements.

Still, while I do not have a

blueprint for international monetary reform, we ought to be
prepared to examine various ways to achieve greater exchangerate stability.

74
Chairman Volcker subsequently submitted the following
in response to written questions from Senator Gorton in connection with the hearing held before the Senate Banking Committee
on February 20, 1986:

One line of questioning which I think would be useful
has to do with the Fed's policy in light of the deficit reduction effort and Gramm-Rudman:
Question:
1)

Can "fine tuning" of monetary policy offset the
contractionary fiscal policy that Congress will
undertake in compliance with the Gramm-RudmanHollings Act?

Answer:

I do not believe monetary policy can be

"fine-tuned" to offset the effects of one particular factor
affecting the economy.

"Fine tuning" implies an ability to

predict with precision and confidence the size and timing of the
effects of both the factor in question and of any changes in
monetary policy to offset it.

In any event, the economic impact

of Gramm-Rudman-Hollings is subject to substantial uncertainties, including the effect of court rulings on its implementation and the extent of offsetting increases in private
spending as the drop in government credit demands reduces pressures "on interest rates and frees saving to be channelled to
private investment.

Moreover, a number of other important

factors in addition to fiscal policy are likely to be affecting
the economy over coming years.

Oil price developments and the

lagged impacts of the readjustment in exchange rates are two of
the more important.
In general, in establishing ranges for money and credit
growth, the FOMC necessarily looks at all the developments that
could be influencing the economy and the relationship of those

75
aggregates to economic performance.

In Implementing policy as

the year progresses, the behavior of the aggregates is assessed
against that of the economy, inflation, and developments in
credit and foreign exchange markets.

If a major change in one

or more important factors — including but not limited to, fiscal
policy-seemed to suggest chat the FOMC's policy objectives were
not consistent with progress toward national economic goals of
sustained growth and price stability, the FOMC would of course
reassess its overall policy stance.

76
Ques t ion:
2)

Mr. Volcker, you have been quoted in today's papers
as saying that "the dollar has fallen enough".
Given that there may still be some room for the
value of the dollar to fall further, at what point
do you think that the Fed will have to act to prevent a further decline?

Answer:

That statement was made in the context of the

size and rapidity of the decline of the dollar in recent months,
not as an expression of a conviction that I knew, or could know,
that the dollar had reached an appropriate "equilibrium" level
that should be maintained over time.

That sense was, I believe,

clear in the total context of my comments.
I know of no reliable way of determining ex ante or
hypothetlcally at what point the dollar might have fallen too
far, and I do not take the view that some further adjustment may
not be necessary over time.

However, we know from experience

that changes can develop a momentum of their own unrelated to
lasting influences, as apparently happened for a period when the
dollar was so strong.

At some point, particularly if infla-

tionary risks were high, such an event could influence Federal
Reserve, as well as other, policies.

If that point is ever

reached, more than action by the Federal Reserve alone is likely
to be required to reverse the slide.
depend on the circumstances.

The precise actions would

77
Question:
3)

Which Is more important—to ease monetary policy in
the face of contractionary fiscal policy, or to
prevent the dollar from depreciating too far?

Answer:

I cannot intelligently

answer the question in

the abstract, and absent other assumptions.

Even the two

factors you mention have offsetting effects on economic
activity—one contractionary and the other expansive.

In other

words, in that setting, it is possible there would be no net
contractionary effect.

# ) Mr. Volcker, we have recently heard a great deal
about Secretary Baker's initiatives to stabilize
exchange rates by coordinating monetary and fiscal
policy among the Croup of Five nations. What is
the Fed's role in these efforts?
Answer:

We have participated in international discus-

sions and have intervened, along with the Treasury, in exchange
markets.

Our basic monetary policy thrust is, of course, set

independently by the Federal Open Market Committee and the Board
of Governors; it remains one of encouraging sustainable economic
growth and progress toward reasonable price stability.

policy implementation we have made an effort to adapt certain
policy instruments, such as the discount rate, in light of
conditions in exchange markets and policy actions abroad as well
as underlying economic and financial conditions here.

78
Question:
,3")

It appears that although OUT deficit problems are
now coining under control, there is still a great
deal of work that must be done by Congress and the
Administration in the way of deficit reduction.
This effort will continue for several years. In
the face of a long-term contractionary phase of
U.S. fiscal policy, what would be the effect of
resorting to a fixed exchange rate regime on your
ability to conduct discretionary monetary policy?

Answer:

Under our present exchange rate system, a

long-term reduction in the federal budget deficit would tend to
reduce domestic interest rates and the exchange rate for the
dollar, as current and expected future pressures on domestic
financial markets would be eased.

There is already some

evidence of this process at work in the wake of the Gramm-Rudman
legislation.
The movements in interest rates and the exchange rate
would help to correct the internal and external imbalances that
had been generated by the budget deficit.

The tendency for

interest rates to decline would also boost domestic expenditure,
offsetting the contractionary impact of the reduction in the
budget deficit.
If, instead, we were operating under a fixed exchange
rate regirr.e, downward pressure on exchange rates would need to
be restrained in part perhaps by interest rate movements here or
abroad depending on the extent to which exchange rate tendencies
were or were not buffered by changes in international reserves.
Whether this would represent a practical constraint on monetary
policy, relative to current conditions, would depend on the
degree of exchange market pressure, the "give" in a fixed rate
system, actions of other countries, and the availability of
international reserve movements or intervention to noderate
exchange rate tendencies.

79
One last question you might ask has to do with the
relationship between the trends in the price of oil and the
value of the dollar vis-a-vis inflation:
Question:
£ )

As we all know, the price of oil has fallen far
more sharply than anyone foresaw even as recently
as a few weeks ago. Is the falling price of oil
offsetting the inflationary effects of the falling
dollar?

Answer:

The fall in oil prices in recent weeks, if

sustained, will exert a significant downward impact on U.S.
inflation that could for a period of time tend to offset the
inflationary effects or the decline in the dollar.

Lower oil

prices are likely to begin to affect consumer prices fairly
quickly, over the next few months.

In contrast, the fall In the

dollar, which has been taking place for twelve months now, has
only just begun to show up in higher import prices.

The rela-

tive timing of these effects suggests that the recent decline in
oil prices is likely to contribute to a continued favorable
performance of prices over the course of this year.

However, as

the effects of the dollar decline are passed through increasingly into import prices, inflation could begin to pick up.

80
Chairman Volcker subsequently submitted the following
in response to written questions from Senator Hattingly in connection with the hearing held before the Senate Banking
Conraittee on February 20, 1986:

Question: As you know, Gramm-Rudman-Hollings calls for
substantial 'across the board budget reductions in the event
Congress fails to meet required deficit ceilings ($144 billion
for the next fiscal year). Assuming Congress makes no progress
on deficit reduction, and $30 to $40 billion of across the board
cuts are required, what would be the effect on the economy?
Would the Federal Reserve be accommodating in order to prevent
dislocation and the possibility of recession?
Answer:

There is no question that fiscal action of the

$30 to $40 billion magnitude you cite is significant, and that-all other things equal — it would have a restraining effect in
the short run on the expansion of demand for goods and services
in the economy.

But I must underscore that phrase "all other

things equal," for the fact is that the prevailing economic
environment would have a major influence on whether the effect
of the fiscal restraint would be a cause for concern.

However,

federal spending would reduce demand on credit markets and lower
interest rates; the net effect on spending would depend on the
degree to which private businesses and spenders came to replace
federal.

Moreover, in the period ahead we may also be experi-

encing a stimulative effect on the economy from the drop in oil
prices and in the dollar on exchange markets.

Thus, the extent

to which Federal Reserve policy would need to adjust to maintain
satisfactory growth in the face of deficit reductions — and of
course maintenance of growth along with attainment of price
stability are basic objectives—would depend on other circumstances at the tine spending cuts were being put in place.

that context, the prospect of deficit reduction itself yields
the positive result of helping to relieve the stresses and
imbalances that have continued to plague our economy and represent a threat to the continuity of expansion.

81
Question: Oil prices have fallen substantially in
recent weeks.Obviously, many regional banks hold large percentages of their portfolio in energy-related assets. Without
mentioning any particular institution, at what level would
prices have to fall before the Fed becomes concerned about a
large bank holding company failing? If Congress provides assistance for banks with large concentrations of agriculture-related
losns, should Congress also consider applying similar aid to
institutions with a commitment to energy projects?
Answer:

The recent fall in energy prices has obviously

placed additional pressures on borrowers whose income is derived
from the exploration and production of oil and gas and on
borrowers who provide services in support of these activities.
This, in turn, has no doubt had adverse repercussions on the
loan portfolios of banking organizations with exposure to the
oil and gas industry.
While the general direction of these effects are beyond
dispute, the impacts on particular institutions will vary
depending on a number of factors.

These include the quality of

an institution's energy loans and of other assets in its portfolio, the volume of its earnings (or lack thereof) obtained
outside the energy a r e a , the adequacy of its capital and loan
loss reserves, and the capability of its management to establish
policies and practices that, will enable a bank to weather a
difficult situation.

Another critical element that is perhaps

most difficult to gauge is how these factors will be perceived
by financial market participants, a consideration of obvious
importance for banks that must depend on market confidence for
their fundiv^g.

82
The Federal Reserve is currently conducting—on behalf
of ourselves, the FD1C and the OCC--speclal

targeted inspections

of large bank holding companies with significant energy
exposure.

I do not believe at this point there is a need for

financial assistance for agricultural or energy banks beyond the
normal resources and policies of the Federal Reserve and the
FDIC.

There is, in my judgment, an urgent need to review and

make more flexible certain emergency provisions of law that
would facilitate, with minimal disruption, failed or failing
banks.

The regulatory agencies have also reviewed accounting

for restructured loans and policies toward capital forbearance
that can be applied to both energy and agricultural banks.

83
Question: Yesterday, I received a Federal Reserve
press release dated February 14, 1986 which reeds, in part, as
follows:
"The Federal Reserve Board and the Federal
Open Market Committee today released the
attached record of policy actions taken by
Che Federal Open Market Committee at its
meeting on December 16-17, 1985."
What justification can be given for withholding such
important economic data for two months? I intend to reintroduce
legislation which I have proposed in the past that will require
that the FOMC minutes be released in a more timely fashion. I
hope that the Fed will work with Congress on this important
issue.
Answer:

Decisions of the FOMC about its basic monetary

policy thrust for the year are made public through a report and
Congressional testimony in February and July of each year
shortly after the FOMC meetings at which they are made.

If the

FOMC alters its basic approach to policy between these regular
semi-annual reports, it is typically announced immediately or
with only a short time lag.

The press release to which you

refer contains the policy directive and record of discussion of
FOliC meeting?, which is not released until after the ensuing
meeting.

The information withheld for a time pertains not to

the basic thrust of policy, but rather to decisions concerning
the implementation of open market operations over the very
short-run within the announced policy framework.
Early release of these decisions risks destabilizing
market speculation.

The instructions of the FOMC are condi-

t i o n a l , in that reserve provision will depend on the behavior of
a number of variables over coming weeks, including the expansion

84
of the monetary aggregates, the behavior of the economy and
inflation, and conditions in credit and foreign exchange
markets.

As participants in credit markets protect themselves

against a variety of possible outcomes, trading can be affected
by a conditional decision, even if never implemented, adding to
volatility in securities markets.

Moreover, concern about these

"announcement effects" may complicate and limit the flexibility
of the FOMC's decision-making process.

It would force greater

consideration of the effects of the words rather than the substance of a decision and would make it more difficult to adopt
and implement necessarily conditional decisions.

The FOMC might

be driven to meeting at shorter intervals — which itself could be
an added source of uncertainty in markets.
Immediate release of the directives also would tend to
focus attention on the short-run tactical decisions of the FOMC,
rather than on its basic policy stance.

The latter, as 1 noted

above, is announced immediately after it is decided, and, quite
properly, is the subject of extensive Congressional hearings and
public scrutiny.

This legitimate debate about basic policy

approaches could well be obscured by the increased public
discussion about the short-run implementation of policy that
would accompany more rapid publication of the regular meeting
directive.

There is little to be gained, and potentially much

to be lost, by inviting attention to the continuing "tactical"
implementation of monetary policy rather than basic policy
directives.

85
Que_s t ion: A monetary policy that does not encourage a
rise in U.S. interest rates obviously contributes to keeping the
value of the dollar down. Assuming then that the Fed is supportive of the initial efforts of the Group of Five to lower the
value of the dollar do you feel multilateral policy coordination
is the next step and do you feel it is possible? France has
proposed an international monetary reform plan that centers
around the use of exchange rate "reference zones" (or target
zones). Do you agree with France that such reference zones are
a logical extension of recent Group of Five decisions? Under
the French proposal, domestic monetary authorities would be
pressed to relinquish "some of their autonomy" in favor of
International Monetary Fund oversight. The French are vague
about this shift in authority—does this represent a danger to
this country's ability to set its own monetary policy?
Answer:

The fortunes of all countries — including the

United States — are inextricably interlocked.

Meaningful pro-

gress in achieving a better functioning international economy,
therefore, is enhanced by international cooperation.

The

initiatives by the Group of Five countries to achieve a configuration of exchange-rate relationships among the major
currencies more reflective of fundamental economic conditions is
a good example of such a cooperative effort.
Proposals for international monetary reform that center
around the use of exchange rate "reference zones" or target
zones represent, I believe, attempts to foster and formalize
further cooperative efforts,.

We ought to be willing to examine

these or other possibilities for achieving greater exchange-rate
stability.

The effects of exchange rates on our economy are too

important to be ignored in poltcymaking, and exchange-market
developments have increasingly been taken into account in the
formulation of U.S. monetary policy.

86
However, major countries do not appear to be prepared
to commit themselves to adjust their monetary or other policies
in any automatic way in response to exchange-rate novements or
movements of other economic or financial variables.

Moreover,

one has to be skeptical of the desirability of directing policy
almost exclusively toward exchange-market considerations or of
having policy exclusively subservient to external objectives.
Finally, from a different perspective, any procedural device to
achieve greater exchange-rate stability cannot In any way
substitute for disciplined and complementary domestic policies
among the leading nations.

Question: In light of recent legal setbacks to the
Fed, i.e., the Dimension and Bankers Trust decisions, what Is
the status and likely outcome of the controversial Citicorp
application concerning securities activities of bank holding
companies?
Answerj

The Citicorp application raises a very signif-

icant issue concerning the scope of the Glass-Steagall Act and
the appropriate role of bank holding companies in the securities
business.

The application, Including the comments of a number

of interested parties, is under consideration by the Board.

The

Board has not yet reached a final decision and therefore it
would be inappropriate for me to express an opinion as to the
likely outcome.

87
Chairman Volcker subsequently submitted the following
in response to written questions from Senator Proxnire in connection with the hearing held before the Senate Banking
Committee on February 20, 1986:

Question: On February 4, 1986, Mr. George J. Clark of
Citibank Tppeared before the Banking Committee and said certain
provisions of H.R. 3838, the House passed tax bill, would doom
the Baker Plan if they were enacted into law. In particular he
opposed the proposed foreign tax credit charges, the elimination
of the bad debt reserve, and change in the deferral of foreignearned income. The most damaging of these to the Baker Plan, he
said would the "the disallowance of the foreign tax credits on
cross border loans". This provision, said Mr. Clark, would
slash the supply of international credit. Do you share
Mr. Clark's views that the provision of H.R. 3838 noted above
would be a disaster for the Baker Plan?
Answej::

The terms on outstanding cross-border claims

on borrowers, in Latin America in particular, now incorporate
the strong presumption that (U.S. and foreign) bank creditors
will be able to claim home-country tax credits for withholding
taxes paid to debtor governments.

An abrupt introduction, such

as provided in H.R. 3838, of a limitation on the creditability
of foreign withholding taxes could significantly complicate the
task of arranging for bank support of the Baker Initiative.
Furthermore, there is some concern about the effect of the House
bill's bad debt reserve-related provision on the capital positions of U.S. banking organizations.

Question: Should banks write-off foreign loans? Many
observers of the international debt situation suggest we are
just kidding ourselves in pretending the amount of debt to some
of the most over-burdened countries will ever be repaid. As you
know, many European banks have already written down their Latin
American debt. Why shouldn't the U.S. banks be forced to do the
same?
If some of the debt were written off wouldn't this make
it easier for the most debt burdened countries to recover and
resume their normal pattern of trade with the United States?
Answer:

To my knowledge, foreign banks have not

written down their claims on Latin American countries in the
sense of relieving the borrowing country of the obligation to
pay.

Foreign banks have been encouraged in various ways, often

including generous tax treatment, to increase their reserves
against such loans, and where appropriate U.S. banks have
received similar encouragement without the assistance of
favorable tax treatment.

If, however, some of the debt were

written off, I would doubt that the capacity of the borrowing
countries to recover and increase their imports from the United
States would be enhanced by that action alone.

For one thing, I

would be doubtful that the country had taken the internal
measures necessary to restore growth and stability.

For

another, banks would be hesitant to finance the country's trade
if they would risk similar write offs in the future.

89
Question: Target zones for currencies. Recently,
there has teen some discussion about establishing target zones
or reference zones for our major currencies. Each government
would be expected to intervene in foreign exchange markets to
keep its currency within the target or zone.
What do you think about this idea?
should be moving towards?
Answer:

Is it something we

I understand the motives of those who propose

target zones or similar arrangements, and we ought to be willing
to examine possibilities to achieve greater exchange-rate
stability.

Exchange-rate movements at times contain information

about the posture and compatibility of economic policies within
a country and among countries.

The effects of exchange rates on

OUT economy are too important to be ignored in policymaking.

fact, exchange-market developments have increasingly been taken
into account in the formulation of U.S. monetary policy.

At the

same time, major countries do not appear willing to commit themselves to adjust their policies in any automatic way in response
to exchange-rate movements or movements of other economic or
financial variables.

Finally, as I noted in the statement

submitted to the Committee, any procedural device to achieve
greater exchange-rate stability cannot in any way substitute for
disciplined and complementary domestic policies among the
leading nations .

90
Chairman Volcker subsequently submitted the following
in response to written questions from Senator Riegle in connection with the hearing held before the Senate Banking Committee
on February 20, 1986:

Question: Tax Reform as It Effects Banks. Two weeks
ago several witnesses testified before the Banking Coimittee
that the foreign tax credit provisions of the House passed bill
are inconsistent with the Administration's "Baker Initiative."
(The Baker Initiative is designed to encourage U.S. banks to
participate in a program that would supply billions of dollars
($20 billion) of new funds to the lesser developed countries.)
The point they made is that on the one hand the Administration seems to be encouraging the banks to lend money to the
lesser developed countries while on the other the House passed
bill i£ taking away their foreign tax credits which will make
the lending significantly more difficult.
What is your position on the foreign tax credit provisions in H.R. 3B38 and on the loan loss provisions of that
legislation?
Answer:

The terms on outstanding cross-border claims

An abrupt introduction, such

as provided in H.R. 3838, of a limitation on the creditability
of foreign withholding taxes could significantly complicate the
task of arranging for bank support of the Baker Initiative.
Furthermore, there may be some concern about the effect of the
House bill's bad debt reserve-related provision on the capital
positions of U.S. banking organizations.

91
Question: State of the Union. In his State of the
Union message the" President directed Treasury Secretary Baker
"to determine if the nations of the world should convene to
discuss the role and relationship of OUT currencies." In so
doing, the President seemed to hint that proposals to change the
monetary system could follow.
What changes if any, do you think should be made to our
international monetary system?
Ansuer;

As I have noted in the statenent that I

submitted to the Committee, I welcome the call by President
Reagan to consider what steps might be desirable to achieve and
maintain greater exchange-rate stability.

We have had enough

experience with the distorting effects of extreme exchange-rate
volatility to justify a reexamination of the functioning of Che
international monetary system.

I share the concern about the

operation of the international monetary system, but one should
not underestimate the complexity of the task of achieving
intellectual and operational consensus about modifying the
current international monetary arrangements.

While I do not

have a blueprint for international monetary reform, we ought to
be prepared to examine various ways to achieve greater
exchange-rate stability.

92
Question: Japan. After conquering large segments of
the world market for manufactured goods, it is By understanding
that the Japanese now are on their way to being the world's
bankers. I am referring to the fact that for the first time,
the share of the international banking business held by Japanese
banks has "clearly exceeded" the portion held by U.S. banks.
How do you account for this increase in Japanese international lending and what are the implications for American
banks and our international competitiveness in the financial
services industry.?
Do you see any possibility that Japan could become the
new OPEC of the world financial system, sucking in money from
abroad through its powerful export industries and spending even
less abroad because of falling oil prices?
Answer:

As long as Japan records large current account

deficits it will accumulate net claims on the rest of the world.
However, these claims need not be accumulated through banking
channels.
The Bank of International Settlements (BIS) publishes
data on the international business of banks according to
nationality of ownership.

Data for September 1985 show that the

share (26 percent) of Japanese banks in total gross international loans for the first time exceeded that of the U.S.
banks (23 percent).

However, these data may be distorted

somewhat by the relatively greater reliance by Japanese banks on
conventional lending operations rather than on the use of other
forms of financial services.
An alternative measure of the role of national banking
systems in international markets constructed by the BIS shows
that, on a net basis, at end-September 1985, U.S. banks ($35
billion) remain larger net suppliers of funds in international
banking markets than Japanese banks ($18 billion).

In fact over

93
the first three quarters of 1985, Japanese banks reported an
overall reduction in their net creditor positions.

These net

creditor data suggest that Japanese banks have not been the
primary channel through which the large Japanese current account
surpluses over recent years have been invested abroad.

Question: Japan's Challenge in the Euromarkets. It is
my understanding that the Japanese stature and presence in the
Euromarkets has been expanding dramatically. For example, last
year 8 Japanese securities houses and banks ranked among the top
50 underwriters of Eurobond issues, playing the lead role in
offerings that $15 billion. In 1984, by contrast, 6 Japanese
firms ranked in the top 50, accounting for new EuroBond issues
°f $6-4 billion.
How do you account for Japan's success and increasing
expansion in the Euromarkets?
Answer:

The financial counterpart to Japan's larger

current account surpluses has been very sizable accumulations of
foreign bond portfolios, particularly U.S. Treasury and corporate securities.

These financial stockpiles have been

purchased by Japanese institutional investors and Japanese
corporations through Japanese investment banks.
The expansion of the role of Japanese firms in the
Euromarkets largely reflects their placing power with Japanese
investors.

However, the building of capabilities to service

sophisticated Japanese customers has also been viewed by these
financial firms as the basis for establishing new international
relationships.

For example, Japanese financial firms have

exploited their placing capabilities by offering attractive
financing packages to U.S. corporate issuers of yen-denominated
securities.

In this way, they have facilitated the financing of

our current account deficit.

94
Question: Mexico. Last week Mexican financial officials tola creditor banks in New York that it will need to
borrow about $9 billion this year to keep its economy afloat as
a result of the recent steep decline in oil prices. That is
more than twice what Mexico told bankers it would need in
December,
Are the Federal Reserve Board and the Administration
planning -- or in the process of mounting -- another emergency
financial rescue package similar to the one it spearheaded in
1982, when Mexico nearly defaulted on its foreign debt?
Is it true that without additional assistance Mexico is
likely to run out of cash in the weeks ahead?
Vlhere do you expect them to get the $9 billion from?
Answer:

While Mexico's current cash balances are

larger currently than they were in 1982, the recent sharp oil
price decline is adding to Mexico's debt servicing difficulties.
However, the situation in Mexico is fluid.

The $9 billion

figure that has been cited as Mexico's financial needs for this
year may well be tod high.

It depends critically on the price

of oil and the volume of oil that Mexico will sell this year.
Another important consideration in assessing the prospects for
Mexico is the nature of the internal response by Mexico to the
new challenges facing the Mexican economy.

In recent bilateral

discussions with Mexican officials, U.S. officials were
impressed by the constructive manner Mexican officials were
addressing Mexico's economic problems, and U.S. officials have
expressed their willingness to assist in finding appropriate
solutions to Mexico's financial problems.

With effective

internal efforts by Mexico, I am confident that Mexico's
external needs could be met by the international banking community and the multilateral financial organizations.

95
Question: Plunge in Oil Prices. It is generally
believed that the plunge in oil prices Is likely to bring on a
recession in such states as Texas, Oklahoma and Louisiana and
poses a serious threat to many banks -- large and small — in
that area.
What can you tell us about the safety and soundness of
the banking industry in those areas?
Answer:

Falling oil prices are causing concern about

the strength of economic conditions and the fiscal health of
certain states, such as Texas, Oklahoma and Louisiana, whose
economic growth is relatively dependent on energy prices and
production.

At the same time, to the extent that banks in these

states hold relatively more loans to firms engaged in oil
exploration, development, production and distribution than banks
in other states, falling oil prices have weakened the loan
portfolios of these banks.
Lower oil prices reduce the current value of production
flows and proven reserves which serve as the collateral for many
energy loans, and strain the cash flow of many oil companies
which have borrowed from banks in these states.

In response,

bankers have taken steps to bolster capital and reserves.

The

data on the attached sheet indicate that, overall, banks in
Texas, Oklahoma and Louisiana generally have higher capital
ratios and reserves than banks in the rest of the country.

is clearly prudent to strengthen capital and reserves when net
loan losses and levels of nonperforming loans are rising, as
they have been for banks in these states, and for banks in
general, over the past few years.

96
While these steps are positive, they do have costs.

strengthening loan loss reserves, banks oust take a direct
charge against current earnings.
ratios have declined.

As a result, performance

For example, for banks in Texas, Oklahoma

and Louisiana, profitability (expressed as return on average
assets) has declined since

1982.

In addition to these steps taken with respect to
existing loans, bankers in these states have begun to establish
more conservative lending policies and practices to better
control future risk.

For example, bankers are less likely to

make loans secured by drilling equipment and would be more
likely to rely on proven producing reserves.
The Federal Reserve is also taking steps to better
evaluate and control risks in energy lending by, among other
things, increasing the frequency of bank examinations and
holding company inspections, promoting more direct communication
with member bank and holding company directors, and issuing
stronger capital guidelines.

97
UNIFORM BANK

PERFORMANCE DATA

PEER fiRpJt" DATA
Insured Commercial Bants In U.S.

09/30/85
Number
Number
Number
Number

of
of
of
of

Banks
Banks
Banks
Banks

In U.S.
In Texas
In Oklahoma
In Louisiana

09/30/84

12/31/84

12/31/83

12/31/62

14,452

14,476

14,469

1,917

1,832
534
296

14,483
1,853

14,455
1,596

535

301

1,727

538
302

525
26
8

509

1.02
1.10
1.02
1.11

1.10
1.41

278

Net Income to Average Assets (%)
U.S.

Texas
Ok 1 a homa
Louisiana

1.06
0.89
0.92
0.93

1.10
1.17

0.95
0.93
0.71
0.84

0.74
0.79
1.56
0.94

0.50
0.63
1.17
0.59

0.76
0.69
1.46
1.02

0.65
08
.0
1.48
0.78

0.57

1.21
1.26

1.09
1.10
1.31
1.11

1.03
1.02
1.10
1.13

10
.0

1.53
1.24

1.05
1.07
1.22
1.10

2.92
23
.5
4.47
4.90

2.46
16
.4
3.46
3.33

2.45
17
.4

2.30

2.27
N.A.
N.ft.

3.54

1.56
2.94
3.22

9.44
9.39
9.62
99
.0

9.37

9.17
9.16
9.20
92
.6

9.05
9.01
9.18
92
.2

9.03

1.13

i.no

1.41
1.26

Net Loan Losses to Average Total
Loans and Leases {%}
U.S.

Texas
Oklahoma
Louisiana

0.62
0.92
0.72

Loss Reserve to Total
Loans and Leases (%}
U.S.

Texas
Oklahoma
Louisiana

0.99
0.68
1.06

Nonperformlng Loans and Leases
to Total Loans and Leases (X)
U.S.

Texas
Oklahoma
Louisiana

3.60

N.A.

Primary Capital to Average Assets (S)
U.S.

Texas
Oklahoma
Louisiana

9.36
9.49
97
.3

9.17
6.93
90
.6

98
EXECUTIVE OFFICE OF THE PRESIDENT
COUNCIL OF ECONOMIC ADVISERS
WASHINGTON, D.C. 20500

Statement

of
Beryl W. Sprinkel
Chairman
Council of Economic Advisers
Submitted for the Record

to the
COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
UNITED STATES SENATE
Thursday, February 20, 1986

99
Chairman Garn, Senator Proxmire, distinguished Members of
the Committee, I am pleased to have the opportunity to submit
for the record this statement of the Administration's views on
monetary policy.

Long-Term Objectives

The Administration's long-term objective for monetary
policy continues to be a gradual reduction in the inflation
rate until price stability is firmly established.

While

inflation has moderated significantly in recent years, current
inflation rates of 3 to 4 percent do not constitute price
stability.

It would be a serious mistake to accept such

inflation as satisfactory.

Since most of the costs of reducing

inflation have already been borne, it would be unfortunate to
allow inflation to reaccelerate thereby necessitating yet
another costly inflation-reducing episode in the future.

The objective of price stability can best be achieved by a
gradual and predictable reduction in monetary growth.

Chairman

Volcker and other Federal Reserve officials have on many
occasions reaffirmed their intentions to gradually reduce
monetary growth in order to foster price stability.
Administration fully supports this policy.

The

In considering

100
growth targets for the Ml aggregate, the Administration
recognizes that some uncertainty exists as to the
between Hi and nominal GNP.

relationship

In particular, it is evident that

Ml velocity has slowed from its postwar historical trend.
Decreases in both inflation and interest rates are partly
responsible for this decline.

It is also likely that financial

deregulation, by allowing interest-bearing checking accounts to
be included in Ml, may have contributed to this change.

Since

these accounts may function partially as savings, individuals
may hold larger Ml balances on average thereby altering
velocity growth.

Accordingly, Ml growth somewhat higher than

would otherwise be the case may be acceptable.

Nonetheless/ it

is difficult to justify an indefinite continuation
Ml growth that occurred in 1985.

of the rapid

Given the lessons we have all

learned about the pernicious consequences of inflation, some
slowdown in monetary growth is called for in the period ahead.
Yet the slowdown should not be abrupt, since such action would
likely disrupt real economic activity in the near-term.
Accordingly, a gradual steady deceleration of monetary growth
seems most appropriate at this time.

Despite the recent slowdown in the growth of velocity, the
evidence to date is insufficient to ^termine precisely the
nature and extent of any permanent change in velocity growth.
Nevertheless, the growth rate of Ml remains one of the most
reliable indicators of the stance of monetary policy.

Given

101
the well-known inadequacies of variables commonly suggested as
alternatives to Ml, the Administration urges the continued
targeting of Ml as a primary intermediate target of monetary
policy.

Near—Term.Concerns of Monetary Policy

Recently, some have expressed concern about three
issues confronting monetary policy in the near term: (a)
Gramm-Rudman-Hollings {GRH) deficit reduction actions, (b) oil
prices declines, and (c) agreements made among the G-5 members
to influence exchange rates and external imbalances.

The scheduled reductions- in Federal budget deficits as
mandated by GRH have prompted some to suggest that reducing
government spending to raeet the deficit targets of GRH may
bring about a recession.

As a consequence, an offsetting

easing of monetary policy is often recommended.

Fears that reductions in government spending will cause an
economic slowdown are unjustified for several reasons.

First,

GRH targets can be met primarily by holding down the growth of
(

real government spending rathe- than cutting its level.

fact, the only significant cut in real government spending is
equivalent to about 0.5 percent of real GNP and occurs in
fiscal year 1987.

Six times in the past 35 years real spending

102
cuts of this approximate relative magnitude have been made
without evidence that they led to recession.

Secondly, the

required spendingcuts will occur at a time when economic
activity is likely to be relatively strong.

Thirdly, as long

as the Federal Reserve maintains steady, predictable monetary
growth, no serious or protracted macroeconomic

disturbances

should be expected from reducing the budget deficit.
Accordingly, an easing of monetary policy does not appear
necessary

in order to offset scheduled reductions in budget

deficits.

A second concern that some believe calls for a monetary
policy response

is the recent dramatic decline in oil prices.

Specifically, it has been argued that the Federal Reserve
should ease policy because the oil price decline lessens
inflationary pressures and therefore provides leeway for the
central bank to promote increased economic activity.

Moreover,

it is argued that lower interest rates will soothe heightened
concerns about the> fragility of certain financial institutions
with sizable exposure to the energy sector.

These arguments are misleading for several reasons.
First, the decline in oi 1 prices is a decline in a relative
price.

As such it is a market signal indicating that current

oil supply exceeds demand.

An easing of monetary policy would

obfuscate that market signal and thereby inhibit the
functioning of market clearing forces.

103
Secondly, while the decline in the relative price of oil
will have some distributional impacts on consumers and
producers of oil, it is not expected to have significant
effects on aggregate nominal economic activity as measured by
nominal GNP.

Nonetheless, the oil price decline should prove

favorable to the real GNP/inflation mix in 1986 and perhaps
somewhat longer.

In particular, oil price declines will foster

increased real GNP growth and lowered measured inflation in the
near-terra.

Since other factors already at work should be

providing the impetus for healthy economic growth, additional
monetary stimulus is neither required nor desired.

The impact of falling oil-prices on measured inflation, it
should be noted however, is a-one-time improvement.

The

Federal Reserve can take advantage of this temporary, one-time
fall in prices to promote a steady deceleration in monetary
growth and thereby improve the prospects that inflation and
expectations of inflation will be completely eliminated and
price stability firmly established.

Third, easing monetary policy is not the appropriate
response to the problems of financial institutions heavily
.exposed to the energy sector.

An expansionary policy for this

purpose would only increase the risks of higher future
inflation and create incentives for financial institutions to
assume more risk, thereby increasing the likelihood of

104
difficulties in the future.

As long as the Federal Reserve

serves as the lender of the last resort to the market and
thereby prevents credit problems in some institutions from
becoming systemic, monetary control as well as the soundness of
the financial system will be ensured.

The G-5 Agreement

It is important to understand the relationship between the
G-5 agreement in September 1985 and monetary policy.

The G-5

agreement was not simply an agreement to intervene cooperatively to force down the value of the dollar.

It was a recog-

nition that the excess of domestic investment over domestic
saving (i.e., the current account deficit) in the United States
is mirrored by the opposite condition in the rest of the
world.

Consequently, the agreement recognized that policy

changes across countries, not just in the United States, are
essential to correct external imbalances.

The agreement

specified that policies designed to achieve increased
convergence of economic performance, especially sustained,
noninflationary growth, were the responsibility of all participants.

In this regard, the United States reaffirmed its

commitment t" decrease the Federal government's claim on
domestic spending by reducing government spending as a share of
GNP, thereby reducing the budget deficit.

The remaining four

countries, in general, committed themselves to policies that

105
promote increased internally-generated economic growth thereby
providing

increased demand £or their own output as well as for

U.S. exports.

While the group rioted and agreed that a

realignment of exchange rates should play a role in resolving
external imbalances, such a realignment cannot be sustained
unless policies are pursued to generate more balanced
growth.

economic

The participants in the agreement realized that

exchange rate manipulation alone was not an appropriate
long-term strategy to redress external imbalances.

It is not clear exactly what affect the G-5 agreement and
intervention carried out under that agreement have had on the
foreign exchange value of the U.S. dollar.
dollar has depreciated on a trade-weighted

Even though the
basis by more than

14 percent since the agreement, its fall began in late February
1985, as it depreciated by more than 15 percent during the
seven months preceding the agreement.

Consequently, it is

difficult to ascertain how much of the depreciation subsequent
to the agreement may be a continuation of the process in
progress at the time of the agreement and how much has been due
to intervention since the agreement.

The impact of intervention and the sustainability o£ its
impact depend critically upon whether the intervention is
sterilized or unsterilized.

Many researchers, including the

working group on exchange market intervention established at

106
the Versailles Summit, have concluded that sterilized intervention (intervention that does not affect domestic money
supplies) has little, if any, long-run effect on nominal and,
more importantly
rates.

for affecting trade flows, real exchange

Unsteriliized intervention (intervention that does

affect domestic money supplies) is tantamount to conducting
monetary policy in foreign exchange markets.

Such intervention

can affect the long-run behavior of nominal exchange rates, and
perhaps also the shorter-run behavior of real exchange rates.
Commitment of monetary policy to the control of exchange rates,
however, interferes with its use"for other important policy
objectives —

most importantly, achieving price stability and

avoiding money-induced fluctuations in domestic real economic
activity.

It appears that the Japanese economy may now be

experiencing some of the contractionary effects of the
tightening of monetary policy that was associated with the Bank
of Japan1s efforts to strengthen the yen.

On the other hand,

if the U.S. Federal Reserve attempted to force down the value
of the dollar with unsterilized intervention, domestic money
growth would increase, rekindling inflationary pressures.

In sum, the concerns relating to (a) Gramm-RudmanHollings, (b) oil price declines, or (c) the G-5, should not
cause the monetary authority to deviate from the policy supported by this Administration; namely, that of gradually and
predictably decelerating monetary growth from the rapid
expansion experienced in 1985.

107
American Enterprise Institute for Public Policy Research
1150 Seventeenth Street, N.W., Washington, D.C. 20036

(202) 862-5800

The Current Status of Monetary Policy

Prepared for the
Committee on Banking, Housing and Urban Affairs
United States Senate
John H. Makin
Director of Fiscal Policy Studies
American Enterprise Institute

February 1986

108
The Current Status of Monetary Policy
Introduction
This commentary discusses background for setting money growth
targets.

A broad range of 5 to 12 percent is suggested for Ml in view

of unstable HI demand.

A 6 to 9 percent range is suggested for M2.

Also discussed are implications for monetary policy of tighter fiscal
policy, lower oil prices, and international economic conditions.

Some

questions for Mr. Volcker are proposed.
The objective of an accommodative monetary policy should be to keep
the money supply at a level equal, as nearly as possible, to the
quantity of money demanded.

Over time that objective requires money

supply growth equal to projected growth of money demand.
Money demand grows at a rate equal to the growth rate of nominal
GNP less the growth rate of velocity.

The growth rate of velocity

measures reduction in the growth of Eoney demand relative to national
income (GNP).
Setting Money Growth Targets
Any discussion of the current status of monetary policy must be
made conditional on the behavior of velocity or equivalently, on the
behavior of money demand which has been highly volatile during the past
year.

During 1985 the economy grew in current dollar terms at about 6

percent.

During that same period the growth rate of the narrowest money

aggregate, Ml, was about 12 percent.

Velocity fell at 6 percent over

the year, one of the most rapid drops ever experienced.

In effect,

there was a sharp increase in the demand for money that probably was
linked to a drop in long-run inflationary expectations.

We have come

through a year during which the Federal Reserve has done a remarkably

109
good job of accommodating a shift in money demand that was not, and in
general could not, have been predicted.

Where we go from here depends

on prospects for the behavior of money demand in 1986 and upon the Fed's
ability to anticipate its behavior.
Beyond a drop in inflationary expectations, some suggest that the
sharp drop in Ml velocity is a reflection of financial innovation.

The

result of such innovation has been to make the checkable deposits
component of Ml more like a saving deposit or a traditional component of
M2.

Therefore, part of the shift in the demand for Ml reflects a change

in the nature of Ml.

Indeed M2, which includes Ml plus overnight repos,

Eurodollars and other deposits, grew at the top of the range set last
February for 1985.

Still, M2 velocity declined at about 3 percent

during 1985, a significant departure from typical postwar behavior.
An important thing to bear in mind in looking ahead and setting
money growth targets is the temporary, if unpredictable, effect of
changes in inflationary expectations and financial innovations on the
demand for Ml and M2.

Once the adjustment to lower

inflationary

expectations has resulted in a larger stock of money in the hands of the
public, the negative effect on velocity growth will disappear.
Likewise, once the effect of financial innovation on holdings of Ml has
been completed, the effect of that shift on Ml velocity will also
disappear.

The overall implication is that, barring another sharp drop

in inflationary expectations, at some time in the next year or two,
velocity growth may revert back toward its postwar trend level of 3
percent.

In the case of Ml velocity, such a shift would represent a

massive swing from -6 percent growth to a +3 percent growth per year.
If such a swing occurred during 1986, zero Ml growth would be sufficient

110
to accommodate nominal growth of 9 percent, or a combination of 4
percent in real growth and 5 percent

inflation.

The most important challenge facing monetary policy today is to
avoid having the intended character of monetary policy sharply altered
hy a sudden move in velocity growth back toward positive postwar trend
levels.

In the intermediate-run period of a calendar year, this

requires the Federal Reserve to monitor Interest rates adjusted for
inflation.

For example, if in the absence of a sharp drop in

inflationary expectations the federal funds rate were to fall sharply
over a quarter, indicating a drop in real interest rates, the result
would be consistent with an unpredicted drop in money demand or,
equivalently, with a rise in the growth rate of velocity.

Such events

would call for a slowdown in money growth rates or a reversal of last
July's upward rebasing of the Ml growth targets.

A good clue to whether

nominal interest rate movements are reflecting real interest rate
movements is to watch the behavior of exchange rates.

If nominal

interest rates fall while the dollar weakens, it is likely that the drop
in nominal rates is largely accounted for by a drop in the real Interest
rate.

If a drop in nominal rates is accompanied by a stable or

strengthening dollar, it is likely that the drop in nominal rates is
reflecting a drop in inflationary expectations.
The recent sharp drop in the dollar against major foreign
currencies—the drop against the yen over the past six months has been
about 20 percent—suggests that the coincident fall in interest rates
has signaled a drop in real interest rates rather than a further drop in
inflationary expectations. These events may presage a beginning of the

Ill
return of velocity growth to higher levels and therefore suggest setting
money growth targets below recently realized actual growth rates.
In view_ofthe high level of uncertainty regarding behavior
velocity over 1986, the range of money growth ta.rgets should be wide.
Retaining an M2 gjrowth target of 6 to 9 percent seems appropriate.

The

Ml growth target should be 5 to 12 percent in recognition of the highly
volatile behavior gf^Ml velocity.

Impact of Fiscal Policy (Gramm-R'adman-Hollings)jin Monetary Policy
A target of a. zero fiscal deficit for 1991, whether it is
accomplished by the Gramm-Rudman-Hollings Act or by other means, sets
fiscal policy on & rigid, contractionary path.

The cut in spending

necessary to achieve the Gramm-Rudman target for fiscal 1987 will be
between 1.5 and 2 percent of GNP, depending on the baseline from which
it is assumed the cuts are made.

In any case, the implication is that

fiscal policy moves from an expansionary path that it has followed since
1981 to a contractionary path.
Some contraction of fiscal policy will likely have a favorable
effect on the economy.

An anticipated reduction in fiscal deficits and

thereby in federal government demands on the credit markets should ease
pressure on interest rates, particularly on real interest rates, and
result in some further depreciation of the dollar.

These effects will

stimulate investment demand and demand for American tradable goods as an
offset to the reduction in demand resulting from a slower growth path
for federal spending. In my judgment cuts in federal spending and
deficits at about half the rate envisioned by Gramm-Rudman would be
sufficient to achieve a ratio of debt to GNP that is stable but also
reduces the pressure on real interest rates.

Cuts at twice that level

112
such as are envisioned under Granm-Rudman are likely to produce a net
reduction in aggregate demand that is greater than can be accommodated
by monetary policy or eased with lower real interest rates or dollar
depreciation.
The suggestion that monetary policy can accommodate a tighter
fiscal policy in principle has some validity, but its execution is far
from simple.

As noted above, the unpredictable behavior of velocity

makes monetary policy an unreliable instrument at best.

To place heavy

demands on it, i.e., offsetting contractionary fiscal policy, may be
asking too much.
In effect, monetary policy has already eased as suggested by the
falling dollar and the pick-up in economic activity that began late in
the fourth quarter and appears to be carrying through the first quarter
of 1986.

If these events signal a combination of continued rapid money

growth and a higher rate of velocity growth, further easing In the fora
of setting higher growth rates for Ml and M2 could precipitate a sharp
increase in inflation or inflationary expectations which would be
signaled by a further, perhaps sharp, drop in the dollar against other
currencies.
To say that the contraction of fiscal policy under Gramm-Rudman
requires an accommodating monetary policy is really to assume away a
very delicate problem in policy coordination.

Little reliable

information about the timing of the effects on major economic variables
of a tighter fiscal policy and/or an easier monetary policy is known.
Humility and caution are the key watchwords that should guide macroeconomic policy over the coming year.

113
The Effect of Recent Declines in the Price of Oil on Monetary Policy
The recent 40 percent drop in oil prices is a plus for the economy
overall.

Its effect on inflation, however saluatory, is temporary as is

the reverse effect of a weaker dollar.

The most that can be expected

from lower oil prices is a slight increase in manoeuvering room for the
Federal Reserve.

The effect on the path of inflation expected in the

United States has been largely offset by a weaker dollar.
Looking ahead, one finds that the situation confronting monetary
policy is a delicate one.

If money growth is set too high, especially

given a resumption of velocity growth, dollar depreciation will outstrip
and eventually erase most of the positive effect on inflation from lower
oil prices.

The result could even be some reversal in the decline of

oil prices.

A good rule of thumb would be to suggest that lower oil

prices and a weaker dollar just ab^ut offset each other in terms of
their effect on U.S. inflation.

In other words, monetary policy should

be set as if neither had occurred since their net effect is roughly 0.
The Impact of International Developments on U.S.^ Monetary Policy
With a rigid contractionary fiscal policy in place under GrammRudman-Hollings or a similar constraint, a move toward pegging exchange
rates or exchange rate target zones would sharply curtail the ability to
use discretionary monetary policy at a time when some heavy demands
might be placed on that instrument.

Exchange rate targets require that

money growth targets be coordinated among major industrial countries.
In a formal sense a rigid fiscal policy and rigid exchange rate targets
require a passive monetary policy.

The quantity of money must be

whatever is necessary to validate a set of predetermined exchange rate
targets.

114
A concrete example illustrates this point. Suppose that in 1986
exchange rates are fixed at current levels.

Suppose also that Germany

and Japan decide to keep inflation low and set money growth targets
consistent with 2 percent inflation.

If the United States were

committed to the exchange rate targets and to the contractionary

fiscal

policy, that combination would force the Federal Reserve to set money
growth targets low enough to validate the exchange rate while inflation
was very low in Germany and Japan.

The upshot could be that the maximum

growth rate for money would be well below the level required to
accommodate a nominal GNP growth rate of 8 percent.
A return to fixed exchange rates or target zones constitutes
another policy experiment.

Such an experiment would be unadvisafale for

the United States to undertake at a time when a particularly delicate
move to readjusting its own policy jnix toward a tighter fiscal stable
money configuration is underway.
Summary
An unusually high level of uncertainty colors all economic policy
setting in 1986.

The American economy has passed through uncharted

waters over the past five years.

An expansion with rising deficits,

falling interest rates, and stable or falling prices is not a typical
postwar experience.

The degree of precision regarding the effects of

changing the policy mix between monetary and fiscal measures is not high
enough to simply design with confidence an accommodating path for
monetary policy in the face of a rigid contractionary fiscal policy such
as is implied by the Gramm-Rudman-Hollings bill.
International economic problems add to the uncertainty faced on the,
domestic front.

A drop in the price of oil means that Mexico and other

115
debtor countries will be unable to service debts owed to banks in the
United States and other industrial countries without a significant
increase in new capital inflows.

It may be decided that such inflows

provide negative reinforcement for bad lending and borrowing policies,
but if that is the case, steps will have to be taken to protect the
depositors of some major American banks.

Such steps usually involve

infusions of new capital and a break-up of affected banks into pieces to
be purchased by other financial institutions.

Given the state of the

American financial system and its difficulties with energy, agriculture,
and real estate loans, we may have to decide whether foreign banks,
particularly Japanese banks which are currently and aggressively seeking
a foothold in the American banking system, will be allowed to purchase
pieces of failed American financial institutions.

116
Statement on Monetary Policy
Prepared for

United States Senate
Committee on Banking, Housing, and Urban Affairs

A. James Meigs, Senior Vice President and Chief Economist
First Interstate Bancorp
and
Jerry L Jordan, Senior Vice President and Economist
Rrst Interstate Bancorp
February 24, 1986

Some Genera! Points About Objectives and Targets.of Monetary Policy
Although inflation has stabilized at an annual rate of about 3.5% to 4%
during the past lour years, there is no assurance that inflation will decline in the
future. To the contrary, we believe that the extraordinarily high rate of monetary
expansion in 1985 and the decline of the dollar on foreign exchange markets
raise a serious risk that inflation will reaccelerate later in 1986 and 1987.
As Chairman Volcker suggested in his recent testimony, an inflation rate
of 3.5% to 4% would not be satisfactory as a long-run goal in any case. The
U.SHeconomy has done much better than that at times in the past and can do
better in the future. Furthermore, without the favorable effects of a strong dollar
and falling oil prices, inflation would have been considerably higher. We
believe that inflation will remain moderate for most of this year, but prices will be
rising more rapidly before the end of the year.
An increase in inflation from its current level could impose severe costs
on the U.S. and world economies. Therefore, we believe it is essential that the
Federal Reserve System begin at once to pursue policies designed not only to
avoid a reacceleration of inflation from its recent 3.5%-4% rate, but to bring
inflation down to zero within the next four or five years.
To meet this goal will require gradually reducing the rate of money
growth, and making it clear that the Federal Reserve will persevere on a longrun course toward price stability. Frequent large departures from announced
monetary targets and reversals of direction, such as those seen in recent years,
damage the credibility of the monetary authorities, increase uncertainty in
financial markets, and increase the costs of reducing inflation.
Implications of gramm-Rudman-Hollinqs for Monetary Policy
Reducing the deficit would be highly desirable, if it were to be done by
reducing growth of expenditures. The amount ol expenditure reduction that is
likely to be achieved through Grammn-Rudman-Hollings, or through any other

117
means, would not endanger the growth of economic activity and employment in
any way.
Any reduction in growth of total national employment and output that
might result from a reduction in federal expenditures would be more than made
up by increases of employment and output in the private sector within a year.
Therefore, it would be neither necessary nor desirable for the Federal Reserve
to cushion the effects of deficit reduction through an easing of monetary policy.
In fact, any attempts by the Federal Reserve to offset allegedly depressing
effects of deficit reduction or Federal expenditure cuts in the short run would be
inflationary in the longer run.
The idea that changes in the mix of fiscal and monetary policies can be
used to stimulate growth and to control inflation is a myth. There simply is no
way to substitute restrictive fiscal policies for expansive monetary policies or
vice versa.
The Congress need not fear that it will cut total federal expenditures too
much. However, it must be concerned about which programs it decides to cut or
to expand. The most useful contribution the Federal Reserve System could
make to solving this difficult problem in allocating national resources would be a
stabfe, predictable policy of gradually reducing growth of the money supply until
inflation is reduced to zero.
implications .of Lower Oil Prices for Monetary Policy

Although lower oil prices will reduce income and employment in some
oil-producing regions of the country and may aggravate credit-quality problems
in some banks, their effects on the total economy will be highly beneficial.
Lower oil prices will enable many businesses to reduce their production costs
and will free up some income for consumers to spend on other goods and
services. However, lower oil prices will not reduce the danger of inflation in the
future; they do not mean that the Federal Reserve will now be able to follow a
more expansive monetary policy than it would have if oil prices were higher.
Energy commodities (gasotin© and fuel oil) comprise only 7% of the
consumer price index; electricity and natural gas account for another share of
less than 5%. In addition, oil prices will not continue to fall indefinitely; their
major dampening effect on inflation is likely to be short-lived.
Implications of the G-5 Agreement to Seek an "Orderly Appreciation
of the Main Non-Dollar Currencies Against tha Dollar"
In his testimony before the House Banking Committee on March 19,
Chairman Volcker warned against the dangers of deliberately depressing the
dollar on exchange markets. We agree with him that trying to depreciate the
dollar through monetary policy would conflict with the System's objective of
reducing inflation.

118
H the Federal Reserve were to try to reduce the exchange value of the
dollar through direct intervention in exchange markets the end result would
clearly be more inflation in the United States than we would otherwise have.
Direct, unsterilized intervention through Federal Reserve purchases of other
currencies would increase the supply of dollars in the world in relation to the
supplies of other currencies.
The monetary authorities of a country can try to stabilize the country's
domestic price level, or they can try to stabilize its exchange rate. They cannot
do both at the same time. Therefore, a policy of trying to reduce the dollar's
value in terms of other currencies would mean accepting a higher inflation rate
in the United States. Other countries have understood this for a long time, and
so they generally consider a falling exchange rate to be inflationary,
This raises the further question of what the Federal Reserve can or
should do if the dollar depreciates against other currencies (i.e, the other
currencies appreciate against the dollar) tor reasons other than Federal
Reserve actions. With or without Federal Reserve intervention, the dollar has
declined by approximately! 6% on a trade-weighted basis since the G-5
agreement was announced last September, and by 23% from its peak monthly
average in February 1985.
Some commentators have suggested that this decline in the dollar
means that the Federal Reserve now could or should reduce U.S. interest rates
by cutting the discount rate or by taking other actions to achieve further
reductions in the dollar exchange rate. We believe, instead, that the arguments
against trying to depress the exchange rate through monetary policy apply
equally as well to trying to reduce interest rates. Both policies are inflationary.
We believe that the rise of the dollar in 1983 and 1984 kept the U.S.
inflation rate two percentage points or more lower in 1985 than it otherwise
would have been with the monetary policies followed from 1980 through 1985.
With the dollar lower on foreign exchange markets now, the moderating
influence of exchange rates on U.S. inflation has ended. The Federal Reserve,
therefore, must now be more vigilant against reawakening inflationary
pressures, not less, than it was when the exchange rate was rising. Chairman
Volcker suggested as much in his testimony on February 19.

Full text of Monetary Policy Oversight : Senate Hearings : Federal Reserve's First Monetary Policy Report for 1986 : Hearing Before the Committee on Banking, Housing, and Urban Affairs, United States Senate, Ninety-Ninth Congress, Second Session

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