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FEBERAL RESERVE'S SECOND MONETARY
POLICY REPORT FOR 1982
HEARINGS
BEFORE THE
COMMITTEE ON
BANKING, HOUSING, AND URBAN AFFAIRS
UNITED STATES SENATE
NINETY-SEVENTH CONGRESS
SECOND SESSION
ON
OVERSIGHT ON THE MIDYEAR MONETARY POLICY REPORT TO
CONGRESS PURSUANT TO THE FULL EMPLOYMENT AND BALANCED GROWTH ACT OF 1978
JULY 20, 21, AND 27, 1982
Printed for the use of the Committee on Banking, Housing, and Urban Affairs
[97-68]
U.S. GOVERNMENT PRINTING OFFICE
WASHINGTON: 1982
COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
JAKE GARN, Utah, Chairman
JOHN TOWER, Texas
DONALD W. RIEGLE, JR., Michigan
JOHN HEINZ, Pennsylvania
WILLIAM PROXMIRE, Wisconsin
WILLIAM L. ARMSTRONG, Colorado
ALAN CRANSTON, California
RICHARD G. LUGAR, Indiana
PAUL S. SARBANES, Maryland
ALFONSE M. D'AMATO, New York
CHRISTOPHER J. DODD, Connecticut
JOHN H. CHAFEE, Rhode Island
ALAN J. DIXON, Illinois
HARRISON "JACK" SCHMITT, New Mexico JIM SASSER, Tennessee
NICHOLAS F. BRADY, New Jersey
M. DANNY WALL, Staff Director
ROBERT W. RUSSELL, Minority Staff Director
W. LAMAR SMITH, Economist
(H)
CONTENTS
TUESDAY, JULY 20, 1982
Pa«e
Opening statement of Chairman Garn
Opening statements of:
Senator Riegle
Senator Tower
Senator Sasser
Senator Schmitt
1
2
'S3
34
34
WITNESS
Paul A. Volcker, Chairman, Board o!' Governors of the Federal Reserve
System
Monetary and credit targets
Blend of monetary and fiscal policy
Concluding' comments
Midyear monetary policy report to Congress
Answers to subsequent written questions of Senator Schmitt
Panel discussion:
Congress blamed
Failure to meet target growth
Need for major change in policy mix
Flight of money to short-term securities
Effect of unregulated money market funds
Turned the corner on inflation
Ideas to change budget process
Poor economy causes large lasting deficits
Economic recovery predicted
Constitutional amendment
Impact of Government borrowing
Huge short-term borrowing
Administration supportive of present monetary policy
Possibilities of lower interest rates
Monetary policy counterproductive
Amendment for national economic emergencies
Small business bankruptcies
Interest rates continue to rise
Pressure on monetary policy
Same debates and arguments
Administration to stand pat on economic policy
Fed response to sinking economy
Record borrowing by the Treasury
Cutting taxes
Rash of farm foreclosures
Investors sitting on short-term money
4
6
10
11
14
79
35
36
38
41
42
44
46
48
49
50
53
53
55
57
58
60
63
64
65
67
70
72
74
77
78
78
WEDNESDAY, JULY 21, 1982
WITNESSES
Murray L. Weidenbaum, Chairman, Council of Economic Advisers
Prepared statement
Selecting a definition of money
83
85
85
IV
Murray L. Weidenbaum, Chairman, Council of Economic Advisers—Continued
Prepared statement—Continued
Setting and achieving monetary growth targets
Variability of money growth
Improved monetary control
Conclusion
Table 1—Composition of M,
Figure 1—Income velocity of money
Panel discussion:
Budget predictions constantly underestimated
Serious economic conditions
Difficult times are behind us
Time is running out
Recession bottomed out
Trillion dollar debt
Reduction of money supply
Grant item veto power to the President
Targeting interest rates
Housing bill vetoed
Bailout approach
Characterizing Fed's monetary policy
Discount rate lowered
Foreign economic growth
Frustration of politics
Letter to Senator Sarbanes regarding the growth of money and its velocity in Germany and Japan compared to the United States
Midcourse correction in economic policy
Donald E. Maude, Chief Financial Economist and Chairman, Interest Rate
Policy Committee, Financial Economic Research Department, Merrill
Lynch, Pierce, Fenner & Smith, New York, N.Y
Prepared statement
The setting
Possible reconciliation
Monthly changes in M m
M2 Growth
Monetary policy conduct considerations
Remarks
Weekly credit market bulletins
•
Credit Market Digest
Serious contradictions
M2 growing above targets
Eliminate "base drift"
Leif H. Olsen, Chairman, Economic Policy Committee, Citibank, N.A., New
York, N.Y
Prepared statement
Panel discussion:
Contemporaneous reserve adjustment
Federal deficits
Balancing the budget
Social security problem
Pa»?p
89
94
98
99
87
92
100
102
104
104
106
107
110
112
113
125
116
118
119
122
126
128
128
132
133
134
135
138
140
141
143
152
158
165
167
168
169
170
176
177
179
181
TUESDAY, JULY 27, 1982
WITNESSES
Beryl W. Sprinkel, Under Secretary of the Treasury for Monetary Affairs
Views and recommendations
Gradual deceleration of money growth
Summary of study titled "The Effect of Volatile Money Growth on Interest Rates and Economic Activity"
Curb excessive Government spending
Prepared statement
Summary
Chart I—Growth in nominal GNP and adjusted monetary growth
Chart II—Growth in Mi and the monetary base
Chart III—Short-term monetary growth and short-term interest
rates
183
184
185
189
200
202
212
214
215
216
V
Beryl W. Sprinkel, Under Secretary of trie Treasury for Monetary Affairs—
Continued
Predicting monetary growth
Federal Reserve targets
Continuous deficit
Good prospects for a recovery
Subsequent additional statement on alternative ways to reduce interest
rates
Steven M. Roberts, Director, Government Affairs, American Express Co
Monetary and fiscal policies
Recommendations
Prepared statement
Newspaper article from the Washington Post entitled, "Companies
Rushing to Borrow Funds"
Testimony of Benjamin M. Friedman, professor of economics, Harvard University, before the House Committee on Banking, Finance
and Urban Affairs
Proposal for fiscal responsibility and lower interest rates
Proposed joint resolution to reduce total Federal outlays as a share oi'
GNP
Analysis of the proposed joint resolution
Controlling total net credit
Comparing M, after 5 years
Adjusting prime rates to cost of funds
Problem controlling target for Mi
Answers to subsequent written questions of Senator Riegle
Reprint of paper by Alan Reynolds titled "The Trouble With Monetarism"
Pa
w
217
21!)
219
222
224
225
225
226
227
247
248
262
269
270
271
272
273
275
278
282
ADDITIONAL MATERIAL RECEIVED FOR THE RECORD
Statement by Jack Carlson, vice president and chief economist, National
Association of Realtors
306
FEDERAL RESERVE'S SECOND MONETARY
POLICY REPORT FOR 1982
TUESDAY, JULY 20, 1982
U.S. SENATE,
COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS,
Washington, D.C.
The committee met at 9:30 a.m. in room 5302 of the Dirksen
Senate Office Building, Senator Jake Garn (chairman of the committee) presiding.
Present: Senators Garn, Tower, Lugar, Chafee, Schmitt, Brady,
Riegle, Proxmire, Cranston, Sarbanes, Dixon, and Sasser.
The CHAIRMAN. The Banking Committee will come to order.
Chairman Volcker, we are happy to have you with us this morning, to hear your report on monetary policy. I hope that we will be
able to have a discussion with members of the Banking Committee
that avoids a lot of rhetoric, as we discuss the current condition of
the U.S. economy, together with the appropriateness of recent prospective monetary policies.
To have a constructive discussion, we must not ignore the very
real economic challenges that we face. Constructive discussion,
however, will also require that we not ignore the equally real progress that has been made since we began our efforts to slow inflation and curtail the government's growth rate—less than 19
months ago.
Mr. Chairman, in the interest of time—we came to hear you
today—and I would put the balance of my comments in the record,
and turn to Senator Riegle for any comments that he might have
before you begin, and then to Senator Dixon.
OPENING STATEMENT OF CHAIRMAN GARN
The CHAIRMAN. I hope that we will be able to avoid rhetoric this
morning as we discuss the current condition of the U.S. economy
together with the appropriateness of recent and prospective monetary policy. To have a constructive discussion, we must not ignore
the very real economic challenges we face. A constructive discussion, however, will also require that we will also require that we
not ignore the equally real progress that has been made since we
began our efforts to slow inflation and curtail government's growth
rate less than 19 months ago.
Certainly, our greatest success has been in combatting what was
acknowledged to be our country's No. 1 economic problem when
Ronald Reagan was elected President. During the 6 months prior
to his inauguration, consumer prices rose at a 10.3-percent annual
(i)
rate. Over the last 6 months, consumer prices have risen at an
annual rate of only 3.7 percent.
By holding firm to a commitment to gradually slow the monetary aggregates' growth rate, the Federal Reserve has played a central role in the successful fight against inflation.
With inflation down, our greatest current challenge is to hasten
a decline in interest rates so that the job-creating potential of our
economy can be released.
Today I applaud the Federal Reserve's commitment to removing
money-growth volatility as a contributor to high rates, as evidenced
by your decision to try to use contemporaneous reserve accounting
to improve your short-term control over the aggregates.
Nevertheless, I remain convinced that it is the Congress that is
primarily to blame for the failure of interest rates to decline as
quickly as inflation. The first budget resolution which we recently
passed calls for steadily declining Federal deficit in the years
ahead: $104 billion in fiscal year 1983; $84 billion in fiscal year
1984; and $60 billion in fiscal year 1985.
But of the $281 billion in spending cuts that will be necessary
over the next 3 years to achieve these declining deficits, only $27
billion—less than 10 percent—have been reconciled or enacted into
law.
Is it any wonder that the financial markets have remained skeptical—as evidenced by the stickiness of interest rates—of Congress
ability to make the budget cuts called for in the budget resolution?
Still, I began this statement with a call for a constructive discussion, one that acknowledges accomplishments as well as remaining
problems. In this spirit, we must acknowledge that an important
start has been made toward lowering interest rates.
In the 4 years before Ronald Reagan began charting a new economic future, rates rose steadily. From an average of only 4.4 percent in December 1976, the yield on 3-month Treasury bills rose to:
6.1 percent in December 1977; 9.1 percent in December 1978; 12.1
percent in December 1979; and 15.7 percent in December 1980.
Yesterday that rate had come back down to just over 11 percent.
Similarly, while the prime rate has not declined nearly enough, it
is down substantially from the 21.5 percent Ronald Reagan inherited.
From much of what you hear and read today, you might think
rates were up—instead of down—from where they were 19 months
ago.
In conclusion, I again call for a discussion that does not fail to
confront problems head-on and also does not fail to give credit
where credit is due.
OPENING STATEMENT OF SENATOR RIEGLE
Senator RIEGLE. Thank you, Mr. Chairman.
Mr. Volcker, it's good to have you back before the committee
today.
As I have had the chance to talk with leading financial and economic people across the country, business people, labor people, and
citizens at the grassroots level, it's clear from everything I am
hearing that the economy is in very, very serious trouble.
If I were to try to assess the bottom line, of what I'm hearing
from this cross-section of opinion in the country, it is that the country now, economically, seems to be on a disaster course, unless
major changes are made, unless the Federal deficits come down,
and come down substantially, unless the interest rates come down,
and come down substantially and stay down for a period of time;
that unless these things are done, we are going to find ourselves in
a situation where unemployment will go higher, the rate of bankruptcies—which is running at 550 firms a week—would likely go
higher.
We've got a number of interest rate-sensitive sectors of the economy in terrible difficulty. Certainly the savings and loan industry
is in that situation. Agriculture and farming are increasingly in
that situation. The auto industry is at less than 50 percent of capacity operation. The steel industry is running at about 40 percent
of capacity. The construction and the real estate industries are devastated.
The headline today, on the front of the business section of the
Washington Post, indicates that housing starts declined 15.3 percent from May—and we're now facing the worst year for housing
in the United States since World War II.
Capital investment plans have dropped off.
If we consider all of this information, it shows that we are really
in extremely serious trouble. The question is: How are we going to
change this?
What is the Fed doing to change it?
What are you saying in your conversations with the President?
What is his response to you?
Are we going to be able to get these rates down?
Are they going to come down soon?
Will they come down enough to make a difference?
And if not, then what is our contingency plan?
If we stay on this course and the damage and the destruction and
the hardship continue to accumulate, then the question is: How do
we propose to treat those problems, which are mounting every day,
in every place that we look?
We have over 10.5 million people out of work in the country; and
that does not count another IVfe million that are no longer included
in the statistics because they have lost their unemployment benefits.
So, the situation is really at a desperate point. I'm going to be
very interested to hear both your assessment of the seriousness of
the problem and how you feel that the Fed and the rest of us can
change these policies and improve the picture as it now appears.
The CHAIRMAN. Senator Brady, do you have any comments you
wish to make?
Senator BRADY. No comments, thank you, Mr. Chairman.
The CHAIRMAN. Senator Dixon.
Senator DIXON. Mr. Chairman, I will make my statement after
the witness has concluded.
The CHAIRMAN. Chairman Volcker, it is yours.
STATEMENT OF PAUL A. VOLCKER, CHAIRMAN, BOARD OF
GOVERNORS OF THE FEDERAL RESERVE SYSTEM
Mr. VOLCKER. Mr. Chairman, I am pleased to have this opportunity once again to discuss monetary policy with you, within the
context of recent and prospective economic developments.
As usual on these occasions, you have the Board of Governors'
Humphrey-Hawkins report before you. This morning I want to enlarge upon some aspects of that report and amplify as fully as I can
my thinking with respect to the period ahead.
In assessing the current economic situation, I believe the comments I made 5 months ago remain relevant. Without repeating
that analysis in detail, I would emphasize that we stand at an important crossroads for the economy and economic policy.
In these past 2 years, we have traveled a considerable way
toward reversing the inflationary trend of the previous decade or
more.
I would recall to you that, by the late 1970's, that trend had
shown every sign of feeding upon itself and tending to accelerate to
the point where it threatened to undermine the foundations of our
economy. Dealing with inflation was accepted as a top national priority, and, as events developed, that task fell almost entirely to
monetary policy.
In the best of circumstances, changing entrenched patterns of inflationary behavior and expectations—in financial markets, in the
practices of business and financial institutions, and in labor negotiations—is a difficult and potentially painful process. Those, consciously or not, who have come to bet on rising prices and the
ready availability of relatively cheap credit to mask the risks of
rising costs, poor productivity, aggressive lending, or overextended
financial positions, have found themselves in a particularly difficult position.
The pressures on financial markets and interest rates have been
aggravated by concern's over prospective huge volumes of Treasury
financing, and by the need of some businesses to borrow at a time
of a severe squeeze on profits. Lags in the adjustment of nominal
wages and other costs to the prospects for sharply reduced inflation
are perhaps inevitable, but have the effect of prolonging the pressure on profits—and indirectly on financial markets and employment.
Remaining doubts and skepticism that public policy will carry
through on the effort to restore stability also affect interest rates,
perhaps most particularly in the longer term markets.
In fact, the evidence now seems to me strong that the inflationary tide has turned in a fundamental way. In stating that, I do not
rely entirely on the exceptionally favorable consumer and producer
price data thus far this year, when the recorded rates of price increase, at annual rates, declined to SMj and 2V2 percent, respectively. That apparent improvement was magnified by some factors
likely to prove temporary, including, of course, the intensity of the
recession; those price indexes are likely to appear somewhat less
favorable in the second half of the year.
What seems to me more important for the longer run is that the
trend of underlying costs and nominal wages has begun to move
lower, and that trend should be sustainable as the economy recovers upward momentum. While less easy to identify—labor productivity typically does poorly during periods of business decline—
there are encouraging signs that both management and workers
are giving more intense attention to the effort to improve productivity. That effort should pay off in a period of business expansion,
helping to hold down costs and encouraging a revival of profits, setting the stage for the sustained growth in real income we want.
I am acutely aware that these gains against inflation have been
achieved in a context of serious recession. Millions of workers are
unemployed, many businesses are hard pressed to maintain profitability, and business bankruptcies are at a postwar high.
While it is true that some of the hardship can reasonably be
traced to mistakes in management or personal judgment, including
presumptions that inflation would continue, large areas of the
country and sectors of the economy have been swept up in more
generalized difficulty. Our financial system has great strength and
resiliency, but particular points of strain have been evident.
Quite obviously, a successful program to deal with inflation, with
productivity, and with the other economic and social problems we
face cannot be built on a crumbling foundation of continuing recession. As you know, there have been some indications—most broadly
reflected in the rough stability of the real GNP in the second quarter and small increases in the leading indicators—that the downward adjustments may be drawing to a close. The tax reduction effective July 1, higher social security payments, rising defense
spending and orders, and the reductions in inventory already
achieved, all tend to support the generally held view among economists that some recovery is likely in the second half of the year.
I am also conscious of the fact that the leveling off of the GNP
has masked continuing weakness in important sectors of the economy. In its early stages, the prospective recovery must be led largely
by consumer spending. But to be sustained over time, and to support continuing growth in productivity and living standards, more
investment will be necessary.
At present, as you know, business investment is moving lower.
House building has remained at depressed levels; despite some
small gains in starts during the spring, the cyclical strength
normal in that industry in the early stages of recovery is lacking.
Exports have been adversely affected by the relative strength of
the dollar in exchange markets.
I must also emphasize that the current problems of the American economy have strong parallels abroad. Governments around
the world have faced, in greater or lesser degree, both inflationary
and fiscal problems. As they have come to grips with those problems, growth has been slow or nonexistent, and the recessionary
tendencies in various countries have fed back, one on another.
In sum, we are in a situation that obviously warrants concern,
but also has great opportunities. Those opportunities lie in major
part in achieving lasting progress—in pinning down and extending
what has already been achieved—toward price stability. In doing
so, we will be laying the base for sustaining recovery over many
years ahead, and for much lower interest rates, even as the economy grows.
6
Conversely, to fail in that task now, when so much headway has
been made, could only greatly complicate the problems of the economy over time. I find it difficult to suggest when and how a credible attack could be renewed on inflation should we neglect completing the job now. Certainly the doubts and skepticism about our capacity to deal with inflation—which now seems to be yielding—
would be amplified, with unfortunate consequences for financial
markets and ultimately for the economy.
I am certain that many of the questions, concerns, and dangers
in your mind lie in the short run—and that those in good part revolve around the pressures in financial markets. Can we look forward to lower interest rates to support the expansion in investment and housing as the recovery takes hold? Is there, in fact,
enough liquidity in the economy to support expansion—but not so
much that inflation is reignited? Will, in fact, the economy follow
the recovery path so widely forecast in coming months?
These are the' questions that we in the Federal Reserve must
deal with in setting monetary policy. As we approach these policy
decisions, we are particularly conscious of the fact that monetary
policy, however important, is only one instrument of economic
policy. Success in reaching our common objective of a strong and
prosperous economy depends upon more than appropriate monetary policies, and I will touch this morning on what seems to me
appropriately complementary policies in the public and private sectors.
THE MONETARY TARGETS
Five months ago, in presenting our monetary and credit targets
for 1982, I noted some unusual factors could be at work tending to
increase the desire of individuals and businesses to hold assets in
the relatively liquid forms encompassed in the various definitions
of money. Partly for that reason—and recognizing that the conventional base for the Mi target of the fourth quarter of 1981 was relatively low—I indicated that the Federal Open Market Committee
contemplated growth toward the upper ends of the specified
ranges. Given the bulge early in the year in Mi, the committee also
contemplated that that particular measure of money might for
some months remain above a straight line projection of the targeted range from the fourth quarter of 1981 to the fourth quarter of
1982.
As events developed, Mi and M 2 both remained somewhat above
straight line paths until very recently. M3 and bank credit have remained generally within the indicated range, although close to the
upper ends. See table I. Taking the latest full month of June, Mi
grew 5.6 percent from the base period and M2 9.4 percent, close to
the top of the ranges. To the second quarter as a whole, the growth
was higher, at 6.8 and 9.7 percent, respectively. Looked at on a
year-over-year basis, which appropriately tends to average through
volatile monthly and quarterly
figures, Mi during the first half of
1982 averaged about 43A percent above the first half of 1981, after
accounting for NOW account shifts early last year. On the same
basis, Mz and M3 grew by 9.7 and 10.5 percent, respectively, a rate
of growth distinctly faster than the nominal GNP over the same
interval.
In conducting policy during this period, the committee was sensitive to indications that the desire of individuals and others for liquidity was unusually high, apparently reflecting concerns and uncertainties about the business and financial situation. One reflection of that may be found in unusually large declines in velocity
over the period—that is, the ratio of measures of money to the
gross national product. Mi velocity—particularly for periods as
short as 3 to 6 months—is historically volatile. A cyclical tendency
to slow, relative to its upward trend, during recessions is common.
But an actual decline for two consecutive quarters, as happened
late in 1981 and the first quarter of 1982, is rather unusual. The
magnitude of the decline during the first quarter was larger than
in any quarter of the entire postwar period. Moreover, declines in
velocity of this magnitude and duration are often accompanied by,
and are related to, reduced short-term interest rates. Those interest
rate levels during the first half of 1982 were distinctly lower than
during much of 1980 and 1981, but they rose above the levels
reached in the closing months of last year.
More direct evidence of the desire for liquidity or precautionary
balances affecting Mi can be found in the behavior of NOW accounts. As you know, NOW accounts are a relatively new instrument, and we have no experience of behavior over the course of a
full business cycle. We do know that NOW accounts are essentially
confined to individuals, their turnover relative to demand accounts
is relatively low, and, from the standpoint of the owner, they have
some of the characteristics of savings deposits, including a similarly low interest rate but easy access on demand. We also know the
great bulk of the increase in Mi during the early part of the year—
almost 90 percent of the rise from the fourth quarter of 1981 to the
second quarter of 1982—was concentrated in NOW accounts, even
though only about one-fifth of total Mi is held in that form. In contrast to the steep downward trend in low-interest savings accounts
in recent years, savings account holdings have stabilized or even
increased in 1982, suggesting the importance of a high degree of liquidity to many individuals in allocating their funds. A similar
tendency to hold more savings deposits has been observed in earlier
recessions.
I would add that the financial and liquidity positions of the
household sector of the economy, as measured by conventional
liquid asset and debt ratios, has improved during the recession
period. Relative to income, debt repayment burdens have declined
to the lowest level since 1976. Trends among business firms are
clearly mixed. While many individual firms are under strong pressure, some rise in liquid asset holdings for the corporate sector as a
whole appears to be developing. The gap between internal cash
flow—that is, retained earnings and depreciation allowances—and
spending for plant, equipment, and inventory has also been at a
historically low level, suggesting that a portion of recent business
credit demands is designed to bolster liquidity. But, for many years
business liquidity ratios have tended to decline, and balance sheet
ratios have reflected more dependence on short-term debt. In that
perspective, any recent gains in liquidity appear small.
In the light of the evidence of the desire to hold more NOW accounts and other liquid balances for precautionary rather than
transaction purposes during the months of recession, strong efforts
to reduce further the growth rate of the monetary aggregates appeared inappropriate. Such an effort would have required more
pressure on bank reserve positions—and presumably more pressures on the money markets and interest rates in the short run. At
the same time, an unrestrained buildup of money and liquidity
clearly would have been inconsistent with the effort to sustain
progress against inflation, both because liquidity demands could
shift quickly and because our policy intentions could easily have
been misconstrued. Periods of velocity decline over a quarter or
two are typically followed by periods of relatively rapid increase.
Those increases tend to be particularly large during cyclical recoveries. Indeed, velocity appears to have risen slightly during the
second quarter, and the growth in NOW accounts has slowed.
Judgments on these seemingly technical considerations inevitably take on considerable importance in the target-setting process
because the economic and financial consequences—including the
consequences for interest rates—of a particular Mi or M2 increase
are dependent on the demand for money. Over longer periods, a
certain stability in velocity trends can be observed, but there is a
noticeable cyclical pattern. Taking account of those normal historical relationships, the various targets established at the beginning
of the year were calculated to be consistent with economic recovery
in a context of declining inflation. That remains our judgment
today. Inflation has, in fact, receded more rapidly than anticipated
at the start of the year potentially leaving more room for real
growth. On that basis, the targets established early in the year still
appeared broadly appropriate, and the Federal Open Market Committee decided at its recent meeting not to change them at this
time.
However, the committee also felt, in the light of developments
during the first half, that growth around the top of those ranges
would be fully acceptable. Moreover—and I would emphasize this—
growth somewhat above the targeted ranges would be tolerated for
a time in circumstances in which it appeared that precautionary or
liquidity motivations, during a period of economic uncertainty and
turbulence, were leading to stronger than anticipated demands for
money.
We will look to a variety of factors in reaching that judgment,
including such technical factors as the behavior of different components in the money supply, the growth of credit, the behavior of
banking and financial markets, and, more broadly, the behavior of
velocity and interest rates.
I believe it is timely for me to add that, in these circumstances,
the Federal Reserve should not be expected to respond, and does
not plan to respond, strongly to various bulges—or for that matter
valleys—in monetary growth that seem likely to be temporary. As
we have emphasized in the past, the data are subject to a good deal
of statistical noise in any circumstances, and at times when de
9
mands for money and liquidity may be exceptionally volatile,
more
than usual caution is necessary in responding to blips.1
We, of course, have a concrete instance at hand of a relatively
large—and widely anticipated—jump in Mi in the first week of
July—possibly influenced to some degree by larger social security
payments just before a long weekend. Following as it did a succession of money supply declines, that increase brought the most
recent level for Mi barely above the June average, and it is not of
concern to us.
It is in this context, and in view of recent declines in short-term
market interest rates, that the Federal
Reserve yesterday reduced
the basic discount rate from 12 to \\l/z percent.
In looking ahead to 1983, the Open Market Committee agreed
that a decision at this time would—even more obviously than
usual—need to be reviewed at the start of the year in light of all
the evidence as to the behavior of velocity or money and liquidity
demand during the current year. Apart from the cyclical influences
now at work, the possibility will need to be evaluated of a more
lasting change in the trend of velocity.
The persistent rise in velocity during the past 20 years has been
accompanied by rising inflation and interest rates—both factors
that encourage economization of cash balances. In addition, technological change in banking—spurred in considerable part by the
availability of computers—has made it technically feasible to do
more and more business on a proportionately smaller cash base.
With incentives strong to minimize holdings of cash balances that
bear no or low interest rates, and given the technical feasibility to
do so, turnover of demand deposits has reached an annual rate of
more than 300, quadruple the rate 10 years ago. Technological
change is continuing, and changes in regulation and bank practices
are likely to permit still more economization of Mi-type balances.
However, lower rates of interest and inflation should moderate incentives to exploit that technology fully. In those conditions, velocity growth could slow, or conceivably at some point stop;
To conclude that the trend has, in fact, changed would clearly be
premature, but it is a matter we will want to evaluate carefully as
time passes. For now, the committee felt that the existing targets
should be tentatively retained for next year. Since we expect to be
around the top end of the ranges this year, those tentative targets
would, of course, be fully consistent with somewhat slower growth
in the monetary aggregates in 1983. Such a target would be appropriate on the assumption of a more or less normal, cyclical rise in
velocity. With inflation declining, the tentative targets would
appear consistent with, and should support, continuing recovery at
a moderate pace.
1
In that connection, a number of observers have noted that the first month of a calendar
quarter—most noticeably in January and April—sometimes shows an extraordinarily large increase in M,—amplified by the common practice of multiplying the actual change by 12 to show
an annual rate. Those bulges, more typically than not, are partially washed out by slower than
normal growth the following month. The standard seasonal adjustment techniques we use to
smooth out monthly money supply variations—indeed, any standard techniques—may, in fact,
be incapable of keeping up with rapidly changing patterns of financial behavior, as they affect
seasonal patterns. A note attached to this statement sets forth some work in process developing
new seasonal adjustment techniques.
10
BLEND OF MONETARY AND FISCAL POLICY
The Congress, in adopting a budget resolution contemplating cuts
in expenditures and some new revenues, also called upon the Federal Reserve to "reevaluate its monetary targets in order to assure
that they are fully complementary to a new and more restrained
fiscal policy." I can report that members of the committee welcomed the determination of the Congress to achieve greater fiscal
restraint, and I want particularly to recognize the leadership of
members of the Budget Committees and others in achieving that
result. In most difficult circumstances, progress is being made
toward reducing the huge potential gap between receipts and expenditures. But I would be less than candid if I did not also report
a strong sense that considerably more remains to be done to bring
the deficit under control as the economy expands. The fiscal situation, as we appraise it, continues to carry the implicit threat of
crowding out business investment and housing as the economy
grows—a process that would involve interest rates substantially
higher than would otherwise be the case. For the more immediate
future, we recognized that the need remains to convert the intentions expressed in the budget resolution into concrete legislative
action.
In commenting on the budget, I would distinguish sharply between the cyclical and structural deficit—that is, the portion of the
deficit reflecting an imbalance between receipts and expenditures
even in a satisfactorily growing economy with declining inflation.
To the extent the deficit turns out to be larger than contemplated
entirely because of a shortfall in economic growth, that add on
would not be a source of so much concern. But the hard fact remains that, if the objectives of the budget resolution are fully
reached, the deficit would be about as large in fiscal 1983 as this
year, even as the economy expands at a rate of 4 to 5 percent a
year and inflation—and thus inflation-generated revenues—remains higher than members of the Open Market Committee now
expect.
In considering the question posed by the budget resolution, the
Open Market Committee felt that full success in the budgetary
effort should itself be a factor contributing to lower interest rates
and reduced strains in financial markets. It would thus assist importantly in the common effort to reduce inflationary pressures in
the context of a growing economy. By relieving concern about
future financing volume and inflationary expectations, I believe, as
a practial matter, a credibly firmer budget posture might permit a
degree of greater flexibility in the actual short-term execution of
monetary policy without arousing inflationary fears. Specifically,
market anxiety that shortrun increases in the Ms might presage
continuing monetization of the debt could be ameliorated. But any
gains in these respects will, of course, be dependent on firmness in
implementing the intentions set forth in the resolution and on encouraging confidence among borrowers and investors that the
effort will be sustained and reinforced in coming years.
Taking account of all these considerations, the committee did not
feel that the budgetary effort, important as it is, would in itself appropriately justify still greater growth in the monetary aggregates
11
over time than I have anticipated. Indeed, excessive monetary
growth—and perceptions thereof—would undercut any benefits
from the budgetary effort with respect to inflationary expectations.
We believe fiscal restraint should be viewed more as an important
complement to appropriately disciplined monetary policy than as a
substitute.
CONCLUDING COMMENTS
In an ideal world, less exclusive reliance on monetary policy to
deal with inflation would no doubt have eased the strains and high
interest rates that plague the economy and financial markets
today. To the extent the fiscal process can now be brought more
fully to bear on the problem, the better off we will be—the more
assurance we will have that interest rates will decline and keep declining during the period of recovery, and that we will be able to
support the increases in investment and housing essential to
healthy, sustained recovery. Efforts in the private sector—to increase productivity, to reduce costs, and to avoid inflationary and
job-threatening wage increases—are also vital, even though the
connection between the actions of individual firms and workers
and the performance of the economy may not always be self-evident to the decisionmakers. We know progress is being made in
these areas, and more progress will hasten full and strong expansion.
But we also know that we do not live in an ideal world. There is
strong resistance to changing patterns of behavior and expectations
ingrained over years of inflation. The slower the progress on the
budget, the more industry and labor build in cost increases in anticipationg of inflation or Government acts to protect markets or
impede competition, the more highly speculative financing is undertaken, the greater the threat that available supplies of money
and credit will be exhausted in financing rising prices instead of
new jobs and growth. Those in vulnerable, competitive positions
are most likely to feel the impact first and hardest, but unfortunately the difficulties spread over the economic landscape.
The hard fact remains that we cannot escape those dilemmas by
a decision to give up the fight on inflation—by declaring the battle
won before it is. Such an approach would be transparently clear—
not just to you and me— but to the investors, the businessmen, and
the workers, who would, once again, find their suspicions confirmed that they had better prepare to live with inflation and try
to keep ahead of it. The reactions in financial markets and other
sectors of the economy would, in the end, aggravate our problems,
not eliminate them. It would strike me as the cruelest blow of all
to the millions who have felt the pain of recession directly to suggest, in effect, it was all in vain.
I recognize months of recession and high interest rates have contributed to a sense of uncertainty. Businesses have postponed investment plans. Financial pressures have exposed lax practices and
stretched balance-sheet positions in some institutions—financial as
well as nonfinancial. The earnings position of the thrift industry
remains poor.
12
But none of those problems can be dealt with successfully by
reinflation or by a lack of individual discipline. It is precisely that
environment that contributed so much to the current difficulties.
In contrast, we are now seeing new attitudes of cost containment
and productivity growth—and ultimately our industry will be in a
more robust competitive position. Millions are benefiting from less
rapid price increases—or acutally lower prices—at their shopping
centers and elsewhere. Consumer spending appears to be moving
ahead and inventory reductions help set the stage for production
increases.
Those are developments that should help recovery get firmly underway. The process of disinflation has enough momentum to be
sustained during the early stages of recovery—and that success can
breed further success as concerns about inflation recede. As recovery starts, the cash flow of business should improve. And, more
confidence should encourage greater willingness among investors
to purchase longer debt maturities. Those factors should, in turn,
work toward reducing interest rates, and sustaining them at lower
levels, encouraging in turn the revival of investment and housing
we want.
I have indicated the Federal Reserve is sensitive to the special
liquidity pressures that could develop during the current period of
uncertainty.
Moreover, the basic solidity of our financial system is backstopped by a strong structure of governmental institutions precisely designed to cope with the secondary effects of isolated failures.
The recent problems related largely to the speculative activities of
a few highly leveraged firms can and will be contained. And over
time, an appropriate sense of prudence in taking risks will serve us
well.
We have been through—we are in—a trying period. But too
much has been accomplished not to move ahead and complete the
job of laying the groundwork for a much stronger economy. As we
look forward, not just to the next few months but to long years, the
rewards will be great: In renewed stability, in growth, and in
higher employment and standards of living.
That vision will not be accomplished by monetary policy alone.
But we mean to do our part.
[Additional material received from the Federal Reserve Board
follows:]
TABLE I.—TARGETED AND ACTUAL GROWTH OF MONEY AND BANK CREDIT
[Percent changes, at seasonally adjusted annual rates]
Actual growth
13
APPENDIX—ALTERNATIVE SEASONAL ADJUSTMENT PROCEDURE
For some time the Federal Reserve has been investigating ways to improve its
procedures for seasonal adjustment, particularly as they apply to the monetary aggregates. In June of last year, a group of prominent outside experts, asked by the
Board1 to examine seasonal adjustment techniques, submitted their recommendations. The committee suggested, among other things, that the Board's staff develop
seasonal factor estimates from a model-based procedure as an alternative to the
widely used X-ll technique that provides the basis for the current seasonal adjustment procedure,^ and release the results.
The Board staff has been developing a procedure using statistical models tailored
to each individual series.n The table on the last page compares monthly and quarterly average growth rates for the current Mi series with those of an alternative
series from the model-based approach.
Differences in seasonal adjustment techniques do not change the trend in monetary growth, but, as may be seen in the table, they do alter month-to-month growth
rates owing to differing estimates of the distribution over time of the seasonal component in money behavior. Shortrun money growth is variable under both the alternative and current techniques of seasonal adjustment, illustrating the inherentlylarge "noise" component of the series. However, the redistribution of the seasonal
component under the alternative technique does on average tend to moderate
month-to-rnonth changes somewhat.
The Board will continue to publish seasonally adjusted estimates for Mi on both
current and alternative bases at least until the annual review of seasonal factors in
1988. A detailed description of the alternative method will be available shortly.
GROWTH RATES OF M, USING CURRENT 1 AND ALTERNATIVE 2 SEASONAL ADJUSTMENT
PROCEDURES
1981
1982
' See Committee of Experts on Seasonal Adjustment Techniques, Seasonal Adjustment of the
Monetary
Aggregates (Board of Governors of the Federal Reserve System, October 1981).
2
The current seasonal adjustment technique has most recently been summarized in the description to the mimeograph release of historical money stock data dated March 1982. Detailed
descriptions of the X-ll program and variants can be obtained from technical paper No. 15 of
the U.S. Department of Commerce (revised February I9B7i and from the report to the Board
cited
in footnote 1.
-1 The model-based seasonal adjustment procedures currently under review by the Board staff
use methods based on the well-developed theory of statistical regression and time series modeling. These approaches allow development of seasonal factors that are more sensitive than the
current Factors to unique characteristics of each series, including, for example, fixed and evolving seasonal patterns, trading day effects, within-month seasonal variations, holiday effects, outlier adjustments, special events adjustments (such as the 1980 credit controls experience), and
serially correlated noise components.
14
GROWTH RATES OF Mi USING CURRENT' AND ALTERNATIVE a SEASONAL ADJUSTMENT
PROCEDURES—Continued
[Monthly ai'e'iige
June..
percenl annual rates]
16
BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM—MIDYEAR MONETARY POLICY
REPORT TO CONGRESS PURSUANT TO THE FULL EMPLOYMENT AND BALANCED
GROWTH ACT OF 1978
BOARD OF GOVERNORS OF THE
FEDERAL RESERVE SYSTEM,
Washington. D.C., July JO, W8J.
The PRESIDENT OF THE SENATE,
The SPEAKER OF THE HOUSE OF REPRESENTATIVES,
Washington. D.C.
The Board of Governors is pleased to submit its Midyear Monetary Policy Report
to the Congress pursuant to the Full Employment and Balanced Growth Act of 1978.
Sincerely,
PAUL A. VOLCKER, Chairman.
SECTION l: THE PERFORMANCE OF THE ECONOMY IN THE FIRST HALF OF
1982
The contraction in economic activity that began in mid-1981 continued into the
first half of 1982, although at a diminished pace. Declines in production and employment slowed, while sales of automobiles improved. Real GNP fell at a 4 percent
annual rate between the third quarter of 1981 and the first quarter of 1982. With
output declining, the margin of unused plant capacity widened and the unemployment rate rose to a postwar record.
By mid-1982, however, the recession seemed to be drawing to a close. Inventory
positions had improved substantially, homebuilding was beginning to revive, and
consumer spending appeared to be rising. Nonetheless, there were signs of increased
weakness in business investment. Although final demands apparently fell during
the second quarter, the rate of inventory liquidation slowed, and on balance, real
GNP apparently changed little. If, in fact, this spring or early summer is determined to have been the cyclical trough, both the depth and duration of the decline
in activity will have been about the same as in other postwar recessions.
The progress in reducing inflation that began during 1981 continued in the first
half of 1982. The greatest improvement was in prices of food and energy—which
benefited from favorable supply conditions—but increases in price measures that exclude these volatile items also have slowed markedly. Moreover, increases in employment costs, which carry forward the momentum of inflation, have diminished
considerably. Not only have wage increases eased for union workers in hardpressed
industries as a result of contract concessions, but wage and fringe benefit increases
also have slowed for non-union and white-collar workers in a broad range of industries. In addition there has been increasing use of negotiated work-rule changes as
15
well as other efforts by business to enhance productivity and trim costs. At the
same time, purchasing power has been rising; real compensation per hour increased
1 percent during 1981 and rose at about a 3 percent annual rate over the first half
of 1982.
16
Industrial Production
Index, 1967= 100
150
140
130
1978
1980
1982
Real GNP
Change from end of previous period, annual rale, percent
1972 Dollars
nr
HI
1978
H2
1980
HI
1982
Gross Business Product Prices
Change (com end ol previous period, annual rate, percent
Fixed-weighted Index
H1
1978
1980
Note Dala lor 19S2 H1 are partially estimated by the FRB
H2
Ml
1982
17
Interest rates
As the recession developed in the autumn of 1981, short-term interest rates moved
down substantially. However, part of this decline was retraced at the turn of the
year as the demand for money bulged and reserve positions tightened. After the
middle of the first quarter, short-term rates fluctuated but generally trended downward, as money—particularly the narrow measure, Mi—grew slowly on average and
the weakness in economic activity continued. In mid-July, short-term rates were distinctly below the peak levels reached in 1980 and 1981. Nonetheless, short-term
rates were still quite high relative to the rate of inflation.
Long-term interest rates also remained high during the first half of 1982. In part,
this reflected doubts by market participants that the improved price performance
would be sustained over the longer run. This skepticism was related to the fact that,
during the past two decades, episodes of reduced inflation have been short-lived, followed by reacceleration to even faster rates of price increase. High long-term rates
also have been fostered by the prospect of huge deficits in the federal budget even
as the economy recovers. Fears of deepening deficits have affected expectations of
future credit market pressures, and perhaps also have sustained inflation expectations. The resolution on the 1983 fiscal year budget that was adopted by the Congress represents a beginning effort to deal with the prospect of widening deficits;
and the passage of implementing legislation should work in the direction of reducing market pressures on interest rates.
18
Interest Rates
Percent
—
1978
1980
6
1982
Funds Raised by Private Nonfinancial Sectors
Seasonally adjusted, annual rate, billions of dollars
300
200
1980
1982
Federal Government Borrowing
Seasonally ad|usted, annual rate, billions of dollars
Combined Deficit Financed by the Public
120
80
40
1978
1980
Note Data for 19B2 H1 are partially estimated by the FHB
1982
19
Domestic credit flows
Aggregate credit flows to private non-financial borrowers increased somewhat in
the first half of 1982 from the reduced pace in the second half of 1981, according to
very preliminary estimates. Business borrowing rose while households reduced further their use of credit. Borrowing by the federal government increased sharply in
late 1981, after the 5 percent cut in personal income tax rates, and remained near
the new higher level during the first half of 1982 on a seasonally adjusted basis.
Reflecting uncertainties about the future economic and financial environment, both
lenders and borrowers have shown a strong preference for short-term instruments.
Much of the slackening in credit flows to nonfinancial sectors in the last part of
1981 was accounted for by households, particularly by household mortgage borrowing. Since then, mortgage credit flows have picked up slightly. The advance was encouraged in part by the gradual decline in mortgage rates from the peaks of last
fall. In addition, households have made widespread use of adjustable-rate mortgages
and "creative" financing techniques—including relatively short-term loans made by
sellers at below-market interest rates and builder "buy-downs." About two-fifths of
all conventional mortgage loans closed recently were adjustable-rate instruments,
and nearly three-fourths of existing home transactions reportedly involved some
sort of creative financing.
Business borrowing dropped sharply during the last quarter of 1981, primarily reflecting reduced inventory financing needs. However, credit use by nonfinancial corporations rose significantly in the first half of 1982, despite a further drop in capital
expenditures. The high level of bond rates has discouraged corporations from issuing long-term debt, and a relatively large share of business borrowing this year has
been accomplished in short-term markets—at banks and through sales of commercial paper. The persistently large volume of business borrowing suggests an accumulation of liquid assets as well as an intensification of financial pressures on at least
some firms. Signs of corporate stress continue to mount, including increasing numbers of dividend reductions or suspensions, a rising fraction of business loans at
commercial banks with interest or principal past due, and relatively frequent downgradings of credit ratings.
After raising a record volume of funds in U.S. credit markets in 1981, the federal
government continued to borrow at an extraordinary pace during the first half of
1982, as receipts (national income and product accounts basis) fell while expenditures continued to rise. Owing to the second phase of the tax cut that went into
effect on July 1 and the effects on tax revenues of the recession and reduced inflation, federal credit demands will expand further in the period ahead.
Consumption
Personal consumption expenditures (adjusted for inflation) fell sharply in the
fourth quarter of 1981, but turned up early in 1982 and apparently strengthened
further during the second quarter. The weakness in consumer outlays during the
fourth quarter was concentrated in the auto sector, as total sales fell to an annual
rate of 7.4 million units—the lowest quarterly figure in more than a decade—and
sales of domestic models plummeted to a 5.1 million unit rate.
20
Real Income and Consumption
Change Irom end ol previous period, annual rate, percent
[T|] Real Disposable Personal Income
P~] Real Personal Consumption Expenditures
HI
H2
M1
1980
1978
1982
Real Business Fixed Investment
Change from end of previous period, annual rate, percent
Producers' Durable Equipment
Structures
' 20
10
H1
1978
1980
H2
H1
1982
Total Private Housing Starts
Millions ot units
2.0
1.5
1.0
1978
1980
Note; Data for 1 962 HI are partially estimated by trie FAB
1982
21
Price rebates and other sales promotion programs during the early months of
1982 provided a fillip to auto demand, and sales climbed to an 8.1 million unit rate.
Auto markets remained firm into the spring, boosted in part by various purchase
incentives. But as has generally occurred when major promotions have ended, auto
purchases fell sharply in June. Outside the auto sector, retail sales at most types of
stores were up significantly for the second quarter as a whole. Even purchases at
furniture and appliance outlets, which had been on a downtrend since last autumn,
increased during the spring.
Real after-tax income has continued to edge up, despite the sharp drop in output
during the recession. The advance reflects not only typical cyclical increases in
transfer payments but also the reduction in personal income tax rates on October 1.
Households initially saved a sizable proportion of the tax cut, boosting the personal
saving rate from SVi percent in mid-1981—about equal to the average of the late
1970s and early 1980s—to 6,1 percent in the fourth quarter of 1981. During early
1982, however, consumers increased spending, partly to take advantage of price
markdowns for autos and apparel, and the saving rate fell.
Business investment
As typically occurs during a recession, the contraction in business fixed investment has lagged behind the decline in overall activity. Indeed, even though real
GNP dropped substantially during the first quarter of 1982, real spending for fixed
business capital actually rose a bit. An especially buoyant element of the investment sector has been outlays for nonfarm buildings—most notably, commercial
office buildings, for which appropriations and contracts often are set a year or more
in advance.
In contrast to investment in structures, business spending for new equipment
showed little advance during 1981 and weakened considerably in the first half of
1982. Excluding business purchases of new cars, which also were buoyed by rebate
programs, real investment in producers' durable equipment fell at a 2 percent
annual rate in the first quarter. The decline evidently accelerated in the second
quarter. In April and May, shipments of nondefense capital goods, which account
for about 80 percent of the spending on producers' durable equipment, averaged
nearly 3 percent below the first-quarter level in nominal terms. Moreover, sales of
heavy trucks dropped during the second quarter to a level more than 20 percent
below the already depressed first-quarter average.
Businesses liquidated inventories at a rapid rate during late 1981 and in the first
half of 1982. The adjustment of stocks followed a sizable buildup during the summer
and autumn of last year that accompanied the contraction of sales. The most prominent inventory overhang by the end of 1981 was in the automobile sector as sales
fell precipitously. However, with a combination of production cutbacks and sales
promotions, the days' supply of unsold cars on dealers lots had improved considerably by spring.
Manufacturers and non-auto retailers also found their inventories rising rapidly
last autumn. Since then, manufacturers as a whole have liquidated the accumulation that occurred during 1981, although some problem areas still exist—particularly in primary metals. Stocks held by non-auto retailers have been brought down
from their cyclical peak, but they remain above pre-recession levels.
Residential construction
Housing activity thus far in 1982 has picked up somewhat from the depressed
level in late 1981. Housing starts during the first five months of 1982 were up 10
percent on average from the fourth quarter of 1981, The improvement in homebuilding has been supported by strong underlying demand for housing services in most
markets and by the continued adaptation of real estate market participants to nontraditional financing techniques that facilitate transactions.
The turnaround in housing activity has not occurred in all areas of the country.
In the south, home sales increased sharply in the first part of 1982, and housing
starts rose 25 percent from the fourth quarter of 1981. In contrast, housing starts
declined further, on average, during the first five months of 1982 in both the west
and the industrial north central states.
Government
Federal government purchases of goods and services, measured in constant dollars, declined over the first half of 1982. The decrease occurred entirely in the nondefense area, primarily reflecting a sharp drop in the rate of inventory accumulation by the Commodity Credit Corporation during the spring quarter. Purchases by
the Commodity Credit Corporation had reached record levels during the previous
two quarters owing to last summer's large harvests and weak farm prices. Other
22
nondefense outlays fell slightly over the first half of the year as a result of cuts in
employment and other expenditures under many programs. Real defense spending
apparently rose over the First half of the year, and the backlog of unfilled orders
grew further. The federal deficit on a national income and product account basis
widened from $100 billion at the end of 1981 to about $130 billion during the spring
of this year. Much of this increase in the deficit reflects the effects of the recession
on federal expenditures and receipts.
At the state and local goverment level, real purchases of goods and services fell
further over the first half of 1982 after having declined 2 percent during 1981. Most
of the weakness this year has been in construction outlays as employment levels
have stabilized after large reductions in the federally funded CETA program led to
sizable layoffs last year. The declines in state and local government activity in part
reflect fiscal strains associated with the withdrawal of federal support for many activities and the effects of cyclically sluggish income growth on tax receipts. Because
of the serious revenue problems, several states have increased sales taxes and excise
taxes on gasoline and alcohol.
International payments and trade
The weighted-average value of the dollar, after declining about 10 percent from
its peak last August, began to strengthen sharply again around the beginning of the
year and since then has appreciated nearly 15 percent on balance. The appreciation
of the dollar has been associated to a considerable extent with the declining inflation rate in the United States and the rise in dollar interest rates relative to yields
on assets denominated in foreign currencies..
23
Foreign Exchange Value of the U.S. Dollar
Index, March 1973 = 100
— 110
— 100
1978
1980
—
90
—
80
T982
Current Account Balance
Annual rate, billions o( dollars
10
20
1978
1980
Note Dala for 1982 H1 are partially estimalea Oy the FRB
1982
24
Reflecting the effects of the strengthening dollar, as well as the slowing of economic growth abroad, real exports of goods and services have been decreasing since
the beginning of 1981. The volume of imports other than oil, which rose fairly steadily throughout last year, dropped sharply in the first half of 1982, owing to the
weakness of aggregate demand—especially for inventories—in the United States. In
addition, both the volume and price of imported oil fell during the first half of the
year. The current account, which was in surplus for 1981 as a whole, recorded another surplus in the first half of this year as the value of imports fell more than the
value of exports.
Labor markets
Employment has declined by nearly IVa million since the peak reached in mid1981. As usually happens during a cyclical contraction, the largest job losses have
been in durable goods manufacturing industries—such as autos, steel, and machinery—as well as at construction sites. The job losses in manufacturing and construction during this recession follow a limited recovery from the 1980 recession; as a
result, employment levels in these industries are more than 10 percent below their
1979 highs. In addition, declines in aggregate demand have tempered the pace of
hiring at service industries and trade establishments over the past year. As often
happens near a business cycle trough, employment fell faster than output in early
1982 and labor productivity showed a small advance after declining sharply during
the last half of 1981.
Since mid-1981 there has been a 21/* percentage point rise in the overall unemployment rate to a postwar record high of 9 Vz percent. The effects of the recession
have been most severe in the durable goods and construction industries, and the
burden of rising unemployment has been relatively heavy on adult men, who tend
to be more concentrated in these industries. At the same time, joblessness among
young and inexperienced workers remains extremely high; hardest hit have been
black male teenagers who experienced an unemployment rate of nearly 60 percent
in June 1982.
Reflecting the persistent slack in labor markets, most indicators of labor supply
also show a significant weakening. For example, the number of discouraged workers—that is, persons who report that they want work but are not looking for jobs
because they believe they cannot find any—has increased by nearly half a million
over the past year, continuing an upward trend that began before the 1980 recession. In addition, the labor force participation rate—the proportion of the workingage population that is employed or actively seeking jobs—has been essentially flat
for the last two years after rising about one-half percentage point annually between
1975 and 1979.
Prices and labor costs
A slowing in the pace of inflation, which was evident during 1981, continued
through the first half of this year. During the first five months of 1982 (the latest
data available), the consumer price index increased at an annual rate of 3.5 percent,
sharply lower than the 8.9 percent rise during 1981. Much of the improvement was
in energy and food prices as well as in the volatile CPI measure of homeownership
costs. But even excluding these items, the annual rate of increase in consumer
prices has slowed to 5Va percent this year compared with a 9J/2 percent rise last
year. The moderation of price increases also was evident at the producer level.
Prices of capital equipment have increased at a 4V 4 percent annual rate thus far
this year—well below the 9'A percent pace of 1981. In addition, the decline in raw
materials prices, which occurred throughout last year, has continued in the first
half of 1982.
25
Consumer Prices
Change from end Of previous period, annual rate, percenl
Excluding Food, Energy, and Horneownership
15
10
Dec to May
1976
1982
1930
Gasoline Prices
Dollars per gallon
1.50
1.00
.50
1978
1982
1980
Hourly Earnings Index
Change from end of previous period, annual rate, percent
H1
1978
1980
H2
H1
1982
Gasoline prices at the retail level, which had remained virtually flat over the
second half of 1981, fell substantially during the first four months of 1982. Slack
domestic demand and an overhang of stocks on world petroleum markets precipitated the decline in prices. However, gasoline prices began to rise again in May in reflection of rising consumption, reduced stocks, and lower production schedules by
major crude oil suppliers.
The rate of increase in employment costs decelerated considerably during the first
half of 1982. The index of average hourly earnings, a measure of wage trends for
production and nonsupervisory personnel, rose at a ti'/4 percent annual rate over the
first half of this year, compared with an increase of 8'A percent during 1981. Part of
the slowing was due to early negotiation of expiring contracts and renegotiation of
existing contracts in a number of major industries. These wage concessions are expected to relieve cost pressures and to enhance the competitive position of firms in
these industries. Increases in fringe benefits, which generally have risen faster than
wages over the years, also are being scaled back. Because wage demands, not to
mention direct escalator provisions, are responsive to price performance, the progress made in reducing the rate of inflation should contribute to further moderation
in labor cost pressures.
SECTION 2: THE GKOWTH OF MONEY AND CREDIT IN THE FIRST HALF OF 1982
The annual targets for the monetary aggregates announced in February were
chosen to be consistent with continued restraint on the growth of money and credit
in order to exert sustained downward pressure on inllation. At the same time, these
targets were expected to result in sufficient money growth to support an upturn in
economic activity. Measured from the fourth quarter of 1981 to the fourth quarter
of 1982, the growth ranges for the aggregates adopted by the Federal Open Market
Committee (FOMCl were as follows: for M>, 2Va to f>Va percent; for M2, ti to 9 percent; and for M;i, fi'/a to 9'/a percent. The
corresponding range specified by the
FOMC for bank credit was 6 to 9 percent. l
When the FOMC was deliberating on its annual targets in February, the Committee was aware that Mi already had risen well above its average level in the fourth
quarter of 1981, In light of the financial and economic backdrop against which the
bulge in Mi had occurred, the Committee believed it likely that there had been an
upsurge in the public's demand Cor liquidity. It also seemed probable that this
strengthening of money demand would unwind in the months ahead. Thus, under
these circumstances and given the relatively low base for the M! range for 1982, it
did not appear appropriate to seek an abrupt return to the annual target range, and
the FOMC indicated its willingness to permit Mi to remain above the range for a
while. At the same time, the FOMC agreed that the expansion in M, for the year as
a whole might appropriately be in the upper part of its range, particularly if available evidence suggested the persistence of unusual desires for liquidity that had to be
accommodated to avoid undue financial stringency.
In setting the annual target for Ma, the FOMC indicated that Mj growth for the
year as a whole probably would be in the upper part of its annual range and might
slightly exceed the upper limit. The Committee anticipated that demands for the
assets included in M2 might be enhanced by new tax incentives such as the broadened eligibility for IRA/Keogh accounts, or by further deregulation of deposit rates.
The Committee expected that M5 growth again would be influenced importantly by
the pattern of business financing and, in particular, by the degree to which borrowing would be focused in markets for short-term credit.
As anticipated—and consistent with the FOMC's short-run targets—the surge in
M, growth in December and January was followed by appreciably slower growth.
After January, M, increased at an annual rate of only 1'4 percent on average, and
the level of Mi in June was only slightly above the upper end of the Committee's
annual growth range. From the fourth quarter of 1981 to June, Mi increased at a
5.6 percent annual rate. M2 growth so far this year also has run a bit above the
FOMC's annual range; from the fourth quarter of 1981 through June, M^ increased
on average at a 9.4 percent annual rate. From a somewhat longer perspective,
Mi has increased at a 4.7 percent annual rate, measuring growth from the first half
of 1981 to the first half of 1982 and abstracting from the shift into NOW accounts in
11*81; and M2 has grown at. a 9.7 percent annual rate on a half-year over half-year
basis.
1
Because of the authorization of international banking facilities iIBF's) on Dec. .'!, 11181. the
bank credit data starting in December litHl are not comparable with earlier data. The target for
bank credit was put in terms of annualized growth measured from the average of December
1!)81 and January !f)S2 to the average level in the fourth quarter of 1982 so that the shift of
assets to IBF's that occurred at the t u r n of the year would not have a major impact on the
pattern of growth.
27
Ranges and Actual Monetary Growth
M1
Billions ot dollars
Range adopted by FOMC for
1981 04 to 1982 Q4
Annual Rates of Growth
1981 Q4 to June
5.6 Percent
1981 04 to 1982 Q2
6.8 Percent
450
1981
1981 H1 to 1962 H1
4 7 Percent'
1982
M2
Billions of dollars
Range adopted by FOMC lor
1981 Q4 to 1982 Q4
Annual Rates of Growth
I960
1900
1981 04 to June
9.4 Percent
1981 Q4 to 1982 O2
9.7 Percent
1981 H1 to 1962 H1
9.7 Percent
185O
1800
l
p
-LL.
1981
1982
28
Although Mi growth has been moderate on balance thus far this year, that
growth has considerably exceeded the pace of increase in nominal GNP. Indeed, the
first-quarter decline in the income velocity of Mi—that is, GNP divided by M,—was
extraordinarily sharp. Similarly, the velocity of the broader aggregates has been unusually weak. Given the persistence of high interest rates, this pattern of velocity
behavior suggests a heightened demand for M, and M? over the first half.
The unusual demand for Mt has been focused on its NOW account component.
Following the nationwide authorization of NOW accounts at the beginning of 1981,
the growth of such deposits surged. When the aggregate targets were reviewed this
past February, a variety of evidence indicated that the major shift from conventional checking and savings accounts into NOW accounts was over; in particular, the
rate at which new accounts were being opened had dropped off considerably. As a
result of that shift, however, NOW accounts and other interest-bearing checkable
deposits had grown to account for almost 20 percent of M, by the beginning of 1982.
Subsequently, it has become increasingly apparent that Mi is more sensitive to
changes in the public's desire to hold highly liquid assets.
Mi is intended to be a measure of money balances held primarily for transaction
purposes. However, in contrast to the other major components of Mi—currency and
conventional checking accounts—NOW accounts also have some characteristics of
traditional savings accounts. Apparently reflecting precautionary motives to a considerable degree, NOW accounts and other interest-bearing checkable deposits grew
surprisingly rapidly in the fourth quarter of last year and the first quarter of this
year. Although growth in this component has slowed recently, its growth from the
fourth quarter of last year to June has been 80 percent at an annual rate. The other
components of M, increased at an annual rate of less than 1 percent over this same
period.
Looking at the components of M3 not also included in M,, the so-called nontransaction components, these items grew at a 10% percent annual rate from the fourth
quarter to June. General purpose and broker/dealer money market mutual funds
were an especially strong component of M2, increasing at almost a 30 percent
annual rate this year. Compared with last year, however, when the assets of such
money funds more than doubled, this year's increase represents a sharp deceleration.
Perhaps the most surprising development affecting M2 has been the behavior of
conventional savings deposits. After declining in each of the past four years—falling
16 percent last year—savings deposits have increased at about a 4 percent annual
rate thus far this year. This turnaround in savings deposit flows, taken together
with the strong increase in NOW accounts and the still substantial growth in
money funds, suggests that stronger preferences to hold safe and highly liquid financial assets in the current recessionary environment are bolstering the demand
for M2 as well as M,.
29
Ranges and Actual Monetary Growth
dollars
Annual Rates of Growth
'981 O4 to June
9.7 Percent
2300
1981 O4 to 1982 Q2
9.8 Percent
1981 H1 to 1982 H1
10 5 Percent
— 2200
1982
Bank Credit
Billions of dollars
Range adopted by FOMC tor
Dec 1981-Jan 1982 to 1982 Q4
1982
Annual Rates ot Growth
30
M3 increased at a 9.7 annual rate from the fourth quarter of 1981 to June, just
above the upper end of the FOMC's annual growth target. Early in the year, M3
growth was relatively moderate as a strong rise in large denomination CDs was
offset by declines in term RPs and in money market mutual, funds restricted to institutional investors. During the second quarter, however, M3 showed a larger increase; the weakness in its term RP and money fund components subsided and
heavy issuance of large CDs continued. With growth of "core deposits" relatively
weak on average, commercial banks borrowed heavily in the form of large CDs to
fund the increase in their loans and investments.
Commercial bank credit grew at an 8.3 percent annual rate over the first half of
the year, in the upper part of the FOMC's range for 1982. Bank loans have increased on average at about a 9Va percent annual rate, with loans to nonfinancial
businesses expanding at a 14 percent annual rate. In past economic downturns, business loan demand at banks has tended to weaken, but consistently high long-term
interest rates in the current recession have induced corporations to meet the great
bulk of their external financing needs through short-term borrowing. Real estate
loans have increased at a 7'A percent annual rate this year, somewhat slower than
the growth in each of the past two years. Consumer loans outstanding during the
first half of the year have grown at the same sluggish pace of 3 percent experienced
last year. The investment portfolios of banks have expanded at about a 5 percent
annual rate, with the rate of increase in U.S. government obligations about twice as
large as the growth in holdings of other types of securities.
SECTION 3: THE FEDERAL RESERVE'S OBJECTIVES FOR GROWTH OF MONEY AND CREDIT
There is a clear need today to promote higher levels of production and employment in our economy. The objective of Federal Reserve policy is to create an environment conducive to sustained recovery in business activity while maintaining the
financial discipline needed to restore reasonable price stability. The experience of
the past two decades has amply demonstrated the destructive impact of inflation on
economic performance. Because inflation cannot persist without excessive monetary
expansion, appropriately restrained growth of money and credit over the longer run
is critical to achieving lasting prosperity.
The policy of firm restraint on monetary growth has contributed importantly to
the recent progress toward reducing inflation. But when inflationary cost trends
remain entrenched, the process of slowing monetary growth can entail economic
and financial stresses, especially when so much of the burden of dealing with inflation rests on monetary policy. These strains—reflected in reduced profits, liquidity
problems, and balance-sheet pressures—place particular hardships on industries
that depend heavily on credit markets such as construction, business equipment,
and consumer durables.
Unfortunately, these stresses cannot be easily remedied through accelerated
money growth. The immediate effect of encouraging faster growth in money might
be lower interest rates, especially in short-term markets. In time, however, the attempt to drive interest rates lower through a substantial reacceleration of money
growth would founder, for the result would be to embed inflation and expectations
of inflation even more deeply into the nation's economic system. It would mean that
this recession was another wasted, painful episode instead of a transition to a sustained improvement in the economic environment. The present and prospective
pressures on financial markets urgently need to be eased not by relaxing discipline
on money growth, but by the adoption of policies that will ensure a lower and declining federal deficit. Moreover, a return to financial health will require the adoption of more prudent credit practices on the part of private borrowers and lenders
alike.
In reviewing its targets for 1982 and setting tentative targets for 1983, the FOMC
had as its basic objective the maintenance of the longer-range thrust of monetary
discipline in order to reduce inflation further, while providing sufficient money
growth to accommodate exceptional liquidity pressures and support a sustainable recovery in economic activity. At the same time, the Committee recognized that regulatory actions or changes in the public's financial behavior might alter the implications of any quantitative monetary goals in ways that cannot be fully predicted.
In light of all these considerations, the Committee concluded that a change in the
previously announced targets was not warranted at this time. Because of the tendency for the demand for money to run strong on average in the first half, and also
responding to the congressional budget resolution, careful consideration was given
to the question of whether some raising of the targets was in order. However, the
available evidence did not suggest that a large increase in the ranges was justified,
31
and a small change in the ranges would have represented a degree of "fine tuning"
that appeared inconsistent with the degree of uncertainty surrounding the precise
relationship of money to other economic variables at this time. However, the Committee concluded, based on current evidence, that growth this year around the top
of the ranges for the various aggregates would be acceptable.
The Committee also agreed that possible shifts in the demand for liquidity in current economic circumstances might require more than ordinary elements of flexibility and judgment in assessing appropriate needs for money in the months ahead. In
the near term, measured growth of the aggregates may be affected by the income
tax reductions that occurred on July 1, by cost-of-living increases in social security
benefits, and by the ongoing difficulties of accurately accounting for seasonal movements in the money stock. But more fundamentally, it is unclear to what degree
businesses and households may continue to wish to hold unusually large precautionary liquid balances. To the extent the evidence suggests that relatively strong precautionary demands for money persist, growth of the aggregates somewhat above
their targeted ranges would be tolerated for a time and still would be consistent
with the FOMC's general policy thrust.
Looking ahead to 1983 and beyond, the FOMC remains committed to restraining
money growth in order to achieve sustained noninflationary economic expansion. At
this point, the FOMC feels that the ranges now in effect can appropriately remain
as preliminary targets for 1983. Because monetary aggregates in 1982 more likely
than not will be close to the upper ends of their ranges, or perhaps even somewhat
above them, the preliminary 1983 targets would be fully consistent with a reduction
in the actual growth of money in 1983.
In light of the unusual uncertainty surrounding the economic, financial, and
budgetary outlook, the FOMC stressed the tentative nature of its 1983 targets. On
the one hand, postwar cyclical experience strongly suggests that some reversal of
this year's unusual shift in the asset-holding preferences of the public could be expected; with economic activity on an upward trend, any lingering precautionary motives for holding liquid balances should begin to fade, thus contributing to a rapid
rise in the velocity of money. Moreover, regulatory actions by the Depository Institutions Deregulation Committee that increase the competitive appeal of deposit instruments—as well as the more widespread use of innovative cash management
techniques, such as "sweep" accounts—also could reduce the demand for money relative to income and interest rates. On the other hand, factors exist that should increase the attractiveness of holding cash balances. The long upward trend in the
velocity of money since the 1950s took place in an environment of rising inflation
and higher nominal interest rates—developments that provide incentives for economizing on money holdings. As these incentives recede, it is possible that the attractiveness of cash holdings will be enhanced and that more money will be held relative to the level of business activity.
SECTION 4: THE OUTLOOK FOR THE ECONOMY
The economy at midyear appears to have leveled off after sizable declines last fall
and winter. Consumption has strengthened with retail sales up significantly in the
second quarter. New and existing home sales have continued to fluctuate at depressed levels, but housing starts nonetheless have edged up. In the business sector,
substantial progress has been made in working off excess inventories, and the rate
of liquidation appears to have declined. On the negative side, however, plant and
equipment spending, which typically lags an upturn in overall activity, is still depressed. And the trend in export demand continues to be a drag on the economy,
reflecting the dollar's strength and weak economic activity abroad.
An evaluation of the balance of economic forces indicates that an upturn in economic activity is highly likely in the second half of 1982. Monetary growth along the
lines targeted by the FOMC should accommodate this expansion in real GNP, given
the increases in velocity that typically occur early in a cyclical recovery and absent
an appreciable resurgence of inflation. The 10 percent cut in income tax rates that
went into effect July 1 is boosting disposable personal income and should reinforce
the growth in consumer spending. Given the improved inventory situation, any sizable increase in consumer spending should, in turn, be reflected in new orders and a
pickup in production. Another element supporting growth in real GNP will be the
continuing rise in defense spending and the associated private investment outlays
needed for the production of defense equipment.
At least during the initial phase, the expansion is likely to be more heavily concentrated in consumer spending than in past business cycles, as current pressures in
financial markets and liquidity strains may inhibit the recovery in investment ac
32
tivity. With mortgage interest rates high, residential construction does not seern
likely to contribute to the cyclical recovery to the extent that is has in the past.
Likewise, the high level of corporate bond rates, and the cumulative deterioration in
corporate balance sheets resulting from reliance in recent years on short-term borrowing, may restrain capital spending, especially given the considerable margin of
unutilized capacity that now exists.
The excellent price performance so far this year has been helped by slack demand
and by exceptionally favorable energy and food supply developments. For that
reason, the recorded rate of inflation may be. higher in the second half. However,
prospects appear excellent for continuing the downtrend in the underlying rate of
inflation. As noted earlier, significant progress has been made in slowing the rise in
labor compensation, and improvements in underlying cost pressures should continue
over the balance of the year. Unit labor costs also are likely to be held down by a
cyclical rebound in productivity growth as output recovers. Moreover, lower inflation will contribute to smaller cost-of-living wage adjustments, which will moderate
cost pressures further.
The Federal Reserve's objectives for money growth through the end of 198,1 are
designed to be consistent with continuing recovery in economic activity. A critical
factor influencing, the composition and strength of the expansion will be the extent
to which pressures in financial markets moderate. This, in turn, depends importantly on the progress made in further reducing inflationary pressures. A marked decrease in inflation would take pressure off financial markets in two ways. First,
slower inflation will lead to a reduced growth in transaction demands for money,
given any particular level of real activity. It follows that a given target for money
growth can be achieved with less pressure on interest rates and accordingly less restraint on real activity, the greater is the reduction in inflation. Second, further
progress in curbing inflation will help lower long-term interest rates by reducing
the inflation premium contained in nominal interest rates. The welcome relief in
inflation seen recently apparently is assumed by many to represent a cyclical rather
than a sustained drop in inflation. But the longer that improved price performance
is maintained, the greater will be the confidence that a decisive downtrend in inflation is being achieved. Such a change should be reflected in lower long-term interest
rates and stronger activity in the interest-sensitive sectors of the economy.
Another crucial influence on financial markets and thus on the nature of the expansion in 1983 will be the federal budgetary decisions that are made in coming
months. The budget resolution that was recently passed by the House and Senate is
a constructive first step in reducing budget deficits as the economy recovers. However, much remains to be done in appropriation and revenue legislation to implement
this resolution. How the budgetary process unfolds will be an important factor in
determining future credit demands by the federal government and thus the extent
to which deficits will preempt the net savings generated by the private economy. A
strong program of budget restraint \vou(d minimize pressures in financial markets
and thereby enhance the prospects for a more vigorous recovery in homebuilding,
business fixed investment, and other credit-dependent sectors.
In assessing the economic outlook, the individual members of the FOMC have formulated projections for several key measures of economic performance that fall generally within the ranges in the table below. In addition to the monetary aggregate
objectives discussed earlier, these projections assume that the federal budget will be
put on a course that over time will result in significant reductions in the federal
deficit.
ECONOMIC PROJECTIONS OF FOMC MEMBERS
Actua
Changes, 4th quarter to 4tti quarter, percent:
Nominal GNP
RealGNP
. ..
GNP deflator
level in the 4th quartet, percent- Unemployment rate
Revised administration forecasts for the economy were not available at the time
of the Committee's deliberation. Our understanding, however, is that the administration's midyear budgetary review will be presented within the framework of the
33
economic assumptions used in the first budget resolution. For the remainder of
1982, those assumptions imply somewhat more rapid recovery than the range now
thought most likely by members of the FOMC, but would be consistent with the
monetary targets outlined in this report on the assumption of growth in velocity
characteristic of the early stages of a number of past recoveries. Looking further
ahead, the Committee members, like the administration and the Congress, foresee
continued economic expansion in 1983, but currently anticipate a less rapid rate of
price increase and somewhat slower real growth than the assumptions underlying
the budget. The monetary targets tentatively set for 1983, which will be reviewed
early next year, would imply, under the budgetary assumptions, relatively high
growth in velocity.
The CHAIRMAN. Thank you very much, Mr. Chairman.
Since you started your testimony we have had additional Senators come in, and although I would like to proceed with the questioning I would ask if any members who have joined us since
Chairman Volcker started his testimony would like to take just 2
minutes for any sort of an opening statement.
If not, we will proceed with the question period.
Senator Sarbanes, do you have any opening comments?
Senator SARBANES. I'll wait until after the questioning period.
The CHAIRMAN. Senator Tower.
Senator TOWER, Mr. Chairman, I have an opening statement I'd
like to file for the record.
The CHAIRMAN. All right, it will be filed for the record.
OPENING STATEMENT OF SENATOR TOWER
Senator TOWER. Mr. Chairman, I would like to congratulate you
for the courage you have shown since assuming your office. In my
view, this Government and the American people owe you far more
than we understand or will acknowledge.
In the face of skyrocketing Government spending, you and your
fellow Governors have been the only component of government
willing to do what is right rather than what is politically popular.
We have all watched as you struggled with the effects of spiraling, and seemingly permanent, inflation. We have seen how this inflation perverted traditional monetary policy theory to the point
where both increases and decreases in the money stock meant
higher interest rates. We have seen your courageous movement
from interest rate targeting to monetary aggregate targeting, just
at the time when institutional changes made all of the old definitions of money obsolete. We have seen you move from very volatile
monetary growth to the recent period of relative stability. Most importantly, Mr. Chairman, we have seen you exercise the courage to
wring the inflation, which is at the bottom of all of this, out of our
economy.
In doing all of this, you resisted enormous political pressures,
and thank God you did. In my view, it is only your independence
which gives you the necessary freedom to avert the overwhelming
pressures to which Congress is so susceptible. I shudder to think
what condition this economy would be in today if we managed
monetary policy with the same dispassionate skill with which we
manage fiscal policy.
The CHAIRMAN. Senator Sasser.
Senator SASSER. Mr. Chairman, I'll submit my statement for the
record.
34
OPENING STATEMENT OF SENATOR SASSER
Senator SASSER, Chairman Volcker, before I ask you some questions for the record let me be very frank with you.
I regard the Federal Reserve Board's monetary policy as a chief
cause of our current economic problems.
High interest rates and tight money are crushing the life out of
our economy.
High interest rates have devestated the housing industry,
We are only building one-half the houses we need every year to
house a growing and changing population.
High interest rates have crucified the small businessman.
Business failures totaled just over 17,000 last year. This year we
will witness 22,000 small business failures—a level that exceeds
that recorded in 1933.
High interest rates are slamming the brakes on our economic
growth.
We are using only 70.8 percent of our manufacturing capacity,
and real gross national product in 1982 may be no higher than the
real gross national product recorded in 1979, the year in which the
Federal Reserve Board's monetary policies went into effect.
Indeed, in your report to the committee you note that the contraction in our economy that began in 1981 is continuing through
1982. And your whole report gives little indication that the Federal
Reserve Board is prepared to adopt a new monetary policy that
will stimulate economic growth.
It is my contention that the Federal Reserve Board's monetary
policies are leading us to the brink of economic chaos.
I have expressed serious reservations about the Board's interest
rate policies ever since they were adopted in 1979.
I expressed these reservations to President Carter, and I have, on
several occasions, offered legislation that would revise the Board's
tight money policies.
Chairman Volcker, the independence of the Federal Reserve
Board does not give it the right to wreak havoc with the American
economy.
The Board has a legal, and I would argue, a moral obligation to
help the economy grow.
The Board has failed to meet this obligation by almost any reasonable standard.
The economic carnage caused by the Board's high interest rate
policies must stop.
The Board must, either voluntarily or by congressional direction,
revise its monetary policies to permit greater monetary growth
that will bring interest rates down and make credit more affordable to American consumers and American businessmen.
The CHAIRMAN. Thank you very much.
Mr. Schmitt.
OPENING STATEMENT OF SENATOR SCHMITT
Senator SCHMITT. Mr. Chairman, when you get to the questions, I
hope I will have that opportunity.
35
Mr. Chairman, I just wanted to welcome you once again to the
committee and tell you, since we last spoke, I like many others
have had to reevaluate my analysis of the economy.
I must say I was one of those at the first of the year that felt if
we held inflation down significantly from where it had been in
1979 and 1980 before the new economic policies were put into
place, that we would see an easing of interest rates.
Clearly, the feel the investor has of 13 percent inflation is still
there. The deficits are still there and greater; there is, I think,
some concern that money growth might be too high for a recessionary period, and it just doesn't seem that anything is going to act—
anything structural is going to act to reduce these interest rates.
And I think in that context the actions of both the financial community and the Fed yesterday are welcome. Now how many points
that will milk out of the interest rates, I don't know, but there does
seem to be this inherent problem that the investor still remembers
inflation, and is afraid to loan his money at less than 13, 14. or 15
percent, The Federal Government is moving toward demanding 50
percent of the credit available in this country, business demand is
still on the horizon when a recovery comes in—and we can have
continually built into our tax code disincentives to save. That's one
of my main concerns about the current tax bill before the Senate.
It does nothing to increase the pool of capital available for investment, but in fact goes the other direction.
Mr. Chairman, I appreciate having that opportunity for a brief
opening statement, and I'll reserve the rest of my comments for
questions.
The CHAIRMAN. Thank you, Senator.
Mr, Chairman, as you well know, you received a lot of criticism
over the last couple of years, and some of it from me, and particularly on the calls many, many times—virtually every time you
have appeared—to do away with weekly reporting of money supply
data and also to go to contemporaneous reserve accounting rather
than lagged accounting.
So having done something about both problems, I think you
should be publicly complimented for announcing that you are going
to use contemporaneous reserve accounting and also the decision of
the Fed since we last met to move to not reporting weekly adjusted
money supply data.
CONGRESS BLAMED
Nevertheless, I remain convinced that it is the Congress that is
primarily to blame for the failure of interest rates to decline as
quickly as inflation. The first budget resolution which we recently
passed calls for a steadily declining Federal deficit in the years
ahead: $104 billion in 1983; $84 billion in 1984; $60 billion in 1985.
But of the $281 billion in spending cuts over the next 3 years
that will be necessary to achieve these declining deficits, only $27
billion, less than 10 percent, have been reconciled or enacted into
law.
My point is simply that regardless of what you do with the discount rate or changes in how you account and handle the money
36
supply of this country, it seems to me it is still up to Congress to
put up or shut up.
Is it any wonder that the financial markets have remained skeptical—as evidenced by the stickiness of interest rates—of Congress
ability to make budget cuts called for in the budget resolution.
So I hope that Congress will not just pass a budget resolution
then, in the individual appropriations process, not reconcile that
budget. We need to send the proper signals to the market.
Mr. Chairman, recently there's been much talk of credit controls.
As you know, this committee and the Congress let the authority for
credit controls expire on June 30. But there has been additional
talk and bills introduced in the House and Senate to not only
revive credit control authority but to expand the scope of the
Credit Control Act.
You were Chairman when President Carter invoked the act in
the spring of 1980, requiring the Federal Reserve to impose credit
controls.
Could you explain for the committee what you learned from that
experience in the spring of 1980?
Mr. VOLCKER. I think one thing we learned, Mr. Chairman, is
that because of psychological effects or influences that are not entirely predictable—at least they weren't predictable to us—you
sometimes get results that are out of proportion to the action
taken.
In early 1980, when we introduced some rather mild controls or
restraints on a limited portion of consumer credit, we found, as
that message was interpreted in the country, that nobody wanted
to spend for a month or two, certainly not to spend on credit—to
exaggerate a bit to make the point—and we had a larger impact
than the action was designed to produce at that time.
I think it is illustrative of the difficulties of adopting an approach of that kind for which you don't have, by the nature of
things, much experience. The effects that you get are not entirely
predictable in those circumstances.
The CHAIRMAN. Well, I'm one who does not want to renew those
credit controls. I think we have plenty of evidence—not only in the
spring of 1980—that they are counterproductive. We can go back to
Tricky Dicky's phase 1, 2, 3, and 4, and so on, that simply did not
work. And I see no reason whatsoever to reenact the Credit Control
Act.
FAILURE TO MEET TARGET GROWTH
The Federal Reserve continues to be criticized for failure to meet
announced targets for growth in Mi, M2, and M3, and in bank
credit. Obviously a major source of the problem is that you do not
have direct control over these aggregates.
Why not announce targets for an aggregate over which you do
have more direct controls, such as bank reserves or the monetary
base? Don't you think this might increase the credibility of the Fed
in the financial markets?
Mr. VOLCKER. I don't know whether it would increase or decrease
the credibility, but I don't think that's an appropriate target for
the Federal Reserve.
37
As to meeting the targets that we do have, there can be two
sources, I suppose, of difficulty, if that's the right word.
One is the problem of meeting the targets themselves. Are the
tools adequate to meet the target in a technical way? The other is
whether conditions have changed in a way that may make it inappropriate to meet a target precisely at a particular point in time.
I would think the first half of this year had some of the characteristics, at least, of the latter situation, where demands for liquidity for precautionary balances, as we judged it, were particulary
strong. As conditions developed, taking account of economic developments, taking account of interest rates and other factors, it
seemed to us inappropriate—not that we couldn't have done it, but
that it was inappropriate—to take a still stronger measure to restrict the growth of money and credit under the conditions that
prevailed.
So I think we always have to interpret the meaning of these targets in the light of circumstances as they develop. The meaning of
the target is that it sets a presumption—and a strong presumption—that you want to operate in that framework. There may be
circumstances in which, taking account of all developments, it's appropriate to allow a little leeway.
I myself think the monetary base tends to be more of a lagging
indicator than a leading indicator, and I don't think it would bring
us better results than looking at what's happening in Mi and the
other aggregates.
The CHAIRMAN. Another criticism of monetary policy is that the
aggregates that you target are too narrow and ignore major sources
of credit in our economy, such as commercial paper. Why not
target a broad aggregate, such as total credit?
Mr. VOLCKER. As you know, we target a number of aggregates
now, and there's been some discussion recently of looking at broader forms of credit aggregates than we include formally.
I think targets are relevant economic variables, and we do and
should look at them. We have not been convinced that as a formal
targeting mechanism they offer a substantial improvement, but we
continue to look at that issue, and I haven't got any preconceived
notions on that score. We haven't seen that that would add much.
But I think it's relevant as a magnitude to look at and to observe
in connection with the other targets.
One difficulty with credit—a technical point—is that some of
that data is not as up-to-date as looking at the other side of the
balance sheet which is essentially what we do in looking at the
monetary targets.
The CHAIRMAN. Episodes such as the recent Drysdale Government securities problem and the failure of the Penn Square National Bank in Oklahoma cause the Fed to inject liquidity into the
economy through the discount window.
What impact does this have on your ability to implement monetary policy and you completely offset the discount window loans
through sales of securities in the open market?
Mr. VOLCKER. The first point I would make is that those incidents have not required any substantial injection of liquidity
through the discount window. If they had, in connection with the
fundamental role of the central bank as lender of last resort—lend
ing to those that are caught up in the secondary repercussions of
an incident of that sort—if that became necessary, the first assumption, I suppose, would be that that would be offset by sales of
securities from the portfolio so that it does not necessarily mean
that we would deviate from reserve objectives or from monetary objectives.
You could conceive of situations in which you might want to provide some additional liquidity to the economy as a whole, and then
you would handle it somewhat differently. But increased use of the
discount window in reaction, to that kind of event has not been at
all significant. If it were significant, it could be offset by open
market sales.
The CHAIRMAN. Thank you, Mr. Chairman.
Senator Riegle.
Senator RIEGLE. Chairman Volcker, I want to try to set the stage
here for some responses from you by making some observations as
quickly as I can. At the outset I recounted several measures of the
damage that's been done to the economy in terms of the high unemployment, the shutdown of the economy, the tremendous
damage that's been done to any number of interest-rate sensitive
sectors of the economy.
I believe that we have a desperate situation on our hands. That's
confirmed by conversations that I've had the last 4 or 5 weeks with
the heads of most of the major banks and financial institutions,
and a number of large corporations in this country.
NEED FOR MAJOR CHANGE IN POLICY MIX
They all to a person feel that the economy is in desperately serious trouble and there is requirement for a major change in the
policy mix. At the same time there's really no sign that change in
the policy mix is coming any time soon or that the key decision
centers—the President and perhaps at the Fed as well—have a
sense that a change is needed.
I can tell you as a member of the Senate Budget Committee that
my "own estimates for the deficit—if we stay with the current fiscal
plan—will be in excess of $130 billion for next year, in the range of
$200 billion for 1984, and a range of $300 billion for 1985.
I don't see how our economy can function if we stay on that
path. As a matter of fact from everything I can see, the President,
who is the most important player in this discussion, is at peace
with these deficits—as a matter of fact, he came in with a budget
that asked for even higher deficits.
I think the high interest rates that we have now are just ripping
the guts out of this economy, and you can see it everywhere you
look: From the financial institutions across to the housing sector
into the industrial base, into agriculture. There really is no part of
the economy that has not now been affected and damaged—and I
think in many cases permanently—by this high interest rate
policy.
So there is a need—a desperate need—for a change in the policy
mix, and yet there's no sign of any change in sight.
39
Now the Congress, according to Senator Baker, is targeting to adjourn on October 2. We have about 45 working days left here, if
one takes out the weekends and the planned recesses.
The window is closing on this session of Congress. Once the Congress shuts down, we're not going to be back into the new Congress
until late in January. You take out the Lincoln day recess in February, and it's going to be the beginning of the second quarter of
next year before the Congress will be in a position to act in a major
way, if we miss the opportunity to make a major change in the economic policy mix at this time.
And I'm greatly concerned that we're missing that opportunity;
I'm concerned the administration is missing it, I think the Congress is missing it, and it appears to be the Fed as well is missing
it.
The lowering of the discount rate yesterday I think shows a
small shift in your own policy, but it is a very small change and it
comes very late in the game, and there's no way of really measuring whether or not this will have any appreciable effect on this
larger set of problems.
I think you ought to be more outspoken in your appeals publicly
and your appeals privately to the President, in your appeals to the
Congress and within the business community.
It's possible from your vantage point that you can have as much
to do with helping to create a sense of urgency about a need now
for a change in the policy mix as anybody.
And I believe if it doesn't happen, you're going to find yourself,
and the Fed is going to find itself, more and more compelled to
have to act unilaterally. Because if we see more bank failures, we
will see more panic, we will see more people moving into more
liquid assets and into short-term Government securities. I've talked
with heads of major investment companies in the United States
who are changing their own personal financial plans because of
their apprehension about the future of the economy.
The thing that worries me now is that we may find ourselves in
period when we're not going to be able to act readily as a Federal
Government to change policy because of the shutdown that occurs
as we come into an election year of this kind.
And I think that we can find ourselves at some point facing some
kind of panic—some kind of financial panic—and possibly even a
genuine fear that a depression could develop.
We have Canada in shambles on our northern border; we've got
Mexico in shambles on our southern border; we've got nonperforming loans by major banks all around the world and across the
United States.
And my question to you is that if this comes, if we miss this very
small opportunity that's left for a major change in the policy mix—
and I'm talking about a substantial reduction in deficits and a substantial change in monetary policy and a big reduction in interest
rates that would come within a matter of weeks—if we fail to get
that done collectively, are you prepared to act unilaterally at the
Fed, should we find ourselves in a kind of growing panic situation.
Will you move then? Will you either increase the monetary targets or will you bring down the discount rate further, if in fact you
find yourself alone out there with the situation worsening and the
40
President not connected to the problem and the Congress not even
in session?
Mr. VOLCKER. I'll make a couple of comments on your comments,
Senator.
I yield to no one in my concern about the budget, and I think
that I've made that plain through the months. I'm not quite as pessimistic as the figures that you cited for the out-years on the
budget.
I do think that we collectively, in a sense, missed a great opportunity this spring to more forcefully and dramatically, through
some process of consensus, take more forceful action on those outyears. As you point out, there is relatively little time left in this
congressional session, and you've got your work cut out for you in
implementing the budget resolution that was passed. I very much
look forward to your coming back for the further large bites that I
think are necessary in the budgetary situation—after November.
But I try to be realistic, and I don't know if there's anything
hugely dramatic, beyond what is incorporated in that budget resolution, that can be done within the next month or two.
I recognize your concerns about the economy and about the financial system, but let me say that I don't share those, to the
extent that you have cited them.
I think that we are clearly in a difficult period. We are still
facing the damages, as you put it. In my mind, they are the damages of handling the long episode of inflation and turning that
around. But I think that we are laying a strong foundation for the
economy. If some of these contingencies of which you speak arose—
I don't believe they are going to arise—I think we can be sure the
Federal Reserve is well aware of its responsibilities as lender of
last resort and provider of liquidity to the economy.
Senator RIEGLE. How much effect do you think the lowering of
the discount rate, of half a point yesterday, is going to have? And
over what time period?
Mr. VOLCKER. I wouldn't isolate that particular move.
Senator RIEGLE. Let me try and isolate it. I realize that there are
a lot of other factors—but just that particular move—what do you
think it, by itself, might accomplish? Obviously you decided to take
it for a reason.
Mr. VOLCKER. We took it in the light of rather sharp reductions
in short-term interest rates that had already taken place in the
market; so, to some extent, you can consider that a move of alinement to changes that had already taken place.
You can ask why the other changes took place. We had the
money supply in pretty good control. Banks have been under less
reserve pressure in recent weeks. The economy appears to be in a
fairly level phase. There are a variety of factors. I think the budgetary progress, limited as it is, helps, relative to the situation of
not having had that progress. A variety of factors have entered in,
and the discount rate change is one part of that complex.
I think that it does tend to anchor the reduction in short-term
rates that took place.
41
FLIGHT OF MONEY TO SHORT-TERM SECURITIES
Senator RIEGLE. Do you see any movement out of people holding
long-term securities and short-term securities? Do you see a flight
of money into shorter and shorter term securities?
Mr. VOLCKER. I think for some months, as my statement suggests, we have seen evidence of a desire for liquidity; and that is
part of that phenomenon.
Senator RIEGLE. What does that mean? What do you interpret
that to mean, the fact that there is this rush toward liquidity?
Mr. VOLCKER. I think it means several things.
This is partly in the realm of speculation. We have a variety of
evidence, survey evidence and other kinds of evidence. It is not
atypical during a recession to have a desire for more liquidity.
This time, more than in some past recessions, some of it may reflect uncertainty about interest rates themselves. Of course, we
have had a high level of short-term interest rates, so it's been attractive, just on sheer financial grounds, so to speak, to park
money in liquid assets.
Senator RIEGLE. If we don't get long-term rates down, if we don't
see some willingness of people to finance long-term investments—
whether it's for houses, factories, or whatever it might be—how are
we actually going to get an economic recovery going?
If everybody is moving in the direction of short-term instruments, then how could we possibly get things moving again?
Mr. VOLCKER. I think it's possible to do so. As I indicated, I think
the recovery in the near term is going to be fed largely by consumer spending, which isn't so dependent upon long-term borrowing—
probably not dependent upon long-term borrowing at all.
I fully agree with you. We would be in a much better position,
much happier position, if long-term rates were lower. When you
emphasize long-term rates, I think that it is, in a sense, illustrative
of the policy problem; this is, we can't control long-term rates and
they're going to depend upon the decisions of those in the marketplace and their having enough confidence to go out and buy longer
term securities. That is one reason why I think that it's so terribly
important, if we're interested in getting interest rates down—and
particularly long-term rates down—that we carry through on dealing with inflation. That's the thing that will really spook the
market in terms of making an investment for the long term. The
investor is making a bet for 10, 20, or 30 years, depending on the
security; he's going to be looking at the chances for stability—or
for greater stability—than we have had over that length of time in
recent years.
Senator RIEGLE. My time is up. I will have more to say later. But
it seems to me that we have not made much progress on that front.
Mr. VOLCKER. We have not so far, I agree.
The CHAIRMAN. Senator Tower.
Senator TOWER. Thank you, Mr. Chairman.
Chairman Volcker, I want to congratulate you on having the
courage to do what you perceive to be right, rather than what may
be politically popular. And although I may be inclined to disagree
with you from time to time myself, I hope that we will never be in
42
a position where we feel tempted to threaten the independence of
the Federal Reserve Board.
I think it's been the only agency of Government that has, regardless of political fallout, proceeded to do what it felt to be necessary.
I can't help but be reminded that you and I are both products of
the London School of Economics. I rather fancy, every time you
make a pronouncement on fiscal or monetary policy, that Lord
Keynes and Harold Lasky start turning in their graves.
Mr. Chairman, many analysts suggest that we have, in effect,
two credit markets, that interest rates are affected by different factors. For example, they suggest that the long-term rates are staying high because of expectations of future inflation, very large deficits, or both; while short-term rates are high because of supply and
demand forces—that is to say, business and Treasury loan demand
is greater than the supply of credit.
Do you agree with that analysis?
Mr. VOLCKER. I certainly agree that you would expect long-term
rates to be affected more by the expectational factors, and shortterm rates probably more immediately by the quantitative magnitudes involved as opposed to the psychology, although the distinction is not a clean one.
EFFECT OF UNREGULATED MONEY MARKET FUNDS
Senator TOWER. Mr. Chairman, to what extent to you believe
that the availability of unregulated money market funds contributes to the continuation of high interest rates?
Mr. VOLCKER. I would not, I think, put a lot of importance on unregulated money market funds in and of themselves.
I do think that the move toward deregulation in the financial
world generally, including banks—and the money market funds
are one manifestation of that—means that the restraint that used
to come out in a rationing of credit in the market now comes out
virtually entirely in interest rates. That has probably meant a
higher level of interest rates in these past few years than you
would have had with the different institutional arrangements that
we had in the 1950's and the 1960's and the early 1970's.
To put it badly, now when money is restrained, banks don't stop
making loans, they just raise the rates until the borrowers are
squeezed out.
In the good old days—if they were good old days; people didn't
like them much when they existed—when there tended to be pressure on the money market, the banks and financial institutions
were, to some extent, rationed out themselves; interest rates would
push up against the ceiling rates, and they would slow down in
making loans. They raised interest rates, too, but not as far, because some of the restraint came through by way of a rationing
process rather than from interest rates alone.
I think this whole thrust—of which money markets are merely
one part—has resulted in a type of money market in which interest
rates are more volatile and higher, at least during the restrictive
phase of policy, than they otherwise would be.
Senator TOWER. This morning, in the Washington Post, Allen
Sinai suggests that the lowering of the discount rate will be of no
43
help before the fourth quarter. He says, in effect, that this quarter
is already lost.
Dp you agree with him? And specifically, what result were you
hoping to achieve as a result of this action?
Mr. VOLCKER. I don't agree that the third quarter is lost, for
whatever reason. We're trying to conduct a policy which continues
the progress on inflation, but also leaves room for recovery. We
have no desire to have interest rates any higher than they need be.
As I indicated, I think that the discount rate move was a reflection,
to a considerable extent, of declines in market rates that had already occurred, and has the effect of anchoring those for the time
being to some degree.
Senator TOWER. Mr. Chairman, we are due to mark up a bill in
the near future that, among other things, is designed to give some
assistance to the thrift industry.
In your view, will providing thrift institutions with banklike
asset powers enable them to- solve their problems before it's too
late for a number of individual institutions?
Mr. VOLCKER. I don't think that providing new powers—more
particularly, commercial loan powers—at this point in time is
going to have much relevance to their near-term problems. I think
that has to be viewed in the context of the direction that you would
like that industry to go in over a period of time.
I don't see it as any saving measure for the immediate future, in
terms of the present squeeze. In fact, there are some dangers in
going into a new business rapidly, in the hopes of increasing
income; you've had some examples recently of banks being a little
overambitious in that area and getting into trouble.
Senator TOWER. Are you saying, then, that nothing can be done
to alleviate the immediate problem?
Mr. VOLCKER. No. I simply was referring to that particular portion of the bill. The legislation you are considering has measures in
it that are directly relevant to the immediate problem. In the capital infusion area and the so-called "Regulators Bill" the considerations are very directly relevant and important for the current
problems in the thrift industry. I think they are very important,
given the current problems that we have in that area.
Senator TOWER. Are you worried about the safety of the financial
industry right now?
Mr. VOLCKER. No. I think that the financial system in this country is a strong one. As I indicated in my statement, we have an
elaborate system, with the Federal Reserve, the FDIC, and so on
designed to backstop that system. I am not concerned about the
system in general.
There are obviously points of particular strain, in that financial
institutions are feeling the effects of the recession, in some cases.
We have been through periods of this sort before—most recently, in
the mid-1970's—but I think that the system has great resiliency
and strength, and great support when and if it's necessary, from
the governmental institutions.
Senator TOWER. Thank you, Mr. Chairman. My time is up now.
The CHAIRMAN. My policy has normally been to recognize Senators on the basis of when they came in, rather than seniority. But
we have had enough come in and go out that I'm not quite sure
44
who came in when. So, unless there are some objections from the
committee, I will simply stick to the seniority system and go to
Senator Proxmire. But if anyone remembers when they came in
and ahead of whom, we can go back to the normal practice.
Senator PROXMIRE. Mr. Chairman, I certainly would not object.
[Laughter.]
Chairman Volcker, as you know, I have been an enthusiastic supporter of yours and your policies—and I still am. And I do think, as
others have indicated, that the problem is that we have had an irresponsible fiscal policy that has gotten out of control. And you
have a very, very painful and difficult job.
On the other hand, I think that we ought to recognize that, when
you started this new policy in October 1979, of concentrating on
money supply, a prime purpose of that was to get inflation under
control. And I think with all the other problems in the economy—
and they are great—the inflation picture has improved, and has
improved sharply.
Last month was an abberration, but over the last 6 months,
there is no question that inflation is much better than it was. As
you know, that big philosopher, George Santana, used to say "fanaticism is redoubling your efforts when you've lost sight of your
objective."
I think that maybe the Federal Reserve Board is a little guilty of
that kind of Santana-defined fanaticism.
Here, as I say, inflation is under control. You are not adjusting—
as I understand it, you are not adjusting your money supply targets' ranges; they are still very conservative. And when we consider what causes inflation—inflation, as I understand it, and most of
us agree, is caused when demand puts pressure on limited production facilities.
Now we have a situation where, in our big industries, our creditsensitive industries, we are operating far, far below capacity. There
is enormous surplus manpower. It seems to me that the latest
report, only a week or so ago, indicated that for the first time in
years we are operating below 70 percent of capacity; the automobile industry, below 50 percent of capacity; the homebuilding industry, even lower than that.
And if we do increase the availability of credit, it would seem to
me that there is no way that that would be inflationary, even if the
increase in availability of credit were quite substantial.
So, how would you address that general notion, that inflation has
improved greatly and it is time that we do ease up, to some extent,
on the availability of credit in a credit-starved economy?
TURNED THE CORNER ON INFLATION
Mr. VOLCKER. I do think we have turned the corner on inflation,
but I don't think the problem is over. Of course, I would not agree
that we have lost sight of our objectives at all. Let me review the
targets.
In particular, based upon all recent historical experience, it is
our judgment that the targets as they are—and note that I have
said we find it quite acceptable to come in around the high end of
those targets—should allow room and be fully consistent with the
45
kind of recovery that most economists have been predicting in the
second half of this year.
That does assume that velocity will be more or less normal; it
doesn't have to be particularly on the high side for a period of business recovery.
What evidence do we have, other than looking at the historical
record, in making that kind of a judgment? I have noted that we do
think there are some potentially and actually unusual characteristics that may require some more liquidity and have required more
liquidity in the first half of the year than an absolutely literal interpretation of some of the targets indicated. If we found that to be
the case in the second half of the year, and there was clear evidence of that, I have indicated we would be willing to run above
the targets for a period of time.
But now we come to the other side of the dilemma. I agree with
you that, as I indicated, a lot of progress has been made on inflation. I agree with you that considering economic conditions, there
is every reason to believe that that progress on inflation can continue during a period of business recovery, certainly as far ahead
as we want to look now.
That's all on the favorable side. But in connection with the discussion with Senator Riegle earlier, look at long-term rates, for instance. To the extent that they are important and a key to sustaining recovery, I don't think we are going to do ourselves or anybody
else a favor with respect to long-term rates if we convey the impression or the actuality that we were no longer worried about inflation. I think it would be counterproductive in terms of impact
precisely on those interest rates that are so significant to business
and the housing area.
Senator PROXMIRE. I certainly wouldn't argue that you ought to
forget about inflation. It's certainly a serious and potential problem. But the difficulty is our deficits are so colossal, the Federal
Government is borrowing so much—you know the figures—the
early 1970's the Federal Government took $1 out of $6 of new
credit, last year took $2 in new credit, next year it will take close
to $3 out of $6 in new credits, crowding the industries like automobiles and homebuilding and so forth, so that they just don't have
credit available without paying very, very high rates.
It seems to me the realistic way to meet that would be to find
some way of making more credit available one way or the other.
Senator Lugar had one kind of proposal for the housing industry. I
supported that, and I think you opposed it, as did the administration. It may have been defective, but some way, it seems to me, we
have to work out an economic system to put our people to work
when obviously that idleness accomplishes nothing. It hurts our
growth, our efficiency, and we just have to find some way to overcome that. And part of it is high interest rates.
Mr. VOLCKER. I think you put your finger on the problem. You
identified the Federal budget as being part of the problem and, in
effect, seem to be asking if you can cure that through monetary
policy. We can't cure the Federal budget through monetary policy.
Now, it's a matter of judgment as to what is excessive money
growth; I fully agree that issue should and can be debated. But we
can't cure the basic problem resulting from the percentage of the
46
credit market availabilities absorbed by the Federal budget by creating an excessive amount of money and credit in total, because
then we would come back to the inflation side of the dilemma.
That would have an adverse impact on interest rates, rather than a
favorable impact on interest rates.
IDEAS TO CHANGE BUDGET PROCESS
Senator PROXMIRE. Let me ask you for some advice that you can
give us, then. Other Chairmen of the Federal Reserve haven't been
reluctant to give us that kind of advice. In fact, as long as I can
remember, every Fed Chairman has indicated to this committee
that the Fed can't fight inflation alone. Federal spending must be
constrained. We now have facing us the largest deficits in our history. The budget process has not convinced anyone that interest
rates can decline. In fact, some observers have said the budget
process doesn't work; it needs reform; we need an amendment to
the Constitution.
If you could change the budget process, what would you do?
Would you put a cap on Federal spending? Would you make the
budget a multiyear process, require a two-thirds vote on budget resolutions? How would you restrain them?
Mr. VOLCKER. I can give you some tentative ideas on that,
anyway. As I observe the budget process in recent years, I think
there is something to be said for making it a multiyear process—
making it, let's say, a 2-year time perspective. It appears that you
are continuously in the budget process now, and I wonder whether
it wouldn't be better to try to set out a framework for a couple of
years instead of for 1 year. You might get a better result.
As far as other' changes are concerned, I have been hesitant, to
say the least, about the particular structure of the balanced budget
amendment that's being considered by the Congress.
Senator PROXMIRE. You favor that or oppose it?
Mr. VOLCKER. I have great sympathy for its objectives, but I have
considerable difficulty with the particular form of the amendment.
Senator PROXMIRE. If you were a Senator, would you vote for it?
Mr. VOLCKER. If I had my druthers—and I was about to suggest
this—I think there is a bias in the system toward deficits and
toward more spending than the collective will would really suggest
is appropriate; it may not be a bad idea therefore to require, as you
were suggesting, more than a majority vote for spending of any
sort, whether or not it depended upon a particular phase of the
budget at a particular time. This is a very sensitive area. I think
you could probably improve the budgetary process if the President
had an item veto.
Senator PROXMIRE. You don't want to answer the question as to
whether you oppose a balanced budget?
Mr. VOLCKER. If I could vote on one of the other proposals, I
would prefer to.
Senator PROXMIRE. Do you think we should support a constitutional amendment balancing the budget or not, requiring by
amendment of the Constitution?
Mr. VOLCKER. I would like to move toward balancing the budget,
but I am not sure I would support that particular amendment.
47
Senator PROXMIRE. I will mark you down as not exactly sure.
Mr. VOLCKER. As I said at one point, I am for it with reservations, and maybe against it with reservations. I applaud the spirit
that's behind it, but I do have some reservations about that particular mechanism.
Senator PROXMIRE. Would you agree with Senator Riegle that
you are leaning no?
Mr. VOLCKER. I think that's probably accurate in this. [Laughter.]
Senator PROXMIRE. My time is up.
The CHAIRMAN. Senator Lugar.
Senator LUGAR. Chairman Volcker, in the past you have explored the problem of inflation, and among other points you have
made is that it's very difficult to break through various flaws, rigidities in our economy; that inflation may be a process in which various groups have the power to enforce prices and to enforce wage
levels, and as a matter of fact, as we have noted even recently,
some things that have been going well in inflation—the regrouping
of OPEC, at least temporarily. We had a spurt in the inflationary
side on the energy, based on 1 month.
In short, even though the policy of Fed, maybe of the whole Federal Government, has been to break the back of inflation, to what
extent are these rigidities that were a part of the picture 1 year, 2,
or 3 years ago still there and to what extent can we have any confidence that we are not likely to have very substantial inflation due
to the fact that people want to maintain their claims and are able
to do so politically?
Mr. VOLCKER. I think you put your finger on the heart of the
problem. We have one tool of policy which works in a rather crude
kind of way against those rigidities and claims of which you speak.
I think there has been some success, but the cost is much higher
than is necessary because of those rigidities and claims.
I would hope that out of this experience and the fact that those
who are in a most exposed position are not always the ones who
are hurt most immediately, we will find a different climate and a
more satisfactory situation in that respect. But it's been a very
long-term problem. It's the kind of problem which is addressed by
so-called incomes policies.
The way we have gone about that in the past in this country has
not been terribly successful, probably damaging on balance. That's
generally been my view of the experience in other countries.
At the same time, there is a lot of hard experience that is potentially relevant to us. There are some countries that do this job
better, reflecting a kind of social consensus, I suppose, as well as
some institutional arrangements that don't exist in this country.
Whether it's a process of annual wage bargaining across the board,
where all the parties take some account of how their particular
claims fit into the national need; whether it's a different climate
within particular countries as to labor-management relationships,
with implicit contracts with respect to employment as well as
wages; I think all of those things are relevant, and I would hope we
could learn from some of that foreign experience over a period of
time. But that's a long-range matter.
48
LARGE LASTING DEFICITS
Senator LUGAR. Let me ask a question that calls for general
counsel. I am disturbed by the fact that I think many of the rigidities are still there, and you may feel they may still be there, too.
We try to influence things so they become more fluid, but what if
we have a situation in which we still have very strong collective
bargaining arrangements, pricing policies, that may not have realism with regard to actual markets for goods and services, and I
wonder if, coupled with this, we have a situation of deficits that we
discuss today and we all condemn these, and really part of the
problem is congressional inability to stop the spending. The greater
part is simply that the economy is working so poorly, that the revenues coming in mean that if we're going to have very large deficits for a long time, largely because people do not make enough
money as individuals or as corporations, the whole tax base is
simply insufficient. So given even minimum requirements of social
security and defense situation and the Government, even at a minimum we have continued to have very, very large deficits because
the economy just didn't work.
For example, if automobiles are still in a decline, the housing situation is more of a disaster this month, steel clearly is still headed
down, agricultural implements already down and getting worse,
farm income not very promising except in the livestock area, clearly not in the grain side; there are just no signals on the horizon
that look toward greater income, and this probably means greater
deficits, not because people were irresponsible, necessarily, in economy—just because the economy doesn't work.
Now, on the one hand you would point out we can't give up the
inflation fight, and I would agree with that, but I wonder if companies and labor unions and various groups in our society are just totally unresponsive to the reality of what we face, and as a result,
continue to accept more and more unemployment and economic
disaster lamenting the political situation, while in fact the signals
just don't get out.
Mr. VOLCKER. If that were literally true, we'd have an impossible
problem. I think your statement is too extreme. I share your very
great concern about these rigidities and claims. But obviously,
people do respond, and we are seeing perhaps a greater response
than might have been expected. I think that is one reason why it is
important that we remain in a posture of concern about inflation,
because nobody is going to give up those claims if they think things
are going to be aggravated by inflation and that Government policy
is going to yield in those respects. I wouldn't be quite as pessimistic
as you are in that respect, or at least as your statement was.
As far as the budget is concerned, I think you have a difficult
enough problem in substance, but in communicating and in analyzing the situation, as I've indicated in my statement, I would discount very heavily that portion of the deficit which arises purely
from poor economic performance. You're quite right, obviously; the
economy isn't expanding. You're not going to get the revenues
normal in an expanding economy, and when you analyze the
budget situation at any particular point in time, I think you've got
to take account of that, but the deficit simply doesn't mean the
49
same thing if it is generated out of poor economic performance as
it does if it appears in a growing, rising economy.
I think the budgetary resolution, the budgetary deliberations, attempted to handle that problem, more or less correctly, by assuming we were going to have a satisfactory period of economic growth
during a time the budget was rising, then looking at the deficit as
it would be in a satisfactory economic environment. I think that is
the appropriate way to approach the deficit problem.
My only problem, looking at the deficit in that light, is that, even
If everything went just right, according to the budget resolution—
and Congress did everything it needs to, and those estimates were
right, and those administrative actions indicated in the budgetary
resolution actually produced every dollar that they were assumed
to produce—you would still end up with as big a deficit next year
as you have this year, assuming that you don't have the complication that you referred to.
Senator LUGAR. Doesn't that imply that the successful game plan
all along would have to have been one of dynamic growth? There
was no way for us to pay our bills without very substantial economic growth in the country, and that there is nothing at least that I
can see in that whole budgetary picture, nor in the monetary
policy of the Fed, that is likely to cause that degree of investment
activity to leap forward. In other words, we're all assuming that
this is a natural consequence. What goes down must come up; but
why? Is there anything out there right now that leads one to believe that investments are going to be made as opposed to money
parked at high interest rates?
RECOVERY PREDICTED
Mr. VOLCKER. When you speak of leaping forward, I don't know
what quantitative magnitudes you have in mind. I don't think it's
a process of leaping forward, but certainly it is one of progressing. I
think there are a lot of things out there that can produce an economic recovery. Business investment is not one of those in the
period immediately ahead; I think business investment is weak and
the economy is going to rise in the next few quarters, in my opinion, because consumption will be increasing, defense spending will
be increasing, defense ordering will be increasing, and because we
have had a very substantial inventory liquidation.
Inventories are notoriously difficult to pick in terms of timing
and magnitude, but it seems to me we should not expect to have
inventory liquidation at the rate of speed that has been occurring
for much longer. That turnaround in the inventory picture alone
can support an advance in economic activity for some period of
time.
What we would hope would happen, of course, is that as we get
into 1983, the business investment picture begins to turn around,
and the housing picture turns around so we have continuing support for economic expansion from those very important sectors of
the economy. It's better than nothing, but we don't want to have
an expansion that's resting on consumption, or even inventory behavior, indefinitely. That's not a very healthy kind of expansion.
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Senator LUGAR. You are confident that, if not automatic factors,
at least substantial factors are likely to lead to consumers buying,
the inventory situation turning around. Do you think this is a sufficient enough phenomenon that it cures itself without direct political action or some economic plan?
Mr. VOLCKER. Yes, I think that is the prospect. That doesn't
mean a very strong recovery in its early stages. It means a somewhat unbalanced recovery in its early stages. But there are indications of rising consumption; there were indications in the second
quarter; the June figure was not good, but the April and May figures showed sizable increases.
Of course, we had a tax cut effective on July 1. We have a large
Government deficit that is pumping out purchasing power. I think
there is hard analysis that suggests there is reason to expect forward movement on the economy.
Senator LUGAR. Thank you.
The CHAIRMAN. Senator Cranston.
CONSTITUTIONAL AMENDMENT
Senator CRANSTON. Mr. Chairman, could you spell out your concerns about the form of the constitutional amendment that is pending on balancing the budget?
Mr. VOLCKER. I testified on this some months ago and looked
very carefully at the Senate report and other discussions. As I said,
I very much sympathize with the objective, but you asked me about
the form. There, questions arise as to what happens when you have
a situation where, let's say, there is an indication of lack of balance
in the budget and you can't get a 60-percent vote to pass the unbalanced budget, because you have an impasse among those who say
"What do you do about it?"
In the analysis of the amendment that I saw it was quite clear
that it wasn't the intent of the authors to give the President any
additional power to do anything about that. There was discussion
about whether the Supreme Court would then step in and demand
action, and it was quite clear in the report that the authors of the
amendment didn't think that was a very good idea. The Supreme
Court shouldn't get into this thorny, political area. It was left, essentially, as I read it—overstating it a bit—that the forces of public
opinion would require that the Congress somehow reconcile the discrepancy.
How successfully would that process work out in a situation in
which—and this is conceivable, anyway—you have strongly held
views on both sides of the issue in a narrowly divided Congress?
Would you go for a 60-percent vote and have an unbalanced
budget? How would you collect a majority to cut back particular
areas? There seem to me difficulties of such a process.
There were also questions, which I have no particular expertise
on, as to how the spending could be accomplished through the back
door or pushed off on the States and local governments.
The objective is admirable. My question is whether there are not
better ways to achieve the objective.
Senator CRANSTON. There is a substantial question about whether or not the courts would not be drawn into the budget process in
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ways that would threaten the separation of powers. There is a
widespread feeling, I believe, that there would be ways to get
around the amendment, that ingenious accounting suggestions
could be provided and that therefore it could be rather meaningless, could raise false hopes, and would therefore rather demean
the Constitution processes.
Mr. VOLCKER. Let me say—I am repeating myself, and I apologize—that if you accept the basic analysis which was put very decisively in that Senate report—that there are institutional and political factors in today's world that push you into more unbalanced
budgets than anybody would think is desirable—then I think there
is something to be said about changing the constitutional processes
to counter that bias that seems to exist. It is a question of how to
do it.
Senator CRANSTON. It certainly is a question about how to do it.
There are faults in the proposed amendment that could be corrected. Whether or not they can be on the Senate floor I do not know.
One of my concerns about enshrining a mandate for a balanced
budget in the Constitution is the relationship between outlays, receipts, and economic assumptions, including monetary policy, aggregates and ranges of growth, which go into attempting to put together a balanced budget. In my view, one of the prime factors in
the gross underestimating of the magnitude of deficits by this administration, by prior administrations, lies in the original assumptions about monetary policies used by OMB which turned out to be
far removed from reality.
So, I would like your comments on the relationship of monetary
policy assumptions to the so-called unexpected deficits that appear
year after year in the budget. Do you feel, in other words, that an
inability to predict what the monetary policy was going to be was
one of the factors that led to an inability to project what the
budget was going to turn out to be and what the deficit would be
accurately?
Mr. VOLCKER. You can make a very general statement that there
are difficulties in economic forecasting, whether it's about monetary policy or anything else, that are going to affect the particular
numbers in the budget as they emerge. I don't think there is any
bias. I am not aware of any reason why there should be in predicting monetary policy explicitly that would lead to a bias in the
budgetary results in one direction or another over a period of time.
One of the difficulties, of course, always in the budgetary process
is projecting the economic environment that will exist. As Senator
Lugar was emphasizing, the revenue outcome obviously, and to a
lesser extent the expenditure outcome, depends on the level of economic activity. That can work in either direction.
The budgetary problem that an amendment ought to be aimed at
is that in good years, bad years, indifferent years the bias toward
deficits seems to exist. I might say, I don't see it as the purpose of
an amendment to enshrine a particular economic theory in the
Constitution, but rather to deal with what seems to be a kind of
political bias that operates in an environment—with whatever particular theory you are operating under at the time.
Senator CRANSTON. That may be part of the purpose, but the
actual effect of the proposed amendment in its present form is to
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fix one economic theory in the Constitution, the theory that a balanced budget is advisable under all circumstances and a provision
limiting the growth of Government in a very severe way by tying it
to national income without defining what national income is.
Mr. VOLCKER. That is why, I suppose, in a kind of conceptual
way, that bias probably exists in good years, bad years, whether
the budget happens to be balanced in some particular year or not.
If you have got a chronic problem of too easy spending, in some
sense, then deal with that directly rather than only in years when
you have an unbalanced budget.
Senator CRANSTON. In relationship to the question I was asking
you about, projecting what is going to happen, would you see any
problem in requiring the President and the Congress, both to propose a statement of outlays and receipts through a constitutional
amendment in order to come up with one that is in balance, would
you see any problem in requiring the President to state the monetary policy which is assumed to underpin the balanced budget
statement just so you have some idea of what to expect and upon
what the balanced budget was based in terms of monetary policy?
Mr. VOLCKER. I think I am skeptical of enshrining that kind of
thought in law, let alone in the Constitution. You have got a problem, a kind of threshold problem, of how you measure monetary
policy; we struggle with that all the time.
But what is the meaning of these particular monetary aggregates
over time? That is a very definite question when you are in a world
of shifting technology and a shifting financial environment. Even
in a particular period of time as this year, I think we have to
evaluate the meaning of growth in any particular aggregate, or all
of them together, in the light of changed circumstances during the
year, and I don't know how you would reduce that to a statistic at
the beginning of the year.
We do it as carefully as we can, of course, in setting these targets; but if everybody were, in effect, putting forward a different
number, you would have even more problems, I suspect, in making
intelligent judgments during the year.
Senator CRANSTON. Your response would seem to underscore the
great difficulty, at the beginning of a year or even before a year is
begun, to predict what is going to happen to the economy and what
the effects of that will be on the budget.
Mr. VOLCKER. I agree with that.
Senator CRANSTON. You have met in recent days with Mr. Meese
and Mr. Baker and other people in the White House. Did their
views on the state of the economy and what monetary policy
should be have any impact on the decision made now to reduce the
discount rate?
Mr. VOLCKER. No, I don't think that decision was affected by any
conversations that I have had with members of the administration.
I have continuing conversations with members of the administration whether or not we are changing the discount rate.
Senator CRANSTON. Are you at liberty to tell us anything about
the views that they have been expressing concern about Fed policy,
its impact on the economy?
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Mr. VOLCKER. I think it is no great secret to say that they, like
everyone else, share concern about the economy, interest rates, and
the whole surrounding set of issues.
Senator CRANSTON. Well, they are naturally concerned, but are
they specifically concerned about the effect of Fed policy, as presently pursued, on interest rates and, hence, on the economy?
Mr. VOLCKER. I don't know exactly what you have in mind, but
in terms of particular criticisms or very specific suggestions, no.
Senator CRANSTON. They have not made any suggestions for any
particular changes in the Fed policies?
Mr. VOLCKER. No.
IMPACT OF GOVERNMENT BORROWING
Senator CRANSTON. Can I ask one more question? My time is up.
What do you think will be the impact on interest rates when the
Government proceeds to borrow some $50 billion or a somewhat
similar sum because of the size of the impending deficit?
Mr. VOLCKER. If you borrow $50 billion, or whatever the figure,
in the next few months, interest rates will be higher than they otherwise would be. But I would be hopeful that we can get through
this period with declining rates. If anything, interest rates are extraordinarily high to start with.
The economy is soft. Private credit demands could well decline
during this period, and they have not been particularly high. There
have been a lot of credit demands on the banking system, and they
are very visible; there is a certain amount of pressure in the banking system because so much of the business credit demands are
short term and focused on the banking system. But, fortunately,
private credit demands in total are not so high at the moment, for
obvious reasons; the economy is soft.
I don't think that Treasury financing job, large as it is, in the
near term presents an insuperable obstacle to lower interest rates
during this period, but it sure doesn't help.
Senator CRANSTON. Thank you very much.
The CHAIRMAN. Senator Brady.
Senator BRADY. Chairman Volcker, I would like to go back to
Senator Lugar's line of questioning, which was generally aimed, I
think, at how does the economy start going again. I have a concern
that we are in kind of a gridlock with respect to interest rates,
where we have all sorts of intersecting forces that sort of met at a
corner, and I don't quite see how we are going to get out of it.
HUGE SHORT-TERM BORROWING
One new phenomenon, and I would like to get your feeling on it,
is that after the 1974 recession the additions to short-term credit
were limited. I think in 1975 and 1976 the flow of funds charts
would indicate that there wasn't a great deal of short-term borrowing. Now we are in a recession in 1981 and 1982, and you have
almost the reverse phenomenon, which is huge borrowing in shortterm markets.
I am sure you have thought about this, and I wondered whether
you have any feeling as to what would alleviate that new phenom
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enon. Why does the phenomenon exist now when it didn't exist in
1974?
Mr. VOLCKER. I think there has been some tendency for borrowing to take place either to maintain or improve liquidity positions
in a period when profits obviously have been reduced. The complicating factor is that businesses generally have had a trend toward
depleted liquidity positions, not just in the last 6 months, but in
the last 20 years, quite literally, and all during the 1970's.
They went into this recession with liquidity positions affected entirely apart from this recession, liquidity positions that were already well depleted, balance sheets that were strained relative to
earlier periods, with less equity, more short-term debts. Then they
get squeezed by the recession and they have to maintain liquidity.
There is a lot of concern about liquidity positions, and so, I expect,
some anticipatory borrowing.
There are some indications that the corporate sector as a whole
is showing increased liquidity. If the economy turns around, and as
the economy turns around, you ought to get some increased cash
flow from profits. And, as confidence returns, you could see less
demand for business credit for a time and, perhaps particularly,
demand less concentrated on the short-term market to the extent
the long-term markets open up at all.
You used the figure of speech gridlock, and I think that is appropriate in some respects, because demand is concentrated in the
short-term market, as the long-term market has not been very inviting. Short-term rates have remained high, and that helps to
keep the long-term rates up; and with long-term rates up, people
borrow short, which tends to keep the short-term rates up.
But gridlocks can be broken; this is taking longer than most
people expected, but the favorable factor in the outlook is, indeed,
that inflation is coming down. I think inflationary expectations are
changing, and that, in a fundamental way, sooner or later, is going
to contribute to breaking that gridlock.
Senator BRADY. If you had to guess where the gridlock might be
broken, where would you think it was going to be?
Mr. VOLCKER. I am not going to guess precisely. Maybe we see
something of that happening now, but I don't want to make a precise forecast.
Senator BRADY. With regard to the two markets that Senator
Tower was referring to, the short-term market and long-term
market, to what degree is the Fed's ability to help—and be imaginative—blocked off by the fact that fiscal policy has produced such
huge deficits? I think we have generally agreed that an important
reason for high interest rates in the long-term sector is high deficits and the expected return to inflation.
Mr. VOLCKER. To a substantial extent that does block it. It is obviously not within our control.
Senator BRADY. So that your ability to do too much which
wouldn't be regarded as monetizing the debt is blocked off by the
fact that fiscal policy really hasn't left you with the options that
you would have if that policy were restrained?
Mr. VOLCKER. That is correct.
Senator BRADY. I don't have any further questions.
The CHAIRMAN. Senator Sarbanes.
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Senator SARBANES. Thank you, Mr. Chairman.
Chairman Volcker, the paper in the last few days has the headline "With Elections, Fed Chairman Gets the Lunch Touch."
I think we'd be interested to know what the lunch touch was and
what it was you were getting at those lunches.
Mr. VOLCKER. Perhaps that gives the wrong impression. Perhaps
I should say I paid for the lunches. [Laughter.]
Senator SARBANES. That puts the conflict-of-interest question at
rest, perhaps, but it still doesn't address the question of the substance of policy.
Mr. VOLCKER. The point I'm making is that I have conversations
with the relevant officials of the administration from time to time.
In particular, I met with Mr. Meese some time ago—quite a few
weeks ago. I happened to meet with Mr. Baker much more recently, and I meet with the Secretary of the Treasury very frequently.
These are just things that are done
Senator SARBANES. Would you say that the policy the Federal Reserve is pursuing in the monetary area is the policy which the administration wishes it to pursue, that the Federal Reserve and the
administration are consonant on monetary policy?
ADMINISTRATION SUPPORTIVE OF PRESENT MONETARY POLICY
Mr. VOLCKER. I am, as I said before, not aware of any real problems in that respect. I think they have generally been supportive of
what we're trying to do and the general way we go about it. But I
guess you had better address the question to them
Senator SARBANES. No; I'm interested in knowing your perspective of their view of your policy.
I take it from your answer that your perspective is that they, in
fact, support the policy which you are pursuing; is that correct?
Mr. VOLCKER. In general terms, that's certainly my impression;
yes.
Senator SARBANES. When you testified in front of the JEC in
June, you said that you and the President had discussed interest
rates a couple of months earlier.
Was that the last time you met and discussed interest rates and
monetary policy with the President?
Mr. VOLCKER. Yes.
Senator SARBANES. You have not met with him since last February?
Mr. VOLCKER. Correct.
Senator SARBANES. Mr. Chairman, I want to say, in the strongest
terms, that I think there's a quality of "Nero fiddling while Rome
is burning" about this entire discussion.
You have used such phrases this morning as "encouraging
signs," "upward momentum," "situation has great opportunities."
It seems to me the one reference in your statement that is pretty
close to being in touch with reality is where you talk about the
crumbling economic foundations of a continuing recession. Unemployment is at the highest level it's been since before World War
II, now at 9V2 percent; business bankruptcies are at an all-time
high, since before World War II.
56
We are confronting an economic situation in which this talk
about "upward momentum" and "when the recovery takes place"
is really not consonant with conditions in the real world.
I'd like to know why you seem to regard lower interest rates as
giving up the fight on inflation?
Mr. VOLCKER. I don't regard lower interest rates as giving up the
fight on inflation. I would regard it as giving up the fight on inflation if we had an unrestrained growth in money and credit, and
that probably wouldn't produce the lower interest rates.
To put it the other way around, I think lower interest rates
would be a sign of success and confidence in the fight on inflation
if they came about in the right way.
Senator SARBANES. We're getting back a little bit to Senator
Brady's question about how to break the gridlock.
You keep referring to the budget problem, and I take it that
problem, as you see it, is large deficits, particularly projected into
future years when there are favorable assumptions being made
about the state of the economy; is that correct?
Mr. VOLCKER. Correct.
Senator SARBANES. Do you concede that the high interest rates
have helped to provoke the downturn which we are experiencing,
and the increase in unemployment from 7.2 percent to 9.5 percent?
Mr. VOLCKER. In a direct sense, yes. But I don't think that's the
whole story. You have to ask why they're so high.
Senator SARBANES. The interest-sensitive sectors of the economy,
housing and autos are depressed. Housing starts are now below seasonally adjusted rates of a million units. Housing, which we have
always counted upon to some extent to lead us out of a recession, is
in a deep depression.
It's my calculation that this increase in the unemployment rate
from 7.2 percent to 9.5 percent represents an addition of between
$60 and $70 billion to the Federal deficit.
Do you differ in any marked way with that calculation?
Mr. VOLCKER. Certainly the weak economy contributes to deficits.
I don't know about your particular calculation, but the recession
has a substantial impact, which I think, to a degree, you should abstract from in your budgetary decisions, as I indicated earlier.
Senator SARBANES. The higher interest rates also increase the
carrying charge on the Federal debt, is that not correct, and thereby also contribute to an enlargement of the deficit?
Mr. VOLCKER. In a direct sense, yes.
Senator SARBANES. In fact, Walter Heller, in a column not very
long ago, said "the Reagan mix of ultra-easy fiscal policy with
ultra-tight monetary policy boosts both interest rates and the Federal debt and thus will cost the Treasury an additional $40 billion
or so per year.
How long can the country endure current economic conditions
without a fundamental loss to the Nation's productive base and to
its social fabric, to which jobs and housing are essential?
Mr. VOLCKER. I don't know the answer to that question. My expectation is, of course, that the economy will begin showing some
recovery.
Senator SARBANES. You've been telling us that for a long time. I
don't want to drag out your past statements.
57
Mr. VOLCKER. I think you can drag out my past statements and
find I've been very consistent in saying that I expected some leveling of the economy in the second quarter.
Senator SARBANES. Some leveling? Do you call the highest unemployment since World War II as some leveling?
Mr. VOLCKER. Yes; some leveling in the second quarter, and I expected some recovery in the second half of the year. That remains
my expectation. I didn't say it was satisfactory. I say, technically, it
does not appear that the gross national product declined in the
second quarter. I'd rather see that than see a decline.
POSSIBILITIES OF LOWER INTEREST RATES
Senator SARBANES. Let me ask you this question. If lower interest rates would have given us more economic activity, avoided the
rise to 9.5 percent unemployment, held down the carrying charge
on the Federal debt, and therefore represented potentially, let's
say, a contribution of $75 billion toward the deficit, then why
wouldn't a policy of the Fed for lower interest rates—and I'm not
talking about opening the floodgates, but about interest rates at a
level that would permit something approximating normal activity
in the interest-sensitive sectors—have been a major contribution to
moving the economy forward, a major and responsible contribution,
without reigniting inflation?
After all, the inflation you're concerned about you tied to the
deficit. And the deficit is related to the high interest rates which
have provoked the economic downturn.
Mr. VOLCKER. I think the trouble with that line of questioning,
Senator Sarbanes, is that it assumes we have some magic wand we
could wave to produce a lower level of interest rates without all
those other side effects that you have just assumed away. I haven't
got all those powers.
Senator SARBANES. Do you have the power to lead us toward
lower interest rates?
Mr. VOLCKER. Not regardless of economic conditions, no.
Senator SARBANES. And what is the relationship that you see in
terms of inflation with lower interest rates at a time when the
economy is working so far below capacity, as it is today?
Mr. VOLCKER. I'm not sure I understand the question.
Senator SARBANES. Suppose we had interest rates today at, let's
say, 12 or 13 percent.
Now, how would that contribute to inflation?
It would seem to me that that would contribute to economic activity that would help to lower the deficit, bring down the carrying
charge. The deficit would be lower.
Mr. VOLCKER. I don't know what interest rates you are referring
to. Some interest rates are below 12 or 13 percent. Some are above.
Senator SARBANES. That's not much comfort for the people in
homebuilding and other sectors.
Mr. VOLCKER. I agree it's not much comfort to them.
Senator SARBANES. What's going to happen to them?
Mr. VOLCKER. You assume I can say interest rates are going to be
8 percent or wherever you want them, and that nothing else is
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going to happen, and that's going to be a wonderful thing for the
economy,
If I could just dictate that interest rates are going to be 8 percent, without any adverse effects, that the money supply is going to
be on target, and that the deficits are going to be fine, I would go
do it. I haven't got that kind of power.
Senator SARBANES. Is there a relationship between the money
supply and the interest rates?
Mr. VOLCKEE. A complex relationship.
Senator SARBANES. Do you control the money supply? Do you
care to accept that proposition?
Mr. VOLCKER. We certainly influence the money supply.
Senator SARBANES. For years, the Fed focused on the interest
rates, which are, after all, the variable that the people in the economy have to work with.
You departed from that a few years back. I don't see that that
departure has enabled us to develop a policy to keep the economy
moving on some reasonable track.
Mr. VOLCKER. I think we have made a lot of progress in some directions, and we have had very heavy costs in the short run.
Senator SARBANES. I'm not ignoring the problem of inflation, but
I think any economic policy that does not address both the problem
of inflation and the problem of full employment is a failure. It's got
to address both of those issues.
We now have a situation where we have the highest unemployment since before World War II. And in some States, the figures, of
course, are double digit. Now, there are people, who see everything
they've done over a lifetime being lost, both workers and businessmen.
COUNTERPRODUCTIVE
And I don't see that the policy of the Fed and the administration—because, as I understand your opening comments, your policy
is in harness or in tandem with the policy which the administration wishes you to pursue is anything but counterproductive. It is
helping to compound the very situation which you say you are concerned about.
You talk about the size of the Federal deficits, and yet we can
trace, albeit in a complex way, a good part of those deficits to a
monetary policy which has helped to promote the economic downturn.
Mr. VOLCKER. Obviously, I don't agree with that analysis. I have
indicated that that part of the deficit that can be attributed directly to subpar economic performance should be analyzed in a different way.
I do agree with your basic comment that economic policy in general and monetary policy in particular has to be concerned with all
the characteristics of our economy. Where I guess I disagree, as a
practical matter, is that we can instantaneously achieve all those
things.
Let me point out that the kind of problems you described for the
American economy, which are very real, are absolutely endemic
among other industrialized countries. You can take practically any
country in the Western world today and find that unemployment is
at the highest level in the postwar period.
Senator RIEGLE. What's the prime rate in Japan—interest prime
rate? I think it's 5% percent.
Mr. VOLCKER. I don't know what the prime rate is in Japan. Interest rates are much lower. Japan has the best economic performance of any of these countries. They have a very low inflation rate.
But even Japan, relative to its performance, has not been growing
very healthily; it's not growing at all now.
Senator SARBANES. They're all related.
I keep getting notes. My time is up.
They re all related to the high interest rates in this country.
Was not that a subject on the agenda at the Versailles Conference?
Mr. VOLCKER. Yes; but I think it's oversimplified to trace all the
problems in the world to particular interest rates in the United
States.
Senator SARBANES. I'm not trying to do that, Mr. Chairman.
I recognize the complexity of the problem. But the point I'm
trying to make is that your presentation, as you continually give it
to the committee, seems to posit that any move to lower interest
rates is giving up the fight on inflation, but that is, first, not accurate and, second, sends the wrong message to the country.
It's my contention that we could move toward lower interest
rates in a reasonable fashion. Again, I'm not talking about opening
the floodgates, but moving toward lower interest rates without igniting inflation, helping to restore activity to the economy and, in
fact, making a contribution both to the fight against unemployment and to the fight against inflation.
Mr. VOLCKER. To the extent that's possible, maybe we aren't in
any disagreement. I agree with you. My only disagreement is
whether one can force that development regardless of whatever
else is happening with respect to monetary growth, credit growth,
the economy in general. I just can't force that.
I agree it would be very desirable to have that happen, and I
think it can happen.
Senator SARBANES. We have got to move in that direction.
I don't think it's adequate to talk about hopeful signs and say
the situation offers great opportunties at the same time that you
can concede that there is a crumbling foundation of continuing recession.
The CHAIRMAN, Senator Dixon.
Senator DIXON. Thank you, Mr. Chairman.
Mr. Chairman, I'd like to switch gears with you for a minute and
then come back to the economic question.
First of all, I want to say I was delighted to hear your expression
of support for a line item veto power for the Chief Executive.
I would like to tell you that immediately prior to our Fourth of
July break, on the occasion of the second veto of the urgent supplemental by the President, I made a statement in the Senate supporting the line item veto and said I'd introduce a constitutional
amendment on that line.
And I expect to offer an amendment to the budget-balancing
amendment giving the President that power.
http://fraser.stlouisfed.org/
Federal Reserve
Bank
of St. Louis
97-656
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In my State, the Governor has a line item veto power, with a
right to override in both legislating bodies by a constitutional majority and save millions of dollars there.
I think it would have a very, very good impact upon the budgetbalancing capability of the Congress at the present.
So, I thank you for your remark.
Mr. VOLCKER. I didn't realize you introduced that amendment. I
congratulate you.
Senator DIXON. One other thing I'd like to pursue with you in
connection with what Senator Cranston discussed with you is the
question of the amendment that will be before us again when we
leave the tax bill.
As you know, in section 3 of that amendment, the three-fifths
majority can be waived upon the declaration of a war.
AMENDMENT FOE NATIONAL ECONOMIC EMERGENCIES
I am going to offer an amendment that would extend that power
to national economic emergencies.
And I wondered if you would express your view on the importance of having that waiver power when we encounter either very
serious recessions or depressions, as we have in the past?
Mr. VOLCKER. I certainly understand what you're after. I suppose
in those conditions you'd get the 60-percent majority anyway. I
would support the substance of what you are saying. I don't know
whether you mean you would leave that up to a Presidential declaration or what.
Senator DIXON. It would be necessary to have an enactment by
the Congress and signature by the President, so it would be a joint
effort of both.
Mr. VOLCKER. I appreciate what you're after. I'm a little cautious
about getting into detail on a piece of legislation that I haven't
seen and analyzed more completely.
Senator DIXON. Mr. Chairman, I'd like to pursue a little bit what
my friends from Indiana, New Jersey, Maryland, and others have
pursued with you here, and that is the question of the basic policy
that you have adopted at the Fed. Early on, after your remarks, I
made a note on my first page, "more of the same." I don't mean
that critically, but would you say it is a fair analysis that you have
come to this committee essentially during my short tenure here,
telling us pretty much the same things, advocating pretty much
the same policies both by the Congress and by the Fed, as the appropriate solution to our problems.
Is that a substantially true statement?
Mr. VOLCKER. Yes.
Senator DIXON, Basically, a monetary policy that you have pursued in the past, one that you have indicated to us again in your
statement today, one you perceive to be the solution to our problem. But I would want to ask you whether, in fact, the evidence is
not to the effect that so far that policy has not worked in the country.
Mr. VOLCKER. I think the evidence is that it's extremely difficult
to turn around in terms of inflation. I think those difficulties multiply when so much of the burden falls on monetary policy. I think
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those are very substantial problems, but I don't conclude from that
that I know of a better policy, because I think we've got to deal
with these problems, using the tools that are at hand.
Senator DIXON. If I might pursue that for a moment with you,
Mr. Chairman, sometimes I think I hear from you and others in
this committee and here on the Hill different things and sense of
perception here of a different world than I find when I go back to
my home State of Illinois—I was back there this past weekend—
unemployment is 11.3 percent. Housing starts in my State were
down the most in the country, down 77 percent last year under the
prior year, which was a terrible year. I spoke in Rock Island
County this weekend, 26,000 people are unemployed, looking for
work and want to work in Rock Island County. The automobile industry is decimated. Every one of my thrifts is against the wall and
coming here, telling me they're hanging by their fingernails. I'm
asking whether in that circumstance our policy can be described as
adequate, and I pursue that by saying this: others have alluded to
the fact, my friend from Wisconsin has, and others, to the fact that
before October 1979, we also targeted interest rates. There were
some other things in your policy that, at least in the perception of
people I know, now appear to be rational policies applied to a given
set of circumstances.
I ask you whether you have ever considered that policy, once
again given the very serious times we've had.
Mr. VOLCKER. Let me describe the policy we had before October
1979. We also were targeting the money supply then. We put more
weight on very short-term interest rates as an instrument to
achieving this same target that we are now aiming at. I'm describing a difference in mechanism to achieve the same target, not a difference in targets. The operational variable, so to speak, has
changed; we now much more importantly target reserves rather
than trying to influence the Federal funds rate from week to week.
The previous policy did not necessarily dictate that given the same
monetary targets you would have had lower interest rates. We
would have aimed at the Federal funds rate as the variable in the
short run, but we might have had to go to a very high rate to
achieve the same control over the monetary target.
I think it's fair to say the difference between that technique and
the present technique is that we had more short-run stability in interest rates, at least in the short-term rates, under the old technique, but I don't think it said anything about the level of the interest rate.
Senator DIXON. But the very nature of the stability of those interest rates in my view had a lot to do with the continuation of
that stability. One of the things I see in the very high long-term
rates is the fear of future inflation and other adverse experiences
that'a keeping that market so high, when under ordinary circumstances, real interest rates, over and above the inflation rate,
would be 2 or 3 percent. Now it's substantially more than that over
the inflation rate.
It just seems to me, and I don't mean to be overcritical of what I
consider to be your tenacity and coolness under fire, but it does
seem to me that the point is that in the past those policies have
produced a better result for the economic commmunity.
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Mr. VOLCKER. One of the reasons we changed—there were a variety of reasons—is that the decade before 1979 had been characterized by rising inflation and progressively poorer economic performance, I might say, over time. We had higher unemployment at the
end of that decade than we did at the beginning. We had a lower
productivity trend and higher inflation. By the end of the decade,
the threat clearly was that the inflation rate would accelerate and
economic performance would continue to deteriorate. The change
in approach was designed to make the point and to implement the
point that the monetary aggregates would be brought under appropriate control and that the inflationary tide would be turned.
With respect to that particular objective, I think there's been a
good deal of success. We've also run into a real problem in the
economy while these changes are taking place.
Senator DIXON. Could I make this point, Mr. Chairman, that I
would concede, as every member will, the results with respect to
inflation from your stated policy, but I have to say to you that we
have had deficits in all but 1 year in the last two decades. To the
best of my recollection, the deficits have been there. I can tell you
this, however, these are the worst economic times we've had in my
adult lifetime. So there has to be some reexamination of some of
the policies that we are following around here, if we're going to
turn this thing around.
It at least seems to me that we ought to look back to what we did
before, if it was a better result.
Mr. VOLCKER. Obviously, I agree with you that policies ought to
be reexamined, and I do not think our total mix of policies is ideal,
to say the least. We are only dealing with one aspect of policy now,
monetary policy. When you talk about changes in policies, presumably, you talk about the whole framework of policy. We have fiscal
problems. I am personally very sensitive to the kind of problems
Senator Lugar raised, which I don't think anybody is working on
very much, but over time should be.
They are a very difficult, intractable set of problems, and when I
look to a longer run, I think they have to be an important component of a successful economic policy that, indeed, reconciles stability with growth.
I think we can get that out of our present policies, but it will
take longer and yield much more distress than would otherwise be
necessary.
Senator DIXON. Then let me ask this final question. Again pursuing the question of that policy with reference to targeting interest
rates as have been done prior to October 1979 and reverting one
more time to a classic example of a really troubled industry,
thrifts, which I suppose in my State are in more difficult circumstances than many others. It came to my attention the other day,
for example, that right now the Federal National Mortgage Association is earning about 10 percent on its portfolio, but is paying over
11 percent for its capital. I want to ask you, given the circumstances, how much longer that kind of an industry can tolerate
these rates before something dramatic happens in this country that
is destructive to our market?
Mr. VOLCKER. I have no quarrel with the proposition that we
would be much better off if interest rates were lower. The only
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question is how to get them there and keep them there. I have no
quarrel with that proposition at all.
Senator DIXON. I thank you.
The CHAIRMAN. Senator Sasser.
Senator SASSER. Thank you, Mr. Chairman.
SMALL BUSINESS BANKRUPTCIES
Mr. Chairman, we've had a lot of discussion here today of esoteric economic theory, but the simple truth is that small business is
being crushed in this country. In my native State of Tennessee,
small business is being snuffed out of existence by high interest
rates. I recently contacted the administrative officer of the bankruptcy courts in my State, and I was absolutely flabbergasted by
these statistics.
In the first quarter of 1981, there were 395 business bankruptcy
filings in my State. In the first quarter of 1982, there were 701
business bankruptcy filings. That's a 77-percent increase in business bankruptcy filings from the first quarter of 1981 to the first
quarter of 1982.
Now I contend, as my small business constitutents have confirmed, that their businesses have failed or are on the verge of failing largely as a result of high interest rates. They are paying 18 to
20 percent to borrow money for capital, and small business just
simply cannot last or last very long in that sort of environment.
Now my question to you is this: What does the Federal Reserve
Board intend to do to ease the interest rate burdens on small business, or are you just going to stand by at the Fed and watch this
rising tide of bankruptcies go on and more and more small business
people go under? Can you give us some hope, Mr. Chairman? A lot
of these people are living on hope.
Mr. VOLCKER. I certainly can give you the hope and the expectation that interest rates will move lower over time. I think the fundamentals point in that direction. No one would be happier than I
to see interest rates move lower, but we come back to the old question of how can that be done within the scope of the tools available
to monetary policy, not only getting them lower, but getting them
to stay lower. We come back to these same old questions of gridlock
or problems that have looked quite intractable. I think, in fact,
they are going to prove tractable, and what's going to make it all
possible is a sense of progress on inflation and continuing progress
on that front to lay the basic groundwork.
Senator SASSER. Let's talk about that just a moment, Mr. Chairman.
Now we have today the highest real interest rates, that is, interest rates corrected for inflation, that we have had in this centuryJust looking at some numbers here, in October 1979, we embarked
upon a new monetary policy under your leadership. At that time in
1979, the prime rate was roughly 12 percent; the GNP deflator was
8.5; and we were running real interest rates of 4.1 percent. By
1980, the prime rate was up to 15 percent; the GNP deflator was 9
percent; and the real interest rate was 6.3 percent. In 1981, the
prime rate jumped to 18.8 percent, with the GNP deflator at 9.2,
meaning real interest rates were at 9.7, almost 10 percent. And in
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1982, with inflation coming down—no doubt about that—the prime
rate's at 16 percent, the GNP deflator at 3.5 percent and real interest rates at 12.6 percent.
INTEREST RATES CONTINUE TO RISE
Now my question is this: if our policy is to try to drive down inflation with high interest rates, it appears to me, Mr. Chairman,
there's been some success in that regard. Now why are interest
rates continuing to go up, and why do we have real interest rates
at the highest point in this century? What's the answer to that?
Mr. VOLCKER. Interest rates, real interest rates are very difficult
to measure. Let me make a preliminary comment. It's hard to
measure what the precise inflation rate is, and real interest rates
really depend on a determination of what expected inflation is,
rather than on any rate you can measure directly.
The prime interest rate is extraordinarily high historically, relative to market rates at the moment. You would not get a different
picture in character, but you would get a different picture in the
extremes that you cite if you used an interest rate other than the
prime rate.
Having said all those things, real interest rates are certainly relatively high. I don't think it's true that they're the highest they've
been in the century, but that's besides the point. They are very
high; there's no question about that by any reasonable
Senator SASSER. You wouldn't agree that they're the highest
they've been since 1900 in real terms.
Mr. VOLCKER. If you make a mechanical comparison between interest rates and the inflation rate, you'll find a few episodes when
they were higher. They weren't very happy periods in economic
history, so I won't pursue that point further, but such rates are not
totally unprecedented. They're very high; there's no dispute about
that fact.
You come back to the question of why, how do you get them
down, what's responsible for it? Going back to late 1979, early 1980,
we begin to look at that period, I guess, with a little nostalgia. It
wasn't a very nostalgic period to live through. The inflation rate
was accelerating, everyone was scared to death about what was
happening to the economy—and rightfully—and about inflation.
Senator SASSER. They're not very sanguine about what's happening to the economy now,
Mr. VOLCKER. I agree with that, which is indicative of the fact
that we've got a problem. It was not born yesterday, but developed
over a considerable period of time. Again, it conies back to the
question of what approaches can we best adopt to deal with that? I
have described what we try to do with monetary policy. I have indicated that we are sensitive to the liquidity needs of the economy.
Unfortunately, we have just one tool of economic policy, and we
are dealing with an accumulation of problems over a period of
time. I can only tell you what I think is best, even in explicit
terms, for getting interest rates down and, as I keep emphasizing,
not just getting them down for a month or two but sustaining a
lower level, in terms of the tools we have at our command.
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Is it a happy situation? No, I'd much rather see interest rates
lower, and I would be delighted to see them decline as rapidly as
they can, consistent with what I think is necessary to keep them at
a lower level.
Senator SASSER. The disturbing thing to me, Mr. Chairman, is
that when we embarked—I say, "we," the Federal Reserve Board
embarked on this course in 1979—I remember vividly your telling
us in the Budget Committee in the spring of 1980 that high interest
rates were a product of inflation, and that they would drive inflation down. Some of us were unconvinced at that time; in fact, I've
never thought that you can combat inflation strictly with monetary
policy. We now find that inflation is coming down considerably. I
had some statistics here earlier that indicated that the GNP deflator for the first quarter of 1982 is 3.5 percent; down dramatically,
yet we still find our interest rate figures high and our real interest
rate figures high.
We see that inflation is coming down, but interest rates aren't
coming down. And we see our economy in very, very serious difficulty now. Comparing this recession of 1981 and 1982—and I'll
yield to you in just a moment—comparing the recession of 1981-82
to the recession of 1973-75, which was a very deep and a very
severe recession, we find that in the recession of 1981-82 corporate
profits are off 30 percent, as compared to only 23 percent in the
previous recession. We find there are 2 million more people unemployed in this recession than there were in the 1973-75 recession,
and we find mortgage delinquency rates are up almost 20 percent.
All of this is occurring. Inflation is coming down, but interest
rates in real terms are at one of the highest levels, I think we'll
agree, in the century.
Mr. VOLCKER. One of the highest.
Senator SASSER. That clearly indicates to me that something is
wrong with this policy that we are pursuing. And if we don't reverse it, Mr. Chairman, I have some very grave fears that we're
going to be in desperate straits, if we're not already.
Mr. VOLCKER. Again, I think I have to answer the Senator by
saying that I'm sure there can be, and should be, improvements in
economic policy in general. I think that some degree of difficulty in
this present situation was inevitable as a transitional matter. But
if you asked me whether it could have been handled better through
a different combination of policies, I would certainly agree with
you.
PRESSURE ON MONETARY POLICY
Indeed, I think too much of the burden was put on monetary
policy, which helps account for the high interest rates.
Senator SASSER. No doubt.
Mr. VOLCKER. There is no question that when monetary policy
carries the full thrust of reversing an inflationary situation, you
are likely to have more pressures, strains, higher interest rates
than would otherwise be the case. That's not the world that I made
or that the Federal Reserve made; that's the world that we live in.
Anything that could be done in any other area to help out, I would
welcome.
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I do think that this pressure on monetary policy is partly responsible for what you observe with respect to interest rates. Where I
may differ with you is whether interest rates should follow a substantially different course, given the environment in which we
have to work.
Senator SASSER. One final question, Mr. Chairman. My time is up
and I will be very brief.
Recently, U.S. News and World Report stated—quoting David
Stockman—that the administration endorsed the Federal Reserve's
tight money policy. Mr. Stockman said of the Board's monetary
policy—and I quote—"We endorsed it, we urged it, and we have
supported it."
Well, almost contemporaneous with that, on Good Morning,
America the Secretary of the Treasury, Mr. Regan, stated—and I
quote him—"High interest rates have brought this economy right
to its knees." And he indicated he directed the Treasury Department to study various alternatives that the administration might
pursue, to lower interest rates or otherwise curb the independence
of the Federal Reserve Board.
Now, in your mind, Mr. Chairman, where does the administration stand on this monetary policy?
Is David Stockman right? Have they endorsed it? Have they
urged it? Do they support it?
Or is the Secretary of the Treasury correct, in being critical of it
and directing studies to try to lower interest rates and perhaps
even do something about the independence of the Federal Reserve
board?
Mr. VOLCKER. As I indicated earlier, in response to Senator Sarbanes, my perception is that they've been generally supportive of
the thrust of monetary policy.
Senator SASSER. So, Mr. Stockman is closer on the mark when he
says "we have supported," than the Secretary of the Treasury is
when he says he's critical of it?
Mr. VOLCKER. I suppose those are questions that have to be directed specifically to them.
Senator SASSER. Thank you, Mr. Chairman.
Senator BRADY. Mr. Chairman, I think I have 1 more minute.
Might I ask one more question?
The CHAIRMAN. You quit 2 minutes early on your last round.
Senator BRADY. Thank you.
Mr. Chairman, I think that I heard you say no one would be happier than you to get lower interest rates.
Is it, therefore, a further conclusion that it's the way you get
them that is your
Mr. VOLCKER. At issue, yes.
Senator BRADY. It seems to me that it's worthwhile noting that
you are Chairman of the Fed, and not economic dictator; you only
have certain tools to work with—three, I believe: operations of the
Federal Open Market Committee, the discount window, and reserve
requirements. Any pushing or aggressive actions in those three
areas are going to return us to where we were in 1978 and 1979. As
I have heard you speak this morning, it seems to me that lower
interest rates are your goal; if you could mandate them, fine.
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But your feeling is that you don't have any such tools before
you?
Mr. VOLCKER. If I could mandate them, and have all these other
happy things happen with no adverse effects, I would mandate
them this morning.
Senator BRADY. Let me ask you one more question, then:
When you put into place the policy, in 1979, that is now in place,
what would have happened if you had not done that?
Mr. VOLCKER. What we were dealing with, fundamentally, was
accelerating inflation. We let that go and get out of hand; even
now, we would be in much more serious economic difficulties had
we not dealt with it. You can argue about the particular technique,
but that fundamental need to deal with and turn around an accelerating inflation seems to me unambiguous, otherwise we would
have been left in much more serious economic circumstances, over
a much longer period of time.
Senator BRADY. How would it have manifested itself?
Mr. VOLCKER. Among other things, it would have manifested
itself in still more serious problems in financial markets and in
higher interest rates.
Senator BRADY. Were we headed toward the economies in South
America, where you have rates of inflation
Mr. VOLCKER. I don't want to be overly dramatic, but we were
certainly going in that direction. We were a long ways from there,
but that's the way things start. The longer it lasts, the more it accelerates, the harder it is to deal with.
Let me just make a point I try to make with practically every
audience: never before in the history of this country have we had
an inflation of the size and duration that we have had since 1965. I
think that left a very great imprint on people's minds, their behavior, their attitudes, their willingness to buy long-term securities,
and the way they look at interest rates. All those things grew out
of the unparalleled inflationary episode that we had in this country.
Senator BRADY. I think that it's worth noting—one more observation is that we have in this country the only long-term bond
market in the world, I believe that is correct?
Mr. VOLCKER. That's right. And that has been, and is, threatened.
Senator BRADY. Thank you.
SAME DEBATES AND ARGUMENTS
The CHAIRMAN. Mr. Chairman, I would like to use my last period
of time to express some great frustration, as I have listened to
these hearings today, and also sadness. And the reason I say this is
that I never seem to hear much different. I've sat on these hearings, now, for 8 years. It's almost like picking up the newspaper in
Salt Lake City. It's been 8 years since I was mayor there, but yet, I
pick up the newspaper out there and read about the present mayor
and the struggles of the city council; and the news is the same,
they are having the same debates and the same arguments over
and over again.
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After 8 years on this committee, I see the positions shift, but not
too much different is going on.
Today we have here a great effort—not only here, but across the
country, and on the floor of the Senate, and all the committee
meetings—there is a great effort for Congress to pass the buck; not
just one party, but both parties—to you. You are one of the favorite
topics of speeches by Congressmen and Senators of both parties, all
over this country: If we could just get Paul Volcker to do something, all this would go away. Never much talk about fiscal policy;
never much talk about our role in it.
And the second target is Ronald Reagan. I realize his program
has been in effect since last October.
You are No. 1; he's No. 2. "The two of you have destroyed the
economy in the last year and a half," without any regard to historical significance of a trillion-dollar debt that was built up before
either one of you were around, of refunding one-third of that debt,
of $340, $350 billion a year—just ignoring the arithmetic complete^This isn't a partisan statement I'm making, because you were
here when Jimmy Carter was President. And my side was sitting
here, asking the same kinds of questions that you've heard today:
"Have you been having lunch with Jimmy Carter?" "Does Jimmy
Carter agree with your policies?" All we've done is change the
roles and the parties.
That's where my frustration and sadness come in, because what
we've heard today is true, from everyone. This economy is sick; it's
very sick. And we're switching roles, regardless of which party we
belong to, to try and assess blame on the Fed and whoever the incumbent President is, and ignoring our role.
That's why I'm so frustrated. Congress seems to be getting away
with that year after year. Every year I've been here, they get away
with it and push it off on someone else.
You can loosen up your money policy tomorrow. Interest rates
will probably go up, in my opinion. Or we can do away with the
third year of the tax cut. We can cut billions out of the military.
We can do all sorts of things. Everything you've heard from everybody, particularly those running for office, Republican or Democrat, who want to find somebody else to blame for these horrible
conditions they're having to explain at home.
It seems to me that we've got to get away from that and start
looking at the arithmetic. And I'm speaking specifically of longterm interest rates. I simply know of no actions that you can take,
no actions that this President can take, because we can bitch and
moan about high deficits and everything else, and there's a fact
that no one can dispute. And that is: That no President has ever
spent a dime not appropriated by the Congress of the United
States. Not George Washington, Abraham Lincoln, Harry Truman,
Jimmy Carter, Ronald Reagan, or anybody else.
So, if we really don't like these budget deficits, why don't we just
shut up and do something about it.
Congress is the only one, under the Constitution, that can appropriate money. If we don't like a $100 billion deficit, we can do
something about it—and no one else. The President can recom
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mend, he can plead, he can threaten, he can veto, he can twist
arms; but it is a fact that only Congress can appropriate money.
So we're involved in so much rhetoric about these deficits, trying
to push it off on you or someone else. That doesn't mean that I
agree with all of your policies. I don't; you know that and everybody else does.
But it is internal within our budget process to solve this interest
rate problem, particularly in the long term, because nobody is
going to be fool enough to loan money over a long period of time, at
reasonable interest rates—I'm not talking about short term. You
can have some influence over short-term rates.
But if they sit there and see half a trillion deficits in the out
years because we're so gutless that we won't even talk about social
security and veterans' pensions and Federal civil service retirement and the entitlements programs that are automatically indexed and growing at an incredible rate, we're not going to solve
that problem and interest rates won't come down.
We can make any of these critics Chairman of the Fed tomorrow.
I would like to make some of them Chairman, and put the whole
thing on them. And I bet you they would be up here saying, "Hey,
I don't have that much power." [Laughter.]
"Good heavens. I can't do anything about that."
I just want to make the point. I'm not trying to blame anybody.
I've got seven kids. I would like somebody to tell me how they're
going to buy a house, what we're going to do about this long-term
market. This President can't do anything about it. You can't do
anything about that long-term market. Only we.
When we have the courage to say to the American people, "Yes,
we have got to talk about slowing the growth of social security, not
cut anybody."
I was talking to a pressman the other day, in Atlanta. He just
didn't seem to understand. So I said, "OK. I can't seem to get
through to you that no one is talking about eliminating anyone
from social security. No one is talking about dismantling. No one is
talking about reducing anybody's pension from their present levels.
But we must talk about making that system solvent, and we must
talk about slowing the increase."
So, I said, "What if you just demanded of your boss that you
were the greatest living media reporter the world had ever had,
and you wanted a $10,000 raise. And your boss said, 'boy, you
really have done a fantastic job and I'm going to give you a $6,000
raise; that's all I can afford within my budget.' "
"So you run home to your wife and you say, 'That lousy boss of
mine just cut our pay by $4,000 a year.' "
Now, that's what we re hearing. No one in this town is talking
about cutting anybody's social security, but until we talk about
slowing the growth of those entitlements programs, you can balance the 1983 budget tomorrow, and I think everybody would be
still surprised. They would say, "Why are long-term mortgage rates
still so high?" Because we haven't scratched the surface of the budgets in 1990 and 1995.
A 30-year mortgage is the year 2012. We're worried about a 1983
budget—which we should. It's too big. The deficit is too large. But
this Congress has not yet faced up to those out years. And interest
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rates will not come down, and the American people better learn
where the problem of long-term interest rates is. It isn't in the Fed.
It isn't in this administration, in the Carter administration, or any
other place. It lies with the people who have the power of the purse
strings, and nobody else. The Constitution says so.
We've got the power to do something about it. And until we do,
the wrath lies on this body—the Senate and the House, on both Republicans and Democrats—who ought to be penalized in this election in November if they haven't got the guts to address these
issues and do something about them.
That's hardly a question period. It was a speech. But it was intended that way because, like I say, the bottom line with me is:
How do my seven kids grow up in this country and buy a house?
Right now they couldn't possibly even hope to buy one.
Senator Riegle.
Senator RIEGLE. Senator Garn, that's a tough speech to follow
right now. I appreciate and share many of the frustrations that you
expressed, but I want to try to nail down where we are going from
here with Chairman Volcker, because I think we are moving into a
period of extraordinarily high risk to the economy. I think we are
into a period in which I think the jeopardy is rising, as we last saw
just before the Great Depression, and I think what is required here
is to steer a course, a change in course that can take us through
these difficulties and bring us through without a far worse financial collapse than we've already seen. And we do have a financial
collapse occurring now. You can measure it, as many members of
this committee have today, by unemployment, depression in the
housing industry.
In my State today, in Michigan, the unemployment rate is 15
percent. That does not count 125,000 workers who have been unemployed so long they are no longer included in the unemployment
numbers. In my State we have had unemployment above 10 percent for 32 consecutive months. Every day my phone is ringing
from business people across the State of Michigan, from large corporations down to the smallest businesses, telling me they can't
survive another month, another 2 months. They are filing for bankruptcy, they are going into chapter 11.
Everywhere I look, that is what I see. It isn't just Michigan; it is
true across this country, and I've been across this country in the
last 30 days talking with people in different places, and this is
what I am finding.
I don't sense that there is a recognition yet within the Fed of the
magnitude of this problem, and despite the good personal relationship that you and I have and which I want to maintain, I don't
sense in your remarks today that you perhaps comprehend the
magnitude of the human suffering and the devastation that's going
on at the foundation of this economy, that I am not sure we are
going to be able to correct, or if we do, it may well take us decades
to do it.
ADMINISTRATION TO STAND PAT ON ECONOMIC POLICY
I think we are about to move into a period of free fall on the
economy. What people are not paying attention to is the Federal
71
Government, for all practical purposes, is about to shutdown for 6
months. That's what's happening. As a matter of fact, in the U.S.
News and World Report of yesterday, which is pretty well tuned
into the White House, what they say here on page 11, they say:
The President will stand pat on economic policy for the rest of the year. Reagan
won't be turned around, even though the oft touted just around the corner recovery
is looking more and more elusive. Political realism is the key. There is not much the
President can do between now and election time to give the ailing economy a quick
fix. White House game plan is to tough it out, insist Reaganomics will work, and
hope things will perk up soon enough to prevent heavy losses in Congress this fall.
The last thing Reagan wants to be accused of is Carterism, being wishy-washy on
major issues. Reagan's advisors argue his steadfastness is a virtue, shifting gears
would send bad signals to financial markets and voters,
I think this is probably accurate. They don't intend to make any
change, any mid-course correction in the policy; nor fight to try to
bring the deficits down. It can't be done in this country without the
President participating. The President is the single most important
leadership figure in this country. That is why he is paid $200,000 a
year to do the job. He can't sit up in the bleachers and complain
about the problems and not participate directly. However, we've
not had that kind of direct participation and the Congress itself
has not responded.
The deficits are out of control, and I don't know of any economist
in the country today that believes the deficit estimates in the first
budget resolution, which is nonbinding that reported that deficit of
$104 billion next year. Deficit estimates range way beyond that
point, and they are clearly much higher than we can tolerate. But
the problem is that once we shutdown here, there are no emergency powers in place today that anybody can operate.
If we find the economy worsening, the Credit Control Act has
just expired. You, in effect, said there is very little that you can do.
The President, for his part, not only doesn't want to do anything at
this point, but it's not clear what emergency powers he has to use
in the period of time that the Congress is not even in session, can't
even meet short of an emergency joint session of the Congress. And
people like Henry Kaufman and Wosinauer, who have great respect in the financial markets, as you well know, are predicting
that interest rates are about to go back up. You may have a momentary drop in interest rates, partly driven by the reduction in
the discount rates yesterday, but their expectation, which is widely
shared in the financial markets and amongst financial experts
across the country, is between now and the end of the year the interest rates are as apt or more apt to be going higher, maybe not to
20 percent but certainly back up to 16.5 or 17 or 18, and as Senator
Sasser points out, there are small business people in this country
who are not borrowing at 16.5 percent—they are borrowing at 18,
19, and 20 and they are going down the drain.
You talk about the other Western economies. I look at Japan;
the prime rate in Japan is 5.75 percent. Their people are working.
Our people want to go back to work and they have a right to go
back to work. But I think what everybody is failing to see here is
that we are about to go into a period of maximum risk and jeopardy in this economy where, if things do get much worse, if interest rates do go higher, we could find the financial structure and ev
72
erything else put in jeopardy beyond anything we have seen since
the 1930's.
We are seeing bank failures. We are seeing a quiet run on financial institutions. We are seeing people move out of long-term securities into short-term securities, and basically what everybody says
is, "Sorry, we can't do anything about it." And in effect, that's
what you're saying today. You are saying your hands are tied,
there is not much you can do.
What I am saying to you is that if that is the attitude everybody
is going to take, if the Fed is going to take that view, the President's going to take that view, the Congress—and it is divided; one
party controls one body of the Congress, the other party controls
the other—if the best that we can say collectively is, "Sorry, we
really can't do anything about this problem," then that's a pretty
sorry admission of the failure on our part to respond to an emergency. That's what we have on our hands.
I just want to conclude by saying this: I've talked to the top financial officers of the major banks in this country at major financial institutions, every single day, and I have for the last 30 days
straight. They share this view. This is their view, this is what
they're saying. This is what they're saying in the private conversations. And so this is not just a question of one person's opinion or
someone else's. There is great alarm, great fear about where we
are heading unless we change this policy mix. Everything that I
see here indicates that everybody is prepared to stay on the course
we're on, and I see that as posing unacceptable dangers to this
country.
I am prepared to go with you and I'm prepared to give people on
both sides of the aisle, hopefully, to go as a group to see the President, to see his economic advisors, to meet with a bipartisan group
of leaders in Congress, to meet with whoever has to be met with so
that we can reach a collective decision, a bipartisan decision to
take action now before this window closes, because once this session of Congress ends, we are going to be locked on course.
I had the head of one of the top banks of this country say to me
a week ago, he said, "This economy is right on the edge."
I said, "Is it going to go over the edge or come away from it?"
He says, "I don't know." He says, "I think it's as apt to go over
the edge as it is to come away from it."
That's the situation we're facing today, and yet there is no plan
here. And my question is this: If things do worsen, if things do
worsen and we see the unemployment rate go up another percentage point or two, we see the bankruptcy rate continue to climb, we
see interest rates start to go back up again, what will the Fed do at
that point?
FED RESPONSE TO SINKING ECONOMY
Mr. VOLCKER. You asked the question—I was about to volunteer
the response. I certainly understand the sense of frustration that
Senator Garn expressed. I understand the concerns you expressed.
Let me say as clearly as I can that I don't share your concern
Senator RIEGLE. You don't need to share it. If it happens, what
response will the Fed make?
73
Mr. VOLCKER. You say we can't do anything. I say we haven't got
any wand to wave to get interest rates down in current circumstances and keep them down. In the kind of situation that you're
calling up here, obviously we have powers to increase the liquidity
of the economy, to respond and protect the banking system and
other financial institutions, and we would exercise those powers—
there shouldn't be any doubt about it—if that kind of scenario
threatened to develop.
Senator RIEGLE. So it would be your plan, if we find the economy
continuing to sink, if interest rates start to go back up again, that
it would be the Fed's intention to use whatever powers it has if it
finds us moving into a greater emergency than we have at the
present time, you are prepared to respond? You are prepared to
take whatever unilateral actions are necessary to see that there is
adequate liquidity in the economy?
Mr. VOLCKER. Yes. If we face that kind of situation, which I don't
expect to face, we would obviously use our powers.
Senator RIEGLE. And what exactly would that involve? What
would you be able to do at that point? How would you be able to
bring the rates down sharply and quickly? I am serious. I am interested in knowing what the mechanical response would be in that
case.
Mr. VOLCKER. What we can do is provide more liquidity to the
economy.
Senator RIEGLE. How would you do that? That's what I'm asking.
Mr. VOLCKER. Through our ordinary tools of policy: Using open
market operations, the discount window, depending upon what was
necessary and desirable.
Senator RIEGLE. If interest rates go back to 17, 17.5 percent
before this year is out, would it be your intention to respond in this
fashion?
Mr. VOLCKER. It would depend upon the whole context of the situation. You just can't pick out one variable and ask me how I
would respond. You are positing the threat of a national emergency, of an emerging depression or something like that. I don't expect
those things to happen, but obviously we would respond if they did.
Senator RIEGLE. Do you think the economy could take interest
rates of 17.5 percent sometime between now and the end of the
year, or higher?
Mr. VOLCKER. It would depend upon what else is happening.
Senator RIEGLE. We know what else is happening. We see the
state of things at the present time. Do you think this system can
take that kind of high interest rate stress at this point?
Mr. VOLCKER. At this point I certainly would not like to see that,
but we're not talking about this point in time.
Senator RIEGLE. I can't find anybody today who is in the financial institution world, who is looking at the balance sheet and interest statements of hundreds of thousands of other companies,
who feels that this country can sustain that at this point. My hope
would be if we find that developing, that you will act. And if the
President remains serene and detached from this problem, if the
Congress demonstrates an incapacity to respond to it, and in fact it
may even be out of session when it develops, I hope you will respond. I'hope you won't wait.
74
Mr. VOLCKER. We would respond with all the powers which we
have, if we thought the basic institutional structure and the basic
economic structure were threatened, within the limitations of what
we can do.
The CHAIRMAN. Senator Proxmire.
Senator PROXMIRE. Mr. Chairman, I'll be quite brief.
You issued today the midyear monetary policy report to Congress
pursuant to Full Employment Balanced Growth Act of 1978. Right
after page 13 you have a graph showing the ranges of actual monetary growth. I am asking this because I want to—it seems to me
this indicates what you are going to do, in all likelihood, because as
I understand you to have said this morning, you don't intend to
depart from the monetary targets that you have set.
Mr. VOLCKER. We expect to be around the upper end of them. We
indicated, if special liquidity problems arise, we are prepared to go
above that.
Senator PROXMIRE. As I look at these charts, Mi and M2, you just
came back to Mu barely, in the latest figure. On M2 you are still a
little bit above the M2 target. As you come to the midrange, that
would be 4 percent for Mi and 7.5 percent for M3. That would be a
restriction. You've just said you expect to be in the upper area, so
that you would continue with what I think all of us would have to
define as a restrained, conservative monetary policy. You would
expect to do that for the rest of the year; is that correct?
Mr. VOLCKER. Relatively restrained. We said we might be around
the upper end of the ranges.
Senator PROXMIRE. The same thing would be true on the table
following page 15 with respect to M3 and bank credit?
Mr. VOLCKER. Yes; let me point out, as I did in my statement,
that with that kind of growth in the monetary aggregates, historical experience would suggest there is quite a lot of room for real
growth in the economy at the current rate of inflation.
RECORD BORROWING BY THE TREASURY
Senator PROXMIRE. I don't want to hash over what we've already
been through, because I don't want to take up that much of your
time. As I tried to point out, the Federal Government is going to
absorb a very large part of the available money supply. There is
going to be record borrowing, isn't that true, by the Treasury, the
rest of this year and next year, way, way beyond anything we've
had before?
Mr. VOLCKER. Yes, but these are not measures of the total supply
of credit in the economy. These are measures of the money supply.
The total supply of credit is of a much larger magnitude than these
numbers.
Senator PROXMIRE. That would be reflected, to some extent, in
the chart in your statement where you say bank credit (see p. 12).
Mr. VOLCKER. A part of it would be. The Government doesn't
borrow very much from the banks. Actually, the banks don't hold
very many Government securities these days, and these would be
consistent with the figure for credit expansion that would allow for
a very large volume of Treasury financing.
75
Interest rates are higher than they otherwise would be because
of that volume of financing. But, certainly, based upon any analytic
relationships we can develop, this kind of growth in money would
be accompanied by growth in credit that is consistent with economic recovery in the latter part of the year. If that's not the case, if
there are extraordinary liquidity demands that impact on these
numbers, I indicated a note of reservation or modification.
Senator PROXMIRE. The reason I have trouble with that is over
the past year or two, the private economy has not been able to
borrow much because interest rates are so terribly high, and in the
next 6 months or a year the Federal Government is going to
borrow more. The available supply of credit would not seem to be
increased, and therefore it would seem to me it is pretty clear that
any objective analysis would suggest we are going to continue to
have high interest rates and restrained economic activity for the
next 6 months or year. I just can't see any room for recovery.
Mr. VOLCKER. I disagree with that analysis. Our analysis would
suggest, on the contrary, that this kind of monetary growth, based
on historical experience, would be consistent with recovery. On M2,
for instance, the arithmetic is simple; in recent years it has been
expanding about as fast as the nominal GNP. In the past three
quarters it's expanded faster than the nominal GNP.
What you would expect, following a period of that sort where
these monetary aggregates have, in fact, expanded faster than you
might have expected, given what's going on in the economy, is that
that would be followed by a period where they are expanding relatively slowly relative to the economy. I'm
Senator PROXMIRE. But the nominal GNP has been stagnant, the
inflation hasn't been that much and the growth in the economy
has been stagnant.
Mr. VOLCKER. The nominal GNP has been stagnant, and the
technical manifestation of that, consistent with these targets, is
that velocity has been low. Experience suggests following a period
of low velocity you have a period of higher than average velocities.
That's what we're assuming will happen. If that doesn't happen,
this would obviously be called into question.
The CHAIRMAN. Do you feel your monetary policy would accommodate that increase, substantial increase in nominal GNP?
Mr. VOLCKER. Yes.
Senator PROXMIRE. Thank you, Mr. Chairman.
The CHAIRMAN. Senator Brady, do you have additional questions?
May I apologize for placing you after Senator Riegle, but you're so
far away, hidden behind the cameras, that I simply missed you.
Senator BRADY. Thank you, Chairman Garn.
I will only add to what Senator Riegle says about talking to
people all across the United States, which I have done myself in
the last month or so, only I have come to a different conclusion
from my colleague. I got very little comment about what the Federal Reserve is doing and what Chairman Volcker is doing. I got a lot
of comment on the subject that Senator Garn has put forward,
which is what are you guys in the Senate doing with regard to
fiscal policy? What about the size of the deficit? So I think the concern is there about where we're going in this country, what the
level of economic activity is. But the people that I talk to don't lay
76
the blame on the Chairman of the Fed or the Federal Reserve
System. They lay it right smack where I think it probably belongs,
which is on the Congress of the United States.
So I would only add that to what we have already heard this
morning. I think we do have—Chairman Garn, you put your finger
on it. There is a great sense in this body of ours—let me just point
up, having been here for such a short period of time, is that somebody's made a mistake and since we don't make mistakes, somebody else must be making them. And I think the case is more
nearly the case that you cited this morning; that we simply have to
have more of a fiscal restraint on this body.
The CHAIRMAN. Might I just say, I share both yours and Senator
Riegle's concerns. You know, we do—Congress does have time. We
have yet, in either body, to look at an appropriations bill, so we
can't cop out on that, that we are going to be out of session. We've
got 13 regular appropriations bills to attempt to implement the
budget resolution. As meager and unsatisfactory as that budget resolution is, I have doubts about the Congress ability to adhere to it.
But we've got time. We've got all the rest of July and August and
September. We might even not have to have a Labor Day recess.
We've got time to put up or shut up on the 1983 budget, because
we have yet to address a single appropriations bill.
Senator RIEGLE. Excuse me. Would you yield, Senator Brady, just
for comment? Apart from how one assigns the responsibility for
events up until the present time, or even in terms of how we break
the gridlock at this point, in terms of the various players playing
their roles, and so forth, leaving that aside in terms of the urgency
of the moment, the need to break the gridlock and to take the fundamental actions to get us on a different course that can bring
rates down, bring down the deficit, and so forth; I don't know
whether you're getting the same sense of urgency on that point
that I am getting, but I find that to be universal. It's up and down
the scale from people at the top of gigantic financial institutions
down to the person running a store on the street corner.
Senator BRADY. I do get that same sense of urgency. I think
there is a great feeling throughout the land that things are not
right, something has to be done, and maybe even a feeling that the
Congress does not understand that.
Having come from the private world just recently, I would say
people underestimate their Congress in the sense of what their situation is. I think at least the Senators I've talked to do understand
the problem, that that urgency is out there. T would only say to my
colleague from Michigan that in breaking the gridlock, we could
strike a mighty blow by doing the thing that Senator Garn has
talked about, by taking the next appropriation bill that conies
through—I do not know what it is going to be, but acting responsibly toward it and give the people of this country the idea that we
are going to face the problems there.
My problem talking about monetary policy, is that I do not think
it addresses the problem. I think the problem is in the area we
talked about, the unlocking the gridlock, for you to have to unlock
it at the short end of the market or the long end of the market. I
think it is very hard to unlock at the short end of the market right
77
now, and the key is to take an absolutely clear step on fiscal policy.
It does not have to continue forever.
I think one of the things we have in Congress is we take a step
in one direction, everybody says we're going to continue doing that
for the next 15 years. We could make some steps in the next 6
months and see how it works, and turn around and go the other
way again, after we get through. So to me, you've got to start somewhere, and I would start with the area of fiscal policy because I
think the chairman of the Fed is absolutely boxed right now.
The CHAIRMAN. Senator Sasser.
Senator SASSER. Thank you, Mr. Chairman. Mr. Volcker, I take it
from what you have said earlier that you do not think we can fight
inflation just with monetary policy either, do you?
Mr. VOLCKER. I think it is much better if we do not just rely on
monetary policy. In theory, you can just use monetary policy, but it
makes things much more difficult.
Senator SASSER. We would be in a better position, I assume, if we
had a match of monetary and fiscal policy operating in tandem?
Mr. VOLCKER. Yes.
CUTTING TAXES
Senator SASSER. I recall your coming before the Senate Budget
Committee in 1980 and advising us at that time that we should not
go forward with our plans to cut taxes. There was some discussion
at that time in 1980 by a number of Members of the Senate; more
specifically, Senator Bentsen and others, about cutting taxes. As I
recall your testimony in response to questions before the Budget
Committee, you advised us against that at that time.
Mr. Chairman, did you give the same advice to the President and
this administration when they embarked upon their expansive
fiscal policy of cutting taxes? Did you discourage them from doing
that?
Mr. VOLCKER. Certainly in terms of the magnitude of the program, yes. It all depended upon how much we were to be able to
cut expenditures obviously, and I had some skepticism he would be
successful in cutting expenditures enough.
Senator SASSER. I would say your skepticism about whether or
not this Congress could cut some $750 billion in expenditures over
a 3 Vz- or 4-year period was well founded.
But I make this point, I think to illustrate that perhaps there is
more responsibility here than some of my colleagues are giving us
credit for. We turned away from the tax cut in 1980 because we
were advised by you and others that that would not be responsible,
and yet we then saw the tax cut coming in 1981.
Let me ask you this: Do you think this tax bill that is before the
Senate now, which will raise some $91 billion in revenues—does
that go far enough in raising the revenues that are needed to attempt to do something about the deficit, or should we go forward
and give consideration to deferring the third year of the tax cut?
Mr. VOLCKER. What I think I said consistently is that I would
welcome and urge further cuts in the deficit, preferably on the
spending side. If you can't do it on the spending side, do it on the
tax side, but preferably cuts would come on the spending side.
78
Senator SASSER. One final question, Mr. Chairman. We have had
a lot of discussion here today about problems that are being occasioned by the economy and economic policy that we are presently
pursuing, and some of my colleagues, I suspect myself included,
appear to be somewhat emotional on some of these issues. But we
are back home every weekend talking to the people and seeing
what the consequences of this policy have amounted to.
And, it is pretty sad to see—I referred a moment ago to the problems of the small business community—we have got over 85,000
farmers in my State. Most of them are small farmers. Most of them
are family farmers. They are in a situation now where the interest
costs for most of them—the interest costs are exceeding their
actual farm profits. The Department of Agriculture is telling us
that their Farmers Home Administration loans—and most of them
have borrowed money from Farmers Home Administration—they
are telling us that their delinquency rates are between one-third
and 50 percent.
RASH OF FARM FORECLOSURES
Now, we are on the verge, Mr. Chairman, of a rash of farm foreclosures in this country like we haven't seen since 1931 and 1932.
And this is particularly sad to see because when these farms go
under it is a whole family generally losing everything they have
got, everything they have worked for for a long period of time.
Now, can't the Federal Reserve Board give these people some
relief? Why can't we ease up on the reserve requirements of those
banks lending to the agricultural sector, who have a large part of
their lending in the agricultural sector?
This is nothing new. Even Arthur Burns did this, and nobody
ever accused Dr. Burns of being a Santa Glaus. He did it in the
1970's, early 1970's, in response, as I recall, to very serious problems then.
Why can't we have a dual rate of interest perhaps for these interest-sensitive sectors of our economy like farmers, like small business people? Maybe we could wring the inflation out of our economy with our monetary policy and at the same time not destroy
these people who are so vulnerable, have no protection really
against this type of monetary policy. What is wrong with that?
Mr. VOLCKER. I have a great deal of sympathy for the human
problems that you describe. I go home occasionally, too. I don't
recall the particular incident that you are referring to, some special policy we had in 1980 where we provided some special assistance to agricultural banks.
INVESTORS SITTING ON SHORT-TERM MONEY
I think if you analyze the situation now you will find the typical
bank in agricultural areas is quite liquid. The problem is not that
those banks don't have money. The problem is, in many cases, they
would prefer to lend it at the high interest rates that they can get
in the Federal funds market or other markets rather than lending
it to the farmer for a period of time at low interest rates.
You come back to the interest rate problem and, particularly, the
willingness to lend for a long period of time at low interest rates.
7!*
This drives me back to the basic problem that we are dealing with:
How do you give that banker— or whoever is lending the banker
money — the confidence to be willing to commit money for a long
period of time at a low interest rate?
You know, you are not going to do it by reducing his reserve requirement so he has a little more liquidity than he has now. Why
isn't he going to take that money and send it where he is sending
it now rather than lend it to that farmer at a low interest rate?
The underlying problem is how can we create conditions in
which confidence returns, particularly in the long-term market? A
number of you today have emphasized the fact many investors are
sitting on a lot of short-terrn money. How can we encourage them
to lengthen their maturities, extend that credit at lower rates of
interest for a long period of time?
I think you come back to this question of confidence and all that
bears upon it in terms of the inflation outlook, the interest rate
outlook, the budgetary situation, and all the rest. It goes back and
bears on our policy to the extent that there is some confidence that
the Federal Reserve itself is going to continue to keep inflation
under control. If you don't have that kind of confidence that somebody is going to do it, that the value of the currency is going to be
maintained, you are not going to have a climate in which lenders
will want to lend for a period of time to the very people you are
talking about or to the big companies or to anybody else.
That is what we have to fight to get in the interests of those very
people that you and I are concerned about.
Senator SASSER. The problem we have got, Mr. Chairman, is
those very people that I am concerned about and which you profess
to be concerned about aren't going to be around economically by
the time this policy runs its full course. The problem is that the
overwhelming majority of them are not going to be able to last out
this year, or certainly not through the spring, at least in the agricultural sector of the economy in my State.
That is the problem. That is their short-terrn problem.
Mr, VOLCKER. I hope and believe that is not true in terms of the
magnitude of the problem, but the problem is very serious. I don't
contest that at all.
Senator SASSER. Thank you, Mr. Chairman.
The CHAIRMAN. Thank you, Senator Sasser. Mr. Chairman, we
appreciate your patience today; and, if you haven't proven anything else to this committee, you have proven you have great sitting power to stay for 3 hours and 10 minutes. We thank you very
much, and the committee is adjourned.
[Whereupon, at 12:40 p.m., the hearing was adjourned.]
[Additional material received for the record follows:]
BOARD OF GOVERNORS,
FEDERAL RESERVE SYSTEM,
Washington, D.C., August 17, JMJ.
Hon. HARRISON SCHMITT,
U.S. Senate,
, D.C.
DEAR SENATOR SCHMITT: Thank you for your letter of July 21. I am pleased to
furnish you with responses to the written questions you submitted in connection
with the hearing held on -July 20. I have also furnished a copy of these responses to
the Senate Banking Committee for inclusion in the record of the hearing.
80
Please let me know if I can be of further assistance.
Sincerely,
PAUL A. VOLCKKR, Chairman.
Enclosures.
Question 1. It has been suggested that the demand for credit for corporate mergers and acquisitions has helped to keep interest rates high. Would you comment on
this please?
Answer. I don't think the demands for credit to finance corporate mergers and
acquisitions have been a significant factor behind the high level of interest rates. In
general, such transactions involve simply a transfer of ownership of shares in an
existing enterprise. They buyer borrows to pay the shareholders of the firm being
absorbed, in the process creating a demand for funds. However, the shareholders
then must do something with the funds they've received, and the reinvestment of
those monies provides funds to the market. In economic terminology, such a transaction gives rise to no net demand for savings—that is, there is no diversion of current income for consumption to investment. Although "imperfections" in the capital
markets might lead to some frictional or transitory impacts on interest rates and
credit availability for other borrowers, the overall effect of merger activity should
not be substantial and does not appear to have been.
I might note that the publicity attending some of the merger transactions has left
people with a somewhat distorted idea of the quantitative dimensions of the credit
flows involved. Figures on the huge lines of credit arranged, sometimes involving
competitive efforts by more than one firm to acquire another, have greatly overstated the actual amounts of credit ultimately taken down. Those sums have not bulked
large at all in the bank loan totals, for example.
Question '2. There has been recent, discussion of the possibility of a wave of unexpected major corporate failures occurring sometime late this year—or next. What is
your view with regard to this possibility?
Answer. I'm sure you can appreciate the difficulty of forecasting the unexpected.
The fact is that we have seen to date some sizable corporate failures. I don't think
these were in all respects "unexpected," for securities analysts and others who have
tracked developments in individual firms closely knew that there were significant
problems brewing for some time. Clearly, there are a good many firms today experiencing considerable stress—struggling with various combinations of weak sales, depressed cash flows, and large interest burdens. I would hope that the upturn in economic activity we are anticipating and the current trend of moderation in interest
rates will result in improved profitability and an alleviation of these financial
strains.
One cannot rule out the possibility of some additional significant business failures, however, either among firms now widely recognized as being in serious trouble
or among other firms whose difficulties may not yet have attracted widespread attention. I certainly do not take this matter lightly, and people in the Federal Reserve are constantly monitoring developments so that if any failures do occur we
are able to assess the situation quickly and take action when necessary to prevent
any generalized liquidity probems that might lead to broad economic dislocation. We
are mindful of the System's fundamental mission as the lender of last resort, and
our commitment to maintaining adequate liquidity in the economy helps to lower
the risk of a damaging "wave" of large business failures,
Question 3. As you know, the Japanese deficit as a percentage of GNP is substantially larger than that of the United States. Yet their interest rates are lower. It is
generally suggested that the Japanese rate of personal saving—close to 21 percent
of disposable income—allows the Japanese to finance their debt at tower rates. The
Japanese Government permits up to $52,000 in principal to generate tax free
income. But in this country we have tended to look at only the demand for credit—
particularly that of government—ignoring our national rate of saving as a component in the solution to our interest rate problem. In your opinion, would the Congress be well advised to consider expanding the incentive to save as a means of getting interest rates down and keeping them there?
More specifically, should the Congress attempt to create specific incentives designed to raise our nation's rate of savings to the K percent level which prevailed in
the early 1970's?
Answer. The tax reduction passed iast year contained in it several measures tbat
work to enhance the incentives to save rather than consume. The lowering of marginal tax rates for individuals and the accelerated depreciation provisions certainly
stand out in this regard, I think these broad measures are likely to be more effective in raising the overall proportion of resources devoted to saving and investment
81
than are many specific savings incentives, which frequently can be expected to do
little more than shift the form of savings and which tend to be cost-ineffective from
the standpoint of lost tax revenues.
The matter of tax revenues raises an important point—namely, that large government deficits work counter to a desire to lower interest rates or to enhance private
capital formation. Federal deficits absorb private savings, so that movement toward
budgetary balance is an integral part of a meaningful effort to improve the financial climate.
One final note: it probably is not wise to focus on any particular magic number of
a goal for saving. The optima] level of saving for an economy is not readily determined, and it may be most important simply to create the kind of general economic
environment and tax climate that does not tilt the scale of incentives against
saving. Moreover, it is really not appropriate to focus solely on the personal saving
rate. Households are important contributors to the pool of savings, but so too are
businesses, the government potentially, and foreigners. This is just one of many reasons why international comparisons of saving behavior must be performed with a
considerable degree of caution; financial structures differ considerably from country
to country.
FEDERAL RESERVE'S SECOND MONETARY
POLICY REPORT FOR 1982
WEDNESDAY, JULY 21, 1982
U.S. SENATE,
COMMITTEE ON BANKING, HOUSING AND URBAN AFFAIRS,
Washington, D.C.
The committee met at 10 a.m. in room 5302 of the Dirksen
Senate Office Building; Senator Jake Garn, chairman of the committee, presiding.
Present: Senators Garn, Riegle, Sarbanes and Dixon.
The CHAIRMAN. The hearing will come to order.
We continue today with the second day of hearings on the conduct of monetary policy. We do not have our first witness here yet;
however, in a year and a half, this committee has started on time.
It will continue to start on time, even when we don't have witnesses here. The chairman will be on time.
So now that we have started and kept the record perfect, we will
hold until Mr. Weidenbaum arrives.
[Brief recess.]
The CHAIRMAN. Mr. Weidenbaum, the committee has already
started, although I was the only one here. I understand that you
were in the building on time.
Mr. WEIDENBAUM. Yes, sir.
The CHAIRMAN. We'll be happy to hear your testimony at this
time.
STATEMENT OF MURRAY L. WEIDENBAUM, CHAIRMAN, COUNCIL
OF ECONOMIC ADVISERS
Mr. WEIDENBAUM. I have prepared a fairly technical presentation this morning. Before I present it, I would like to highlight a
few key points.
First, the Federal Reserve's monetary policy has been the key to
the successful unwinding of inflation that we have witnessed
during the past year and a half.
Second, the administration and the Fed have been, and continue
to be, on the same wavelength during this entire period; that is, we
consistently agree that slowing down what had been an unsustainably rapid growth in the money supply is basic to achieving a less
inflationary economy.
And three, there are many technical problems that arise in the
conduct of monetary policy. My prepared testimony deals mainly
with those technical problems, but in the context that I have just
sketched out. That is, I present the following analysis from the
84
viewpoint of strong and continuing support for the efforts of the
Federal Reserve in dealing with the serious problem of curtailing
inflation in a careful and responsible way.
I am pleased, of course, to appear before your committee to discuss the current conduct and performance of monetary policy.
[The complete statement follows:]
85
Statement
of
Murray L. Weidenbaum, Chairman
Council of Economic Advisers
Mr. Chairman and Members of the Committeei
I am pleased to appear before your Committee to
discuss the current conduct and performance of monetary
policy.
During this period of painfully high interest
rates, it is appropriate that we intensively scrutinize
both the objectives and the implementation of the Federal
Reserve's monetary targets and its monetary control
procedures.
Let me begin by underscoring the point that the
Administration and the Federal Reserve agree on the basic
dimensions of monetary policy.
Both, the Administration
and the Fed believe that a gradual reduction in the growth
of the money supply is the best policy for achieving price
stability.
This reduction is best accomplished when the
Fed enjoys independence from the routine pressures of the
political process, and understands unequivocally that its
primary mandate is to attain and maintain price stability.
Selecting a Definition of Money
The Federal Reserve can eliminate inflation most
rapidly and least painfully if it concentrates on
announcing an appropriate target for money growth and then
achieving that growth as closely as possible.
A key'
decision in this process is choosing the specific
definition of money for which growth is to be targeted.
Selecting a particular definition of money to target
is not a simple task.
As is true of almost all economic
data, the proper statistical definition of money is at
86
times less clear than we would like.
In recent years new
types of financial assets have been created, such as money
market mutual funds, and the characteristics and usage of
old assets have changed.
For example, with the invention
of the NOW account in 1971, an asset appearing in our
statistics as a savings account became checkable.
The
evolutionary character of our monetary system means that
the definition of money shall not remain static for the
purposes of monetary policy.
The Federal Reserve should and does revise its
definitions of money as changes in our monetary system
occur.
It did this most recently in 1980 when it began to
include NOW accounts along with demand deposits and
currency in its definition of M-l.
Table 1 shows the
changing composition of M-l over the last several years.
While currency has remained a stable 27 to 28 percent of
the money supply, demand deposits have declined from 69
percent of M-l at the beginning of 1979 to 53 percent in
early 1982.
Meanwhile, NOW accounts and other checkable
deposits have risen rapidly from 4 percent to almost 20
percent- during the same period.
Economic theory suggests and the data confirm a
predictable relationship between the growth rate of money
and the future growth rate of total spending and income in
the economy.
This relationship is remarkably stable when
examined over periods long enough to average out
87
Table 1
COMPOSITION OF til
(In Percent)
Other
Checkable
Deposits
Quarter
1979:2
1979:3
1979:4
27.1
27.0
27,0
27,3
68.9
68.3
67.9
67.5
4.1
4.7
5.1
5.2
1930:1
1980 .-2
1980:3
1980:4
27.4
28.2
27.9
27.8
67.0
65.8
65.4
64.9
5.6
6.0
6.6
7.3
1981:1
1981:2
1981:3
27.8
27.7
28.0
27.9
58.8
55.9
54.S
54.0
13.4
16.4
17.1
18.0
52,6
19.6
1979 i 1
1981 i 4
1982:1
Source:
Board of Governors of the f
transitory disturbances and statistical noise.
The
relationship between money growth and nominal GNP does not
necessarily hold closely on a quarter-to-quarter basis,
however, since money growth tends to affect income only
after a lag that tends to toe somewhat irregular and
unpredictable.
Of the alternative definitions of money,
the growth of M-l demonstrates the highest statistical
correlation with the growth of nominal income.
It is sometimes suggested, though, that more broadly
defined measures of money may show a stronger relationship
with spending and income than M-l.
If so, they would
provide a more appropriate focus for monetary policy.
Several more comprehensive definitions of money are
available. For example, H-2 includes various liquid
assets, such as savings accounts and money market funds,
that are relatively close substitutes for currency and
checking accounts.
However, statistical tests comparing
M-l and M-2 suggest that changes in M-l provide a more
reliable indicator of changes in national income.
A
four-quarter moving average of M-l growth captures almost
all of the changes of a four-quarter moving average of
nominal GNP growth; a moving average of M-2 does not
perform as well.
Given this evidence, I believe that it
is best to continue to place primary emphasis on
89
controlling the rate of growth of M-l, while watching the
other monetary measures for signs of unexpected
developments.
Setting^ and Achieving J^Ojie^aj^Growth_Tg.rget^B
Since 1975 the Federal Reserve has announced annual
targets for monetary growth.
These targets are expressed
in terms of a range, with two to three percentage points
between the high and the low ends.
For 1982, the Fed's
target for M-l growth is between 2-1/2 and 5-1/2 percent.
Over the last six years the Fed has frequently failed
to hold M-l within its target ranges.
In 1981 and the
first few months of 1982 the Fed first undershot and then
significantly overshot its targets.
Published minutes of
Federal Open Market Committee meeting show that the Fed's
trading desk in New York was often given instructions to
aim M-l growth in a direction substantially away from the
mid-point of the annual target range.
While the Fed
admittedly faces technical problems in pinpointing
month-to-month monetary growth precisely, it is capable of
exercising greater year-to-year control than it has
achieved to date.
Frequently, the Fed has stated that its primary
reason for adhering only loosely to it M-l targets in
previous years was its desire to achieve other objectives
as well.
Before October 1979 great weight was given to
short-run stability in the federal funds rate, and the Fed
90
was unwilling to adjust the federal funds rate rapidly
enough to hit the announced monetary targets. In the
second half of last year considerable weight was given to
the target range for M-2.
At other times, other variables
have assumed importance.
Although the Fed 1 s desire to achieve simultaneous
targets for numerous variables is understandable, I
believe it is generally an error to allow those objectives
to sidetrack the goal of meeting H-l targets.
Nominal
income growth has continued to demonstrate a more stable
relationship to the growth of M-l than to any of the other
monetary aggregates. This is true despite the
proliferation of financial innovations and new forms of
checking accounts.
In the absence of compelling evidence
that the relationships between M-l and other economic
variables are changing, the M-l target range provides
sufficient leeway to adjust M-l growth up or down to
reflect short run developments such as higher or lower
than expected growth in M-2.
The rationale moat frequently cited for the Fed
missing its H-l targets over the last several years is
that the growth of velocity is changing.
The velocity of
money, or its rate of turnover, can in fact complicate the
relationship between money and income.
Fluctuations in
the velocity of money affect national income in the same
manner as do fluctuations in the supply of money.
91
Fortunately for policy makers, the underlying growth
of M-l velocity has proven remarkably constant and
predictable for the last several decades.
Velocity growth
has averaged about 2 percent a year since the begining
of 1981, a figure which is close to the average growth of
3 percent from 1959 to 1981.
Quarterly velocity changes
have varied widely throughout the recent past, and
particularly in the last 18 months, as a partial
consequence of volatile money growth.
But the observed
path of velocity growth becomes far smoother as the
measured intervals are lengthened.
Most movements from a
long-run 3 percent growth trend disappear when the growth
rate of M-l velocity is measured year-to-year as shown in
Figure 1.
Admittedly, there is no inherent reason why the
growth rate of M-l velocity should remain constant
indefinitely.
There are presently forces at work which
may affect velocity growth trends, although in different
directions.
On the one hand, the increasing popularity of
money market funds, which are included in M-2, have
probably tended to increase the growth of M-l velocity. On
the other hand, the decline of inflation and the spread of
interest-bearing transactions accounts have probably
tended to decrease the growth of M-l velocity.
At
present, there is no indication that one of these two
forces is dominating the other and thus systematically
shifting the trend of M-l velocity growth.
INCOME VELOCITY OF MONEY
SEASONAUV ADJUSTED. QUARTERLY
RATIO SCALE, TURNOVER RATE
rtr\—
12
- 1.2
1.0
1960
Source:
1965
1970
1975
Hoard u£ Governors oE the Federal Reserve System
1980
19BS
93
The relative predictability of velocity is convenient
in that it allows the Federal Reserve to rely on a fairly
stable relationship between the growth of money and the
growth of nominal income.
Unless and until a long-term
shift in the money velocity trend becomes apparent, the
Federal Reserve should follow a path of stable M-l
growth.
As recovery proceeds,
announced reductions in
both targeted and realized money growth are essential to
minimizing the costs of permanently eliminating
inflation.
Unannounced and unanticipated reductions in
money growth will depress output and employment until
wages and prices adjust to the lower level of nominal
income consistent with lower money growth.
Conversely,
sudden and unexpected increases in money growth will
rekindle fears that the Fed is not truly committed to
reducing inflation.
It is clear that inflationary expectations are
adjusted only as the actual course of monetary policy
proves consistent with policy objectives.
The credibility
of the Fed, like the credibility of anyone else, is
enhanced when it achieves what it says it is planning to
achieve.
For the Federal Reserve, this requires
establishing money growth targets which are consistent
with a sustained decrease in the rate of inflation, and
then adhering to those targets.
The more success the Fed
enjoys in meeting its targets, the less time it will take
before the public is convinced of the Fed's credibility,
and the more rapidly wa9es and prices will adjust to
noninflationary monetary policies.
Variability^ of MqneyGjrowth
So far 1 have emphasised the need for the Federal
Reserve to concentrate on M-J as its principal monetary
target variable, and to meet its annual targets for growth
in M-l.
I would also like to discuss the importance of
the Fed's achieving smooth, monetary growth within a given
year.
Due to uncertainty about the Fed's future actions,
public expectations about future rates of monetary growth,
and hence future inflation, have become more volatile in
recent years as current money growth has become more
volatile.
This is understandable, since it is difficult
to determine whether a deviation of money growth from a
targeted growth path represents a temporary discrepancy or
a fundamental change in the growth trend of money.
Statistical tests applied to past data suggest that
the best guide to future monetary growth levels is
primarily the growth rate for the most recent period.
Given this historical regularity/ the marXet may not
necessarily believe that current Federal Reserve policy
does indeed involve a distinct break with its previous
95
policies, and that the Fed will in fact correct current
deviations from targeted growth rates at some future point
in time.
Consequently, when money growth strays above
the target range, even temporarily, long term interest
rates rise as both higher money growth and inflation are
expected in the future.
Thus, at least in the current monetary environment,
unanticipated changes in short-run money growth tend to
destabilize interest rates across the maturity spectrum,
and not just short rates.
If the Fed could achieve more
precise control over money growth, that would lessen
capital market fears that departures of money growth from
target may indicate a beginning of a new trend.
Also,
fluctuations in longer-term interest rates would prove
much smaller.
The justification given most frequently for temporary
shifts in money growth by the Fed is that unstable demand
for money requires fluctuations in the money supply.
Without shifts in money growth, it is hypothesized,
short-terra changes in the demand for money would result in
large and sudden swings in interest rates.
This argument
is essentially identical to the assertion that short-term
variability in velocity justifies shifts in money growth.
The problem with attempting to control the money supply
in accord with perceived short-term shifts in money demand
ia that, while achievable in theory, it proves
96
counterproductive in practice.
It is usually difficult to
determine at any point in time whether an apparent shift
in the demand for money is due to a change in the demand
for money relative to the pace of economic activity, or
due to a change in the level of economic activity itself.
If economic activity is decreasing, lowering money
growth will only serve to worsen an economic slowdown.
Conversely, raising money growth when economic activity is
picking up will aggravate the inflationary consequences of
rapid economic expansion.
Past attempts by the Federal
Reserve to offset hypothesized shifts in money demand and
to control interest rates have led to variations in money
growth which have exacerbated previous business cycles.
An excessive focus on shifts in the short-term demand for
money and their effects on interest rates have caused both
money growth and inflation to accelerate. This was
certainly true in the years between 1965 and 1980.
Even if temporary shifts in the demand for money were
easily identified, which they are not, the Fed would be
well advised to ignore them.
growth data —
We can infer from velocity
which in part reflect shifts in money
demand -- that deviations from trend tend to reverse
themselves within a year.
Insofar as variations in money
growth are used to smooth interest rate paths, only rates
on debt instruments of very short maturities —
less than six months —
probably
would be significantly affected.
97
Moreover, in the current environment, variability in
interest rates on long-term maturities, such as mortgage
rates and various bond rates, is actually likely to be
increased rathet than decreased, as changes in money
growth lead to changes in the market's forecast of future
inflation.
In short, the gains from offsetting temporary
disturbances in money demand are small, transitory, and
problematical.
The costs in terras of destabilizing
expectations and higher long-term interest rates are
significant and clear.
Economists who are skeptical of the importance of
lowering volatility point out that a number of countries
which enjoy relatively low inflation rates, such as
Germany and Switzerland, have more variable monetary
growth than the United States.
This observation is
interesting, but it is also misleading.
The United
States has experienced increasing monetary growth on
average over thg last 15 years, and is trying to reverse
that trend.
West Germany has experienced nearly constant
money growth, on average, since 1960, and in Switzerland
money growth has actually declined.
As a consequence of
their prudent monetary policies in the past, the German
and Swiss central banks enjoy the confidence of the
public. They can afford to allow considerable
month-to-month variability in money growth without
generating high and volatile inflationary expectations.
98
In contrast, the United States Government -- no
matter how sincere the anti-inflationary efforts of the
Federal Reserve, the Administration, and the Congress
—
must convince people that its behavior in the future will
differ significantly from the past.
The legacy of
previous monetary expansion seriously constrains our
monetary authorities/ who face the unenviable task of
establishing the degree of credibility enjoyed by their
German and Swiss counterparts.
Improved.Monetary Control
The major departures of money growth from targeted
trends on a quarter-to-quarter basis that we have seen in
recent years are by no means inevitable.
The Federal
Reserve is technically capable of achieving fairly smooth
M-l growth, measured over periods of several months rather
than week to week.
According to a 1981 Federal Reserve
study on monetary control procedures, the growth rate of
M-l from quarter to quarter need not deviate on average
more than plus or minus one percentage point from target,
at annualized rates.
Attaining this degree of precision
would result in a substantial improvement over current
performance.
I am pleased to note that changes in Federal Reserve
procedures are occurring which should improve the
controllability of money growth in the future.
The recent
99
decision of the Federal Reserve to adopt
contemporaneous
reserve accounting should allow the Fed's open market
operations to have a more immediate effect on total bank
reserves and M-l.
Also, the phasing in of more uniform
reserve requirements for different forms of bank accounts,
as required by the Monetary Control Act of 1980, should
u.2lp to reduce random fluctuations in money growth.
Improved control of the money supply remains within
the Federal Reserve* s grasp.
A reduction in the
fluctuations in money growth might result in more variable
interest rates on loans of very short maturity. But tbe
change would help to stabilise the longer-term interest
rates that matter most for investment decisions and
general economic performance.
Conclusion
We have learned over the last several years that
reducing inflation, while essential for a strong economy,
entails large but temporary costs in the form of lower
employment and dampened economic activity.
The challenge
for the Federal Reserve, as well as for the Administration
and the Congress, is to achieve price stability while
minimizing the toll that must be paid for it.
Monetary
policy has played a critical role in achieving the
substantial reduction in inflation that we have
experienced over the last year-and-a-nal£.
The Federal
Reserve, by adhering to the current direction of its
policies in a predictable and reliable fashion, can play
an essential part in demonstrating that stable prices and
healthy economic growth are both compatible and mutually
reinforcing.
100
Mr. WEIDENBAUM. Thank you, Mr. Chairman, for your forebearance.
The CHAIRMAN. Thank you, Mr. Weidenbaum. Yesterday we had
a very long session with Chairman Volcker and as I sat and listened to not only the testimony, but the questions from both Republicans and Democrats, I made the comment, Murray, that nothing much seemed to change. Some of the roles reversed.
Yesterday, the minority was valiantly trying to make certain
what you've said in your testimony, that, in general, the administration agrees with Fed policy. And I can remember when the
Chairman came here and we Republicans were trying to make sure
that we, for political reasons, that Carter and Chairman Volcker
were in lock-step going down.
And I listened to all of these figures and all of this detailed economic philosophy and, I don't know, I'm to the point where I
wonder if it even means anything, because there was no disagreement among members of this panel yesterday, Republican or
Democrat, about the problems of high interest rates and high unemployment and the crisis that this economy is in.
BUDGET PREDICTIONS CONSTANTLY UNDERESTIMATED
But after 8 years of sitting on this panel and listening to economists, and you know how I feel about you personally—so I don't
mean this personally at all—what does it all mean? Everybody's
wrong. We come in and we hear all these figures and we have all
of these predictions, and they're meaningless because they never
corne true. Do our economists have crystal balls? I mean, it's just
absolutely amazing.
In 8 years here I've seen administrations—and this one is doing
what every other one has done—making projections that simply
don't fit into the world of reality. You would think we would learn
from hindsight because no budget presentation by a President, an
administration, either Republican or Democrat, or from Congress,
or from the Congressional Budget Office, from anybody, since I
have been here, has come anywhere close to what actually happened. And they've all been underestimates, without exception.
Every single time every year.
Now do we ever get smart? Does anybody get smart? Economists?
Republicans? Democrats? Presidents?
People are out there suffering, Murray. And we hold these hearings and we talk about these things, and the reason I sit here and
sometimes don't even particularly listen, is because 6 months from
now, nobody's going to be right. They never have been before.
I'm just asking a very practical question: Isn't it possible for
people to have a little commonsense and say, nobody's predictions
have been right, at least while I've been in politics. Why don't we
try and be a little realistic and look at past history for making projections? But I don't think that anybody has a right to criticize
anybody else and say, this administration's estimates are off. I can
go through what Congress has done in the last couple of years. We
haven't come close.
Nobody—Alice Rivlin isn't close to hers. She's supposed to be independent of anybody and just advise. I haven't found a set of fig
101
ures on this economy or any budget year that have been anywhere
close to the reality of what has actually taken place.
Mr. WEIDENBAUM. Mr. Chairman, the short answer to your point
is, yes. As you often do, you've hit the nail on the head. The record
for specific monthly and quarterly forecasts of the economics profession is not very good.
The CHAIRMAN. How about yearly?
Mr. WEIDENBAUM. Much better.
The CHAIRMAN. Not much.
Mr. WEIDENBAUM. Over the years, the standard private forecasts,
as reported in blue chip indicators, have been quite close to the
mark. I don't want to give them a commercial, but let's just say a
wrapup of what 30 or 40 major private forecasters are saying.
In our case, in February 1981, we forecasted the year. We said
that real growth would be 1.1. It turned out to be 2 percent. We
said that inflation would be, the CPI would be 11.1. It was a shade
under that.
Frankly, I think as general guides, that was useful. But there's
something more basic. And that's why I'm so pleased that this is a
hearing focusing on monetary policy. I think you don't need pinpoint accuracy in forecasting.
The CHAIRMAN. Murray, what I'm talking about has nothing to
do with pinpoint. The administration—well, let's go back to all of
them, the most current one—remember the $45 billion deficit?
Mr. WEIDENBAUM. Now I don't take credit for
The CHAIRMAN. Remember some of us were sitting down there
and saying, hey, hey, hey, and you believe in the tooth fairy, too.
But they persisted. And I sat and served in a Congress that in June
of 1980 passed the first concurrent budget resolution; I mean, not
estimates, passed it and said, we're going to have a $200 million
surplus. And by August, it was a $27 billion deficit. By the time we
got to January and February, it was a $70 billion deficit.
I mean, we're not missing by a little bit. These aren't fine. I
mean, they're just gross. It has nothing to do with partisan politics.
If you're the out-party, you criticize; if you're the in, it's all right
and you try and cover it up. But it knows no party bounds, no political philosophy. Just the grossest of errors on the budget over
and over and over again. Who's kidding who? Those people are out
there suffering. They don't even know what M> is. They could care
less. They know they're unemployed. They know they're paying
16V2, 17 percent interest, and we're playing games with numbers
that are always wrong.
Mr. WEIDENBAUM. There's something basic here, Mr. Chairman,
and that is the kind of monetary policy that we have developed not
only doesn't depend on forecasts, but I think, objectively, has
worked. Let me give you just three dates, and they're not chosen at
random, frankly: January 1977; January 1981, and today.
January 1977, the prime interest rate was 7 percent. January,
1981, the prime was 21 percent. Today, it's 16 percent. And I'm not
saying that from a partisan basis because I'm not going to relate
that to who was in office, but what was the policy during that
period.
During the more recent period, the policy has been to slow down
the growth of the money supply. During the previous period, the
102
policies were quite different than that. I think, visibly, embarking
on the policy of monetary restraint has succeeded, more slowly
than you and I would like it, of course, and more slowly than we
expected, frankly. But it has succeeded in bringing down interest
rates. And it didn't require an economic forecast; it required the
adoption of the appropriate monetary policy, which, of course, is
the whole thrust of my statement.
And I maintain that the basic reason not only that we've gotten
this progress on interest rates, but the very substantial progress on
inflation, is the monetary policy that has been followed in the past
year and a half.
The CHAIRMAN. Well, relatively speaking, the reduction from
21l/g to 16Va percent interest is good, although they used to put
people in jail for charging 16 percent interest. It's known as usury.
I never thought I would live long enough to pray every night for a
12-percent prime and think people were giving money away at 12.
Well, my point was simply one of frustration and without regard
to political party or economic philosophy of various economists. I
think our track record on forecasting and trying to manage the
monetary and fiscal policy of this country is so poor, that I wonder
about the science of economics, the practicalities of at least not
being able to learn from past experience.
Now I admit, some of the estimates that I'm talking about lie
solely in the political field, in administrations and in this Congress,
who, for political purposes, I guess, exaggerate one way or another.
Mr. WEIDENBAUM. Well, a wiser man than I has said that economic forecasting is neither an art, nor a science; it's a hazard and
one not covered by OSHA.
The CHAIRMAN. Senator Riegle?
SERIOUS ECONOMIC CONDITIONS
Senator RIEGLE. Chairman Weidenbaum, we did have a long session yesterday with Chairman Volcker, And I must tell you, both
from the vantage point of my State of Michigan, which is the hardest hit State by the recession and the economic conditions, and all
across the country, all 50 States, that we have a desperately serious
economic situation on our hands.
All the major indicators right now bear that out: Unemployment—we've got 10V2 million people out of work across the country, and at least another million and a half that aren't counted in
the statistics any more because they've been unemployed for so
long, as well as estimates of maybe another 5 million that are substantially underemployed. We've got business failures right now
running at an all-time record rate since the Depression. We're
Losing 550 a week. We're losing one every 20 minutes around the
clock, 7 days a week, and many of them good, solid businesses, wellmanaged businesses. They're being ground down by the high interest rates and the general conditions of recession.
We've got financial institutions failing. We've got virtually every
S. & L. in the country in trouble, and many in very desperate serious trouble. We've got the auto industry below 50 percent of capacity, the steel industry running at about 40 percent of capacity.
We've got a depression in the housing and construction industry.
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We've got agriculture in deep trouble in many areas of the country.
We have a bona-fide interest rate crisis. And we can talk about the
half-point drop in the discount rate and the fact that the prime has
dropped to 16 percent. But I have to agree with the Chairman: 16
percent is really no consolation in terms of the problem we face
today, and most small businesses can't borrow at 16 percent.
They're borrowing at 2, 3 points above prime, if they can get the
money. So we've got an urgent situation on our hands.
In this week's issue of U.S. News & World Report, it says as follows on page 11. And they seem to have a pretty good reading on
the thinking in the White House. They lead with this statement:
The President will stand pat on economic policy for the rest of the year. Reagan
won't be turned around, even though the oft touted "just around the corner" recovery is looking more and more elusive. Political realism is the key. There's not much
the President can do between now and the election time to give the ailing economy
a quick fix. The White House game plan is to tough it out, insist Reagartomics will
work, and hope that things perk up soon to prevent heavy losses in Congress this
fall. The last thing that Reagan wants is to be accused of "Carterism," being wishywashy on major issues. Reagan's advisers argue that this steadfastness is a virtue;
shifting gears would send bad signals.
And it goes on in that vein.
I hope that's wrong.
Mr. WEIDENBAUM. It is. I'd be glad to explain.
The CHAIRMAN. I hope you're prepared not to stand pat on economic policy. You know, you're a person who brought a reputation
into this job because of your fine service over many years as an
economist, as a professor, as a person of stature and standing in
your own right. And I find it hard to imagine that we can let the
conditions that go on that we're seeing today without someone like
you blowing the whistle on this and saying that the policy mix
needs to change.
The deficit next year, I believe, as a member of the Budget Committee, will exceed $130 billion. I think we'll be lucky to hit $130
billion because spending is out of control. Defense spending has
gone wild. There are so many sacred cows in the budget that
haven't been touched that you could put a list from here to the end
of the room.
1 think the deficits in the out-years, 1984 and 1985, will be in the
$200 and possibly even as high as $300 billion range. And let me
tell you something. As I talk to bankers across the country, people
on Wall Street, heads of major corporations—that's what they believe. That's what their economists are telling them. That's the
basis upon which they're making their plans.
And capital investment plans right now, as you know, have
fallen literally to a record low. We are not seeing the supply-side
spurt that was supposed to take place at this time.
So in light of this, my question to you is this. The President
seems to be disconnected from these realities. What he says in his
public statements does not show a recognition of the seriousness of
this problem. I don't know what his thinking is, but I find it inconceivable that you would not see these problems. I just have too
much confidence in your own ability, in your own professional
strength to see that we have an urgent situation on our hands, and
I would want to believe that you were fighting in every way to try
to change it, to change the policy mix, to bring the deficits down, to
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fight to get a lowering of interest rates now before we see a broader collapse in the economy.
So my question is: Are you making that kind of an effort? What
is going to happen? Can we have any hope that we'll see a change
in policy between now and the end of the year? Or are we just
going to be in this state of paralysis on economic policy while more
and more damage and hardship and suffering in this country takes
place?
DIFFICULT TIMES ARE BEHIND US
Mr. WEIDENBAUM. I'd like to answer that this way. In the second
quarter of 1982, real economic growth equalled 1.7 percent. That is
the first positive sign of an expanding economy that we've had
since the middle of last year. So I think it is quite clear that the
worst of the difficult times that you so accurately described are
behind us.
I can assure you that the President not only is intimately aware
of the economic situation. I briefed him as recently as yesterday
afternoon in the Oval Office. But he cares deeply and is convinced
that his program, as fully carried out, will restore the health of the
American economy, with high levels of employment and economic
growth and low inflation.
Very frankly, those budget deficits that you referred to are
deeply worrisome. They are much, much larger than I would like
to see. I have said repeatedly, in public, as well as in private, for
months now, that I think we need to see the budget deficit decline
from its peak in this recession year of fiscal 1982. It's going to take
a lot more budget cutting up on this side of Pennsylvania Avenue
to achieve that objective.
I think there are too many sacred cows in the Federal budget. I
don't limit them to any one department. Specifically, I'd start, in
alphabetical order, appropriately enough, with the Agriculture Department. There are sacred cows there, but I would include every
department, military and civilian, in the further budget restraint
that is necessary in order to get those deficits down because I do
believe that the high interest rates—and again, I've been saying
that consistently—the high interest rates are the key barrier to a
strong recovery.
TIME RUNNING OUT
Senator RIEGLE. Let me make a suggestion to you because I'm
afraid what's happening here is we're running out of time. We're
running out of time both in terms of the economy and the structural strength and damage that's being done, and also, we're running
out of time in this session of Congress. We have about 45 working
days left between now and an October 2 adjournment.
The CHAIRMAN. Forty-four. We had 45 yesterday.
Senator RIEGLE. Forty-four days. [Laughter.]
Mr. WEIDENBAUM. Republicans are always pretty sharp on numbers. [Laughter.]
Senator RIEGLE. Howard Baker has announced that we will adjourn, his target date is October 2. So that gives us very little time;
the window is closing on this session of Congress.
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Once the Congress goes out of session, there's also been an indication by the leadership that they would prefer not to see a postelection session. So who knows whether there will be one or whether anything can be accomplished. But then the new Congress will
not come in until late in January and with the startup time in getting organized, setting up new committees in the House and
Senate, and so forth, and you've got a situation where the Jefferson, Jackson, the Lincoln day recess is in February—it will be
really the first part of the second quarter of next year before the
Government as a whole is able to deal with the economic policy
problem or with the whole fiscal monetary mix issue.
And so we're about to go into a period where, for about 6, 7 or 8
months, it's going to be very difficult for our Government as a
whole to function. Even the President, if he wanted to act unilaterally, with the Credit Control Act just expired—I mean there are
limits
Mr. WEIDENBAUM, Thankfully.
Senator RIEGLE, Well, that may be your view.
Mr. WEIDENBAUM. It is.
Senator RIEGLE. And the time may come when you wish you had
those powers. Let's hope now.
In any event, if the President wanted to act unilaterally, he's
quite limited and constrained with respect to economic policy initiatives. He would need the Congress, especially if we're going to do
something about spending, if we're going to do something about the
fiscal side of things.
So in light of that, in light of the jeopardy that the economy is
now in and with the window closing on this session of Congress, I'd
like to make this suggestion to you. I think it would be very constructive if the President were to decide to take hold of this economic problem in his own hands directly in this form—that he
would convene a kind of emergency budget summit meeting and
invite the leaders of the Congress from both parties to meet with
him, with him running the meeting, maybe at Camp David, some
setting such as that. Invite Paul Volcker and the members of the
Fed to come to such a meeting. And the meeting might go on for 2
or 3 weeks, for as long as it might take to work out a bipartisan
agreement on major budget reductions for 1983, 1984, and 1985.
Then we could come back and legislate the program into place so
that the financial markets and capital investment decisionmakers
across this country could count on it, so that, in turn, we could get
a monetary policy response that would substantially reduce interest rates now. Not to 16 percent and with 16, maybe going back to
18 or 20 between now and the end of the year, as Henry Kauffman
and some others are predicting may happen, but to give us a certain reduction in interest rate so that we could start to see the
economy move and people go back to work.
If we could get just 1 percent of the unemployed people, 1 percentage point of our 9 ¥2 percentage points of unemployed people
back to work, we could reduce the deficit by $30 billion.
Frankly, I don't see any way that we're going to tackle this problem on the scale that it needs to be tackled unless the President
himself were to lead that process directly and invite the rest of the
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key players on a bipartisan basis to take part in such a piece of
work.
There has been no such meeting. The "Gang of 17" that met for
weeks and weeks and weeks, the only time that the President or
Tip O'Neill, either one, participated was in the last meeting, which
was really window dressing after it was clear that the whole process had failed.
We need to start again. Would you be willing to support that
idea and present that idea to the President?
RECESSION BOTTOMED OUT
Mr. WEIDENBAUM. I'll be glad to transmit your suggestion, Senator. But it strikes me, very frankly, on the basis of my knowledge
of recent American economic history that usually, crash efforts do
just that. If they don't crash, they come in far too late, way after
the economy has turned. And it strikes me, when I look at the
economy, clearly, we have bottomed out of the recession. The economy is beginning to turn up.
I look at a table of interest rates—I'll be glad to submit it for the
record—at every maturity, from the Federal funds rate, Treasury
bills, prime rate, 3-year money, 30-year bonds, municipal bonds, interest rates across the spectrum are coming down.
In other words
Senator RIEGLE. What about unemployment?
Mr. WEIDENBAUM. Unemployment has stabilized.
Senator RIEGLE. Isn't it rising? Aren't we likely to see a rise in
unemployment?
Mr. WEIDENBAUM. It was 9.5 percent the last 2 months. It sometimes lags behind the upturn in the economy.
Senator RIEGLE. Is it rising or is it staying steady or is it dropping?
Mr. WEIDENBAUM. My point is that the crash efforts don't come
onstream promptly enough to deal with today's problems. When
they come onstream, they exacerbate
Senator RIEGLE. The bottom line is that unemployment is rising.
Mr. WEIDENBAUM. If I may. They exacerbate the inflationary
pressures during the upturn, which upturn is already
Senator RIEGLE. How about housing starts? Are they up? How
about auto sales?
Mr. WEIDENBAUM. They have hit bottom.
Senator RIEGLE. They hit bottom?
Mr. WEIDENBAUM. If you look at the trend of housing starts, they
hit bottom sometime late last fall. They are still at a very low rate
and will take a further decline in mortgage rates.
Senator RIEGLE. You must not have seen the article in yesterday's Post, the fact that they had just dropped again. Auto sales
just dropped,
Mr. WEIDENBAUM. The monthly decline
Senator RIEGLE. Bankruptcies are still rising. Unemployment is
still rising. You say we're turning up. What are the measures of
the fact that we're turning up?
Mr. WEIDENBAUM. The total level of economic activity, after you
boil out the. inflation, has risen in the last 3 months. Has it risen
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rapidly? Of course not. Do we expect that it will rise more rapidly
in the coming quarters? Yes. The tax cut effect of July 1 is an important incentive for spurring this economy.
But, very frankly, if we learn from the lessons of the past, the
stop-and-go policies don't work. You talk about a crisis in interest
rates. Frankly, I question that. With the prime rate at 16 percent,
what did
you call the interest rate situation when the prime rate
was 211/2 percent in early January 1981? Was it a prisis then?
Senator RIEGLE. You know, in Japan today, the prime rate is 5%
percent.
Mr. WEIDENBAUM. Yes.
Senator RIEGLE. And they have a lot more of their people at
work than we do.
Mr. WEIDENBAUM. And I think if the budget deficits were smaller, if Congress had appropriated less spending over the years, we'd
have lower inflation in this country.
Senator RIEGLE. Murray, this administration came in and asked
for bigger budget deficits than we've passed, bigger ones. If we
passed the budget you brought to us, we would have deficits larger
than the ones I'm talking about.
Mr. WEIDENBAUM. I'm not here to defend the budget deficit.
Senator RIEGLE. I mean, that is really, I think, just
Mr. WEIDENBAUM. I didn't mean to be partisan.
Senator RIEGLE. It isn't a question of being partisan; it's a question of being honest about it. You folks came in here asking for
bigger budget deficits than that. That's the fact.
Now you come around with the constitutional amendment on a
balanced budget, which somebody has described as a "figleaf'—an
entirely accurate characterization. You can't come in here and ask
for a budget with deficits that go up to $200 billion and beyond and
turn around in the same breath—I'm speaking now of the administration—and say you're for balanced budgets and you're for fiscal
restraint.
That's a total contradiction.
Mr. WEIDENBAUM. It's news to me that we've asked for deficits in
that category.
Senator RIEGLE. Pardon?
Mr. WEIDENBAUM. It's news to me, frankly; I'm not aware that
we've ever asked for estimated deficits in that category.
Senator SARBANES. Would the Senator yield?
Senator RIEGLE. Yes, my time is up.
The CHAIRMAN. In just a moment. It's your time. His time is up
and I will turn to you, Senator Sarbanes,
Senator SARBANES. Thank you, Mr. Chairman.
TRILLION-DOLLAR DEBT
The CHAIRMAN. Let me just make one quick comment, Don, and I
don't want to prolong this at all. I don't like the administration's
budget request. But you simply can't constantly try to blame it
there, either, and ignore the fact that before this President ever
came, without regard to previous Presidents, parties, or Congresses,
there was a trillion-dollar debt with a carrying cost of over $100
billion, from whoever was here in either party or any President.
108
Now that simply cannot be ignored. It didn't make any difference who was inaugurated in January 1981. There were certain inherited problems from the past that have driven some very large
problems, particularly decisions because people thought in previous
administrations that interest rates would come down. They started
refunding the national debt.
All I'm asking is forget Republicans and Democrats. I'm getting
sick of it, absolutely sick and tired of people going for partisan advantage. I'm not saying you are. I'm just saying, in general. I'm
trying to say it's happened since January or it was all Franklin
Roosevelt's fault or somebody else's.
Who cares? Who cares? When are we going to face up to the fact
that we've got a trillion-dollar debt that Congress, with both Republicans and Democrats in it, has been on a wild spending spree
for years. And there is a trillion-dollar debt and there is interest of
$120 billion a year. There are vested interests, with everybody's ox
to be gored and they want to cut somebody else's but not theirs.
And until we come to that agreement and quit playing games,
whether it's the administration, Ronald Reagan, this Congress,
Paul Volcker, we're going to be back here next year. We can have
more Democrats in the House. We can elect a Democratic President in 1984 and nothing's going to change except the people will
suffer until we quit playing partisan games and trying to assess
blame and wake up to the arithmetic—the arithmetic of what has
been built up over a long period of time.
Senator Sarbanes?
Senator SARBANES. Mr. Chairman, well ahead of any discussion
of playing partisan games is the question of whether you're going
to get the truth and the facts.
Chairman Weidenbaum, I listened to your response to Senator
Riegle. What did the administration estimate that the deficit would
be when it submitted the budget to the Congress this year?
Mr. WEIDENBAUM. For fiscal 1983?
Senator SARBANES. Yes.
Mr. WEIDENBAUM. Approximately $103 billion. I do this from
memory, you can appreciate.
Senator SARBANES. It was under $100 billion, wasn't it?
Senator DIXON. I think originally $97 Vfe billion.
The CHAIRMAN. $96 billion.
Senator SARBANES. You were very careful to have it under $100
billion, weren't you?
Mr. WEIDENBAUM. I'm not sure of the meaning of that.
Senator SARBANES. Then it was examined and everyone agreed
that it was in the range of $160 billion to $180 billion, isn't that
correct, including the President himself?
Mr. WEIDENBAUM. You're referring to estimates in the absence of
any budget cuts or revenue increases?
Senator SARBANES. I'm referring to an accurate estimate of what
you submitted.
Mr. WEIDENBAUM. I don't associate—of course, I defer to the
Budget Director on these matters—but I don't associate
Senator SARBANES. The CEA is a professional organization, supposedly. I spent a good year of my life working for Walter Heller
when he was the chairman. I know the enormous pride within the
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organization in its professionalism. I think there's serious question
now that that professionalism has been compromised.
On Friday, the 2d of July
Mr. WEIDENBAUM. I object to that, Senator.
Senator SARBANES. I'll give you the basis of that assertion. On
Friday, the 2d of July, the New York Times carried an article concerning the resignation of Jerry L. Jordan, a member of your Council.
Mr. WEIDENBAUM, That's right.
Senator SARBANES. In that article, it says, and I quote:
Mr. Jordan was known to have had some problems with the Administration's
budget forecasts for 1982 through 1985, which formed the basis for the President's
original budget proposal for the Fiscal Year 1983. He was one of the first economic
officials in the Administration to acknowledge that the revised mid-year forecast
which was issued in mid-July, 1981, just before the President's tax bill was considered in Congress, was not properly done and would have shown a worsening deficit
picture if it had been.
What's your comment on that?
Mr. WEIDENBAUM. I never heard those statements. I read that
hearsay in the paper. But it's quite clear that as the economy unfolded, as Congress acted on the tax program and on the spending
proposals, that the deficit was going to be larger than originally estimated. There was no question about that as the year progressed.
The question, of course, and this goes back to the chairman's
opening discussion, was the ability to pinpoint those numbers. It's
quite clear that enacting fewer budget cuts and more tax increases
than had been assumed in the estimates would have reduced the
deficit.
Senator SARBANES. Are you now engaged in an exchange with
the chairman of the Joint Economic Committee, Congressman
Reuss, with respect to working papers of the CEA, which show that
the forecasts were much more pessimistic than what was stated in
public?
Mr. WEIDENBAUM. The short answer is no, because, one, these
were not working papers of the CEA. But two, what Mr. Reuss is
referring to is the quarterly breakdowns, which add up to the published annual numbers.
By the way, ever since March, 1981, in public testimony, I pointed out the likelihood of one or more quarters of negative growth
last year.
Senator SARBANES. Chairman Reuss said:
The Administration concealed from the American public information it had that
Administration policies would produce a full-scale recession. At the same time this
information was available, the American public was being told that we were on the
verge of recovery and sustained growth.
Mr. WEIDENBAUM. I guess he wasn't paying attention to rny testimony before his committee when I said
Senator SARBANES. I think he was paying attention to your testimony.
Mr. WEIDENBAUM. Excuse me?
Senator SARBANES. I think he was paying attention.
Mr. WEIDENBAUM. Well, in March, 1981, and in many subsequent
public statements to his committee and other committees, I said
no
that we had a soft, soggy economy at the time and that I wondered
about the prospects of one or more quarters of decline.
Senator SARBANES. Mr. Chairman, I remember very, very vividly
a session before the Joint Economic Committee and what I perceived to be the acute embarrassment of Professor Jordan with respect to the testimony which the Council had" submitted and that, I
think, is supported by this Times article which I just quoted.
Let me ask you this question. We asked Chairman Volcker yesterday whether he thought he was pursuing the monetary policy
which the administration wished him to pursue?
He said, well, he thought so, but we would have to ask the administration about that. I did pursue with him the question of
whether it was, at least, his perception that he was pursuing a
policy which you wished him to pursue? And he said, yes, that was
the case.
So at least that's the perception he has, that he's on track with
you. And I take it that your testimony here this morning is to the
effect that, indeed, the Federal Reserve is on track with the administration with respect to the monetary policy which it is pursuing.
Is that correct?
Mr. WEIDENBAUM. Approximately. I use somewhat similar, although not identical, language to the effect that we're on the same
wavelength. We consistently supported their policy of slowing down
the growth of the money supply.
I tried to word that, frankly, consistent with my awareness of the
independence of the Federal Reserve, that it is their decision and
their determination, of course.
Senator SARBANES. Is it your assertion that West Germany has
not had any money growth since 1960?
Mr. WEIDENBAUM. No, that's not what I said. West Germany has
experienced nearly constant money growth. In other words, the
money growth, quite clearly, has been maintained. It hasn't fluctuated as sharply.
Senator SARBANES. In other words, there's been money growth.
Mr. WEIDENBAUM. Of course.
Senator SARBANES. At what rate?
Mr. WEIDENBAUM. I don't specify in my statement.
Senator SARBANES. Could you tell us that?
Mr, WEIDENBAUM. I'll be glad to supply that for the record (see p.
123).
Senator SARBANES. You don't have that in mind?
Mr. WEIDENBAUM. At my fingertips? No, sir.
REDUCTION OF MONEY SUPPLY
Senator SARBANES. Now, is it your view that there should be a
reduction in the growth of the money supply in this country?
Mr. WEIDENBAUM. From the level that obtained a year and a half
ago? Oh, yes, sir, a reduction in the growth rate of the money
supply. For example, the second half of 1980, which I think is the
appropriate base
Senator SARBANES. No, I'm asking whether at the moment, do
you think that the next step forward would be to reduce the
growth in the money supply?
Ill
Mr. WEIDENBAUM. In the very short-term, I think that it's appropriate for the Fed to aim at the top end of the target range, as
Chairman Volcker stated yesterday.
Senator SARBANES. Well, what are the factors that you consider
in trying to determine how the money supply should move?
Mr. WEIDENBAUM. A variety. First of all, the Fed sets those
target rates and we have consistently supported them because
they're consistent with our projections.
Senator SARBANES. Well, what should they consider? What is it
that you should consider when you set the target rate?
Mr. WEIDENBAUM. I wouldn't presume to instruct the Federal Reserve on how to set the target ranges. What we did do
Senator SARBANES, I'm not asking you to do that. I'm just asking
you what are the factors that you should be looking at in reaching
a judgment on what the target rate should be?
Mr. WEIDENBAUM. Target rate—the target range as opposed to
the movement within the range in a given point in time.
Senator SARBANES. You have to make some judgment whether
they're doing a good job or not. What are the factors you look at in
making that judgment?
Mr. WEIDENBAUM. First of all, in the February 1981 white paper,
we stated the objective of reducing the growth rate of the money
supply between 1980 and 1986 by about one-half. And therefore,
the reductions in the targets that the Fed has announced since
then are consistent.
Senator SARBANES. Well, what is your premise as to how an economy will function? If an economy is expanding, is there need to
have a growth in the money supply to accommodate expansion?
Mr. WEIDENBAUM. Oh, of course. The serious question is how rapidly, because
Senator SARBANES. The West Germans have been expanding
their money supply, haven't they?
Mr, WEIDENBAUM. Of course. Growth in the money supply is
what we're talking about. But we've seen, unfortunately, when
that growth is too rapid, it only exacerbates, it only feeds the inflationary pressures.
Senator SARBANES. So you think that the growth in the money
supply should be cut by half; is that correct?
Mr. WEIDENBAUM. Between 1980 and 1986. That's the target we
set in our economic white paper in 1981.
Senator SARBANES. What is your assumption about what's going
to happen to the growth of the economy between 1980 and 1986?
Mr. WEIDENBAUM. We assumed in the white paper long-term
growth, significant long-term growth, brought about in good measure by a series of tax cuts.
Senator SARBANES. Assuming
Mr. WEIDENBAUM. If I may attempt to answer the remainder of
your question, Senator, in terms of where the Fed should aim, I
think it's apparent that the second half, for about 6 months in
1981, approximately April to October, the money supply hardly
grew at all. And therefore, I think it's not surprising at all
Senator SARBANES. Were you supportive of that?
Mr. WEIDENBAUM. In retrospect, I think that that was too slow.
Senator SARBANES. Were you critical of it at the time?
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Mr. WEIDENBAUM. In my informal meetings with the Chairman
of the Federal Reserve, I did give my advice.
Senator SARBANES. Were your public statements at the time supportive of the Fed's policy?
Mr. WEIDENBAUM. The policy, you appreciate, Senator, was to
attain the growth targets. The practice was sometimes different.
From time to time, frankly, I needled them and said I wish their
aim would improve in achieving their policies.
Senator SARBANES. You needled them, where?
Mr. WEIDENBAUM. In various public statements, testimony.
Senator SARBANES. You did needle them in public statements?
Mr. WEIDENBAUM. In fact, I'd say we endorsed the target. Their
policy is embodied in the targets. I noticed that sometimes they are
above the targets, sometimes they're below the targets. I don't
mean this critically, but I wish their aim would improve and I'm
sure they do, too.
Senator SARBANES. That's some needle. Well, my time has expired.
The CHAIRMAN. Senator Dixon?
GRANT ITEM VETO POWER TO THE PRESIDENT
Senator DIXON. Chairman Weidenbaum, you said in your testimony that you would like to see more fiscal restraint by the Congress. Yesterday, when Chairman Volcker was here, he expressed
the view that one of the best things that the Congress could do
would be to grant item veto power to the President.
We have that power in my State with the Governor and it has
achieved remarkable financial savings in my State. I believe that
43 of the 50 States actually give the Chief Executive an item veto
power.
Do you support that concept?
Mr. WEIDENBAUM. I cannot speak for the administration on that
budget matter, but personally, as a long-term student of the
budget, I think it's a fine idea.
Senator DIXON. Your testimony, I think it can be fairly said, Mr.
Chairman, is basically an endorsement of the general policies of
the Fed. Would that be a fair characterization?
Mr. WEIDENBAUM. That's right. Yes, sir.
Senator DIXON. And you've indicated in there that the policy of
the Fed, which this year targets money growth of 2]/2 to 5Vz percent, if I recall correctly, is acceptable to you. I believe you've indicated, or at least implied here, that you felt the high side of the
target range would be a more acceptable policy for the Fed, in your
view.
Mr. WEIDENBAUM. Well, what I really was doing was commenting on Paul Volcker's testimony here before your committee yesterday, where he indicated that the Federal Reserve would be aiming
primarily to operate at the top end of the range and indicated circumstances in which they might occasionally go above it.
And it strikes me that that is appropriate for the circumstances.
Senator DIXON. That would be your view as Chairman of the
President's Council of Economic Advisers, that that target range,
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the high side of it, at least, would be acceptable, from your standpoint.
Mr. WEIDENBAUM. Under those circumstances, yes.
Senator DIXON. And that was basically the policy last year.
Mr. WEIDENBAUM. Well, no. Last year, the policy was to operate
within the range, and as I pointed out to Senator Sarbanes, for 6
months, they operated without any growth. And then the growth
was quite rapid from about November on. And the whole thrust of
my statement that I prepared for your committee is that I think
we'd have a healthier economy if the Fed could achieve a more
stable growth. And I've gone into the technical details as to how to
try to achieve that more stable growth pattern.
Senator DIXON. But essentially, the policy of the Fed, in the time
that I've been here and the time of this administration, has been a
monetary growth in the target area indicated here, and that has
been the stable policy of the Fed throughout this administration's
tenure to date; would that not be a fair statement?
Mr. WEIDENBAUM. Our position has been consistent in terms of
supporting the Federal Reserve in its policy of slowing down the
growth of the money supply and we've consistently supported the
specific targets that they independently set.
Senator DIXON. I characterized the presentation of Chairman
Volcker yesterday as more of the same. And I would say that that
is the policy he has represented to us as the policy of the Fed.
Would that be your view?
Mr. WEIDENBAUM. I need to distinguish between policy and practice because, in practice
Senator DIXON. I'm talking about the target ranges, not the variations.
Mr. WEIDENBAUM. Well, you see, last year, the Fed, the year as a
whole undershot the target range. They came in below the bottom
end of the target range.
Senator DIXON. You'd like to see them on the high side this
year?
Mr. WEIDENBAUM. Having undershot last year, I think it's appropriate to be on the high side thus year, especially with the slow recovery that's underway. But as a long-term matter, I think they
ought to operate within their target.
TARGETING INTEREST RATES
Senator DIXON. How do you feel about targeting interest rates,
looking at interest rate as well as monetary supply, as was done
prior to October 1979? What's your view on that policy?
Mr. WEIDENBAUM. Very negative.
Senator DIXON. You think that's a mistake?
Mr. WEIDENBAUM. Yes, sir. That was the key to the inflation that
we've been suffering from and that we have tried so painfully to
unwind.
It sounds attractive, I know, but we found that it doesn't work.
Senator DIXON. Basically, your opinion is that you endorse the
2M> to 5Va percent target range in monetary growth of the Fed.
You oppose the idea of targeting interest rates, as had been done
up until October 1979. And taking into account the variables that
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might occur between the bottom and the high side of that range,
you find that acceptable policy.
Mr. WEIDENBAUM. Yes, sir.
Senator DIXON. Well, then, I guess my question would be, given
the fact of the terrible economic experience in the country that
we're all aware of right now—for instance, I'm a graduate of your
fine university, Washington University, September 1949. In my
entire adult career, in employment, owning businesses, needing to
meet a payroll, making a profit sometimes, experiencing a loss
other times, there's never been an economic situation in this country in my adult lifetime, in my view, as severe as the one that we
have right now.
So I guess my question would be: What, then, does it take for the
Fed to make some kind of a response to the economic situation in
the country other than what you find acceptable in the policy they
apply right now to respond to interest rates, the dramatic unemployment situation, and the economic experience in the country?
Mr. WEIDENBAUM. First of all, I don't think that the Federal Reserve is the only game in town, so to speak.
Senator DIXON. I can see that,
Mr. WEIDENBAUM. A while ago, we were discussing the Federal
budget, and I don't mean this in either a partisan fashion or Congress versus the administration, because I think, in the course of
many administrations, Republican and Democratic, Congress and
the executive branch have developed a stream of Government
spending which I think is too high, which has been growing too
rapidly; and that I think dealing with that, slowing down the
growth of Government spending, which is not part of the Fed's responsibility, is a very integral part of economic policy in our country.
For example, if the deficit were half the size that it is today, I
think that this economy would be in a lot better shape. Interest
rates would be lower.
Senator DIXON. Do you really think on the basis of your experience—and I grant you all of your fine reputation. I think well of
you, personally—do you really believe that the recession in this
country has bottomed out? Is that your statement to this committee at this point in time, in July 1982, that this recession has bottomed out?
Mr. WEIDENBAUM. Yes. In fact
Senator DIXON. Things are going to get better from here on in?
Prosperity is just around the corner?
Mr, WEIDENBAUM. I didn't quite say that.
Senator DIXON. You have said that, I think, here. Prosperity is
just around the corner.
Mr. WEIDENBAUM. There's an old forecasting rule: If you ever
make a good forecast, never let them forget it. In late March of
1982, I stated in a speech in, I guess, New York City, that I thought
the economy had hit bottom. Well, we've now learned as of 10 a.m.
this morning that for the period of April through June, the economy did grow, a modest 1.7 percent in real terms, after boiling out
the effects of inflation.
Senator DIXON, Mr. Chairman, you know, you're familiar with
the St. Louis area. That's why I can visit with you this way. I just
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saw some unemployment statistics. For instance, in my hometown
of Belleville, a beautiful, lovely city, as you know. Many live in my
town and work in St. Louis. Unemployment is 16*/2 percent. They
were talking about all the cities around, and I want you to listen to
this because you know the area.
Granite City, over 20 percent. That's a steel town. You'd understand that. East St. Louis, lOVb percent. Now you and I know that
in East St. Louis, 40 percent of the people probably don't have
work. You know why the figure is lOVb percent? They don't count
them any more. They've been out of work under this administration so long, they don't even count them any more.
Now the statistics—we have 11.3 percent unemployment in my
State. Bankruptcies there in the first quarter of this year were
higher than in the first quarter of 1933.
I go home every weekend. I listen to you and to other witnesses,
men whom I respect, whose reputations are excellent, hearing on
the Hill about what a wonderful situation things are right now and
everything's getting better. The recession has bottomed out. And I
go back home and nobody tells me that on Main Street, Somebody's
wrong in this country,
Mr. WEIDENBAUM. I share your view that if that is the posted unemployment rate for East St. Louis, it's far too low. The reality is
much more severe. And it's been true a long, long time, to everyone's misfortune.
Nevertheless, the Midwest, our region of the country, as a fact,
has been much harder hit than many other regions of the country.
Senator DIXON. But could I—I know my time's just about up, Mr.
Chairman. Let me say this in conclusion. Not too long ago our distinguished chairman and Mr. Lugar, the distinguished senior Senator from Indiana, two men who I think would share a reputation as
strong supporters of the President, at the top of the list with
anyone whom you might suggest in the Congress of the United
States
Mr. WEIDENBAUM. Indeed. I agree with that.
HOUSING BILL VETOED
Senator DIXON. Men who are friend to the President and his interests, had a bill to respond to the housing needs in our country.
Housing starts in my State dropped last year 77 percent. And the
year before was a lousy year. It would have employed 650,000
people in this country to put carpenters, plumbers, bricklayers,
masons, and others to work.
I can understand the philosophical differences of the President
with that idea, but he vetoed it. And I come to hearings here and I
hear my friend, Mr. Volcker, say that we're going to stick to the
game plan we've had for 2 years, more of the same, and you endorse it and say it's fine, maybe get on the high side instead of the
low side or the target ranges. And I don't see anybody suggesting a
thing to do about what's happening in the country.
When I spoke in Rock Island this last Sunday and spoke to
people there and found out that 26,000 people who want to work in
Rock Island can't get work, and they want it, I would like to know
116
how in the world things are going to get better if all we do is have
meetings and say things are going to be OK if we stick to the plan?
Mr. WEIDENBAUM. Senator, I think that we need to learn from
past experience. The sad experience of the past is something like
the Lugar bill, when it gets enacted—I recommended a veto, I
make no bones about that—comes onstream far too late. But in
this environment, I think legislation like that would only push interest rates up further.
Senator DJXON. Well, I hope it came far too late, Mr. Chairman. I
respect you. I hope your opinion is right. But I don't see things
changing in the country. I don't want to suggest a banana before
we've got a banana. But I don't see things getting better in the
country. I respect your opinion, but if they're not getting better in
the country and we don't do anything here, next year we'll be talking, but it will be too late.
BAILOUT APPROACH
Mr. WEIDENBAUM. I do believe that the answer is not for Congress to take the kinds of actions that will increase the deficit because if there is any part of the economy that will be hardest hit
by a further increase in interest rates, it's the housing industry. I
think that's why you found parts of the housing industry supporting the President's veto. They realize that if we shifted to the bailout approach, to well-intentioned programs to spend more Federal
money to specific sectors of the economy, which increase the deficit
and increase pressure on interest rates, we would hit hardest those
sectors of the economy that we're trying to help the most.
Senator DIXON. I thank you and it's nice to see you again.
Mr. WEIDENBAUM. Thank you, sir.
The CHAIRMAN. Mr. Chairman, let me just make a comment on
the so-called Lugar bill. If you or the President or anyone else want
to disagree with the philosophy, and I normally would, too, except
sometimes you have to get the ox out of the mire.
The thing that bothers me is that when that was referred to as a
bailout bill in terms of cost, without regard to the structure or how
it should be done, because besides being chairman of the Banking
Committee, I also happen to be chairman of the HUD Independent
Agencies Appropriations Subcommittee. And there are some facts
that ought to be known.
President Carter requested 225,000 units of subsidized housing.
President Reagan requested 175,000 units of subsidized housing.
That subcomittee cut it to 150,000 and did the President 25,000
better, as did this authorizing committee.
Then in December, we cut it to 143,000 additional cuts; 52' percent of all of the recisions in the 1981 budget came out of that subcommittee. In 1982, 82 percent came out of that subcommittee.
When the urgent, urgent, urgent March supplemental came up,
that didn't pass until last week. And in that bill, the bill came over
from the House—every other single subcommittee of the Senate,
the Senate Appropriations Committee added money to that bill,
except one—the HUD Independent Agencies Subcommittee, which
took an additional $6.9 billion out, which made the total bill, which
made all the other subcommittees whole so that we could say the
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Senate had a bill that was lower in total cost than the House supplemental.
So we had to take more than all—well, they all added. Not more
than they took. They took none.
The Lugar, not as compromised in the conference, but out of
committee, added $1 billion back in, leaving only a net reduction of
$5.9 billion.
Those are facts, not opinions, to justify mine or Senator Lugar's
position. Simply flatout facts. So if people want to oppose it on philosophy and say it's too late, we shouldn't have done it, all of that,
OK. But it is totally unfair to call it a bailout.
And people would come up to me on the floor and say, Jake,
Dick, I would support your bill if you found me a billion-dollar
offset. Billion-dollar offset? We had a $6.9 billion offset just in that
bill. And 52 percent of the rescission in 1981 and 82 percent in
1982.
Now I would suggest my subcommittee has done its share and it
was not fair at any point along the line, for whatever other reasons
you wanted to veto that bill, to say that the Lugar bill was a
budget buster and a bailout. That simply is not the truth.
Mr. WEIDENBAUM. Mr. Chairman, I'm ready, willing, and most
anxious to state that if every other subcommittee bit the bullet the
way your subcommittee did, this country, as well as the budget,
would be in far better shape than it is today.
I can only add, and that needs to be underscored, I don't think
the public realizes the contributions of your subcommittee.
The CHAIRMAN. I'm not looking for compliments. I'm just trying
to refute that this was a bailout bill to add $l/s billion back in, $1
billion and then $Vfc billion when it came out of the conference
committee. You characterized it as one of the budget-buster types
of bills.
Mr. WEIDENBAUM. Well, from where I sit, almost every bill is a
budget buster because of those triple-digit deficits. In good conscience, I can report that every time there is an issue, I have urged
the President to recommend less spending rather than more spending on every single department, every single agency, where the
issue has arisen.
The CHAIRMAN. Well, my only point is I would suggest more
pressure on some of the other subcommittees.
Mr. WEIDENBAUM. Amen.
The CHAIRMAN. And let them do their share of the budget cutting as well, rather than lumping it in one particular area. I would
hope that we can finish with one more round because we do have
two additional witnesses. So I will not take any more of my time
because we do have two distinguished witnesses that I would not
like to run short of time.
Senator Riegle?
Senator RIEGLE. I'll try to move as quickly as I can in light of
that, Mr, Chairman. You make a good point.
David Stockman is quoted in the U.S. News & World Report for
July 19—you may have seen this interview. And this is the question that is posed by the magazine and here is his response:
Question: Do you give Reagonomics credit for the Federal Reserve Board's tight money policy?
118
Stockman's answer: "We endorsed it. We urged it. We have supported it."
Is that accurate?
Mr. WEIDENBAUM. I'd let Dave Stockman speak for himself.
Senator RIEGLE. Well, he's speaking for the administration.
CHARACTERIZING FED'S MONETARY POLICY
Mr. WEIDENBAUM. He's the Budget Director. I've never called the
Fed's policy tight. I've called it restraint because if you look at the
growth of the money supply in 1982, today, it certainly isn't tight.
Senator RIEGLE. Well, how would you characterize it? He is
saying here that in terms of the Federal Reserve's monetary policy,
"We endorsed it. We urged it. We have supported it."
Is that an accurate statement?
Mr, WEIDENBAUM. The policy. But I describe the policy not as
one of tight money, but as one of restraint.
Senator RIEGLE. I'm not sure it matters how one characterizes
that. Ten people might have different views. But the fact of the
matter is that Federal Reserve policy, however one describes it
Mr. WEIDENBAUM. Policy.
Senator RIEGLE [continuing]. He says that the administration endorsed it, urged it, and supported it. Is that an accurate statement?
Mr. WEIDENBAUM. Yes, but remember, the key word is "policy."
That isn't to endorse each and every move that the independent
Federal Reserve has made.
Senator RIEGLE. So you're not challenging his statement here.
Mr. WEIDENBAUM. My policy is to explain my position and to let
my colleagues explain theirs.
Senator RIEGLE. Now earlier you said in your quote—I missed
the actual quote, that "prosperity is just around the corner." Did
you, in fact, say that today?
Mr. WEIDENBAUM. Not guilty. [Laughter.]
Senator RIEGLE. OK; Let me tell you what I did hear with my
ears from your lips, and that is you said that the economy is turning up. That you did say.
Mr. WEIDENBAUM. Yes, sir.
Senator RIEGLE. OK; Now that is an important statement because you're the President's chief economic adviser. You're coming
here in a series of important hearings. That is news. If it is your
view and the view now of the administration that, in fact, the economy is "turning up," turning up, which is your phrase, that is a
significant statement. And is that what you really mean to say?
Mr. WEIDENBAUM. Oh, yes, but it's not news because I state an
opinion. It's news because at 10 a.m., the Department of Commerce
released the official numbers on the GNP for the second quarter of
1982. They estimate an increase in real GNP for the second quarter
of 1.7 percent.
Senator RIEGLE. I don't want to get into that in any great detail.
Mr. WEIDENBAUM. That's an upturn.
Senator RIEGLE. I understand. But you and I both know that the
Commerce Department, when they make these estimates, often has
to adjust them. They also produced an estimate on housing starts.
They had to go back and change that. They had to scale it back.
119
They have on a number of others as well. It may well be that this
will prove to be what the true performance was, and perhaps it
won't. Maybe they'll have to adjust. They made a series of adjustments. In fact, it's become more common in the last year to have to
make major adjustments than it is to leave the numbers stand as
is.
I don't know whether that's the case here or not.
Mr. WEIDENBAUM. You're right.
Senator RIEGLE. So I don't know. I hope that the numbers are
right. I know the unemployment data. If anything, when unemployment experts across the country look at it, they feel it's understated for a variety of reasons. Partly seasonal facts, partly the fact
that we don't, in the numbers, count people who have been unemployed and exhausted their unemployment benefits.
In Michigan, for example, just to give you an idea, in our State,
we have had unemployment—this is an important fact—above 10
percent for 32 consecutive months—32 consecutive months. If you
can imagine what that would do in terms of devastating an area.
We happen to be the eighth largest State, so I'm not talking about
a small neck of the woods—this is increasingly a pervasive national
problem.
I don't want to rehash what we said before, but you've got a
number of other critical measurements like unemployment, like
housing starts, like business failures, where the news is getting
worse. Unemployment is rising. Business failures are rising. Liquidity problems among businesses are rising. Farm foreclosures
are rising. The problem of the thrift industry is getting worse.
So there is a wealth of data there. Now you may not see it. You
may not value it as highly.
Mr. WEIDENBAUM. Oh, I monitor those statistics.
Senator RIEGLE. But they don't go away. And this preliminary estimate of second quarter growth by the Commerce Department
doesn't in any way address these enormous crisis-scale problems in
the interest rate sensitive sectors of the economy. And that's, of
course, what we're here to talk about today, is monetary policy.
DISCOUNT RATE LOWERED
Now I think the Fed, when they just lowered the discount rate
yesterday by half a point, I think would have done better had they
lowered it by a full point. I think we're at a stage now in the economic situation where we still need the other kind of meeting led
by the President that I spoke about—a real serious budget meeting
to get the deficits down and get a corresponding change in the
monetary policy that would bring interest rates down.
But without that taking place, which I would much prefer to see,
if the Fed is going to have to act without any direct help from the
administration at this point leading this kind of process, which
should involve members of both parties, would you support them
taking the discount rate down, say, a full point rather than a half
point?
Mr. WEIDENBAUM. I have tried to avoid being put into the position of seeming to give public instructions or even private instructions.
120
Senator RIEGLE. I'm not asking you to instruct them, I want your
professional opinion as to whether or not a full point drop in the
discount rate would be good medicine, given the overall mix of economic facts today, or would it not? I mean, would you feel that you
would say that it would be?
Mr. WEIDENBAUM. Well, you appreciate, I look upon interest
rates more as as result than a cause. So if the cause of high interest rates
Senator RIEGLE. We're not talking about high interest. We're
talking about the discount rate, which is the Fed rate.
Mr. WEIDENBAUM, It reflects the reality that market interest
rates have been coming down in recent weeks. I think that's the
key reason we saw a drop in the discount.
Senator RIEGLE. Well, would you have been upset if they had
dropped it a full point?
Mr. WEIDENBAUM. Not at all.
Senator RIEGLE. So you could certainly accept and feel good
about a full point drop?
Mr. WEIDENBAUM. Well, I've tried to avoid taking any position on
the specific administrative actions of the Fed, I do think that the
kind of monetary policy that Paul Volcker described in his testimony yesterday will get us declines in the interest rates.
Senator RIEGLE. I want to extend another invitation. I made a
suggestion earlier. This is in the form of an invitation. I think it
would be healthy and constructive if the President and yourself
and the other economic advisers would come out into the country
into some of the centers of high unemployment, and I would list
Detroit, really, at the top of the list, because it's
Mr. WEIDENBAUM. I've just come back from several days in St.
Louis, which is suffering, as Senator Dixon pointed out.
Senator RIEGLE. Let me tell you what my idea is here. I think it
would be helpful to the President and to the administrative economic policy people, yourself and the others, if you were to come
into some of the major cities where we have massive unemployment and spend several hours talking informally with unemployed
workers, with business people who either have just lost their businesses or are about to—any number that you can find and talk
to—many of them, by the way, who were ardent supporters of the
President in 1980. So you would not be playing with a stacked deck
in talking to these folks.
But they are coming to me in increasing numbers, just as Senator Dixon said they are in Illinois and across the country, because
they are in desperate straits. They cannot survive. They are being
ground down and destroyed day by day. I think the President and
those of you who are his chief economic advisers owe it to yourselves, and I think you owe it to the country, to the people who are
caught in this situation, to sit down in a series of meetings and to
discuss this firsthand, to get a feel for it.
I'm not talking about some kind of a show business thing or a
rigged thing. I think it's better if the press is kept out, so it doesn't
become a media extravaganza. I think it would be very constructive if 20 or 30 unemployed workers would have a chance to talk
directly to the President, just talk with him, just be able to explain
what it is they're facing.
121
I don't sense that that is happening. I follow quite closely what
goes on and I don't get the feeling that the President has had any
series of meetings with groups of unemployed workers or businesses that are on the verge of bankruptcy or business people who have
just lost their businesses. I think it would be constructive for the
country, for the economic policy process, and for these people if you
could start to do that.
And I'd like to ask you to come to Michigan. I will play whatever
helpful part I can in identifying people like this or meeting places
where this could go on. But I think you owe it to the country to do
this.
Mr. WEIDENBAUM. Senator, I've just been back for a few days in
St. Louis, which was anything but a media event, where I spoke to
many people at every stage of the happiness spectrum, from
owners.of growth industries to people out of work, to people whose
companies were in trouble, to students who were looking for jobs,
to students who found jobs. And I think that that is useful. And
there's been absolutely no shortage of groups coming into the
White House, meeting with the President, the Vice President,
members of the Cabinet, with the senior staff.
Senator RIEGLE. Have you invited in a group of unemployed
workers? Has there been that kind of meeting?
Mr. WEIDENBAUM. Per se, not to my knowledge. Have there been
representatives of groups that have suffered high unemployment,
such as blacks and Hispanics? Yes, many. Have there been meetings with businesses, small as well as large, especially those who
are suffering from the high interest rates? Innumerable.
Senator RIEGLE. Well, Mr. Weidenbaum, we've got 10 */2 million
people out of work in the country. That is a conservative estimate.
Those are the official Government figures. Can't we get some of
those people, the ones who are bearing the brunt of what's happening today, can't we give them an opportunity to sit down in a serious, working discussion with the President?
Mr. WEIDENBAUM. As an economist, I'll have to ask you the question: And what do we ask them? Having been unemployed—not recently—I understand how many of them are suffering and suffering deeply. But the serious question is: How can you reduce unemployment, how can you restore a healthy economy, without getting
back into the escalating double-digit inflation
Senator RIEGLE. Well, I think
Mr. WEIDENBAUM [continuing]. And very frankly, I think
Senator RIEGLE. Let me tell you something. It isn't sufficient. It
isn't sufficient to say there is no way. I mean, if you believe that,
you shouldn't stay in this job another minute. Obviously, there is a
way. There have been suggestions offered. A budget meeting of the
type that I suggested earlier that could really do something about
the deficits and, in turn, monetary policy. There are any number of
ideas. You folks are standing pat. That's the problem.
Mr. WEIDENBAUM. On the contrary. First of all, we have encouraged the Congress, and the ball is in your court, if I state that correctly. You are currently acting on the budget right now, which is
appropriate, which is proper. I wish you well in terms of cutting
the budget more rather than less.
Senator RIEGLE. My time is up.
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Mr. WEIDENBAUM. I don't see the need for conferences, but the
will to cut spending.
The CHAIRMAN. Senator Sarbanes?
Senator SARBANES. Mr, Weidenbaum, in response to Senator
Garn's comment that every bill is a budget-buster, is that true of
bills that cut the revenue base?
Mr. WEIDENBAUM. I had in mind on the spending side, but I must
agree that the short answer to your question is yes.
Senator SARBANES. I think that's an important point to make,
don't you?
Mr. WEIDENBAUM. As an economist, I couldn't have given you
any other answer.
FOREIGN ECONOMIC GROWTH
Senator SARBANES. Are there countries which you think have
done a better job with their economy in the decade of the 1970's—
West Germany, for example, or Japan?
Mr. WEIDENBAUM. Yes.
Senator SARBANES. You think they have done a better job?
Mr. WEIDENBAUM. I haven't made a formal comparison to offer
the committee. But in terms of their record on inflation and on
growth, yes, we don't lead the parade. We didn't lead the parade
over the 1970's.
Senator SARBANES. What, then, is your comment on the fact that
the annual average trend growth
rate in the money supply, 1970 to
1980, in West Germany was 9J/2 percent, Japan, 13.4 percent, and
the United States, 6.1 percent?
How do those figures, and the comment you just made about the
effective performance of those two economies, square with your assertion earlier that we need to cut the growth rate of money in this
country?
Mr. WEIDENBAUM. In my paper, 1 discuss the technical subject of
velocity in great detail. My understanding is that velocity of the
money supply in this country has been much more rapid than the
velocity in Japan or in West Germany.
Senator SARBANES. Are you asserting that as a fact?
Mr. WEIDENBAUM. That is my understanding. My staff experts
have informed me of this. I'll be glad to give you the details for the
record.
[The following information was subsequently supplied for the
record:]
123
,
THE CHAIRMAN OF THE
COUNCIL OF ECONOMIC ADVISERS
WASHINGTON
July 29, 1982
Honorable Paul S. Sarbanes
Committee on .Banking,
Housing and Urban Affairs
United States Senate
Washington, D. C.
20510
Dear Senator Sarbanes:
This letter supplies the information requested at the
hearings of the Senate Banking Committee on July 21 regarding
the growth of money and its velocity in Germany and Japan
compared to the United States. I was asXed to square my
assertion that money growth in the United States needs to be
cut with the fact that during the 1970s U.S. money growth was
actually lower than in Germany and Japan, where economic
performance was better.
Actually, as shown in the attached table, the economic
performance of these three countries over the entire decade of
the 1970s was not very different. However, in the last half of
the decade the inflation performance of Germany and Japan
improved compared to that of the United States, For the decade
as a whole, both inflation and real growth were somewhat higher
in the United States than in Germany, but lower than in Japan.
The United States experienced about the same growth of
nominal GNP as these countries in the 1970s, despite lower Ml
growth, because the growth of Ml velocity was substantially
greater in the United States. A mare highly developed
financial system, combined, with restrictions on interest,
payments on Ml balances, prompted the public to economize on
its holdings of Ml over time, creating an annual growth of Ml
velocity in the United States of 3.6 percent in the 1970s. In
contrast/ Ml velocity actually fell in both Germany and Japan.
The effect of money growth on inflation is clearly
illustrated when the first and second halves of the 1970s are
compared. Annual Ml growth in Germany was cut'by an average
1.9 percentage points in the last half of the decade, with a
resulting decline in the annual average inflation rate of 2.7
percentage points. Japan reduced its annual Ml growth by 11
percentage points on average, producing a 5.6 percentage point
decline in the annual inflation rate. However, annual average
Ml growth in the United States rose by .9 of a percentage
point, and the resulting increase in inflation was ,7 of a
percentage point, on average.
124
Thus, in the latter half of the decade the German «wd
Japanese record on inflation improved compared to our own.
Paradoxically, U.S. money growth was lower than in Germany and
Japan, but our inflation rate was higher. The reason for this
is that the growth in the income velocity of Ml continued to be
significantly higher in the United states. U.S. money growth
must therefore be cut even more in comparison with these
countries if we are to achieve a comparable degree of price
stability,
I would,, also like to point oat that, despite the reduction
in Ml growth 'in Germany and Japan, the growth of real GNP
improved in both countries. Over a period of several years a
reduction in money growth only affects inflation, and any
temporary effects on output and employment disappear. Over the
long run, the rate of growth of real GNP is determined by the
growth of labor and capital, and their productivity -=- not by
the expansion in Ml.
Sincerely,
/s/ MLW
Murray L. Keienbaum
Federal Reserve Bank of St. Louis
1970-1980
{Percent Change
at Annual Rates)
Growth
Growth
Growth
Growth
of
of
of
of
United States
Ml
Ml Velocity
Prices
Real GNP
West Germany
9.2
-1.0
5.2
2.8
6,6
3,6
6.8
3.2
1970-1975
United States
Growth
Growth
Growth
Growth
of
of
of
of
HI
Ml Velocity
Prices
Real GNP
West Germany^
10.2
-1.4
6.6
2.1
6.2
3,1
6.5
2.6
1975-1980
United States
Growth of Ml
7.1
Growth of Ml Velocity
4.0
Growth of Prices
Growth of Real GNP
7.2
3.7
West.Jj errna ny
8.3
-0,7
3,9
3.6
125
Senator SARBANES. I'd like to have those. In addition, also, if that
is the case, to what do you attribute the difference in the velocity
rates?
Mr, WEIDENBAUM. I have to confess that I have not made any
study of velocity in Japan or West Germany, but I'll be very
pleased to amplify
Senator SARBANES. Well, I also ought to make the further comment that the table I'm looking at indicates that the money growth
rates in other countries were above those of West Germany and
closer to those of Japan than they were to those of the United
States. We, apparently, are an exception to the experience in all of
these other countries.
Mr. WEIDENBAUM. Many of these other countries have had serious inflationary problems. The reason I compared West Germany
and Switzerland is that these have been good examples
Senator SARBANES. But your point on West Germany was simply
that they had been able to hold to a constant growth rate; not that
they weren't—they may well be growing faster than we're growing,
as these figures would indicate.
Mr. WEIDENBAUM. But the very notion
Senator SARBANES. The implication of your statement was, as I
understood it, that we had allowed the money supply here to grow
more than they have. That's, in fact, not the case.
Mr. WEIDENBAUM. More volatile and more rapid, so more unpredictable.
Senator SARBANES. Well, it may be more unpredictable; it's not
greater in terms of the percentages, as these figures I've just given
to you would indicate.
Mr, WEIDENBAUM. Well, that shows the problem that faces monetary policy in the United States, because over the years, it has
Senator SARBANES. Now do you think that the high interest rates
have contributed to the economic downturn?
Mr. WEIDENBAUM. Yes.
Senator SARBANES. You do? Now you posited the deficit as the
problem that we're trying to deal with, and I recognize that problem. Hasn't the economic downturn brought about a significant increase in the deficit?
Mr. WEIDENBAUM. Oh, by all means, yes.
Senator SARBANES. So the high interest rates, which ostensibly
are up there to check inflation, are in fact contributing to enlarging the deficit, which in turn heightens apprehension about this
deficit and therefore, keeps interest rates high.
Mr. WEIDENBAUM. Of course. But we've never advocated the high
interest rates; we've advocated policies to bring down the interest
rates.
Senator SARBANES. Now in response to Senator Riegle's question
about the Japanese economy, its unemployment and its prime rate,
isn't it also true that the Japanese deficit as a percentage of their
economy is larger than ours?
Mr. WEIDENBAUM. Yes, and so is their savings rate.
Senator SARBANES. And how about in West Germany? The same
thing?
Mr. WEIDENBAUM. Yes, the savings rate and the deficits are both
higher.
126
Senator SARBANES. Are you familiar with the story in this morning's Washington Post on the Commerce Department, the announced revisions in personal income statistics stretching back to
1977?
Mr. WEIDENBAUM. I glanced at the story. I am generally aware of
the revision that the Commerce Department has been making, yes.
Senator SARBANES. And what was the thrust of that revision?
Mr. WEIDENBAUM. The personal savings rate was a little higher
than had been reported.
Senator SARBANES. Yes. I just want to quote this article. It says:
The changes wipe out part of the sharp declines in the personal savings rate expressed as a percentage of disposable personal income that appeared in Government
statistics beginning in 1977.
And it goes on to say that the supposed sharp drop in the savings
rate was the premise on which the economic policy of the supply
side theorists was developed, but it now turns out that that was a
faulty premise.
Mr. WEIDENBAUM. As I always have tried to describe the situation, the supply of saving in this Nation in recent decades has not
been adequate to finance the type of rising investment which is
necessary for rapid economic growth. And I see no reason to
change that position.
Senator SARBANES. Thank you, Mr. Chairman.
FRUSTRATION OF POLITICS
The CHAIRMAN. Thank you. Mr. Chairman, I suppose I finish
your portion of the hearing where I started: with the same amount
of frustration of politics as usual without regard to political parties
in this town. Again, as with Paul Volcker yesterday, I can remember the line of questioning from my colleagues on the Democratic
side in making sure that we tied the administration to Volcker,
and the only difference 2 years ago in 1980, before the election, it
was Republicans on this side who were trying to tie Paul Volcker
and Jimmy Carter together. And Chairman Schultz of the Council
of Economic Advisers, the same line of questioning you've been getting today came from our side.
So I'm not assessing any blame to anyone. I guess—I don't
know—I have a great sense of frustration that we can't maybe get
out of our traditional roles in a two-party system and forget it for a
while and see what we can all do together.
The criticisms about errors in estimates of this Administration
are factual. They have been. It's for everybody to see. We start out
with a budget estimate deficit of $45 billion. A lot of us felt it
wasn't realistic and it shouldn't have been stated. As I say, it's
been true the entire time I've been here, by both Republican and
Democratic administrations, who, I guess, the tendency is always to
try and present the most positive viewpoint rather than being totally realistic because you worry about the political consequences.
That is not peculiar to one party or another. They've both been
guilty of it. And the ones who have made the greatest errors of all
in estimation of budgets—not in just estimates—since I've been
here in the Congress in our appropriations process. Year after year,
127
we always seem to be suddenly surprised that we're spending a lot
more money than we intended to at the beginning of the year.
So I just, again, express my frustration with the unbelievable
problem abounding in this country and maybe I'm terribly naive
and it's impossible for people elected to public office to forget what
their party labels are, who happens to be the opposite, and say,
hey, let's try and do something about it.
But we appreciate your testimony.
Senator SARBANES. Mr. Chairman, I'd like to make one observation on that comment. The criticism on this side of Chairman
Volcker and of the Chairman of the Council and of the President in
the previous administration was as sharp as it has been with respect to these witnesses. And if there's been any difference with respect to how things have worked, I think it has been a diminution
of a comparable approach on the part of the other side of the aisle.
I think we were very sharp. I think a review of the transcripts
during that period will demonstrate that. And I think that Chairman Volcker was taken to task as much, if not more so, in the previous administration by the Members on this side as he's been
taken to task in this one.
The CHAIRMAN. Paul, there are a lot of Republicans who, from
the very beginning, have not only been very critical of Volcker
with this administration, but we have resolutions from both sides
of the aisle before this committee for very structural changes in
the Fed.
Senator SARBANES. We were also critical of the President for his
economic policies, Mr. Chairman.
The CHAIRMAN. Well, and there's a lot of criticism from our side,
too.
Senator SARBANES. I'm looking for it.
The CHAIRMAN. We're big boys and I think you—well, I have sat
here and totally agreed with you on the inaccuracy of the estimates. But the point of it is, let's not kid ourselves, we can sit here
and try and defend one side or another. There is plenty of blame
for both sides and there is politics as usual going on throughout the
entire Congress. I've seen it happen over and over again.
But certainly, Paul, there are always exceptions to that and I
would agree with you: Members on both sides who do not participate in that. No doubt about it, But I saw people who were for the
Panama Canal Treaty when Gerald Ford was President working on
it and Republicans for it, Democrats against it. When Jimmy
Carter proposed it, we had a certain number on both sides who just
switched and suddenly, because Carter was proposing it, we
shouldn't ratify the Panama Canal Treaty and others who went the
other way.
That's a fact of political life and there are always exceptions to
people on both sides of the aisle on this committee and the Congress who do not participate that way. I just feel that right now,
the country is in such dire financial straits, that we ought to be
able, a lot more on both sides ought to be able to rise above that.
Senator SARBANES. Mr. Chairman, I would agree with that, and
on that point, I would simply make the observation on the Panama
Canal treaties that I note that President Reagan made so much of
it in 1976 in his primary campaign against Gerald Ford and so
128
much of it in 1980 in his presidential campaign against Jimmy
Carter, and yet has not uttered one word about the treaty since he
took office and has reaped all the benefits which flow to the Nation
from those treaties.
That's a good example, I think, of the kind of attitude you're
talking about. I wish we had more of it.
The CHAIRMAN. But there are some people who are realistic
enough to recognize that once something has been passed and ratified by two-thirds of the Senate, that it wouldn't serve much purpose, with all of these other problems, to yell and scream about it.
Senator SARBANES. Well, it wasn't recognized in 1980, after ratification had already happened. But it was recognized once the responsibilities of office came down upon the administration. I must
say, to the administration's credit, that they have recognized the
benefits of those treaties and why they protect our national interest. We have not heard one word about them, not a single word.
The CHAIRMAN. Well, but there are some of us who still think
that it was a lousy treaty, and yet, I haven't made a speech on it
for 2 years. There are other more important things to deal with.
That's past history.
Senator Riegle wanted to make a final comment.
Senator RIEGLE. Mr. Chairman, I'd just like to make one parting
comment to you, and that is this, I think the economy is in very
serious trouble. I think, because of the continuing high interest
rates, we have a genuine crisis in the interest-sensitive sectors of
the economy. I think it is worsening rather than getting better.
MIDCOURSE CORRECTION
I believe we need a major adjustment in the economic policy, a
midcourse correction, as has been described by many. And I think
we need it now, right now. Not 6 months from now, 3 months from
now, or at any other time. And I think the chance to do it is rapidly diminishing.
I speak now in terms of the administration leading the process
which has to involve people on a bipartisan basis. And I urge you
to monitor things very carefully because you have to be the person,
more so than anybody else, that blows the whistle for the President. If a bad situation is developing where there is a need for an
intervention to change the policy mix, incorporating the efforts of
the Congress, you have to be the person to blow that whistle. And
if you miss that—you know, I like you well enough that I don't
want to see you end up some day as the fellow that they put it on
your tombstone that, "Here lies Murray Weidenbaum, the economist who was in charge when the economy went over the cliff."
I mean, I don't want that to have to be there, and I know you
don't, either.
But we're on a course right now that poses great dangers. And I
think your chance to act now may become more and more difficult
the longer you wait. I just want to leave you with that thought.
The CHAIRMAN. I suppose one of the ironies of this whole situation is the budget deficits wouldn't be nearly as big if inflation had
not come down. So you win a partial fight on inflation and it compounds this other problem.
129
Let me just close, and hopefully, this will be the close. [Laughter.]
I want to repeat what I said yesterday at the end of the hearing,
that regardless of whether people like the administration's policy, I
happen to think that the policy is correct. I have supported it, as
you well know, all the way along. But the ball really is in Congress
court right now, without a doubt. Whatever the initial recommendations on the budget were—bad, good, indifferent, or whatever—
the fact of it is that we have passed the budget resolution, which is
a reduced deficit from the earlier projections, still way too high, in
my opinion. But nevertheless, I have grave doubts as to whether
Congress has the ability to discipline itself in the 13 appropriations
bills to meet that budget target that was set by the two budget
committees in both the House and the Senate.
I don't think, at least at this point in time, with July, August,
and September left, 44 days, or however many it is, that the major
responsibility for doing something about this economy at least to
meet that horrible $103 billion or $110 or $130, lies upon the Congress. Nobody else can do anything about it. We are the only ones
that have the ability to appropriate money.
I suppose what we need—Murray and Don may agree with this—
you know, it's easy for Senators and Congressmen, having been on
both sides of the government, been in the executive as a mayor,
been in the legislative branch. It's much easier in the legislative
branch because you can take most any position you want and you
don't have any responsibility whatsoever. It's almost like in flying.
You're in the left seat and you've got a check pilot over there and
he's not flying the airplane, but boy, he can find everything you
did wrong. And that's the traditional adversary relationship between the legislative and the executive branch of Government.
I almost think it's too bad that there isn't somebody that could
call Senators and Congressmen to a hearing and ask us questions
about why we have so badly fouled the fiscal policy of this country.
It would be an interesting concept.
Mr. WEIDENBAUM. Can I give you a 10 second answer, because
there's enough blame to go along both sides of the aisle, both
Houses, both branches. We really haven't at critical times, and it
really goes back to the Vietnam war, made the difficult choices.
We say guns and butter. We had guns and butter and fat, literally, if you look at the Federal budget.
Senator RIEGLE. We still do.
Mr. WEIDENBAUM. Yes.
Senator RIEGLE. We still do. It hasn't changed.
Mr. WEIDENBAUM. That's the problem.
Senator SARBANES. But in that context, I welcome your recognition that cutting the revenue base is a budget-buster as well.
Mr. WEIDENBAUM. It's part of the reason that the deficit is as
large as it is, no doubt about it.
Senator RIEGLE. You know, Mr. Chairman
Senator SARBANES. Particularly projected out into the future
years.
Mr. WEIDENBAUM, Yes, sir.
130
Senator SARBANES. And what you've done is to project a policy
that shows large deficits at a time that you're assuming an economy with fairly low unemployment.
Mr. WEIDENBAUM. With declining unemployment.
Senator SARBANES. Yes, which is really serious.
Mr. WEIDENBAUM. And that worries me a great deal.
Senator SARBANES. Yes, indeed. Yes, indeed.
Senator RIEGLE. Mr. Chairman, I don't know that this will ever
end, but this has been an important discussion.
The CHAIRMAN. It will because when you finish, I'm not going to
say another word. [Laughter.]
Senator RIEGLE. You'd better wait on that until you hear what
I'm going to say.
You made a good point, I think, Mr. Chairman, about serving in
both the executive capacity, as you have, and also in a legislative
capacity and how these two things have to try to work together.
I served in both parties here in the Congress. I've served as a Republican. I've served as a Democrat. I've served as a Republican
under Presidents that were both of my party and the opposite
party and I've done so as a Democrat. So IVe seen it all four ways
from the inside.
I just want to make this observation because it is not understood
in terms of the dynamics of how we get out of this trap, this economic trap that we are in at the moment. And that is that we can
talk about the Congress taking the lead. There are 10 good reasons
why the Congress is not capable of taking the lead and leading the
country out of this kind of an economic quandary.
The CHAIRMAN. No, 535. [Laughter.]
Senator RIEGLE. And here is one of the dilemmas that is faced.
Take Howard Baker, a man I respect enormously, a leader of the
Republicans and of the Senate today because his party is in the
majority. Let's leave Tip O'Neill aside. How can Howard Baker, as
a practical matter, come in here and in any sweeping way challenge the policies or the spending preferences of an incumbent administration of the same party? It is virtually impossible and I
know of no majority leader in recent history that has done it. And
I am not saying that Howard Baker should be expected to somehow
be different than his predecessors in either party.
But the hard fact of the matter is that the party in power in the
White House, having control here in the Senate, leadership of that
party is not really free to map out a different economic course that
is sharply at odds with the President. As a matter of fact, I think
they've gone as far as they can in terms of scaling the deficits
down from what the President asked for. You fellows asked for
more spending, for bigger deficits. That is just the fact of the
matter.
On the House side, you've got Tip O'Neill of the other party
nominally in charge, but he is not really. On the key test votes on
economics, Tip O'Neill has not been able to deliver the votes for his
point of view and the White House has, in fact, been able to deliver
the votes for its point of view.
So it is just important to bear in mind the dynamics on the legislative side this time for anybody to say in textbook fashion, why
doesn't the Congress lead the country out of this quagmire over
131
both fiscal policy and the contradiction of fiscal and monetary
policy. The hard fact of the matter is that the Congress is inherently incapable of doing that right now. I wish that were not the
truth. I wish we were able to do it. But we need somebody else and
the country needs somebody else. That is, we need the President
and the administrative machinery making that kind of an effort.
And if you do not have that, if you have a President or an administration that is serene, that is at peace with what is happening, that thinks that things are going to get better on their own
and does not want to go out and lead an effort for a major adjustment in the policy mix, a mid-course correction, it will not occur. It
cannot occur. And you do not have to take this from me. You can
sit down with the head of any major bank in this country today,
any major financial institution, any major corporation that has
looked at this thing and they will say precisely what I am saying—
that you cannot lead a major adjustment in policy, one, without
the President, or two, without the President in front leading that
work effort.
I am prepared to work on a bipartisan basis within that kind of
work effort, but, my friend, I can't call that meeting, Tip O'Neill
can't call it, Howard Baker can't call it, Jake Garn can't call it. No
one can call it. The only person that can really put this puz/le together, in a leadership sense, is the person who is the elected
leader of the entire country, and that happens to be the President,
and you work for him.
I've made my suggestions, but until that step is taken, we are
not going to get out of this paralysis that we are in.
Mr. WEIDENBAUM. Let me assure you, when Senator Baker, Senator Garn, the other Republican Senate leaders, come to the White
House and meet the President ——
Senator RIEGJ.E. You have to involve both parties.
Mr. WEIDENBAUM [continuing]. That is a very independent,
tough-minded group.
Senator RIEGLE. You have to ask both parties.
Mr. WEIDENBAUM. That makes their views known loud and clear
to us. Obviously, no longer being a member of our party, you are
not invited to those Republican meetings,
The CHAIRMAN. I could call a meeting and nobody would come.
Senator RIEGLE. I'd come. I'd come, Jake. [Laughter.]
The CHAIRMAN. I'm glad you reserved one final comment for me.
A vote is going to get us out of this. That is simply, you are right.
A group of 535 people have an almost impossible task to lead. But
however bad this budget resolution is, we can, at least, play our
part by attempting to meet those budget guidelines in the appropriations process.
Murray, we thank you for coming. And gentlemen, if Mr. Olsen
and Mr, Maude would come to the witness table—we do have a
vote, I will go and return as rapidly as I can and stay as long as
necessary so that we can hear your testimony.
The committee will stand in recess for 15 minutes. [Recess.]
The CHAIRMAN. The committee will come to order. Mr. Olsen, in
utter frustration, probably went out into the hall.
Mr. Maude, why don't you go ahead and start and I am sure he
will return quickly.
132
STATEMENT OF DONALD E. MAUDE, CHIEF FINANCIAL ECONOMIST AND CHAIRMAN, INTEREST RATE POLICY COMMITTEE,
FINANCIAL ECONOMIC RESEARCH DEPARTMENT, MERRILL
LYNCH, PIERCE, FENNER & SMITH
Mr. MAUDE. I want to first of all apologize, Mr. Chairman. We
had 80 copies of this sent down by Federal Express. They received
it yesterday morning. The courier got it and did not believe that
this was the correct address and never delivered it, and we are still
trying to track it down.
I think I did manage to have 8 copies sent down. I think you've
got a copy and Senator Riegle does, too. Because I did not have
enough copies to pass out, I had wanted to just very briefly summarize this, but this won't take more than 10 minutes. I think it
would be appropriate for me to read through it because many other
people in the room do not have a copy.
[The complete statement follows:]
133
Summary of Statement Made By
Donald E. Maude
Chief Financial Economist
Chairman, Interest Rate Policy CommitLee
Merrill Lynch
1 am indeed pleased to have the opportunity to testify before, this
Comittee on the occasion of the semi-annual Humphrey-Hawkins hearings or.
Federal Reserve policy and at a time, when the spotlight bas temporarily
s h i f t e d from the fiscal to the monetary sphere.
Obvious]y, given the impor-
tance of monetary policy to our n a t i o n ' s f u t u r e economic direction and as one
whose vocation it is to scrutinize the F e d ' s activities on a day-to-day—and
sometimes on an hour-to-hour—basis, I can appreciate the importance of such
semi-annual reviews of polity.
In this spirit, my remarks this morning w i l l
be confined to the state and conduce of monetary p o l i c y .
However, I cannot
emphasize s u f f i c i e n t l y the importance of fiscal policy and the role that prospective huge budgetary d e f i c i t s over the years ahead will p J a y in Jetermining the direction of Interest rates and our f u t u r e economic health,
tlo
alteration in the way the Fed conducts policy on the monetary side—no natter
how dramatic it nay be—can pave the way £or sustained lover interest rates
arid vigorous economic recovery in the absence of a rcajor resolution on the
fiscal side.
At the outset, I would like to provide my broad view cm the conduct of
monetary policy under the stewardship of Federal Keserve Board Chalnr^ii
Paul Volcker.
After more than a decade of misguided ttonetary policies that
culminated in a worldwide wave of inflationary p s y c h o l o g y , a massivi: a t t a c h on the d o l l a r in the foreign exchange m a r k e t s , a f l i g h t f r o m f i n a n c i a l to
real asse.ts and a t o t a l d e s t r u c t i o n In the Central B a n k ' s c r e d i b i l i t y .
Chairman Volcker has aln.ost single-handedly reversed the tide.
I'nder his
leadership, the Fed li ^s ti-mained the onl> an v.i-in f l a t ion grime in town.
134
Through perseverance and determination in. sticking to course, he has regained
in two years the anti-Inflation resolve c r e d i b i l i t y t h a t bad increasingly
befn in a s t a t e of erosion throughout the L 9 7 C ' s .
substantial costs have been Incurred.
Of course, In the p r o c e s s ,
It would be sad indeed if one of those
costs turns out to be the Central Bank's loss of independence.' f r o m the political arena.
Were the Fed r.o find 1 ts
be no game in town at all.
Independence r p l i n q u i s l i e d , there would
Furthermore, I can a s s u r e you that even any slight
hint of such n possibility would seiid the financial markets in a total state
of ctiaos and interest rates soaring to new heights.
This is not to say, however, t h a t the Fed's conduct n£ policy since the
appointment of Chairman Volcker and the i n c e p t i o n of a more m o n e t a r i s t doctrine of reserve targeting in October 1979 has been impeccable and that there
J.E r.o need for some a d j u s t m e n t s in policy I m p l e m e n t a t i o n .
I n d e e d , it
has
been a n y t h i n g but perfect and some a d j u s t m e n t s In i m p l c n e n t a t i o n and monetary
aggregate definitions are not only appropriate, but mandatory in my view.
An
elaboration ot my observations along these life? w i l l provide the thrust of
my t e s t i m o n y .
The Setting .
I need not elaborate here on the dismal economic performance that has
t r a n s p i r e d since the adoption o£ the F e d ' s new operating procedures in late
1979,
(A more d e t a i l e d articulation was put f o r t h In a speech I made to The
National Press Club back in May and which I submit for the r e c o r d . )
Suffice
It to point out that the U.S. economy has experienced no real growth and
declining production since the end of 1979—a performance u n p r e c e d e n t e d over
the postwar period.
In addition, the unemployment r a c e , as all
of you well
know, stands at a new postwar high, the auto, housing and c a p i t a l spending
sectors remain strangled by s t r a t o s p h e r i c real r a t e s of Interest and bank-
135
ruptcitis f o i i l J i L u t : i-i- iL.i'JU at an a l a r m i n g pace.
Corporate balance- eheett, are
seriously sti j i n e d , s a v i n g s and loan associations, J n the niai r t j art? p a y i n g
mort tor uioiity t-lian tiit-y arc t-arnlng on asstts and experiencing a drain on
capiLjJ with <;ath passing Jay, commercial banks are exceedinS-1}' tight ^Jid
state and local govfemnients are Increasingly seeing surpluses dv/Indlo—or
even turiilng i n t o d t ' l j c i t s .
In short, we have a serious l i q u i d i t y p r r b l x r n on
uur hands.
I point oikt thtse dfevelopments not to play the role of an a l a r m i s t ,
merely suggest that eoBie pieces of the economic-financial-monetavy p u z z l e
have to be missing.
This would especially appear to he the case since these
d i f f i c u l t i e s have been intensifying rapidly over the f i r s t half of this year
when stated tt-l and H-2 growth was running well in excess of the upper erd of
the Fed's targets, thus forcing a restrictive monetary policy.
In e i f c c t ,
on the one hand, economic, financial and interest rate developments suggest
to me that the Fed has been overly restrictive.
On the other hand, the mone-
tary aggregates—as officially defined—suggest to me that the Fed has been
overly accommodative.
Somehow, une would think that the reconciliation of
such an anomaly would receive the highest of priorities.
Possible ReconclliaLion It ia my judgment that the true stance of monetary policy Is more
accurately reflected by tht dismal state of the economy, severely strained
liquidity in the corporate sector and financial system and historically high
real rates of interest than by stared monetary aggregate growth thus far this
year.
As such, the Fed, in chasing a f t e r monetary t a r g e t s in order Co sus-
tain credibility in the credit markets, lias been p u r s u i n g an unduly restrictive course.
Under such circumstances, one could make a valid case for a more
accommodative policy than is presently in place.
136
I am very much aware that this statement represents music to your collective ears.
However, before you turn up the volume. It should be emphasized
that any accommodation on the part of the Fed should have as a prerequisite
further tightening on the expenditure side of the fiscal side.
relief from monetary accommodation will be short-Jived.
Otherwise, any
Indeed, I am sure
that Chairman Volcker has considered the possibility that such accommodation—
if it served to take the edge off of the urgency to take more responsible
measures on the fiscal side—could very well backfire and exacerbate the situation.
Convincing the Chairman that tfiie would not be the case—by actions,
not by words—might go a long way in reaching the fiscal-monetary detente so
urgently needed.
tfr-_lj. jtot_ What Ij: js_5up])oagd_Tg_Be_Or_ Haa_ Been.
Without getting tech-
nical to any large degree here, it is my view that the M-l that has been growing way above targets and forcing a restrictive policy thus far this year is
not a valid measure of what it has gauged through the years.
Technically, M-l
Is supposed to measure the level of "transactional" (or readily spendable)
deposits and currency in the system.
It Is not supposed to include savings-
type deposits or balances being built up for precautionary reasons.
past, 11-1 served tte purpose well.
In the
However, with historically high interest
rates and resulting financial innovations over the years, its ability to capture strictly transactional balances and to exclude savings balances has
diminished significantly.
In this regard, as you know, banks were allowed to introduce nationwide
NOW accounts beginning in January 1981. n'ith the knowledge that some of the
increase in such accounts would come f r o m savings accounts and would not
represent transactional balances, the Fed utilized a "shift-adjusted" M-1B
measure last year to more accurately reflect what was going on with spendable
137
balances.
This adjustment was dropped in December, though, and since then
all "other checkable" deposits have been, defined as "transactlonal" in nature.
As the following table shows, the Fed's own survey assured that as recently
as October of last year, fully one-half of rtie increase in these deposits
was coining from savings accounts—and should not be included in the targeted
M-I measure.
In November, the shift ftom savings accounts declined to 22.6X
and in December it rose to 30.42.
With the slowdown in the growth in other
checkable deposits from May to October, it does seem reasonable to assume
that the dollar magnitude of such shifting had diminished significantly. By
way of example, a f t e r drawing $9.5 billion out of savings accounts from
January to April, NOW accounts subsequently only pulled an additional S J . O
billion from savings accounts from April to the end of October.
However, since October, these deposits have surged by $18.3 billion—
accounting for 91% of the M-l increase.
Certainly, it would seem reasonable
to ae that this surge indicated that shifting from savings accounts had
resumed.
Yet, for some unexplainable reason, the Fed stopped making such
adjustments after December.
Had they continued to use such a measure, M-l
growth in June would have been 0 . 7 % below the upper end of target—not 0.12
above.
This estimate is based upon the assumption that only 2k'i of the growth
in NOW accounts was coming from savings—the average percentage of shifts in
1981.
I suspect that even a larger proportion emanated from non-transactional
sources.
(The analytical underpinnings for such a view, articulated in the
attached January 29 edition of the WEEKLY CREDIT MARKET BULLETIN, is
mitted for the record.)
sub-
138
In addition to c a p t u r i n g r o n - t r a n . i a c t i o n a l savings-type d e p o s i t s ,
there
is reason to suspect that the s t a t e d M-l m^asur;' h a s i n c l u d e d *'on-tran.s-actioiifll " p r e c a u t i o n a r y " balances as we! L — e s p e c i a l l y uvfi
Jaiuiary period.
t h e Xcivemhcr-
Such b a l a n c e s , of c o u r s e , should net be i n c l u d e d in P*-I (and
have not in tlie past).
I n d e e d , ehc b u i l d u p of tliesi; b a l a n c e s i-'ss due c<_
ec:onon;ic w e a k n e s s - - n o t ccor.omi*.- s t r e n g t h .
(For t L c t e c c r c l , ii: c h t n t c f i - u ' d ,
I have i n c l u d e d the K c b n s a r y 5 e d i t i o n of the WEEKLY CKF.I'IT !i,\,.KV.7
SSitft Adj.
Ml-B
Change
1981 —
Jan.
Feb.
Marth
April
May
June
July
Aug.
Sept.
Oct.
Nov.
Dec.
j.4
1.5
- n. I
5.0
8.9
- 4.1
- O.P
0.9
3../,
fa..8
- 3..5
I .3
0. 7
1.. 3
1.6
0.3
1.7
3.5
4,4
1981 Total:
1982-Jan.
Feb.
JLirch
April
May
June
- I. 0
- 0,. 1
I,, 5
2 ..8
3 .?
16.3
139
H-2A _S_o_t_What It JB Supposed To ftc _0r Has Been.
Another force keeping
the Fed on a restrictive course has been above-target growth in
tt-2.
Indeed,
such rapid growth forced the Fed to remain tight last spring even when M-l
growth vas well below target.
paet.
However, M-2 today Is not what It was in the
(In this regard, 1 have attached for the record an analysis o£ the
problew with M-2 that was done in the CREDIT MARKET DIGEST last September.)
In short, vhat the analysis argues Is that M-2 growth has been overly
stated by historically high interest rates and the growing proportion of its
components earning market rates of interest.
exist in the 1960's and early 1970's.
These two factors did not
In e f f e c t , as high interest is credited
to the M-2 components, it represents 3 transfer of funds from borrower to
deposits included in M-2—not newly created money by the Fed or enhanced
overall liquidity.
While the analysis is too lengthy to detail at this time, the following
table should make ray point clear.
In it,
I have presented tlie a c t u a l M-2
level for each of the past nine years and the first two quarters o£ this year
along with the annual d o l l a r amount of increase.
In column t h r e e , 1 have
computed the amount of the M-2 growth that stemmed from interest credited
(on the assumption that interest was reinvested in the initial deposit).
After subtraction of interest is indicated in column four—the actual net new
increase in M-2 (theoretically due to Federal Reserve policy).
As can be
seen in the final two columns, stated M-2 growth (which includes interest
credited and net new increases in H-2) was 8.32 in 1980, 9.8Z In 1981 and
roughly 9.6S over the f i r s t half of this year.
However, if we net out
Interest, we find that "interest-adjusted M-2" rose by a mere 2.02 in 1980,
1.7% last year and roughly 1,9% over the f i r s t half of this year.
Such weak
growth over the period, as r e f l e c t e d in the adjusted measure, would seem more
140
In sync with the economic and ftnanclai situation t h a t has yrevailetl over
that period of time.
M-2 Growth Before and A f t e r
Adjustment
For Interest Credited
M-2
1974
1975
1976
1977
1978
1979
I960
1981
19B2
I Qtr.
II Qtr.
890.0
973.9
HOI.8
1244.5
1354.3
1469.9
1591-7
1747,3
1851.5
1894.9
Int. Adj.
M-2
Incr.
Int. Adj.
M-2
115.6
121.8
155.6
42. S
50.0
55.9
63.2
79,5
98.0
135.0
41. 1
77.9
86.6
46.6
36.1
23.8
20.6
1009,0
1095.8
1142.4
1178.5
1202.3
1222.9
176.4
173.6
148.0
155.0
28.4
16.6
1251.3
1269.9
M-2
Incr.
Inrereat
Credited
83.9
127.9
142.7
109.8
In summary on the foregoing p o i n t s , it
931.1
Int. Adj.
M-2
Growth
Stated
M-2
Growth
4.6
8.4
8.6
4,3
3.2
2.0
1.7
9.4
13.1
13.0
8.8
8,5
8.3
2.2
9.8
9.4
1.5
9.8
is &y view that if the appropriate
a d j u s t m e n t s co make M-l and M-2 consistent with what tHey were- in the past
w e f p made (namely transactions balances and primarily net now savings and time
deposits), ve would find t h a t both have been growing below targets for some
time now.
It
is curious that the Fed has not deemed such an a p p r o a c h
a p p r o p r i a t e under the circumstances.
141
Certainly, the stated rapid M-l and M-2 growth since October of last year
does not seem consistent with the Fed's reserve posture over the sa»e period.
From November to June, for eKanple, nonborrowed reserves have grown at a
ntere 3.42 annual rate and total reserves at a 5.72 annual rate.
Generally,
thee^ are not reserve growth rates t h a t produce rapid money growth.
Let me
make it quite clear, though, that I am tint advocating a cavt in by the Fed
for political expediency.
would be disastrous,
Accotmcdation activated by this consideration
t am advocating accommodation on pure fundamental
economic, monetary and financial grounds.
Mone_tary_ PoHjry Conduct: Considerat_ions ,
1)
Refine M-l measure to net out savings-type and transactions!
balances and use an interest-adjusted H-2 measure.
2)
Continue following a policy geared to the consideration of both M-l
and M-2 (do not j u s t slavishly target and respond to one aggregate) and do so
in the context of bank credit growth.
If bank c r e d i t growth is nodest and
M-l and M-2 growth rapid, Cor example, the monetary aggregates should p l a y a
diminished role in policy formulation and vice versa.
3)
Eliminate "base d r i f t " from annual targeting.
Targets f o r each
succeeding year should be based upon Che midpoint M-l and M-2 levels of the
present y e a r ' s targets ( f o r more detailed analysis, see attached edition of
the May 21 WEEKLY CREDIT MARKET BUIXETIN).
Had this been done for this
y e a r ' s targets, M-) growth thus fat would have been below the lower end of
the 2-1/2% to 5-1/2?. range,
4}
growth.
Smooth out the roller-coaster movements in nonborrow'd reserve
Such a roller-coaeter course can be seen from the following graph.
As can be seen, the r o l l e r - c o a s t e r reserve growth has heen matched by r o l l e r coaster M-l growth.
142
MQNBORHOWED RESERVES AND M-1
(13-Week Moving Avev age Percent CTiange with M-1 Lagged by Two Months!
ON0J F M A M J J A S O N O J f M A M J J A S Q N D J F M A M J
1379
1980
19S1
I<182
5)
Immediately Institute the proposed practice of publishing the mone-
tary statistice (K-l) on a four-week moving average basis to smooth out the
week-to-week, "noise."
6)
Key the discount rate to a level 2% to 3Z above the twelve-month
Moving average rate of inflation as measured by the personal consumption
deflator.
Thie would be changed each month with Inflation.
As such, an eas-
ing of rates would occur during decelerating inflation and rising rates during
accelerating inflation and act as an automatic stabilizer.
143
Remarks by
Donald E. Maude
Chl*f Financial Economist
Chairman, Interest Rate Policy Committee
Merrill Lynch
_
/. The Setting...
M*y5,1»82
The battle of the budget continues to ebb and flow here in Washington
as political positioning between the Democrats and Republicans, in anticipation of the summer campaign and autumn elections, appears to be the
order of the day—and the key motivating force. The Democrats, on one
hand, seem to feel no urgency to make tough and politically unpopular decisions that could alleviate the budgetary deficit logjam on interest rates
and economic recovery, indeed, as things stand right now, they seem to be
basking in the enviable position of entering the campaign against an opposition party and incumbent administration whose economic recovery program thus far has turned out to-be a total failure. The Republicans, on the
other hand, have appeared more conciliatory in the budget deliberations as
they, too, seem to sense that failure to deliver their program's promise for
declining interest rates and brisk economic recovery could be devastating
to chances of victory in November. In effect, the budget appears to have
become a political tennis ball, moving from court to court with the participants'primary goal being the determination of the political affiliation of
winners and losers in November.
Unfortunately, the real winners and losers from the outcome of this volley will not be those residing on this side of the Potomac. Instead, it will be
those working on Wall Street and residing on Main Street across the nation.
Indeed, presently at stake is no less than the very survival of key industries
and financial institutions that are so critically needed to sustain the American system of capitalism. It is indeed a pity and a clear and present danger
to the nation's financial fabric that these latter economic and financial considerations have apparently continued to take a back seat to political maneuvering in the all-important and critical battle of the budget.
To some, of course, this would appear to be an overdramatization of
the situation and a myopic obsession with budgetary deficits that should
be taken with a grain of salt as coming from one subjected to day-to-day
shattering on the battlefield of the bond and money markets—and having a
Keynesian-oriented training to boot. Obviously, this might preclude one's
ability to step back and see the clearer "big picture". After all, everyone
including the President has told us that deficits really do not matter that
much. To the monetarists, there is nothing wrong with the financial markets that could not be rectified by a credible monetary policy. To many in
144
the administration, the heart of the problem has been a monetary policy
that produces erratic week to week movements in the money supply—not
deficits. Smooth out money supply growth and all the financial markets'
problems will go away. To the supply siders, rates would plummet and the
economy would enter into a sustained period of brisk economic growth in a
noninflationary environment if only we would return to the good old days of
the gold standard. To some in Congress, the problem of high interest rates
does not lie with their failure to further cut expenditures, but with Paul
Volcker. Replace the Fed Chairman and the financial markets' problems
would disappear.
Others, such as Arthur Laffer, would say that nothing has to be done.
Just give the President's program time to work. The "real" part of the program in the form of a full 10% tax reduction has not even taken effect yet.
When it does, there will be a surge in private savings and consumer
spending—both at the same time—and from a tax cut that will be spread
over a year's time, mind you, that wilt boost the economy and allow the fiscal 1983 deficit to be financed smoothly in a declining interest rate environment. In fact, this scenario seems to be the consensus forecast among
most private economists.
Many political analysts as well would adhere to such a scenario. After
all, this is a critical off-Presidential election year in which the incumbent
administration needs to maintain most—or all—current Republican representation in order to further carry out its program, ft will do everything in its
power to engineer an environment of declining interest rates, rapid economic growth and declining unemployment and a moderate rate of inflation. The same, of course, was true during the off-Presidential election year
of the first Nixon Administration in 1970. However, that year witnessed the
fifth postwar recession, a 51 % increase in the unemployment rate and an
unthinkable 4.8% annual rate of increase in consumer prices—the second
largest yearly gain over the postwar period. The next major Congressional
etection year came in 1974—a period during which the nation experienced
double-digit inflation, historic highs in interest rates and the steepest recession of the postwar period. The 1976 Presidential election year saw an
economic "pause1' that many feel helped lead to the defeat of President
Ford. In the 1978 election year, the Carter Administration did manage to
stave off a recession, but only at the cost of fostering policy moves that led
to a total destruction of credibility in the international financial markets
and the need to sharply boost interest rates with a dollar support package
145
just four days prior to the election. And need one elaborate about the environment during the 1980 Presidential election year of recession, doubledigit inflation and sharply rising interest rates during the summer
campaign and autumn election period. From this recent history of election
year economic and financial environments, it becomes quite clear that
Murphy's Law is still alive and well.
II. Where We Presently Stand—The Stark Realities...
While the economy remains quagmired in its eighth postwar recession,
it is becoming increasingly clear that the worst is behind us. With the recession now some ten months old, it is likely that economic recovery is just
around the corner. After all, postwar business cycle history shows that the
average duration of recessions has generally been around eleven months.
What is more, the depth of the present recession in terms of contraction in
both broad and narrow economic measures is about comparable to previous recessions. At the same time, the nation has benefited from a dramatic deceleration in inflation. Indeed, producer prices have declined for
two consecutive months and consumer prices in March posted their first
decline in seventeen years. Certainly, these considerations do not paint an
ominous picture by any means.
However, the recent recession must be viewed against a backdrop of
economic levels from which it started. It came on the heels of a rather anemic and short-lived, one-year expansion subsequent to the 1980
recession—an unprecedented development, (nstead of contracting from
expansion peak levels of activity, the economy began contracting from
close to trough levels. As a result, I would offer the foflowing quite sobering
observations:
... In the Economy, since trie end of 1972, real GNP has actually declined by 0.3%. This decline over a ten-quarter span is unprecedented in
our postwar history, which has seen real GNP expand at an average annual
rate of 3.5%. The lost real output since the end of 1979—the difference between historical experience and actual results—comes to a whopping
$127.3 billion. Industrial production stands more than 9% lower than at the
end of 1979 and the degree of idleness in the nation's factories is flirting
with a postwar record. Not surprisingly, in the process corporate profits
have plunged by a whopping 31 % since early 1980—on an after-tax basis.
146
Business failures are up 92% since 1979 and are flirting with depression
levels. What's more, the size of current liabilities of such failures have more
than doubled over the same period.
The consumer sector as well does not have much to cheer about.
Wages and salaries in real terms, for example, are 7.3% lower now than in
early 1980 and the savings rate remains at historically low proportions.
Consumer confidence is now at the lowest level since the Conference
Board began recording the pulse of sentiment, and buying plans continue
on the decline. The value of consumers1 home equity has stopped going up
and has actually posted a slight deterioration since last August. The unemployment rate is now at a postwar record of 9.4% and, if one includes "discouraged workers", it is close to 13%. Mortgage loan delinquencies at the
savings and loan associations are some 27% higher than in early 1980.
Add to this the fact that new home sales are at a postwar record low,
housing starts have run below one million units for eight consecutive
months—the longest sustained period of starts running below this benchmark level—auto sales are close to postwar lows even at a time when
major promotional programs have been in place, International Harvester,
the plight of the airlines, the trucking industry and farmers and it is quite
difficult to celebrate about the fact that recovery may be around the cornet.
... In the Corporate Sector, balance sheets are in the worst state of
health ever. Even in the face of sharp inventory liquidations and capital
spending paring, capital expenditures are still outpacing internal cash flow
by 13% at a time of severe profit squeeze. The failure of the bond market to
open up for sustained periods of time has made nonfinancial corporate balance sheets laden with short-term debt. During the fourth quarter of last
year, for example, the ratio o1 short-term to total credit market debt stood
at a record 42%. Throughout the 1950'sand 1960's, this ratio ranged between 26% and 30%. It was considered alarming in the mid-197Q's when it
moved up to the mid-30 % area. Available liquid resources are at alarmingly
low proportions. Liquid assets as a percent of total financial assets, for
example, stood at a meager 19% during the fourth quarter of last year. In
the 1950's, this ratio was as high as 50%. In the 1960's, concern was expressed on the corporate sector's ability to meet current bills from liquidity.
Liquid assets as a percentage of current liabilities was in the 60% area in
the 1950's and the 40%-50% range in the 1960's. Now, it stands at 22%.
147
With such a financial state, it is little wonder that many corporations
have been precluded from raising funds in the capital market and have
placed the burden on the banking system. The interest servicing burden on
corporations alone is eating up almost 50% of internal cash flow. Back in
the 1960's, it was less than 10%. This has obviously kept the rating
agencies—Moody's and Standard and Poor's—burning the midnight oil.
Thus far this year, for example, of the accelerating pace of rating changes
that have taken place, more than two-thirds have represented downgradings.
. . . In the Financial System, even the average citizen on Main Street
is familiar with the plight of the S&L's. Net of interest credited, they have
only experienced inflows in two out of the last thirteen months (October
and February). Last year the S&L's experienced a $4.6 billion erosion in capital and fully 85% of such institutions are losing money every day they
open for business as the return on assets is now falling short of the cost of
funds by 1 1/2%. Unless a sharp decline in rates ensues, the spread
threatens to get still wider. Even with a sharp and sustained decline in
rates—a highly unlikely event—a/most 800 more S&L's will be operating
with no capital by the end of 1982. It is because of this that forced mergers
by the Authorities are on a sharply accelerating track. Certainly, given the
current situation, the relatively meager $6.3 billion reserve held by the Federal Savings and Loan Insurance Corporation does not offer one great solace.
While the commercial banks have avoided the type of plight experienced by the thrifts, they have not come away unscathed. Given the dismal
state of the corporate sector and international problems that have surfaced, problem or nonperforming loans have continued on the ascent and
remain at exceedingly high levels—a highly atypical development during a
recession. Over the past eight years or so, the banks' equity to asset ratio
has declined by almost 16%. In short, bank balance sheets give the appearance that we are at the peak stage of an economic expansion—not the
trough of a recession. The banking system, given continued strong loan
demand by corporations an an exceedingly stringent reserve policy by the
Fed, has yet to rebuild its balance sheet. No wonder, all but one of the top
ten banks in the nation have had ratings lowered on their senior debt.
... State and Local Government, as well are severely feeling the
pinch from combined recession and exceedingly high jnterest rates. By the
end of this year more than half the states will be operating with surplusses
148
below the critical 5% level. In about fifteen states, actual deficits will be
posted. Services have been scaled back and many states are increasingly
looking for increased revenues through taxation. Keep in mind, these
states are just now beginning to feel the squeeze from budget cuts on the
Federal level. This is occurring at a time when many states are not allowed
to go to the capital markets at current interest rates and many localities
incur the risk of downgrading of ratings.
. . . In the Farm Sector, the very cornerstone of the American economy, a plight not witnessed since the Great Depression is in progress. In
real terms, for example, net farm income plunged from $17.7 billion in 1974
to $8.7 billion in the fourth quarter of 1981. Squeezed by weak crop and livestock prices, costly machinery and prohibitively high interest rates, many
farmers now find mortgages at the risk of foreclosure. Those who have
been forced to liquidate have had to settle for 50 cents on the dollar. Many
farmers find income as low as during the Great Depression. Certainly,
given the state of the manufacturing sector, it is difficult to say how these
beleaguered farms can be absorbed elsewhere into the economy. Unfortunately, as long as rates merely stay where they are, this plight will heighten
over the months ahead. Already we have seen the repercussions of this situation on the budgetary deficit as it has had to be enlarged in response to
the initiation of recent price supports.
And with all of this abounding afl around us because of the twopronged pinch of a recession and exceedingly high interest rates, one stil)
gets the impression that a good portion of the budget batt)e is political in
nature and that an eleventh hour sense of urgency just does not exist.
III. Where We Go From Here...
Certainty, given the preceding considerations one would hope that
there is nowhere for the economy to go from here but up. At the same time,
one would hope that the only place interest rates could go from present
real levels, not witnessed since the Great Depression, would be down.
While some degree of confidence can be attached to the former, the same
cannot be said about the latter.
Looking at the matter in greater detail ia our view that the reliquef ication of the consumer sector with respect to debt-to-income ratios and the
149
final workoff of unwanted inventories during the first quarter and on into
the spring months are in the process of sowing the seeds for economic recovery during the summer months. Such seeds, of course, will be fertilized
with the July 1 enactment of the 10% tax cut and Social Security benefit
cost of living increase. The key question that one must ask, however, is how
sustainable will such a recovery be. The key here, of course, lies in the interest rate outlook.
With further paring in capital spending, inventory reduction and a moderation in money supply growth in May and June, it most certainly is probable that recent upward pressures on interest rates will abate quite
modestly. Unfortunately, such a tranquil environment in the financial markets will probably further reduce the sense of urgency in Washington to
make the hard choices that are required to materially reduce prospective
budgetary deficits. This is quite disconcerting since the spring tranquility
should shift to a summer eruption in the financial markets. As we shift from
spring to summer, there will indeed be signs that the economic recovery is
in the process of unfolding. Unfortunately, this will probably give the markets the worst of both worlds. On the one hand, the recovery will be strong
enough to impart a negative psychological tone on the credit markets and
possibly rekindle fears of crowding out. On the other hand, though,it will
not be sufficiently robust to meaningfully boost internal corporate cash
flow—an event that normally is counted upon to alleviate short-term borrowing needs. At the same time, the markets and the Fed will have to brace
themselves for a potential major explosion in money supply growth in early
July. As was the case in April, some of this growth will be related to technical phenomena and faulty seasonal adjustment factors. Unlike the April
bulge, however, it will also be predicated upon fundamental grounds as the
economy is in the process of recovery, the 10% tax cut goes into effect and
the cost of living increase in Social Security benefits will be providing an
infusion of real spendable money into the system. Given the likelihood that
money supply growth will be well in excess of targets going into July, the
Fed will have no choice but to forcefully tighten policy. The story does not
end here. As we shift from the second to the third quarter, the Treasury's
net new cash needs will be in the process of tripling—from about $14 billion in the second quarter to $40 to $45 billion in the third quarter. Add on
top of this actual financing pressure the fact that the OMB's "Mid-Season
Review" places projected budgetary deficits for fiscal 1983 well into the
triple-digit territory and the ingredients for retesting the old highs in longterm rates will be firmly in place. It is during this period that some commer-
150
cial paper issuers may be forced out of the market into the banking system
and long-term issuers may decide to "throw in the towel" in order to access
the availability of funds at any price.
Quite obviously, we are slowly building the foundation for a potential
majof crisis environment during the summer months. One can only hope
that such an environment will represent sufficient encouragement to the
Administration and Congress to take major initiatives toward making the
hard choices that would materially reduce looming budgetary deficits
ahead. If in fact these initiatives are taken, the summer pressure in the financial markets can lead to an autumn respite. If indeed such initiatives
are genuine, meaningful and credible to the financial markets, the road
could be paved for a continuation of a more-than-cyclical deceleration in
inflation and a sustained decline in interest rates to inflation-adjusted
levels that bear a more realistic semblance of underlying fundamental realities.
Tfie fate of interest rates, the future economic contour and the success
or failure of the Economic Recovery Program, therefore, rests here in
Washington—not several hundred mites north in Wall Street.
IV. Is the Present Quagmire intractable?
Certainly, one cannot take a great deal of heart from the present situation and events that are likely to unfold over the quarters immediately
ahead. We seem *o be stock within a vicious cycle in which large budget
deficits and historically high real rates of interest beget weaker economic
performance, which beget stilt higher deficits and, in turn, higher real rates
of interest. On the monetary front, a Federal Reserve policy designed to
bring down interest rates at the expense of excessive reserve growth would
initially foster economic growth and would allow Federal deficits to recede
in the short run. However, a policy fostering excessive money growth would
uitimatety lead to accelerating inflation—possibly lo new peak rates, an
economic recession and growing budgetary deficits. On the other hand, a
responsible monetary policy geared to gradually reduce the rate o1 growth
in money at a time when Treasury financing needs are huge would require
sufficiently high real rates of interest to keep private corporate borrowing
in the capital markets at a minimum. This, in turn, would lead to diminished
capital spending and dismal productivity growth which might ultimately
lead to accelerating inflation.
151
This is not to say, though, that the potential tor a rosier future does not
exist. Just think of what has transpired over the past several years. Inflationary psychology and behavior has been broken to the quick. The commodity price bubble has burst. The price of gold is less than half its level of
1980. Silver has taken even more of a pounding. Masses that were running
out of financial assets into real assets, collectables, etc., are now reverting
back to more productive forms of investment. The speculative housing bubble has been pierced. Labor, far from placing as their major priority the
practice of keeping up with inflation, is now willing to take pay cuts just to
maintain the present working status. The previous worldwide oil shortage
has turned into a glut, seriously jeopardizing OPEC's clout in influencing
economic and financial events around the world. The Administration is
desperately attempting to reverse the trend of accelerating Federal Government expenditures. And, last but certainly not least, the monetary
authorities have achieved impressive success in reducing the year-overyear rate of growth in money supply for three consecutive years now.
Certainly, forces toward disinflation have been more dramatic than one
could have hoped for just one short year ago. Unfortunately, however, there
remains one substantial logjam precluding a reversal of the vicious cycle in
which we find ourselves. In short, budgetary deficits at the Federal level are
out of control. If nothing is done about them, all the gains that we have experienced over tne past year or more could evaporate as quickly as they
evolved—and all of the severe economic pain and the lost output would
have been for nought.
The information set lorth herein was obtained from sources which we believe reliable, but we Qo not guarantee
i!s accuracy. Neithet me information, nor any opinion expressed, constitutes a solicitation by us of the purchase
or sale of any securities or commodities.
152
JMerrill Lynch
Pierce
'Fennei 6 Smith Inc.
Financial Economics Research
verview & Preview
The credit markets sounded an upbeat role during the
past week despite the release at economic and financial data tha: could just as easily have estendert the
recent tailspin in debt prices. On tha economic from,
the upturn in The index of leading indicators, the Ihiid
consecutive monthly increase in the ratio of coincident
to lagging indicators, the rise in durable goods oideis
for December and the laiest fall in initial unemployment
claims ail reinloice recent indications that the thrust of
•he recession is losing momentum. On the financial
front, the surge in the roomy supply during the first
two weeks of January portends continuing uncertainty over how the Federal Reserve will resolve the
perpleung problem of nigh monetary giovjth in 9 recessionary environment while the largar-than-ax peeled
S1O Billion Treasury refunding package highlights the
burgeoning deticit financing needs of the Government.
Nonetheless, in contrast to the undeniably negative
response that Euch news would have elicited several
weeks ago, market participants chose to anticipate
possible favorable developments ttiis time around.
These include, most importantly, a signiiicant reversal
in the money supply bulge in the weeks ahead, a
reduction in inventory financing on the pan of businesses, reduced near-term pressure on the fed lo
adopt some tightening measures such as a discount
iate hilie and the prospect of a successful lelunOing
operation. It will be recalled that tha last Quarterly
refunding in November kicked off a major rally and the
latent demand ffu !he issues included in the upcoming
package appears to bs st'oog, particularly- among institutions seeking fo lock in yields to accommodate IRA
accounts and among foreign investors. However, the
apparent positive market psychology that exists going
inio the refunding period is a fragile one indeed and its
sustenance will depend critically on the actualization at
theie anticipated favorable developments.
Special Analysis
S'anding at tho Crossroads. «1B Per) now finds itself
almost totally l)o«ed into a cornet whereby, in order to
reinforce its fragile credibility at this ciitical juncture, it
is compelled to adhere 10 a determined and telatwety
stnr* monetarist approach to policy. However, this
comes at a time when monetary growth thus far this.
Weekly
Credit Market
Bulletin
January 29.1982
year is already well in excess of targets, real rates of
interest ara at postwar record levels (almost triple ttie
levels of the 1960's and most of the J 970'sJ and the
economy remains in a recession with the unemployment rate on the verge of mowing above the "magic"
9% area. At the same time, it finds an Administration
that appears complacent about and unwilling to attack
the problem of burgeoning budgetary deficits as lar as
the eye can see. Furthermore, the moral support the
Fed had enjoyed over the Administration's first yaat iri
office ts now crumbling rapidly—though through 3
UniQuely disguised facade. Cleariy, the Fed will bfl
standing atone in the highly pressurized political environment of 3 critical election year.
To be sure, the present quagmire in which the monetary authorities now find themselvas so deeply entrenched stems largely from a supply-side fiscal
philosophy within the Administration that has chosen
toignore the devastating impact — both real and expectations! in nature —of huge budgetary deficits on (he
financial markets. However, part of the Fed's present
predicament in which an even more draconian policy
stance may Be required in 1982 than in 198'—the
year of a recession--may \>e from its own doing and
from a failure to achieve its Ml-fl growth targets last
year.
Looking at the matlel in greater detail, the Fed has
established an already stringent 2 !4 %-5'/i % taigel for
its newly defined M-1 in I 982 -slightly lower than the
1981 shifi-art|u5ted Ml-B target of 3V7%-e% and
flDC'acmOly lower ilnan fie unadjusted M1 -B target of
6%-8'/i%. At <he same time, they have retained the
1981 M-2 target range of 6%-9%. Given the normal
relationship between nominal GNP growth and monetary growth that has prevailed throughout the 1960's
and 1 970's and assuming [hat the rise in the GW
dellator can decelerate from about 9% in 1991 to
aiound"'% in 1 982, the Fed's targets leave little (com
fO> ieal GMP growth for the year - less than 2%. However, even to achieve this subpar pace of real growth,
the aggregates would have lo grow at the upper end of
their targeted ranges. What's more, due to seasonal
and technical factors they will, from time |o time,
exceed these rajiges which mould most certainly elicit
a restrictive monetary posture lhai would further insure a weak economy.
153
Adding to the problem is the tact Chat the Fed is
calculating its allowable average M-1 leval for the
fourth quartet of 1982 off of an artificially low fourthQuarter 1981 base. Specifically, with en actual 1981
growtrtin MI-Bof 4-9%. its average leval during the
199J lour In. quarter stood at S 437.6 billion. However,
this average M1 B level loll 'a> short of what it would
have been had growth been Within its actual targeted
range of 6%-8'/i%. As the following table shows, had
the Fed merely achieved MI -B growth a! the lower end
o* its targets, the fourth-quarter 1981 base would
have been $442 billion-s4.<i billion higher. Had [lie
F«it hJr the midpoint of its targets —presumably the
ultimate goal in targeting, the base would have Been
$447 2 WNiqrt-$9,6 billion higher.
In this regard, it is important (o note tha! Ihft maximum
allowable 1982 fourth-quarter M1-B level-whicn
would result from uppur-encf-of-ranger growth — is a
(unction of the fourth-quarter 1981 base off of which
it is calculated. For instance, as the table also shows,
had the Fedusedthe lower end of its 1981 target level
as a base. Ml -B could average $466.3 billion in the
fourth quarter of this year and not exceed the upper
end of its 5.5% target. However, using the lower
actual base. Such a levef would represent a rate of
growth 1% above the upper target or $4.6 billion.
Using the midpoint of the 1981 target as 9 base, the
allowable levy of Ml-B during the fourth quarter
would be $47 1 8 billion with a 5.5% annual tale of
gronih. However, such a level off of the actual 1 981
base would result in a rate of growth of 7.8%-almost
2Yi% or S T O . T billion above the upper end of the
targets.
In effect, by the use of the below-target 1981 fourthquarter M1-B level as a base of calculation tor 1982.
(he Fed is compounding its stringency in terms of
actual allowable Ml 6 levels. This is known as negative base drift- in marked contrast to the positive Base
drift the Fed has enjoyed over the years when actual
M1 -B growth came in above tai-gets. Just as failure to
take into account base drift in setting targets during
those periods was criticized as an overly accommodative posture, failure to take into account negative base
drift can be criticized as overly restrictive —especially
at a time when real high rates of interest prevail and the
economy is sluggish at best.
Further compounding the Fed's problem is the fact that
it has ceased adjusting M-1 lor shifts into other checkable deposits from savings accounts. This would make
sense if the level of other checfcables had been terelmg
olt for some time, since it would imply thai all shifting
had reached a conclusion. However, as recently as
Novtfjiijicr, other checkjble deposits had increased by
£ 2 8 billion and it was assumad by the Fed that about
32% of the rise sifinunEil from transfers from savings
accounts As a result, the monthly increase in shift-
irli Si,,rf MARIA F RAMIREZ, MaiJset ft,
adjusted M1-B was almost 51 billion less than the
increase in unadjusted Ml-8. Beginning in December,
however, Ihe Fed ceased distinguishing from increases
in other checkables emanating from demand and savings deposits and began tracking the old gross Ml-B
under the new definition of M-1. This is rather curious
in light of the fact thai other checkable deposits rose
again in December—by $2.2 billion —and lumped bv a
whopping $5.6 biflion over tha (irst two weehs oi
January. Given these jumps in uther chetkables, we
suspect that the Fed has unwittingly bloated the M-1
figures with some balances thai are not transactional in
nature and has failed to make proper adjustments.
With regard to M-2 as well, it afjpeors the Fed is placing
itself in an untenable srtuanon by aiming for 3 6%-9%
target, given the fact that over 47% of its component
is now earning market related rates of rnrerest. As &
result, at least a 7 Vi % rate of growth is already locked
in on the basis of interest credited —and not net new
creation ol savings balances caused by Fed induced
money creation. This leaves little leeway for the expan
sion of transacdonal balances or of net new savings
balances without the Fed seriously overshooting its
targets. Given these consrdera(ions and the overly
restrictive posture the Fed would have to assume in
order not to surpass its targets for 19e2-wrtrt its
negative consequences for the economy it is our
view that the Fed should show some flexibility in
formulating ihefourth-Quarter 1981 base to be utilized
for target calculations, continue to shift adiust Ml-1 and
make the appropriate interest rate credited adjustment
in setting M-2 targets.
THE POTENTIALLY RESTRAINING IMPACT
ON FED POLICy OF PRELIMINARY
1982 M-1 GROWTH TARGETS
I'lll'l]
lo.(,(M
MMit
IVQB18IH
H*J«tU«<l
ilTup"
$442 0
447.2
4S2.4
Wl" Ifcn
WQ32
Hn Hn.lVI) M4'l LMNI fa
!l*i] lull
W Q 12HK
HUl&Htt fcs(«t 'H
$466 3
471.8
477 3
DONALD E. MAUDE
Chief Financial Economist
Cha/rfnan !int>rt!!s! Hail* Policy Commit fee
ROBERTA. SCHWAftTZ
Senior Financial Economist
Vve Chairman Interest Rate PoitCY Committee
154
Merrill Lynch
Pieice
Fenner fi Smith Inc.
Financial Economics Research
Market Overview & Preview
Thef rscal-monetary policy clash was heightened in trie
Marches iast week as the Treasury came to market
with a record S 10 billion quarterly financing operation
at the very lime the Fed was implementing $ further
tightening move, The credit markets' response was
understandable, Institutional investors, feeling no urgency to rush into the Treasury's auctions vnrth the
knowledge that there will continue to be far too many
such Eruptions over the months, quarters and years
ahead, seemed content to earn comparable yields in
the short-term markets. As a result, the dealer community apparently ended up with the lion's share of the
newly auctioned Treasury securities — leading to a further weakening in the markets' technical tone.
While this fiscal-monetary clash will continue to be
played out in the trenches. for some lime to come,
market participants will also be viewing it at the higher
otttcial policy levels this week with the release of the
President's budget message and Chairman Volcksr's
semi annual testimony before Congress. Qo the fiscal
side, it is likely that a rather optimistic scenario of
declining budgetary deficits over the years ahead will
be presented. However, such a scenario will no doubt
be viewed with more than a fair share of skepticism.
Viewed with far less skepticism on the other hand, will
be statements by Chairman Volcker to tha effect ttiat
the Fed will continue to pursue its goal of reducing the
rate ol growth in money and credit. Ironically, such
statements should prove heartening to institutional
investors who will benefit greatly from a tough monetary policy resolve. However, it W'fl require both firm
statements and an unwinding o( the recent monetary
bulge to pry this group loose from the sidelines. In the
meantime, a tough monetary stand can only be interpreted as a negative development to a dealer community that makes its trading decisions on ''. ,t basis of the
day-to-day overnight financing rateSpecial Analysis
Tha Economic-Monetary Growth Contradiction, existent for somfl months now, continues to perplex analysts both within and outside of the Fed and has
Weekly
Credit Market
Bulletin
Fabrusry 5,1982
managed to create more than its tail share of uncertainty in the financial markets. Such a sharp contradiction between the pace of economic activity end
monetary growth deserves heightened focus when
one takes into account the fact that the 5.2% annual
rate of decline in real GNP during last year's fourth
quarter was more severe than all but thiee other quarterly contractions during, previouspost^aT recessions
At the same time, ihe rapid 9.4% annual regie of growth
inM-1 from October to December was only surpassed
in si* other quarters since 197Q. What is more, while
the economy apparently continued to slip in January,
M-1 growth seems destined 10 post an annual Mte of
growth in excess o( 20%
Of critical importance to both the Fed and the financial
markets is the manner by which this contradiction will
be resolved. On this mattei. two points of view appear
to have emerged. In one camp are those whu h-isVit
the view that strong growth in M-l since October is
fundamental in nature and thai the economy Over the
period was significantly stronger than suggested by
the GNP data. In the other camp are those who feel Tin:
rapid M-l giovuth was only partially fundjmental in
nature and certainly not reflective Q| actual underlying
economic conditions.
Those in the former camp woutfl expect strengthening
economic statistics and little —if any —dissipation in
the recent monetary biulge over the months immediately ahead to reinfotee theit view. Under these conditions, of course, the Fed would be required to take
further forceful tightaning actions. Those Of tile latter
persuasion, on the other fund, would enpect continued
economic weakness to be reflected iii the statistics
and a meaningful weakening in monetary growth over
the remainder of the first quarter. Under [hese conditions, the Fed would not have to take Either tightening
actions and the resulting weakening in the demand for
funds coulo1 allow interest raies 10 ease once more
It is our view that the interpolation of the tatter co<»u
bears the most semblance to reality and that its rpiuking scenario is ttie most likely onp to prevail. To foe sure,
the worst of the recession was probably witn^saei) in
October of last year. However, this by no means implies
(ConnnuBti on Pdge 4'
155
that the recession is avee. The inventory liquidation
phase, which brings witrr it cutbacks in production,
rising unemployment and dtciioished short-term business credit demands, is almosi always (he last to
come-and, indeed, the necessary ingreOient paving
Ihe way lor an ensuing recovery. Admittedly, given the
normal lagged impact, there is no question that the
Fed's highly aggressive reserve provision over the
summer and early autumn m on ids and the sharp decline in interest rates in November <lnl Corilnbule to an
acceleration in monetary growth. Hovvever, there are
several cofjerit leasons to view trie magnitude ant)
nature of growth with a great deal ol suspicion
Specifically, several quite atypical developments in
(lefJosir flows in progress since late October might
suggesi that the dismal economic environment and
uncefiafnTy over future employment ore spec ts during
Novemoei ami December-3 time when the Confereice Board's tonsuiriBr confidence index plunged by
I -" " , -causr-d a dramatic surge in precautionary Balance preferences. This cautious mood, in turn, seems
10 have led to the diversion ol nontransactional (including certain lime deposits and holdings of credit market
instruments) funds into M-1 type deposits. Such a
diversion of fiwids could have been further bolstered in
January as individuals may have temporarily parked
funds in readily accessible deposits until they have had
time to bettef choose among 'he myriad of Individual
Retirement Account programs being advertised in the
media.
Perhaps prodding an important clue to the desire to
build up precautionary balances- even at the expense
of some interest income — mas the shift in The behavior
of time and savings ficoosiis since late October. Specif
ically, after increasing al an average monthly Dace of
SB.4 billion from December, 1980 to October, 1981,
time deposits Ohich carry competitive rales of inter
est, but are not liquid! increased at a monthly rate of
54 2 billion over the November December period. Savings deocisi's. on thp r.ir.er hind, Iia<i been declining at
an average monthly clip of SB.3 billion over thy
December-October period However, over the
November-December period, these mere liquiO deposits actually lose by 54 1 tjiNfofi.
While renewed caution resulted in some shifting
Brnong M 2 Components, it gfso probably ted 10 some
shifting from M-2 type accounts into M-1. In effect,
Ihe dramatic slowdown in lime cferjosi! growth probably stemmed from the desire to allow some six-momti
money market CD's to mature and ro place tne proceeds in a more liquid savings. NOW or demand sc-
'flesea/eriStaff MARIA F RAMIREZ. Manke' £conrjn
coTini as a precautionary measure This would appeal
To be suggested by the 1981 and last month's pattern
0( "other checkable" deposit growth.
B/ way of illustration, with the introduction of natfinwide NOW accounts last year, Other checkable daposits soared by S39.2 billion ovei Ihe January-April
period. From April to October, however, (hey ortly
Increased by $5.6 billion a S900 million monthly
rate. On the other hand, iince October they fiave
increased by 5 ) 1 . 8 billion- close to a S4.0 billion
average monthly pace. Because November was the
last monlh that irte Fed rtisiinguishsd between what
portion of the other checkable deposit increase came
from demand deposits and what portion came from
sayings-type denosits, oiiehas in inake individual |Udgmeht wilh regard^ to OCD yromih over the last two
months.
Inthislattar regard, it is interesting to note thai of the
$44.7 billion increase in other clieckables from December, 1980 to October, 198), Ihe Fed assumed
that S33.8 billion came from demand deposits. Not
coincidentally. over the same pefiod, actual demand
deposits posted a S32.7 billion decline - almost an
equal offset. Vet, the $1 t.B billion inoease in other
checkables since October tame al ilie same time that
demand deposits lose by SS.3 billion. Even more noteworthy is the fact that S 7.5 billion of ihedher checkable deposit increase came over the first three weeks in
January — a time when one could reasonably assume
sauings-ty&e money was temporarily being parked
prJoi to making an IRA account decision. Under the
Pect's new M-1 definition, though, these would be
classified as transactional balances-a rafner tjueslirjnabla procedure
Glvet Ihe preceding consideunions, therefore, i( is our
view that some of the recent M-1 strength stems from
economic weakness—not stiength-and a tertipowy
parking of savings-type funds in NOW accounts As
such, it is likely lhat the Fed's response to the monetary surge will be a steal deal more restrained than
would have beer) ihecase in other periods of encessrve
M-1 growth.
DONALD E. MAUDE
Chief Financial fconomis i
Chairman Interest felt foln y Cuniniiltee
ROBERT A. SCHWABTZ
Senior Financial fcoimmist
Vice Chairman interest Rale Policy Committee
156
Merrill Lynch
Pierce
FennerS Smith Inc.
Financial Economics Hesearch
Weekly
Credit Market
Bulletin
May 21.198?
Market Ovetview & preview
The fixed-income market en)oyed a major rally during
the past week, particulaily the Treasury bill sector, iri
response to steoped-up purchases by investors seeking quality instruments, a larger- than-expected infusion of raseryes into the banking systein on (tie r-art ot
the Fed, a considerably reduced dealer inventory position resulting from the Fed's activity and additional
data depicting a weak housing market, sluggish income giowih and a subdued inflation rate. Of the
aforementioned factors, the key ingredient sparking
the market's strength was the Fea's more aggressive
easing postuiE which may lend credence to ihe view —
discussed in The Special Analysis betovv— that the Central Bank has been overly restrictive in its pursuit of
unrealistic monetary targets. To be sure, there is some
question as to what extern the Fed's activity was
related to the unsettled conditions stemming from Ihe
difficulties experienced byg securities firmasocnoserl
to rnoie lonOamental considerations. In ail likelihood.
the former has played a role which suggests that the
fed may pull back somewhat once the market's fears
are allayed. Such a pullback, however, should still leave
policy in a mote accommodative mode than was in
effect several weeks ago. Accordingly, most if not all of
the inteiest rate declines recorded over the past week
should remain intact over the next month or so. Thereaitei, however, the economic and monetary environment is eipectefl to tuin decidedly less positive toi the
fixed-nicome market.
Special Analysis
The Oihei Side si the M-1 Base Drift Coin is cvming
home 10 hsvnl rhe Fell thai finds itself hopelessly
fioserf iriro a corner in which it feels compelled So
rigorously pursue monetaiy targets in order to maintain
rts bald earned and ectinfjrtHcatly costly trttt-inflation
credibility. Unfortunately, (he Fed's attempt to hrt moving targets lor aggregates that continue to u.idetgo
change as each day passes has tended to peipewale
the we(y excesses rn both directions that the pursuit ol
nianeiansm was intended to eliminate And, unless a
di as (ic iedressirtg of the entire taigeiing procedure arid
aggregate definitions is fonheoming soon, continued
Viewing the matter i.-> greater detail, li is no secret thai
The Fe't's attempt !o hit M-1 racers since the mid19?D's ftfts been mat wir/> Is-ss than resounding success. In this regard, it would seem reasonable to
assume that trie most appropriate measure of the f eQ's
targeting success or lack thereof would be its history oi
coming close to the midpoint of specified annual
ranges estaUtishud for the fourth quarter ol each year.
tr> addition, in those years in which actual growth rates
did deviate from target midpoints, a successful approach to targeting would mandate that [he miss be
consistent with the underlying economic and inflation
environment. For example, in years of expanding eco
norriK activity and accelerating inflationaty pressures.
one would assume that the miss should be biased
below the midpoint as the Fed seeks to "lean against
the wind." In periods, of declining economic activity
and decelerating inflationary pressures, the Fed would
seem [iistified to aim lor .1 growth rate above thy laiget
midpoint.
As the lollo Lvuig fable ctejrty shows, ho wever. trie only
year in which !ne Pea came clust? to the midpoint o/rts
targeted tangs was in !976 when the fouith ttuartef
1375 to fourth-Quarter 1976 yrowtft came in just
0 2% above the target mirtooait. In each olthe following tour years when the economy mas expanding and
inflation accelerating, actual growth exceeded the midpoint <if target ranges by anywhere from 1.3% in
1978 10 2.4% in 1 377. Whai is more, in three of those
four yeais the actual growth of M-1 surpassed the
upper and of Ihe fed's targeted range. Ironically, the
Only year in which M-1 gro wth fell short of the targeted
midpornl was in 1981 -a yea( of recession and a
dramatic deceleration in inflation
Such a performance is mo$t disconcerting rfi antl of"
itself Even nxtre ilisiufbintj. however. Jias been lite
impact ol "base tint!" on iheperpetuation of excesses
doting periods ot over accommodation and stringency
during periods of under acccmmoriat'nn. Such a php(ContinuedorrPageil
157
nomenon can be seen from columns 3 and 4 in the
table. In column 3, tar example, is shown what the
actual fourth-quartai average M-1 level -would have
bean each year had the Fed achieved target midpoint
growth over the actual level that prevailed during tfie
fouuli quarter of the previous year. In column 4 is
shown the actual M-1 fev6(s thai «nsusO Item the
year's growth ana that were utilized by the Fed as a
base of calculation lot the subsequent year's targets.
In 1977, for example, M-1 would have averaged
5325.0 billion in the fourth guartei had the Fed
achieved the 5.5% target midpoint growth. However,
since M-l grew at an annual rale of 7.9% in 1977, the
actual level stood at $333.3 billion — some SB.3 billion
higher than the midpoint of large J.
By setting its 1 978 target growth rale of M-1 off of the
actual prevailing base of $333.3 billion —and not off of
what would have been the on-iarget level—the Fad in
essence built in and validated the S8.3 billion 1977
excess through the process o( base dull. Most disconcerting was the Performance in 1 979 —a time of rapidly accelerating inflation. Alter already incorporating
the I 977 and 1 978 target overshoots of $8.3 billion
and $9.8 billion respectively into the new base level for
1979 growth calculation of 5360.8 billion, the M-1
increase was soma 515.9 billion in excess of the target
midpoint. This base excess or drift was also validated
in the setting of !98O targets off of a S3S7.5 billion
fourth-quarier 1 979 base level.
In nf/ec:, had the actual growth rates over this period
been calculated off (tf the midpoint of ffie previous
year's target —ana no! the acrua/ higher level—M-1
gtawth would have been !'.O%in 1378, 10.4% in
1973 and 11 3%,,, ;9SD. As a result, the actual M-1
level Ity The fourth qusrl&r of 1980 stood $42.3 billion
fiigher Iliac the level that would have existed had the
fsa hit the midpoint of its targets over the 1976-' 960
period. The difference in effect represents accumulated base drift for the period. Given this consideisliori.
(ftere'ore, there is Hale wonder thai inflationary exressesbuitt up dramatically and the recession that was
anticipate!/as early as 1978 was forestalled for two
years.
The other side of the base drift coin, however, ts now
corning home lo roost and is serving to *)(a£erbale the
strains in the financial system and recessionary tendencies In 1981, for example, M-l growth was 2.3%
below the midpoint of ihs Fed's targets. As a result,
the M-1 base level off of which targeted 1982 giowth
is being calculated is $436 7 billion- $9.5 billion beluw th" base that would have been produced wiih
target mirfpnint growth. In essence, not only :s the M-1
target for 1982 3.5% lower than thai in !981, bull! is
being cutciifared off of a base $3.5 billion tower than it
won/if have been hart fie red hit its 198 I targets.
Along these lines, it should be liept in mind that the Fed
set the 1982 targets in July of last year—supposedly
on the Bssurrtpiion that the midpoint of 1 981 targets
would have been achieved.
Given the overly accommodative pasture aided and
abetted by positive base drifi over ifie 1976-80 petlod. the Fed was able to sustain negative (inflationadjustedl shori-ierm rales of anywhere from 1.0% in
T98O to 3.3% in 1979. Certainly, Ihese rates of
inlflrest told the true tale of the Fed's posture. Given
the overly restrictive posture in T381 and thus !ar this
year, on the other hand, teal short- term fates were a
positive 5.2% last year am/stsrKt close to the doubledigit area at present—aider! and abetted by negative
basesirifs. Cerfamfy, this combined with key sectors of
the fcofomy close to depression levels, a sA»arp decetGf9tJQniFi inflation and minimal reserve growth over trie
past year or so would appear to tell the true tale of the
fed's posture at present. In light of past and recent
developments, it is our view that the fed should eliminate the practice of base drift and target each year's
money Supply growi'i using the target midpoint level in
the fourth i/uarlei of each year as the basis of the
subsequent year's growth. In this way, the Fed would
find that M-1 growth in early May has bean running at
an annual rate of 1.8% —below, not above, targets. In
future years, such an approach would preclude the
Fed's abilitv of validating and perpetuating either excesses or deficiencies. In effect, if excess growth were
to develop one year, it would have to be squeezed o Jt
the next and vice versa. Such an approach would buy
tha Fee breathing room this year while, at the same
time, serve as a discipline on the Fed jn subsequent
years-thus sustaining monetary eiedibility. Certainly,
this approach would be preferable to a raising of the
1982 target ranges.
DONALD E. MAUDE
Chiei Financial Economist
Chairman Interest flare Policy Corrtmrtree
158
Merrill kynch
A bimonthly supplement to the
Weekly Credit Market Bulletin
and Daily Credit Market Comment
PERSPECTIVE &
PROSPECTIVE
MONITOR
Special Analysis
• The M-2 Targeting Dilemma:
Has The Fed Be«n Chasing Its
Own Tail?
Page 8
Donald E. Maude
Cniet Financial Economisl
Cliairman Interest Rate Policy Committee
Robert A. Schwartz
Senior Financial Economist
Vice Chairman 'merest Rale Policy Committee
159
Special Analysis
The M-2 Targeting Dilemma: Has The Fed
Been Chasing Its Own Tail?
Since January of this year the pace of economic activity
has stagnated, the i-ilc oi inflation has receded dramatically from the double-digit 10 the single-digit territory,
bank credit growth has moved comfortably within the
Fed's 6%-9% target for (he year and shift-adjusted MI-B
through July had grown at a rate well Wow the lower
end of Ihe Fed's 3-1/2% io 6% bug-term large! Still,
with all of this, until just recently the Fed has kept a tight
lid on reserve growth and the Fed funds rale was allowed
to continue trading in the 18% 20% range during the
May-July period — well above the 15% average of February and March.
A major reason for ihe Fed's posture during the spring
and early summer monihs lies with the tact that M ' 2 had
been growing above, the upper limit of its 6-l/2%-9%
target range. In Ihe past, with (he Fed giving equal
weight to both Ml-B and M-2 in (he formulation ol policy, a similar confluence of events would haue brought
forth n respectable easing in policy and in (he Fed funds
rate. Over the past several months, however, such has
not been the case. The Fed's departure from past practices stems from a decision reached at the March FOMC
meeting, when Ihe Committee decided lhat -"greater
weight than before be tjtuen Io the behavior of M 2" in
formulating monetary policy
At that lime, ii was iiurei'd thai a change in emphasis
wasappropiiate in tight of (he f.id lhat Ihe nationwide introduction of NOW ocenunls, uncc th« beginning ol the
year had caused a massive shifting of deposits that was
expected to continue distorting measured Ml-B growth
to what the Committee considered an "unpredictable extent." In eliect, Ihe Fed was giving recognition to the impact that instiluticuial changes and exceedingly high
interest rales wern hawing on transactional balances and
decided to focus more on M 2, which measures bath
transaction at and nontransactional (sav ing- type 1 balances.
As a resuli of this decision based Upon the staffs analysis, the Fed chose to ignore the fact that real GNP declined by 1.9% and the price deflator receded Io an
annual rale of 6% during the second quarter and lhat by
June Ihe role oi growth of =hift-adjusted M l - B stood 11/2% below the lowt'r end of its long-term (fourth-quarter J'JSl over fourth-quarter 198O) target. Instead, it
mjifitainifd a tight rein on n-serve growth in response to
an 8.3% annual rate oi growth in M-2 which stood al Ihe
upper end ol its long-term target Still, while the Fed's rationale for initially questioning the reliability of the Ml-B
data is somewhat uiuler<;t>inf]<iblc. oni; has to question
the inconsistencies between weak economic activity, decelerating inflation, weal* bank credit and below target
Ml-R gtowtli on Ilie om' h.i»rl -uid excessive M 2 (.trowlh
on the oihei Wliaf is s0 dticonterung about tlie Fed's
shift m emphasis to M-2 is that il has been done and largeis have heen OTtahlislied accortlirigly apparently without the Fed taking rogmzante of the dramatic impact thai
institutinnal ch-inaes shifting household iriueslment pat
terns and exc«edmgly high inierest rates have had on
nontransactionat balances as wall.
ll is oui view that failure of the Fed to do so over the
year ahead would preclude any cneaiiingluj i B Wf on tin;
interest rate front on a sustainable basis, ihprpby serviivj
to ihwait the Administration's economic recovery program before it has a chance to materialize nntl fjuar<ii)tiving that Federal budgetary deficits will mount sdl) furihcr.
This would bt' !he case since, according to our rnlculdtions (to be elaborated upon later in the Analysis) an 8%
plus M-2 growth over the next year would appear extremely likely even with zero growth in its components Ml-B, time and savings deposits, money market f u n d s ,
overnight RP's and Eurodollar deposils. With these other
components growing over the year ahead, ol course, excessive M-2 growth would appear all bul assurer! In such
a likely event the question then becomes, ctin aftri ihcAiU
a more reslrjciive monetary policy be successfully cmpfoyed to reduce the M-2 rate of growth? To gam stinw
insight Into the ansiveis Io these questions, oiie must first
recognize what impart Institutional changes, alls-red investment preferences of consumers and practices of fi
nancial institutions, munetacy agyreyale tl,'limiii)ii L il
considerations and a high interest rale environment have
had on M-2 —as contrasted ro actual Fedtral Receive
policy actions
The Changing Nature of M-2
Since the Mid-1970's...
Sei^era) dramatic and critical institutional deuelupments
in the financial system and nuiltyts have emi.-ry.jt.! >»ici'
the mid-1970s. These developments, in turn, have had
a profound impact on M-2 growth over the past sei/erdl
years. In the past, it should be kept in mind. M-2 merely
consisted oi currency, demand deposits and time anci
savings accounts of commercial banks Tile yield on the
latter accounts was governed by Regulation Q During
past periods, the monetary mechanism Worked quite
well, though it was not without its temporary painlul elfeds on tile banking system and the housing market and
inequities to small savers who were generally precluded
from the opportunity of earning compeiiiive market rsi^s
of interest on money market instruments—whose denominations were loo iarge for all but the most wealthy
individuals and large institutional investors During periods of monetary tiqhlness. yields on credit nirttfti'l in
slrumenfs (Treasury bills, federal Ayeticy sedulities, etc }
tended to rise above those du.iilahle on time aiiJ W'inys
accounts —causin a disinter medial ion fiom M-2 Kpe deposits into the credit markets This changing iloiv of
funds, ol course, resulted in a weakening in M-l and M2 growth and subsequently led the ivay tar an ensimj in
monetary policy and interest rates.
In the 1970's, however, the financial system began
'lirvL'k'pinij ways to .iddjit to the rnonL'r.iry yniji.nl on
flows. The firs! response in the early 1970s was '.'te tieation of the money market mutual fund as a vf hide by
which small saveis tauld take advantage of competirii'f
money mjrlit't yields. It was not until the Sale 1970'* ushered in sustained historitdlly high interest rates, however.
160
thai ihey began to giow rapidly. The second response
came irom financial institutions during the summer o!
1978. iwhen Li was felt that 7%-S% money maikdi rates
u/ould lead in massive ttis intermedia lion and a collapse
in the housing market. Al that lime, (he Federal Reserve
and the Federal Home Loan Board decided to allow
commercial banks and npnbank thrifts to issue special 6month money fnarkel re: filicates and 30-month savings
C(.'itilk.lies at market rale* o/ interest (lied Jo the compii
i.iWe maturity Treasury yield) and in denominations
small enough Id iilwacl funds from sni.ilter savers and investors. The mosl recent response by institulions who are
pieduded from liquidating sixuruics bcriiuse of Ihe subsiantial realized losses that would be incurred has been
the increased uiili;ation of such portfolios lo gain funds
through RP's
In recognition of the fact that a glowing proportion of
what Tht- Fed considered alternatives to traditional savinys account type vehicles that ivery not being captured
by ihf uld defmiuom of M-2. this a<jc;te(!ate was roiiefined m !f!7^ lo include deposits of nonhank thrills,
nioni'y market funds, RP's and tufOrioltar deposits Ap
7'irirenily not rfctigiitzi'd Uy ihf f't'il at the lime would he
the rijle played by th? shirtiny comprisilion of sailings, and
investiiwriis and interest rates themselves in M-2 growth
Looking at this mailer m more specific terms, the rapidly yrowing role mat ioteiest rales themselves hiiue
played in M-2 ijtowlti is illustrated [n Ihe following bar
chart. As it shows, the noninteresl hearmij component of
M-2-which i* the same as M l - A - m 1974, the year of
'he previous cyclical p?ak in interest rates and monetary
reli,iinl. represented 30% of the total. Biisically alUif ihe
reniainde.i of M-2 was represented by time and sai'iny*
^(counls ihat earned a low uonmarket rale of teturn oi
about 3% By 1977, iU> noninterest bearing component
had declined to 25% yf the lolal and time and savings
dein^ilb tose lo about 73% furlh*i increasing the proportion of M 2 earning intevc-ii However, only 2% o(
the lotal actually earned a higher nidrket rate of interest
and tlial jjas only slightly more than 5%. Since mid1978, however, money maikel rales have risen lo levels
almost three limes higher than rates than can be cunied
on savings and short maturity time deposits and the
yrcnvlh u( spetial money market tcrudcates and money
m.irkt-l funds have literally e\|il<n!(=(l. As a result, during
the second quarter of thii yeai, Ml A represented only
21 TP of the total, liontndrliH interest e.irriiiig rfaposils
39% and higher yielding m.irket rates of inleveit components a lull 40% of the total. Tlw.s«? higher yielding com
ponerits are up sharply front 19% in 1979 and 32% ill
1%0 The rapidly rising proportion of M-2 stains mflikct raieio! inlciest since 1977 has aHJin™i.illy htscn aurjmented by an .icru.il doubling 111 \Sit- level of money
alas
(actors is reflected in "la
The ciJnihlnalK o( thes
tile I. which shuvvs a bredlidi-i i of the components ol
, MM!) in the upper
nortltafisniiK'nai M-2 (M-2 i
part ul Ihe table is the actual n raije duilar level (or each
slinurwl intcti'it 1.110 i>(
i.ornpoii.>nt since 107 !> nnd ti
r e t u r n p^id The bottom of r
table slinws ihe aity.il
dolldi amount o! mrereit Ih.ii acc
d lo ttdd; component d u r i n g the same p^nod !-(w
accounts for
e>iampl«, we have, assumed an inlfrest
inl
rate of 5.2% pS!
year Print to 1179, romnicrrjall hh.'ink^ were allowed to
pay 5% and nonbanli t h r i f t
l/4% an such deposits
Alter 1979, however, (ht L
j was r.iiwd to 5-1/4%
ant) 5-1/2% r.'spectiwiy G
rnllv. llleii' deposit 1 : haue
been dbout e.qu,illy fii--iribii]i'(.l !>.><wc-i'ji thu
the thrifts For nine deposits, thf cattjl.wov,s were soniewh.it more complex sintf (ticij intlofli' rc<jul.ir nJliir vi.-ly
low yieldmij liuii.' account-- atni hujhci y) B 'ldiii;j. special 6monlh money mnikel ('l)\ and 30 nionlii saunvjt r«rtjfi
161
NoBtraaoctioinl M-2 Ca»pn«i«t« Aad latent*! Puld
HofltnM. M~l
flHi-t«l*
I*W
'cr
fin^M rtii
IMm*
«•••
TIM EH*-
l«W
1. A'lmn LM|* & Fm>UU|lUM^UMin
1975
I 735 4
»83.9
5.8%
447.7
58
1976
861. J
1977
963 a
486.5
S.fi
1978
]<H4.1
476.1
61
416.7
7.0
1979
1J42.1
396.S
79
1 980
12SS 6
W8I
3720
99
1Q
t^WJ J
360.7
104
«Q
1316.0
L—1
5.2%
5.2
5.2
5.2
5.2
5.2
5.2
52
13404
3%6
4S49
533S
656. 5
7099
782 B
7989
Jbft.
6.6%
6.6
6.6
6.?
7.6
9.1
11 1
11.5
Fwd aia...
*L*wt.
L*Ml
*«£"
1 36
55%
5.8
5.3
7.8
11.0
126
3.4
3.8
10.3
43.6
698
929
119.3
15.5
16.2
H&A.
(Ml
1 T.5
13.6
18.6
23.9
253
26 1
326
37.1
Js£
5.3«
51
43
80
11. 1
134
n.2
18.3
il. AdUfl LqtrrtAt P>1d
l'J7D
97 ft
977
KJ4
07
OH
208
102
02
0.2
08
48
S3
l'J6
Ififi
86 7
928
11 4
192
56
t!97
229
y?H
500
559
632
97'J
Tib
24 9
24.4
21 9
')SO
980
1263
1376
[(/•
no -
cales — itie composition of which has undergone major
shifts tlitciugh the years.
By way of example, up uniil mid-1978, all time deposits were of (he lo«/e; yielding nature. The allowable
yield schedule on such deposits varied from 5% lo 7-3/4%
up until the lale-19?0's and from 5-1/4% to 7-3/4%
thereafter, depending upon maturity and the depositoty
institution For simplicity, we have conservatively estimated art uileiesl rats o! 6 6% on these accounts. By the
second Quatlet o! this year, however, the composition of
lime deposits was dr.imotically different The lower yielding jugular time accounts had declined to 32% ol the total, 30-month certiiicates moved to 10% and special
money market CDs soared to 58% of the fofa! To take
1'nebe shifts into account, we calculated ihe relum on
nvjney maiket C.fH by usintj the average 6-month Trea.
:,ury bill rale lor the p.-nods ami on 30 month certificates
by uyna Ihe Iw'i year avc-faye yield on comparable malurity Treasury notes- off ai which their returns are
peqijcd Wi'ujhdna rh<- toMl tune deposit component according^, we fmd that the rate of return rose from 6 7%
in 1*17? IG 11 5% during the second quarter of this year.
For the yield on money market funds, we haue used the
90 rlay commei-eiaJ paper rate as a proxy and for overnight HP's and Eurodollar deposits we useil the average
Fed funds rate.
These inierebt earning:, estimates, we would poin!
out, are on the conservative side since money market
tund yields have at limes exceeded (hose on commercial
paper, Eurodollar dopdiir^ generally yieW more than Ihe
was
262
300
36.1
50.0
646
* 428
I9
^8
38
Fed funds rale and (he olher chetkables in Ml-B were
not imputed with any inferest return —when in (act they
do earn aver 5% irt genera). Oti the olhet hand, we do
acknowledge the possibility thai actual interest income
estimated on 6-rnonth money market CD's and 30month cerliricates may be overstated somewhat for a
given period when rates were higher than the ptecedrrtg
period since some ol these instruments are those thai
wete issued during the prior period at the (hen existing
yields. The combination of these considerations, however, would suggest that the overall returns iiid'Caled are
sufficiently representative.
Asthe table shows, the interest rate faclor In M-2 sifjce
]97 7 ha5 increased dramatically. In 1977, interesi paid
amounted to $55.9 billion-or $4.7 brHrori per month.
During the second quartur of Ids year. tiKercii ( wid i,m
ai an arirulai rate of $137 6 bifiion-or $11 ,S Ulion per
month. Table II provides still another way of looking at
the matter by showing the aciual dollar changes in M-2
and interest paid and (he percemasje ol the total change
represented by interest alone. Back in 1975. for examp|B| 36 8% of the increase in M-2 was accounted for by
interest. In 1980, interest paid represented %.9% of the
increase in M-2. These statistics point to the dilemma
now faced by the Fed. Given annualized interest payrvienis on M-2 components in Jime running at an annual
rae ol $138.6 billion and should no auslamed decline in
interest rates occur Over the ne«t year, the inteifist component alone will provide an 8% rate ol growth in M-2
ouei the period Yef, if the Fed dogmatically pursues an
162
M-Z growth target of 6-1/2%-9-t and other components groui as well (even if Ml-B growth remains at the
lower end ol the. Fed's 1982 targets} M-2 growth on balance will be al the upper end or aboue its target, ii this
turns out to be the case, however. there would be little
reason to expect any easing in policy or decline in interest rales. What's even more disconcerting is the fact that
the trend giovoth of market related components of M-2
has accelerated recently. This would imply even higher
interest rale component giowlh as each month goes on.
In effect, the Fed will find ilself likened to the dog ihat
continues to chase its own tail. The faster it chase?, the
faster the elusive tail mowes. The same could be the case
uiith M-2 targeting without taking info account the interest rate factor.
Despite Ihe dramatic bloating effect interest has recently had on M-2 growth, one might make the case that
the source of M-2 growth is really a moot point. The important consideration is deposits have in fact grown at an
overly rapid rate. However, in this tegaid, one must define the relevance of M-2 and determine if the current aggregate does in (act measure what ii is supposed to
gauge. Along these lines, it has been pointed out in Federal Reserve literature that the purpose ol the M-2 measure is twofold: first, to measure the availability o( new
lendable funds in financial institutions and. second, to
measure overall liquidity—or spending potential—in Ihe
economy.
Gross M-2 As A Proxy Of The Availability
Of New Lend able Funds
One of the majot concerns on the part of the monetary
authorities u/rth rapid M-2 growth over the second half of
last year and thus far this year is that it suggests that Ihe
banking system—both commercial banks and nonbank
thrifts—are flush with newly created funds that can be
unleashed al any moment to fuel an inflationary pace of
economic activity. Yet. this perception about all financiaitype institutions just does not mesh with Ihe well-known
plight of nonbank ihiiflE and the relatively modest increase in total commercial bank credii since the beginning of ihe year.
Tible 11
RelaUoitihlp Between M-2 Cbtagvf
And The IMcnM B»rt CompiNMrt
(iflBbwu Al Annual Rtfet)
XdK-1
P*itod
Lnwl
iBCtrtV
PiU
1975
1976
1977
197S
1979
1980
1981
IQ
KQ
$1022.4
11€*.7
1116.2
144.3
127.4
1D74
1240
105.4
I 42.8
50.0
55.9
63.2
79.5
98.0
137.2
180.1
IZ6.3
1376
12941
1401.5
15255
1603.9
1&98.3
17«.3
faliraal
3t.8%
34.7
43.9
see
641
93.0
92,1
76.4
Again, the problem of using M-2 as a proxy rests with
the fact that it measures changes in "gross" deposits not
net new deposits after required interest payments ate deducted. This is quite ironic when one considers the fact
that the outflow of funds from the savings and loan associations has been a highly publicized phenomenon- For
example, many in the iinancial community are aware
that the S&L withdrawals exceeded new deposits by
$4.6 billion in April, a minor bit m May and a whopping
$5 & billion in June. Yet, they are not aware tha_t aftei
taking into account interest credited to accounts, ihe outflow in April was only $2.9 billion and gross deposits and
interest actually increased by $1.7 billion in May and
close to $500 million in June. The reason increases in
deposit levels due to interest crediting is not deemed important in the thrift industry is du« to the fact that it does
nol represent nel new external sources of deposits with
which mortgage lending can he expanded. In effect, increases in deposit levels clue to interest crediting merely
represent a shifting of funds from one area of the institution io the other—usually from operating revenues or
capital. If a net deposii outflow is just rnalchecl by interest
credited, the institution has not gained any net new external funds.
The same case applies to the commercial banking system components of M-2. Net new lendable funds that
banks previously did not have only materialize when the
gioss deposit increase exceeds the amount of interest
that has to be transferred from one area of the bank to
the actual accounts. Table 111, which shows the iinancial
institution M-2 sources of funds—M-2 less money market
fund shares—indicates that throughout the last half o( the
1970's gross deposit increases did exceed interest paid-,
resulting in nel deposit gains. However, two key developments have tended to mute such gains and to lead to
actual net losses in 1980 and the first half of 1981 First,
gross annual gains in time and savings deposits declined
from a high of $120 billion in 1976 to $33.5 billion in
1980 and $19.2 billion during the second quartet of this
year. At the same time, intetesi paid on such accounts
moved from $49.1 billion in 1976 to 185 4 billion in
1980 and $1(1.6 billion during the second quanei of
1981. As a result, what were net gains of $70.9 billion in
lime and savings deposits in 1976 became net outflows
of $51.9 billion in 1980 and a S92.1 billion annual rate
during the second quarter of this year As the table
shows, these outflows ivere further augmented by net
outflows faun overnight RPs and Eurodollar deposits in
S980 anc3 the first quarter of Ihis year and were stemmed
somewhat by an increase during the second quarter. In
1980, these outflows were negated to a certain exienl by
an increase in demand deposits and currency and other
checkable deposits. However, on a net after interest
basis, at depository institutions. M-2 declined by $40.5
billion in [980, $22.1 billion during the tost quarter of
thisyeai and al an annual rate of $44.0 billion during the
second quarter.
This net oAitflow of deposits, of course, forced the financial institutions to scramble lot funds from more
broadly defined M-3 sources—such as large time deposits, term RP's and Eurodollars and CD purchases by
163
the proportion of these holdings moved back above 158 "h
ol the total Since that time, however, the pattern has
changed dramatically in 19HO, iore*amp)t, Jt-spite lofty
interest rates throughout ihe major part of the year, the
proportion of liquid financial asset acquisitions represented by credit market instruments deilintii Jo 15.5%
During (he first quarter of this year, the household sector
actually liquidated credit market instruments at an annual
rate of $23.5 billion.
This does no* imply lhat lha individual's interest in
market-related high yielding investments has diminished,
however. Instead, with convenience that money market
funds afford and the fact thai iheir purchase does not encompass Ihe payment of a commission (or load), they
have taken the place of former investments in credit market instruments. During (he first quarter oi this year, for
example, almost 75% of the increase in liquid financial
asset holdings were in the form of money market fund
shares. Unlike credit market instruments, however,
money marvel funds represent part of M-2. Indeed, fully
63Sb of the M-2 increase since last December has been
accounted for by money market funds. To the extent thai
money market fund share holdings represent an alternative to other investments, however, one could seriously
question their inclusion in a monetary aggregate intended to measure savings-type deposits that have the
potential of being converted into transactional balances
at any time. Given the fact that the number of times
checks are actually drawn on these funds over the course
of a year is minimal, it is difficult to differentiate them
from other credit market instruments thai are not in
eluded in M-2
Due to such shifting investment preferences between
credil markei instruments and alternatives classified technically as deposits and the growth of the economy over
the years, a more accurate measure oi liquidity should
take these developments, into consideration. In the following table, for example, is shown the total of all deposits (which would include money market funds) and
credit market instrument as a percent of bolh disposable
personal income and current dollar GNP As it shows,
both measures of liquidity reached a high in the 1977-79
period and has since declined. Indeed, deposits and
credil market instruments as a percent ot GNP was lower
during the first quarter of this year than was (he case during the highly illiquid 1974 crunch period. The lack of an
oi/erabundance of liquidity in the economy has been further mirrored in Ihe rate of growth of M-2 plus other liquid assets thus far this year. Specifically, afler growing at
an average annual rale of 10.5% during the 1977-79 period, this measure of liquidity slowed to 9.1% in 1980 to
an annual rale of 9.5% in the first quarter of this yeai
and to less than 7% in April and May. This stands in
sharp contrast to the acceleration tn M-2 growth over the
comparable periods.
Table 111
Net Changes In Bank Related
M-2 and M-3
IS Billions At A
nnud Rs '3
M-Z
Nun MHF
M -»
f**r*od
1974
1975
1976
1977
1978
1979
1980
1981
IQ
ffQ
PjnoJ
1974
1975
1976
1177
197H
1979
I960
198 1
IQ
IIQ
fe MI -A
$11.2
12 6
17.1
23 4
23 2
N*t
C*»jift
In Oth.
Ctiat^B
I.SHT
Chut>
InRH.
HP1,*
Egm.
Check.
Dgft.
$ 0.1
0.7
16
14
4.2
-0.1
5.4
4.2
34
- 1.4
- 5.1
- 5.6
11.2
18 1
ii4
10 1
6.4
S- 2.3
59.3
70.9
42.2
8.0
- 8.6
-51.9
-812
• 1'tf,
119. 2
563
-54.8
-92.4
M-3
N«
NCI
Cb.net
Nfl
Quiw
1°
<Jua*<
TnmRP'i MMFCD 1 L«*
* EiirM. Holding. Tl
-_
_
19.1
09
-17.8
71
19.0
79
11.4
57
335
b4
284
0.1
-15.5
6.8
17 1
•4.S
-6.5
Nil
N«
Ml-B
(Vef
CH*fig>
Ufa
19
54.4
-22. 4
_
Tcul
M-3
Cbanflc
Tn
Tool
Non-MMF
M-2
S 9.0
72.5
95.0
71.2
38.8
1S.5
-*>.5
-22.4
-440
fouf
C"aa_
NMCjuusc
_
_
-18.5
-10.7
26.9
50.6
33.9
a4
MD
84.3
981
894
49.4
-32.1
505
-22 1
28.1
-66.1
money market funds, as. is indicated in Ihe lovuet hall of
(he (ab!e. Still, even with these other sources, the institutions experienced a net outflow of $32.1 billion in 1980,
a net gam of $28 1 billion in the first quarter and an outflow of 566 1 billion duiiny the second quartet. In effect,
the bloating effect of the interest rate factor since 1979
has masked the fact that a respectable amount of aciual
disintermediation has been underway—and has dramatically accelerated over the past several years.
M-2 As A Proxy of Overall Liquidity
In The Economy
Table IV shows shitting financial asset preferences of the
household sector since the mid-1970's During the last
period of cyclically high interest rates in 1973 and 1974,
for example, over one-third of the acquisition of liquid financial assets were in lh« iorm of credit market instruments—primarily in U.S Government securities. As
rates came down in 1976, on the other hand, funds
flowed back into the banking system and credit market
instrument holdings declined to about 15% of all such
assets. In 1979, as rates once again began la rise sharply.
Conclusion
A substantial portion of rapid M-2 growth throughout th*
major portion of 1980 and thus far this year seems to be
more reflective of recent Institutional changes in the fl-
12
164
Tabk IV
Breakdown Ot Liquid Financial Auct HottUmgm
Of The HoutehoM Scctoi
(1 Bllhons Al S <\ Atfrniri RaUs)
r*w-i<.*
Prrlod
ClHltt Mkt.
l»H llama
W7S
1974
19?r>
]97<i
W)
1-I7S
I ').-'>
IIHTJ
IU6.3
1M4
ll«y
IQ
JivtroAMfU
146 1
S386
38 S
TO&
ZZ7
16H.5
.16 <i
lf«4
W.I
£11 1
I')7Q
HI 5
JO 6
199 ]
123 5)
<<Miinfcmii _rn B
HofToul
33 1!%
McnwyNU.
Fwid*
5 -
0%
23
1.1
0
Olhef
Dwrvrt*
977
:w M
JMe
3'L 4
16 3
155
?•);!
148
632
8SO
12*. 2
131 S
12.'i 4
•Jft 2
1372
(1181
1484
745
74.2
372
?r. 5
155
217
nancia! system, shitting household investment preferences, definitional roni[derations with regard to the
agijrt?g;ites nurf historically hkjh interest rate;. It has not
in our uit'u;. s^iveii as an accuiale or reliable proxy of the
availability of r.e* lendablc funds in the financial institutions or overall liquidity in iVie economy As such, continued emphasis on this aggregate as a determinant of
monetary poJiry ove* the quarters ahead would only inSure its continued iap«i giowlh and lofty interest rale
levels <irnl a sustained pyvioci n( economic stagnation.
Such a policy would seam to us to be ill-advised
Initt't'il blind puisuit of such established Teirgeis lhal
were *.(.•( tony before (he Fed had any inkling of recent
ilevi'lopmoiils u-oiild jppcaf enWtly iiuitk-ss This Is the
case since the most rapidly growing cotnponents of M-2
recently are those completely outside f>i the Fed's direct
control and their growth is being fostered — not cuii.iilcit K' hi'ih inlercst r.ilei and .1 restTiclwp monelaru
poky A].>iijj these lunjs. ii is ,i widely acwpwd iact ot liicin teritr.il banking circles lhat the hroadet lh? aggregate,
lha less Jirccl control rwer il is capable ol Uiinij exeTled
ll is Siccnuso of this that the Fed hili pursued a policy oi
controlling reserves under ils operating procedures established iii October 1979. Measured in these terms, thy
Fed ha«i been light since the end of last year indeed.
Sinco that time, total reserves have grown at a meager
1.1 '& annual rate and n on borrowed reserves haue actually declined at an annual rste of 0.7%
GiveTi this coiistdeialiOTi. one u/ou'd certainly question the reliability of "arow" M-2 growth over the Same
period <ii a proxy of the stance and as a guide to the con
duct of monetary policy These measures combined with
sluggish Ml-B growth ovei the (itst fieli oi 1981 seem
more consistent with the recent iweakoess in interesl-rale
adjuM.'d — not gross-M-2 gfowlh. Perhaps the Fed
shouU ink*- Ihfse two measures into acicounl m tslablish
ing targets arid gauging the impact of its policies. This
Woulti riirtnte a lou/er interest-adjusted a.tid a highfr
gloss M 2 large! ranije ihii! is currently being puisued
Whan all is said and done, therefore, the conduct ot
monewjy policy on the basis of Ihe performance o! a sin-
HoKvMkl.
FiuHliAii
% rfTfftat
CwtH MIct
CndllMkt.
2,4
13
-
n
n2
b.1*
S7
O<bnDtp«m
^»« % i4
fel.l
810
60.5
:VJ3
733
,145
7M2
(.SS
r
4> I
i.'J6
gle measure of money supply —whether il tre MV-B or M2 —carries with it suhstantiai risks Tliese risks have not
Iven fully appreciated by those in the nionetaiisl tsrnp
who heivi; claimed through Ihe years (tint the simple way
to achieve sustained economic growth and reasonable
price stability is through the establishment of an apprormate steady path of 'money supply" growth.
As a result, there is no getting away from the fact that
monetary policy is more an art than a science As such,
any one monetary measure musl be complemented by
orher measures of money, reserves, the overall level of
interest rales. Ihe slate o( ihi> economy and inflation and
inflationary expectations in the formulation of monetary
policy. It is upon all of [hew faUois —noi jusl a single criterion—lhat the success of lack thereof of the Fed's policy
stance should be gauged. Using this broader criterion,
the Fed has been anything but expansionary since November 1980 as has been siHjqestecl by vapid gross M-2
ijiuwllt A-, ,i re»ull, Prtt policy rws l»-cn wijnrficunlty
more creiiihle than skeptics apparently jwiceive.
Table V
Relative Measures Of
Liquid Financial Assets
(1 BiU«ins Al S.A Annual Rales)
Period
1^73
Llg. F>n. Audi
A. •» ijl DPI
1974
H5%
66
u75
81
1976
104
1977
1478
1979
1^80
1981
IQ
Llq. F D.A«<U
A.^ UIGNf
88
7 J
7 '!
12 9
fib
Hji
H7
H7
IO.M
7 ft
103
7U
128
12.9
165
Mr. MAUDE. I need not elaborate here on the dismal economic
performance that has transpired since 1979. A lot of those were alluded to this morning in terms of the state of illiquidity—and I am
departing from the text—in terms of the state of illiquidity in the
corporate sector, the fact that fully 85 percent of all S. & L.'s now
who open their doors are losing money each day because of the
negati/e spread of IVb percent. The farm sector—we all know how
serious the situation is there. We know that we've been in a recession, or practically in a recession, for almost 3 years, which is unprecedented in post-war history. Production is lower now than it
was 3 years ago. The gross national product, even with the increase
that we got for the second quarter, which is illusory, I would suggest—we are looking at an economy which is really, really in dire
straits.
If you look at the corporate sector, the balance sheets are more
liquid than they have been since the Depression. We already know
that bankruptcies are at depression levels.
SERIOUS CONTRADICTIONS
With the confluence of these situations and the fact that inflationary psychology has been snapped hi the bud, at least temporarily, in the commodities markets, in terms of labor negotiations—it
seems to me, as recently as last year, that there were some very
serious contradictions going on.
This became even more clear to me during the first half of the
year.
We're looking at a situation where we were in the eighth
postwar recession. We're looking at a situation where inflation had
been decelerating very dramatically. We're looking at a situation
where we were getting depression levels in housing and autos and
all this illiquidity, and yet, all along, for the first 5 months of the
year, we had all these situations at the very time that the Fed was
having to maintain a restrictive policy because the stated rate of
growth of Mi and the stated rate of growth of M2 was running
above targets.
Something had to be inconsistent there. You don't have money
supply in terms of what it's supposed to measure and what it has
measured in the past, going above targets during a period when
you've got these economic events going on. And it led me to do a
little bit of work.
In terms of Mi, for example, and there's a lot of importance on
Mi and Ma—I heard it mentioned more here today than I have a
lot of other hearings, but it's important in terms of the rational expectations in the credit markets. When the Fed sets a target for an
aggregate and it fails to hit that target, it does risk the chance of
losing its credibility.
I was very disturbed to a certain degree to hear Chairman
Volcker indicate that he was willing to tolerate Mi growth above
target. I am agreed that they have to be accommodative. But I
think that there are technical things that Chairman Volcker can
do and the Fed staff can do to take away that risk of credibility
loss and still allow them to be more accommodative.
166
My studies in Mi, for example, have shown that MI has really, if
you make the proper adjustments and you try to measure transaction balances, which is what Mi historically has measured, if you
make the appropriate adjustments out of the stated Mi, you probably will have found out that all through the first half of the year,
Mi has been growing at the lower end of its targets.
Now I make that conclusion on the basis of two criteria. You
know last year, the Fed, because of the nationwide introduction of
NOW accounts, the Fed initially allowed for an adjustment to Mi
by shift adjusting that proportion of NOW accounts or other checkable deposits that they presumed through survey came from savings accounts, in order to net out savings money from Mi.
They did that all last year. During the spring and the summer,
this big surge in the demand for people to shift money into NOW
accounts started to wane. Other checkable deposits started increasing by a modest amount every month during the summer.
So at the end of the year, the Fed assumed that that had transpired and they went into an Mi definition without distinguishing
any more how much of that M, was coming from other checkable
deposits.
I don't know why they did that, because starting in October,
there was a renewed surge in other checkable deposits. I've got a
table indicating that in my statement. And what you'll find out is
that if you take the MI increase from October, which is when we
had the major acceleration, you'll find out that 86 percent of that
increase was in the form of other checkable deposits, or what
Chairman Volcker refers to as NOW accounts.
Now in my mind, given the fact that the economy had hit the
low point or actually, was declining rapidly, consumer confidence
underwent a sharp contraction in November and December. In my
mind, a lot of this buildup in Mi was due to the fact that people
were scared. They were not letting their money roll over in 6month money market CD's.
I can assure you—I have done the work on it—the data flows in
terms of what happened to savings deposits and money market
CD's shows that there was a major move out of anything with a
fixed rate obligation or a fixed maturity obligation because people
were getting scared.
So I think a lot of the Mi buildup in November and December,
and I think it can be justified on a careful analysis of reserve and
savings and demand deposit flows, and I think that that has done
this internally.
They couldn't make the proper adjustment and I guarantee you,
Mi was not growing above targets, Mi that we used to know as a
transaction balance measure.
I am kind of perplexed that the Fed has not deemed it worthy to
go back to making these appropriate adjustments and announcing
it to the market. So I think that that makes a lot more sense than
merely indicating that we're willing to let money grow above targets. Explain why you are, come out with adjusted numbers that
the markets can look at.
167
M2 GROWING ABOVE TARGETS
The other anomaly that I found out, especially during the spring
of last year, as we were starting to slip into the recession, was that
the Fed was adhering to a very tight policy during the spring and
summer of last year. M, was growing way below targets. Why were
they adhering to a policy? Because M2 was growing way above tarCLS.
gpf"Q
That led me to look at something else which I found very perplexing. If you take into account the fact that we've had major institutional changes over the second half of the 1970's and the fact
that back in 1974, 1 percent of M2 was earning a market-related
rate of interest. As of last year, 47 percent of M2 was earning interest.
Now this interest being credited to the accounts and being rolled
over is not net new money being created by the monetary policy;
it's merely money being shifted from a bank's capital or a bank's
profits into an account.
I think the perfect example there is if you look at the S. & L.
flows—the savings and loans. Interest being credited there is being
taken now directly from capital. That's why you're seeing capital
erode every month that the numbers come out and it's going to
consumers. But that doesn't mean that this is net new money being
created by the Fed. But it is picked up by Ma.
And if you were to look more realistically, if you were to equate
M2 and all the monetarist studies, look at relationships based upon
M, of the last 50 years and even more, and M2 of the last 50 years
and even more, my argument is equate what we're looking at now
with what it was 10 years ago and 15 years ago.
What I did do was to go back and look at M-, in 1974, which had no
money market funds in it—it had small savings deposits—net out the
interest that was being paid, and come out with an interest-adjusted
M,.
Now I carry that through to the later years and obviously, the
interest-adjusted part gets larger. If you look at column 3, in 197475, the interest credited to M2, time and savings accounts, is $42.8
billion. In 1981, it was $135 billion. In the second quarter of this
year, it was $155 billion. This is just interest being credited.
So what I did was to take the stated M2 and net out the interest
and what we find is a completely different pattern of M 2 growth.
Instead of growing 8.5 percent in 1979, 8.3 in 1980, 9.8 last year,
and around 9.6 the first half of this year, if you adjust for interest,
you will find out that the pattern of M2 follows the pattern of the
economy over the past 3 years. It went from 4.3 in 1978, down to
3.2 in 1979, 2 percent in 1980, 1.7 percent last year, and roughly 1.7
percent the first half of this year.
I think if you look at the adjusted numbers, they tend to track
much more closely with what we've been seeing in reality. And I
think that these numbers have not been measuring what they're
supposed to measure.
I'm not refuting the relationships of what we used to know as Ma
with the economy in inflation and what we used to know as Mi.
What I'm merely suggesting is that appropriate changes have to be
made.
168
Let me just list a couple of proposals that I would make to the
Fed if I were capable of doing so.
First of all, I would refine those definitions of Mi and M2. Second,
I would continue, as Chairman Volcker has been doing, to follow a
policy geared toward looking at a number of aggregates and a
number of variables, not just slavishly adhering to an Mi or an M2
target. I think that bank credit should be looked at much more
closely than it is right now.
ELIMINATE "BASE DRIFT"
Another thing that I think is very important, and I don't want to
get technical, but this has been going on for a couple of years underneath people's noses without realizing it—I think the Fed
should be forced to eliminate the use of what we call the "base
drift." Now base drift worked to the Fed's advantage through the
1976-79 period. Merely what that means is the fact that if the Fed
overshoots their target in any one year, when they set their targets
for the year after, they use that higher fourth quarter base to calculate the growth rates.
So what they're doing is validating excessive growth in periods of
inflation when they overshoot the targets.
Likewise, if you look at the other side of the coin, last year the
Fed missed their targets. They came in below their targets. So
what that did was to cause the Fed to have to go through negative
base drift, which in effect meant it had to be substantially more
restrictive than it would have had to be.
So I think that an appropriate policy would be to have the Fed
go back each year they have to set—they have to use as a base to
calculate the growth rates for the subsequent year the midpoint of
the target for the current year. That will allow base drift either in
a positive way or in a negative way.
I think another thing that I would recommend, and I don't want
to join in with the administration on this, I would recommend that
they try to smooth out their operating procedures. I think if you
look at the chart on page 11 of my presentation and look at the
rollercoaster course in nonborrowed reserves, which is the broken
line, and the rollercoaster course in Mi, you'll find out that had
they tried to smooth out their nonborrowed reserve provision,
which is what they target, you could have had a much smoother
course of money supply.
I think next to finally the Fed ought to immediately institute
their practice of publishing 4-week moving averages of Mi. I don't
know why they haven't come through with that. With all the gyrations in money that we saw in June and July, that was an appropriate time to do it. My studies have shown me that they would
reduce the volatility on an average by more than 1 billion if they
would do something like that. It's not that difficult a thing to do.
Why are they dragging their feet?
Finally, another recommendation which I think is worthy of consideration—I know the monetarists will kill me for this—but I
think it might be an interesting exercise to see what would happen
if the discount rate were geared toward some rate of inflation. For
example, the 12-month moving average of the personal consump
169
tion expenditures, maybe 2 or 3 percent above it. It would not put a
control on the Fed funds rate, but at least on the discount rate it
would be sensitive to inflation.
If that were intact in 1980, I doubt that we would have needed
credit controls because the discount rate would have gone up to 20
percent. And that's the floor on the Fed funds rate. The funds rate
would have gone even higher. I think you would have had the recession, or at least a slowdown, long before we had to put on credit
controls.
I think, by the same token, if it followed inflation, if it followed
the deceleration we've seen over the past year, I don't think you
would have seen the economy as weak as it is now, either, because
it is a floor.
I don't say control the Fed funds rate. Let that still operate according to the supply and demand for reserves. But the discount
rate does have an influence. And to the extent that that could have
brought it down, that may have helped. And to the extent if the
Fed does enter into a new inflationary posture, they have no
choice. The discount rate has to go. It would be changed every
month with the release of the personal consumption expenditure.
With that, Mr. Chairman, I'll conclude.
The CHAIRMAN. Before we turn to Mr. Olsen, let me just say on
your last three comments, on the nonborrowed reserves, the weekly
reporting and the floating discount rate, I badgered the Fed about
that for at least the last 3 or 4 years. They've never come here to a
hearing that I didn't ask them why they didn't do those things.
So I can't answer why they have not. But on those three points, I
certainly agree with you. The mechanics of handling that would Joe
much better if they would change their procedures.
Mr. Olsen?
STATEMENT OF LEIF H. OLSEN, CHAIRMAN, ECONOMIC POLICY
COMMITTEE, CITIBANK, N.A.
Mr. OLSEN. Thank you, Mr. Chairman. I welcome this opportunity to share with you some of my views on monetary policy and the
economy.
I have submitted a very brief statement that is well within the
confines of the 10-minute limit on witness' remarks and I would
like to go through it rather quickly.
The CHAIRMAN. Our problem is not controlling witnesses; it's
ourselves that are hard to control. [Laughter.]
[The complete statement follows:]
170
Statement by
i*il H. Olsen
Chairman Economic Policy Committee
Citibank, N.A.
Mr. Chairman, I welcome this opportunity to shore some of my views on
monetary policy and the economy.
There is today a very considerable concern about the high level of interest
rates. There are many people who believe these interest rates are high because
the Federal Reserve is pursuing an overly restrictive monetary policy. This
reasoning leads to the conclusion that interest rates could be reduced rather
quickly if only the Federal Reserve would adopt a more expansionary monetary
policy. In my opinion, Mr. Chairman, this proposition is invalid and it could
lead to serious mistakes if it becomes the rationale
for a change in Federal
Reserve policy.
The primary objective of monetary policy is not interest rates, but
income. Changes in the rate at which the money supply grows, together with
its velocity or turnover, determine increases in the money value of all output of
goods and services in the United States. Or to put it another way, the growth
of the
money supply determines the rate of increase in dollar income.
Over the past four years, the monetary authorities have sought to slow
the average growth of money income in an effort to reduce the rate of inflation.
In this regard, the monetary authorities should be credited with success in
reducing inflation from 9-10% in 198i to an estimated 6-7% in the current calendar
year. Inasmuch as the Administration has explicitly supported this objective of
monetary policy, it, too, should be commended for the cooling of inflation.
Inflation in 1976 averaged only 5.2%. By 1961 inflation, as measured by the
GNP deflator had risen to more than 9%. But this year inflation is expected to
average only 6-7%. Achieving this reduction in inflation has not been pleasant.
171
Real output has not increased since the first quarter of 1979.
The year-long
recession that began in July 1981 partially explains this stagnation in physical
volume of production.
But monetary policy, on average, has achieved a slowdown
in nominal income in these past three years and because of the imprecision in
the execution of monetary policy, it also produced the recession that we are
now suffering.
Clearly disinflation is not painless.
But I would quickly point
out that returning to inflationary monetary policies is hardly a painless alternative.
And there are some measures which could to help to mitigate the distress of
the from high and accelerating inflation to decelerating and lower inflation,
Ambiguity regarding both the near-term and the long-term course of
economic policies sharpens the pain of disinflation.
For example, there are
employed people who are so thoroughly convinced that efforts to combat
inflation will fail
that they are seeking very large wage increases to protect
themselves. The political cost of ending inflation, they reason, is too high.
Their large wage demands, if met by employers, can only be sustained in these
times of weak demand by trimming the total wage bills through layoffs.
The
lucky ones who retain their jobs have higher wages but at the expense of
increased unemployment.
Businessmen are also plagued by uncertainty when they look at the
abortive antiinflationary efforts that litter the political lan<3scape of the past 15
years. Why, they ask, should this episode be any different.
It is only a natter
of time before monetary policy will have to yield to the political pressures for
the reacceleration of money growth.
And the financial markets continue to
behave as if they expect that inflation will accelerate once again in the years
ahead. The unwillingness to buy long-term bonds is a manifestation, not only of
the losses that have been
inflicted
on investors by accelerating inflation over
the past 15 years but the fear that this history will be repeated.
172
Are these fears and uncertainties justified? Look at the debate over
fiscal policy alone. The refusal to reduce government spending sufficiently to
achieve a meaningful reduction in the federal deficit is used to support the
belief that inflation wiU accelerate again.
I recognize that substantially higher
taxes could also reduce the deficit but such an increase in taxes is not as
beneficial as cutting spending.
Higher taxes finance higher levels of federal
spending, and higher spending is associated with higher inflation.
In the heat of
political debate partisans quite naturally seek to intimidate opponents whom
they believe to be responsible for the distress and the pain caused by efforts to
reduce inflation.
But members of Congress should be mindful that such debates
only serve to convince the people that inflation will soon accelerate. Congressmen
are often quoted word for word by members of investment policy committees
who are arguing against purchases of long-term, fixed-rate government and
corporate bonds. People in the financial markets are not unmindful that
government is issuing long-term, fixed-rate bonds to finance current consumption
of those Americans who are beneficiaries of the various federal transfer programs.
The failure to acknowledge explicitly that it is the intent of policy to reduce
inflation permanently is feeding cynicism. And that cynicism is heightened by
partisans who are intent on raising the political costs of fighting inflation.
A Congressional resolution providing explicit bipartisan agreement that
monetary and fiscal policies are engaged in a long-term effort to reduce inflation
and that this policy will not be reversed, as it has been so many times in the
past, would do a great deal to reduce the uncertainty about the political will
and ability to reduce inflation.
Such a resolution should acknowledge that this
effort began in the Carter Administration and continues in the present Administration.
Those members of Congress who see no need to persist in the program of
disinflation could, vote against such a resolution.
But it would provide the
173
American people with a. clearer intent of Congress in supporting
or rejecting
the long-term efforts, particularly of monetary policy in reducing the rate of
inflation.
Monetary policy has been successful in trimming the average rate of
growth of money and all money income over the past 3 1/2 years. But it has
achieved this slowdown with disturbingly wide swings in the rate of growth of
money which were reflected in the performance of the economy.
The swings in
the rate of growth of money that are troubling are not week to week, or month
to month, but those that occurred ovur six to nine month intervals or, if they
were of shorter duration, of unusual magnitude.
Money supply contracted by 3% at an annual rate in the second quarter
of 1980. The imposition of credit controls contributed significantly to this decline.
It was then followed by an increase of about 15% at an annual rate from early
July through mid-December of that year. And from April to October of 1981
there was no increase in the money supply.
As « consequence, the economy
contracted by siightly more than 1% in money terms and by nearly 10% in real
terms in the second quarter of 1980.
It then recovered at an extraordinarily
rapid rate, culminating in a nearly 20% increase in mney terms and nearly 9%
in real terms in the first quarter of 1981. These percentages are all at annual
rates. The economy declined in real terms in the second quarter of 1981 by
1.6% at an annual rate, rebounded very moderately in the third quarter and then
declined very sharply in the fourth quarter of 1981 and the first quarter of 1982.
174
What we have is the evidence of volatile money and a volatile
economy.
The very sharp acceleration in the economy in the second half
of 1980 raised inflation expectations particularly in the financial markets
but elsewhere as well.
It discredited the anti-inflationary economic policies
and that damage is still being repaired.
So it is highly desirable, in restoring
the credibility of policy, to achieve a more stable and persistent path
far both money growth and economic growth.
It would be very damaging to the anti-inflationary effort and to
the long-term credit markets in particular if monetary policy were suddenly
to become highly expansionary in a vain effort to extricate the economy
from its present predicament.
Some increase in money is desirable, but
a sharp and prolonged spurt would be destabilizing.
Focusing on the current situation I would begin by noting the increase
in money supply that occurred in October of last year through to mid-January.
It grew at an annual rate of about 15%. The economy has yet to reflect
the stimulus of that increase,
it was muted by the decline in the turnover
of money in the first quarter of the year.
The secular or normal trend
of velocity currently is estimated to be at about 4%.
With a return to
this more normal velocity, we could expect the economy to grow in money
income terms — nominal GNP — at about 9-10% beginning at some point
in the months immediately ahead.
However, since mid-January there
has been no increase in the money supply and were this to persist through
the third quarter, the recovery would be stifled.
What I am saying is
that some increase in the money supply is clearly necessary bringing it
along the upper end of the Federal Reserve target path of 5 1/2% from
the fourth quarter of last year to the fourth quarter of this year.
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It appears that the economy for the month of June was below the
average for the second quarter.
If July does not exhibit a relatively strong
upturn, it will be difficult for the third quarter average of real economic growth
to run above the second quarter-
Anecdotal information from retailers suggests
that July business is not doing very well.
To put it into more technical terms,
velocity or the turnover of money does not yet appear to be accelerating.
furthermore, it appears that money supply in July is likely to decline unless
the Federal Reserve moves more aggressively to reduce the federal funds rate
in order to achieve an increase in bank reserves and money. That seems to be
happening now with the announcement of the reduction of the discount rate of
one half of one percent. It appears that the underlying demand for credit
in the economy by ail borrowers — households as weil as businesses — is diminishing
and had the Federal Reserve persisted in pegging the federal funds rate at
an unsustainably high level, it would as a consequence have intensified the
drag on monetary growth.
Recovery in the economy, incidentally, will help to lower short-term
interest rates. Improved corporate earnings and cash flow will diminish the
need for leaning heavily on short-term borrowing.
It has been particularly
distressing to many corporations in this recession that the bond market has
been so inhospitable that persistent fears of inflation continue to haunt
portfolio managers. The heavy reliance on short-term debt at a time of
declining corixirate profits has reduced the liquidity of corporations.
Prolonged recession would exacerbate this condition and further jeopordize
the credit worthiness of many companies.
Consequently, economic recovery
becomes rather important as we move through the third quarter.
1 believe that a recovery will take place. I believe that the velocity
of money will begin to increase.
Consumption spending will strengthen as the
summer ends as a result of increased disposable income arising out of the
tax cut, and finally I believe that the monetary authorities will succeed
in holding the rate of growth of money at the upper end of their target
range,
A 5-6% rate of growth of money supply coupled with a 4% velocity
should give us 9-10% nominal income.
And the persistence of the Federal
Reserve in holding to its targets will help to enhance its credibility in the
financial markets,
ff Congress explicitly supports the Federal Reserve
in that effort by additional reductions in the federal budget, simultaneously
with the recovery, confidence would be greatly strengthened.
176
Mr. OLSEN. Thank you, Mr. Chairman.
The CHAIRMAN. Thank you, Mr, Olsen.
After listening to a lot of witnesses and reading a lot of statements about monetary policy and the vast differences of opinion
that you can get, I'm not really going to delve into where we ought
to be and what, exactly, the discount rate ought to be. But I'd like
to ask you, Mr. Olsen, if you agree with Mr. Maude and me that,
structurally and internally, the nonborrowed reserves, the reporting of Mi and things that I was complimenting Mr. Maude on because I agreed with him, do you agree that the Fed could do a lot
better job specifically in some of the mechanics, and whatever targets they picked and all of that, be able to smooth out the handling
of the money supply?
Mr. OLSEN. I do believe that there is more that they could do. In
my prepared remarks, partly to be brief, I pointed to the undesirable volatility in the rate of growth of money and the high volatility
in the performance of the economy as a consequence over the past
3 years. And I do believe that additional steps taken earlier could
well have avoided a good deal of that degree of volatility.
CONTEMPORANEOUS RESERVE ADJUSTMENT
We now expect to see the introduction of contemporaneous or
near-contemporaneous reserve adjustment next year. The Federal
Reserve has decided to proceed with that. One of the haunting
prospects is that some years later we'll look back and it will have
made a contribution to a more stable policy and you'll wonder why
wasn't it done 2 or 3 years earlier instead of debated for such a
long time?
The CHAIRMAN. Yes, I wondered that. You can go back in the
hearing records and over and over again, I didn't understand why
they were on lagged reserve accounting and didn't go to contemporaneous reserve. I never could get any satisfactory answers. We
never did have any witnesses that did not agree that reporting
weekly Mi figures was ridiculous, that they were meaningless, they
weren't accurate.
I was at an international monetary conference in London. Everybody I talked to said it's silly and I said, why do we do it? So finally, they've decided they're going to get off that; yet, they haven't
implemented it yet. They've announced that they would.
So I don't expect any magic or any great changes as a result of
these, but I think that they would be very helpful, at least.
Let me ask you, Mr. Maude, a question. One thing that disturbs
me, and you've heard me enough even earlier today saying where I
think the major blame is. Without question, it's with the Congress
of the United States because the Fed can't fight inflation alone. If
we had had a more restrictive fiscal policy, then the Fed wouldn't
be a target. Everybody would probably be saying, gee, the Fed has
done a marvelous job. They simply have to be coordinated to go
hand-in-hand. And yet, over and over again, over the past couple of
years, I have had people say, if Congress will just do this. And I'm
saying this in the context that we have not done enough.
But in January 1981, no one would have believed that we would
take $14 billion out of the 1981 budget and $36 billion out of the
177
1982 budget. We performed, relatively speaking, far better than
anybody else and there was no response.
You can go back to Chairman Volcker before this committee and
say, well, if Congress will just do this, then this will happen.
Now as I said earlier, they've all been wrong, but how much is
enough? Either one of you can respond. How much is enough to get
some response in the market on fiscal policy?
Mr. MAUDE. I think you've got to show direction and I think it's
got to be convincing, I think the financial markets have been battered around for so many years with resolutions which, as former
Treasury Secretary Simon said, have really never been worth the
paper that they've been written on.
It's going to take more than resolutions. It's going to take you
more than
The CHAIRMAN. Let me interrupt you there. I agree. Passing
budget resolutions that are not implemented, passing one in the
summer of 1980 that said we're going to have a $200 million surplus was nothing but a 1980 election year document. I agree with
all of that.
But in this case, there was a difference for the first time in $50
billion of already-appropriated money, not reductions in future appropriations. It had already been appropriated in those 2 budget
years and was rescinded.
Now that hadn't happened. So I understand the rhetoric of the
years past and the unkept promises over and over again. And if I
were in the money-lending business, I'd say, hey, those guys never
tell the truth. But we've essentially had no response from a dramatic turn-around, even though not nearly enough. But $50 billion
was not a resolution. It wasn't a statement. It was removed from
existing budgets.
Mr. Olsen?
Mr. OLSEN, The answer isn't a simple one, but let me go back a
little bit in history. Apart from the fact that accelerating inflation
over the past 15 years eroded the value of fixed-rate obligations,
the acceleration in money growth in the second half of 1980 appears to have been particularly damaging to the credibility of the
fight against inflation.
We saw bond prices plummet and long-term interest rates, including mortgate rates, rise very rapidly in the second half of 1980.
In the winter of 1980-81, in debates held around the investment
policy committees and finance committees of countless financial
firms across the country, the dominant view that emerged was that
long-term fixed-rate lending had lost its economic legitimacy.
There were explicit decisions to substantially back away from
the purchase of such investments, in some cases, in totality. Those
resolutions continue to hold at many of those financial firms.
FEDERAL DEFICITS
That was before, incidentally, the size of the present Federal
deficits were even known. At that time, the deficits that were then
being viewed were somewhere in the neighborhood of perhaps $50
or $60 billion, not well in excess of $100 or $150 billion.
178
When those budget deficits came along, even though we have
had a cooling off of inflation, those budget deficits are being employed to continue to support the argument that fixed-rate, longterm lending has no legitimacy.
The CHAIRMAN. Let me play the devil's advocate on that point
because you know that's what I'm doing because I cannot be considered anything but a fiscal conservative and I'm sure that you're
aware of that. My voting records and attitudes on budget deficits
have been very clear for a long period of time.
But as a percentage, GNP, all sorts of other measures you want
to make, these deficits, in real terms and those relative comparisons, aren't any bigger or as big as many others in past years. And
yet, there was not this response then. There was high inflation,
higher than now, and bigger deficits, relatively speaking.
And I'm not using that argument to defend these. I'm not one of
those who says there's a smaller percentage
Mr. MAUDE. I think there's one key difference. There is one key
difference this time around which is troublesome. In the past, deficits were cyclically-induced and they always occurred the latter
stages of a recession and at the beginning of the recovery. Theoretically, even though history doesn't show that it worked out this
way, because spending kept on increasing rapidly, but theoretically, as the economy picks up, you could look forward to the possibility of, if not a surplus, at least a dwindling deficit.
Now with the 3-year tax cut in place and with the indexation of
tax rates going onstream later on in 1985, now the markets are
looking at deficits that are increasing year after year during a
period of time when very strong economic growth is projected as
well. And that can only bring forth a clash.
The CHAIRMAN. We've only had a balanced budget once in the
last 22 or 23 years. So if they were expecting surpluses, they were
awfully naive.
Mr. OLSEN. Let me offer also an answer to your question. The
budget deficits of 1975-76, as ratio to GNP or whatever measure,
were as large as the deficit that is occurring this year and would
occur next year. We made those relevant measures, incidentally,
and we have even made the arguments, pointing out that interest
rates fell in 1975 and 1976.
The decline in long-term interest rates in particular in those 2
years, in economists' terms, reflected the fact that portfolio managers had declining inflationary expectations, or at least they weren't
increasing. And one of the reasons why was because we came out
of the 1974-75 recession with a decision on the part of portfolio
managers to increase the proportion of bonds in their portfolios
and reduce equities because equities had gone through such a bad
time in the 1974 recession.
So they bought bonds for 3 years, raising those ratios and it reflected, in fact, that they weren't that concerned about inflation.
The Secretary of the Treasury in those years had the good fortune of having to finance a deficit into a market that was extremely hospitable in which inflationary expectations were not particularly high because of the recent past history did not give them
reason to have a great deal higher inflationary expectation.
179
The present environment is different. In the present environment, the portfolio managers have very high inflationary expectations. The present deficit has to be financed into a market that is
not hospitable at all.
Additionally, as Mr. Maude has pointed out, if I can add one
point to it, in the past, either explicitly or implicitly, everybody
knew that monetary policy would become more expansionary in
order to bring about a strong recovery in the economy. Rising revenues would reduce the deficits. Less well known was that ultimately, inflation and bracket creep would not only diminish the
deficits further, but, as a matter of fact, give additional funds to
support increased spending very substantially over time.
In this case, monetary policy is clearly committed to a moderate
course and will not finance a rapid recovery in the economy in
order to cause deficits to melt. And that's something else which the
financial markets are aware of.
This fiscal policy hasn't gotten on board to fight against inflation. Monetary policy has. And that's why the financial markets
are distressed.
The CHAIRMAN. Well, I agree with you there. I made that point
over and over again, that we have not done our job in Congress,
have not done our part in trying to solve the problem.
BALANCING THE BUDGET
But one of you mentioned the tax cuts that are in place. It seems
to me that when you're trying to balance the budget, that there are
two ways to do it. Obviously, you can cut spending or you can increase taxation. When you're looking at the capital markets, however, and the available venture capital, investment capital, for
whatever purpose, it doesn't seem to me to make much difference
whether you're out borrowing it, except for the interest cost, or
taking it away from the people in the form of taxation.
So to those who want to do away and cut the tax cuts, when even
after them, we're still being taxed at one of the highest levels in
the history of this country, far higher than traditional levels, that
that isn't an answer at all to try and reduce the pressure on the
markets because of these large deficits by taking the money out of
the pool of available capital through taxation rather than through
borrowing.
Now I agree, borrowing is worse, but not a lot. Except for your
interest costs, which adds to the deficit. But still, it's not going to
be available for long-term capital investments if you're taxing it
away.
Mr. OLSEN. You're absolutely right, Mr. Chairman, and in addition to that, you haven't cut the taxes if you are financing the tax
cut with borrowed money. You only cut taxes when you cut spending by the amount that you've cut taxes. You can just as well send
the taxpayer a postcard the day after he gets his tax cut and ask
him, would you please lend us back the money that we just gave
you?
You're absolutely right in your description of that and Congress
and the administration, to the degree that they're not reducing the
deficit, they really haven't cut the taxes.
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And there was another point I mentioned in my
The CHAIRMAN. We haven't cut taxes in any event with the
bracket creep and the increase in the social security taxes. In real
terms we haven't cut them, let alone what you're talking about.
Mr. OLSEN. Not if you're going to have to borrow the money to
finance the deficits over time.
The CHAIRMAN. Let me ask you this question. What do you think
the condition of the economy would be today, regardless of all of
the comments that Reaganomics is failing, supply side economics is
failing, if we had gone on with that additional $50 billion of spending—and I'm talking about budgets where it was rescinded, where
this is not prospective. This was done and those budgets were already there and we rescinded that kind of spending.
What would the economy be like today?
[Pause.]
Ronald Reagan doesn't exist. Supply side economics didn't exist.
We just continued on that path, spent that additional $50 billion?
Mr. MAUDE. I was going to say Brazil, possibly, but go ahead.
Mr. OLSEN. Well, as a matter of fact, your question is fascinating
to me because as I heard Senator Riegle and Senator Sarbanes
questioning Mr. Weidenbaum so vigorously and characterizing the
distress in the economy today, I thought to myself, well, suppose
we had not attempted to fight inflation 4 years ago, but instead, we
had continued along the path in which inflation was now beginning
to accelerate rather markedly, and government spending was now
beginning to rise at a rather alarming rate. You were getting above
10 and going toward 15 percent and above,
I wondered if we were holding these hearings today and there
had been no change in policy and we would be looking at, say, a 15
percent rate of inflation at the present time and government
spending rising at 15 percent plus per year, whether you wouldn't
have had cries of distress throughout the country also, particularly
by all those people who are on relative fixed incomes, for example.
And in addition to that, with inflation running at that rate, we
would have substantially higher interest rates than we have today.
They would have been characterized as high nominal rates, but
they would have still been very high.
The CHAIRMAN. I'm not trying to be partisan at all because I
don't care who solves the problem, as I've said the last couple of
days and many other times—Republicans or Democrats, I'm not
much interested in that. But to say that supply side economics is
not working, regardless of who proposed it, I happen to think it is,
not nearly as well as I would like to. As I said earlier, I'm not
happy with 15 percent interest rates and the whole condition of the
economy.
But I do sincerely believe that had we not made some of these
changes, you would have had far more serious problems as well.
And the longer we avoid tackling the problems of the entitlements
programs and the transfer of payments because it's not politically
possible to do so—I pity future congresses, whether they're controlled by Democrats or Republicans. They will have a problem
that can only be much worse than it is today. I don't think there's
any doubt about that.
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SOCIAL SECURITY PROBLEM
The social security problem itself, forgetting the budget, the solvency issue has to be faced. Sooner or later, the day of reckoning
will come. And my colleagues on either side of the aisle that don't
even dare mention the word social security, let alone talk about
slowing the growth of it, boy, it's going to be a lot tougher—politically, economically, every other way, the longer that decision is
deferred.
But I guess politicians, as long as you can postpone something to
the future, you'll face it then rather than now, because I think we
have an obligation to all those people who are on social security,
totally apart from this argument of the overall budget, to make
certain that that system is solvent so that they will get their pensions and that generations who are now young and paying these
tremendously high taxes to support it, can expect that they will
have a pension as well.
The more I study it, I think we can blame the Fed and we can
blame Ronald Reagan and we can coin the term "Reaganomics"
and I think the major fault has to lie here in the Congress of the
United States. And I don't know how anyone can interpret it any
other way in light of the facts. The Fed didn't create that trilliondollar debt. It didn't have anything to do with it at all.
Presidents can recommend. We can blame them for what they
recommend, but we don't have to agree with what they recommend.
I get a kick out of blaming this President or any other because of
the deficits. I guess it's a tribute to their forcefulness that they just
coerced all us independent souls into voting their way because we
don't have to when we get over on that floor. We can vote any way
we desire if we have the courage to do so.
I just, as I said over and over again, feel very frustrated about
the prospects until Congress becomes part of the solution rather
than part of the problem because I think that most every other segment of the economy is trying. Management is. Labor certainly has
been attempting to contribute to the problem with unprecedented
cutbacks in their wages and fringe benefits.
It seems like very part of the team is trying to play, except Congress, and we're going on about our business as usual.
Gentlemen, I don't have any more questions. I do appreciate your
patience in waiting so long into the lunch hour. I hope that your
stomachs are not growling too badly.
But thank you very much for coming today. The committee is adjourned.
[Whereupon, at 1:07 p.m., the hearing was adjourned.]
FEDERAL RESERVE'S SECOND MONETARY
POLICY REPORT FOR 1982
TUESDAY, JULY 27, 1982
U.S. SENATE,
COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS,
Washington, D. C.
The committee met at 9:30 a.m. in room 5302, Dirksen Senate
Office Building, Senator Jake Garn, chairman of the committee,
presiding.
Present: Senators Garn, Riegle, and Proxmire.
The CHAIRMAN. The committee will come to order.
Today the Banking Committee continues the third day of hearings on monetary policy and we are very happy to have before us
this morning Beryl Sprinkel, Under Secretary of the Treasury for
Monetary Affairs.
Mr. Secretary, we will be happy to hear your testimony at this
time.
STATEMENT OF BERYL W. SPRINKEL, UNDER SECRETARY OF
THE TREASURY FOR MONETARY AFFAIRS
Mr. SPRINKEL. Thank you, Senator Garn. It's a pleasure to be
with you today to discuss the administration's views on monetary
policy.
This administration assumed office with the firm conviction that
the process of inflation is a major obstacle to vigorous economic
performance and expansion of individual opportunity. As a result,
a major part of the President's economic recovery program was the
call for a gradual deceleration of monetary growth to a noninflationary pace. The basis of this monetary program was and still is
the recognition that sustained inflation—no matter what may be
the initiating force—requires the accommodation of excessive
money creation,
Since that recommendation was made, monetary policy has
become the subject of much public debate and controversy. In the
process, the administration's views on monetary policy have sometimes been misunderstood and misinterpreted. Our views are actually very basic and straightforward, so I would like to take this opportunity to restate them as concisely as possible. In addition, I
will mention some things that we do not advocate, but which are
frequently attributed to us.
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VIEWS AND RECOMMENDATIONS
Basically, our views and recommendations can be summarized as
follows:
One, the primary cause of the accelerating inflation that has occurred in the United States over the past \Vz decades has been a
persistently excessive rate of money growth.
Two, reducing the rate of money growth is essential to controlling inflation.
Three, inflation, and the inflationary expectations that it generates, have been a major factor in the secular rise in interest rates.
Four, since inflation and high interest rates are an anathema to
sustained economic growth, noninflationary monetary policy is a
prerequisite to restoring the sound economic prosperity that we all
seek.
Five, the deceleration of money growth should be accomplished
in a gradual, steady and predictable fashion, in order to minimize
the economic disruptions and costs associated with moving the
economy from an established inflationary path to a noninflationary
one.
Now let me mention some views that many are attributing to us
that we do not hold:
One, we do not expect the Federal Reserve to achieve precise
week-to-week or month-to-month control of the money supply. They
do not have the power to do so, and efforts to try to do so would
likely prove to be extremely destablizing. We do believe, however,
that the Federal Reserve has the ability to maintain the average
quarterly rate of money growth within the announced target
range.
Two, we do not advocate the use of high interest rates to fight
inflation. High interest rates are the legacy of persistent inflationary money growth, not an element of anti-inflationary monetary
policy. Stubbornly high interest rates are the inevitable result of
letting inflation occur in the first place, A reacceleration of money
growth would cause further inflation and guarantee even higher
interest rates in the future.
Three, we do not believe that monetary policy is the source of all
economic problems, nor is it the cure-all for all ills. Prudent monetary policy is a necessary condition to achieve real economic
growth and prosperity, but it is not the panacea.
A year and a half ago we recommended that the rate of money
growth be slowed permanently. That recommendation is completely consistent with the stated policies and objectives of the Federal
Reserve. The target ranges for 1982, and those which the Federal
Reserve has tentatively set for 1983, are appropriate to provide for
both economic recovery and continued progress on inflation. The
Fed has made significant progress to date toward achieving noninflationary money growth, and we fully support their plan to persevere in that policy. Our support for prudent, noninflationary monetary policy has not changed or waivered.
To the contrary, the progress on inflation over the past year
should serve to encourage us all that the ultimate goal of a permanent reduction in inflation is within our reach, if only we continue
along the path of a sustained deceleration of monetary growth. But
185
if we succumb to the temptation to declare victory too soon, by mistaking success in the first major skirmish for a permanent routing
of the enemy, then we will not only prolong and worsen inflation,
but significantly reduce the chances of ever bringing it under control.
While earnest in intentions, those who counsel a return to the
quick-fix prescription of easy money are advocating actions that
are actually inimical to the very thing they seek—permanently
lower interest rates. Faster money growth would soon validate the
very fears which have been responsible for the maintenance of
high long-term interest rates—fears that the current slowing of inflation will be temporary. While there might be some immediate
easing of short-term interest rates in financial markets—and I am
not even certain of that—long-term interest rates would soon rise,
reducing greatly the potential for future output and employment
growth. Periodic calls for the Fed to loosen the monetary spigot
also serve to exacerbate the credibility problem.
For this reason, the administration supports the Federal Reserve's decision to maintain the existing money growth targets,
rather than giving in to the pressures to revert to inflationary
monetary policy. We would hope that the objective of permanent
elimination of inflation through a sustained monetary discipline
would be a bipartisan, national goal. It should not be allowed to
become an issue of partisan politics. Neither the administration
nor the Federal Reserve is happy about the level of interest rates,
and neither views these rates as a necessary evil in the fight
against inflation. However, the solution is not to sacrifice the
policy which is in place, but to assure the public that the policy
will remain in place.
The record of the 1970's clearly shows that a little more money
growth does not provide a lasting increase in production and employment. Any boost to production and employment that comes
from accelerating money growth is temporary, while the inevitable
permanent effects are inflation and higher interest rates. Accelerating inflation, escalating interest rates, and the resulting deterioration of the incentives to save and invest are, in fact, powerful
and pervasive deterrents to sustained growth. Also, it is folly to
trust that faster money growth would now result in more production because various segments of the economy are operating at less
than full capacity. The experience of the past 15 years should be
ample evidence that inflation is not a problem which arises only
when the economy is fully employed. Sustainable economic expansion requires a financial system based on a reliable dollar and that
means monetary discipline.
GRADUAL DECELERATION OF MONEY GROWTH
To some, perhaps, the administration's repeated call for a gradual, stable and predictable deceleration of money growth may now
seem trite or dogmatic. Let me assure you that it is neither. There
are very real, very important economic reasons why we have repeatedly made this prescription. That is, a deceleration of money
growth that is not gradual, not stable and/or not predictable has
very real, adverse economic consequences.
186
First, let me discuss the importance of a gradual deceleration of
money growth. After more than a decade of accelerating inflation
and rising interest rates, inflationary expectations had become
deeply entrenched in economic institutions and behavior. It would,
of course, have been technically possible for the Federal Reserve to
reduce money growth abruptly to a noninflationary rate. But it
was felt that such a sudden move would cause severe short-term
economic disruption and hardship. The gradual approach would
provide the public more time to adjust its inflationary expectations
downward, thereby minimizing the transitional costs in terms of
lower output and higher unemployment. The transition is drawn
out by this approach, but the immediate negative impact on real
economic activity is reduced. Specifically, we recommended that
the rate of money growth be cut in half by 1986—with a steady deceleration each year.
It would be naive to expect that such progress toward a noninflationary economy could be made without experiencing some economic hardship. Some of the disruptions associated with the transition to a noninflationary economy are of course being felt now.
These hardships are not to be dismissed. In terms of its implications for the long-run prosperity of the Nation, however, the importance of controlling inflation cannot, in my opinion, be overstated.
The hardships are temporary, but the damages of allowing inflation to accelerate would be lasting and pervasive.
The administration realizes that even temporary economic disruptions have real consequences for people here and now. We recognize, however, that many attempts to provide immediate relief
ultimately result only in more severe problems. Also, it is a mistake to presume that all problems in the economy are the result of
monetary restraint. In many cases, they are more properly characterized as long-term, structural problems that cannot be cured by
returning to inflationary money growth. Many of our most serious
sectoral problems today reflect the damage of a decade of rising inflation and interest rates; these problems would only be compounded by the resurgence of inflation and further increases in interest
rates that would accompany faster money growth. Not only would
the trend of unemployment continue upward, the dislocations and
economic pain that would accompany the next effort to establish a
noninflationary monetary policy would be even greater.
Let me now turn to the importance of stable money growth. I
want to reiterate and emphasize that when we say stable money
growth, we do not mean precise week-to-week or even month-tomonth control. There are too many factors over which the Federal
Reserve has no control that cause temporary aberrations in the
money stock to expect such precision. However, the Federal Reserve itself maintains that the average quarterly growth of Mi can
be controlled within a band of plus-minus 1 percent. Thus, on a
quarterly basis, the Federal Reserve has the ability to keep MI
within its announced target range. Such stability in money growth
would greatly enhance the stability in the financial markets and
provide for lower interest rates.
The stability of money growth takes on greater importance when
viewed in the context of the record of monetary actions over the
past decade and a half. On several occasions since 1965, money
187
growth was slowed abruptly in response to concerns about inflation. But, in each case, the effort was soon abandoned and the rate
of monetary expansion subsequently was accelerated further. In
each case, the economy suffered the immediate costs of monetary
restraint—recession and rising unemployment—but was denied the
lasting benefit of reduced inflation. This stop-and-go pattern is, of
course, exactly what many are advocating that the Federal Reserve
do once more. The result was a steadily rising long-term rate of
money growth, punctuated by several short periods of monetary restraint. The rising trend resulted in an ever-worsening inflation
and an upward-ratcheting of interest rates, while the brief bouts of
monetary restraint generated or intensified economic recessions.
These episodes eroded confidence in the willingness or ability of
the government to fulfill its promises to control inflation.
This effect on the credibility of anti-inflationary monetary policy
is seen clearly in the pattern of long-term interest rates since the
mid-1960's. With each stop-go episode, long-term rates became increasingly resistant to the Government's assurances that anti-inflationary policies would be maintained. The lows in long-term interest rates which were recorded near each cyclical trough have risen
sequentially with each successive cycle. The reason is obvious—accelerated money growth, renewed inflationary pressures and rising
interest rates have followed each recession.
Because episodes of reducing money growth have occurred
before, history alone gives the financial markets no assurance that
we are witnessing a permanent shift to noninflationary policy. If a
period of slow money growth is followed by a long period of rapid
money growth—as it was in late 1981 and early 1982—that uncertainty is reinforced. It signals to the financial markets that their
worst fears and doubts may be coming true—that the Government
cannot be relied upon to adhere to noninflationary monetary policy
over the long run; that anyone who bets on inflation coming down
and staying down—that is, anyone who lends money at a lower interest rate—can count on losing it to the tax of inflation.
In the current environment of uncertainty and concern about the
budget deficit, the effects of volatile money growth are magnified.
Hence, the stability of money growth is a particularly important
aspect of monetary policy in the current situation. With the experiences of the past decade fresh in the public memory, erratic money
growth adds to the uncertainty that noninflationary monetary
policy will, once again, not be maintained over the long run. That
skepticism helps keep interest rates high, even as actual inflation
falls.
A sustained increase in the rate of money growth in the last half
of this year or an announced increase in the money growth targets
would simply reinforce and justify that skepticism. Discussions,
proposals and political pressures to increase money growth have
themselves contributed to the problem of high interest rates by
adding to the markets' fears.
To repeat, random variations in monetary growth from 1 week or
1 month to another are to be expected, and there is no reason to
attempt to offset such changes. The task is to assure that these
random changes do not persist and become several months or quarters of very rapid or very slow monetary growth. To the extent,
188
therefore, that the Fed is successful in holding quarter-to-quarter
money growth closer to announced target ranges, the credibility of
long-term policy is greatly enhanced. The evidence gathered at the
Treasury Department indicates that reducing the quarter-to-quarter variability in money growth would give market participants
greater confidence about the future and remove one of the factors
which has been a source of continued upward pressure on longterm interest rates.
Senator Garn, shortly we will have this study completed and,
with your permission, I would like to submit it for the record and it
should be in the next few weeks. All the research is completed.
We've got some fine-tuning on the words. I think it's important.
The CHAIRMAN. We would be very happy to do that.
[Summary of the study referred to follows:]
189
August 13, 1982
The Effect of Volatile Money Growth on Interest Rates
and Economic Activity:
Summary of A Study*
Four types of policy action are capable, JJ^JJEJj*cij>lg,
of reducing market interest rates, to some degree)fKetour
are changes in debt management, reductions in spending or tax
changes that reduce future budget deficits, direct controls,
and improvements in the conduct of monetary policy. The focus
of this study is on the effects of variable monetary growth.
The analysis is conducted, however, within a general model of
the economy, which incorporates the influence of other factors
and the interplay of various factors through the markets for
assets, goods, and money. The results presented here were
generated from a condensed version of this model. The complete
results will be presented in the full technical report.
The principal conclusions of the study, to date/ are:
(1)
Sustained high variability of money growth has
increased uncertainty about the expected return
from holding bonds. The study suggests that the
market charges a risk premium on long-term bonds
of 4% to 6% to compensate for the risk of loss
of capital values arising solely as a result of
the variability of money growth.
(2) Variability of HI growth cannot be reduced to zero.
If variability is reduced to the level of 1977-79,
however, interest rates on long-term bonds would
fall 2% to 3%.
"*
(3)
Short-term interest rates would be reduced also.
(4)
Lower monetary variability should not be accompanied
by faster money growth. Paster money growth would
certainly raise interest rates. One reason is that
market participants would not believe that the
ThTisi~is'""a "summary of" a research effort by the Office of Monetary
policy Analysis of the U.S. Treasury, requested by and submitted
to Beryl W. Sprinkel, under Secretary for Monetary Affairs. The
research has been conducted by Professor Allan H. Meltzer of
Carnegie-Mellon university and Angelo Hascaro of the Treasury
Department. The full technical report is in the final stages
of preparation.
190
current reduction in inflation will persist if money
growth is reaccelerated. A second reason is theft
temporary changes in money growth — up and down —
are a main cause of variability in economic activity,
in addition to contributing to risk premiums in
interest rates.
(5)
Reducing the variability of money growth would reduce
the variability of GNP growth. A main finding of
the study, replicated for different periods and
using different measures of money, is that, on
average. Federal Reserve actions have added more
variability to the economy than they have removed.
The estimates suggest that improvements in the
implementation of monetary policy can reduce the
magnitude of fluctuations in GNP growth by onefourth to one-half of their present values.
(6)
Much of the increase in variability of money growth
since late 1979 comes from two sources. One is the
imposition and removal of credit controls in 1980,
The other is the monetary control method of the
Federal Reserve. The following comparison of money
growth, using quarterly average growth (at annual
rates) for the period before and after October 1979.
shows how much money growth has been reduced, and
variability increased, in the recent period.
191
11 '.Quarters
Beginning
October 1979
11 '.Quarters
Ending
September 1979
(1st .Quarter 19773d .Quarter 1979)
(4th iQuarter 19792nd .Quarter 1982)
Average Growth of Ml
8.3%
6.3%
Standard Deviation
1.5
5.2
Range for HI Growth
5.2 to
Average Growth of
Monetary Base
8.6%
7.1%
Standard Deviation
1.0
2.7
Range for Base Growth
7.1 to 10.5
1,9 to 10.3
-3.1 to +14.8
10.3
1980 IV - 1982 II
Average Growth of Ml
5.8
Standard Deviation
3.9
Average Growth of Base
6.1
Standard Deviation
3.3
Range: 0.3 to 10.9
Range: 1.9 to 10.3
Ijiterest Rates, Inflation and Monetary .Variability
To estimate the effect of monetary variability on interest
rates, the sources of change in quarterly values of money and
monetary velocity were separated into "predictable" and unpredictable components. The "predictable" components of money growth
and velocity are the parts that can be forecast from knowledge
of seasonal factors and the past history of each series. The
unpredictable, or random, component includes everything else.
192
The anticipated rate of inflation is estimated in a Similar
way.* Anticipated inflation for next quarter is the rate at
which prices are expected to rise on the basis of the momentum
in the price series and knowledge of seasonal and other factors,
The momentum of inflation reflects the maintained rate of
money growth, but factors such as sustained shifts in the
demand for money can also affect the aeries. Random and transitory price changes are removed from the measure of anticipated
inflation by the procedure which is used.
The rate of interest has four components.
(11 A rea^ rate representing an estimate of the
productivity'Ur^capital. In the results presented here, the
expected return on capital is embodied in the intercept term
of the regression.
(2) The effect of anticipated inflation. l£ there ate
no effects of taxes and inflation on real rates, anticipated
inflation raises market interest rates point for point.
Recent estimates for the United States suggest that taxes and
other factors reduce the effect of anticipated inflation on
interest rates by about one-half, in the results presented
here, anticipated inflation refers to the expected rate of price
change in the next quarter only.
(3) A risk factor representing the variability of the
unpredictable component of money growth.
(4) A risk factor representing the variability of the
unpredictable component of monetary velocity. All unpredictable
changes in GNP growth, other than those resulting from unpredictable money growth, influence interest rates through this component.
This study indicates that item (3) -the risk premium
which is generated by variable money growth -is a principal
reason the current "real" rates are considered to be high.
The empirical results, using the ten-year U.S. Government
bond^rate are presented in jhe following table.
*
The rate of price change is an endogenous variable in the model
which is used in this study. Thus, the expected rate of
price change should be consistent with the structure of the
model, including information about the probable pattern of the
exogenous variables. Time series analysis alone is not sufficient to guarantee this result. This shortcoming has been
corrected, with no appreciable effect on the results which are
presented here. The complete results will be presented in
the full technical report of the study.
193
Interest Rate Equation:
iQuarterly:
Long-Terra Interest Rate
1969.Q4 - 1982Q2
Dependent Variable:
Independent Variable
51 Observations
10 Year Government Bond at Constant Maturity
Coefficient
Std. Error
t-Statistic
Constant
3.19347
1.015
3.146
Expected Inflation^
0.30238
0.1198
6.780
Velocity Volatility2
0.19315
0.0903
2.140
HI Volatility
0.73328
0.1081
6.780
Rho
0.6222
0.1271
4,897
3
Summary Statistics
R-Squarect:
Adjusted R-Squared: 0.9033
F-Statistic (4,46): 117.S
Durbin-Watson Statistic: 2.1042
Sum of Squared Residuals: 27.81
Standard Error of Regression: 0.7775
'.Q(8 degrees of. freedom)_t 9.355
1 Expected inflation is the next period's inflation forecast. The
forecast is derived from a time-series model estimated over 1953Q31980Q1, ARIMA (0,1,1), on the quarterly logarithmic first-difference
of the GNP deflator. Values to 1980Q1 are in-sample estimates, while
subsequent values are one-step-ahead forecasts using the ARIMA model.
2 velocity volatility is the square-root of the average of the sum of
squares of velocity innovations over four periods with a one period
delay. The innovations are from an ARIMA (Q,l,2) model estimated
over 1953G3-198QQ1, with subsequent values being obtained from onestep-ahead forecasts to 1982Q1.
3 Ml volatility is the square-root of the average of the sum of squares
of Ml innovations over four periods with a one period delay. The
innovations are from an ARIMA (1,1,0) model estimated over 1953.Q3198QQ1, with subsequent values being obtained from one-step ahead
forecasts to 1982Q1.
194
A series of charts show the effects of components (2), (3)
and [4) on the ten-year U.S. Government bond rate from 1969 IV '
through the second quarter of 1981. Each component IB
multiplied by its estimated effect on interest rates to obtain
the contribution of that factor to the interest rate. The
solid line in each chart shows the forecast of interest rates
based on all four of the factors and the clotted line is the actual
interest rate. The broken line in the lower portion of the chart
shows the contribution of a particular factor.
Chart 1
Comparison of 10 Year Bond Rate
Estimated Rate from Equation, and
Contribution of Velocity Volatility
actual = dotted line
fitted = solid line
velocity volatility effect=dashed line
12
69
70
71
72
73
74
75
76
77
78
79
80
8L
82
Chart 1 shows the contribution of the velocity effect. The
variability of unpredictable changes in velocity contributes
between 0.3S and 1.3% during the period. There is a slightly
rising trend in recent years. Federal Reserve statements place
heavy emphasis on the effects of these changes, but this study
suggests that this influence has been relatively small. The most
that can be expected from reductions in the variability of the
demand for money (or velocity), based on the findings of this
study is about 1/2% reduction in long-term rates.
195
Chart 2
Comparison of 10 Year Bond Rate
Estimated Rate from Equation, and
Contribution of Monetary Volatility
actual=dotted line
fitted=solid line
HI volatility effect=dashed line
69
70
71
72
73
74
75
76
77
78
79
80
81
82
Chart 2 shows the effect of variations in the unpredictable component of money growth — called Ml volatility on the
chart. The effect of Ml volatility on the interest rate can
be seen clearly in the peaks reached in 1971, 1975, and 1981
and in the troughs reached in 1972 and 1978. The chart indicates that a return to the lower monetary variability of pre1979 should be be accompanied by a decline of 3% to 4% in the
ten-year bond rate.
A common problem with estimates of this kind, however, is
that the very large increase in variability and large increase
in interest rates after 1979 might tend to cause an overestimate
of the importance of monetary volatility. Therefore, the response
was reestimated for the period 1969 IV-79 III. A similar, but
lower estimate of the effect of variability, is obtained. Using
both estimates, a 2% to 3% reduction in interest rates on longterm bonds is a reasonable estimate of the response to more
stable monetary growth.
196
Chart_3
Comparison of 10 Year Bond Rate
Estimated Rate from Equation, and
Contribution of Expected
Inflation
actual=dotted line
f ittecl=solid line
expected inflation effeet=dashed line
16
12
"•»• **" **«•«*»
69
70
71
72
73
74
75
76
77
78
79
80
81
82
Chart 3 shows the effect of expected inflation. The
surge in interest rates from 1972 to 1974 and the decline to
1976 reflects the strong influence of changing expectations
of inflation following the removal of price controls/ the
Soviet wheat purchases, the oil shock and the aftermath of
these events.
197
The Effects of^ Less Variable Honey Growt.h^_gn._GMP Growth
The Federal Reserve tries to reduce fluctuations in the
economy by varying interest rates, reserves and money growth.
Their ability to reduce fluctuations is limited, however, by
two difficulties, one is the difficulty of producing accurate
forecasts, a difficulty shared by all forecasters. The other
is the difficulty of knowing whether observed changes in economic
behavior are temporary or persistent.
Mistaken forecasts and
misinterpretations of observed changes would cause the Federal
Reserve (and everyone else) to misperceive and misinterpret
what is happening, persistent changes could be treated as
temporary or transient; transient changes could be misperceived
as permanent. As a result of these, and perhaps other
errors arising from efforts to smooth the money market, or
from the use of lagged reserve accounting, a complex structure of
reserve requirements or inaccurate seasonal adjustment, the
Federal Reserve can, in principle, add more variability to the
growth of GNP than it removes. Consequently, the Federal
Reserve can make "business cycles" worse.
To estimate the amount of variability introduced and the
amount removed, the study computes: (1) the variability of
the predicted component of GNP growth; (2) the maximum
variability in the predicted component that would occur if
money growth remained constant; (3) the sum of the predicted
and random components — variability of actual GNP; and (4)
the maximum variability of (actual) GNP if money growth
remains constant. These calculations are shown in Table 1,
columns (1) and (2).
198
Table 1
variability of Quarterly GNP Growth with Current
Monetary Policy and with Constant Money Growth
(annual rates in percent)
(1)
__^
Period
1953-80
Actual
Policy
(2)
(3)
Constant
Hj^Growth
Constant
Basg Growth
Predicted Component
0.9
0.7
0,6
Total GNP Growth
1.9
1.9
1.8
Predicted Component
0.7
0.6
0.5
Total GNP Growth
1.7
1.6
1.6
Predicted Component
3.8
1.8
0.9
Total GNP Growth
5.9
3.9
2.1
1953-69
1969-80
Column (3) shows similar calculations with growth of the
monetary base constant. Again, these are estimates of the
maximum variability. Actual variability would be lower, since
reducing uncertainty about monetary growth would reduce the
variability of interest rates and the demand for money.
These results indicate that, on average, constant money
growth (or constant base growth) would have probably reduced
the variability of GNP and, at least, would not have increased
it. For the period 1969-80, in which the oil shock and the
Government's reaction to the situation had a large negative
influence on GNP growth, the reduction in variability of GNp
growth is greater than 50%.
These findings suggest that the Federal Reserve operations
have increased the variability of economic activity. Less
variable money growth, on average, should produce steadier
growth in GNP.
199
Actual and potential Contrpl_pf Money
Last year, the Federal Reserve released a study of
monetary control in i960. According to their estimates, 95%
of the time the error in controlling the quarterly (or annual)
growth of Ml could be held within ^1%.
Actual control in I960 — and in most other years for
which the Federal Reserve announced targets — was much less
precise. The actual performance shows an average deviation
from target in the range of -2.0 to + 2.5%.
A principal reason for the poor performance is that the
Federal Reserve attempts to forecast either interest rates/ or
the demand for money and credit. Their forecasts are relatively
inaccurate, so they introduce large errors into the control
procedure. In addition, use of lagged reserve accounting,
seasonal adjustment, borrowing arrangements and other procedures
also increase variability.
Significant reductions in interest rates and in the variability
of GNP can be achieved, if the volatility of money growth is reduced.
The size of further reductions in interest rates that can be
achieved are approximately:
(a) 1/2% by reducing the variability of monetary velocity;
(b) 3% to 4% by reducing the anticipated rate of inflation.
The latter cannot be achieved entirely in the near term. This
study suggests that some reduction in anticipated inflation has
occurred, and further reductions are likely this year if money
growth is held within the announced target. A reduction in expected
inflation to 6% from present levels reduces long-term interest
rates by about 1%.
200
Mr. SPRINKEL. Thank you, sir.
This leads me to the predictability part of our prescription for
monetary policy. To the extent that money growth proceeds in a
reliable pattern, uncertainty is reduced and interest rates can fall.
In the current environment, the problem of the predictability of
future monetary policy is compounded by concern about the Federal budget. The perception of unbounded growth of Government
spending into the future raises fears that higher inflation and/or
higher tax rates lie ahead.
The financial markets fear that the Federal Reserve will be pressured into monetizing the implied deficit. That is, financing spending by creating new money. These fears are aggravated by congressional statements about the need for faster money growth. Any signals that the Fed is coming under political pressure to revert to inflationary money growth only adds to the concern.
CURB EXCESSIVE GOVERNMENT SPENDING
Both the Congress and the administration, by their actions, must
demonstrate to the public that the Federal Government has the
collective will to discipline itself now and in the future against the
fiscal excesses which have otherwise come to be expected of it. We
must face the fact that any Government spending—no matter how
well intentioned its goals or beneficial its impact—imposes costs on
the economy. In the short term, Government spending can be financed three ways—through taxation, by creating new money or
by borrowing. Ultimately, however, only two sources of revenues
are available—direct taxation and/or inflation. Therefore, the situation is simply this: If we are to allow Government spending to
grow unchecked as it has over the past several decades, we will
face accelerating inflation—and the escalating interest rates that
go with it—high and rising tax rates or both. There are no other
choices and the current situation in financial markets should be
heeded as a sign that the public is aware.
Monetary policy issues and its impact in the economy are more
complicated than the simple "tight" money/"easy" money characterizations that are commonly made.
The experience of a decade of accelerating inflation and rising interest rates has radically altered the behavior and expectations of
the American public. As workers and producers, as savers and consumers, and as borrowers and lenders, our collective behavior has
been contaminated by inflationary psychology. The mechanism by
which increases in money allowed interest rates to fall, and the
economy to expand—which most of us learned in Economics 101—
has been shown to be such a simplified view that it is no longer
very useful. The public has become so attuned to the long-run relationship between money growth and inflation that those favorable
short-run effects of accelerated money growth are increasingly
transitory.
In addition, the way in which a given monetary policy is pursued—whether it be "tight" or "easy" in the common parlance—is
extremely important. The same monetary policy—in terms of the
amount of money growth provided by the monetary authority—can
have very different effects on the economy. For example, an annual
201
increase in money of 6 percent has very different economic implications if it results from no growth for 6 months, followed by 12-percent growth for 6 months, instead of, say, 6 months of 5-percent
growth and 6 months of 7-percent growth. The ultimate result in
terms of money growth would be the same, but the immediate
impact on the economy would be radically different.
Recognizing the important economic implications of the pattern
of the rate of money growth, the administration recommended, and
has consistently supported, not just a deceleration of money
growth,- while deceleration is vital to controlling, we believe that it
is best if that deceleration is achieved in a steady and predictable
fashion. We made that recommendation 18 months ago, believing
that such a policy would provide the monetary restraint needed to
control inflation, but with the least possible disruption of economic
activity. That is, given the task of controlling inflation, we believe
that that goals could be achieved with the least possible loss of
output and employment, if the deceleration of money growth were
steady and predictable. No economic event or development in the
past 18 months has altered that view and conviction.
Thank you, sir,
[Complete statement follows.]
202
STATEMENT OF BERYL W. SPRINKEL
UNDER SECRETARY OF THE TREASURY FOR MONETARY AFFAIRS
BEFORE THE
COMMITTEE ON BANKING, HOUSING AND URBAN AFFAIRS
UNITED STATES SENATE
WASHINGTON, D.C.
Tuesday, July 27, 1982
Chairman Garn, Senator Riegle, and distinguished Members of
the Banking Committee, it is a pleasure to be with you today to
discuss the Administration's views on monetary policy.
This Administration assumed office with the firm conviction
that the process of inflation is a major obstacle to vigorous
economic performance and expansion of individual opportunity-
As
a result, a major part of the President's economic recovery program
was the call for a gradual deceleration of monetary growth to a
noninflationary pace.
The basis of this monetary program was and
still is the recognition that sustained inflation —
what may be the initiating force —
no matter
requires the accommodation of
excessive money creation.
Since that recommendation was made, monetary policy has become
the subject of much public debate and controversy.
In the process,
the Administration's views on monetary policy have sometimes been
misunderstood and misinterpreted.
Our views are actually very
basic and straightforward, so I would like to take this opportunity
to restate them as concisely as possible.
In addition, I will
mention some things that we do rio^ advocate, but which are frequently
attributed to us.
203
Basically our views and recommendations can be summarized as
follows:
(1)
The primary cause of the accelerating inflation that
has occurred in the u,s. over the past decade and a
half has been a persistently excessive rate of money
growth.
(2)
Reducing the rate of money growth is essential to
controlling inflation.
(3)
Inflation, and the inflationary expectations that it
generates, have been a major factor in the secular
rise in interest rates.
(4)
Since inflation and high interest rates ace an anathema
to sustained economic growth, noninflationary monetary
policy is a prerequisite to restoring the sound economic
prosperity that we all seek.
(5)
The deceleration of money growth should be accomplished
in a gradual, steady and predictable fashion, in order
to minimize the economic disruptions and costs associated with moving the economy from an established inflationary path to a noninflationary one.
Now let me mention some views that many are attributing to us
that we do not hold:
(1)
We do not expect the Federal Reserve to achieve
precise week-to-week or month-to-month control of the
money supply.
They do not have the power to do so, and
efforts to try to do so would likely prove to be extremely
destabilizing.
We do believe, however, that the Federal
204
Reserve has the ability to maintain the average quarterly
rate of money growth within the announced target range.
(2)
We do not advocate the use of high interest rates to
fight inflation.
High interest rates are the legacy of
persistent inflationary money growth, not an element of
anti-inflationary monetary policy,
stubbornly high interest
rates ate the inevitable result of letting inflation
occur in the first place, ft reacceleration of money
growth would cause further inflation and guarantee even
higher interest rates in the future.
(3)
He do not believe that monetary policy is the source of
all economic problems, nor is it the cure-all for all ills,
prudent monetary policy is necessary to achieve real
economic growth and prosperity, but it is not the panacea.
A year and a half ago we recommended that the rate of money
growth be slowed permanently.
That recommendation is completely
consistent with the stated policies and objectives of the Federal
Reserve.
The target ranges for 1982, and those which the Federal
Reserve has tentatively set for 1983,.are appropriate to provide
for both economic recovery and continued progress on inflation.
The Fed has made significant progress to date toward achieving
noninflationary money growth, and we fully support their plan to
persevere in that policy.
Our support for prudent, noninfla-
tionary monetary policy has not changed or waivered.
To the contrary, the progress on inflation over the past year
should serve to encourage us all that the ultimate goal of a permanent
reduction in inflation is within our reach, if only we continue
205
along the path of a sustained deceleration
of monetary growth.
But if we succumb to the temptation to declare victory too soon,
by mistaking success in the first major skirmish for a permanent
routing of the enemy, then we will not only prolong and worsen
inflation, but significantly reduce the chances of ever bringing
it under control.
While earnest in intentions, those who counsel a return to
the quick-fix prescription of easy money are advocating actions
that are actually inimical to the very thing they seek —
lower interest rates.
permanently
Paster money growth would soon validate the
very fears which have been responsible for the maintenance of Jiigh
long-term interest rates —
inflation will be temporary.
easing of short-term
fears that the current slowing of
While there might be some immediate
interest rates in financial markets, long-term
interest rates would soon rise, reducing greatly the potential for
future output and employment growth.
Periodic calls for the Fed
to loosen the monetary spigot also serve to exacerbate the credibility
problem.
For this reason, the Administration supports the Federal Reserve's
decision to maintain the existing money growth targets, rather
than giving in to the pressures to revert to inflationary monetary
policy.
We would hope that the objective of permanent elimination of
inflation through a sustained monetary discipline would be a bipartisan, national goal.
It should not be allowed to become an
issue of partisan politics.
Neither the Administration nor the
Federal Reserve is happy about the level of interest rates, and
neither views these rates as a necessary evil in the fight against
206
inflation.
However, the solution is not to sacrifice the policy
which is in place, but to assure the public that the policy will
remain in place.
The record of the 1970s clearly shows that a little more money
growth does not provide a lasting increase in production and
employment.
Any boost to production and employment that comes from
accelerating money growth is temporary , while the inevitable permanent
effects are inflation and higher interest rates.
Accelerating
inflation, escalating interest rates, and the resulting deterioration
of the incentives to save and invest are, in fact, powerful and
pervasive deterrents to sustained growth.
Also, it is folly to
trust that faster money growth would now result in more production
because various segments of the economy are operating at less than
full capacity.
The experience of the past fifteen years should b«
ample evidence that inflation is not a problem which arises only
when the economy is folly employed.
Sustainable economic expansion
requires a financial system based on a reliable dollar and that
means monetary discipline.
To some, perhaps, the Administration's repeated call for a
and_ gr ed ic t a b 1 e deceleration of money growth may
now seem trite or dogmatic.
Let me assure you that it is neither.
There are very real , very important economic reasons why we have
repeatedly made this prescription.
That is, a deceleration of
money growth that is not gradual, not stable and/or not predictable
has very real, adverse economic consequences.
First, let me discuss the importance of a gradual deceleration
of money growth.
After more than a decade of accelerating
207
inflation and rising interest rates, inflationary expectations had become
deeply entrenched in economic institutions and behavior,
it would,
of course, have been technically possible for the Federal Reserve
to reduce money growth abruptly to a noninflationary rate-
But it
was felt that such a sudden move would cause severe short-term
economic disruption and hardship.
The gradual approach would
provide the public more time to adjust its inflationary expectations
downward, thereby minimizing the transitional costs in terms of
lower output and higher unemployment.
The transition is drawn out
by this approach, bjt the immediate negative impact on real economic
activity is reduced.
Specifically, we recommended that the rate
of money growth be cut in half by 1986 —
with a steady
deceleration
each year.
It- would be naive to expect that such progress toward a noninflationary economy could be made without experiencing some economic
hardship.
Some of the disruptions associated with the transition
to a non-inflationary economy are of course being felt now.
hardships are not to be dismissed.
These
In terms of its implications
for the long-run prosperity of the nation, however, the importance
of controlling inflation cannot, in my opinion, be overstated.
The hardships are temporary, but the damages of allowing inflation
to accelerate would be lasting and pervasive.
The Administration realizes that even temporary economic disruptions have real consequences for people here and now.
We recognize,
however, that many attempts to provide immediate relief ultimately
result only in more severe problems.
Also, it is a mistake to
presume that all problems in the economy are the result of monetary
208
restraint.
In many cases, they are more properly characterized as
long-term, structural problems that cannot be cured by returning to
inflationary money growth.
Many of our most serious sectoral
problems
today reflect the damage of a decade of rising inflation and interest
rates; these problems would, only be compounded by the resurgence of
inflation and further increases in interest rates that would accompany
faster reoney growth.
Not only would the trend of unemployment
continue upward, the dislocations and economic pain that would
accompany the next effort to establish a noninflationary monetary
policy would be even greater.
Let me now turn to the importance of stable money growth., I
want to reiterate and emphasize that when we say stable money
growth, we do not mean precise week-to-week or even month-to-month
control.
There are too many factors over which the_Federal Reserve
has no control that cause temporary aberrations in the money stock
to expect such precision.
However, the Federal Reserve itself
maintains that the average quarterly growth of HI can be controlled
within a band of +1 percent.
Thus, on a quarterly basis, the
Federal Reserve has the ability to keep Ml within its announced
target range.
Such stability in money growth would greatly enhance
the stability in the financial markets and provide for lower interest
rates.
The stability of money growth takes on greater importance when
viewed in the context of the record of monetary actions over the past
decade and a half.
On several occasions since 1965. money growth
was slowed abruptly in response to concerns about inflation.
But,
in each case, the effort was soon abandoned and the rate of monetary
209
expansion subsequently was accelerated further.
In each case, the
economy suffered the immediate costs of monetary restraint —
and rising unemployment —
reduced inflation.
recession
but was denied the lasting benefit of
This stop-and-go pattern is, of course, exactly
what many are advocating that the Federal Reserve do once more.
The result was a steadily rising long-term rate of money growth,
punctuated by several short periods of monetary restraint.
The
rising trend resulted in an ever-worsening inflation and an upwardratcheting of interest rates, while the brief bouts of monetary
restraint generated or intensified economic recessions.
These
episodes eroded confidence in the willingness or ability of the
Government to fulfill its promises to control inflation.
This effect on the credibility of anti-inflationary monetary
policy is seen clearly in the pattern of long-term
since the mid-1960's.
interest rates
With each stop-go episode, long-term rates
became increasingly resistant to the Government's assurances that
anti-inflationary policies would be maintained.
The lows in long-term -
interest rates which were recorded near each cyclical trough have
risen sequentially with each successive cycle.
obvious —
The reason is
accelerated money growth, renewed inflationary pressures
and rising interest rates have followed each recession.
Because episodes of reducing money growth have occurred
before,
history alone gives the financial markets no assurance that we are
witnessing a permanent shift to noninflationary policy.
If a
period of slow money growth is followed by a long period of rapid
money growth —
as it was in late 1981 and early 1982 —
uncertainty is reinforced.
that
It signals to the financial markets
210
that their worst fears and doubts may be coming true —
that the
government cannot be relied upon to adhere to noninflationary
monetary policy over the long run; that anyone who bets_ on inflation
coming down and staying down (that is, anyone who lends money at
a lower interest rate) can count on losing it to the tan of inflation.
In the current environment of uncertainty and concern about
the budget deficit, the effects of volatile money growth are
magnified.
Hence, the stability of money growth is a particularly
important aspect of monetary policy in the currrent situation,
with
the experiences of the past decade fresh in the public memory,
erratic money growth adds to the uncertainty that noninflationary
monetary policy will, once again, not be maintained over the long
run.
That skepticism helps keep interest rates high, even as actual
inflation falls.
A sustained increase in the rate of money growth in the last
half of this year or an announced increase in the money growth
targets would simply reinforce and justify that skepticism.
Discussions, proposals and political pressures to increase money
growth have themselves contributed to.the problem of high interest
rates by adding to the markets' fears.
To repeat, random variations in monetary growth from one week
or one month to another are to be expected, and there is no reason
to attempt to offset such changes.
The task is to assure that
these random changes do not persist and become several months
or quarters of very rapid or very slow monetary growth.
To the
extent, therefore, that the Fed is successful in holding quarterto-quarter money growth closer to announced target ranges, the
211
credibility of long-term policy is greatly enhanced.
The evidence
gathered at the Treasury Department indicates that reducing the
quarter-to-quarter variability in money growth would give Market
participants greater confidence about the future and remove one of
the factors which has been a source of continued upward pressure
on long-term
interest rates.
This leads me to the predictabili ty part of our prescription
for monetary policy.
To the extent that money growth proceeds in a
reliable pattern, uncertainty is reduced and interest rates can
fall.
In the current environment, the problem of the predictability
of future monetary policy is compounded by concern about the
Federal budget.
The perception of unbounded growth of government
spending into the future raises fears that higher inflation and/or
higher tax rates lie ahead.
The financial markets fear that the Federal Reserve will be
pressured into "monetizing" the implied deficit:
spending by creating new money.
that is, financing
These fears are aggravated by
Congressional statements about the need for faster money growth.
Any signals that the Fed is coming under political pressure to
revert to inflationary money growth only adds to the concern.
Both the Congress and the Administration, by their actions,
must demonstrate to the public that the Federal Government has the
collective Vill to discipline itself now and in the future against
the fiscal excesses which have otherwise come to be expected of it.
We must face the fact that any government spending —
no matter
how well intentioned its goals or beneficial its impact —
costs on the economy.
imposes
In the short term/ government spending can be
212
financed three ways —
borrowing.
through taxation, by creating new money or by
Ultimately, however, only two sources of revenues are
available —
direct taxation and/or inflation.
situation is simply this:
Therefore, the
if we are to allow government spending
to grow unchecked as it has over the past several decades, we will
face accelerating inflation (and the escalating interest rates
that go with it), high and rising tax rates or both.
There are no
other choices and the current situation in financial markets should be
heeded as a sign that the public is aware.
Summary
Monetary policy issues and its impact in the economy are more
complicated than the simple "tight" money/"easy" money characterizations that are commonly made.
The experience of a decade of accelerating inflation and rising
interest rates has radically altered the behavior and expectations
of the American public.
As workers and producers, as savers and
consumers, and as borrowers and lenders, our collective behavior has
been contaminated by inflationary psychology.
The mechanism by
which increases in money allowed interest rates to fall, and the
economy to expand —
which most of us learned in Economics 101 — has
been shown to be such a simplified view that it is no longer very
useful.
The public has become so attuned to the long-run relation-
ship between money growth and inflation that those favorable short-run
effects of accelerated money growth are increasingly transitory.
In addition, the way in which a given monetary policy is
pursued —
whether it be "tight" or "easy* in the common parlance
is extremely important.
The same monetary policy —
—
in terras of the
213
amount of money growth provided by the monetary authority — can
have very different effects on the economy.
For example, an annual
increase in money of 6 percent has very different economic implications if it results from no growth for six months, followed by 12
percent growth for 6 months, instead of, say, six months of 5 percent
growth and six months of 7 percent growth.
The ultimate result in
terms of money growth would be the same, but the immediate impact
on the economy would be radically different.
Recognizing the important economic implications of the pattern
of the rate of money growth, the Administration recommended, and
has consistently supported, not just a deceleration of money growth;
while deceleration is vital to controlling inflation, we believe
that it is best if that deceleration is achieved in a steady and predictable fashion.
He made that recommendation IB months ago,
believing that such a policy would provide the monetary restraint
needed to control inflation, but with the least possible disruption
Of economic activity.
That is, given the task of controlling
inflation, we believe that that goal could be achieved with the
least possible loss of output and employment, if the deceleration
of money growth were steady and predictable.
or development
No economic event
in the past 18 months has altered that view and
conviction.
oOo
214
CHART I
Growth in Nominal Gross National Product and
Adjusted Monetary Growth
16
ADJUSTED MONETARY GROWTH;
(solid line)
14
'14
NOMINAL' GNP GROWTH
(dotted line)
12
12
"10
I I I I I
62
64
Note:
66
68
70
72
74
76
78
80
82
Adjusted monetary growth is the sum of the
4 quarter growth in M1 and the trend growth
of Ml velocity; GHP growth is over 4 quarters.
215
CHART II
G r o w t h in HI .and the M o n e t a r y Base
20
16
MONETARY BASE
(dotted line, right
1
scale)
/
12
r4
t8
GROWTH IN «1
(solid line, left scale)
1 I I I I I I I I I I [ | I I I I I I I I I I |II 1 1 I I I I II I [ II I I 1"t2
1979
1980
1981
Growth is annuallEed race o v e r Ill-weeks ago
Data are 4 rweek moving averages
1982
216
CHART III
Short Term M o n e t a r y G r o w t h and
Short Term Interest Rate*
16
; ;; *\f
JI
THREE MONTH
».""• TREASURY BILL
\-f
'• (right scale)
MONETARY
GROWTH
(left scale)
J F M A M J J A S O N D J F M A M J J A S O H D J F M A M J
1980
1981
1982
N o t e : Data for Ml are four week moving a v e r a g e s
g r o w t h is relative to one year ago
217
The CHAIRMAN. Thank you, Mr. Secretary. May I say that I appreciate the directness of your testimony. There has been before
this committee a lot of speculation on the administration's position.
Is it this or that or something else? After your testimony today,
being as specific as it is, there should be no doubt about what the
administration's position is on this subject.
Mr. SPRINKEL, I hope you're right.
The CHAIRMAN. Well, there are some who will still not want to,
but if they read your statement, it certainly could not be considered wishy-washy testimony in any way whatsoever. It is very specific if they care to read it.
In his testimony before this committee last week, Federal Reserve Board Chairman Paul Volcker stated that:
Periods of velocity decline over a quarter or two are typically followed by periods
of relatively rapid increase. Those increases tend to be particularly large during cyclical recoveries.
In your statement today you say while the Federal Reserve
cannot control money growth precisely week to week or month to
month, growth of the monetary aggregates over a calendar quarter
can be controlled.
In controlling money growth over a quarter, to what extent
should the Fed make allowances for the quarterly changes in velocity of which Chairman Volcker referred to last week?
PREDICTING MONETARY GROWTH
Mr. SPRINKEL. I think it's very risky to attempt to, first, predict
velocity and then take actions and predict what kind of monetary
growth will occur with respect to those velocity changes. We know
something about velocity. We know, for example, that it has a cyclical component and also a secular component.
If we refer, for example, to Mi velocity, we know that the secular
trend in Mi velocity has been approximately 3l/4 percent per year
on the plus side. We also know that during periods of recession
when you look back and compute present velocity at the time, it
goes down, just as in periods of recovery it goes up.
To get that average 3 Vi or so percent, in the early phase of a recovery it tends to rise at a more rapid rate than 31A percent. I can
remember a famous debate in this town some years ago when Dr.
Burns said that there would be a 5-percent increase in velocity in
the first year of an economic recovery and everyone knew that that
was wrong except it turned out to be right, and I expect that same
sort of phenomenon to occur in the present environment as the recovery gets underway. And I would certainly not believe it would
be useful therefore to slow down the rate of money growth because
velocity is going to snap back in the early phase of this recovery.
The Federal Reserve can control money growth with some degree
of precision. It cannot impact velocity. Velocity is determined essentially by the public and I would hope that the Federal Reserve
would set their monetary targets as they have and stick to their
course. This means that a given amount of money growth will give
you more stimulus when velocity is rising rapidly as it does during
the early phase of a recovery, but it also avoids the squeeze later
218
on. If you continue stable money growth you're not likely to get a
sharp decline in economic activity subsequently.
The CHAIRMAN. How would you evaluate the Fed's proposal to institute contemporaneous reserve accounting?
Mr. SPRINKEL. I'm very pleased by that move. On prior occasions
I have represented the administration's views on what could be
done technically to improve the ability of the Federal Reserve to
get better control of the volatility of money growth and usually the
first prescription mentioned was moving from lagged reserve accounting to contemporaneous reserve accounting. Essentially they
have announced they will do that sometime, between now and,
hopefully, next spring.
In addition, moving toward a more flexible discount rate policy,
that is a discount rate kept in line with the market rates—and
there's some evidence they're doing that because they cut the discount rate recently—is, in our opinion, very important.
And the third point that I think is relevant is: To focus on what
they can control, namely, total bank reserves or the base. If they
do those three things, I'm quite convinced that we'll have reasonably stable growth in money. They have started and we applaud
that action.
The CHAIRMAN. How expensive do you think it will be for the
commercial banks?
Mr. SPRINKEL. Well, it's going to be costly to some of them.
There's no doubt about that. And that was one of the major reasons that many commercial bankers opposed it. There's an easy solution. If we're getting a public benefit out of moving toward contemporaneous reserves, as I believe we are—I think we will all
benefit from getting more stable growth in money—it seems to me
this should be a public cost, not a private cost. And the way to do
that is slightly cut bank required reserves. Bank reserves are a tax
and slightly reducing that tax will, of course, offset any added cost.
Now there's a question of equity, how much cost each bank incurs
in moving toward contemporaneous reserves—but in principle, if
we're concerned about the undue cost to banks, then it seems to me
that the simple thing to do is to slightly cut reserve requirements
and that will offset the increased costs.
The CHAIRMAN. One of our witnesses last week, Donald Maude,
from Merrill-Lynch, argued, "reported data on Mi and M2 are
giving misleading indications as to how restrictive monetary policy
has been." With regard to Mi, Mr. Maude argued that NOW accounts have accounted for 91 percent of the increase in Mi since
last October and, two, that most of this growth has represented
shifts of savings accounts, not growth of transaction balances.
With regard to M2, Maude argued that high interest rates have
caused interest credited to be a much larger component of the
growth in M2 and that interest credited is not newly created money
or enhanced overall liquidity. Adjusting for NOW accounts and interest credited, Maude found Mi grew at an annual rate of 4.8 percent during the first half of this year and M2 grew at an annual
rate of only 1.9 percent.
Do you believe that because of the arguments made by Mr.
Maude that monetary policy may have been far too tight this year?
219
FEDERAL RESERVE TARGETS
Mr. SPRINKEL. So far this year, the Federal Reserve is within its
targets. Now early in the year, as you know, it was over its targets,
but in recent weeks they ve moved back somewhere in the upper
end of the Mi range.
Now it's indeed true that as interest rates move around, either
up or down, this has an effect on how you and I and others allocate
our liquid assets. This is inevitable. This cannot be controlled by
the Federal Reserve. It will be controlled by us. Hence, it has an
impact on how fast, Mi and M2 grow, one vis-a-vis the other.
As I pointed out earlier, I view the trend in bank reserve growth
and/or base growth as being much more indicative of whether
monetary policy is tight or easy and there is no evidence that I can
find based either on the growth in monetary base or in bank reserves that Federal Reserve policy has been unduly tight.
For example, if we take the rate of growth of the adjusted monetary base since last October, the annual rate of growth has been 8.3
percent and that's fairly expansive. There were periods when it
was high. More recently it's been lower. But it's averaged about 8
percent.
If, instead of looking at changes in monetary base, you look at
what's happened to bank reserves—adjusted reserves—since last
October, the growth in adjusted reserves has been 8.1 percent. No
evidence, from my point of view, that we have had an unduly restrictive monetary policy, on average, since that time. There has
been some volatility in the series and, again, in more recent weeks
and months there's been less growth in bank reserves than there
was previously, but essentially we've been on a path that leads to
expansion in some of the M's, with some changing mix between
them. If we are in a pattern of significant further decline in interest rates, I'm sure that the next person that testifies can again
point out that there's been a change in the mix, but I think we
should not be misled as to whether or not monetary policy has
changed.
What the Fed can do is control reserves or the base. They cannot
control that mix. Therefore, I think it's very risky to point to
changes in the mix and say that Fed policy has been too tight or
too easy.
The CHAIRMAN. Thank you, Mr. Secretary.
Senator Proxmire.
Senator PROXMIRE. Thank you, Mr. Chairman.
Secretary Sprinkel, as you know, I have great admiration for
you. I've heard you testify before this committee many, many times
over the years and in your private capacity at Harris Bank and
you're certainly a very able economist as well as a very consistent
one.
CONTINUOUS DEFICIT
I didn't hear much or haven't had a chance to see much in your
testimony about the role of the deficit in high interest rates. It
seems to me that the colossal deficit that the Congress has run
over the past 20 years, the fact that we have a trillion dollar national debt, the fact that we face huge deficits this year, as your
220
Secretary, Secretary Regan, said the other day; next year $110 billion. He hopes in the future it will be less. Many disagree with that
and say it might be more.
But it seems to me that that has to be a big element in keeping
interest rates high. I don't know how we can avoid that. The Federal Government, as I understand, now takes not the $1 out of $6 it
used to take in the early 1970's for example; it takes more than
half or is going to take more than half.
Do you feel that this continuous deficit isn't an important role?
Is that why you didn't put much emphasis on that?
Mr. SPRINKEL. Well, I did indicate the disadvantage of sharp increases in Government spending which have been essentially responsible for these recurring deficits. I think it's very important
that we get spending under control as your question indicated. I
also think it's important that over time we get that deficit under
control. It's an unmitigated evil. I can think of no advantages of a
large deficit; I can think of a large number of disadvantages.
One part of your question was directed at the relation between
the interest rates per se—nominal interest rates I presume you
meant, the actual ones that are printed in the newspapers these
days—and the size of the deficit. Intuitively, I believe that it has
some kind of an impact. I'm quite confident that, other things
being equal, the larger the deficit, the higher the real rate of interest. But the problem is, when I try to find support empirically—
and we have spent a lot of time at Treasury and I've encouraged
some of my friends on the outside to do the same thing—I can't
find the empirical support. That doesn't mean it doesn't exist. It
may be there, but the effect is faint and it gets swamped by the
many other factors that affect interest rates.
Senator PROXMIRE. Let me just ask you, Mr. Secretary, don't you
think that the present situation gives you some empirical evidence,
the fact that now the deficit is so big the Federal Government is so
enormous and interest rates are so unprecedentedly high, just as
the level of deficits that we face in the future and have faced recently is almost without precedent.
Mr. SPRINKEL- Well, that's sort of a self-fulfilling observation, but
if it's really true you should be able to find over a lot of time in the
past in the United States and in other countries that same relation, and if your staff can find it I'd appreciate it if they'd give it to
me.
Senator PROXMIRE. All right. Let me suggest this. In the past
there's been the expectation, which is very important as you know
in the level of interest rates—the expectation that the deficits are
temporary. Often they've been associated with war, for example,
which we know we assumed in the past will last 3 or 4 years.
That's what's happened. After the war we've had far less—the deficits have dropped very sharply and the demand for Government
has dropped sharply.
Now we face the situation where I think many, many investors
think this is going to go on indefinitely, maybe 10 or 15 years. It's
gone on for 20 now, year after year after year, and they seem to be
accelerating. So why wouldn't that be an important factor in investor psychology, particularly on long-term rates, when investors say,
"I'm not going to put my money in a 30-year obligation or 20-year
221
obligation because if I do inflation is going to be so high and the
demands by the Government for credit are going to be so big that
those interest rates are going to continue high.
Mr. SPRINKEL. I think it is an important factor in the psychology
of the marketplace. I can put it in slightly different terms.
Suppose they, No. 1, believe that that deficit is going to persist,
as you suggest, and they have every reason for believing it, because
it's been around for a long time. We've had a surplus of a half billion dollars or so only 1 year in the last 15 or so. And if they believe that a substantial portion of that deficit is going to be financed with new money—that is, monetary policy is going to accommodate the financing of the debt—then there's every reason to
believe that money growth is going to accelerate and therefore interest rates are going to go higher, and therefore should stay high,
and not go down.
Conversely, let's suppose the Federal Reserve has at long last
convinced all of us that this time they're not going to move back to
accelerating money growth, but you still have a big deficit. Clearly,
the deficit per se, even if not financed with new money, has an adverse impact on the economy. It absorbs savings, $100 billion plus a
year.
On the one hand, we're trying to encourage the Congress and
with some success, of adopting laws that will encourage savings, investing, and provide more incentives for work; and then on the
other hand, we have a large deficit which is going to absorb those
increased savings or existing savings. Therefore, we will not get the
shift of resources from consumption toward capital investment and
therefore not get a recovery that has in-depth capital formation, resulting in higher productivity improvement. So even if it does not
lead to inflationary expectations and therefore higher nominal interest rates, I think there's good reason to believe that it will deter
the achievement of our mutual objective of getting healthier economic growth.
So I have no disagreement at all with you concerning the adverse
effects of deficits on the economy. The only problem I have is
trying to look at data in the past and find a very close relation between the size of deficits and the level of the nominal interest
rates.
Senator PROXMIHE. Now I also got the impression from your testimony that you feel that if we are simply steady and persistent, if
we stick with the policy of the gradual increase in the money
supply and don't depart from it with some kind of quick fix, as you
say, that we're going to get things under control.
As I look at it, however, we now have a record, at least the
record for the last 41 years, in the percentage of unemployment,
9.4 percent; we have business failures right and left. We have particular difficulty in the credit sensitive industries because interest
rates are so high. We're operating, as you know with less than 70
percent of capacity, a very low level on the basis of any historical
experience. The credit sensitive industries are even worse off, automobiles operating at less than 50 percent of capacity; homebuilding
at far less than 50 percent of capacity.
How far down does the level of capacity have to go before we get
some substantial relief here in interest rates? It seems to me that
222
you're saying, "it's all well enough for us to be patient here in
Washington," but it's pretty hard to be patient if you're in these
industries that are failing, if you're an employer or employee. I just
don't get from your testimony any notion of how we can turn this
thing around other than just hope that something is going to turn
up if we stick with it for another 10 years.
Mr. SPRINKEL. The reason, of course, is that I was addressing
monetary policy, not the prospects for the improvement in the
economy. The one important change that I didn't hear you mention
was the very sharp reduction in the rate of inflation.
Senator PROXMIRE. Until the last 2 months.
Mr. SPRINKEL. Until the last 2 months. The question is which
series do you believe, and I guess I don't believe the last 2 months.
I do not believe it's 12 percent, just as I didn't believe it was zero
percent earlier in the year when the indexes were saying that. I
think the inflation is 5 to 6 percent, somewhere in that range.
Now there is no doubt that the economy has gone through a
wrenching recession. I just returned from the Midwest, close to
your home area, as well as the west coast, and they have a depression in some parts of particular industries, and I certainly have
great sympathy for the painful adjustments that are occurring.
GOOD PROSPECTS FOR A RECOVERY
Now the question is, Is there any prospect of a recovery and is it
going to be a lasting recovery? I think there are good prospects for
a recovery. I've been in the forecasting business for 30 years, until
when I came down here. I've been through eight recessions now.
Never can one tell with absolute certainty when the turning point
has come or the time you know for sure you're well on your way,
but you have to watch the odds and the odds certainly have been
shifting over the past few months, from my point of view, toward
greater probability of recovery. Leading indicators have been up.
Money supply, after having very slow growth in parts of last year,
has had more growth of late. Inflation rates have come down. We
know that as inflation rates have come down that any increase in
nominal income will result in some real output growth. We know
that the sharp contraction in real GNP in the fourth quarter of
last year and the first quarter of this year became a slight positive,
1.7 percent, which is nothing to write home about, but it's certainly
better than a sharp contraction.
So that I would say that all the signs point to the probability of a
moderate rate of expansion in the months ahead. Now can it be a
lasting one, which is another part of your question? It cannot be a
lasting one, in my opinion, unless interest rates continue to move
down. There has been in the last month or so a very sharp decline
in interest rates. Yesterday the prime was cut again in some
banks
Senator PROXMIRE. Short-term rates.
Mr. SPRINKEL. Also long-term rates. They're off about 100 basis
points from approximately a month ago. Short-term rates are off
more than that, closer to 150 or 175 basis points.
I firmly believe that the probability is that interest rates will
continue to move down. If we've got a 5- to 6-percent inflation rate
223
and the world believes it, you and I believe it, and the marketplace
believes it and we believe we are going to keep it, that implies interest rates in the 7-, 8-, 9-percent range, not in the 14- to 15-percent range. When we came into office, as you may remember, the
prime rate was 21.5 percent. Yesterday some of them moved to
15.5. We expect to see further downward movement, and therefore,
if we are to have a sustainable recovery which will lighten the load
on those that have gone through this very painful cyclical adjustment, we must achieve further declines in interest rates. That's
why my testimony focused on consistency, continuity in both monetary and fiscal policy to convince the marketplace that this time
we mean it, so that the downward adjustment in interest rates,
which is well under way, will continue into the months ahead.
All the recoveries that I remember were led by consumer spending, not by capital spending. Capital spending comes along 9 or 12
months later, but it's not going to come along if we don't get those
long-term interest rates down in the months ahead. I'm confident
we will do so, but I don't know for certain.
Senator PROXMIRE. I have one other question, Mr. Secretary. The
witness who follows you, Mr. Roberts, has indicated that he thinks
that Mi is a grossly misleading indicator these days because of the
change in the way people now keep their cash, keep their liquid
assets I should say, and that total net credit would be a far more
appropriate target policy and that it ought to be used as an additional target, not the exclusive target but an additional target.
What's your feeling about that?
Mr, SPRINKEL. Well, just as I think it's very difficult for the Federal Reserve to control Mi, M2, M3, it's even a greater difficulty for
them to control total credit. They can't do it. That is, they have no
handle for controlling total credit just as they have not a very good
handle for controlling Mi or M2.
Senator PROXMIRE. Would you say no handle?
Mr. SPRINKEL. Well, they can affect bank reserves, but there's
not a close relationship between changes in bank reserves and
changes in total credit. There is a reasonable relation between
changes in bank reserves and Mi, but when the public shifts its
preferences among the various components of money, as when interest rates move a lot, that relation becomes looser. Now I keep a
chart that relates Mi to total spending and it's a pretty good relation. That is, this is a fairly sensible objective to try to control Mi,
but they can't do it with great precision because of the shifts that
you referred to. They can control the monetary base and/or bank
reserves with precision. There will still be a little noise in the Ms,
and ever more noise total credit. But to answer your question precisely, I do not think the Federal Reserve should go even further
into the series that they have even less control over and set that as
an objective, and how can the Congress enforce someone achieving
an objective it does not have the power to achieve?
I would like to see them move back and set their objectives in
terms of the series they can control; namely, either bank reserves
or the monetary base.
Senator PROXMIRE. For the record, I wonder if you could provide
us with a series of options to get interest rates down. You obviously
come down very hard and clear on what you feel is the best policy
224
and I'm grateful for that testimony, but I think there may be other
options the committee might like to consider because I think all of
us are very aware of the fact that high interest rates are at the
heart of our problem and we'd like to consider the broadest possible choices. At least this Senator would.
Mr. SPEINKEL. I'll be glad to think about a few, but the only
ones—I have thought about them—and the only ones that I think
will really work and continue to work are the policies I have already discussed.
Senator PKOXMIRE. That's fine, but you might just mention some
of the others and give us a word or two as to why you think they're
not appropriate.
Mr. SPRINKEL. I'll be glad to.
[The following statement was received for the record:]
STATEMENT OF BERYL W. SPRINKEL, UNDER SECRETARY OF THE TREASURY FOR
MONETARY AFFAIRS, ON ALTERNATIVE WAYS To REDUCE INTEREST RATES
(Requested by Senator Proxmire*
Interest rates remain high primarily for two reasons—they contain an expected
inflation premium and a risk premium. The route to lower interest rates is therefore, first, to control inflation; thai requires noninflationary money growth. Second,
the risk premium now contained in interest rates could be reduced steadier and
more predictable money growth and if the uncertainties surrounding the growth of
government spending and the deficit were reduced.
It is frequently suggested that interest rates could be reduced by either reaccelerating money growth or by some form of direct controls, such as credit allocation or
usury ceilings. Increasing the rate of money growth would not produce a lasting decline in interest rates. Any immediate drop in interest rates that might accompany
faster money growth would be extremely short-lived; ultimately, faster moneygrowth causes inflation and generates inflationary expectations which causes interest rates to rise, not fall. Inflationary money growth in the past is a major cause of
current high interest rates. Reverting to inflationary money growth would only
assure that high interest rates will continue into the future.
There is no evidence that direct controls on credit allocation or interest rates
would be effective in reducing interest rates in the long run. Such controls may hide
the symptom of high interest rates lor a time, but they are not a cure for the underlying problem. The experience with credit controls in 1950 is a good case in point:
interest rates fell temporarily while the controls were in place, but rose again to
new highs once they were removed. In addition, credit and interest rate controls are
difficult and expensive to administer, and, by interfering with the normal functioning of the financial markets, cause enormous distortions and inefficiencies in the
allocation of credit.
Senator PROXMJRE. Thank you, Mr. Chairman.
The CHAIRMAN. Thank you, Senator Proxmire.
Secretary Sprinkel, I'm sure there will be some additional questions for you in writing. Senator Riegle apologizes for not being
able to stay. He's also a member of the Budget Committee and had
to attend that other meeting. But I certainly appreciate the directness not only of your testimony but of your answers. We are often
accustomed to witnesses, particularly economists, before this committee who are always hedging their answers and it is refreshing
to have someone who, as you always have, gives direct responses.
We may not always agree, but it's nice to know exactly how you
feel and we thank you very much for that.
Mr. SPRINKEL. Thank you, sir. It's a pleasure to be here.
The CHAIRMAN. Thank you very much.
225
Next I'd like to call to the witness table someone who is used to
being on the other side of the table, on this side, Steven M. Roberts, who used to be a staff member of this committee, a very
valued staff member. We are happy to have you before the committee today in a different capacity, the other side of the table. We appreciate your willingness to be here and testify, so if you'd like to
proceed.
STATEMKNT OF STEVEN M. ROBERTS, DIRECTOR, GOVERNMENT
AFFAIRS, AMERICAN EXPRESS CO.
Mr. ROBERTS. Thank you very much, Senator Garn. It is a treat
to be on this side of the table.
The CHAIRMAN. And making real money in the private sector,
right?
Mr. ROBERTS. You mean what I made when I was on the other
side of the table wasn't real money? [Laughter.]
I'm grateful to you and the members of this committee for this
opportunity to share with you my views on the conduct of monetary policy by the Federal Reserve. I am here today because of my
deep concerns about high and volatile interest rates and their
effect on our economy, and about the serious conflicts that exist between fiscal and monetary policies.
MONETARY AND FISCAL POLICIES
Monetary policy is an important element in our overall economic
strategy and the Federal Reserve's ability to act flexibly and independently of day-to-day political pressures must be guarded and
protected. Fiscal policy is the other important component of economic policy. But, as you well know, it lacks flexibility and political independence, and, more importantly, at this point, credibility.
Unfortunately, observers throughout the world do not believe we
have the ability to manage our fiscal affairs appropriately. The reaction by our financial markets to the first budget resolution is
clear evidence of skepticism in this country with regard to the Congress commitment to reduce spending and deficits. And, the persistence of high real interest rates is a clear signal that our policy mix
needs to be changed—fiscal policy is too loose and monetary policy
too tight given our current economic conditions and problems.
Looking at the current situation pragmatically, I have serious
doubts that genuine substantive changes in fiscal policy can be accomplished until after the elections. At that point the serious questions concerning entitlements and defense spending can be debated
in a less politically charged, more rational atmosphere.
But that does not mean that we should sit back and be complacent. Events can be permitted to proceed without additional shifts
in policy. In my view this will mean most probably an anemic recovery with the strong possibility that governmental and private
credit demands will exceed supply and interest rates will rise as recovery begins, thereby limiting the chance for even moderate economic growth.
I believe that there is an urgent need for the Congress, the administration, and the Federal Reserve to seek innovative ways to
restore confidence in our economy and its institutions and to set
226
the tone for releasing the enormous economic strength that this
country has hiding underneath the burden of high interest rates
and skepticism.
There are things that can be set in motion now that would be
very helpful to getting us on the right track.
RECOMMENDATIONS
Specifically, I would recommend the following actions:
First, for monetary policy, I would drop Mi as an intermediate
target for monetary policy because that variable is grossly misleading.
Second, I think the Federal Open Market Committee should immediately adopt a "total net credit" aggregate as an additional
target for policy.
Third, the Federal Reserve should immediately bring together
senior representatives from the private sector to function like the
Committee on Interest and Dividends of the early 1970's—charged
with a mandate to come up with specific alternatives to get interest rates down and to reliquify major sectors of the economy.
Fourth, this committee should serve as a catalyst in rebuilding
the vitality of our long-term financial markets which are now very,
very quietly still. You should undertake an in-depth set of hearings
on the problems facing those markets and what can be done to restore their strength.
Fifth, the Federal Reserve should be asked immediately to stop
reporting Mi data weekly and to move ahead quickly with other
technical changes to improve the monetary policy process.
With regard to fiscal policy, the time has come for a thorough
reexamination of the fiscal policy process, a process that is too big
and too complex for piecemeal change. This could be done by the
passage of legislation to establish a commission—much like the
first Hoover Commission in 1946—to look at ways to make Government more effective.
Second, to increase the credibility of fiscal policy the budget process needs to be improved—a multi-year spending cap to reduce Federal outlays as a share of GNP should be adopted by the Congress
now (whether or not the balanced budget amendment to the Constitution is approved).
Finally, while the Hoover-type commission is being organized,
the Budget Committees of the House and Senate should set up several specific private sector advisory groups to recommend changes
in the budget process by November 30 of this year. There should be
individual groups from the business community, from the accounting professions, and other specific constituencies as deemed appropriate. This would allow necessary changes in the budget process to
begin immediately with the start of the next Congress.
Rather than going into the details of these points, I'd like to
have them included in the record and answer any questions that
you might have.
[Complete statement follows:]
227
STATEMENT OF
STEVEN H. ROBERTS
DIRECTOR - GOVERNMENT AFFAIRS
AMERICAN EXPRESS COMPANY
Thank you, Chairman Garn.
I am grateful to you and the members of the Committee for
this opportunity
to share with you my views on the conduct of
monetary policy by the Federal Reserve.
I am here today
because of my deep concerns about high and volatile interest
rates and their effect on our economy, and about the serious
conflicts that exist between fiscal and monetary policies.
Monetary policy is an important element in our overall
economic strategy and the Federal Reserve's ability to act
flexibly and independently of day-to-day political pressures
must be guarded and protected.
Fiscal policy is the other
important component of economic policy.
But, as you well know,
it lacks flexibility and political independence, and, more
importantly, at this point; credibility.
Unfortunately,
observers throughout the world do not believe we have the
ability to manage our fiscal affairs appropriately.
The
reaction by our own financial markets to the first budget
resolution is clear evidence of skepticism in this country with
regard to the Congress* commitment to reduce spending and
deficits.
And, the persistence of high real interest rates is
a clear signal that our policy mix needs to be changed
—
fiscal policy is too loose and monetary policy too tight given
our current economic conditions and problems.
228
Looking at the current situation pragmatically, I have
serious doubts that genuine substantive changes in fiscal
policy can be accomplished until after the elections.
At that
point the serious questions concerning entitlements and defense
spending can be debated in a less politically charged, more
rational atmosphere.
But that does not mean that we should sit back and be
complacent.
Events can be permitted to proceed without
additional shifts in policy.
In my view this will mean most
probably an anemic recovery with the strong possibility
that
governmental and private credit demands will exceed supply and
interest rates will rise as recovery begins, thereby limiting
the chance for even moderate economic growth.
I believe that there is an urgent need for the Congress,
the Administration, and the Federal Reserve to seek innovative
ways to restore confidence in our economy and its institutions
and to set the tone for releasing the enormous economic
strength that this country has hiding underneath the burden of
high interest rates and skepticism.
There are things that can be set in motion now that would
be very helpful to getting us on the right track.
Specifically, 1 would recommend the following actions:
229
- FOE Monetary Policy
o
Drop M-l as an intermediate target for monetary policy
—
o
that variable is grossly misleading.
The FOMC should immediately adopt a 'total net credit'
aggregate as an additional target for policy.
o
The Federal Reserve should immediately bring together
senior representatives from the private sector to
function like the Committee on Interest and Dividends
of the early 1970's —
charged with a mandate to come
up with specific alternatives to get interest rates
down and to reliquify major sectors of the economy.
3
This Committee should serve as a catalyst in rebuilding
the vitality of our long-term financial markets by
undertaking in-depth hearings on the problems facing
those markets.
>
The Federal Reserve should be asked immediately to stop
reporting H-l data weekly, and to move ahead quickly
with other technical changes to improve monetary policy.
230
- For Fiscal Policy
o
The time has come for a thorough re-examination of the
fiscal policy process, a process that is too big and
too complex for piecemeal change.
This could be done
by the passage of legislation to establish a Commission
—
much like the first Hoover Commission in 1946 — to
look at ways to make government more effective.
3
To increase the credibility of fiscal policy the budget
process needs to be improved —
a multi-year spending
cap to reduce Federal outlays as a share of GNP should
be adopted by the Congress now (whether or not the
Balanced Budget Amendment to the Constitution is
approved).
D
While the Hoover-type Commission is being organized the
Budget Committees of the House and Senate should set up
several specific private sector advising groups to
recommend changes in the budget process by November 30
of this year.
There should be individual groups from
the business community, from the accounting
professions, and other specific constituencies as
deemed appropriate.
Let me now turn to a more detailed discussion of each of
these points.
231
First, the nacjrowly defined money stock —
H-l _-_- has
serious definitional and prediction problems because^ of HOW
accou_nts__and__ other financial innovations that make
Interpretation of observed changes difficultat best.
Therefore, H-l should be dropped as an intermediate target for
monetary policy.
It makes no economic sense for the FED or
anyone else to focus attention on a variable whose definition
is changing by actions in the market almost daily, whose
behavior is impossible to predict, and whose relationship to
income, employment, prices, and trade is uncertain.
I am not alone in this recommendation.
In fact, Frank
Morris, the President of the Federal Reserve Bank of Boston and
a member of the POMC, has also made this same point publicly.
For many years the relationship between H-l and each of the
final targets of monetary policy, namely, income, employment,
prices and trade were fairly close and predictible.
However,
during the mid-1970's circumstances began to change and such
changes have continued.
three events —
The changes were brought about by
continued high inflation rates, continuing high
interest rates, and financial deregulation.
Innovation in financial markets is extremely fast.
New
financial products such as overnight repurchase agreements,
money market funds. Eurodollars, NOW accounts, money market
funds, and cash management accounts are appearing with
232
increased frequency as individuals and corporations seek to
earn a market rate of return on liquid assets.
These important
and popular money substitutes cannot be incorporated into the
definition of M-l quickly enough to maintain the meaningfulness
of that aggregate,
—
indeed, the appropriate definition of money
M-l in particular —
has proven to be quite elusive. Recall
the FED's attempts to have two different M-l variables several
years ago.
I think they used the names "M-1A" and "M-1B".
Last year the PED used a variable that was called "M-l shift
adjusted".
Thus, the PED has recognized that there are
significant problems with the M-l concept.
But nevertheless,
FED policy continues to focus on what is a very misleading
variable.
Deregulation has already complicated the fomulation of
monetary policy based on changes in growth of the monetary
aggregates.
With additional financial deregulation being
considered the situation will get even worse.
Here is what one
senior staff member of the Federal Reserve Board's Division of
Research and Statistics recently said;
As you know, monetary policy formulation is now keyed to
selecting targets for growth in the monetary aggregates
that are expected, to produce certain results in terms of
income/ output, prices, etc. Deregulation, especially of
the terms of deposit liabilities may well complicate this
process by changing the relationship of income to money —
defined to include primarily some collection of deposit
liabilities. As early as 1978, the creation of the 6-month
MMC, by reducing constraints on the availability of
233
mortgage money at s&Ls, probably meant more income could be
financed at higher interest rates with the same level of
money. More recently, the nationwide spread of HOW
accounts last year induced shifting of funds into these
accounts, which are included in narrow money—HI, from
savings accounts and other non-Mi sources, thereby
distorting the relationship of Ml growth to income flows.
The Federal Reserve made some rough adjustments to our data
to take account of these shifts, but these adjustments were
not fully understood or accepted by many observers of
monetary policy, and they probably did not raise the level
of comprehension of monetary policy by the general public.
Moreover, reflecting their use as a savings vehicle,
deposits in NOW accounts this year do not seem to have
behaved exactly as funds held in demand deposits used to,
further complicating monetary policy formulation. More
generally, as deposit categories are deregulated, their
character may change, and with this change policy makers
would no longer be able to rely on historic relationships
in evaluating their choices. These problems may be most
acute in the transition phase to a new deposit structure—
as they were last year with NOW accounts— but they are
likely to persist as a byproduct of deregulation for some
time.
If the above statement by the Federal Reserve's own staff
is accurate, and I believe it is, not only is M-l a very
misleading indicator of policy at this time, but more
importantly all of the monetary aggregates must be interpreted
with extreme caution.
During what may be a lengthy transition
period reliance solely on monetary aggregates as short-term
indicators of FED policy should be avoided.
I agree with my monetarist friends who say that over the
long-term/ that is over the full course of the business cycle,
it is important to maintain growth in the monetary aggregates
at rates consistent with reducing inflation.
however, be done in an intelligent manner.
This must,
It does not mean
234
that the FED should be slaves to M-l, or any other aggregate,
on a week-to-week basis, or even on a month-to-month basis.
Technical complexities and market induced changes in the
definition of what money means to those who use it cannot be
easily incorporated into monetary aggregate measures or
targets.
Furthermore, we have seen recently that changes in
velocity in the short-run can be very misleading and in some
circumstances could result in faulty policies.
During this transition to a deregulated financial
environment monetary policy will continually be grasping at the
appropriate monetary target variables.
I recommend that the
FED look at all available indicators not just the monetary
aggregates.
Other useful indicators should include:
intermediate targets such as nominal and real interest rates
and net total credit, or the ultimate objectives themselves,
income, employment, prices, and trade.
The FED should be asked
to explain their policies in terms of the affect they have on
these variables as well as on the monetary aggregates.
Several people, including Secretary Sprinkel have
recommended that the Federal Reserve adopt the monetary base or
nonborrowed reserves as a target variable.
I believe that
there would be serious problems with this.
First, both of
these variables should be viewed not as targets of monetary
policy, but rather as instruments of policy that might be used
235
to attain the intermediate target objectives.
targets are two different things.
composed of two parts —
Instruments and
Second, the monetary base is
currency and. nonborrowed reserves.
Changes in currency are beyond the control of the Federal
Reserve, they represent a derived demand.
Whenever a bank is
in need of currency it can be obtained from a Federal Reserve
Bank, most often by a debit to their reserve account.
While
the FED could take additional action to offset the demand for
currency it is questionable that they should do so in all
instances.
Third, the FED is already using nonborrowed
reserves as its instrument variable, and adjusts changes in the
instrument according to changes in economic and financial
conditions as they occur.
Second, the federal Reserve for its^jgjjrXjnust recog_ni_z_e_
that c^ ec! it^avai 1j bi 1 i ty an d q r owt h ace j u s t a s_jjnpor t ant a_s
monetary grpwth_-_ _jjgct. r^naj^re ingne t arj. sjn _i_s com ing jindei:
and abroad.
The FOHC shouj.d_be
asjted to_^ immediately hold public hearings^^n_tj]e_a^visability
of establishingi^LS ^ne^gf^i^s intermediate targets tqt:al^nej:
credit— the outstanding^ indeb^t^anesj_oj^jall U.S. nonfinancial
borrowers.
Their present credit aggregate — bank credit — is
seriously inadequate because it represents only a small portion
of the total.
Establishing a target for total net credit,
moreover, would be entirely consistent with the objectives and
requirements of the Humphrey Hawkins Act.
236
DuiJirtg the past several years an increasing number of well
qualified observers of monetacy policy have recommended to this
V
and other Congressional Committees that the Federal Reserve
adopt a more useful credit aggregate target than the one they
currently use —
bank credit.
Unfortunately/ the FED has only
paid lip-service to such recommendations, or has argued that
they cannot control anything but bank credit.
According to Professor Benjamin H. Friedman of Harvard
University, based on a variety of methodological approaches,
total net credit in the united States bears as close and stable
a relationship to U.S. nonfinancial activity as do the more
familiar asset aggregates like the money stock.
research has shown that the U.S. nonfinancial
Friedman's
economy's
reliance on credit, scaled in relation to economic activity,
has shown almost no trend and very little variation since world
War II.
Secular increases in private debt have largely
mirrored a substantial decline (relative to economic activity)
in federal government debt, while bulges in federal debt
issuance during recessions have mostly had their counterpart in
the abatement of private borrowing.
This type of stability
would make total net credit a useful target for monetary
policy.
Henry Kaufman of Salomon Brothers has indicated much
the same thing in testimony before this committee some years
ago.
So that you have the full benefit' of his views I have
237
attached to my testimony a piece of recent testimony given by
Professor Friedman,
I recommend it to you.
Having a broad credit aggregate as an intermediate target
for monetary policy would have the added benefit of bringing
into clear focus the effects that borrowing by the Federal
government, directly and indirectly through Federal credit
programs, has on the availability of credit to the private
sector.
The large deficits this year, and projected for the
next several years, will, given a fixed supply, put upward
pressure on interest rates since rates are the "main" allocator
of credit among competing users.
I emphasize the word "main"
because the Federal government does have a unique position as a
borrower .
Third, the ^ede^caj^Reser^ve should iminedjLatej/yjejtab^lish a
Committee^ to _function_ like^he^Commrttee on Interest arid
DividendSj_which_w_as jj
hold j^ng down^_i n t e re s t r a t e s . Since the shift in the Federal
Reserve's policy strategy in October 1979 interest rates have
been set primarily, and credit allocated, by participants in
financial markets.
Therefore, participants in financial
markets must also take on some additional responsibility for
the economic well-being of this country.
Individual companies
will act in the short-run in their own best interest and in
ordinary circumstances they should.
However, circumstances are
238
now such that participants in financial markets must be brought
together and they must act collectively to get interest rates
down in the long-run best interest of the country.
This can be
done by private initiative without resorting to mandatory
controls/ but rather voluntarily with some input from the
Federal Reserve.
We in the private sector can no longer enjoy
the luxury of merely sitting back on the sidelines carping
about policy-makers' dilemmas.
Everyone is asking a very pertinent question about monetary
policy:
What can be done to get interest rates down so that
the economy can be revived?
Chairman Volckec's response to
this question has been that the FED has little leeway to act.
We can, of course, debate whether this is true.
But, as long
as the Board thinks this is true they will be reluctant to act.
Some observers have suggested that credit controls be used
to do what the FED cannot or will not do.
The politics of
current circumstances preclude this type of action.
I think it
highly unlikely that the President will ask for credit control
authority to be restored and thus I consider the issue dead.
However, this does not preclude the Federal Reserve oc the
Administration from turning to the private sector for voluntary
action/ nor does it preclude the use of 'jawboning", a tactic
that has been successful in similar circumstances in the past.
239
During the period of Nixon wage and price controls the
Committee on Interest and Dividends was created to advise the
Federal Reserve on ways to keep interest rates down.
One
suggestion that was made by the CID and adopted by many banks
was to have their prime rates set according to formulas linked
to their cost of funds.
While the exact formulas differed many
banks set their prime 3/4 to 1 percentage point above the cost
of funds.
While circumstances differ now, I think similar
innovative suggestions would be found by senior financial
executives that would result in a significant lowering of the
prime and other short-term rate in very short order.
But, this
and similar initiatives must come from the private sector with
guidance from either the FED or the Administration.
No lender
will voluntarily reduce their spreads unless they have good
reason to believe that their competitors will do likewise.
I
am confident that if something akin to the Committee on
Interest and Dividends was re-established tomorrow that
additional innovative ways to lower interest rates through
private sector initiatives could and would be found.
FQurth,._ tbe___p_qtentia1 loss of aur_j,ong_-1erm_bond markets
sjiould jio Ignge^r^be^ ignored.
It would be a serious mistake to
permit all borrowing to be concentrated in short-term
instruments which can be subject to significant internal and
external shocks.
As mote and more financing is done
short-term, fluctuations in short-term interest rates will
240
reach every nook and cranny of the economy quite quickly, which
may be neither desirable nor healthy for the long-term.
committee shQujj^innnedjately undertake a broad _set_ of hearings
jesj. gnej t o u n_d_g rst_agd_ the _pr ob 1 em_s i n Ion g ~ t e_r m ma r k eit.sL wha t
they Imply for^ the future of our fin^angj.a^l^ system ,^an^
approaches to infjsinq^rigw_liXe into those rnarketsr.
It would
be a serious mistake to let those markets evaporate, which is
exactly what has happened in Europe.
This issue needs little further explanation. A story in
last Friday's Washington Post explains the situation very
clearly, and therefore, I have attached a copy of it to this
testimony.
Investors and borrowers have avoided the long-term
bond markets for some time for two reasons;
the high costs of
borrowing long, and uncertainty about the future. As a result
corporations have turned t'o short-term sources of funds for
both liquidity needs and perhaps even to finance needed
investments.
Many corporate treasurers are taking this
approach in anticipation that rates vill drop and that they
then can find more permanent financing at more favorable rates.
But, what are the implications for the long-term markets if
rates do not fall or worse yet rise and stay high?
Will the
long-term markets be lost forever or for an extended period of
time and will all financial decisions in the future be based on
short-term or floating rate credit?
What would the
241
implications of this be for future investment spending?
What
dangers does this pose foe stability of financial markets?
These are important questions that should not be avoided.
This
is why I urge this Committee to hold comprehensive oversight
hearings on this issue as quickly as possible,
^ut iti
place several technical changes ^in its procedure that it has
in di cat e d . t w i 1 1 ma k e a nd sho u 1 d a 1 so cons id er
3 ever a 1 ot he r s . Important changes in the reporting of weekly
M-l data and reserve accounting have been announced but not
implemented.
The FED should also consider linking the discount
rate to market rates and staggering reserve maintenance
periods.
Both of these latter changes would tend to smooth
interest rate movements.
This committee has been instrumental in getting the FED to
consider changes in the reporting of weekly H-l data and lagged
reserve accounting.
Although the Board has approved in
principle these changes they have yet to be put in place.
While the Board should be complimented for their decisions,
they should also be urged to move ahead quickly to implement
those decisions.
I would also note that I think the Board has
not gone far enough on its decision about weekly H-l data.
Consistent with my recommendation that M-l be dropped as a
target variable I think that the Board should publish H-l only
once a month.
242
It is my understanding that the Board is now considering an
additional change to the maintenance of required reserves.
This change would basically divide those institutions required
to hold reserves into two groups, and would have each group
report in alternate weeks -- thus the term, "staggered reserve
periods".
This would be a significant and useful change
because it would permit banks in one group to provide excess
reserves to banks in the other group, thereby reducing the
variability in interest rates that occurs now as all banks
scramble to meet their reserve requirements on the same day.
I would also suggest that the discount rate might usefully
be tied to market rates of interest once the FED moves to a
contemporaneous reserve system.
discount rate more frequent.
This would make changes in the
And, although the FED would lose
the so-called "announcement effect" that changes in the
discount rate now have, that loss would be small by comparison
to the gain in control of reserves.
Consideration should also
be given to making the discount rate a penalty rate during
periods when additional restraint is needed.
S. 1 xt j\ , t o_f\i rtjigr_. the po s s i b i I i ty^ Qr^credj. bjJL
_f_l_g_cal policy an^d^^j^e ^budget process, a bi-partisan body of
k no w 1 e dgeabj^e _p_e_rs o_n_s ,_ much 1 i k e t he or igji^ai j^ jHooye^ Cgmm i s s ion
_in__I_9_46_/ _3hould_ be established by l_aw.
In _fac_tf this process
243
has already been jget in motion.
Last year Senators Roth and
Eagleton introduced S. 10 in the Senate and Congressman Boiling
introduced H.R. 18 in the House to create a Commission on More
Effective Government.
The mandate given by the legislation
could and should focus on the fiscal policy process in general,
and the budget and appropriations processes more specifically.
The idea for such a Commission has been endorsed by the
President.
I understand that s, 10 has been passed by the
Senate by a vote of 79 to 5, but that H.R. 18 is still pending
in a House Subcommittee.
I would urge you and your colleagues
to ask the House to move ahead with its consideration of H.R.
18 or S. 10 as quickly as possible.
The Commission's work may
take eighteen to twenty-four months so additional delays in its
formation could be costly.
I admit that the challenge that faces us/ and I mean that
collectively, to control Federal spending is immense.
But it
is not beyond our capacity to get tough on spending.
However,
the Balanced Budget Amendment to the Constitution, if it is
adopted, is no panacea.
Additional approaches to deal with the
problem, such as a legislated spending cap with appropriate
changes in the Budget Act to make it effective and credible,
can be constructed and enacted.
I need not get into this issue in much detail, because the
members of this committee are more aware than I about the
244
public perception of fiscal policy and the budget process.
Steps need to be taken now to give the congressional budget
process more credibility.
The best way to do this is to show
significant self-restraint/ not just once but over a period of
time.
The FED by adhering to targets that it has set during
the past several years has shown that this approach works to
restore credibility.
The Congress can do the same, but again
time is of the essence.
Attached to my testimony is a draft proposal for a Joint
Congressional Resolution that may be useful in this regard. It
proposes five year goals for reducing Federal outlays as a
share of GHP.
While this is not a new approach, it is timely.
The Chairman of my company, James D. Robinson III, has been
discussing this type of resolution with various members of
Congress, the Administration, and the business community.
It
has been well received, not because it is a cute-all for our
fiscal problems —
it is not —
but because it represents a
starting point foe changes in the budget process.
Also
attached is a short talking paper explaining the need for this
type of approach.
Some type of credible action to reform the budget process
is needed now.
The financial markets would react favorably to
such a meaningful and credible commitment to reduce federal
outlays over the next several years.
The establishment of
245
goals to accomplish such reductions would be useful, but only
if the goals are adhered to by the Congress.
This will require
changes in the Budget Act to establish such goals and to put in
place a mechanism foe adhering to the goals.
Seventh, ._ Credibility. In fj.scal policy needs to be
established ^nd^it^annot wait for an amendment jo the
Ccjnst^it.uti^on^ tq^ _be_enacted__aiid__rat if ied_ by the jtatea.
The
Congressional Budget process^ needs to be improved an& _a jirnif
jgdeJby^ the Congress immediately tp make
cpmmitmerit can be made now by^ resolution
goal jbg reduction of
federal outlays^ as a share of gjcoss natigna^ prgduct_gver_
the^ next f iye yeajrs^, say^ t^o 2j percent or less or some other
ap£ r^p r i a t e p e re e nt ag e •
Other changes in the budget process
such as the establishment of a credit budget, the establishment
of a capital budget, the establishment of a multi-year budget
[say for two years), a 2/3 vote for any budget resolution, a
line item veto for the President, and other ideas should be
explored.
Finally, while ^he j-dea^of^a^Hoc^ver-tYpe^ Cjjminissign
i^swa^ through CongrejS^ and^ thg process of organizationj, the
ajpprojpriate jojnmittees of the Congress shojjld
on reforming
246
To _fu_cthet_ the possibility _£p_t credible changes, in the
budget. process^ non-partisan, _np ^-political private ^_sect_or.
ajvisory groups^
t he agp ropr i aj.e. cprom i^tegs__gf t h e jjongrgss; . If the private
sector, and especially the financial markets are concerned
about fiscal policy, federal spending, and federal deficits
they should do their part in recommending useful changes in the
process.
This would be yet another example of private sector
initiative and should include representives of financial
markets, the business community, accounting firms, and other
important constituencies.
These advisory groups should be
formed quickly and given a short time frame within which to
make their recommendations, so that changes in the budget
process can proceed to be considered as soon as the 98th
Congress begins its work.
Thank you.
247
&K Utasljmglon
Friday, July 23,1982
Companies Rushing to Borrow
By James L. Rowe Jr.
Wuninjloii Pan stiH HUM
NEW YORK, July 22-Companies have been rushing to sell short'
term bunds and notes during the
past few weeks HI a frantic attempt
to take advantage of the sharp decline in interest rates.
The list of companies that haw
sold what analysts Hay is more than
$1 billion this week and last reads
like a who's who of corporate America DuPont, F<id Motor Credit,
Caterpillar, General Mills, Getty Oil,
Mead, Champion International
At 6:25 p.m. today, BankAinerica
Corp, which owns the nation's sec-
ond-biggest bank, announced that it
was selling (300 million at notes,
But with ran exception!, moat
companies that would have sold 20year bonds five years ago are selling
note that mature within five yean
or leas, according to Bernard Harmon, vice president of the brokeiag*
firm Drexel Biunham Lambert Inc.
The window » open, but it's open •
crack," he said..
Most companies ue reluctant to
aeH debt securities (such as not**
and hoods) that mature in more
than 10 years became, even with the
ateep fall in interest costs during the
past four week*, rates remain historically higb, ,
,.
'Furthermore, potential p
of Song-terra bonds still are
buying then, remembering
all previous "rallies" since tta
interest-rate siege began four
ago, sharp declines in
quickly followed by returns to '
highs,
-_
Investors who Bought
rallies were left with securities
leas than their face, value whed
roee again. _,.*
See COMP AMKS,<
three years, inveatnrs can redeem
COMPANIES, From C9
But James W. Simpson, managing them or extend them for another
director o.f industrial finance for three years at an interest rate set by
Merrill Lynch White Weld, the in- a formula lied to other interest rates.
vestment banking arm of the na- The final maturity of these notes
tion's biggest securities firm, said will be 1997.
BankArtrerica's so-called money
investors are starting to get interestmultipliers are the equivalent of BOed in buying longer-term securitie&
"For the first time in a year," called zero-coupon bonds. Instead of
Simpson said, "the yield curve is receiving interest every qauter or
- positive-" That means an investor every nix months, investors pay a
> gets a higher return for a 20-year price leas than face value and receive
bond than for a six-month note. the full amount of the note at matu' When short-term rates are higher rity. The notes will pay $1,000 at mathan long-term rates, there is no rea- turity. An investor who buys a money
son for an investor to take the risk of multiplier that matures on Dec. 15,
putting funds out for a longer peri- 1987 pays. I5W>. For a note, that returns $1,000 on June 22, 1993, an
od.
i
And Hemy Kaufman, the oft- investor pays $250 today.
William Keneiael, a principal of
•, quoted economist It" Salomon
• Brothers whose forecasts are closely the investment banking firm Morgan
watched, is predicting today that Stanley & Co., said that companies,
short-term interest rales will decline for the moat part, are using the
further. He also says those declines funds they raise in the bond market
to pay off short-term borrowings
' probably will be short-lived.
| But long-term investments still from their banks ur in the commerare not attracting investors or issuera cial paper market. The bank prime
^ and. in the early stages of the rally, rate, for example, is IE percent
r many companies are setting notes
Rates have plummeted in recent
weeks, according to William Sullivan
with a new gimmick exlendability.
of the Bank of New Yorfe, because
For esample. Caterpillar Tractor
sold $150 million of three-year ex- recent declines in the money supply
have permitted the Federal Reserve
tendable notes that carry a yield of
i U'/i percent t*> alarl At the end of to loosen its monetary policy.
248
July 14, 1902
TESTIHOBY BEFORE THE j]Nimp_STA_TES HOUSE OF REPRESENTATIVES
CCMMITTEEJ3N BflMKIHG,
FINflHCE^jffD^Ura_
SUBCOMMITTEELCK JKJMBSTIC HMETflRY
KJLICT
Benjamin M. Friedman
Professor of Economics
Harvard University
A CREDIT ia»ffiT_Fps_.psEraRy POLICY
He.
1 am grateful for the opportunity to review with this committae the
proposal for an alternative monetary policy framework that. I presented to it
almost a year ago.
During the past year, as the U*S, economy has undergone its
second business recession of the 1980s, monetary policy has been more than
ever the focus of national attention.
As people have continued to examine
closely the course of monetary policy and its impact on economic events, they
have increasingly begun to question not just the specific stance ol monetary
policy at any tine but also the operating framework that defines U.S. monetary
policy.
In particular, many people have questioned whether the framework
now in use, which centers on specific target rates of growth for the monetary
aggregates, is the best way to conduct monetary policy today.
I believe
that this more fundamental concern is highly appropriate, and I hope that the
committee's inquiry into possible alternative targets for monetary policy
will further the prospects for a serious evaluation of this issue — and,
if a sufficient consensus emerges, for actual reform.
I am honored to take
part in this discussion.
I believe that reform of the U.S. monetary policy framework is now
249
overdue; that the exclusive emphasis on monetary aggregate targets has outlived
its
usefulness? and that a broader framework, based on both money and credit,
would be more appropriate in today's economic and financial environment.
Specifically, I propose that the Federal Reserve System adopt an explicit
two-target framework in which it would focus both on the money stock and on
the quantity of credit outstanding.
I believe that a two-target aoney-and-
credit framework for monetary policy would be more likely to achieve the
objectives of economic growth, economic stability and price stability that
both th* Congress and the American public seek.
In this testimony I will first review several factors that account
for the recent widespread disillusionment with the monetary target approach
which now dominates U.S. monetary policy making.
Next, I will outline the
basic idea underlying the use of an intermediate target for monetary policy,
and state four important criteria for choosing such a target.
I will then
say why, on each of these four criteria, credit is just as good a target
as is money.
Finally, I will outline the two-target money-and-credit frame-
work that I have proposed, and explain why it is likely to be superior to
the current money-only framework,*
Bie ^isillusioninBnt with Honetary^Targefc5
Monetary aggregate targets have occupied center stage in U.S. monetary
policy making in recent years.
3he Federal Reserve System firet used such
targets in a formal way in 1970. In 1975 the Congress passed House Concurrent
Resolution 133, requiring the Federal Reserve to formulate monetary policy
•In what follows I will draw heavily on several of my recent papers, especially
"Tine to Re-Exandne the Monetary Targets Framework" (New Biglanfll Economic^
Review, March/April, 1982) and "Monetary Policy with a Credit Aggregate Target'
(forthcoming in the Journal jif Monetary Economics, available now in mimed) .
See these two papers for further detail, including supporting evidence on
the comparisons between money and credit.
250
In terms of specific money growth targets to be reported to Congress in
advance, and in 1978 Congress reinforced this requirement under the HumphreyHawkins Act.
In October 1979, the Federal Reserve publicly reaffirmed its
commitment to monetary aggregate targets, and adopted a bank-reserves operating
procedure for seeking to achieve then.
Several strands of economic opinion and analysis, shared in varying
degrees among people concerned with monetary policy, apparently led to this
focus on monetary aggregate targets.
One was the belief that the supply
side of the U.S. economy was essentially stable, and that economic fluctuations
were due mostly to instability in aggregate demand which a more stable
money growth rate could help avoid.
Another was the widely perceived problem
of determining hew any given level of interest rates would affect the economy,
as rapid and volatile price inflation made "real" interest rates ever more
difficult to measure; by contrast, measuring "money" was supposedly straightforward.
Still another was the increasing focus on price inflation itself
as a major economic policy problem, together with the belief (apparently
supported by the then available evidence) that the rate of money growth
placed an effective ceiling on the economy's inflation rate.
Finally, a
matter of importance at least to economists was the belief that behavior
in the economy's financial markets, including especially decisions by households and businesses about how much money to hold, was more dependably stable
than were important aspects of behavior in tha economy's product and factor
markets.
No doubt other influences, perhaps including political and even
personality factors, were also at work in bringing about the adoption of the
monetary targets framework during the 1970s, but this set of ideas probably
comprised the central thrust of that important development.
Each of these
251
propositions, if true, would have represented a significant argument in
favor of the use of monetary targets, and the joint validity of all of them
would have< constituted an overwhelming case for that way of designing and
carrying out monetary policy.
i
Regardless of whether or not the best possible assessment of the
available evidence actually supported these propositions at that time (a
question which in hindsight people may debate without limit), they do not
appear consistent with the facts today, ttte experience of the 1970s, and
of the 1980s to date, has sharply contradicted each of them.
Oil shocks
and agricultural price shocks have powerfully illustrated the importance
of instability on the economy's supply side as a cause of economic fluctuations,
As financial market participants have shown their innovative skills by
developing a wave of new financial instruments and new ways of using old
ones, measuring "money" has become anything but straightforward.
Price
inflation has been able to outpace by substantial margins the ceiling
supposedly set by money growth rates, at least for several years at a tine,
tad economists' historical relationships describing the public's demand
for money have all but collapsed.
For all of these reasons, today's disillusionment with the monetary
targets framework for U.s, monetary policy is not sinply a matter of
unhappiness over the economy's recant performance.
After all, any specific
adverse economic e^ierience could be due to either poor policy decisions or
poor execution, or even bad
luck, rather than an inadequate framework.
The desire for change today is instead more fundamental, and therefore more
persuasive.
The well understood propositions that would favor the exclusive
reliance on monetary aggregate targets, if they were true, just do not
match today's environment.
252
Using^and Choosing Monetary Policy Targets
Central banks have often found it useful to formulate and implement
monetary policy by focusing on some intermediate target or targets.
Under
an intermediate target strategy, the central bank specifies soae financial
variable(sj — i n the United States today, the major monetary aggregates
— to stand as proxy for the real economic targets at which monetary policy
ultimately aims, such as economic growth, price stability, employment, and
international balance.
The result IB, in effect, a two-step procedure.
The central bank first determines what growth of the intermediate target is
most likely to correspond to the desired ultimate economic outcome.
It then
sets some operating instrument over which it can exert close control — in
the United States either a short-term interest rate or, since October 1979,
the quantity of reserves — so as to achieve that growth rate for the
intermediate target itself.
The essence of the intenwsdiate target strategy is that, under
it,
the central bank is required to respond quickly (and fully) to any information
reflected in the movements of whatever the intermediate target happens to
be.
Under the current framework in the United States, with monetary aggregates
used as the intermediate targets, any movement in the public's money holdings
immediately creates a presumption that the Federal Reserve System should
react.
In principle the Federal Reserve is always free to change the money
growth targets, of course, but in practice It is typically reluctant to do
so.
Ihe intermediate target strategy instead calls for actions aimed at
regaining the stated targets, so that the economic signals contained in
movements of the monetary aggregates create a presumption of immediate response,
Ely contrast, the presumption of this strategy, strictly implemented, is that
there will be no response to signals arising from other sources but not
253
reflected in the intermediate targets.
If the intermediate target strategy with the monetary aggregates as
the central targets is faulty, what should the Federal Reserve da in
its place?
One plausible response to the changed circumstances 1 have
summarized above would be to reject the usefulness of any intermediate
target at all for monetary policy.
Without an intermediate target, the
Federal Reserve would focus its policy directly on the nonfinancial economy
— which, after all,
policy.
constitutes the ultimate reason for having a monetary
Such a direct approach may well constitute the most effective
policy framework, and an informed public discussion of the idea would be
highly useful.
Even so, ft practical assessment of the situation suggests
that, at least for the immediate future, both the Congress and the Federal
Deserve itself are firmly committed to having some kind of intermediate
target to facilitate monitoring monetary policy on an ongoing basis.
Today's
hearing on alternative targets for monetary policy appears to be in this
spirit.
The question at hand, then, is to choose some alternative intermediate
target to use in addition to (or perhaps even instead of) the monetary
aggregates, as a focus of monetary policy.
To be sure, an enormous variety
of financial variables is available for this purpose.
Hie problem is not
just finding potential targets but identifying targets which, if used, would
lead to a superior performance for monetary policy.
The structure Of the intermediate target strategy itself suggests
four important criteria for choosing such a target.
First, and most obviously,
the target should be closely and reliably related to the nonfinancial
objectives of monetary policy.
Second, movements of the target should
contain information, about the future for current but not readily observable)
254
movements Of the nonfinancial objectives of policy.
A close relationship
per ee is necessary but not sufficient to make a useful target.
Third, the
target must be closely related to the operating instruments which the central
bank can control directly — i n the U.S. context, once again, either reserves
or a short-terra interest rate.
There would be little point in having an
intermediate target Chat the central bank could not reasonably expect to
effect within some tine horizon like a calendar quarter or a half-year.
Fourth, data on the target must be readily available on a timely basis.
Ihese four criteria will largely determine the suitability of any
financial variable — including the monetary aggregates as under the current
framework, or a credit aggregate as I have proposed, or any other alternative
that the committee wishes to consider — as an intermediate target for
monetary policy.
Evaluating Credit &s a^ Monetary_^Policy JT&rget
I have proposed a credit target for D.S. monetary policy because 1
believe that at least one specific credit aggregate, total net credit (the
outstanding indebtedness of all U.S. nonfinancial borrowers), satisfactorily
meets each of the four criteria I have stated above.
Before proceeding
to such a conclusion, it is essential to ask at the Outset, "satisfactory"
in comparison to what?
Because the current framework used by the Federal
Reserve System relies on monetary aggregate targets, the immediate standard
required to support a proposal for change is that the proposed new target must
meet these four criteria at least as well &s do the monetary aggregates that
ax* the current focus of monetary policy.
meat
1 believe that total net credit does
each of these four criteria at least as well as the monetary aggregates.
First, results based on a variety of methodological approaches
255
consistently indicate that total net credit in the United States bears as
close and as stable a relationship to U.S. nonfinancial economic activity
as do the more familiar asset aggregates like the money stock {however
defined} or the monetary base.
Moreover, in contrast to the familiar uset
aggregates, among which there appears to be less basis for choice fron this
perspective, total net credit appears to be unique in this regard among
major liability aggregates. Unlike the asset aggregates, the stability
of the relationship for total net credit does not just represent the stability
of a sum of stable parts.
Because this first criterion for selecting a monetary policy target
is the me that always receives the most attention, and rightly so, it is
worth reviewing the relevant evidence with some care,
Bie U.S. nonfinancial
economy's reliance on credit, scaled in relation to economic activity, has
shown almost no trend and but little variation since World War II,
After
falling from 156% of gross national product in 1946 to 127% in 1951, and then
rising to 144% in 1960, total net credit has remained within a few percentage
points of that level ever since,
(The yearend 1981 level was 143%.)
Other-
wise it has exhibited a slight' cyclicality, typically rising a percentage
point or two in recession years (when gross national product, in the
denominator, is weak) and then falling back.
Although the individual conponents
of this total have varied in sharply different directions both secularly
and cyclically, on the whole they have just offset one another.
In brief,
the secular rise in private debt has largely mirrored a substantial decline
(relative to economic activity) in federal government debt, while bulges in
federal debt issuance during recessions have mostly had their counterpart
in the abatement of private borrowing.
For purposes of monetary policy, however, what matters is not just
256
stability in the sense of zero time trend but stability in a more subtle
(and, importantly, a dynamic) sense.
Empirical analyses relying on several
different methodologies —ranging from comparisons of "velocity" ratios,
to comparisons based on detrended data, to "predictive" performance in
regression equations explaining the variation of nominal income, to more
complicated analyses based on bivariats and multivariate vector autoregreesion
systems — all show that the relationship between total nonfinancial debt
*nfl economic activity is fully as stable and regular as is the relationship
for any of the Federal Reserve's standard "M" aggregates (on either the
pre- or post-1980 definitions) or the monetary base.
Further, the stability of the credit-to-income relationship is a
phenomenon in no way restricted to the United states in the post World
War II period.
Ti'he U.S. nonfinancial economy's reliance on debt relative
to economic activity has shown essentially no trend over the past 60 years.
(She 1921 level was 142%.)
Nonfinancial borrowers' outstanding debt rose
significantly in relation to gross national product only during the depression
years 1930-33, when the economy was deteriorating rapidly and many recorded
debts had defaulted 3e facto anyway.
Otherwise the postwar stability in
the United States appears to be continuation of a pattern that dates back
at least six decades.
Among foreign economies, analysis of post World Wax
II data thus far has demonstrated a similar comparability of the credit-toincome and money-to-income relationships in Britain, Canada, Germany and
Japan. In sum, there is ample ground for believing that total net credit
is as closely related to nonfinancial economic activity as is any of the
monetary aggregates that are so central to today's monetary policy framework.
Second, the finding that the credit-to-income relationship is as
regular and as stable as the money-to-income relationship would be of little
257
interest in a monetary policy context if the economic behavior underlying
these results were such that money "causes" income while income in turn
"causes" credit.
The evidence contradicts that notion, howeverj indeed,
if anything, they suggest the opposite.
"Hie relevant causal links between
financial «ni3 nonfinancial economic variables appear to be highly complex,
but results based on econometric exogeneity tests show that money and credit
play royghly parallel roles, with credit somewhat more significant than money
in determining the variation of either zeal income or prices.
Still further
results of decomposition of variance, based on a variety Of different
statistical specifications so us to avoid spurious conclusions, suggest
not only that current movements of financial variables do contain potentially
important information about future movements of nonfinancial economic activity
but also that credit contains more of such information than does money.
Third, while it would be difficult for the Federal Reserve System
to exercise very precise control over the total net credit aggregate over
short time horizons, recent experience has demonstrated that the monetary
aggregates are not easy to control either.
What matters for the choice of
monetary target variable, once again, is the comparison of money and credit.
Evidence based on both quarterly and monthly regression relationships
suggests that, if the Federal Reserve chose to pursue a total net credit
target, it could achieve a degree of control over that target fully comparable
to what is possible for the major "M" aggregates.
Itie exact comparisons
differ accordina to the time horizon used for judging successful control,
and also according to whether the operating instrument the Federal Reserve
used would be nonborrowed reserves (as since October 1979) or the federal
funds rate (as before that date).
In sun, however, the evidence is
consistent with the Federal Reserve's being able to inlluence a total net
258
credit target, via either a reserves or an interest rate instrument, in a
way that is at least comparable to its influence over the monetary aggregates.
Fourth, any intermediate target procedure based on & credit aggregate
target would be useless if the relevant credit data were not readily
available on a within-quarter basis.
Although the standard vehicle in which
the Federal Reserve publishes data on the total net credit aggregate is the
flow-of-funds accounts, a publication which appears only once per quarter,
the great bulk of the underlying data are actually available monthly. As
of yearend I960, for example, the toal net credit measure for the united
States was 53,907.5 billion, of which 53,486.6 billion, or 89%, consisted
of items regularly reported each month.
Somewhat ironically, most of th*
items not currently reported on a monthly basis are the lending activities
of various components of the federal government itself.
Of the $420.9 billion
of 1980 yearend total net credit not reported on a monthly basis, $352.6
billion represented credit advanced directly by the U.S. Government or by
its sponsored credit agencies and mortgage pools.
If the federal government
were merely to comply itself with the reporting requirements it already
imposes on the private sector, therefore, more than 98* of the total net
credit aggregate would be available monthly.
Moreover, even without any
extra reporting effort, the credit data currently available on a monthly
basis comprise an aggregate that fully meets the first three criteria for
choosing a monetary policy target.
The correlation between the complete
total net credit series and what is now available monthly is very high
1.99985), and the sum of what is available monthly exhibits just as close a
relationship to nonfinancial economic activity as does the complete series.
In sum, total net credit, measured by the outstanding indebtedness
of all U.S. nonfinancial borrowers, meets each of the four criteria for
259
choosing a monetary policy target at least as well as do the monetary
aggregates.
A Proposal jor^i TVo-Target Honey-and-Credit Framework
I therefore propose that the Federal Reserve System adopt an explicit
two-target framework, in which it would focus both on the money stock and
on the quantity of credit outstanding.
The Federal Reserve should pick one
monetary aggregate, presumably HI, and one credit aggregate, total net credit;
specify target ranges for both; and provide the quantity of reserves (or set
a short-term interest rate) aimed at achieving these two targets. A
deviation of either money or credit growth from its respective target range
would then constitute a signal warranting reassessment of that reserve
provision path (or interest rate level).
One potential difficulty
in implementing this hybrid money-and"-credit
framework is a problem inherently associated with any policy of pursuing
two targets instead of one.
achievable?
What if both targets are not simultaneously
For all practical purposes, however, the Federal Reserve's
current policy framework already suffers from just this problem, as the
experience of Ml and K2 during 1961 demonstrated.
If only Kl had mattered,
the Federal Reserve would have had to conclude early on that its policy was
too restrictive in relation to the specified target.
By contrast, if only
M2 had mattered, it would have had to draw the opposite conclusion.
In
resolving these conflicting concerns, the Federal Reserve had to decide on
the relative importance of Ml and M2, and to determine why one was growing
more slowly than anticipated and the other more rapidly,
A two-target framework based jointly on money and credit would in
part have the same features.
If money and credit were both growing
in
line with their respective targets, then -the Federal Reserve would judge the
260
prevailing reserve provision path (or short-terra interest rate) to be
appropriate.
If both vere above target, then the implication would be to
slow the provision of reserves (or raise the interest rate).
If both were
below target, the implication would be to speed the reserve provision path
(or lover the interest rate).
If one vere above target and one below,
however, then — just as now, with an Ml and an M2 target — the Federal
Reserve would have to assess which was more important under the circumstances,
and determine why one was moving in one diiction and one in the opposite
direction relative to their respective stated targets.
The key advantage Of an explicit two-target framework based on both
money and credit, in comparison to a two-target approach based on two
separate definitions of the money stock, is that it would draw on a more
diverse information base to generate the set of signals that presumptively
natter for monetary policy.
Money is, after all, an asset held by the public,
and each monetary aggregate is just a separate subtotal of the public's
monetary assets.
By having an HI and an M2 target, as at present, the
Federal Reserve is relying solely on the asset side of the public's balance
sheet but adding up those assets in two separate ways.
By having a money
target and a credit- target, the Federal Reserve would create a presumption
of responding to signals from both sides of the public's balance sheet.
3he evidence that is now available indicates —not surprisingly, on sowe
reflection — that both sides of the balance sheet do natter.
This two-target money-ana-credit policy would reguire no legislation.
Oi the contrary, the Humphrey-Hawkins Act directs the Federal Reserve to
specify a target for credit growth as well as for money growth.
In practice,
however, the Federal Reserve has typically specified such a target but then
ignored it.
Moreover, it has chosen to focus only on credit extended through
261
the banking system, which the available evidence indicates is far from the
best source of information about the ecimomy, even from within the liability
•ide of the public's balance sheet. Nothing in the legislation, however,
requires that the Federal Reserve place its primary en^hasis on money to the
exclusion of credit, or that it focus only on bank credit among the
available credit Measures,
in a legislative sense, therefore, a two-target
money-and-credit framework would simply have the Federal Reserve be evenhanded within the requirements already laid down by the Humphrey-Hawkins
ACt.
In conclusion, I will simply restate my belief that a two-target
money-and-credit framework for monetary policy would be superior to the
current money-only framework, and that, over time, a monetary policy based
on both money and credit would be likely to help achieve a more satisfactory
performance of the American economy — to the advantage of all.
Mr. Chairman, thank you £or the opportunity to present my view to
this committee.
262
June 2b, 1982
A PROPOSAL FOR FISCAL RESPONSIBILITY
AND LOWER INTEREST RATES
The Dilemma:
Fiscal policy is too loose and monetary policy too
tight.
The 3-5 year outlook is for budget deficits perhaps
averaging $200 billion a yean.
Interest rates are far too high. Hot since the
Civil War have real rates of interest been this high.
Politics make any meaningful budget compromise
unlikely.
There is no probability that entitlements
will be touched until after the November elections.
Absent any meaningful change in the intermediate
term outlook for budget deficits/ the securities
markets will not recover and interest rates will
remain excessively high.
High U.S. interest rates have led to an over valued
collar.
High U.S. interest rates are causing
interest rates offshore to remain higher than local
economic conditions warrant.
This in turn has had a
serious negative impact on most foreign economies.
263
Most expect recovery later this year.
Few think it
will be strong or sustainable because of the
conflict between tight monetary policy and the
pent-up demand for credit.
It fiscal policy remains out of control, rates won't
fall much and the recovery will be short lived.
Further, the next cycle will begin with historically
high interest rates.
Most observers expect consumers to lead us out of
recession.
Their ability to do so is reduced if
interest rates are high and credit is not
available.
(At these real rates of return, the
incentive for consumers to stay in short term
investments is substantial.)
IZ.
The Conditions and Outlook
inflation is down considerably
energy prices have fallen and are unlikely to
rise much over the next 18-24 months (barring
serious problems in the Middle East)
food is plentiful and retail prices look
relatively stable
wage settlements are starting to be made on a
much more realistic basis
264
Unemployment is high; especially in certain
industries and regions, and among minority groups
and the young
Overall, plants are operating at, postwar lows, 70%
of capacity or less
Many product, commodity, and service prices are
falling and there is very little possibility
for the markets supporting much in the way of
price increases.
Host capital investment projects and much investment
spending is being deferred, reduced or eliminated.
Businesses are focusing on remaining liquid or in a
number of instances remaining solvent under the
burden of high borrowing costs.
The financial markets appear to be in a fragile
condition, with almost all borrowing concentrated in
the short-end and no activity at all in the
long-term bond market.
Maturities and exposure
continue to pile up.
A number of companies —
put out of business.
record rates,
large and small —
will be
Bankruptcies are occurring at
if the system causes good companies,
not just the inefficient, to go up, then there is
something wrong with the system.
265
ill.
Proposal: Demonstrate a credible resolve by Congress to
yet spending tinder control.
L.
Pass a Spending Ceiling Bill.
Congress should take
immediate steps to pass a Congressional resolution
that would impose an aggregate cap on federal
government spending for five years (three would be a
minimum).
This could be as a % of GNP and/or a
maximum allowable annual rate of growth.
The
resolution should proscribe and call for a permanent
amendment to the Budget Act of 1974 early in the
next Congress establishing multi-year spending
goals.
This would:
clearly reflect to the business and financial
world that fiscal policy is headed in the right
direction
allow the Fed to ease monetary policy
create pressure for restraint in government
spending that heretofore has been provided by
tight monetary policy (i.e., some say high
interest rates are needed to force fiscal
responsibility; this would be a roore liveable
substitute)
By focusing on aggregate spending as a share of
GNP, the political issues of which program
266
(entitlements vs. defense vs. tax increases,
etc.) are avoided until after the
election....as they will be anyway,
be an important step toward materially lower
interest rates
l.
Use such a move by Congress to
Encourage the Administration to be realistic
about the need to tackle entitlements and
defense —
with the President in a strong
leadership role.
Encourage the Fed to materially ease monetary
policy.
(This move by congress —
if strong
enough to represent a credible beginning to
more responsible fiscal policy —
can give the
Fed an acceptable reason to change their
policy.)
Encourage business and labor to lobby within
their own tanks for a slowdown in price/wage
increases.
3.
In view of current economic conditions and the
outlook I think, we have a window of opportunity
whereby the Fed should change direction and increase
the money supply with an objective of inducing
substantially lower interest rates.
267
Lower interest rotet would take the pressure
off operating margins —
this removes
temporarily the need for price increases.
Host
manufacturers are operating at such low
utilization rates their motivation is to sell
product, not to increase prices.
Substantially lower interest rates would allow
the "re-liquification of America."
One of the
substantial problems existing today is the
level of exposure of many companies to short
term debt maturities.
A downward move in
interest rates would allow refunding and
re-spacing of maturities, and increase profit
margins.
4.
A number of people will violently object to such a
move by the Fed.
Comments will be made that the Fed
has lost its backbone, returned to whipsaw
management, buckled under the pressure of Congress
or the Administration, etc.
It will be claimed that
this will lead to renewed and. substantial inflation.
In my view, economic conditions will not permit
this to happen.
There is very little
opportunity in the marketplace to increase
prices in the near term.
substantially
Conversely,
lower interest rates offer the
268
opportunity to get companies back into a sound,
liquid condition.
Improved liquidity plus
lower cost of capital should restore their
interest in bringing capital projects back on
stream.
Some will claim that the long markets will not
respond.
Investors have been burned before and
such a move by the Fed would be a clear signal
they would be burned again.
I challenge this
because any substantial downward move on short
rates will ultimately bring long investors back
into the market.
Bond portfolio managers
cannot afford to watch rates move materially
lowec without being enticed into the longer
markets.
I believe traders and speculators
will provide the short term momentum that will
then attract the more permanent investors.
In
addition/ the spending cap will send a positive
signal to the markets regarding fiscal policy.
In conclusion, we should keep in mind that such a
cap will
(a)
force the hard trade-offs to be made within the
budget process
(b)
serve also as a restraint to excessive
taxation/ and
(c) by leading to lower interest rates, generate
higher tax revenues for the Treasury through
higher profit margins and a growing economy.
269
PROPOSED JOINT RESOLUTION TO REDUCE TOTAL FEDERAL OUTLAYS AS
A SHARE OF GROSS NATIONAL PRODUCT
a. The Congress hereby adopts the goal of maintaining Federal
budget outlays at a level no greater than 20 percentum of
the Nation's gross national product (defined as the final
value of all goods and services in the economy).
b. The Congress, in furtherance of that goal, hereby
establishes as its interim goals for reducing the share of
the nation's gross national product accounted for by
Federal outlays (expressed as a percentage of projected
gross national product) &s follows: 21.9% for fiscal year
1984, 21.4% for fiscal year 1985, 20.9% for fiscal year
1986, 20.4% for fiscal year 1987, and 19.9% for fiscal year
198B| and
c. Not later than Hay 15, 1983 the committee on the budget of
each Bouse shall report legislation to amend Public Law
93-344, the Congressional Budget Act of 1974, to require:
1. that the budget resolutions for fiscal year 1984 and
each subsequent'years shall set forth percentage'goals
for total federal outlays as a share of the projected
gross national product for the current fiscal year and
each of the four succeeding fiscal years,
2. that the budget resolution for fiscal year 1984 shall
incorporate the percentage goals specified in part (b)
of this resolution, and
3. that, for fiscal year 1985 and each subsequent year,
the committee on ttie budget for each House shall report
to its House a budget resolution which meets or falls
below the percentage goal for total Federal outlays as
a share of projected gross national product that was
set forth for that fiscal year in the most recently
adopted First Budget Resolution.
270
ANALYSIS OF THE PROPOSED JOINT RESOLUTION
a. This section represents a commitment by the Congress to
reduce the share of GUP accounted for by Federal outlays to
20 percent or lese. The 20 percent figure Is taken from
the Full Employment and Balanced Growth Act of 1978 as
aaended by Public Lav 96-10. That amendment requires the
President to set numerical goals foe reducing the share of
GSP accounted for by Federal outlays in his Economic Report.
b. This section represents the establishment of interim goals
for the next five years by the Congress to reduce the share
of GHP accounted for by Federal outlays. Th« 21.91 figure
for Fit 1984 is taken from the projections included in the
First Concurrent Resolution on the Budget for FT 1983
adopted by the Congress, subsequent reductions of 0.51 per
year are specified for the next four fiscal years.
c. This section directs the budget committees of each house to
report changes in the Budget Act by a date certain to
incorporate
(1) a mechanism for establishing five-year numerical goals
to reduce the share of GNP accounted for by Federal
outlays in each budget resolution;
(2) to maintain in the first budget resolution for FY 1984
the interim numerical goals specified in this proposed
joint resolution;
<3) a mechanism whereby the budget committee will report a
budget resolution which meets or falls below the
numerical goals set forth in the most recently adopted
First Budget Resolution. The purpose of this is to
assure that the numerical goals previously specified
are a meaningful commitment by the Congress.
This section of the resolution purposely leaves the
details of bow the Budget Act is to be amended to
accomplish the establishment of goals to reduce outlays
as a share of GHP to the budget committees for two
reasons. First, because of the complexities of the
Budget Act itself. Second, because of the complexities
that are certain to arise in establishing a mechanism
for setting specific numerical goals in the budget
process. It is recognized that some flexibility roust
be built into the process to handle such things as
unexpected national emergencies such as war, sharp
changes in interest rates, or sharp changes in economic
conditions. It is left to the Budget Committees to
decide what type of mechanism is needed to alter the
numerical goals once they are established, for example,
a two-thirds vote of each house. Also, the Budget
Committees may want to establish a mechanism for
flexible adherence to the goal of reducing the share of
GNP accounted for by Federal outlays. For example, a
base night be established and a trend line established
that represent 0.5% reductions each year with the
flexibility to permit overages or underagea in a given
year to be made up in the next year in order to keep
the long-term goal on track..
271
The CHAIRMAN. We will be happy to include them in the record.
CONTROLLING TOTAL NET CREDIT
In your statement you suggest that the Federal Reserve should
target total net credit. Given that the Federal Reserve has no authority to set reserve requirements on such financial instruments
as commercial paper and long-term corporate debt, how could the
Federal Reserve control total net credit?
Mr. ROBERTS. I think the Federal Reserve today has a very big
hand in controlling total net credit because the bank reserves that
they do control set the level at which money growth will proceed
and money growth, in turn, has an influence on the savings-investment process, and therefore, on the availability of funds to be borrowed and lent. Thus, I think to a very great extent they already
do have an influence on total net credit.
To be sure, there may be additional powers that would be desirable to increase their influence on total net credit. At this point I
am not prepared to recommend what those powers should be, but
perhaps some additional powers are necessary.
Let me use Germany as an example. They control the money
supply and they also control credit very tightly. To be sure the
Bundesbank has additional powers of persuasion given the limited
number of banks in Germany, than the Federal Reserve has. So in
that sense the Federal Reserve does not have comparable powers of
persuasion as the Bundesbank.
The CHAIRMAN. In your statement you say, "The Federal Reserve's ability to act flexibly and independently of day-to-day political pressures must be guarded and protected." You would certainly
get no argument from Senator Proxmire and me over that. You listened to our speeches about the independence of the Fed for a long,
long time.
Mr. ROBERTS. I think I wrote some of them.
Senator PROXMIRE. You sure did, mine.
The CHAIRMAN. Does that mean that you would oppose proposals
to make the terms of the Fed Chairman and Vice Chairman coterminus with the President?
Mr. ROBERTS. I would not oppose making them closer to the
terms of the President. I think exactly coterminus might prove to
be a little bit difficult to deal with.
I think one proposal that was made several years ago was to
have a 1-year lag between the appointment of the Fed Chairman
and the election of a President. That I think would be livable and I
see no problem with it.
The CHAIRMAN. You do not feel even that would, at least in a
small way, threaten the independence of the Fed? You've got a
Chairman that is a year hangover and you know that 1 year later
the President is going to be able to pick his Chairman?
Mr. ROBERTS. I don't think that that would challenge the
independence of the Fed any more than the powers that a sitting
President now has to influence the Fed Chairman,
The CHAIRMAN. What about the proposal to make the Secretary
of the Treasury a member of the Board of Governors?
272
Mr. ROBERTS. That I would have additional problems with. I
think that that would politicize the process of monetary policy and
I think it would be a dangerous precedent to set. I think one evidence of that is the fact that the Secretary of the Treasury was on
the Board before 1933 I think and was then removed when the new
powers of the Federal Open Market Committee were set up.
The CHAIRMAN, I'm certain you would oppose the proposals of
some that would put the Fed under the control of the Treasury?
Mr. ROBERTS. I most certainly would.
The CHAIRMAN. I would have been terribly disappointed if you
had said otherwise.
COMPARING Mi AFTER 5 YEARS
In your statement you say, "The Federal Reserve should stop targeting Mi because of NOW accounts and other financial innovations." Last week, Murray Weidenbaum, outgoing Chairman of the
Council of Economic Advisers, described to this committee how the
definition of Mi has evolved over time to take account of such financial innovations. Chairman Weidenbaum concluded that as a
result of this evolving definition of Mi that growth of M, demonstrates the highest statistical correlation of the growth of nominal
income.
How do you explain your apparent disagreement with Chairman
Weidenbaum?
Mr. ROBERTS. If you look at Mi now as compared to what Mi was
5 years ago in terms of definition, I think there's a drastic difference. Five years ago before we had NOW accounts, before we had
money market funds, before we had 6-month money market certificates, Mi was a true measure of transaction deposits.
Now what we have in Mi is a mixture of both transaction deposits and savings deposits and I think that savings deposits have a
different relationship to GNP, employment and prices than transactions accounts. I think additionally, as the deregulation process
proceeds, and the DIDC creates new instruments that have transaction-like characteristics, that you could have enormous shifts of
funds out of what are savings accounts or what are money market
funds or what are other similar instruments into Mi, and you
would see an explosion in the Mi measure that would have nothing
to do with economic activity. I wouldn't know how to interpret that
large increase in M t in any other way than that it has no relationship to past or prospective economic activity. It's merely a shift of
funds, encouraged by a new instrument, that is not an increase in
transaction accounts in the pure sense.
The CHAIRMAN. Steve, I had the opportunity to at least glance
through your testimony and may I say on fiscal policy that I am
very impressed with your recommendation. I think that the reexamination of the budget process is something that we've proven in
the last 2 years absolutely needs to be done. It is not functioning
well at all and we've put ourselves into the position of making
some choices that have been very difficult.
I also agree very much with your recommendation about caps on
Federal spending as a share of GNP. Senator Proxmire said earlier
to Secretary Sprinkel, "What about the need to overcome this
273
spending glut that has been going on?" We're so far higher than
traditional spending levels of GNP and, in my opinion, that simply
cannot be dismissed and say it's all monetary policy; we can just go
on increasing the percentage of spending and have no repercussions on the economy. I think that's utterly ridiculous and it's overlooked constantly by Members of Congress and others.
Although I support the balanced budget amendment, we simply
cannot go ahead and pass that during an election year, have it take
a year or 2 to go through the States which I think it will, and then
2-year implementation after that, and not start controlling our
spending now. You can't keep going on the way we're going and
then suddenly there's an amendment that says you've got to do it
and you've got to fall off a big cliff to accomplish it. So it seems to
me your recommendation is absolutely on target that, fine, pass
the constitutional amendment, but we've got to start disciplining
ourselves in the meantime, and that means reducing that percentage of GNP that we are constantly appropriating year after year.
We're kidding ourselves; that constitutional amendment will
become only a political document for an election year unless we
start disciplining ourselves. So I'm very impressed with your testimony on fiscal policy.
Mr. ROBERTS. Let me say that I think the Congress could take a
lesson from the rules that it has charged the Fed to follow; that is,
to set annual targets, multiyear targets, and then discipline itself
to meet those targets. And that's what the recommendation in my
testimony is designed to do. But it's got to be like the Fed, a multiyear commitment for a gradual reduction in spending in a share
of GNP.
If you'll recall, in 1979, Senator Proxmire and yourself were instrumental in getting the Full Employment and Balanced Growth
Act amended to require the President to establish goals for reducing outlays per share of GNP. If it's good enough for the President,
it ought to be good enough for the Congress.
The CHAIRMAN. It is, but you've also been around this body long
enough to know that the hardest part of your recommendation is
the part where you recommend that we discipline ourselves.
Senator Proxmire.
Senator PROXMIRE. Mr. Roberts, I want to congratulate you on
what I think is an excellent statement. You've been around the
committee long enough to know what serves the interest of the
committee and what doesn't.
ADJUSTING PRIME RATES TO COST OF FUNDS
Your recommendations are concise and to the point and I think
they're very timely. One of your first recommendations is that the
Federal Reserve should immediately bring together senior representatives from the private sector to function like the Committee
on Interest and Dividends, which was important during the early
1970's. That was the Nixon appointment at that time and as I understand it they adopted, you say on page 13, "One suggestion that
was made and adopted by many banks was to have their prime
rates set according to formulas linked to their cost of funds."
274
Is that the kind of recommendation that you would expect would
be timely and appropriate now and would help to get interest rates
under control?
Mr. ROBERTS. I think it would be very timely. I'm not sure what
the spread should be. Conditions were different in the early 1970's
than they are now. But if you look at current short-term rates, you
have a prime rate of 15.5 or 16 percent; you have CD rates of about
11 percent, which is the cost of bank funds, and there's a huge discrepancy, much different than three-quarters or 1 percent. Draw
your own conclusions.
The same point was made this morning with the announcement
of the cut in the prime in a Washington Post article, that the
spread between the cost of funds is now huge and that additional
cuts in the prime rate should be forthcoming.
Senator PROXMIRE. Is that showing up in the increased profitability of banks?
Mr. ROBERTS. I think in general, rather than
Senator PROXMIRE. I can't understand that. You know we have a
very competitive banking system. The banks are very eager to lend
money, as they showed in the Oklahoma case—sometimes a little
too eager. But if the cost of funds is around 11 percent, this indicates a lack of effective competition, doesn't it?
Mr, ROBERTS. I think there is competition in the market. Bank
profits are generally higher when interest rates are high, than
when they are low. This is especially true now, as opposed to 10
years ago, because of the increased use of floating rate instruments
and discrete pricing of banking services. I think that the banks will
adjust downward, but there's a tendency for the prime to trail the
market on the way down and to lead the market on the way up. I
think that's a natural inclination. Anybody who wants to make a
profit and maintain a spread would react rationally.
My suggestion is that now that the Fed, after October of 1979,
has given the marketplace the ability to set rates and not to dictate
to the marketplace what rates should be, and therefore, that participants in the marketplace have some responsibility for the wellbeing of the economy, not only their own well-being.
Senator PROXMIRE. Well, you say in your recommendations, "The
Federal Reserve should bring together senior representatives of the
private sector." Who would be the kind of people that would be appointed to that? The representatives, obviously, of the banks, savings and loans—what other—corporations?
Mr. ROBERTS. Financial and nonfinancial corporations, brokerage
houses—anybody that has a major financial interest in the way the
economy is moving ahead. I think it should be a broad group and I
think it should have a broad mandate to look for innovative ways
to get interest rates down.
Senator PROXMIRE. Well, that's very helpful.
Now, Secretary Sprinkel testified that there's no evidence that
monetary policy is too tight. You say fiscal policy is too loose and
monetary policy is too tight.
How do you answer Secretary Sprinkel's argument that monetary policy is about right?
Mr, ROBERTS. Secretary Sprinkel also said that he judges the inflation rate to be 5 or 6 percent, with the prime rate of 15.5 to 16
275
percent. That means a 10 percent real rate of interest, which I
think is a signal that monetary policy is too tight. Look at bankruptcies. How do you judge bankruptcies? Is that an indication that
monetary policy is too tight or too loose? There are lots of other
things besides the rate of growth of the money supply, however you
measure it, that the Fed needs to look at, and some of those variables are indicators.
PROBLEM CONTROLLING TARGET FOR MI
Senator PROXMIRE. You seem to be coming on with the notion
that you would increase the rate of growth in the money supply.
Your only specific suggestion in here—you didn't say that in your
testimony. You said that you would drop Mi and develop a total
net credit and rely on the recommendations of these experts that
would be appointed to some extent. But should we ease up on the
rate of increase in the rate of credit and money supply? That's the
real fundamental question.
Mr. ROBERTS. I think there should be some easing, yes. I don't
think the targets should be changed, but I agree entirely with
Chairman Volcker that if for a period of time money growth is
above target that in this current economic environment there
should be little problem. We have so much excess capacity that it
would not be inflationary.
Senator PROXMIRE. Money growth is above target. Why shouldn't
we change the targets under those circumstances? Why shouldn't
we increase the targets?
Mr. ROBERTS. Well, first of all, I think the target for Mi ought to
be dropped. I said that in my testimony. Therefore, I see no reason
for changing it. If you want to make a change, drop it.
Senator PROXMIRE. Drop the ranges that we've asked the Federal
Reserve to tell us about?
Mr, ROBERTS. For Mi'
Senator PROXMIRE. For Mj?
Mr. ROBERTS. And maintain them for M2 and M3.
Senator PROXMIRE. I see. Now I just had one other question I
think.
Secretary Sprinkel said that it was impractical to expect the Federal Reserve to control the total net credit. You've answered this in
part in response to the Chairman, but I'd like to get a more specific
answer.
He said we have trouble controlling M,, which we do; M! is
easier to control than the total net credit. You have indicated that
there are some areas of total net credit—I guess Sprinkel did—outside the purview of the Federal Reserve. Are you suggesting that
we broaden their power over commercial paper, for example, and
some of the other credit aggregates they don't have any control
over?
Mr. ROBERTS. I think that's something to be explored. I wouldn't
say, yes, they should have increased control over commercial paper
or anything else at this point. But as I look at the historical evidence presented by Professor Friedman from Harvard and several
other economists who have looked at these things very carefully,
there's a steady and persistent relationship between net total
276
credit adjusted for the rate of growth of the economy. It's about 143
percent adjusted for the way the economy changes.
The Fed has some influence to change that by supplying additional reserves if need be, especially if total net credit is lagging
sorely behind what historical evidence suggests it should be.
I look at the evidence and I'm convinced—and I wasn't convinced
when I was on the committee staff several years ago—but I am
convinced now based on this new research that the Fed ought to
pay attention to total net credit, that bank credit is just one part of
it but it's not the entirety, and you learn something from total net
credit. You learn right now that the Federal Government is going
to take almost 50 percent of the share of all credit generated if you
include off-budget and on-budget items in the next year. That
means that the private sector is going to be crowded out. There's
important information there.
Senator PROXMIRE. You can make an argument on that, but my
question is whether or not they can actually control it?
Mr. ROBERTS. They can control it just as well as they can control
M2 or M3. Reserves are no longer set on savings and consumer time
deposits of any type, but changes in reserve availability influences
their growth indirectly.
Senator PROXMIRE. I also get from your argument and your presentation this morning that maybe the decision in October 1979 was
wrong; forget about interest rates and concentrate on'the rate of
increase in the money supply. I say that because there is this colossal spread. Interest rates seem to be way out of tote with what they
ought to be in view of the cost of funds. So why shouldn't there be
some return perhaps to an attempt on the part of the Federal Reserve to bring interest rates down as such, rather than simply the
money supply?
Mr. ROBERTS. As you know, in October 1979 I supported that
change in policy because I thought it was important to focus in on
the rate of growth of money. However, I think that conditions have
changed. Mj doesn't mean the same thing now as it did in 1979, as
Mr. Maude's testimony of last week clearly shows. NOW accounts
weren't here in 1979. I think, also, that tight adherence to the rate
of growth of the money supply week to week, month to month,
quarter to quarter even, has proven to be quite hard to follow.
That's why the Full Employment Act requires that the Fed target
the rate of growth of money over a year's time and I think that the
tight adherence to monetarism can in certain circumstances—and I
think we're in those circumstances right now—be fairly dangerous.
Therefore, at this point, I think the Fed ought to look at other variables.
Senator PROXMIRE. Including interest rates?
Mr. ROBERTS. Including interest rates, including real interest
rates especially.
Senator PROXMIRE. Thank you.
Thank you very much, Mr. Chairman.
The CHAIRMAN. Mr. Roberts, we're happy to have you before us
today. I have no additional questions. Senator Proxmire, do you
have any more?
Senator PROXMIRE. It was a very good statement.
277
The CHAIRMAN. Very good. Thank you very much. We appreciate
you returning to the site of your previous activities.
Mr. ROBERTS. Thank you.
The CHAIRMAN. The committee is adjourned.
[Whereupon, at 10:45 a.m., the hearing was adjourned.]
[Additional material received for the record follows:]
278
Answets to Additional Questions For Steven M. Roberts
From Senator Donald W. Riegle
0.1. Whom would you appoint and what exactly would be the
mandate and time frame of your proposed Committee to get
interest rates down?
A. As I indicated in my testimony the private sector has a
responsibility for acting in the national interest in
setting terms and conditions on credit because of the
Fed's October 1979 shift toward controlling money and
reserves and letting the marketplace set interest
rates. Prior to October 1979 the FED set interest
rates and the marketplace would often have to allocate
credit in non-price terms. Some type of allocation
system, perhaps, should be restored.
What I have in mind is a public-private group to
generate innovative ideas to reduce interest rates and
then to obtain broad support from the private sector to
put those ideas into action.
Committee membership might include;
Public Sector
Secretary of Treasury
Chairman of the Federal Reserve Board
Chairman of the Council of Economic Advisors
Private Sector'
Representatives of large, medium, and small
banks
Representatives of non-bank financial
institutions
Representatives of major manufacturing
corporations and small business
I would also recommend that Arthur P. Burns, now
Ambassador to the Republic of Germany and a former
Chairman of the CID, and Secretary Schultz, a former
member of the CID, be asked to participate.
Also,
former FED Chairmen Martin and Miller, and former
Treasury secretaries Dillon, Fowler, Simon, Connolly,
and Blumenthal could contribute needed ideas and
support.
279
One group of bankers that might be asked to serve on
such a committee would be the Federal Reserve's Federal
Advisory Council which is made up of twelve bankers,
one from each Federal Reserve District, and already
advises the Board regularly. Other bankers might also
be "included to broaden the base.
People like Peter G. Peterson of Lehman Brothers, Jim
Robinson of American Express Company, the Chairman of
Ford Motors, the Chairman of General Electric/ and
other prominent business leaders would also add to the
collective wisdom of the body.
The mandate should be to find several complementary
ways to get interest rates down without fueling
inflation. This may mean some non-price rationing of
credit and some self restraint by borrowers.
The time frame for formulating approaches to the
problem should be short — within the next 30-45 days.
The Committee should function for a year or less as
needed.
Let me stress that the initiative has to be voluntary,
but with broad compliance based on a consensus that
steps are necessary and the burdens need to be shared
more broadly than they are currently,
0-2. You recommend in your testimony that the "FOMC should
immediately adopt a 'total net credit" aggregate as an
additional target for policy". What do you mean by a
•total net credit" aggregate?
A. "Total net credit"'is a term used by Professor Friedman
at Harvard. It includes the outstanding indebtedness
of all U.S. non-financial borrowers. He suggests that
this indebtedness be scaled to economic activity. At
year-end 1981 outstanding indebtedness of all U.S.
non-financial borrowers was 143% of gross national
product.
Q.3. How would the FED accumulate the data and measure the
total net credit?
A. The Federal Reserve publishes data on total net credit
in its quarterly flow of funds accounts. As of
year-end 1980, total net credit was $3,907.5 billion.
Much of the underlying data are available and reported
regularly each month. According to Friedman, $3,486.6
billion or 89% of the total year-end 1980 data was
available from monthly series. Much of the monthly
280
data that were not available was federal government
borrowing. The government could improve its own
reporting system to bring the monthly data availability
close to 100% of that available quarterly.
0.4.
How would the FED establish a target for total net credit
and how would the FED adjust monetary policy to achieve
such a target?
A. Total net credit adjusted (or scaled) for GNP growth
has been fairly steady at 142-143%, except during the
1930's depression and just after WWII. If 143% of GNP
is taken as the long-term stable trend, then the FED'S
target would be calculated from its forecast for GNP
for the year multiplied by 143%.
If, during a recession, GNP grew more slowly than
predicted, the scaled net total credit aggregate would
rise above 143% because the denominator would grow more
slowly than the numerator. To get the aggregate back
down to 143% the FED would adjust policy to improve
GNP. This is an over-simplification, of course, in
essence, more money or lower interest rates would tend
to increase GNP.
Q,5. How would targeting of total net credit assist in
achieving monetary policy objectives such as economics
growth, price stability, employment and international
balance? What is the relationship between total net
credit and these objectives?
A. Using total net credit as an additional target variable
would provide additional important information as to
economic activity and what monetary policy should be
doing to achieve its ultimate objectives for income,
employment, etc. To continue the example from the
previous question, an acceleration of total net credit
might serve as an early indication of weakness in GNP,
as additional credit is needed to finance economic
activity. The opposite might also be true: a
deceleration might indicate strength in internal cash
flow, profits and output.
I suggest that Professor Friedman's work on this be
sought by the Committee to answer the last part of this
question.
281
0.6. What economic signals would be contained in various
movements and fluctuations of total net credit?
A. See answer to Question 5.
Q.7. How would the Federal Reserve System exercise very precise
control over the total net credit aggregate in the short
run?
A. It would not and should not exercise precise control of
total net credit or any other intermediate target
variable over short-time horizons! Monetary policy
objectives can only be attained over longer time
periods (a year or two) because of the lags between
policy changes and changes in intermediate or final
targets.
Changes in economic variables over short-time horizons
can be and often are misleading. It is long-term
trends that are important.
0.8. What, if any, new powers would the FED need to adequately
implement or credit aggregate (target) such as you have
suggested?
A. Ho additional powers are necessary. However, it might
be desirable to give the Fed some additional authority
to provide incentives to lenders to increase lending in
certain areas — such as agriculture, autos, small
businesses. But such powers would need to be
considered carefully. Experiences of other central
banks should be looked at. I can mention two variables
that have been looked at in the past — loan to deposit
ratios, and capital-asset ratios. The current system
might be improved if the FED had greater control over
these variables.
282
The Trouble with Monetarism
ALAN REYNOLDS
In the entire history of this country, before 1968, long-term interest rates were never above 5-6 percent. Since then, however,
interest rates have tripled. Young people now think it is perfectly
normal that mortgage rates can only go up—as they have in every
single year since 1972.
Something terrible happened to the economy after 1968, got
even worse after 1972, and deteriorated into acute stagnation after 1979. There has been virtually no increase in real output per
employee for nearly a decade. World trade grew by 7 percent a
year for twenty-five years before 1973, but that growth was cut in
half since then (actually falling one percent last year).
•It is time to retrace our steps, to find out what went wrong.
Advice from the familiar economic experts will not be better
than it has been. A Keynesian adviser to J.F.K. now argues that
budget deficits force the Federal Reserve to print less money; a
founder of the rational expectations school says deficits force the
Fed to print more. The head of a huge forecasting empire, built
upon the idea that deficits stimulate investment, now casually argues the exact opposite. The monetarist economist for a New York
investment bank says the Fed is doing such a great job, that inflation and interest rates must be due to fiscal policy after all. An Ivy
League professor, who has always argued that any inflation was a
trivial price to pay for the low unemployment that would surely
result, is now solemnly interviewed about what to do about inflation. The fiscal expert at a conservative think tank says deficits
will be inflationary unless inflation shrinks them. A prominent
monetarist who has always emphasized long-run trends in M2
now worries only about ten-week wiggles in Ml.
To uncover the source of change, it is useful to look at what has
stayed the same. Federal tax revenues rose by 15.8 percent in
1981—far more than .the incomes-of taxpayers. Marginal tax rates
are still going up, not down. 1 Does anyone really believe that the
1. Stephen A. Meyer & Robert J. Rossana, "Did The Tax Cut Really Cut
Taxes?" Federal Reserve Bank of Philadelphia Business Review (January-February 1982).
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Policy Review
economy would have performed better if the tax collector had
grabbed an even larger share? Nondefense spending will be at
least 17.4 percent of GNP in fiscal 1982, up from 15.9 percent in
1979. Would anyone seriously argue that recession could have
been avoided if the O.M.B. had only let federal spending drift
even higher?
No, this problem is monetary, not fiscal. For all practical purposes, "Reaganomics" means whatever the Federal Reserve is
doing. If interest rates were remotely close to historical normality
(namely, 3-5 percent), the budget would be in surplus. In fact,
there is substantial evidence that expected inflation causes budget
deficits rather than the other way around.2
Criticism from Wall Street
The media would have us believe that "Wall Street" is not
concerned about monetary policy, but only about deficits. Polls of
dozens of institutional investors by Oppenheimer and Polyconomics, however, indicate that this is overwhelmingly untrue.
Fortune's poll of executives says the same.
Barton Biggs, the managing director of Morgan Stanley, recently
described monetarism as "the God that failed." He reprinted a letter of February 22 from Peter Vermilye, Chief Investment Officer
at Citibank, saying "the level of interest rates is a better barometer of tightness than the growth of the money supply in this era of
conflicting monetary currents." The economists at Morgan Stanley and. Citibank are staunchly monetarist, but those responsible
for investments are not.
Many other Wall Street traders and economists have long been
extremely critical of monetarism, including Henry Kaufman of
Salomon Brothers, George McKinney of Irving Trust, Peter Canelo of Merrill Lynch, and Edward Yardeni of E. F. Hutton. The
widely-read Morgan Guaranty Survey (of February 1981) wrote that
the nation "would be ill-served by rigid mechanical monetarism."
"The widely-cited budget deficit problem," says Maury Harris
of Paine Weber, "is due importantly to Federal Reserve policies
that keep interest rates high." "Until such time as the Fed abandons monetarism," says David Levine of Sanford Bernstein, "our
2. Brian Horrigan and Avis Protopapadakis, "Federal Deficits: A Faulty
Gauge. . ." Federal Reserve Bank of Philadelphia Business Review (March-April
1982). Also unpublished studies by Gerald Dwyer at Emory and Roger Kormendi. University of Chicago.
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Monetarism
21
financial markets will be in disarray."3 These are not uncommon
views on Wall Street, though the media decided that this news is
not fit to print. Instead, we hear the same tired voices agonizing
over the budgetary consequences of monetary disorder.
This is not the first time that the United States has contemplated a fiscal cure for a monetary crisis. The huge tax increases
of 1932 and 1968 demonstrated that it does not work.
Today's monetary crisis is not new, but it has escalated into
risky territory. The entire dollar economy worldwide is dangerously illiquid, precariously dependent on short-term debt. Longterm financial markets are moribund. People, and the institutions
entrusted with their savings, are unwilling to commit funds for
long-term uses. Nobody trusts the money. Interest rates are held
up by the rising risk of default right now, and by the risk of renewed inflation in the future.
We have the worst of two worlds: Much of the nation is experiencing deflation while expecting an inflationary "solution." By April
1982, most indexes of commodity prices were at least 15-20 percent lower than a year before. Cotton was down about 25 percent—
the same as in 1932—aluminum prices were down even more.
Even the broad indexes of producer and consumer prices had
posted some monthly declines. Even as the old guard was chanting that budget deficits cause inflation, inflation again went way
down as the deficit went up—just as in 1975, or 1933.
Yet even falling prices fail to persuade bond buyers that they
will not be exploited once again by future inflation. Indeed, the
more that current price indexes are squeezed by forcing producers
into bankruptcy, the more likely an inflationary bail-out becomes.
Existing monetary techniques can thus depress measured inflation for even a year to two without making a serious dent in expected inflation. Trouble in long-term markets requires a long-term
solution, a credible set of monetary institutions to protect ihe purchasing power of the dollar.
Selling what exists at failing prices does not necessarily make it
easier to produce more at stable prices. Liquidation of inventories,
commodities, assets, and real estate has depressed current price
indexes, but it has also raised the cost of living in the future. The
value of lifetime savings has fallen, so people will have to work
3. Dr. Harris' remark is from testimony before the Joint Economic Oummittee, April 22, 1982; David Levine's is from a speech to (he New York Assrx'iation
of Business Economists. April 6, 1982
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Policy Review
harder in the future to attain any expected standard of living.
That makes the future look relatively grim, causing people to prefer present consumption. In this situation, providing added tax
incentives to save will not finance future productive capacity, because any added savings remain in the short-term money market.
The problem is that the United States has no long-term monetary policy at all—nothing that inspires confidence. Instead, the
nation alternates between robbing lenders with inflation and
bankrupting borrowers with deflation. There is no way of knowing which is coming next, so activities requiring long-term financial contracts are severely restricted. There is no unit of account
that is expected to hold its value over decades, and therefore little
possibility of building for the future by borrowing against expected future earnings.
No indexing scheme gets around the problem of unpredictable
money. A household cannot budget for the future, for example, if
monthly mortgage payments can vary in ways that income may
not.
Monetarism was fun when it simply involved second-guessing
the Fed. The self-appointed "Shadow Open Market Committee"
would solemnly announce that there was too much or too little
money, without assuming any genuine responsibility.
Things are different now that prominent monetarists are in positions of great authority. Monetarists can and do influence the
Fed now, and are even in a position to propose sweeping monetary reform, legislation, or international conferences. Instead, we
still get the habitual second-guessing. The Republican section of
the latest Joint Economic Report, for example, writes: "Looking back,
it would have been better if money had grown closer to 5 or even
6 percent per year in the second and third quarters of 1981 instead
of at annual rates of 3.6 and 2.9 percent." Such retroactive finetuning serves no useful purpose. The bond and mortgage markets
did not collapse over the past decade because money growth was
one or two percentage points too slow for six months.
Founders of Monetarism
It can, of course, be argued that what we are experiencing is not
genuine monetarism. When reality fails to live up to the promise
of theory, it is always the fault of reality. Since October 1979,
when the Fed did most of what the monetarists advised, interest
rates, Ml and the economy have gyrated wildly. The monetarist
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Monetarism
response is that the problem originated with lagged reserve requirements in 1968, or the Fed should have stepped even harde;
and faster on monthly ups and downs of M1 (for example, by pushing the fed funds rate higher in January 1982, when Ml surged).
Is there any example of monetarism anywhere that ever worked?
Some point to Switzerland, where Ml rose 23 percent in 1978, fell
7 percent last year, and has been far more erratic over short periods than in the U.S. Switzerland has a gold cover on its currency.
Others point to Chile, where they stopped hyperinflation by usint^
fixed exchange rates. France tried a quantity rule from 1919 in
1925, but it blew up with a 50 percent inflation rate.
But the fault runs deeper than the Utopian nature of monetarism. The fault lies in the deliberate demolition of proven monetary
institutions (of the sort now used in Switzerland and Chile) for the
sake of a hypothetical quantity rule that has never been put into
practice.
This requires a brief digression into the development of monetarist policy proposals. The early "Chicago School" of economics,
around 1927-41, may have been more favorably inclined toward
free markets than Harvard, but not much. Like most academics,
the early Chicagoans were intimidated by the intellectual consensus
of the day. It was thus conceded that industrial and labor markets
were largely monopolized and rigid, so the influential Chicagoite
Henry Simons redefined "laissez-faire" as strict legal limits on
the size of corporations and the power of unions.
To Simons, the "utter inadequacy of the old gold standard. .
seems beyond intelligent dispute." The experts would simply
"design and establish with greatest intelligence" a "definite mechanical set of rules" for money. Simons' modest proposal involved "above all, the abolition of banking, that is, of all special
institutional arrangements for financing at short-term. . .If such
reforms seem fantastic, it may be pointed out that, in practice,
they would require merely drastic limitation upon the powers of
corporations (which is eminently desirable on other, and equally
important, grounds as well)." 4
The idea of a fixed rate of growth of the money supply originated in 1927 with the even more interventionist left wing of the
"Chicago School," namely Paul Douglas. Douglas (later a Sen4. Henry C. Simons, "Rules Versus Authorities in Monetary Policy
in Landmarks in Political Economy (University of Chicago, 1962).
(193d
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ator) was then quite excited about a "planned economy" and
"public ownership," and even called himself a socialist.5
"The obvious weakness of fixed quantity," responded Simons,
"as a sole rule of monetary policy, lies in the danger of sharp
changes on the velocity side." Moreover, "the abundance of what
we may call 'near moneys/ " Simons wisely added, creates a
"difficulty of defining money in such manner as to give practical
significance to the conception of quantity." Just as Simons' solution to big business was to make it illegal, his solution to free financial markets was to make them illegal too. Then a quantity
rule might work.
By 1948, Keynes had infected even Chicago, as shown by Milton Friedman's "Monetary and Fiscal Framework for Economic
Stability." That proposal was to run budget deficits in recessions
and "the monetary authority would have to adopt the rule that
the quantity of money should be increased only when the government has a deficit, and then by the amount of the deficit." The
budget could be balanced over the cycle, or lead to "a deficit sufficient to provide some specified secular increase in the quantity of
money."
Some might worry, said Professor Friedman, that "explicit control of the quantity of money by government and explicit creation
of money to meet actual government deficits may establish a climate favorable to irresponsible government action and to inflation." "This danger," he added, "can probably be avoided only
by moving in a completely different direction, namely, toward an
entirely metallic currency, elimination of any governmental control of the quantity of money, and the re-enthronement of the
principle of a balanced budget." 6 By implication, that was still
beyond "intelligent dispute." Needless to say, the nation did not
move in the latter direction, nor did Professor Friedman ever really
advise it to do so.
By 1962, in his magnificent Capitalism and Freedom, budget deficits no longer worked to stabilize demand. The task had become
one of steering between the Scylla of a gold standard and the
Charybdis of wide discretionary powers. Professor Friedman initiated the caricature of an "honest-to-goodness gold standard, in
5. J. Ascheim & G. S. Tavlas, "On Monetarism and Ideology" Banca Nazionale del Lavoro Review (1979).
6. Milton Friedman, Essays in Positive Economics (University of Chicago,
1953) pp. 133-5.
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Monetarism
25
which 100 percent of the money consisted literally of gold." Since
that sort of standard is indeed ridiculous, Professor Friedman instead suggested raising M2 by 3-5 percent every year. With practice, however, "we might be able to devise still better rules, which
would achieve even better results." 7 This was a return to Paul
Douglas, neglecting the doubts of Henry Simons and Frank
Knight.
On January 1, 1968, Milton Friedman wrote "We should at
once stop pegging the price of gold. We should today as we should
have yesterday and a year ago and ten years ago and in 1934—announce that the U.S. will no longer buy or sell gold at any fixed
price. .. .That would have no adverse economic effects—domestically or internationally." 8 The advice was taken that March.
Professor Friedman later acknowledged "direct links" between
his views and those of Jacob Viner, quoting Viner as saying, "if
the mere cessation of gold payments did not suffice to lower substantially the international purchasing power of the dollar I would
recommend its accompaniment by increased government expenditures financed by the printing press."9
When the term "monetarism" was coined by Karl Brunner in
1968, it represented a healthy backlash against the excesses of fiscal fine tuning. Yet monetarism too was part of the Keynesian
tradition of demand management. The tools would be different,
but the objective was still to manage the rate of growth of aggregate demand, whether over short or longer periods of time.
Early monetarists were often quite activist demand-siders. John
Culbertson, in 1964, argued that the U.S. should "give up our
self-imposed constraints" and "make an end of monetary restriction." By breaking all links with gold, he said, we could safely
pursue a "moderately expansive" policy of increasing the money
supply "something like 6 to 8 percent." As unemployment came
down to 4 percent, we might then print a bit less.'"
Some monetarists still cannot resist offering advice for fine-tuning
the growth of money to achieve some cyclical smoothing. Robert
Hall (who joined me as a member of President Reagan's inflation
7. Milton Friedman, Capitalism and Freedom (University ul Chicago. 1962)
Ch. 3.
8. Milton Friedman, An Economist's Protest (Thos. Morton, 1972) pp. 98-99.
9. R. J. Gordon (ed.), Milton Friedman's Monetary Framework (University of
Chicago 1970) p. 167.
10. John M. Culbertson, Full Employment or Stagnation3 (McGraw Hill 1964}
pp. 234-235.
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task force before the election) wanted to increase the money supply
at a 20 percent rate for at least six months in late 1976.M
"The year 1973," notes Robert Gordon, "represented the highwater mark of monetarism." 12 By then, all of the old-fashioned
obstacles to scientific demand management had been toppled. The
U.S. took the silver out of coins in 1964, lifted the gold cover on
Federal Reserve notes in 1965, set the gold price free in March
1968, reneged on converting foreign dollars into gold on August 15,
1971, and embraced floating exchange rates by March 1973.
The monetarists cheered. They had provided the intellectual
rationale for the demolition of all institutional constraints on monetary policy. There was a promise to replace the old rules with
new rules, but it has not happened. What happened is that rules
were replaced by random whim.
Henry Simons was right in 1936 to prefer rules to discretion,
but wrong to propose an alternative that could only work if flows
of money and credit could somehow be tightly regulated.
"The defects of monetarism," writes Samuel Brittain, "are
that it concedes too much power to official intervention, underrates the influence of competition in providing money substitutes,
and takes official statistics far too much at their face value. Friedmanites are often very good at analyzing how controls and regulations in the economy generally will be avoided or will produce
unintended effects quite different from those their sponsors desire.
But too often they evince a touching faith in government in their
"'own special sphere."13
Meaningless Money
Monetarism is properly a method of analysis or prediction, not
a policy. No particular policy necessarily follows from a monetarist view of the world. Monetarists have favored a wide variety of
policies, including some sort of commodity standard.
The meteoric rise of monetarism had much to do with its simplicity, and to the persuasive talents and personal charm of its
major salesmen. Monetarism begins with a seductive tautology:
The rate of growth of spending or "demand" (nominal GNP)
11. Business Week (November 15, 1976) p, 26.
12. Robert J. Gordon, "Postwar Macroeconomics" in Martin Feldstein
(ed.), The American Economy in Transition (University of Chicago 1980) p. 146.
13. Samuel Brittain How to End the Monetarist Controversy (Institute for Economic Affairs 1981) p. 84.
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Monetarism
27
depends on the rate of growth of money (M) plus velocity (V).
Converting the old quantity equation into annual percentage increases, then M + V = GNP.
If we could count and control M, and if we could predict velocity, then we would reach the Keynesian heaven of managing "aggregate demand." And if we could also predict how much of that
rise in GNP would be real growth and how much would be inflation, then we could use all this to "control" inflation. The only
trouble is that nobody can do any of those things. Even if anyone
could, there is no reason to suppose that these devices would actually be used to avoid inflation or deflation.
Basically, the goal of managed money is to control $3 trillion in
annual spending through periodic adjustments in about $45 billion of bank reserves. Not an easy task.
First of all, what is money? In March 1979, the Shadow Open
Market Committee noticed that "there is now a large and rapidly
growing volume of financial assets not subject to ceiling rates on
deposits. . .and in some cases not subject to reserve requirements."
By February 12, 1982, one member of the Shadow Committee,
Erich Heinemann of Morgan Stanley, was showing more concern:
The improvements in the monetary definitions are unfortunately minor in comparison with the more fundamental conceptual problems associated with measuring money. To what
extent are household money market mutual fund shares
transaction or savings balances? Are institutional holdings of
overnight RPs or overnight Eurodollars transaction balances
since they are available each morning for spending? Are institutional holdings of marketable and highly liquid shortterm credit instruments such as Treasury bills, certificates of
deposit, and banker's acceptances so easily convertible into
transaction balances that they should be so treated;* If we exclude them from transaction measures, such as M - l , are we
missing a large and important source of corporate liquidity?
Anyway should holdings of Treasury bills, which are more
liquid than CDs, be included in L, while CDs arc included in
M-3? The questions go on and on, and few of them can be
answered unambiguously- The questions linger, and the
quality of virtually any definition of money remains uncertain. In this context, the redefinitions are minor refinements
in the hopelessly difficult task of measuring money.
These sorts of doubts have often marked the beginning of the
end of confidence that controlling some arbitrary measure of
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money is a practical way to ensure its value. At the end of 1975, I
wrote a paper for Argus Research on "The Increasing Irrelevance
of Ml." In 1979, when some prominent monetarists were saying
that money growth was too slow, I wrote (with Jeffrey Leeds) that
failure to count money market funds and repurchase agreements
was understating the six-month rate of money growth by more
than seven percentage points.14
Peter Canelo, a top bond analyst at Merrill Lynch, likewise became disillusioned about monetarism through his enormously detailed weekly reports on what the various M's really mean. Lately,
Phillip Cagan of Columbia, one of Professor Friedman's first and
best proteges, has expressed similar doubts.'5
On October 6, 1979, the Fed essentially announced that it
would let interest rates approach infinity, if necessary, to slow the
growth of bank reserves and Ml. The C. J. Lawrence survey of
bond managers' forecasts for long-term government bond yields
went from 9 percent on September 14, 1979, to 12.3 percent in
five months.
Now, there is no question that high interest rates can drive
money out of Ml and bank reserves, but that also raises velocity.
At high interest rates there is a powerful incentive to keep as little
money as possible in Ml deposits, which pay little or no interest.
Banks have an equally powerful incentive to use "liability management" 16 make the most loans with the least required reserves,
since reserves at the Fed earn no interest.16
Money market funds have been more than doubling in size
each year and, at about $160 billion, are much larger than the entire stock of currency. You can write checks on most of these
funds, or transfer to a checking account with a phone call. Overnight repurchase agreements and Eurodollars usually exceed $40
billion, and are curiously lumped together with 8-year certificates
in M2. Such cash management devices have only been significant
for two or three years, making the old historical relationships (such
as postwar velocity "trends") quite suspect.17
14. "Understating Monetary Growth," first Chicago World Report (MarchApril 1979).
15. See James Grant's column, Bamwt'j July 27, 1981, and Sanfurd Roie's
column, American Banker (Nov. 24, 1981).
16. James Earley & Gary Evans, "The Problem Is Bank Liability Management," Challenge (January-February 1982).
17. M. Dotsey, et al., "Money Market Mutual Funds and Monetary Control," Federal Reserve Bank of New York Quarterly Review (Winter 1981-82).
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Monetarism
29
MasterCard plans to offer a "sweep account" for small depositors, where check balances are kept within a desired range, and
any excess or shortage is moved around from money market funds
or other near-monies. If the Fed counts demand deposits at the
wrong time of the day, they might not find much. There are other
devices on the horizon such as CDs with check-writing privileges,
checks on Visa cards, and retail repurchase agreements. The
whole idea of measuring M is growing more obsolete by the day.
The Fed makes the rules of the monetarist game, because the
Fed defines the M's. The definition has changed four times since
late 1978. How could any long-term rule be formulated in terms
of a quantity of money when the definition of money is necessarily
subject to continuous change?
Money numbers are also constantly revised. In early 1982, we
finally learned that a 5.4 percent rate of decline in Ml in the previous May was really a 10.8 percent rate of decline; a 14.5 percent
increase in November turned out to be 10.1 percent. How could
the Fed possibly stabilize Ml before anyone knows how much it
rose or fell?
High interest rates drive money out of Ml into interest-earning,
highly-liquid devices that have little or no reserve requirements.
So neither Ml nor reserve aggregates (the base) have the same
meaning as they did when interest rates were much lower. Most
of the financial innovations are roughly counted in M2 or M3,
but those measures also contain much larger amounts of longerterm savings.
A fall in interest rates might well induce people to keep more of
their income in M l , but that shift from M2 into Ml would not be
inflationary. An increase in real output would raise the need for
cash to finance more transactions, but supplying that demand
would not be inflationary. A rise in the savings rate would probably increase M2, but that too would not be inflationary. It depends on real growth and velocity.
In the fourth quarter of 1981, the interest rate on 3-month
T-bills fell from 15 percent to 11.8 percent. The growth rate of
M3, which is dominated by interest-sensitive instruments, slowed
from 11.2 to 9.2 percent. The growth of Ml, which is discouraged
by high rates, rose from zero to 5.7 percent. The monetary base
slowed down. What does all this mean? Not much.
Monetarists still can't decide on a meaningful and controllable
measure of money. Phillip Cagan of Columbia and David Laidler
of Western Ontario strongly favor M2. The St. Louis Fed and
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Robert Weintraub of the Joint Economic Committee are sticking
with MI. Allan Meltzer of Carnegie-Mellon seems to be leaning
toward the monetary base. Milton Friedman used M2 last year to
show that money growth had not slowed down, but uses Ml this
year to show that money growth has not been steady.
It makes a lot of difference. It should be obvious that high interest rates artificially depress Ml and raise its velocity, that the
monetary base shows almost no predictable relationship to anything in the past two years, and that broader aggregates are not
controllable by the Fed.18 Besides, the broader aggregates have
been speeding-up in the last yar or two, so the traditional Friedmanite long lag with M2 supposedly points to more inflation
ahead while Ml or the base does not. (M2 rose 10 percent in
1981; M3, by 11.4 percent.)
Not all of the confusion, however, suggests that money is undercounted. Most of the monetary base and a big chunk of Ml is
simply currency. David Whitehead of the Atlanta Fed estimates
that most of the big bills (and 69 percent of all currency) are
hoarded.19
In a period of great financial uncertainty and insolvency, the
prospect of a major surge in the demand for currency should not
be ruled out, despite the lost interest. In this case, the monetary
base would be particularly misleading, as it was throughout the
Great Depression. A lot of "currency in circulation" would not
really be in circulation.
Volatile Velocity
Monetarists have a double standard when it comes to judging
the stability of the money supply or velocity. Comparing percentage changes between fourth quarters, velocity fell in 1967 and
1970, yet rose by 5-6 percent in 1965, 1966, 1973, 1975 and 1978.
Robert Weintraub complains that this is "selective and myopic...
terribly short-sighted and gives very misleading signals."20 He insists that velocity data should be smoothed by comparing averages
18. Nancy Kimelman, "Using Monetary Targets as Intermediate Targets:
Easier in Theory Than in Practice," Federal Reserve Bank of Dallas Voice (December I98i). Patrick Lawler "The Large Monetary Aggregates as Intermediate Policy Targets," Federal Reserve Bank of Dallas'Voice (November 1981),
19. "Money Suppjy Gauge May Be Inaccurate," Washington Report (April 20,
1982).
20. Maxwell Newton published the exchange in New York Post January 15,
1982.
294
Monetarism
31
over the whole year with the year before, or better still, by comparing three-year averages.
When it comes to the money supply, however, monetarists certainly do not mind comparing changes between fourth quarters
(this is the way Fed targets are set), or even changes between 8-10
week periods converted into compound annual rates of change. 21
If quarterly changes in velocity are likewise expressed as an annual rate of change, as Professor Friedman does for even shorter
periods with M l , then velocity swings far more wildly than money
—up 13.2 percent in the first quarter of 1981, down 4.5 percent in
the second, up 9.5 percent in the third, down 1.2 percent in the
fourth, and down 10.5 percent in the first quarter of 1982. Monetarists are able to contrast the "stability" of velocity with the instability of Ml only by hiding the numbers.
Velocity was relatively predictable in the stable world of Bretton Woods, but all models to predict velocity broke down after
1972-73, when the U.S. suspended gold convertibility and endorsed floating exchange rates. Interest rates now move as much
in a day as they used to in a year. Thus, a survey on the demand
for money by David Laidler laments that "it was never possible
completely to get away from the conclusion that the function has
shifted after 1972." "After all," Professor Laidler notes, "monetary policy is implemented over time, and unless the relationship
it seeks to exploit can be relied upon to remain stable over time it
cannot be used successfully." 22
At the end of i960, a rigorous study by Robert Weintraub said,
"We expect the trend rate of rise of MlB's velocity to drop from
3.2 to about 2% per year, with the spread of NOW accounts. Wo
would compensate for this by adjusting the long run target for
yearly M1B growth upward by 1 to 1 V2%." y t
Velocity is officially classified as a coincident cyclical indicator,
so it fell with the sharp fall in real output from last October
21. Milton Friedman, "Monetary Instability." Xetrswerk (Dcicmber 21,
1981).
22. David Laidler, "The Demand and Supply of Money Yet Again," paper
presented to a Carnegie-Rochester conference, April 197!'. $<re also Albert
Friedberg, "Gold and Demand-Side Monetarism," Bondwefk (November 9.
1981).
23. House Subcommittee on Monetary Policy, The Impact of iHf Federal Rewf
System's Monetary Policies on (he Nation '$ Economy (U.S. Government 1980) p. 43. In
this model (p. 33) "it lakes two to four years for changes in m<>nr\ growth to
change the rate of inflation." so the slowdown in inflation in 1 ( 'H1 must have
been due to slower money growth around 1977-79?
295
32
Policy Review
through March. The only half-hearted expansion the U.S. has experienced lately was between the third quarters of 1980 and 1981.
At that time, velocity of both Ml and the base did not rise by 2
percent, or by 3.2 percent, but by 6 percent. Is this the new
"trend" for velocity if and when the economy recovers? Nobody
has the slightest idea.
Whatever "stability" can be found in long-run trend of Ml velocity is only because Ml has been redefined. The old Ml velocity
showed an even clearer tendency to accelerate during each cyclical
expansion, averaging 3.1 percent from 1961-69, 3.5 percent from
1970-73, and 4.9 percent from 1975-79. And the gyrations were
becoming larger.
The unpredictability of velocity became even worse after the
October 1979 emphasis on the M's. "Erratic velocity behavior of
the traditional monetary aggregates led the Federal Reserve to redefine the aggregates, However, the new monetary aggregates
have also exhibited erratic velocity behavior. . . ,Paradoxically, the
regulatory framework necessary to control the growth of a given
aggregate sets in motion forces that ultimately reduce that aggregate's usefulness in policy implementation." 24
A popular new theory in Washington implies that the ten-year
collapse of bond and mortgage markets Is due to the ten-week
wiggles in Ml since October 1979. Since the Fed stopped stabilizing interest rates, interest rates have, of course, been less stable.
Ignoring what interest rates do to the velocity of Ml, monetarists
say it is changes in Ml that cause changes in short-term interest
rates, rather than the other way around.
It isn't a very persuasive argument, so this is how to "prove"
it: First, take a four-week moving average of the volume of bank
reserves and calculate the percentage change from the same period a year before. Plot this on a scale from 1 to 7 percent. Then put
current interest rates on three-month T-bills on a scale from 10 to
17 percent. For 1981, believe it or not, these two series do appear
to move up and down together (though not in 1980 or 1982).
The Shadow Open Market Committee of March 15, 1982 concludes that "this leaves little doubt that interest rates rise and fall
24. Bryon Higgins & Jon Faust, "Velocity Behavior of the New Monetary
Aggregates," Federal Reserve Bank of Kansas Economic Review (Sepiember-October 1981). Also John Wenninger, et. al., "Recent Instability in the Demand
for Money." Federal Reserve Bank of New York Quarterly Review (Summer
1981).
296
Monetarism
33
directly with growth m reserves." But if 7-percent annual growth
of reserves "causes" 17-percent interest rates and 1 percent
growth of reserves "causes" 10-percent interest rates, then bank
reserves must have been falling very rapidly when interest rates
were 4 percent (?) A simpler explanation is that the recession lowered both interest rates and reservable deposits last fall.
Output or Prices?
In his classic 1956 restatement, Milton Friedman wrote that
"the quantity theory is in the first instance a theory of the demand
for money. It is not a theory of output, or of money income, or of
the price level."25 But the elaborate efforts to predict the demand
for money broke down with collapse of gold convertibility and
pegged exchange rates in 1972-73.
The late Harry Johnson of the University of Chicago decided
that monetarism was a passing fad, partly because of the monetarists' habit of "disclaiming the need for an analysis of whether monetary changes affected prices or quantities." 2 *' Allan Meltzer, for
example^ acknowledges that "none of our models predict changes
in output reliably." Few even try. Two leading Keynesians likewise admit that their models too "were demand-oriented, and paid
almost no attention to the supply side of the economy."J; Hem-tine supply-side counterrevolution.
But even if the growth of money plus velocity were under control, that is not enough. It is not a matter of indifference whether
an 8-percent growth of nominal GNP consists of 8-percent inflation and zero growth or zero inflation and 8-percent real growth.
"An increase in real activity raises the demand for real money,
which, given nominal money and the rate of interest, is accommodated via a decline in the price level."28 Real growth is anti-infl^
tionary in fundamental and lasting ways. Yet growth may be stifled
by a monetarist regime that cannot distinguish between a demand
for cash to finance more real growth (or to guard against insolvency) and some sort of inflationary impulse.
25. Milton Friedman (ed.), Studies in Ike Quantity Theory of Money, (Universm
of Chicago 1956) p. 4,
26. Harry G.Johnson, On Economics and Society (University of Chicago 197T)
27. A. H. Meltzer, "The Great Depression" Journal of Monetary Efonami,-\
(November 1976); Alan Blinder & Robert Solow, "Does Fiscal Polity Slill Matter" Ibid.
28. Eugene Fama "Money and Inflation" (unpublished. .Vitjmt l l »79\.
297
34
Policy Review
When not openly applauding stagnation as a "Phillips Curve"
cure for inflation, monetarists sometimes make slow money growth
an end in itself. "A renewed economic expansion," said a prominent monetarist newsletter last July, "would not be promising for
innation. . .or effective monetary control."29 This is what the debate between monetarists and supply-siders is all about. Supplysiders want a monetary policy conducive to increased output at
stable prices, not a policy to stamp out each glimmer of economic
growth in order to keep Ml down. The supply of money is at best
a tool, not a goal, and its value must be judged by results.
Time Lags
Monetarism has to postulate a time lag between changes in
money and changes in nominal GNP or prices. Otherwise, the results are often perverse. From April through October last year,
the monetary base grew at a 2.6 percent annual rate, consumer
prices at 10.5 percent. From October to February, the base grew
at a 10 percent rate, but consumer prices rose at only a 4.3 percent rate. Without a lag, the uninitiated might suppose that faster
growth of the monetary base caused slower inflation, or that the
two series are not closely related.
Milton Friedman recently wrote that "the lag between a change
in monetary policy and output is roughly six to nine months; between the change in monetary growth and inflation, roughly two
years/' 30 At the St. Louis Fed, R. W. Hafer says "a 1.0 percentage point increase in the growth of M1B yields an identical increase in the growth of nominal GNP within one year."31 The
President of the St. Louis Fed, however, seems to be defending a
zero time lag, since his table relates money growth to simultaneous
changes in GNP.32 An Atlanta Fed Conference on supply-side
economics in April 1982 saw David Meiselman arguing for a lag
of 7 quarters, Beryl Sprinkel for a few months. Pick one; something is bound to fit.
29. Morgan Stanley, "Money and the Economy" July 13, 198J. (Lindley
Clark of the Wall Street Journal has also written of the virtues of anemic growth).
30. Quoted in Antonio Martino, Containing Inflationary Government (Heritage
Foundation 1982) p. 34.
31. R. W, Hafer, "Much Ado About M2," Federal Reserve Bank of St.
Louis Review (October 1981). Hafer does not realize that critics of Ml are not
necessarily saying M2 is any better.
32. Lawrence K. Roos, "The Attack on Monetary Targets," The Wall Street
Journal (February 3, 1982).
298
Monetarism
35
If the lag Is unknown, there is no way to tell if monetarism is
right or wrong. There will always be some past period of relatively
faster or slower growth of some M to "explain,' 1 after the fact, whyinflation or output went up or down. That sort of retrospective, ad
hoc monetarism is inherently immune to serious testing.
If the lag is known, however, rational expectations would make
it disappear. Knowing that more money now would cause more
output in six months would make it profitable to build inventories
right away, thus eliminating the six-month lag. Knowing that
more money would cause inflation in two years would make it
profitable to speculate in commodity markets and generally buy
before prices went up—thus eliminating the two-year lag.
If the time lag were known, people would act on that information and eliminate the lag. If there is nonetheless an unknown lag;
then there is no way of knowing which change in output or price
was caused by which change in the volume of cash. Monetarism
would then be of little value for predicting the future or even explaining the past. If there is no lag at all, then the causality between money and spending could easily be backwards. That is,
decisions to spend more might cause an increase in the supply of
money, as people sold assets to get cash.
On the face of it, one might suppose that decisions to spend are
based on income, assets, and credit conditions—not merely on
how much one happens to keep in a checking account. The idea
that total spending can be controlled by controlling the forms of
wealth became popular largely because of the apparent discovery
of lags between money and GNP.
The notion of money having a known effect on something in the
future was thus crucial to plausibility of monetarism, but there is
still no justification for it in theory or fact, nor any agreement on
how long the lags are.
Do-It-Yourself Monetarism
The supply of money provides some information, even aside
from velocity and price. Table 1 shows quarterly changes and annual trends in the monetary base, Ml, and in nominal and real
GNP. Quarterly changes in Ml appear to explain simultaneous
changes in nominal GNP in a few periods, but that causality
could obviously be backwards (e.g., observe the generous rise in
monetary base and falling Ml during the sharp recession in the
second quarter in 1980). And what sense can be made of the first
and third quarters of last year, when GNP grew very rapidly as
299
36
Policy Review
TABLE J
Money, Spending and Production
(annual rates of change, rounded)
Quarterly
I
1980
1980 II
1980 III
1980 IV
I
1981
1981 II
1981 III
1981 IV
I
1982
Year-to-Year
Base
Ml
GNP
Real
GNP
8
6
10
9
7
- 3
15
12
5
10
0
6
11
13
- 1
12
15
19
5
11
5
1
3
-10
2
4
9
- 2
1
- 5
- 4
5
7
4
2
10
Base
Ml
GNP
8
8
8
8
4
6
10
8
8
7
8
6
4
6
7
7
10
6
5
7
8
9
11
13
12
10
5
Real
GNP
2%
-1
-1
0
1
3
3
1
-2
Source: Federal Reserve Bank of St. Louis
the base and Ml slowed sharply? The task here is to discover the
stability of velocity and the appropriate Jag.
The older tradition is that longer-term trends are what matter.
On such year-to-year comparisons, Ml growth was unchanged
between the third quarters of 1980 and 1981, though the base
slowed significantly. With money growth unchanged or tightened,
depending on definitions, what happened to the trend of nominal
GNP? It rose by 50 percent over the year. A few months later,
Lawrence Roos wrote that "Both M1B growth and GNP growth
have been decreasing steadily since 1979. "33
Do either the quarterly or annual changes in nominal GNP
look "too slow" before the fourth-quarter collapse? If so, then the
recession after last July might be blamed on inadequate "aggregate demand," requiring bigger budget deficits or more Ml. If
not, maybe it is time to discard demand management.
It Won't Work
To summarize, rebuilding long-term financial markets requires
a credible long-term policy to maintain reasonable stability in the
purchasing power of the dollar. Such a rule cannot be expressed as
a quantity of money because (1) the definition of money is rapidly
33.
Op. at
300
Monetarism
37
changing, (2) velocity is increasingly unpredictable, (3) any lags
between changes in money and GNP are implausible or at least
unpredictable, (4) spending depends on more than cash balances
and desired cash balances depend on more than planned spending, and (5) nobody can tell at the time if a rise in money and
spending is financing more real output or rising prices (except by
watching prices instead of money stocks).
But that isn't the end of it. If a quantity rule for money could
somehow pass these hurdles, it still would not work.
If people thought a quantity rule would work, they would expect inflation to average about zero for decades. The rush to buy
long-term-bonds would quickly drop interest rates to around 3-6
percent. At such rates, the convenience of checking accounts and
currency would make it a waste of time to employ complex cash
management schemes. The demand for Ml would surge; velocity
would fall.
No fixed growth of Ml or the monetary base could cope with
such a sudden rise in the demand for cash. Real cash balances
could only rise, as desired, if prices fell abruptly. Sudden deflation would surely prompt an equally sudden violation of the rule.
Knowing that, people would not believe the rule in the first place.
If the move to slow growth of Ml was done gradually, to minimize the risk of deflation, that too would not be believed. People
would rightly reason that the next president or Fed chairman
would probably abandon the predecessor's long-term plan. Thus,
long-term interest rates would remain high, and velocity might
well speed up by more than Ml was slowing down. With rates
high, any temporary reduction of inflation would raise real interest rates, causing bankruptcies that would force abandoning the
gradual rule.
Advocates of a quantity rule have had 14 years to agree on one
and put U into action. Next time, it will not take that long for interest rates to triple again. Does that have to happen before anyone will admit that this experiment with managed money, like the
Continental and Greenback dollars, is also a failure? How bad do
things have to get before economists will admit that they made a
mistake by endorsing the demolition of proven monetary rules
from 1965 to 1973?
Price Rules
If monetary policy cannot effectively stabilize prices indirectly,
by controlling quantities of M, then why not focus directly on
301
38
Policy Review
some sensitive measure of price? If such prices are falling, that
would be a sign that the demand for money exceeds the supply—
time for the Fed to buy bonds (or gold), or to lower the discount
rate or reserve requirements. If prices start to climb, it is time to
tighten.
In 1962, this was still the dominant view. Professor Friedman
then wrote, in Capitalism and Freedom, that "the rule that has most
frequently been suggested by people of a genuinely liberal persuasion is a price level rule; namely, a legislative directive to the
monetary authorities that they maintain a stable price level."
If monetary policy had followed a price rule in 1928-31, the deflation could have been nipped in the bud. As Lauchlin Currie
noted in 1934, "the three years that preceded the depression witnessed a considerable fall in prices not only in this country but
throughout the world."34 Another possible price rule—real interest rates—likewise showed that monetary policy was too tight in
1928-32. Alternatively, the sizable inflow of gold into the U.S. in
1929-30 was an equally clear signal that the supply of dollars was
inadequate. The Fed, as Milton Friedman observes, was "contracting the money supply when the gold standard rules called for
expansion."35
A quantity approach to money, on the other hand, would have
given ambiguous signals about deflation until it was too late.
There was no significant decline in the money supply until March
1931, and the monetary base continued to rise throughout the
1930-33 deflation, as people held more currency and banks held
more reserves. A policy of slowly increasing the monetary base, as
some now propose, would not have prevented the Great Contraction. Any price rule or gold standard, however, would have worked.
Broader price indexes, such as the producer price index, are too
sluggish, among other problems (they are revised months later;
seasonal adjustments and weighing of items are dubious; discounts and quality changes are missed, etc.). Looking at broad
price indexes makes it easier to wrongly blame inflation on the "oil
shock" of 1974, though commodity prices began rising sharply in
34. Lauchlin Currie, "The Failure of Monetary Policy to Prevent the Depression of 1929-32" in Landmarks in Political Economy (University of Chicago,
1962).
35. H. G. Manne & R. L. Miller, Gold, Money and the Law (Aldine 1975),
p. 75. Also M, Friedman & A. Schwartz, A Monetary History of the United States
(Princeton 1963) p. 361.
302
Monetarism
39
1972. Instead, a price rule must work with instantly available spot
commodity prices.
Money and commodity prices often move in roughly similar directions, as Robert Weintraub has noted, so monetary policy at
those times could just as well moderate big swings in either one.
When the two diverge, however, commodity prices invariably give
a more accurate picture of emerging trends in the economy. Growth
of Ml was essentially unchanged from 1973 to 1975, at 4.4-5.5
percent, but a price rule would have required a much tighter policy throughout 1972 and 1973, and a much easier policy from April
1974 to July 1975 (when spot commodity prices fell 28 percent).
Table 2 contrasts the monthly information provided by Ml and
commodity prices in 1980-81. Either series pointed in the correct
direction in 1980, but commodity prices convey a much better
picture of the liquidity squeeze from October 1981 into early
1982. The seemingly rapid growth of Ml this period was not sufficient to prevent massive liquidation. An easier policy would havt*
been prudent and desirable, providing people understood that the
process would be reversed as soon as commodity prices began to
turn up. In other words, chasing the elusive M's from week-to-'
TABLE 2
Should the Fed Target Prices or Ml?
1980
Ml
Jan.
Feb.
Mar.
Apr.
May
Jun.
Jul.
Aug.
Sep.
Oct.
Nov.
Dec.
Commodity
Prices
0.8
0.8
0
- 1.3
-0.2
1.2
1.1
1.8
1.4
1.2
0.5
-0.7
2.1
2.0
-1.7
-4.7
-7.8
-3.9
3.8
5.2
2.1
0.8
1.3
-2.1
1981
Price
Rule
loose
loose
tight
tight
tight
tight
loose
loose
loose
loose
loose
tight
Ml
0.8
0.4
1.2
2.1
- 1.0
-0.2
0.2
0.4
0
0.4
0.8
1.0
Commodity
Prices
Price
Rule
-2.3%
light
tifiht
Icose
-2.5
2.0
1.1
-IA
loose
-2.1
t.3
tiijht
tight
loose
1.0
loose
-2.2
-2.0
-2.4
-2.3
tight
tight
tight
tighf
Source: U.S. Department of Commerce, Business Conditions Dignt. Series 85 and
23.
303
40
Policy Review
week prevented the only sensible response to an unnecessarily
wrenching deflationary experience.
Other sorts of price targets have been proposed, but most are
less direct ways of achieving similar results. Ronald McKinnon of
Stanford proposes pegging exchange rates with countries that have
a somewhat better track record on inflation, such as Germany and
Japan. Edward Yardeni of E. F. Hutton and Donald Hester of
the University of Wisconsin suggest keeping real interest rates
from drifting too high or too low. Stabilizing commodity prices
would do all this and more.
If real interest rates are "too high," there is liquidation of commodities, inventories and assets in order to acquire cash. Commodity prices fall. The dollar's exchange rate will likewise be artificially high, due to short-term capital inflows. Stabilizing the
price of gold also stabilizes real interest rates, commodity prices,
bond yields and exchange rates. Stabilizing any one of those things,
if it could be done, would also tend to stabilize the others.
Since broader price indexes are too insensitive, wliat about narrowing the list to only one commodity—namely, gold—that is
notoriously sensitive to every whiff of inflation or deflation (including the inflationary propsect of war)?
The London gold price dipped in February 1980 and fell 17
percent in March, correctly signalling the March-June decline in
commodity prices. Gold rose 17 percent in June 1980, announcing the start of the July-November reflation. Gold prices have
fallen since just before the presidential election, stabilizing only
during the spurt in both money growth and commodity prices in
March-April 1981. Watching gold prices works well, and limiting
the extremes would work even better. That is no more difficult
than stabilizing wild gyrations in interest or exchange rates,
which has often been successfully accomplished.
Participants in the gold market are not only concerned about
current inflation, but about future inflation. Price movements thus
tend to be exaggerated, when not on a gold standard, reflecting
changing expectations about future inflation. This may be a useful
characteristic, because it is the expectation of future inflation that
destroyed the bond market.
In October 1979, when the Federal Reserve announced that it
would henceforth pay more attention to quantities of money and
less to results, the gold price went from $355 to $675 in only four
months. Other factors may have been involved, but it looks like a
vote of no confidence. Conversely, the gold price fell sharply ever
304
Monetarism
41
since the election of President Reagan. No forecaster or monetary
aggregate did as good a job as the gold market of predicting howabrupt the disinflation would really be. Money growth was not
clearly slow until May-September of last year, and even then the
M's were throwing-ofT conflicting signals.
Convertibility
Paying more attention to the consequences of monetary policy—prices, interest rates and exchange rates—would be a major
improvement, but still remains a matter of discretionary management.
In order to institutionalize a price rule, it is necessary to convert
dollars for gold, and vice-versa, on demand at a fixed price. The
"right price" is that price at which we observe neither inflation
nor deflation. The only way that foreigners or speculators could
upset the fixed gold-dollar ratio would be by monopolizing the
stock of gold or dollars, which is clearly impossible.
Stabilizing the value of dollars in terms of gold is not "price fixing" any more than stabilizing an index of prices would be called
"price fixing," **Just as every commodity has a value in terms of
the unit," wrote Ralph Hawtrey, "so the unit has a value in
terms of each commodity.Il36
There has been a lot of misinformation spread around about
the U.S. gold standard in the classical period (1879-1914) or the
Bretton Woods era (1945-1973). When the period of managed
and floating money since 1968 or 1973 is fairly compared with any
sort of gold standard, gold systems show far more real growth,
better stability of prices in the short and long run, longer expansions, more world trade, and long-term interest rates never above
5-6 percent.37 In any case, we can improve upon historical performance by learning from the mistakes.
In 1978, Jurg Niehans of Johns Hopkins observed that "commodity money is the only type of money that. . . can be said to
have passed the test of history," and wondered if "the present period will turn out to be just another interlude." "The analysis of
commodity money," Niehans regretted, "has made hardly any
36. Ralph Hawtrey, Currency and Credit (Longmans Green 1919) Ch 1.
37. My Gold Commission testimony is condensed in Economic Impact 1982/2
(U.S. Govt. Printing Office), and the Federal Reserve Bank of Atlanta will soon
release my talk in the proceedings of an April conference on supply-side economics.
305
42
Policy Review
progress in the last fifty years. Actually, more knowledge was forgotten than was newly acquired."38
In the past few years, however, there has been a gradual rediscovery of the value of commodity money in the work of such scholars as Robert Barro, Fischer Black, Benjamin Klein, Robert
Mundell, Robert Hall, Thomas Sargent, Robert Genetski, Richard Zecher, Paul McGouldrick, Michael Bordo and others. This
is just the beginning.
David Ricardo wrote about the central bank in England during
1816, a period of fiat money very much like the present. "In the
present state of the law," wrote Ricardo, "they have the power,
without any control whatever, of increasing or reducing the circulation in any degree they may think proper; a power which should
neither be entrusted to the state itself, nor to anybody in it, as there
can be no security for the uniformity in the value of the currency
when its augmentation or diminution depends solely on the will of
the issuers."
"The issue of paper money," said Ricardo, "ought to be under
some check and control; and none seems so proper for that purpose as that of subjecting the issuers of paper money to the obligation of paying their notes either in gold coin or bullion." 3<>
The Bullion Committee explained the task before Britain reinstated the gold standard in 1821: "The most detailed knowledge
of the actual trade of the country, combined with the profound
science in all principles of money and circulation, would not allow
any man or set of men to adjust, and keep adjusted, the right proportions of circulating medium in a country to the wants of
trade."
Britain took Ricardo's advice and enjoyed over a century of
unprecedented monetary stability and economic achievement.
Eventually, the United States will do the same. There is no viable
alternative.
38.
39.
Jurg Niehans, The T&eory of Money (Johns Hopkins 1978) pp. 140-41.
David Ricardo, The Principles of Political Economy and Taxation.
306
STATEMENT
on behalf of
-.
NATIONAL ASSOCIATION OF REALTORS®
regarding
MONETARY POLICY
to the
SENATE COMMITTEE ON BANKING, BOUSING
AND URBAN AFFAIRS
by
DR. JACK CARLSON
August 12, 1962
I
am
Jack
Carlson,
Executive
Vice
President
Economist of the NATIONAL ASSOCIATION OF REALTORS
On behalf
of the
nearly
600,000
and
Chief
fit)
^.
members of
the
National
Association, we greatly appreciate the opportunity to submit our
views on the Monetary Policy.
RECOMMENDATIONS
(1)
We
recommend
Federal
addition
this
Reserve
to
particularly
and
to
Committee
use
consider
short-term
consistent
with
during periods of
instructing
interest
money
time
when
targets
growth
the
in
targets,
the appropriate
long and short-term monetary growth targets of the Federal
Reserve are being met.
307
(2)
We
recommend
recommending
fact
that
monetary
to
to
this
committee
the Federal
reductions
targets
to
in
Reserve
money
be
that
that
in
velocity
have
increasingly
upward
during
these
It is our recommendation
and
be
should
increased
by
one
remainder of this year and for
(3)
We
recommend
to
Federal Reserve
this
We recommend
Federal
averaging
that
the weekly
expectations.
averaging of the money
the
the
growth
reduced
money
the targets
it
that
it
point
can
for
the
encourage
the
The
recommend
information
growth
to the
by
which
policy of
the
in the financial markets
money
stock
inappropriate response to the problem of
erroneous
caused
date for implementation
run money
Open Market Commit tee are formed
through
of
that
reducing
expectations on the short
the
accounting.
to this committee
that
of
1983.
to set a suitable
Reserve
view
the money
percentage
committee
of contemporaneous reserve
(4)
periods
velocity.
consider
restrictive,
Federal Reaerve should consider modifying
targets
it
plan
to
measures
is
an
the formation
of
implement
the
stock measures should be cancelled.
The Federal Reserve should implement measures
to increasre
the information by which these expectations are formed and
not reduce it.
(5)
We recommend to this commit tee that it request the Federal
Reserve to consider holding monthly briefings in New
York
308
and
Washington
for
financial
market
economists,
practitioners, and others whose opinions weigh
the
formation
committee
as
of
Investor
to
the
expectations and
feasibility
of
this
heavily
report
to
in
the
proposal.
The
purpose of the briefing would be to reduce erroneous policy
expectations
relate
to
in the financial markets particularly
factors
that
influence
short
and
as they
medium
term
policy modifications by the Open Market Committee.
SUMMARY
(1)
Since
Policy
late
have
in
1979,
major
elements
of
Federal
been in direct
conflict
in that
the
Economic
Federal
Reserve has pursued
on anti-inflationary policy of credit
restraint
Congress
pursued
while
an
the
inflationary
and
policy
of
the Administration
fiscal
stimulation
have
to
increase economic growth and employment.
(2)
The result of this policy mix is an unusual set of elconomic
conditions, i.e., lower inflation, higher unemployment, and
stagnant economic growth co-existing with high and volatile
interest rates.
(3)
High and
volatile
interest
rates, by keeping
the
housing
and auto industries, business investment and trade in goods
and services depressed is preventing economic
has Inflationary implications for the future.
recovery and
309
(4)
We agree with
has
to be
deficits
Federal Reserve
far more
before
a
done
Chairman Volcker
on
sustained
the
and
that
there
fiscal
side
in
reducing
robust
economic
recovery
can ensue.
(5)
Interest rate volatility is knovn
depressing
credit
volatility
growth
has
dependent
primarily
path for money
industries.
been
supply
to be a major factor
the
as
result
order
to
produce
a
of
represented
Federal Reserve's capacity to control
in
This
steadily
an
In
rate
erratic
by Ml.
The
the supply of credit
growing
money
supply
is
limited.
(6)
The Federal Reserve
should adopt, as has been
recommended
by
a
requirement
Its
own
staff,
contemporaneous
reserve
system in order that they have greater short run
accuracy
In managing reserves to meet money growth objectives.
(7)
The
current
expectations
responded
assets.
have
economic
of
to
This
conditions
investors
this
by
policy
confused
consumers
holding
has caused
necessitated
and
have
large
changes
and
they
amounts
In money
modifications
the
of
have
liquid
velocity
by
the
that
Federal
Reserve with respect to the monetary growth targets.
(8)
These
policy
modifications
have
not
been
effectively
communicated to the financial markets and have resulted in
erroneous
Interest
early
monetary
rates
part
of
policy
have,
1982
anticipations
the refore,
than
they
been
would
expectations had been more accurate.
by
the
higher
have
been
markets.
during
If
the
policy
310
(9)
The
Federal
Reserve
erroneous' policy
should
Implement
expectations
in
measures
the
to
financial
reduce
markets,
particularly as it relates to factors that Influence shorti
and medium-term
policy modifications with respect
to
monetary growth targets.
(10)
The economy
currently
reduced
priority
growth.
is now poised
from
the
Federal
reducing
Reserve
inflation
to
should
shift
encouraging
its
economic
It now can safely allow money to grow at least one
percentage point above
particularly
the
preferences
would
for recovery and with inflation
and
the current
case
with
low money
target range.
current
velocity.
This is
high
The
liquidity
result
of
this
be to further lower interest rates and relieve some
of the pressure from the interest sensitive industries and
thrift institutions.
A more rapid economic
recovery would
result from this policy change.
Since
late
policy of bank
the
growth
in
1979,
the
Federal
nominal
rates
toward
GNP.
has
pursued
a
reserve management for the purpose of regulating
of
several
prespecified annual target ranges.
approach
Reserve
reducing
The
inflation
theoretical
monetary
aggregates
within
The policy was adopted as an
by
limiting
justification
is
the
growth
of
that, although
there will be short-run impact on real output and employment from
restraining
money
growth,
the
intermediate
and
long-term
adjustment would primarily come out of the inflation component of
nominal GNP which is the desired result.
At the time, reducing
311
inflation,
rates
in
which
was
excess
of
growing
eighteen
during
some
percent,
months
had
at
acquired
annualized
a
national
constituency for making it the primary domestic policy priority.
Although
been
the
volatile,
path
their
of
growth
yearly
growth
1980, 1981, and the first half
theory,
inflation
also suggests
reduction
of
This
not
has
has
occurred.
and
the
has
money
declined.
slowing
Interest
rates
of
declined
However,
declined
real
output
INFLATION HNO INTEREST RATES
23-T
1380
iNFLflTIQN — LINE
PRIME RATE — SHORT DASH
CORPORATE BDHD RATE — LONG DASH
theory
growth.
a n d , particularly
Figure 1
1379
over
with the
interest rates, have reached and maintained record highs.
1978
has
as consistent with
rates should have
the
aggregates
steadily
of 1982; and
significantly
that Interest
Inflation
in
1981
1382
real
312
Figure 2
PERCENT CHRKGE IN REflL GNP
3-r
1378
1379
1380
1361
1382
figure 3
UNEMPLOYMENT RflTE
5.3'
1376
1373
1380
1381
1362
313
Figure 4
til GROWTH COnPflRED TO TflRSETS
20-P
13--
-3-
1377
1378
1373
1360
1381
1382
HI CROUTH — LINE
THRGETS — DASH
Figure 5
H2 SRQWTH COMPRRED TO TRRGETS
12-T
10--
1377
1378
(12 GROUTH — LINE
TARGETS — DASH
1379
1360
1381
1982
314
The
primary
expectations
Is
reason
for
that while
anti-inflationary
policy
this
departure
the Federal
of
from
Reserve
credit
was
theorltlcal
pursuing
restraint,
an
successive
Congresses and Administrations have direcly contradicted this by
pursuing
a
policy
of
fiscal
growth and employment.
stimulation
Because
the large and accelerating
to
increase
economic
the demand for money generated by
borrowing
requirements
resulting from
this fiscal stimulation is large relative to available money, and
does
not
depend
on
levels
of
output
and
cost
of
funds,
the
private demand for money had to carry the burden of adjustment to
this conflict in policy.
Interest rates remain high, contrary to
the expectations of theory, because the assumption in theory that
the demand for money depends on the price of money and levels of
economic
output
has
not
held.
currently
suffer are in place
The
high
interest
to effect the downward
rates
we
adjustment
in private demands for money in order that the large and
growing
public demand for money can be accommodated despite the policy of
deceleration
in
money
growth
being
implemented
by
the
Federal
Reserve.
This conflict in Federal fiscal and monetary policy has
currently
left
low
inflation,
us with
high
an
unusual
unemployment,
set
and
of
economic
stagnant
coexist Ing with high and volatile interest rates.
conditions:
economic
growth
315
Figure 6
THE FEDERRL DEFICIT
140-T
120H100-i-
1378
1381
1373
Figure 7
FEDERAL DEFICIT fii 0 PERCENT OF PERSONAL SflVINGG
1978
1373
1382
316
Figure 8
FEDERHL DEFICIT Rfi fi PERCENT OF
FERSONBL SAVINGS P. US OKPORBTE SWINGS
1373
1390
1382
Figure 9
FEOERfiL DEFICIT flS fl PERCENT OF TOTflL PRlVRTC WVIHG6
23-P
1378
1373
1380
1981
1382
317
_Figure 10
FEDERflL DEFICIT flS fl PERCENT OF NQMINflL GNP
The adjustments
cases,
been
forced
unprecedented
since
Indus try has suffered more
months now,
on private
the
borrowers
Great
have.
Depression,
than the housing industry.
housing activity has declined, and
accelerated during the last twelve months.
In some
and
For
owner
history.
Home
needs
this decline
sales
the
at
any
other
time
in
United
This includes the drop through the years
have
dramatic and stark
in
than
national
fallen
55
percent
(from
forty
has
More Americans during
the last forty months have lost the opportunity to satisfy
hone
no
peak
1929
to
their
States
to 1933.
trough)
in
contrast to the physical volume of other sales
economy
which
have
dropped
only
about
three
318
percent.
About
3.5
million
households
have
been
denied
o p p o r t u n i t y t o q u a l i f y f o r a d e q u a t e housing o f t h e i r o w n .
Figure 11
HOUSING STflRTS flND HOME SfiLES
1373
1380
1382
1381
HOUSING STflRTS — LINE
HOME SflLES — DflSH
Figure 12
_
RGRL EFFECTIVE CONVENTIONS. "ORTGfiGE RflTE
1373
the
319
This
loss
has
occurred
while
the
demographic
demand
for
housing is not significantly decreasing, even before considering
replacement
demand.
buyers
from
caused
home
The
achieving
investment
owners
in
their
to
their
loss
has
not
only
kept
dream
of
home
ownership,
as
much
lose
homes.
This
as
loss
would-be
one-half
occurred
interest rates for new mortgages (interest
home
but
of
has
their
because
real
rates after adjusting
for inflation) have increased from the normal three percent level
during
the
post-war
period
to
highs
of
of
6.9
percent
during
1981, near 15 percent in 1982, and 8.2 percent forecast for
The higher
real
Interest rates, rising
from
three
1983.
percent
to above 14 percent, have caused a loss of at least 25 percent of
the current marketable value of every American's home, as well as
any
other long-lived
and
agricultural
equity
of
one-half
away
investment
real
people's
property.
homes
is
such
as
When
sixty
commercial,
one
considers
percent,
this
of all Americans' equity in their hones
because
of
high
real
interest
Industrial,
rates
the average
means
nearly
has been
resulting
taken
from
this
Along with housing, other credit sensitive Industries
have
caught
auto
policy conflict.
been
in
the
jaws
of
this
policy
industry and other consumer durable goods
affected.
goods
Industries
that
support housing
such as lumber, steel,
suffered
severe declines.
conflict.
industries are heavily
and consumer
plastics, rubber,
tfith
The
the general
durable
and others
decline in
have
output,
and also because of the high cost of funds, Investment in plant
320
and
equipment
has
fallen
drastically.
Prolonged
depression in
investment lo bousing and business structures and equipment will
virtually guarantee high prices and lagging productivity in the
future.
Figure 13
REffl. YIELD ON NEW ISSUES Of
HIOH QRflDE CORPQRflTE BONOS
13-T
1378
19SO
1981
1382
321
Figure 14
PERCENT CHfiNfiC IN NONRESIDENTIflL INVESTMENT
10-r
1978
It
against
has
1373
always
inflation
been
would
1380
known
not
by
be an
1962
1381
all
of
easy
one.
ua
that
the
There
was
Buffering by many in order to achieve price stability.
fight
to
But
be
the
method of solely relying on monetary policy as the tool to obtain
price
stability
predominantly
has
resulted
distributed
in
the
in
the
credit
casualties
sensitive
being
industries.
Nevertheless, substantial progress has beea made in reducing the
cost
of
production
and
there
Is
now
opportunity for
strong
sustained economic growth with more suitable prices.
Along
with
steadily growing.
the
fall
in
prices,
real
incomes
have
been
Consumers have been liquidating their debt and
322
the
debt
years.
price
and
service
Although
ratio
there
been
has
index
lately,
the
housing
costs
and
will
be
acceleration
statistical
again
as
quirks.
energy
This may limit
lacks
market
leading
there
the
some
increases
have
are
Energy
been
or
on
it
in
OPEC
credibility
to an
given
upward
Bide,
the
bias
goods, as well as
to moderate with
actual wage
prices
depressed
relation
but
should
trend
to
other
continue
growth
a
and
to be
in prices
registered
an
as
appropriate
our
lot erst
in
some
These indicate
inflationary.
currency markets
currencies
Nevertheless, its continued
economic
be
toward
On
Wage demands have finally begun
renewed
strong,
housing
finished
materials,
that
position on the international
build
inflation.
for
declines being
not
to
of
The rise in home
and capacity utilization is extremely low.
will
this
production agreements.
cases
growth
energy
results
moderate and give reason for optimism that the growth
in the future will be moderate.
consumer
beginning
current
crude
been in
believe
the
in measured
producer
the
to
are
are
has
centered on
reasons
surpluses
renig
lowest
Increase
short-lived,
producers
optimistic
Intermediate
is
future increases in oil prices.
prices
more
to income
The
dollar's
is currently
lower
rates
value
too
in
dec line.
strength will also help keep renewed
noninflationary.
Finally,
our
current
confused
economic state has driven investors to cautious liquid positions
so
they
are
now
poised
and
capable
of
investing
opportunities that vovld arise in a recovery.
in
Che
new
323
Figure 15
PERCENT CHflNGE IN PRODUCER PRICES
WO BVEJWGE HOURLY EflRNINGS
20-r
1378
1380
1381
1362
Figure 16
PRODUCER PRICES — LINE
OVERflfiE HOURLY EARNINGS — DflSH
CflPflCITY UTILIZflTION
1978
1379
1380
1981
1382
324
U.S.
Figure 17
TRflOE-HEIGHTED EXCHHNGE RflTE
.80'
1378
1379
I960
1381
1382
!_•... ; Figure 18 •
PERSONflL SflVINSS RflTE
8.0-T
7.3--
7.Q--
1978
1373
1380
13S1
1382
325
However,
until
the
removed.
there
will
conflict
be
no
between
strong
fiscal
and
sustained
monetary
The economy is now at a crossroad.
economic recovery and prosperity.
many
and
businesses
that
have
Interest rates do not
One
recovery
policy
road
leads to
The other to depression as the
survived
so
far
come down and a
begin
to
fail
national
inflation was
consensus
two
the nation's
is now for reducing
years
top
ago
was
economic
the federal
when
recovery does not occur.
The way to get on the right road ta not now in dispute.
the
is
that
priority,
Just AS
controlling
the
consensus
deficit and borrowing,
lowering
Interest rates, increasing employment and raising the standard of
living of Americans-
Although
the recent
budget resolution has
been a step in the right direction, we agree with Federal
Chairman Volcker in saying
the
fiscal
robuat
side
in
economic
that there has to be far more done on
reducing
recovery
Reserve
can
deficits
ensue.
before
This
is
a
sustained
and
particularly
the
case if the Congressional Budget Office is correct in saying
even with
budget
the expenditure cuts and
resolution,
federal deficits
billion over the next three years.
tax
increases
will
be
in
near
that
the latest
$140
to
$155
This state of affairs simply
cannot be allowed to continue.
Reduction
disaster
reduction,
is
I
of
to
the
be
avoided.
sincerely
recommendations of
federal
request
the NATIONAL
deficit
In
you
is
order
give
crucial
to
bring
if
about
consideration
ASSOCIATION OF
economic
to
this
the
REALTO.RS ^—' whi ch
326
(1)
Federal spending growth must be slowed dovn and r e d u c e d In
all
parts
of
entiClement
year
the
programs,
has overrun
Congress
by
the
have
many
the
other
rate
enacted
by
including
programs.
of
Spending
to
responsible
the
for
subsequently
the
defense,
the P r e s i d e n t
compared
been
c u t s w h i c h were
and
budget,
Che conml t m e a t s
CR)
^—'
REALTORS
President
and
double
years.
of
federal
and
the
last
ten
recommending
proposed
Congress
this
last
by
year
the
that
a f f e c t e d real e s t a t e and we called upon other i n d u s t r i e s to
follow our e x a m p l e of a c c e p t i n g the necessary
(2)
Deferral
of
tax relief
s c h e d u l e d for 1984
planned
should
for
July
sacrifices.
1983
and
indexing
be c o n s i d e r e d among ways Co meet
t h i s need.
(3)
Tax
increases
and
investment,
reductions
first
to
discourage
should
to help
place
limit
recommended
be
consumption,
adopted
along
the d e f i c i t .
individual
but
not
with
REALTORS
tax
relief
savings
spending
tinin the
w
should
be
United to five p e r c e n t across the board each y e a r , i n s t e a d
of ten p e r c e n t , and that the tax r e l i e f s h o u l d be no larger
thaa
(4)
spending
Finally,
reductions
w«
Constitutional
recomaecded
Amendment
pending
and
people's
income
to
taxes
and
achieve a
that
to restrain
Congress
budget
adopt
by
a
the growth of f e d e r a l
in
relationsbiop
to
restrain
the
balanced
to
growth
the
of
growth
of
deficits.
327
Although reduction in the federal deficit has priority over
the range of policy options, Improvement in the exercise of
monetary policy is also of high importance.
have
been
began
extremely
targeting
volatile
money
growth
objective. Also, partly as a
on money
growth
prohibitive
declined.
since
result
targets, real
levels
Monetary
even
as
the
Federal
Reserve
its
primary
policy
of
interest
though
Interest rates
this
concentration
rates
inflation
have
reached
has
sharply
policy improvements must address
interest
rate
volatility,
problems
of
erroneous
policy expectations with respect to money growth,
and prohibitively high real interest
the
these
formation
rates.
These
of
vill be
the issues to which our recommendations on monetary policy
Improvements will be addressed.
With
respect
to the volatility
that Increased rate volatility
policy
technique
excessive
resulted
magnitude
primarily
tbe money supply.
factor
in
Reserve's
of
from
capacity
the
money
volatility
credit
to control
consequence
we
have
erratic
dependent
experienced
growth
industries-
the supply
of the
However,
interest rate volatility
produce a steadily growing money
of credit
path
the
has
in
is a major
The
Federal
in order to
supply and stable Interst rates
has been demonstrated to be limited.
rates, we know
growth.
an unnecessarily
Excessive
depressing
is an inherent
targeting
of
of interest
328
Techniques of controlling the monetary aggregates have been
discussed and
has
received
requirements,
lag.
the current
That
seven-day
policy
considerable
required
is,
for
reserves
are
to
end-of-day
week,
reserves
seven-day maintenance week ending
the computation week.
lagged
attention.
average
confutation
of
reserve requirements
Under
be
met
lagged
with
deposits
are
to
reserve
a
two-week
during
be
a
held
given
during
a
fourteen daya after the end of
Vault cash also is lagged two weeks.
That
is, vault cash held during the computation week Is to be used co
satisfy
reserve
weeks later.
deficiencies
requirements
during
Also, member banks
in
the
next
the
maintenance
is
reserve
called
the
two
could not only make up reserve
maintenance
week,
but
carry forward excesses into the next maintenance week.
provision, which
week
carry-over
could
This
last
provision, obviously
complicated reserve accounting.
Studies
by
the
staff
of
the
Federal
Reserve
found,
as
reported In a staff paper to the Board of Governors on September
14,
1981,
that
requirements
reduced
(LRR)
widespread
among
to
banks
required
reserved
in
time
to
However,
LRR
the
size
clearing
through the Federal Reserve.
added
maintenance
to
week
are
support
depository
costs
the
the
there was
adjust
typically
lagged
institutions
of acquiring
of
for
because
current data
their
these
reserve
reserve
adjustments
on
their
positions.
for
Movements in reserves
accompanied
it
banks
over
by movements
in
deposits in the same direction, and with contemporaneous reserve
requirements
(CRR),
changes
in
excess
reserves
are
partially
329
offset
by
the
associated
contrast, with
LRB this
changes
offset
in
does
required
not
occur
reserves.
and
In
necessitates
larger reserve adjustments at the end of each maintenance week.
The
additional
study
continues
by
saying
adjustments, which are made
that
id
reflecting
part
via
ttieae
the federal
funds transactions and member bank borrowing, LRR added somewhat
to pressures for fluctuations la the federal funds rate near the
end of the maintenance period.
defensive
open market
Accordingly, the volume of system
operations
needed
to constrain
settlement
day fluctuation in the funds rate increased.
Finally,
the
staff
report
says
LRR
impact on the precision of monetary control
rate operating
target, which
relied
has
mainly
on Influencing
However, under a reserve operating
short-run
monetary
market
Interest
demanded.
the
rates
to
by
delaying
changes
response
the
For example, with fixed weekly
money
target) LRR Impairs
the
In
discernible
under a federal funds
demanded.
control
no
quantity
targets for
of
mofiey
of
money
reserves,
switch to CRR would speed up the impact of changes id money
or required reserves and interest rates by two weeks.
Empirical
evidence comparing the relation beteen reserves and money in
years
before
and
raon t h-t o-motith
after
monetary
the
switch
control
to
could
LRR
be
suggested
noticeably
the
that
Improved
under reserves targeting by a return to CRR.
Also included
in the paper were
the recommendations of the
staff which state that the return to CRR would
• tart-\ip
and continuing
costs
for both
entail substantial
depository institutions
330
and
the Federal
more
Reserve
complex
pass-through
system
feasible.
would
relationships,
over
proposed
With
regard
the
the
than
in
their
to
the
potential
for
monetary
also be considerably
particularly
the
present
for
reserve
lagged
reserve
Nonetheless, the staff IB of the view that a
as
offer
It would
administratively,
requirement system.
CRR
System.
targets,
memorandum
benefits
of
is
such
operationally
a
system,
improved month-to-oonth
though
the
monetary
CRR
control
control
gains
would be appreciably less over longer periods, say a three to six
month horizon.
The
staff
went
on
to
recommend
a
CRR
system
with
the
following features :
(1)
Only
depository
Institutions
reporting
deposits
weekly
would be subject to CRR.
(2)
CRR
would
apply
only
to
transactions
deposits;
requirements on other reservable liabilities would
reserve
continue
to be met on a lagged basis.
(3)
Vault cash holdings In a previous period would
continue Co
be counted as reserves in the current maintenance period.
(4)
The computation period for transactions balances would end
on
Monday,
two
days
before
the
end
of
the
maintenance
period .
5)
Both the computation and maintenance periods would
weeks in length rather than the present one week.
be
two
However,
for purposes of the monetary statistics and the estimation
of
required
reserves,
deposits
reported on a weekly basis.
would
continue
to
be
331
(6)
The current carryover limit of plus or minus two percent of
daily average required reserves would seem appropriate.
t..=
f,*.**.^*,*.^
recommendations
ouuu^«.n.ui,
of
this committee
the
Federal
encourages
«.
l ^»« iv «-
Reserve
the Federal
endorses
staff
and
Reserve
the
requests that
to set a suitable
date for implementation.
The
unusual
attitudinal, and
of
monetary
conditions
amounts
been
management
and
of
they
developed
public,
and
accounts
in
very
confused
liquid
account a and
conditions
technological
have
consumers
economic
savings
Hew
characteristics
are
Since
now
are
the
current
of
this
financial
conditions
ways >
to
regulatory,
all made the art
The
expectations
accounts
current
new
difficult.
responded
assets.
having
evolution, have
the
have
and
investors
by
holding
1nstrumente
of
both
widely
causing
mo net a ry
economic
large
that
have
transaction
available
them
and
to
to
use
aggregates
the
these
that
are
targeted for policy purposes ate defined on the basis of accounts
that
segregate
policy
sustain
the
based
on
and
more
transaction
those
and
aggregates
importantly
saving
is
for
functions,
sometimes
short
run
setting
difficult
Interest
to
rates,
difficult to Interpret.
Chairman
increase
la
Ml
Volcker
has
testified,
during
the
early
"the great
part
of
the
bulk
of
year—almost
the
90
percent of the rise from the fourth quarter of 1981 to the second
quarter
of
1982—was
only about a fifth of
concentrated
total Ml
in
NOW
is held
in
a c c o u n t s , even though
that form."
He also
332
states, 'In contrast to the steep downward
savings accounts
stabilized
in recent years,
or even
increased
in
savings account
1982, suggesting
of a tfigh degree of liquidity to many
their
funds.
A similar
trend In low interest
tendency
holdings
have
the importance
individuals in allocating
to hold
acre
savings
deposits
has been observed In earlier recessions."
In the Federal Reserve's Midyear Monetary
Congress
it
included
In Ml, the so-called
items
states,
grew
quarter
of
at
June
market mutual
increasing
a
"Looking
10-3/4
1982.
funda
at
at
percent
were
components of
annual
rate
purpose and
30
percent
accounts in that
market
they have
mutual
funda
characteristics
of
each
four
past
fourth
money
this
M2,
year.
represents a sharp
are
The report continues,
the
theae
the assets of such money
and savings accounts.
of
the
to
also
component of
rate
funds acre than doubled, this year's increase
Money
not
broker/dealer
annual
Compared with last year, however, vhen
deceleration."
from
an especially strong
a
M2
non-transaction components,
General
almost
the
Policy Report
similar
both
to
NOW
transactions
"after declining in
years--failing
16
percent
last
year—savings deposits have increased at about a 4 percent annual
rate
thus
far
flows, taken
and
the still
stronger
this
year.
together with
This
turnaround in
the strong
substantial growth
preferences
to
hold
safe
increase
in money
and
savings deposits
In
funds,
highly
NOW
accounts
suggests
liquid
that
financial
assets la the current recessionary environment are bolstering the
demand for M2 as well as Ml."
333
This
these
increased
aggregates
demand
to
for Ml and
gross
national
implications because the determination
excessive
money
or
constraining
aggregate
if you will.
to gross
based
national
affects
the ratio of
This
has
policy
of whether money growth is
on
an
assumed
product.
ratio
An assumed
of
the
velocity
That is how the target ranges are decided upon.
Chairman
Committee)
is
M2
product.
Volclcer
was
individuals
"the
Committee
sensitive
to
indications
others
for
liquidity
and
apparently
stated,
reflecting
concerns
and
(Open
that
was
the
Market
desire
or-^sually
uncertainties
of
high,
about
the
business and financial situation," he also states, "Judgments on
these
seemingly
technical
considerations
inevitably
take
considerable importance in the target-setting process because the
economic
for
and
interest
dependent
finaneial
rates)
on
the
consequences
of
demand
a
particular
for
determination of whether money
level
depends
on
the
reference to Federal
growth
was veil
reserve
Ml
money."
the
or
In
M2
consequences
increase
are
words,
the
other
Is tight or loose at a particular
velocity
above
(including
to
a
considerable
policy early
target,
Chairman
extent.
In
this year when money
Volcker
states
"In
the
light of the evidence of the desire to hold more NOW accounts and
other
liquid
balances
for
precautionary
rather
than
transaction
purposes during the months of recession, strong efforts to reduce
further
the
growth
inappropriate."
rate
of
the
He continued,
monetary
"Moreover—and
aggregate
appeared
I would
emphasize
this--growth somewhat above the target ranges would be tolerated
for
a
time
in
circumstances
la
which
It
appeared
that
334
precautionary
economic
than
or
liquidity
uncertainty
anticipated
and
motivations,
turbulence,
demands
for
during
were
money."
a
leading
The
period
to
stronger
Chairman also
that the behavior of velocity and Interest
of
races weighed
stated
heavily
In this policy determination.
The problem with this is that just as the Federal Reserve's
policy decisions on acceptable money growth is complicated by the
velocity
problem, It Is doubly
financial
community
expectations
that
who
have
difficult
recently
of Federal Reserve policy,
policy.
The
Importance
of
for
the members of
had
to
to
form
Federal
trade
the
based
on
expectations
Reserve
policy
on
Is
indicated by the attention that is paid to the weekly release of
the monetary aggregates.
This
attention has been so great
the expectations formed by them have been of some concern
Federal
Reserve.
Recently,
the
Federal
Reserve
has
that
at the
said
it
Intends to counter this by averaging the weekly numbers to reduce
their
volatility
and
hopefully
their
importance
In
forming
expectations about Federal Reserve policy.
It is our feeling
that this is
the exact
opposite of
the
approach the Federal Reserve should take to this problem. Instead
of
trying
to
reduce
the
information
available
to
the
financial
markets for forming expectations on Federal Reserve policy, they
should
be
increasing
expectations
interest
above
of
rates
Federal
interest
rates
it.
emmlnent
were
inflated
the
tightening
formed
Reserve
During
because
targets.
long
early
part
of
year
of
money
and
higher
of
persistent money
growth
expectations
higher
The
growth
this
of
term interest rates and drove long
335
tern borrowers
into
the short
term
market
which
those rates as well.
The statements of Chairman
policy
of
considerations
indicate
that
these
the Open Market
helped
Volcker on the
Committee
expectations were overly
Inflate
at
the
pessimistic.
time
When
the Open Market Committee modified its policy due to velocity and
liquidity
preference
changes,
the
modification
effectively communicated to the financial markets.
was
not
This resulted
in erroneous expectations and probably resulted in interest rates
being higher than they would have been if policy expectations had
been more accurate.
Ve believe the Federal Reserve should implement measures to
reduce
erroneous
particularly
as
policy
they
expectations
result
from
modifications by the Open Market
Reserve
policy
similar
periodically
and
responds
reports
to
their
in
abort
the
and
Committee.
to
Congress
questions,
financial
medium
term
markets
policy
Juat as the Federal
on
Federal
they
should
Reserve
perform
function for members of the financial markets.
a
What we
propose is that the Federal Reserve hold monthly public briefings
in New York and Washington for financial market officials and tbe
public whose opinions weigh heavily
expectations.
These
briefings
meeting of the Open Market
the
Federal
Reserve
In the formation of investor
should
be
Committee and
Chairman,
a
Federal
held
soon
should
Governor,
Also discussed would be factors
or
The subject of
the meetings would be the short-run targets for money
the Committee.
each
be conducted by
Reserve
possibly a member of the Open Market Committee.
after
growth of
which could cause
336
variance
from
the Committee's
targeted grovth path and
what
the
likely Committee response to those variances would be.
It Is our feeling
that such briefings would
reduce much of
the uncertainty in the financial markets vith respect to Federal
Reserve
policy
certainly
fox
reduce
management
the
of
money
impact of volatile
grovth*
This
movements
ID
would
the money
stock measures on interest rates and could, therefore, reduce the
large risk premiums that
are currently imbedded in those rates.
We strongly encourage this committee to request that the Federal
Reserve consider this proposal and report on its feasibility.
Finally, 1 would
high
real
reduced
Interest
level
measure
rates
to address
that are
inflation.
To
the problem of
enduring
be
despite
sure,
the
sustained
our
current
primary
policy
to be taken to remedy this problem is to reduce excessive
borrowing
Reserve
by
must
interest
and
of
like
the
also
rates at
employment
Federal
have
a
levels
with
Government.
responsibility
necessary
low
However,
to
help
to promote
Inflation
and
the
maintain
growth
stable
Federal
in
poised
for
a
recovery.
With
wage
growth
output
prices.
economy, though currently languishing la a deep recession,
moderating,
real
The
is now
capacity
utilization low and consumer liquldty high, we now have our best
opportunity
to
initiate
a
sound
recovery
inflation.
Our priorities Must now
will
the
bring
country
back
to
low
rates
of
turn to this recovery which
economic
policy must do Its part to help bring
with
prosperity.
Monetary
the recovery about, and to
337
continue to play
a role In sustaining
strong economic growth
by
keeping real interest rates from reaching excessive levels.
*..,. „«,.*„„„„ »u
—»~—
*~
..-.
has
In
the past
and continues to support the Federal Reserve's policy of gradual
reduction in the rate of growth of money and credit in order to
reduce
inflation-
However,
we
would
like
to
additionally
recommend at this time that this committee consider requiring
Federal
the
Reserve
Federal
through
Reserve
amendments of
Act,
to
utilize
disposal to maintain real short-term
evels
and
the
the
monetary
monetary
policy
Interest
(3 to 4 percent) during any periods
short-term
relevant
growth
sections of
tools
rates
the
at
its
at historic
of time that the long
targets
of
the
Federal
that
during
Reserve are being met The
adoption
periods where
of
this
low Inflation
proposal
would
and
real
high
insure
interest
rates
while money growth Is within the short _and long run target
of
the Federal
from
restraining
encouraging
real
Reserve, monetary
inflation
economic
interest
growth
rates.
It
policy would
by
and
Is
reducing
higher
our
ranges
shift In priority
money
employment
feeling
exist
that
growth
by
current
to
reducing
Federal
Reserve policy has not been aggressive enough in helping to bring
economic
recovery
even
though
growing at acceptable rates.
the
appropriate
monetary
inflation
is
low
money
Our recommendation will ensure
policy
priori ties
are
relative to the prevailing economic conditions.
and
being
is
that
exercised
Consistent
With
with
this
idea
of
matching
prevailing economic considerations, it
the
Federal Reserve should
targets
the
given
the
resulting
current
allow
rates
money
current
1983.
low
of
to
and
industries
recovery
review its short
liquidity
money
at
result
relieve
one
percentage
of
this
of
would
the
be
and
thrift
institutions.
would
surely
result
Unfortunately,
however,
this
to
policy
more
this
and
unless
runaway
Federal
and
the
through
interest
economic
modification.
Federal
Reserve
be expected
are
low
sensitive
rapid
other
and
safely
above
lower
policy
deficits
growth
the
now
interest
policies to lower real Interest rates can not
maintained
can
point
further
from
A
from
also
of this year
pressure
that
the public
Considering
the remainder
some
of
the Federal Reserve
least
priorities
feeling
run monetary
preferences
velocity.
inflation,
grow
target range for
The
rates
high
policy
is our
to be
brought
under
control and reduced.
In conclusion, I would like to say that the Federal Reserve
must be commended for
this
country.
its effectiveness in reducing inflation in
However,
the
execution
of
Federal
fiscal
and
monetary policy mus t be improved and made consistent if we are to
have
a
strong
with high
of
living
sustained
recovery
and
balanced
employment, low Inflation, and an
for
all
recommendations
are
Americans.
here
It
is
presented
to
to
economic
growth
increasing standard
this
end
this
that
our
committee.
@FedFRASER