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FEDERAL RESERVE'S SECOND MONETARY POLICY
REPORT FOR 1983
HEARINGS
BEFORE THE
COMMITTEE ON
BANKING, HOUSING, AND UKBAN AFFAIES
UNITED STATES SENATE
AND THE
SUBCOMMITTEE ON ECONOMIC POLICY
NINETY-EIGHTH CONGRESS
FIRST SESSION
ON
OVERSIGHT ON THE MIDYEAR MONETARY POLICY REPORT TO CONGRESS PURSUANT TO THE FULL EMPLOYMENT AND BALANCED
GROWTH ACT OF 1978
AND
THE ISSUE OF MONETARY POLICY AND THE PROBLEMS THAT CAN
CONFRONT IT GIVEN THE FEDERAL BUDGET AND THE CURRENT
STATE OF THE ECONOMY
JULY 21 AND 28, 1983
Printed for the use of the Committee on Banking, Housing, and Urban Affairs
U.S. GOVERNMENT PRINTING OFFICE
WASHINGTON
COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
JAKE GARN, Utah, Chairman
JOHN TOWER, Texas
WILLIAM PROXMIRE, Wisconsin
JOHN HEINZ, Pennsylvania
ALAN CRANSTON, California
WILLIAM L. ARMSTRONG, Colorado
DONALD W. RIEGLE, JR., Michigan
ALFONSE M. D'AMATO, New York
PAUL S. SARBANES, Maryland
SLADE GORTON, Washington
CHRISTOPHER J. DODD, Connecticut
PAULA HAWKINS, Florida
ALAN J. DIXON, Illinois
MACK MATTINGLY, Georgia
JIM SASSER, Tennessee
CHIC HECHT, Nevada
FRANK R. LAUTENBERG, New Jersey
PAUL TRIBLE, Virginia
M. DANNY WALL, Staff Director
KENNETH A. McLEAN, Minority Staff Director
LAMAR SMITH, Chief Economist
SUBCOMMITTEE ON ECONOMIC POLICY
SLADE GORTON, Washington, Chairman
WILLIAM L. ARMSTRONG, Colorado
CHRISTOPHER J. DODD, Connecticut
CHIC HECHT, Nevada
ALAN CRANSTON, California
JOHN WILLS, Legislative Assistant
(II)
CONTENTS
THURSDAY, JULY 21, 1983
Page
Opening statement of Chairman Garn
Opening statements of:
Senator Lautenberg
Senator Gorton
1
2
3
WITNESSES
Paul A.VoIcker, Chairman, Board of Governors, Federal Reserve System
Questions on recovery over the long term
Changes needed in monetary targets for 1984
Prepared statement
The budgetary situation
The international dimension
Wage-price trends
Monetary policy in 1983 and beyond
Concluding remarks
Appendix 1
Appendix II
Midyear monetary policy report to Congress
Section 1: The outlook for the economy
Section 2: The Federal Reserve's objectives for growth of money and
credit
Section 3: The performance of the economy in the first half of 1983
Section 4: The growth of money and credit in the first half of 1983
Chrysler early payoff of Government loan
How the IMF quota increase helps the United States
Recent decline in M, velocity
More restraint on Reserve positions
Budget resolution and moratorium legislation
Growth change between Mi and the economy
Danger ahead if deficit not cut
Credit, wage demands, and prices
Full employment and productivity still far offPublicity of Mi and tax indexing
Goal is for a moderate, sustained recovery
4
5
6
9
11
13
14
16
23
24
30
39
40
47
51
66
76
77
78
81
82
84
86
88
91
93
96
AFTERNOON SESSION
Martin Feldstein, Chairman, Council of Economic Advisers
Rising interest rates and inflation
Money growth rate must be decreased
Spending cuts and additional tax revenue
New York Times story erroneous
Moderate growth is safest policy
Consequences if adjustments not made
Depreciation of dollar and increased savings
Congress and President must get proper fiscal mix
Prepared statement
,
Beryl W. Sprinkel, Under Secretary for Monetary Affairs, Department of the
Treasury
How to get lower interest rates
The relationship of money growth to velocity
am
99
99
102
104
104
106
109
Ill
112
115
134
134
136
IV
Beryl W. Sprinkel, Under Secretary for Monetary Affairs, Department of the
Treasury—Continued
Controlling the money supply
FED needs gradual slowdown of money growth
Prepared statement
Treasury borrowing will absorb savings
Must get better control of off-budget spending
Alan Blinder, professor of economics, Princeton University, Princeton, N.J
Lowering the budget deficit
Guides to monetary policy
Prepared statement
Dr. A. James Meigs, senior vice president and chief economist, First Interstate Bank of California, Los Angeles, Calif
Reduce growth of Mi
Importance of curbing money growth now
Prepared statement
Potential for shortrun tradeoffs
Real and nominal interest rates
Our present policy mix looks dangerous
FED adjustments will slow recovery
FED should keep inflation down; be cautious
Must have some inflation to cut interest rates
Adjustments in policy must be made now
Page
137
139
141
160
165
166
166
168
172
191
191
194
196
211
213
216
218
220
222
223
THURSDAY, JULY 28, 1983
Opening statement of Senator Gorton
Opening statement of Senator Heinz
225
299
WITNESSES
Daniel Patrick Moynihan, United States Senator from the State of New York.
Prepared statement
Paul A. Volcker, Chairman, Federal Reserve System Board of Governors
Prepared statement
The formulation of monetary policy
The "Coordination" of fiscal and monetary policy
Targeting the GNP
Conclusion
Federal Reserve press release—domestic policy directive—meeting
held May 24, 1983
Federal Reserve press release—domestic policy directive—meeting
held May 28-29, 1983
Appendix
Coordination of fiscal and monetary policy
FED has to make assumptions
There is no easy solution to inflation
Stabilization and intervention on value of dollar
Estimates of effects of interest rates on exchange rates
FED has taken cautious approach to changes
Economic confidence in U.S. returns
Congressional budget resolution is helpful
Must maintain balance between interest and inflation
226
228
232
233
235
241
245
246
248
264
283
288
290
291
293
295
299
301
303
305
FEDERAL RESERVE'S SECOND MONETARY
POLICY REPORT FOR 1983
THURSDAY, JULY 21, 1983
U.S. SENATE,
COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS,
Washington, D.C.
The committee met at 9:30 a.m., in room SD-538, of the Dirksen
Senate Office Building, Senator Jake Garn (chairman of the committee) presiding.
Present: Senators Garn, D'Amato, Gorton, Mattingly, Hecht,
Trible, Proxmire, Cranston, Riegle, Dodd, Dixon, Sasser, and Lautenberg.
OPENING STATEMENT OF CHAIRMAN GARN
The CHAIRMAN. The Banking Committee will come to order.
At last week's confirmation hearing I announced that the committee vote would not be taken on the President's nomination of
Paul Volcker for a second term as Chairman of the Federal Reserve System's Board of Governors until the completion of Mr.
Volcker s testimony this morning. I delayed the vote because I believed the members of this committee should have the opportunity
to question Chairman Volcker on prospective monetary policy
before voting on his nomination.
Chairman Volcker was not at liberty last week to discuss the
monetary growth targets adopted at the previous day's meetings of
the Federal Open Market Committee. Those targets are of particular importance because of the recent behavior of the monetary aggregates since the fourth quarter of last year: M-i has been growing
at an annual rate of about 14 percent, well above its target growth
range of 4 to 8 percent.
On the other hand, growth in the other aggregates has been
within their target ranges, near the upper boundaries of those
ranges however.
In the real economy, it is clear that a strong economic expansion
is underway. Recent upticks of interest rates are very worrisome to
the committee.
Our objective is clear. We all want the maximum rate of economic growth that can be achieved without renewed inflation and another upsurge in interest rates. These qualifiers are necessary because if we let inflation and high interest rates return, our economic expansion will prove to be very short lived.
I believe that a key element in building the investor confidence
that will be essential to a long-run economic expansion is to have a
(l)
credible monetary policy. A credible monetary policy, in turn, requires credible targets for growth in the monetary aggregates. Failure to hit targets and frequent revisions in targets and/or in the
definition of the targeted aggregates undermines the credibility of
monetary policy.
This morning I hope we can help to build the needed credibility
in monetary policy. At the end of Chairman Volcker's testimony, it
is my intention to ask the committee to vote on his confirmation
for a second term as Chairman of the Board of Governors of the
Federal Reserve System. After that vote we will resume our hearing on monetary policy with Senator Gorton chairing the hearing.
Witnesses after Chairman Volcker will be addressing the issue of
coordinating monetary policy and fiscal policy as well as the issue
of the appropriateness of the Federal Reserve's current monetary
policy.
Section 6 of the conference report on the first budget resolution
for fiscal year 1984 requested the Banking Committee consider developing a Senate resolution on the coordination of monetary and
fiscal policy. As a member of both the Banking Committee and the
Budget Committee, as well as chairman of this committee's Economic Policy Subcommittee, Senator Gorton is taking the lead in
evaluating the desirability of such a resolution and that is the purpose of his chairing the remainder of the hearings.
A subsequent hearing will also be held when Chairman Volcker
will be asked to specifically address the coordination issue.
Mr. Chairman, before I turn to any of my colleagues, I can't
resist stating publicly what I said to you privately as you came up.
I just had breakfast with Arthur Burns. As he sat there chewing
on his pipe, I tried to convince him that he should come over. I
thought the photographers—with all the years they've spent taking
pictures of your profile with the cigar and the years they spent in
this committee with him and his pipe—would have a real photographic coup. If I could have gotten him to come over and the two
of you to sit together, you with your cigar and him with his pipe,
the photographers would have gone crazy. But I couldn't convince
him to come over and do that. He was afraid we would start asking
him questions as well and he wouldn't be released after the pictures. [Laughter.]
Senator Proxmire.
Senator PROXMIRE. I have no opening statement, Mr. Chairman.
I would just say that your remarks are very useful because they
indicate that the Fed for years has been operating behind a smokescreen. [Laughter.]
The CHAIRMAN- Are there any other of my colleagues who wish
to make any opening statements before we turn to Chairman
Volcker?
OPENING STATEMENT OF SENATOR LAUTENBERG
Senator LAUTENBERG. I've got a brief one, Mr. Chairman, if I
may, if no one else has. I promise not to quote the poet Proxmire
today.
Mr. Chairman, I welcome our witnesses today. The decisions
made on monetary policy over the next few months will have a
major influence on the future of the economy and whether recovery will continue, how deep it will reach, whether it will grind to a
halt.
To me, the causes of our economic problems are self-evident.
They stem from a massive mismatch of fiscal and monetary policy
which goes to the heart of the administration's program. It has
proved impossible to finance the enormous increases in defense
spending at the same time we are drastically cutting revenues even
with the deep slashes in domestic programs.
The result of this policy has been a deficit to a size unimaginable
only a few short years ago, not only for this year but projected out
into the indefinite future and I quote here, "as far as the eye can
see," in Mr. Stockman's words.
All discretionary domestic programs would have to be eliminated
from the budget to come close to making up the $1 trillion debt
President Reagan's program will have over the next 5 years.
I told Chairman Volcker last week that I thought the administration was putting him in an untenable position because of the posture taken on the budget. I am still of that opinion. It's unrealistic
to expect the Fed to keep inflation in check with tight money without raising interest rates and choking off the recovery and it's good
to have Chairman Volcker and the other as witnesses before this
committee today. Each of them should address these questions.
I would submit that the budget resolution passed by the Congress
is a responsible starting point for a bipartisan and effective policy
for the economy.
I was unhappy to read in this morning's paper that we may be
abandoning any attempt to increase the revenues. I think that
would be disastrous. It will be painful to implement policies to
reduce that deficit, but I think what we had represents the best
compromise the Congress could devise to start getting the deficits
down.
Thank you, Mr. Chairman.
The CHAIRMAN. Thank you, Senator Lautenberg.
Senator Gorton.
OPENING STATEMENT OF SENATOR GORTON
Senator GORTON. Thank you, Mr. Chairman.
It would be pleasant one day to have the Chairman before us testify on a simple straightforward policy issue with relatively modest
stakes. That does not seem to be in the cards. A salient feature of
the economic environment which confronts the Chairman is the
large Federal budget deficit and the demands which they will place
on the Nation's credit markets.
Tuesday, Treasury Secretary Regan, in testimony before the
Joint Economic Committee, offered the opinion that the current
economic recovery and congressional spending restraint might be
sufficient to eliminate the existing budget deficit or at least to
reduce it to such levels that the Congress could forgo future tax increases. I hope that Secretary Regan is right, but I doubt it.
The structural deficit built into the Federal budget is very large,
probably in the $100 billion range. In my view, this is too large to
be acceptable. Reduction of the budget deficit is Congress job.
The Federal Reserve Board will have to deal with the problems
that the large budget deficit causes. Treasury borrowing is creating
great demands on the credit markets. To the extent that the Federal Reserve accommodates these credit demands by expanding the
monetary supply more rapidly, it runs the risk of reigniting inflation.
On the other hand, a monetary policy which is too tight will increase interest rates unnecessarily damaging the vulnerable credit
sensitive sectors of our economy.
Some increase in interest rates might be required not only to
ration off existing savings but also to encourage more savings.
Higher interest rates will also bring more foreign capital to our
shores which, unfortunately, we need so much, but to the extent
foreign capital inflows increase, the value of the dollar will be bid
up, reducing our international competitiveness to serve in world
markets.
Tradeoffs among these conflicting goals, significant in the best of
time, is made more difficult by deficits of the magnitude which are
experiencing now. Savings which would otherwise be used to finance productive investments, enriching our children, will instead
be used to finance the Federal Government's expenditures. Most of
these expenditures are current consumption rather than investment type activities, so not only does Federal borrowing threaten
the current recovery by creating upward pressure on interest rates,
it also reduces systematically the amount our society invests and,
hence, reduces the size of the capital stock we pass on to our children.
Given the inability of Congress to agree on a budget which implies a more favorable fiscal policy, a disproportionate burden for
trying to meet agreed upon national goals falls to monetary policy.
Unfortunately, the Federal Reserve Board is limited in what it can
do. The Federal Reserve must boil down all of these policy goals
into a decision about essentially one magnitude—how much to
expand the money supply.
Given an imperfect ability to control even this magnitude, as
well as uncertainty about the ultimate effect of changes in the
money supply on real economic activity, the task is an unenviable
one.
The Senate Banking Committee is required under the first concurrent budget resolution to report by September a resolution expressing its sense of appropriate monetary policy. The report which
the Federal Reserve Board provided yesterday deals essentially
with this issue and I look forward to hearing your testimony,
Chairman Volcker, as well as that of other distinguished witnesses
representing Government, the financial industry, and academia.
The CHAIRMAN. Thank you.
Mr. Chairman, please proceed.
STATEMENT OF PAUL A. VOLCKER, CHAIRMAN, BOARD OF
GOVERNORS, FEDERAL RESERVE SYSTEM
Mr. VOLCKER. Mr. Chairman, my statement bears a certain resemblance to a statement I delivered yesterday, and I won't read it
in full. I might draw your attention to the fact that I attached a
couple of appendices that deal with questions that have arisen here
and elsewhere about definitions of money in relationship to the
GNP and about the issue of targeting such variables as nominal
GNP, real GNP, inflation, and the rest. I won't review that in
detail, but note that that is attached to the statement.
So far as the statement itself is concerned, I will just summarize
briefly by saying, as you indicated earlier, that we are in the midst
of an economic recovery that I think has now attained a good deal
of momentum in the short run, although there are still questions,
of course, as to the strength and balance of that recovery as time is
extended.
QUESTIONS ON RECOVERY OVER THE LONG TERM
The fact that the economy is recovering rather rapidly now, I
think, brings closer the day of concern about yome other obstacles?
that have been apparent all along and that stand in the way of
confidence that we can sustain this recovery over a long period of
time consistent with the growth of productivity, the growth in
income, and particularly the price stability that we need.
And I do emphasize in the statement that the budgetary problem
that's been referred to here this morning and that we discussed
last week is really the No. 1 obstacle to the kind of balance and
sustainability that we want in the recovery.
One aspect of that I should bring out briefly: The pressures en
financial markets that stem from the relatively large demand for
funds augmented by the deficit have been a factor drawing into
this country—it's the largest and richest country in the world—a
large amount of capital from overseas. That may have some advantages in the short run, in that it does help finance the deficit directly or indirectly, but the only way we can draw capital from
overseas on a net basis is by running a current account deficit, and
under current circumstances that means a large and, m fact, growing trade deficit, which is a factor in the business situation. It is a
distortion, in my mind, in the economy, and it is an adverse element in the business picture.
It raises questions about stability of the exchange rates and the
international monetary system in the future. We have tho immeasate problem in the international area of the debt strains, the pressures, arising in so much of the developing world and particularly
in Latin America. That problem, of course, has required an immense cooperative effort by debtors and creditors and governments
and central banks around the world. It has been managed successfully in the sense that it is under control, but the problem has by
no means gone away. It's not going to go away for a while, in my
judgment.
Fundamental'^, much depends upon growth in the industrialized
world and particularly in the United States, and of course that
problem wouJd be greatly eased if we had a decline in interest
rates over time; even shortrun increases in interest rates work
against early solutions to that problem. It is a great complication
and, I think, a threat to the American recovery and American financial markets if it's not managed successfully. In that connection, i believe the IMF legislation is going to come up in the
House—it's already passed the Senate, as you well know, and it
seems to me terribly important that that legislation be passed.
The final point I make in the nature of questions or threats or
obstacles, before getting to monetary policy in the statement is the
question of whether the favorable price, wage, and productivity
trends that we have seen in the past year will be sustained in an
environment of growing business, higher profits, more employment,
fewer layoffs, and a more buoyant atmosphere generally. There is
still an understandable concern, a skepticism about the inflation
outlook. There is a danger that both business and labor will revert
to practices that became normal in the 1970's of anticipating inflation and moving aggressively to increase wages and prices. The
irony would be, of course, that in the end that would threaten the
increase in real wages and real profits and productivity that we
need. That's a question that sometimes has raised the issue of incomes policies. They have not been very successful here or elsewhere, and I don't think that's a viable approach now, but I do
think it's important that we keep our markets as open and competitive as we can, whether we talk about the external side or internal
markets, and that is a continuing challenge because competition
will be needed to keep that problem under control and create an
environment in which aggresive wage and price setting will not undermine our hopes for a sustained recovery with price stability.
CHANGES NEEDED IN MONETARY TARGETS FOR 1984
As far as monetary policy is concerned, that discussion begins on
page 8 of my statement. I note that we have had some relationships between monetary growth and economic activity that have
deviated from the trend of normal cyclical changes over earlier
years for a variety of reasons'. We have had some institutional
changes. We have had an economic setting that I think has disturbed some of those relationships.
But if we look at this year, with the economy recovering rapidly,
the broader monetary and credit aggregates that we have been emphasizing moved generally consistent with the ranges that we set
in February.
As you know, the price trends were favorable during this period
and in those circumstances the Federal Reserve had a rather accommodative approach with respect to bank reserves, and interest
rates were broadly stable at the much lower levels to which they
declined last year. But in the second quarter, and particularly as
the second quarter proceeded, against a background of a considerable pickup in business activity, monetary and credit growth did
show some tendency to increase more rapidly. Through this period
Mi growth has been particularly rapid, and I think more rapid
than seemed consistent with long-term progress against inflation
and orderly recovery.
Beginning in late May, the Open Market Committee has taken a
slightly less accommodative posture toward the provision of bank
reserves through open market operations, and borrowings by the
banks at the discount window have increased. That action was
taken with the fundamental view that whether we look at the domestic problem or whether we look at the international problem,
limited, timely and potentially reversible measures now when the
economy is expanding strongly, are clearly preferable to the risks
of permitting a situation to develop that would require much more
abrupt and forceful action later to deal with new inflationary pressures of a long sustained pattern of excessive monetary and credit
growth.
We have had an increase in interest rates over this period of
about 1 percent in terms of market rates. I would emphasize that
apart from our actions and, increasing to a degree the pressure on
bank reserves, we have had an increase in credit demands during
this period. I emphasize that because we have had an increase in
total credit demands, private and public, even though business
credit demands during this period remained low or at the lower
levels they reached earlier.
Of course, with the economy expanding rapidly, you would
expect business credit demands to pick up sooner or later, too, and
therein lies the threat to the future with Government credit financing being very well maintained, to put it euphemistically.
With an increase in mortgage and consumer credit demands already showing, if you pile in some business credit demands on top
of that, you've got potential problems in financial markets. That is
one perspective in which to view the budgetary situation.
Looking ahead, we reaffirm the basic targets for M2 and M3 that
we had set for this year and the target for total nonfinancial credit
as well. I might mention, in that connection, that target, as we
knew at the time, for total credit would permit credit expansion
somewhat greater than the growth in GNP, and we thought that
that was likely this year for a variety of reasons and tolerable, but
I think it raises some question over a period of time whether credit
growth at that rate of speed is compatible with progress both in the
economy and on the inflation front. That's something that we're
going to be wanting to review closely as we look ahead.
Tentatively, looking into 1984, the decision was to reduce all
three of those targets, M2, M3 and credit, by one-half percent; we
anticipate during that period that the growth of the economy
would be less rapid than in the first year of economic recovery.
There have been questions raised about whether we can sustain
the inflationary progress during that period. I think generally
views within the Committee are more divided on that point. I think
the anti-inflationary effort has a certain degree of momentum, but
we are facing the test as to whether we can maintain that record
during a period of recovery. It is a very critical test, and the limited reduction in those ranges tentatively set for next year are designed to give room for recovery, but consistent with containing the
inflationary situation.
The Mi targets have been a cause of considerably more debate.
The decisions are more difficult. As you noted and as I noted, Mi
has been rising at a rapid rate of speed to date and a more rapid
rate of speed than seems consistent with the inflationary situation—or the lack of inflation—that we would like to see.
We have examined that as carefully as we can and we do think
there are reasons why the trend in MI may be changing and why
the cyclical characteristics may be changing. They are importantly
but not entirely tied up with the fact that we now pay interest on
transactions balances to a considerable extent through NOW accounts. We have had nationwide NOW accounts for 2 or 3 years.
We now have super NOW accounts which not only pay interest but
pay a market rate of interest, and it is natural to believe that now
that you can get interest on transactions balance holdings you will
hold more transactions balances relative to other assets than was
the case earlier. But even making allowance for those factors, I
think it's clear that growth in Mi has been larger than is likely to
be consistent with progress on the inflation front. What we have
essentially decided to do is look ahead from the point that we are
at now, set a new target of 5 to 9 percent for the rest of this year,
and look to a reduction of that by about 1 percent toward next
year.
It's a rather wide range, purposefully so, because the bottom part
of that range would be appropriate if velocity returns to more
normal relationships and there are some signs that that process
may be beginning. Something toward the higher area would be
more appropriate if the growth in money was more in line with the
nominal GNP rather than a rapid increase of velocity characteristic of past periods of recovery.
That is the basic outline of the targets that we are setting for
next year. I would just conclude by saying that I think in the past
6 months or more we have made more rapid progress toward our
economic objectives than we might have anticipated, but partly because of that rapid progress on the real side of growth in the economy I think the urgency of dealing with the obstacles that are clearly there to sustaining growth and stability have become even more
pressing.
Those obstacles are very well known. What we need is a consensus on the specifics of how in a practical way to deal with them. I
don't think there can be any assumption that monetary policy,
however one conducts monetary policy, can substitute for such an
important variable as budgetary discipline. It can't substitute for
open competitive markets. We can't manufacture savings through
monetary policy and we can't deal with structural financial weaknesses. All those problems have to be addressed.
There are lots of examples in other countries around the world of
the dangers of procrastination and delay in the face of political impasse and in the hope the problems will subside by themselves.
They seldom do, and if we don't act in time we face the possibility
of shattered confidence, and once that is lost, you can only rebuild
it with great difficulty over a period of time.
We are not in a state of crisis today, but there is certainly urgent
areas where action is needed and needed very promptly. Thank you
very much.
[The complete statement follows:]
PREPARED STATKMENT OF PAUL A. VOI.CKER, CHAIRMAN, BOARD OK GOVERNORS OF THE
FKDERAL RESERVE SYSTEM
I welcore t.ii s opportunity to discuss Federal Reserve
monetary pal icy w i-h the Bankir.g Cor.:r.i-tee in the context cf
current and prospective ecor.cTr.ic conditions and other policies
at home and abroad.
You have before ycur the Xidyear Xcr.etary
Fcl icv Report to the Congress prepared ir. accordance with the
Humphrey-Hawkins Act.
This morning, I will highlight or expand
upon seme aspects of that Report.
I an also attaching appendices
discussing the role of the monetary aggregates and the
appropriateness cf the Federal Reserve setting and announcing
objectives for a variety of economic variables, since questions
in these areas have arisen in bath the Senate and House Banking
Cor.-nittees.
We meet at a time when economic activity is plainly advancing
at a rate of speed significantly faster than we, the Administration,
C he Congress, and most other observers thought likely at the start
of the year.
Over the past six or seven months of expansion, out-
put has risen about as fast as in the average postwar recovery,
more than 1 million more people are employed, and the unemployment
rate has dropped by nearly a percentage point from its peak.
The very sizable gain in the Gross National Product during
the second quarter in substantial part reflected a cessation of
inventory liquidation —
business.
and perhaps snail accumulations — by
That is not unusual in the early stages of expansion,
and does not necessarily suggest continuing gains at the same
rate of speed.
But it is also evident that domestic final sales
and incomes are now increasing fairly rapidly, that the midyear
tax cut has released further purchasing power, and that consumer
and business confidence has improved.
Consequently, strong
forward momentum has carried into the third quarter, and
potentially beyond.
10
The expansion so Jar has been accompanied by remarkably
good prioe performance.
Finished producer prices were essentially
unchan-ed over the first naif of 1 ?8 3 , and ccns^rrer prices '..'ere
up at a rate of only 3 percent through .'-'ay and by abcu- 2-1/2 ~er~er
over the last twelve months.
Perhaps -ore significant for the
future, the rate of nominal wage increase -- at about a 4 percent annual rate —
is now at its lowest level sir.ce the mid-
1960's, while average real wages, as in 1932, are rising.
That
pattern has been assisted by sizable productivity gains.
In all these respects, we are clearly "doing better."
Yet, even as the economy has expanded and the inflation record
has remained good, widespread forebodings remain evident for
the future.
Those concerns are understandable and justified
so long as some major policy issues —
issues that I emphasized
in my testimony to you earlier in the year -- remain unresolved.
Indeed, the very speed and vigor of the recovery in its early
stages has increased -he urgency of facing up to those problems.
I have repeatedly expressed the view that we have come
much of the way toward setting the stage for a long-sustained
period of recovery, characterized by greater growth in productivity and real incomes and by much greater price stability.
Responsible and prudent monetary policies must be one important
element in making that vision a reality.
But it would be an
illusion to think that monetary policy alone can do the job,
and before turning to monetary policy in detail, I want to
touch again upon some crucially important aspects of the
environment in which monetary policy must be conducted.
11
The Budget.ary Situation
I an aware of the enormous effort in the Congress ever
recent rnor.ths to shape a responsible budgetary resolution -- indeed
to preserve an orderly budgetary process.
But the concrete
results of that effort to date appear ambiguous at best, measured
against the challenge of reducing the growing structural deficits
embedded in the current budgetary outlook.
The current fiscal year is iike.lv tc see a budget deficit -not counting Treasury or other market financing of off-budget
credit programs —
of the GNP.
of some $200 billion, or about 6-1/2 percent
Forecasts of future years necessarily entail judg-
ments about Congressional action yet to be taken as well as
economic factors.
Should Congress fail to implement the expenditure
restraints as well as the revenue increases contemplated
in the
recent Budget Resolution -- and doubt has been expressed on that
point within the Congress itself —
deficits appear likely to
remain close to S200 billion for several years, even taking
account of economic growth at the higher rates now projected.
The hard fact remains that, as economic growth generates income
and revenues to reduce the "cyclical" element in the deficit,
the "underlying" or "structural"
position of the budget will
deteriorate without greater effort to reduce spending or increase
revenues from that incorporated in existing programs.
We would
be left with the prospect that Federal financing would absorb
through and beyond the mid-1980's a portion of our savings
potential without precedent during a period of economic growth.
12
That outlook raises & fundamental question about the
consistency of the budget outlook with the kind of economy we
want.
That is particularly the case with respect to such heavy
users of credit as housing and business investment.
To put the
issue pointedly, the government will be financed, but others
will be squeezed out in the process.
While that threat has been widely recognized, there has
also been a comfortable assumption that the problem would not
become urgent until 1985 or beyond.
That might be true in the
context of a rather slowly growing economy.
But the speed of
the current economic advance certainly brings the day of reckoning
in financial markets earlier.
In the second quarter, total non-
federal credit demands were already increasing substantially, even
though business demands were essentially unchanged at a relatively
low level.
Potential credit market pressures have been ameloriated
by a growing inflow of foreign capital,taut a net capital inflow
can be maintained only at the expense of a deep trade deficit.
Banks have been sizable buyers of government securities during
the early stages of recovery while business demands for credit
have been relatively slack.
But there has also been some tendency
for overall measures of money, liquidity, and credit to rise
recently at rates that, if long sustained, would be inconsistent
with continuing or even consolidating progress toward price stability.
All of this, to my mind, points up the urgency of further
action to reduce the budgetary deficit to make room for the credit
needed to support growth in the private economy.
Left unattended,
the situation remains the most important single hazard to the
sustained and balanced recovery we want.
13
The International Dimension
The pressure-s on our capacity to finance both rising
private credit demands and a huge budgetary deficit have, as
I just noted, been one factor inducing a growing net capital
inflow.
One short-.term consequence is lower domestic
interest
rates than might otherwise be necessary, and maintenance of
extraordinary strength of the dollar at a time of rising trade
and current account deficits.
trends can be questioned.
But the sustainability of those
The picture of the largest and
strongest economy in the world relying, in a capital-short
world, on large inflows of funds to finance, directly or indirectly, internal budget deficits is not an inviting one for
the future.
The implication would be a persistently weak trade
position, instability in-the international financial system and
exchange rates, and lack, of balance in our recovery.
More immediately, the pressing debt problems of much of
the developing world —
America —
centered in, but not confined to, Latin
remain a clear threa-t to financial stability.
In
the period since we last discussed these issues, the strains
have been successfully contained, but by no means resolved.
To be sure, there are clear signs of progress with necessary
economic adjustment in some instances —
notably in Mexico.
Within the past week, Brazil -- which, along with Mexico, is
the largest debtor -- has taken forceful and encouraging domestic
actions that should provide a base for renewed IMF support and
for added private financing.
returned.
But "normalcy" has plainly not
14
Confidence and market-drien-ed financing patterns cannot
be fully restored without sustained growth among the industrialized
countries, so that the debtors can earn their way with greater
exports.
Lower interest rates will be important as well.
that process will take time.
IMF —
But
Meanwhile, failure to provide the
which is the international institution at the center of
the adjustment and financing process —
with adequate resources
to do its job would deal a devastating blow to the extraordinary
cooperative effort that has been marshaled to manage the
situation, with potentially severe consequences for the U. S.
financial system as well as the developing world.
Early action
by the House on the Administration1 s request in this matter is
thus one key element in a program to sustain recovery.
Wage-Price Trends
I touched earlier on the relatively favorable wage-priceproductivity trends of the past year,
a new test —
we are now approaching
whether those trends can be extended into and
through a period of recovery.
Today, orders are rising,
businesses are hiring, layoffs are sharply diminished, and profits
are improving.
After the inflationary experience of the 1970's,
the temptation could arise to revert to what some might consider
"normal" behavior —
to anticipate inflation, to return to
wage increases characteristic of the earlier decade, to
fatten
profit margins as fast as possible by raising prices
15
in a stronger market rather than relying or. volume increases.
But pressed collectively, -he ircny would be that such behavior,
by inciting doubts about, -he infleticr.ary outlook and affecting
interest rates, would impair prospects for continued growth
in real wages, in profits, and in employment.
We and other industrialized countries have had little
success in dealing with that threat through so-called "incomes
policies."
But government policy can make a powerful contribution
toward moderation through two avenues:
first, by making evident
in its fiscal and monetary management that inflationary
pressures will continue to be contained, and second, by insisting
upon open, competitive markets.
In that respect, open markets internationally serve
our continuing basic interest in spurring efficiency and
competition.
Virtually every country has made compromises
with protectionism during the period of recession.
With
growth underway, it is time not only to halt but to reverse
that trend
to help sustain expansion and the gains against
inflation.
Moreover, as the economy grows stronger, I hope we will
seriously turn more of our attention to the many purely domestic
inhibitions to competition, and to reducing the artificial
supports for prices and costs in some industries.
All too
often, they work at cross purposes to the needs of the economy
as a whole.
16
Monetary Policy in _J 1 3S_3_ and Beyond
This setting 'of gratifying immediate progress, vet
evident loo—,ing threats, has provided the environment for
decisions with respect to monetary policy.
As you are well
aware, interest rates dropped sharply during the second half
of 1982'as the recession continued, and, with inflation subsiding, reserve pressures en the banking system were relaxed.
Growth in money and credit has been ,cuite plainly, adequate to
suoport growth in economic activity -- indeed more growth in
the first half of 1983 than had been generally anticipated.
During much of the period after nid-1982, institutional
change, as well as adjustrr.ents by liquid asset holders to the
sharp drop in interest rates, to declining inflation, and to
the uncertainties of the recession, appeared to be affecting
one or another of the monetary aggregates.
In particular, the
behavior of Ml in relation to economic activity and the nominal
GNP has raised questions about whether the patterns in velocity
established earlier in the postwar period n;ight be changing,
cyclically or on a trend basis.
For that reason, less emphasis
has been placed on that aggregate in policy implementation.
For
a time, the enthusiastic reception cf the public to -- and
aggressive marketing l-y depositary institutions of -- the new
ceiling-free Money Market Deposit Accounts plainly affected
growth in M2.
Consequently, the target base for 1983 for that
aggregate was set at the February and March average, rather than
the fourth quarter of 1982, to avoid rr.ost of those distortions.
17
Mere broadly, giver, -he questions about interpreting seme cf
the mcne-nary and credit aggregates, judgments as to the appropriate degree of pressure or. bank reserve positions have
been conditioned by available evidence about trends in econcrr.ic
and financial conditions , prices {including sensitive commodity
prices!, exchange rates, and other factors.
Through nest of the first half of the year, as the
economy picked up speed, the broader monetary and credit
aggregates moved consistently with the ranges set in February.
At the same time, trends in overall price indices were
relatively favorable, and sensitive commodity prices, af-er
an increase frorr. cyclically depressed levels early in the
year, appeared to be leveling off in the second quarter.
The
continuing exceptional strength, of the dollar in foreign
exchange markets and the international financial strains did
not point in the direction of restraint.
In all these cir-
cumstances, a broadly accommodative approach with respect to
bank reserves appeared appropriate, despite much iiighex growth
in Ml —
alone among the targeted aggregates —
than anticipated.
In -he latter part of the second quarter, against the
background of growing momentum in economic activity, monetary
ar.d credit growth showed some tendency to increase more
18
rapidly, and Mi growth remained particularly high -- higher,
if sustained, than seemed consistent with Icrng-terrr. progress
against inflation and sustained orderly reccve-y.
Ir. these
circumstances, the Federal Open Market Co~j~ittee, beginning
in late May, has taken a slightly less accommodative posture
toward the prevision of bank: reserves through open ~arket
operations, leading to seme increase in borrowings at the
discount window.
Whether viewed from a dcrestic or inter-
national perspective, limited, timely ana potentially
reversible measures now, when the economy is expanding strongly,
are clearly preferable to the risks of permitting a situation
to develop that would require much more abrupt and forceful
action later to deal with new inflationary pressures and a
long-sustained pattern of excessive monetary and credit growth.
These steps have been accompanied by increases, ranging
from 3/4 to 1 percent or more,in both long-and short-term
market interest rates.
th-ese limited changes —
Apart from any monetary policy actions,
particularly in the intermediate and
longer-term areas of the market —
appear also to have been
influenced by larger private and government credit demands
currently, as well as by expectations generated by stronger
economic -nd monetary growth and the budgetary deficit.
Over the more distant future, balanced and sustained
economic growth —
with strong housing and business investment -
19
would appear more likely to recuire lower rather than higher
interest rates.
That outcome, however, can be assured cr.ly
if the orogress acainst inflation car. be cc-solicaned and
extended.
In considering all these factors, the FCMC basically
concluded that the prospects for sustained growth and for
lower interest rates over time would be enhanced, rather
than diminished, by rrodest and timely action to restrain
excessive growth in money and liquidity, given its inflationary
potential.
But I must emphasize again that the best assurance
we could have that monetary policy can in fact do its part by
avoiding excessive monetary growth within a framework of a
growing economy and reduced interest rates over time lies
not in the tools of central banking alone, but in timely
fiscal action.
Looking ahead, the Committee decided that the growth
ranges established early in the year for M2 and M3 during
1983 (.7-10 percent and 6^-9^ percent, respectively), are still
appropriate.
The most recent data, while showing somewhat
larger increases in June, are still within (M2), or about at
to the upper end (M3), of those ranges, (charts and tables attached-)
As anticipated, the massive shifting of funds into M2
ar a result of the introduction of Money Market Deposit Accounts,
and to a more limited extent into Super NOW Accounts, has abated.
He assume these new accounts, and the further deregulation of
time deposit interest rates scheduled for October 1, will have
little impact on growth trends in the period ahead.
Given the
reasonably favorable trend of prices, the ranges should be
consistent with more real growth, than thought probable at the
start of the year.
20
The Committee also decided to continue the associated
ranges for growth in' total domestic nor.-financial credit of
3H to 11*5 oercent.
As you know, 19S3 is the first ti-~ie the
Committee has set. a range for a broad credit aggregate, and
it is not given the same weight as the broader monetary aggregates
at least while we gain experience.
VTe are aware that, consistent
with the established ranee, growth in credit during 1383 could
exceed nominal GNP, although the long-term trend is for practically
no change in the ratio of credit to income (i.e., "credit velocity'
is relatively flat) .
Somewhat faster growth in credit is con-
sistent with experience so far this year, and may be related to
the relatively rapid expansion in Federal debt.
For 1984, the Comnittee tentatively looks toward a
reduction of 1/2 percent in each of those ranges, for M2, M3,
and nonfinancial domestic credit.
That small reduction appears
appropriate and desirable, taking account of the need to sustain
real growth while containing inflation.
Those carpets appear
fully consistent, in the light of experience, wizh th^ economicprojections of the Corjnltt'se • as well as those of the Adrai::istrati;
and those underlying the Budget Resolution).
The targets are, of course, subject *.c- re-lew around
year end.
One question that prises is whether the fiOmev.Sst more
rapid growth in credit ;.han norr.inil GNP will, cz shoy 11 desircfclv.
continue, consistent with progress coward price steoility and
toward a more conservative pattern of private finance than
characteristic of the years of infj.^t^on.
Acain, try.1,
on aggregate deb' expansion sterr.- '.r.g fron ths-i !?•• Jcera:jre a source of concern.
21
no re dif fi~i:l t.
.-.s discussed further in Appendix I to this
rar.ecus or laggsd relationship, hss varies; significantly frc~i
the recession and failing tc "snap back" as quickly.
While a
number cf rrore temporary factors rr.ay have contributed, a significant part of the reason appears to be related to the fact that
a iriajcr portion of the narrow "money supply" now pays interest,
and the "spread" between the return available to individuals
from holding Ml "money" and narket rates has narrowed
sub-
stantially, more than the decline in market rates itself implies Put another way, NOW accounts, where the growth has been nost
rapid, are not only transaction balances, but now have a "savings'
or "liquid asset" component.
For a tinie at least, uncertainty
about the financial and economic outlook, and less fear about
inflation, nay also have bolstered the desire to hold money.
Growth in Ml —
nine months —
alone.
'in running well above our targets for
has not, however, been confined to HOW accounts
Moreover, there are signs that the period of velocity
decline may be ending.
In looking ahead, with the economy
expanding and with ample time for individuals and others to
have adjusted to the rapid decline in interest rates last year,
we Tnust be alert to the possibility of a rebound in velocity
along usual cyclical patterns, even though the longer-term
trend may ie changing.
22
I.", monitoring Ml, the committee fel- that an appropriate
approach would be to assess future growth fror, a base of the
second auarter of 1963, looking Coward growth close -o, cr
below, norr.inal GN?.
Specifically, the range was set at 5 to S
percent for the remainder of this year, and at 1 percent lower
4-S percent —
for 1934.
—
Thus, the Committee, in the light of
recent developments looxs toward substantially slower, but not
a reversal, of Ml growth in the f-arure.
Velocity is expected
to increase, although not necessarily to the extent common in
earlier recoveries.
The range specified is relatively wide, but depending
on further evidence with respect to velocity, either the upper
or lower portion of the range could be appropriate.
As this
implies, Ml will be monitored closely but will not be given
full weight until a closer judgment can be made about its velocity
characteristics for the future.
We are, of course, aware that
proposals to pay interest on demand deposits could, if enacted,
influence velocity trends further over time.
These targets are designed to be consistent with continuing
growth in economic activity and reduced unemployment
of sustained progress against inflation —
in a framework
and indeed are designed,
insofar as monetary policy can, to contribute to those goals.
The targets, by themselves, do not necessarily imply either further
interest rate pressures or the reverse in the period ahead —
will depend on other factors.
much
In particular, progress in the budget
and continued success in dealing with inflation should be powerful
factors reducing the historically high level of interest rates over
time, to the benefit of our private economy and the world at large.
23
Concluding Remarks
In important ways, ever, more progress reward our
cor,tinning economic objectives has been rr.ade curing the
past six months than we anticipated.
But it is also true
partly because economic growth has increased —
—
that the need
to deal, promptly and effectively, with the obstacles to
sustained growth and stability have become more pressing.
Those obstacles are well known to all of you.
There is,
indeed, little disagreement, conceptually, about their nature.
What has been lacking is a strong consensus about the
specifics of how, in a practical way, to deal with them.
There
should be no assumption that monetary policy, however conducted,
can itself substitute for budgetary discipline, for open and
competitive markets, for inadequate savings, or for structural
financial weaknesses.
The world economy offers ample illustration of the
dangers of procrastination and delay in the face of political
impasse, and in the hope that problems will subside by themselves -- only to be faced, in crisis circumstances, with the
need for still stronger action in an atmosphere of shattered
confidence.
That great intangible of confidence, once lost,
can only be rebuilt laboriously, step by step.1
Here in the united States we have, with great effort,
already gone a long way toward rebuilding the foundation for
growth and .stability.
We are not today in crisis.
economy -- for all its difficulties —
The American
still stands as a beacon
of strength and hope for all the world.
We know something of the risks and difficulties Tihat
could turn the outlook sour.
But I also know that the actions
necessary to make the vision of stability and sustained grcwth
a reality are within our grasp.
We have come too far, with too
much effort, to fail to carry through now.
24
APPENDIX I
Questions have been raised about the practicality or identifying
a particular concept of money that has a stable relationship to oroader
economic objectives, such as economic activity, prices, and employment,
and about the related issue of whether the recent "breakdown" in velocity
behavior relative to historical norms is temporary or longer-lasting.
Both these questions bear directly on the role of monetary aggregates in
the formulation and implementation of monetary policy.
No single concept or definition of money or credit aggregates
can reasonably be expected always to provide reliable signals about
economic performance, or about the course of r^onetary policy and its
relation to the nation's basic economic objectives of sustainable ecorranic
growth, high employment, and stable prices.
One reason is that market
innovations and regulatory changes can alter the significance of the
various aggregates at different times.
Usually, however, such changes
take place gradually without basically altering relationships over the
shorter-term.
On occasion, their impact may be mare sizable and abrupt,
both in terms of influence on measured monetary aggregates and their
relation to over-all economic performance.
Definitions of the monetary
aggregates can be, and have been, adapted to significant institutional
changes, although all definitions of "money" necessarily involve at the
margin a degree of arbitrariness.
The various money and near-money
assets often serve a variety of functions for their holders that cannot
be precisely distinguished statistically.
Even in the absence of institutional changes in financial
markets, changes in the public's desires to hold liquidity as compared
with "normal" past patterns can, through impacts on velocity, alter growth
25
rates in the aggregates that may oe consistent with broader ecor.onic
developments.
These shifts in liquidity preference Historically have
occurred during periods cr.eracterizec by unusual ecor.otr.ic uncertainties
associated w i t h such developments ^s protracted economic weakness, fears
of inflation, or instability in the financial system.
Consequently, trie use of monetary and credit aggregates as guides
Cor policy and in interpreting likely economic developments requires continuing judgment about tne impact of emerging institutional developments
and changing public preferences for money and credit demands, particularly
when the economic or financial environment has changed drastically.
In
that context, the value of the aggregates for policy depends not so much
on the "stability" oi their relationships to other economic variables, but
on the predictability of these relationships, taking into account structural
shifts tftac are i<nown to be in process.
Monetary targeting is based on the
presumption that structural changes will not be so raoid or so unpredictable
as to undermine the usefulness of the aggregates as annual targets, although
over time they rray need to oe adapted to ongoing behavioral changes.
For the past decade or so a series of institutional changes have
affected the meaning and interpretation of the several monetary aggregates.
Around the mid-1970s, various instruments and techniques began to be
developed in financial markets that enacled depositors to economize on
holdings of cash and to earn interest on highly liquid balances that to
sane extent substituted far cash.
This new financial technology, abetted
by legislative and regulatory changes that permitted depository institutions to compete more effectively, changed the shape of financial markets.
The Federal Reserve adapted its definitions of monetary aggregates to
trie emerging institutional structure.
26
The narrowest.definition of money—Ml—was designed to measure
transaction balances, and thus cojld be expected to bear a closer, mere
predictable relation to aggregate spending than the broader measures,
which were affected as well by attitudes toward saving and wealth.
The
measure of Ml was redefined a few years ago in light of institutional
changes to encompass transaction-type balances held in forms other than
demand deposits.
In particular, interest-bearing savings accounts subject
to a regulatory ceiling rate but with checkable features (such as regular
HGM accounts) were included in the measure, and later such accounts that
could pay a market rate were also added (super-NOH accounts).
However,
these accounts served broader purposes for their holders than siinply
facilitating transactions.
longer-term savings.
They also were an attractive repository for
Thus, interpretation of Ml was affected, and made
less certain, especially over the past year or more, by its
changing
character; and the weight placed on this aggregate in policy implementation was necessarily altered during such periods of transition.
Over the last several guarters, the income velocity of Ml has
fallen considerably and been much weaker than experience over comparable
stages of post-war business cycles would have suggested, whether velocity
is measured contemporaneously as the relationship of GNP to money in the
current quarter or is measured on a lagged basis as ^e relationship of
GNP to money one or two quarters earlier.
This occurred as the share of
NOW accounts in the aggregate expanded, as financial markets adjusted to
lower rates of inflation, and as economic uncertainties were heightened
during the recent period of economic contraction.
The unusually large
and sustained drop in Ml velocity may in the circumstances in large part
27
reflect an enhanced aexisnd for Ml chat arose from the ieclir.e ~r\ ir.flaticn
and the related sharp fall in -£r<et ir.terest rates curing zr.e second r.slf
of 1982. The availability of interest-bearing ><OW accounts nay have race
depositors even more willing to hold funds in Mi-type accounts as market
interest rates declined.
In addition, 11 was probably boosted by heightened
savings and precautionary demands.
These savings demands originally mani-
fested themselves in the contractionary phase of the current economic cycle,
out apparently have to a degree continued into the expansion phase.
The "breakdown" in the pattern of the velocity of HI, in the
sense of its unusual behavior during the current economic cycle, may well
be abating.
Its income velocity declined much less in the second quarter
of this year than it had over the previous five quarters—which ttay suggest
that velocity is beginning to move back toward a more familiar and predictable pattern of behavior.
Of course, the radical change in composition
of Ml over the past two and a half years—with interest-bearing MOW accounts
(some subject to ceiling rates and some at market rates) presently representing about one-third of the deposits included in Ml, a share that will
probably grew—suggests that the pattern of Ml velocity, even after a
transition period, may come to vary from what it had been in the past,
While the relatively short experience with an XL measure that
includes a prominent savings component (NOW accounts] tends to heighten
uncertainty when predicting velocity behavior, it is by no means clear
that our understanding of emerging velocity trends will be so limited
as to preclude reasonable estimates of the outlook for velocity.
Efforts
to re-estimate :noney demand equations in light of recent institutional
developments have helped explain a considerable part of recent velocity
irovements, and can be expected to be of assistance in projecting velocity.
28
Institutional, changes have also affected the oroader aggregates—
y2 and M3—ar.d they have zeen recafiried as necessary tc incorporate new
instruments, such as :ncney -iarket f j n d s , repurchase agreements, Sure-collars,
and money market deposit accoar.ts.
k'itr, the definitional coverage of sroad
money measures enlarged, they encorrpass a very wide spectrum of liquid
assets, so that these r^easures would tend to be less distorted than Ml
by Einancial innovations and sn.fts of funds among various liquidity
instruments.
Very large shifts of funds, as were associated with the
introduction of ;<MDAs, could distort particular money measures for a
relatively short time, as was the case particularly for M2 in early 19S3.
While the velocity of M2 departed from historical norms during
the past several quarters, it did so to a lesser degree than Ml. Durng
tie recent downturn M2 velocity declined only somewhat more than it had
in past cyclical contractions on average.
Thus fat ir* the recouery pnase
of the cycle, the velocity of M2 has turned upward on average
(after
rough allowance for the distorting influence of shifts associated with
the introduction of WDAs) within the range cf experience of previous
cyclical expansions.
With regard to credit, institutional developments, the process
of deregulation, and the eirergence of innovative financing techniques in
bond and other markets have contributed CO reducing the special significance of bank credit as the cutting edge of changes in credit availability.
As a result, more weight has been placed on a broad treasure of total
credit—in particular, the aggregate debt of domestic nonfinancial sectors—
for helping to tracs credit -,eeds as related to the overall econorty and to
g-jide monetary policy in that respect.
29
In a r i e f , several -*:~.ey ere credit r~-s,:res taken as a grc-u;;,
together with an updating, cr d e f i n i t i o n s sni -essurerent "ecnnig-jes as
and ir. the light of a Icnc sweep cf history cannot De ignored.
>.1-.ile it
is true individual aggregates frcr tij-ne to tire ray be distorted oy special
cevelopn«nts and may r.ot readily trac.< tr.e perfcrnance of the econcmy, the
pres'jnption remains of a icr.ger-terrr, stacility and p r e d i c t a b i l i t y in
relationships.
30
Questions ha<.*£ beer, raised ahou- -y views or. -he
variety of econcr.ic variables.
As yen /'.now, -he "CMC already
reports its "projecticr.s" cr "forecasts" for GNP, inflation,
and unemployment.
These projections are included with the materials
I an reporting to the Ccrjr.ittee today, as they have been at earlier
hearings.
I believe the practice of reporting-the full range and
the "central tendency" of FOMC members' expectations about the
economy may be useful in reflecting the general direction of our
thinking, as well as suggesting the range of possible outcomes for
economic performance in -he 12 or 18 months ahead, civen our monetary
policy decisions and fiscal and other developments over those periods.
There is a sense in which those projections reflect a view
as to what outccme should be both feasible and acceptable —
given
other policies and factors in the economy; otherwise monetary policy
targets would presumably be changed.
But I would point out that,
like any otFTer forecast, -hey are imperfect, and actual experience
has sometimes been outside the forecast ranges.
Moreover, I believe there are strong reasons why it would
be unwise to cite "obj actives" for nominal or real GNP rather
than "projections" or "assumptions" in zhese Reports.
The surface appeal of such a proposal is
understandable.
If a chosen path for GNP over a 6 to 18 month period could be
achieved by monetary policy, specific objectives might appear
to assist in debating ar.d setting the appropriate course for
31
Unfortunately, the preir.ise of that approach is not
valid —
certainly not ir. the relatively short-run.
The
Federal Reserve alcr.e cannot achieve within close li-.its a
particular GXP objective —
else would choose.
real cr r.cr.ir.al —
it or anyor.e
The fact of the natter is -.onetary policy
is net the only force determining aggregate production and
income.
Large swings in the spending attitudes and behavior
of businesses and consumers can affect overall income levels.
Fiscal policy plays &n important role in determining economic
activity,
within the last decade, we also have seen the
effects of supply-side shocks, such as from oil price increases,
on aggregate levels of activity and prices.
In the last six
months, even without such shocks, the economy has deviated
substantially from most forecasts, and from what might have
been set as an objective for the year.
The response might well be "so what" —
better to have scmething to "shoct at."
it's still
But encouraging
manipulation of the tools of monetary policy to achieve a
specified short-run numerical goal could be counterproductive
to the longer-term effort.
Indeed, we do want a clear idea of
what to "shoot at" over time —
growth.
sustained, non-inflationary
But the channels of influence from our actions —
the
purchase or sale of securities in the market or a change in the
discount rate —
to final spending totals are complex and in-
direct, and operate with lags, extending over years.
The attempt
to "fine tune" over, say, a six-month or yearly period, toward
a numerically specific, but necessarily arbitrary, short-term
objective coald well defeat the longer-term purpose.
32
Equally dangerous would be any i-plicit sssu—ption, in
specifying an "objective" for 3\"?, that rrcnetary policy is
so powerful it could be relied uper. "c achieve ~r.aTi objective
whatever else happens with respect to fiscal pclicy or otherwise .
Such an impression would be no service ~c the Congress
or to the public at larce; at worst, it would work against
the hard choices necessary on the budget and other matters,
and ultimately undermine confidence in monetary policy itself.
Some of the difficulties could, in principle, be met by
specifying numerical "objectives" ever a longer period of time.
But, experience strongly suggests that the focus will inevitably,
in a charged political atmosphere, turn to the short-run.
The
ability of the monetary authorities to take a considered longer
view —
which, after all, is a major part of the justification
for a central bank insulated from partisan and passing political
pressures —
would be threatened.
Indeed, in the end, the
pressures might be intense to set the short-run "objectives"
directly in the political process, with some doubt that that
result
would give appropriate weight to the longer-run con-
sequences of current policy decisions.
I would remind you that we have paid a high price for
permitting inflation to accelerate and become embedded in our
thinking and behavior, partly because we often thought we could
"buy" a little more growth at the expense of a little inflation.
The consequences only became apparent over time, and we do not
want to repeat that mistake.
33
?u~ another way, decisions cr. monetary po_icy shculc.
actions bevcnd a short—term forecast heritor..
This sirr.piy
can't be incorporated into ar.r.ual numerical objectives.
As a practical matter, I would despair cf the ability
of any Federal ?,eserve Chairman tc obtain a ~eanir.gful agreement
on a single numerical "cb jactive" among 12 strong-willed
members of the FCMC in the short run —
xearingful in the ser.se
of being taken as che anchor for iTnmediate policy decisions.
Submerging differences ir. the outlook in a statistical average
would, I fear, be substantially less meaningful than the present
approach.
As you know, we adopted -his year the approach of
indicating the "central tendency" of Comr.itoee thinking as well
as the full range of opinion.
These "astirr.a _es" provide, it
seeir.s -o me, a fccus fcr deba~a and discussion about policy
that, in the end, should be superior to an artificial process
of ''objective" serting that nay obscure, rather than enlighten,
the real dilemmas and choices.
Questions have also been raised on the issue cf
inrsmational coordination of monetary po icy and whether
or not to stabilize exchange races multilaterally.
I can deal
wirh these important issues here only in a most summary way.
34
Coordination, in the bread sense of working -ocether
toward more pries stability ar.d sustained growth, is plainly
exchange rate and ir.cerr.aticr.sl financial stability ir. the
common interest.
But seated so broadly, i- is clearly a
goal for economic policy as a whole, r.ot j-s^ monetary policy.
The appropriate level cf interest razes cr monetary
growth in any country sre dependent in par- on -he posture of
other policy instruments and economic conditions specific to
that country.
For that reason, explicit coordination, interpreted
as trying to achieve a corsncn level of, for instance, interest
rates or money growth, may be neither practical nor desirable in
specific circumstances,
essential —
"vhat does seem to me desiralle —
is that monetary
and
(and other} policies tere and
abroad be conducted with fill awareness of the policy posture,
and possible reactions, of ethers, and the international
sequences.
con-
In present circ'^ms~ances, we work toward that
objective by informal consultations in a variety of forums
with our leading trade and financial partners, recently on
some occasions with the presence of the Managing Director
of the IMF.
As this may imply. I believe a greater degree of exchange
market stability is clearly desirable, in the interest of our
own economy, but that must rest on the foundation of internal
stability.
In recent years, in my judgment, the priority has
clearly had to lie with measures to achieve that necessary
internal stability.
In specific situations, particular
35
actions ir.ay appear zo ccnflic- v^-'r. the desirabili-y cf exchar.ge
Gr ziscal and rr.cne-ary ^c_icy is IE" -mr, i~-i~a-, as _ —iscusse,
earlier in my s-aterr.ent.
Such "~cr.flic-s" should di-.inish as
internal stabili.y is mere fi™ly established.
The idea of a r?.ora str'jc-^red ir.-err.atior.al sys^eTn of
exchange rates to enforce greater stability in the international
monetary and trading system raises issues far beyond those I
can deal with here.
I do not believe it wo^ld be practical
to move toward such a system at -he present :ime, but neither
would I dismiss such a possibili-y over time should we
and others maintain progress coward the necessary domestic
arereauisites.
36
19S4
M3
6 - 1 / 2 to 9 - 1 / 2
M o n i t o r i n g F.anges
1983
X-l
5 to 9l/
Total credit!' S - l / 2 to 11-1/2
1984
1. February-March 1983 average taken as base.
2. Q2 1983 taken as base.
3. Represents growth in domestic nor.financial s e c t o r debt between y e a r e n d s .
Percent change, f o u r t h quarter to fourth quarter:
Nominal GNP
9-1/4 to 10-3/4
Real GNT
4 - 3 / 4 to 6
I m p l i c i t d e f l a t o r for GXP 4 to 5-1/4
Unemployment rate
9 to 9 - 3 / 4
A b o u t 9-1/2
- 1984
P e r c e n t c h a n g e , f o u r t h quarter to f o u r t h q u a r t e r :
•,'ominal Gtjp
Real GfJP
1 to 10-1/4
3 to 5
I m p l i c i t d e f l a t o r for GNP 3-3/4 to 6 - 1 / 2
UnemolowLent r a t e
8-1/4 to 9 - 1 / 4
9 to 10
4 to 4 - 1 / 2
4 - 1 / 4 to 5
8-1/4 to
8-3/4
37
Ranges and Actual Money and Credit Growth
Total Domestic Nonfinanciai Sector Debt
Dec 1962 ic June 1963
39
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
July 20, 1983
Letter of Transmittal
BOARD OF GOVERNORS OF THE
FEDERAL RESERVE SYSTEM
Washington, D.C., July 20, 1983
THE PRESIDENT OF THE SENATE
THE SPEAKER OF THE HOUSE OF REPRESENTATIVES.
The Board of Governors is pleased to submit its Midyear Monetary Policy Repor! to the Congress pursuant
to the Full Employment and Balanced Growth Act of 1978.
Sincerely,
Paul A. Volcker. Chairman
40
Sect Ion I:
The Outlook for ttie Economy
When the year began, an economic expansion was under way, but
it
was widely expected t h a t the recovery, at least in Its Initial phases, would
be s i g n i f i c a n t l y less rapid than the average postwar cyclical upswing.
The
economic recessions of the e a r l y 1980s and more moderate than anticipated
i n f l a t i o n had exposed serious financial strains both at home and abroad—strains
that In part grew out of practices that developed during years of I n f l a t i o n .
Consumer confidence was still at a low ebb, and a high degree of caution
was apparent in the business community.
Interest r a t e s , d e s p i t e having
declined substantially, were still at levels that appeared likely to inhibit
strong growth of a c t i v i t y in Interest-sensitive s e c t o r s , and a weak demand
for U . S . exports was expected to damp the pace of economic expansion.
By the second q u a r t e r , however, the recovery had gained vigor, and
was following In most respects a typical cyclical pattern.
Advances In resi-
d e n t i a l construction were exceptionally large during the f i r s t h a l f , and there
were sustained increases In consumer spending, particularly for durable goods.
Businesses continued to liquidate inventories at a rapid pace through the
f i r s t q u a r t e r , but then apparently began rebuilding stocks in the second quarter
as f i n a l demands strengthened,
Employment gains became s u b s t a n t i a l as
the recovery gathered speed, and the unemployment rate In June—while still
high historically—was three-quarters of a percent below the earlier peak.
Given the. nomentum of the recovery—and the added stimulus of
another reduction in personal taxes at midyear—there is a strong likelihood
that teal GNP «ill continue growing at a healthy pace- through the second half
of 1983.
Gains In employment have generated sizable increases in income,
41
w h i c h in turn are laying the groundwork for f u r t h e r advances In consumer
spending.
And, business spending on equipment appears to be turning up.
The
cumulative forces of economic expansion thus appear to be well established.
Real GHP growth in the second half as a whole may not match the
rapid second-quarter pace, which p a r t l y reflected the sharp swing in i n v e n t o r y
positions.
In addition, given the level of housing s t a r t s reached in the
second q u a r t e r , and with mortgage interest rates no longer falling, outlays
for
residential construction seem unlikely to continue rising at the extraor-
dinary pace of early 1983.
Business spending for s t r u c t u r e s may still be
sluggish in the second h a l f , particularly with o f f i c e space in ample supply
in most cities.
The foreign sector, too, will be exerting a restraining
i n f l u e n c e on growth of o u t p u t in the United States, owing to a strong dollar,
relatively slow growth in the other industrial nations, and financial d i f f i c u l ties besetting many developing countries.
Employment is likely to continue expanding as the recovery in o u t p u t
progresses,
with gradual declines in the unemployment rate.
However, if past
experience is any g u i d e , the strengthening economy will itself prompt more
job-seekers to enter the labor f o r c e , thereby reinforcing the i n e r t i a of the
unemployment rate.
Consequently, unemployment will remain high, relative to
the earlier postwar p e r i o d , for some time.
The near-term outlook for i n f l a t i o n continues to be reasonably
favorable.
Wage pressures have moderated f u r t h e r into 1983; p r o d u c t i v i t y is
i m p r o v i n g ; and the continued strength of the dollar is limiting increases
in the prices of imported goods.
A partial rebound in energy prices during
the early s p r i n g , following the pronounced weakness earlier in the year,
42
already appeared to be abating by midyear.
A spurt in some food prices
resulting from bad weather does not appear to be cumulating into a major
price advance.
Given these considerations, as well as the favorable first-
half price performance, the chances appear excellent Chat inflation rates
for 1983 as a whole will be as low as, or even lower than, those of 1982.
At the same time that the general trend of price Increase is
still slowing, there are indications that some of the cyclical influences
that helped reduce Inflation during the recession have waned.
With demands
for goods and services strengthening, price discounting Is diminishing;
and the downward pressures on prices and wages in some markets will lessen
as orders and labor demand rise.
evitable.
Such developments are to some extent In-
What is of critical importance is that these cyclical influences
not Impair more lasting progress toward reduction in the underlying rate
of inflation, as reflected in the interactions of wages, productivity,
and costs.
Recently, the concerns on that score have been heightened somewhat
by several factors.
Preliminary indications are that growth in nominal
GNP approached [1 percent In the second quarter.
That high rate of spending
growth is a welcome development insofar as it has come about in the context
of accelerated real output growth and moderating prices.
However, growth
in some measures of money and credit also have been relatively large recently,
and growth in nominal spending at the present rate over a sustained period
would suggest renewed inflationary pressures,
The vigor of the private economy at midyear also has underscored
the potential problems associated with federal budget deficits that will
43
remain massive in the years ahead, unless there are decisive actions to reduce
expend!Cures or—absent such action—to increase revenues.
Prospects for
interest rates are related to a number of factors, including importantly
the actual and perceived trend in inflation.
In 1982, when the economy was
mired in recession and the inflation rate was falling, record-large government
deficits were consistent with declining interest rates.
However, should public
credit demands remain at or near record highs while private credit demands
are expanding rapidly In response to rising business activity, the outlook
for interest rates would clearly be affected.
The difficulties of controlling federal deficits are evident In
the legislative developments of recent months, during which there have been
extensive and laborious efforts to arrive at a workable budget resolution.
These difficulties notwithstanding,
unless there is further progress in
reducing deficits, the risk of strains In credit markets Intensifying is
apparent, impairing the prospects for a balanced economic recovery.
FOHC Members' Economic Projections
Members of the Federal Open Market Committee believe that the current economic recovery will be well maintained over the remainder of 1983
and on through 1984.
The central tendency of forecasts of the FOMC members
show this year's growth in real GHP falling in a range of between 5 and 5-3/4
percent—a significantly stronger rate of growth than in the projections
pre-
viously submitted to Congress in the Monetary Policy Report of last February.
Real growth in 1984 is expected to be about one percent slower than In 1983,
and the unemployment rate is projected to trend lower through the end of next
year.
44
Most FOMC members expect tilts year's increase in the GNP implicit
price d e f l a t o r to range between 4-1/4 percent and 4-3/4 percent—about the
same as last year's increase and in line with the projections of the February
Monetary Policy Report.
There is less consensus about the i n f l a t i o n outlook
for 1984, with some concerned t h a t inflation
is likely to accelerate.
However,
most FOMC members feel t h a t , with appropriate policies, prices overall are
likely to rise in the same range as, or only a shade more r a p i d l y t h a n , in
Economic Projections for 1983 and 1984
Range
FOMC Members
Central Tendency
Administratton
1983
Percent change, fourth quarter to f o u r t h q u a r t e r :
Nominal GNP
9-1/4 to 10-3/4
Real GNP
4-3/4 to 6
I m p l i c i t d e f l a t o r for GNP 4 to 5-1/4
9-3/4 to 10
5 to 5-3/4
4-1/4 to 4-3/4
10.4
5.5
4.6
Average level in the f o u r t h
quarter , percent:
Unemployment rate
9 to 9-3/4
About 9-1/2
1984 Percent change, f o u r t h quarter to fourth q u a r t e r :
Nominal GNP
7 to 10-1/4
Real GNP
3 to 5
Implicit deflator for GNP 3-3/4 to 6-1/2
9 to 10
4 to 4-1/2
4-1/4 to 5
9.7
4.5
5.0
Average level in the f o u r t h
q u a r t e r , percent:
Unemployment rate
8-1/4 to 9-1/4
8-1/4 to 8-3/4
8.6
45
1983.
The cyclical strengthening of demand associated with the recovery
is one factor in this inflation projection, but price developments next year
will also reflect a number of special factors, such as policies to reduce
farm product supplies and raise farm incomes, coat pressures from increased
payroll taxes, and the possibility of some weakening in the foreign exchange
value of the dollar.
The central tendency projections of the FOMC members, for prices
as well as for real GNP and unemployment, are closely in line with the economic
assumptions prepared by Che Administration for its mid-session review of the
budget.
While most FOMC members are relatively optimistic about the prospects
for maintaining economic growth and containing inflation over the next year
and a h a l f , they also are mindful of potential d i f f i c u l t i e s that could disrupt
the outlook and cause the n a t i o n ' s economic performance to be less favorable
than is now expected.
There is,
as already noted, the prospect that federal
budget deficits will remain extremely large into the indefinite f u t u r e ; as the
p r i v a t e recovery lengthens, the dangers associated with those d e f i c i t s are
likely to increase, posing a threat to both the inflation outlook and the
sustainabllity of a balanced expansion.
There also art; some broader risks, not specifically related to the
budget, that some of the progress against inflation could be reversed as the
p r i v a t e economy strengthens.
The persistence of inflationary expectations
is evident both in recent surveys of private opinion and in the behavior of
financial markets, in which borrowers remain willing to pay high nominal rates
of return on long-term debt instruments.
As the recovery progresses, wage
46
and price developments will need to be monitored with great care to make
sure that these still-present expectations of Inflation are not undecgirding
a new round of acceleration in actual wage and price increases.
More generally, the United States has become much more integrated
into the world economy than it was a decade ago, and our economic fortunes
have become closely linked with those of other nations.
Because of those
close linkages, the economic difficulties of many foreign nations, particularly
the serious financial problems still plaguing many developing countries, could
affect this nation's economic performance in the period ahead.
To some extent, these risks in the economic outlook can be moderated
by appropriate policies.
For example, the risk of a further deterioration
in the economic prospects facing the developing nations can be lessened if
lenders, borrowers, national authorities, and international organizations
maintain the high degree of cooperation that has become evident in the
past year.
Prompt action by the United States to bolster the resources of
the International Monetary Fund and of the multilateral development banks is
an essential element in managing successfully a difficult adjustment process.
This country's budgetary problems alao are manageable, provided the
Congress and the Administration take action.
The Federal Reserve, for its
part, remains committed to monetary policies that will provide enough money
and credit to support economic growth in a context of containing inflation;
without reductions In future fiscal deficits, the goal of maintaining a
balanced recovery while at the same time holding down inflation could prove
elusive.
47
Section_2j
The Federal Reserve's Objectives for Growth of Honey and Credit
The Committee reviewed its target ranges for '983 and established
tentative ranges for 1984 in light of its basic objectives of encouraging
sustained economic recovery while continuing to make progress toward stability
in the average level of prices.
In setting these ranges, the Committee recog-
nized that the relationships among the money and credit aggregates and economic activity in the period ahead ate subject to considerable uncertainty;
consequently, it was emphasized that, in implementing policy, the significance
to be attached to moveoents in the various aggregates would depend on evidence
about the strength of economic recovery, the outlook for prices and inflationary expectations, and emerging conditions in domestic and international financial markets.
With respect to the ranges for the broader monetary aggregates—M2
and M3—the Committee reaffirmed the 1983 ranges of 7 to 10 percent and 6-1/2
to 9-1/2 percent, respectively, that had been established earlier in the year.
The tentative ranges for next year set for these aggregates were reduced onehalf percentage point to 6-1/2 to 9-1/2 percent and 6 to 9 percent, respectively, as measured in both cases from the fourth quarter of 1983 to the fourth
quarter of 1984.
It was expected, in setting these tentative ranges, that shifts into
nwney market deposit accounts (MMDAg) would not significantly distort growth
in the broader aggregates, particularly M2, in contrast to the experience in
the early part of this year.
(A diacussion of this and other monetary devel-
opments earlier this year can be found in Section 4.)
However, it was also
48
recognized that Che greater
f l e x i b i l i t y in liability management for banks
ami t h r i f t i n s t i t u t i o n s r e s u l t i n g f r o m the availability of MMDAs, together
with the recent decision of the Depository I n s t i t u t i o n s Deregulation Committee
to eli-iinate ceiling rates on titan deposits A/ by October 1 of this y e a r ,
would be a f a c t o r encouraging somewhat more rapid growth in M2 relative to
M3, as banks and t h r i f t s may rely relatively less on large CDs and o t h e r
money market liabilities in funding credit expansion.
With greater growth
in real (and nominal) GNP than anticipated earlier—but in the content of
moderating i n f l a t i o n — a c t u a l growth in M2 and M3 may reasonably be higher in
the ranges than thought likely e a r l i e r .
The FOMC also agreed that principal weight would continue to be
placed on the broader monetary aggregates in the implementation of monetary
policy, in view of the continuing u n c e r t a i n t i e s t h a t attach to the behavior
and trend of Ml over t i m e .
As discussed in Section 4, an unusual, sizable
decline in the v e l o c i t y of Ml has been experienced over the past several
q u a r t e r s , likely r e f l e c t i n g in part the fact that interest-bearing NOW accounts
have become an important component of M l .
These a c c o u n t s , which have both
savings and transactions characteristics, appear to have increased the response
of Ml demand to changes in market interest rates, which may explain a good part
of the a c c e l e r a t i o n of Ml growth beginning last summer.
Also, particularly in
the course of 1982, demand for Ml may have been increased because savers
sought to hold funds in highly liquid forms in light of various economic and
financial u n c e r t a i n t i e s .
Recent evidence suggests that the decline in tho velocity of ML may
he abating.
1.
The income velocity of Ml evidently declined only modestly in the
E x c e p t for a c c o u n t s less than $2,500 maturing in 31 days or less.
49
second quarter of this year.
With the upward Impact on Ml demand of earlier
iirerest rate declines having faded, and given the sizable build-up in liquid
balances that has taken place, it seems probable that some pick-up in the
velocity of Ml will develop over the quarters ahead, in closer conforraance
with cyclical and secular patterns of earlier years.
Whether any rise in velocity would be as strong as in earlier decades
of the post-World
II period remains uncertain.
Experience to date with a mea-
sure of Ml that reflects to a greater extent the savings propensities of the
public, as well as transactions demands, has been relatively limited, which
makes it difficult to assess its behavior under varying economic circumstances.
Moreover, it is not clear how responsive Ml demand will be to market interest
rates over the period ahead if Super NOW accounts, which yield a market
return to holders, become a more important element in the aggregate.
(If
the authority to pay interest on transactions balances were extended beyond
currently eligible accounts, this too would affect Ml behavior, presumably
in the short run increasing the demand for the aggregate, but no specific
allowance has been made for that possibility.)
Taking account of these various uncertainties, for the purpose of
monitoring Ml behavior, the Committee established a growth range of 5 to 9
percent (annual rate) for the period from the second quarter to the fourth
quarter of this year.
The decision to establish a new base for monitoring 11
reflected a judgment that the rapid growth over the past several quarters
should be treated as .1 one-time phenonemon, neither to be retraced or long
extended.
A monitoring range of 4 to 8 percent was tentatively established
for rhe period from the fourth quarter of 1983 to the fourth quarter of 1984.
50
These ranges anticipate no further decline In the velocity of Ml during a
period of relatively strong growth in economic activity and allow for the
likelihood of some rebound in velocity.
Ml growth would be expected to
move lower in these ranges as and if velocity strengthens.
The Committee reaffirmed the' range of 8-1/2 to 11-1/2 percent used
for monitoring the behavior of domestic nonfinancial sector debt in 1983.
That range was reduced to 8 to 11 percent for 1984.
The federal government
next year is expected to continue absorbing an unusually large share of overall credit supplies.
The Conmiittee's range would encompass the possibility
of growth of total debt in excess of likely GNF growth (and the long-term
trend of credit in relation to GNP) in light of the analysis of various
factors bearing on credit growth.
Nevertheless, the prospect of intensifying
conflict between sustained large government requirements and growing private
sector credit demands is a serious concern.
51
Section^:ThePerformance, of the Economy In the First Half of 1983
The economic expansion that began at the end of 1982 gathered
momentum over the first half of 1983.
After increasing moderately in the
first quarter, real gross national product registered a strong advance in
the second quarter, as production and employment rose in a broad range of
industries.
An apparent completion of the recession—induced inventory
liquidation accounted for much of the second-quarter growth; but domestic
final sales also strengthened considerably, and forward-looking indicators
point to further output gains in the months ahead.
To be sure, a number of serious economic problems remain. The
economic recovery is far from complete.
ian labor force was still unemployed.
At midyear, 10 percent of the civilMany companies continue to face major
adjustments in an effort to stay competitive in their industries here and
abroad.
Some domestic energy producers remain in financial d i f f i c u l t y , as
do many producers in the agricultural sector.
The nation's external sector
continues to be a weak link in the recovery, as exports are being limited by
a strong dollar, the sluggishness of a number of other industrialized economies
and the severe adjustment problems of much of Latin America; the international
indebtedness and related economic difficulties of a number of developing countries remain a matter of particular concern.
This country's period of moderating inflation lengthened in the
first half of 1983.
In 1982, many price measures recorded the smallest
increases in a decade, and price developments so far this year have been
even more favorable.
Transitory elements clearly have played a part in
52
Real GNP
Change from end of previous period, annual rale, percent
1972 Dollars
uiiui
1977
1979
—nrnir
1981
1963
GNP Prices
Change from end of previous period, annual rate, percent
Fixed-weighted Index
1977
1979
1981
Interest Rates
Home Mortgage
3-month Treasury Bill
1977
1979
1981
1983
* Data lor 1983 HI are Based oi'»V on advance D'Oiections Irom Ihe Commerce DepaMmenl
53
this improving price performance, but there also continue to be indications
of more lasting progress.
In particular, productivity has been improving
and increases in compensation continue to moderate, so that the interactions
between costs and prices, which imparted a stubborn momentum to inflation
through the 1970s, are still working to reduce the underlying or trend rate
of i n f l a t i o n .
However, even though prices have slowed dramatically, concerns persist that i n f l a t i o n will reaccelerate as the recovery progresses.
To a con-
siderable extent, these concerns arise from the experience of past business
cycles and from an expectation that the federal government's budget deficits
will remain massive in the years ahead, making more d i f f i c u l t the sustained
application of a noninflationary monetary policy.
Because of such concerns
about the f u t u r e , as well as the present high level of actual government
borrowing, short- and long-term interest rates in the first half of 1983 continued to be quite high, relative both to historical experience and to the
current pace of inflation.
As had been true during the recession, government debt rose very
rapidly in the first half of 1983; in addition, household borrowing picked
up as the expansion accelerated.
Even though the growth in business borrow-
ing remained relatively low, total debt outstanding in the domestic nonfinancial sectors grew at an annual rate of about 10-1/2 percent—a faster pace
than In 1982.
Debt grew faster fn the second quarter than in the f i r s t .
Money holdings also increased rapidly in the f i r s t half of 1983,
as a strengthening of private spending bolstered the demand for transactions
balances and as lower Interest rates led many Individuals and businesses Co
54
hold a larger portion of their financial assets in the form of money balances.
In addition, money growth also was affected by portfolio shifts arising from
the progressive liberalization of deposit rate regulations; these shifts were
especially important In boosting growth of the broader monetary aggregates
early In the year.
Interest_rates
Short-term interest rates had fallen sharply in the second half of
1982,
when the recession was deepening; and by the end of last year, rates
were only about half the peak levels of 1981.
Yields then fluctuated In a
relatively narrow range through most of the first half of 1983, before moving
a little higher around midyear as the recovery strengthened.
At midyear,
short-tenn yields were generally 50 to 125 basis points above their December
levels; the Federal Reserve discount rate remained unchanged over the f i r s t
half of the year.
Long-term rates eased further into early 1983, extending the decline
that began in mid-1982.
The further reduction in long-term yields resulted
from beliefs that the recovery might be relatively weak, thereby limiting
private credit needs and, at the same time, enhancing the prospects for a continued moderation of price inflation.
In the second quarter, however, long-term
rates turned up slightly as economic activity strengthened further and as market
participants began to focus more directly on the potential effects of heavy
federal borrowing and the implications of continued rapid money growth,
C on s uroe r S pending
Much of the vigor of the current expansion has arisen from increases
in income and spending In the household sector.
Throughout the recession,
55
Real Income and Consumption
Change from end ot previous period, annual rate, percent
[TO Real Disposable Personal Income
| [ Real Personal Consumption Expenditures
1979
Real Business Fixed Investment
Change from end of previous period, annual rate, percent
(Ill Producers' Durable Equipment
| | Structures
-
Ml*
1
1 1
1 Jl
1
1
1
TJ r
1
I
1
I
1
Total Private Housing Starts
Annual rate, millions ot units
1977
1979
1981
1983
56
the nominal disposable incomes of consumers had been unusually well maintained
by a combination of countercyclical transfer payments, rising interest income,
and reductions in tax rates.
A rapid decline in inflation enhanced the pur-
chasing power of these nominal income gains, and by the end of 1982, real disposable personal income was about 2 percent above its prerecession level of
mid-1981.
Households have strengthened their balance sheets considerably
in recent years by acquiring large amounts of liquid assets and holding down
the accumulation of new indebtedness.
In addition, a sharp, sustained rise
in stock prices added considerably to household wealth a f t e r mid-1982.
Thus,
when aggregate wage and salary income began rising with the upturn in a c t i v i t y ,
consumers were well positioned to boost spending on goods and services.
After a period of sluggish growth through most of 1982, consumer
spending improved toward the end of last year and strengthened f u r t h e r in
the f i r s t half of 1983.
Second-quarter spending, in particular, was quite
vigorous, as purchases of autos and other big-ticket items increased markedly.
Sales of domestic autos were at an annual rate of about 6-3/4 million units
in the second quarter, the best quarterly sales pace since mid-1981; sales
of foreign models were maintained at a rate of about 2-1/4 million units.
With income growth accelerating, economic prospects brightening,
and interest rates lower than in 1982, consumers became more willing to take
on new debt in the first half of 1983.
In addition, lenders showed a greater
interest in making consumer loans, partly—in the case of depository institutions—as an outlet for investing the large inflows to new accounts.
Thus,
a f t e r rising only 4 percent in 1982, Installment debt rose at more than a
57
7 percent annual rate in the f i r s t q u a r t e r , and still faster growth appears
to have occurred in the second q u a r t e r .
Business Spending
Economic conditions in the business sector also have improved.
Reduced interest rates, the elimination of unwanted inventories, and an expanding economy have relieved some of the financial strains brought on by
the recession and, at the same time, have created a better climate for investment spending.
Business cash flows improved in the f i r s t h a l f , as profit
margins widened considerably.
Buoyed by rising investor confidence, stock
prices rose Lo new highs, enabling businesses to rely heavily on equity
financing while limiting the growth in indebtedness.
In addition, encouraged
by bond yields that were well below earlier peaks, firms strengthened their
balance sheets by shifting their borrowing Coward longer-term maturities.
These general trends n o t w i t h s t a n d i n g , many firms that were weakened by the
recession continued to face financial d i f f i c u l t i e s
in the f i r s t half of 1983,
and the number of business bankruptcies—though declining—remained high.
Business investment spending, which fell nearly 8 percent in real
terms during the recession, turned up in the f i r s t half of 1983, as real outlays for equipment rose in both the first and second quarters.
In contrast
to e q u i p m e n t , spending for structures f e l l appreciably during the f i r s t
half of 198 3, led by reduced outlays for commercial and i n d u s t r i a l buildings.
W i . c h o f f i c e and i n d u s t r i a l vacancy rates now q u i t e high, it
may be some time
b e f o r e the expanding economy begins to generate a sustained increase in
outlays for these t y p e s of f a c i l i t i e s .
58
Businesses had liquidated Inventories at a rapid pace during the
recession in an e f f o r t to bring stocks more in line with the recession-reduced
sales levels, and the momentum of that liquidation carried into early 1983.
More recently, with final sales continuing to rise, businesses appear to
have begun a cautious rebuilding of stocks.
In the second quarter, a move
from sizable inventory liquidation to an apparent small accumulation of
stocks provided a strong impetus for increased production, resulting in a
rise in second-quarter GNP much larger than the advance in final sales.
Residential construction
Responding to lower interest rates, activity in the housing sector
rose sharply in late 1982 and increased further in the first half of this
year.
At the end of last year, mortgage rates were about 5 percentage points
below the peak rates reached in the fall of 1981, and they continued to trend
gradually lower before firming in the past two months.
Mortgage credit flows
increased strongly in the f i r s t half—especially at thrift institutions, whose
fund availability was enhanced by the advent of new deposit instruments.
In response to the drop in financing costs, as well as demographic
influences, home sales turned up in 1982 and rose rapidly through the first
half of 1983.
By the second quarter of 1983, sales were up nearly a third
from the final quarter of 1982; both new and existing homes shared in the
sales gains.
With the inventory of unsold new homes quite low, rising sales
have supported a strong advance in new construction activity.
Continuing
the uptrend evident in 1982, starts of new single-family homes in the first
five months of 1983 rose to a level about three-fourths above a year earlier—
a sharper rebound than many analysts had expected in light of prevailing
59
mortgage rates.
Starts of multifamily units also have been quite strong so
far in 1983, partly reflecting enhanced profitability in the markets for
rental property.
Low levels of housing construction over the past few years
clearly left a sizable pent-up demand that has provided strong support for
new construction activity.
Go ver nme n t sector
Federal spending declined moderately during the f i r s t half of 1983,
but the drop resulted mainly from transitory factors, particularly a reduced
rate of accumulation of farm inventories by the Commodity Credit Corporation
(CCC).
Abstracting from these inventory swings, federal expenditures were
still trending up in the f i r s t half.
Excluding outlays of the CCC, federal
purchases of goods and services, in current dollars, appear to have increased
at an annual rate of more than 10 percent from the f o u r t h quarter of 1982 to the
second quarter of this year.
The federal budget deficit was extremely large in. the f i r s t half
of 1983.
Because of changes in tax laws and, until recently, slow growth in
taxable incomes, receipts have Increased only moderately from the levels of
two years ago.
During this same period, spending has increased considerably,
owing to increased defense purchases, recession-Induced transfer payments,
and, on average, relatively high payments to support farm incomes.
As a
result, the combined federal deficit (unified plus off-budget) accumulated
to about $95 billion over the first half of 1983, three times the level of a
year earlier.
During the first h a l f , direct federal borrowing (which does not
include federally guaranteed loans or the debt of sponsored credit agencies)
absorbed more than two-fifths of all funds raised in credit markets by the
domestic nonfinancial sectors.
60
Real state and local government purchases edged lower In the f i r s t
half of 1983, extending the gradual decline evident over the preceding two
years.
Real outlays for employee compensation and new construction spending
were held down by the budget concerns still apparent among many states and
localities.
As in 1982, a number of governmental units raised taxes to
relieve pressing financial d i f f i c u l t i e s .
By midyear, however, some of the
budgetary strains began to ease, as rising economic activity expanded the
state and local tax base, boosting the sector's overall operating budget
back into surplus.
Borrowing by state and local governments also increased rapidly,
thougb part of the rise probably reflected a rush to market debt instruments
in advance of a new requirement that securities be issued in registered,
rather than bearer, form; the requirement deadline took e f f e c t on July 1,
after having been postponed from January 1.
In a d d i t i o n , tax-exempt borrowers
took advantage of lower interest rates to refund or pre-refund bond issues
that were sold when borrowing costs had been higher.
The International Sector
As in 1982, net exports continued to exert a negative influence on
U.S. economic activity in early 1983;
slow growth in foreign industrial econo-
mies and a strong dollar have both constrained export sales.
At the same
ti.me .
the vigorous expansion in the U.S. domestic economy pushed imports higher, so
that the trade account showed an increasing deficit over the f i r s t half of
the year.
An additional element limiting prospects for U.S. exports is the
serious external financing problems facing a number of developing countries,
including some that are major trading partners of the United States.
Among
61
these nations, reduced trade volume and depressed commodity prices have
limited export earnings and—in the face of high world interest rates—made
debt repayment d i f f i c u l t .
So f a r , these repayment problems have been con-
tained through an extraordinary degree of cooperation among borrowers, private
c r e d i t o r s , national authorities, and international organizations; in many
instances, existing debts have been restructured, new funds have been raised,
and the borrowing nations are implementing programs to restore Internal financial stability, to increase their debt-servicing capacity, and to convince
international lenders of their creditworthiness.
Nevertheless, the process
of adjustment is still far from complete.
Labor markets
Labor markets began to strengthen around the turn of the year, and
by June, payroll employment had increased 1.1 million from its
December
trough, regaining more than one-third of the losses sustained during the
recession.
Job gains have been widespread over the past six months, with
especially large advances in services and
raanufactuiinp.
In m a n u f a c t u r i n g ,
employment Increases during the past six months have retraced nearly a f i f t h
of the 2 million jobs lost during the 1981-82 recession.
Employment growth
in the services industry, which had slowed during the recession, appears to
be showing renewed vigor as the expansion has taken hold,
The total number of unemployed workers declined by almost a million during the f i r s t half of 1983, and the civilian unemployment rate f t i l
to 10 percent, three-fourths of a percentage point below the postwar peai.
reached last December.
L a y o f f s had begun easing late last year, and with
labor demands strengthening through the f i r s t h a l f , many f i r m s have started
62
Nonfarm Payroll Employment
Millions of persons
1977
1979
Unemployment Rate
1979
63
rehirlng.
Despite these gains, jobless rates at midyear remained far above
the levels of late 1979, before the two back-to-back recessions that added
greatly to labor market slack in the early 1980s.
Wages and Labor Costs
The Ealloff of labor demand during the recession, along with the
general unwinding of inflation, led to a sharp slowing in the rate of wages
and labor cost increases, and that slowdown has continued into the first half
of 1983.
From the fourth quarter of last year to the second quarter of 1983,
the average hourly earnings of production workers rose at about a 4-1/4 percent
annual rate, the slowest rate of nominal wage increase since the mid-1960s.
But, because the rise in consumer prices has slowed even faster, the slower
nominal wage gain has been consistent with increases in real purchasing
power.
The slowing of nominal wage increases has been broad-based, affecting
nearly all major industrial and occupational groups.
With inflation easing,
workers in general are feeling less pressure to catch up with past inflation
or to try to stay ahead of anticipated future inflation.
In addition, in
industries particularly hard hit by recession, as well as by heightened
domestic or foreign competition, workers have agreed to contract adjustments
calling for wage freezes or outright wage reductions.
Unit labor costs also moderated further in the first half of 1983,
as strong productivity gains reinforced the impact of smaller wage increases.
In the nonfarm business sector, labor costs rose at only a 1-1/4 percent rate
in the first quarter, and evidently the second quarter advance also was quite
moderate.
64
Consumer Prices
Change from end of previous period, annual rate, percent
H
1977
1979
Producer Prices
Change from end of previous period, annual rate, percent
TUT
Hourly Earnings Index
Change from end of previous period, annual rate, percent
1977
1979
1981
1983
'price changes (or 1993 HI are baaed on data for the DecemDer to May period
65
The sizable productivity gains of recent quarters have been an
especially encojra^ing development because they may reflect not only the
customary cyclical patterns of an economic expansion, but also some improvement In the trend rate of productivity growth.
Work rules in many establish-
ments art; being revised to enhance efficiency, and qualitative reports from
the business sector point to strong efforts to trim costs and improve market
competitiveness.
Pr ice developments
Price developments continued to be favorable in the first half of
1983.
The consumer price index rose at an annual rate of only 3 percent
from December to May, and over the first half, the producer price index for
finished goods actually declined.
An acceleration of prices from the first
to the second quarters resulted mainly from swings in energy prices that
appear to be temporary and front the transitory effects of adverse weather on
the prices of some foods.
The prices of raw industrial materials rebounded
from depressed levels early in the year, but have leveled- off in recent months.
In otlipr m a r k e t s , including those for both consumer goods and capital equipment,
price inflation in the second quarter still seemed CO be trending lower.
Price increases during the past year have been the smallest since
the early 1970s, and the period of moderating inflation has now extended over
2-1/2
years.
Still, the recent period of slower price increases has by no
means erased the memories of accelerating Inflation during the previous two
decades.
The recent deceleration in prices occurred during a business reces-
sion, and there remains a deep-seated skepticism about whether the gains
against I n f l a t i o n can be maintained as the period of economic expansion is
extended.
The task of economic policy Is to overcome that skepticism by
preserving the gains already won against inflation while sustaining the
economic expansion that took hold in the f i r s t half of 1983.
66
Section _4_:_ _ The Growth of Money and Credit in the First Half of 1983
The 1983 ranges for the monetary and credit aggregates announced in
February were chosen by the Federal Open Market Committee with the objective
of providing sufficient liquidity to support economic recovery while continuing to encourage progress toward price stability.
In setting those guidelines,
the Committee recognized that the relationship between growth of the monetary
aggregates and economic activity had deviated from usual historical relationships during 1982, and looking ahead, account had to be taken of the possibility
that past patterns might be shifting in some respects.
Specifically, during 1982, monetary growth had been quite rapid
relative to income; the velocities of both Ml and M2 had registered exceptionally large declines over the year.
Although these declines in velocity were
thought likely to be in part temporary—Ml velocity In particular commonly has
increased appreciably in the early stages of a recovery—it also was felt
that the experience of 1982 might well be indicative of a more basic shift
in the underlying demands for money.
Institutional changes have led to the
increased availability of transactions accounts that bear interest, which
would be likely to increase the public's willingness to hold Mi-type accounts.
These accounts are used partly as repositories for savings, as well as to
support transactions, and this tendency was expected to be reinforced by the
introduction of Super NOW accounts.
The Committee also recognized that the introduction of new deposit
instruments had affected, and would continue to a f f e c t , the behavior of the
broader aggregates. A very substantial inflow of funds into money market
67
deposit accounts (MMDAs) from market instruments had greatly inflated growth
of M2 at the end of 1982 and in the early weeks of 1983.
It was anticipated
chat further flows Into these accounts, and to a lesser extent into Super NOW
accounts, would continue to affect the aggregates for some time, although the
impact could not be determined with a high degree of accuracy.
In implementing policy, Committee members agreed that, for the time
being, primary emphasis would be placed on the broader aggregates.
It was
expected that distortions resulting from the Initial adjustment to new deposit
instruments would lessen.
The behavior of Ml would be monitored, with any
Increase in the emphasis placed on that aggregate dependent on evidence that
its velocity behavior was assuming a more predictable pattern.
Debt expansion,
although not targeted directly, would be reviewed in assessing the behavior of
the monetary aggregates and the stance of monetary policy.
The Committee em-
phasized that, given the above uncertainties, policy implementation in 1983
would require a greater degree of judgment, involving crucially the evaluation
of the relationship of monetary growth to movements in income and prices, until
such time as the aggregates returned to more predictable behavior.
The specific target ranges announced in February were:
for M2, an
annual rate of 7 to 10 percent for the period from February-March of 1983 to
the fourth quarter of 1983; and for M3, 6-1/2 to 9-1/2 percent for the period
from the fourth quarter of 1982 to the fourth quarter of 1983.
Also for the
latter period, a tentative range was established for MI of 4 to 8 percent,
with the width of this range reflecting the relative uncertainty about the
behavior of this aggregate.
An associated range of growth for total domestic
nonfinancial sector debt was estimated to be 8-1/2 to 11-1/2 percent, December
68
to December, while bank credit growth was expected to be between 6 and 9
percent for the year.
Growth in M2 and M3 appears to be broadly consistent with the
get ranges adopted In February.
tar-
M2 expanded at a 9 percent annual rate from
the February-March base period through June, a little above the mid-point of
its
range.
M3 growth was somewhat stronger and, at 9-1/2 percent from the
fourth quarter of 1982 through June, was at the upper end of its
path.
target growth
In contrast, Ml continued to surge, with growth averaging 14 percent
at an annual rate from the f o u r t h quarter of last year.
In setting the annual target range for M 2 , the Committee selected
the February-March base period to reduce the distortions resulting from the
massive inflows to MMDAs following the introduction of these accounts in
*
December. Moreover, the range of 7 to 10 percent was one percentage point
higher than that set for 1982, to allow for some residual s h i f t i n g from outside M2 into these accounts through the remainder of the year.
There is
growing evidence that the stock adjustment to MMDAs Is abating; inflows to
these new instruments slowed from around $17 billion per week in February to
an average of about SI billion weekly in June.
Thus, it appears that the
distorting effects of these Instruments have, as expected, become relatively
minor as time has progressed.
The interest rates offered on these deposits—
in absolute level and relative to other short-term rates—have fallen considerably from the extraordinary yields posted immediately following the introduction of this account.
Since March, the average rates on MMDAs have been
below rates available on virtually all market Intruments, although they remain
somewhat above the returns on money market mutual f u n d s .
69
Ranges and Actual Money Growth
M2
Range adopted by FOMC for
Feb /Mar. 1983 to 1983 Q4
Feb./Mar. 1983 to 1863 OP
2150
8.2percen!
Feb./Mar. 1983 to jnn<> 1983
2100
O I N i D
M3
Ran ge adopted by FCMC for
9tf2 Qd to 1S83 O4
J
I
F
I M
9 - ! percen'
70
Ranges and Actual Money and Credit Growth
M1
Billions of dollars
Rates of Growth
(annual rate)
Range adopted by FOMC for
1982 Q41o 1983 Q4
1982 Q4to 1983 Q2
13.4 percent
1982 Q4to June 1983
13 9 percent
O
I H
I D
1982
J
| J | A | S
1983
Total Domestic Nonflnancial Sector Debt
Range adopted Dy FOMC to(
Dec 1982 to Dec 1983
O | N
71
The recent behavior of other components of M2 also appears to reflect
the waning of the public's initial adjustment to the availability of MMDAs.
Runoffs of small denomination time deposits and M2-type money market funds,
which were substantial during the first quarter, have slowed considerably, and
in fact small time deposits registered a slight increase in June.
Savings de-
posits, which likewise had declined by record amounts earlier in the year, increased at a moderate rate in May and June.
For M3, the range selected of 6 to 9 percent was identical to that
for 1982.
It was believed that M3 would be less affected by the new accounts
because some of the funds flowing into them would come directly from large
deposits and, in any case, many depositories have the option of reducing their
Issuance of large CDs in response to greater inflows to MMDAa or other core
deposits.
However, the extent to which this would occur would depend in part
on changes in the public's perceptions of the desirability of insured deposit
accounts relative to open market instruments and the willingness of depositories to make use of their new deposit authority to increase the extent of their
financial intermediation.
In the event, large CDs In the aggregate declined
sharply in the months following the introduction of the new accounts, but
have tended to pick up recently as inflows to MMDAs have slowed.
Besides running off large CDs, commercial banks responded to the
Influx of MMDA funds by increasing their holdings of liquid assets, principally Treasury securities; commercial bank holdings of Treasury securities expanded at an annual rate of more than 50 percent during the first half of
the year.
Small banks in particular, which rely less on managed liabilities
than do large banks, invested heavily in these assets.
Savings and loan
72
associations appear to have relied largely on asset adjustments to MMDA
inflows.
These institutions showed a sharp acceleration in their holdings
of cash and Investment securities over the first quarter of 1983, and only
moderate declines in large time deposits.
In the second quarter, with slower
inflows to the new accounts and an apparent pickup In mortgage lending,
issuance of large time deposits by S&Ls registered a sizable increase.
The impacts on Ml of portfolio shifts into the new accounts are
difficult to assess, but would appear to have been largely offsetting.
Funds
shifted into Super NOWs from outside Ml likely were about equal in magnitude
to the outflow of funds from Ml Into MMDAs.
Nevertheless, Ml has been grow-
ing at a rate well above the 4 to 8 percent range that was set in February
and much faster relative to nominal GNP than has been normal during periods
of economic recovery, when velocity has tended to rise at above average
rates.
In fact, the income velocity of Ml continued to decline during the
first half of the year, although the second-quarter decline was modest.
The decreases In Ml velocity may reflect in substantial part the
changing nature of Ml.
With interest-bearing regular NOW accounts and Super
NOWs making up a growing share of Ml, this aggregate is becoming Increasingly
influenced by components that bear interest and thereby may attract "savings"
as well as transactions balances.
Indeed, there is evidence that the intro-
duction of nationwide BOW accounts at the beginning of 1981 has made Ml more
responsive to fluctuations in market rates.
With market rates registering
large declines in the latter half of 1982, the opportunity cost of holding
NOW accounts—which carry a ceiling rate of 5-1/4 percent—fell sharply.
73
As money demand usually responds to falling rates with a lag, this would
help explain the strong growth of Ml in the latter half of 1982 and early
1983.
More recently, however, some of the s t r e n g t h likely reflected growing
transactions needs accompanying the pickup in economic activity.
Given the
limited experience with NOW and Super NOW accounts, uncertainty surrounding
Ml behavior remains Substantial, but account needs to be taken of the possibility that more normal cyclical patterns may be returning.
Full data are not yet available for the second quarter, but preliminary indications are that the aggregate debt of domestic nonfinancial sectors
grew over the f i r s t half at a rate somewhat above the mid-point of the 8-1/2
to 11-1/2 percent range projected by the FOMC, with a marked increase In the
second quarter.
This aggregate was swollen by federal borrowing, which has
accounted for more than 40 percent of total credit flowing to domestic nonfinancial sectors since December.
As indicated in the accompanying table,
growth in federal debt has been very rapid in recent quarters, averaging in
excess of 20 percent at an annual rate over the last four quarters.
Residen-
tial mortgage financing and consumer credit have picked up since last year,
reflecting the strengthening of these sectors.
Business borrowing has remained
moderate due to reduced needs for external financing and has been concentrated
mainly in longer m a t u r i t y debt; short- and intermediate-term business borrowing
has been weak since the fourth quarter of last year.
Borrowings by state
and local governments were strong during the f i r s t half, as noted earlier,
partly reflecting heavy issuance of tax-exempt bonds in advance of the July
1 registration date and borrowing for future refunding of higher cost debt.
74
Domestic Nonflnancial Sector Debt
(Annual rates of growth, in percent) 1
Total
U.S.
Government
Households
Nonfinancial
business
Annually*
1979
1980
1981
1982
12. 1
9. 9
9. 9
9. 5
6 .0
11 .9
11 .8
19 .4
15. 1
8. 7
8. 2
5. 6
13. 5
10. 1
11. 3
7. 4
7 .4
9 .3
7 .0
13 .4
Quarterly^
1982
3rd quarter
4th quarter
10. 1
9. 8
24 .5
24 .5
4. 9
5. 9
8. 1
3. 7
9 .2
18 .2
9. 6
11. 4
19 .1
23 .0
7. 4
8. 5
5. 3
5. 4
13 .5
19 .1
1983
1st quarter
2nd quarter?
p—preliminary
1. Based on end of period data.
2. December to December.
3. End-of-quarter to end-of-quarter.
State and
local govt
75
Commercial bank credit, boosted by heavy acquisitions of Treasury
securities, has expanded at a 10-1/2 percent annual rate since December.
Reflecting the general weakness in business demand for short-term credit,
business loans at commercial banks were about flat over the first half, while
bank mortgage and consumer lending has picked up.
Some of the build-up of
Treasury securities could be a temporary response to strong inflows to MMDAs,
held as a hedge against possible withdrawals as rates on MMDAs remain below
market yields.
On the other hand, since some investors evidently shifted
funds to insured MMDA accounts from open market instruments, the increase in
investment holdings could mark a permanent increase in overall intermediation
by commercial banks, thereby raising bank credit above its normal range.
Indeed, as t h r i f t institutions likewise have become more competitive with
the Introduction of MMBAs, the share of total credit extended by all depository institutions rose appreciably over the first half of this year; about
40 percent of domestic nonfinancial credit was extended by depositories
during the f i r s t h a l f , compared with an average of less than 30 percent from
1980
through 1982.
During the first half, commercial bank acquisitions of
Treasury securities helped to absorb the massive Increase in Treasury financing, but, .as private demands for credit pick up in response to rising business
activity, such an absorption of Treasury debt may be more d i f f i c u l t within
the context of non-inflationary growth of the monetary aggregates.
76
The CHAIRMAN. Thank you, Mr. Chairman.
May I note the presence of a quorum. We have 13 out of the 18
members of the committee. The chairman is here, Senators Hecht,
Gorton, Mattingly, D'Amato, Trible, Proxmire, Riegle, Lautenberg,
Cranston, Sasser, Dixon, and Dodd. So we will be able to conduct
business and vote on your nomination at the end of your testimony
and questioning period.
CHRYSLER EARLY PAYOFF OF GOVERNMENT LOAN
Mr. Chairman, let me ask you a question first of all that is off
the subject of your testimony today but I think is important in
light of Chrysler paying their loan guarantees off early.
Senator John Chafee has told the Chrysler Loan Guarantee
Board, on which you sit, that if the Board fails to exercise its
Chrysler warrants he will introduce a bill to cut the Treasury's appropriations by $250 million, which is approximately the present
market value of the warrants.
Also, Senators Trible and Hawkins urged selling warrants last
June when the profit would have been in the neighborhood of $220
million.
If Chrysler offered the Board $250 million or the market value at
the time of the offer, would you be willing—your vote—to accept
that offer?
Mr. VOLCKER. The options in that area are under a very extensive review. Reselling the warrants to Chrysler is one possibility, if
the price were fair and equitable in relation to the market.
One additional question that arises in connection with selling to
Chrysler is, of course, Chrysler's cash and liquidity; we don't want
to leave Chrysler in a weakened position. We have a responsibility
to look toward the future viability of Chrysler, its performance in
the automobile market as a going concern, and that is a variable to
consider as to how much cash drain would be appropriate for
Chrysler to absorb in terms of the possibility of rebuying the warrants.
But all of those options are under very close consideration currently.
The CHAIRMAN. I understand that, but it seems to me that one of
the things Chrysler would like to do, which I certainly favor, is to
get out from under the Government so they can make market decisions and determine their own future. I was a great critic of the
loan guarantee program and voted against it. I still believe it was a
bad precedent, even though it was successful, and I'm glad that it
was; but nevertheless, it seems to me that if Chrysler is willing to
pay the market value, that at least in the opinion of this Senator
they ought to be allowed to do it, dissolve the Loan Guarantee
Board, and run their company as a private corporation without the
Government attempting to judge what they should do. And there's
sentiment within the Senate along that line, as I have mentioned.
The Government gets their profit and Chrysler gets back to running without Federal overseers.
So I can let you know there is some sentiment that fair market
value seems to be fair to the Government and fair to Chrysler, if
they are willing to do it.
77
Mr. VOLCKER. Let me simply say again that I think Chrysler is
essentially out from under the Loan Gu'arantee Board when it
repays its debt, but I think we all agree that disposal of these warrants at an early date would be desirable to just get the Government completely out of it. We don't want to carry the warrants in
an equity position over a period of time, and selling them back to
Chrysler is one option. It depends partly on the price.
Senator RIEGLE. Would the chairman yield at that point?
The CHAIRMAN. Yes, I would be happy to.
Senator RIEGLE. I would be very brief. I just want to say that I
strongly support what Chairman Garn has said here. I think the
time to resolve the issue is now and if an offer were to be made for
today's fair market value, I think that represents a very handsome
profit to the Government and the thing that I would be concerned
about in the alternative is if there is inordinate delay here and the
market can either go up or down and in a sense we put the Government in sort of a risk position of playing the market, and I'm
not sure that's wise.
The other point I'd make is this, and that is if one presumes if
Chrysler were to pay fair market value today for the warrants
themselves that they in turn can turn to the private market which
I think historically you have favored and I certainly favor, then
this is probably a good time for them to do that.
Mr. VOLCKER. It's clearly a possibility. They can pay for them by
taking them to the private market.
Senator RIEGLE. But it seems to me with this issue hanging over
everybody's head that becomes more difficult. So I would just like
to support what the chairman has said and I think fair market
price would meet anybody's definition of a fair resolution of the
problem.
Mr. VOLCKER. We haven't got that offer, by the way, I might say.
The CHAIRMAN. Senator Trible, I mentioned your name. Do you
wish to make any comment?
Senator TRIBLE. Only that I concur that the taxpayers assumed
substantial risks. Fortunately, the risk was well taken, but there
should be a reward. There should be a payment and I believe the
time has come for us to act.
The CHAIRMAN. Thank you.
HOW THE IMF QUOTA INCREASE HELPS THE UNITED STATES
Mr. Chairman, you briefly touched on the IMF and, as you accurately stated, it did come out of this committee and was approved
by the Senate. There's a good deal of opposition building in the
House of Representatives. I have had some questions, even though
I supported it all along until I found out Ralph Nader was against
it and now that reaffirms my feeling that it's something that we
should do.
But would you elaborate on the importance to our own economic
recovery? In other words, going back to why I supported it, there is
plenty of blame for banks in this country and in many cases their
loan policies, and if I could have figured out a way to punish the
banks without punishing the country, our own economy and jobs, I
would have done so. I couldn't figure out how to do that, how to
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separate it out, and I felt it was a much, much larger issue than
just the quick little political thing of let's not bail out the big
banks.
I would appreciate it if you would elaborate on the importance to
our own economic recovery of approval of the IMF quota increase,
Mr. VOLCKER. I would be glad to. Before I get to that point, if I
may make one further point about the banks, because I think it's
been one of the issues which raises questions in many people's
minds.
I think all of us have a lot to learn from the experience of the
past decade. As you well.know, this committee attached provisions
to the Senate bill dealing with supervision of banks in the future.
The bank supervisors have already taken steps to strengthen and
tighten supervisory and regulatory measures with respect to international lending by banks. I think it ought to be clear that that is
integral to the IMF legislation itself—the legitimate, necessary attempt to look ahead to deal with the possibility of the recurrence of
this problem.
So far as the IMF legislation itself is concerned, its importance
lies in the fact that the IMF is at the very center of the effort of an
international dimension involving hundreds of banks and dozens of
countries and central banks—both the debtors and the governments of the industrialized world—to achieve the adjustment that
is necessary to put this situation on a sustainable basis over time
and to provide the interim financing. The IMF is necessary to
make this a viable and orderly procedure.
The IMF is at the center of both aspects of that process. The adjustment process, in the first instance, and that they bring a little
money to the table—not to replace bank financing but to supplement and, indeed, provide the center for more. If that process
breaks down—and we are dealing not just with money but with the
intangibles of confidence and willingness to go ahead in this difficult area—if that process breaks down and we have a string of defaults by these countries, it clearly will impact back on the capacity of those banks in the United States that we are most directly
concerned with and on other major banks around the world to finance economic expansion. If their capital positions are weakened,
if their stability is cast in any doubt, the natural reaction is going
to be to cut back on other types of lending, particularly lending
that involves any kind of risk at all and a lot of lending does. It
will react back on the interest rates that they pay and must pay,
and the interest rates in dollar markets generally. It could react
back on the exchange rate. It could indeed lead to a flight to the
dollar that would damage our trade position.
I think there is a very substantial risk that a breakdown of the
effort to manage this debt crisis, in which the IMF is right at the
center, would feed back in a most adverse way on our ability to finance recovery, and I think that is the essential American interest
and the urgency in this bill.
RECENT DECLINE IN Mi VELOCITY
The CHAIRMAN. What, in your opinion, has been the cause of the
recent decline in MI velocity?
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Mr. VOLCKER. A structural reason is the fact that we now have
one-third of the deposits in Mi in the form of NOW accounts that
pay interest; that's new, only 2 or 3 years old. We had a decline in
interest rates last year that was quite sharp, as you know.
You would expect that during a period of declining interest rates
velocity might decrease, and that's been a normal cyclical pattern
in the past. We slow down from the trend, if not actually decrease.
Against historical experience, we have had the abnormal phenomenon of a sizable decrease for something like six quarters,
which is unusual. Part of the reason seems to be that as interest
rates fell sharply, the interest rate return forgone for holding M i .
in the form of a NOW account was cut very sharply. The Treasury
bill rate was as low as 7 or 8 percent for a while. NOW account
rates were a little over 5 percent, so the expense of holding money
was reduced to about 2 percent for people who had NOW accounts.
Under those circumstances, it's not surprising people want to
hold more in the form of NOW accounts than in the past, when
they only got zero interest on a demand deposit. That appears to be
a factor that may be changing both the trend and the cyclical characteristics of Mi.
I would not argue that that explains the whole thing by any
means. I think we had very difficult economic circumstances last
year. We had a big change in the inflation rate which was on the
plus side. The uncertainties in the business picture, plus the progress against inflation, could well have led to—in this case temporarily, I think—deciding to hold more cash, and that gets reflected
in a decline in velocity.
I would point out that in recent months, particularly, the speed
of the increase in Mi, while the NOW accounts tend to dominate—has also extended to currency and demand deposits. That is
one factor that raises the question about whether the speed isn't
indeed, too great. I think it is.
The CHAIRMAN. Well, if you get an increase in speed, could you
get a surge of spending again?
Mr. VOLCKER. Yes.
The CHAIRMAN. Even though money growth is slowed?
Mr. VOLCKER. Yes, you could indeed. Mi is only one indicator,
and we are looking at the broader aggregates and, in fact, putting
more emphasis on those.
M 2 had a very sharp distortion earlier this year when the money
market deposit account was introduced. But looking through that,
that behavior seems more normal in terms of past experience. A
surge in Mi velocity once again could be in line with cyclical experience. You have to be cautious about it. But we have not looked at
Mi alone. In fact, we have deemphasized Mi; the growth of credit
and the broader aggregates has been much more in line with our
intentions, and it suggests that the inflationary situation and the
economic situation will not be out of control because those other
indicators are performing quite "normally."
The CHAIRMAN. Senator Proxmire.
Senator PROXMIRE. Chairman Volcker, you just told the chairman of the committee, Senator Garn, that you're putting more emphasis on the broader aggregates, and you just say emphasis, and
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when you presented your statement orally I didn't detect what I
may have misread into your written statement.
In your written statement you indicate that the MI variable will
be monitored rather than targeted, as the case of M2 and M3. That
seems to me to be quite a difference and quite a change and if it is
not targeting it seems to me that I could challenge you perhaps on
whether or not you conform with the law which requires—and I
read now—"that the Board of Governors shall transmit to Congress
on February 20 and July 20, among other things, the objectives and
plans of the Board of Governors with respect to the range and
growth or diminution of the monetary and credit aggregates."
Doesn't that require that you give us a targeted range rather
than tell us you're monitoring it?
Mr. VOLCKER. I don't think so, but we're getting into semantics.
What we meant to indicate by that distinction between what we
call a "targeted" range and a "monitoring" range is a difference in
emphasis, which we reported before; that is, we are currently putting more weight on M2 and Ma and less weight, certainly than we
did earlier, on MI . That does not mean we ignore it.
Senator PROXMIRE. It does not mean what?
Mr. VOLCKER. It does not mean we ignore Mi. The growth in MI
has certainly been a factor in our policy decisions, but it's a matter
of degree, a matter of weight, and that's what's meant to be conveyed by this distinction.
Senator PROXMIRE. I don't disagree at all with the notion that Mi
had become a less measurable aggregate because of the super NOW
accounts which pay interest. But it seems to me one of the apparent reasons that you're monitoring rather than targeting is because you don't have that much control over Mi.
If that's the case, why isn't it appropriate for the Congress to increase the list of monitored variables to include interest rates or
nominal GNP? Interest rates, of course, is what the leader of our
party, Senator Byrd, and the leader of our party in the House, Majority Leader Wright, have advocated.
Mr. VOLCKER. I'm tempted to say that I think interest rates and
the nominal GNP get adequately monitored. The question of stating objectives for nominal GNP or real GNP or inflation in the
short run is the subject matter of appendix 2 of my statement. I
conclude there that while it is useful to set forth what we call projections or forecasts or assumptions of those variables, it would be
counterproductive to give them the weight, in the short run, of
something called objectives, for a variety of reasons that I try to
outline in the appendix.
Among other things, it leads to an illusion that the Federal Reserve can control things closely enough so that in a 6-month or 1year time period you can hit that kind of objective, to use the word.
Senator PROXMIRE. So you're saying that Mi is still an objective
but it's less of an objective than Ma?
Mr. VOLCKER. Yes. Less weight is put on it currently than M2
and Ma and more weight may be put on it later. If we had more
confidence in the velocity outlook, I think we would restore more
weight to it. It reflects a degree of uncertainty about the range of
assumptions one has to make about velocity. It's certainly watched
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and looked at and taken into account in policy. It's just a question
of the weight given to it.
MORE RESTRAINT ON RESERVE POSITIONS
Senator PROXMIRE. Now there was an interesting division of
opinion in the Federal Open Market Committee meeting on May
24. A majority of the members indicated that they favored marginally—and I quote—"marginally more restraint on reserve positions
for the near term." In your testimony today, however, you indicate,
and I quote, "a broadly accommodative approach with respect to
bank reserves appeared appropriate."
Mr. VOLCKER. That was before that meeting.
Senator PROXMIRE. What's that?
Mr. VOLCKER. Before that meeting.
Senator PROXMIRE. That's right. And indeed the base for MI was
moved forward and its percentage targets raised by one point.
What happened between the May 24 meeting and July 12 to persuade the Federal Open Market Committee to shift gears?
Mr. VOLCKEH. I don't think we shifted gears between May and
June or July. The actions since May have been in the direction of
somewhat more restraint.
Senator PROXMIRE. Since May?
Mr. VOLCKER. Since May, yes.
Senator PROXMIRE. Well, aren't you raising MI? Doesn't that
move in the opposite direction?
Mr. VOLCKER. MI was already raised by events.
Senator PROXMIRE. Well, you just announced today that you
raised it, or 2 days ago you announced it.
Mr. VOLCKER. We have accepted in effect the large upward movement in Mi over the first half of the year as a base for looking at it
into the future. That already existed.
The question was what was the meaning of keeping the old
target? Did we want to move so aggressively as to aim at getting
Mi back in that original target, which would have taken a reduction or virtual stability from now until the end of the year. Did we
want to aim for, essentially, a complete flattening out of Mi for the
rest of the year at a time when the other targets and the other aggregates were moving more or less in accordance with plan?
It is also true, whether one looks at credit or whether one looks
at the broader monetary aggregates, that they are showing some
symptoms of rising a little rapidly too.
Putting all this together, we turned toward a less accommodative
policy, but I think that's perfectly consistent with the rebasing of
Mi.
Senator PROXMIRE. During your May 24 meeting the Open
Market Committee voted to tighten somewhat its current monetary
policies, as I said. It's interesting to note that five of the seven
board members, including yourself, voted to tighten, while three of
the five Reserve bank presidents voted against that action.
I wonder if there's a message there. Does this mean that people
in Washington are less sensitive to problems of the economy compared to people in the field?
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Mr. VOLCKER. I don't think I would conclude that from that
single vote.
Senator PROXMIRE. Why not?
Mr. VOLCKER. Five out of seven Board members, two out of five
bank presidents in a particular vote
Senator PROXMIRE. Three out of five were against it. They
wanted to ease credit. They thought we needed lower interest
rates.
Mr. VOLCKER. I think you will find more unanimity in subsequent developments. [Laughter.]
Senator PROXMIRE. They got the message. [Laughter.]
In your confirmation hearing before this committee you indicated that a $50 billion reduction in the deficit could have a meaningful effect on interest rates, and I think that's very welcome kind of
advice that the Chairman of the Federal Reserve Board can give
us. We both realize it would be practically impossible to persuade
Congress to cut spending and increase taxes by $50 billion, but it
might be a little less difficult if we had a measure of the beneficial
effect of such an action.
What's your best judgment on this question? How much would
interest rates be likely to drop if Congress really could cut the deficit by $50 billion? It would give us a figure that would be very,
very helpful, believe me.
Mr. VOLCKER. I've looked at some of the evidence. Of course, you
get mixed numbers coming out of econometric equations. If you
talk about $50 billion from what it otherwise would be, you're talking about a quarter of the deficit. I just am very reluctant to give
you a figure. So much depends on whether that was taken as an
indication of
Senator PROXMIRE. Give us a range. Give us something.
Mr. VOLCKER. One percent more.
Senator PROXMIRE. One percent?
Mr. VOLCKER. Compared to what it would otherwise be.
Senator PROXMIRE. In other words, we might get a drop in the
mortgage interest rates or at least less of an increase of 1 percent?
Mr. VOLCKER. I would think in that magnitude anyway, yes. That
would be my own judgment, and I would guess more than that if it
were taken as a first step toward further progress, and that would
be very important.
Senator PROXMIRE. Well, that's very, very encouraging.
Mr. VOLCKER. It's a difference from what it would otherwise be.
BUDGET RESOLUTION AND MORATORIUM LEGISLATION
Senator PROXMIRE. Now the congressional budget resolution for
fiscal 1984—and Senator Gorton had a great deal to do with this—
requires both Banking Committees to report a resolution on monetary policy by September 30.
One of the assumptions behind this provision is any reductions in
the budget deficit brought about by the budget resolution would
reduce pressure on monetary policy.
Dp you think if the budget resolution actually achieves or will
achieve a reduction in the budget deficit that would reduce the
pressure on monetary policy?
Mr. VOLCKER. My interpretation of that would be in that direction if the budget resolution were followed literally. It goes some
distance in that direction, although some of the bigger changes are
delayed for some time. As already has been suggested by someone
earlier here today, there is great skepticism about whether even
the provisions of the budget resolution will be carried through on
the spending side and, perhaps even more particularly, on the revenue side.
As a matter of reporting what markets or others judge about the
budgetary outlook, there is a very large degree of skepticism and a
very large discounting as to whether the provisions of that budget
resolution will in fact be enacted.
Senator PROXMIRE. Do you share that skepticism?
Mr. VOLCKER. Let me modify that statement. I share it in terms
of what has happened so far. I have to remain optimistic that Congress will take a new look and in fact move more aggressively. I
expect that will happen at some point. The question is, how soon?
What I would hope is that with the economy expanding more rapidly with the evident threat that that presents for an earlier collision in the financial markets—in fact, I think we see some symptoms of that now—that the skepticism I just expressed will be overcome.
Senator PROXMIRE. My time is up, Mr. Chairman.
The CHAIRMAN. Senator Hecht.
Senator HECHT, Mr. Chairman, Senator Proxmire just spoke to
you and I spoke to you the last time you were here—you requested
the Congress cut the budget $50 billion. That was the first step you
said.
Now if this doesn't happen, do you favor tax increases?
Mr. VOLCKER. Yes. I consistently said if you can't do it on the
spending side, you should do it oh the revenue side.
Senator HECHT, Isn't this in opposition to the administration in
light of Secretary Regan's comments about the increased revenues
brought on by the robust recovery?
Mr. VOLCKER. It may be. I'm not sure. I would emphasize the
word "may."
Senator HECHT. All right. We'll go on.
Over the past 2 months I have heard from several financial advisers who are counseling their clients to stay on the sideline. Are
these recent actions by the Federal Reserve going to convince these
advisers that now is the time to get into the game, to get America
on a prolonged recovery?
Mr. VOLCKER. The advisers will have to make up their own
minds about that. I think we are in the midst of a recovery with
some momentum, as I said, and certainly our actions' are designed
as best we can to encourage a continuing recovery with the fundamental of keeping inflation under control; it's that balance that
you have to achieve.
Senator HECHT. I was surprised by your letter of support of the
Treasury's deregulation bill. Do you still support the moratorium?
Mr. VOLCKER. Yes. I think the moratorium should be enacted
promptly so that the situation can be held in place, so to speak, for
a limited period, while the comprehensive legislation which is
sorely needed can be debated and dealt with.
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Let me say our support for that legislation is based upon a long
series of discussions that we had. It fundamentally rests upon the
proposition that there will be adequate supervision of the entire
bank holding company, including the nonbanking activities.
Senator HECHT. What constitutes a limited time specifically?
Mr. VOLCKER. We proposed in legislation that you run the moratorium through the end of this year, on the assumption or hope
that perhaps you could act this year. I would hope that you would
act, if it's not possible this year, in a 9-month time perspective.
Senator HECHT. In your midyear report you state that there are
several factors which could disrupt a lasting recovery—deficits, inflationary expectations, and a series of financial problems that
plague the developing nations. In regards to developing nations,
you state that the debt problem had been contained through extraordinary cooperation between borrowers, private creditors, national authorities, and international organizations.
Has Brazil ceased to cooperate?
Mr. VOLCKER. No. Brazil has taken strong steps recently, and I
believe that they are now well on their way toward a new or revised agreement with the IMF that would create a foundation for
making the adjustments that are necessary and the provision of
the financing that is necessary.
Senator HECHT. Do you feel the latest money for the IMF will
bring about a recovery in Brazil?
Mr. VOLCKER. I think that this legislation is essential for the
IMF to continue to play this role and for people having confidence
that it will continue to play the role. The money isn't necessary, in
the short run, for Brazil or any other country. The quota looks
ahead to next year and the following year.
Senator HECHT. Do you feel this amount will be all that we will
be asked to contribute to the IMF?
Mr. VOLCKER. Not forever.
Senator HECHT. Let's say for the next year?
Mr. VOLCKER. For the next year, yes; for the next several years.
Senator HECHT. The next several years.
Thank you, Mr. Chairman.
The CHAIRMAN. Senator Riegle.
Senator RIEGLE. Thank you, Mr. Chairman.
GROWTH CHANGE BETWEEN MI AND THE ECONOMY
With respect to following up on the Mi discussion, so far this
year the growth has been about 14 percent, well above your target
that you had before, and now you have taken the target range up a
percentage point and next year you mean to crank it back a percentage point,
I assume that you're changing the base. In other words, you're
taking the 14 percent growth and fo'ding that into the baseline so
in effect you're measuring the new target off a changed base which
just now includes that larger burst of credit growth in that area
that's taken place. Is that right?
Mr. VOLCKER. Yes,
Senator RIEGLE. So if we wanted to, we could look at it really two
ways. We can take the new range which is 5 to 0 percent and we
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could look at that on the basis of this changed base, or I suppose, if
we wanted to, we could take and not change the base and go back
and make a calculation and then it would be higher?
Mr. VOLCKER. Yes. I made that calculation but I don't know that
I have it with me. You can obviously do that. You can get the same
result at the end of the year by not changing the base but by
changing the percentages.
Senator RIEGLE. If you have that, I'd appreciate your giving it to
us for the record. I would not ask you do the calculation now, but I
think that might be a little easier for people to try to make sense
out of what's happening here if we look at it both ways.
Mr. VOLCKER. Here it is. If we used the same base but changed
the ranges to get the same result, you would have a range of about
9.3 to 11.5 for the year as a whole.
Senator RIEGLE. I think it's useful to look at that because that is
quite a dramatic change from what we had before. You can argue
we needed that because of world change and the components of MI
have gone through a change, but could you just take a minute and
explain, if you take that higher figure, what would have caused the
very substantial jump up from the old target to the new target if
you stayed with the constant base?
Mr. VOLCKER. If I could give you an absolutely adequate explanation, we would be giving more weight to Mi. I can give you an explanation that goes in the right direction, but I don't want to pin it
down to the last percentage. Again, we think that one factor here
is the fact that NOW accounts have become the dominant form for
holding the transactions balance of individuals, and that probably
makes it more interest rate sensitive. When interest rates go up
and down over the cycle, you would expect bigger changes in velocity, and that probably changes the trend to some degree over time.
You've had a relatively long-term trend of Mi rising about 3 to 4
percent less than the GNP. I would not be surprised to find 10
years from now, looking back, that that trend would have changed
so that MI rises more rapidly relative to the GNP, but how much
more rapidly is, in advance of the event, very difficult to judge.
We would also expect that the payment of NOW accounts at a
fixed interest rate—they have a ceiling, except for the Super NOW
accounts—that may give more fluctuations in Mi for every change
in interest rates. You have a fixed rate in Mi, you have a market
rate that is fluctuating, and when market rates fluctuate it has a
disproportionate effect on willingness to hold Mi.
We now have Super NOW accounts. Looking ahead a little further, I think we're going to be proposing legislation to pay interest
on demand deposits, generally, without a ceiling. When you introduce that kind of change, it is going to change the growth relationship between Mi and the economy.
As a first approximation, you would think, if interest were paid
on demand deposits and on MI generally, MI ought to grow about
in line with the economy. It probably won't have much cyclical
fluctuation under those circumstances, if the interest rates go up
and down with the cycle. NOW account interest rates are not going
up and down with the cycle, but once those interest rates are freed,
they will presumably go up and down with the cycle.
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You may have a situation—we don't have it yet and I can't prove
it because we're not there yet—of Mi growing much more in line
with nominal GNP in the future, once that further change is made.
DANGER AHEAD IF DEFICIT NOT CUT
Senator RIEGLE. I think that's a helpful explanation.
Let me move to something else in your statement that I think is
very important. Starting on page 3, and I'd ask you to respond as I
go along here, but it seems to me that what you have given us here
is a very strong warning today that our financial house is not yet
in order and that there are some real problems that have to be
dealt with if we're going to get the kind of future economic performance that we want.
Mr. VOLCKER. I'm trying to make the warning as strong as I can
responsibly make it.
Senator RIEGLE. Without scaring people to death.
Mr. VOLCKER. Yes.
Senator RIEGLE. The tightrope you're on of trying to maintain
confidence and help create a more positive confidence and at the
same time be realistic about the dangers is a very difficult assignment and I appreciate the difficulty of it.
But I want to draw attention to three or four things you said
here because I think the statement that you have given the committee today, the prepared statement, is the strongest one that I
have seen you give yet in terms of highlighting the dangers and
the concerns you have and giving us a warning about some policy
changes that need to be made, and I just want to touch on two or
three points here.
On page 3, you say here, "the underlying or structural position
of the budget will deteriorate without greater effort to reduce
spending or increase revenues." We talked about that before. You
say here, "We would be left with the prospect that Federal financing would absorb through and beyond the mid-1980's a portion of
our savings potential without precedent during a period of economic growth."
You go on on the next page and you say in summary of the next
paragraph, "To put the issue pointedly, the government will be financed, but others will be squeezed out in the process." I think
that's a very clear expression of your concern that if things are not
altered that's the box that we are in and the problem we face inevitably without further policy changes.
Then you go on to say, "While that threat has been widely recognized, there has also been a comfortable assumption that the problem would not become urgent until 1985 or beyond." I'm repeating
what you have given us this morning. You say, "That might be
true in the context of a rather slowly growing economy." Then you
say, "But the speed of the current economic advance certainly
brings the day of reckoning in financial markets earlier." And that
means that this is a serious problem and it's closer in, and I appreciate your honesty in saying so, and that may well mean that it
could be prior to 1985 which is with specific reference to the reference you make in the prior line.
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You then go on to talk about the only way we're going to be able
to continue to finance this deficit that we're running is with foreign money which we are doing at least on a short-term basis is if
we continue to run a deep trade deficit. That's contained in the
next paragraph.
You go on to say that there's been some tendency for overall
measures of money, liquidity and credit to rise recently at rates
that, if long sustained, would be inconsistent with continuing or
even consolidating progress toward price stability, and you get into
the price-wage concerns you have a little bit later on.
But then you say, "All of this, to my mind, points up the urgency"—your word— 'urgency to reduce the budgetary deficit" and
you continue in that vein. "Left unattended, the situation remains
the most important single hazard to the sustained and balanced recovery we want."
Then you go on to speak about the IMF problem, the wage and
price problem. I might just say parenthetically, I don't find much
in here on unemployment. I think there ought to be more. I say
that as a suggestion to you.
But the bottom line of what I'm getting here and your statement
is is that you're putting the committee and the Congress and the
country on notice that we have to make some additional major financial adjustments here if we're going to be able to have the outcomes we want; namely, lower inflation rate, lower unemployment,
and economic growth, a sustained economic recovery.
Is that a fair summary of what you're telling us?
Mr. VOLCKER. Yes; and I particularly appreciate the emphasis on
the need for early action, because I think we have deluded ourselves—particularly against the background of the speed of the recovery—that this problem can wait.
Let me give you some figures for growth in credit in the second
quarter according to our preliminary estimates, which I think illustrate the problem. The total amount of credit to the domestic nonfinancial economy went up by about $100 billion, a pretty big jump,
in the second quarter. These are all seasonally adjusted annual
rates.
The U.S. Government went up about $50 billion. As I recall it,
the Government borrowed something like $40 billion last quarter.
That's supposed to be a quarter of seasonal surplus. Far from being
a quarter of seasonal surplus, the Government had to borrow $40
billion.
What's listed here as private nonfinancial—mainly mortgage
credit and consumer credit—went up about $45 billion, almost $50
billion, in the second quarter.
The nonfinancial businesses went up hardly at all; they were at
a low level. That's not atypical in the early stages of recovery.
State and local governments went up quite rapidly.
What happens when the nonfinancial business begins borrowing
to support recovery—which they are going to do sooner or later
and more so the more rapidly the economy expands. The current
level of their borrowings is about $50 billion below what it was last
year when the economy wasn't all that strong. It's $100 billion
below what it was in the second quarter of 1981. It is at recessiondepressed levels.
What happens when that changes and Government borrowing
hasn't subsided but continues to go up, and presumably mortgage
credit will continue to go up and consumer credit will continue to
grow in an economic expansion? What happens when you get that
swing-around in business credit? There isn't any room for it, not
within our credit targets, not within our monetary targets.
Senator RIEGLE. Well, I'll just conclude by saying there are some
people today who feel that now—and I think it's partly reflected
even in the big uptake in the market yesterday, but more and
more you hear it—that now we're into such a strong recovery
phase that we don't really need to do anything else. In other words,
there are no more major financial policy changes that are needed,
that this whole thing now is going to take care of itself, and what I
hear you saying in the most moderate way that you can phrase it
with words, is that that's not the case.
Mr. VOLCKER. I tried to say it in the most forceful way.
Senator RIEGLE. And that other major financial adjustments are
needed here.
Mr. VOLCKER. Yes.
Senator RIEGLE. Thank you.
The CHAIRMAN. Senator Gorton.
CREDIT, WAGE DEMANDS, AND PRICES
Senator GORTON. In a sense, following up on what Senator Riegle
has said and one of Senator Proxmire's statements as well, we tend
often to treat the Chairman as the Federal Reserve, but as Senator
Proxmire pointed out, occasionally there are differences among
members of the board.
I'm interested in the rather arcane and mysterious nature of the
exercise you follow in arriving at target ranges for money aggregates and credit aggregates.
Looking at credit for a moment, how do you arrive at a number
which you think to be a desirable expansion of credit and how do
you decide how accommodative to be to such things as an increase
in Federal financings?
Mr. VOLCKER. This is a difficult question because this is the first
year we've targeted aggregate credit and so, in a sense, we are still
learning in that area.
But if you look at that particular aggregate that we are now targeting, its long-term trend is very close to the trend in nominal
GNP. There are some cyclical fluctuations in all these things, but
the trend over a period of time is flat.
I think you start with the presumption that that trend is going
to continue. That trend has been as stable as any of these trends in
relationship between financial aggregates and the nominal GNP
over a long period of time.
We looked more closely as to specific influences this year, such
as the Government deficit, the financing picture of businesses, and
so forth, and we tried to reach some conclusion as to what is tolerable, in connection with the kind of economic outlook you would
like to see of recovery and declining inflation.
As I indicated in the statement, some of that analysis suggested
that this year credit might reasonably rise more rapidly than GNP.
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That gives me a little concern, simply because you start with the
presumption that the basic trend is not much different and that
may be perfectly acceptable for 1 year and the range encompasses
the area of nominal GNP. But we want to look at that pretty hard
next year and in the future, because I wouldn't want to contemplate that rising faster than GNP over a period of time. That would
imply certain peculiarities and weaknesses in the financial structure, or excess liquidity and inflation. I think those are some of the
considerations that we brought to bear.
Senator GORTON. In February when you testified, you emphasized the importance of moderation in wage demands in keeping
the rate of price increases down. That raises two questions in my
mind.
First, are wage increases a symptom or a cause of inflation?
Mr. VOLCKER. That's been argued interminably through the
years and I would say in some circumstances it is one and in other
circumstances the other. I don't think they are particularly an independent cause; that's probably been true for a decade or more.
But they can be a very powerful factor in maintaining an inflationary momentum once started. I think that was certainly true in
recent history. Other times it may have been a more independent
cause.
But what I am concerned about now is that we are coming off
the period of 10 years when roughly a 10-percent wage increase
became quite normal. That was understandable in the context of
accelerating inflation. But if people really think that is normal and
they want to go back to that kind of a pattern, then you pose a
very striking conflict between monetary growth, credit growth that
seems desirable in terms of holding inflation under control, and the
amount of money that's required to finance that kind of wage increase. The net result would be very unsatisfactory economic performance and you would end up with lower real wages and unemployment and all the rest.
How do you approach that problem? The wage trend has been favorable—favorable in both senses of being low in nominal terms
but growing in real terms—and that's what you want. You want a
situation where wages are moving toward a noninflationary level
in nominal terms but where the average worker has more real
income. That's what we have had for the past 18 months. We've
had that combination for the first time in more than a decade.
We've had an increase in real income for the first time in 4 years.
If we can keep that process going, then in a sense, we've won.
How do you do that? I would emphasize two things. We haven't
been very successful in doing it directly, through the so-called incomes policy, but I think you have a posture of public policy—monetary policy and fiscal policy—that says to the world we are not
going to stand for a resurgence of inflation, so don't expect that.
Nobody is going to be completely convincing, given the attitude of
the last 10 years, but we can certainly move in that direction. We
must be as convincing as we can be. The more time that passes, the
more convincing we can be.
The second thing we can do is make sure that we are not aiding
and abetting the process in terms of our own trade policy by just
looking at our own interest. Throwing on import quotas every time
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an industry gets in trouble is not giving the right signal, in my
opinion. We can look to a whole string of domestic measures that
have been in place for years and years that one would hope, in an
expanding economy, could be alleviated or eliminated. The old
Davis-Bacon kind of approach, the Government Services Contract
Act kind of approach, are striking examples. A little progress has
been made recently in easing some of the repercussions administratively.
You could argue, and it has been argued in the past, that raising
the minimum wage too rapidly tends to ratchet this up. I think
that danger has been avoided recently. But there are many other
areas where attention can be given to internal competition, so that
a firm can see rather directly the repercussions of its own actions
in excessive pricing or excessive wages is going to hurt its competitive position. If that message isn't there, then there's no incentive
for restraint.
Senator GORTON. From the first time that I've heard you until
right up to 15 or 20 minutes in answer to an earlier question, you
have indicated a strong preference for closing the Federal deficit by
reducing spending, but you've gone on to say that if tax increases
were the only available tool or were a proper combination tool,
then that was a better course of action than allowing large budget
deficits to continue.
Does that general opinion on tax increases extend to indexing
personal income tax rates? In particular, do you feel that repeal of
tax rate indexing would send some kind of signal to the economy
that Congress was not serious about fighting inflation?
Mr. VOLCKER. I know there are strong arguments on both sides
and I'm sympathetic to some of the arguments for indexing. But,
on balance, I would prefer not to have tax indexing.
Senator GORTON. Finally, in February you testified also before
this committee that the great liquidity created by new money
market deposit accounts would show up as reduced bank lending
rates. Indeed, at that time, you suggested that it was beginning to
happen.
What happened to that interest rate decline and why?
Mr. VOLCKER. I think market rates were stable since that time
until recently. With the recent increase in market rates, I don't
think you can say that bank lending rates are high relative to
market rates currently. I think you could make that case in the
context of our earlier discussion last fall during certain periods.
But market rates stopped going down when the prime rate got reduced to 10.5 percent; based upon past relationships, it didn t look
particularly high relative to market rates. That s certainly true
now, much more so than in February or whenever we met before.
Senator GORTON. Thank you, Mr. Chairman.
The CHAIRMAN. Thank you, Senator Gorton.
Before I turn to Senator Lautenberg, I would think it might be
wise to warn the committee of a procedural problem. Due to the
defense authorization bill on the floor and the difficulties we've
had there, I've been advised that each day there has been a routine
objection to committees meeting past 12 o'clock; so, I just wanted to
let my colleagues know that. We will also have a cloture vote sometime in that period. So, we do have a time deadline of noon. I'm not
91
trying to preclude anybody from talking. It's just a warning that
we have some procedural problems beyond the control of the committee.
Mr. VOLCKER. I might say to Senator Gorton, just looking at
some numbers here, that consumer lending rates did continue to
come down through the spring somewhat, at commercial banks.
The CHAIRMAN. Senator Lautenberg.
Senator LAUTENBERG. Thank you, Mr. Chairman, and I take your
caution personally and thank you very much. My comments and
my questions will be fairly brief. Unfortunately, one of the disadvantages of arriving on the seat here late—and I don't mean this
day, I'm talking about my seniority—has one asking questions
after many of the good ones have been presented, but I just have a
couple that I'd like to review.
i.
FULL EMPLOYMENT AND PRODUCTIVITY STILL FAR OFF
It's very obvious, Chairman Volcker, that I think Senator Riegle's comments were those that you agree with very correctly and
that is that through this optimism or perspective on the rapidly
growing economy that there are warnings, there are concerns, and
I think even in your written testimony when you say there should
be no assumption that monetary policy, however conducted, can
itself substitute for budgetary discipline; that while we have the
chance to continue with the recovery, the risks are indeed great
and that we should not expect, if your comments are clearly understood, that monetary policy can substitute for anything other than
the set of natural adjustments that have to take place, including
the reduction of the debt.
Is your voice heard in the White House or in the policymaking
centers on fiscal policy? Is there communication directly or, as I
said in my opening statement, are you expected to pick up the
problem and, like a good soldier, knowing full well that indeed the
battle may be a futile one?
Mr. VOLCKER. My views are no secret, and I have expressed these
views on many occasions. They are the same privately as they are
publicly. I think you have witnesses from the administration later
who can tell you how they listen and what their own views may be.
Senator LAUTENBERG. In that connection, I think we have some
testimony coming from Chairman Feldstein who says in his comments, "I think that the Federal Reserve policy announced yesterday by Paul Volcker bringing Mi growth rate down to the 5- to 9percent range for the remainder of the year is appropriate." He
goes on to say that it's very important to bring the actual Mi
growth rate down to this range.
If I heard you correctly, I think you see the Federal Reserve
acting more in a monitoring position, rather than aggressive limiting of the growth rate. Do I understand that correctly?
Mr. VOLCKER. No; I wouldn't say that, looking at the aggregates
generally. Again, it would depend upon the performance of all of
them viewed as a whole. We would certainly be more aggressive if
the general tendency was to rise. If we had one aggregate that was
out of line and the others were clearly within line, I think we
would be less aggressive, but we would have to look at all of them.
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Senator LAUTENBERG. I was interested in your response to Senator Gorton's question about whether wage increases might follow
or lead, and I think there's always a debate about that, whether, in
fact, wages lead or lag price increases. It's my view that labor has
taken a big chunk of the recession results that we have seen and
that we are just now beginning to see I think some price decreases
or price restraint catch up with that.
However, I hear that the increase in purchasing power of real
wage increases is limited to a very small segment of our society. In
fact, I think it kind of counterbalances out to 30 percent of our
people are enjoying about 65 percent of the real purchasing power.
Are you aware of those figures?
Mr. VOLCKER. I haven't got a breakdown of those figures, but if I
might comment, you say labor has borne the brunt of the recession.
It has certainly borne the brunt in terms of unemployment. Looking at those working, these averages say that those who kept a job
have been better off, and more better off than they've been for
some years; that there has been a real increase in average wages.
My impression is that that has been rather widely dispersed.
Senator LAUTENBERG. That's true with the exception of a very
important factor, and that is that there are more people out of
work for a longer period of time than we have ever experienced.
Mr. VOLCKER. Clearly, there is a severe unemployment problem.
Senator LAUTENBERG. And the prospects of returning to either
the jobs they held or new jobs is relatively grim. We don't see the
kind of robust return to employment that is apparent in the
growth in the economy.
Mr. VOLCKER. Employment has been increasing pretty fast recently. The unemployment rate is down about 1 percent, but employment is up over 1 million, as I recall the number, in 6 months.
Of course, it's important to keep that process going and to get an
increase in the labor force during this kind of period.
You see on an industry level that restraint on cost generally and
on wages in particular, to keep an industry competitive, is going to
be favorable to employment in that industry.
The automobile industry, the steel industry—very high wage industries compared to the average—have clearly had competitive
problems. They have clearly had unemployment problems. The
competitive problems are related to the unemployment problems,
and the more that can be done in terms of those competitive problems, the better off all the workers will be in that industry, including those presently unemployed.
Senator LAUTENBERG. Unfortunately, what's happening I think is
that rather than go to a responsible fiscal policy, raising the revenues, watching our expenses carefully, I think there is a tendency
now to believe that we can substitute trade restrictions and other
kinds of restrictive policies for that, and it gets to be a popular
theme, but I think ultimately does not get a very positive result.
Mr. VOLCKER. I think it works against the very employment and
real income objectives we need, if it leads to noncompetitive industries.
Senator LAUTENBERG. Chairman Volcker, just one more question.
This afternoon we have Professor Blinder testifying. He's going
to say that it's premature to be concerned about a rekindling of in-
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flation now. He maintains "that it would take 2 to 3 years of real
growth at a 6-percent rate before we begin to approach the full employment zone."
What do you see in terms of capacity constraint kind of problem,
given the pace of recovery?
Mr. VOLCKER. It's going to take some time to return to what you
think of statistically as full employment or a high level of capacity
utilization, but I have to disagree entirely that you don't worry
about inflation during this period.
We have learned, I would hope, from long experience that we
have to worry about inflation all the time or it's going to get ahead
of us and then it's much more difficult to deal with.
Senator LAUTENBERG. Keeping my promise, Mr. Chairman, I
yield up my time before I get the white slip.
The CHAIRMAN. Senator Mattingly.
PUBLICITY OF Mi AND TAX INDEXING
Senator MATTINGLY. Mr. Chairman, with all the discussion about
MI which has constantly gone on ever since I have been in Congress, I guess it depends on which side of the issue you're on that
particular day, but the "M" may want to stand for manipulation. I
think some people have accused others of wanting to manipulate
Mi or said Mi's been manipulated, but I'm glad to hear you say
there's going to be less emphasis placed upon M,.
My concern is that the debate that's constantly gone on about
MI, the coverage given by the press on Mi, terrifies the business
sector, because no one knows what to expect.
My question to you is, why doesn't the Fed abandon the use of
MI or use a more reliable indicator such as M2?
Mr. VOLCKER. Through the years, I think it's fair to say that Mi
has been a reasonably reliable indicator, probably more reliable
than some of these other indicators. We do not believe that is the
case right at the moment because of the uncertainties. That's the
reason we have deemphasized it, but not forgotten about it, and we
will appraise developments in Mi and see whether it returns to a
more predictable relationship.
Senator MATTINGLY. You say it's been deemphasized, but that's
never the way it gets played in the media. When the people look at
it, they very seldom see anything about M2 or Ma- It's always Mi.
Mr. VOLCKER. There's certainly more attention paid to Mi possibly because we publish it weekly while data for the other aggregates is not publishable weekly, but I would think the emphasis on
MI recently has not necessarily reflected a basic increase in emphasis on Mi, but simply the fact that it's been running as high as it's
been running. If it were running 9 percent or 8 percent, it would
still look high historically, people probably wouldn't be looking at
it as much as they do when it's 12, 13, and 14 percent. That's consistent with deemphasis.
I think what's gotten people looking at it a bit is that rapid
growth has now persisted for quite a period of time. It is, in my
view, evaluated together with other factors, a source of concern—
not just looking at Mi alone, but looking at it in the context of
other things going on.
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Senator MATTINGLY. Since I have been in the Congress, MI has
always had erratic growth, if we look back in 1981 and 1982. What
about the possibility of publishing these figures less frequently, because it does have an impact on the financial market. I think
maybe the stock market yesterday may be the latest indicator of
the market interest in monetary policy.
Mr. VOLCKER. I have railed against these weekly figures before
and so has the chairman of the committee. The only problem is we
would probably be worse off with the speculation that would take
place if we didn't publish them weekly. We're not dealing with a
situation where Mi has gone up at a 14-percent rate for 2 months.
It's gone up at that rate on the average for 6 or 8 or 9 months.
That's an entirely different perspective. If it had just been a very
brief period, it probably would have little attention. I think at some
point it should get some attention. We have not given it the same
emphasis that we gave it earlier, but, again, that doesn't mean zero
attention. We don^ put blinders on when we look at the numbers.
Senator MATTINGLY. I don't want to beat that to death, but possibly you're not giving it the attention, but yet people on the outside
read newspapers and watch TV and listen to the radio and the emphasis is on Mi. You don't hear anybody talking about Ma or Ms,
never. Why don't you consider using some other measure other
than Mi?
Mr. VOLCKER. We do.
Senator MATTINGLY. I meant dropping possibly MI out or making
it
Mr. VOLCKER. I think it would be misleading. In my personal
opinion, it would be misleading to drop Mi because while there is
attached to it the need to interpret these recent movements, and
while we have in the light of that uncertainty, deemphasized it,
I'm not ready to say it is entirely meaningless, when the movements are as large as they have been for as long a period—and it
takes both of those things. Still, it's a matter of degree. We're certainly not reacting to Mi alone. We are looking at it in the context
of all these other indicators; our basic targets remain M2 and Ma.
Senator MATTINGLY. On the question of taxes, I believe you said
you were opposed to tax indexing; is that correct?
Mr. VOLCKER. On balance, yes.
Senator MATTINGLY. Are you opposed to the indexing that was
passed, the indexation of the taxes—are you opposed to what we
did 1 Vz years ago?
Mr. VOLCKER. Yes. To put that in context, I don't like the tendency toward indexing in general and, in that general context, I
have been reluctant to see tax indexing. I expressed that at the
time it was passed.
Senator MATTINGLY. OK. In your future dealings with the President, are you going to recommend to him the repeal of tax indexing? Are you going to recommend to him that we raise taxes, because you said earlier that we need to raise taxes?
Mr. VOLCKER. I recognize that the President has a very strong
view on tax indexing.
Senator MATTINGLY. That's right. I do, too.
Mr. VOLCKER. I think he is, as I understand it, quite committed
to that course. You asked me for my personal opinion and I gave it.
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Senator MATTINGLY. Will you be going to the White House or
will you be talking about it with him?
Mr. VOLCKER. My view on indexing is known, and my view on
the necessity for some revenue increases, if expenditures can't be
reduced in the dimension we're talking about, is well known. It's
not new. I talked about it in the White House.
Senator MATTINGLY. We don't have much impact on monetary
policy in the Congress but we do have an impact on the fiscal
policy. We certainly ought to leave monetary policy to you. But in
the fiscal policy arena—and you and I have talked about this—we
need to reduce spending.
Why do you want to go back to the way it used to be that got us
in all the trouble in the first place?
Mr. VOLCKER. I shouldn't be getting into the details of fiscal
policy. That is, indeed, your job. My emphasis is on the fact that
these deficits are too big, and that you should deal with them however you can. My basic economic judgment is, to the extent you can
deal with them through spending, you're going to have a better
economy. You asked me my judgment. If you tell me that's not possible—as some people tell me that's not possible or only possible to
some degree—and you're faced with the dilemma of not having reduced spending far enough, do you then accept the budget or do
you increase revenues? If you're faced with that problem, I recommend you increase revenues.
Senator MATTINGLY. You're for the fiscal year 1984 budget resolution that passed the Congress?
Mr. VOLCKER. The budget resolution involves a lot of particular
judgments about particular programs. I have nothing to say about
them, and properly have no recommendation about them. The
budget resolution, literally enacted, just looked at from what comes
out of the other end of the sausage grinder, so to speak, would
make some progress toward reducing the deficit, and I think that is
constructive.
Senator MATTINGLY. Do you think there could be a comparison
made between the budget resolution and MI, in that both of them
ought to be deemphasized?
Mr. VOLCKER. I think the budgetary process is a disciplining
process and hopefully will be retained. That's a process, not a
result.
Senator MATTINGLY. Thank you.
Thank you, Mr. Chairman.
The CHAIRMAN. We do have a vote. It's on a motion to instruct
the sergeant at arms to establish a quorum and will then be immediately followed by the cloture petition. Senator Sasser is next. Do
you want to come back, or do you want to question until we get the
five lights? It's your choice.
Senator SASSER. Mr. Chairman, why don't I question until we get
the five lights and maybe we can at least get my questioning period
behind us.
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GOAL IS FOR A MODERATE, SUSTAINED RECOVERY
Mr. Chairman, you said a moment ago in response to a question
from my friend, the distinguished Senator from Georgia, that you
really shouldn't be advising us on fiscal policy.
Well, I disagree with you, because I think your counsel on fiscal
policy to the Congress and to the administration can be very important.
In my view, one of the problems that we have now is that we
have been operating our fiscal policy on one track and monetary
policy on another track, and I think that has gone a long way
toward putting us into the economic difficulty that we have encountered over the past 2 or 3 years. And I, for one, am delighted
to get your views on the question of indexing because I have been
long concerned about how you could index on the payout end with
the entitlement programs, gear them into the Consumer Price
Index and raise them, and on the same level, on the revenue end,
index that. It appears to me that you're really burning the candle
at both ends about indexing on revenues and payouts.
So I, for one, am glad to get your views on matters affecting
fiscal policy.
You stated during your testimony last week before this committee that we were experiencing an average economic recovery, running, according to the figures I have, the first 6 months of this year
at 4.6 percent, accelerating some now.
Now some disagree with that because the average of real GNP
growth in all other postwar recoveries has been about 8.5 percent.
Mr. VOLCKER. I don't think that high for the first year of recovery; about 7 percent, as I recall.
Senator SASSER. We're talking about the first 6 months.
Mr. VOLCKER. The first 6 months? So much depends upon a particular quarter when you have a period of only 6 months.
Senator SASSER. I think we will agree that this recovery has been
slower getting underway.
Mr. VOLCKER. The first quarter was slower than is typical. The
second quarter, I think, was a very strong quarter and the third
quarter is likely to be high, too.
Senator SASSER. You stated that Mi will grow between 5 and 9
percent for the balance of this year and it's grown so far this year
at the rate of about 14 percent—13.9 percent, I think would be
more accurate.
Now what is this new monetary policy going to do to real GNP
growth during the next several months? Can you make a strong
case that this is going to reduce our real GNP growth?
Mr. VOLCKER. I would not call it a new monetary policy, but as I
just said, I think we went into the third quarter with a good deal of
momentum and I would expect a rather large GNP growth during
the third quarter. I would also expect that thereafter it would probably slow down. It can't continue at that rate of speed and, on balance, in the interest of the sustainability of the recovery, it
wouldn't be desirable to continue at the same rate of speed as the
second quarter. That's fine for a quarter or two.
Senator SASSER. We've got a long way to go, I think, Mr. Chairman, to get back to where we were.
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Mr. VOLCKER. We do, indeed, have a long way to go, and, if I may
just make that point, I want to get there. I don't want to go very
rapidly for a couple quarters and then get turned off. We are not
going to make it in a couple of quarters. I want to be able to keep
it on the long road.
Senator SASSER. Well, I want to stay on the long road, too, but I
don't want to get overly euphoric because we've had a couple of
good-looking quarters here.
Mr. VOLCKER. Neither do I.
Senator SASSER. Looking at the rate of business failures year-toend June 30 this year compared to June 30 last year, we've got a
26-percent upkick in business failures; 1982, through June 30 of
that year, 11,948 business failures; through June 30, 1983, 15,137.
So I don't want to see us tighten this monetary policy down too
quick, too fast, and abort this recovery.
You indicate in your monetary report—I quote from it—"The
Federal Reserve Board, for its part, remains committed to monetary policy that will provide enough money and credit to support
economic growth in the context of containing inflation."
Mr. Chairman, I question you as to what the Federal Reserve
Board's target is for containing inflation. What is an acceptable
rate of inflation that wouldn't trigger a further tightening of the
money supply?
Mr. VOLCKER. I'll just give you a very personal view looked at
over a much longer period of time than the horizons of this statement. I think we ought to get the inflation rate down to the point
where we can say there isn't any inflation, basic stability. That
doesn't mean no change in the price index in any particular year,
particularly during a period of recovery; it means, whatever the
precise statistics are, people should not be planning on inflation.
They ought to be living in a context where they think the dollar is
better and it's going to be stable, now and in the future, where
they don't plan on price increases. I think that's healthy for the
long-term growth of the economy.
We're not going to achieve that in the next few years.
Senator SASSER. That's an ideal world and I think both you and I
would agree that we can't really manipulate monetary policy looking in the direction of hoping realistically for zero inflation, can
we?
Mr. VOLCKER. Not in the next few years.
Senator SASSER. Well, we haven't been able to do that in the last
50 or 60, have we?
Mr. VOLCKER. We did it pretty well for a good many years in the
1960's. It wasn't bad in the 1950's. We had a little inflation in the
1950's, but not really enough to worry about, although we used to
worry about it in the 1950's. That's when I began as an economist
in the Federal Reserve. It went up to 2 or 3 percent at times and
we worried about it. But the trend during the 1950's, on the average, was between 2 and 3 percent, maybe lower, and when it gets
that low it begins to be hard to tell that there is any inflation, although that was on the edge of it. You get quality changes—the indexes aren't perfect, and all the rest. You might have stability in
the wholesale price index which would be a pretty good indicator of
no inflation. We haven't had any change in the wholesale price
98
index now for the first half of this year, but that was at the bottom
of the recession. If we could achieve that during a period of recovery, or on the average over the years, we'd be home free, but I recognize that having achieved that in the first 6 months of this year
is not an indication that we are home free, because that was close
to the bottom of a recession.
Senator SASSER. One quick final question, Mr. Chairman, if I
may.
In a recent article, a Washington Post reporter, John Berry, reported that Dr. Martin Feldstein—I see him in the room here—who
will testify later, believes that high real interest rates are already
producing a "lopsided economic recovery" with interest-rate-sensitive and trade-oriented sectors of the economy facing much weaker
growth than other sectors of the economy.
And we see now that home mortgage rates are once again punching up close to 14 percent, that homebuilding is starting to decline
and fall off again, in the last numbers coming out the month of
June.
Do the new monetary targets now announced by the Federal Reserve Board remedy this problem?
Mr. VOLCKER. No.
Senator SASSER. Are they concerned about that problem, Mr.
Chairman?
Mr. VOLCKER. I have been one of those who has consistently and
persistently and strongly pointed to the danger of overly large
budget deficits and, as you point out, the danger of a lopsided recovery. That's the same message that I've been trying to give here,
and it's nothing that can be cured by monetary policy.
The budget deficits—unless they're corrected—are going to take
an extraordinary part of our savings. In the end, those same savings are needed to finance home building. If you're worried about
home building, you ought to be at the beginning of the parade to do
something about the budget deficit, because there's just a conflict
in the market between extraordinarily large budget deficits and
mortgage needs generated by a strong housing picture.
Senator SASSER. Thank you, Mr. Chairman.
The CHAIRMAN. Senator Dixon.
Senator DIXON. Mr. Chairman, I'm going to waive my questioning of Chairman Volcker to accommodate the chairman who otherwise would have to wait until we return from the vote. May I ask
when will we vote on his nomination?
The CHAIRMAN. Well, I appreciate that because we will have this
vote and another one, and I'd hate to hold the Chairman, but I
would hope the committee would return immediately after the vote
on cloture so we could hold our vote, and I will encourage all committee members to do that.
I will announce, because of the difficulties we have had on the
floor, that we will have no additional witnesses this morning. Mr.
Sprinkel, Mr. Blinder and Mr. Meigs will come back this afternoon
at 2 o'clock and Mr. Feldstein will be rescheduled at 9:30 in the
morning.
Thank you very much, Mr. Chairman. We appreciate your testimony today and hopefully we will have a recommendation on your
nomination within an hour.
99
The committee will stand in recess for about 30 minutes.
[Whereupon, at 11:10 a.m., the hearing was recessed, to be recovened at 2 p.m., this same day.]
AFTERNOON SESSION
Senator GORTON. The meeting will come to order.
We are delighted to have Martin Feldstein with us. As is generally the case, his entire statement will be included in the record as
if read in full, and I understand he intends to give a brief version
thereof.
Mr. Feldstein.
STATEMENT OF MARTIN FELDSTEIN, CHAIRMAN, COUNCIL OF
ECONOMIC ADVISERS
Mr. FELDSTEIN. Thank you very much, Senator. I am very
pleased to be back here again.
When I appeared before this committee in February, the economic outlook was still very uncertain, but since then the economy has
shifted into high gear and is now proceeding at a very satisfactory
pace for this stage of the recovery. I think there is every reason to
believe, with the right policies, we could be at the beginning of a
sustained expansion with a declining rate of inflation.
As you probably know, the Commerce Department this morning
announced that GNP growth for the second quarter was a very fast
annual rate of 8.7 percent. That brought the annual growth rate
for the first half of the year to 5.6 percent. The growth spurt at
that pace is a welcome indication that the recovery is on track. The
growth at that speed is typical of this phase of the recovery.
The 8.7-percent growth was higher than the second quarter
growth in three of the seven postwar recoveries and slower than
the second quarter growth at the end of four of them.
Of course, the recent rate cannot be expected to continue for
more than a few quarters. The administration projects real growth
in 1984 will be 4*/2 percent, followed by 4 percent annual rates
through 1988.
Although there is significant uncertainty about the forecast for
individual years, with appropriate economic policy it should be possible to achieve an average growth rate above 4 percent for the
next 5 years.
I should emphasize, however, that our projections assume that
Congress will enact the President's budget, thereby providing an
unambiguous assurance that budget deficits will be declining rapidly in the second half of this decade. If such a budget is not enacted
in the next few months, real interest rates are likely to remain
high or rise further, significantly reducing the chance of the
healthy and balanced recovery.
One of the most gratifying aspects of the past half-year has been
the remarkable price stability. The level of consumer prices in May
was only 1 percent above the level of 6 months earlier.
RISING INTEREST RATES AND INFLATION
The very good news about inflation is no excuse for complacency.
Inflation will stay under control only if we keep it a high priority
100
of Government policy. The inflation rate has often been relatively
low during the first year of an economic recovery but has then
risen substantially in the years ahead.
Thus, the inflation rate rose from 0.7 of 1 percent in 1961 to 6.1
percent in 1969. Inflation then started the next recovery at 3.4 percent in 1971 and rose to 8.8 percent 2 years later.
During the expansion that began in 1975, the inflation rate
almost doubled, rising from 7 percent to more than 13 percent.
Experience shows that the rate of inflation rises when the level
of demand is too high or when it is rising too fast. Once inflation
starts to rise, expectations begin to change, and the anticipation of
further increases in inflation make it that much more difficult to
reduce the rate of inflation.
So despite the remarkable success of reducing inflation since
1980, it is particularly important to remain vigilant and to prevent
any rekindling of the inflationary spiral.
The principal problem facing our economy at the current time is
the high, rising level of real interest rates. These high interest
rates are hurting key sectors of the economy, have raised the international value of the dollar to an unprecedentedly high level, and
are generating calls for monetary policies that, if pursued, will
cause rising rates and inflation.
Let me comment briefly on each of these points.
As you know, interest rates have been rising sharply for the past
10 weeks. The interest rate on Treasury bills is now over 9 percent,
a full percentage point higher than at the beginning of May.
Long-term Treasury bonds have also risen more than a percentage point. Other market rates have moved up in parallel.
Short rates have not been as high as they are now since last
summer, and all rates have not been as high since last fall.
The increase in short-term market interest rates is likely to
cause banks to raise their prime lending rate almost any time. The
prime is now lOVfe percent, but it is usually about 2Va percentage
points above the Treasury bill rate, and since the Treasury bill rate
is now 9 percent, the prime by that traditional historic standard
would be about 11% percent.
Moreover, the basic cost of incremental funds for the banks, as
measured by the rate on large CD's has increased about a percent
and a half since the banks lowered their prime from 11 to lOVa percent.
Real interest rates are abnormally high for this stage of the recovery. During the first year of the past six recoveries, the real interest rate on Treasury bills was never as high as 2 percent. At
present the real Treasury bill rate is at least 5 percent.
Since it is the real interest rates on short-term and long-term securities that keep the exchange value of the dollar high and cause
problems for interest-sensitive industries, the current high real
rates are a cause for serious concern. The high real interest rate on
long-term bonds has caused the dollar to rise about 40 percent
since 1980 relative to the other major currencies, even after adjusting for differences in inflation.
The strong dollar has caused a decline in exports and a rise in
imports that is likely to result in a record merchandise trade defi-
101
cit this year of more than $60 billion. By next year there is a substantial risk that the trade deficit will be more than $100 billion.
The high real interest rates are also reducing the pace of activity
in a number of key interest-sensitive sectors. For example, while
capacity utilization rates in industries like food and textiles, that
are not particularly interest sensitive, are essentially back to their
1980 levels, the capacity utilization rates in an interest-sensitive industry like iron, steel, or machinery are still very much below the
1980 levels.
It will, of course, be next year, the second year of the recovery,
that the behavior of interest-sensitive sectors of the economy will
be particularly important. The first year of the recovery is helped by
the turnaround in inventory accumulation and the rise of consumer
spending.
Experience shows that the GNP growth rate in the second year
of recovery typically slowed substantially from the first year's
growth. By the second year of the recovery the inventory turnaround is essentially complete, and an expansion of the usually interest-sensitive sectors has to play a larger role.
The fundamental reason for the high level of real interest rates
is the widespread expectation of large budget deficits for the remainder of the decade. Despite the recent increase in the projected
rate of economic growth, budget deficits are likely to remain in the
$150 billion to $250 billion range unless legislative action is taken.
It is sad but true that increases in the rate of growth reduce deficits by amounts that are very small relative to projected deficits. A
full 1-percent increase in the GNP reduces the deficit by less than
$15 billion.
Budget deficits of $150 to $200 billion would absorb funds equal
to between one-half and two-thirds of the net private savings of
households, businesses, and State and local governments. To reduce
the borrowing demand of private investors and households to
remain relatively small would inevitably require high real interest
rates.
Despite the fundamental importance of the projected budget deficits as determinants of the existing level of real interest rates,
much of the day-to-day public discussion of interest rates focuses on
the Federal Reserve. Perhaps that is only natural. The Federal Reserve does affect interest rates, and the seemingly mysterious
nature of open market operations is a natural subject for speculation, since the financial markets are aware of the Federal Reserve's monetary targets. Any unintended increase in one of the
monetary aggregates induces expectations of further Federal Reserve tightening and therefore immediately raises interest rates.
It is important, however, to recognize that the fundamental equilibrium of real interest rate reflects the basic supply and demand
for funds in the economy. If the Goverment increases its demand
for funds, the real interest rate will rise. If individuals want to
save more, the real interest rate will fall.
Although the Federal Reserve could temporarily lower shortterm interest rates by explicitly adopting a policy of rapid expansion of the money stock, this would subsequently lead to higher
rates of inflation and higher market rates of interest. As long as
the Federal Reserve follows a prudent monetary policy that avoids
102
raising the future inflation rate, large outyear deficits will inevitably mean high real interest rates.
MONEY GROWTH RATE MUST BE DECREASED
Experience shows that faster money growth leads to higher inflation and higher interest rates. Although the relationship with
money, inflation, and interest rates is complex, the essence of the
relationship can be illustrated by comparing 5-year averages from
the first half of the 1960's to the last half of the 1970's.
That is what I have put on the table on page 11, which shows
that when one goes from one 5-year period to the next, the growth
rate of money increases 5-year period after 5-year period; the inflationary increases 5-year period after 5-year period; and the Treasury bill rate is pulled up with it, although any notion that a sustained increase in money growth rates can cause a sustained decline in interest rates is contrary to both experience and economic
theory.
Although no one can like the high real interest rates they see
today, it would be a mistake for the Federal Reserve to pursue an
expansionary monetary policy aimed at reducing those rates.
The effect of such a policy would be an ineluctable resurgence of
inflation and a new rise in market rates of interest. Only by reducing the growth of Mi can the interest rate be reduced.
The appropriate aim of monetary policy should instead be to provide enough money and credit to permit continuation of real
growth with stable or declining inflation.
For 1984, for example, the administration forecast projects 4x/2percent growth in real GNP and a 5-percent rise in prices, as measured by the GNP inflator. These two figures imply that nominal
GNP will rise 9.7 percent. A faster rate of growth of nominal GNP
would be expected to result in both a higher rate of real GNP
growth and a higher rate of inflation.
The historic experience indicates that nominal GNP rises about 3
percent faster each year than the stock of Mi. That is, individuals
and businesses have on average reduced their use of Mi per dollar
of GNP at a 3-percent annual rate. This suggests that an Mi
growth rate of about 7 percent would be compatible with the nominal GNP growth forecast by the administration.
Although an Mi growth rate of 7 percent is in the middle of the
newly announced Federal Reserve target range for Mi, it is very
much below the actual growth rate of Mi during the past several
months. In the 3 months from March to June, Mi grew at a rate of
12 percent.
If the historic trend and philosophy prevails, persistence of Mi
growth at 12 percent would lead to a nominal GNP growth of 15
percent, or about 5 percentage points higher than the administration is forecasting. This would undoubtedly mean inflation rates
.substantially greater than the 5 percent we have forecast, probably
inflation rates as high as 7 to 10 percent by 1984-85.
It is for this reason that the growth of Mi must be slowed. It is,
of course, always possible that institutional changes or other factures are causing a decline in the MI philosophy, implying that the
current Mi growth is not excessive.
103
Last fall and winter, I repeatedly defended the Federal Reserve's
policy of allowing Mi to grow rapidly in the second half of 1982 and
explained at that time that the apparently rapid growth was in
fact just a one-time level adjustment in the stock of money that
would permit interest rates to adjust to the lower level of inflation
that had already been achieved.
Similarly in the first quarter of this year, the introduction of the
super NOW accounts, the money market deposit accounts, made
the interpretation of changes in Mi so uncertain that criticism of
the 17-percent Mi growth would, I think, have been inappropriate.
Although it is possible that the Mt growth figures are still being
distorted by the regulatory changes earlier this year, a detailed examination of the individual components of M! provides no real support for that view.
Money targets must, of course, never become ends in themselves.
They must be understood as a way of achieving an appropriate
long-run path for the economy. If sustained experience shows that
the money targets are not compatible with the desired level of
GNP growth, then the money targets themselves must eventually
be recalibrated.
But in the absence of clear evidence of a velocity change or reasons to believe that a shift of money demand has occurred, a
money growth target based on the past velocity periods is an appropriate basis for guiding the monetary aggregates.
I think that is what Chairman Volcker said this morning in
answer to one of the questions, and while it would be wrong to
worry very much about 1 or 2 months of abnormal money growth,
a persistent rate of growth that is roughly twice a suitable target
value is unacceptable and should be decreased.
I think that the Federal Reserve policy announced yesterday and
then again here this morning by Paul Volcker, of bringing the MI
growth rate down to the 5- to 9-percent range for the remainder of
the year is appropriate. It is now very important to bring the
actual Mi growth rate down into this range.
Short-term interest rates have risen in anticipation of such a
policy aimed at slowing the growth of ML Further increases in interest rates may continue in the months ahead. It is, of course, impossible to know how much further, if at all, interest rates must
rise in order to bring Mv growth back to an acceptable rate.
The financial future markets and the interest rates on 1- and 2year bonds indicate clearly that financial investors expect shortterm rates to continue rising. While no one likes to see interest
rates rise, an increase in interest rates over the next few months
would be far better than a continuing surge of money growth that
led by 1984 or 1985 to a revival of rapid inflation followed by another economic downturn.
I don't mean to imply by that that I think that such an increase
in interest rates makes it inevitable. It may, indeed, fall for other
reasons, but if there is an upward pressure it would be a mistake
to try to offset it by an explicit shift away from the Fed's MI
target.
104
SPENDING CUTS AND ADDITIONAL TAX REVENUE
Although the focus of these hearings is on monetary policy, I
cannot conclude without returning to the problem of budget deficits. Budget deficits of the magnitude that may prevail in the years
ahead would do very substantial harm to the American economy.
The lower rate of capital formation would hurt production, decrease growth, limit the rise in real incomes, and weaken our international competitiveness.
In the near term, large anticipated budget deficits and the high
real interest rates that they cause make the recovery unbalanced
and therefore inherently more fragile. The prospect of large budget
deficits very much complicates the task of monetary policy.
The budget that the President submitted to Congress earlier this
year recognizes the importance of reducing the deficit and proposes
legislative action to shrink the deficit to about 2 percent of GNP by
1987-88 as a result of domestic spending cuts and revenue increases.
The share of GNP devoted to domestic spending by the Federal
Government has doubled since 1960, rising from 8 percent to 16
percent. Shrinking that share is essential if we are to avoid perpetual deficits or unacceptable tax increases.
Spending cuts must also be accompanied by additional tax revenue. Ideally, the extra revenue will be forthcoming without a rise
in tax rates because economic growth substantially exceeds our
forecast. But if this does not occur, the President's budget calls for
an increase in tax rates that begins in October 1985—a 5-percent
surcharge on personal and corporate tax payments and a $5-abarrel tax on imported and domestic oil, contrary to what some
people are apparently telling the press behind the veil of anonymity.
The administration remains firmly committed to these standby
tax increases and to the budget of which they are so vital a part.
Two aspects of the administration's tax proposal should be noted.
First, there should be no increase in tax rates in either this year or
next while the. recovery is still getting established.
Second, the subsequent additional tax increase should be enacted
this year in order to reassure financial markets and other investors
that the deficits will indeed be shrinking. The resulting change in
projected deficits would permit an immediate decline in long-term
interest rates and a favorable judgment of the exchange value of
the dollar.
The combination of spending restraint and the enactment this
fall of such tax legislation would provide the much needed evidence
that budget deficits will indeed begin to decline sharply after the
recovery is firmly established, and that evidence would be the key
to a sound and healthy recovery in the months and years ahead.
NEW YORK TIMES STORY ERRONEOUS
Senator GORTON. Mr. Feldstein, are you telling us that the story
in the New York Times this morning is in error?
105
Mr. FELDSTEIN. Yes. I am telling you exactly what I said, that the
administration remains firmly committed to standby tax increases
and to a budget of which they are so vitally a part.
I can't remember exactly what the story said. I remember vividly
that the headline said just about the opposite of this, and the headline was clearly wrong. I would have to go back to read the story to
comment on the story.
Senator GORTON. I will read the first paragraph of the story to
you.
The Reagan administration, according to several officials, has quietly dropped the
President's contingency tax plan the President wanted enacted this year so the tax
will automatically go into effect in late 1985.
Mr. FELDSTEIN. There is no dropping of the standby tax. There is,
if anything, a reaffirmation that the standby tax, as part of the
whole budget proposal, is still very much alive in our minds.
Senator RIEGLE. Would the Senator yield so I can ask one question on that one point?
Senator GORTON. Go ahead.
Senator RIEGLE. I thank you for yielding.
I think it is important what you are saying here now. The problem is the television cameras that were here this morning, and
Chairman Volcker disappeared.
But if that is the case, if what you are saying represents not just
your view but the President's view, I would just say to you that it
is essential that he say so publicly, and until such time as he affirms that in the most clear-cut Reaganesque language as he is
fully capable of doing, I don't think what you are saying is going to
be believed because the New York Times is not going to run off
front page stories citing unnamed several officials within the administration unless, in fact, they are hearing that from the officials
within the administration, and we are getting different signals
from other people publicly.
Don Regan is saying things that don't exactly square with what I
hear you saying now, I feel that maybe he is the chief spokesman,
or you, for the President.
Somebody has that title presumably, but I just want to say to
you unless the President says that forcefully and follows it up with
action coming out of the administration to the Members of the
House and the Senate that are involved here—your saying it, quite
frankly, is not going to carry the weight it needs to carry.
Mr. FELDSTEIN. My impression is that this question was going to
arise in the usual daily press briefing. Then White House spokesman, Larry Speakes, would confirm that there is no move away from
the original proposals.
Senator GORTON. I would have to say that there is a great deal of
merit to Senator Riegle's comment.
For example, the same story here, a couple of paragraphs later
on, goes on to report the reaction to these unnamed administration
officials of Chairman Rostenkowski of the House Ways and Means
Committee, who said, well, if this is the case he is not going to go
ahead in that committee with an attempt to comply with the first
budget resolution.
106
My own comment would have to be that I would regard that as
an irresponsible response to an irresponsible change in the administration position if, in fact, the administration had changed its position.
Mr. Rostenkowski, a few months ago, supported the Democratic
budget proposal in the House of Representatives which calls for
considerably larger tax increases than those eventually passed in
the first budget resolution. If, as he clearly states here, he regards
the first budget resolution as a responsible course of action, as we
do here in the Senate, it would seem to me a dereliction of our own
duties to react to one mistake in policy by following a mistake in
policy of our own.
I am delighted at your rather forceful restatement of what has
been administration policy since January. I certainly hope that the
best and most eloquent possible spokesman—without any criticism,
obviously, of you—that the highest possible language.
Mr. FELDSTEIN. I think what the Times story indicated is that
there is a growing fear that the spending cuts that the President
proposed as part of the same budget were not moving ahead.
Senator GORTON. That is a valid criticism. I know, on the other
hand, that the chairman of the Senate Finance Committee, Senator
Dole, believes very strongly that increases should be accompanied
by spending cuts beyond those proposed in the first budget resolution. Of course, nothing in the first budget resolution prohibits that
kind of action, but they are obviously impossible without support,
for the very minimum, the revenue increases which the President
recommended in January.
If I can, I will go on to a related question.
MODERATE GROWTH IS SAFEST POLICY
Chairman Volcker suggested this morning that, with all due allowance for uncertainties, $50 billion of deficit reduction would
translate into interest rates being 1 percentage point or perhaps a
little bit more lower than what otherwise would be the case.
Do you agree with that proposition?
Mr. FELDSTEIN. It is very hard to put a specific number on it.
That didn't strike me as an unreasonable number. I think he was
careful to say that it depends upon what people thought was coming
next. I think the passage of something like the administration's
budget, with the substantial reductions that implies year after
year, could easily cause long-term real rates to decline by a full
percentage point.
Senator GORTON. By the same token, the failure to abide by the
structures of the budget resolution or of that budget would have a
correspondingly negative impact, I would assume?
Mr. FELDSTEIN. It is not clear how much the financial markets
have already given up on Washington for dealing with this problem. They have already given up all hope, and the bad news is
here.
I think there is some glimmer of hope left in the financial community that we are going to find a way of dealing with this problem.
107
Senator GORTON. I would like you to look at page 14 of your
statement. I would like your answer to perhaps an even more fundamental question.
In the first full paragraph on that page you deal with the relationship between the growth in Mi and the growth in both nominal
and real GNP and inflation. Is the implication of what you say
there that we can choose between relatively low inflation
and a
modest growth in real gross national product. Say 4L/2 percent per
year, or that we can have higher real growth in the economy by
paying for it with higher inflation in the range of 7 to 10 percent?
Is that a choice which we have, which you are simply making the
moral or ethical statement that the former of those is preferable?
Or is that not really a choice, except for a short period of time?
Mr. FELDSTEIN. In the short run, for a year, if we pursued a
monetary policy that produced a higher nominal GNP growth by say
5 percentage points, some of that would show up in a higher rate
growth and some of that would show up in inflation. If we continue
to pursue that higher nominal GNP growth for another year or two,
all of the real growth effects would probably be gone and we'd simply
find ourselves with a 5-percent higher inflation.
There is a little bit of shortrun trade off, but only a shortrun possibility, and even that no one can be very precise about.
Senator GORTON. I want to make very, very certain that you are
not telling me, the President, or the Congress of the United States,
that we can exchange, that we can have a higher rate of growth,
real growth than would otherwise be the case, by paying for it with
a somewhat higher rate of inflation, and sustain that condition
over any but the shortest period of time.
Mr. FELDSTEIN. That is correct. You cannot have a sustained
higher rate of real growth at the price of taking more inflation.
You can only, at best, affect it in a temporary way.
Senator GORTON. Are you saying, by the same token, the prescription of monetary growth which you outline here is likely to
result, as we look at a 2- or 3- or a 4-year period, in a total of more
real growth in the economy than would be the case with a much
higher rate, a significant higher rate of inflation?
Mr. FELDSTEIN. I think the danger of a significantly higher rate of
money growth and inflation is that at some point, we would be
back in a situation where to stop that inflation, we would see the
monetary authorities putting their foot on the brake, and that
would send us down into another recession that would leave us
with a lower level of real growth than if we had pursued a more
moderate course.
Senator GORTON. Let's take the potential alternative. It's not
even tied to this administration. Let's say the Federal Reserve had
not stepped on the brakes. What would have been the result under
those circumstances? Could we have continued to grow simply at
the expense of double-load, double-digit inflation?
Mr. FELDSTEIN. I think at a certain point the economy could not
take an inflation rate that had gone from 7 percent to 12 or 13 percent in 5 years and might go on moving up to higher and higher
108
rates. The distortions and losses resulting from that would be intolerable. It is only a question of when, not whether we were going to
have that kind of turnaround.
Senator GORTON. And a nation that follows that course of action
turns inevitably into a Brazil or a Mexico?
Mr. FELDSTEIN. If it keeps getting higher and higher, yes, you can
get to the 120-percent inflation rate we were seeing in Brazil.
Senator GORTON. I will defer to Senator Riegle.
Senator RIEGLE. I think the Chairman is raising an important
issue. We could spend a lot of time on all of this. I think if one goes
back and takes apart the inflation surge that we're dealing with, in
which the Fed responded with a very tough policy, basically, to
shut the economy down for all practical purposes, and we went into
a major extended recession, which we are just beginning to come
out of—I'm not here to argue for inflation. I'd prefer to argue
against inflation, but there are certain factors that drove that inflation. Oil prices were one. We were sort of digesting those conditions. Others are fundamental shots of upward price levels that
were then working themselves through the price-wage adjustments,
and so forth.
I suppose one never knows, unless one plays it out, whether all of
that keeps pyramiding and eventually you end up looking like a
Brazil or somebody else. At some point those things work their way
on through, and then if you don't have more fundamental upward
price shocks, you level out at a new level and go on from there and
we don't have these rapid bursts.
I simply make the point that I am not confident that we know
one way or the other. We're just in the process now of adjusting
the Mi targets. In so doing, we are inflating the base with the 14percent growth rate.
So we are talking about a new target in the 4- to 8-percent range,
or I should say 5 to 9 percent range, which is actually increasing
the levels, but by consolidating the recent bursts of the base, to go
back to the old base, it's HVfe percent. Well, that's a bigger story,
with bigger implications than if one says it's 5 to 9 percent.
I want to come back to the inflation thing later, but I think there
are some really critical issues that we have to try to deal with, and
the Chairman, I think, has opened one up here on the question of a
tax issue, and the matter of taking and putting all of the components of macroeconomic policy together in the right mixture so we
get the things we want: sustained growth, low inflation, and unemployment, and so forth.
Senator Gorton has worked as hard as anybody in the Senate to
try to help maintain budget discipline. And others on the committee, including myself, have worked with him, and we've managed,
to a degree at least, to keep the budget discipline alive only by a
one-vote margin in the Senate on a bipartisan basis.
Let me ask you this question. I'm concerned that this whole
thing may very well fly apart here, despite everybody's best intentions, including your own.
109
CONSEQUENCES IF ADJUSTMENTS NOT MADE
As I read your statement, which you wrote very carefully and is
conditioned carefully, it is based on the assumption that we're
going to get both the spending cuts asked for and the revenue increases. In other words, if we can get what you ask for, you make a
case that the thing will work.
The problem is all the evidence that's piling up indicates that as
of today we're unlikely to get either. We're not going to get the
spending debts either in the amount or the areas asked for, and
there is a very real question as to whether we're going to get into
tax increases.
And so I would just ask you this question, and that is, let's say
we don't, let's say that we get nothing close to the spending cuts
envisioned or sought and say we don't get tax increases, standby or
otherwise, and then you have to sort of go through and run the calculation again, what would your outlook be then?
Mr. FELDSTEIN. I think there are two things I want to emphasize.
The first is that would very much affect the kind of recovery we
have with housing, plant equipment, trading goods sectors, all significantly depressed relative to what they would otherwise be.
Senator RIEGLE. That's because interest rates would go up.
Mr. FELDSTEIN. Interest rates and the cost of capital somehow have
to be higher; crowding out has to occur. With the Government's
borrowing $150 to $250 billion, 5 percent of GNP against a net
savings rate of 7, a gross savings rate of 16, there's a displacement.
Senator RIEGLE. Long-term private investments are presumably
the ones that are hardest hit.
Mr. FELDSTEIN. They will be crowded out. The exchange rate, as
we've already seen, will move to draw in funds from abroad and
that will have very serious effects on all kinds of American industry, very serious effects.
The second aspect is what this does to the viability of the whole
recovery, and that's a big question mark. We've never run a recovery with real interest rates at the levels we now have.
As I said in the prepared statement, we have real interest rates
of about 5 percent now for short-term Treasury bills. They have
been negative in several of the recoveries in the first year.
The trade deficit clearly puts pressure on critical sectors of the
economy. So I think that we run a substantial risk. That is not to
say it's going to happen, but the risk is much more substantial
than I think it should be. A risk, the recovery will not make it
through next year or the year after, if we don't deal with these
deficits, and that really means we are sure of financial markets of
not just 1 year, but several years of continually declining deficits.
Senator RIEGLE. I tend to agree with what you said. My own assessment is the risk is a substantial risk, if we work the right basis
in place here. Let me tell you what my concern is from sitting on
this side of the table.
Very often in the last year-and-a-half approaching a Presidential
election, a kind of paralysis sets in. The tough question is nobody
wants to cut spending very much, nobody wants to raise taxes very
much. So what happens is, things just start to freeze into place.
Major things tend to get postponed, and then time just runs and
no
what I've just heard you say sounds to me like in the next IVfe
years, if not the next few months, is really critical in making the
policy adjustments needed to keep us on track.
Mr. FELDSTEIN. That's right.
Senator RIEGLE. The thing that concerns me now is that I'm
hearing talk from colleagues, and I hear some on both sides of the
aisle, to the extent that maybe this whole thing now is sort of selferecting. In other words, we've really sort of taken all the actions
we need to. The stock market shows a lot of lift, not just yesterday,
but over a period of time, and that the recovery itself will solve all
these problems for us. Even the Treasury Secretary is now saying
that he thinks there is going to be sort of a revenue bonus
coming—my phrase, not his—and speaking about coming off the recovery and really eat into this deficit.
I'm frank to say I don't see much of that.
Mr. FELDSTEIN. As I said in the prepared statement, an extra 1
percent in the level of GNP is worth about $15 billion. That is not
a trivial matter, even these days, but we are comparing it to $150
to $200 billion worth of deficit. So it helps.
Senator GORTON. You're not going to get a 12-percent GNP increase.
Senator RIEGLE. I guess what I'm getting to is this. I think we're
after some of the same things in terms of the outcomes we would
like to see and the stakes are awfully high, because in the end it
gets paid for, not by who gets elected, that's part of it, by who gets
hurt, the people who are caught on the far end of this lose their
jobs, their businesses, whatever.
Mr. FELDSTEIN. I continue to believe there's not as much of a difference in substance between the different players in this as readers of the newspaper might think. Look at the administration's
budget. Look at the congressional budget resolution. They are important differences. They both agree that there has to be significant
revenues started up within the 3-year program and fiscal year 1986
is where most of the money is. They both agree that domestic
spending has to be reduced below the current services level. And
that's in the budget resolution, as well as in the administration
budget.
Senator RIEGLE. Let me put it to you this way. I would say today
the odds are, I would say, about 85-15 that you're not going to see
these major policy actions in your plan taken on the spending cut
side or on the revenue side.
I just don't see events moving that way. They seem to be moving
the other way. Like just a change in withholding of interest and
dividends has revenue impact. There are others that are occurring
like defense. So you kick things up on the expenditures side. We
just voted on that just this week. All the hard evidence that one
can see suggests that we're not going to make these adjustments.
My question to you is, should they not be made, rather than this
set of outcomes based on the assumption that they are made, what
is your assessment of what's likely to happen if, in fact, we're on
those other kind of trend lines and these actions are not taken?
Mr. FELDSTEIN. It depends on the rise we're looking at. We're
looking at over the next year through 1984
Senator RIEGLE. Let's take it over that period, say, through 1985.
Ill
Mr. FEDLDSTEIN. Let's look at the next 2 years to the middle of
1985. The most likely thing is that we will continue to have a recovery. It will be what I call a lopsided recovery in which key industries are hurt, interest sensitive industries, export industries,
but we will muddle through. We will have a smaller capital stock
when we finish. We will have destroyed some firms along the way.
We will have hurt our international position, but we will muddle
through. But there is risk, which I think is less than a 50-percent
chance, but a sizable risk, that we won't make it through the next
2 years in this way, and that the distortions that were built into
the recovery may cause it to fail.
The alternative risk that we face is that we will see interest
rates continue to move up, and there will be overwhelming pressure to do something about those rates.
I think the Fed is basically committed to not allowing an inflationary course to develop, but I don't know what would happen
under the wrong kinds of pressures from Congress to accommodate
or offset those higher interest rates, and we could then find ourselves moving into a period in which we lose the gains that we've
made on inflation, although I think we're running a very grave
risk in moving down this path.
Senator REIGLE. My time is up.
DEPRECIATION OF DOLLAR AND INCREASED SAVINGS
Senator GORTON. A few moments ago, you made a statement that
the value of the dollar keeps getting built up in international markets by capital inflows which respond to our high interest rates.
Obviously, on the trade side, this puts us at a significant competitive disadvantage.
Other than that general proposition, can you estimate with any
degree of precision the sensitivity of the value of the dollar to, say,
1 or 2 point fluctuations in interest rates around, above or below
the current level? For example, can you estimate how much our
balance of trade might be improved by a drop in the value of the
dollar at any given level?
Mr. FELDSTEIN. We do have staff estimates of those numbers. I
could get for you after this hearing an indication of what those
numbers are. I would add quickly, that there are a lot of problems
with trying to estimate import, even more so, export demand relation, but I can supply you with the rest of it. It is clear that we
didn't go from a current account surplus 2 years ago to a large
current account deficit by accident. And the principal reason for it is
this appreciation of the dollar.
Senator GORTON. We would appreciate your doing so.
[Information supplied for the record can be found on p. 114.]
Senator GORTON. On another subject, in the shorter run to stimulate the economy or to increase employment I would see a need to
increase the level of savings in the economy both to finance the
growing government debt and a higher level of capital accumulation.
Generally speaking, we focus on this from the point of view of
tax policy, but is there a monetary policy in fact, a monetary policy
that could be used to encourage capital accumulation?
112
Mr. FELDSTEIN. I think not in this sense we were talking about
monetary policy until now, except perhaps to the extent that
higher rates of interest have a postive effect on savings. The
lawyer definition of monetary policy, including some deregulation,
which allows small savers to get higher rates of interest at any
market level, allowing them to share in these interest rates, I
think, has a long-term positive effect. It is clear that the principal
ways of effecting savings are not in monetary policy.
Senator GORTON. Thank you.
Senator Reigle?
Senator REIGLE. Yes, sir, I do.
CONGRESS AND PRESIDENT MUST GET PROPER FISCAL MIX
Let me just cover a couple of things here along the same lines. I
want to see us work this out. I want to see us work it out before
this political paralysis overtakes us all and we do not get the right
policy mix into place, because the very sectors that you say are
going to take the pounding is where I happen to come from, and we
have been pounded. I do not think we can take another pounding.
We have lost an enormous number of companies, and there is a
lot of shrinkage, but for those that have survived it does not necessarily mean that they could survive another death march.
What worries me here—the analogy is the fiscal policy where we
have had our foot on the accelerator and going full blast for the
last several years here, and then we had our foot on the brakes on
monetary policy in an extreme way, which helped take interest
rates up so high that the economy started to shutdown in a major
way, in fact, worldwide. We came very close to the edge of a catastrophic sort of shutdown.
It seems to me that what we have been witnessing in the last 2
months is we still have our foot down on the accelerator, the floorboards on our fiscal policy, as measured by the deficits. And on the
other hand, we are now seeing the Fed seeing the first signs of
things overheating, so they are now starting to ease their foot
down on the brakes, and they say we are not going to go down very
much; we just sort of want to lightly depress the brakes here and
we hope this gives the right signals and so forth and so on and cool
things off.
The thing that worries me is that if we continue with our foot on
the accelerator over here on fiscal policy, I think we are kidding
ourselves to believe that a few light touches on our monetary
policy can do it.
I think all the other things we have talked about here make that
unlikely. Those deficits, at $200 billion-plus rates, as they roll along
and accumulate will undo us. They will throw us back into a condition like we had before.
You made a comment a few minutes ago to the effect that we
would then run the risk of losing everything we have gained. All
the travail we have been through to make some gains would, in
fact, evaporate, and it would all be for naught. Let us hope that
does not happen.
I guess my appeal to you is this; that is, I think the only way we
are going to avoid that happening is we really need an honest-to-
113
God package deal. That is what we sort of did in the Budget Committee; we got some domestic spending restraints, and we cut the
defense increase back. There was a lot of squealing and squawking
in some quarters, but that was the judgment of Congress.
I would think at this point, unless it is very strongly your view—
you do not have to agree with the exact mix, but the fact that we
have to have a mix gives us the same bottom line—if that is your
view, it seems to me you are going to have to use every muscle and
your persuasive power and leverage at your command to help bring
that about.
It seems to me that the President himself will have to become
convinced that that is the case. I have no way of knowing whether
he is or is not. Frankly, he is not extremely visible on this question
right now.
My thought to you would be this, and that is, I think the window
is closing on us here to try to do this, and we cannot possibly do it
without him. We need him not just as a passive player, but he has
really got to get deeply and actively involved, presumably because
he is convinced that that needs to be done.
I do not know if you can get the convincing done or not, but if
you cannot and we cannot get him involved with people like myself
and Senator Gorton and others on both sides of the aisle who are
willing to try to stretch and meet and work the thing out, it is not
going to happen. If it does not happen, it seems to me we are going
to miss a chance we all had to try to do it.
My hope would be that you would think about that and see if
there is not some way that we could try to trigger a whole new
effort and emphasis within the administration with the President
himself along these lines, because I think if he were willing to be a
major force in leading this effort, I think we could get it done. If he
is not an active leader in that respect, I think it is almost a certainty that it will not be done.
Mr. FELDSTEIN. Let me repeat again I have no doubt about it in
my own mind that the President would still be very pleased to see
the outcome of the package that he has proposed in February with
the standby tax. But I think that is only part of the package, and
we should also see a set of reductions in domestic spending.
The difference between the congressional budget resolution and
the administration's position is not, I think, an original one. But I
think there is no indication coming from the Congress. As you said
yourself, there is a willingness to make some of those tough spending cuts, but the difference is on the order of about 3 percent of
domestic outlays.
If there was a clear indication that Congress was prepared to
make those additional cuts, to go a little bit beyond what the congressional budget resolution lays down, then I think you would be
at the levels of spending and would be in a position where the
standby tax could be fully supported by the administration.
Senator RIEGLE. I think if we put together a package that would
involve working out some understanding on domestic spending
cuts, including something on entitlements, something in the revenue area, which presumes nobody is going to get everything they
want, including the President, something on defense—you need the
package, you need to package it in the end, because if you do not
114
get all the pieces you do not get the total, so you cannot just take
part of it because you cannot just get part of it. You have to have
all the parts to get any of the parts, and you have got to have all
the parts together to get the total and the bottom line to get the
deficit reduction.
I think it is possible, but I really believe this window is shutting
on us awfully fast here. I would like to see us get through the
window before it shuts. I hope that is helpful to you.
Mr. FELDSTEIN. Thank you.
Senator GORTON. Thank you very much.
RESPONSE TO SENATOR GORTON'S QUESTION
THE
CHAIRMAN
COUNCIL OF
OF THE
ECONOMIC
ADVISERS
WASHINGTON
October 20, 1983
Dear Senator Gorton:
When I testified before your committee on July 21, you
asked for estimates of the relation between interest rates,
exchange rates, and the trade balance. My stafE estimates
that a one percentage point decline in real long-term interest
rates in the U.S. would produce a decline in the value of the
dollar of five percent. This of course assumes no change in
aq/tual or expected inflation. At current levels of imports
arid exports, this fall in the dollar would improve our trade
balance by about $10 billion. This improvement would not
occur instantaneously, however. The full effect of the
dollar's decline might take up to two years.
Sincerely yours.
Martin Feldstein
Honorable Slade Gorton
U. S. Senate
Washington, D. C. 20510
THE COMPLETE STATEMENT FOLLOWS
115
Inflation, Monetary Policy and Budget Deficits
Martin Feldstein*
Thank you, Mr.* Chairman.
I am very pleased to be back
with this distinguished Committee again.
When I appeared before this Committee in February the
economic outlook was still very uncertain.
Since then, the
economy has shifted into high gear and is now proceeding at a
very satisfactory pace for this stage of the recovery.
There
ia every reason to believe that, with the right policies, we
could be at the beginning of a sustained expansion with a
declining rate of inflation.
I know that there is no need for me to review here the
recent favorable experience with employment, production,
income and sales.
On the basis of that experience, the
Administration in June revised up our projections for real
economic growth.
We now project a real growth rate of 5.5
percent from the final quarter of last year to the final
quarter of 1983.
Based on the revised estimate of a
percent growth rate in the first two quarters of this year
(released this morning by the Commerce Department), our forecast implies real growth in the second half of the year at a
percent annual rate.
*Chairman, Council of Economic Advisers. Testimony
before the Senate Committee on Banking, Housing, and
Urban Affairs, July 21, 1983.
116
We also project that the real growth rate for 1984 will
be 4.5 percent, followed by 4 percent annual rates through
1988.
Although there is, of course, significant uncertainty
about the forecasts for individual years, with appropriate
economic policy it should be possible to achieve an average
growth rate above 4 percent for the next five years.
I should emphasize, however, that our projections assume
that Congress will enact the President's budget, thereby
providing an unambiguous assurance- that budget deficits will
be declining rapidly in the second half of this decade.
If
such a budget is not enacted in the next few months, real
interest rates are likely to remain high or rise further,
significantly reducing the chance of a healthy and balanced
recovery.
testimony.
I shall return to the deficit problem later in my
First, however, I want to comment on the current
inflation situation and the prospects for keeping inflation
down in the future.
inflation
One of the most gratifying aspects of the past half year
has been the remarkable price stability.
consumer prices in May —
data are available —
six months earlier.
The level of
the most recent month for which the
was only 1 percent above the level of
Over the past 12 months, the rate of
inflation of consumer prices has been only 3.5 percent.
The
level of producer prices was actually lower in June than it
was last November when the recession ended.
That implies
117
that there will be continuing good news in consumer prices
as these goods move from producers to retailers.
The sharp improvement in labor productivity this year
and the moderate overall rise in labor compensation at
current prices imply that unit labor costs are increasing at
a low rate that also portends good inflation news.
In the
first quarter of 1983, unit labor costs in the nonfarm
business sector rose at an annual rate of only 1.2 percent,
down dramatically from the 7.2 percent increase in 1982 and
the 11.2 percent increase in 1980.
Although an abnormal rise in farm prices or an increase
in import costs could cause a temporary jump in the inflation
rate, we anticipate that the broadest measure of inflation
—
the GNP deflator -- will rise only about 4.5 percent this
year, or half of its rate of increase in 1981 . With a
continuation of sound policy, inflation should remain
essentially stable or decline in the years ahead.
The very good news about inflation in recent months is
no excuse for complacency.
Inflation will stay under control
only if we keep it a high priority of government policy.
The
inflation rate has often been relatively low during the first
year of an economic recovery but has then risen substantially
in the years ahead.
Thus, the inflation rate rose from 0.7
percent in 1961 to 6.1 percent in 1969, the final year of
that recovery.
Inflation then started at 3.4 percent in the
first year of the 1971 recovery and rose to 8.8 percent
118
two years later.
And during the expansion that began in
1975, the inflation rate rose from 7 percent to more than
13 percent.
Experience shows that the rate of inflation rises when
the level of demand is too high or when it is rising too
fast.
And once inflation starts to rise, expectations begin
to change and the anticipation of further increases in
inflation makes it that much more difficult to reduce the
rate of inflation.
Now, after a respite of just two years
from the period of double digit inflation, the expectation of
continuing relative price stability is still very fragile.
So despite the remarkable success in reducing inflation since
1980, it is particularly important to remain vigilant and to
prevent any rekindling of the inflationary spiral.
A wise friend of mine once commented that inflation is
not a disease like appendicitis that can be cured with a
single operation.
weight.
Instead, inflation is like being over-
We have to work at the problem all the time if we
want to keep either inflation or our weight under control.
*
Although I think the analogy is very fitting, there is
one important way in which inflation is more difficult to
control than our weight,
when we eat too much, the extra
weight shows up immediately on our scales.
In contrast,
there are often substantial lags between the pursuit of
119
inappropriate policies and the subsequent increase in
inflation.
That's why it's so important to consider the
future consequences of current monetary and fiscal policy.
The President is strongly committed to avoiding a new
round of inflation in the current recovery.
I believe that
Paul Volcker shares this concern and is determined to pursue
a monetary policy that he believes has the greatest
likelihood of achieving a sustained expansion with stable or
declining inflation.
Interest. Rates
The principal problem facing our economy now is' the high
and rising level of real interest rates.
These high interest
rates are hurting key sectors of the economy, have raised the
international value of the dollar to an uncompetitively high
level,, and are generating calls for monetary policies that,
if pursued, would cause rising rates of inflation.
Let me
comment briefly on each of these points.
As you know, interest rates have been rising sharply for
the past 10 weeks.
The interest rate on Treasury bills is
now over 9 percent, a full percentage point higher than at
the beginning of May.
Long-term Treasury bonds have also
risen more than a percentage point since then and are now
11.3 percent.
parallel.
Other market interest rates have moved up in
Short rates have not been as high as they are now
since last summer and long rates have not been as high since
last fall.
120
The increase in short-term market interest rates is
likely to cause banks to raise their prime lending rate at
almost any time.
The prime is now 10.5 percent but is
usually about 2.5 percentage points above the Treasury bill
rate.
Since the Treasury bill rate is now 9 percent, the
prime by that standard would be about 11.5 percent.
More-
over, the basic cost of incremental funds to the banks as
measured by the rate on large CD's has increased about
1.5 percentage points since the banks lowered their prime
rate from 11 percent to 10.5 percent.
Real interest rates are abnormally high for this stage
of an economic recovery.
During the first year of the past
six recoveries the real interest rate on Treasury bills —
i.e., the excess of the Treasury bill rate over the rate of
inflation -- was never as high as 2 percent.
At present, the
real interest rate on Treasury bills is at least 5 percent.
Since investors' long-term price expectations cannot be
observed, the long-term real rate cannot be measured with
precision.
Nevertheless, the market rate of more than 11
percent for long-term governments suggests an unusually high
real long-term interest rate.
In this regard, it is
important to note that any future decline in long-term market
interest rates caused solely by reductions in the public1s
expected inflation rate would leave real interest rates high.
121
Since it is the real interest rates on short-term and longterm securities that keep the exchange value of the dollar
high and cause problems for interest sensitive industries,
the current high real rates are a cause for serious concern.
The high and rising real interest rate on long-term
bonds has caused the dollar to rise about 40 percent since
1980 relative to the other major currencies after adjusting
to differences in inflation.
Just since January of this
year, the dollar has risen an average of nearly 8 percent
relative to other major currencies.
The strong dollar has
caused a decline in exports and a rise in imports that is
likely to result in a record merchandise trade deficit this
year of more than $60 billion.
By next year there is a sub-
stantial risk that the trade deficit will be more than $100
billion.
Many key American industries are hit particularly
hard by this fall in the competitiveness of U.S. exports and
the increased attractiveness of imports.
The high real interest rates are also reducing the pace
of activity in a number of interest sensitive sectors.
For
example, while capacity utilization rates in industries like
food and textiles that are not interest sensitive are
essentially back to their 1980 levels, the capacity
utilization rates in an interest sensitive industry like iron
and steel or the non-electrical machinery industry are still
very much below 1980 levels.
And while the real value of
residential construction has increased sharply since the
122
beginning of the recovery, nonresidential construction was
way lower in May (the most recent month for which data are
available) than it was when the recovery began.
As a result,
the real value of total new construction was the same in May
as it was in November 1982.
It will of course be in 1984, the second year of the
recovery, that the behavior of the interest sensitive sectors
of the economy will be particularly important.
The first
year of the recovery is caused by the turnaround in inventory
accumulation and the rise of consumer spending.
Experience
shows that the GNP growth rate in the second year of recovery
typically slows substantially from the first year's growth.
By the second year of the recovery, the inventory turnaround
is essentially complete and an expansion of the usually
interest sensitive sectors has to play a larger role.
The fundamental reason for the high level of real
interest rates is the widespread expectation of large budget
deficits for the remainder of the decade.
Despite the recent"
increase in the projected rate of economic growth, budget
deficits are likely to remain in the $150 billion to $200
billion range unless legislative action is taken.
It is sad
but true that increases in the rate of growth reduce deficits
123
by amounts that are very small relative to the projected
deficits; a full 1 percent increase in the GNP reduces the
deficit by less than $15 billion.
Budget deficits of $150
billion to $200 billion would absorb funds equal to
between half and two-thirds of the net private saving of
households, businesses, and State and local governments.
To
reduce the borrowing demand of private investors and households to the remaining small amount of funds would inevitably
require high real interest rates.
Despite the fundamental importance of the projected
budget deficits as determinants of the existing level of real
interest rates, much of the day-to-day public discussion of
interest rates focuses on the Federal Reserve.
is only natural.
Perhaps that
The Federal Reserve does affect interest
rates and the seemingly mysterious nature of open market
operations is a natural subject for speculation.
Since the
financial markets are aware of the Federal Reserve's monetary
targets, any unintended increases in one of the monetary
aggregates induces expectations of further Federal Reserve
tightening and therefore immediately raises interest rates.
It is important, however, to recognize that the
fundamental equilibrium real interest rate reflects the basic
supply and demand for funds in the economy.
If the
government increases its demand for funds, the real interest
rate will rise.
If individuals want to save more at every
interest rate, the real interest rate will fall.
Economists
traditionally called the interest rate that balanced the
124
supply and demand for funds the "natural" interest rate,
Although the Federal Reserve1s monetary policy can cause the
market's real interest rate to depart temporarily from this
"natural" rate of interest, the fundamental determinant is
not monetary policy but the supply and demand for funds.
As
long as the Federal Reserve follows a prudent monetary policy
that avoids raising the future inflation rate, large outyear
deficits will inevitably mean high real interest rates.
Although the Federal Reserve could temporarily lower
short-term interest rates by explicitly adopting a policy of
rapid expansion of the money stock, this would subsequently
lead to higher rates of inflation and higher market rates of
interest.
Experience shows that faster money growth leads to
higher inflation and higher interest rates.
Although the
relationship among money, inflation and interest rates is
complex, the essence of the relationship can be illustrated
by comparing five-year averages from the first half of the
1960s through the last half of the 1970s.
Table 1 shows that
the average rate of growth of Ml (using the 1983 definition
of that variable) rose in each successive five year period.
The average rate of CPI inflation also rose and carried with
it the average yield on Treasury bills.
Any notion that a
sustained increase in money growth rates can cause a
sustained decline in interest rates is contrary to both
experience and economic theory.
125
MONEY GROWTH, INFLATION. AND INTEREST BATES
Average
Ml
Growth
Average
CPI
Inflation
1960-64
2.8
1,2
2.9
1965-69
5.0
3.8
5.0
1970-74
6.2
6.7
5.9
1975-79
7.1
8.2
6.7
Period
Average
3-Month Treasury
Bill Rate
126
Although no one can like the high real interest rates
that we see today, it would be a mistake for the Federal
Reserve to pursue an expansionary monetary policy aimed at
reducing those rates.
The effect of such a policy would be
an ineluctable resurgence of inflation and a new rise of
market rates of interest.
Only by reducing the growth of
Ml can the interest rate be reduced.
Monetary Aggregates
The appropriate aim of monetary policy should instead be
to provide enough money and credit to permit a continuation
of real growth with stable or declining inflation.
For 1984,
for example, the Administration forecast projects a 4.5
percent growth of real GNP and a 5.0 percent rise in the
prices (as measured by the GNP deflator).
These two figures
imply that nominal GNP, i.e., GNP in current prices, will
rise at 9.7 percent.!/
A faster rate of growth of nominal
GNP would be expected to result in both a higher rate of
real GNP growth and a higher rate of inflation.
What rate of growth of M2 is consistent with a rise of
nominal GNP at a rate of about 9.7 percent?
Historic
experience indicates that on average nominal GNP rises at
I/ The"nominal GNP growth rate is slightly greater than
the sum of the two component growth rates because
(1.045) (1.050) = 1.097.
127
about the same rate as the rate of increase of M2 some months
earlier.
Of course, sometimes GNP grows faster and sometimes
it grows more slowly.
But a useful starting point is
therefore to assume that the economy will require a rate of
growth of M2 of about 9,7 percent for the next 12 months to
produce the projected rate of nominal GNP growth.
This required M2 growth rate is consistent with the
Federal Reserve's target range of H2 growth of between 7
percent and 10 percent, and with the actual M2 growth rate of
about 9 percent during the past three months.
Although the
M2 growth rates earlier this year were much higher than 10
percent, I am reluctant to put any weight on that experience
because of the major changes caused by the introduction of
MMDA's and Super NOW accounts.
The historic experience indicates a different
relationship between nominal. GNP and Ml with nominal GUP
rising about 3 percent faster each year than the stock of Ml.
That is, individuals and businesses have on average reduced
their use of Ml per dollar of GNP at a 3 percent annual
rate. This suggests then that a Ml growth rate of about 7
percent would be compatible with the nominal GNP growth
128
forecast by the Administration.
Although an Ml growth rate
of 7 percent is in the middle of the newly announced Federal
Reserve target range for HI, it is very much below the
actual growth rate of Ml during the past several months.
In the three months from March through June, Ml grew at a
rate of 12 percent.
if the historic trend in velocity
prevails, a persistence of Ml growth at 12 percent would lead
to nominal GNP growth of 15 percent, or about 5 percentage
points higher than the Administration's forecast.
This would
undoubtedly mean an inflation rate substantially greater than
the 5 percent that we have forecast, probably an inflation
rate as high as 7 to 10 percent by 1984-85.
It is for this
reason that the growth rate of Ml must be slowed.
You may have heard comments from some individuals who
say that a fast rate of Ml growth can be ignored since the
recent M2 growth is compatible with the Administration1s
forecast growth of nominal GNP.
I do not agree with them.
Most economists who have studied the relationships between
the monetary aggregates and GNP believe that Ml has been a
somewhat better guide than. M2 to the future path of income
and inflation,
whether or not one accepts that judgment,
some weight must be given to the behavior of Ml in assessing
the appropriateness of monetary policy.
Moreover, the
appropriate goal of policy at this time should be to slow Ml
without reducing the growth rate of M2.
129
It is, of course, always possible that institutional
changes or other factors are causing a decline in the Ml
velocity (the ratio of nominal GNP to Ml}, implying that the
current Ml growth is not excessive.
Last fall and winter I
repeatedly defended the Federal Reserve's policy of allowing
Ml to grow rapidly in the second half of 1982, and explained
at that time that the apparently rapid growth was in fact
just a one time "level adjustment" in the stock of money that
would permit interest rates to adjust to the lower level of
inflation that had already been achieved.
Similarly, in the
first quarter of this year, the introduction of the Super HOW
accounts and Money Market Deposit Accounts made the
interpretation of changes in Ml so uncertain that criticism
of the 17 percent Ml growth rate would have been
inappropriate.
Although it is possible that the Ml growth
figures are still being distorted by the regulatory changes
earlier this year, a detailed examination of the individual
components of Ml provides no real support for that view.
Moreover, without the sharp decline in interest rates of the
type that occurred last summer, there will be no interestinduced decline in velocity; if anything, the current rising
interest rates will increase velocity and add to the risk of
inflation.
The money targets must, of course, never become ends in
themselves.
They must be understood as a way of achieving an
appropriate long-run path for the economy.
If sustained
experience shows that the money targets are not compatible
130
with a desired level of GNP growth, the money targets must
eventually be recalibrated.
But in the absence of clear
evidence of a velocity change or reasons to believe that a
shift of money demand has occurred, a money growth, target
based on the past velocity experience is an appropriate basis
for guiding the. monetary aggregates.
And while it would be
wrong to worry very much about one or two months of abnormal
money growth, a persistent rate of growth that is roughly
twice a suitable target value is unacceptable and should be
decreased.
I think that the Federal Reserve policy,
announced yesterday by Paul Volcker, of bringing the Ml
growth rate down to a 5 percent to 9 percent range for the
remainder of the year is appropriate.
It is now very
important to bring the actual Ml growth rate down into
this range.
Short term interest rates have risen in anticipation of
such a policy aimed at slowing the growth of Ml.
Further
increases in interest rates may continue in the months
ahead.
It is, of course, impossible to know how much
further, if at all, interest rates must rise in order to
bring Ml growth back to an acceptable rate.
The financial
future markets and the interest rates on one-year and
two-year bonds indicate clearly that financial investors
expect short-term rates to continue rising.
While no one
likes to see interest rates rise, an increase in interest
rates over the next few months would be far better than
131
a continuing surge of money growth that led by 1984 or 1985
to a revival of rapid inflation followed by another economic
downturn.
The anticipation that the Federal Reserve will pursue an
appropriate policy to slow Ml growth explains why, despite
the rapid growth of Ml, the financial markets do not appear
to be concerned about a near-term rise in inflation.
The
price of inflation hedges like gold has not risen as it would
if a new inflationary surge were feared.
Similarly, the rise
in the exchange value of the dollar shows confidence that the
purchasing power of the dollar will not be eroded and a
belief that the rise in interest rates represents a rise in
real rates and not a compensation for faster anticipated
inflation.
Budget Deficits
Although the focus of these hearings is on monetary
policy, I cannot conclude without returning to the problem of
budget deficits.
Budget deficits of the magnitude that may
prevail in the years ahead would do very substantial harm to
the American economy.
The lower rate of capital formation
would hurt production, decrease growth, limit the rise in
real incomes and weaken our international competitiveness.
132
In the near term, large anticipated budget deficits and the
high real interest rates that they cause make the recovery
unbalanced and therefore inherently more fragile.
The
prospect of large budget deficits very much complicates the
task of monetary policy.
The budget that the President submitted to Congress
earlier this year recognizes the importance of reducing the
deficit, and proposes legislative action to shrink the deficit
to about 2 percent of GNP by 1987-88 as a result of domestic
spending cuts and revenue increases.
The share of GNP devoted to domestic spending by the
Federal Government has doubled since I960, rising from 8
percent to 16 percent.
Shrinking that share is essential if
we are to avoid perpetual deficits or unacceptable tax
increases.
Spending cuts must also be accompanied by additional tax
revenue.
Ideally, the extra revenue will be forthcoming
without a rise in tax rates because economic growth
substantially exceeds our forecast.
But if this does not
occur, the President's budget calls for an increase in tax
rates that begins in October 1985: a 5 percent surcharge on
personal and corporate tax payments and a $5-a-barrel tax on
imported and domestic oil.
The Administration remains firmly
committed to these standby tax increases and to the budget of
which they are so vital a part.
133
Two aspects of the Administration's tax proposal should
be noted.
First, there should be no increase in tax rares in
either this year or next while the recovery is getting
established.
Second, the subsequent conditional tax increase
should be enacted this year in order to reassure financial
markets and other investors that the deficits will be
shrinking.
The resulting change in. projected deficits would
permit an immediate decline in long-terra interest rates and a
favorable adjustment of the exchange value of the dollar.
The combination of spending restraint and the enactment
this fall of such tax legislation would provide the much
needed evidence that budget deficits will indeed begin
declining sharply after the recovery is firmly established.
And that evidence would be the key to a sound and healthy
recovery in the months and years ahead -
134
Senator GORTON. I have to apologize to our next three witnesses.
We now have a rollcall. And I will try to be back within 15 minutes. We will then start with Secretary Sprinkel immediately.
[Recess.]
Senator GORTON. Mr. Secretary, our apologies for using up so
much of your day. I am grateful for your patience.
As you know, your entire statement will be included in the
record as if read in full. If you would like to summarize it, you
may.
STATEMENT OF BERYL W. SPRINKEL, UNDER SECRETARY FOR
MONETARY AFFAIRS, DEPARTMENT OF THE TREASURY
Mr. SPRINKEL. Thank you, Senator Gorton. It is a pleasure to
appear before your committee to discuss monetary policy. I will
present an abbreviated version of my testimony.
While it often seems impossible for economists and politicians to
agree either among themselves, or with each other, about much of
anything, it is clear that we all agree on the desirability of low interest rates. It is often vaguely asserted that there is some group of
people out there somewhere that favors high interest rates; I
cannot imagine who those people would be. This administration
has sometimes been accused of pursuing a policy of high interest
rates; nothing could be further from the truth. We have consistently emphasized the need to reduce inflation and interest rates as a
prerequisite to sustainable real economic growth and can, I believe,
point with pride to the reduction in inflation and interest rates
that have occurred in the past 2 ¥2 years.
In the current situation, domestic as well as international concerns provide compelling economic arguments for lower interest
rates. Domestically, the level of interest rates will be an important
determinant of the mix of output growth as the economy expands;
lower interest rates would encourage capital investment that is
needed to expand job opportunities, improve productivity, and enhance the ability of U.S. industry to compete abroad. On the international front, the implications of a sustained increase in U.S. interest rates are serious. Since much of the debt negotiated by less
developed countries carries variable interest rates, their repayment
burdens are highly sensitive to increases in U.S. interest rates.
HOW TO GET LOWER INTEREST RATES
The desirability of lower interest rates is clear; that is not the
issue. The issue is how do we achieve them. The only way that interest rates can be expected to resume the decline that began about
1 year ago is if we—the administration, the Congress and the Federal Reserve—take the monetary and fiscal actions needed for a
low-interest-rate environment. Economic and political rhetoric will
not do the job, we cannot stand on the shore and order the tide not
to come in.
It is important to remember that interest rates—though still
higher than any of us would
like—are now considerably lower than
they were 1 year ago and 2 1 /2 years ago. The table in my text shows
the current level of some representative short- and long-term
market interest rates and the substantial declines that have oc-
135
curred since a year ago and since December 1980. There has been
an impressive improvement in other rates as well; the prime rate,
for example, is now 600 basis points below where it was a year ago,
and 1,100 basis points below its December 1980 level. Obviously, we
would all like to see continued progress. In that regard, it is particularly troublesome that market rates have ceased their decline
and have begun to rise again since early May. That also is in the
table.
It is equally important, I think, to understand the timing of the
movement in rates over the past year. As is illustrated in chart 1,
nearly all of the decline in short-term rates achieved in the past
year occurred during July and August 1982; this is shown by the
dotted line in the r chart. Since last fall, short-term market rates
have followed thei usual uneven path, but they have achieved no
further net decline; the 30-day commercial paper rate is now 98
basis points above the low point it reached in the last week of
August 1982. Long-term rates fell for a longer period of time last
summer and fall, but also leveled off by early November, and have
recorded no further net declines; the rate on long-term Government bonds is now 109 basis points above its November low.
The solid line on the chart depicts the 13-week rate of money
growth which began accelerating dramatically in September and
has remained in the double-digit range ever since. Thus, the facts
clearly contradict the widespread and much-publicized views that
interest rates fell last year "after the Fed eased up on money
growth." By the time the acceleration of money growth became evident last fall, the decline in short rates had already occurred. Furthermore, the rapid money growth of the last 9 or 10 months has
not provided for any further decline in rates.
There is some validity to the commonsense notion that more
money growth induces lower interest rates. The actions taken by
the Federal Reserve to expand money growth increase the reserves
available to the banking system; initially, this increased liquidity
can, and in some cases does, cause short-term interest rates to fall.
If reserve and money growth continue at a rapid rate, however,
eventually this liquidity effect is offset by, and ultimately is dominated by, the market's long-term concerns about excessive money
growth. These concerns may take the form of inflationary expectations which tend to put upward pressure on long-term rates, or uncertainty about the prospects of tightening actions by the Federal
Reserve, which, in turn, puts upward pressure on short-term rates;
or some combination of the two.
How quickly and how strongly the upward rate pressures emanating from an acceleration of money growth outweighs the initial
liquidity effects depends on several complex issues, such as the initial state of inflationary expectations, the previous path of money
growth relative to its target range, the credibility of Federal Reserve and administration policy actions and statements, and current and prospective economic and financial market conditions.
The public's expectations and reactions to Federal Reserve actions
are frequently very important to the behavior of interest rates;
they and many other forces, limit the Federal Reserve's ability to
determine, or even influence, interest rates with the precision that
the public typically presumes is possible. In particular, the Federal
136
Reserve has no ability over any prolonged period of time to generate lower interest rates by increasing the rate of monetary expansion; under some circumstances, its ability to do so even for the immediate, short run can be severely limited.
The accumulating evidence of a stronger-than-expected recovery
is a predictable result of a highly stimulative monetary policy.
Historically, a sustained acceleration of money growth causes an
expansion in economic activity 6 to 9 months later. And that is no
different this time. Economic stimulus is, however, only the immediate, temporary effect of accelerated money growth; if excessive
money growth is maintained, the permanent effects are rising inflation and rising interest rates which are pervasive deterrents to
real economic growth.
In this context, the recent rise in interest rates—while not yet
large enough to pose a real threat to the economy—is an ominous
sign. The financial markets are well aware of the inflationary potential of more months of rapid money growth. This concern is
compounded by the budget situation; large projected deficits generate concern that the Federal Reserve may monetize them. This possibility reinforces the widespread skepticism that the Government
will adhere to noninflationary policies over the long run.
THE RELATIONSHIP OF MONEY GROWTH TO VELOCITY
A common justification of the record-high money growth over the
past 10 months is the decline in velocity that has occurred in the
last year. Arithmetically, velocity is simply the ratio of nominal
GNP to the money supply. In terms of the public's behavior, velocity represents the fundamental behavioral relation between the
amount of spending the public does and the quantity of money in
its hands.
Historically, velocity in the United States has been reasonably
predictable, despite changing economic conditions and substantial
institutional changes. This reliable relation is the basis of a policy
of controlling the rate of money growth in order to influence the
rate of growth in nominal GNP. It is the premise for the recommendation that moderate, noninflationary money growth will, over
the long run, facilitate real economic growth without inflation and
for the recommendation that stable money growth would minimize
the fluctuations in nominal GNP growth.
The decline in velocity that has occurred leads some to believe
that the basic relation between money and nominal GNP growth
has been altered, and that therefore money growth should be permanently increased to compensate for a permanently lower rate of
velocity growth. The decline in velocity leads others to suspect the
validity of the basic policy approach of controlling the rate of
money growth. Since the issue is very important to the conduct of
monetary policy, and is also widely misunderstood, I believe it is
important to explore the historical and recent behavior of velocity
in more detail.
First, it is important to recognize that velocity typically declines
during a recession. Furthermore, the decline in inflation and inflationary expectations in the last year and a half would also be expected to cause velocity growth to fall. Therefore, a part of the de-
137
cline in velocity can be attributed to its normal cyclical behavior,
reinforced by the substantial decline in inflation. But as many
have observed, the decline in velocity in the recession that ended in
1982 was larger than that for previous ones.
An often-overlooked fact is that a substantial proportion of the
recent decline in velocity can be directly attributed to the acceleration of money growth itself. An acceleration of money growth in
one quarter cannot be expected to induce higher nominal GNP
growth in that same quarter; it takes two to three quarters for an
increase in money growth to stimulate spending and induce an associated increase in nominal GNP growth. Since a large increase in
the rate of money growth causes no immediate increase in nominal
GNP—it is the numerator in that ratio—and velocity growth is
simply the ratio of nominal GNP growth to money growth, the immediate effect of accelerated money growth is likely to be a contemporaneous decline in velocity. Ultimately, the accelerated
money growth stimulates nominal GNP growth and velocity rebounds. And that is what is currently happening. But if money
growth continues at a rapid pace, as it has over the last 10 months,
velocity could continue—and it was for a while—to be suppressed
until nominal GNP growth catches up to the increased money
growth. It was announced this morning that the rate of nominal
GNP growth last quarter was 13.2 percent, reflecting not what happened to the money supply in the second quarter but what happened to the money supply in the quarters prior to that. The initial
catch-up of nominal GNP growth may consist of an above-average
increase in real GNP, but if accelerated money growth persists,
real growth will abate as inflation takes over.
As chart 2 illustrates, the large swings in velocity since 1980 coincide with similarly large swings in money growth in the opposite
direction. This is particularly the case for the widely-cited decline
in velocity observed in the last quarter of 1982.
An immediate decline in velocity would therefore be expected
with an acceleration of money growth of the magnitude that has
occurred in the last three quarters. This is particularly true since
it followed a prolonged period of relatively slow growth, the lagged,
depressing effect of which was still being felt on nominal GNP
after money growth was reaccelerated. If money growth is slowed
over the next few quarters, velocity would be expected to rise. This
may well have started in the second quarter. This would occur, not
only as a result of the slowdown in money growth, but also because
the lagged effect of the past few quarters of rapid money growth
will continue to stimulate nominal GNP.
This sounds a little complicated, but it really is not. Pumping in
a rapid increase of money today does not immediately affect nominal GNP. However, it does affect imputed velocity and causes it to
go down sharply.
CONTROLLING THE MONEY SUPPLY
Those who emphasize the importance of controlling the money
stock have never based their recommendation on the presumption
that velocity was stable from one quarter to the next or even from
one year to the next. It is the long-run predictability of the velocity
138
relationship that makes monetary targeting a reliable basis for stabilization policy. At the same time, the short-run, unpredictable
fluctuations in velocity indicate that attempts to tailor money
growth to perceived or expected changes in velocity are not likely
to be successful. The lag in the effect of money growth on economic
activity, and the variability of that lag, not only imply that fluctuations in velocity will occur, but also that attempting to fine-tune
money growth to those fluctuations is a very risky, and potentially
damaging, approach to monetary policy.
Those who believe that a permanent decline in velocity has occurred, and that it necessitates a permanently higher rate of
money growth, typically attribute the change in velocity to the effects of financial innovation and deregulation. Since the payment
of market interest rates on transaction accounts—which are included in the Mi measure of the money supply—represents a fundamental change in our financial system, it is possible that it has altered the public's behavior with respect to their money holdings. It
may be that the observed decline in velocity partially reflects a
fundamental and lasting change in the public's behavior. If so, the
issue becomes an empirical one of determining the change in either
the level or trend rate of velocity and adjusting the money growth
targets accordingly. Even after adjusting recent money growth for
the growth of deposits now included in Mi that may have attributes of savings, money growth remains high by any historical
standard.
Basing policy on the presumption that a permanent change in
velocity has occurred is very risky. This is not the first time these
arguments have been made. It has happened many times, and on
each occasion velocity came back to its normal pattern, as I expect
it to do this time. In the current situation, it is a risk that is biased
in the direction of more inflation, higher interest rates, and lower
real economic growth in the years ahead. The risk of allowing
money growth to continue at its current pace is not just the inflationary threat it poses for the future; in addition, postponing action
to slow money growth carries the risk that once corrective actions
are taken, they will be damaging and destabilizing to the economy—meaning by that, the recovery is squelched.
Short-term fluctuations in the velocity relationship have led
some to assert that control of money growth is no longer a viable
approach to monetary policy. Others have become impatient with
controlling money growth because it seems abstract and removed
from the very real economic problems we face, such as inflation,
high interest rates, or unemployment.
I think that we sometimes lose sight of why it is that we are so
concerned, at least some of us, about controlling the money supply.
We do not seek to control money just to give the Federal Reserve
something to do, or because it is an interesting exercise. Money
growth is important because of its predictable long-run relation to
the growth of nominal GNP, and its close correlation with the rate
of inflation over the long run.
Effective monetary policy actions require only that there exist
some economic variable—be it the money supply, monetary base, or
the price of widgets—that meet two conditions: First, it must be
controllable—and ideally with some precision—by the Federal Re-
139
serve. This condition eliminates a lot of potential candidates, including the price of widgets.
Second, it needs to be an economic variable that is related in a
reliable way to the economic variables we ultimately wish to affect:
prices, output, and employment growth.
While the money is not a perfect variable on which to base monetary policy, it is far more reliable and technically workable than
most of the alternatives. With the exception of some measures of
bank reserves and the monetary base, most of the alternative variables proposed as targets for monetary policy fail the first condition listed above; namely, controllability.
In addition to the monetary discipline they can impose, money
growth targets can be an important shorthand description of the
central bank's intention with respect to future inflation. Once a
tradition of setting and achieving credible monetary targets is established, the targets can also give very important information to
the financial markets and investors. That information can contribute much to promoting financial market stability and reducing the
uncertainty that surrounds investment decisions.
It is a futile and ultimately self-defeating policy to use excessive
monetary expansion in an attempt to drive interest rates down. In
the long run, the results of that policy are just the opposite: high,
or rising, interest rates. Economic developments over the past two
decades demonstrate the point that inflationary monetary policy
yields not only more inflation, but less real growth, and higher unemployment and higher interest rates as well.
The table included provides long-term 5-year averages for money
growth, inflation, interest rates and real economic growth since
1960, plus the averages for 1981-82. As is shown in the table, the
average rate of money growth has accelerated steadily since 1960.
This rising trend of money growth has been associated with a similar acceleration in the average rate of inflation, as shown by the
GNP deflator, and long-term interest rates, as represented by the
Corporate AAA bond rate.
Note, however, that persistent monetary stimulus did not result
in lasting economic growth. In the two decades from 1961 to 1980,
the 5-year average of money growth more than doubled, but average growth in real GNP declined. Furthermore, the average unemployment rate was more than a full percentage point higher in the
1976-80 period than in the 1961-65 period. Thus, more than doubling the rate of money growth over the two decades did not "buy"
us more real growth or less unemployment; it "bought" us higher
inflation, and interest rates, and lower growth and higher unemployment. The inflation and high interest rates caused by prolonged excessive monetary expansion are detrimental to real economic growth and over the long run outweigh any short-run stimulus that may be induced by accelerating money growth.
FED NEEDS GRADUAL SLOWDOWN OF MONEY GROWTH
Well, where do we go from here? The task that now confronts
the Federal Reserve is to achieve a gradual slowing in the rate of
money growth and avoid any severe or prolonged period of excessive monetary restraint. Continuing to allow money to grow at an
140
excessive pace will not produce the lower interest rates that all of
us desire. With enormous uncertainty in the financial markets
about monetary policy and the rise in long-term rates in the last
months, the financial markets are likely to react adversely to a
continuation of rapid money growth.
Those who oppose a slowing in the rate of money growth do so
because they fear the rise in short-term rates that may accompany
such a policy. It is likely, however, that any rise in rates associated
with the slowing of reserve and money growth would be relatively
short lived. Furthermore, the short- and long-term rates are already rising in response to the protracted period of excessive,
above-target money growth. While the temporary rise in interest
rates that may accompany a slowing of money growth is nothing to
applaud, it is preferable to the permanent rise in long-term rates
that can be expected if money growth continues unabated.
In the recent past, the effects of institutional change have generated considerable uncertainty and controversy about the behavior
of the monetary aggregates. Those uncertainties have made it difficult to interpret the path of money growth in recent months. Some
form of uncertainty is inherent in the process of conducting monetary policy, and risks are always associated with the alternative
policy actions available to the Federal Reserve. The challenge for
policymakers is to pursue policies that minimize the implied risk to
economic performance and stability. My concern is that the path of
money growth that has occurred in the last 10 months does not
represent a policy that minimizes risk. To the contrary, it is a
highly risky policy, with the risk heavily skewed toward higher inflation and interest rates in the years ahead.
It is best that the Federal Reserve not attempt to reverse the
recent surge in money growth, as any severe or abrupt restriction
of money growth would almost certainly be damaging to the economy. What is needed, and I hope that is what we will get, is for the
Federal Reserve to take the policy actions immediately required to
provide a gradual slowdown of money growth.
It is vitally important that we remain sensitive to the danger of
repeating the mistakes of the past when rapid money growth has
been allowed to continue into the recovery phase, laying the
groundwork for a renewed resurgence of inflation. Recognizing the
lag in the effect of money growth on inflation, it is clear that if
actions to slow the rate of money growth are delayed until an
actual increase in inflation is observed, it will be too late to take
the necessary preventive actions.
Thank you, Senator Gorton.
[The complete statement follows:]
141
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.
Thursday, July 21, 1983
Chairman Garn, Senator proxmire, other distinguished members
of the Committee, it is a pleasure to be here today to discuss
monetary policy with you.
While it often seems impossible for economists and politicians
to agree, either among themselves, or with each other, about much
of anything, it is clear that we can all agree on the desirability
of low interest rates.
It is often vaguely asserted that there is
some group of people out there somewhere that favors high interest
rates; I cannot imagine who those people would be.
This Adminis-
tration has sometimes been accused of pursuing a policy of high
interest rates; nothing could be further from the truth.
We
have consistently emphasized the need to reduce inflation and
interest rates as a prerequisite to sustainable real economic
growth and can, I believe, point with pride to the reduction in
inflation and interest rates that have occurred in the past two
and one-half years.
In the current situation, domestic as well as international
concerns provide compelling economic arguments for lower interest
rates.
Domestically, the level of interest rates will be an
142
important determinant of the mix of output growth as the economy
expands; lower interest rates would encourage the capital
investment that is needed to expand job opportunities, improve
productivity, and enhance the ability ot U.S. industry to
compete abroad.
On the international front the implications
of a sustained increase in U.S. interest rates are serious.
Since much of the debt negotiated by less developed countries
carries variable interest rates, their repayment burdens are
highly sensitive to increases in U.S.
rates.
The desirability of lower interest rates is clear; that is
not the issue.
The issue is how to achieve them.
The only
way that interest rates can be expected to resume the decline
that began about one year ago is if we -the Administration,
the Congress and the Federal Reserve -- take the monetary and
fiscal policy actions needed for a low interest rate environment.
Economic and political rhetoric will not do the job; we cannot
stand at the shore and order the tide not to come in.
It is important to remember that interest rates -- though
still higher than any of us would like —
are now considerably
lower than they were a year ago, and two-and-a-half
years ago.
The table below shows the current level of some representative
short- and long-term market interest rates and the substantial
declines that have occurred since a year ago and since December
1980.
There has been an impressive improvement in other rates
as well; the prime rate, for example, is now 600 basis points
below where it was a year ago and 1100 basis points below its
December 1980 level.
Obviously, we would all like to see
143
continued progress.
In that regard, it is particularly trouble-
some that market rates have ceased their decline and have begun
to rise again since early May; this is shown in the last column
of the table.
.Changes in Short- and Long-Term Market Interest__Rates
Most Recent
Weekly Average
(7/15/83)
Change (Basis points) Compared to:
One Year
Ago
(Week of
7/2/82}
2 Months
Ago
(Week of
5/6/83)
2 1/2
Years Ago
(Week of
12/26/80)
3-month CD rate
9.51%
-570
-809
+119
3-month Treasury
bill rate
9.07
-374
-555
+ 104
Corporate
AAA rate
12.13
-294
-76
+84
Long- term
government
bond rate
11.12
-230
-26
+112
It is equally important to understand the timing of the movement in rates over the past year.
As is illustrated in Chart 1
on the next page, nearly all of the decline in short-term rates
achieved in the past year occurred during July and August of
of 1982; this is shown by the dotted line in the chart.
Since
last fall, short-term market rates have followed their usual
uneven path, but they have achieved no further net decline; the
30-day commercial paper rate is now 98 basis points above the
low point it reached in the last week of August, 1982.
Long-term
rates fell for a longer period of time last summer and fall, but
also leveled off by early November, and have recorded no further
net declines; the rate on long-term government bonds is 109
basis points above its November low.
144
The solid line on the chart depicts the 13-week rate of
money growth which began accelerating dramatically in September
and has remained in the double-digit range ever since.
Thus,
the facts clearly contradict the widespread and much-publicized
view that interest rates fell last year "after the Fed eased
up on money growth."
By the time the acceleration of money
growth became evident last fall, the decline in short rates
had already occurred.
Furthermore, the rapid money growth of
the last 9-10 months has not provided for any further declines
in rates.
There is some validity to the common-sense notion that more
money growth induces lower interest rates.
The actions taken by
the Federal Reserve to expand money growth increase the reserves
available to the banking system; initially, this increased liquidity can cause short-term
interest, rates to fall.
If reserve and
money growth continue at a rapid pace, however, eventually this
liquidity effect is offset by, and ultimately is dominated by,
the markets' long-term concerns about excessive money growth.
These concerns may take the form of inflationary expectations
(which puts upward pressure on long-term rates), or uncertainty
about the prospects of tightening actions by the Fed (which
puts upward pressure on short-term rates), or a combination of
both.
How quickly and how strongly the upward rate pressures
emanating from an acceleration of money growth outweigh the
initial liquidity effects depends on the complex interaction
of a variety of factors including the initial state of inflationary expectations, the previous path of money growth relative
145
to its target range, the credibility of Federal Reserve and
Administration policy actions and statements, and current and
prospective economic and financial market conditions.
The
public's expectations and reactions to Federal Reserve actions
are frequently very important to the behavior of interest
rates; they, and many other forces, limit the Federal Reserve's
ability to determine, or even influence, interest rates with
the precision that the public typically presumes is possible.
In particular, the Federal Reserve has no ability over any
prolonged period of time to generate lower interest rates by
increasing the rate of monetary expansion; under some circumstances, its ability to do so even for the immediate, short run
can be severely limited.
The accumulating evidence of a stronger-than-expected
recovery is a predictable result of a highly stimulative monetary
policy; historically a sustained acceleration of money growth
causes an expansion in economic activity six to nine months
later.
Economic stimulus is, however, only the immediate, tempo-
rary effect of accelerated money growth; if excessive money
growth is maintained, the permanent effects are rising
inflation and interest rates which are pervasive deterrents to
real economic growth.
In this context, the recent rise in interest rates
—
while not yet large enough to pose a real threat to the recovery ia an ominous sign.
The financial markets are well aware of
the inflationary potential of more months of rapid money
growth.
This concern is compounded by the budget situation;
146
large projected budget deficits generate concern that the Fed
may monetize them.
This possibility reinforces the widespread
skepticism that the government will adhere to noninflationary
policies over the long run.
The Behavior of Velocity
A common justification of the record-high money growth of the'
past ten months is the decline in velocity that has occurred in
the last year.
Arithmetically, velocity is simply the ratio
of nominal GNP to the money supply.
In terms of the public's
behaviot, velocity represents the fundamental behavioral relation
between the amount of spending the public does and the quantity of
money in its hands.
Historically, velocity in the U.S. has been reasonably
predictable, despite changing economic conditions and substantial
institutional changes.
This reliable relation is the basis of
a policy of controlling the rate of money growth in order to
influence the rate of growth in nominal GNP.
It is the premise
for the recommendation that moderate, noninflationary money
growth will, over the long run, facilitate real economic growth
without inflation and for the recommendation that stable
money growth would minimize the fluctuations in GNP growth.
The decline in velocity that has occurred leads some to
believe that the basic relation between money and nominal GNP
growth has been altered, and that therefore money growth should
be permanently
increased to compensate for a permanently lower
rate of velocity growth.
The decline in velocity leads others
to suspect the validity of the basic policy approach of
147
controlling the rate of money growth.
Since the issue is
very important to the conduct of monetary policy, and is also
widely misunderstood, I believe it is important to explore
the historical and recent behavior of velocity in more detail.
First, it is important to recognize that velocity growth
typically declines during a recession.
Furthermore, the decline
in inflation and inflationary expectations in the last year
and a half would also be expected to cause velocity growth to
fall.
Therefore, a part of the decline in velocity can be
attributed to its normal cyclical behavior, reinforced by the
substantial decline in inflation.
But, as many have observed,
the decline in velocity in the recession that ended in 1982
was larger than that for previous ones; the average decline in
velocity for previous postwar recessions was 1.3%, compared
to 3.7% from third quarter 1981 to the fourth quarter of 1982.
An often-overlooked fact is that a substantial proportion
of the recent decline in velocity can be directly attributed
to the acceleration of money growth itself.
An acceleration
of money growth in one quarter cannot be expected to induce
higher nominal GNP growth in the same quarter; it takes two or
three quarters for an increase in money growth to stimulate spending and induce an associated increase in nominal GNP growth.
Since a large increase in the rate of money growth causes no
immediate increase in nominal GNP, and velocity growth is simply
the ratio of nominal GNP growth to money growth, the immediate
effect of accelerated money growth is likely to be a contemporaneous decline in velocity.
Ultimately, the accelerated money
growth stimulates nominal GNP growth and velocity rebounds.
But
148
if money growth continues at a rapid pace, as it has over the
last ten months, velocity could continue to be suppressed until
nominal GNP growth "catches up" to the increased money growth.
The initial "catch-up" of nominal GNP growth may consist of an
above-average increase in real GNP, but if accelerated money
growth persists, real growth will abate as inflation takes over.
As Chart 2 illustrates, the large swings in velocity since
1980 coincide with similarly large swings in money growth in the
opposite direction.
This is particularly the case for the widely-
cited decline in velocity observed in the last quarter of
1982.
when money growth is accelerated, an immediate and initial
decline in velocity is not surprising or unusual.
For example,
from the first to the second quarter of 1971, money growth was
accelerated from a quarterly growth rate of 7.2% to 9.3%; velocity
which had risen at an 8.4* annual rate in the first quarter fell
at a 1.8% rate in the second quarter.
Thus, an increase in money
growth induced a substantial decline in velocity even though the
economy was in the early stages of a recovery.
An immediate decline in velocity would therefore be expected
with an acceleration of money growth of the magnitude that has
occurred in the last three quarters.
This is particularly true
since it followed a prolonged period of relatively slow money
growth, the lagged, depressing effect of which was still being
felt on nominal GHP after money growth was reaccelerated.
If
money growth is slowed over the next few quarters, velocity
would be expected
to rise.
This would occur, not only as a
result of the slowdown in money growth, but also because the
149
lagged effect of the past few quarters of rapid money growth
will continue to stimulate nominal GNP.
Primarily because of the lag in the effect on nominal GNP
growth of a change in the rate of money growth, velocity can be
expected to display sizeable short-run fluctuations, particularly
when money growth is volatile.
Since 1980, the variation in
velocity has increased; comparing the period since the beginning
of 1980 with the preceding Is years, quarterly variability of
velocity has more than doubled.
The increased fluctuations
observed in velocity growth, however, have coincided with a proportionate increase in the volatility of money growth; comparing
the same two periods, variability in money growth has also more
than doubled.
Those who emphasize the importance of controlling the money
stock have never based their recommendations on the presumption
that velocity was stable from one quarter to the next or even
one year to the next.
it is the long-run predictability of
the velocity relationship that makes monetary targeting a reliable
basis Eor stabilization policy.
At the same time, the short-run,
unpredictable fluctuations in velocity indicate that attempts
to tailor money growth to perceived or expected changes in velocity
are not likely to be successful.
The lag in the effect of money
growth on economic activity, and the variability o£ that Lag,
not only imply that fluctuations in velocity will occur, but
also that attempting to fine-tune money growth to those fluctuations
is a very risky, and potentially damaging, approach to monetary
policy.
150
Those who believe that a permanent decline in velocity has
occurred, and that it necessitates a permanently higher rate of
money growth, typically attribute the change in velocity to the
effects of financial innovation and deregulation.
Since the
payment of market interest rates on transactions accounts (which
are included in the Ml measure of the money supply) represents a
fundamental change in our financial system, it is possible that
it has altered the public's behavior with respect to their money
holdings.
If so, it is logical that people may now choose to
hold larger money (Ml) balances relative to spending and income;
such a behavioral change would mean a decline in velocity.
It
may be that the observed decline in velocity partially reflects
a fundamental and lasting change in the public's behavior.
If so,
the issue becomes an empirical one of determining the change in
either the level or trend rate of velocity and adjusting the
money growth targets accordingly.
Even after adjusting recent
money growth rates for the growth of deposits now included in Ml
that may have attributes of savings, money growth remains high
by any historical standard.
Basing policy on the presumption that a permanent change
tn velocity has occurred
is very risky.
In the current situ-
ation, it is a risk that is biased in the direction of more
inflation, higher interest rates and lower real economic growth
in the years ahead.
The risk of allowing money growth to continue
at its current pace is not just the inflationary threat it poses
for the future; in addition, postponing action to slow money
growth carries the risk that once corrective actions are taken,
they will be damaging and destabilizing to the economy.
151
The Importance of_Cgntrolling Money Growth
Shoct-term fluctuations in the velocity relationship have
led some to assert that control of money growth is no longer
a viable approach to monetary policy.
This view is typically
based on arguments about the pace of financial innovation and
deregulation and the changing characteristics of money in out
economy.
Others have become impatient with controlling money
growth because it seems abstract and removed from the very real
economic problems we face, such as inflation, high interest
rates or unemployment.
I think that we sometimes lose sight of why it is that we
are so concerned about controlling the money supply.
We do not
seek to control money growth just to give the Federal Reserve
something to do, or because it is an interesting exercise.
Money
growth is important because of its predictable long-run relation
to the growth of nominal GNP, and its close correlation with the
rate of inflation over the long run.
Effective monetary policy actions require only that there
exist some economic variable —
be it the money supply, the mone-
tary base, or the price of widgets —
First, it must be controllable —
precision —
by the Federal Reserve.
that meets two conditions:
and ideally with some
This condition eliminates
a lot of potential candidates, including the price of widgets.
Second, it needs to be an economic variable that is related
in a reliable way to the economic variables we ultimately wish
to affect —
prices, output and employment growth.
152
While the money supply is not a perfect variable on which
to base monetary policy, it is far more reliable and technically
workable than most of the alternatives.
With the exception of
some measures of bank reserves and the monetary base, most of
the alternative variables proposed as targets for monetary
policy fail the first condition listed above, controllability.
Interest rates, for example, are superficially an appealing
variable for monetary policy —
in the sense that they are
visible and easily understood by the public.
The Federal
Reserve cannot, however, control interest rates with an acceptable level of precision over the long run.
Even if the Federal
Reserve were able to control interest rates with reasonable precision, the relationship between interest rates and nominal GNP
growth is not well understood or reliable,
without a depend-
able relation between the level or rate of change in interest
rates and economic activity, interest rates do not provide the Fed
with reliable information on when to change interest rates {if
they could}, or by how much, to have the desired effect on the
economy.
Furthermore, in the past, attempts to control interest
rates have resulted in an inflationary bias in monetary policy.
Many people find the idea of using nominal GNP as a target
for monetary policy to be appealing.
A policy of controlling
money growth, however, implies controlling nominal GNP growth
because money growth and nominal GNP growth are closely related.
In the case of monetary targeting, money growth is both the
target for policy and the instrument of Fed policy actions.
The Federal Reserve has no direct control over nominal GNP, so
it is not a workable variable to use as a monetary policy
153
instrument.
Nominal GNP is, in effect, the ultimate goal or
target of a policy of controlling the money supply; controlling
money growth is a means by which nominal GNP growth is stabilized.
A central bank has no power to control real economic variables over the long run.
Therefore real variables —
such as
real GNP growth, real interest rates, the unemployment rate
are also not viable targets for monetary policy actions.
—
The
only thing that a central bank can do over the long run is to
assure price stability; that is accomplished by providing for an
appropriate rate of monetary expansion.
Beyond providing price
stability, which can enhance real economic growth and financial
market stability, a central bank can do nothing in the long run
to promote employment, lower interest rates, or to stimulate
higher real economic growth.
In addition to the monetary discipline they can impose,
money growth targets can be an important short-hand
description
of the central bank's intentions with respect to future inflation.
Once a tradition of setting and achieving credible money
targets is established, the targets can also convey important
information to the financial markets and investors.
That informa-
tion can contribute much to promoting financial market stability
and reducing the uncertainty that surrounds investment decisions.
The Long-Run Effects of Excessive Money Growth
It is a futile and ultimately self-defeating policy to use
excessive monetary expansion in an attempt to drive interest
rates down.
In the long run, the results of that policy are
just the opposite —
high, or rising, interest rates.
Economic
154
developments over the past two decades demonstrate the point that
inflationary monetary policy yields not only more inflation, but
less real growth, and higher unemployment and interest rates as
well.
The table below provides long-term (5-year) averages for
money growth, inflation, interest rates and real economic growth
since I960, plus the averages for 1981-82.
As is shown in the
table, the average rate of money growth has accelerated steadily
since 1960.
This rising trend of money growth has been associated
with a similar acceleration in the average rate of inflation,
as shown by the GNP deflator, and long-term interest rates, as
represented by the Corporate AAA bond rate.
Note, however, that persistent monetary stimulus did not
result in lasting economic growth.
In the two decades from
1961 to i960, the five-year average of money growth more than
doubled, but average growth in real GNP declined.
Furthermore,
the average unemployment rate was more than a full percentage
point higher in the 1976-1980 period than in the 1961-65 period.
Thus, more than doubling the rate of money growth over the two
decades did not "buy" us more real growth or less unemployment;
it "bought" us higher inflation, and interest rates, and lower
growth and higher unemployment.
The inflation and high interest
rates caused by prolonged, excessive monetary expansion are
detrimental to real economic growth, and over the long run
outweigh any short-run stimulus that may be induced by accelerating
money growth.
155
Average Annual Rates of Change
Ml
GNP Deflator
1961-1965
3.5%
1.6%
1966-1970
5.0
1971-1975
6.1
1976-1980
7.4
1981-1982
6.8
Corporate AAA
Bond Rate
Real GNP
Unemployment
Rate
4.4%
4.7%
5.5%
4.2
6.4
3.2
3.9
6.6
7.9
2.6
6.1
7.3
9.4
3.7
6.8
7.7
14.0
0.1
8.7
Where Do We Go From^ Here?
The task that now confronts the Federal Reserve is to achieve
a gradual slowing in the rate of money growth and avoid any
severe or prolonged period of excessive monetary restraint.
Continuing to allow money to grow at an excessive pace will not
produce the lower interest rates that all of us desire,
with
enormous uncertainty in the financial markets about monetary
policy and the rise in long-term rates in the last months, the
financial markets are likely to react adversely to a continuation
of rapid money growth.
Those who oppose a slowing in the rate of money growth do
so because they fear the rise in short-term rates that may
accompany such a policy.
It is likely, however, that any rise
in rates associated with the slowing of reserve and money growth
would be relatively short lived.
Furthermore, short and long-
term rates are already rising in response to the protracted
period of excessive, above-target money growth.
While the
156
temporary rise in interest rates that may accompany a slowing
of money growth is nothing to applaud, it is preferable to the
permanent rise in long-term rates that can be expected if money
growth continues unabated.
In the recent past, the effects of institutional change have
generated considerable uncertainty and controversy about the
behavior of the monetary aggregates.
Those uncertainties have
made it difficult to interpret the path of money growth in recent
months.
Some form of uncertainty is inherent in the process of
conducting monetary policy, and risks are always associated
with the alternative policy actions available to the Federal
Reserve.
The challenge for policymakers is to pursue policies
that minimize the implied risk to economic performance and
stability.
My concern is that the path of money growth that has
occurred in the last ten months does not represent a policy that
minimizes risk.
To the contrary, it is a highly risky policy,
with the risk heavily skewed towards higher inflation and interest
rates in the years ahead.
It is best that the Federal Reserve not attempt to reverse
the recent surge in money growth as any severe or abrupt restriction of money growth would be damaging to the economy.
What is
needed is for the Federal Reserve to take the policy actions
immediately required to provide a gradual slowdown of money growth.
It is vitally important that we remain sensitive to the
danger of repeating the mistakes of the past when rapid money
growth has been allowed to continue into the recovery phase,
laying the groundwork for a renewed resurgence of inflation.
Recognizing the lag in the effect of money growth on inflation,
it is clear that if actions to slow the rate of money growth
are delayed until an actual increase in inflation is observed,
it will be too late to take the necessary preventive actions.
oOo
157
Chart 1
HMEY (Ml) GPCWB MD SH3RMHW WISEST RUGS
1962-1983
iiiiMiiiiiiiMiiiiiiiiiniinniuiiiiii
Note: data for Ml are four week noving averages; growth Is relative to
13 weeks ago.
Prepared ty the Office of Monetary Policy Analysis. Telephone 566-6261.
Acceleration of Honey (Ml) Rroi*th
- 197901 TO 198301(ANNUALIZED PERCENT PKR ANNUM)
elocity
CHART 2
Acceleration in Money Growth
(Inverted tikht *c«le)
-15
15
•THE fcCCEtEBATlON OF MONEY GROWTH IS CURRENT QUABTFRr.Y RROWTH LESS
QUARTERLY CRoWTH LAGGED TVO QUARTERS
VELOCITY GROWTH is QUARTER TO QUARTER
159
Senator GORTON. Thank you very much, Secretary Sprinkel.
In February, Chairman Garn expressed a great deal of concern
over the failure of short-term interest rates to fall in the fact of
then-sharply declined inflation rates.
I'd like to followup with the questions he asked you then. In your
view, is the current level of rates charged on short-term consumer
loans consistent with the rate of inflation we've experienced for the
first half of 1983?
Mr. SPRINKEL. Short-term real rates, if you measure real rates by
actual inflation rates, appear very high.
I would also add that long-term rates, measured by current inflation rates, also appear high in terms of longer term history. I think
it is mportant to note that we should not use the current rate of
inflation to try to estimate real rates. What we should use is the
expected rate of inflation over the period of time that the financial
instrument is outstanding. The present actual rate of inflation is
not too far off, probably, of the expected rate of inflation over the
next, say, 6 months. But as you look at the longer-term instruments, it is very clear that the public does not believe that we in
Washington will exert the necessary discipline to keep the inflation
rate at present levels; that is, the real rate will come down with
rising inflation. What we want is the real rate to come down, not
with rising inflation, but through a decline in nominal rates.
Senator GORTON. There's no question about that, but should it
affect short-term rates?
Mr. SPRINKEL. Not very much, because we are only talking about
a brief period of time, and no one to my knowledge, that in the 6
months ahead there is going to be an enormous burst of inflation.
I think that part of it has to do with the uncertainty in financial
markets stemming from volatile monetary policy. We did a study
at the Treasury some months ago, measuring the effect of increased volatility of monetary growth, which has been evident
since 1980, and the answers came up rather clearly that it added
significantly to both the short-term rate and to the long-term rate.
You might say that Treasury bills do not carry much risk. But
for many of the people that buy and sell Treasury bills, there is a
lot of risk. You can lose millions of dollars in a short period of time
if you are a dealer in Treasury bills and suddenly the rate moves
against you; and therefore, it tends to result in dealers insisting on
a higher rate of return in order for them to take that risk. So I
think the volatility of monetary policy is part of it.
Also, on occasion, and this may be one of those occasions, there is
a growing expectation that the Federal Reserve will slow the rate
of growth in money. I expect them to do so. Certainly, the Chairman indicated they would do so. And again, when that expectation
begins to develop, that tends to raise short-term rates. That should
be a temporary phenomenon. If, in fact, there is a slow-down in
money growth and if, in fact, we are successful in keeping the inflation rate down, it would be helpful if we had less volatility in
money growth, which would also make it possible to get rates down
to more reasonable real rate levels.
160
TREASURY BORROWING WILL ABSORB SAVINGS
Senator GORTON, Mr. Secretary, I'm interested in your assessment of the actual degree to which Treasury borrowing to finance
the deficit will absorb savings which would otherwise be available
for investment. The projected 1983 deficit is now about $175 billion.
The calendar 1983 gross private sector savings are estimated at
about $544 billion. The capital consumption and allowances project
a net private savings of about $178 billion. Abstracting from international capital it would appear that financing the government
will absorb perhaps 100 percent of the net private savings of 33
percent of gross private savings.
Obviously, this situation sounds more serious when the Government deficit is compared to net private savings. Is this the appropriate comparison to be using? In other words, to what extent do
depreciation figures represent real savings available for investment
in productive enterprises?
Which comparison to gross or net savings gives a more accurate
picture of Federal demand on our credit?
Mr. SPRINKEL. Well, in general, I hold firmly to the view that
deficits compete for savings that would otherwise be available in
the private sector. Fortunately, from one point of view, during a
period like we have just gone through, when the budget deficit rose
very substantially, it was accompanied by a reduction in the
demand for credit in the private sector. There was inventory liquidation going on, there was a slowdown in capital investment; and
those are not favorable trends.
We know if we are moving into a period of sustained economic
growth, that short-term credit, and then longer term credit,
demand from the private sector will be rising. It is during that
period that I think it is very critical that we pull down the size of
the Federal deficit, both in absolute amount, as well as relative to
GNP.
I think that from the standpoint of money, moving from one type
of investment into another, to the extent that we can create the
prospect of low rates of inflation, there will be shifting from real
assets to financial assets. This could have a favorable effect on interest rates, whereas it would have a not so favorable effect on real
assets. If you look at the trends in inflation and what happens to
real assets, real assets prices go up much more than inflation. That
is, the name of the game a few years ago was to buy land, homes,
gold, silver, commodities, you name it. And they didn't want stocks,
and they didn't want bonds. But as inflation came down and inflation expectations came down, not as much as actual inflation, it
has become very clear that commodity prices had moved down,
dropping sharply. In many cases, home prices are no longer soaring. Paintings aren't doing very well. And investors are moving
into financial assets.
I think it is an oversimplification to argue that you should look
at either gross new savings or net new savings as the variable that
is going to give you the clue as to whether or not we get interest
rates down. We can get interest rates down in the period ahead
with an expanding economic activity if we can gradually reduce
the deficit and, at the same time, make more firm expectations
161
that inflation will continue to go down. This will result in further
shifts in the financial assets, which is where money goes when they
expect inflation to be down and stay down. So I am not sure that
either of those figures will give you a good clue if you're having
major changes in inflationary expectations.
Senator GORTON. Next, would you comment on one of the questions I asked Dr. Feldstein, and that is the relationship between
the value of the dollar as it moves up and down to our exports and
imports, our balance of trade. How much can we expect to lose or
how much can we expect to gain by even relatively small movements of the value of the dollar?
Mr. SPRINKEL. We also have some estimates—I heard Chairman
Feldstein's response—and I will be glad to give them to you. I
would be surprised if they are much different from his, but I have
not seen his. The effect is not immediate, of course. It tends to
work with a lag, and therefore it is our view that even if the dollar
were weaker today it would not be a significant factor on our balance of trade until at least the latter part of 1984, not 1983. It
takes quite some time.
It is true that relative real interest rates sometimes have an observable effect on the dollar exchange rates. It is also true that on
other occasions it may be having an effect, but you can not demonstrate it. I think that is certainly too simplistic, and I am sure
Marty would agree with me, to say that it is relative real interest
rates alone that determine the value of the dollar vis-a-vis other
currencies. For example, you often hear the argument that there is
an important safe haven effect on the dollar; meaning by that, that
we have a nation of political stability. When instability occurs
abroad, money tends to move to the United States.
There are other reasons why money moves to the United States.
They include the fact that we have open capital markets. Investors
do not like to put money into an economy when there is a great
risk that they will not be able to get an attractive return on that
money, to bring money home, or to bring the money home in stock.
But also what I think is underemphasized is that the Congress
and the administration, over the past 2V2 years, have taken significant actions to improve the probability of high rates of return on
investments in the United States: The tax cuts, encouraging savings and investments, the changes in the corporate income tax.
We're now witnessing a very sharp increase in corporate profits
along with previous sharp increases in equity prices. All of those
factors have increased the value of the dollar.
There is a great tendency to compare the value of a dollar today
with its low, which was achieved in the middle of 1980. But remember, 1980 followed a period of several years of very sharp inflation
acceleration in the United States vis-a-vis the rest of the world. I
would hope that we do not go back to out-inflating the rest of the
world, and hence we are not likely to go back to as low a dollar as
we had in July of that year.
There seems to be room over time for some gradual depreciation
of the dollar, but I must say it is hanging very firmly. It depends
partly on what other nations do. As long as we do a good job in
keeping inflation under control, I would expect a reasonably strong
dollar most of the time.
162
Incidentally, I would add that one of the very important responsibilities the United States should shoulder, in my opinion, is to try
to maintain reasonable stability over domestic purchasing power of
the dollar. The dollar is the kingpin in international finance, and if
we have great volatility in our country, especially in a weakening
direction, it creates great problems in the international financial
arena.
I also realize that not only do foreign observers complain when
the dollar is weaker, they also have been complaining recently
when it was strong. But clearly, the fact that the dollar has been
strong is going to lead to deficits in our monetary account; and certainly a greater one in our trade account. However, it does provide
demand for goods in other countries, and could certainly help the
worldwide recovery.
So I do not believe we should look at relative real interest rates
as the only measured determinant for the value of the dollar vis-avis other currencies.
[Additional information supplied for the record by Mr. Sprinkel
follows:]
163
Effect of Changes in the Dollar Exchange Rate
on the U.5. Merchandise Trade Balance
The U.S. merchandise trade balance is the net result of the
effects of a number of economic variables on U.S. exports and imports.
Generally economic growth at home and abroad, relative inflation
rates, the stage of the business cycle here and abroad and exchange
rates ate major determinants of the trade balance.
Other develop-
ments such-as tariff or quota changes and expectations about future
chanqes are sometimes also important factors in the growth o£ exports
and imports.
The exchange rate of the dollar helps determine the pr ice of
exports and imports, and thereby can have important and sizeable
impacts on the merchandise trade balance.
Estimating the size and
timing of these potential exchange rate impacts on exports., imports
and the trade balance is difficult and complicated, and at best
produces best guesstimates based on the relationships that have
existed in the past.
On the basis of the Treasury Department's econometric work on
the determinants of U.S. exports and imports, we estimate that the
net long-run impact of dollar appreciation is to worsen the trade
balance by 52.2 (annual rate) for each 1 percent the dollar appreciates on a weighted average basis against our major trad ing
partners.
These estimates would also suggest that dollar depre-
ciation would improve the trade balance by the same $2.2 billion
for each 1 percent fall in the dollar's value.
occur immedlately.
These effects do not
The response of exporters and importers to a
164
change in the value of the dollar —
tiveness —
and hence in U.S. price competi-
takes time to be realized in the form of new orders.
As a result of this lagged response to an exchange rate change, the
full impact is reached sometime between one and two years following
the exchange rate change.
While estimates of the length of this
time lag vary, our own work suggests that it is seven quarters
long.
According to our econometric work, the time paths of these
impacts on exports and imports suggest that the effect on the trade
balance will follow what is called a "J-curve" profile.
That is,
the trade balance initially moves in the opposite direction from
its longer term path.
In the case of a depreciation the trade
balance initially worsens before it begins to improve.
In
the
case of dollar appreciation, the initial impact (during the first
two quarters) is to lower the dollar cost of imports (except oil
imports), and hence to improve the trade balance.
However this "terms of trade" qain soon begins to be offset
as both U.S. and foreign buyers react to the deterioration in U.S.
price competitiveness resulting from the rise in the dollar.
As a result, the volume of exports declines, and that oE imports
rises.
In addition, the terms of trade gain itself starts to deteri-
orate as:
(a)
U.S. exporters lower their prices in an effort to
maintain market shares; while
165
(t>)
foreign exporters exploit their leeway to raise prices without serious loss of market share, causing some rebound from
the initial drop in U.S. import prices.
By the end of the second year of a dollar appreciation, our
econometric work would suggest that (at current levels of trade)
the value of U.S. exports will decline by $2.0 billion for every
1 percent that the dollar appreciates.
At the same time the value
of U.S. imports will rise by about S200 million.
These two effects,
lower exports and higher imports, would jointly result in a worsening
of the trade balance by some $2.2 billion per 1 percent dollar
appreciation.
MUST GET BETTER CONTROL OF OFF-BUDGET SPENDING
Senator GORTON. I have one last question, which Senator Trible
has asked me to put to you.
We seem to be fixed on the Federal budget deficit as the major
cause of our present problems. Bad as it is, the on-budget deficit
isn't the total picture. We have a substantial amount of off-budget
deficit spending by Federal loan guarantees with which we need to
deal as well.
If we can't reduce the amount of budget deficit, can we get some
of the same benefits by controlling off-budget spending and loan
guarantees to a greater extent than we do at the present time?
Isn't it really important to bring budget discipline to bear on these
two areas by means of federal financing? Likewise, in connection
with the Federal Financing Bank, by improving credit budgeting
activities?
Mr. SPRINKEL. Yes; I certainly agree with that. However, I am
not sure that I would argue that the principle problem is the
budget deficit. That is, indeed, a problem, but I think the most important problem is Government spending. We had a persistent
trend of allocating more and more resources to the Federal Government vis-a-vis the private sector. We came to this town with the
hope and expectation that we could reverse that trend. So far, we
have not been completely, but with the help of the Congress, we
can be successful by controlling domestic spending, and also continuing to make progress in controlling off-budget items.
There are some serious additional borrowing requirements forced
on the Treasury by the fact that their off-budget expenditures do
not show up in the budget. We are strongly in favor, over time, of
getting those off-budget items back on the budget, so the Congress
and the administration can evaluate them, and perform a better
job of controlling them than if they are hidden in an off-budget
form.
As you know, in the past couple of years, there has been a reporting of the off-budget factors; that helps some, but we would
still like to get them back on the budget.
166
Senator GORTON. Thank you very much. As you know, Senator
Trible has introduced a bill on just that subject and has a great
deal of interest in it.
Thank you very much, Mr. Secretary. We are very pleased to
have had you with us this afternoon.
Mr. SPRINKEL. Thank you very much.
Senator GORTON. We now have a panel consisting of Professor
Blinder and Dr. Meigs. If they will come forward, we will be happy
to listen to them.
We apologize to them and to the Secretary for using up their
whole day, when we had hoped to complete their work by noon.
Your statements will be incorporated in full. I appreciate your
oral presentation. We'll hear from both of you.
STATEMENT OF ALAN BLINDER, GORDON S. RENTSCHLER
PROFESSOR OF ECONOMICS, PRINCETON UNIVERSITY
Professor BLINDER. Thank you, Senator Gorton. Every time I testify on the subject, it seems that monetary policy is at a critical
juncture.
That may be always true. It certainly seems to be true today. I'm
going to paraphrase my statement and skip certain portions.
I come to you today as a representative of a majority group:
people who are worried about what the Federal Reserve might do
to us. Oscar Wilde once said that "experience is the name we give to
our mistakes."
By this definition, the Fed has gained a great deal of experience
in recent years. And I think we have some reason to fear that it
may be about to gain more.
My testimony covers three questions that I presume to be of concern to this committee. First, given the large current and prospective budget deficits, what are the choices left open to the Federal
Reserve?
Second, should the Fed take action to curtail the rapid growth of
the monetary aggregates? And third, if the monetary aggregates
are unreliable indicators, where can the Fed turn for guidance?
LOWERING THE BUDGET DEFICIT
Given the lateness, I'm going to omit the third section of the testimony unless you have some questions.
Let me start with deficits. Realistically, the outlook is for very
large deficits now, in the near term, and in the long-term future.
Large deficits expand demand and put upward pressure on interest
rates, leaving the Fed to choose between two rather unpleasant alternatives.
A tight monetary policy would counteract the expansionary effects of fiscal policy and push real interest rates even higher. Such
high interest rates would certainly crowd out both business investment and homebuilding, If pushed hard enough, tight money can
lead to recession.
An easy monetary policy on the other hand would limit the
extent to which the large borrowing requirements of the Federal
government drive up real interest rates.
167
Such an easy-money policy would lead to a stronger economy and
a greater share of investment in GNP, which presumably are good
things, but it would also probably lead to more inflation.
In my view, analysis of the risks involved in each scenario points
overwhelmingly toward a mildly expansionary policy right now.
Consider what might happen if the Fed, goaded on by a perceived
need to do something about the high growth rates of the money
supply, hits the brakes too hard. The young recovery, which is still
gathering steam and is rather fragile, could be stopped dead in its
tracks and we could witness a third recession in the 1980's.
But this time the unemployment rate would not start from the
6.2-percent level in 1980, nor from the 7.2-pecent level in 1981, but
from a 10-percent rate, which is awfully close to the highest we
have experienced in this country since the Great Depression.
This scenario is horrible to contemplate, but unfortunately is not
impossible. We should remember that after the 1980 recession the
economy grew for only three quarters before a recession came
again. And it was not some dark mysterious force that brough us
back-to-back recessions but rather the excessively tight monetary
policies of the Federal Reserve.
Lately we have been hearing so many rosey reports about the recovery that its strength and durability may seem beyond question.
But I d like to submit that it's not.
Much of the growth to date appears to have come from a swing
in inventory behavior from a very rapid rate of liquidation at the
end of 1982 to a very small rate of liquidation in the last quarter.
During the first quarter of this year real GNP grew at a 2.6-percent rate, but only half of that was in real final sales. In the last
quarter, according to the preliminary numbers released this morning, real GNP grew at a healthy 8.7-percent rate, of which 5.5 was
real final sales. The rest was inventory investment. And there will
be more coming from inventories in the next quarter.
Interest rates have already risen enough to threaten the boom in
housing. Net exports, as has been mentioned here several times,
continue to be weak owing to our misalined exchange rates, and
business investment remains weak owing to the great amount of
unused capacity.
So what we have left propelling the economy upward is the Pentagon and the consumer. As far as the consumer goes, the savings
rates that we've witnessed in the last few months are so low that I
think everybody believes they are unsustainable and that rate of
increase of consumer spending simply cannot be exected to continue. So the risks of clamping down too hard on money and credit
are very real.
Now let us consider the risks in the easy money alternative. If
the Fed eases up just as the economy is taking off on an exuberant
boom, the result would be an excessively rapid recovery, bringing
with it dangers of renewed inflation. No one would welcome this
outcome after all we have been through.
However, since the boom would be starting from 10-percent unemployment and 75-percent capacity utilization, there is plenty of
room for expansion before we begin to stretch our resources of
labor and capital to the limits. So the Fed has a long time to recognize the error of its ways and to make adjustments.
168
A relapse into serious inflation seems highly unlikely. Instead
the likely cost of a small error in the expansionary direction is a
slowdown in the rate of progress against inflation.
So let me tote up the score. If monetary policy is too tight,
there's a real danger of another recession. If monetary policy is too
easy, the current progress against inflation could be arrested.
It would, of course, be best if the Fed would do exactly the right
thing. Unfortunately none of us knows what exactly the right
thing is and we must therefore consider it extremely likely that
the Federal Reserve will gain more of what Oscar Wilde called experience.
In other words, we can't avoid the gamble, as much as it would
be nice to avoid it. And to me it is clear on which side we should
place our bets.
I would like to point out that I'm not suggesting a drastic change
in the Fed's policy. My recommendation is merely that the Fed
stop the upward creep of interest rates and perhaps nudge them
down a little.
From reading his testimony to the House yesterday, and to the
Senate today, I'm really not quite sure whether Chairman Volcker
agrees or disagrees with this view of interest rates. There are paragraphs in that testimony that could be read either way.
Senator GORTON. That may very well be deliberate.
Professor BLINDER. That may very well have been deliberate. I
couch my recommendation in terms of interest rates, not in terms
of any of the M's. That was deliberate.
Frankly, I neither know or care whether such a policy would
mean faster or slower growth of Mi or M2 during the 6 to 12
months.
GUIDES TO MONETARY POLICY
The Federal Reserve doesn't know either, but it does seem to
care. In this section of the testimony I would like to point out and
explain some of the dangers of using the M's as guides to monetary
policy and, in so doing, I guess I will establish beyond a shadow of
a doubt that those people that Secretary Sprinkel was just talking
about are real—real people are saying these things.
In discussing targets for monetary policy, we should not lose
sight of the fact that the M's are not goals in themselves but only
instruments for controlling nominal GNP.
But nominal GNP growth is the sum of the growth rate of money
plus the growth rate of velocity. If velocity growth slows, the
money supply must grow faster or the economy will stagnate. If velocity growth accelerates, money growth should slow down.
The monetarist doctrine that monetary policy should be based on
the M's is predicated on the belief that velocity growth is either
stable or highly predictable.
A few years ago this doctrine may have been tenable. Now it is
not. Deregulation and rapid financial innovation have radically
transformed the ways people make payments and store their
wealth, and continue to do so.
Whenever such changes affect the demand for any of the assets
included in the M's, velocity shifts. And if such changes come in
169
rapid succession, they will cause rapid and unpredictable shifts in
velocity.
This is exactly what has happened in recent years, and is likely
to keep happening.
Let me take as examples the high monetary growth rates that
people have been talking about. Some of those numbers have been
put on table 1 which follows page 6 in the testimony.
Since November 1982, M2 has grown at a 16.3-percent annual
rate, a sharp acceleration from the 9.2-percent rate recorded during
the previous 12 months.
Does that signal a return to inflation? I don't think so.
Most of you will recall that a new type of bank account called a
money market deposit account was authorized beginning in December 1982. Many people found this account an attractive new way to
store their wealth and funds poured in.
Funds in those accounts now exceed $350 billion, having started
from zero. You might wonder how a version of M2 that excludes
the money market deposit accounts would have behaved over the
period since November 1982.
The answer is, as you can see on that table, that the annual
growth rate of M2, exclusive of MMDA's has been minus 20 percent.
So which is the right growth rate for M2? Positive 16 percent
growth rate or negative 20 percent?
I don't know and the Fed doesn't know. As a consequence, no one
knows what to make of the reported growth rate of M2.
The other perennial favorite monetary aggregate, Mi, began to
accelerate a bit earlier than M2, starting in June 1982. During the
12 months ending in June 1982, Mi grew about 5% percent. Then,
from June 1982 to May 1983, Mi grew at a whopping 13 percent
annual rate, causing much consternation among monetarists.
Well, what happened? The story with Mi is a bit less clear.
Chairman Volcker in his testimony called attention to the NOW
accounts and the super NOW accounts which bear interest, whereas Mi didn't use to pay interest. These accounts are included in a
component of Mi which the Fed calls "Other Checkable Deposits."
They're called OCD's in table 1.
You might be interested to note that the annual growth rate of
these OCD's since June 1982 has been 41 percent. If we exclude
OCD's from Mi the recorded Mi growth rate would have been only
6.4 percent.
That looks like a low number. On the other hand, had the Fed
decided to put the MMDA's into Mi, which it very well could have
done, the recorded growth rate of Mi period would have been 102
percent.
Thus, depending on some subleties of definition, the Fed could
have reported an MI growth rate anywhere between 6 percent and
102 percent.
There is obviously room for fun with numbers here. The point of
taking you through them is only to show that monetary growth
numbers are very liable to be meaningless in a period of rapid financial change.
Data on money supply are informative only if we also have a
good understanding of what is simultaneously happening to money
170
demand. But when there is rapid financial innovation, we simply
have no such understanding.
If my arguments about financial innovation and the demand for
money are correct, then the data should show that recent fluctuations in the growth of nominal GNP were dominated by velocity
movements rather than by changes in the growth rate of money.
Table 2 and figures 1 and 2 which follow in my testimony show
that this is true.
A quick perusal of the numbers in table 2 leads, I think, to two
conclusions. First, that quarter-to-quarter movements in nominal
GNP show no resemblance whatever to quarter-to-quarter movements in money growth.
Second, that nominal GNP movements from quarter to quarter
do show a striking resemblance to velocity movements.
Figure 1 which follows immediately after page 9, plots the
growth rate of nominal GNP against the growth rate of Mi. It
offers a convenient way to assess the monetarist position.
According to monetarism, changes in nominal GNP growth are
dominated by changes in the growth rate of Mi. A monetarist
would expect a close positive association with a slope near 1, indicating that each percentage point increase in money growth leads
to 1 percent faster growth of nominal GNP.
Obviously, something has gone wrong. In recent quarters the relationship has actually been inverse. Nominal GNP grew slightly
slower—I shouldn't say slightly, grew noticeably slower when Mi
grew faster.
Figure 2 which follows figure 1 offers a similar opportunity to
assess an extreme antimonetarist view. According to this view,
growth of Mi is irrelevant to the growth of nominal GNP. I hasten
to add that I am not advocating this extreme point of view.
Figure 2 plots the growth rate of nominal GNP against the
growth rate of velocity, and there you can see a very strong positive relationship showing that the extreme antimonetarist view
gets much more support from recent data than does monetarism.
My purpose in displaying these figures is not to argue that
money growth has nothing to do with nominal GNP growth—
though that happens to have been true for the last 2V& years—but
only to illustrate how unequivocally the intellectual case for monetarism has evaporated in recent years under the pressure of financial innovation.
The moral of the story is clear: he who targets on the growth
rate of money when velocity is behaving erratically is looking for
trouble. And we have had some trouble in the last few years.
The last quarter of 1981 and the first quarter of 1982 illustrate
just how bad things can get. During these two quarters, MI grew at
a 7-percent rate, which sounds quite reasonable.
Unfortunately at the same time MI velocity fell at a 6-percent
rate, leaving the annual growth rate of nominal GNP a scant 1
percent. The consequence was a 5-percent rate of decline or real
GNP and a terrible recession.
History might well have repeated itself a year later had the Fed
stubbornly adhered to the monetarist dogma. During the fourth
quarter of 1982 and the first quarter of 1983, Mj velocity fell at an
8-percent annual rate.
171
Fortunately, Chairman Volcker had renounced monetarism—
temporarily, he said at the time—in October 1982, and Mi was allowed to grow at a 14-percent rate. So disaster was averted.
Well, today there are voices urging the Federal Reserve to bring
monetary growth rates back into line with the targets. If the Federal Reserve listens to these voices, it is flirting with danger. For
as long as velocity keeps declining, seemingly high money growth
rates are not only appropriate, but are actually essential if the recession is to be avoided. And I believe Chairman Volcker's testimony this morning recognizes this point.
As I said, the rest of the written statement has to do with alternative ways to target monetary policy.
Senator GORTON. Thank you.
[The complete statement follows:]
172
MONETARY POLICY AFTER MONETARISM
Testimony of Alan S. Blinder, Gordon S. Rentschler Professor
of Economics. Princeton University, to the Senate Banking
Committee. July 21. 19B3,
E^ery time I testify on this subject, monetarv p o l i c y seems
to be at a c r i t i c a l jjncture. Perhaps it always is. Anyway, tnis
hearing is c e r t a i n l y no exception.
I come to you today as a representative of a majority group:
people who are worried about what the Federal Reserve m i a h t do.
Oscar W i 1 d e sai d that ex perience is the name we gi ve to our
m i stakes. &>' t h i s d e f i n i t i o n , the Fed has gained a great deal of
°:;ppi-ierice in recent years. And there is reason to -fear that it
may be about to gain more.
My testimony w i l l coyer three questions that I presume to be
of concern to this Committee. First, given the large current and
prospective budget deficits, what choices are left open to the
-ec~ Second, should tne Fed t a l e actian to cur tail the rapid
growth of the monetary aggregates^1 Third, if the monetary
aggregates are unreliable indicators, * 'iere can the Fed tu'-n for
guidance 0
J. DEFICITS AND MONETARY POLICY
The Budget Resoluti on just passed by Congress projects a
very large deficit for Fiscal 198A. And unless there is a radical
change in fiscal policy, large deficits —
of GNF —
perhaps as high as 67.
w i l l persist into the -future. Large deficits expand
demand end put upward pressure an interest rates. 1esving the Fed
173
AL TtF'NAT IVE I s The Fed can counteract the expansionary
effects of -fiscal p o l i c y by si owi ng growth o-f the money suppl y
and t i g h t e n i n g credit. A "tight monev" p o l i c y of this sort,
presumabl y embarked upon in the name of -fighting i nf1 ati on, woui d
push interest rates even higher, and crowd out both business
investment and homebui 1 d i ng. If pushed hard enough, tight money
can lead to recession, as has happened all too -frequently in
ALTERNATIVE: 2: Dn the other hand, the Fed can ease credit
conditions in order to l i m i t the extent to which the unusually
larce b arrow: ng requi rerrtents o-f the Federal government dr 1 ve up
intorsTr rates. Such an "easy money" p o l i c y would lead to s
stronger economy and a greater share of investment in SNP.
Un-f or tunst el y. it might also lead to more i n f l a t i o n .
Faced with this predicament, what should the Fed do? In my
view, analysis o-f the i-isi-.s involved in each seen an o poi nt s
over whe 1 Til nci 1 y toward a m i l d l y expansionary policy right now.
Con-si der what might happen i -f the Fed, goaded on by a
perceived need to "do something" about the h i g h growth rates ot
the Ms, hits the bral-es too hard. The young recovery, which is
s t i l l gathering steam and is rather f r a g i l e , could be stopped
d&ad in its tract- 1 s. The third recession o-f the decade could
174
-f"."..•> r,;... 5?>.it t n i = time the unemployment rate w o u l d not start
the
f'-ciTi 6.2V. levee] o-f 1980. nor -from the 7.2V. levp] of 1981. but
-from ei 107. r^te —
c 1 ose to the hiqhest we have e\ perienced since
the Grea t Depression. An unempl oyment rate o-f 127. or \~'/. coul d
e-asL1y resutlt.
T h i = scenario is h o r r i b l e to contemplate. But it is by no
means impossible. We should remember that a-f ter the 1980
rece^si on the econoiTiy grew for only three quarters before
recpssion came again. And it was not same dark mystenous force
th'^t br ought. ^^, b^ck—to-back rpcessions, but rether the
e;-.ce.^.sively tight man^t ary policies a-f the Federal Reserve.
Letely. we have been hearing EO many rosey reports about the
recoverv that its strength and d u r a b i l i t y may seem beyond
q i p f t i o n . But they are not. Much of the growth to dare appears tc
he ve come f rorr. a swi ng in inventory behavior from r a p i c
1 i qvi da.t i on in 1 982: 4 to perhaps some accumulation in 19S3: 2.
During the first quarter of 1983. real BNF' grew at a 2.67. rate,
but resl final sales grew at only a 1.37. rate. Second quarter
data were not yet available when I prepared this statement, but
indications were that inventory movements piayed a major role in
producing good growth in 1983:2.
Interest rates have already risen enough to threaten the
boom i r housing. Net exports conti nue to be weal DWIng to our
m i s a l i g n e d exchange rate and to continuing recession
in Europe.
And business investment re-sins weak owing to the great amount of
unused capaci ty. Thi s 1 eaves only the Pentagon and the consumer
175
p rape-11 1 i ng the et onoiny upwards. To m v m i n d , this spells a f r a g i l
r ec over'- - . So the r i si s o-f c l a m p i n g down' too ha^d on money aid
c r e d i t are real indeed.
Now 1 et us consider the risks in the easy money alternative.
Suppose the Fed eases up just as the economy takes o-ff on an
exuberant booin. The r esul t woul d be an excessively rapid
recover1,', b r i n g i n g with it dangers of renewed inflation —
an
outcome that no one WOLI! d wel come. But how probable is this
scenario, and how bad is the resulting i n f l a t i o n l i k e l y to be"1
Suppose we really are on the verge o-f a strong and lasting
recovery. Since the boom would be starting from 107. unemployment
snc! 75'-. c a p a c i t y u t i l i z a t i o n , there is p l e n t y o-f room -for
e x p a n s i o n before we begin to stretch our resources o-f labor and
capital. S p e c i f i c a l l y , it wan Id tal't? two to three years o-f real
:::- Dwt r, = t = h','. rate before we began to approach tne f u l l
ertp 1 oym^nt ^one. even using a rather pessimistic definition af
-ful 1 employment.
This means that the1 Fed has a 1 dng 11 me to recognize the
error o-f its ways, and to make adjustments, i-f it -finds that it
has embarked on an excessively expansionary policy. A relapse
into serious inflation seems unlikely. Instead, the l i l - e l y cost
o-l s srr.al: e^ror in the expansionary direction is a slowdown in
our progress against inflation.
So let us tote up score. If monetary policy is too tight,
there is a real danger of another recession. If monetary p o l i c y
is too easy, the current progress against inflati on could be
176
f; -f •-_ -ie-c . .It uou'l d b*2 be-rt, o-f course, i f the Fed
e, =.\itj , the
thing'
waul d do
right thing. But, since no nine I news what "the right
ir. we must consider it extremely l i v e l y that the Fed w i l l
ci'jn njjr e experience?. We have no choice but to gamble, and to me
it is .Tlear on w h i c h side we should place our bets.
I am not suggesting 3. drastic change in the Fed's policy. My
recommendation IB merely thet the Fed stand guard against the
L pw;-rd creep o-f i nterest rates and perhaps nudcje them down a
l i t t l e . Unfortunately, the Fed 7 s recent pronouncements have
pointer in the opposite direction.
7. n-'EFATIMG PROCEDURES FDR MONETARY POLICY
1 n advocating a m i l d l y expansive monetsr\' policy. I have
s=-,i c nT'thjng about how to translate such a vague directive into
concrete targets +or money growth. That omission was dell berate,
FrankIv, I neither know nor care whether such a policy means
•faster or slower growth o-f Ml or M2 in the n<=;;t 6-12 months.
The
Fed doesn't know either, but it does seem to care. And,
un-fortunately. cert am
acts o-f Congress (such as the
h-imphrey-Hawkins Act! encourage an excessive p recce up at i on with
the morietarv aggregates. In this part o-f my testimony, I warit to
point out and ex p l a i n the dangers of using the Ms as guides to
monetary policy.
177
aiscussing targets -for monetar / policy, we should not
I cse ;E j gnt of the -fact that the Ms are not goal s in themselves,
b'.'t only instruments -for controlling nominal BMP. We care about
mDney growth only because o-f its presumed effects on the growth
of norm na 1 GNP. But nominal GNF1 growth as, the sum o-f the growth
rate of monev pi us the growth rate of velocity. If velocity
growth E. 1 ows, the money supply must grow -faster ar the economy
w i l l i_-tegnate. If velocity growth accelerates, money growth
shcul a s,". ow dawn .
The monetarist doctrine that monetary policy should be based
on the !1s is predicated or, the belief that velocity growth is
e i t h e r = t ab 1 e o~- h i g h l y predictable. A few years ago. ths s
riijiivr i '.~\& m<='.' hu ve beer, t enable. Now
it is not. Deregulation anc.
f~ap: c f i n a n c i a l innovation have? r a d i c a l l y transformed the ways
pe-opl e mai'e payments and store tneir weal th. Whenever sucn
cfit-ngss affect the aemarta for any D+ the assets included in the
\'.r., ve-'i ac. 11 y sh i f t s. And
:-f such changes come in rapid
succe^E^ion, they w i l l cause rapid and unpredictable shifts in
velocity. This is exactly what has happened in recent years, anc!
is l i l e l v to !• eep happening.
Lfjt me t a l e as examples the high monetary growth r^tes that
have created so much controversy in recent months and have put
pressure on the Fed to tighten up.
Since November 1982.
(See Table 1.)
(12 has grown at a Id. 3V. annual rate-, f
sharp acceleration from the 9.27. rate recorded during the
previous 12 months. Is this cause to sound the i n f l a t i o n a r y
178
Table 1
Annual Growth Rates of Selected Monetary Aggregates
June 1982 -
yay 1983
M2
16.3%
M2 less MMDAs
-20%
Ml
13.1%
Ml less OCDs
S.4 5 ,
Ml plus HMDAs
179
a'l armT^' Hardly. Most o-f you w i l l recall that a new tyoe o-f ban:
account, called a money market Deposit account (MMDft.1. was
^L'tho'i^ed B e g i n n i n g in December 1931'. Many people -found this
account an attractive new way to store their weal tn , and -funds
f 1 owed in. Starting -from zero in November, balances in rlMDAs no..
e;;ceed 5331!' b i l l i o n . You might wonder how a version o-f 1*12 that
excludes the t-IMDAs has behaved since November
3982. The answer is
that the annual growth rate of M2 exclusive of MMDAs has been
So which is the "right" growth rate for M2, + 167. or —20X7 1
7
dan t \ new, and neither does the Fed. If all the -funds that are
now in MMDAs, came from elsewhere within M2. then 167. wcul d be the
relevant figure. On the other hand, if all the -funds in MMDAs
came trom assets not included in M2, then —207. waul d be more
: r.di ca t; ve pf monetary growth. Obviously, the truth L i e s het'-ien
t he-,e t WTJ e" tr ernes. But where"? The sad fact is that we just Co
not know, and therefore cannot make any sense of the reported
growth rate of M2.
The other perrenial favorite monetary
aggregate, Ml, began
to accelerate a bit earlier., in June 19S2.
During the 12 months
ending in June 1932, M* grew 5.47.. Then from June 1982 to rtay
1°B3, Ml grew at a whopping 13.17. annual rate, causing much
consternation among monetarists. What happened?
Here the story is a b i t less clear, but December 1932 also
marked the introduction of Super NOW accounts. These accounts, as
w e l l as the conventional NOW accounts, are included in a
180
~cmp orient o-f M l whi ch the Fed c a l l s "Other Check able Deposi ts. "
r OL: may be interested to know that the annual growth rate of
C'f-is?'- Checkable Deposits -from June 19S2 to May 1983 was 41V.; if
these were excluded -from Ml. the recorded Ml growth rate would
HC? ve been onl y 6 . 4X.
On the other hand, had the Fed decided to put the MMDAs into
Ml, the recorded growth rate of Ml would have been 1027.. Thus,
depending on some subtleties o-f definition, the Fed could have
reported an Mi growth r^te anywhere between 6V. and 102','..
There is obviously room -far fun with numbers here. My
purpose in taking you through them is only to show that monetary
growth numbers are l i a b l e to be meaningless in a period of rapid
financial innovation. 031 a on money SUPPLY are inforrnati ve onl y
if we have a good understanding of what is simultaneously
happening to monev DEMAND. But when there is rapid financial
innovation, we have no such understand!ng.
THE RECENT DOMINANCE OF VELOCITY MOVEMENTS
If my arguments about financial innovation and the demand
for money are correct, then the data should show that recent
•fluctuations in the growth of nomi nal BMP were domi nated by
vel oci ty movements rather than by changes in the growth rate o-f
money. Table 2 and Figures 1 and 2 show that this is true.
Casual perusal o-f the numbers in Table 2. leads, I think, to
tvio concl usi ons. Fi rst. that quarter—to—quarter movements i n
nomi nal SNF1 growth show no resembl ance to quarter-to-quarter
181
Table 2
Quarterly Growth q£ Annual Rates (seasonally adjusted)
(in percentage points)
Nominal
Ml
Velocity
Quarter
GKP
1981:1
1981:2
1981:3
1981:4
19.6
5.3
5.0
9.2
11.4
3.0
3.1
3.3
1982:1
1982:2
1982:3
1962:4
-1.0
6.8
5.8
2.6
3.3
6.3
13,7
-10. 8
3.4
-0.5
-9.8
1983:1
8.3
14.9
-5.7
Ml
11.0
13.9
-3.6
8.1
-0.3
M2
M2
Velocity
10.3
11.8
-4.6
10.4
10.0
1.0
-6.4
S.9
-9.1
1.2
9.6
-0.4
-5.0
-6.4
21.9
-11.2
7.0
11.4
182
movements i n monev growth. Second, that nominal BNF' movements clo
show a striking resemblance to veloci ty movements.
The two diagrams, which use the Ml concept of money, show
these same conclusions graphical1y. Nine points are plotted in
each diagram, one each -for the nine quarters -from 1981:1 through
1983:1.
Figure 1, which plots the growth rate of mammal GNF' against
the growth rate o-f M l , o-f-fers a convenient way to assess the
manetsrist position, fleeording to monetarism, changes in nominal
GNF' growth are domi nsted by changes in the growth rate o-f Ml. A
monetarist waul d expect a ci ose posi tive associ ati on with a slope
near 1, indicating that each percentage point increase in money
growth 1 eaas to 1 percent -faster growth of nominal GNF1.
Ob vi OLI&J y, son t-? thing has gone wrong, In recent quarters the
reiat i onshi p has actually been i nverse: during these 9 quarters,
nomi nal GNP grew si ower when Ml grew -faster.
Figure 2 o-f-fers a similar op port Lin i ty to assess an extreme
anti-monetarist view, -far more extreme than anything I would
personal 1 y advocate. Accordi ng to this extreme vi ew, growth o-f Ml
is i rrel evant to the growth o-f nomi nal GNF. which is i nstead
control 1ed by changes in velocity. Figure 2 plots the growth rate
o-f nominal GNP against the growth rate o-f vel oci ty. A strong
positive relationshi p is apparent, showing that the extreme
ant i -mane tar i st vi ew gets much more support -f rom recent data than
does monetarism.
183
184
e
185
Mv purpose in d i s p l a y i n g these figures is not to argue that
mnnpy crowth has n o t h i n g to do with n o m i n a l CNR growth
(though
ths t ha'= been true -for the past 2 1/2 years) , but only to
i l l u s t r a t e haw u n e q u i v o c a l l y the intellectual case -for monetari sm
ha'.- col 1 s.psed -
MONETARY POLICY AND MONEY GROWTH TARGETS
The moral o-f the story should be clear; he who targets on
the growth rate o-f mor\ey when velocity is behaving erratically is
l o o k i n g -far trouble.
The I ast quarter o-f 1981 and the
f irst quarter o-f
1982
p r o v i d e a v i v i d e;; ampl e of just how bad things can get. During
these two quarters, HI and M2 grew at 77, and 9.57. rates
respectively. These sound l i k e reason =>bl e rates . Unf or tun at el y,
Ml v e l o c i t y FELL at a l m o s t a 67. rate and M2 vel ocity fell at mc^e
than an B'd r <=> t i? . 1 eavi ng the annual grawt n rate of nsmi nal GNP e
scant 17.. The consequence was a 57. rate of d e c l i n e of real BMP
and a terrible recession.
History m i g h t have repeated itself a year
later had the Fed
stubbornly adhered to monetarist dogma. During the fourth quarter
of
1*582 and
the
-first quarter o-f 1^8"., Ml velocity -fell st an 67.
annual rate and M2 velocity fell at a 77'. rate. Fortunately.
Ch? i rmsn Voi cl'er hi ad renounced monet ar i sm —
temporer i l y , he said
- in October 19B2, and Ml and M2 were all owed to grow very
r spicily
!
,147. and
It"/, respectively). So nominal BMP' wss at least
permitted to grow at a mediocre 5.47. pace. Real economi c
186
per-f ormanee dun ng these two quarters was not great; but nei t n=rwas it catastrophic.
The a p p l i c a t i o n to the present situation is obvious. There
are voices today urging the Fed to b r i n g money growth rates bad
into l i n e w i t h targets. I* the Fed listens to these voices, it
w i l l b*? maJ1 i ng a grave mistake. For as 1 ong as velocity keeps
d e c l i n i n g , seemingly high money growth rates are not only
appropriate, but are actually essential i-f recessi on is to be
,7-voi ded.
4. GU7DEPOST5 FOR MONETARY POLICY
I h;--ve argued that the u n p r e d i c t a b i l i t y o-f vel oc 11 y renders
mcrnE't^ry growth rates useless. So where should the Fed look tor
guidance?
When the thermostats in our homes work properly., we know how
to u.se them. But when they ma.l-function, we ignore these
mechanical devices and rely instead on our senses. The Fed should
da the same. It should take its eyes uf-f the de-fectiv^ monetsr--.'
thermostat and look instead at what is going on in the
economy.
INTEREST RATES
Interest rates always carry a clue about what velocity is
doing. I-f the Fed sets a monetary target and -finds that i nterest
rates rise unexpected! y, the evi dence is pointing to - f a l l i n g
velocity. The monetary growth target probably should be adjusted
187
u1',; ~- * .- a t o
c: am pen site;.
Conversely,
•f si l i n g un&"r>ee tedl y „
it
IE,
rate
targetting,
The m a j o r
Fed - f i n d s interest
return to
it
the
old
p o l i c y of
j u s t i f i c a t i o n -far
Ehc.-jld
forget
~-
:s
j nt ers?-i£ t
pegged.
the
aboirt
o-f
trier: it
it
— has proven
v e l o c i t y s t a b i l i z e s , we
money g r o w t h t a r g e t s .
important
Psth«?r
short—run
1979 change to short-run
Unless and until
to r e a l i z e that
r a t e s does not mean that
the c.esa=
be:
1ncorrect,
the
stiauld; because t h a t ' s e x a c t l y what
money t a r g e t t i n g — s t a b l e and p r e d i c t a b l e velocity
t o be w i l d l y
rates
shou] d be a d j u s t e d d o w n w a r d .
*_hi s, sounds like a
interest
the
then v e l o c i t y is p r o b a b l y r i s i n g cmd
rior.et ary g r o w " n tar get
I*
if
means t h s t
short-run t a r g e t t i n g on
i n tere = t
rates shoul d be
the Fed should d e c i d e ,
s t s b i 1 i nsti on p o l i c y ,
s'nou 1 d proceed t o put
where interest
in v i e w of
rates
should
them there.
W3MINAL GNF TARGETS
Recent l y ,
suggested that
t a r g e t s -for
many e c o n o m i s t s and (member & o-f
the Fed adopt
monev.
Several
t a r g e t s -for
bills to
Congress have
nominal
this e f f e c t
GNP
instead of
are now pending
i n Congress.
I~
principle,
t a r g e t t i n g on nomi rial
sol ut i on t o the probl em cf
velocity.
target
For e x a m p l e ,
if
erratic
however,
and u n p r e d i c t a b l e shifts 1 , in
vel aci t y f a l l s ,
a u t o m a t i c a l l y c a l l s for
long-run t a r g e t s -for
SNP i <s the cor'recrt
faster
nominal
a f i :r ed nominal
money g r o w t h .
GNP p r o S a b J v would require
the Fed to f o r m u l a t e short-run t a r g e t s *or i n t e r e s t
GNP
In p r a c t i c e ,
rates,
as I
188
nave just suggested. An p::amfi!le w i l l
show why.
Suppose the Fe?d decides that it wants 8'/. growth o-f n o m i n a l
&h'F in a gi ven ypsr. To i mpl emen t this deci?i or,. it must project
the behavior ot velocity, and then -formulate s target -for money
aro'-ut h accord i ngly. For example, i-f it expects velocity to grow
b>' 27., it w i l l seel 6','. growth o-f money.
But neither current nominal BMP nor current velocity are
observed because a-f lags in the data. So we are always operating
somewhat in the dark. As just ment i oned, however. interest rates
con t a i n valuable and ti mel y i n-f ormat i on about velocity. Thi s
in-formation can and should be used to adapt the short-run monev
growth target to the 1 ong—run nomi nal GNF target, as descri bea
above.
Thus 1 conclude that short—run interest rate targetting is
not something di-f-ferent -from nominal GIMP targetting. Rather, both
are prongs o-f a coordinated policv.
CREDIT AGGREGATES
Another recent suggest!an has been to use a credit aggregate
either to supplement or to replsee the monetary aggregates. The
credit aggregate most o-ften discussed is Benjamin Friedman's
concept o-f "net credit." Fr i edman -found that the ratio o-f
net
credit to nominal GNP was remar kably stable -from 1960 through
I960, and suggested that this ratio might provide a sounder basis
-for p o l i c y than ^ he ratio o-f Ml to 6NP
(that is, velocity).
lows
Table 3 contains some data relevant to this c l a i m . It sht
189
(4)
190
the? behavior o-f -four concept?, of " ve] DC: i ty. " obtained
respectively by d i v i d i n g nominal GNP by Ml, M2, Friedman'^ net
c r e d i t , and « p r o v i s i o n a l measure? of gross c refill that I am
d e v e l o p i n g in mv current research.
Over the 1960—80 period. Ml velocity grew at a 3.17, annual
r^te w h i l e M2 vel oc i t y was constant. The recent behavi or o-f
monetary velocity, by either measure, has departed sharply -from
these historic norms. This, of course, is just s restatement o-f
the unusual recent behavior o-f velocity that I have been
empnasi zing.
Column
^rorn 1960
(Z1 shows similar data -for Friedman's net credit,
to I960, the velocity measure i m p l i e d by his credit
aggregate showed almost no trend. But in the last five quarters,
this measure o-f velocity -fell at a 5.67. annual rate. Thus, the
breal 1 -from hi star i c norms in the behavior o-f Friedman's credit
vel ocity is auite s i m i l a r to the breal in the behavior o-f
monetary velocitv, though s l i g h t l y smaller.
Column (4) shows the corresponding -figures for my measure of
gross credit. From I960 to 198O, credit velocity by this measure
fell at a I'/, annual rate. Over the last -five quarters, it -fell at
a 4.67. annual rate. Thus the same qualitative break in behavi or
appears, but the departure -from the historic norm is smaller
yet.
These data show that measures of credi t velocity have
e x h i b i t e d a recent break in behavior that is qualitati vely
s i m i l a r to, but quantitatively smaller than, the break in the
191
• ••?". = . ; o~t -ve
;-!;
o-f
n.C'n&t ar v
s~' De?en
L r, *- [•?!-•-, = c . tr tf:-
t ,T rge'_
crpdit
c .'€!-
i.;'--L-
=-.i . ; «r-
=
In
choice
"iv
mn™,f?) ,
inte-es^
^ t r i a b l e -for
must
though
be
cr ed j t
chosen r
velocity.
trhpre
the c h o i c e
however,
it
and - f o c u s
rates,
Wilde mijht
Ouarter-to-quarter
a-f
is
f1uctust:one
Thus ,
e case
which c r e d i t
-for
1 -f
an
choos;ng
£-.ggrec;'te
to
on<?n q u e s t i o n .
^ieiM,
be-suse
targets
1 es =>
vf.'l or. i t v .
credit
is b e b e t t e r
still
to
i n s t e a d on the t h i n g s
in v e s t m e n t ,
hdve
versus mone?y
s^id,
the
poses s. - f a l s e
eschew
that
learn
intermediate
really
i n f l a t i o n and real
F e d should
all
GNP,
-fram its
matter
like
As Oscar
experience.
Senator GORTON. Dr. Meigs.
STATEMENT OF DR. A. JAMES MEIGS, SENIOR VICE PRESIDENT
AND CHIEF ECONOMIST, FIRST INTERSTATE BANK OF CALIFORNIA
Dr. MEIGS. The first point, I'm concerned about the excessive
growth of Mj since June of last year. I attribute the surprisingly
strong economic recovery to this sharp acceleration, which has
fooled all the forecasters. But there has been enough monetary
stimulus injected already, I believe, to raise the inflation rate 2 or
more percentage points by the end of 1984. That is already built in.
If we were to have another year of such very high money growth, I
think the inflation rate would be over 10 percent by the end of
1985.
The second point. More inflation means higher interest rates. I
don't have to dwell on the effects of a very sharp rise in interest
rates over the next couple of years.
REDUCE GROWTH OF MI
So I urge your committee to support the Federal Reserve program to reduce the growth of Mi without delay. In my written
statement I suggest an 8-percent rate be adopted through the end
of this year, which is inside the Federal Reserve's recommendation
of 5 to 9 percent.
I would remind you that if they just hold to 9 or to 8 to the end
of this year, by the end of the year we will have had a growth rate
of over 11 percent for about a year and a half. That is very high.
Cutting back, of course, does raise some risks, it always does. One
of the risks is that for a short time we will have higher interest
rates, maybe for 6 to 9 months, as the Federal Reserve tries to slow
down the growth to the money supply.
The second risk, any deceleration of money growth would cause a
somewhat slower economic recovery, and as we have found many
times in the past, too abrupt a slowdown could mean a new recession by 1984.
192
I still believe it is much better to start now than later. It is necessary to face a shortrun risk if we are to have in the longer run
less inflation and lower interest rates and more growth in real
income and employment.
I would like you to turn to the charts at the end of the statement
because they summarize a great deal of useful evidence on money,
interest rates, and inflation.
On the first chart we plotted the 3-month Treasury bill rates
and the growth of Mi.
Because the Federal Reserve often says we should not pay attention to shortrun movements in Mi, we here have plotted the
change in Mi over the previous 12 months in the belief that 12
months movement in one direction is significant, as Chairman
Volcker has said many times.
One thing that is very clear on this chart is that every time the
growth rate of the money stock increased interest rates went up
later, several months later. Every time the money growth rate decelerated or fell, bill rates fell later.
Most of us were taught in economics textbooks to expect just the
opposite to happen, but the experience in financial markets since
the 1960's should cause some rewriting of the textbooks.
The second point, over the whole 20-year period, doubling the
money growth rates meant the doubling of interest rates.
It is very interesting that today Mr. Volcker, Mr. Feldstein, Mr.
Sprinkel all made the same points, some of them using almost the
same charts.
There is one not so little problem. You will notice that rates generally continue to rise for a while in each case after money growth
decelerates. I think that is one of the reasons why there is so much
concern that slowing down money growth is going to cause higher
interest rates.
In my view, the main reason for the rise in interest rates persisting is because of the preceding acceleration in money growth, not
the slowing down.
The next chart is another very familiar chart to all of us. Here
we plotted current inflation against money supply growth 2 years
earlier. That is because in general money supply growth rates
affect the inflation rate with about a 1V2- to 2-year lag.
On this chart we simply shifted the money growth rate series 2
years to the right. So if you look at, say, the inflation peak in 1974,
it is matched on that chart with the money growth peak of 1972, 2
years earlier.
What is striking on this chart is that each upsurge of inflation
coincides with an upsurge in money growth which happened 2
years before, and each fall in inflation rate coincides with a fall in
money growth, which also happened 2 years before.
My conclusion is the Federal Reserve has to reduce the growth of
money supply in order to reduce the inflation rate and also to
reduce interest rates.
The first chart demonstrates that the Federal Reserve cannot
reduce interest rates by increasing the growth of money supply.
They can only be successful in this for a very short time. I work in
the financial markets, and I would consider that short time almost
down to a few minutes.
193
The alarming thing on both of these charts is the period of
money growth rates on the far right, that is, over the preceding
year. On the interest rate chart it would suggest that interest rates
will go up some more this year before they can turn down, even if
the Federal Reserve is successful in curbing the growth of money
supply very soon, and that is a debatable question.
And then on the inflation chart, the rise in money growth there
is plotted for the years 1984 and 1985, and you see the very, very
steep rise in the money growth there. There is nothing like it until
you go back to the year 1944 in our history of the United States.
So that suggests there is a very significant inflation danger for
1984 and 1985 unless something is done. So I would say the Federal
Reserve does have a problem. If they want lower inflation, I do believe they will have to quell a new outbreak of inflation before they
can extend the downtrend of inflation that was underway in 198283.
Now to the question of targets, MI or M2 or interest rates. Much
has been said about the effects of deposit rate deregulation on Mi.
There are two general views.
One I would say is sort of the Federal Reserve view. It has much
support from outside economists. This view is that changes in the
interest paid on deposits makes people want to hold more MI. I
accept that. Then holders of this view go on from that to say that
explains why Mi grew so fast.
The second conclusion is that this new MI that is paying interest
has less kick than old Mi. So I would suggest if you hold that view
you may wish to call this decaffeinated Mi. The second—oh, yes,
with the decaffeinated Mi you don't need to worry about inflation
in cases of very high growth in this Mj.
The second view, which I would call the monetarist view, and not
all monetarists hold this—I would be honest with you on that—has
two parts: First, that Mi has simply not been distorted nearly as
much as some of the popular discussions would lead one to believe.
I work in a bank. I can see what goes on.
The variable that has really been distorted is M2. M2 is vastly different from what M2 was 2 years ago, because M2 now carries the
counterpart of money market mutual funds, which are not very
closely related to the GNP or anything else.
It is very interesting that the Board itself is now coming to the
same view in their midyear report in which they say that Mi has
not really been distorted in the year 1983. Also, I noticed that
Chairman Feldstein made the same point, that the distortion of Mi
is simply not true.
The second point about this is that the nature and characteristics of Mi have changed, that is, now they pay interest. I would say,
yes, that might well account for some increase in Mi. It might
cause, for a time, a slowdown in the growth in velocity of Mi. But
no matter how much you believe that, it is very hard to believe
that it is enough to offset a 13- or 14-percent growth of Mi in a
year.
The contest between the two views—and I think Beryl Sprinkel
referred to this—is an empirical question. It will be a while before
we know for sure, but I would suggest to you that the way the
194
economy is behaving is providing more support for the second view
than for the first. That support is in two parts.
One is the behavior of interest rates. Financial markets are behaving as though MI is still important. M! matters to financial
markets.
The second part, the very strong economic recovery, is consistent
with the view that a big acceleration of Mi would cause a rise in
economic activity 6 to 9 months later. We are certainly having
that. Many holders of the first view about the nature of MI being
so changed it is no longer any guide to policy, were forecasting a
very anemic recovery until very recently.
I say there is not much time left on the other side to argue that
we should abandon what we have learned from the experience of
hundreds of years on the strength of suppositions about some new
characteristics of money.
IMPORTANCE OF CURBING MONEY GROWTH NOW
A couple of points: Why do it now? Why curb money growth now
rather than later?
We now have some favorable circumstances. Chairman Volcker
alluded to that several times. You know, the inflation rate is low
now; we have very large stocks of commodities and very large crops
coming on; and no OPEC oil shock is likely.
That gives us perhaps 1 or 2 years grace period in which to work
on this problem of potential inflation in the future. But I would
suggest to you that there is not time to waste.
One way to see that is to look at 1976 and 1977.
You can see on the inflation chart that inflation accelerates well
before the economy approaches the zone of full employment. Inflation tripled within 2 to 3 years, twice in the decade of the 1970's.
So inflation could come back with a rush. It is not something that
is very slow moving and slow to respond to monetary forces, especially now when consumers, managers, and investors have become
aware of where inflation conies from, are very sensitive to it, and
sensitive to changes in Government policy, which would suggest to
them there is going to be more inflation in the future. That
changes their behavior in all kinds of markets.
I want to say something about this issue of the coordination of
monetary and fiscal policies.
You hear a lot about the problems that the budget creates for
the monetary authorities. Every Federal Reserve Board Chairman
comes to these committee hearings to lecture you on budget deficits
and so forth, because these are safely out of their control. They do
prefer to talk about budget policy and the difficulty it creates for
monetary policy, but I would say it is a two-way street.
I assert that you cannot have a good budget policy unless you
have a good monetary policy. By good monetary policy I mean one
of getting inflation down and keeping it down so that you have a
stable monetary framework, you have a stable price level. I would
say that you could request the Federal Reserve to pursue such a
policy simply to get inflation down and hold it down so that you
could create a budget policy with much better ability to predict
195
costs of programs, to predict revenues. Your budget would be less
distorted by an alternation of recessions and inflationary booms.
So that completes my statement. I will be happy to answer any
questions.
[The complete statement follows:]
196
STATEMENT PREPARED FOR HEARINGS BEFORE THE
SENATE BANKING COMMITTEE
Jiily 21, 1983
By A. James Meigs
Senior Vice President S Chief Economist
First Interstate Bank of California
It is a privilege for me to appear before this committee when you
are considering matters of such crucial importance to the future stability and prosperity of the U.S. and world economies.
Monetary economics
and monetary policy have been my principal research interests since I
joined the Federal Reserve Bank of St. Louis in August 1953.
Now, as
Chief Economist of First Interstate Bank, I see daily evidence of how
sensitive world economic conditions and financial markets are to changes
in U.S. monetary policies.
The sharp acceleration in growth of the money supply over the past
year is the main reason the economic recovery is suddenly exceeding
practically all of the governmental and private forecasts that were
published during 1982. The boost to economic activity and employment is
welcome, but it may prove to be a costly one.
Enough monetary stimulus
has already been injected to raise inflation two or more percentage
points by the end of 1984, I believe.
If monetary expansion were to
continue for another year at the rate of the past year, inflation would
rise to more than a 10% annual rate by the end of 1985.
Well before such a rise in inflation reached its peak, both
long-term and short-term interest rates would rise by comparable
amounts, because world financial markets are now extremely sensitive to
signs of future inflation.
We need not dwell here on the damage a, say,
five-percentage-point rise in interest rates could do to financial
intermediaries, including banks and savings institutions, to
197
interest-sensitive activities, such as homebuilding, auto sales, and
business investment in plant and equipment, and to the less-developed
countries that are having trouble with their debts.
I urge you, therefore, to support a Federal Reserve policy of
reducing monetary expansion without delay. The annual growth rate of Ml
should be reduced immediately to 8%, in my opinion, and held there
through the second half of this year.
Thereafter, money growth should
be reduced in small steps until it reaches a rate that would produce a
zero inflation rate.
There will never be a better time to begin.
I say this knowing
that slowing monetary expansion after an acceleration such as the one we
have seen over the past year will present two painful, but probably
unavoidable short-run risks:
1.
With the Federal Reserve's current monetary control
procedures, an effort to curb monetary expansion could drive
the federal funds- rate and other short-term rates higher
fcr as long as six to nine months.
A slowing in monetary expansion would slow the pace of
economic recovery. Slowing too abruptly could lead to a new
recession.
fts I suggested earlier, the longer the Federal Reserve waits to
face these risks, the more serious they will become.
But facing these
short-run risks is essential if we are to have less inflation, lower
interest rates, and more growth in real income and employment in the
long run. I agree with Chairman Volcker's comment before this committee
on July 14 that "Sometimes a restraining action in the short run may
avoid the need for much larger actions later."
198
In the rest of this statement, I offer for your consideration a
review of choices available to the Federal Reserve, some reasons why
conditions are more favorable for a change of course today than they
would be later, and some comments on the coordination of monetary and
fiscal policies.
Choices Available to the Federal Reserve
Interest Rates.
The monetary authorities, like everyone else,
would like to see interest rates fall.
But as Chairman Volcker and
other Federal Reserve spokesmen have explained many times, the Federal
Reserve cannot reduce interest rates simply by increasing supplies of
bank credit and money.
To the contrary, an attempt to do so under the
conditions the System faces today would at most delay the rise of
short-term rates and would mean higher rates later.
The only way the
Federal Reserve can reduce interest rates and keep them down is to
reduce inflation and inflation expectations.
That would require reduc-
ing growth of bank credit and the money supply, not increasing it.
During the early stages of a Federal Reserve policy of reducing
money growth rates, short-term interest rates would actually rise for a
time. That surely would raise a storm of criticism from people who do
not understand the market constraints within which monetary policies
must operate.
Nevertheless, many people in financial markets do under-
stand the linkages among monetary expansion, inflation, and interest
rates, which is one reason interest rates have been rising in recent
months in the face of high rates of monetary expansion. In effect,
financial markets are both anticipating and demanding some action from
the Federal Reserve to slow the pace of monetary expansion.
Recent high
199
rates of monetary expansion have been pushing interest rates upward in
two ways:
1.
Experienced lenders and borrowers in financial markets expect
high rates of monetary expansion to mean higher inflation
rates later and so they taKe action to protect themselves
against higher future inflation. These responses tend to
raise long-term interest rates.
Expecting the Federal Reserve to curb monetary expansion
sooner or later, lenders and borrowers in the money market
respond to announcements of high money-growth rates by trying
to protect themselves from the increase in interest rates that
they think must come when the Federal Reserve clamps down.
That is why the announcement of a surprisingly large increase
in the weekly-average money supply on a Friday afternoon
usually will drive interest rates upward within a few minutes
after the news gets on the wires.
Chart 1 demonstrates how futile it would be now for the Federal
Reserve to try to hold interest rates down by increasing growth of the
money supply.
It shows twelve-month rates of chanqe in Ml —
to avoid
over-emphasizing the influence of short-term changes in money supply
—
on the solid line and monthly-average three-month Treasury bill rates on
the dashed line.
Each sustained rise in Ml growth over the two decades
covered was followed within a few months by a rise of interest rates,
although most of us had been taught in economics textbooks to expect
just the opposite to happen. Each sustained decline in Ml growth was
followed by a fall of interest rates.
200
As the ranges of money-growth rates rose, over the long period
covered in Chart 1, so did interest rates. Between the first half of the
1960s and the second half of the 1970s, a doubling of average Ml growth
rates was accompanied by a doubling of average Treasury bill rates.
It is also clear from the chart that interest rates usually continued to rise for a time after money-growth rates turned downward and
continued to fall for a time after money-growth rates turned upward.
This helps to account for the fears that a shift to monetary restraint
now will mean higher rates.
The view I present here would place more
emphasis on the preceding monetary acceleration than on monetary restraint as the cause of rising interest rates.
The large rise in Ml
growth from June of last year through June of this year, for example,
suggests that interest rates should continue to rise for several months
more, even if the Federal Reserve succeeds in turning the money-growth
rate downward soon. The rise of roughly 150 basis points in bill rates
between October of last year and today is consistent with this explanation.
Forecasters who believe that rates instead will fall in the
second half of this year must implicitly assume that people in financial
markets will interpret this latest upsurge in growth of Ml differently
than they did the earlier ones shown on the chart.
Inflation.
of nearly 15%
achievement.
Bringing inflation down from a peak twelve-month rate
in early 1980 to 3.5% in May of this year was a stunning
Yet it seems neither likely nor desirable that the Federal
Reserve would settle for a 4%-5% inflation rate as the best that could
be done from now on.
The Chairman has declared his determination to
continue the fight against inflation.
However, I am afraid the Federal
Reserve will have to quell a new outbreak of inflation over the next two
201
or three years before it can extend the downtrend in inflation that was
underway between I960 and mid-1983.
On Chart 2, we have plotted twelve-month rates of change of the
Consumer Price Index with changes in Ml.
Because changes in Ml affect
inflation with about a two-year lag, we shifted the money-supply series
two years to the right. Thus the inflation rate for 1980 is matched on
the chart with the Ml growth rate for 1978, two years before, that
helped to determine it.
It is easy to see in this way that each major
upsurge of inflation on the chart coincides with an upsurge in growth of
Ml that happened two years earlier. Each fall in inflation coincides
with a fall in money growth that happened two years earlier.
What this chart implies for inflation in 1984 and 1985 illustrates
the policy problem the Federal Reserve faces now.
The rise of Ml growth
from mid-1982 through mid-1983 (plotted in mid-1984 to mid-1985) indicates the direction, if not necessarily the magnitude, of changes in
inflation rates to follow in 1984 and 1985.
The OPEC oil-price shocks
of 1973 and 1979 contributed to the height of the 1974 and 1980 inflation peaks and the fall of oil prices this year brought inflation to
a lower level than would be indicated by monetary influences alone.
Nevertheless, it is evident that monetary accelerations and decelerations preceded and dominated the swings in inflation rates.
All of the evidence we have from the history of the United states,
as well as the experience of many other countries, indicates that an
acceleration of monetary expansion lasting as long as a year will have a
significant impact on prices a year-and-a-half to two years later.
know nothing yet that would invalidate that evidence.
We
Therefore, I
believe inflation will be higher in 1985 than it is today, even if the
202
Federal Reserve has already begun to moderate growth of the monetary
aggregates.
How much higher inflation will be in 1985 will depend in
part on when and how the Federal Reserve acts to slow monetary expansion.
The monetary authorities have no other choice but to reduce money
growth if they are to control inflation.
Targets: MI, H2, MX, or Interest Rates?
The introduction of new
forms of interest-paying deposits, such as NOW accounts, money market
deposit accounts, and Super NOWS, certainly has complicated problems of
interpreting reported changes in the monetary aggregates.
The changes
in deposit regulations enter the interpretation problem in two main
ways:
1.
To explain why Ml and the other aggregates have grown so
rapidly over the past year.
To explain how changes in Ml, M2, and other aggregates should
be expected to influence economic activity, inflation, and
interest rates differently than they would have before
deregulation.
These are complex, difficult problems and probably will provide
manor research topics for years to come.
But people with management
decisions to make in government, business, and in their own households
cannot afford to wait for a long period of consumer testing of these new
monetary aggregates before deciding what to do.
At the risk of
over-simplifying, therefore, I would like to discuss two main approaches
to the interpretation problem.
The first is my approximation of the Federal Reserve System's
current view. It has the support of many economists outside the System
as well.
According to this view, the payment of interest on deposits
203
included in Ml, combined with a general desire to be more liquid, has
made people want to hold more Ml-
This increase in demand for Ml is
said to explain why Ml has grown so irrach.
It also implies that a given
increase in what we might now call decaffeinated Ml would have less
influence on economic activity, prices, and interest rates than the same
increase in old Ml would have had.
Holders of this view are not as mvich
disturbed by the high rate of growth of new Ml shown on the charts over
the past year as they would be if they thought it was as potent as old
Ml.
Although the other monetary aggregates have also been made more
attractive by deregulation and have also grown rapidly since last year,
their recent performance is considered to be satisfactory; or at least
not far enough out of line to cause inflation and interest rates to
rise, until very recently, holders of this view have been forecasting an
anemic recovery in economic activity, a stable or falling inflation
rate, and falling interest rates.
The alternative view, held by some but not all monetarists, is that
the acceleration in growth of the monetary aggregates was not produced
by distortion of Ml or by an increase in the demand for money but rather
by an apparent return by the Federal Reserve to its pre-October, 1979
procedures of controlling monetary growth through pegging federal funds
rates or net borrowed reserves.
When total private and governmental
demands for credit rise, as they have since last year, or are expected
to rise, an attempt by the Federal Reserve to moderate increases in
federal funds rates or net borrowed reserves leads to increasing open
market purchases of securities, faster growth of bank reserves and the
monetary base, and faster growth of Ml, M2, and other higher order Ms.
This is still a matter of conjecture, until we have a more detailed
204
explanation from the monetary authorities, but there is some support for
it in the Federal Reserve Bank of Mew York report, "Monetary policy and
Open Market Operations in 1982."
The report refers to Ml increases
exceeding projections in September, October, and November of last year.
Such overshooting of targets in the past has been attributed to the
inability or unwillingness of the Open Market Committee to adjust
federal-funds-rate targets quickly enough to keep money growth on track.
The monetarist view concedes that payment of interest on deposits
included in Ml may have increased demand for Ml enough that a given
change in Ml would have less influence on economic activity, prices, and
interest rates during the period in which the new forms of deposits were
being introduced than it would have had before deposits bore interest.
However, a 13%-14% increase in Ml in a year is too much for its effects
on economic activity, prices and interest rates, to be completely or
largely offset by an increase in the demand for Ml, in this view. It
should also be noted that the introduction of money market demand
accounts (MMDAs) early in this year, has exerted a dampening effect on
the demand for Ml.
The new accounts provide incentive for people to
shift funds from HOW accounts, in Ml, to MMDAs, in M2, in order to earn
higher rates.
Most monetarists, therefore, have been forecasting a
strong economic recovery and higher interest rates this year and more
inflation in 1984 and 1985.
Only time will tell which of these two views will provide the most
reliable guide to monetary policy and to decisions in businesses and
households.
However, there are two main types of evidence to suggest
that the traditional monetarist view is likely to prevail.
205
The first of these is the behavior of financial markets.
Interest
rates are behaving as though lenders and borrowers in financial markets
still believe Ml is important.
This can be seen in the rises of inter-
est rates and falls in bond prices and stock prices in recent weeks.
The other main evidence is in the strong economic recovery.
Economic activity is increasing about as monetarist forecasters would
have predicted if they had known how much Ml was going to grow.
Many,
however, had expected the Federal Reserve to keep money growth closer to
its announced target rates and so actual growth in economic activity and
employment has exceeded their forecasts, too.
Why Do It Now?
There is an understandable temptation for all of us to shrink from
the costs of curbing inflation.
The costs of the battle since 1979 have
been very high all over the world.
But, if inflation is allowed to
return to double-digit rates, it will be even more difficult to cure
next time.
Fortunately, the initial conditions are much more favorable for a
program of reducing monetary expansion today than they were in 1979.
In
the first place, inflation is running at less than 5% per year in the
United States and is down considerably from past peaks in all other
major industrial countries.
is low.
The likelihood of another oil-price shock
Stocks of agricultural and other commodities are high and this
year's crops are again likely to be large, according to early indications.
Many business firms are poised to reap large productivity gains
as a result of measures they took during the recession.
And deregu-
lation promises more competition and even price reductions in some
industries.
206
These favorable initial conditions by no means guarantee that
getting money growth back under control will be painless.
But they will
provide a year or two of more favorable circumstances than would be
encountered if the Federal Reserve is persuaded to delay taking action.
It is sometimes believed that such favorable conditions would provide a
much longer period of security from inflation threats than one or two
years.
That was the mistake made in 1976 and 1977, when apparent slack
in the economy seemed to promise abundant room and time for applying
stimulative policies.
As can be seen on the inflation chart, however,
inflation can return with a rush.
Inflation tripled within two to three
years twice during the decade of the 1970s.
There is no time to waste.
The Coordination of Monetary and Fiscal Policies
There has been a seductive notion for some time that monetary
policy and fiscal policy are easily substituted for one another.
Therefore, a country that would like to enjoy low interest rates and
price stability at the same time could combine an easy monetary policy
with a restrictive fiscal policy.
Or if it wants to stimulate demand
without depressing interest rates it could combine a restrictive
monetary policy with an expansive fiscal policy.
Unfortunately, it has
not been demonstrated in any country that either of these mixes would
work in the way intended.
We have already seen on Chart 1 that the Federal Reserve cannot
reduce interest rates by increasing monetary expansion.
If it is feared
that rising government spending and budget deficits raise interest
rates, there is nothing the Federal Reserve can do about that, except to
hold inflation and inflation expectations down by controlling growth of
the money supply.
207
Substituting monetary policy for fiscal policy, or vice versa, or
elaborate devices for coordinating the two are not the answers to
improving government's contribution to the performance of the economy.
Both have vital roles to perform and each would be made more effective
by a reduction of instability in the other.
It is often charged that the irresponsible fiscal policies of
politicians make it impossible for their more sober central-bank
brethren to conduct proper monetary policies.
But it also can be argued
that the failure of the monetary authorities to use their powers to best
effect makes it extremely difficult for governments to maintain
appropriate fiscal policies.
By appropriate fiscal policies I mean
spending and tax policies that are determined by the conscious choices
of the electorate, rather than by accidental effects of recession and
inflation.
Neither fiscal nor monetary policy is suitable for short-run
stabilizing operations, despite the many recommendations that either or
both be made more flexible.
Financial markets and markets for goods and
services would work better if they could be assured of stable,
dependable fiscal and monetary policies for years ahead.
Avoidance of federal deficits when the economy is fully employed
and of sudden swings in expenditures would vastly simplify the problems
of the monetary authorities.
The central-bank practice of helping
treasuries sell new debt even when this help seriously impairs monetary
policy grew out of the fact that fiscal policies have been poorly
managed in most countries for longer than anyone can remember.
Monetary policy can make its greatest contribution to the budget
process by reducing inflation and keeping it down.
That would have a
208
direct benefit in reducing the carrying costs of the public debt.
And,
more important, it should greatly increase the ability of all units of
government to estimate future costs of programs and to predict revenues.
The government, like businesses and households needs a stable monetary
framework and a stable price level to maximize productivity and
efficiency in delivering services.
Therefore, I repeat my
recommendation to this committee to support a Federal Reserve policy of
reducing monetary expansion without delay.
THREE-MONTH TREASURY BILL RATE AND GROWTH OF Ml
u CHANGE OVER YEAR AGO FOR Ml)
to
o
64
66
68
70
72
74
76
78
80
82
CURRENT
INFLATION & MONEY SUPPLY GROWTH TWO YEARS BEFORE
to1
i-
o
FIRST INTERSTATE BANK
ESEARCH & PLANNING
62
64
66
68
70
72
74
76
78
80
82
84
211
Senator GORTON. Thank you both very much for providing enlightening statements as well as for your patience during the
course of the day.
Professor Blinder, you put your view in a very cogent and a very
witty fashion. You did say, however, a quarter of the way into your
statement that you weren't really quite sure about the degree to
which you disagree with Chairman Volcker, the statements which
he made here today and in the House yesterday.
Are you more sure about the degree of disagreement you had
with Dr. Feldstein?
Professor BLINDER. No, but I think I am with Secretary Sprinkel.
Senator GORTON. I think I am as well. That is why I asked the
question in the other fashion.
Let me ask you the question which I asked of Dr. Feldstein,
based on one portion of his testimony.
Do you differ from him profoundly enough to disagree with his
statement, his absence of belief in the ability to trade inflation for
sustained higher real growth? Do you believe that we could create
over an extended period of time higher real growth by paying the
penalty of inflation of 7- to 10-percent rate?
Professor BLINDER. As long as you put in the words "sustained"
and "over a long period of time," I agree with him 100 percent. The
evidence is very clear and the economic theory, for a change, goes
along perfectly with the evidence in that issue.
POTENTIAL FOR SHORT-RUN TRADEOFFS
Where I would disagree with Mr. Feldstein—and very vehemently, in fact—is over the short-run tradeoffs. I listened to what he
was saying. I thought he grossly underestimated the potential for
making such a tradeoff. Whether or not that is a good idea or not
is another question entirely.
Regarding the potential for making such a tradeoff in the short
run, I think the evidence is overwhelmingly pointing to a very
strong tradeoff in the short run. The issue of disagreement—were
he and I at the same table we could iron this out very quickly, I
think—is a question of emphasis, like whether the glass is half full
or half empty. I don't think there would be a large disagreement if
we could thrash it out together with numbers.
I would like to just cite as a piece of evidence that the slowdown
in nominal GNP growth or money growth or rising interest rates
in 1981 and 1982 had a very profound effect on the growth of the
real economy. It wasn't an accident.
There is no inherent reason why this process is not reversible. By
juicing up the economy enough by easing money, we could have a
boom of a magnitude comparable to the bust we had in 1981-82.
That may be a bad idea for a number of reasons, but I took the
question you asked me as simply a question of whether there is
such a tradeoff in the short run.
Senator GORTON. Is it a good or bad idea?
Professor BLINDER. I think it is not such a bad idea, to tell you
the truth. The question is always how much. Let me put some
numbers to it. I think it wouldn't be a bad idea to have 6 percent
212
real growth in the economy for a couple of years starting from
today, and the projections are not for that kind of growth.
I think it wouldn't be a bad idea if we beat the unemployment
rate down to 7 percent in less than 3 or 4 years, which is what the
projections are.
If that is an answer to your question, I say, yes, it is a pretty
good idea.
Senator GORTON. I suspect that everyone else who has been here
today would say the same thing.
Professor BLINDER. Well, I don't think so in terms of whether it
is a good or bad idea. I was hearing the opposite.
Senator GORTON. Would you, Dr. Meigs, disagree that if we could
get unemployment down to 7 percent and have a couple of years of
6 percent real growth that that would be a bad idea?
Dr. MEIGS. Yes, because there is no longrun tradeoff. The problem is that if you have an acceleration of, say, money growth you
get the first effects on real output and the effects on prices come
with 2-year lags.
We have had many experiments in this country and other countries with such attempts to stimulate growth in the short run with
an expansive monetary policy, and over the long period of the two
decades I show on my charts. Secretary Sprinkel referred to them,
Dr. Feldstein referred to them—in the United States and all the
major industrial countries of the world. What we ended up with
after two decades of experimenting was higher average levels of
unemployment, higher inflation, and lower growth.
In the late 1970's, many countries, even before the United States,
decided that that was not a very useful policy track.
Senator GORTON. Again, I am going to sharpen the differences a
little bit more.
I didn't take Dr. Feldstein to say that he thought that would be a
bad idea. I got the thrust of his testimony to be that we couldn't do
it, that the positive impact of that kind of monetary policy would
be much briefer than a couple of years before it resulted in inflation and stagnation.
Dr. MEIGS. It depends again on how rapidly we try to do it. As I
say, we have tried it. You can certainly stimulate growth of real
activity for a couple of years. I believe that you would have more
inflation in the third year.
What I did warn against is that sudden changes in either direction do have sharp effects on output. Just as it can be potentially
dangerous to overstimulate, too sharp a deceleration puts us into
another recession. We have done that several times, twice in the
last 5 years.
So that is why I would recommend being cautious on the deceleration just to avoid that. It is hard to avoid. Not many countries
have succeeded in doing that. If it were done cautiously though, we
might at the price of a little higher inflation 2 or 3 years down the
road that we would otherwise have.
Senator GORTON. Professor Blinder's written testimony, which he
didn't finish, ends with the statement that it is better to eschew
intermediate targets and focus instead on things that really
matter, like interest rates, investments, inflation, and real GNP.
213
I expect there probably would be very strong agreement on that
proposition.
Professor Blinder, let me ask you this.
Every other witness who has testified today, while they might
well agree with that as a proper goal, would, I suspect, say that the
restrictions which you give us would not in fact have that effect.
Isn't the very fact that people in a position such as they hold—
the Chairman of the Federal Reserve Board, the President's Economic Advisor, for that matter Dr. Meigs here who reflects, I suspect, the very strongly held views of the private sector—isn't the
very fact that they believe that way something which would make
their beliefs come true if, in fact, we should have a much more expansionary monetary policy?
Haven't we just seen in the last few months every slight indication that the monetary supply was expanding too fast, accompanied
by increased interest rates rather than decreased interest rates and
a fear of a return to inflation?
Professor BLINDER. I don't think that is true. The Federal Reserve, in something around mid-1982, decided that they had overstayed monetary tightness and decided they should abandon monetarism, at least temporarily, and ease up on bank reserves and let
the banking system expand much faster than it had been. Recovery
started from that point, and interest rates started to go down.
We know from the minutes of the FOMC that were just recently
revealed that they decided, I think it was May, that they should
tighten monetary policy a notch because they are worried about
these high monetary growth rates. Since then interest rates have
been going up.
REAL AND NOMINAL INTEREST RATES
So I don't think it is true that interest rates will move in the opposite way from what I have been saying. The important distinctions here are between short-run and long-term effects and between real and nominal interest rates. When you accelerate monetary growth—if we can impute any meaning to that statement,
let's say you raise the rate of growth for banking services—that
forces interest rates down. If the accelerated rate of increase of
bank reserves is maintained, sooner or later there would be more
inflation on that account. While interest rates may well still be
lower, nominal interest rates are probably going to be higher.
This is the distinction that is too infrequently made in asserting
that higher money growth always leads to higher interest rates.
The interest rates that are being talked about are nominal interest
rates. And it is true that after a while—and it may not be a very
long while—higher money growth results in higher nominal interest rates. But it is presumably the real interest rates that are relevant to savings and investment decisions.
Senator GORTON. I want to followup on that question, but first I
want Dr. Meigs to followup on what Professor Blinder just said.
Dr. MEIGS. People in the financial markets learned some very
hard lessons in the 1960's. As late as 1965 people did not pay much
attention to anticipated inflation and its effects on interest rates.
There is nothing like losing money in large quantities to sharpen
214
one's perception, and that happened as the inflation rate rose, interest rates rose. People who had bought bonds in great confidence
around 1965 lost plenty.
So now people in financial markets don't merely look at past
prices to form inflation expectations; they look at what governments do. They look at the budget. They look at the trend of government spending. They look at the monetary policies of the
United States and other countries.
And they react very sensitively. Sometimes they overreact. If
people in the financial markets believe that the Federal Reserve or
the Bank of England or the Bank of France or any other central
bank is beginning to accelerate growth of the monetary aggregates,
you can believe interest rates will begin to rise and without much
delay. That is just a fact of life today. It is one of the things that
does put more discipline on central banks than used to be the case.
Senator GORTON. I think this is appropriate followup. In a television interview last week, Henry Kaufman said that the link between nominal interest rates and expected inflation was not as
good as it used to be, and that we could infer expected inflation by
simply subtracting, say, 3 percent from nominal interest rates.
Obviously, I can't ask you to explain Mr. Kaufman's comments,
but I am puzzled by the suggestion, and I would like you to address
it. Do you think of nominal interest rates as being the sum of the
real rate in the 3-percent range and current expectation in inflation rate, or is there another intervening factor which must be
used to explain it?
Dr. MEIGS. One of the big issues is whether there is a constant
real rate of interest. I think most people no longer believe that.
Secretary Sprinkel talked about this. He said in a year people
looking back would say today's inflation rate, today's nominal rate,
indicates a real rate of interest of, let's say, 6 or 7 percent when
they used to think it would be only 2.
What is relevant there is not the current inflation rate but how
much people expect there will be in the future.
Now what happened is last time we had a fall in the inflation
rate many people were disappointed that interest rates did not
come down as much as the inflation rate came down. But if you
look at the history of interest rates, this is not at all uncommon.
We have had many periods with similar lags.
A second point, a lot depends on the credibility of monetary
policy and fiscal policy. A lot of people have seen inflation brought
down dramatically. Between 1974 and 1976 it came down in a very
similar way to this, but within 3 years the inflation rate was doubled or tripled.
So, in financial markets, people are rather cautious and do not
really believe that the Federal Reserve or the Government will persist on a course of subduing inflation long enough to make it last.
Then another point, there has been so much instability.
All those factors tend to explain to me why real interest rates
are higher than some people think they should be, but real interest
rates are not a very easy thing to manage. One thing that would
bring them down over a long period of time would be for the fiscal/
monetary authorities to follow, very stable policies, with very few
215
big changes, and bring the inflation rate down to zero, which I
think would mean a high rate of growth in real output.
Senator GORTON. Professor Blinder.
Professor BLINDER. If I understand what Mr. Kaufman was
saying, 1 think it is correct. The nominal interest rate is the sum of
the real interest rate plus the expected, looking out to the future,
rate of inflation.
There was a period of time from, oh, say 1953 to about 1971, give
or take, when the real interest rate in this country, however measured, was quite stable. It fluctuated a little bit, but didn't have
major movements.
Since the mid-1970's that hasn't been true, and real interest
rates have moved about a great deal. So while it is still true that
the nominal interest rate is the sum of the real interest rate plus
the expected inflation, it is not true that the nominal interest rate
is the sum of an unchanging real interest rate plus the expected
inflation.
If we go back a few months, it wasn't uncommon for short-term
interest rates, like T-bill rates, to move by a 100- or 200-basis points
within a couple of weeks. Those things were happening not too
long ago.
I don't think anybody could believe that the expected 3- or 6month inflation rate had moved that much within a couple of
weeks. The only explanation for that is a change, a very large
change, in real interest rates.
Senator GORTON. Do you agree with Dr. Meigs that a proper goal
is a zero inflation rate?
Professor BLINDER. No. I think the thrust of my answers to other
questions you have asked about the longrun tradeoff is that there
isn't much relationship between the longrun inflation rate and the
real growth rate.
So we might have 3% percent steady real growth rate in this
country and zero percent inflation or 5 percent or 10 percent or
even 25 percent.
Brazil was mentioned earlier. Brazil has enjoyed 6 to 8 percent
real growth continuously though their inflation rate gyrated from
100 down to 15 back to 120; 6 to 8 percent real growth. You can
have these kinds of real growth no matter what the inflation rate
is.
The critical question—and the reason I say very strongly "no" to
your question—is: How do you get from here to there? We know
how we got from a 10-percent rate of inflation, down to a 4-percent
rate of inflation, and it hurt a lot.
If you want to get down from a 4-percent to zero, it is going to
hurt a lot again, and I don't think it is worth it.
Senator GORTON. Dr. Meigs.
Dr. MEIGS. It is true that we don't know very much about what
determines longrun real growth rates or the connection between
them and inflation.
My argument on the superiority of zero inflation is simply that if
you try to target anything else the monetary authorities will never
hit it. If you say, we should tolerate a 5-percent inflation rate, it
wouldn't be long before it's 7 or 8. And one thing that has been
observed is that the higher inflation rates become the more unsta-
216
ble they become. That does distort a lot of managerial decisions, investment decisions, and I believe gives us a lower real output than
we would have otherwise. So you could hold the monetary authorities responsible for aiming to get a zero inflation rate over a long
period of time.
One of the advantages of that would be that we would get a
better allocation of capital.
It doesn't make a whole lot of difference except I don't think
Americans would like to live like Brazilians, even with a higher
real growth rate.
Senator GORTON. Senator Riegle, I have gone over my time, but I
have finished with the questions I intended to ask, and I must be
someplace else. So I will simply turn the gavel over to you, and you
can ask questions as long as you wish.
OUR PRESENT POLICY MIX LOOKS DANGEROUS
Senator RIEGLE [presiding]. I do want to make two points and
then raise a question with you. I think your assertion, Dr. Blinder,
that the Fed changed their direction dramatically last year is obvious on its face, and if anybody needs proof of that, just the fact
that they have operated so long above their own targets—I mean
they set the targets—has set them to thinking that that is where
they wanted it, and then when they consistently ran substantially
above their targets—what logical conclusion can anybody draw
when their targets are off and so in fact they set new targets,
though they didn't state that? They just decided they had to shoot
higher, and in fact have done so. And now they are folding a 14percent increase into the base so that in fact with the new targets
they are talking about a HVfe-percent increase off the old base. It
certainly gets lost in the numbers here and nobody will pick up on
it.
Everybody worries about next year's deficits, and in this year's
deficit at the end of the year we end up with a lot of money in supplementals, and it goes way out of sight.
But everybody stopped looking at 1983 because 1984 is what is
going on.
It seems to me in some respects the Fed is doing the same thing.
To go to the question of monetary policy, it seems to me that
monetary policy is a very, very important instrument when it
comes to solving the inflation problem. You can do something with
inflation, depending on what makes up that inflation, where you
are.
The notion that you can hammer it down to zero with monetary
policy I think is a very dangerous policy, with no disrespect to your
view to the contrary.
I think if you look at all the structural weaknesses we have now
there is a lot of it, and we haven't solved our problems at all. But if
we were to decide what we want to do was to face more and really
bring out what is left of inflation, I think it wouldn't take long
before we would have some serious international defaults. We have
a problem right now in getting the House of Representatives to
vote for the IMF authorizations, which should they not be provided, you would have the banks backing away themselves.
217
It wouldn't take long. I don't know what the impact would be on
confidence in the national markets if a major country defaulted, in
addition to those that have already in a sense defaulted, and so
forth.
I think if you talk in terms of using monetary policy in terms of
getting inflation down to zero that would be a highly dangerous
strategy.
What I would really like to pose to you is the question that I
have been trying to pose really in a way to Chairman Volcker and
to Chairman Feldstein and others, and that is where we are now in
terms of the overall policy mix and is that policy mix sufficient as
it is now, absent any major further adjustments, to sort of take us
on through to the kind of future we would like to see—declining
unemployment, renewed growth, low inflation, and so forth.
When I pose that question to myself I think we are in a very
dangerous condition. I don't know that that's exactly a fool's paradise, but I think it is close to that, if we think that if we make no
further change that we would get all the nice things and not have
the very miserable day of reckoning somewhere up the road,
whether it comes in 6 months, 9 months. I can see it coming.
But I see it coming, because it seems to me we have got some
fundamental contradictions in the overall macroeconomic policy
mix, if you will, that there is irreconcilable contradictions. Obviously there are enormous deficits and the fiscal problem is real and we
are not doing anything about it. The President has backed away
from it and the Congress seems to be backing away from it.
I was saying earlier we're in a 1 Mi-year window now headed for
the Presidential election, and that tends to make hard decisions all
the harder. I don't think the Congress is going to deal with the
fiscal problem in a meaningful way and the President already has
slipped out the side door on that issue several weeks ago.
So you've got the deficits, you've got the trade deficits. We've got
a $70 billion trade deficit. It's rising. I have every reason to think it
is going to continue to rise for reasons of the fact that we have an
exchange rate problem. Also foreign countries are in trouble. They
can't be importing our goods; they've got to be exporting more of
their goods as part of the way to get the extra money.
So we're in a very, very difficult situation there. If the merchandise trade deficit can go from $36 billion to $70 billion in 12
months, what is to say it can't go to $110 billion over the next 12
months? What does that mean? It worries me.
The savings rate is not terrific. We are not beginning to save at
the level we need to save to finance everything we want. Caspar
Weinberger can't find anyplace to save any money in the defense
budget. Other things are hard in terms of any further reductions in
entitlement costs and other domestic spending.
Unemployment is still very high. We are starting out here at a
point where each time the plateau level seems to crank up 2 or 3
percentage points, but we're now over the 10-percent level.
I mentioned the foreign debts. I think the international situation
is far more perilous than anybody would care to talk about. Everybody kind of tiptoes around that problem because if you shatter
confidence you make your problems worse. So everybody basically
whistles by the graveyard on the international debt problem.
218
Behind that comes the wage-and-price problems. Paul Volcker is
sensitive to that. He's starting to talk a little bit about that.
So as a matter of fact you're going to get a certain level of costprice push, wage push, and inflation coming along here under the
best of circumstance, and perhaps a lot of it under the worst of circumstances. We haven't dealt with any of that. It's very hard to
deal with. Who wants price-and-wage controls? At least not people
in political positions. We don't seem to be able to devise an incomes
policy.
So those issues sort of tend to get lost in the shuffle. When we
may be running along at 70 or 80 percent of capacity and you've
got 10 million unemployed they don't seem like big problems. But
they are out there; they are unsolved; and they are going to come
back and haunt here, I think, quite soon.
FED ADJUSTMENTS WILL SLOW RECOVERY
So I add all that up and I say to myself, all right, how do we
solve this. Well, the way we solved it the last time is the Federal
Reserve basically put their foot on the brakes and we had a very
tight monetary policy. We shut the whole works down to a very
substantial extent internationally.
Now the Fed is back in the same box, because now they feel no
fiscal restraint. None of these other things are being dealt with. So
what's happening? The only policy tool that seems to be one that
anybody can get ahold of is Fed policy, so now they are trying to
put their foot on the brake, and God knows, most people are saying
don't put your foot down hard, just hit it a couple of times.
If they start to put their foot on the brakes everybody else
around says I'm glad you're doing that because now we don't have
to do the part we thought we could do. Let the Fed get it done.
Then the problem is the Fed is left with a situation where if
they're going to try to deal with the contradictions it is almost inevitable that they are going to have to tighten down further and
further and further because this credit crunch has come. We're
going to have to pay for these deficits. The savings rate isn't there,
and we can't just count on money flowing in from abroad especially
for long-term investment for things that are not short term in
nature, whether it's housing, plant reconstruction, or what have
you.
So we are right back in the situation where interest rates are
going to have to go back up, and if they go back up they are going
to shut down the economy.
We don't have a workable policy mix at the moment.
I would like to say one other thing and I would like your reaction to it.
Look at the financial markets. It seems to me what the financial
markets are doing in a general sense is tracking exactly what has
happened here. The stock market went into the tank when the
economy hit rock bottom. The economy starts coming back, interest
rates start coming down, people start getting out of bonds and into
stocks, you get a lot of institutional money, profits start to reappear in terms of corporate earnings, the stock market is oversold, it
219
has to rise and starts to rise, and everybody sees that as the place
to go and invest a lot of money.
So you get an upward rise in the stock market. It's almost like
physics. You can almost predict it is going to happen. That is not to
say that it is going to keep going forever or that these contradictions aren't going to catch up with us here sometime soon.
I'm very much concerned that they are. And I'm very much concerned that if we don't face reality pretty quickly here and fight
awfully hard to make the adjustments we're going to find ourselves
going right back down the downside of this. It's just a question of
when it happens.
I would like your reactions to that set of concerns I'm expressing
and whether or not you agree or disagree.
Professor BLINDER. I heard what Dr. Feldstein said in answer to
that question before. In large measure I agree with that. As he put
it, the most likely scenario under no change in fiscal policy is that
we will continue to manage some kind of a recovery, but a very
lopsided recovery. And it will be lopsided in a very predictable way:
The housing industry will be left behind, the automobile industry
will be left behind, and in general the export competing industries
will be left behind because of the problems caused by the exchange
rate.
As you say, if the Government is doing all this borrowing and
private individuals are not doing all the savings, where do we get
the money from? We borrow it abroad. We have to attract it by
high interest rates. That's all very nice, since we don't have to save
it ourselves. All of us like to live on someone else's credit. The way
we pay the piper for this is by the rise in exchange rates, which is
simply annihilating the export industries in the United States.
That's very problematic. When you think of what those export
industries are, and where are they located, much of what we think
of as the industrial base of the United State is either an export industry or should be an export industry, or an export competing industry—steel, automobiles, chemicals.
So that's not a very happy prospect.
You could conceive of an economy that is booming along with
consumer goods and toys and the steel industry and auto industry
are going to hell and the export industry shuts down. The GNP
may keep going up if the toy industry is growing fast enough, but I
don't think that is the sort of thing that you would like to see. It's
certainly not the sort of thing that I would like to see.
The other thing to be said about that—he also said this, and I
would like to emphasize it more—is that this is only the best guess
as to what would happen under constant budget policies. But there
is a risk that things could be a whole lot worse.
The risk comes from two places, one of which Feldstein mentioned, the other of which he didn't, but I mentioned in my testimony. The first is that we don't really have experience with a protracted recovery with these kind of real interest rates. So we are
guessing.
One aspect of your statement that I disagree with is when you
said it's like physics. It's not like physics. We are not quite sure
how the economy will really react to this particular thing we're
putting in, the very high real interest rates.
220
Senator RIEGLE. What I meant to have reference to was the fact
that under certain conditions you'd have people bailing out of
bonds, getting into stocks, and I think there is a certain tip point
that is akin to physics when you get sort of a basic turnaround on
interest rates.
Professor BLINDER. There is some reason to worry that maybe we
can't muddle through with these high interest rates. I think the
chances of that are well less than 50 percent. We probably can
muddle through in a lopsided way. But it's a worry.
Senator RIEGLE. You say the chances that we can are less than
50 percent?
Professor BLINDER. The chances are that we cannot. The chances
are well over 50 percent that we could have a slow or moderate
lasting recovery in a lopsided way even with these high real interest rates.
Senator RIEGLE. Could you tell me what that eventually leads to?
Could we do that for 5 years, 10 years, 15 years?
Professor BLINDER. To recover back to something like full employment, if we grow at something like 4 or 5 percent a year, it is
going to take something in the 5- to 7-year range, at which point
you have something that looks like a fully employed economy that
has a smaller housing industry, a smaller auto industry, and lots of
other smaller industries and bigger industries in certain other
things, especially in consumer goods, maybe some particular machine tools, especially short-life capital equipment that is very
much favored by the ACRS. Those kinds of things would be expected to grow relative to the rest of the economy.
The second thing that I emphasize in the testimony is that the
Fed might make a mistake while just muddling through. The process is a subtle one. We don't know what velocity is going to do for
the next 2 years, just as we didn't know 2 years ago what it was
going to do for the following 2 years. And they could make a gross
error as they did in 1981 and 1982, and push us back into another
recession. And that is not a negligible possibility.
Senator RIEGLE. Where would you put that probability at?
Professor BLINDER. A third to a quarter. It's a big guess. If I
knew what was going through Chairman Volcker's mind, I could
make a better guess. But I don't.
FED SHOULD KEEP INFLATION DOWN; BE CAUTIOUS
Dr. MEIGS. On the first point, I certainly would not advocate any
forceful attempt to have inflation down to zero in a couple of years.
It looks to me more like a 5- to 10-year project if we're lucky.
I think what we need is more longrun monetary policy, and then
the same thing in fiscal policy.
If you change the numbers of the thermometer you don't change
the temperature on the room. The problem is more persistent than
that, and I would say just looking at fiscal policy over the long
period in the United States it has been consistently biased against
saving and investing. Shares of income going to Government have
been rising for years, and it is a process that is accelerated by inflation where you have bracket creep in the income tax.
221
So these should make interest rates higher as opposed to pulling
capital from abroad and capitalizing the economy in the form of
goods that hurts some of our producers.
These are all very difficult problems.
But the Federal Reserve cannot offset these effects by creating
money to reduce interest rates, because the financial markets
simply will not allow the Federal Reserve to push interest rates
down for more than a few days or for a few minutes.
We have had a history of great instability in monetary policy. I
said earlier that this disability in monetary policy has helped
damage fiscal policy. The answer to me is you have to constantly
look at the economy becoming as stable as possible in both fiscal
and monetary policy. Avoid big changes and work very carefully in
the long term, because in the budget you have a very difficult and
vital problem allocating the Nation's resources—how much defense
do we need, how much of this or that. These functions cannot be
handled very well if you are preoccupied each budget year with the
fact that we are in a recession this year and next year in a boom
and then in a recession.
I say, tell the Fed to get their act together, be very cautious, get
inflation down, and stop trying to do too much. That will help you
in your budgeting problem, which is not an easy problem.
Sure, we have lots of problems, but we're still a lot better off
than many countries in the world. I'm not that discouraged about
the future.
Senator RIEGLE. Let me give you one more thought to react to.
I'm an optimist. I've been here 17 years in the Congress and have
had some chance to see it on this end. I represent Michigan. We're
in our 38th consecutive month with unemployment above 10 percent and our 15th above double digits. So I've had a chance to sort
of look through the window from that vantage point. But I also had
a chance last year to serve as the ranking Democrat on this committee while we were trying to keep the S&L industry from sinking
beneath the wave, and managed to do that through legislative
action, including some devices, such as accounting devices among
other things, to basically sort of pass that problem so we could get
on into, hopefully, recovery, which seems to be underway now.
The thing that concerns me here is if deficits are going to continue to run over $200 billion, and it is my best surmise that they
will—I think if Senator Gorton were here he would agree with
that, although I don't know. He has to speak for himself. A large
part of that $200 billion deficit is not cyclical deficit that is going to
get better.
We have made some fundamental changes that give us a very adverse and, if you will, lopsided fiscal policy. It is coming in the
midst of an enormous structural change in the world economy
where things are just different. I mean the relationship with ourselves to Japan, not just in all those things that are obvious, but in
other things. It has changed fundamentally. It is going to take an
awful lot of effort to get ourselves repositioned in terms of that
puzzle.
The thing that I am concerned about here is if the deficits are
not going to be below $200 billion and we are not going to be able
to jack up the savings rate substantially—I mean we are headed
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into a credit crunch here that is inescapable, and especially in light
of the fact that everybody is saying that the Fed ought to accommodate it when it comes, but the fact of the matter is it is inescapable, it's going to come. What's going to prevent it from coming?
It seems to me that if that is the case we had better all admit it,
we'd better admit—if that is what's coming, if those are sort of basic
components of the overall policy mix, that we are headed for a day
of reckoning here that is going to be very severe.
If you don't believe that, if the deficits of that size don't matter
when you put it together with the world trade picture and the interest rate picture and so forth, if you look at the savings rate picture and you say it doesn't matter, then that is something else
again, and I want to hear that if that is what you believe.
It seems to me what is happening here is almost an unconscious
tendency to finesse that question, because if you have to face it
square on then you have to really make a pretty strong statement
about an awful lot of things having to happen some time soon.
People basically don't like to do that.
MUST HAVE SOME INFLATION TO CUT INTEREST RATES
Can we take deficits above $200 billion in the next 5 years and
just sort of still have it all work out?
Dr. MEIGS. I would prefer that we not do that.
Senator RIEGLE. I know you prefer it, but the question is will it
undo us. That is the issue.
Dr. MEIGS. No.
Senator RIEGLE. It will not drive interest rates up in your opinion?
Dr. MEIGS. It will make the economy perform not as well as it
would without this problem. As Mr. Blinder said, there is a change
in the character of the economy. It has had a lot more economic
activity run by Government and less by the private sector. I think
over time that means a lower growth rate. But other countries
have tolerated such things. I don't like that, because I would prefer
a budget policy where you really have control over expenditures
and consciously allocate things and not have the budget grow by
accidental accretion or inflation.
But that is a longrun problem, I have no easy answer to that.
Senator RIEGLE. Do you want to react to that?
Professor BLINDER. I would say that the Fed can prevent this inevitable, or rather noninevitable, credit crunch, but at the price of
declaring a truce in the war against inflation. The word that is
often used is reinflate the economy rather than disinflate the economy. And that is the way the Fed would do it, by monetizing a
goodly share—not a goodly share; we're only talking about a few
percent anyway. The Fed typically monetizes 4, 5, or 6 percent of
the deficit. I don't know how much we're talking about. Maybe
we're talking about monetizing 7, 8, or 9 percent of the deficit. I'm
not sure. But they can prevent the high interest rate consequences
that we talked about, but at the cost of injecting more liquidity
into the economy and losing ground in the war on inflation. And
that's the trade off that we have.
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The other thing I want to stress about that is that there is no big
rush. We are not at this point now. The credit demands of the private economy are still moderate; the economy is still quite depressed even though we've had two quarters of positive growth.
And there isn't any problem selling the Government's bonds right
now. So it is not something that requires panicy action. But if
things continue as they are, we will likely progress the way you've
described. And if the Fed is going to stop it, it is going to have to
inject more money and credit or something like that.
Senator RIEGLE. You're going to have a very hard time doing
that because people like Mr. Meigs are going to scream very loud
when that happens. The Fed will start the tightening process because that's the only show in town, and the more they do the less
is done on the other parts of the policy that could also accomplish
the same end without requiring so much tightening, and then we
are going to start down the slope again, and at some point either
political pressure or just the sheer requirements of the economy
are going to cause them to do exactly what they did last year, that
is, they are going to reverse gears. They absolutely reversed gears
and they started pumping money out like mad. But it depends on
when you start it. If you want to start from the time they started
pumping the money back in, then you could say, well, the gain that
we have made is x billions in inflation savings.
You can also do a calculation of x hundreds of billions in lost
production and the other damages that's been done in the meantime. Recessions are enormously expensive, and the country loses
years in terms of things it doesn't do because it's got big chunks of
itself sitting idle, including the pileup of Federal deficits. We are
carrying these $200 billion deficits in the national debt and paying
interest, and that can be rolled over forever more.
Dr. MEIGS. I agree with you on that. But there is one big problem
with what you said about the Fed suddenly increasing its speed.
We are always reacting to the Federal Reserves' most recent mistake. If you look at their behavior over two decades you would believe that the Federal Reserve has only two speeds—too fast or too
slow. They never hit it in the middle. What I would urge you and
your committee to urge them to do is for once hit to the targets
that they announced in advance and to do it cautiously and don't
be constantly overshooting and undershooting. They do damage in
both directions everytime they do that.
ADJUSTMENTS IN POLICY MUST BE MADE NOW
Senator RIEGLE. I would make one final observation to you before
we wrap it up here, and that is that I think we are at a certain
critical moment right now. We need some major additional policy
adjustments on the fiscal side and some other areas as well, and we
are in effect trying to do it on the international debt side.
I think we also need a trade policy that is more thoughtful, more
up to date than we presently have, because I think it is hurting us
as well.
But if the President of the United States personally as the top
elected officer in the country and his administration is not actively
involved and sees this as a major item, sees this as a top priority,
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and this is not taking a major part of every day to work this out
with Members of the Congress in both parties to wind the policy
mix up, to really deal with fiscal policy, make the trade-offs—
maybe that means more cuts in defense spending than he wants,
more restraint in domestic spending than somebody else here in
the Congress might want. But in the end you come up with a deficit that is not $210 billion, but it's $170 or $180 billion, and you
really get on down the sloping track and do some of these other
things, and you try to start on some kind of an incomes policy if
it's nothing more than jawboning—it could be a friendly jawboning. We went through jawboning in the extreme in Chrysler. We
mandated it by law. It worked quite well, as a matter of fact. Everybody has come out ahead as a result of it.
It seems to me that that is what we ought to be doing right now.
But that is not what we are doing. That isn't the national debate;
that is not where the focus is; that's not where the work is going.
Where I think you can be especially helpful is if in thinking
about this, if it was the judgment of the top professional economic
strategists and thinkers like yourselves who are out either in the
university world or private sector—to the extent that needs to
happen, if you don't say so and if you don't ask for it and others
like you are not part of the consensus that are sort of ringing the
bell and saying, look, we really need some major adjustments here,
we need more concentration on getting this done, and there is a
moment here in time where perhaps now we can take a look at
things, it becomes less and less likely to happen, and we're going to
go skating right down through the next year and half. You just
watch and see if that isn't the case.
Barring some extraordinary effort to come in and start to make
further adjustment in this overall policy mix—if you want to come
back here in the spring of 1985, regardless of who runs and wins
the Presidency, I think you will find that barring some kind of an
additional major focusing effort of the kind I described that this
thing is not going to work properly because it is not engineered at
the moment to work properly. We still have the contradiction between the fiscal and monetary policy, and that desperately needs to
be resolved and is not in the process of being resolved.
In any event, it is good to have you here. I appreciate what you
said. I have read both your statements and I think they are helpful
to us and made a contribution to the record.
Thank you very much.
[Whereupon, at 5:27 p.m., the hearing was adjourned.]
MONETARY POLICY RESOLUTION
THURSDAY, JULY 28, 1983
U.S. SENATE,
COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS,
SUBCOMMITTEE ON ECONOMIC POLICY,
Washington, D.C.
The subcommittee met at 2 p.m., in room SD-538, of the Dirksen
Senate Office Building, Senator Slade Gorton (chairman of the subcommittee) presiding.
Present: Senators Gorton, Garn, and Heinz.
OPENING STATEMENT OF SENATOR GORTON
Senator GORTON. Good afternoon and welcome once again to this
hearing room, Chairman Volcker. You have spent a great deal of
time here. Thanks for returning so soon after your appearance last
week.
The committee has had an opportunity to discuss your monetary
policy report at some length and my opening remarks will be brief.
We are interested in your views on a topic closely related to the
monetary policy report you provided last week. As you know, section 6 of this year's first concurrent budget resolution requests the
Banking Committees report to their respective Houses a resolution
expressing the sense of Congress as to appropriate monetary policy.
My own interest in this issue arises out of my interest in the
Federal budget and its numerous effects on the economy. Most of
my colleagues on the Banking Committee have, of course, longstanding interest in monetary policy generally. The budget resolution provision reflects I think two concerns. First, there is the obvious issue of monetary policy itself and the problems that can confront it given the Federal budget and the current state of the economy.
Second, there is the underlying issue of congressional oversight
of monetary policy. The nature of the Federal Reserve System
which is described as independent within Government is I think a
uniquely American solution to the conflict between the need to insulate to some degree the central bank from short-term political
pressures and the need to insure that it is ultimately responsive to
the will of the people.
There is continuing tension in the relationship with the Federal
Reserve Board to the Congress and the Executive, but I think it is
for the most part a creative tension. Clearly, the nature of the institution puts a premium on the integrity of the men and women
who run it. We have been fortunate in having a succession of
highly respected Governors of which you are the most recent.
226
I believe the system has worked well to date but it is always important for Congress to exercise vigorously its oversight responsibilities.
With that introduction, I look forward to hearing your testimony
after a statement by the chairman of the full committee.
Senator GARN. I have no statement. The chairman has had to
listen to me so much lately that I came just to listen to him today.
Senator GORTON. Senator Moynihan did, however, come to introduce his fellow New Yorker and although we have a vote beginning
I don't want to have him come back, and we will certainly be delighted to hear what our good Senator has to say.
STATEMENT OF DANIEL PATRICK MOYNIHAN, U.S. SENATOR
FROM THE STATE OF NEW YORK
Senator MOYNIHAN. Well, Mr. Chairman, I thank you and it's an
honor indeed to welcome and introduce to this committee a fellow
New Yorker.
I have a statement, Mr. Chairman, that I'd ask be placed in the
record as if read.
Senator GORTON. Without objection.
Senator MOYNIHAN. I would offer only the briefest observations
about the sequence of legislative concerns and acts that have
brought us here today. We are participants in what could well be a
major event in American economic history, the attempt to understand and, if need be, reform the institutional arrangements by
which we set economic policy in the U.S. Government.
As the chairman would know better than I, our Nation's institutional arrangement for economic policymaking are singular. Ours
is the only democratic nation of any economic size in which fiscal
policy and monetary policy, the two essential parts of macroeconomic policy, are set by different institutions. In consequence, we
have experienced difficulties in coordinating these policies in a
single program.
If you want to take a historical view, you could say that of all
the great issues that troubled 19th century America, the one never
fully resolved focused on who properly has the power to create
money. This issue was present at the creation—when Alexander
Hamilton advised President Washington that it should be managed
by a national bank, while Thomas Jefferson objected that the Constitution provided for no such arrangement, and Hamilton Desponded such was implied in the Constitution, and thus began the fundamental struggle between implied and strict constructionism.
We went from one national bank to a second, and back to none,
from greenbacks to species, and a national banking system to help
finance the Civil War. We closed the 19th century with Mr. Bryan
going on about the cross of gold, and no one knowing quite what to
do about bank panics or monetary expansion. After the devastating
panic of 1907, a commission was established under Senators Aldrich and Vreeland, which led to the creation of the Federal Reserve System. An arrangement which continues to this day, but
one with vastly larger powers and responsibilities, which have
never been better performed than by Chairman Volcker.
227
Even so, the Government's spending and taxing responsibilities—
the fiscal coordinating mechanisms have evolved, and their absence
has led us into great difficulties.
It is my view, and the view of many others, that the great recession that we have just been through came about, in very considerable measure, through a clash between uncoordinated monetary
and fiscal policies in 1981.
The executive branch commenced a vastly expansionary fiscal
policy—large reductions in taxes, with continued growth in spending, especially defense. This necessarily brought on great deficits,
deficits that have no precedent in our entire history. Whatever
they were called, they were vastly expansionary.
The Federal Reserve, whether in response—that is something
only the Chairman can speak to—or whether simply lacking a coordinating assumption, proceeded with the tightest monetary policy
in more than a generation.
The specifics are that in 1980, the central measure of the money
supply—and Mi, I know the Chairman has many reservations
about its definition—but in 1980 Mi grew 7.3 percent; in 1981, on a
thrift adjusted basis, it grew by 2.3 percent. This was the sharpest
1-year plunge in money growth rates in the postwar era and the
tightest monetary policy since 1959.
In December of 1981, I suggested that a very expansionary fiscal
policy and very tight money policy had produced a program at war
with itself, and one that would bring on a deep recession. Which
did indeed come about, with the highest unemployment rate since
the depression of the 1930's, and the lowest rates of industrial capacity utilization. At the end of last year, the steel industry was
operating at under 30-percent capacity. This program also produced
the sharpest 1-year plunge in corporate profits in the postwar era,
the worst budget and trade deficits we have ever known, the highest sustained real interest rates, I believe, in the economic history
of the United States.
With that in mind, on March 31, 1982, in the Budget Committee,
of which you, Senator Gorton, are a distinguished member, I introduced legislative language to better coordinate our fiscal policy,
which is nominally set in the budget, with monetary policy. The
specific language was of no great consequence. But the idea, I
think, was. And in the last stages of the budget consideration, with
the chairman of the Budget Committee, your friend and mine, Senator Domenici, I offered language which in effect acknowledged
this grave matter. For the first time in congressional history, we
spoke to the director of monetary policy. Last year's budget resolution directed the Federal Reserve to reevaluate its monetary targets in light of the fiscal policies in that resolution.
In this year's budget cycle, we in the Budget Committee became
somewhat more ambitious, with rather more specific ideas as to
what to do. Even as in the House very specific proposals on that
matter were advanced. In discussions with the distinguished chairman, Senator Garn, and Senator Proxmire and others of this committee, we reached agreement that the budget resolution should
propose that the committee take up this issue and report to the
Congress on how monetary and fiscal policy should be better coordinated for the coming fiscal year and that is what has brought
228
us here today. I think for me to add more would only be to tell you
what you already know are my views.
I might just say in closing, however, that a number of us have
introduced legislation to establish a National Commission on Monetary Policy, a body that would in effect be a successor to the Aldrich-Vreeland Commission, with 20 members appointed by the
President from the executive branch, the Congress, and the Federal
Reserve System. This Commission would investigate the entire
matter of policy coordination in depth, and recommend reforms in
our institutional arrangements to facilitate the degree of explicit
coordination deemed most desirable and proper.
My only purpose in appearing here today, besides the honor of
introducing Mr. Volcker, is to say that this question of institutional
arrangements goes beyond this year's budget or next year's budget,
this recovery or the next downturn. It has to do with how we
manage our basic economic affairs, and whether arrangements
which in some significant way can be said to be premodern, or
which at least certainly predate the role of the United States in
the world economy are still adequate. And whether better arrangements can be made, and better policies agreed to by our respective
bodies.
With that Mr. Chairman, I thank you for your great courtesy.
Senator GORTON. We thank you for your fascinating ideas, Senator.
[Complete statement follows:]
STATEMENT OF SENATOR DANIEL PATRICK MOYNIHAN
This is an occasion of some moment, one with considerable history. The Federal
Reserve has always been accorded considerable independence. And such it should
be. The Federal Reserve is an institution of Government, one of several crucial economic policy institutions. As such, all must work together. Such it must be, and
such it usually has been.
In this regard, the Federal Reserve has long maintained an effective working relationship with the economic policymakers of the executive branch, especially with
the Department of the Treasury. This is natural and necessary. The chief instrument of Federal Reserve monetary operations is the open market transaction—the
sale and purchase of Treasury securities on the open market, to contract or expand
the supply of bank reserves. And the Treasury is responsible for the issue and redemption of Treasury securities.
But the interrelationship between monetary policy and the other dimensions of
Federal economic policy go beyond this matter. We have learned a hard lesson in
the last 3 years, and that is that if fiscal and monetary policies are not properly
coordinated, the Nation's economy will suffer.
Thus, in 1981, the economy found itself buffeted by, on the one hand, the most
expansionary fiscal policy in our history—with projected and actual deficits far
beyond those ever seen previously—and on the other hand, the most contractionary
monetary policy in more than a generation. Mi the central measure of the Nation's
money supply, had grown at a 7.3 percent annual rate in 1980; the next year, in the
face of the hemorraging deficit projections, M( growth (shift-adjusted) plummeted to
2.3 percent. This was the tightest money policy since 1959, and the sharpest 1-year
plunge in money growth rates in the postwar era.
The results of this collision of fiscal and monetary policy—a "policy at war with
itself," I called it in December 1981—were predictable. Interest rates rose to new
highs, especially real interest rates, and economic growth, halted.
What followed is well-known: the worst recession since the Great Depression.
More than 12 million unemployed. The highest business bankruptcy rates since the
1930's. The largest budget and trade deficits in the nation's history. The lowest capacity utilization rates in the postwar era.
The clash of policy did not go unnoticed. In March 1982, with Senators Riegle and
Sasser, I proposed a budget plan based on a new mix—real coordination—of fiscal
229
and monetary policy. Both extremes would be moderated. Fiscal policy would
become more restrained, as monetary policy eased. We called on the Federal Reserve to return to the monetary growth path suggested by the President, in his Program for Economic Recovery of February 18, 1981. Under this proposal, the growth
rate of Mi was to decline by about 0.6 percentage-points annually, from 1980
through 1986—instead of the 5 percentage-point drop from 1980 to 1981. We asked
the Joint Economic Committee and Data Resources Inc., one of the nation's preeminent econometric forecasting firms, to simulate the results of our proposal to coordinate fiscal and monetary policies.
The results were startling. The recession would end by summer 1982, and vigorous sustained economic growth would be restored.
This plan was not adopted. But working with the distinguished chairman of the
Budget Committee, we did manage to attach monetary policy language to the
budget resolution in May 1982, language subsequently adopted by the House of Representatives and by the entire Congress in the conference report in June 1982.
Under this resolution, the Federal Reserve was directed to reevaluate its monetary growth targets, in light of the reductions in the deficit mandated by that
budget resolution. May I tell you, this represented the first direct congressional expression of views on the conduct of monetary policy in the Nation's history. The
working relationship between the Congress and the Federal Reserve would never be
quite the same.
And the Federal Reserve listened, as it properly should. Within 1 month, the Reserve began to ease monetary policy dramatically. Within 6 months of this ease, the
economy began to respond, to turn-around and begin to grow.
This recovery, however, began at a very tepid rate. The real growth rate for the
first quarter was less than 3 percent—about 40 percent the rate for the first quarter
of previous postwar recoveries. Unemployment was projected to remain in the
region of 9 percent for 2 years, and corporate profits and personal income would
grow at seriously subnormal rates.
This was not acceptable. Vigorous economic growth, and sustained economic
growth, should be the central goal of national economic policy, and all the economic
policy institutions of Government would have to work together to achieve it. Such,
at least was my view.
On March 2, 1983, with Senator Hart, I introduced a resolution stating this goal
and a means of achieving it. The economic recovery should be at least comparable
to the recoveries from previous postwar recessions, and the Federal Reserve should
do its part to ensure it. According to our resolution: "Resolved, it is the Sense of
Congress that, in order to ensure healthy economic recovery, the Federal Reserve
System shall manage monetary policy to accommodate the growth in the Nation's
nominal gross national product required to achieve real economic growth comparable to the average rate for the first eight quarters of previous postwar recoveries."
Once again, we had not proposed such a policy shift without being quite certain as
to the probable consequences. With the assistance of the Joint Economic Committee,
we asked Data Resources Inc., to simulate the economic policies required to meet
the goal of the resolution. That is, we asked DRI and the Joint Economic Committee
if we could coordinate monetary policy with fiscal policy—given the dimensions of
fiscal policy—to achieve 5.4 percent average annual real growth in 1983 and 1984,
which would be comparable to the real growth rates for the first 2 years following
previous postwar recessions.
DRI and the Joint Economic Committee told us that it would be done, and the
results would be heartening. Unemployment would drop to 7.6 percent by 1985, instead of the then-current projections of 8.9 percent. The interest rate on Treasury
bills would drop to 6.9 percent by 1985, instead of the then-current projections of 7.4
percent. The nation's GNP in 1985 would be some $203 billion larger than that projected by the administration. It could work.
The point of our resolution was not based on the specific numbers. The point was,
and remains, simple: vigorous economic growth, consistent with reasonable price
stability, must be considered the central goal of national economic policy, and the
Federal Reserve must coordinate its policies with the fiscal policies of the Congress
and the Executive Branch in order to help meet this goal.
Working with the distinguished chairman and ranking minority member of this
committee, we fashioned compromise monetary policy language for the Budget Resolution. The key sections of this compromise language read: ' As there is a need for
coordination between fiscal and monetary policy; And, as there is a need for vigorous economic growth consistent with reasonable price stability; Now, therefore,
the House Committee on Banking, Finance and Urban Affairs, and the Senate Committee on Banking, Housing, and Urban Affairs are requested to report to their re-
230
spective bodies, no later than June 30, 1983, a resolution expressing the Sense of the
Congress as to the coordination of the Federal Reserve's monetary policy with the
fiscal policy reflected in this budget resolution."
This was truly historic. This represented the first congressional statement in our
history that fiscal and monetary policy are not independent entities, but rather
must be considered part of a larger whole. Monetary policy could no longer go off on
a collision course with fiscal policy—something I am certain the Federal Reserve
would never intentionally do. But inadvertant collisions of policy could be averted if
conscious coordination were undertaken before the fact. This is the intention of the
monetary policy language.
And in the current circumstances, this coordination must be achieved with one
central goal in view: "vigorous economic growth consistent with reasonable price
stability."
The version adopted by the entire Congress, in the conference report, retained all
these provisions. Moreover, it went a bit further: it requested the Banking Committees to report, not only on how the Federal Reserve should coordinate its policies
with fiscal policy to achieve the central goal, but further what information will be
necessary to ensure policy coordination in the future, information regarding the assumptions and goals of the Federal Reserve System.
This is what brings us together today.
And may I say that the Federal Reserve System under the leadership of Chairman Volcker, has moved decisively to work together with Congress and the Executive to achieve vigorous economic growth. Chairman Volcker announced last week
that the target growth range for Mi, the central measure of the Nation's money
supply, would be changed in two ways. First, the formal target was raised from 4 to
8 percent, to 5 to 9 percent. At the same time, Chairman Volcker announced that
the new growth targets would be measured, on a prorated basis, from a base of Mi
in the second quarter of this year, instead of the fourth quarter of last year.
This is what this means. The average for M, for the second quarter of this year
was $505.3 billion. Assuming M, grows at an annual rate of 5 to 9 percent over the
second half, Mi should fall between $517.9 billion and $528.04 billion in the fourth
quarter. Measured from a base of the average for the fourth quarter of 1982 to the
fourth quarter of 1983, this means that M, will have grown by between 9.3 and 11.5
percent.
This would be the most growth-oriented monetary policy in postwar history. The
previous peak for M, growth was 9.2 percent, reached in 1972—or 0.1 percentagepoints less than the low end of the current range, measured on a fourth-quarter to
fourth-quarter basis.
There are pitfalls in this growth path. We must be certain that such growth is
consistent, not only with vigorous economic growth but also with reasonable price
stability. But there is also an important lesson to be learned from this policy. Such
stimulative monetary growth is necessary, precisely because of the unprecedented
depth of the preceding recession. And these depths reflected the failure to effectively coordinate fiscal and monetary policies in 1980 and 1981. Never again can we
permit such an uncoordinate, see-saw pattern to capture national economic policy.
It is the business of this committee, as of the entire Congress and the Federal Reserve, to ensure that it never happens again.
This means, first, that the real factors in economic life—economic growth and reasonable price stability—must be the operative goals of monetary policy. We have
tried the experiment of monetarism, in which narrow and shifting conceptions of
the monetary aggregates determine the operations of monetary policy. It is clear
that this approach has failed to produce its predicted results. And the recent actions
of the Federal Reserve demonstrate that the Federal Reserve concurs that strict
monetarist doctrine can not control the operations of monetary policy. We have
learned from experience, which is all responsible policymakers can hope to do.
It is also clear that we must go on to ensure better coordination between fiscal
and monetary policy in the future. We must expand the routine exchange of information regarding economic objectives and information, between the Federal Reserve
and the Congress. We must have the basis to project the consequences of alternate
modes of coordination—before the fact—so we never again find ourselves forced to
respond, after-the-fact, to uncoordinated parts of a single economic policy.
We should all be satisfied that the Federal Reserve joins Congress in a commitment to manage national economic policy so as to avert any prospect that sharply
rising interest rates will abort the current recovery. But we must explore more
closely what reforms will be required to assure sustained economic growth, and
growth which lifts all sectors of our economy.
231
However, vigorous real economic growth was in the second quarter—and the 8.7
percent real growth rate announced by the Commerce Department is indeed heartening—many dangers still lie ahead. The deficits remain in the region of $200 billion, as far as David Stockman's eye can see. The budget resolution directed that
some $73 billion in additional revenues be raised to help close these deficits over the
next three years, most of these revenues in fiscal year 1986. The President's Budget
proposed $46 billion in new revenues in fiscal year 1986, the same figure in the
budget resolution. The administration must now join Congress in supporting specific
measures to raise these revenues. In this context, the spending restraints of the
budget resolution can be carried out as well.
These deficits have helped maintain real interest rates in the region of 5 to 7 percent. May I tell you there is no sustained economic recovery in our history in such a
real interest rate atmosphere. And the results of such real rates are predictable.
The most interest-sensitive industries remain deeply depressed. Steel, once the backbone of American industrialization, has remained stalled at less than 60-percent capacity utilization for the last 5 months. Our export industries remain crippled. Our
trade deficit last year hit a new record, more than $36 billion. Martin Feldstein,
chairman of the President's Council of Economic Advisers, forecasts a trade deficit
this year of more than $60 billion. And he sees "substantial risk" that the trade
deficit for 1984 could top $100 billion.
These deficits, which will cripple our export sector, are closely related to the appreciation of the dollar on the world's foreign exchange markets. And this appreciation is directly related to the high level of US real interest rates. Since 1980, the
value of the dollar has risen 40 percent against the currencies of our major trading
partners, after adjustments for inflation. Since January of this year, the dollar's
value has risen another 8 percent. We will not be able to redress our trade imbalance unless we bring down US real interest rates, so the over-appreciation of the
dollar which cripples the ability of our products to compete effectively abroad can
be reversed. This will require continuing coordination of fiscal and monetary policies.
How to achieve this coordination on a routine basis remains largely unknown.
We've never tried to do so before. We've never had as great a need to do so before.
The monetary policy resolutions on the last two budget resolutions were the start.
These hearings are the critical next step. Permit me to mention a third course we
should consider.
On April 20, 1983, I introduced legislation, with Mr. Cranston of this subcommittee, to establish a National Commission on Monetary Policy. This Commission shall
be charged with investigating, not the technical operations of the Federal Reserve,
which properly should be left to the Federal Reserve, but rather to what degree and
in what manner fiscal and monetary policy should be coordinated on a routine
basis. The Commission would investigate,
—What economic developments and factors, here and abroad, should be taken
into account in fiscal and monetary policy?
—What are the costs and benefits, both economic and political, for our current
arrangements, which is to say, the present coordination of fiscal and monetary
policy?
—How can we achieve the degree of coordination deemed appropriate by the Commission?
—How much information about economic conditions, policy goals and intentions
should be routinely exchanged by the Federal Reserve, the Congress, and the executive branch, and by what means?
—How can we best ensure that monetary policy shall be compatible with the economic objectives of Congress?
These questions would be considered by 20 members, appointed by the President.
The President would name five members from the executive branch, including the
Chairman of his Council of Economic Advisers who would serve as the Commission
Chairman. I would also expect the President to name officials such as the Director
of the Office of Management and Budget, the Under Secretary of the Treasury for
Monetary Affairs, and the Under Secretary of State for Economic Affairs, who are
deeply involved with these matters on a daily basis.
Each House of Congress would also recommend five members each. And the
Chairman of the Board of Governors of the Federal Reserve System would recommend five members as well, drawn from current and past members of the Board
and current and past presidents of the regional Federal Reserve Banks.
We are just now emerging from the worst economic downturn in more than 50
years. The human costs and economic costs were, and still are, enormous and cruel.
It left us with new records for the lowest capacity utilization for American manufac-
232
turing, the highest unemployment, and the sharpest plunge in corporate profits,
since the Great Depression. It helped destabilize the world banking system and
nearly destroyed the world trading system. These were all consequences of a profoundly misguided combination of expansive fiscal and restrictive monetary policies.
An economic program at war with itself.
We can do better. Let us find out precisely how. I commend the activities of this
subcommittee in this task. Now we must go forward.
Senator GORTON. Senator Heinz.
Senator HEINZ. Mr. Chairman, I note we have 4 to 5 minutes to
get over to the floor and cast our vote on 10 percent withholding. I
have a few brief remarks. Might I withhold them until we return?
Senator GORTON. Yes, you certainly may. We will be back as
promptly as we possibly can. Thank you, Senator Moynihan.
[Recess.]
Senator GORTON. Thank you, Mr. Chairman, for your patience.
Senator Heinz does intend to come back and may have a statement
at that time, but in the interest of your time, I'm delighted to ask
you proceed.
STATEMENT OF PAUL A. VOLCKER, CHAIRMAN, BOARD OF
GOVERNORS, FEDERAL RESERVE SYSTEM
Mr. VOLCKER. Mr. Chairman, perhaps instead of reading my
statement in its entirety, I could condense the points that I wanted
to make in the statement.
Senator GORTON. I would be delighted to have you do that and, of
course, your entire statement and the appendixes will be included
in the record in full.
[Complete statement follows:]
233
Statement by
Paul A. Volcker
Chairman, Board of Governors of the Federal Reserve System
before the
Subcommittee on Economic Policy
of the
Committee on Banking, Housing, and Urban Affairs
United States Senate
July 28, 1983
234
I am pleased to have this opportunity to discuss
issues bearing on the coordination of monetary and fiscal
policies and on the request to this Committee, contained in
the First Budget Resolution, to frame a sense of the Congress
resolution with respect to appropriate information bearing on
the assumptions and goals of monetary policy.
Chairman Garn
has also requested a review of how the Federal Reserve formulates
monetary policy and the types of assumptions or goals that are
used in policy formulation.
Broadly stated, the goals of all our general economic
policies are clear enough -- we all want to see sustained
economic growth, high levels of employment, and price stability.
Those general economic objectives are basic to the formulation
of monetary or other policies.
But, as you know, we cannot always
reach all those goals in the short run or continuously, and
monetary policy, by itself, cannot satisfy all of them even
over time.
Fiscal, regulatory, and other policies of the government and wage and price policies in the private sector
all affect economic activity, prices, productivity, and the
rate of economic growth, and particularly bear upon our ability
to reconcile our several goals.
Moreover, the domestic economy
has come to be influenced more and more by external developments.
The oil price shocks are only the most obvious example.
The
recent problems with major debtor countries, exchange rate
235
behavior, and economic growth in other countries, as it affects
demand for our exports, all have influences on our economy in
one degree or another, frequently in ways that cannot be fully,
or at all, compensated for by monetary policy.
But the Federal Reserve does need to take account of
these kinds of developments at home and abroad as it formulates
policy, and they could affect prospects for achieving the basic
economic goals of economic activity, prices, and employment
within a given time frame.
The fiscal policy of the Federal
Government is one of the most important of those factors, but
not the only one.
The Formulation of Monetary Policy
Monetary policy is reflected mainly in decisions by the
Board of Governors on the discount rate and by the Federal Open
Market Committee, which normally meets eight times a year, about
open market operations.
The members of the Board and the Committee
regularly receive a wide variety of economic and financial information about the economy in preparation for these decisions.
The
great bulk of that information consists of publicly available
statistics, surveys, and reports, but the material is also analyzed
and summarized by staff at the Board, in written documents as well
as oral presentations.
The staff often presents forecasts for
several quarters ahead, based on a combination of econometric and
judgmental techniques.
Alternative forecasts may be set forth,
depending upon different policy assumptions, and areas of uncertainty are emphasized.
Individual members of the FOMC will
also have available to them analyses and forecasts prepared at
the different Federal Reserve Banks.
236
At meetings of the POMC, Committee staff also usually
sets forth, for purposes of discussion, alternative approaches
that might be considered by the Committee in its formulation of
policy decisions.
This material attempts to set out the impli-
cations of possible approaches, including alternative monetary
and credit targets for a year ahead, as well as an evaluation
of alternative short-run approaches to attainment of such targets.
These analyses suggest the direction of possible impacts on
market developments, recognizing those developments may be
dominated by other factors including, over time, budgetary
decisions.
The FOMC also reviews closely recent developments
in domestic and international financial markets and the
implementation of Federal Reserve operations since the last
meeting.
Policy discussions center on the members' own assessments of the economic and financial outlook, and their view
of its implications for the formulation of policy.
Underlying these discussions, there is common acceptance
of the broad goals I stated at the start, which are, of course,
incorporated in law.
At the same time, individual members may
well have different points of concern or emphasis in the short
run, they may disagree about the outlook, and they bring to the
table different conceptual or analytic emphases.
For instance,
some members will tend to put more weight on particular money supply
developments, while others will put more stress on the developing
conditions in credit markets.
I believe all members consistently
237
recognize the need to consider the implications of current
policy over a considerable period of time, but, in particular
situations, there will be differences as to the relative weights
put on short or longer-run factors, or on price, growth, or
other objectives.
(I have attached in this respect records of
discussion for two recent meetings.
These policy records,
which are released to the public about seven weeks or so after
each meeting, indicate the range of economic and financial
variables that are taken into account in the formulation of
policy.)
These differences in approach are natural to a degree
in a committee structure made up of independently appointed
officials.
In the end, the differences have to be reconciled
in a specific operational decision.
But the differences in
emphasis and assumptions about the economic outlook that lie
behind the decision are one reason why we have felt it more
constructive to provide the Congress, in our semi-annual reports,
with a range of assumptions about economic variables rather than
a simple "objective" about which, in the short run at least,
any consensus might well be artificial.
When setting a course for monetary policy, the Committee
members take the government's fiscal policy basically as a
"given."
There is often, of course, a degree of uncertainty
about the likely budgetary developments, particularly in the
period before a budget resolution is adopted and implemented.
Looking several years ahead, the uncertainties increase.
238
Typically, however, the dimensions of the budget can be
approximated well enough to provide a reasonable basis for
assessing the direction of its impact on overall economic
performance and credit market conditions.
As you know, the FOMC expresses its policy intentions
over time, as required by the Humphrey-Hawkins Act, in terms
of monetary and credit targets.
Those annual targets are
expressed in ranges and attention is paid to several measures,
rather than a single statistical definition of money or credit.
The use of ranges rather than "point" targets reflects in part
the impracticality —
and many would argue the undesirability —
of controlling monetary growth precisely.
More broadly, the
ranges, and the related judgment about which target or targets
are more significant at particular times, provide an element
of, to me appropriate, flexibility in the face of shifts in
relationships of the aggregates to the economy or other unforeseen
developments.
The Committee can, of course, change targeted growth
ranges {as was the case in July with respect to the Ml ranges)
if deemed necessary or desirable in the light of events.
But I
believe there is, and should be, a presumption that such changes
will be made only in the light of highly persuasive evidence.
The results of the FOMC's deliberations about longer-run
money and credit targets, and the associated economic outlook,
are presented to the Congress twice a year in the Board's "Monetary
Policy Report Pursuant to the Full Employment and Balanced Growth
Act of 1978."
In that report, we currently provide the Congress
with annual ranges of growth for M2, M3, Ml, and total credit.
239
In addition, the Congress is given associated economic projections
covering the same period for nominal GNP, real.GNP, the implicit
price deflator, and the unemployment rate.
In February these monetary ranges and associated
projections are shown only for the current year.
economic
in July, the
monetary ranges and projections are shown for the current year
and the ensuing year.
The associated projections are shown in a range sufficient
generally to encompass all Committee members, and —
this year —
beginning
also for a much narrower range (labelled the "central
tendency") to capture the expectations of most Committee members.
These projections or forecasts reflect the views of the individual
Committee members as to the implications of monetary policy
decisions, as well as other factors, such as fiscal policy, but
the members may not have a common view in those respects.
Those
projections are also compared with Administration forecasts for
the same period, and they could also be compared with forecasts
by the Congressional Budget Office or the assumptions that lie
behind the budget resolution adopted by Congress, depending upon
the time period.
These semi-annual reports to Congress, as presently
structured, seem to me to provide a reasonable basis upon
which the Congress can evaluate the implications of the Federal
Reserve's monetary policy and to come to a view about whether
monetary and fiscal policies are appropriately complementary.
No doubt, they can be improved —
which I take it is one of
240
your concerns about which I will say a few words in a moment.
At the same time, I believe we should be cautious about placing
too much weight —
in either monetary or fiscal policy -- upon
a particular, and fallible, projection.
The uncertainties inherent in any economic forecast are
one reason why the presentation of ranues of views, rather than
a "point" forecast, is useful.
Even so, events have, not in-
frequently , carried one or more economic variables outside the
forecast range, and part of the policy problem is deciding how
to respond to such unforeseen developments.
Some unexpected
changes may be favorable -- stronger growth or lower inflation -and would not necessarily call for any adjustment in policy;
others may be clearly unfavorable in terms of expectations or
longer-term objectives; perhaps more frequently there will be
a mixture of "good" and "bad" news.
In none of these cases
should it automatically be assumed that policy adjustments to
reach a pre-set objective for the year are necessarily desirable.
In that connection, the essence of the policy problem is
the need to look beyond any short forecast period to the longerterm cumulative effects of policy on the economy.
What may appear
a reasonable and desirable trade-off in the short run —
say,
between more growth and less inflation, or more growth and budgetary
restraint -- may well turn out to have sharply adverse effects
if repeated over time.
241
The "Coordination"_ of Fiscal and Monetary Policy
On the face of it, more "coordination" always sounds
better than less -- in our fiscal and monetary affairs as in
other policies.
But, in concrete instances, coordination may
have an ambiguous meaning.
Does it mean, for example, that
measures which increase a deficit should be accompanied by
more rapid money growth, so that the larger deficit could
presumably be readily financed for a time —
at the longer-run
risk of inflation? Or does it mean that a higher deficit should
be accompanied by less rapid money growth to help assure that
the deficit does not generate inflationary pressures -- at the
possible expense of greater near^-term market pressures?
Answers will depend on particular circumstances, on judgments
about the relevant time frame, and other factors.
Similar questions can be asked about measures to reduce'
the deficit.
Should the Federal Reserve raise money growth,
leave it unchanged, or lower it if Congress takes steps significantly to reduce the deficit below current expectations built
into the economic outlook?
The answer would again depend in
part on one's analytic framework, but more pragmatic answers
would depend on assessment of the effects on interest rates,
credit markets, and private spending of reduced Federal credit
demands, the sensitivity of inflationary expectations to changes
in money targets, and judgments about the trend of business
activity.
242
As this suggests, there is no simple trade-off between
fiscal and monetary policy.
The budgetary decision will, of
course, affect the distribution of the available supply of
credit in the economy and interest rates, and the mix of consumption and investment, but monetary policy cannot automatically
offset the distributional or market effects of fiscal policy.
I interpret the Congressional interest in coordination
as seeking ways to elucidate these choices rather than implying
a simple or fixed trade-off between fiscal and monetary policy.
I also believe the present reporting framework provides an
appropriate basis for such analysis and discussion, but that
it could be improved in one aspect.
Specifically, during the past year, the FOMC has
presented an annual range of growth for total nonfinancial debt
of domestic economic sectors as one of its longer-range money
and credit targets.
It may be of further help to the Congress
in its deliberations on the budget if, in that framework, we
amplified the discussion of the implications of the budget outlook, or alternative budgetary outlooks depending on whether a
budget resolution has been passed, for the distribution of debt
between the private and governmental sectors and for potential
credit market pressures.
While I have often touched upon these
matters in testimony, implications or risks with respect to the
availability of credit to the mortgage market, the bond market,
and other loan markets could be noted more directly in the Report
itself.
243
As this Suggests, there is no simple trade-off between
fiscal and monetary policy.
The budgetary decision will, of
course, affect the distribution of the available supply of
credit in the economy and interest rates, and the mix of consumption and investment, but monetary policy cannot automatically
offset the distributional or market effects of fiscal policy.
I interpret the Congressional interest in coordination
as seeking ways to elucidate these choices rather than implying
a simple or fixed trade-off between fiscal and monetary policy.
I also believe the present reporting framework provides an
appropriate basis for such analysis and discussion, but that
it could be improved in one aspect.
Specifically, during the past year, the FOMC has
presented an annual range of growth for total nonfinanciai debt
of domestic economic sectors as one of its longer-range money
and credit targets.
It may be of further help to the Congress
in its deliberations on the budget if, in that framework, we
amplified the discussion of the implications of the budget outlook, or alternative budgetary outlooks depending on whether a
budget resolution has been passed, for the distribution of debt
between the private and governmental sectors ^nd for potential
credit market pressures.
While I have often touched upon these
matters in testimony, implications or risks with respect to the
availability of credit to the mortgage market., the boTid market,
and other loan markets could be noted more directly in the Report
itself.
244
Such judgments, in the nature of things, could not be
precise, and many other important factors —
the inflation out-
look, the strength of economic activity, and others -- impinge
strongly on credit flows and interest rates.
Moreover, I do
not believe a central bank should engage in the highly uncertain
process of interest-rate forecasting.
Within that limitation,
however, I do believe our Reports could constructively be
amplified in the way I have suggested.
With regard to the specific request that the Senate
Banking Committee report by September 30 a sense of the
Congress resolution bearing on the coordination of monetary
and fiscal policy under present circumstances, I would note the
economic projections in our Mid-Year Report were based on a budget
assumption that is not greatly different from that contained in
the most recent budget resolution, although we did factor in
the contingency that some of the savings and revenue action
called for in the resolution might not be achieved.
The pro-
jections with respect to growth and inflation are also generally
consistent with the Administration forecasts and do not differ
greatly from assumptions underlying the Budget Resolution.
As I spelled out in my testimony last week, I do believe
prospects for lower interest rates and for sustained and balanced
recovery would be enormously assisted by more vigorous and earlier
action to deal with the budgetary deficits.
As things now stand, risir.c
private credit demands, in reflection of rising private activity,
245
are beginning to clash with the continuing heavy financing needs
of the government.
The FOMC has not felt that an appropriate
response to that development would be still higher targets for
monetary and credit growth, with the potential for greater
inflation (and ultimately higher interest rates) that course
could imply.
More progress toward reducing the deficit would
maximize the prospects, consistent with these targets, for lower
interest rates over time, supporting housing and other interestsensitive sectors of the economy in particular, and reducing the
risks of credit market congestion generally.
Targeting the GNP
The question has been raised whether "coordination"
would not in some sense be better achieved if the Federal
Reserve were to provide "objectives" for nominal and real
GNP and prices instead of the projections we now give.
not believe so.
The issue is more than semantic.
I do
As detailed
in the Appendix to this statement, a GNP objective for monetary
policy would turn attention away from the role of other public
and private policies in affecting economic activity and prices,
promise much more than could be delivered, and risk concentration
on short—term (and not readily controllable) results at the
expense of continuing longer-range objectives.
246
I well understand that budgets must incorporate certain
assumptions as to business activity, both because of the
necessity for specific revenue and spending forecasts and
because the timing and nature of the underlying policy decision
may be influenced by the near-term outlook.
But we should not
lose a sense of skepticism about the accuracy of any forecast -as illustrated by events this year.
Moreover, to the extent
possible, the budget outlook and structure should be evaluated
independent of a particular phase of the business cycle.
For
instance, in making judgments looking ahead as to how much the
deficit should be cut, estimates of the structural, continuing
portion of the deficit are relevant.
I do not believe it wise in either monetary or fiscal
policy, to commit ourselves to a particular short-term objective
for, say the GNP or prices, that may or may not turn out to be
attainable, and the acceptability of which may depend upon circumstances unknown at the time the objective is established.
Conclusion
Debate and consensus about our longer-term economic
objectives and methods of reaching them are inherent in the
policy-making process.
Through our reports and testimony, we
in the Federal Reserve want to contribute constructively to that
process —
and I believe we do by means of detailing our monetary
policies, by setting forth our economic projections and assumptions,
and by publishing and analyzing economic data and trends.
have suggested, we could provide additional analysis on the
possible effects of broad fiscal policy decisions.
As I
247
We have not wished, and do not now wish, as an organization
to make more specific recommendations about budgetary policy,
such as the nature of saving or spending decisions, areas that
are not our responsibility, although I, or others in the Federal
Reserve, are sometimes asked to comment as a matter of personal
opinion.
I also believe we should resist the temptations to
set out short-term "objectives" in such specific terms as to
invite unrealistic expectations, counter-productive "fine tuning,"
and ultimate disappointment,
within those limitations, I look
forward to working with you in responding to the request in
the Budget Resolution to explore possibilities for improving
the flow of information, understanding, and "coordination."
* * * * * *
248
FEDERAL RESERVE press release
For Use at 4:30
p.m.
July 15, 1983
Hie Federal Reserve Board and the Federal Open Market
Committee today released the attached record of policy actions
taken by the Federal Open Market Committee at its meeting on
May 24, 1983.
Such records for each meeting of the Committee are made
available a few days after the next regularly scheduled meeting
and are published in the Federal Reserve Bulletin and the Board's
Annual Report.
The summary descriptions of economic and financial
conditions they contain are based solely on the Information that
was available to the Committee at the time of the meeting.
Attachment
249
RECORD OF POLICY ACTIONS OF THE
FEDERAL OPEN MARKET COMMITTEE
Meeting Held on Hay 24, 1983
Domestic policy directive
The information reviewed at this meeting suggested that growth
in real GNP would accelerate, perhaps rather substantially, in the c u r r e n t
quarter, a f t e r an increase at an annual rate of about 2-1/2 percent in the
f i r s t quarter.
To a considerable extent, the expected pickup in growth
reflected an apparently marked f u r t h e r slowing in the rate of inventory liquidation, with an. ending of Liquidation possible during the quarter.
At the
same tine final demands for goods and services, which had strengthened In
late 19B2, were being relatively well maintained.
The rise in average prices,
as measured by the fixed-weight price index for gross domestic business
product, appeared to be continuing at about the moderate pace recorded over
the past year.
The index of industrial production rose 2.1 percent in April, the
largest monthly increase since the summer of 1975, to a level about 6 percent
above its
recent trough in November.
Gains in output were spread across a
broad range of i n d u s t r i e s , and were particularly strong for consumer durable
goods and durable goods materials.
Production of business equipment, which
had contracted sharply since late 1981,
turning up in March.
also rose substantially in April after
Rates of capacity utilization in manufacturing and at
materials producers increased from record lows late In 1982 to around 71
percent in April.
250
Nonfarm payroll employment increased more than 250,000 in April,
after an increase of about 200,000 in March.
Employment gains in manufacturing
and service industries accounted for the bulk of the rise in both months.
The civilian unemployment rate edged down further to 10.2 percent in April.
The dollar value of retail sales advanced 1.6 percent in April,
about the same as in March.
Outlays at apparel and furniture and appliance
stores were brisk, but a major factor in the April gain was increased spending
on new cars.
Sales of new domestic automobiles, which had held at an annual
rate of slightly over 6 million units since November, rose to a rate of 6.4
million units in April and strengthened somewhat further In early May.
Total private housing starts declined somewhat In both March and
April, hut at an annual rate of 1.5 million units in April, they were still
about 40 percent above the depressed 1982 average.
Newly issued permits for
residential construction picked up in April, reflecting a marked increase in
permits for multifamily units.
Sales of new and existing homes increased sub-
stantially In the first quarter of 1983.
The producer price index for finished goods edged down In both March
and April; prices of energy-related items, which are lagged one month In this
index, declined considerably further while prices of consumer foods increased.
The consumer price index rose 0.6 percent in April, after having edged up 0.1
percent in March; more than one-third of the April increase reflected the rise
in gasoline prices associated with Implementation of the higher federal excise
tax.
Thus far In 1983 the consumer price index has increased little, and the
index of average hourly earnings has risen at a considerably slower pace than
In 1982.
251
Since late March Che trade-weighted value of the dollar In foreign
exchange markets had remained In a narrow range near its
recant high level.
The U.S. foreign trade deficit in the first quarter was about one-third less
than in the preceding q u a r t e r , as oil
imports dropped sharply, reflecting a
decline in price and a considerable reduction In volume.
At its
meeting on March 28-29, 1983, the Committee had decided that
open market operations in the period until this meeting should be directed at
maintaining generally the existing degree of restraint on reserve p o s i t i o n s ,
a n t i c i p a t i n g chat such a policy would be consistent with a slowing from March to
June in growth of M2 and M3 to annual rates of about 9 and 8 p e r c e n t respectively.
The Committee expected that growth in Ml at an annual rate of about & to 7 percent over the three-month period would be associated w i t h its objectives for
[lie broader aggregates.
The Committee members agreed that lesser r e s t r a i n t
on reserve positions would be acceptable
in the context of more pronounced
slowing in the growth of the m o n e t a r y aggregates ( a f t e r taking account of any
distortions relating to the introduction of new d e p o s i t accounts) of of evidence of a weakening in the pace of economic recovery.
If monetary expan-
sion proved to be appreciably higher than expected, without being clearly
explained by the e f f e c t s of ongoing i n s t i t u t i o n a l changes, it was understood
that the Committee would consult about the desirability under the p r e v a i l i n g
circumstances of any s u b s t a n t i a l f u r t h e r r e s t r a i n t on bank reserve p o s i t i o n s .
The intertneeting range for the federal f u n d s rate was retained a t 6 to 10
percent,
Growth in M2, which had slowed to an annual rate of about "11 percent
in March, decelerated f u r t h e r in April to an annual rate of about 3 p e r c e n t .
252
The deceleration reflected, in part, substantial shifts of funds into
individual retirement and Keogh accounts before the April 15 tax date.
Growth in M3 slowed to an annual rate of about 4-1/2 percent, after expanding at an 8-1/4 percent pace in March.
Partial data suggested that
expansion in both M2 and H3 had picked up in early May, but growth to date
still appeared to be below the annual rates of 9 and 8 percent respectively expected by the Committee for the period from March to June.
Ml declined at an annual rate of about 3 percent in April but,
according to preliminary data, strengthened markedly in early May.
Thus far
tn the second quarter, growth in HI appeared to be running substantially above
the annual rate of 6 to 7 percent deemed consistent with the Committee's expectations for the broader aggregates.
Growth in debt of domestic nonfinanciai sectors appeared to have
continued in April at about the sane pace as in the first quarter.
Over the
first four months of the year, debt expansion was estimated at an annual rate
of about 9-1/2 percent, well within the Committee's range of 8-1/2 to 11-1/2
percent for the year.
Funds raised by the U.S. treasury grew at about twice
the rate of total debt expansion, while private debt rose at a moderate pace.
Growth in total ctedit outstanding at U.S. commercial banks slowed somewhat
In April, as banks continued to acquire sizable amounts of Treasury securities
but reduced substantially their holdings of business loans.
Growth in total and nonborrowed reserves slowed appreciably in April
and early May, as weakness in transaction deposits over much of March and in April
was reflected with a lag in reduced demand for required reserves.
Apart from
253
large borrowings around the end-of-quarter statement date early In the Interrogating period, adjustment borrowing from the Federal Reserve discount window,
including seasonal borrowing, fluctuated within a range of about $200 million
to $67$ million.
Special factors, such as relatively sizable weekend borrowing
associated with wire transfer problems, contributed at tines to increased demands
for borrowing.
Excess reserves also continued to be volatile and were relatively
high on average.
Federal funds generally traded In a range of 8-1/2 to 8-3/4
percent during the intermeeting interval.
Market interest rates changed little on balance over the intermeeting interval.
Short-term interest rates declined about 1/4 percentage point
while most long-term rates were slightly lower or up only marginally.
Market
rates had fallen considerably in the early part of the period but had risen
again moat recently, as growth in the monetary aggregates seemed to be strenthening, signs of economic recovery became more widespread, and prospects increased
that private credit demands would strengthen while Treasury borrowing remained
exceptionally large.
Average rates on new commitments for fixed-rate conven-
tional home mortgage loans at savings and loan associations fell about 30 basis
points further.
The staff projections presented at this meeting indicated that growth
in real GNP in tbs second half of the year would be a little higher than had been
expected, though probably slowing somewhat from the second-quarter pace.
Recent
evidence, including increased spending for business equipment, strength in new
orders at durable goods manufacturers, and survey reports of marked improvement
in consumer attitudes, suggested somewhat stronger private final demands from
businesses and consumers than had been anticipated previously. The unemployment
254
rate was projected to decline only modestly from its recent high level, and the
rise in the average level of prices was expected to remain moderate.
In the Committee's discussion of the economic situation and outlook,
a number of members expressed general agreement with the staff projection, but
several emphasized that economic activity might well prove to be stronger than
projected, especially during the quarters immediately ahead.
Members observed
that consumer sentiment appeared to have improved considerably, and that retail
sales should benefit from the increased market value of financial asset portfolios
as well as from the federal tax cut at midyear.
A turnaround from sharp Inventory
liquidation to little change, or possibly even some accumulation, was seen as
likely and would have a pronounced positive impact on GNP and on income flows,
at least for a quarter or two.
Members also commented that an increasingly
stimulative fiscal policy would add strength to the recovery over the period
ahead, and an unduly large federal deficit was likely to create problems later
as private credit demands expanded.
While all Committee members anticipated continuing and possibly substantial improvement in economic activity over the months ahead, a number also
questioned the balance and sustainablllty of the recovery.
They noted that,
though business capital spending was showing signs of reviving, It would need
to improve markedly further to foster an extended recovery.
Such spending
could be Inhibited If a continuing need to finance large federal deficits
engendered rising Interest rates as the recovery proceeded.
The outlook for
exports was also thought to be relatively weak, although exports should eventually
improve if the foreign exchange value of the dollar were to decline substantially
and if major disturbances in international financial markets were averted.
One
255
member commented that housing activity could be less strong than was widely
anticipated and another observed that consumer spending could prove to be
disappointing, particularly If consumers did not react more positively to the
approaching tax cut than they had to the 1982 reduction.
Another member
commented that recent indications of a more vigorous recovery might reflect
mainly a short-lived inventory adjustment.
Other members expressed a differing view and emphasized that the
prospects for an extended recovery were relatively favorable.
In support of
this view It was observed that substantial improvements in consumer spending and
inventory Investment were likely to be followed by increasing capital Investment,
In the pattern characteristic of earlier cyclical expansions.
In this connection
some members stressed that the expansion might well gather momentum and prove
to be much stronger than the staff was projecting, partly because the recovery
would follow a relatively long and severe recession.
At this meeting the Conmittee reviewed the monetary growth ranges that
it had established in February for the year 1983.
It decided not to change any
of the ranges or the relative Importance of the various aggregates for policy,
pending a further review at the July meeting.
Growth of the broader aggregates
appeared to be within the Committee's ranges for the year.
Earlier in the year,
growth of M2 had oeen affected to a major extent by large shifts of funds
associated with the introduction of money market deposit accounts; such shifts
had slackened substantially, although MMDAs were still expanding at a somewhat
faster rate than the staff had projected earlier.
Ml had grown substantially
In excess of the Committee's expectations In the latter part of 1982 and the
first quarter of 1983.
Staff analysis based on recent research suggested that
this earlier growth reflected to a substantial extent lagged responses to the
256
decline in interest rates that began during the summer of 1982.
That decline
had enhanced the attractiveness of HOW accounts, which serve as a vehicle for
savings as well as for transactions.
The performance of Ml would continue to
be affected by substantial uncertainties relating Co the interest and Income
sensitivity of fixed-ceiling NOW accounts and also by the growing importance
in Ml of the oore recently introduced Super NOW accounts, which bear a marketrelated rate of interest.
While the effects of earlier declines in interest
rates should now be diminishing, given the relative stability of rates over
recent months, some time would be needed to evaluate the evolving role of Ml
as a vehicle for savings.
Turning to policy for the short run, the members noted a staff analysis
which suggested that maintenance of the existing degree of restraint on reserve
positions might be associated with second-quarter growth of M2 and M3 marginally
below the rates established by the Committee at the previous meeting, but with expansion of Ml above the level anticipated by the Committee, given the surge in Ml
growth during the first part of May.
The staff analysis also Indicated that,
within limits, alternative policy courses would have relatively little impact on
the second-quarter growth of the monetary aggregates In light of the limited time
remaining in the quarter, but would affect their growth more substantially over
the months ahead.
In the course of their discussion, Conmittee members expressed differing
views with regard to the appropriate course for policy in the weeks immediately
ahead.
The members were narrowly divided between those who favored some increase
in reserve restraint over the next few weeks and others who preferred to maintain
the degree of reserve restraint contemplated at the March meeting.
This divergence
257
reflected varying assessments of the strength and sustalnablllty of the economic
recovery; differing views with regard to the interpretation of the monetary
aggregates; and different opinions concerning the risks associated with the
likely Impact of alternative policy courses on domestic interest rates.
Members
also noted the potential sensitivity of international financial conditions and
the foreign exchange value of the dollar to firmer credit conditions in the
United States, suggesting for some a dilemma for monetary policy stemming in
substantial part from the budgetary situation.
Members who supported retention of the current short-run policy
emphasized that the growth of the broader monetary aggregates, on which the
Committee had focused, was within the Committee's 1983 ranges for the year to
date.
Moreover, such growth seemed to be falling a bit short of the second-
quarter targets that the Committee had set at the previous meeting.
Expansion
in total domestic nonfinancial debt also appeared to be within the range for
1983 that the Committee had established for monitoring purposes.
Ml clearly
was growing at a pace well above the Committee's expectations, but many members
continued to view that aggregate as an unreliable guide for policy and they
preferred to give little or no weight to its performance, at least for the present.
A number of members were also concerned that under current circumstances
even a modest tightening of reserve conditions might have a disproportionate
impact on sentiment In domestic and international financial markets and lead to
sizable increases in domestic interest rates.
In their view increases in interest
rates would have adverse consequences foe interest-sensitive sectors of the
economy and possibly for the sustainability of the economic recovery.
Indeed,
one member believed that lower interest rates were likely to be needed to ensure
258
continued economic expansion.
Moreover, appreciably higher U.S. Interest rates
might have particularly damaging consequences internationally by raising the
foreign exchange value of the dollar and Intensifying the severe pressures on
countries with serious external debt problems.
Other Committee members, however, weighed the risks associated with
alternative policy courses differently.
They felt that at least limited tighten-
ing of reserve conditions was desirable in light of the very rapid growth in Ml
against the background of accumulating evidence that the economic recovery was
accelerating.
While, consistent with previous decisions. Ml was not given so
ouch weight as a monetary policy target as it had had earlier, a number of
members nonetheless saw a need to move toward restraining its growth, which
clearly was running well above the pace for the second quarter that the Committee
had expected would be consistent with the behavior of the broader aggregates.
Several members commented that slightly greater restraint on reserves
would be desirable at this point to minimize the possible need for more substantial restraint later, reducing the interest rate impact on financial markets
over time and helping to sustain the expansion.
Reference was made to the favor-
able effect such a move might have on market perceptions about monetary policy
and the outlook for containing Inflation, with the consequence that prospects for
stable or declining interest rates in long-term debt markets would be enhanced
as the recovery proceeded.
The view was also expressed that the external debt
difficulties of a number of foreign countries were continuing problems.
The
Federal Reserve could best contribute to the resolution of those problems by
following policies that would foster sustained, noninflationary economic growth.
Deferring any action could well pose a greater dilemma at a later time.
259
At the conclusion of the Committee's discussion, a majority of the
members indicated that they favored marginally more restraint on reserve
positions for the near term.
Although these members differed on the precise
degree of additional restraint that they preferred, they indicated their
acceptance of a directive calling for only slightly more restraint on reserve
positions than had been approved at the previous meeting.
It was understood
that at this point H2 and M3 seemed to be on courses that would bring their
growth to slightly below the rates of 9 and 8 percent respectively that had
been set at the March meeting for the second quarter, but that Ml would probably
expand at a rate well above the growth that had been anticipated for the quarter.
The members agreed that lesser restraint would be appropriate in the context
of more pronounced slowing in the growth of the broader monetary aggregates
within th«ir 1983 ranges and deceleration of Ml growth, or of Indications that
the pace of the economic recovery was weakening.
It was understood that the
intermeeting range for the federal funds rate, which provides a mechanism for
Initiating consultation of the Committee, would remain at 6 to 10 percent.
At the conclusion of its discussion, the Committee issued the
following domestic policy directive to the Federal Reserve Bank of New York:
The Information reviewed at this meeting suggests
that growth in real GNP has accelerated in the current
quarcer following a moderate increase in the first
quarter. Industrial production increased sharply in
April after rising at a moderate pace in previous months;
nonfjirm payroll employment and retail sales rose considerably in March and April. Housing starts declined
somewhat in both months but were still well above
depressed 1982 levels. Data on new orders and shipments
suggest that the demand for business equipment is
reviving. The civilian unemployment rate edged down
to 10.2 percent in April. Average prices have changed
little and the index of average hourly earnings has risen
at a much reduced pace in the early months of 1983.
260
The weighted average value of the dollar against
major foreign currencies has remained In a narrow range
near Its recent high level since late March. The U.S.
foreign trade deficit fell substantially in the first
quarter, reflecting a sharp drop in the value of oil
Imports.
Growth in M2 and M3 decelerated further in April to
relatively low rates but appears to have picked up recently.
Ml declined in April but has strengthened markedly In
early May. Growth in debt of domestic nonflnancial sectors
appears to have been moderate over the first four months of
the year. Interest rates have changed little on balance
since late March.
The Federal Open Market Committee seeks to foster
monetary and financial conditions that will help to
reduce inflation further, promote a resumption of growth
in output on a sustainable basis, and contribute to a
sustainable pattern of International transactions. At
its meeting in February the Committee established growth
ranges for monetary and credit aggregates for 1983 in
furtherance of these objectives.
The Committee recognized
that the relationships between such ranges and ultimate
economic goals have been less predictable over the past
year; that the impact of new deposit accounts on growth
ranges of monetary aggregates cannot be determined, with
a high degree of confidence; and that the availability of
interest on large portions of transaction accounts,
declining inflation, and lower market rates of interest
may be reflected in some changes in the historical trends
In velocity. A substantial shift of funds into M2 from,
market instruments, including large certificates of
deposit not Included in M2, in association with the
extraordinarily rapid buildup of money market deposit
accounts, distorted growth in that aggregate during the
first quarter.
In establishing growth ranges for the aggregates for
1983 against this background, the Committee felt that growth
in M2 might be more appropriately measured after the period
of highly aggressive marketing of money market deposit
accounts had subsided. The Committee also felt that a
somewhat wider range was appropriate for monitoring Ml.
Those growth ranges were to be reviewed in the spring and
altered, if appropriate, in the light of evidence at that
time. The Committee reviewed the ranges at this meeting aud
decided not to change them at this time, pending further
261
review at the July meeting. With these understandings,
the Committee established the following growth ranges: for
the period from February-March of 1983 to the fourth quarter
of 1983, 7 to 10 percent at an annual rate for M2, taking
into account the probability of some residual shifting into
that aggregate from non-M2 sources; and for the period from
the fourth quarter of 1982 to the fourth quarter of 1983,
6-1/2 to 9-1/2 percent for M3, which appeared to be less
distorted by the new accounts. For the same period a
tentative range of 4 to 8 percent was established for Ml,
assuming that Super NOW accounts would draw only modest
amounts of funds from sources outside Ml and assuming that
the authority to pay Interest an transaction balances was
•not extended beyond presently eligible accounts. An
associated range of growth for total domestic nonfinancial
debt was estimated at 8-1/2 to 11-1/2 percent.
In implementing monetary policy, the Committee agreed
that substantial weight would continue to be placed on
behavior of the broader monetary aggregates expecting that ,
distortions in M2 front the initial adjustment to the new
deposit accounts will abate. The behavior of Ml will
continue to be monitored, with the degree of weight placed
on that aggregate over time dependent on evidence that
velocity characteristics are resuming more predictable
patterns. Debt expansion, while not directly targeted,
will be evaluated in judging responses to the monetary
aggregates. The Committee understood tiiat policy implementation would involve continuing appraisal of the
relationships between the various measures of money and
credit and nominal GNP, including evaluation of conditions
in domestic credit and foreign exchange markets.
The Committee seeks in the short run to increase only
slightly the degree of reserve restraint- T^ action was
taken against the background of M2 and M3 remaining slightly
below the rates of growth of 9 and 8 percent, respectively,
established earlier for the quarter and within their longterm ranges, Ml growing well above anticipated levels for
some time, and evidence of some acceleration in the rate
of business recovery. Lesser restraint would be appropriate
in the context of more pronounced slowing of growth in the
broader monetary aggregates relative to the paths implied
by the long-terra ranges and deceleration of Ml, or indications of a weakening in the pace of economic recovery. The
Chairman may call for Committee consultation If it appears
to the Manager for Domestic Operations that pursuit of the
monetary objectives and related reserve paths during the
period before the next meeting is likely to be associated
with a federal funds rate persistently outside a range of
6 to 10 percent.
262
Votes for thia action: Messrs. volcker,
Gramley, Keehn, Martin, Partee, Roberts, and
Walltch. Votes against thia action: Messrs.
Solomon, Guffey, Morris, Rice, and Mrs.
Teeters.
Messrs. Solomon, Guffey, Morris, Rice, and Mrs. Teeters dissented
from this action because they wanted open narket operations to continue being
directed coward maintaining approximately the degree of reserve restraint
approved at the previous meeting.
In the view of these members, a firming
of reserve conditions was not warranted by the performance of the monetary
aggregates or by the current economic situation.
M2 and M3 were expanding
more slowly In the second quarter than the Committee had anticipated at its
previous meeting and for the year to date these broader aggregates, along
with total domestic nonfinancial credit, were growing at rates that were
within the Committee's 1983 ranges.
Ml had been expanding at a pace markedly
in excess of the Committee's expectations in recent weeks and for the year
to dace, but this aggregate was not viewed as a sufficiently reliable guide
for policy, at least for the present, since its performance was substantially
distorted by various developments and it was not predictably related to nominal
GNP.
Under current economic and financial circumstances, the implementation
of firmer reserve conditions would also incur an undue risk of an exaggerated
reaction in domestic and international financial markets.
Substantially higher
domestic interest rates would have damaging consequences for interest-sensitive
industries and could limit the recovery In economic activity.
These members
agreed that current interest rate levels appeared to be more consistent with
continuing economic expansion in the months immediately ahead, but Mrs. teeters
263
believed that lower interest rates might well be needed later to sustain the
recovery.
These members also referred to the potentially disruptive international
impact of rising U.S. interest rates.
Messrs. Solomon, G u f f e y , and Morris in
particular believed that the already strong dollar In foreign exchange markets,
the tenuous situation of some of the developing countries, the still fragile
economic recovery In other industrial countries, and the continuing weak outlook,
for U.S.
exports counseled against an Increase In reserve restraint.
On June. 23 the Coramittee held a telephone conference to review recent
developments in the domestic and International economy and financial markets
since the May 24 meeting.
Evidence suggested that economic, activity was
continuing to strengthen at a somewhat more rapid pace than had generally been
anticipated earlier.
weeks.
Some interest rates had increased modestly in recent
Growth in monetary aggregates, particularly Ml, had been relatively
rapid although growth in M2 and M3 remained close to the targets established
for the quarter as a whole.
Against that background, the consensus was that a modest increase
in reserve restraint, within the framework of the directive adopted at the
May 24 meeting and consistent with recent reserve conditions, remained
appropriate.
264
FEDERAL RESERVE press release
For Use at 4:30 p.m.
May 27, 1983
The Federal Reserve Board and the Federal Open Market
Committee today released the attached record of policy actions
taken by the Federal Open Market Committee at Its meeting on
March 28-29, 1983.
This record also includes policy actions taken
during the period between the meeting on March 28-29, 1983, and the
next regularly scheduled meeting held on May 24, 1983.
Such records for each meeting of the Committee are made
available a few days after the next regularly scheduled meeting
and are published in the Federal Reserve Bulletin and the Board's
Annual Report.
The summary descriptions of economic and financial
conditions they contain are based solely on the information that
was available to the Committee at the time of Che meeting.
Attachment
265
RECORD OF POLICY ACTIONS OF THE
FEDERAL OPEH MARKET COMMITTEE
Meeting Held on March 28-29, 1983
I.
Domestic policy directive
Based on partial Information available for Che first quarter, It
appeared that real GNF rose moderately In the first three months of the year,
following a decline at an annual rate of about 1 percent in the fourth
quarter of 1982.
The turnaround in economic activity reflected a consider-
able slowing in the pace of inventory liquidation.
Meanwhile, private final
sales In real terms, which had risen in the fourth quarter, continued to
increase.
The rise In average prices, as measured by the fixed-weight price
Index for gross domestic business product, slowed further.
Final sales were sustained by a narked strengthening In housing
activity In early 1983.
Private housing starts rose to an average annual
rate of 1.7 million units in January and February, up nearly 40 percent
from the pace in the fourth quarter.
Newly issued permits for residential
construction also rose substantially over the two-month period.
Sales of
new homes Increased in January, the latest month for which data were available; although sales of existing homes dipped In February, they were appreciably higher In the first two months combined than In the fourth quarter.
Other elements of final sales were not quite so strong on balance
as in the fourth quarter of last year.
Personal consumption expenditures
continued to expand In early 1983, but at a slower rate than In the previous
quarter.
The nominal value of retail sales fell in January and February,
primarily reflecting declines in sales at automotive outlets, gasoline
266
stations, and furniture and .appliance stores, although sales at general
merchandise and apparel stores rose appreciably from their level in the
fourth quarter.
Sales of new domestic automobiles continued at an annual
rate of about 6.1 million units, the same as in the fourth quartet.
Spending for business fixed Investment has remained weak in recent
months.
Shipments of nondefenee capital goods fell sharply in January and
edged down further in February, and new orders dropped appreciably in February
after firming for several months.
Outlays for nonresidentlal construction
increased in January, but high vacancy rates for office buildings and the
reduced drilling activity associated with declining oil prices apparently
have damped such expenditures recently.
The Department of Commerce survey
taken in late January and February indicated that in 1983 business outlays
for plant and equipment would decline about 1-3/4 percent in nominal terms,
about the same as in 1982.
Nonfana payroll employment rose about 150,000 on balance over
January and February, after an extended period of declines.
The month-to-
month employment figures, which showed a substantial rise in January and
a decline in February, were distorted by unusual weather patterns.
But
employment in manufacturing—particularly in the auto and related metals
industries—increased in both months.
unchanged in February at 1U.4 percent.
The civilian unemployment rate was
Industrial production hss risen at
an annual rate of about 7-1/4 percent since its trough in November, less
than the average pace in the early stages of previous cyclical recoveries.
The producer price index for finished goods fell nearly 1 percent
over the first two months of the year, reflecting sharp declines in prices of
267
energy-related Items.
The consumer price Index was virtually unchanged over
the period, as a substantial drop In prices of gasoline and other
petroleun
products was about offset by moderate increases in prices of most other commodities and services.
Food prices have changed little thus far in 1983 and
In February were only 2 percent above their level a year earlier.
The advance In the index of average hourly earnings has slowed
further In recent months.
With productivity apparently continuing to improve
In early 1983, cost pressures in the nonfarm business sector have abated further
In foreign exchange markets the trade-weighted value of the dollar
had risen about 2 percent on balance since the Committee's meeting in February.
The U.S. merchandise trade deficit declined marginally in January.
Exports
rose sonewhat and total imports continued at about the fourth-quarter
rate,
as oil Imports dropped sharply while non-oil Imports strengthened.
At its meeting on February 8-9, 1983,
the Committee established the
following ranges for growth of the monetary aggregates:
for the period from
February-Match of 1983 to the fourth quarter of 1983, 7 to 10 percent at an
annual rate for M2, taking into account the probability of some residual
shifting into that aggregate from non-M2 sources; and for the period from the
fourth quarter of 1982 to the fourth quarter of 1983, 6-1/2 to 9-1/2
percent
for M3, which appeared to be less distorted by shifta associated with nev
deposit accounts.
For the same period, a tentative range of 4 to 8 percent
was established for Ml, assuming that Super NOW accounts would draw only
modest amounts of funds from sources outside Ml and that the authority to
pay interest on transaction accounts would not be extended beyond currently
eligible accounts.
An associated range of growth for total domestic non-
financial debt was estimated at 8-1/2
to 11-1/2 percent.
268
At Che February meeting, the Committee agreed that the near-term
outlook for growth In the monetary aggregates remained subject to unusual
uncertainties and that an appropriate assessment of such growth would need
to take account of the distortions that might continue to be created by the
introduction of new deposit accounts.
Consequently, the Committee decided
that open market operations In the period until this meeting should be
directed toward maintaining the existing degree of restraint on reserve
positions.
It was agreed that lesser restraint would be acceptable in the
context of appreciable slowing of growth in the monetary aggregates, to or
below the paths Implied by the long-term ranges.
H2 grew at an estimated annual rate of about 24 percent In February,
only a little below the exceptional pace in January, as Its growth continued
to be greatly affected by shifts of funds from market instruments and other
non-H2 sources Into the new money market deposit accounts (HMDAs) Included
in M2.
M3 grew at annual rates of about 12 and 13-1/2 perceht in January
and February respectively.
However, growth in both of the broader aggregates
appeared to have decelerated substantially during March.
The deceleration
reflected in part a marked slowing in the volume of funds shifted into MMDAs
from market instruments and apparently also a moderation in the underlying
growth of the nontransaction component of these aggregates.
Growth in Ml
accelerated to an extraordinary annual rate of about 22 percent in February,
and, on the basis of preliminary data, was estimated to have remained rapid
in March, though probably slowing somewhat from the February rate.
An
acceleration in growth of NOW accounts and a large increase in holdings of
currency contributed to the expansion in Ml.
The Income velocity of Ml
269
apparently declined sharply In the first quarter, continuing the trend
tUat became evident in the course ol
1981.
Total and nonborrowed reserves declined appreciably In February,
but turned up In March.
The behavior of reserves did not reflect the
strength in the aggregates largely because required reserves at member
banks were lowered by shifts out of personal savings and snail time deposits
InCo nonreservable HMDAs and there was an associated runoff of largedenomination CDs.
The monetary base grew considerably more than the reserve
measures, owing to the rapid expansion of currency In circulation.
Adjust-
ment borrowing (including seasonal borrowing) fluctuated between $140 million
and $600 million over the intermeeting period.
Excess reserves were also
volatile and were somewhat higher than usual on average; strong demands
for excess reserves at times appeared to be related to slow responses by
banks to reductions In reserve requirements.
Federal funds continued to
trade near the 8-1/2 percent discount rate over most of the intermeetlng
interval, though rising to around S-3/4 percent in the week prior to this
meeting.
Most short-term market Interest rates rose about 3/8 percentage
point over the intermeeting interval, while bonii rates declined about 3/8
to 1/2 percentage point.
The average rate on new commitments for fixed-rate
conventional home mortgage loans at savings and loan associations declined
20 basis points further. At the end of February, the prime rate charged by
most commercial banks on short-term business loans was reduced by 1/2 percentage point to 10-1/2 percent.
270
Total credit outstanding at U.S. commercial banks, which had
grown at an annual rate of about 6 percent In the fourth quarter of 1982,
expanded at an average annual rate of about 10 percent over the first two
months of this year.
Banks acquired a sizable volume of securities, partic-
ularly Treasury securities, and also expanded their loana somewhat.
Very
preliminary data suggested that the total debt of domestic non-financial
sectors was increasing in early 1983 at a rate near the lower end of the
Committee's estimated range for the year.
There was a sharp Increase In the
share of debt financed through depository Institutions, which had experienced
massive Inflows of funds aa a result of aggressive marketing of the newly
authorized MMDAs.
Staff projections presented at this meeting indicated that real
GNP would probably grow at a moderate pace throughout 1983, with unemployment remaining high.
Private final purchases were projected to pick up
somewhat In the latter half of the year, partly in response to the third
phase of the tax cut.
It was anticipated that the liquidation of business
inventories would end by midyear and that some restocking of depleted inventories would occur in the second half.
The rise in the average level
of prices was expected to remain moderate, even as economic recovery proceeded
over the balance of 1983, given the favorable outlook for oil prices and the
prospects for continued limited increases in unit labor costs.
In the Committee's discussion of the economic situation and outlook,
the members agreed that a recovery in economic activity appeared to be under
way, although several commented that the evidence available thus far was too
271
fragmentary to permit a firm evaluation of the strength of the upturn*
Whilt: the ataff projection of moderate growth for 1983 as a whole was
cited as a reasonable expectation, members commented on the many uncertainties surrounding the economic outlook and expressed differing views regardIng the direction of possible deviations from tue staff projection,
SOLO members saw the ataff projection as the middle of a plausible
range of possible outcomes for 1983, given the outlook for fiscal and monetary policy.
Several members believed, however, that the risks of a devia-
tion were in the direction of a shortfall.
tial obstacles to a vigorous recovery.
These members stressed poten-
These Included the possibility of
further unsettlenent in International and domestic financial markets, the
outlook for poor export markets, and the prospects for continuing weakness
in business investment, at least over the quarters Immediately ahead, against
the backdrop of low capacity utilization rates in industry and recent overbuilding of many types of commercial properties.
Reference was also made to
the retarding impact of relatively high real interest rates, and some members
expressed the view that an appreciable rise in Interest rates, if such a rise
were to occur, could greatly inhibit the recovery in interest-sensitive sectors
of the economy, such as housing and automobiles which had tended to lead the
recovery thus far.
A differing view was expressed which stressed the possibility of
a stronger recovery that, like many previous recoveries in the postwar period,
would tend to gather momentum as it developed.
In support of this view. It
was noted that private final purchases had risen appreciably in the fourth
and first quarters, and such purchases could strengthen markedly further in
272
reaction to the federal tax cut at midyear and anticipated improvement In
business spending.
Moreover, cutbacks In Inventories had been unusually
pronounced during the recession, so that gains in consumer spending would
tend to be translated directly into increased production.
Members referred to the favorable outlook for prices in 1983,
partly associated with an Improved trend in productivity and reduced wagecost pressures, but some members also commented that the longer-run outlook
for Inflation and for a sustainable recovery would be influenced greatly by
progress in holding down future federal deficits and by success in achieving
the Committee's objectives for monetary growth.
It was noted that the effects
of an expansionary federal budget would be offset to some extent by efforts
of state and local governments to curb expenditures and to raise taxes.
On
balance, however, it appeared that markets remained apprehensive about the
outlook for the federal budget, and that concern was reflected in continued
pressures on interest rates, especially In long-term debt markets.
In discussing a policy course for the weeks immediately ahead,
Committee members recognized that substantial uncertainties affected both
the economic outlook and the interpretation of the monetary aggregates.
Concern was expressed about the implications of the rapid growth in the
monetary aggregates, particularly if It should continue.
However, it was
also noted that the rapid expansion of recent months, given the distortions
related to various institutional changes, probably did not have the significance for future economic and price developments that it might have had In the
past.
It was generally recognized that much of the recent growth in the broad
273
aggregates, especially M2, reflected shifts of investment preferences by
individuals away from market instruments toward the new MMDAs, given the
very attractive rates being offered on the accounts by depository institutions
In a highly competitive environment.
Note was also taken of the marked
slowing In monetary growth that appeared to be In train for March, and of
a staff analysis suggesting that underlying growth of the broad aggregates—
as well as growth in MI—might be moderate in the months ahead as the lagged
effects of earlier declines In market interest rates dissipated.
With
respect to Ml, most members felt that persistence of its unusual sharp
decline in velocity early this year cast doubt on the aggregate as a
principal guide for policy at this time; however, a view was also expressed
In favor of giving HI more weight in the formulation of the Committee's
policy.
In evaluating the overall financial situation, it was also pointed
out that Che strength of the aggregates needed to be judged In the context of
the apparently moderate expansion of domestic nonfinancial debt and of the
relatively high level of real interest rates.
With the economic recovery
still In Its early and fragile stages, the view was expressed that strong
upward pressures on interest rates would involve an unacceptable risk of
unduly retarding, and perhaps aborting, the recovery.
The view was also ex-
pressed that a sustainable recovery might not develop at the present levels
of nominal and real interest rates.
On the other hand, no member expressed
sentiment for a substantial easing in the existing degree of reserve restraint
in the absence of clear evidence of a pronounced slowing in monetary growth
or of indications that the economic recovery was faltering.
274
While a few members indicated a preference for leaning In the direction of sligVitly Ttore, or slightly less, restrain an reserve positions in the
period immediately ahead—depending on their assessment of the economic outlook,
credit conditions, and the monetary aggregates—all of the members found
acceptable a policy calling for maintaining generally the current degree of
reserve restraint, pending the availability of further evidence on the behavior
of the monetary aggregates and on the economic situation.
The members antici-
pated that such a policy course would be consistent with substantial slowing
In the growth of M2 and H3 to annual rates of about 9 percent and 8 percent
respectively over the period from March Co June; these growth rates assumed
that shifts of funds into the new deposit accounts from market Instruments
would have only a relatively small further Impact on the broad aggregates—
perhaps no more than a percentage point or so In the case of M2.
The Committee
also expected that Ml growth at an annual rate of about 6 to 7 percent over
the three-month period would be associated utth its objectives for the
broader aggregates, assuming basically no distortion in Ml on balance from
the newly introduced accounts.
Should these assumptions about distortions
froa the new accounts prove to be incorrect, it was understood that appropriate
adjustments would have to be made in the monetary growth objectives.
The Committee members agreed that lesser restraint on reserve positions would be acceptable In the context of more pronounced slowing in the
growth of the monetary aggregates, after taking account of any distortions
relating to the introduction of new deposit accounts, or of evidence of a
weakening in the pace of the economic, recovery.
If monetary expansion proved
to be appreciably higher than expected, without being clearly explained by
275
the effects of ongoing institutional changes, it was understood that the
Committee would consult about the desirability under the prevailing circumstances of any substantial further restraint on bank reserve positions.
It
USB further understood that the interneeting range for the federal funds rate,
which provides a neenanism for initiating consultation of the Committee, would
be retained at 6 to 10 percent.
At the conclusion of Its discussion, the Committee Issued the
following domestic policy directive to the Federal Reserve Bank of Sew York:
The information reviewed at this meeting suggest*
that real GNP rose moderately in the first quarter,
after a decline in the fourth quarter; the turnaround
reflects a considerable slowing In Inventory liquidation.
Private final sales apparently increased only slightly
less than In the fourth quarter with housing activity
strengthening further. Business fixed Investment has
remained weak. Sonfarm payroll employment rose on
balance In January and February, after an extended
period of declines; the civilian unemployment rate
was unchanged In February at 10.4 percent* In early
1983 the rise In average prices and the advance In
the index of average hourly earnings have slowed
further.
The weighted average value of the dollar against
major foreign currencies rose somewhat on balance
between early February and late March. The U.S.
merchandise trade deficit declined marginally In
January,
H2 continued to grow at an exceptional rate In
February and M3 also expanded at a rapid pace, but
growth in both of Che broader aggregates appears to
be decelerating substantially in March. The deceleration reflects In part the marked slowing in growth of
money market deposit accounts (MMDAs) in recent weeks
and apparently also a moderation In che underlying
growth of these aggregates, abstracting from shifts
from market instruments, HI has expanded rapidly
since late January, largely reflecting accelerated
growth in NOW accounts. Growth in debt of domestic
nonfinancial sectors appears to have been moderate
276
in the first quarter. Short-term interest rates have
rieen somewhat since eerly Feornary while long-term
rates, including mortgage rates, have declined.
The Federal Open Market Committee seeks to foster
monetary and financial conditions that will help to
reduce inflation further, promote a resumption of
growth in output on a sustainable basis, and contribute to a sustainable pattern of interaatlonal transactions. At its meeting In February the Committee
established growth ranges for monetary and credit
aggregates for 1983 in furtherance of these objectives.
The Committee recognized that the relationships between
such ranges and ultimate economic goals have been leas
predictable over the past year; that the current impact
of new deposit accounts on growth rates of monetary
aggregates cannot be determined with a high degree of
confidence; and that the availability of interest on
large portions of transaction accounts, declining
inflation, and lower market rates of interest may be
reflected in some changes in the historical trends in
velocity. A substantial shift of funds into M2 from
market instruments, Including large certificates of
deposit not included in M2, in association with the
extraordinarily rapid build-up of money market deposit
accounts, has distorted growth in that aggregate during
the first quartet.
In establishing growth ranges for the aggregates
for 1983 against this background, the Committee felt
that growth in H2 might be more appropriately measured
after the period of highly aggressive marketing of
money market deposit accounts has subsided. The
Committee also felt that a somewhat wider range was
appropriate for monitoring Ml. Those growth ranges
will be reviewed in the spring and altered, if appropriate, In the light of evidence at that time.
With these understandings, the Committee established
the following growth ranges: for the period from FebruaryMarch of 1983 to the fourth quarter of 1983, 7 to 10 percent at an annual rate for M2, taking Into account the
probability of some residual shifting Into that aggregate
from non-M2 sources; and for the period from the fourth
quarter of 1982 to the fourth quarter of 1983, 6-1/2 to
9-1/2 percent for M3, which appeared to be less distorted
by the new accounts.
For the sane period a tentative
range of 4 to 8 percent was established for Ml, assuming
that Super HOW accounts would draw only modest amounts
of funds from sources outside HI and asftuming that the
277
authority to pay interest oil transaction balances is not
extended beyond presently eligible accounts. An associated
range of growth for total domestic nonfjnanctal debt was
estimated at 8-1/2 to 11-1/2 percent.
In implementing monetary policy, ttie Committee agreed
that substantial weight would be placed on behavior of the
broader monetary aggregates, expecting that distortions in
M2 from the initial adjustment to the ne« deposit accounts
will abate. The behavior of HI will be monitored, with
the degree of weight placed OD that aggregate over time
dependent on evidence Chat velocity characteristics are
resuming more predictable patterns. Debt expansion, while
not directly targeted, will be evaluated in Judging responses
to the monetary aggregates. The Committee understood that
policy implementation would involve continuing appraisal
of the relationships between the various measures of money
and credit and nominal GNP, including evaluation of conditions in domestic credit and foreign exchange markets.
For the short run, the Committee seeks to maintain
generally the existing degree of restraint on reserve
positions, anticipating that would be consistent with a
slowing from March to June In growth of M2 and M3 to
annual rates of about 9 and 8 percent, respectively.
The Committee expects that Ml growth at an annual rate
of about 6 to 7 percent would be consistent with Its
objectives foe the broader aggregates. Leaser restraint
would be acceptable in the context of mote pronounced
slowing of growth in the monetary aggregates relative
to the paths implied by the long-term ranges (taking
account of the distortions relating to the introduction
of new accounts), or indications of a weakening in the
pace of economic recovery. The Chairman may call for
Committee consultation if it appears to Che Manager for
Domestic Operations that pursuit of the monetary objectives and related reserve paths during the period before
the next meeting is likely to be associated with a
federal funds rate persistently outside a range of
6 to 10 percent.
Votes for this action:
Messrs. Volcker, Solomon, Granley,
Guffey, Keehu, Martin, Morris,
Partee, Rice, Roberts, Mrs. Teeters,
and Mr. Wallich. Votes against this
action: None.
278
2.
Review of continuing authorizations
The Committee followed Its customary practice of reviewing
all of its continuing authorizations and directives at this first
regular meeting of the Federal Open Market Committee following the election of new members from the Federal Reserve Banks to serve for the year
beginning March 1, 1983.
The Committee reaffirmed the authorization for
foreign currency operations, the foreign currency directive, and the
procedural instructions with respect to foreign currency operations In
the forma in which they were currently outstanding.
Votes for these actions:
Messrs. Volcker, Solomon, Gramley,
Guffej', Xeebn, Martin, Morrla,
Partee, Rice, Roberta, Mrs. Teeters
and Mr. Wallich. Votes against these
actions: None.
3.
Authorization for domestic open market operations
On the recommendation of the Manager for Domestic Operations,
System Open Market Account, the Committee amended paragraph l(a) of the
authorization for domestic open market operations to raise from S3 billion
to $4
billion the liait on intenneeting changes in System account holdings
of U.S. government and federal agency securities.
The Manager noted that
in recent years the Committee had found It necessary to authorize temporary
increases in the limit with greater frequency because of the longer Intervals between Committee meetings and the Increased size of the net variation
in market factors affecting reserves.
In 1981 and 1982, such temporary
Increases had been authorized In half of the Intermeetlng periods.
A per-
manent increase In the limit to $4 billion would reduce the number of
occasions requiring special Committee action, while still calling to the
279
Committee's attention needs for particularly large changes.
The Committee
concurred in the Manager's view that such an increase would be appropriate.
The Committee also approved the deletion of paragraph 2 of the
authorization which had authorized, under certain conditions, the direct
lending of securities held in the System account to the U.S. Treasury and
the purchase of special short-term certificates of indebtedness directly
from the Treasury.
Paragraph 2 had been in a state of de facto
suspension
since June 1981 when the statutory authority on which it was based expired.
In the past, the Congress had enacted the legislation for limited periods and
occasionally had allowed it to lapse prior to Its renewal.
Since no legisla-
tion to renew the authority was under consideration, the Cowalttee concurred
in a staff recommendation to delete paragraph 2 and renumber the remaining
paragraphs in the authorization.^/
Accordingly, effective March 28, 1983, the authorization for
domestic open market operations was amended to read as follows:
1. The Federal Open Market Committee authorizes and directs the Federal
Reserve Bank of New York, to the extent necessary to carry out the most
recent domestic policy directive adopted at a meeting of the Committee:
(a) To buy or sell U. S. Government securities, including securities
of the Federal Financing Bank, and securities that are direct obligations
of, or fully guaranteed as to principal and interest by, any agency of
the United States In the open market, from or to securities dealers and
foreign and International accounts maintained at the Federal Reserve Bank
of Hew York, on a cash, regular, or deferred delivery basis, for the System
T ? T h e following conforming amendments to other Committee documents were
also approved: deletion of section 270.4(d) of the Regulation Relating to
Open Market Operations of Federal Reserve Banks and redesignation of the
remaining paragraph as 270,Md); and deletion of paragraph 2 of the Resolution
of Federal Open Market Committee. Authorizing Certain Actions by Federal Reserve
Banks during an Emergency, and renumbering of remaining paragraphs.
280
Open Market Account at market prices, and, for such Account, to exchange
maturing U. S. Government and Federal agency securities with the Treasury or
the individual agencies or to allow then to mature without replacement;
provided that the aggregate amount of U. S. Government and Federal agency
securities held in such Account (including forward commitments) at the
close of business on the day of a Meeting of the Committee at which action
is tflhen with respect to a domestic policy directive shall not be
increased or decreased by more than $4.0 billion during the period commencing with the opening of business on the day following such meeting and
ending with the close of business on the day of the next such meeting;
(b) When appropriate, to buy or sell in the open market, from or
to acceptance dealeca and foreign accounts maintained at the Federal
Reserve Bank of New York, on a cash, regular, or deferred delivery basis,
for the account of the Federal. Reserve Bank of New York at market discount
rates, prime bankers acceptances with maturities of up to nine months at
the time of acceptance that (It arise out of the current shipment of
goods between countries or within the United States, or (2) arise out
of the storage within the United States of goods under contract of sale or
expected to move into the channels of trade within a reasonable time and
that are secured throughout their life by a warehouse receipt or similar
document conveying title to the underlying goods; provided that the
aggregate amount of banker1! acceptances held at any one time shall not
exceed $100 million;
(c) To buy U. S. Government securities, obligations that are direct
obligations of, or fully guaranteed as to principal and interest by, any
agency of the United States, and prime bankers acceptances of the types
authorized for purchase under l(b) above, from dealers for the account of
the Federal Reserve Bank of New York under agreements for repurchase of
such securities, obligations, or acceptances in 15 calendar days or lees,
at rates that, unless otherwise expressly authorized by the Committee,
shall be determined by competitive bidding, after applying reasonable
limitations on the volume <if agreements with individual dealers; provided
that In the event Government securities or agency issues covered by any
such agreement are not repurchased by the dealer pursuant to the agreement
or a renewal thereof, they shall be sold In the market or transferred to the
System Open Market Account; and provided further that in the event bankers
acceptances covered by any such agreement are not repurchased by the seller,
they shall continue to be held by the Federal Reserve Bank or shall be sold
in the open market.
2. In order to ensure the effective conduct of open market operations,
the Federal Open Market Committee authorizes and directs the Federal
Reserve Banks to lend II. S. Government securities held in the System Open
Market Account to Government securities dealers and to banks participating
in Government securities clearing arrangements conducted through a Federal
Reserve Bank, under such instructions as Ihe Committee may specify from
time to time.
281
the Federal Open Market Committee authorizes and directs the Federal Reserve
Bank of Mew York (a) for System Open Ma fleet Account, to sell U. S. Government securities to such foreign and International accounts on the bases
bet forth In paragraph Ha) under agreements providing for the resale by
such sdcounta of those securities withlfi 15 calendar days on terms comparable '.3 those available on such transactions In Che market; and (b)
for New York Bank account, when appropriate, to undertake with dealers,
subject to the conditions Imposed on. purchases and sales of securities In
paragraph l(c), repurchase agreements In U. S, Government and agency
securities, and to arrange corresponding sale and repurchase agreements
between Its own account and foreign and International accounts maintained
at the Bank. Transactions undertaken with such accounts under the provisions of this paragraph may provide for a service fee when appropriate.
Votes for these actions:
Messrs. Volcker, Solomon, Ciramley, •
Guffey, Keehn, Martin, Morris,
Partee, Rice, Roberts, Mrs. Teeters,
and Mr. Halllch. Votes against these
actions: None.
Subsequently, on May 9-13, 1983, Members of the Committee voted to
increase from $4 billion to S5 billion the limit on changes between Committee
nieetings in System Account holdings of U.S. government and federal agency
securities specified in paragraph l(a) of the authorization for domestic
open market operations, effective May 10 for the period ending with the
close of business on May 24, 1983.
Votes for this action:
Messrs. Volcker, Gramleji, Guffey,
Keehn, Martin, Morris, Partec,
Rice, Roberts, Kcs. Teeters,
Messrs. Wallich, and Timlen.
Votes against this action: None.
(Mr. Timlen voted as alternate for
Mr. Solomon.)
This action was taken on recommendation of the Manager for Domestic
Operations.
The Manager had advised that since the March meeting, large net
purchases of securities had been undertaken to meet reserve needs due to
282
increases In currency In circulation and required reserves, reducing th*
leeway for further purchases over the interneeting Interval to slightly
under SI billion.
It appeared likely that purchases tn excess of that
leeway would be required over the remainder of the intersecting period.
4.
Agreement with Treasury to warehousei foreign currencies
At its meeting on January 17-18, 1977, the Comnittee had agreed
to a suggestion by the Treasury that the Federal Reserve undertake to
"warehouse" foreign currencies—that Is, to make spot purchases of foreign
currencies from the Exchange Stabilization Fund (ESF) and simultaneously to
make forward sales of the same currencies at the same exchange rate to the
ESF.
Pursuant to that agreement, the Committee had agreed that the Federal
Reserve would be prepared to warehouse for the Treasury or for the ESF up
to S3 billion of eligible foreign currencies.
At this meeting the Committee
reaffirmed the agreement on the terms adapted on March 18, 1980, with the
understanding that it would be subject to annual review.
Votes for this action:
Messrs. Volcker, Solomon, Gramley,
Guffey, Keehn, Martin, Morris,
Pairtee, Rice, Roberts, Mrs. Teeters,
and Mr. Walllch. Votes against this
action: None.
283
APPENDIX
Questions have been raised about my views on the Federal
Reserve's setting and announcing "objectives" for a variety of
economic variables.
As you know, the FOMC already reports its
"projections" or "forecasts" for GNP, inflation, and unemployment.
These projections were included with the materials I reported to
the Committee last week, as they had been at earlier hearings.
I believe the practice of reporting the full range and the
"central tendency" of FOMC members' expectations about the
economy may be useful in reflecting the general direction of our
thinking, as well as suggesting the range of possible outcomes for
economic performance in the 12 or 18 months ahead, given our monetary
polic-y decisions and fiscal and other developments over those periods.
There is a sense in which those projections reflect a view
as to what outcome should be both feasible and acceptable -- given
other policies and factors in the economy; otherwise monetary policy
targets would presumably be changed.
But I would point out that,
like any other forecast, they are imperfect, and actual experience
has sometimes been outside the forecast ranges.
Moreover, I believe there are strong reasons why it would
be unwise to cite "objectives" for nominal or real GNP rather
than "projections" or "assumptions" in these Reports.
The surface appeal of such a proposal is understandable.
If a chosen path for GNP over a 6 to 18 month period could be
achieved by monetary policy, specific objectives might appear
to assist in debating and setting the appropriate course for
monetary policy.
284
Unfortunately, the premise of that approach is not
valid —
certainly not in the relatively short run.
The
Federal Reserve alone cannot achieve within close limits a
particular GNP objective —
else would choose.
real or nominal —
it or anyone
The fact of the matter is monetary policy
is not the only force determining aggregate production and
income.
Large swings in the spending attitudes and behavior
of businesses and consumers can affect overall income levels.
Fiscal policy plays an important tole in determining economic
activity.
Within the last decade, we also have seen the
effects of supply-side shocks, such as from oil price increases,
on aggregate levels of activity and prices,
In the last six
months, even without such shocks, the economy has deviated
substantially from most forecasts, and from what might have
been set as an objective for the year.
The response might well be "so what" —
better to have something to "shoot at."
it's still
But encouraging
manipulation of the tools of monetary policy to achieve a
specified short-run numerical goal could be counterproductive
to the longer-term effort.
Indeed, we do want a clear idea of
what to "shoot at" over time —
growth.
sustained, non-infiationary
But the channels of influence from our actions — the
purchase or sale of securities in the market or a change in the
discount rate —
to final spending totals are complex and in-
direct, and operate with lags, extending over years.
The attempt
to "fine tune" over, say, a six-month or yearly period, toward
a numerically specific, but necessarily arbitrary, short-term
objective could well defeat the longer-term purpose.
285
Equally dangerous would be any implicit assumption, in
specifying an "objective" for GNP, that monetary policy is
so powerful it could be relied upon to achieve that objective
whatever else happens with respect to fiscal policy or otherwise.
Such an impression would be no service to the Congress
or to the public at large; at worst, it would work against
the hard choices necessary on the budget and other matters,
and ultimately undermine confidence in monetary policy itself.
Some of the difficulties could, in principle, be met by
Specifying numerical "objectives" over a longer period of time.
But, experience strongly suggests that the focus will inevitably,
in a charged political atmosphere, turn to the short run.
The
ability of the monetary authorities to take a considered longer
view —
which, after all, is a major part of the justification
for a central bank insulated from partisan and passing political
pressures —
would be threatened.
Indeed, in the end, the
pressures might be intense to set the short-run "objectives"
directly in the political process, with some doubt that that
result
would give appropriate weight to the longer-run con-
sequences of current policy decisions.
I would remind you that we have paid a high price for
permitting inflation to accelerate and become embedded in our
thinking and behavior, partly because we often thought we could
"buy" a little more growth at the expense of a little inflation.
The consequences only became apparent over time, and we do not
want to repeat that mistake.
286
Put another way, decisions on monetary policy should
take account of a variety of incoming information on GWP or its
components, and give weight to the lagged implications of its
actions beyond a short-term forecast horizon.
This simply
can't be incorporated into annual numerical objectives.
As a practical matter, 1 would despair of the ability
of any Federal Reserve Chairman to obtain a meaningful
agreement
on a single numerical "objective" among 12 strong-willed
members of the FOMC in the short run — meaningful in the sense
of being taken as the anchor for immediate policy decisions.
Submerging differences in the outlook in a statistical average
would, I fear, be substantially less meaningful than the present
approach.
As you know, we adopted this year the approach of
indicating the "central tendency" of Committee thinking as well
as the full range of opinion.
These "estimates" provide, it
seems to me, a focus for debate and discussion about policy
that, in the end, should be superior to an artificial process
of "objective" setting that may obscure, rather than enlighten,
the real dilemmas and choices.
Questions have also been raised on the issue of
international coordination of monetary policy and whether
or not to stabilize exchange rates multilaterally.
I can deal
with these important issues here only in a most summary way.
287
Coordination, in the broad sense of working together
toward more price stability and sustained growth, is plainly
desirable —
indeed it must be the foundation of greater
exchange rate and international financial stability in the
common interest.
But stated so broadly, it is clearly a
goal for economic policy as a whole, not just monetary policy.
The appropriate level of interest rates or monetary
growth in any country are dependent in part on the posture of
other policy instruments and economic conditions specific to
that country.
For that reason, explicit coordination, interpreted
as trying to achieve a common level of, for instance, interest
rates or money growth, may be neither practical nor desirable in
specific circumstances.
essential —
What does seem to me desirable — and
is that monetary (and other) policies here and
abroad be conducted with full awareness of the policy posture,
and possible reactions, of others, and the international consequences.
In present circumstances, we work toward that
objective by informal consultations in a variety of forums
with our leading trade and financial partners, recently on
some occasions with the presence of the Managing Director
of the IMF.
As this may imply, I believe a greater degree of exchange
market stability is clearly desirable, in the interest of our
own economy, but that must rest on the foundation of internal
stability.
In recent years, in my judgment, the priority has
clearly had to lie with measures to achieve that necessary
internal stability,
In specific situations, particular
288
actions may appear to conflict with the desirability of exchange
rate stability; that possibility is increased when the "mix"
of fiscal and monetary policy is far from optimal, as I discussed
earlier in my statement.
Such "conflicts" should diminish as
internal stability is more firmly established.
The idea of a more structured international system of
exchange rates to enforce greater stability in the international
monetary and trading system raises issues far beyond those I
can deal with here.
I do not believe it would be practical
to move toward such a system at the present time, but neither
would I dismiss such a possibility over time should we
and others maintain progress toward the necessary domestic
prerequisites.
COORDINATION OF FISCAL AND MONETARY POLICY
Mr. VOLCKER. You referred at the start to the fact that there are
really two different issues that are involved in the Senate resolution. One is policy itself. I don't address the substantive policy in
my statement, but I do address the question of coordination with
monetary policy, and I certainly address the question of how we
can contribute to appropriate congressional committees and congressional oversight over the Federal Reserve, which I take it is a
large part of the concern.
The statement does describe at some length the way we go about
formulating policy, which is a matter that Chairman Garn raised
in his letter to me, and I think it bears upon some of these points.
I make the point that if you look at long-range economic objectives, I don't think there's any particular dispute. Those long-range
objectives are specified in legislation and they are quite natural.
We all want to see growth and price stability and high employment, but I do make the point that monetary policy isn't the only
thing that affects our ability—either short-term or long-term—to
reach those goals. Discussions among the public or even in the Congress sometimes give me the impression that the thought is abroad
that the Federal Reserve, by itself, can do all these things. I'm sure
that's a misstatement, but I do encounter that impression.
As far as monetary policy is concerned, it's made by a committee
of independently appointed people who bring their own analytic
views, their own judgments to the table, and they are not always
going to agree on just how the economy works or what the outlook
is.
The job of the Chairman is to get some agreement on a specific
operational decision and the Chairman has to be successful in that
job, but I think it's asking to much to expect anybody to mold a
consensus or command unanimity about the outlook or on a particular analytic approach to policy. Differences in that area are inner-
289
ent in the fact that you're working under a committee system. It is
unrealistic to ask the Federal Reserve to present an institutional
objective, when policy is made by individuals who may not agree in
the short run on how to express broad objectives as a particular
growth pattern in GNP or a price level or an employment level or
whatever.
We, of course, have to take fiscal policy more or less as a given.
We do express our policy intentions, as indeed required by law, in
terms of monetary and credit aggregates, and we do present in
some detail the results of that process and the outlook to the Congress at least semiannually and informally more frequently; we
have just gone through that process, as you well know.
As part of that, for some time, we have given you a range of projections about the outlook; more recently we tried to narrow it
down, with the so-called central tendency that the majority of the
committee members feel is a likely outcome.
I might say, as I indicated in testifying last week, I think inherent in such a forecast is some knowledge of monetary policy and an
implicit feeing that the forecast, insofar as monetary policy can
affect it, must be broadly acceptable or we would change policy, to
the degree that monetary policy can influence it.
In that connection—and this bears upon setting out more shortterm objectives—because something happens differently than you
expected at the beginning of the year doesn't necessarily imply
that policy should be changed. You could, conceivably, have a
better result than you anticipated at the beginning of the year;
even if you have a worse result it may not be something that you
can improve, in terms of the ultimate objectives, by shifting policy.
I make that point because I think the crux of policy is trying to
look beyond today or next month or next quarter—or even the current year—to the results of your actions over a period of time. Of
course, none of that can be really incorporated in a short-term forecast or "objective," or whatever you call it.
Let me return to the question of coordinating fiscal and monetary policy. Coordination is a word upon which I'm sure the U.S.
Senate and the U.S. Congress would vote unanimously: more coordination is always better than less. But when you get to the details, when you get to the specifics, there's a question about what
you mean by coordination.
If the Congress and the administration, let's say, greatly increased the deficit, what's the implication of that? More rapid monetary growth, because we should accommodate the deficit, and let
inflation go? Or should we try to offset it in some sense by less
rapid monetary growth? I think we've all heard the answer is "coordination," but that doesn't respond to the question of what policy
should be, which I think depends upon the circumstances. You
could ask the reverse, what would be an appropriate response to a
reduction in deficit?
The point I'm making is I don't think there's any simple or automatic tradeoff between fiscal actions and monetary policy actions.
A budgetary decision inevitably will affect the distribution of the
available supply of credit in the economy and is going to affect interest rates. It will affect the mix of consumption and investment.
290
But monetary policy can't automatically offset those distributional
or market effects of fiscal policy, whatever it does.
I interpret your interest in coordination as seeking a way, as
part of your oversight function, as part of your fiscal policy responsibilities, of elucidating the choices involved in this area. Our reporting framework should, and I think it does, contribute to that
necessary elucidation and debate. I'm going to suggest at least one
way in which it might be improved.
FED HAS TO MAKE ASSUMPTIONS
This year—just to make it more concrete—we have set forth a
growth range for total debt in the economy that we think is consistent with the objectives we want to achieve over time, consistent
with the monetary targets. It occurs to me that it may be of some
help to the Congress, if in your deliberations on the budget, we
build on that a bit, amplify the discussion to include the implications of the budget outlook or—depending upon the state of your
deliberations—alternative budgetary outlooks on the distribution of
debt between the private and governmental sectors and the potential credit market pressures.
These are things I've often touched upon in my own testimony,
but I think they could be more directly noted and analyzed in our
report itself; that is, the question of the implications or risks with
respect to the availability of credit to the mortgage market, the
bond market, or the loan markets.
I don't want to suggest that this is an area where one can be at
all precise, because many other factors, including, for instance, the
inflation outlook and the growth of the economy itself, impinge
upon credit flows and interest rates. I also believe very strongly
that the central bank should not try to involve itself in the highly
uncertain business of forecasting interest rates. But I do think this
is an area where our reports might usefully be amplified somewhat.
As to the immediate question of what the Federal Reserve is
looking at in terms of the assumptions underlying the budget resolution, I think you will find, in our midyear report, that our assumptions aren t really greatly different from those contained in
the budget resolution, although I must say that in analyzing the
budget outlook we assume, rightly or wrongly, that some of the
savings and some of the revenue actions called for in the resolution
might not be achieved. I could make the same general statement
about the administration forecasts. They are broadly consistent
with the ones that we set out, and I have to repeat again that to
the extent there is an understandable concern about lower interest
rates, it would be enormously helpful—from that viewpoint and
from many other viewpoints—that still stronger action be taken
against the deficit than is implied in the budget resolution.
Certainly- we have not felt that it's appropriate, in the present
circumstances, to raise our monetary targets because the budget
deficit was going to be bigger than the budgetary resolution implied because we think the potential of that action for more inflation and for higher interest rates would be entirely counterproductive. In the statement I do discuss more directly the question of tar-
291
geting the GNP or some portion of the GNP, either nominal or
real, and the inflation rate, as a target or as an objective rather
than as a projection, or a forecast or an assumption. That may
sound like a semantic difference, but I don't think it is.
I have attached an appendix that I attached to my statement last
week. I do think there is a real danger that stating these as objectives would turn attention away from the role of other public and
private policies affecting economic activity and prices, that it would
implicitly promise more than could be delivered, and that it would
risk concentration on short-term and not readily controllable results at the expense of continuing long-range objectives. And 1
think there are lessons in history in that connection.
We have to make assumptions, but I don't think we should deify
them as objectives, particularly when the actuality may turn out to
be better than the assumption made at the beginning of the year,
which is likely to be the case this year, for example. We would not
have been so bold, I suppose, as to propose as an objective economic
growth as rapid as we are getting now. That doesn't say that it's
bad, but, just because we said it was an objective to have rapid
growth at the beginning of the year, I don't think we should necessarily take the policy for that reason, which is what citing it as an
objective may have implied.
Those are the basic points that I make in my statement. I might
just add one other point, Mr. Chairman.
I listened to Senator Moynihan. I don't want to raise all the
questions he's raised—although I'd be glad to deal with them—but
he did put it as an issue of who controls monetary policy. I assume,
in an institutional sense, that ultimately, obviously the Congress
does, but it's delegated to us. I don't deal with that question here,
but our view on that would be very strong so I don't have to recite
it here.
Senator Moynihan gave me permission to amend his statement,
if I may, to say that certainly the institutional arrangements in
Germany are very much parallel to our own
Senator GORTON. Senator Moynihan authorized me to correct the
record in the same fashion, Mr. Chairman.
Mr. VOLCKER. I would go further arid say his statement was a
little too sweeping in that there are many other countries, too.
That is a basic institutional issue, of course, which I don't deal
with in this statement but I'm well prepared, I hope, to defend the
present relationships.
THERE IS NO EASY SOLUTION TO INFLATION
Senator GORTON . Mr. Chairman, in the fascinating hearing
before this committee at which you led off the testimony a week or
so ago, late during that hearing Professor Blinder from Princeton
took a minority point of view. In a way, I guess he tempted all of
us by saying that there was an easy way out. The thrust of his testimony was that there was so much unused capacity in our economy at the present time that we could well afford for a period of
some 2 years a relatively expansionary monetary policy, more expansionary than that which has been approved by the Federal Reserve Board, with great risk of inflation and with a niuch greater
292
possibility of causing real growth in the economy of 6 percent or
more for perhaps 2 calendar years,
I wonder if you could comment on the risks which might be inherent in following that advice.
Mr. VOLCKER. The first comment I would make, I guess, is to
beware of easy solutions, or be wary of them anyway.
The economy, obviously, has some considerable potential to grow
during this period and has been growing fairly rapidly, but the
kind of question you raised is precisely the kind of question that
gives great debate around the table of the Open Market Committee.
I think, myself that historically that kind of reasoning has often
led the Federal Reserve in the past to be too easy, precisely at this
stage in the cycle, in the thought that the economy has lots of
room to grow and nothing much can go wrong now. You begin setting in motion forces that are not necessarily present today, but
that can be stirred up today to come back and bite you next year or
the following year.
It is terribly important that we build upon this progress that we
have made against inflation and retain a healthy sense of caution
about actions that might lead to a revival of inflation in the future.
There's a great deal of skepticism on that point in the marketplace and among the American population now, as you know, given
history. If you take the view, as certainly I do, that the prospects
for a long, sustained recovery depend upon a sense of having inflation under control, a sense of stability, then you have got to be cautious.
What does that mean concretely? I can only answer by saying, of
course, that many people say our policy has been inflationary recently. We debated that point in recent meetings. We arrived at
the conclusion, given to you last week that some restraining action
or less accommodative policy was appropriate at this stage, taking
account of the growth of liquidity, the growth of money, the degree
of momentum in the economy. Taking all those things into account, we reached the judgment to take the modest steps that we
did take over the last couple of months.
Senator GORTON. The risk of Professor Blinder's proposal, therefore, I guess, is there's a serious risk of inflation and a kind of cycle
through which we went in 1980, 1981, and 1982.
Mr. VOLCKER. Yes, if what he is saying, by implication, is that we
should have an easier monetary policy now, we obviously disagree
with him or we would have arrived at that conclusion ourselves.
I'm not sure that's what he was saying or whether he was looking
to the future. I haven't read his testimony.
Yes, we certainly do keep an eye out for the future inflationary
potential of what we are doing now, not just in the interest of keeping inflation under control, but also because we think that's fundamental for a sustained economic growth.
Senator GORTON. In an intriguing and perhaps offhand note in
your written testimony at page 5, you have the remark that many
would argue the undesirability as well as the impracticality of controlling monetary growth precisely.
293
The impracticality is obvious, but it nonetheless seems that if it
were possible to control monetary growth precisely that it would be
desirable.
Why do you characterize increased control of monetary growth
as undesirable?
Mr. VOLCKER. That issue gets debated. I suppose that phrase reflects my sensitivity to the debate that issue gets within and outside the Federal Reserve.
If you take the view that, in the technical jargon, the demand for
money changes—and as a theoretical proposition everybody would
agree with this—if you really knew money demand was changing
or velocity was changing over a period of time, you would want to
accommodate that. You reach precisely the policy objective you had
in mind in setting a monetary target. If you had a firm conclusion
that the relationship between money and the economy was changing you would want to change the target.
There are those who say "Set a single target, hold right to it; so
you're more likely to be deluded into thinking you see a change
when it isn't permanent; so let's stick to the target through thick
and thin." That's one view.
The other view is, "No, these changes are not all that infrequent;
you can afford a certain amount of elasticity even when you're not
sure; forgetting about the technical problem of actually reaching
the target, it's only sensible for that reason to allow a little play, a
little cushion. It's not going to do you any damage in the long run
and it's going to make things much smoother in the short run."
To put the point rather precisely, if you held money growth precisely to the trend and made no allowance for anything else going
on in the economy and the financial markets, refused to acknowledge anything was going on, you would get a very strong volatility
in interest rates.
You've got a tradeoff between how much volatility in interest
rates you want and how much play you want to leave in the money
supply.
STABILIZATION AND INTERVENTION ON VALUE OF DOLLAR
Senator GORTON. In an appendix to your testimony you touched
on the issue of exchange rate stabilization but note that the issues
involved are so complex as to permit only a summary comment.
Nevertheless, I think it might be appropriate to pursue the question. We all know that capital inflows in response to our high interest rates are keeping the value of the dollar high and making it
difficult for American producers to compete in world markets.
What do you see to be the problems or the obstacles in the way
of Federal Reserve Board intervention to try to bring the value of
the dollar down at least temporarily? Is it possible? Is it desirable?
Or what influence would the Board have over that?
Mr. VOLCKER. I think it is possible to do some intervention from
time to time, but I think you ought to approach it rather cautiously. I think intervention is a limited tool; there may be specific instances in which it is useful, and I would be prepared to intervene
when judgment led one to that conclusion.
294
There is a danger of putting more weight on intervention than
the instrument can bear. If you don't do anything else but intervene in the markets, in some circumstances that may be helpful; in
other circumstances the markets are so big that it could even be
counterproductive. If they're suspicious about your motives, your
intervention is going to be relatively small compared to the totality
of money going through those markets.
To put it another way, if you're going to affect the exchange rate,
you'd better be prepared to do something more fundamental than
intervention alone. Intervention will be most useful when it is
moving in a way clearly consistent with other policy measures. It
gives an additional message. It works in the same direction. If it is
supportive of basic policy, then I think the chances of its being
helpful are good. If it's running in conflict with other basic measures, the market will overwhelm any impact.
The worst result would be if you thought you could avoid the
basic measures that might be needed by using this tool of intervention so you delay doing other things that should be done.
There are pluses and minuses, but I think intervention can sometimes have a useful subsidiary role.
Senator GORTON, Following up on that question, I'd like to ask
you a question which was presented both to Martin Feldstein and
Secretary Sprinkel last week.
Do you have any estimates of the sensitivity of the value of the
dollar to, say, one or two point fluctuations in interest rates above
or below their current level, either that you can give us right now
or that the Board could submit to us?
Mr. VOLCKER. I can't give you any right now. I could probably
give you the results of some econometric investigations of that subject, but I would do it with some hesitancy, only because what we
do know is that estimates made on that basis are not very accurate; in particular circumstances it seems to affect the market
quite differently depending upon, I suppose, the set of expectations,
what else is going on in the current account or whatever.
Right now the dollar is, I suppose, on the average, as high and
maybe higher than it was a year ago or 18 months ago. Interest
rate differentials with other countries are quite different than they
were 18 months ago. You have had a number of occasions in the
past couple of years which—just looking directly at interest rates
and exchange rates, just taking those two variables—don't make
any sense against the common assumption, which has some justification, that higher interest rates mean a higher exchange rate or
conversely.
We can give you some theoretical or econometric analysis, but
take it with a healthy grain of salt.
One would readily agree, all other things being equal, that one
would ordinarily expect that an increase in the interest rate differential is going to strengthen the dollar or conversely.
[Chairman Volcker subsequently submitted the following information for inclusion in the record of the hearing:]
295
Estimates of Effects of Interest Rates on
Exchange Rates
The quantitative evidence on the relationship between interest
rates and exchange rates should be interpreted with care. Two important
points should be made at the outset. First, econometric estimates of
coefficients relating interest rates and exchange rates vary a great deal
depending on the period studied and, furthermore, the estimates derived
from the data for any given period are not very precise in statistical
terms. Second, changes in interest rates may occur in response to a
variety of factors and consequently the effects on exchange rates
associated with a given change in interest rates may vary substantially.
For example, a decrease in the fiscal deficit, holding the money supply
constant, normally would be expected to lower interest rates and also to
lead to a decline in the foreign exchange value of the dollar.
Similarly, an increase in the growth rate of the U.S. money supply also
wou'd normally be expected to depress both interest rates and the dollar
in the short run.
However, higher inflation from the monetary expansion
could lead to subsequent increases in interest rates and the dollar might
depreciate further to compensate for the higher U.S. inflation.
Research on the relationship between interest rates and
exchange rates by the staff of the Federal Reserve Board has been
conducted along two lines.
The first exploits single-equation models of
exchange rates, the second makes use of a large structural econometric
model.
296
The single-equation studies use regression analysis to explain
movements in the weighted-average foreign exchange value of the dollar
with several variables including interest rates and inflation rates.- A
variety of similar equations have been estimated over various time
periods.
In sum, they suggest that the effect of reducing U.S.
short-
term interest rates by one percentage point, holding all other factors
constant, ranges from a depreciation as small as 0.1 percent to a
depreciation as large as almost 4 percent.
The size of the coefficient
relating interest rates to exchange rates (and its statistical
significance) v a r i e s with the period analyzed, the frequency of the data,
and with the particular specification of the equation estimated.
An alternative method of analyzing the effects of interest
rates on exchange rates has been to use the large-scale Multi-Country
Model (MCM) developed by the Federal Reserve Board s t a f f .
The MCM
includes a model of the U.S. economy as well as models of four of
most important trading partners:
Kingdom.
its
Canada, Germany, Japan and the United
In the MCM both interest rates and exchange rates are
simultaneously determined by the structure of the model, responding to
changes in economic policies, as well as to changes in other factors such
as investors' portfolio preferences.
The strength of an approach such as
that of the MCM is that such models have fully articulated structures and
can allow for interest rates and exchange rates to be affected in several
different ways.
Furthermore, this type of approach allows for the
interaction both within and among economies in the form of "feedback"
\_l
The "exchange rate" in these studies is a weighted average of
bilateral exchange rates for the dollar against the G-10 countries
and Switzerland. The weights are multilateral shares of total
trade.
297
effects.
The potential drawback of the MCM, indeed of any model, is that
simulation results are dependent on the particular model being a
reasonably accurate representation of the economy in terms of both the
structure specified and the coefficients of the equations.
Financial
sectors of international models have always proved particularly difficult
to construct.
The simulations discussed below are subject to these
qualifications, since they take the MCM's structure, which at best
reflects normal relationships, as appropriate for the analysis of a
specific question in specific circumstances.
In simulations with the
MCM, the historical responses of exchange rates to the induced changes in
interest rates are attributable solely to the initial change imposed on
the model that, in turn, works through the specific structure of the
model.
In the MCM, a reduction in U.S. government expenditures leads
to a decrease in short-term U.S. interest rates as well as a depreciation
of the dollar.
After four quarters, a decline of one percentage point
in U.S. short-term interest rates resulting from such a fiscal action is
associated w i t h about a 1/4 percent depreciation of the dollar and after
?/
eight quarters with a one percent depreciation.—
It should be noted
that the longer the simulation is continued, the more the results are
affected by the multiple interactions in the model.
In the MCM, an increase in the growth rate of the U.S. monetary
aggregates also causes U.S. interest rates to fall and the dollar to
depreciate, but a monetary expansion has different effects elsewhere in
2/ The depreciation of the dollar is against a multilateral, tradeweighted average of the currencies of the other four countries in the
MCM, but since these are the major currencies in the 10-country average
described in footnote 1, the results are roughly comparable.
298
the economy—on output, inflation and the current account. Because of
these different effects, a one percentage-point decline in U.S. shortterm interest rates resulting from a faster expansion of the money stock
is associated with 3/4 percent depreciation of the dollar after four
quarters of simulation and 1.6 percent after eight quarters.
A part of
this depreciation in effect compensates for the higher inflation rate
induced by the more expansionary monetary policy.
These two simulations show that, depending on the source of the
initial change in interest rates, exchange rates may move either more or
less than in proportion to the change in interest rates.
In other
simulations movements in interest and exchange rates need not even be
positively related.
For example, a simulation in the MCH of an
autonomous shift by private wealth holders out of financial assets
denominated in foreign currencies and into assets denominated in U.S.
dollars produces a decline in U.S. interest rates and the dollar
appreciates.
This brief discussion of research and analysis undertaken at
the Federal Reserve Board underlines two important propositions to keep
in mind when analyzing the effects of changes in interest rates on
exchange rates.
that precise.
this point.
First, the simple correlation between the two H s not all
The studies using single-equations clearly demonstrate
Second, in more elaborate models it is crucial to specify
the original source of any interest rate movement.
The results of
simulations with the MCM show that even if one (unrealistically) assumes
that the structural relationships are known with certainty, the
relationship between changes in interest rates and changes in exchange
rates is not simple and cannot be captured in a single figure.
299
Senator GORTON. Thank you. At this point I will defer to Senator
Heinz.
Senator HEINZ. Thank you very much.
OPENING STATEMENT OF SENATOR HEINZ
The requirement contained within the budget resolution that
Congress examine the relationship between monetary policy, fiscal
and budgetary policy, and the economy provides a confrontation of
introspection that is long overdue.
Those who have looked to monetary policy to find the root of our
economic evils would do well to remember the Biblical quotation
from the Book of Matthew: "And why beholdest thou the mote that
is in thy brother's eye, but considerest not the beam that is in
thine own eye?"
For decades Congress has avoided taking responsibility for the
effect of big spending budgets on interest rates, employment, and
economic growth by making a scapegoat out of the Federal Reserve
Board,
Mind you, I am not absolving the Fed of what I believe have
been past excesses of rapid stop-go fluctuation in money growth.
While the Fed can, and recently has, contributed to lowering inflation and interest rates, it can and has in times exacerbated the already dangerous situation caused by runaway Federal spending. As
I said in my statement at your confirmation hearing, my respect
for you comes from my belief that you have learned many lessons
during your many years as Chairman of the Fed, and have adopted
a more moderate long/term strategy. It is my hope, and my greatest concern that you, Mr. Volcker, not return to past patterns of
dramatic short-term reversals of policy under the guise of fine
tuning.
In recent weeks the financial markets have probed everywhere
for indications of future Fed policy and have hung on your every
word. I would think that what we do in this committee with the
resolution we are required to report will be more important than
anything that has come before. Indeed this quiet little provision in
the budget resolution may be more important than the budget
itself. It will allow Congress, in the simplist terms, to vote on
whether it will acknowledge that the control over the economy
rests upon control over levels of Federal spending as a percentage
of GNP or whether Congress will continue to avoid the harsh decisions of budgetary triage and continue to scapegoat the Fed.
Mr. Chairman, welcome back. I think you have probably seen
enough of the Senate Banking Committee in the last week or two.
FED HAS TAKEN CAUTIOUS APPROACH TO CHANGES
I would just like to observe that there are an awful lot of people
who do look to monetary policy to be the rescuer of the economy.
And since for decades Congress has avoided taking responsibility
for the big budget deficits and their effect on interest rates and on
employment and on economic growth, they have tended to make a
scapegoat out of the Federal Reserve System and it rather reminds
of the seventh chapter, third verse of Matthew, which is, "And why
300
beholdest thou the mote that is in thy brother's eye, but considerest not the beam that is in thine own eye?"
I wouldn't want you to think that the lack of Congress looking at
itself in the mirror—and I'm sorry to say that seems to be a failing
regardless of what the nature is of one's party affiliation—does not,
in my judgment necessarily absolve the Fed of what I have told you
on previous occasions I believe to be excesses of rapid stop and go
fluctuation in the money growth.
I do think, as I said at your confirmation hearings, that you and
the Board of Governors have learned from past mistakes and, in
my judgment, you have adopted a very different monetary policy
than we had in 1979, 1980, and 1981.
If you look at the fluctuations, particularly in Mi, but they're not
absent from M2 on a quarterly basis, annualized quarterly basis,
there is tremendous volatility and fluctuation in those aggregates,
especially in Mi.
It is sometimes argued that those numbers are not adjusted for
the latest kind of instruments that now get counted in MI, NOW
accounts and so forth, but, unfortunately, there is still so much
volatility in those historical numbers that I don't find that a credible assertion. Even if it were on its face true, one would have to
believe that the market, if it understood that to be true, would not
have reacted with the kind of volatility that it did react where interest rates were involved.
I give you that lengthy preface because my question is really
this. Would you agree that the Fed has embarked on a course of
action where it has learned not to try within a very short space of
time—let us say where it has discovered that the growth range has
been overshot—to try within a very short range of time to correct
that within a matter of a short period by tightening up? Would you
agree that the Fed has in a sense made more cautious policy in
that regard?
Mr. VOLCKER. I think we have had a more cautious policy in that
regard in the past year or more, yes, but I would put that in the
right setting.
Senator HEINZ. I would agree, by the way, with that timeframe. I
think it's been over the last 12 months.
Mr. VOLCKER. You referred to a basic change in policy. We're
really getting into semantics—pure semantics, I guess. I would
argue that our basic policy objectives and general approach have
not changed.
What has changed is that we have quite different economic circumstances, quite different in two respects. For the obvious reason
that we had a recession, inflation is way down. While there's still a
lot of skepticism about inflation, people feel much better about it
than they did before. There isn't the speculative fervor; there isn't
the anticipation that there was before. We are in different circumstances in that way.
We also had—I agree with you—institutional changes that explain all these ups and downs in the money supply, but we do have
some unusual questions about changes in trends or the cyclical patterns in MI velocity.
If you take the economic conditions and those questions about
the possible shifts in behavior pattern of Mi, then yes, under those
301
circumstances, we have indeed been more cautious about moving
highly aggressively whenever a figure got off a track that was set
earlier, particularly with respect to Mi. That is why we de-emphasized it.
Senator HEINZ. Picking the interest rate of your choice, how
many basis points within such an interest rate would you attribute
to the more or less agreed upon three components of such rates—
the basic price of money, so-called supply-demand price, inflation,
and the so-called risk premium?
Mr. VOLCKER. I don't think I can give you a statistical answer.
Senator HEINZ. After one does protracted statistical analysis on a
subject such as this, then one adjusts it for gut feeling.
Mr. VOLCKER. I don't know how you define the risk premium.
Are you thinking of risk as fluctuation in interest rates in the
future?
Senator HEINZ. I would define
Mr. VOLCKER. You're not thinking of the risk premium on a
second class company or something?
Senator HEINZ. I'm talking about the basic uncertainty that remains after you deducted the basic price of money—some people
have said that's 2 to 3 percent—the inflation rate, and what is left
is generally classified as that which is due to uncertainties.
Mr. VOLCKER. I thought you were going to put the Government
deficit in there someplace.
Senator HEINZ. Well, there is a little uncertainty. It did occur to
me.
Mr. VOLCKER. That can enter in, of course, in two directions, the
basic supply and demand, as you term it, and uncertainty.
Senator HEINZ. I might tell you, in this Senator's judgment, that
is one of the big factors.
Mr. VOLCKER. Let me attempt an answer which isn't going to be
very satisfactory.
ECONOMIC CONFIDENCE IN UNITED STATES RETURNS
Looking at very short-term rates, they are largely reflecting
what I think you had in mind when you said basic supply and
demand. People don't, theoretically, have to worry about what the
future interest rate is going to be or the future inflation when
they're dealing with overnight money. I don't think that's strictly
true, but you start from that point.
As you get longer in the maturity spectrum, then I think currently—and this would differ a great deal depending upon the time
period you're in—the inflation premium is going to merge into
what you're calling the risk premium and is going to be very substantial, but it also reflects the balance of supply and demand.
Senator HEINZ. I guess, to simplify the analysis, I would say take
either a 5- or 10-year maturity, subtract what you believe to be the
price of money, and today's inflation rate, and attribute the rest to
a variety of fears, including the fear of inflation.
Mr. VOLCKER. All right. I can't give you an answer which
Senator HEINZ. I've got a feeling that this is going to be lengthier
than time will allow.
302
Mr. VOLCKER. I can't give you a good answer, so let me repeat
that.
Senator HEINZ. Let's not.
Mr. VOLCKER. Let me observe that surveys—not necessarily of
the general population but of people in financial markets—that ask
"what do you think the inflation outlook is?" Tend to be answered,
"between 6 and 7 percent." These surveys are asking about 5 years
from now and 10 years from now.
When you compare that to the current inflation rate of, say, 3.5
or 4 percent, if you really believe those surveys, I suppose you
would say something like 3 percent is that extra inflation premium, because they don't believe the current inflation rate is going to
last.
That may be an overestimate, but if you got very literal about
applying the results of those surveys, that's the answer you would
get.
Senator HEINZ. Let me get your reaction to a somewhat different
point of view. I understand you recently received a letter from several members of the House of Representatives which said, "Almost
every other indicator besides Mi fails to support the wisdom of a
rise in interest rates. The dollar has risen and remains quite strong
against the strongest foreign currencies. The prices of gold and
other sensitive commodities have remained stable, if not soft, indicating an absence of speculation on future inflation. The growth of
M3 has slowed over the past 8 months at the same time as Mi accelerated, and even Mi shows recent signs of slowing without a rise
in the discount rate."
Do you basically agree with that statement?
Mr. VOLCKER. Not entirely. The best answer I can give to that
statement is my testimony. I was aware of that letter before I testified and, as I pointed out, during the second half of the second
quarter at least, there were other indicators of liquidity, money,
credit, rising more rapidly than, let's say, made us entirely comfortable, apart from Mi, M2 and M3 growth were on the high side in
June, for instance. The credit figure in the second quarter was substantially bigger than the credit figure in the first quarter. And, of
course, we are aware of the outlook for the deficit. We are also
aware that over the last couple of months certainly—I'm not
making a long-range forecast—the economy had assumed a lot of
forward momentum. That isn't bad in itself, but your risks looking
ahead were more balanced than they had been for some time in
terms of the sustainability of the recovery. We were looking at all
those factors.
I think the international exchange rate, debt considerations,
clearly in the short run were on the other side. You can see in our
policy record that they were factors which weighed heavily on our
minds in the other direction in terms of the short-term policy decision.
Senator HEINZ. Is that because everybody else just is in worse
shape than we are?
Mr. VOLCKER. From the perspective of the rest of the world—entirely apart from interest rates and all the rest—we look to be in
pretty good shape. In relative terms, yes, I agree with what you
say. There is a confidence in the United States in the basic busi-
303
ness climate, the economic outlook, the political climate relative to
other countries. I think those are all big considerations during this
period of economic history.
Senator HEINZ. Well, my time has expired. I would just observe
that, unless you've been doing something that we didn't know
about, the United States has not had to go to the IMF and accept
terms of conditionality in return for help in refinancing its debt,
although, I must say, that there are times when I wish the United
States, for other reasons, would go to the IMF and sign onto a conditionality program because one of the first things they ask you to
do is get your domestic budget in order.
At the present rate we're going, it may take the IMF to reduce
the budget deficit because, notwithstanding the heroic efforts of my
friend, Slade Gorton, and other members of the Budget Committee,
we haven't exactly scored a stunning victory in that particular
effort.
Mr. Chairman, I thank you for your responses to a variety of
questions. To sum up what I hear you saying is that we can expect
a properly cautious management of the aggregates by the Federal
Reserve System, that to the extent that we have interest rate pressures and threats to the economic recovery they come about because of fears of future inflation fueled by very large deficits, that
the reason there is a considerable amount of relaxation of current
tension in the interest rates markets is largely because of shortterm factors and not the least of which is our economy if you look
at others around the world looks good when you look hard at them,
and that, as a consequence, I would extrapolate from that, for the
purposes particularly for which we're holding the hearing, that
there is likely to be a period of reasonable stability in interest
rates, reasonable stability in economic recovery, but that we cannot
necessarily count on that lasting indefinitely, and that the Congress would, therefore, be well-advised to look beyond this particular fall or next spring when the swallows will be coming back to
Capistrano.
CONGRESSIONAL BUDGET RESOLUTION IS HELPFUL
Mr. VOLCKER. Let me just add to that last comment of yours that
I think there has been a feeling, if I interpret it correctly, in the
Congress and maybe elsewhere, that this budgetary problem that
we all face has a fuse for 1985: I could imagine circumstances in
which that might be true, with rather slow growth of the economy,
not too much housing—a positive growth, but a rather subnormal
recovery.
1 don't think that's true at all if you have a more rapid recovery,
which everybody would like to have. Then I think that fuse becomes much shorter. You have some intimations of it in the
market now. That's partly what went on in the second quarter and
coming into the third quarter. We have had a sizable increase—not
massive, but noticeable—in private credit demands entirely in the
consumer and mortgage area. We have had a continuing high
budget deficit, and the faster the economy grows, the more consumer and mortgage demands you have. You will have business de-
304
mands added to them. If the budget problem isn't addressed during
that period you've got a problem.
Senator HEINZ. You're saying that an apparent smooth road
doesn't mean you can't run headon into a truck coming the other
way and the chances are enhanced if you're going too fast?
Mr. VOLCKER. That's right. I think you can even see the truck.
It's not just speculation that there might be a truck. The truck is
there. It's visible. It's only a question of how far away it is.
[Laughter.]
Senator HEINZ. My analogy—Senator Gorton hasn't yet recovered—stands fine-tuned. Thank you, Mr. Chairman.
Senator GORTON. You have stated that to a certain degree you've
used the budget resolution as an indicator, though far from a perfect indicator of where fiscal policy is going.
From your point of view, would it improve the budget resolution
for these purposes if it also contained a more complete accounting
for control of the Federal credit activities?
Mr. VOLCKER. Yes, if that's feasible. It's one other area of uncertainty, so to speak.
Senator GORTON. And for that matter, all activities?
Mr. VOLCKER. Yes. I certainly would approve of general control
of the government finances. It depends upon their credit activity.
Those financed through the Treasury, you might consider, do not
much substitute for market credit.
I think this is a distinction from the general traditional kind of
guarantee programs, like an FHA mortgage. I would certainly not
look at guaranteed mortgages in their totality as an additional
demand on the credit markets. Much of that would occur anyway
through the conventional market.
But particularly if you focus on those Federal programs, with
heavy subsidies, directly financed through the Treasury, they are
very much like
Senator GORTON. Let me broaden the question. Looking at the
question procedurally as opposed to the substance of the budget, do
you have other suggestions for ways in which the budget process
leading to a budget resolution could be helpful to the Federal Reserve Board in its formulation of monetary policy?
Mr. VOLCKER. In a procedural sense, the procedures the Congressional Budget Office goes through when making forecasts, putting
their budgetary figures in economic perspective, is helpful. The
passage of the budget resolution itself is already helpful because it
provides a focus for the overall budgetary result that was lacking
earlier.
That procedure is far from perfect in achieving its result, as you
well know, but I don't think I'd have any particular procedural
suggestions. I sometimes wonder these days, in watching the inherently very difficult budgetary process in the Congress, whether the
day isn't coming when we ought to go on a 2-year budget cycle.
Senator GORTON. Thank you.
305
MUST MAINTAIN BALANCE BETWEEN INTEREST AND INFLATION
Now I'm going to interject with a question from Senator Tower
which goes to the concern which you shared with me before the
hearing started today and ask you for your public comment on it.
Many analysts suggest that the LDC debt situation has increased
the risk premium contained in interest rates. Would congressional
failure to pass the IMF bill increase the financial risks and therefore, in your view, put some upward pressure on interest rates?
Mr. VOLCKER. I have no doubt that it would be perceived to increase the financial risks, even though it's not going to affect funding in the short run. This money is for next year and beyond.
There's no question in my mind that it would be perceived to increase those risks and, compared to what otherwise would happen,
have the result your question implies.
Senator GORTON. One last summary question on a subject on
which you've already testified to a degree, but one last clear question.
You make the obvious assumption that as you attempt to steer
monetary policy you have two risks on either side. One is reigniting inflationary expectations and thus inflation itself. The other is
the unnecessary driving up of short-term interest rates.
Obviously, miscalculation in either direction imposes some costs
on the economy.
In which of those directions do you perceive that the costs are
greater at the present time and, by implication, which danger occupies at this time and in general a more prominent place in your
thinking?
Mr. VOLCKER. In a sense, I agree that those are the kinds of risks
that have to be balanced.
Let me just say that a factor in my thinking, at least recently,
has been the observation that currently the economy has a good
deal of momentum which, in my judgment, is not going to be upset
or put fundamentally off course by a modest increase in interest
rates, even though we start with interest rates that are higher
than I think are appropriate or desirable, and may be necessary for
the longer-term health of the economy.
Any tightening action that may have been necessary now is also
potentially reversible, in my judgment, without the kind of damage
you suggest.
In balancing those concerns, we certainly reached the conclusion
that a little action now is preferable to the risk of having to take
much stronger action later if we didn't take a little action now.
Senator GORTON. Mr. Chairman, I thank you for your courtesy,
your clarity, and your counsel.
Mr. VOLCKER. Thank you, Senator.
Senator GORTON. With that, we will allow you to go to further
business and the meeting is adjourned.
[Whereupon, at 3:25 p.m., the hearing was adjourned.]
@FedFRASER